Network Equipment Technologies, Inc. F3Q09 (Qtr End 12/26/09) Earnings Call Transcript

Network Equipment Technologies, Inc. (NWK)

F3Q09 Earnings Call

January 28, 2009 at 4:30 pm ET

Executives

Leigh Salvo - Investor Relations

Nick Keating - President and Chief Executive Officer

John McGrath - Vice President and Chief Financial Officer

Analysts

Greg Mesniaeff - Needham & Company

Presentation

Operator

Ladies and gentlemen thank you for your patient. Your conference call will begin shortly. Again, thank you for your patient and please standby.

Good day ladies and gentlemen, and welcome to the Q3 2009 Network Equipment Technologies conference call. My name is Michel, and I will be your operator for today. At this time all participants are in a listen-only mode. We will conduct a question and answer session toward the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the call over to Ms. Leigh Salvo. Please proceed ma’am.

Leigh Salvo

Welcome everyone to our call this afternoon, during which we will discuss results for Network Equipment Technologies’ third fiscal quarter of 2009. With me today are Nick Keating, President and CEO; and John McGrath, CFO.

In keeping with the Safe Harbor provisions of the Private Securities Litigation Reform Act, I want to remind everyone that we will be making some forward-looking statements and projections today, including those relating to future revenue, operating results and financial condition. Investors are cautioned that these statements are based on current estimates and assumptions that involve risks and uncertainties that might cause actual results to differ materially from those expressed or implied in the forward-looking statements. These risks and uncertainties include federal government budget matters and procurement decisions, the timing of orders, market acceptance for our new products, timely completion of product development initiatives, relations with and performance by third-party technology providers, new competition and technological changes, success in building new sales channels, circumstances regarding specific sales that can affect the recognition of revenue, and progression of patent litigation and other risks including those identified in the Company’s filings with the SEC, including Forms 10-K and 10-Q and in other press releases and communications.

The Company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Additionally though an audio archive of this call will be available on the Company’s website for at least 12 months, the statements made on this conference call are only made as of January 28th, 2009, and we disclaim any duty or intention to update forward-looking statements.

In addition to financial measures presented in accordance with GAAP, we will also be discussing certain non-GAAP financial measures that are adjusted from results based on GAAP to exclude certain expenses, gains, and losses. These non-GAAP measures should not be considered a substitute for, or superior to, GAAP results. Please refer to the press release issued today for further detail regarding the non-GAAP measures. Reconciliation to GAAP can be found in the press release which is posted on our website.

Our agenda today begins with NET’s CFO, John McGrath, who will provide a detailed review of our financial results. Nick Keating, CEO, will then comment on the quarter’s financial and operational highlights. John will then discuss our financial outlook and we will open the call for your questions.

This time I would like to turn the call over to John McGrath.

John McGrath

Thank you, Leigh. As we reported earlier today, total revenue for the third quarter of fiscal 2009 was $19 million, up 3% from the prior quarter and down 35% from the third quarter of fiscal 2008. Product revenue was $15.3 million, a 4% increase from the prior quarter and a 40% decrease from the same period last year.

Government product revenues improved to $12.2 million in the third quarter representing an increase of 18% from Q2 2009 and a decrease of 43% from Q3 last year. Product revenue from our commercial business was $30.1 million, down 28% from the prior quarter and down 27% from Q3 last year. We believe our commercial business was impacted by the financial crisis as customers delayed purchases as well as fluctuations in the value of the dollar.

Service and other revenue was $3.7 million, down 5% compared to the second quarter and up 3% compared to the third quarter last year. Gross margin as the percentage of revenue was 45.3%. This is up from a negative 25% in Q2 and down from 49.3% from Q3 last year. Included in total gross margin in Q2 was an impairment charge for intangible assets of $9.7 million which represented 52.6% of revenue and inventory charges representing 12.5% of revenue.

The declining gross margin from last year primarily resulted from higher service cost. Product margins of Q3 were 55.3% compared to a negative 31.9% in Q2 and 54.2% in Q3 last year. Service and other margins from Q3 increased to 3.8%, up from 1.4% in the prior quarter and down from 14.2% in the third quarter of the prior year. Service margins in fiscal 2009 have been negatively impacted by our investment in professional service capabilities and training for our distributors related to our unified communication strategy.

Third quarter operating expenses were $14.6 million including $1.4 million of restructuring charges related to severance issues and excess facilities. Operating expenses were $49.1 million of the prior quarter which included a charge of $34.2 million related to the impairment of goodwill and other intangible asset.

Operating expenses were $13.7 million in Q3 last year. Including the restructuring we announced earlier this month, total headcount is currently at 255 employees, a decrease of 40 from the end of the second quarter. Sales and marketing expenses at $5.2 million were down 9% compared to Q2, primarily due to the elimination of the intangible asset amortization and the headcount reduction and were flat compared to the third quarter a year ago.

