Avanex, Inc. (AVNX)
Q3 2006 Earnings Conference Call
May 8, 2006, 4:30pm Eastern
Dr. Jo S. Major, Jr., President and CEO
Cal Hoagland, Sr. VP and CFO
Maria Riley, Investor Relations
John Harmon, Needham & Company
Todd Koffman, Raymond James
David Fore, Sur Terre Research
Welcome to the Avanex Corporation Q3 Fiscal Year 2006 Conference Call. At the request of Avanex Corporation, this call is being recorded for replay purposes. Please note that all lines will be in a listen only mode until the question and answer portion of today’s call. With us on today’s call are Jo Major, President and CEO and Cal Hoagland, Sr. VP and CFO. I would now like to turn the call over to Maria Riley of Stapleton Communications. Ms. Riley, you may begin.
Good afternoon and thank you for joining us today. To begin, I’d like to remind you that this call contains forward-looking statements, including statements regarding cost-reduction and restructuring measures, transfer of manufacturing operations to lower cost regions, fourth quarter fiscal revenue and operating performance reductions, improvements and gross margins, cost savings and liquidity, market trends and our competitive position, our product development and manufacturing strategy and changes in the market for our products. Actual results could differ materially from those projected and/or contemplated by the forward looking statements. Factors that could cause actual results to differ include general economic conditions, the pace of spending and timing of economic recovery in the telecommunications industry and in particular, the optical networks industry. The company’s inability to sufficiently anticipate market needs and develop products and product enhancements that achieve market acceptance, problems or delays in our restructuring activities or in integrating the businesses acquired from Office Help, Corning and (inaudible) semiconductor, or in reducing the cost structure of the combined companies. The company’s inability to achieve the anticipated benefits of the acquired businesses or to successfully transfer manufacturing operations to lower cost regions. Any slowdown or deferral of new orders for products, higher than anticipated than expenses the company may incur in future quarters, or the inability to identify expenses which can be eliminated. Please refer to the risk factors contained in the company’s SEC filings including the annual report on form 10K filed with the SEC in September of 2005 and subsequent quarterly reports on form 10Q filed with the SEC.
Avanex assumes no obligation and does not intend to update any forward looking statements, whether as a result of new information, future events, or otherwise. In addition, because non-GAAP information is presented in order to comply with regulation G, please note that there is a reconciliation table between GAAP and non-GAAP measures included with the press release. I would like to take this opportunity to remind you that Jo Major will present at the 8th annual Piper Jaffray Hardware and communications conference at the New York Palace Hotel on May 10th, 2006 at 8:40am, Eastern Time. With that, I will now turn the call over to Jo Major, President and CEO.
Jo Major, President and CEO.
Thanks Maria. Good afternoon everyone and thank you for attending today’s cal. Before we start the discussion of our third quarter performance, I’d like to highlight two executives that were added to the team during the quarter. First, we brought on Brad Kohl as Vice president of Operations. Brad joined the team in March and brings to Avanex great depth of experience in contract manufacturing throughout the Pacific Rim, supply chain management and cost control. In addition to his strong manufacturing experience, Brad is also served as a CFO in privately held companies. So we’re looking forward to him really working on our margins and fixed costs, as we grow the company. Next we welcomed Cal Hoagland to Avanex in April, as the company’s CFO. He has demonstrated a strong ability in strategic corporate finance and control. Cal brings many years of experience and leadership to Avanex and will assist us in achieving our financial goal of driving the company to growth and profitability.
Moving on to the discussion of the third quarter, I’m please with our financial and operating performance this quarter. Our revenue showed a healthy reb9ound. Revenue in the third quarter was $40.1 million, up 11% from $36.1 million in the prior quarter. In addition to this strong growth trend, our revenue from customers other than Alcatel is up 22%, quarter on quarter. Another significant milestone for the company was achieving environmental compliance with European ROHS standards. The process of becoming compliant with these standards was a big, difficult project for Avanex. We’re very proud of this team achievement. The ROHS directive required that new electrical and electronic equipment comply to strict limitations on hazardous materials such as lead and cadmium. We’re very excited to be able to offer to all of our customers around the world, ROHS compliant products across all of our product lines. We believe we are the first broad-based supplier of optical components to be fully ROHS compliant across all product lines. The vast majority of our product is already shipping as ROHS compliant.
It is important to note something about the July 1, 2006 compliance date. Our customers must be compliant to ROHS standards by July 1st. they need to have compliant materials several months ahead of this date so that they can build compliant product. This means that for companies like Avanex, the time to be compliant is really now, not July 1st.
