Ixia Q3 2008 Earnings Call Transcript

Ixia (XXIA)

Q3 2008 Earnings Call Transcript

October 23, 2008, 5:00 pm ET

Executives

Brent Novak [ph] – VP, Finance

Errol Ginsberg – Chairman and Chief Innovation Officer

Atul Bhatnagar – President and CEO

Tom Miller – CFO

Analysts

Matt Robison – Pacific Growth Equities

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the Q3 2008 earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. Please note that this conference is being recorded.

I will now turn the call over to Mr. Brent Novak [ph], Ixia's Vice President of Finance. Mr. Novak, you may begin.

Brent Novak

Good afternoon and thank you for joining us on today's conference call to discuss Ixia's third quarter results. This call is also being broadcast live over the web, and can be accessed in the Investor Relations section of Ixia's website at www.ixiacom.com for 90 days.

With me on today's call are Errol Ginsberg, Ixia's Chairman and Chief Innovation Officer; Atul Bhatnagar, Ixia's President and Chief Executive Officer; and Tom Miller, Ixia's Chief Financial Officer.

After the market closed today, Ixia issued a press release discussing the results for its third quarter ended September 30, 2008. We would like to remind you that during the course of this conference call, Ixia's management may make forward-looking statements including financial projections, statements as to the plans and objectives of management for future operations, and statements as to the company's future economic performance, financial condition, or results of operations.

These forward-looking statements are not historical facts, but rather are based on the Company's current expectations and beliefs. Words such as "may," "will," "expects," "intends," "plans," "believes," "seeks," "estimates," and variations of these words are intended to identify forward-looking statements. The company's actual results may differ materially from those projected in these forward-looking statements.

With that said, I'd now like to turn the call over to Ixia's President and CEO, Atul Bhatnagar. Atul?

Atul Bhatnagar

Thanks Brent, and thanks everyone for being on the call.

During the third quarter, we generated revenue of $47.3 million, non-GAAP earnings of $0.10 per diluted share, and GAAP earnings of $0.01 per diluted share. Overall, we had a solid third quarter as we grew revenue 3% over the second quarter, achieved non-GAAP gross margins of 81.2%, and kept our operating expenses flat with the prior quarter. As I will discuss more fully later in the call, our third quarter results were characterized by improvements in our service provider and government sectors.

Software revenues also increased to the highest level in three quarters to help bolster our gross margins. We announced some exciting product developments during the quarter centering on our industry leading 40-gigabit and 100-gigabit Ethernet test initiatives. We also launched TESLA, our industry-wide test automation initiative, and announced some important enhancements to our IxLoad software, but more on those topics later, I'm now going to ask our Chief Financial Officer, Tom Miller, to go through the third quarter financial results.

Tom Miller

Thank you, Atul.

I should mention that unless specifically noted otherwise, we are discussing all numbers on a non-GAAP or pro forma basis prior to non-cash charges for the impact of stock based compensation, amortization of acquisition-related intangible assets, and an impairment charge related to certain investments, as well as the related income tax effects of such items.

These non-cash charges in the third quarter consists of $2.4 million related to stock based compensation, $1.4 million for the amortization of acquired intangible assets, $4.3 million impairment charge on our holdings of Lehman Brothers bonds, and a net tax benefit of $2.2 million related to these items.

A full reconciliation of the non-GAAP financial measures covered in this call to the most directly comparable GAAP measures is available in the Investor Relations section of our website at www.ixiacom.com.

Total revenues for the third quarter were $47.3 million, which compares to $45.9 million in the immediately preceding second quarter of 2008, and $44.0 million in the third quarter of last year. Interface cards accounted for 68% of our revenues. Software accounted for 18% of revenues, and the remaining 14% represented revenue from chassis, warranties, and other products.

From a geographic perspective, domestic revenues represented 65% of our total revenues with Canada representing 6%, EMEA 13% and AsiaPac 16% of revenues.

From a customer perspective, 52% of our revenues in the third quarter came from network equipment manufacturers, 18% from service providers, a combined 16% from enterprise, university, and government customers, and 14% from distributors, communication chip manufacturers, and other accounts.