R&D expense was $5.1 million down 12% in the prior quarter and down 11% from Q3 last year. The decrease for the second quarter related to efficiencies from consolidation and functions as part of our integration with Quintum. The decrease for the prior year reflects completion of engineering projects near the beginning of fiscal 2009.

G&A expense in Q3 was $2.9 million down 11% from Q2 and up 4% from Q3 last year. The sequential decrease reflects the reduced use of outside services which in Q2 included the outside evaluation of impairment of good will and intangible assets. Other income in Q3 ’09 was $19.1 million, compared to $6.3 million for Q2 ’09 and $254,000 in Q3 of the prior year, included in other income in the current fiscal year were gains from the early retirement of convertible debt of $18.8 million, $6.4 million and $3.7 million in Q3, Q2, and Q1 respectively.

Net interest income in the third quarter was $35,000 compared to expense of $142,000 in the prior quarter, and income of $676,000 in Q3 of the prior year. The decrease from the prior year is the result of higher interest expense from the December 2007 issuance of our three and three quarters percent convertible debt which was not fully offset by related interest revenue. Our investments now consist in large part of low yield US Treasury securities.

The third quarter of fiscal ‘09 had a tax provision of $61,000 as compared to a tax benefit of $63,000 in the prior quarter and tax expense of $47,000 in the third quarter a year ago. Although we have significant tax loss carry forward, we incurred tax expense from international taxes and alternative minimum tax.

Net income in the third quarter was $13.1 million or $0.42 per share. In Q2, we had a net loss of $47.5 million or $1.66 per share and in Q3 last year we had net income of $1.5 million or $0.5 per share. As for non-GAAP results, the Company had a net loss in Q3 ’09 of $3.2 million or $0.11 per share, compared to net loss of $8.1 million or $0.28 per share in the prior quarter and net income of $2.6 million or $0.9 per share in Q3 last year.

Cash balances at the end of the third quarter were $101.6 million, down $30 million from Q2. During the quarter we used $23.1 million for the buyback and convertible bonds and $311,000 for the repurchase of shares of the Company’s common stock.

Accounts receivable was $12 million, an increase of $433,000 from Q2, and a decrease of $8.4 million compared to Q3 '08. The decrease from the prior year was primarily related to lower revenue levels. DSOs at 58 days in Q3, 57 days in the prior quarter and 59 days in Q3 last year. Our DSOs target remains below 70 days.

Finally, net inventory was $8 million in the third quarter, a decrease of approximately $313,000 as compared to the prior quarter, and a decrease of $5 million from Q3 of the prior year. Although there was a decrease in inventory owned by NET, we currently have deposit of $9.3 million for inventory helped by our contract manufacturer of the greater than 90 days. This amount is shown on the balance sheet and other current asset.

I will turn the discussion over to Nick Keating, our CEO.

Nick Keating

Thank you, John. From a macro standpoint, we are focusing on four initiatives: expanding our relationships with partners and enterprises, seeking Voice over IP applications for unified communications, introducing our new products into the worldwide government market, finalizing development on several key products and continuing to streamline of our operations and cost structure. I will discuss our progress on each of these objectives and then turn the call back to John for our financial outlook.

First, I would like to review the recent actions we have taken to reduce our expense base. As announced a few weeks ago, we took steps during Q3 and the early part of the current quarter to streamline operations and reduce costs. These included a 14% reduction in staff that eliminated redundant functions following the integration of Quintum and we are tightly focused our research and development activities. These actions have lowered our expenses while allowing us to fully fund our most strategic product development programs. We will continue to look for additional opportunities to improve efficiencies and trim expenses.

During Q3 we also brought bought back a signification portion of our convertible notes, reducing our debt and strengthening our balance sheet. As a result of this buybacks, write offs and cost reductions that we have taken over the past few quarters; we reduced our quarterly expenses by $3 million.

Turning now to our unified communications business. We see our greatest near term opportunity emerging in Voice over IP applications for Unified Communications. In a recent presentation by the head of Microsoft UC Group, Microsoft highlighted that the next wave of unified communications will bring capabilities directly into a wide array of industries and markets integrating business applications of all kinds through the desktop, the mobile phone and web browser. For instance, Frost & Sullivan forecasted 72% compound annual growth rate in the UC application and service markets from 2008 through 2014.

In today’s economic environment, IT priorities are centering on cost reduction initiatives. Collaboration and unified communication applications are the most widespread new technologies under evaluation by large enterprise users. In a recent survey by CDW, leading IT equipment in services provider, about 25% of the IT organizations polled had began implementing unified communications with the remainder beginning the assessment and planning space.

