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DragonWave (NASDAQ:DRWI)

F3Q13 Earnings Conference Call

January 10, 2013, 8:30 am ET

Executives

Russell Frederick - CFO

Peter Allen - President, CEO

Analysts

Paul McWilliams - Next Inning Technology

Doug Taylor - TD Securities

Maher Yaghi - Desjardins

Operator

Good day ladies and gentlemen, and welcome to the DragonWave, Inc. Third Quarter Fiscal Year 2013 results conference call. [Operator instructions.] I’d now like to turn the call over to your host, Mr. Russell Frederick, DragonWave’s chief financial officer. Please go ahead sir.

Russell Frederick

Thank you operator. Good morning everyone. I would like to welcome you to our third quarter fiscal year 2013 financial results conference call. With me today are DragonWave’s Chief Executive, Peter Allen. John Lawlor is away today.

As a reminder, today’s call is being webcast live on the DragonWave investor relations website at www.DragonwaveInc.com. You can access presentation slides from the same site. The webcast will be archived on our site and available for replay shortly after we conclude the call.

I hope you have had an opportunity to read the earnings press release we issued after the close of markets in North America yesterday, which provides detailed financial information on DragonWave’s third quarter results.

On slide two please. Before I begin, I would like to remind everyone that today’s call contains forward-looking statements or information. Actual results could differ materially from the conclusions, forecasts, or projections in the forward-looking information.

The forward-looking information reflects certain material factors or assumptions. Factors which could cause actual results to differ materially, or that were applied in drawing such conclusions or making such forecasts or projections, are contained in the risks factors section of our annual information form dated May 11, 2012, which has been filed on SEDAR and EDGAR.

Material risk factors and assumptions related to our revenue forecast for the upcoming quarter include our expectation regarding our customers’ plans and requirements, the volume and timing of orders, shipments, and revenue recognition.

Material risk factors and assumptions relating to our expectations for the Microwave Transport Business acquired from NSN and our relationship with NSN include our beliefs regarding the growing prospects in our industry and markets, our ability to successfully integrate the product lines acquired from NSN, our expectations regarding potential synergies and prospects for the business, and our expectations regarding end customer demand.

On slide three, I will now revenue the company’s financial results, and then Peter will provide a business update and discussion. Following Peter’s remarks, we will open the call for questions. And we do plan to finish the call by 9:30 this morning, Eastern time.

On slide four please, I would like to remind everyone that all currency figures are in U.S. dollars, and were prepared in accordance with us generally accepted accounting principles, unless we specifically state otherwise.

On slide four, you can see that the total revenue for the third quarter of fiscal year 2013 was $38.5 million, compared to $44.2 million in the second quarter of fiscal year 2013, and $11.8 million in the third quarter of fiscal year 2012.

DragonWave had one customer, namely Nokia Siemens Networks, who generated more than 10% of revenue in the third quarter. Revenue through our new NSN OEM channel partner totaled $25.6 million, or 67% of total revenue in the quarter.

On slide five, please. Gross margin for the third quarter of fiscal year 2013 was 19%, compared with 15% in the second quarter of fiscal year 2013, and 41% in the third quarter of fiscal year 2012. Let me remind you that the gross margin in the second quarter reflected an inclusion of an inventory impairment provision of $2.6 million. Without this inventory provision, the gross margin in the second quarter was 21%.

Total expenses in the third quarter of fiscal year 2013 were $19.9 million, compared to $25 million in the second quarter of fiscal year 2013, and $13.9 million in the third quarter of fiscal year 2012. We have taken action to rationalize and reduce our expenses.

Because the revenue levels are below original expectations, you will see a gain on the P&L of $5.4 million as a result to an increase to a contingent receivable balance. This is almost completely offset by an impairment charge of $4.4 million taken against the tangible assets.

The comprehensive loss applicable to shareholders in the third quarter of fiscal year 2013 was $13.9 million or $0.36 per basic and diluted share compared to a loss of $8 million or $0.23 per basic and diluted share in the third quarter in fiscal year 2012.

Please move to Slide 6, which highlights some of the key balance sheet metrics. Day sales outstanding for the third quarter of fiscal year 2013 was 71 days based on ending balance. This compares to 46 days in the second quarter of fiscal year 2013 and 102 days in the third quarter of fiscal year 2012.

