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ModusLink Global Solutions Inc. (NASDAQ:MLNK)

F1Q09 Earnings Call

December 4, 2008; 05:00pm ET

Executives

Joe Lawler - Chairman of the Board, President and Chief Executive Officer

Steven Crane - Chief Financial Officer

Analyst

Brian Gaines - Unidentified Company

William Martin - Charles Schwab Investment Management

Larry Smith - Unidentified Company

Mike London - JP Morgan

Bernard Metzger - Metzger Group Inc

Operator

Welcome to the ModusLink Global Solutions first quarter 2009 operating results conference call. At the company’s request, this conference is being recorded. Please note that all lines will be in listen-only mode until the question-and-answer portion of today’s conference. (Operator Instructions)

Now I would like to turn the call over to Mr. Joseph Lawler, Chairman, President and CEO; and to Mr. Steven Crane, Chief Financial Officer. Please go ahead, Mr. Crane.

Steven Crane

Good afternoon, everyone and thank you for joining us for ModusLink Global Solutions fiscal 2009 first quarter conference call. I am Steve Crane, CFO and I’m joined today by Joe Lawler, Chairman, President and CEO.

In just a few moments Joe will share his thoughts on the financial performance and the market environment over the past quarter. After Joe’s comments, I’ll review in more detail our fiscal 2009 first quarter results which we released earlier today.

Before we start, I want to remind you this call is being broadcast as a live webcast from our website at www.moduslink.com. Please also note that the information we are about to discuss includes forward-looking statements for purposes of the Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties. The company’s actual results could differ materially from those discussed herein.

Factors that could contribute to such differences include, but are not limited to those items noted and included in the company’s SEC files including our annual report on Form 10-K and quarterly reports on Form 10-Q.

The forward-looking information that is provided by the company in this call represents the company’s outlook as of today and we do not undertake any obligation to update forward-looking statements made by us. Subsequent events and developments may cause the company’s outlook to change.

During this call we will be referring to non-GAAP measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP measure can be found in our earnings release issued earlier today, a copy of which is posted in the investor section of our website.

I’d now like to turn this call over to Joe Lawler. After our formal remarks we’ll be happy to take your questions. Joe.

Joe Lawler

Thanks, Steve. As we begin fiscal 2009, we are all navigating in uncharted waters due to this uncertain economic environment. However, we’ve made important progress in our business in the past few months, and I’d like our investors to take away a few main points from our call this afternoon.

First; like many other companies, the deteriorating economy has affected our business and in the first quarter we have seen lower volumes from existing engagements which I’ll refer to as our base business. There’s an extreme sense of uncertainty regarding the economy and consumer spending has been significantly affected.

Over the past two months we’ve been aggressively taking action to mitigate the affects of the weakening economy on our business. We are focused on effectively managing costs across the organization and restructuring areas where we can gain efficiencies while delivering excellent client service.

Second; our revenue increase compared to the first quarter of last year as we experienced revenue growth for new engagements, contributions from our recent acquisitions and a foreign exchange benefit. However, our overall profitability was negatively affected due to volume decreases in our base business and unfavorable mix of work in our Americas and Europe businesses and the charges related to restructuring actions which I’ll talk about in a moment.

Third; we continue to operate from a position of strength. Our value proposition for new engagements is strong because companies in the markets we serve continue to look for opportunities to reduce their supply chain costs. The strength of our value proposition has been the primary driver of the increase in new business and our pipeline, which continues to be significant.

Financially, our balance sheet and cash balance remains very strong and we have no debt. We believe these factors will enable us to weather the weak economic outlook and become a leaner and stronger company. I’ll talk more about these points in a moment but first I’ll provide a brief overview of our first quarter sales and gross margin performance.

Net revenue for the first quarter increased 6.1% compared with the same quarter last year. The growth was primarily due to an increase of 246% from new business, contributions from our recent acquisitions and the foreign exchange benefit.

Like many other companies, we continue to experience the impact of a significant slowdown in consumer spending, and as a result we saw lower overall volumes in our base business and the delayed start-up of new engagements in the first quarter. The effects were most apparent in the Americas and Europe due to our clients reducing their production volumes.

