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Zhone Technologies Inc. (NASDAQ:ZHNE)

Q3 2008 Earnings Call

October 21, 2008 5:30 pm ET

Executives

Morteza Ejabat – Chairman of the Board, President, Chief Executive Officer

Kirk Misaka Chief Financial Officer

Analysts

Eric Kainer – ThinkPanmure, LLC

Greg Mesniaeff – Needham & Company, LLC

Presentation

Operator

Good day, and welcome to the third quarter 2008 Zhone Technologies Incorporation conference call. I am Emmanuel and I will be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question-and-answer session towards at the end of the conference. (Operator's instructions) As a reminder this conference is being recorded for replay purposes.

I would now like to introduce Kirk Misaka, Zhone’s Chief Financial Officer. Please proceed.

Kirk Misaka

Hello and welcome to the third quarter 2008 Zhone Technologies Inc. conference call. I am Kirk Misaka, Zhone’s Chief Financial Officer. The purpose of this call is to discuss Zhone’s third quarter 2008 financial results as reported in our earnings release, which was distributed over Business Wire at the close of market today and has been posted on our website at www.zhone.com. I am here today with Mory Ejabat, Zhone’s Chairman and Chief Executive Officer.

Mory will begin by discussing the key financial results and business developments of the third quarter. Following Mory’s comments, I will discuss Zhone’s detailed financial results for the third quarter and provide guidance for the next quarter.

After our prepared remarks, we will all conclude with questions and answers. As a reminder this conference is being recorded for replay purposes and will be available for approximately one week. The dial-in instructions for the replay are available on our press release issued today. An audio web cast replay will also be available online in www.zhone.com following the call.

As you know, during the course of the discussion today we will make forward-looking statements including those related to projections of profitability, earnings, revenue, margins, operating expenses or other financial items. The anticipated growth and trends in our business, product lines or key markets, new product introductions and the migration of customers to newer technologies, Zhone’s market position and focus and statements that express our plans, objectives and strategies for future operations.

We would like to caution you that actual results could differ materially from those contemplated by the forward-looking statements. We refer you to the risk factors contained in our SEC filings at www.sec.gov, including our annual report on form 10K for the year ended December 31, 2007, and our quarterly reports on form 10Q for the quarter ended March 31, 2008 and June 30, 2008.

We would like to caution you not to place undue reliance on any forward-looking statements which speak only as of the date on which they are made and we undertake no obligation to update any forward-looking statements.

During the course of this call, we will also make reference to pro forma EBITDA and pro forma operating expenses. Non-GAAP measures, we believe are appropriate to enhance an overall understanding the past financial performance and prospects for the future. These adjustments to our GAAP results are made with intent of providing greater transparency to supplemental information used by management in its financial and an operational decision making.

These non-GAAP results are among the primary indicators that management uses as a basis for making operating decisions, because they provide meaningful supplemental information regarding our operational performance and they facilitate management’s internal comparison to the Company’s historical operating results and comparisons to competitor’s operating results.

The presentation of this additional information is not meant to be considered an isolation or as a substitute for measures of financial performance prepared in accordance with GAAP. We have provided GAAP reconciliation information for pro forma EBITDA within the press release, which as previously mentioned has been posted on our website at www.zhone.com.

With those comments in mind, I would now like to introduce Mory Ejabat, Zhone’s Chairman and Chief Executive Officer.

Morteza Ejabat

Thank you, Kirk. Good afternoon, and thank you for joining us today for our third quarter 2008 earnings call. Let me briefly discuss the financial result before providing an update on the business.

For the second consecutive quarter, economic conditions proved to be challenging and cause us to miss our revenue and margin guidance. Revenue was $32 million, equal to our recently updated guidance of approximately $32 million, but below our earlier financial guidance of between $36 million and $37 million. So, the revenue shortfall was attributed to the global credit contraction which caused many of our customers to defer or reduce their network expansion plans.

