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EXFO Electro-Optical Engineering, Inc. (NASDAQ:EXFO)

F4Q08 Earnings Call

October 15, 2008; 5:00 pm ET

Executive

Germain Lamonde - Chairman, President and Chief Executive Officer

Pierre Plamondon - Vice President of Finance and Chief Financial Officer

Vance Oliver - Manager of Investor Relations

Analyst

Ben Jekic - Desjardins Securities

Chris Umiastowski - TD Newcrest

Deepak Chopra - Genuity Capital Markets

Michael Urlocker - GMP

Ajit Pai - Thomas Weisel Partners

Operator

Welcome to the EXFO’s fourth quarter and year-end results for fiscal 2008 conference call. (Operator Instructions). I would now like to turn the conference over to Vance Oliver, Manager of Investor Relations.

Vance Oliver

With me on the line today are Germain Lamonde, EXFO’s Chairman, President and CEO; and Pierre Plamondon, Vice President of Finance and CFO.

A reminder that this conference call will include certain forward-looking statements and/or estimates concerning our intents, beliefs or expectations, regarding future events that may affect EXFO. Please note that such comments will be affected by risks and/or uncertainties, which may cause the actual results of the company to be materially different from those expressed or implied today.

For more information about EXFO, I encourage you to review our Form 20F, which is on file with the Securities and Exchange Commission. Our Annual Information form is available with Canadian Securities Commissions as well. All dollar amounts in this conference call are expressed in U.S. dollars unless otherwise indicated.

So without further delay, I will turn the call over to Germain.

Germain Lamonde

While the fiscal year proves to be another great year of performance, but also the year of great transformation as we made a number of vital changes to maximize our mid-term and long-term value creation. First we acquired Navtel Communications and Brix Networks to build EXFO into a leader in next generation IP testing and service assurance.

Second we opened a high volume low complexity manufacturing center over in Shenzhen, China and bolstered our software development team in Pune, India, to expand our global presence and deliver the most innovative but also competitive solutions in the industry; and third, not the least we increased our sales marketing and branding actions mainly among key focus accounts and in targeted countries to expand our coverage and long-term growth perspective.

These initiatives among others helped us increase our sales by 20.2% year-on-year or more than twice the industry growth rate, to a record of $183.8 million in fiscal ’08. In the last five years, our compound annual growth rate for sales stands at 24.3% and at 19.3% over the last 10-year period, which incidentally are including the gloomy 2001, 2003 time where it was difficult as it had a downturn.

I believe most investors are well aware that EXFO has gained market share and grown substantially faster in the industry year-in and year-out, quite an accomplishment for 23 years in a row and certainly an area of great pride to myself.

Few however are realizing that we have increased EBITDA faster in sales in four of the last five years. In fact we increased our EBITDA margin from negative 1.1% in fiscal 2004 to 14.8% in 2007, despite a very strong headwind from the Canadian dollar, which appreciated by about 30% during the timeframe. Know that our 2007 EBITDA margin would have been at 12% if you exclude the one-time gain.

In fiscal ’08, our EBITDA margin reduced slightly to 11.2% because we accepted some short-term impact against more important long-term benefits with the acquisition of Brix Networks and the opening of our new manufacturing center in China. Now that we are at that level we believe that we have still room and capacity to expand our EBITDA margin further in the longer-term, we think it’s doable to reach eventually 16%.

Back to 2008, although the Brix acquisition was negative to earning for the last part of fiscal 2008 as expected, it should be neutral to earnings in 2009, extreme amortization of intangible assets and stock-based compensation costs and should be accretive thereafter to significantly contribute both towards not only growth in revenue, but also to our long-term growth in earnings.

On the other hand, our manufacturing facility in China was slightly negative to earnings in fiscal ’08, but should really be accretive in 2009 and beyond and will enable us to become more competitive in the marketplace and globally and extend further market share gains.

Now talking of the acquisition of Navtel and Brixs; looking at these two acquisitions that occurred in fiscal 2008, we purchased both Navtel Communications and Brix Networks based on their excellent fit with our long-term growth strategy and we’ll strongly be contributing to transform EXFO into a leader into next-generation converged IP networks and get us higher up into the protocol track where a better margin can be generated.

Navtel provides EXFO with the most advanced and scalable test solutions for IMS Networks and fundamental architecture leading to seemless wire-line and wireless and therefore ability for credible play deployments. Their product targets, the front end of the present technology lifecycle or network equipment manufacturers and network service provides us labs that are increasingly strategic to our business.

Brix Networks on the other hand is a technology leader in converged voice-over IP data and IPTV service assurance solutions and it comes at the tail end of the technology lifecycle where networks with providers or EXFO’s main customers are in need to monitor the quality of service and quality with their experience of their network in the real time and full time, if they want to avoid customer churn. This is imperative to the less predictable and more highly dynamic nature about today’s networking in which bandwidth is dynamically allocated based on the hierarchy of various IP applications.

Prior to these acquisitions, EXFO’s protocol business has been focused on transport and datacom layers or layer one to layer three of the protocol stack. While Navtel and Brix solutions address mostly layer two to layer seven, which are much more software intensive and higher margin, we believe that our high growth transport in datacom business with it’s Transport Blazer and Power Blazer product offerings combined with the test and service assurance solutions from both Navtel and Brix are providing us with unique opportunities to leverage key technologies across all three business segments within our new protocol and business.

Navtel’s direct focus on NEMs and NSP labs also provide us with a better idea of what’s coming down the telecom supply chain for NSPs and likewise, our market presence with the NSPs is opening many doors for Brix’s assurance solutions and the size and the reputation and the financial strength of EXFO are helping Brix to secure larger and more frequent deals.

Going forward, Navtel and Brix represent the blueprint to our acquisition strategy. Our strategy is very simply based on first and foremost strong organic growth, supported by acquisition of the small to mid-sized companies that are providing us with best-of-class technologies in nascent and high growth markets. Consequently, we do occasionally acquiring slightly unprofitable companies at the beginning of their sales growth curve, but in that case that must be exponential in the near future.

