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Westell Technologies (NASDAQ:WSTL)

F3Q09 Earnings Call

Jan 21, 2009 9:30 am ET

Executives

Bernie Sergesketter - Chief Executive Officer

Amy Forster - Chief Financial Officer

Chris Shaver - Chief Technology Officer

Tim Reedy - President and Chief Executive Officer, ConferencePlus

Tim Pillow - Chief Marketing and Strategy Officer

John Seazholtz - Chairman of the Board

Analysts

Todd Koffman - Raymond James

Dan Mendoza - Agincourt Capital

Jeff Lindroth - Leaving it Better LLC

Brad Evans - Heartland

Richard Greulich - REG Capital

Steven Becker - Greenway Capital

Steve Bauman - The Weiser Capital

Operator

Good morning ladies and gentlemen and welcome to the third quarter FY ‘09 earnings call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. We will not be taking questions from the media or individual shareholders. However, if you queue up for a question we will record your name and phone number and someone from the company will contact you. Please note that this conference is being recorded.

Before we begin, we would like to read Westell’s Safe Harbor statement. Certain statements contained herein that are not historical facts or that contain the words believe, expect, intend, anticipate, estimate, may, will, should or derivatives thereof and other words of similar meanings are forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those expressed in or implied by such forward-looking statements.

Factors that could cause actual results to differ materially include, but are not limited to product demand and market acceptance risks, need for financing, an economic downturn in the U.S. economy and telecom markets, the impact of competitive products or technologies, competitive pricing pressures, new product development, excess and obsolete inventory, commercialization and technology delays or difficulties, including delays or difficulties in developing, producing, testing and selling new products and technologies, the effects of Westell’s accounting policies, the need for additional capital, the effect of economic conditions and trade, legal, social and economic risks such as import licensing and trade restrictions and other risks more fully described in the company’s Form 10-K for the fiscal year ended March 31, 2008 under the risk section factors.

The company undertakes no obligation to publicly update these forward-looking statements to reflect current events or circumstances after the date hereof or to reflect the occurrence of unanticipated events or otherwise. During this call, we will discuss adjusted net loss and adjusted net loss per share, these non-GAAP financial measures that provide a better understanding of our underlying performance. Please refer to our earnings release in the Investor Relations section of our website to obtain a reconciliation of U.S. GAAP to these measures.

I will now turn the call over to Bernie Sergesketter, President and CEO. Mr. Sergesketter, you may begin.

Bernie Sergesketter

Good morning and thank you for joining Westell Technology’s third quarter fiscal 2009 earnings conference call. I am Bernie Sergesketter, Westell Technology’s Chief Executive Officer. Joining me on the call today are Westell’s Chairman, John Seazholtz; Chief Financial Officer, Amy Forster; Chief Technology Officer, Chris Shaver; Chief Marketing and Strategy Officer, Tim Pillow; and the President and CEO of ConferencePlus, Tim Reedy.

During the call today, I will take a few moments to comment on our fiscal third quarter and then I’ll ask Amy to provide a more detailed description of our financial results. After Amy has reviewed the financials we will open the call to your questions.

As some of you may have seen, earlier this morning the company announced the appointment of a permanent Chief Executive Officer. I’d like to take a few moments to talk to you about Richard Gilbert.

Overall Rick brings over 32 years of network and communications industry experience to Westell along with a wealth of understanding and how to lead complex organizations and develop strategic plans. Most recently as CEO of Kineto Wireless, Rick was responsible for setting the strategic direction of the company and overseeing its rapid growth as the key innovator and leading supplier of UMA technology.

In 1999, he guided Copper Mountain Networks through a successful IPO and over the next six years developed the company into a leading provider of broadband access products. Before that he was the President of ADC Kentrox, one of the fastest growing and most profitable divisions of ADC Telecommunications. He has held numerous other senior management positions in his career and had the privilege of working on the space shuttle project well at IBM in the 1970s.

We believe that Rick will leverage his years of knowledge and experience to drive Westell to meet its potential and fully capitalize on its opportunities. Rick will join Westell February 23. We are excited to see him put his mark on the company and we’re confident in his ability to implement the necessary steps for Westell to achieve its long term goals.

It has been a privilege for me to have served as interim CEO over the past seven months. During this time I’ve placed emphasis on putting initiatives and controls in place that should provide the company the best opportunities to succeed. Although my last official day with the company as an employee is February 28, I will continue to work with the Board, Rick, Amy and the rest of the team in a consulting capacity in order to facilitate the transition.

Now, let’s discuss our results for our fiscal third quarter of 2009. Despite some of the most challenging economic conditions on record, operationally our performance was in line with our expectations due to our continued focus on taking active expense reduction measures.

To-date considerable progress has been made on our cost containment initiatives and we have identified a number of sources of additional value within our business. By streamlining our business, we will be better able to capitalize on the strength of our products as well as on our customer’s market position. As I have said before, we are operating in sectors with strong potential and we have the products that our customers want.

Starting with CNS, Customer Network Solutions formerly are called CNE. During the third quarter, we reported a decline in revenue within our CNS group on a GAAP basis. As Amy will discuss in greater detail shortly, the primary result of the lower reported revenue is related to the classification of our UltraLine Series3 gateway and resulting software related accounting requirements associated with recognizing revenue of this product.

Given the significant increase in UltraLine Series3 unit sales in the quarter, we believe that adjusted revenue measured on product shipments provides more transparency into the company’s underlying sales trends. We therefore have also provided adjusted non-GAAP financial measures that include revenue and related costs of the UltraLine Series3 product based on shipments. The non-GAAP measures also exclude a non-cash goodwill impairment charge taken in the quarter.

