Anne Fazioli - Vice President, Investor Relations Robert J. Pera - Founder, Chairman and Chief Executive Officer Craig L. Foster - Chief Financial Officer.

Kiera Kilkowski - BofA Merrill Lynch John Lucia - JMP Securities LLC Jess L. Lubert - Wells Fargo Securities, LLC Timothy Long - BMO Capital Markets U.S. Matthew S. Robison - Wunderlich Securities Inc. Rajesh Ghai - Macquarie Research Tavis C. McCourt - Raymond James & Associates, Inc. Sanjit Singh - Wedbush Securities Inc.

Kulbinder Garcha - Crédit Suisse AG.

Presentation:.

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Good day, ladies and gentlemen, and welcome to the Ubiquiti Networks' Q3 2014 Q&A Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today's call, Anne Fazioli. Ms. Fazioli, you may begin. .

Thank you, Andrew, and thanks, everyone, for joining us today. I'm Anne Fazioli, Vice President of Investor Relations for Ubiquiti Networks. I'm here with Robert J. Pera, Founder, Chief -- CEO and Chairman of the Board at Ubiquiti Networks; and Craig Foster, our Chief Financial Officer.

Before we get started, I'd like to review the Safe Harbor statements. Some of the statements we will make during this call constitute forward-looking statements, including perspective on our future financial results, products, market conditions and competition.

These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed during the call.

Information on risk factors and uncertainties is contained in our most recent filings on Form 10-K with the SEC and other SEC filings, which are available on the SEC website at www.sec.gov. Forward-looking statements are made as of May 8, 2014, and we assume no obligation to update them.

We hope you've reviewed management's prepared remarks, which are posted as a transcript on the Events & Presentation and quarterly results section of our Investor Relations website at ir.ubnt.com. This will be a Q&A only call. Please limit yourself to two questions. And time permitting we will allow for a follow-up question.

Andrew, we are ready for questions. .

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[Operator Instructions] And our first question comes from the line of Kiera Kilkowski from Bank of America. .

This is Kiera on behalf of Tal Liani. I just had 2 quick questions for you. It looks like, again, this quarter, there was strong investment in engineers, which is an -- obviously important for your business.

Will these additional engineers be working predominantly on existing products in the pipeline or are the new products you referenced totally new to Ubiquiti? And then second, if you could just maybe talk about some of the dynamics you're seeing in the competitive environment in your different product lines, that would be great. .

I'll take the first one. Most of the R&D hiring, if not all the R&D hiring, is focused on new initiatives, mainly in software.

The second part of your question, can you repeat? About competitive [dynamics] [ph]?.

Oh, yes.

If you could just maybe give us an update on the different competitive dynamics you're seeing in your different product lines given the fact there's been some recent IPOs, et cetera?.

Can you just be more specific, which... .

Yes, specifically in the wireless LAN market, there's been some new companies that have been making some strides in terms of different verticals that they've been targeting and stuff.

And I'm just wondering if that's impacting you at all or what you're seeing in the dynamics?.

So, I think our messaging is the same now as it's been for the past couple of years. The way we see wireless LAN, professional wireless LAN solutions is customers largely are getting ripped off by overpriced equipment built on relationships and traditional business models.

We're focused on R&D and bringing to market superior performance products at disruptive price points and enabling markets these guys don't see. So on a volumes basis, our volumes are much greater than traditional wireless LAN companies. And I don't -- we're not focused on taking market share from these companies.

It's not really material, because we're a volume player. But over time, you'll see us taking market share from these guys. I think it's starting now. And what that represents is really a validation of our technology. People are going to say our technology is inferior and I strongly believe that's not the case. We're an R&D-focused company.

I'm a product CEO. I run R&D. I take great pride in that. Our focus is in R&D. And I think, over time, we'll take market share from those traditional brands and it will validate that we are a technology company. But it's not our focus.

Like I said, we're focused on driving and creating new markets that these guys aren't getting -- or aren't seeing or capturing. .

Our next question comes from the line of John Lucia from JMP Securities. .

In the prepared remarks you said you increased inventory dramatically this quarter as you account for the strength in the back half of the year, yet you're only forecasting for 1% sequential growth in Q4.

Can you walk us through the reasoning behind that? Does the modest growth in the outlook reflect a buildup of inventory in the channel? Or what's going on there?.

Okay. So there's a couple of things happening, this is Craig. First of all, that we have lead times that go into our shipping. So for majority of the next quarter, it's really shipping off the backlog that we created in the last quarter, which is the quarter we just completed. And knowing that -- there's 2 dynamics to the inventory buildup.