So let’s talk now of fiscal 2008 and provide some highlights. Clearly, we initiated a number of changes in ‘08 with a long-term horizon, but progress was made in several fronts that are worthy of mention. I’m especially proud of our Telecom Division, which increased sales 24% year-on-year led by 97.4% growth in our protocol activity, that includes partial revenue contribution from Navtel and Brix in ‘08.

During the last three years, our protocol test business has grown by a CAGR of 74.4% or if your strictly looking at organic growth, that’s grown for three years at a CAGR of 64.5%, which is quite amazing. In fiscal ’09, we expect this segment to represent about one-third of our Telecom business and we expect that that segment long-term to both contribute not only to revenue growth, but substantial as well into earning growth.

Not coincidentally, our gross margin also improved for six consecutive years to reach 58.9% in fiscal ’08 and I’m really optimistic that it will continue its upward trajectory in the upcoming years to reach 62% and eventually beyond.

Looking at our optical test business, sales increased 12.7% year-on-year, which is less than our typical 18% to 20% growth for this segment. The drop in spending at our largest customer Verizon, which went from $22.5 million in fiscal ’07 to $13.6 million in fiscal ’08 is largely responsible for the reduced growth rate in optical testing as the optical revenue reduced between ’07 to ’08 in optics, it has grown in other segments of our business, so reducing it further, the optical contribution at Verizon.

So we are not losing ground at this account for our optical business and we’re remaining very well entrenched for the home deployment, but we are getting market share and this accounts for other areas such as transport and datacom testing. So our protocol business is making progress with that account.

In terms of our copper access test business in fiscal ’08, sales were down 3.9% year-on-year, but I’m really pleased that revenues are now increasingly derived from our new access to 100 SharpTESTER platform and all the related modules that we sell along with it; as well as we have diversified very, very much more, our customer base for this business units with a number of new customer wins.

Indeed we’re now engaging Tier-1 on larger and cutting edge opportunities, which resemble the same path for growth that our successful protocol test business had been following. When we acquire the business from Consultronics we more-or-less had the vast majority of our business made with only three accounts and this is not the case anymore.

Now let’s talk about long-term visions, strategy and some of our metrics going forward. I’d like to say at this point and I would like to share with you some highlights of our three year strategic plan, so that you’ve got a better idea of where we’re headed and what we’re trying to accomplish. I believe that this new information will help our shareholders to better understand our long-term directions that EXFO’s management is taking towards value creation and how we plan to grow revenues and earnings.

Our vision is to become the market leader in global and telecom test and service assurance industry. Especially, in the testing of next-gen converged IP networks, by offering innovative solutions in high growth segments that extend across the life cycle with a strong focus on network operators. From the network infrastructure standpoint, we will increasingly climb the protocol stack, the triple-play service and next-generation converged IP networking through advanced test and assurance solutions.

We expect network service providers will remain our primary end-market, while targeting high growth niches along network equipment manufactures. We do not intent to become a one stop-shop for our customers, but rather continue to be a strong player in selected high growth markets. We will follow this roadmap by offering best-in-class solutions, both in terms of quality, functionality and ease-of-use, while providing the highest level of customer satisfaction.

To achieve our long term vision, we plan to expand our leadership position in the protocol optical test segment, while growing our protocol test business even faster to eventually surpass optical in terms of sale. This plan is largely predicated on organic growth while mainly through market share gains.

We will also seek early in the gain leading hedge companies in high growth markets to accelerate our growth and we’ll also be looking at partnerships and alliances going forward to also maximize value for our shareholders, but in our high value benchmarking performance, we have established three copper performance objectives to build the success of our three year plan.

First, we plan to increase our sales by an excess of two time the industry growth rate and maintain 20% CAGR during the next three year period. We want to grow EBITDA even faster than sales during that period of time, so we plan to have EBITDA being above 20% growth basically as an average of the next three years and we also plan to raise gross margin to a sustainable level above 60%, targeting 62% within a three year timeframe.

These objectives will guide our actions in the next few years and we are committed to maximize shareholder value. Hopefully, this new information will draw attention to EXFO’s long-term potential and offer investors a more complete picture of our investment proposition.

Finally, let me provide you with our financial outlook for the first quarter of 2009. As you know the macro-economic environment is very challenging these days and it has been compounded by the recent crisis in the financial markets. The fundamental however for the telecom industry remains unchanged.

Bandwidth demand continues unimpeded in the access network and the migration towards next-gen IP networks is a key driving force in the core networks and we’ll still being committing substantial investments on behalf of the network operators, so we remain optimistic about the industry.

From EXFO’s perspective, we have not witnessed any major drop-off in our Telecom business with the exception of Verizon in the U.S. Verizon accounted for 7.4% of our sales in fiscal ’08, but we still manage to post a recorded sales of $183.8 last year, so it’s gradually losing importance. Everywhere else in 2008 wherever you slice it, from a geographic or from a Telecom business unit standpoint we’ve increased our sales year-on-year quite substantially.

Now looking at booking trends in the early part, for the first quarter of 2009, once again we are witnessing softness at Verizon, while effectively solid everywhere else. It’s like our growth elsewhere is rather solid. Perhaps we’re seeing more orders push out or some order push out, but certainly not cancellations. One area of the concern maybe of our industry and life sciences division, which is showing science of less demand from customer driven products, like say phones and things of that nature that are actually assembled using our light curing systems.

Given this mixed marketing environment, the significant fluctuations in the Canadian dollars and I would say a slightly lower visibility than normal, we are forecasting sales between $45 million and $50 million in the first quarter of ’09 and we’re expecting GAAP net result between a loss of $0.03 per share to a net earning of $0.01 per share. We know that our GAAP earnings outlook includes a $0.02 per share in after-tax amortization of intangible assets and stock-based compensation costs.

At this point, I will turn the call over to Pierre to discuss our financials; Pierre.