Non-GAAP net loss for the 3rd quarter was $0.06 per share, compared with a net loss of $0.07 per share in the previous quarter. We decreased our non-GAAP net loss by 9.4% from the second quarter of 2006.
I am very pleased to announce that in the third quarter our customers rewarded us with strong orders. In addition to seeing an increase in bookings, we are also beginning to see our customers place orders for shipments further into the future.
During the quarter, our balance sheet was substantially strengthened as $21.4 million of debt was converted to equity and we raised $44.7 million in net proceeds through a common stock offering.
We reached important operational milestones in executing our global restructuring plan and we have now substantially completed all manufacturing transfer activities.
The transfer of assembly operations from Italy and France, including Active componentry, Tangay transponders and lithium modulators was completed in the third quarter. At this point, virtually all of our production is done at contract manufacturers with operational control now at our Asian operations center.
The operational performance of our new manufacturing model continues to improve. On-time shipping performance has improved over the same time period in the previous quarter. We’re also starting to see more normal shipment behavior. To give you insight into our improved performance, I will again provide you with information regarding our month (inaudible) shipping performance. But I will not provide this information going forward.
Using October of 2005 as our month one reference point, April, which is the first month of our fiscal fourth quarter, had preliminary shipments up approximately 50% from October shipments. Again, Avanex is now getting into a more normalized shipment pattern and as such, we will not refer to month one shipment performance going forward.
We implemented SAP in Italy, to allow further operating efficiencies. We will implement SAP in France this quarter, at which time all North American, European, and Bangkok sites will have a common operating system.
Avanex is committed to simplifying our structure, reducing the cost of non-value add activities and allowing the companies to expand revenue rapidly as the market returns. Our worldwide headcount at March 31st was 604 employees, compared with 605 at the end of the prior quarter. Our North American and European headcount decreased from 449 to 414, an 8% reduction, while headcount in Asia increased from 156 to 190.
In the fourth fiscal quarter, we are completing a real estate restructuring of our Nosai campus, with the intent of vacating yet another building by the end of this quarter. We expect to achieve further reductions in our operating costs as a result.
As we complete this manufacturing restructuring, development resources are becoming available for substantial new market opportunities. The third quarter was quite a strong bookings quarter for Avanex and includes several new product introductions. I’ll discuss some of those new products in a moment.
Our 10% customers in the quarter were Alcatel, Nortel and Sysco. Tellabs was also a very significant customer during the quarter. We’re obviously very excited about being able to serve these customers and consider it a high point that the sales into both Tellabs and Nortel were largely based on the strength of recent design wins.
The equipment we shipped to Tellabs was for a newly developed amplifier and is to be used in a major upcoming deployment with a Tier 1 carrier. Again, revenue growth from customers other than Alcatel is a strongpoint; with revenue growth for these customers up 23% quarter on quarter.
In March, we participated in the optical fiber communications conference and launched several new products at OSC and throughout the quarter. We introduced low cost compact amplifiers, low cost optical filters for (inaudible) the home deployment, submarine componentry, new low-cost sub-system protection switch module and Tangay tunable MSA transponders. These products have been conceived and designed to reduce the cost of next generation flexible network architectures.
It is important to note that many of these products were co-developed with our Shanghai product development center, resulting in significantly lower, overall development costs. Our goal, again, is to deliver value to our customers; providing them with cost savings through Avanex innovation.
I will now turn the call over to Cal for details on the financials.
Cal Hoagland, CFO.
Thank you, Jo. Before I begin I’d like to say that I’m happy to join the Avanex team, which has made significant progress over the past year. The industry is expanding and Avanex has worked hard to position itself to take advantage of that opportunity by driving for profitability. I look forward to being a key member of the management team and contributing towards Avanex’s achievement of that goal and well beyond.
Now on to review the company’s third quarter financial performance. I will first review our performance on a GAAP basis, then discuss non-GAAP measures, and then move onto the company’s balance sheet.
Revenue from the third fiscal quarter were up 11% to $40.1 million, compared with $26.1 million in the prior quarter and compared with $20.3 million for the third fiscal quarter of the prior year. Gross margin for the quarter was 4.1% compared with 8.1% in the prior quarter and -2.7% in the third quarter of the previous year. Gross margin in the quarter was reduced by a $1 million inventory provision for estimated non-ROHS compliant product, as well as a $1.3 million inventory provision related to cessation of manufacturing at our New York facility. For the fourth quarter we expect gross margin to increase.