Inventory at the end of the third quarter of 2013 stood at $29.7 million compared to $31.1 million at the end of the second quarter. Inventory turns in the third quarter were 4.1 compared to 3.4 turns in the second quarter.

Total cash, cash equivalents and restricted cash was $36.8 million at the end of the third quarter of fiscal year 2013 compared to $44 million at the end of the second quarter where cash used is just $7.2 million.

We incurred a cash adjusted loss of $10.5 million which was partially offset by a change in working capital of $5 million, purchases of $0.9 million of long-term assets and capital lease payments of $0.8 million.

This concludes my remarks and I will now turn it over to Peter Allen.

Peter Allen

Thank you, Russell. Good morning, everyone. Last quarter, I thought it would be appropriate to provide greater detail into the breadth of the activities that we are involved in connected with the integration of the Micro Transport Business we purchased from Nokia Siemens Networks. Today, I will provide an update on some of those items.

On November 30th, we announced that we had completed the transaction to acquire certain Chinese operations of Nokia Siemens Networks Micro Transport Business in China as all of the Chinese regulatory requirements had been met.

Approximately 100 employees of Nokia Siemens Networks based in Shanghai joined DragonWave and we were delighted to welcome our new colleagues in China to the DragonWave team.

While the Chinese service arrangements came to an end on November 30th, the Italian service arrangements are still in place. Nokia Siemens Networks is currently undergoing a major restructuring in Italy and there has been some labor unrest in the Nokia Siemens Networks group that is providing the services, including periodic withdraw services.

In early January 2013, unions representing this group of Nokia Siemens Networks' workers notified us that a strike had been commenced for all Microwave Transport people on related global functions in Italy.

We are adjusting our other resources in China and Canada to adapt to this and we are in discussions with Nokia Siemens to assist them as they address this issue.

Last quarter I talked about our activities to reduce the number of future manufacturing sites. Overall, these plans are going well and we are slightly ahead of our plan. We did, however, experience short-term supply challenges that impacted our quarter.

One of the manufacturing facilities that serves us experienced difficulties in the period leading up to the end of the quarter. Eventually this was traced to a faulty component that was in the supply chain of that factory but not the others. This has now been corrected and product flow has returned to normal.

We look forward to completing all our integration tasks and advancing the opportunity of building our market globally.

I'm very pleased to inform you that we have appointed a new Vice President of Global Sales. (Barry Duhall) has been promoted from within the DragonWave's sales executive ranks to this position.

He was previously -- he has previously had large account sales management expertise at Nortell, Alcatel Lucent and (Starin) and with the acquisition of the Nokia Siemens Networks Microwave Transport Business, he was the perfect choice and we are thrilled to have him in this role.

(Barry) is based in London, England, so this also provides some geographical diversity for the DragonWave senior management team.

As I have said before, the quality of the mobile broadband operator base served by our unique combination is very strong. And we see strong bid activity in most regions. For Q4, while our guidance reflects some modest growth over Q3, we continue to see weaker than expected demand in Europe for this quarter.

We continue to look at the pipeline and we will adjust our actions appropriately as we see that pipeline mature. Ours is a business that has lead times modulated in less than 10 weeks, and so therefore we have an older profile that reflects this.

So whatever’s going to happen is going to happen quickly. I would say the pipeline geographically is very diverse, and let me emphasize that our overarching objective is a targeted return to the profitability of our business. We will continue to monitor our progress and determine whether we need to make adjustments to meet our key objective of returning to a profitable business model.

I would now like to turn the line over to the moderator to start the question and answer session.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from Paul McWilliams of Next Inning Technology. Please go ahead.

Paul McWilliams - Next Inning Technology

In prior calls, you had stated that your objective was to hit profitability in fiscal Q2 2014 with revenue around $75 million and what I would assume would be a gross profit in the area of 26.5% to 27% and opex around $16 million to $16.5 million. Can you reiterate if that is still a goal that we should measure you to?