With the revenue shortfall, gross margin, pro forma EBITDA and cash flow were also negatively impacted on the short term basis. Until the economic environment improves we will continue to reduce operating expenses and improve gross margin by reducing the cost of our products. Kirk will give you more details on our financial performance and guidance later.

Before turning to the business side, let me bring you up-to-date on the status of our NASDAQ listing. As you know, we decided to do a reverse stock split in order to

regain compliance with the $1 minimum per share bet price required for continued inclusion on NASDAQ global market.

You may recall that NASDAQ has given us until December 8th to regain compliance. Recently, we also temporarily suspended the minimum bet price requirement until January 16, 2009. At our shareholders meeting on October 16th, our shareholders approved the reverse stock split up between 1-for-5 and 1-for-10. They planned to proceed with the process to complete the reverses stock display and regain compliance fairly in advance of the deadline.

Now let me talk about our business. On products and customers, this quarter we announced training releases targeting the good areas in the market. For the FTTx application using video as a tool in the last 300 fee, we launched the Bitstorm HP, a 24 Port one year platform that support symmetric 100 megabits per second services over single copper pairs. HP support the default play services in multi-building unit in a private to denote applications. For operators, it was involved get in to a port for the leverage of the copper loss or [inaudible] distances.

We also launched the Bitstorm RP, a platform that provides up to 45 megabit per second of ADSL2+ connectivity over two-bonded copper pairs supporting robust rates of distances up to three months. We also released a major offer to our unique SMLS access operating system, the common sort foundation for our full range of access for phone factors and service price. SMLS version 1.14 includes new capabilities for advanced networking, quality of service control, more into interoperability and security. These software features are critical to adjusting the needs of our customers in all regions we serve.

As they continue to adopt most sophisticated network and technologies such as GPON, EFM, video sale tool, [inaudible] ADSL2+. These past quarters, there are number of cost servings and in every case the selection of Zhone for the next place of the access network was base on our online single platform for forward-looking access technologies such as GPON and active, as well as magazine enterprises such as OSDN.

Now, I would like to turn the call to Kirk to provide more details about our financial results for the last quarter and to discuss our financial guidance for next quarter. Kirk.

Kirk Misaka

Today’s Zhone announced financial results for the third quarter of 2008. In our press release the traditional comparison of financial results for the third quarters of 2008 and 2007 is presented alongside a comparison to the second quarter of 2008. As we have done on previous earnings calls most of our discussion today will focus on the sequential comparison to second quarter results.

As Mory mentioned, revenue for the third quarter of 2008 was just go over $32 million, which met our revised guidance but fell short of our original financial guidance of between $36 million and $37 million. Global economic weakness affected both our domestic and international businesses.

We continue to serve approximately 700 active customers worldwide and experienced less customer concentration as compared to the past. We did not have any 10% customers and our top five customers represented approximately 30% of revenue for the third quarter as compared to 37% for the second quarter.

Third quarter revenue was $32 million declined by 20% when compared to second quarter revenue of $40.1 million. Until global economy begin to improve, we do not believe we can sustain consistent revenue growth, therefore we are forecasting that fourth quarter revenue will be basically flat at approximately $32 million.

As for growth margins, they improve to 30.1% for the third quarter of 2008, despite the lower revenue level because we anticipated the sales weakness earlier in the quarter and we are able to partially but not fully reduce our manufacturing operations. Going forward, we have further adjusted our variable manufacturing labor and other costs to the lower revenue forecast and therefore expect margins to improve to between 31% and 33% for the fourth quarter.

As for operating expenses, total pro forma operating expenses for the third quarter of 2008 were $15.4 million approximately $2 million less than last quarter and within our $15 million to $16 million guidance range. Pro forma operating expenses excluded approximately $400,000 of expenses related to reduce in the work force and operations to match the lower revenue level.