We are pleased with the improvements we have made in our cost structure over the past several quarters. We achieved a sequential improvement in our operating expenses. Included in the third quarter’s operating expenses are increased share-based payments of $1.1 million, up quarter over quarter by $0.6 million. Combined R&D, sales and marketing and general and administrative operating expenses were $12.4 million in the quarter, up from $12.1 million in the prior quarter and $17.2 million in the third fiscal quarter of the prior year. Combined R&D, sales and marketing and G&A operating expenses, including share-based payments, were 31% of revenue in the third fiscal quarter, compared with 33% of revenue in the prior fiscal quarter and 43% of revenue in the third fiscal quarter of the prior year.
Total GAAP operating expense in the quarter were $11.4 million, compared with $15.6 million in the prior quarter and $18.1 million in the third fiscal quarter of last year. We may see operating expenses increase in the fourth fiscal quarter, due to stock activities and implementing SAP in France.
During the quarter, we had a restructuring charge of $0.2 million. The cash outlay from restructuring in the quarter was approximately $7.1 million. We expect a $3.5 million cash outlay for restructuring in the fourth fiscal quarter.
In the third quarter GAAP net loss was $10.2 million or a net loss of $0.06 per share, compared with a net loss of $18.5 million of net loss of $0.13 per share in the prior quarter and a net loss of $18.9 million or a net loss of $0.13 a share in the third quarter of the prior fiscal year.
As mentioned before, our gross margin in the third quarter of fiscal 2006 was reduced by a $1 million inventory provision for estimated non-ROHS compliant product, as well as a $1.3 million inventory provision related to cessation of manufacturing at our New York facility. Without those two elements, and without share based payments, our calculated gross margin is 10.1%, compared with the prior quarter’s 8.2%, calculated in the same manner.
On a GAAP basis, our net loss continues to decrease. Non-GAAP net loss was $8.9 million or a net loss of $0.06 per share, in the third quarter of fiscal 2006, which compares with a non-GAAP net loss of $9.9 million or $0.07 per share in the 2nd quarter fiscal 2006, which compares with a non-GAAP net loss of $18 million or $0.12 a share in the third quarter a year ago. Non-GAAP net loss, excludes share based payments, amortization of intangibles, restructuring costs and (inaudible) property and equipment. And the inventory provision for estimated non-ROHS compliant inventory in the third quarter of fiscal 2006 and loss and debt refinancing in he second quarter of 2006.
During the quarter, our balance sheet significantly strengthened. Cash and investment balances at March 31 were $82.1 million, compared with $48 million at the end of the prior quarter. The March 31 cash and investment balances include net proceeds of $44.7 million from our March offering of 24.1 million shares of common stock. Not including the cash infusion from this offering, cash burn for the quarter was $10.5 million, compared with $6 million in the previous quarter. Cash burn increased from the prior quarter because in the second quarter we received $1.8 million for excess equipment sales, which reduced that quarter’s cash burn. We expect to receive $5.3 million in French tax credits over the next couple of quarters. In addition, we expect to receive significant VAT Tax credits over the next 2 quarters. Factors that cause cash flow to vary from quarter to quarter are restructuring (inaudible) and disbursements.
During the quarter, we saw a sharp reduction in our outstanding debt. $21.4 million of outstanding debt was converted into equity. Our convertible note balance at March 31, 2006, was $6.1 million, and that compares with over $26.7 million at the end of December 31, 2005. To date, during the fourth fiscal quarter, an additional $1.7 million of debt was converted to equity. With that, I’d like to turn it back over to Jo for a recap and a look at our guidance for fiscal Q4.
Thanks, Cal. We’ve been working hard to build a cost-competitive and successful company. As we’ve discussed today, we have achieved several important objectives. We’re returning to revenue growth. We’ve increased our revenue by 11% while completing all planned manufacturing transfers from Italy and France, on schedule.
We were rewarded by our customers with strong bookings, including significant bookings into future quarters.
We met the requirements to become a ROHS compliant company across all of our product lines. Again, we are now a ROHS compliant company.
We launched a series of impressive products that have gained significant interest from our customs and from the overall industry.
Our net loss on a non-GAAP basis has improved from $0.07 per share in the 2nd fiscal quarter of this year to a net loss of $0.06 per share in the third fiscal quarter of this year.
For the fourth fiscal quarter of 2006, we are forecasting revenues to be in the range of $42-$45 million and we expect gross margin to increase. With that, we’ll now welcome your questions and I’ll turn it over to the operator.
Thank you. At this time we are ready to begin the question and answer session. If you would like to ask a question, please press star one. You will be announced prior to asking your question. To withdraw your question, press star 2.
John Harmon, Needham and Company, you may ask your question.
Hi, good afternoon. Since you said your restructuring was largely completed in the third quarter it seems like we’re starting off the quarter with kind of a new Avanex, with a new operating model. I was wondering what you could do to share it with us.