One is, yes, we do believe that there's a strong second half of the year that will materialize for existing products and for new products.

And going into the quarter, we were at -- right at the last couple of weeks, we were just beginning to sell our new airFiber 5 product line, but we had to build a significant amount of inventory so that we could be prepared for the onslaught of deliveries coming up. .

So the inventory is mostly airFiber?.

No. So we built -- probably, I would say, we've built about $20 million of inventory of existing products, and about $10 million extra of inventory for new products, one of them being airFiber that hadn't shipped yet. .

Okay, that's helpful. And then, I just wanted to get into the enterprise side. It only grew 1% sequentially. I was expecting at least 10% sequentially in that business.

Can you just walk us through why it only grew 1% this quarter?.

Yes. So actually, the volumes were up. The -- what really changed is -- and you know primarily the end product -- we -- inside that line, it's primarily UniFi. And the product mix changed for the quarter. So we actually shipped in volumes, collectively, across UniFi. It actually increased a significant amount for us.

But the change in the dynamics was -- we had a decrease in ASPs because the cost of an AC device is about 1/4 the cost of our end devices... .

I think what Craig means is we had an early adoption period with AC. AC products are priced significantly higher. And the volumes overall have increased in UniFi. But the initial seeding of the market of AC subsided a little.

But I think you'll see that grow just as our higher-end UniFi products, that are higher-end products across the company, grow after initial seeding and deployment. I wanted -- I always say you can't draw conclusions looking sequential quarter-to-quarter. I think you really got to take a year-over-year view. .

Okay. So just so I understand, the volumes for -- in the pipeline increased? Or if the volume -- I mean, the AC part... .

No, the actual volumes increased. But the ASP went down. .

Because of the mix between AC and N. .

So you're selling the mix for AC -- the AC products $300 is the price, right, and N is $80.

So if you sold more AC, how would that bring the ASPs down?.

You're in opposite. Sold more N than AC. .

Okay. And then one last question, just on the geographic mix. Just generally, the Americas business was down 10% sequentially, and EMEA was doing really well.

Can you just talk about, just generally, how that worked out and just what the geographies look like?.

Yes. I think it has more to do with the philosophy of how we're shipping products into a channel. And a big case that we had in the last year was, we've started to analyze a lot of -- we grabbed a lot of data from our channel and we analyzed it and we want to make sure the channel has the right amount of inventory.

And so the discipline that we show is that we're not going to ship into regions that we believe has adequate inventory.

And for regions that don't have enough inventory, based on our stochastics, we're going to increase the volumes based on -- so it's not a question of the order demand, it's really a question of discipline in terms of how we're shipping into these different regions. .

Our next question comes from the line of Jess Lubert from Wells Fargo. .

A couple of quick ones.

First, on the inventory, is it fair to assume that you expect that to settle the edge lower over the next few quarters now that airFiber 5 is shipping and you've got the ScanSource and Ingram Micro relationship up and ramping?.

Yes, I think that's correct. So we're giving guidance that we should be holding inventory of around 6 to 8 weeks. .

Okay. .

But I think it's moving to those levels [indiscernible]. .

Okay. And then, I was hoping you’d touch upon maybe the early market reception for airFiber 5 and the airMAX AC products.

What you're hearing from customers? How impactful those products can be over the next few quarters?.

airFiber5 is receiving outstanding performance reviews. And if you go to our forum or other sites', other community forums on the Internet, IT forums. And I think it's going to be a -- well, it is a big hit. It's gonna grow. .

And then, last one for me. Just on the OpEx, 10% of sales in the quarter. I was hoping you could touch upon how you're thinking about hiring going forward, if this is kind of the level we should be thinking about? And if you can help us understand from an absolute dollar perspective in Q4, how we should be thinking about R&D versus SG&A.

I would imagine some of the marketing dollars come down. Does R&D continue to grow from here or does it level off in absolute dollars? That would be helpful. .

Yes. I can't tell you short term. Like I said, in previous calls, I have -- or the company has ambitious vision and R&D is what's going to accelerate that vision. So we're looking to grab every R&D resource we could find that can accelerate that vision. I'm the lead recruiter of technical staff in the company.

So I can’t predict whether we're going to find 5 guys that fits our criteria next quarter or we find 100 guys or 200 guys. But if they're there, I'm going to grab all of them. So it's not like we're filling reps, it's -- I think it's a function of how we can recruit new talents and -- when the opportunities arise. .