Pierre Plamondon

So, as mentioned earlier in the call annual sale increased 20.2% to a record height of $183.8 million in fiscal 2008 from $152.9 million in 2007. In the fourth quarter of 2008, sale reached $50.9 million compared to $48.6 million in the previous quarter and $43 million in the fourth quarter of 2007. This 20.2% year-over-year sale increase is mainly due to market share gains in the optical and protocol test business, which increased sale 12.7% and 97.4% year-over-year respectively.

Partial revenue contribution from Brix and Navtel acquisition totaling $5.4 million including $3.2 million in the fourth quarter and increased penetration in the Americas, Europe, Middle East, Africa and the Asia-Pacific region where sale increased 12.8%, 26.2% and 40.1% year-over-year respectively.

Overall for fiscal 2008, net bookings increased 17.8% to a record height $184.6 million for a book-to-bill ratio of one. In the fourth quarter 2008, net bookings totaled $45.7 million compared to $50.7 million in the third quarter 2008 and $39.5 million in the fourth quarter of 2007. Gross margin improved to 58.9% of sale in fiscal 2008 compared to 57.4% in 2007.

In the fourth quarter of 2008, gross margins amounted to 59.9%, compared to 60.9% in the previous quarter and 57.9% in the fourth quarter of 2007. We increased gross margins in 2008 mainly because our sale enabled us to better absorb our fixed manufacturing costs.

We increased sales of our software intensive product protocol test solution. We received a partial contribution from Brix and Navtels on our margin products and we benefited from a lower cost of raw material as the Canadian dollar increased considerably against the U.S. dollars year-over-year. We anticipate that our gross margin will vary between 59% and 61% for fiscal 2009.

Moving to operating costs, selling and administrative expenses amounted to $61.2 million in 2008 compared to $49.6 million in 2007. The year-over-year increase in the SG&A is mainly due to the impact of the Brix and Navtel acquisition, the hiring of additional sale and marketing personnel to support our growth, our commission paid on increased sale, administrative expenses related to ramping up manufacturing operation in China and enhancing R&D operation in India and finally the huge negative impact on the Canadian dollars since the increase on average 11.4% versus the U.S. dollars in fiscal 2008.

As expected with the announced acquisition, our SG&A finished above our long-term range of 30% to 32% with expenses amounting to 33.2% of sale in 2008 compared to 32.4% in 2007. In the fourth quarter of 2008, selling and administrative expenses totaled $70 million compared to $15.7 million in the third quarter of 2008 and $13 million in the fourth quarter of 2007.

We expect that our SG&A will range between 32% and 34% in fiscal 2009 to support the higher margin potential of our Brix and Navtel product offering, which typically has a longer and more expensive sales cycle.

Net R&D expenses totaled $26.9 million or 14.6% of sale in fiscal 2008, compared to $16.7 million or 10.9% of sale in 2007. The impact of the Brix and Navtel acquisition, increased headcount of our R&D software center in India and the stronger Canadian dollar in 2008 are responsible for the year-over-year increase in net R&D spending.

In the fourth quarter of 2008, net R&D expenses amounted to $7.3 million compared to $7.4 million in the third quarter of 2008 and $2.3 million in the fourth quarter of 2007. These remind us that in the fourth quarter of 2007, we have a one-time revenue impact, R&D tax credit of $3.2 million which understate our spending in that quarter.

We expect that our net R&D expenses will fluctuate between 14% and 16% of sale in fiscal 2009, since Brix and Navtel software intensive project required a higher investment in R&D and especially for Brix, those investments in R&D won’t be eligible for R&D tax credits.

In fiscal 2008, the GAAP net earnings reached $18.4 million or $0.27 per diluted share, including $5.3 million for the recognition of previously unrecognized future income tax assets and the extraordinary gain of $3 million related to the negative goodwill on the acquisition of Navtel Communication and the net recovery of income taxes of $1.2 million. These items were partially offset by $3 million in after-tax amortization of intangible assets and the $1.3 million in stock-based compensation costs.

In 2007, GAAP net earning totaled $42.3 million or $0.61 per diluted share, including $27.8 million in recognition of previously unrecognized future income tax assets and tax credit and the $1.1 million for government grant recovery. These items were partially offset by $2.9 million in the after-tax amortization of intangible assets and the $1 million in stock-based compensation costs.

In the fourth quarter of 2008, GAAP net earnings amounted to $3.3 million or $0.05 per diluted share, including $1.2 million in after-tax amortization of intangible assets and $0.4 million in stock-based compensation costs. As usual in the fourth quarter our payroll expenses were sequentially down due to the positive impact of the summer holidays.

Looking at segmented results, our Telecom division sale increased 24% to $161 million in 2008, while our Life Sciences and Industrial Division sale slightly dropped 1.2% to $22.8 million. Our Telecom division generated $9.5 million in earning from operation in 2008, while our Life Sciences and Industrial Division delivered $2.5 million in earning from operation for a total of $12 million for the company.

In terms of geography, the America represented 56% of sale in 2008, Europe, Middle East and Africa totaled 28% and Asia-Pacific 16%. Looking at customer diversification our top customer Verizon represented 7.4% of sales in 2008, compared to 14.7% in 2007.

As mentioned previously, we believe that we’re not losing market share on this account; on the contrary, we are increasingly winning product approval including a major win on the protocol testing side with the Power Blazer multi service test market. The good news is that excluding sales to Verizon, our Telecom sale would have increased 37.2% year-over-year and sale to the U.S. would have increased 28.7%.

Moving into a few key points on the balance sheet, our cash position decreased to $87.5 million or $1.30 per share at the end of Q4 from $96.5 million in the previous quarter. The sequential decrease is mainly due to an unrealized foreign exchange loss of $6.9 million on our cash and short-term investments denominated in Canadian dollars since the Canadian currency significantly weakened just at the end of Q4.

We also paid out $4.7 million for the redemption of share capital under our share buyback program. Overall for fiscal 2008 we repurchased 1.7 million share for a total of $8.1 million. In addition we still have a short-term loan of $1.5 million and spent $1.5 million for the depreciated capital assets. These amounts were partially offset by $5.3 million in cash flow from operation in Q4.

