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Aware, Inc. (NASDAQ:AWRE)

Q3 2008 Earnings Call Transcript

October 23, 2008, 5:00 pm ET

Executives

Rick Moberg – CFO

Michael Tzannes – CEO

Analysts

Jeffrey Myers – Wachovia Capital

Stanley Cohen – Atrium Advisers

Operator

Please standby. Good day everyone and welcome to the Aware Inc. third quarter 2008 earnings release conference call. As a reminder, today’s conference is being recorded.

At this time, I would like to turn the call over to Mr. Rick Moberg, Chief Financial Officer for opening remarks. Please go ahead, sir.

Rick Moberg

Thank you, operator. Good afternoon and welcome to Aware’s third quarter 2008 earnings conference call. I’m Rick Moberg, the company’s CFO with Michael Tzannes, our CEO. Thank you for joining us today.

First of all, I’ll review the financial results for the quarter, then Michael will talk about the business and then we’ll take questions. A recording of this call would be available on our website at www.aware.com after the call is completed.

First, I’d like to point out that various remarks we may make about the future expectations, plans and prospects for the company and the DSL and biometrics market constitute forward-looking statements for the purposes of the Safe Harbor Provisions under the Private Securities Litigation Form Act of 1995.

Our actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors including those discussed in the section titled Factors that may affect future results in our annual results in Form 10-K for the year ended December 31, 2007. This form 10-K is on file with the SEC.

Now, I will discuss financial results for the quarter.

Revenue for the quarter decreased 14% to $6.4 million from $7.5 million in the third quarter of 2007. For the nine months ended September 30, 2008, revenue decrease 6% to $18.4 million compared to $19.7 million for the first nine months of 2007.

On a GAAP basis, our net loss was $700,000 with $0.03 per diluted share for the quarter. This compares to net income of $1 million or $0.04 per diluted share in the third quarter of last year. For the first nine months of 2008, our GAAP net loss was $3.2 million or $0.13 per share. During the same period last year, our net loss was $32,000 or $0.00 per share.

We also report net income and EPS on a non-GAAP basis. Our non-GAAP result excludes stock-based compensation expenses. These expenses were $397,000 this quarter and $1.1 million for the first nine months of 2008. Excluding these charges, our non-GAAP net loss was $266,000 or $0.01 per diluted share for the quarter and $2.1 million or $0.09 per share for the first nine months of 2008. Our reconciliation of GAAP to non-GAAP results has been included in today’s earnings release.

Product revenue was $3.9 million for the quarter compared to $3.9 million last quarter and $5.1 million in the third quarter of 2007. Sequentially, product revenue was flat. Both biometrics software and DSL testing diagnostics hardware and software revenues were relatively unchanged in the last two quarters. The year-over-year decrease in product revenue was due to lower sales of DSL testing diagnostic hardware and software.

Contract revenue which includes license and engineering service fees was $2 million for the quarter compared to $1.8 million last quarter, and $1.9 million in the third quarter of 2007. The sequential increase in contract revenue was a result of increase revenue from DSL licensing contracts which was partially offset by lower revenue from biometrics professional services. The year-over-year increase in contract revenue was the result of increase revenue from biometrics professional services which was mostly offset by lower revenue from DSL licensing contracts.

Royalty revenue was $437,000 for the quarter compare to $443,000 last quarter and $508,000 in the third quarter of 2007. Royalties was sequentially flat. The year-over-year decrease in royalties was primarily the result of lower DSL chipset sales reported to us by our customers.

Third quarter spending was $7.3 million versus $7.7 million last quarter. The $400,000 spending decrease was primarily due to lower cogs and lower engineering expenses. Third quarter spending was $7.3 million versus $6.9 million in the third quarter of 2007. The $400,000 spending increase was primarily due to higher cogs on biometrics professional services revenue, merit salary increases that were granted in Q4 of last year, legal fees and these three expensive reasons for expenses going up were offset by lower cogs on hardware sales this quarter.

Our reported product gross margins were 87% this quarter compared to 84% last quarter and 82% in the third quarter of 2007. The higher margin this quarter reflects a higher proportion of software revenue in product sales. Our hardware margins are generally in the 35% to 45% range. This quarter they’re slightly below this range because of the provision we took to reserve a portion of our inventory. Excluding this provision, hardware margin would have been in this range.

Interest income for the quarter was $244,000 which was lower than last quarter and the year ago quarter. The decrease was primarily due to lower money market interest rate since the beginning of the year, and our decision in Q1 to shift our cash into safer investments given the current credit market conditions. At September 30, our cash was $37.8 million. Our receivables were $4.4 million which equates the DSO of 62 days, and our inventory was $1.8 million, which was down $300,000 from last quarter. Also, as of September 30, we had no debt and there were 23.3 million shares outstanding.