And then just a follow-up to that on the SG&A side, I think it's going to be -- you're probably going to see it come down a little bit as the advertising from Ubiquiti World Network subsides a little bit. And then on the R&D side, you're going to see -- a lot of our R&D hires are actually happening overseas. We're seeing incredible talent overseas.

So when we think about the numbers of people that we potentially will be hiring, they come at a lower full time employee cost than a traditional Silicon Valley. .

Yes. So just to make a note about that. I always say we recruit internationally because of the talent over location. A lot of companies recruit and establish offshore development offices because of cost over location.

So, yes, it's a nice side effect, that maybe we get some cost savings hiring internationally instead of within Silicon Valley, but that's not our intention. If we hire outside the U.S., it's because we find very unique talented developers and we built around them in those areas of the world. .

Our next question comes from the line of Tim Long from BMO Capital Markets. .

A few here. I'll go one by one. Craig, first, for you. I hate to go back to the inventory, but last quarter, I think your comment was you thought the inventory level was about optimized in that low $30 million.

So I'm just curious, what's changed over the 3 months? Is something in the outlook changed or something in the product road map changed? Then I'll come back with another. .

Yes, I think that as we look forward -- in the past, we've had some problems with supply and we had some capacity constraints. And we feel like it's necessary to make some major investments to kind of roll that forward and have enough inventory, so that we can get it in to the channel properly.

I mean, if you look back 1 year ago, we were having problems in the channel, like we were having massive stockouts. And the channel does have a decent amount of volatility. So we need to be prepared, especially for the second half, to be able to pull that volatility without any disruption on supply.

And so I see this as an escalating de-risking of the supply-chain that we have. And ultimately, what this is going to do is, it's going to bring down lead times, or [a distributor have] [ph] the right amount of inventory. .

Anecdotally, 1 year ago we were -- yes, we were sending everything to our distribution on a monthly basis. And as of last week, 70% of our orders are either weekly or biweekly to our distribution channel.

And I think that's a major change in terms of the way that we're thinking about how to fulfill and how to better service the channel with a steady supply of goods. .

Okay. And could you walk us through both, maybe combined Ingram and ScanSource, a little bit larger distributors.

Just walk us through your timing on when you think they could become meaningful to distribution and potential benefits from those relationships?.

Well, I mean, ScanSource, we just announced it last week, and they placed their first order, I believe, this week. It'll be -- they're not -- our expectation is they're not going to be a top 5 distributor in the next 3 quarters or so.

But I think that given their substantial outreach, at least here in the U.S., that they have the potential to be a top 1 or 2 distributor here in the U.S. But it's going to take some time. .

Okay. And then just the last one. This is probably tough to put numbers on. But I'm just curious, the service writer business has done well again. And I know you're in the early stages of Ubiquiti World Network. But do you have any sense as to the return on investment you're getting? It seems like the initial feedback is really positive.

Anything that you could point to as far as tangible revenue benefits from that yet? And then, I'm done. .

Yes, I think -- I think, Tim, it’s super early. So this is only as of the time we reported. We were only 7 weeks into the program. In our press release, we actually put out a couple of links to some, I guess, you call them video testimonies, but some early feedback of early adopters of Ubiquiti World Network.

And guys are getting -- one of them -- somebody put in $18,000 of advertising and their return on that is they're going to get $220,000 back in revenue. That's their expectation. So I think that there's going to be tangible results. It's just going to take some time for total adoption across the entire WISP market. .

Our next question comes from the line of Matt Robinson from Wunderlich. .

First, on -- I'll belabor the inventory a little bit more. You guys introduced UniFi video software a few weeks ago, and we -- I haven't seen, unless something happened in the last couple of days, I haven't seen much about the new cameras.

I was wondering if perhaps -- you mentioned airFiber 5, which started to ship, in that 10 million for new products, should we be thinking that some of that was for airVision or UniFi video, whichever you're going to be calling it, going forward?.

Yes, I think that's a fair assessment. .

Any color on when we might be able to start to see those products come into the market?.

I think you'll see -- obviously, you'll see an announcement from us very soon. .

And I think one of the earlier callers asked about airMAX AC. Is that -- that we've seen some indications that it's been through some degree of FCC approval testing.

And what would we -- what should we be thinking about for timing there?.

I think we're pretty -- it's in the very-soon category as well. .

And maybe a little bit after the new cameras, is that the way we should look at it?.

Yes, I think that's right. .

And you mentioned second half several times, I think one of the earlier callers was focusing on the fact that we're halfway through the second half on a fiscal basis.