During the quarter, we continued to actively ship our next-generation UltraLine Series3 gateways and commenced shipment of our ProLine ADSL modems to AT&T. Our customers recognize the Westell brand as one that represents quality and reliability. We have experienced very positive market reaction and we anticipate the UltraLine Series3 will remain the gateway of choice as our customers continue to expand their fiber offerings.

Despite this continued expansion and end-user growth, we need to remind you that the marketplace for fiber technology is hypercompetitive and as a result has led to compressed margins. In addition to the continued UltraLine Series3 shipments, we are pleased to report that we have commenced shipping our ProLine ADSL modem to AT&T under our 22 state contract.

As you may recall, this contract was a result of the merger between BellSouth and AT&T that took place in late 2007. Although the process to begin shipping units under the new contract took longer than we originally planned, we are pleased that AT&T has chosen Westell as their partner in the continued deployment of their broadband services.

Outside Plant; the group that was most affected by the economic slowdown was our Outside Plant division as the weakened economy impacted demand for telecommunication infrastructure equipment. The combination of project delays due to financing difficulties along with overall softness in new purchasing activity adversely impacted revenue during our fiscal third quarter.

While we know that our performance during the third quarter was not an isolated incident, we also cannot predict how long this economic slowdown will last or when companies will release the capital to accelerate their telecommunication infrastructure projects.

ConferencePlus; one of the unique abilities about our conferencing segment is its ability to produce consistent results regardless of broader market conditions. This resiliency is a valuable asset and why we believe in the success of this business over the long term.

We continue to see an increased usage of conference calls and teleconferencing services as a result of the economic crisis, which generated a revenue stream that served to partially offset the loss of a significant customer earlier in the fiscal year. We believe that as additional companies become more cost conscious, the demand for traditional as well as interactive Web conferencing services will expand further.

Additionally, in response to favorable valuations, we acquired the remaining minority interest in ConferencePlus for $3.6 million. ConferencePlus is now a wholly-owned subsidiary that provides teleconferencing, multi-point videoconferencing and web teleconferencing services.

In general, over the last few months we have witnessed some unprecedented economic circumstances and we understand the importance of being prepared for prolonged macro economic headwinds in the near-term, while continuing our efforts of building a stronger profitable company for the long-term.

Although the timing of potential projects and new orders will always have an impact on the recognition of quarterly revenue and earnings, we understand the need to maintain our focus on working towards profitability.

During our fiscal third quarter, the company repurchased nearly 1.2 million shares, bringing the total number of shares repurchased by the company during calendar year of 2008 to 2.6 million shares.

Going forward the company intends to opportunistically utilize its authorized share repurchase plan once the blackout period ends. However, given the current credit environment and the importance of maintaining a solid cash balance, we do not expect to repurchase shares at the same level or with the same frequency during our fiscal fourth quarter.

With that I’d like to turn the call over to our CFO, Amy Forster, who will walk through our financial results. Amy.

Amy Forster

Thank you, Bernie. On a GAAP basis, Westell reported a net loss for the third quarter fiscal 2009 of $4.1 million or $0.06 per share compared to a net loss of $2.5 million or $0.04 per share during the third quarter of last year and compared to a net loss of $5.1 million or $0.07 per share in the previous quarter.

The company has shipped $10.9 million of our UltraLine Series3 product to-date and has deferred the revenue and cost on a GAAP basis, because we have not established fair value for certain undelivered software elements. While we have delivered products that meets our customers’ current requirements, we are contractually obligated to provide specified software features when and if our customers request them.

Additionally in the quarter, we recorded $1.4 million non-cash goodwill impairment charge related to the January 2007 acquisition of NoranTel. Although our annual impairment test does not occur until the fourth quarter, the current economic conditions and NoranTel’s performance were an indication that impairment could be present and we therefore accelerated such testing.

On an adjusted non-GAAP basis, which includes revenue and costs for our UltraLine Series3 product as it ships and excludes the $1.4 million non-cash goodwill impairment charge, the net loss for the third quarter was $2.5 million or $0.04 per share. As Bernie mentioned, we believe this non-GAAP measure provides additional insight into our current revenue trends and operating performance.

On a GAAP basis, total revenue from continued operations for the December 2008 quarter was $38.3 million compared to $43.7 million in the same quarter of last year and $43.1 million in the last quarter. Revenue on an adjusted non-GAAP basis was $47.5 million for the quarter and includes $9.2 million of UltraLine Series3 shipped in the quarter. Adjusted non-GAAP revenue was lower than our guidance. The shortfall was not a demand issue, but a delay in end-user launch by our customer, which in turn impacted shipments in the quarter.

GAAP revenue by product line for the fiscal third quarter of 2009 compared to the fiscal second quarter of 2009 was as follows. Customer Networking Solutions revenue decreased 13% to $15 million from $17.2 million. Outside Plant equipment revenue decreased 17% to $12.4 million from $14.9 million. Conferencing Services revenue decreased 1% to $10.9 million from $11.1 million.

On a GAAP basis, revenue in our CNS products decreased $2.2 million from last quarter. Even though we shipped over $2 million of revenue to AT&T in the current quarter, the unit shipments were down to other customers. You may recall that a large customer ran a promotion last quarter that boosted the sales of our gateway product in that period.

Outside Plant revenue was down $2.5 million quarter-over-quarter due both to seasonality and the impacts of the current economic environment. While the third quarter is typically seasonably low for the conferencing services due to the holidays, ConferencePlus revenue was relatively flat quarter-over-quarter.