Inventory decreased from $38.1 million at the end of Q3 to $34.9 million at the end of Q4, mainly due to increased shipment in the fourth quarter. As a result, inventory turns have increased from 2 to 2.3 times in the last quarter. Finally DSO slightly decreased from 57 days in the third quarter to 56 days in the fourth quarter.

Now I would turn the call over to the operator for the start of the Q-&-A. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Ben Jekic with Desjardins Securities.

Ben Jekic - Desjardins Securities

Two quick questions, first question Germain, could you elaborate a little bit more on the numbers at Verizon. I mean year-over-year, a $22.5 million dropping to $13.6 million appears somewhat steep and then in the optical testing division you said the growth was 12.7%, is that business generally lost or did it go to somebody else and how is that this doesn’t make you worried?

Germain Lamonde

Okay. Well, essentially to answer that question, first of all lets say that, yes the significant reduction in revenue at Verizon to be frank, it has come up even faster than we expected, but we probably reached the point where first of all we’ve gone across now, the mid point in their deployment program for FiOS is at more than [Inaudible] past now, so we don’t see that necessarily this is like over with a TDH expenditure for them.

We think they will still be getting more orders, but as of late they went through a number of reasons why they had to slowdown expenditures. They were facing imminent strike or basically had to prepare for that. They had a number of reasons to slow it down temporarily. First of all, we clearly say that we are not losing ground at that account and if there is any additional business to be obtained for us in optical testing at that account, we will be in the ones getting it; we are in top shape there, there is no question.

We got very strong product offering. We have kept investing to have a leadership position technically and we are maintaining the very large majority of the business to say the least if not all the business we are getting. So, that strong reduction in revenue at Verizon, as you have seen it’s about a $9 million revenue reduction, impacted directly our growth in the optical segment, basically we lost several points there.

Had it not been Verizon, if you net the Verizon from our optical business, we would have seen a growth rate in the range of 20% as we’ve seen in the prior years. We are still believing that we are getting market share in that segment.

Ben Jekic - Desjardins Securities

And my second question is if I’m not mistaken, you have not provided the level of sales expected from new products in you three year metrics. Is there anything we should read into that vis-à-vis the current market environment and maybe you are delaying some R&D projects or --?

Germain Lamonde

No, no; actually in fact the reason is it’s just very simple and I think you will probably enjoy the answer, but fundamentally just that we’ve been told times and times again that this was the nature that really had the least impact for our shareholders and we try to provide metrics that really had an impact for shareholders.

To be frank now things are really going very strong; in fact the revenue from new products this year came out at 35%, I think it’s a very good number. We’ve launched 27, 28 new products in the last 12 months which is the best in our history; we were at about 22, the year before. Our innovation programs are more active than ever. Our R&D teams are very, very focused in delivering on a lot of value with new products.

So, you’ll see us being as innovative as in the past, clearly we’re not going to take a step down there and we only thought that there was a metric that wasn’t too much meaningful to our shareholders; that’s the reason why we dropped it, but fundamentally we are not expecting any departure from where we used to be in the 35% a year and we think we are going to keep rolling around this and maybe even better.

Operator

Your next question comes from the line of Deepak Chopra with Genuity Capital Markets; please proceed with your question.

Deepak Chopra - Genuity Capital Markets

I was wondering can you talk maybe a little bit of the weakness you are seeing sequentially, what customers are you seeing? What are they telling you, is it delays? Is it cancellations maybe and what parts of the networks are you seeing in more of the front end in terms of fiber to the home deployments, IPTV or back end, maybe just a bit of clarity of what’s happening in the market you see?

Germain Lamonde

Okay, maybe I’m going to surprise you, but to be frank we’re not seeing any weaknesses. Let me get back to this; there’s maybe two points where we see a bit of weaknesses, but generally speaking when we talk to our customers, we’re not seeing a lot of question marks. Projects are going through, maybe the lease critical projects might get pushed out or delayed, but fundamentally the demand in telecommunication for bandwidth, for new application, the benefit carriers to go towards merchandise network is making it so beneficial that you’ve got to keep investing, so we think that the fundamentals remain very strong.

When I’m looking at our booking so far in this quarter without getting into too much details, I would say the bookings so far is quite strong, except maybe for two areas, one is Verizon. So Verizon went down substantially year-on-year, but when I’m comparing the first quarter last year with the first quarter of this year, well first of all last year, the best quarter with Verizon was the first quarter and this year it’s still going south into this first quarter.

Again, we think in this case that maybe Verizon is taking a unique approach to their CapEx management or maybe again they have short-term, maybe enough of our test products on the optical side. I can tell you that we’re working with them and we won basically a number of approvals on the protocol test side; high speed product solutions like 10-gig and so forth, but fundamentally right now we are seeing them being slow this quarter and so that’s one area. If I’m looking at our growth outside in telecommunication outside of datacom, I’m quite pleased, very, very much quite pleased.

The second area that’s actually a bit soft right now is our Life Sciences Division. Our recent Life Sciences is only accounting right now for only 12% of total revenues, so it’s not really a very big deal, but nevertheless a lot of the products we’re providing there are lamps being used for UV curing that are actually being used epoxy curing in precision assembly and many of these production assemblies are linked to consumer goods I guess and we think there is a little bit of softness there with those. We think it’s actually temporary. We see basically customers in this piece of our business to be still committed to projects, but it’s a little bit slow in going through the expenditures.

So, our forecasts are still good. We don’t see like a fall-off in that segment, but we’re seeing it short-term to be a bit more slowly than normal, but overall within our Telecom space, some customers maybe trying to leverage the situation for to their benefit, trying to turn it into a customer market, but we think right now as far as we’re concerned, our forecast, our funnels, the deals we’re working on are quite nice. We just got confirmation of a very meaningful deal that we will not be recognizing revenue in Q1, but will actually be interesting in terms of our bookings, so honestly we think that things are not in a bad shape, but Verizon is a bit slow right now.