Peter Allen

I think certainly the return to profitability is a goal you should measure us to. I think what I’ve been trying to indicate in last quarter’s call and this quarter’s call is we’re very watchful as to whether or not that profitability will have to be achieved at that $75 million level, or probably now more likely at a lower level, as we watch our pipeline and the status of bids made and RFPs that are on the table right now, and are imminent. From all of that, we judge what we think our forward revenue rate is going to be, and we’ll adjust our plans accordingly.

Paul McWilliams - Next Inning Technology

In adjusting down to a lower revenue level, would you say that the profitability would come from lower opex, or higher GP?

Peter Allen

A combination of all factors.

Paul McWilliams - Next Inning Technology

Okay. Your cash usage for this quarter was less than projected, even though sales came in lower. Can you help me understand what adjustments you made there?

Russell Frederick

You know, when I gave the range of around $15 million last quarter we had expected that there would be a lot more working capital pressure in terms of payments being made on payables. So that was really the main source of the cash usage coming in lower than I said. But that being said, for this quarter, I think that will normalize, where some of those payments that were not made last quarter will now be made this quarter.

Paul McWilliams - Next Inning Technology

So what would be your projection for cash usage in fiscal Q4?

Russell Frederick

I would think it would be in the range of around $15 million. I would say that number again for this quarter.

Paul McWilliams - Next Inning Technology

When you lowered your revenue guidance, I believe that you said there that certain items that you couldn’t ship in November would be pushed to December, yet we’ve got a fairly low revenue guidance for this current quarter, below where we were in fiscal Q2, at the midpoint. What’s going on there?

Peter Allen

Let me go over what I said in my prepared remarks. There were two, really, factors that affected our quarter last time round. And the one that I referred to was the challenge we had in manufacturing. About two weeks before the end of the quarter, we started to experience significant difficulties in one of the manufacturers that serves us.

And because we weren't experiencing it in other areas, we thought it was something unique to that process or test environment. And it meant that the pipeline of orders that we had for that last two weeks could not be shipped.

We were able to resolve the problem early in Q4. It was traced to be a -- actually a faulty component in the -- there was a design flaw in one of the components that fed into the product and why it was related just to one factory was -- there was multiple sources and the alternate supply chain was serving the other factory.

So we were able to isolate it, correct it and get production resumed in the early parts of Q4 and, as I said in my prepared remarks, the product is flowing normally at this time.

There was some order -- the other factor, I think, for the quarter was that there was some order phasing issues. Orders that we were expecting earlier in the quarter came later in the quarter and were too late to make the -- to make Q3.

So with both of those factors hitting us last quarter, I would say we are more cautious about things that could affect our revenue in Q4 and beyond and have tried to reflect that in our guidance.

Paul McWilliams - Next Inning Technology

What confuses me a little bit is under those conditions I would have expected that $7 million shortfall roughly from midpoint to push into the fiscal Q4 and make it bigger than your forecast.

Peter Allen

And certainly that particular order will phase into this quarter. But, Paul, we were here by some -- these surprises in the quarter and it made us more -- it makes us more aware of being more resilient to surprises in the future.

Paul McWilliams - Next Inning Technology

One last question, with a higher mix towards driving away products this quarter than last, I would have expected the gross margin to be higher than last on an adjusted basis last time if I take out the adjustment for that inventory right now. Why was the gross margin lower?

Russell Frederick

Yes, so in the DragonWave piece, Paul, there was a large component of OEM activity as well. So that would be the main reason I would point to address the question you asked. And, of course, when we're selling through OEMs, whether it's MSN or others, the margins are lower to allow for that other step in the channel.

Paul McWilliams - Next Inning Technology

I imagine somebody else will ask about it but I did forget, the Sprint situation with Clearwater and (inaudible), do you have any clarity as to whether or not there's plans to continue to build the Clearwater network, build out the balance of it that would stall?

Peter Allen

I think it's far too early to be able to answer that question, Paul. I think it's very positive. The soft bank involvement in Sprint is clearly coming along with some cash to improve the capitalization and give them more room to do hopefully the things that they want to do in their network.

But as you know, that then has to be a decision point whether or not if Sprint is successful in acquiring Clearwater. Now we have the situation where Dish has provided an unsolicited bid. That's all got to play out I think before people will make firm network deployment plans.