Were you may be talking about calendar second half, when you're talking about positive seasonality?.

Yes. Sorry, I -- having a 6/30 year end doesn't help. But yes, that's more of the calendar year back half. And that coincides with some of the weather and some of the other things that are kind of stronger months for us. .

And it doesn't look like you've had a lot of trouble with the geopolitical issues in the -- in Eastern Europe, at least not during the quarter.

Has anything changed on that front since these numbers came through?.

Not really. But I think we should ask Mr. Putin what his plans are. I think, yes, we're monitoring -- right now there's no embargos. The ports are open. It seems like that's what we need to track. And right now, that's not in the cards for what they're talking about from sanctions, but that could change.

But I think it's fair to say and I'll just say it now, is that our total exposure in terms of direct shipments into Ukraine or Russia is [inaudible] 2% of our revenue. .

You've got -- good number.

You've got [inaudible] distributors from other countries that ship into that region too though I imagine, right?.

So, I think -- we know that there's a couple other guys that more than likely move some products into Russia, but I think it's not 4% total exposure by any means. .

Our next question comes from the line of Rajesh Ghai from Macquarie. .

Congratulations on the strong results. I just wanted to delve a little deeper onto airFiber 5, if I could. You mentioned there were some strong initial activity.

I was wondering if that activity on standalone backhaul -- use cases or is it kind of your WISP customers trying to expand the range of services, that they can provide a range -- or the area that they can provide services to?.

AirFiber 5 is a special product. So it works on the worldwide license band, I figure it's on license band.

It's a true Frequency Division Duplex radio, which means it has microsecond latency, which is far better than any of our airMAX devices or any other devices in this [inaudible], and at a price point of under $2,000 a link it makes it applicable to a lot of different applications. WISP backhaul is one. Cellular Backhaul, potentially.

Building-to-building communications. And I think in airFiber 24’s case it was limited. It had a lot of range imitations. airFiber 5, we're seeing it deployed in links of beyond 50 miles, I believe. And it has speeds. Some people have links beyond 1 gigabit per second. So they're pretty phenomenal product.

And I think you'll see it take off over the next quarters. .

And on the guidance, of you could provide color on either what trajectory you see for revenues in both segments and overall gross margin?.

Yes. So we -- I mean, the segments are really dependent on the product mix and it continues to [comp] [ph] around a little bit. But I think that we'll probably do about 20% or 22% in the enterprise segment, and the rest in the service provider.

And gross margins, we continue to reiterate and say that our gross margins will -- it's dependent on product mix and it'll probably be -- it'll be between 43.5% and 44.5%. .

Do you expect enterprise to kind of decline sequentially?.

No, I think it'll start to increase. .

Our next question comes from the line of Tavis McCourt from Raymond James. .

Robert, I just had one, just a clarification on the airMAX AC product line. And in terms of the -- not just the timing, but how we should expect that to roll out. So in other words, there is kind of the infrastructure side and I don't know if there's a CPE side to that upgrade as well. And then, obviously, there's different geographies.

So is that an upgrade that we should expect to roll out reasonably quickly all in 1 quarter? Or will it be a little bit more structured across geographies at different times, or different parts of the network at different times?.

I think it's going to be structured by different product introductions within the family. The first products we release will be point-to-point airMAX AC. And then, subsequently, we'll release multi-point AC. And I think what you'll see is very similar to what we call airMAX and our AC products.

Over time, you'll see people replacing their legacy products and their legacy stations to our new standard, and the performance is going to be significantly better. .

And have you decided on a price-point strategy there? Obviously, in the wireless LAN business, you passed through a lot of that cost, obviously.

Is that something you intend to do in the airMAX business or is that to be determined?.

Every product we release, we try to set a new standard for price performance. airMAX AC will be no different. .

And does both the point-to-point and point-to-multipoint have the AirPrism technology or is that just going to be on one?.

Our plans are to use AirPrism in both point-to-point and point-to-multipoint applications for airMAX AC. We will have lower-cost non-AirPrism options, however, also. .

Our next question comes from the line of Sanjit Singh from Wedbush. .

In regards to the WiFi business and the mix shift to N versus AC, was there anything from an end market standpoint whether particular types of customers, whether the shift in that, that would drive more N versus AC? Are people just looking for basic connectivity where it ends fine enough? I guess I'm trying to understand why would someone be looking at N at this point in the WiFi cycle, given that AC has been around for a good amount of time now?.