I’d like to make sure that there’s a little bit of clarity and Cal and I will talk about this. What we’ve done is we’re completing the restructuring of our manufacturing operations. And there’s … if you ask me the question differently and say are you going to take the company in new directions and do some interesting things with it, the answer is yeah. We have a lot of things that we’re going to do moving forward. The manufacturing restructuring is getting, we’re completing that. So let’s just say what we did and we’ll talk about where we see margins and the operating structure going forward.
So we decided that we were going to take all supply chain, all purchasing, all logistics and consolidate it into a single low-cost environment. It’s kind of a new thing for the industry. We’ve largely completed that. Bangkok is up and running and really controlling an awful lot of the operational infrastructure of the company now. We also took all of our manufacturing and placed it into the contract manufacturing environment. That’s completed. Again, if you look at the comment that we’re already pushing double digits for gross margins and Cal really didn’t talk about some pretty substantial secondary costs involved with finishing the transition and sort of engineering the labor required to become ROHS compliant. So, we do see our margins continuing up. As we’ve said in the past, we think that this is going to be, while a consolidation, this is going to be a pretty competitive place. We see a fair amount of growth ahead of us but we think it’s prudent to structure the company for gross margins that are on the order of low 20’s and to have a real healthy company with margins in the low 20s.
As the industry starts consolidating and you see less competitors out there I think we’ll be able to push those numbers higher.
Does that help John?
Our next question comes from Todd Koffman. You may ask your question.
Yeah, just a clarification. You signaled you’re off to a strong start in the quarter during the month of April and you gave a metric relative to October of 2005. I think you said shipments vs. October are up 50%. What was the shipment level in October that the 50% is up on? Was it about $10 million?
We actually didn’t provide an absolute number. In both January we gave reference to January over October and we felt, because we still are completing some manufacturing transitions, that again we’re referring revenue levels in month one back to October would be healthy for the investment community. So we actually haven’t given you an exact number there, but we wanted to say relative to what we did in October, which was a difficult quarter for us, shipments in April were up 50%.
Just as a quick follow on. You signaled that you have continued to receive strong orders. Then I thought you were signaling something to the effect that the lead times are stretching out. Did I understand that correctly?
The lead times for our products were actually…during the transition, certainly the lead times we offered our customers moved out. We are very actively trying to pull our cycle times down and our lead times down so that we can offer high levels of service to our customers. Some of our customers are worried that they need to sort of book in their capacity now. So they’re starting to place orders for several quarters out. Even for product that ostensibly would have a lead time much shorter than that. So, it’s as if the orders are coming in to reserve capacity as opposed to orders coming in because the lead times are that long. Does that help you understand the difference Todd?
Yes it does, thank you very much.
Dave Fore, Sur Terr Research, you may ask your question.
Hi guys. Just a couple of question. First on the gross margin guidance for next quarter, is that based off of the normalized margin, the (inaudible) 1% or is it based off of the actual reported gross margin?
We see if moving up on both metrics.
Are there any more provisions for inventory write-offs in the first quarter?
I think that inventory provisions in a company that’s a technology based company are a typical part of it. I think that these things were kind of different this time around and we wanted to highlight them to you so that we could express to you that they’re a little outside of the norm.
Certainly I’m very, very proud of the company going ROHS compliant. We had to take our inventory reserve for that, which isn’t as exciting. But you know, we’re only going to go through becoming ROHS compliant once. That’s behind us. We’re up to speed with our customers and that’s a really good thing for the company. Same thing, we’re only going to close the NY factory once and that’s why Cal broke those out. Some level of inventory reserves have always been a part of our business Dave and you’ve seen those kind of in previous quarters. But these were a little different and we wanted to call them out for you.
Okay great. And then one question on the growth side going forward. Now that the restructuring is complete. As we look to fiscal ’07, should we start thinking about more of a return to typical industry growth rates for the company?
Well, most people in the industry think that the overall growth at our level and you have to look at a bunch of different reports to come up with some sort of average, but between 10 and 20% is (inaudible). So certainly the March quarter growing 11% is well ahead of that as an overall tagger. If you think of us growing at 15%, certainly my expectation of the company is that we’re through a lot of our restructuring. Our development resources are more pointed forwards and we should be at least able to keep up with market growth rates if not beat them.
Okay great. Excellent commentary, Jo.
Jason Mauricio Erte, you may ask your question.
Yeah hi there. Two quick questions. One, the ROHS compliance, was that mainly in the third quarter or has that been a process over the course of the fiscal year? And second, you talked about new design wins. When do you expect products using those components will be shipping and recognizing revenues from those?