Honestly there is a bit of a trend in the marketplace right now. The more people speak of a recession and what have you, the more we are creating it, but the Telecom operators right now, we are seeing it, we are experiencing it and again we are only like a small piece of that global telecom industry, but from our angle, we don’t see too many drawbacks.

Deepak Chopra – Genuity Capital Markets

So the sequential decline you’re seeing in the top line is primarily just Verizon; so ex-Verizon things you would characterize as relatively good then to summarize it?

Germain Lamonde

Absolutely.

Deepak Chopra – Genuity Capital Markets

Maybe could you give the number of what Brix and Navtel represents of revenues into Q4?

Germain Lamonde

In Q4 they accounted for $3.2 million

Deepak Chopra – Genuity Capital Markets

And how should we expect that business to ramp in the coming quarters as you fully integrate those acquisitions?

Germain Lamonde

Well, I want to say that as we said earlier in the call, Brix was negative to earnings in fiscal ’08 and we need in fact to scale up the business. In fact their natural growth rate before acquisition was in the range of 30% internally and our view was if we were able to at least reach 30% growth we’ll be able to bring the business to a breakeven level.

Right now what we can say is that, it’s a great business. It’s a great team of people, they have got great products and technology and I would say that our customers first of all they need that type of business and systems and they really enjoy the fact that now Brix is a part of a bigger organization and it’s got more financial capabilities and strength and more history; it’s helping them to have trust.

So we are starting to win deals that according to the very sales people of Brix would have probably not being won if they had been on their own. So basically even the Brix sales people sometimes will tell us that such and such a deal, came in or at least was helped by the fact that “hey now we are a part of the big organization” and as such a system like that, like a converged service assurance management solution, once you’re deploying it, its more or less like an annuity.

There are constant additions to the network or additional probes to be deployed and there are annual service revenues and so on and so forth. They need to have a supplier that will be around for the long run and that’s what EXFO’s providing. With the strong financial back-ups that we have with our history and 20 to 23 years now we’ve been in business, we are helping to provide the confidence to support the deal that Brix wants to win. Technically they have an outstanding solution and kudos to the whole team in Brix for what they did, they did a wonderful job.

Deepak Chopra – Genuity Capital Markets

Maybe in terms of just a gross margin profile, I guess you’re taking about moving sort of 60% or more for the next fiscal year, is that the correct way to characterize it?

Germain Lamonde

Yes, it’s correct. Now we have been sticking it out, moving it up to 62%. Longer-tem we think there is room; for this year we talked of 59% to 61%; well clearly we are expecting this year to be up again. Longer-term we think we can actually be 62% or even beyond that point eventually.

Short-term we’ll see if we start seeing a bit more pricing pressure or not, at this stage we are not seeing it, but if there is a bit of a slowdown in the economy sometime, some players like to deploy it. We believe we can offer better products and we don’t intend to be going crazy in terms of discount.

We’ll see also in the next little while, how the Canadian currency has been applied. As of late the Canadian currency’s been a little bit plummeting which for us is actually a good news. In fact it can actually help us improve margin, improve profitability, so at this time we are not counting on this for our earning guidance for this quarter; we are not counting on that too much, but there is a little bit of an upside potential if the Canadian currency would be by an chance of luck going down or staying down where it’s at these days.

Deepak Chopra – Genuity Capital Markets

Could you remind us of the sensitivity for the company to $0.01 swing in the Canadian dollar?

Germain Lamonde

We can say that more or less, it’s about $700,000 per year per penny, for a full year basis onto the bottom line impact.

Pierre Plamondon

Before tax.

Deepak Chopra – Genuity Capital Markets

Before tax?

Germain Lamonde

So after tax, you can basically reduce that by about 30% or some.

Deepak Chopra – Genuity Capital Markets

When did the acquisitions close again, the exact date or did you have them for the full Q4 period?

Pierre Plamondon

Yes, we had the full Q4 for both acquisitions, both closed in Q3.

Operator

Your next question comes from Chris Umiastowski from TD Newcrest; please proceed with your question.

Chris Umiastowski - TD Newcrest

I just wanted to elaborate a little bit more with you on the weakness going into the current quarter on the revenue line. So Germain just to clarify, excluding Verizon would you expect a sequentially up quarter in sales?

Germain Lamonde

If we exclude Verizon yes, things are really looking good.

Chris Umiastowski - TD Newcrest

And then can you remind me, I missed the exact number you gave on the call, but for the quarter rather than for the full-year, how much did Verizon represent?

Pierre Plamondon

For the whole year Verizon represented 7.4% for sales.

Chris Umiastowski - TD Newcrest

No, I wanted the number for the full quarter though?

Pierre Plamondon

$15.8 million

Germain Lamonde

No, 4.3% for the quarters.

Germain Lamonde

So basically what’s happened at Verizon is they were pretty much on a reducing ramp from the first to the fourth quarter fiscal ’08 and that reducing ramp is continuing in the first quarter so far this year, but right now it’s more like a reducing ramp for like five quarters in a row now.

Chris Umiastowski - TD Newcrest

So, to get a sequentially up quarter excluding the impact of Verizon, I mean they would have to be 1% to 2% of your sales in the coming quarter, is that right?

Germain Lamonde

First of all if you go back and look at our numbers in fiscal ’08, we obviously talked about 20%, 20.2% growth year-on-year, that’s everything included. Now if you are excluding Verizon, basically our total growth for the business would have been at 37.3%. So, that’s our growth in fiscal ’08, if you are excluding Verizon. So that tells you that the growth of the business is actually quite strong.

Chris Umiastowski - TD Newcrest

Okay, all I’m doing is, I’m taking the fact that 4.3% of your sales for this quarter came from Verizon which is $2.2 million and I’m saying how much of that has to be gone in order for you to come in at least for the flat quarter excluding Verizon and basically the high end of your guidance $50 million, I’d have to assume that if all of the loss came from Verizon, basically the 50% haircut for that account which puts it at 2% of revenue will be low in order for you to actually have a sequentially up quarter without Verizon counting in there.