Base business was down 12.5% in the first quarter, while revenue from new business excluding acquisitions more than tripled, increasing from $13 million in the first quarter of fiscal 2008 to $44 million in the first quarter of fiscal 2009. We expect the new business trend to continue, although we also expect the economy to continue to affect our base business.

Gross margins for the first quarter were 9.6% of revenue compared with 14.2% reported in the first quarter of fiscal 2008. The lower margin was primarily due to the product mix, the costs associated with on-boarding and ramp-up of a significant amount of new customer engagements in the Americas and Europe, as well as lower base business in both regions and that typically has higher margins.

As we’ve discussed in the past, new engagements initially begin at a lower gross margin due to various startup costs and normalize thereafter. While gross margin was lower than we expected for the quarter, margins have historically fluctuated, and when comparing gross margin to the first quarter of last year, it’s important to note that gross margin in the year-ago period was particularly strong due in part to a favorable work mix and the significantly lower amount of new business in that quarter.

I want to take a few minutes to talk about the economy and the actions we are implementing to manage through this difficult environment. This is clearly one of the most challenging economic periods we’ve experienced, both for our company and the technology markets we search specifically computer hardware, software, storage, communications and consumer electronics because any decline in consumer spending adversely affects the amount of product that flows through the global supply chain network.

We are approaching this downturn by focusing on outstanding execution for our current clients, leveraging our value proposition and effectively managing our cost structure while still closing new business for the future.

The strength of our value proposition should help mitigate the effects of the softening economy. Our supply chain solutions and global footprint, which enable clients to meet their need for faster time in the market, lower costs and improved customer service are important in this type of environment. Although our pipeline has been reduced somewhat since last quarter’s earnings call due to the impact of the economy, it remains strong with significant new opportunities for the future and we expect new business in fiscal ‘09 to be significantly ahead of any prior year.

Although we cannot control our client’s volumes, our ability to effectively bring aboard new engagements positions us for good growth when the economy improves. Until the economy does recover, we are aggressively taking actions to reduce our costs and improve efficiencies.

For example, we are eliminating expenses and overhead. We have reassessed our global organization across all functional areas and are reducing our employee positions in the Americas and Europe by approximately 20%. In addition, we are lowering our capacity to align it with lower volumes. We are closely monitoring our client’s unit forecasts and eliminating unnecessary capacity.

We are consolidating operations in multi-site locations in Europe and in the Americas, and we are shutting down-sites with no near-term volume requirements. In the first quarter we’ve taken a charge of $6.4 million for restructuring actions underway and we expect to take total restructuring charges of $12 million to $17 million in fiscal ‘09.

We are accelerating our Lean Sigma initiatives to drive higher productivity levels and to enable faster start-up of new business. We are also working to improve margins and reduce risks associated with the start-up of new engagements by focusing our sales organization on lower complexity work.

We have significantly reduced our capital investments for the near term and we are closely monitoring inventories and accounts receivables. At the same time we are taking all of these actions, we continue to win new business in the marketplace and view this as a positive sign for the longer term, especially when base business volumes begin to increase again.

We believe that our actions to reduce costs and increase efficiencies will save us more than $20 million this fiscal year after restructuring charges and more than $40 million in annual cost reductions. Steve will provide more detail in a few minutes.

While our near-term focus is on effectively managing our business through the softening economy, we continue to execute our core strategy, the elements of which are: (1) increasing revenue in our target markets; (2) expanding existing client relationships through the introduction of new solutions and driving operational efficiencies such as Lean Sigma to yield improving profit margins.

Our target markets of computer hardware, software, storage, communications and consumer electronics represent a significant opportunity for long-term growth. An example of our progress is our recently announced engagement with Creative Labs, a worldwide leader in digital entertainment products.

Creative Labs will leverage ModusLink’s forward logistics capability to support its customers across the Americas. Creative recognized the value of our highly integrated global supply chain infrastructure and ability to drive greater efficiencies in the Creative Labs supply chain.