During the third quarter, we repurchased 466,000 shares of our stock at a total cost of $1.5 million. Since our stock repurchase program was initiated last year, we have repurchased a total of 609,000 shares at a total cost of $2.3 million. We intend to repurchase more shares in Q4 subject to the provisions and limitations of SEC rule 10B-18.

At the end of the third quarter, we had 120 full-time employees, 85 of whom were engineers. That completes my financial commentary. And now, I’d like to turn the call over to Michael.

Michael Tzannes

Thank you, Rick.

Biometrics revenues this quarter continued to excel. The combination of a comprehensive software product line with exposure to multiple biometrics end markets and a broad customer-based of OEMs and system integrator s delivered revenue across multiple fronts. We continue to see newer product offerings and secure credentials and border control delivering strong results, validating our strategy to address these opportunities.

Border control infrastructure upgrades involving the use of 10 fingerprints are driving increased performance requirements, and we’ve benefitted from the demands of this upgrade cycle.

We continue to participate intuitive [ph] infrastructure build outs, and are beginning to see opportunities in post credentials issuance biometric identity management applications. We also continue this quarter to see a contribution from our professional services offerings.

During the quarter, we announced our relationship with Sun Microsystems, involving the integration of our BioSP and Sun’s identity management solutions. This collaboration is producing a biometrics-enabled identity management platform for Smart card issuance and multifactor authentication. It puts us in a position to gain broader exposure to government and private sector credentialing and identity insurance applications.

Our biometrics product line over the first nine months of 2008 has grown significantly compared to last year, and it continues to exceed our internal revenue and profitability plans. With our broad exposure to legacy and emerging biometrics applications, we are very pleased with our position in the biometrics market.

In DSL test and diagnostics, we continue to make progress with test infrastructure opportunities in the United States, Europe and Asia. Our customer base is comprised of test head, handheld and DSLAM suppliers as well as telcos.

Our product offerings include hardware and software modules for provisioning, maintaining, and troubleshooting DSL networks as well as a software server-based product that offers a soft test capability. This product, our LDP, is being marketed as an alternative to – or in conjunction with more traditional hardware-based test infrastructure. We’re selling this through OEMs such as AKAM [ph], as well as directly to certain phone companies. We believe that the trend towards soft test is a strong one that we would be able to benefit from. We recently announced the deployment of our LDP at West Kentucky Rural Telephone. This win is an important indication of the readiness of the product and the value proposition we deliver to the market.

We also won a prestigious award from Frost & Sullivan for the growth that our test and diagnostics business is demonstrated since 2006. The opportunity for us in test and diagnostics largely lies ahead of us with IPTV and VDSL2 solutions still in early stages of deployment. Our OEM customer-based gives us global reach and include market leaders such as Spirants and JDS Uniface. JDS Uniface is in fact demonstrating an improved DSL handheld test platform that incorporated hardware and software modules from Aware at the OSP Expo 2008 show this week.

In licensing, we signed a new contract with one of our existing customers for the development of a next generation VDSL chip. Our exposure to expansions in the VDSL market continues to be good to our relationship with Infineon. We believe that VDSL remains the predominant option for phone companies to deliver IPTV and triple play services. While the quality of our DSL IP products is world class, we continue to pursue a strategy of diversification with our silicon IP R&D assets. One of the most promising of these alternatives is the developments we have underway in GHN [ph] it’s the next generation technology for high-speed wired home networking. For members of home grid and alliance we found and along with industry leaders such as Intel, Texas Instrument and Infineon, and believe that this opportunity is a good match between our silicon IT expertise and the market needs. We’re also pursuing other options which leverage our IP assets. Our overarching goal is to return to profitability and deliver shareholder value over a reasonable time horizon.

For the year, we are reiterating our $24 million to $28 million guidance for revenues. Shooting the high end of this range will depend upon our ability to execute on our licensing initiatives.

At this point, we’d like to turn the call over to you and take your questions.

Question-and-Answer Session

Operator

(Operator instructions) And we’ll take a question from Jeffrey Myers with Wachovia Capital.

Jeffrey Myers – Wachovia Capital

Okay. Thanks a lot guys. Just a quick question with the DSL test business, I think when your customers reported a sizeable piece of business in the US, I’m just wondering – with the timing on that, that you record revenue immediately. When they record revenue where before or after – I guess outside of the water, what prospect are you looking at in the DSL test business?

Michael Tzannes

Well, I’ll answer the second question first. So the prospect in the DSL test business are – appeared to be very good to us. We think that the driver for those things right now is DSL2 and IPTV deployments, which are – as I’ve said earlier, in the initial phases of roll out around the world. Certainly, the economic conditions right now, pretty much globally are going to put some question mark around some of the spending with phone companies might incur, and we’re hearing that from some of the industry participants. But having said that, broadband continues to be a core offering for many telephone companies around the world, and we think that a test infrastructure around that is generally an efficient way for them to deploy those services more economically.