Having said that, I think throughout this whole story is the thread that Spectrum is a very, very important asset to enable the mobile broadband service. And Clearwire has very strong assets in that area. So I would be personally surprised that somebody who’s prepared to invest in acquiring that asset wouldn’t be prepared to move forward with the network deployment to utilize that asset. But the timing of that, there’s no way to assess that at this point with all of these other acquisition processes having to be fulfilled.

Operator

Our next question comes from Doug Taylor of TD Securities. Please go ahead.

Doug Taylor - TD Securities

Am I reading the MDA correctly when it says that you can now blow only up to $20 million against your line of credit given where you stand now against your covenants? Just wanted a clarification there.

Russell Frederick

That’s correct.

Doug Taylor - TD Securities

Second, just on your cost base, where are you right now relative to the $5.5 million, I think, in total quarter savings that you were targeting from all your previous restructuring plans? Are all those baked into your numbers right now, or is there more to come?

Russell Frederick

I would say that most of it is baked in, and you see it in the reduction from the Q2 expense level at $25 million, and we came in at $19.9 million for this quarter. You know, there may be, for this quarter, potential to reduce expenses again, but by no means by that same kind of order of magnitude. And we’re looking for the opportunities to reduce expenses, but those reductions are already included.  

Peter Allen

Let me add to that. Of course our integration activities are far from complete. We still have multiple manufacturing facilities serving us. We still have lots of work to be able to produce all of our products in the right locations and transfer testing capabilities.

We still have the situation where we have services coming to us from NSN. So the first order of business, I think, in terms of getting the cost base to the right level is to execute and finish the execution on all of our integration plans. And that’s what we’re focused on at this time.

As I said in my prepared remarks, as we examine our pipeline over the next period, we will continually look at whether or not those integration plans are sufficient to achieve the objective that we’ve set ourselves is that return to profitability, and if they’re not, we’ll adjust accordingly.

Doug Taylor - TD Securities

And so your objective to return to profitability, I think before it was targeted at four quarters after the NSN acquisition. Are you now saying that should just happen this year? Are you pushing at that expectation?

Peter Allen

I would say there’s more pressure on achieving that, for sure. But no, I’m not at this stage prepared to say that we’re not going to be profitable in the after four quarters.

Doug Taylor - TD Securities

Okay, so in the the near term, then, should I take the expense commentary you’ve made as saying that $19-20 million would be the range you’d expect for opex, assuming that you’re on track with your revenue guidance? Or it should be lower?

Peter Allen

No, what I’ve been, I think, trying to tell you is that we would expect that our opex will continue to be favorably impacted as we complete our integration programs over the next couple of quarters.

Doug Taylor - TD Securities

Okay. The strikes that are going on at Nokia right now, how do you see that impacting your results financially?

Peter Allen

Well, operationally, we’re, as I said in my prepared remarks, having to make adjustments where some of the services that we’ve been receiving from that group will have to be accommodated by other resources in the DragonWave portfolio of resources, which includes Shanghai and Ottawa. So we're having to adjust the work that they're doing to cover for that.

Obviously it's not helpful and we are hopeful that working, supporting NSN that they'll be able to resolve matters in Italy at the earliest opportunity. But at the moment, we're sacrificing some other things and some of those other cost savings in order to adapt to the situation.

I at this stage -- it's been in place for a week now, so the impact in operations at this stage is not significant.

Doug Taylor - TD Securities

But do you have a forecast of what it could be going forward?

Peter Allen

It's very difficult for me to talk about how NSN is going to be able to deal with a strike of their employees. I really don't think I'm in a position to provide any guidance or forecast about that.

Doug Taylor - TD Securities

Just a couple housekeeping questions -- what was the amount of Clearwater revenue in the quarter and (inaudible) revenue while I'm at it and then I'll pass the line?

Russell Frederick

Both were very low -- I think in the several hundred thousand range for each of them, Paul.

Peter Allen

Of course, with the (inaudible) range of products, they've been somewhat overtaken by the in-house portfolio that we have acquired from the Nokia Siemens acquisitions. So one of our inspiration plans, as you know, is to rationalize that product in favor of those in this area that we acquired from Nokia Siemens.

So obviously those (inaudible) are now in a rundown mode and, therefore, you cannot -- you shouldn't expect to see significant revenues from those products in the future.