Our second area of focus is expanding existing client relationships through the introduction of new solutions. We have added new solutions that build upon our core supply-chain management capabilities and the launch of aftermarket solutions is one example.

Our acquisitions are an important component of our strategy to develop new solutions and many of our aftermarket solutions come from the acquisition of PTS Electronics and we continue to be excited about the outlook for these services in fiscal 2009. We are getting some very good cross-selling opportunities with the sales teams and expect PTS to show strong growth over last year. The integration of our acquisition of Open Channel Solutions is progressing well and the outlook for OCS also remains positive for fiscal 2009.

The third area of focus for the company is to improve our margins and operational efficiencies. In the near term, we’re focused on the initiatives I outlined a few moments ago, which are eliminating expenses in overhead, lowering capacity and complexity of new business start-ups and accelerating our Lean Sigma initiatives across the entire platform. These efforts, together with our revenue growth initiatives, should enable us to increase efficiencies and achieve our long-term operating targets.

In summary, our revenue performance increased compared to the first quarter of last year due to revenue from new engagements which more than tripled and we benefited from revenue contributions from our recent acquisitions as well as foreign exchange. However, the outlook for our full fiscal year has declined because of the serious weakening of consumer spending which will negatively impact our revenues.

We are approaching the soft economy by focusing on right sizing our business which means outstanding execution for current clients, leveraging our value proposition to gain more new business and aggressively managing costs. Our pipeline for new engagements continues to be strong as companies in the markets we serve look for opportunities to reduce their supply chain costs and we continue to operate from a position of strength.

Our balance sheet and cash balance remains very strong, and we have no debt. We believe these factors will enable us to weather the economy better than others.

I will now turn the call back over to Steve to comment further on our financial results.

Steven Crane

Thank you, Joe. For the first quarter of fiscal 2009, ModusLink Global Solutions reported net revenues of $291.4 million. This compared to net revenue of $274.7 million for the same period one year ago, looking deeper into the key drivers. While new business revenue increased by $31 million, or 246% over last year, our base business declined $32.6 million or 12.5%. In addition, the two recent acquisitions contributed $16.4 million in revenue and foreign currency translation had a positive impact to the quarter.

I will now review our revenue results on a geographic basis. Revenue in the Americas increased 14.4% from $84.2 million in the first quarter of fiscal 2008 to $96.3 million in the first quarter of fiscal 2009. Base business in the Americas declined by $9.4 million and was offset by new business revenue growth of $8.2 million with the balance due to the inclusion of our recent acquisitions.

Revenue in Europe increased 6.6% from $103.8 million in the first quarter last year to $110.7 million in the first quarter this year, primarily due to new business revenue growth of $14.4 million and a favorable impact of foreign currency translation, partially offset by reduction in base business of approximately $11.2 million or 7.5%.

Finally, revenue decreased slightly in Asia from $86.7 million in the first quarter of fiscal 2008 to $84.4 million in the first quarter of fiscal 2009, due to lower volumes which decreased base business revenue by $12.3 million, which is partially offset by $8.6 million of new business related revenue.

The company’s gross margin decreased 28.1% in dollar terms from $39.1 million in the first quarter of fiscal year 2008 to $28.1 million in the first quarter of fiscal year 2009. As a percentage of revenues, gross margins declined from 14.2% in the first quarter of fiscal 2008 to 9.6% in the first quarter fiscal 2009.

This decline in gross margin percentage is primarily driven by adverse shift in client work, the costs associated with the on-boarding and ramp-up of new client engagements in the Americas and Europe, and lower capacity utilization rates, especially in the Americas, partially offset by higher margin business from our recent acquisitions.

Gross margin percentage was also adversely affected by $3.7 million, a deferred revenue as a result of some client transactions not meeting all of the required revenue recognition criteria at the end of the period. Had this revenue been recognized in the period, gross margin would have been 10.8%. This deferred revenue would be recognized in a future period when the remaining revenue recognition criterion is satisfied.

Operating expenses increased $8.9 million or 29.9% from a year ago due to increased restructuring charges which I will discuss further in a moment, the inclusion of the recent acquisitions and allowance for doubtful accounts of $1.6 million.