Our top 5 non-distributor customers represented approximately 37% of revenues in Q3 and included Cisco, AT&T, Alcatel Lucent, Juniper, and Hewlett-Packard. Sales to Cisco, our largest customer, were $9.2 million representing 20% of revenues.

Non-GAAP gross margins were 81.2%, up 220 basis points from 79% in the second quarter of 2008, and above our target range for non-GAAP gross margins of 78% to 80%. The higher sequential gross margins were due in part to product mix as we saw a nice sequential increase in software sales. We expect that our non-GAAP gross margin to be in the 78% to 80% range for the fourth quarter of 2008.

Non-GAAP operating expenses in the third quarter of 2008 were $31.3 million, slightly below the $31.4 million recorded in the immediately preceding second quarter of 2008. As a percentage of revenue, operating expenses were 66.1% of sales in the third quarter compared to 68.4% in the immediately preceding second quarter.

As we held operating expenses relatively flat, the decrease in operating expense percentage is primarily due to the sequential increase in revenue. We will continue to focus on controlling the growth of operating expenses in Q4.

R&D expenditures were 24.5% of revenues in the third quarter, down from 25.6% for the immediately preceding second quarter. In dollar terms, R&D expenses decreased by $139,000 from the immediately preceding quarter due in part to lower travel costs.

Sales and marketing expenses represented 28.9% of revenues in the third quarter of 2008, down from the 30.9% for the immediately preceding second quarter. In dollar terms, sales and marketing expenses decreased by $474,000 from the immediately preceding quarter primarily due to lower sales force training costs not incurred in Q3 when compared to Q2.

G&A expenses represented 12.6% of revenues in the third quarter of 2008, up from 11.9% for the immediately preceding second quarter of 2008. In dollar terms, G&A expenses increased by $508,000 sequentially from the second quarter due mainly to higher professional fees.

On a year-over-year basis, GAAP net income for the third quarter of 2008, which includes stock based compensation charges, amortization of acquisition-related intangible assets, and impairment charge – and an impairment charge, was $483,000 or $0.01 per diluted share compared to a net income of $1.9 million or $0.03 per diluted share for the third quarter of 2007.

Third quarter 2008 non-GAAP net income, excluding the effects of non-cash charges and related tax effects, was $6.3 million or $0.10 per diluted share. This compares to $5.8 million or $0.08 per diluted share for the same period last year.

The non-GAAP effective tax rate, which is the ratio of non-GAAP income tax expense to non-GAAP pretax income, decreased to 25.9% in the third quarter of 2008 from 34.4% in the second quarter of 2008 due to the release of FIN48 liabilities as certain statutes or limitations expired in the third quarter of 2008.

For the fourth quarter of 2008, we expect the non-GAAP effective tax rate to be in the 23% to 30% range as we expect to record additional research and development credits related to the recent renewal of the applicable federal legislation.

Now, turning to the balance sheet, cash and investments were approximately $217 million at September 30th, which compared to $221 million reported three months earlier. Cash flows from operations for the third quarter of 2008 were $5.4 million compared to $11.0 million in the immediately preceding second quarter. Capital expenditures for the third quarter of 2008 remained flat at $2.3 million when compared to the immediately preceding second quarter.

Accounts receivable increased from $35.9 million on June 30th to $37.2 million as of September 30th. Based on trailing figures, our day sales outstanding increased slightly to 72 days from the 71 days reported three months earlier.

Inventory increased on a sequential basis from $9.7 million to $11.5 million at September 30th. This trailing inventory balance equates to a turnover of 3.1 times.

The number of full time employee equivalents as of September 30th was 797 as compared to 786 at the end of the second quarter.

Looking forward, while we continue to operate in a challenging economic environment, we did have a good third quarter and or sales funnel for the fourth quarter is strong.

At this time, we expect fourth quarter revenues in the range of $44 million to $48 million, and we expect fourth quarter revenues from Cisco to be $8 million to $10 million. We currently expect non-GAAP EPS of $0.05 to $0.08 per diluted share in the fourth quarter with comparable GAAP EPS estimates of breakeven to $0.03 per dilutes share.