Operating expenses included depreciation of approximately $400,000 and stock-based compensation of approximately $600,000. As Mory mentioned, we will continue to reduce our operating expenses until our revenue outlook improves. We anticipate total operating expenses for the fourth quarter of 2008 to drop to between $14.5 million and $15.5 million including approximately $1 million for the expenses, for depreciation and stock-based compensation.

Finally, pro forma EBITDA for the third quarter of 2008 was a $4.6 million loss and larger than our estimate of EBITDA loss of between $2 million and $3 million. We expect the pro forma EBITDA loss for the fourth quarter to range between $3 million and $4 million with the goal of returning to break even quarterly pro forma EBITDA some time in 2009.

As for the balance sheet, cash and short-term investments at September 30, 2008, were $41.3 million which declined from $50.1 million at June 30, 2008, mostly attributable to the EBITDA loss and other working capital changes occurring during the third quarter. Our total debt obligations remained basically flat at $34.2 million on a combined basis our net cash balance or cash net of debt obligations decreased from $15.8 million at the end of the second quarter, $7.1 million at the end of the third quarter. Again, as a result of the EBITDA loss and other working capital changes occurring in the third quarter.

As for other balance sheet changes, inventory levels increased from $37.2 million as of June 30, 2008 to $42.9 million as of September 30, 2008. As we added material for new product introductions and ended the temporarily, excess material related to our higher revenue forecast, while accounts receivable decreased by $3.7 million to $26.6 million at September 30, 2008 but the number of day sales outstanding on accounts receivable for the third quarter coming in at 75 days as compared to 68 days for the second quarter.

Finally, the average basic and diluted EPS shares were 150.4 million for the third quarter, increasing only slightly from the 150.3 million in the second quarter. The slight increase resulted primarily from stock option exercises by management and employees. With that financial overview, I will turn the call back to Mory for a few final comments before we open the call up to questions and answers. Mory.

Morteza Ejabat

Thank you, Kirk. A new product releases and customer wins were unfortunately overshadowed by weaker than expected financial performance. The third quarter proved to a challenging as the global credit contraction caused many of our customers to delay or reduce their plans to expand their networks. I think global economies improve. We do not foresee sustainable revenue growth. However, we hope to be able to return to work even our positive cash in the pro forma EBITDA some times in 2009. Until then we will continue to work hard and we will soften the expenses in order to minimize losses and cash loss. Thank you for joining us today. We will now open the call to questions. Operator, please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of [inaudible]. Please proceed.

Analyst

Okay. When you comment on earning calls; we have some percentage of the new quarters revenue are coming from. What is the typical level of revenue visibility and how does that compare to third quarter?

Morteza Ejabat

Will you repeat your question and said it slightly. Hello.

Analyst

Hello.

Morteza Ejabat

Will you repeat your question again please?

Analyst

Sure. When you comment to an earning call where some percentage of the new quarters revenue are coming from. What is the typical level of revenue visibility and how does that compare to third quarter?

Morteza Ejabat

Okay. When we started quarter, we really our business is both on shift with in the quarter or whatever they both shift so the visibility is very narrow, majority of our business in our third months of the quarter. So that is where we have the hard case taken to quarter, in comparison to the last quarter, we are still the same position. That is why we are forecast in a flat work.

Analyst

Okay. One more question. Is there any new tactics that carriers are using to fund their projects?

Morteza Ejabat

Are there any new carrier tactics --

Analyst

Tactics they are using to fund their projects?

Morteza Ejabat

Okay. I have to ask this question again. Are there any new carrier tactics?

Analyst

Yes.

Morteza Ejabat

Can you explain that please?

Analyst

Sure. My question is that, are there any new tactics carriers are using to fund projects?

Morteza Ejabat

Oh, yes. The carriers are funding projects base on their needs today, and normally it is base on the areas that they are trying to offer new services either like PTV or EFM or FTTx. These are the new projects that carriers are looking at and if there is no requirement for those, they do not deploy any thing.

Analyst

Okay. I would like to add one more question on that…

Morteza Ejabat

Okay.