Before I discuss margin details, I want to call your attention to a change in our segment reporting. In the past, we have disclosed margin information at the equipment and services levels. The equipment segment contains both CNS and Outside Plant business units. We will now disclose certain financial information for both the CNS and Outside Plant on a stand-alone basis.

On a GAAP basis the CNS segment gross margin for the quarter was 14%, compared to 11% in the prior quarter. The improvement in the current quarter is due to product cost reductions that were in excess of price reductions. We are working diligently on cost improvements, but do not expect to see an increased margin in the near-term. Margins on a non-GAAP adjusted basis were 10% in the current quarter.

Outside Plant segment gross margins were 41% in the current quarter compared to 42% in the prior quarter. Services segment gross margin was 47% in the current quarter compared to 45% in the prior quarter. The increase in the current year and quarter was due primarily to operational cost efficiencies.

Operating expenses for the current quarter decreased 18% to $15 million excluding the goodwill write-off, compared to $18 million last quarter. The current quarter expense included a restructuring charge of $808,000 related to employee severance costs.

Prior quarter general and administrative expenses included severance of $472,000 and an additional $840,000 of non-cash stock-based compensation expense that resulted from the accelerated vesting of restricted stock, both for former CEO, Tom Mader. The remaining reductions reflect the ongoing cost saving initiatives the company has undertaken both with regard to lower payroll costs and other operational costs.

Some other important points of interest for the quarter are as follows: the company acquired the 8.5% ConferencePlus minority interest for $3.6 million. The company purchased 1.2 million shares under its $10 million share buyback program; $8.4 million remain under the program.

Cash and short-term investments at the end of December was $44 million compared to a balance in September of $50 million. The $6 million decrease in the current quarter was due primarily to the $3.6 million buyout of ConferencePlus minority interest mentioned earlier.

Capital expenditures were less than $100,000. Non-cash items include goodwill impairment of $1.4 million, depreciation expense of $1 million and tangible asset amortization of $486,000 and stock-based compensation expense of $605,000. Deferred revenue as of December 31 is $11.5 million and includes $10.8 million for our UltraLine Series3 product.

We began the quarter with 484 employees and ended with 451. Verizon represented 47% of our revenue for the quarter and AT&T was 13% and lastly, NASDAQ extended the suspension of the bid price requirement and barring any future suspensions, the company has until late August to comply.

I will conclude my remarks with the discussion of our guidance for the fourth quarter ending March 31, 2009. We expect revenue for the fourth quarter to be in a range of $38 million to $42 million and we expect to incur a loss within a range of $0.03 to $0.04 per share with a full valuation allowance recorded on tax benefits generated in the period. This guidance does not include the $9 million to $11 million of expected shipments of our UltraLine Series 3 product in the quarter.

I will now open the floor to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Todd Koffman - Raymond James.

Todd Koffman - Raymond James

Can I just get a clarification on the; I think it was $9.2 million UltraLine Series3 deferral? Was that product that was physically shipped in the quarter for $9.2 million?

Bernie Sergesketter

Yes, it was. Go ahead, Amy.

Amy Forster

I’m sorry. Yes, that is correct. $9.2 million was shipped in the quarter.

Todd Koffman - Raymond James

And you’re waiting for what? Or what are the requirements that will ultimately allow you to recognize that revenue?

Amy Forster

The question is what are the requirements that will allow us to recognize that revenue? As I mentioned earlier Todd, there are some contractual obligations to provide some specific software enhancements to the product and although we’ve provided a product to our customer that fully has met their needs and expectations, because of this contractual requirement and the fact that we are not able or have not been able to establish fair value for those undelivered elements, we are required to defer that revenue.

Todd Koffman - Raymond James

So when you gave your guidance for the March quarter, it also did not include the recognition of that revenue. So, is it fair to assume that you don’t expect to get those software enhancements included in the product shipped during the March quarter?

Amy Forster

That is correct.

Bernie Sergesketter

We’re going to work to get that done, but we can’t guarantee that we’ll have it done, but yes, we’re going to work to get that work done before the end of the next quarter.

Todd Koffman - Raymond James

So, it begs the question then, are those products physically being deployed into customer locations for use or not yet?

Bernie Sergesketter

No, absolutely. They’ve been deployed and it’s very successful. The quality is outstanding; our customer is very, very pleased; the end-users are very pleased it’s going very well.

Todd Koffman - Raymond James

Then just one last question, do you expect to ship additional UltraLine Series3 product to that customer against that deployment in the March and June quarters, in addition to the $9.2 million worth of product?

Amy Forster

Correct Todd. As I indicated when I gave guidance, it did not include our anticipated shipments in the fourth quarter of that product in the range of $9 million to $11 million.

Todd Koffman - Raymond James

No, I know, but I’m just trying to get a sense as to whether the deployment is continuing to go forward, with the customers need for additional UltraLine Series3 product, new additional incremental units in the March quarter?

Bernie Sergesketter

Over and above the $9 million to $11 million?

Todd Koffman - Raymond James

Yes, that’s correct.

Bernie Sergesketter

No, the $9 million to $11 million is our estimate of what we will ship during the fourth fiscal quarter.

Todd Koffman - Raymond James

Okay. So even though you have $9.2 million deferred in the December quarter, you expect to ship additional units with a revenue value of about $9 million?

Bernie Sergesketter

That’s correct. Additional that’s correct.

Operator

Your next question comes from Dan Mendoza - Agincourt Capital.