The difference between anticipated GAAP and non-GAAP results relate to the expected non-cash charges and the associated tax effects including non-cash charges relating to stock based compensation.

We estimate at this time that our stock based compensation charges will be between $2.5 million and $3.0 million for the fourth quarter of 2008 on a pretax basis.

With that said, I would now like to turn the call over to Atul.

Atul Bhatnagar

Thanks, Tom.

As I said earlier, overall, we had a very good third quarter with regards to revenues and profitability. We saw incremental improvement in the US, driven by our service provider and government business.

Our software revenue dollars jumped back 24% over the second quarter driving our gross margins to a robust 81.2% and our non-GAAP operating margins to 15.1%. I want to discuss our third quarter results in detail and then I will address some of our exciting product initiatives that were announced in the quarter.

We had an excellent third quarter hitting our top line guidance and exceeding our earning guidance. Our strong earnings performance in the quarter was driven by a combination of our 81.2% gross margin and our tight control on operating expenses, which were down by approximately $100,000 sequentially from Q2. Gross margins in the third quarter benefited from an increased level of software revenues that accounted for 18% of our total revenues, our highest level in 3 quarters.

IxChariot and IxLoad, which I will talk more about in a moment, were both strong in the third quarter. We have implemented some specific demand creation sales and marketing programs to drive our IxChariot sales, so I expect to see an increase in Chariot revenues in the upcoming quarters.

With respect to Load modules, we have been able to drive costs down on some high volume cards, even with some decline in average selling prices, as is the norm in hi-tech. We have been able to increase our overall gross margins.

As Tom indicated, we expect our margins to be in the 78% to 80% range for the fourth quarter. However, we are cautiously optimistic that we may be able to realize some upside if we continue to keep our software sales high and drive down hardware costs even further. I am very pleased that we were able to hold our operating expenses flat this quarter even as revenues increased sequentially by 3%.

As I have stated before, with a head count of just under 800 people, we have the ability to meet new market challenges by redeploying existing resources rather than hiring new ones. Over the past several quarters, we have worked to reshape Ixia’s existing workforce to meet new market opportunities.

With the exception of the sales force, we have been very reluctant to add new staff. This expense discipline has resulted in an increase of non-GAAP operating margin to 15.1% this quarter. Our goal is to push operating margins closer to 20% or higher on a consistent basis, but that will come over time with higher revenues and continued expense control.

We continue to make key advances on strengthening our global sales force. Since the beginning of the year, we have made several important hires in senior sales management positions that have re-energized the sales force, and we have opportunistically made changes throughout the sales force in an effort to improve and expand on what was already a strong and professional group of sales people.

As we mentioned on prior calls, we have invested heavily in sales training in the first year, and we are starting to see the benefit of that training as we expand our market share. One area where we can see the impact of new hires and training is in the service provider sales acceleration.

Our service provider sales increased by 21% over the second quarter. We saw good results in both Europe and US. In Europe, BT led the way while in the US; AT&T delivered a very strong quarter and made our top five customer list for the second consecutive quarter.

One of the key reasons for this continued strength at AT&T is our investment in the sales force in both presales and post sales support. At a large diverse account such as AT&T, there are many groups that have a need for Ixia’s test solutions. We have dedicated sales personnel, both presales and post sales, to ensure that AT&T fully understands the products and get a maximum out of their investments.

With this increased focus on customer support and service, we have been able to achieve success within multiple functional groups and in multiple geographic locations. As we expand our service provider sales force, we will target additional large service providers, both in the US and abroad, with dedicated sales and service in an effort to replicate this success.

As expected, the government sector also contributed to our strong third quarter. This is in line with our historic trends for the government in the third quarter as they hit the end of their budgetary year. In fact, the government business, when combined with our strong global service provider revenues and the uptick we notice in the enterprise sector, help produce a solid quarter for our non-Cisco business.