There is no question we are seeing the impact of the weakened macro economy as evidenced by the pressure that we have seen in our base business volumes. In a response to the weakened economy and consumer demand, we are executing a plan to cut costs and streamline our operations. These actions include reducing headcount, shutting and restructuring facilities and simplifying our service offerings.

Through these actions we expect to save $20 million this fiscal year net of the restructuring charges and to reduce our costs by over $40 million on an annualized basis. We expect these efforts will position us for improved profitability when the economy returns to more normal conditions.

For the first quarter of fiscal 2009, the company recorded an operating loss of $10.8 million compared to operating income of $9.1 million in the first quarter of fiscal 2008. Other income declined by $6.1 million from $2.2 million in the first quarter of fiscal year 2008, to a loss of $3.9 million in the first quarter of 2009, primarily due to lower interest income, a decline in ventures related activities and unfavorable foreign exchange rate changes.

As a result of the above, the company’s pretax loss for the first quarter fiscal year 2009 was $14.7 million versus a pretax income of $11.4 million in the first quarter of fiscal year 2008.

The company recorded a tax expense of $4 million for the quarter. We continue to evolve and drive our tax strategy to both support our business strategy and to maximize the use of our US NOLs. With all of the above factors for the first quarter of fiscal 2009, ModusLink Global Solutions recorded a net loss of $18.6 million or $0.41 per share compared to net income of $8.6 million or $0.18 per diluted share in the first quarter of fiscal 2008.

Non-GAAP operating income represents total operating income excluding net charges related to depreciation, restructuring and amortization of intangibles, stock-based compensation and non cash charges. ModusLink’s non-GAAP operating income for the first quarter of fiscal 2009 was $3.3 million versus non-GAAP operating income of $17.1 million for the same period in fiscal 2008, a decrease of 80% as a result of all the factors mentioned earlier.

The company believes that non-GAAP operating income or loss provides investors with a useful supplemental measure of the company’s operating performance by excluding the impact of non cash charges and the restructuring activities. Each of the excluded items were excluded because they may be considered to be non-operational or non cash in nature. Historically the company has recorded significant impairment and restructuring charges.

Non-GAAP operating income or loss does not have any standardized definition and therefore is unlikely to be comparable to similar measures presented by other reporting companies. Non-GAAP operating income and loss should not be evaluated in isolation of or as a substitute for the company’s financial results prepared in accordance with Generally Accepted Accounting Principles of the United States.

As of October 31, 2008, our balance sheet remains strong. At October 31, 2008, we had working capital of approximately $216.3 million compared with $238.7 million at July 31, 2008 and $294.9 million at October 31, 2007. Included in working capital as of October 31, 2008, were cash, cash equivalents and marketable securities totaling $121.3 million compared to $162.1 million at July 31, 2008 and $261.2 million at October 31, 2007. We continue to have no outstanding bank debt.

The difference in our cash position of approximately $40 million between the end of fiscal 2008 and the end of the first quarter of fiscal 2009 primarily reflects the seasonal buildup of working capital, plus the working capital needs of the acquired companies. The difference in the cash position of approximately $140 million year-over-year primarily reflects the use of approximately $53 million cash for acquisitions, approximately $38 million in connection with the company’s stock repurchase program and approximately $25 million for bank debt repayment.

Our balance sheet continues to be a strong foundation as the company navigates the current economic storm. Based on having a strong cash position and no debt, we feel confident in our ability to not only weather the storm but with the tough actions we are taking to effectively become a leaner and stronger company.

As part of our stock repurchase program, the company purchased 478,000 shares of our stock at a total cost of $3 million or an average price per share of $6.28 during the first quarter. Our repurchase authorization is for up to $50 million and through the first quarter of 2009 we have spent a total of approximately $38 million.

Looking forward, due to the uncertainty in the economy, our visibility for future performance is significantly affected. Like other companies closely tied to consumer spending, the economic slowdown is happening during our seasonally strongest time of the year. We are updating our outlook to reflect the increased risk in the market and the possibility of an extended economic slowdown.