Analyst

Have you seen more constancy from bigger or smaller customers from geography or any of their helpful insights in to more optimistic or pessimistic market segments?

Morteza Ejabat

We see a globally cautious approach to deploying product or services in the region with the exception of Middle East. We see some improvement over there.

Analyst

Okay.

Morteza Ejabat

Alright. Next question.

Operator

Your next question comes from the line of Kainer, Eric. Please proceed.

Eric Kainer - ThinkPanmure, LLC

Hi there. This is Eric Kainer with Needham & Company calling for Greg Mesniaeff.

Morteza Ejabat

Sure.

Greg Mesniaeff – Needham & Company, LLC

Hi quick question. Can you give us an update on your SkyZhone product and how that product is ramping in Q3? I think in the last call you said that it was really going to pick up in Q1. How is that tracking along as of now?

Morteza Ejabat

It is meeting our expectation. This is the wireless raise that the services provide their offer remarks platform and they use it for several different applications from online security to opening internet access. They are things some movement but not as much as the anticipated for Q3. There has loss of charge, we have having loss of charge in different countries and different regions but when they materialize it is remain to a scene with this sardonic situation.

Greg Mesniaeff – Needham & Company, LLC

Okay. I got it. Another question. Some of the weakness that is saw in Q3 with the international fails, was that one geography in particular over that? I think you said, you sold a little but it would waited more towards one to another?

Morteza Ejabat

No. It was not. As I mentioned, Middle East was doing very well, in South America and South Asia, and European countries there is so some problems over there and lots of our customers got the require EFP payment of letter of credit, could not get their letter of creditive process or current globe financing.

Greg Mesniaeff – Needham & Company, LLC

Okay. Great. Thank you very much.

Morteza Ejabat

Sure. Next question.

Operator

Your next question will come from the line of Chad Smith, Smith Capital. Please proceed.

Chad Smith - Smith Capital, LLC

Excuse me. Hi, guys. How are you doing? Thanks for taking call.

Morteza Ejabat

Sure.

Chad Smith - Smith Capital, LLC

I got it. A couple of questions and really they have more to deal with kind of the big picture and not so much with regard to trends are seen in the market place or the overall malaise that were experiencing economically. But with all do respect, I mean, obviously the macro economic environment affecting every body and now that is affecting you as well. But unfortunately, I am afraid as we are look at things, as we really work of things. Well elastically, I do not know if you guys have the time at this particular moment to going to way out to the storm as it were going to waiting for the general global economic environment to pick up. I know look at your situation analysis with the balance as it is, and you guys have been a great job. I am really trying to be good stewards of every thing. I am going to considering a situation but with the net cash position where it is, and the burn rate that you guys are experiencing. I am getting a little bit concerned about what the in gain is distribute in a moment with day sales outstanding and if any other further problems come with respect to credit availability with some of your customers and push out continue. Now the trend has been continue, I know you are guiding level for this quarter, which is great. But the trend has been, you guys, it come in later on the quarter in guide lower even further and I am going to little concerned about the, a couple of quarters out, we were going to in some, you guys, burning if your net cash to take it down to a negative net cash position.

So my really question really is, have you guys been thinking about the physically with the very attractive product line that you have and I want to comment on all you have continue put out there in terms of innovative products? But as sustain the learn entity, as a stand in an operation. How much longer can you holdout in the financial position that you are in? Going to waiting for the overall global economic environment to pick up and I really want to see you guys making and turn the thing around but I am just really trying to get a feel realistically.

Morteza Ejabat

Well, let me – you have lots of questions. So let me try to see if I remember to answer them all. First of all you mentioned that we come at the end of the quarter and the things done. That is correct. But if you look at the past several quarter. We have been really the indicator of what is happening in the industry and if we announce to third quarter, all of our competitors or majority of the competitors would do the same. In spite of today’s audit standing, just understanding the DSOs, we had one customer that owed us a large amount of money in the Middle East but I do not know if you know or not, at the end of the quarter it was a Holiday in the Middle East and the bank did not process the payment. They got the payment. They are anticipating our DSOs to go down this quarter by a good magnitude.