Yes. I think that answer is -- there's an easy answer to that, that is if you look at the markets that were growing and building, a lot of that's happening outside the U.S. or outside of North America. And we'll call it -- they're walking into situations where they're going from no WiFi to -- no access WiFi to a WiLAN solution.

And the better price entry point is in the N space. .

Got it. And then trying to take some of Robert’s comments on the R&D investments, and then maybe your long-term financial profile.

As your growth rates converge to the 25% revenue growth target you've set long term, is there anything on the margin side that's changed or is your margin profile, long term margin profile lower? Or is what Robert's comments just kind of opportunistic hiring, is there any change in outlook over your long-term margin profile?.

To repeat what I said last call, when we first entered the public market, I was very proud of our financial margin profile. I've shifted my focus on accelerating a vision at the sacrifice of that financial profile. That doesn't mean the financial profile will be any worse, it could get a lot better.

It just means I'm completely focused on accelerating the vision. .

Our next question comes from the line of Kulbinder Garcha from Credit Suisse. .

I have just a couple and they're both kind inventory linked, I'm afraid. I just want to understand one thing. So you've had the significant ramp in inventory, but not much of that revenue is going to come through in the next quarter. Yet, you're confident that it's in the back half. I just want to understand if that's the dynamic.

And what was the reason for the inventory buildup on existing products? The new products, I understand, because you have to launched them yet. On the existing ones, I'm not sure. And the second part of my question, just on channel inventory. I think you mentioned in the prepared remarks, they were roughly the normal range.

What is the normal range? Does it vary a lot by region? Or does it vary a lot by region currently? I'm just a bit curious about that. .

Let's start with your last question first about what the right amount of inventory is in the channel. So it's more on a global basis and then we look at it by distributor some of our distributors are better capitalized than others. But on an average, our -- the distributors are holding inventory for 4 to 5 weeks, and that goes across all regions.

In North America, our distributors are better capitalized and they're able to carry more inventory and they prefer to. And in some of the far reaches of the world, some of our distributors are carrying 2 to 3 weeks. .

But sorry, Craig.

Would it be fair to say then it's -- they're all in the 2 to 5 week range and that hasn't really changed?.

Yes, there's -- nothing has changed in there, and that's how we're trying to manage it. But we're managing it on a global basis. So we're managing on a regional basis. And then, we're managing it by distributor based on their past behavior. And then your question on the inventory. So I think I said a little bit of this before.

But this concept of that we've had stockouts and we've had a massive mismatch in supply and demand has potentially cost us sales in the past.

And one of the things that we're trying to alleviate, especially since we do have cash to spend on inventory, our inventory doesn't expire like food or newspapers or some business like that, it's okay for us to build inventory because if there is a run or as we continue to accelerate until the latter half of the year, I want to be able to fulfill that demand without any interruption in supply.

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I guess the question then is, Craig, can you phase them all? Because it's not coming through in the next quarter. I guess, that's what's surprising in a sense. I get your point. You don't want to have stockouts. You want to fulfill customer demand. You don't want to be caught short and miss out on revenues and those kind of things.

But it all seems to have spiked up fairly significantly now, but it's not necessarily being quite -- taken your revenues up meaningfully into the June quarter. .

Yes, but going into the end of the quarter, I'd say, we had some buildup of some products that haven't shipped yet. And then towards the last half of the quarter we just completed, we had a few new products that we'd also built on the airMAX line that we had to build some extra inventory for. And we're looking at kind of 6-day week lead times.

So looking at what's going to happen in June, July, August, we need to make sure that we're ready for it. .

Well, I think you got to look at it -- it's not a situation where we build inventory to orders and we're sitting on inventory. It's not like that at all. I told the operations guys, I don't want to hear or see any more complaints in our customer community, where people are complaining about not being able to get stock of our products.

These guys are operators. They're installing on rooftops and they're deploying. And they're held back by a lack of supply. It hurts. It hurts our brand name. It hurts our goodwill with the customers. And that's what I want to protect from a long-term point of view.

So whether the fault is with the distributors or whether the fault was with our operations not being optimal, I told our guys that I don't care. I just don't want to see this bump. So we're building inventory. And I'm perfectly fine using cash from our balance sheet to build inventory so we have more than enough.

Some of this inventory is at our warehouses in China. Some of it is even seen and has made into the local markets where we're working with distributors to ensure all our operators worldwide don't have any supply shortages. So it was, on my part, a long-term strategy to repair the goodwill. And yes, that’s what it is. .

Thank you. That is all the time that we have for questions today. I would now like -- ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. And you may all disconnect. Everyone, have a great day..