Germain Lamonde

I would almost venture to say that no matter how low Verizon would be, it is less and less meaningful, as you said its like 4% in the last quarter..

Chris Umiastowski - TD Newcrest

Well, that’s why I just want to verify that my math is correct hear, that you’re essentially counting on Verizon dropping by 50% in Q1.

Germain Lamonde

Well, I won’t give you the exact percentage by which they might drop but I would say they might drop quite substantially. If I’m just basing it on what we are seeing in the first six weeks, but again six weeks is not a full quarter, we’ll see. It’s difficult right now.

One element that we didn’t discuss on the call here is that when we are doing our first quarter prediction, the first half of the quarter typically tends to be a bit slow, we are back from summer vacation, we’ve got also internally some of our own international sales meetings, domestic sales meetings and so far so it’s a bit typically like a slow time and typically the second half of the quarter tends to be quite a bit stronger.

Typically in the second half of Q1 which ends basically from mid October to the end of November, which we haven’t had visibility on as of now is a time where typically there is year end money; this is where it’s going to come. So we can account this much this year on year end money; that’s given the overall environment and the question marks that are being asked and so on and so forth, we don’t think it will be prudent to be banking on strong year end money.

Chris Umiastowski - TD Newcrest

Okay, so does that explain why your guidance range for revenue is a bit wider than normal?

Germain Lamonde

Yes, being a bit wider is that in a way yes, to take that into account and also to the fact that keep in mind that we kept the spread to be the same from the time we used to be reporting 20 mills a quarter until now. So relatively speaking our spread got reduced by more than the factor of two overtime.

I also would like to say that as we are getting more and more into a system business with Brix and we think this is a great business to be in, but in system business sometimes you may have a bit more fluctuation on meaningful deals that you might actually not recognize revenue in a given quarter. Based on things sometimes it might be a little bit more like outside of your own control.

So that’s why in fact having a wider range is just normal, but keep in mind that percentage wise, that range that we are now giving of $5 million between the minimum and maximum is less than what used to be with $3 million or $4 million of range when we used to be at $27 mills a quarter.

Chris Umiastowski - TD Newcrest

So and then again I also wanted to touch on Verizon a bit more because my perception is that when you say on a conference call that you don’t believe you’re losing share, I think you probably have a lot of reasons for saying that, but unless you elaborate on them, some people are going to walk away feeling pretty skeptical all of that and wondering if you really are losing share and just aren’t willing to see it or admit it and so I was hoping given I know the kind of CEO you are, you’re really close to your customers, maybe if you could elaborate a bit more. Aside from the protocol business, what’s going on at Verizon that would give you a lot comfort and help them give us comfort, but you’ve really do have a strong footing with Verizon.

Germain Lamonde

Well, the bulk of our business at Verizon was for a long time, the Optical Test business and at the peak we went up to $27 million with them. I think we have had years up to $24 million or $23 million. I’m not going to give you an exact percentage, but the very vast majority of that was actually optical test equipments.

Now, within this optical test equipment business, that has been going south for sure, there is no question and as I’ve said, we’ve been selling them so many instruments, I really wonder if they are all being used, but I’m just teasing a little bit here, but we sold them a number of instruments. Now that’s where we’ve been impacted. We’re not losing deals in optics; clearly we are firm believers that we own that business. There is all evidences towards that unless the small things, like some of your small accessories, but fundamentally we own the business very largely.

Now, we use to be pretty much a no-show when it came to protocol test business, it’s not the case anymore. So, now we are much more successfully entrenched into protocol test solutions, we got through our protocol walls and we are clearly making enroll to that account. I’m not going to say that we own that account, in fact we’re clearly sharing this account, but where EXFO was outside looking in, now we’re inside and expanding.

So fundamentally, I think that our businesses are growing and we think that other businesses within EXFO that will also be benefiting from that as well both services assurance, Brix and Navtel and so forth, so we think that our position is quite strong.

Chris Umiastowski - TD Newcrest

Okay and then maybe I’ll just ask one more before I turn it over. Can you give a sense of what do you think of the 40-gig and I guess the 100-gig; it’s probably a bit too early for that given that’s just trials, but 40-gig seems like it’s starting to roll a little bit? How is that impacting your interaction with customers? Are they starting to ask for solutions around that in any kind of material way?

Germain Lamonde

Well, I would say this is still early in the game, but clearly we are making gains, we’ve got significant product approvals, Tier-1 accounts that have approved our 40-gig solutions. We have clearly best solution for our protocol test solution in 40-gig, operators are increasingly looking into it now and starting to deploy commercially systems at 40-gig.

We are will entrenched, well positioned and it’s starting to really help us growing our protocol test business and I think it’s going to continue to have a very positive impact, long-term in our protocol segment. We maintain organically 65% in three year CAGR, we reached last year 65% CAGR internally and 97% in Brix and Navtel. We think we’ll still be showing very good numbers in that segment moving forward, 40-gig is one piece of it.

Now 100-gig is further away, NEMs are at the early stage of designing, testing and everything. It’s at an area where we play today and I think we can say that we’re clearly working in that direction as well. We think this is an area that EXFO is going to take a position, but the market readiness for 100-gig in terms of substantial or meaningful market deployments; I think we’re more looking into sometime mid point 2010 or late 2010 for meaningful and commercial deployments.

I think still now we’re seeing experience, we are seeing operators deploying them, Verizon has reported on their use of the Navtel system and many, many other players are reporting on systems being used, Cisco is very active, many players are very active. So, we think this is a space that is coming, no question, we’re seeing a lot these days, but that’s going to come up in the field.

Operator

Your next question comes from Michael Urlocker from GMP; please proceed with your question.