The other thing is, as we have mentioned and we continue doing so, we improved our operating expenses and gross margins. And we believe, we have a good run rate today as we look at the industry to a safe, in a good cash position until the storm is over. Did I answer all your questions?

Chad Smith - Smith Capital, LLC

Yes. But let me just follow up, if you do not mind, are there any provisions in your current debt instruments that having kick in clause if you guys going to a negative net cash position, I mean, if no, you look at – your cash position is okay right now. But if you look at again as you reconcile your net cash. It is going to down to worth $7.5 million, I think that was you said. But you guys get in the position where the ratio was there, are certain to diminish because a couple of quarters and negative cash burned. Does that kick out or get anything with you’re your loan covenances?

Kirk Misaka

Chad I will take that, this is Kirk. The majority of our debt, about $20 million, is mortgage on our campus, and that provision is only pictured by the campus and has no cash requirements or liquidity requirements. The line of credit that we have, up to 15 million is with the bank. It has a liquidity covenant of 1.5 times, our cash and the accounts receivable and that liquidity covenant will run in compliance. And if I just have to make a comment, our campus is worth more than what our mortgage is.

Chad Smith - Smith Capital, LLC

Alright. Okay. And then finally just kind of this respect, when respect to that general question asked about, when I said the word as in the independent going concern. Again I got to talk about with you another point in the past Kirk. But with your product line that you have, again, I believe in very enviable product line that you currently have and you continue to create new products and innovation there. And the diversity of your customer base, all that is wonderful but strategically I am going to feel, for you guys, had begun to think about strategically –does it make more sense for you to look at strategic options maybe again?

Morteza Ejabat

We do all the options and opportunity and with the environment, I do not know who the great strategic partner for us. If we have any crystal ball, I would like to hear that.

Chad Smith - Smith Capital, LLC

Well, I will try. I am going to say one last question that is the best trigger point and again, market capitalization being down where it is, obviously, this is a little bit of stretch to what it is now but what is your annualized, if you can come up with just a rough estimate, where does it annually cost you guys to continue on as publicly traded entity in terms of all the cost related to obviously SEC filings and certain docs and compliances, etc, etc? What is all of the aggregate cause of that on an annualized basis amount to the company and the reason I asked is that number relative to your market capitalization is probably a pretty ridiculous number right now.

Morteza Ejabat

It is a pre-large number. It is just shy of a million dollars annually to comply with the internal and external cost.

Chad Smith - Smith Capital, LLC

Okay. So I just threw it out there as you know, as a percentage of market capitalization that particular ratio would arguably kind of point to the question - does it make any sense for you guys to continue to be publicly traded when you have to deal with all the headache, when you to deal it or yet. You have got potentially a lot of good opportunity ahead of you from a business standpoint.

Kirk Misaka

Chad, we are here for a long run. We are not here for today or tomorrow or take advantage of it, $1 million saving and do other things. We are here for a long term. We know, as you mentioned, we have a great product. We have a great customers, the customers sales are really in kind of economic turmoil. I am sure they are going to come out of it. The economy is going to improve. The small businesses are going to get going again either domestically or internationally and it is where our products will be and where the customers have to use our product and we will work on it. So we are looking at in a long term not in the short term.

Chad Smith - Smith Capital, LLC

Okay. That is for me. Thanks for a lot for your answers, I appreciate it.

Operator

(Operator Instructions). At this time, there are no more further question in Q&A. I would now like to turn the call back over to Mory Ejabat for closing remarks.

Morteza Ejabat

Thank you again for joining us today. We appreciate your continued support and looking forward to speaking with you on our next conference call, when we hope to announce improved financial performance. Operator?

Operator

That concludes the presentation.

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