Dan Mendoza – Agincourt Capital

I’ve got a handful of questions. To follow up on the UltraLine 3, looking at the pro forma numbers, it looks like the gross margin on the deferred revenue was about 2%. Am I missing something?

Amy Forster

Dan, this is Amy. Your question is, is the margin 2% on UltraLine and that is correct.

Dan Mendoza – Agincourt Capital

Okay. So I guess, I have an additional question, is John or someone from the Board on this call?

Bernie Sergesketter

Yes, John Seazholtz is on the call.

John Seazholtz

Yes, I am.

Dan Mendoza – Agincourt Capital

John, why is a business that has 2% gross margin a good business to be in when it’s losing a lot of money and burning a lot of cash?

John Seazholtz

One reason is that, we have the ability to reduce the cost of the product and increase the margins. The second is that, we have underway software features that will have good margins and, like a number of platforms in industry, the applications and the opportunity for the profits are more significant in the applications than in the underlying physical platform.

Dan Mendoza – Agincourt Capital

Okay, but you’re in three businesses, two of them have 40% plus gross margin and are nominally profitable businesses; the core, the business that you’re partly concerned about has 2% gross margins and your company’s cash balance is down $25 million plus in the last three quarters. I’m not sure you guys have got the time or the resources to see all those opportunities through.

John Seazholtz

Yes, I’ve read your e-mails to that effect and taste.

Dan Mendoza - Agincourt Capital

Okay. So, do you think that the Board has done a good job protecting shareholder value?

John Seazholtz

We wouldn’t be doing it, if we didn’t think it was a proper course of action.

Dan Mendoza - Agincourt Capital

Okay. Well, I mean I don’t know, I’ve been in this business for over 15 years and I’ve never come across a Board that has treated shareholders with such disdain and then so inactive, indecisive and invisible when it comes to protecting shareholder value. Why are you buying out the minority interest in ConferencePlus, what’s strategic about that?

Bernie Sergesketter

Well, let me address that Dan. We believe we are a minority share owner who was interested in liquidating his investment and we believe that valuation wise it is an opportune time and in the interest of our share owners to have done that and bought an amount. Now I’m going to ask Amy to comment on the price and the fact that it’s not only for the business, but for a piece of cash as well.

Amy Forster

That’s correct. Dan, as you know the businesses are typically valued on a debt free cash, free basis. However, over half of the valuation or the value that we paid to the minority interest was a payout for cash that was on the books as well.

Dan Mendoza - Agincourt Capital

Okay. Just to be clear, was the minority holder Tim Reedy or someone else?

Bernie Sergesketter

No, it’s someone else.

Dan Mendoza - Agincourt Capital

Okay. So I guess I still am struggling to understand. I mean you could have bought back 20% of the stock of Westell for the price that you paid for 8.5% of the conferencing business that you own 92%; the numbers don’t make sense.

About 92% of the business for $20 million and owned CMS and Outside Plant and had $40 million in cash. It’s just a total disconnect here at the Board level. $20 million in cash and you are valuing the conferencing business at $40 million, you’ve got $40 million in cash and so that’s $80 million, not including two other businesses. Your stock is trading at $19 million and you bought back $300,000 in stock, it’s just absurd.

Bernie Sergesketter

Well, the evaluation is not $40 million because you have to take into account the cash; that’s over half of what...

Dan Mendoza - Agincourt Capital

$1 million, but anyway?

Bernie Sergesketter

We believe that the conferencing business has a lot of upside potential over the next couple of years and that this was a good thing to do.

Dan Mendoza - Agincourt Capital

I do too, but you own 92% of it already and the entire value of the company is only $19 million. You could buy the whole conferencing; you could buy all of Westell, which includes 92% of the conferencing business for a much better valuation and support the stock and support shareholders.

So, at any rate, I mean you guys brought in consultants, you talked about that on the last conference call. You said they would be back with the results of whatever it was that they were looking at in the quarter, we heard nothing from you during the quarter on what the strategic plan was going forward and now there is nothing; there’s been not one mention of what the strategic plan is for Westell going forward on this call.

Does that mean that we’re not going to get that from your tenure Bernie and that now, we had Tom get his strategic plan; the Board didn’t listen to it. We had you come in, give your plan, the Board didn’t listen to it. We’ve had consultants come in and now we’ve got a new CEO who’s been hired. Does that mean that we’re going to have to wait for him to come in, assess how the business is before we have a plan that makes sense for Westell where we actually get profitability and figure out what business we want to be in?

Bernie Sergesketter

Well Dan, there has been a lot of work that’s gone on the strategic evaluations. We’ve implemented some cost containment efforts that have resulted in some better results this quarter versus the quarter before. We’ve been very, very careful in terms of those cost containment issues, so that we did not jeopardize opportunities going forward. We had new product rollouts during this last quarter, the UltraLine Series3 as well as the modems for AT&T that have been very, very successful, have gotten very positive customer feedback.

The consultants have come in and they have recommended some new customer segments, some new pricing models that we’re still doing some final evaluation on and all of this I’ve already started working with Rick Gilbert in terms of bringing him up to speed on this and I am going to be available to Rick and the leadership team so that the work we’ve done, we don’t have time lags in terms of him finalizing what our strategy is going forward.

Dan Mendoza - Agincourt Capital

Well, with all due respect to Rick Gilbert, his last publicly traded company ended up selling for $10 million when they had $20 million in cash and it seems like we’re on our way to that already with Westell and I don’t know why anybody would take a job with this Board of Directors when the Board of Directors has voting control and doesn’t let their Chief Executive Officer make executive decisions.