For fiscal year 2009 we now expect revenue in the range of $1 billion to $1.1 billion. At the high end of the guidance range, the company assumes that the current economic environment, which has resulted in a decrease in base business revenue, will persist throughout the year. At the low end of the range, the company assumes continued deterioration of the economic environment which would add further detrimental affects on base business.

While operating income is dependent on many variables and difficult to predict in the current environment, we expect operating income in fiscal 2009 to be in the range of break-even to an operating loss of $20 million.

In constructing this range, we are assuming that restructuring for the full fiscal year will be in the range of $12 million to $17 million. We also anticipate that approximately 20% of our employee positions in the Americas and in Europe will be eliminated by our restructuring actions in fiscal 2009. While these actions will positively affect us during this fiscal year, the impact will be weighted to the second half of the fiscal year.

I’ll now turn it back to Joe.

Joe Lawler

Thanks, Steve. I look forward to speaking with you again on our next call, but now Steve and I are happy to answer any questions you may have. So Mary, would you open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Gaines – Unidentified Company.

Brian Gaines - Unidentified Company

One question; just on that working capital, $40 million; how much of that was seasonal build versus coming from the acquired companies?

Joe Lawler

Brian, the seasonal build was the bulk of it. The working capital from the acquired companies was in the range of $2 million to $3 million from the end of the year.

Operator

Your next question comes from William Martin - Charles Schwab Investment Management.

William Martin - Charles Schwab Investment Management

Can you just clarify on your guidance, the operating income, is that a non-GAAP number, or is that GAAP and what do you anticipate on a cash basis the business to generate or burn in ‘09?

Joe Lawler

I don’t know if there’s such a thing as GAAP operating income, but it is GAAP operating income in effect when you look at the P&L, so it is not our non-GAAP measure. In terms of the business, we do expect the business will generate cash throughout the year and expect that we will end up higher than this level, because there’s a seasonality to our working capital. We’re typically in the high end of our season right now and that should reverse itself.

Operator

(Operator Instructions) Your next question comes from Larry Smith – Unidentified Company.

Larry Smith - Unidentified Company

This quarter, you didn’t mention anything. I always love to ask you about the @Ventures; anything exciting going on in that area?

Joe Lawler

Thanks for the question, Larry. As we made the name change in September over to ModusLink, we really did focus the company on the core operating business and so yes, I didn’t include any comments on @Ventures which has been a good solid treasury activity for us. We had, I would say, minor activity.

We had a net $2 million of investment in the existing portfolio businesses this quarter, in the first quarter, but one of those was in a company called Carbon Flow, which you can look at online. It was a net new investment in a space that we haven’t specifically been in before and the rest of the portfolio continues, even in this tough economy to progress nicely.

We’ve generated good returns from @Ventures, as you well know, over the past couple of years, but the core focus for the company really has been on the core supply chain business.

Operator

Your next question comes from Mike London – JP Morgan.

Mike London - JP Morgan

You gentlemen are very consistent. You keep making money and the shareholders don’t. I’m kind of curious as to how you anticipate being able to lay off 20% of your employees in the Americas and Europe. Are you expecting business to be down or how are you going to do the work with 20% less employees and then also, if you anticipate that you’ll have operational savings of $40 million on an annual basis, where’s that going to come from?

Joe Lawler

Mike, the answer to the first question is through a number of fairly significant reengineering activities that have been going on since really about September of this year. As you I think will recall, we are anticipating strong growth in our business this year and so we expected to see expansion of the business, strong expansion in the Americas and Europe. In fact, what we’re now seeing is not that strong expansion and as a result, we are reacting to that.

We’re reacting to it by taking out capacity and when we take out capacity, then we down-size the number of people associated with that. We’re reengineering activities through things like Lean Sigma which help us eliminate people faster and we’ve of course asked our people to do more with less. So some people have expanded responsibilities while we’re taking out headcount.

The operational saving that we’ve spoken about, $20 million this year, $40 million annualized, is principally the result of that headcount reduction as well as the capacity reductions that we’re talking about as well.