We are continually finding new customers, new markets, and new industries that provide us opportunity for growth. And once again, this success outside of Cisco is driven by investment in our sales force. Having a focused, better trained, and more geographically dispersed sales team has allowed us to develop a more diverse customer base.

This diversity allows us to have a more predictable and balanced revenue stream and a larger addressable revenue base, but the true key to Ixia’s success and growth is product leadership. It is our goal to be out in front of new technologies and market trends. We want to be first to market with high quality, high performance products that lead the needs of this rapidly changing and evolving market.

While Frost & Sullivan has recognized Ixia as the leader in gigabit and 10-gigabit Ethernet test products, we have not stopped there. In the third quarter, we started to ramp up deliveries of our new IxYukon 10-gigabit Ethernet cards, and we have made some exciting product announcements regarding our 40-gigabit and 100-gigabit Ethernet test products.

Last quarter, I announced the introduction of IxYukon, our industry leading high-density 10-gigabit test platform. IxYukon is available with eight fully functioning 10-gigabit ports per card. This density translates with staggering 96 ports of 10-gigabit Ethernet ports per chassis, whereas our nearest competitor can provide only up to 24 ports per chassis.

This gives Ixia a 4-to-1 port density advantage along with a significant benefit with respect to the power consumption. This density is valued by developers and quality assurance engineers, as it leads to efficiencies in lab space utilization, power consumption, and test platform manageability.

I am pleased to announce that in the third quarter of 2008, Ixia increased its sales of 10-gigabit Ethernet by about 19% over the same quarter last year confirming our belief in the growth of this market.

The IxYukon family contributed strongly to Ixia’s overall sales. The IxYukon product line contributed a significant portion to our overall 10-gigabit Ethernet sales in the third quarter of 2008, its broad appeal continues to grow, and IxYukon is well on its way to becoming one of the leading products in Ixia’s portfolio by early next year.

As we are extending our leadership in the 10-gigabit Ethernet market, Ixia has again distinguished itself as the first company in the world to offer 100-gigabit high-speed Ethernet test solution.

In September, Ixia announced the world’s first commercially available 100-gigabit Ethernet test system designed to facilitate the rapid development and deployment of 100-gigabit Ethernet networks and equipment. Several large network equipment manufacturers are evaluating the purchase of this system and Ixia expects to shift the first 100-gigabit Ethernet Development Accelerator System in Q4 of this year.

Also in September, Ixia demonstrated its 40-gigabit Ethernet test system at the Broadband World Forum in Brussels, Belgium. Working with the leading service provides and equipment manufacturers, it has become very apparent that Ixia will be the leading vendor in both 40-gigabit Ethernet and 100-gigabit Ethernet high-speed Ethernet test markets. Our focus on high-speed Ethernet continues to underscore the prudent investment in core markets that will continue to expand Ixia’s market share in the years to come.

In addition to the strong leadership in the Ethernet market, Ixia continues to show great traction in applications testing space. Our IxLoad product, which services the multiplay application market, had another record breaking quarter. There has been a significant trend towards IP conversions in the industry.

Service providers all over the world have made significant investment in their infrastructure to offer multiplay services. Our timely investments to align with technologic trends in Triple Play, IPTV, Voice-over-IP, and application delivery services are beginning to pay off. Our IxLoad business continues to grow and we concluded the third quarter with our highest ever IxLoad revenues.

We are very proud to announce that Frost & Sullivan has recognized Ixia as the market share leader with 38.5% market share in the Triple Play market. This combined with our already leading market share in 1-gigabit and 10-gigabit Ethernet testing as reported by Frost & Sullivan in January 2008, recognizes Ixia as the comprehensive market share leader across layer 2 through layer 7 technologies.

Of particular interest in the application space is the recent success we have had in the voice-over-IP market. Over the past year, Ixia has invested in providing industry leading voice test services on our converged IP test platform. During the third quarter, we saw significant momentum globally with our voice-over-IP test solution, which is sold as part of IxLoad.

IxLoad has the ability to simulate real world problems which is exactly what our customers want to test realistically combining voice, video, and data together in one test environment. With Ixia’s solution, our customers are also able to create scenarios like malicious attacks and power fluctuations. This is a new paradigm in testing voice-over-IP services.