This Board just doesn’t care or is really lacking in brain cells. I’ve never seen anything like it; it’s remarkable, that 2% gross margin business. It’s burning lots of cash and losing lots of money is what the focus is part of the strategic plan when you’ve got two profitable businesses with 40% plus gross margins. It’s a shame.

Operator

Your next question comes from [Jeff Linroth] - Leaving it Better LLC.

Jeff Lindroth – Leaving it Better LLC

The consultants, would you give me just an idea of what the expense has been so far, just an approximation and describe the benefits, however you’d like to characterize them achieve, that we’re on the way to enjoying or we have enjoyed already?

Bernie Sergesketter

Our total expenditures for the consultants is $36,000 plus some very diminimis travel expenses and again the work is not finalized. We’re in the latter stages just of doing the due diligence to make sure that what has been recommended has legs.

Jeff Lindroth - Leaving it Better LLC

Okay. Also would you please talk about the software and services that we’re anticipating are going to be attached to these obviously relatively lower margin CNS products. Where would you say you are in terms of getting to where you want to be? Would you say you’re 10%, 25%, half way there in term of getting to where you say “Hey now we have this nice mix of hardware and software and services in just producing the margins we want?”

Bernie Sergesketter

I’m going to ask Tim Pillow to address that, Jeff.

Tim Pillow

Again, one of the key strategies here is now that we have a toehold if you would, within this leading service provider account who’s doing fiber to the home deployments is there’s a lot of variations on the theme in terms of the product that they’re interested in deploying.

So the two specific examples I would give is; one is a more optimized wireless performance product using the standard 802.11n and that would be an example again of a product that again our customer is interested in deploying within certain segments of their customer base in order to give them better and superior wireless performance in larger homes.

We’ve actually implemented that skew variation that does yield better margins for our business assuming a customer goes with adoption of it, that we’ve actually shipped product to the customer labs for evaluation of that skew and again are optimistic, as one example, that that kind of a variation if you would on the UltraLine Series3 will be a product that gains popularity in terms of their deployment.

We’ve got another variation of the product that uses a technology called DSL2 to serve certain segments again of this customer’s marketplace, expands their addressable market and again this is a variation around the core theme, but has a set of hardware and software inside of it which again we believe is promising and again that product is also in an evaluation stage with the customer.

So, these are a couple examples and I’ll call it the product skew variation side of where we believe we can bundle various pieces of hardware and software together in terms of improving our margins. In addition to that, we have a set of programs that are going on basically where we’ll introduce new chipsets; new tweaks if you would to the architecture within the product that again would contribute positively in terms of the margin picture going forward.

Jeff Lindroth – Leaving it Better LLC

I guess I’m kind of repeating the question, but would you say we are in the early stages; I mean, I realize it’s a bit of a moving target, but where do you think we are compared to where you envision us?

I mean, obviously, we are not where we want to be in terms of margins, and I’m not asking you what margins we are going to have where you envision, but I’m asking you from where we are today, in terms of fully implementing these things which are going to augment margins, I’m trying to get a handle on how far down the road you are and how much further you think we have to go?

Tim Pillow

Sure. So, I think historically and given our track record with other products in the portfolio, such as ProLine and VersaLink where we’ve gone through these kind of learning curves before, I could typically take this three to four quarters, if you would, to get to the kind of nominal gross margins which we would expect from this segment of the business, to give you some kind of calibration.

Jeff Lindroth – Leaving it Better LLC

Okay, that’s helpful. One more question and Tim, I don’t think this is a question for you, but in terms of SG&A, in terms of where we are, where we think we are going to be, do we see any opportunity for that in the next six to 12 months to reduce that?

Amy Forster

Jeff, this is Amy. The question is do we think we’re going to reduce SG&A in the next six to 12 months. As you know Jeff, we typically only give financial guidance a quarter out in advance. I am not anticipating a large increase in our fourth quarter OpEx and you’ll also know or recall; in my script I described an 18% decrease in the third quarter compared to the second quarter. So, we have really taken a lot of OpEx out of the system already, both in terms of employee, cost as well as other operational costs.

Bernie Sergesketter

Which is going to flow through obviously, into the fourth quarter.

Operator

Your next question comes from Brad Evans – Heartland.

Brad Evans – Heartland

I realize there’s a lot of frustration on this call and I don’t want to pile on, but I dual class share structure not withstanding for John and Bernie, I feel like I have to say this and it’s a shame, but I have to remind the Board that you have a fiduciary responsibility to all shareholders and it’s a legal obligation to protect the value for all shareholders. That’s a comment and not a question and I think there’s a lot of frustration on the call, but I do think there’s a crisis of confidence with this company and it starts at the Board level in terms of really treating all shareholders fairly and I really urge you guys to consider that there are obvious steps that you can take to unlock some value within the company.

It sounds like the consultant engagement has been just on the description that you gave us is pretty disappointing. I mean when you look at the elusiveness of profitability and the continued cash burn, I mean it doesn’t take a rocket scientist to conclude that the company doesn’t have the financial resources to really be a leader in all three of the businesses that you’re currently engaged in and it makes a lot of sense to probably become smaller and focus on one or two businesses as opposed to three.

With that comment having been made, I just don’t understand why the company doesn’t take a more strategic alternatives review of the entire organization, including hiring an independent investment bank to help the company kind of understand what the options currently are available to you, to try to unlock value to restore the devastation that shareholders have endured. Any thoughts on that, please?

Bernie Sergesketter

Well Brad, thank you for those comments and I understand very clearly what you’re saying and we have done work in those areas that I’ve already started to discuss with Rick Gilbert and he’s going to be working with the Board in terms of this shareowner value.