Michael Urlocker – GMP

Germain, I’m sure you can appreciate, we are in or at least many investors perceive we are in a period of increased uncertainty regarding capital spending and anecdotally there have been reports of the commercial paper market drying up for such companies as even AT&T’s for a couple of day, a few weeks ago. So this kind of creates a presumption largely reflected in the collapse of equities of reduced outlook on capital spending and I wonder having been a survivor of the tech-rack where a lot of assumptions had to out of the door for a few years, I wonder if you could share with us, not a debate or a factual discussion about whether there is a slowdown, but instead if you could share with us how you plan to mitigate against the risk of that kind of severe compression on CapEx.

Germain Lamonde

It’s a very good question and as I said earlier, as of now besides Verizon, we’ve not experienced something that looks like a slowdown in CapEx or a slowdown in needs for our products. Now with that being said, I have to really make a big caveat; our products are not CapEx. They are typically fair in expenses, they are expense items. For the bulk of it, some of them are CapEx, like when we’re talking 40-gig and 10-gig type of test solutions, they would be CapEx, but typically they are not CapEx, they are $2000, $5000 and many of them are expensing them.

So, I’m not going to go in great details about which companies might be actually in default of getting enough money to fund their CapEx plans and everything, but we think that there is a clear need for them to spend money towards IP converged network because this is going to save them money in the long-term. So, you’ve got to invest now, but you’re going to reap the benefits over term and you’re going to win clients and you’re going to improve you margin and reduce your cost of operation and so on and so forth.

So, they’ve got it keep going and the one thing that’s quite unique about the EXFO is that there is quite a meaningful part of our business that is associated with that. All of our protocol business which will account to somewhere in the range of a third of our business in the next 12 months, is actually all about next-gen, there is no legacy stuff at EXFO that doesn’t exist and when it comes to optical test equipments while there is no such thing as next-gen or legacy, optical is all about bandwidth.

So, I think basically we are playing in the right things right now to be surfing the right ways in the marketplace. So, we think that what they are going to be going to fund their next-gen initiatives might be to the expense of legacy, but next-gen will get funded, so that’s why we should know.

Internally what we might be doing right now to prepare for, that is obviously we’re putting a very conscious look at any additional hiring; there’s no question. If there is any positions to be filled we are very, very careful about that and we are very careful about any discretionary expenses that can respond and increasingly we’re putting also some additional scrutinize and asking our people to find ways to reduce expenses. Whether it’s traveling expenses and so on and so forth, we’re trying to careful about where we go with being fiscally responsible, we are trying to be careful about this, but at this point, there is no reason for us in anyway to perform to plan for a staff reduction or any of that or any restructuring.

We think fundamentally what we’re seeing right now in terms of growth for the demand of our products; in terms of our booking growth so far, we are come in only six weeks so far in this quarter, but what we are seeing so far, it’s actually not looking bad, not looking bad at all. Now we are clearly going to be monitoring that situations very tightly, so no questions that we’ll be actually onto this like a frequent basis, but right now we don’t see a big need for that.

We have also made major initiatives in the last few years to help us be very cost efficient. As you know, we opened up a new manufacturing center in China, which is going to reduce our cost of operations. So, it’s reducing, it’s actually going in the right direction. Same way, we are increasingly now counting on more people in India to do some of our R&D work. Now globally, this is helping us to reduce the number of positions to be hired in the next 12 months in America, while this is in our Boston, Montreal, Quebec City of Toronto R&D centers, we tend to get more bangs for the buck going to India.

Michael Urlocker - GMP

I understand you are being cautious on hiring and that’s reasonable in prudent. I gather from my discussions in the industry that there is something like a flood of talented networking engineers and especially optical engineers emanating from places like Ottawa. Are you seeing an opportunity to add selectively better qualified staff?

Germain Lamonde

Well, we’re not going to just jump and hire people because they are available. We are really tracking and working according to our strategic plan. We’ve got basically clearly budgets and the risk is there. I think for the positions we decide to fill, we’re probably going to get easier access to top talents and yes, this is the case where the market is a little bit more open for employers that have got a good track record to bring on people.

I will say that, I would be misleading if I told you that something keeps us awake at night, the fact that there might be some turbulence to the marketplace, but I will say that we’re not seeing it, but we are managing, so that we can deal with it, if it does happen.

Operator

Your next question comes from Ajit Pai with Thomas Weisel Partners; please proceed with your question.

Ajit Pai - Thomas Weisel Partners

A couple of quick questions; I think the first one is, when your just looking at your Life Sciences and Industrial Division, I think you’ve talked about some weakness there because of selling into the cell phone market, if I heard that right. Could you give some color as to what you see happening in that business and would the intent to scale that business go forward or what you expect out of that business for the next couple of years?

Germain Lamonde

Well, I will say that we have some specific opportunities that we believe are very interesting to grow that business further. It’s a business that is not exactly our core business, so we’re not actively looking at setting it, but it’s a good business that is profitable, it typically has been providing us with tremendous growth. What we’re seeing short-term is a little bit more questionable, but we still believe that fundamentally we got a business there that should be providing some growth.

Is this something that fits within the EXFO model like for the next five years and 10 years that we plan to make investments in a big way and acquire businesses to build that division, the answer is no, but it’s not something that we think actually needs to be changed or what has it.

Ajit Pai - Thomas Weisel Partners

Okay, but the business right now, if you had to say it’s at corporate average EBITDA margins, you’d say it’s at corporate average or better?

Germain Lamonde

It’s a little bit better.

Ajit Pai - Thomas Weisel Partners

And then when you’re looking at the cost reduction program or rather in terms of shifting your production over to China to some of your SKUs, could you give us some metric, a measurable metric about how much has happened? When do you expect to get that fully done?

Germain Lamonde

Well, I will say that I don’t have really a specific metric. We got a few things we are measuring inside, but nothing really for communication, but I would say that we vary in the game. It was slightly negative to earnings in fiscal ‘08, because you’ve got all the ramp up costs to start with, but when it comes to fiscal ’09, it’s clearly going to be adding to the bottom line, it’s going to profitable and we think that over time, it’s going to be over a few years, but we’re going to eventually going through probably around 50/50 split between the two plants.