So we think there’s a real opportunity there. We think we’ve got a good position in that market that begins with the core expertise we have in the underline technology and is represented in a pretty broad array of hardware and software, and the soft test product the LDP that I talked about. Specific to an opportunity in the US, I can’t say anything more than what you heard. There appears to be a real opportunity in one of the really large carriers here. It appears that one of our customers is in a good position there. We, generally, will see the revenue at around the same time.

I would venture to say that they would, so they’ll buy from us, hardware and software. Put it in their product and then sell that product to the phone company. So there’ll be some log in terms of when they see the revenue versus when we see it. We would see it shortly before them, but not a significant value. It would be in a month’s timeframe. When we’ve been actually hearing about this opportunity for some time, and there had been a number of this type of opportunity that exist out there through this particular customer and others. So until they come to fruition, you can’t really count the – look at the size of that opportunity, yes. But it does look like there’s a real opportunity there. It looks like we’re in a pretty good position.

Jeffrey Myers – Wachovia Capital

Right. Okay. Let me ask you one more and this is – I’m asking this because it doesn’t sound to a lot of other people in the queue and –

Michael Tzannes

Go ahead.

Jeffrey Myers – Wachovia Capital

I’m not sure this is a conference call question but this will really serve a fundamental question. You guys supply the core technology – this important businesses, DSL, DSL test, but it seems like your customers are reporting significant revenues but you guys don’t seem to be able to get out of the single digit million revenue areas. So – at what point where in what business you see, you guys really taking the next step in capturing more of every opportunity in anyone of the places where you are.

Michael Tzannes

Well, certainly on the biometrics side we’ve seen tremendous growth year-over-year. We’ve expanded the product line there significantly. We expanded the types of opportunities. We’re addressing – there’s a number of biometrics market segments that we addressed, that we didn’t addressed several years ago and that’s all bearing fruit. So that product line is progressing very – in a very healthy way. It’s very profitable and it’s growing in a significant way, pretty much anyway you look at it. The test product line is in a less mature state, so you don’t see as steady as predictable set of revenues. But like I was saying earlier, the opportunity really seems to be in the future, not – it doesn’t appear to us to be the distant future but the near to median term future. And I think we’re in a good position there. And that could certainly be a very significant amount of revenue when you combine the hardware and software opportunity that we’re addressing. The biggest challenge we have which we’ve been talking about for some time now is on the licensing side where we have an excellent capability in the company, and continuing to focus that just going to DSL became evident earlier this year. It wasn’t going to generate the returns that we needed to see. So we’ve been looking at other areas where we can try to leverage that expertise. And I think there are opportunities for us to do that, and that’s where we’re focus in that particular area.

Jeffrey Myers – Wachovia Capital

Right. Let me just take the question back, I guess, to the DSL test business. It sounded that you guys have the major customers you’d want to inspire in the – JDSU – I’m sure those guys come by and they’re probably doing, I don’t know, hundreds and millions of dollars in DSL test? Or, you know, let’s see the hundreds and millions of dollars in DSL test. But I guess – so what’s the – how do you grow that business? Do you increase penetration within those customers? Do you –

Michael Tzannes

Yes. It’s a combination of things. I mean, some of their business is going to be Legacy business which were not exposed to, so our predominant strength is in current and next generation solutions, VDSL2 base things, IPTV base things. They’re not widely deployed yet. That’s why I talked about the future being important for us. If you go in to the company, if you talked about JDS Uniface certainly have a lot of test solutions that are not DSL at all. And then, they have some test solutions that are older generation DSL. So we wouldn’t have currently exposure to those things. They do have test solutions that are next generation JDS DSL that are based on our technology and our hardware and software. And when those grow in size, we would also see growth on our side.

Jeffrey Myers – Wachovia Capital

Got you. Okay, great. Thanks a lot.

Michael Tzannes

Thank you.

Operator

And we’ll move to our next question from Stanley Cohen with Atrium Advisers.

Stanley Cohen – Atrium Advisers

Hi, Michael, how are you?

Michael Tzannes

Hi, Stanley.

Stanley Cohen – Atrium Advisers

First, on the biometrics business, last quarter you had about – you actually had a $1.1 million contract with set of customers. Would it do anything about certain looks of this quarter?

Michael Tzannes

There wasn’t. Now, it was a pretty broad set of customers across a lot of different market segments, and no one stood out to that extent this quarter.

Stanley Cohen – Atrium Advisers

Yes. I mean, if you take out that contract – I mean, the growth rate from that business – I mean, I don’t know.

Michael Tzannes

It’s very structural.

Stanley Cohen – Atrium Advisers

Yes. I mean, like 70% – up 70% quarter-to-quarter.