While continuing to build great products and expand our market share, I also want to share with you some of the key areas where Ixia is extending its thought leadership. In Q3, we launched a major industry wide initiative called TESLA in collaboration with key leaders in the IP test and measurement industry.

TESLA, which stands for Test Lab Automation is an open automation alliance that is bringing the industry together to advance the goals of test automation. This is an unprecedented move where industry participants are collaborating to solve complex challenges involving next generation networks.

Test of the open unified IP Test Automation Framework not only solves the multivendor interoperation challenge, but also promotes the use of efficient, standardized test practices. We expect this to benefit all members of the alliance as TESLA initiatives take IP Test Automation to a whole new level.

During September, we expanded our IxRave Service Verification Solution with the release of IxRave Voice that enables service providers to ensure voice-over-IP quality of service in a cost effective and intuitive manner.

IxRave Voice utilizes a unique probeless web-based system that is easily accessible at multiple levels of service provider organizations including field service technicians and network operation teams.

Service providers are seeking proactive software solutions that assure retention of their new and existing revenue streams while lowering their cost of operation. The IxRave Voice solution has achieved both of these goals in its first deployment in mid-sized cable operators.

IxRave Voice strongly complements our existing IxRave solutions that achieve tightly integrated and automated multiplay service verification for tier 1 and tier 2 residential and business service providers.

I want to close this call by addressing the current business environment and our guidance for the fourth quarter. Over the last several weeks, there has been a lot of uncertainty and volatility regarding the economic outlook. While a downturn in business can impact Ixia and its customers, we have always believed that we are somewhat insulated from the direct impact of a market downturn.

As we have always emphasized, Ixia’s products are more closely tied to product development and innovation cycle rather than our customers direct product sales and shipment. Our customers may pull back and cut some of their R&D related capital spending in a downturn, but they will still have a need to continue their new product development and testing so that they can maintain their competitive position in the market.

As our focus has always been on delivering testing capability for the latest emerging technologies and providing the highest level of support and service, we believe that we are very well positioned to sustain and grow our business in a difficult business environment.

Although, there is some uncertainly with the current quarter, we have given a wider range of expected revenue than normal. We are confident in our ability to deliver compelling new products and services in an effort to deliver continued growth for our shareholders.

Thank you very much for joining me. Operator, you may now open the line for Q&A.

Question-and-Answer Session

Operator

Thank you. We will now begin the question and answer session. (Operator instructions) Our first question comes from Matt Robison of Pacific Growth Equities. Please go ahead.

Matt Robison – Pacific Growth Equities

Hi Gins, a nice quarter, a couple of questions. First, why was inventory up so much?

Errol Ginsberg

I do not think there is any particular reason for that. I think that it was down a little bit the last few quarters and it just – it tends to ebb and slow a little bit, and you know, some of it is stocking up on Yukon where it was a new product for us. We launched it last quarter and we just wanted to, on that particular product, make sure we had enough in stock to meet demand, but I do not think there is anything really unusual about the level and I think it tends to go up and down a little bit.

Matt Robison – Pacific Growth Equities

It seems like it was one of the bigger factors that you are not achieving the level of operating cash for you since the June quarter?

Errol Ginsberg

Yes.

Matt Robison – Pacific Growth Equities

Regarding Yukon, I think it was 7% of sales in the June quarter. You did not say it in the September quarter, scared of (inaudible)?

Errol Ginsberg

No, we would rather not give out that number. It was up significantly from that and it is really – for people who want high volume, 10-gig, it is really the card of choice. We sell it in a 4 and 8 port form, and it is a very popular card, and it is doing quite well for us.

Atul Bhatnagar

Yes Matt, this is Atul. Another comment I will make is Frost & Sullivan will announce the 10-gig market share in Q1 of next year, sometime there, and you will see Ixia is accelerating very well in 10-gig sales.

Matt Robison – Pacific Growth Equities

Well, hopefully, you will also employ a high end of your guidance. So, why did the software rebound?