Brad Evans - Heartland

Well, I would urge you. I guess I’ll just be more blunt about it. I would urge you and the Board to really seriously consider engaging an investment banker to explore strategic alternatives for the business and I recognize we’re in the middle of a financial crisis, so it’s not optimal timing, but clearly we’ve gotten to the point where I don’t think anything can be not put on the table here to help restore some value to shareholders.

I have one question on the operating expense line Amy. That was one bright spot in the quarter. I mean your cash operating expenses were down significantly versus the last quarter. So just further on to your comments, we should not expect any further cost savings on a go-forward basis? The run rate that we’re on; $13.8 million, if you exclude the non-recurring items and the goodwill amortizations of cash operating expenses, $13.8 million that’s a good number to be using going forward?

Amy Forster

Yes, in the fourth quarter payroll taxes kick in and we have a couple of programs that we would like to spend some money on. So, I don’t anticipate any further reductions in this fourth quarter Brad.

Operator

Your next question comes from Richard Greulich - REG Capital.

Richard Greulich - REG Capital

I have a question; in the non-GAAP reporting of the UltraLine sales and the associated gross profit, what was sort of inherent in those numbers and what was the warranty or sort of return expense that was assumed?

Amy Forster

This is Amy. The question is what is the warranty expense that was assumed? I don’t have that number at my fingertips, but I can tell you that what we did was we looked at how the product is performing in the field so far, which has been very favorable and is very similar to our historical and our legacy products. So, the accrual was based on similar type rates that we used when we introduced the VersaLink product.

Richard Greulich - REG Capital

Okay. Is that likely to go up or down over time?

Amy Forster

Well, obviously when you have an accounting estimate for something like warranty, you accrue your best estimate at the time and that estimate will change based on new facts and data that come into play in the future. So currently I’ve accrued our best estimate. Will that go up or down? It probably will just based on new facts and data, but I can’t predict that at this point in time.

Bernie Sergesketter

I am encouraged by the results of the initial installations.

Richard Greulich - REG Capital

When you kind of take out that for non-GAAP purposes, when you have the revenue and the gross profit, are there other operating expenses that are somewhat associated with that business that if you truly had to separate it out and put it out aside, would go away as well?

Amy Forster

This is Amy and again the warranty is a good example. The warranty expense has not been deferred; it has been expensed in the quarter. There probably are some operational costs that were considered period costs in this period, but nothing that is of major substance.

Richard Greulich - REG Capital

In prior calls and maybe I missed this in this call, there was talk about trials with the cable MSO. Did you mention that this call or is there any status report on that?

Tim Pillow

Yes. Tim Pillow. So yes, we have done trials with several multi service operator cable players and it responded to several RFPs. We have equipment that’s under evaluation with them. What we’re currently targeting again in terms of minimizing our cost of potentially entering that marketplace is to work via a partner in order to diminish our channel cost if you would for entry into that marketplace and we’ll look forward to keeping you posted on the status around those partner relationships here overtime.

Richard Greulich - REG Capital

Have you at this point established any firm working agreement with a marketing partner there?

Tim Pillow

No, we have not.

Richard Greulich - REG Capital

Okay and would it be likely that the gross profit on that business would be much different from what the Verizon business currently is in terms of the new product?

Tim Pillow

Yes, it would be.

Richard Greulich - REG Capital

Let me go back to the valuation of the services business. I’m relatively new to the company, so if you could just real quickly refresh my memory as to why was there somebody owning a minority part? How did that happen?

Amy Forster

This is Amy. The question is how did the minority interest come about? When the company was started the executive that was in charge of starting the company was given an ownership position in that company, so it’s primarily the former CEO of that entity that owned that minority position.

Richard Greulich - REG Capital

Was there any put involved in terms of contractually whereby the company was obligated to buy out his part?

Amy Forster

The company was under no obligation to buy out that minority interest.

Richard Greulich - REG Capital

Okay. If you could just, aside from simply saying it was a good valuation, could you explain how you arrived at that price and why it’s a good valuation?

Amy Forster

I can in general terms. So the question is how we came up with the value?

Richard Greulich - REG Capital

Yes and why would it be good?

Amy Forster

Okay. So what we did was we obviously did a forward-looking valuation based on discounted cash flow analysis for the forward-looking business, also taking into consideration the cash that was in the business and we applied a minority discount to that value to come up with the value and the reason that we believe it was a good time to do that for Westell was that the minority holder was interested in liquidation. So, we were able to apply a pretty substantial discount for that minority valuation. Does that answer your question?

Richard Greulich - REG Capital

Yes, I mean I think based actually on operating income in the prior fiscal year, it seems reasonably attractive. Obviously based on a multiple of this year’s operating income, it doesn’t. So I guess that assumes you’re looking for things to improve?

Amy Forster

Well I think that’s the point. We believe that that business will return to its historical profitability levels. So, buying it out that the performance has had a hit due to a loss of a major customer this year makes it a good time to do that.

Richard Greulich - REG Capital

And could you go into just a brief detail of the compensation terms for; I can’t recall his last name the new CEO?

Amy Forster

This is Amy. So, the question is what are the compensation terms? I’d prefer that we defer that an 8-K will be filed with the full agreement for Rick Gilbert, our new CEO. That will becoming out in the next few days so you can just stay tuned for that.

Richard Greulich - REG Capital

Okay and then just to go back to the gross margin on the Verizon new product, the UltraLine. Aside from software enhancements and future improvements there, are there any changes in pricing over the next, let’s say two to three quarters worth of shipments or will the pricing be what they were in the prior quarter?