Operator

(Operator Instructions) Your next question comes from the line of Maher Yaghi - Desjardins.

Maher Yaghi - Desjardins

I wanted to ask you for maybe more clarity on what the return to profitability path. I heard you correctly, you still stand behind your initial expectation of returning profitability sometime in I guess 2013, calendar 2013.

Can you maybe talk a little bit about the issues that you faced this quarter in terms of production and pushouts and orders? In your thought, have they affected your view on the profitability of the business and how you can achieve that profitability because it seems those issues should not, in my view, affect the timing of the profitability metrics you had set out initially because they seem like you are indicating issues that you should deal with over the next couple of quarters and should not continue beyond that time.

So I'm not -- I'm having a hard time understanding why those issues are affecting your profitability views on the company.

Peter Allen

So let me try and cover that for you. So let's go back to the issues that affected the quarter. As I said, there was this manufacturing problem that was caused by -- eventually identified as caused by a faulty designed component.

What we've done in response to that is try to do a review of all of the similar components in our products to identify whether or not other latent faults are present that we haven't been able to find so that we don't get caught with a surprise like this in the future.

And I would agree with you that that is not an ongoing factor either in our ability to supply or in our view of the profitability of the business. As I indicated in the response to a previous question, another factor to the quarter was that some of the orders that we were anticipating to be booked and shipped in the quarter came later than expected. And that lead time between when we get involved with an opportunity and we provide a response to an opportunity to the point at which we receive an order and ship it, and all of the dynamics that go on in that chain, clearly have taken longer in this instance than we expected.

So when we look at our future pipeline, I think we are applying more critical judgments about the cycle time, about when the opportunities will convert into revenue. And that is a factor on profitability. If these current opportunities just come later, obviously the pipeline is stretched over a longer period, and that means that the rate of revenue is reduced, or the growth of revenue is reduced. So that is a factor in the future profitability.

Right now, if you looked at our business in the last quarter, as I indicated, I think, in the call concerning Q2, our business now is quite global. 23% of our business was in North America. Assume that percentage in Europe. India was about 17%, Asia was 14%, the Middle East was 16%, and 8% the rest of the world. So you can see that we have a geographical diversity to our business now that’s quite significant. In that I would say I see good activity in most areas, both in terms of pipeline orders, pipeline RFPs, and general business activity.

But the one region that I would say remains disappointing and below our previous expectations is Europe. And so we have good, positive pipeline and bid activity going on in most places, but one of the regions, Europe, a pretty significant one, is still tracking lower than I would expect.

So a combination of these factors, all the bids that we’re looking at, what we now view as the cycle time between an opportunity and when it converts into revenue for us, are all the factors that we’re taking into account to judge our revenue opportunity over the next few quarters in the drive to get to profitability, and as that dynamically changes, because it does, we will be faced with the challenge of adjusting our cost base accordingly.

Maher Yaghi - Desjardins

I see. And my last question is on your credit facility. Can you maybe give us some visibility as to what types of covenants are restricting your ability to use the maximum of $60 million available on that credit facility, because like you mentioned in a prior question, you can borrow up to $20 million right now.

Are you expecting those covenant ceilings to be more easy as you advance in the year, and will that allow you to potentially have more access to cash from that facility?  

Russell Frederick

Let me try and give some color. The credit facility is, as we’ve described before, a working capital facility. And it’s mainly driven off the accounts receivable that we have in place. So as your accounts receivables fluctuate, that is the primary driver of how much access to credit you have.

So at our current level of receivables, and then combined with the covenants -- and the covenants are the standard type of covenants that these kinds of arrangements have. I’m not comfortable describing them in detail on this call.

But the main message is that the primary driver is the AR. So as we generate more sales, the credit line access opens up for us and then you have to test it against the covenants that are there to say, yes, we're OK to borrow more.

Operator

I'm showing no further questions at this time. I'd like to turn the conference back over to management for any closing remarks.

Peter Allen

Well, I'd like to thank everybody for joining us this morning on the call and look forward to speaking with you soon. Thank you.

Russell Frederick

Thank you.

Operator

Ladies and gentlemen, this does conclude today's conference. You may all disconnect and have a wonderful day.

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