Rick Moberg

Yes, I think that the business is up over 50% if you compare the first nine months of last year to the first nine months of this year.

Stanley Cohen – Atrium Advisers

Right. But I mean, in previous quarters, you – the shrunk orders have always been with the large contracts, then now it seems like you just have a broad base of business that is growing –

Rick Moberg

I don’t think large contracts are that outside the norm for us. It’s just, you know, one of the ways

Stanley Cohen – Atrium Advisers

Right. But you didn’t have on this quarter.

Rick Moberg

That’s correct. That’s a good point. I understand your point. It’s a positive –

Stanley Cohen – Atrium Advisers

Was there anything special with all these small customers this quarter that’s close to stuff like this?

Michael Tzannes

There’s a lot of activity. I think we have a lot of activity across a lot of friends, and we have a lot of exposure now to some of the areas that we just started getting in to several years ago, and we have a more mature presence now. I thought a little bit from the business opening remarks, about how we’re starting to see some post issuance of this pip cards. You start to see some more general biometric applications emerging where they are actually using the cards for something. We’re starting to gain some exposure there. And that, we think could be a trend that offers some real opportunity for us for some time, so we’re encouraged by that trend. You know, we have exposure to a lot of the government systems. I talked about this before. A lot of this government programs, like US business and others. So it’s a combination of lots of good things across lots of fronts.

Stanley Cohen – Atrium Advisers

On the other side, this is the first time that the contract of you saw that biometric business, even though it’s only a year old, there’s a slight take down.

Michael Tzannes

Yes. Of all the thing that biometric does, that’s certainly the least material. So that’s something we started doing – I think the first revenue we recorded was Q4 of last year where our strategy there is to have a balance of both the software product sales that we have and professional services going forward but it’s not nearly – it’s not something whereas well known for as our product offerings. So it’s going to be a little more lumpy at this point.

Stanley Cohen – Atrium Advisers

Okay, so that means there’s a couple of orders or they stay about the same or –

Rick Moberg

Yes. No comment on that at this point. I mean, we’re going to – as I said, our strategy is to try and keep those things both active in terms of means to grow the exposure to the business.

Stanley Cohen – Atrium Advisers

Okay. Well, so Rick, on those – you mentioned that expenses are up slightly because of the legal expenses you got due to the unnamed customer dispute with license revenue?

Rick Moberg

Yes.

Stanley Cohen – Atrium Advisers

And can you say about how much that was?

Rick Moberg

Well, there’s two reasons of legal expenses were up. Primarily, because of this customer suit that they were involve with, and also we’ve been doing a lot of work in patent filings and legal fees there. I don’t have a specific number but probably somewhere in the range of $100,000 or so.

Stanley Cohen – Atrium Advisers

Okay. Can you hold on that (inaudible) was 256?

Rick Moberg

Excuse me.

Stanley Cohen – Atrium Advisers

I mean, your net loss non-GAAP was about $256,000?

Rick Moberg

That’s right.

Stanley Cohen – Atrium Advisers

Yes, I mean, if they would have paid last quarter, you would have the legal fees? This financial picture should be somewhat different.

Rick Moberg

Right, that’s true.

Stanley Cohen – Atrium Advisers

Okay. I think that’s – as far as you have the current customer doing those contract with you this quarter, is it more to come from that customer and also, Michael, can you speak to cutting expenses on the licensing side given DSL customers is not what used to be.

Michael Tzannes

Yes. There is opportunity with this customer continue going forward. And there’s no sign that that customer or either of our customers are shying away from the DSL market, despite the fact that there’s not a lot of interest from new participants. These folks continue to stay very engaged in the market. So there are opportunities there for us. In terms of getting out of the current situation wherein on licensing, the focus is to find ways to generate revenues through alternative means. And we have new technology we’re looking at in the GHN, in GPAN [ph], in 10 gigabit per second. We have a strong patent asset that we’ve been looking at our opportunities to try to leverage in to revenue. So the focus there is to try to write that situation by improving the top lines.

Stanley Cohen – Atrium Advisers

Okay. This is the first time I’ve heard GPAN, is there something new going on there?

Michael Tzannes

Yes, it may be slightly new. I mean, it’s something we’ve had going on for some – not a real long time but it’s an opportunity we see that’s coming from the marketplace back to us, and we’re responding to it.

Stanley Cohen – Atrium Advisers

Okay. Thanks a lot.

Michael Tzannes

All right, Stanley.

Operator

And with no further question, I’d like to turn the call back over to you Mr. Tzannes for any closing remark.

Michael Tzannes

All right. Thank you. We will be at the AeA Conference in San Diego, the first week of November. If you happen to be at that conference, please look us up and we look forward to speaking with you again next quarter. Thank you very much. Goodbye.

Operator

And thank you for participating in the Aware Inc. conference call. You may now disconnect.

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