Atul Bhatnagar

Let me add a few things, and maybe Tom can add a few more comments. I think we definitely focused on demand generation on some of our software programs like IxChariot, and in a very focused manner reaching our installed base, reaching new customers, and I think that made a difference and those programs will continue.

Tom Miller

Right, and also, I mean, you will notice that in the quarter, government and carriers were higher sequentially and they tend to be big software buyers, more so than the (inaudible).

Matt Robison – Pacific Growth Equities

Yes, I recall that and, you know, there was kind of a mystery why it declined so much over in a year. I guess that that is the story, at least one of the moments of the story. Is federal, was that a big part of that enterprise and government?

Tom Miller

Yes, I mean, in Q3, we always see a surge from the government, and so it was part of the reason enterprise and government were up.

Matt Robison – Pacific Growth Equities

Sure, and is that also part of the reason why obviously that you don’t need a lot of specific reasons to be cautious with guidance in this environment, but is that – should we also attribute that the seasonality of federal to be part of the reason your guidance is significantly lower for the current quarter?

Tom Miller

That will be part of it. I think – it is lower, but it is wider, it is what it is.

Matt Robison – Pacific Growth Equities

Yes, sure.

Tom Miller

It is wider and higher and so it is really that like a lot of people were entering the quarter with some uncertainty, we are seeing a good funnel and we are seeing decent demand out there in activity, but we just cannot really say with a 100% certainty that we are going to hit the high end of what our funnel might indicate, and so it is more that we are baking in a little caution into the wider range.

Matt Robison – Pacific Growth Equities

Okay. It almost seems like you start to say you had a good start to the fourth quarter, but you are caught yourself.

Atul Bhatnagar

No, no. Matt, actually Tom pretty much nailed it. We have very good funnel, all indicators are good, but looking into the macro economic situation, I think it calls for more judiciousness.

Matt Robison – Pacific Growth Equities

I am agreeing to that, but you were kind of running at top speed, I think, when you gave your tax rate guidance Tom, can you tell us again what the tax rate is for GAAP and non-GAAP for the current quarter?

Tom Miller

For the – you want that for the third quarter or the fourth quarter?

Matt Robison – Pacific Growth Equities

Well, for the third quarter, I think, we have got it, but the guidance please.

Tom Miller

I believe what we said was a 23% to 30%, and the reason for that is, there is always a little bit of range on where it will be, but then as we give a wider revenue range, that also has an impact on what the effective rate is.

Matt Robison – Pacific Growth Equities

And we should apply both – that sort of a range which I guess could with the midrange for lack of further information, would you apply that to both GAAP and non-GAAP?

Tom Miller

I would apply that to the non-GAAP. That is the non-GAAP range. The GAAP range, and we will have to discuss why in a separate call, but we have a range of 50% to about 140%, and we can go over some of that offline.

Matt Robison – Pacific Growth Equities

Yes.

Tom Miller

Some weird things in the GAAP effective rate.

Matt Robison – Pacific Growth Equities

Yes, as I suppose, now federal was seasonally strong, often times we see that slipping into the subsequent quarter if companies cannot get it all done. Should we think that you might see some of that in the December quarter?

Tom Miller

Excuse me, what was that.

Matt Robison – Pacific Growth Equities

Federal was seasonally strong. Do you think some of that could slip and could extend over into the December quarter?

Atul Bhatnagar

No think it is difficult. Both federal and the service provider business tend to be a little lumpy, very difficult to – but there is one fundamental we are holding on very strongly, and that is both these segments value scalability and performance, and with Ixia’s innovation, our goal is to make sure that we can do a few things for them which nobody else can do, and through that magic have, you know, a little more uniformity than lumpiness, and so far that seems to be working.

Matt Robison – Pacific Growth Equities

Well, thanks a lot for taking my questions and keep up the good work.

Tom Miller

Yes, thanks.

Operator

(Operator instructions) We have no further questions at this time.

Errol Ginsberg

Excellent.

Atul Bhatnagar

Well, thank you very much for joining us, and we will be updating you again in the next few months, thanks again.

Operator

Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.

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