Tim Pillow

So we’ve got a contractual agreement with the customer that does impact the pricing over the term of the agreement.

Richard Greulich - REG Capital

Okay. I assume that’s on a negative?

Tim Pillow

That’s a fair assumption.

Richard Greulich - REG Capital

Okay and is there any over the next two to three quarters or what would be the reason why there might be or might not be any cost reduction then associated with manufacturing?

Chris Shaver

This is Chris Shaver, CTO. We actually do have our first significant cost reduction ready to submit probably in the next 30 days to 60 days to our customer.

Richard Greulich - REG Capital

And that would be based on product redesign or what would the cost reduction be based on?

Chris Shaver

It is a product redesign, so reducing the complexity of the product, making the manufacturing cost lower.

Richard Greulich – REG Capital

Okay, this is going to be really broad, but what’s the chance that you got the business now based on obviously reasonably good reliability, very low price, but the next iteration comes up and ActionTec or someone else comes in and does the same thing to you so the next iteration you don’t get ahead of the game in terms of gross profit? What do you do about that?

John Seazholtz

Well again, I think historically, particularly with this customer, we’ve got almost 10 million units of CPE deployed in their network; we have an enviable track record relative to the reliability of those products. Right now we have a multiyear agreement that’s in place, but obviously as with any customer they’re free to rebid and repropose or if you would remarket at any time at their will as the service provider, but we’re confident again based on our initial deployments and the initial performance of the product which has been very favorable, that we would stand well in those kind of competitive matrices.

Richard Greulich – REG Capital

Okay and then I think lastly, the gross margin itself on the equipment side of the business plummeted quite a bit, aside from the Verizon part of the business. What were the reasons for that and what’s the chance of getting that back up over 20% in the near term?

Amy Forster

Actually, if you refer back to my script, margins in the CNS business increased from 11% in Q2 to 14% in Q3.

Richard Greulich – REG Capital

You’re right, I think I missed that.

Bernie Sergesketter

Right, so it actually was the opposite.

Amy Forster

Yes, we had a cost reduction in place that outpaced our price reduction.

Richard Greulich – REG Capital

I apologize. When I was going through my notes, I think I was referring to the overall equipments, which wouldn’t be a fair comparison. I appreciate it. Thank you very much.

Operator

Your next question comes from Todd Koffman - Raymond James.

Todd Koffman - Raymond James

I just have a follow-up on this action to buy out that minority stake in ConferencePlus. It just financially looks a little odd and was wondering what the reason was? Maybe your valuation for ConferencePlus is not so absurd and clearly financially it would have been smarter to or it looks on the surface to be smarter to take a much, much larger stake in the total Westell, but what was your reasoning for taking that ownership? I mean clearly you didn’t just do it out of the goodness of your heart to monetize a founder. Was there a reason behind it?

Bernie Sergesketter

Well, we thought it was an opportune time to do it because the minority holder was interested and did want to liquidate and we did, we were able to put a discount on it that we thought made it an opportune time to go forward.

Todd Koffman - Raymond James

Just a follow-up and I apologize; I’m just so confused on this. The fact that original founder wanted to sell, what does that do for Westell?

Bernie Sergesketter

Well, it gives us 100% ownership and we believe and I’ll ask Tim Reedy to comment on this and we don’t give guidance over another quarter, over the next quarter, but we believe that there is very good value appreciation looking forward in that business. Tim, would you like to comment on what you see in terms of your business?

Tim Reedy

Sure Bernie, this is Tim Reedy, President and CEO of ConferencePlus and going into this next quarter we believe that we’re going to be able to achieve some margins back to where we were on an operating income level in prior quarters. We had a tough year in terms of the loss of one significant customer; we’ve reduced our costs not only on the Telco’s side, but on the operating expense side and we expect going into this next quarter to see improved financial performance.

Operator

Your next question comes from Steven Becker - Greenway Capital.

Steven Becker - Greenway Capital

I just want to reiterate the sentiment of the gentleman from Heartland. I mean I’ve been talking to management here for over a year and on multiple occasions I’ve asked you guys to consider engaging someone to help sort this out. I’ve also asked that the Board considered adding some independent directors who might be able to help push this company in the right direction. Can you guys address whether that’s a possibility and if so where you are in that process?

Bernie Sergesketter

We’re of course bringing in Rick Gilbert who is very, very experienced in this whole arena. He was experienced with ADC and with Copper Mountain and with Kineto and I think I have a lot of respect for him. I think he is going to have the skill set and the perspective to come to some very good recommendations.

Steven Becker - Greenway Capital

But, he’s going to be hugely conflicted. I mean if there is an opportunity to sell your modem business, the last thing he’s going to want to do is sell the business and his core strength and focus on the OSP business. I mean, I’m talking about bringing in someone who’s truly independent or a couple of individuals who are truly independent and can take a fresh look at this and don’t have any allegiance to any particular business, their only allegiance is to the shareholders.

Bernie Sergesketter

Well, I don’t know that that’s fair Steven to say that. I think he’s going to be focused. From my discussions with him, I spent two full days with him very recently and from my discussions with him, he’s going to be very focused I believe on improving shareowner value, whatever that takes.

Steven Becker - Greenway Capital

Okay, can you again discuss a little more the decision to buy the minority interest in ConferencePlus as opposed to buying back stock? I mean on the one hand on this conference call you’ve talked about the desire to preserve capital, yet again it would seem it would make a heck of a lot more sense to retire equity at these levels than to have paid what backs into and seems like a pretty rich value for ConferencePlus?