Maybe we just split those into two. The first part is ROHS. The main spending on ROHS to become compliant really was in the third quarter. We didn’t allow the engineering and temporary help that we brought in the company to push us through that hurdle, but it was largely in the third quarter.
The other one is, for design wins, how long is it until we get revenue? For us, when we track design wins…let me speak to you about design wins. Design wins are actually customer revenue driven. So when we talk to you about a big design win quarter, that’s actual revenue from recently introduced products. Maybe (inaudible) for the new products that we’ve announced, many of which are sort of revolutionary in the way that they reduce costs and introducing functionality to the industry. How long does it take for those to generate revenue? And that answer is a little bit more nuanced, Jason. For some of them that are purely standard products, that can be 3-6 months. In some of the products that change the way functionality works, they have a longer designing cycle that’s 6-12 months. So you know, we’re starting to lay the groundwork for growth on the 6 month to 18 month timeframe.
Okay and just a follow up on that. Some of your competitors suggest that newer products tend to command better profitability than older products do. Is that your sense as well?
Certainly when you look at the product line that came into Avanex when all of the acquisitions were made, the margin structure of those products was highly variable and I think two things are happening. One is, we’re becoming substantially more disciplined about what products we’re going to introduce and what kind of margin structure we’ll accept for those. So, we typically do a lot more scrubbing up front to make sure that we’re introducing product with respectable margins. The other thing is quite honestly, over time the products that have very, very low margin structure, we’re exiting. Two things are happening: one is we’re exiting products that are less profitable and I would generally agree that products that are coming out of the development pipeline are introduced into the market at a higher direct margin of profitability.
Great. That’s fantastic. Thanks Jo.
We have a follow up from John Harmon, Needham & Company.
Hi, I got cut off before I could even respond to your answer. Back to gross margins. Since you really are kind of at a new level, maybe you could give us kind of a range of gross margins that would correspond to your revenue range. You talked about gross margins in the low 20s. About when would you expect to see that? And I was wondering if you could break up the charges again that you were talking about the exit charges for the NY facility.
Cal, why don’t you go ahead and the ROHS charge, the charge of exiting the NY facility; why don’t you go ahead and summarize those again?
Right. The ROHS was about $1 million. And that’s the inventory related for estimated non-sell through as you do the transition. Not talked about in the conversation was that we incurred engineering costs, we incurred other costs that are also part of cost of goods sold this quarter. And, since that process is completed, we’ll be out of that in addition. In the area of NY, that was about $1.3 million related to the cessation of business there.
John, the 2nd part of your question really had to deal with giving more detailed guidance on gross margins. And, one of the things I do want to kind of repeatedly iterate to investors, in fairness to them, we’ve taken four factories all producing annual revenues of many tens of millions of dollars, and we’ve shut all of those and put them into a brand new manufacturing environment. We’ve been there for a few months now. So there’s…I think it’s prudent to be a little bit conservative about all of the pieces falling in place and us recognizing all of the benefits at once. Because you do get some surprises on the inventory side. Or ROHS, quite honestly, was a more expensive endeavor than we initially thought it was going to be and in fact if you look at the people that we compete with, their comments about ROHS are much the fact that ROHS is not a real easy thing for them either. So there are some unexpected bumps that you get in this transition.
We’re comfortable telling you that we continue to see the operating structure improve and margins improve, but we’d like to let a few of these things calm down a little bit before we increase the level of specificity in our guidance. Apologies for that, I know that you’re hungry for that information but it’s just a little early.
Okay. The reason I’m asking is just that I don’t see the operating leverage. I’m curious though, given that your moving to a contract manufacturers you really have to redesign and re-qualify all of your products anyway. I’m sure you tried to make them ROHS compliant, why did you do this also?
Actually, those are two separate activities and we adopted very much, as much as we could, we adopted sort of an Intel model of moving manufacturing. Which is basically to copy what you have and get it over there quickly and efficiently. Again, we move factories very, very quickly. Our execution suffered a little bit because of that. We didn’t really try and do all of those things at once. In other words, when we brought a product over, we just brought the product over, we moved the inventory over and we started manufacturing and tried to settle that down as quickly as we could. We really left ROHS compliance as we separate activity. So you can criticize that approach, but our approach was really, let’s get the stuff over there and get manufacturing and then let’s make ourselves ROHS compliant.
Okay. Thanks very much.
Once again, to ask a question, please press star 1.
At this point, I think we’re going to go ahead and complete the call. We appreciate everybody attending and operator can you go ahead and close off the call for us?
Thank you for joining today’s conference call. At this time you may disconnect.
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