We think that these actions in a normal economy would not have been necessary. We were anticipating good growth this year that would have translated into really strong earnings performance for us in fiscal ‘09. The world has changed a tremendous amount in the past 90 days. We are not sure when it’s going to recover so we’re taking these actions now and yet we do feel that markets will get better in the quarters ahead and when they do, we will have a more efficient, leaner organization to be able to executed with.

Remember also that one of the things that affects us, when we talk about base business, we’re talking about a business where maybe we were running 100,000 units a week and that’s dropped to 90,000 units a week. The reason that we get such high margin is if you can continue a production run with incremental 10,000 units without the incremental setup costs associated with that, we expect to get a good lift as things start to return to a more normal state. So thanks for the question.

Operator

Your next question comes from Brian Gaines – Unidentified Company.

Brian Gaines – Unidentified Company

Just two quick ones; the $3.5 million in deferred revenue, should I assume that all the costs that would be associated with that deferred revenue were expensed in 1Q and the second question is just if you can clarify, just on the cost save; I think you said $40 million annual cost saves and then you said it would be maybe $20 million this year and that was net of restructuring. So am I to think that you think you can actually get $35 million in cost saves this year and then you’re netting out that approximately $15 million in restructuring expenses?

Joe Lawler

You got it, Brian. On the first, yes you’re right. The costs associated with that are reflected in Q1. On the second issue, your numbers are exactly right.

Operator

(Operator Instructions) Your next question comes from Bernard Metzger – Metzger Group Inc.

Bernard Metzger - Metzger Group Inc

Gentlemen, a very disappointed shareholder here. It looks like we just had another very poor quarter. Could you explain to me why quarter after quarter the operating expenses seem to be going up despite our investing $35 million in an ERP system and probably other expenditures towards becoming more efficient? How does that happen?

Joe Lawler

Through the end of last year we were investing heavily in an ERP system and one of the things we talked about as we came out of last fiscal year is that we would be taking out $8 million to $10 million of project related cost associated with that program. We will, in fact and we are in fact taking that cost out.

The ERP program is a program that does give us long term benefit. At the time that we put it in, we certainly did not anticipate an economy that was going to result in 12.5% lower based business volumes and so many of the savings that we’ll get from that program are dependent on the volumes that run through our operation.

We’ve commented that one of the reasons for the SG&A increase in the quarter is associated with some of the charges that we’ve taken, the addition of the acquisitions that are in there as well. I think what you’ll see, as a result of these restructuring actions; you’ll see some of those costs start to come down. You’ll certainly start to see the benefits of the ERP program as we see a more normative state with volumes going forward.

We continue to stay very committed to the financial model that we’ve been talking about for a couple of years which is getting margins up in that 12% to 14% rate; getting our SG&A levels down, so that we’re delivering 5% type operating levels. I think we are on a good trajectory for that type of model until we hit just an amazing economic storm over the past 90 days or so and we’re dealing with that, with the cost actions that we’ve talked about today.

Operator

Your next question comes from William Martin - Charles Schwab Investment Management.

William Martin - Charles Schwab Investment Management

I was just wondering if you could provide some anecdotal insights into how your customers are positioned. Are they sitting on big inventories or are they extremely lean at this point and how are they approaching things?

Joe Lawler

That’s a terrific question. The five markets that we referred to, the five vertical areas that we really focus on, technology markets, I would say they are seasoned as a result of what happened back seven, eight years ago and they’re being very careful not to let inventories get out ahead of them. So I would say they’re reacting very quickly to what’s going on and what they anticipate is going to go on from the consumer standpoint.

So it’s certainly not our sense; you can probably judge that from the fact that our volumes are down, but it’s certainly not our sense that they are taking any risks on inventory accumulation, which probably bodes well for just how these markets will recover, but we still expect that it’s going to be a tough number of quarters out ahead of us. They learned from the burst of the bubble. Many of these technology companies were in much, much tougher shape at that time frame.

Operator

Thank you. That concludes today’s question-and-answer session.

Joe Lawler

Okay. Thanks very much. We appreciate your calling in today. We look forward to talking to you on the next call.

Operator

Thank you, sir. That concludes today’s conference. You may disconnect your lines at this time. Thank you.

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