We’re nowhere near that yet, we’re still early in the game, but we’re going to ramp up, because the number of products you can actually transfer in a quarter, you can transfer that many new products if you’re really tracking and focusing on quality. We are long-term focused business. While we are outpacing the industry for growth, it would bring better market driven innovation and we’re servicing the heck out of our customers, which means that quality really matters to us.

So right now, I’m glad to say that despite we’ve opened our factory in China, our quality metrics has never been anywhere near that good. So, basically China is not negative to our quality, but we are taking the time to transfer products properly and at a certain pace, we’re not rushing.

Ajit Pai - Thomas Weisel Partners

To use that 50/50 metric in the future, do you know is that towards the end of your three year plan that you just laid out fiscal ’11 and also the 50/50, that number of units, is that in terms of revenue?

Germain Lamonde

Well, I think we’re talking about dollars and that’s within the three year time, I think you’re probably about right.

Ajit Pai - Thomas Weisel Partners

Okay. So, it’s three years and you’re talking about dollars?

Germain Lamonde

Correct.

Ajit Pai - Thomas Weisel Partners

Okay and then when you’re looking at the amount of cash you have in your balance sheet right now, so it’s a much better position going into this downturn, you’ve also buffed up your business in terms of scale through in your acquisitions. Right now how would you prioritize the uses of cash in a go forward basis?

Germain Lamonde

Well, we have obviously a program to buyback some shares that could potentially use some cash. We’re not saying that we would not be doing acquisitions. In fact, we think it might be a good time to make great deals; I think it’s more the buyer’s time. When you’re looking at multiple these days, at these type of multiples I would buy great businesses, so we could do some good acquisitions, but again it’s a buyers time so with buyers prices.

As far as us managing our cash more wisely, we’ll be paying more attention to generate more cash from that operation and we think fundamentally that it’s great at this time, at this juncture to have a good cash position; cash is king as you know.

Ajit Pai - Thomas Weisel Partners

Last question, when you’re looking at the Brix acquisition that your folks made, could you give us some color as to when you’re selling now into a different part of your customer base, even though it is your core customer base; could you give us some color as to the challenges and achievements, the positive surprises you’ve had with that business once it’s become a part of EXFO?

Germain Lamonde

Well, I would say that if there is one surprise, it’s that we’re surprised to which degree they have a tremendous product offering. We think technically, they are still the leader in the marketplace. We think that this market segment is extremely important in the long-term. I like the fact that obviously some of their business is with the wireless operators, which used to be not too much of a segment for EXFO, so it’s helping us expanding the wireless segment now and so it’s more like good news and bad news I would say.

I like the fact that now we can claim that some deals that they may not have won on their own would actually be able to convince the clients now, because they are a part of a bigger organization that’s got money in the bank. I think it’s actually quite good. I’m quite pleased with that.

Ajit Pai - Thomas Weisel Partners

But any wins that you can talk about?

Germain Lamonde

No, I’m not going to talk about any wins now, but stay tuned you might actually be reading some press releases.

Operator

And we have a follow-up question from the line of Michael Urlocker from GMP; please proceed.

Michael Urlocker - GMP

I wonder if Germain you could just give a little bit of descriptive observation of how was progress in the consoltronics business?

Germain Lamonde

Well actually, I was mentioning on the call earlier that we were down I think somewhat 3% year-on-year in terms of revenues. Well actually it might sound like bad news, well the answer is no, actually I’m pleased. Now, we’re starting to see a few good things, a few good signs.

I’ve been keeping my fingers on the pulse of how are the new products that EXFO has introduced in the marketplace since we’ve acquired the business. How these products announce the tracking in the market. What we’ve seen in the last 12-months is a shift and as we’ve announced basically new products early into fiscal ’08, we’re starting to see customers to drop the purchase of the old legacy products and we’ve seen basically sometimes the same customers or new customers adopting our new solutions. So that’s quite positive.

The second very positive news, when we bought the business, I’m not going to give a percentage, but they were very highly concentrated on three accounts only. These three accounts in fiscal ’08 were a far smaller piece of the business. We’ve been able to gain a large number of new accounts that are extremely exciting and I will say also that now we’ve got a product offering that’s extremely competitive and very focused on the trend in the marketplace that the large Tier-1 leading technology operators are looking for.

We are working right now with customers on large deals with a vision of creating basically a link between instruments and systems and a vision of creating basically the smart use of access equipments to create the most advanced networks of the future. So, we think we’re very well positioned actually and I think that this is a segment that now will really get going now and get growing.

Michael Urlocker - GMP

Our sense when we talked to a number of customers was that the products were very impressive to your customers, the new products and so we’re kind of anxious to see that in the results and I guess your indication is you’re making a good progress towards that.

Germain Lamonde

Correct, if I say that maybe we have not grown the total revenue last year, I can tell you that the adoption rate of these new products is quite fun, is quite great and we’re working on bigger deals, we initially were talking to Tier 3 and gradually we got to talk to Tier 2 and we are now starting to talk with Tier 1. What we really are experiencing with this now is pretty much the same as we did with protocol test business where we took the time to reinvent the product line to make it the best in class and then we start to experience very solid growth.

Our growth in our protocol test business is traditionally what we call the transport and datacom test business has grown 65% CAGR in the last three years, particularly in our very major business and I’m not going to say that 65% is our number for access, but we think that we can actually grow the business quite substantially on a long-term.

Operator

There are no further questions at this time.

Vance Oliver

For those people who joined us late and like to listen to a replay of the conference call, the phone number is 402-977-9141 and the reservation number is 21393109. It will be available one hour after this conference call until 7:00 pm on October 22. A replay of this conference call is also available on EXFO’s website at www.exfo.com under the Investors section. On behalf of the entire EXFO team, thank you for joining us today.

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Source: EXFO Electro-Optical Engineering, Inc. F4Q08 (Qtr End 08/31/08) Earnings Call Transcript
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