Bernie Sergesketter

I don’t know that I can add anything Steve to what we’ve already said. I think in my comments to Todd and to Jeff and Richard, we’ve covered all the points.

Steven Becker - Greenway Capital

So, at this point in time you’re not going to be buying back anymore stock?

Bernie Sergesketter

No, we will be, we do intend to buy. We have authorization to buy back $8 million more, so no, that’s definitely on the table.

Steven Becker - Greenway Capital

Okay, but you had that authorization for quite a while, the stock is completely liquid. You could buy as much stock as you want on any given day and you haven’t utilized it. Is that a reasonable expectation by the end of next quarter that you’ll buy back more stocks?

Bernie Sergesketter

Well, our plans right now are to buy back more, but not necessarily as much as we bought in the past, but we do have plans. We do plan to continue to buy back.

Steven Becker - Greenway Capital

Well, speaking as a large shareholder, I sure would like to see some independent voices added to this Board. I reiterate the frustration of every speaker on this call.

Operator

Your next question comes from Jeff Linroth - Leaving It Better LLC.

Jeff Linroth - Leaving It Better LLC

Yes, just one quick follow-up. I know you can’t comment on the details of this investigation into the trading of the securities, but one of the things you do say in the risk statement is that, if it becomes a lengthy ordeal it could impact your financials materially. What’s been the impact of that if you would quantify it even or qualitatively describe it?

Amy Forster

Jeff, this is Amy. I will qualitatively describe that. I don’t have the exact impact in front of me, but obviously our prior quarters and prior year legal expenses that run through G&A were impacted by that SEC investigation. In the last quarter and partially in the second quarter we have spent less money on that action.

Jeff Linroth - Leaving It Better LLC

Okay, that’s what I was hoping for. Thank you.

Operator

Your next question comes from Steve Bauman - The Weiser Capital.

Steve Bauman - The Weiser Capital

Amy, when you hit customer concentration numbers, I’m sorry I just missed it. Was that based on the non-GAAP revenue number or the GAAP revenue number?

Amy Forster

No, that was based on the GAAP revenue number.

Steve Bauman - The Weiser Capital

So, non-GAAP Verizon is actually much, much higher than that since essentially all of the non-GAAP revenue is to that customer?

Amy Forster

That’s correct.

Steve Bauman - The Weiser Capital

Okay, great thanks. Then a question for Tim Pillow, talking about the VDSL2 potential variance of the UltraLine Series3 product; can you just talk a little bit more about that application? I think if I recall correctly, at one point Verizon was talking about doing a VDSL2 in a significant minority or it maybe even a majority of their MDU deployments. Is that still the plan?

Tim Pillow

Yes, you’re right on. VDSL2 is absolutely critical; the MDU or Multi-Dwelling unit apartment dwellings which again within their footprint are a very, very significant percentage of the addressable market for them. So, we do think there is a good opportunity there for some upside. Again, I’ll call it the interoperability testing and the variations on that theme have taken much longer than anyone have ever thought in that area, but yes VDSL2 for MDU inside of their footprint is specifically the targeted market and the targeted opportunity for that technology.

Steve Bauman - The Weiser Capital

Okay, my impression was that Verizon had somewhat moved away from that with kind of the advent of bendable fiber and the opportunity there, but you guys still think that that VDSL2 is a good opportunity?

Tim Pillow

That’s correct and again, it’s one of the assets in the toolkit; it’s absolutely not the only asset inside of the toolbox. Bendable and other technologies are also being considered for applications in that segment, but again it’s a large segment and even again if we’re willing to capture a given percentage of it we think it’s attractive.

Chris Shaver

This is Chris Shaver. On the case of the bendable fiber installations, they would install what’s known as the single-family unit or fiber-to-the-prem version of our UltraLine Series3 products. So, we have both products qualified for deployment in Verizon’s network of VDSL2 variant for those installations and obviously the SFU variant.

Steve Bauman - The Weiser Capital

Alright, so you see guys are in some sense indifferent to their technology implementation then?

Chris Shaver

That’s correct.

Steve Bauman - The Weiser Capital

Great and then I’m going to have a question on this ConferencePlus sale as well, because I’m obviously scratching my head as everyone else is on the call. Was the ownership structure that as it existed prior to you guys buying out the minority stake; was that ownership structure an issue at all when you guys looked for potentially divesting this business; I don’t remember what it was 12 or 18 months ago?

Bernie Sergesketter

No.

Amy Forster

This is Amy, Steve. There were drag along, tag along rates, so that was not an issue.

Steve Bauman - The Weiser Capital

Okay. So it wasn’t a desire to clean that up, that wasn’t why you guys entered into this transaction?

Amy Forster

Correct.

Steve Bauman - The Weiser Capital

Okay, well, I think the first caller did a great job of explaining the math and how really confusing it is that you guys would buy that minority stake when you could buy the minority stake much cheaper through your public equity. So, hopefully the Board is listening and we will rethink that decision. Thanks very much.

Operator

This concludes the question-and-answer session. I will now turn it back to Mr. Sergesketter for closing remarks.

Bernie Sergesketter

Thank you very much all for joining us on the call. Thank you for your questions. Any questions that you have where you didn’t have an opportunity to ask them directly, I believe you have the information where if you get those questions to us we’ll have someone get back to you. So, I appreciate your support and interest in Westell. Thank you very much.

Operator

Thank you ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may all disconnect.

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Source: Westell Technologies F3Q09 (Qtr End 12/31/08) Earnings Call Transcript
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