According to industry analyst in spite of a slowdown in an economic recession starting in 2008 and possibly continuing for a few more years. Enterprises stand on unified communication applications and technologies is expected to increase as Company is focused on cost cutting travel reduction and productivity enhancements. Replacing existing PBX infrastructure could be very expensive and disruptive to an enterprise that wants to implement unified communications. However, NET’s products could be used to build a network that since in front of an enterprise’s existing VoIP infrastructure offering seamless VoIP integration at a fraction of the cost and enabling our customers to get the full benefit and cost savings from a UC environment.

Last quarter, I indicated that our Voice over IP products was being used by more than 30 pilot programs. Today that number has more than tripled with new pilots being added weekly. Our long range objective is to support the global 5,000 in their migration to software powered voice through Microsoft-backed opportunities through our channel partners and through other applications providers.

We take a few minutes to elaborate on our business cycle for UC implementation.

Working through a network of systems integrators and distribution partners, we start with a small pilot of typically two to four notes usually at an enterprise headquarters’ location where IT innovation occurs. A pilot typically takes three to four months to complete. At that point the opportunity arises to move in the early deployment. This is often done locally and then typically spreads regionally.

Currently in this early stage of adoption it could take a year or sometimes more to go from a campus or regional deployment to national and ultimately to a global deployment. Obviously, not all roll-outs will be global but our expectation is that once a customer experiences the business benefits of unified communications, the network implementation expands.

We are involved in pilots all over the world. Today we have 14 direct sales offices and a rapidly growing base of international and domestic UC partners that can support customers in 90 countries. Most recently we have seen greater momentum in the number of new partners in the US, Australia, Japan, and France where we are seeing growing UC interests.

The Middle East has also been a market that is growing in VoIP and UC based applications. To address this market, we have recently opened the sales office in Dubai and have already completed our first UC sales.

With regard to our Federal Government business we saw a modest return in certain programs particularly DoD projects. Overall, we continue to expect our government business to be lumpy with programs that are subject to delays until we have a federal budget in place.

We also believe that there is an ongoing opportunity to government for secure voice and deployable systems. We are developing a strategy and moving forward on establishing relationships or providing UC solutions for local, state, federal, and international government customers.

Turning next to product development. We announced the completion of several products certifications and new releases during the past quarter. This included certification for Microsoft exchange unified messaging from both our VX and Quintum platforms, which complements our existing certification from Microsoft OCS. Our products provide a seamless solution for both Microsoft OCS and Microsoft Exchange Server and these certifications simplify customer decisions about migrating to unified communications.

In Q3 we also delivered a significant number of product releases which span across all of our product lines. Enhancements to our VX Series included advanced call routing functionality, utilizing Microsoft active directory and the Lightweight Directory Access Protocol or LDAP solutions which simplifies migration to new UC platforms.

Our VX Series which can now rout incoming faxes directly to end users Microsoft Exchange Mailboxes. For government secure voice customers, our latest product release supports government specified call precedents and preemptions standards over packet networks. This new product release also provides functionality for next generations secure IP telephones.

Turning to the last to the four initiatives I mentioned upfront, we will continue to streamline our operations in cost structure. In an effort to streamline our business processes improved efficiencies and increased productivity we consolidated the NET and Quintum backed office responsibilities into our Freemont headquarters allowing us to run on a single IP platform. The transition of product manufacturing to Flexus is complete and we have a new master manufacturing service agreement in place.

Finally, worldwide customer service for all NET in Quintum product lines has been integrated under our operations group providing better flexibility and coordination between production manufacturing and service related inventories.

In summary, although we have seen modest overall growth in revenues these past two quarters and a significant increase in pilot programs for unified communications opportunities, we believe that the uncertain economy and continued delays in some government funding may affect our customer spending through the first half of calendar 2009.

Before I turn the callback to John, I want to mention that tomorrow NET will be presenting a webinar with Frost & Sullivan entitled “The Right Strategy for VoIP and Unified Communication”. The discussion will address topics such as market trends, IT concerns, productivity gains, and cost savings, and enabling voice services in Microsoft OCS deployments. IF you are interested in listening, the link to register can be found on the home page of our website. A replay will also be made available. Now, at this time I would like to turn the call back to John to provide detail on our financial outlook and some closing remarks.

John McGrath

Thank you Nick. As we mentioned last quarter, the government will operate on continuing resolutions until the new administration and Congress can conclude a final budget. This continues to make timing of government revenue difficult for us to predict. Further we believe that commercial revenue could be soft for the first half of the calendar year as to follow-up from the financial crisis remains uncertain.

As such, we expect Q4 revenues to remain at the same levels we have seen in previous quarters this fiscal year. We will have better visibility in this fiscal year 2010 on our year end conference call in April. As Nick mentioned, we will continue to be prudent with our cash in this difficult times. We expect our cash rate even revenue level to drop to the range of $22 million to $24 million per quarter which will better position us as we enter our next fiscal year in April.

We will continue to look for additional opportunities to further reduce our break even revenue level. It should be noted that we expect to take charges in the fiscal fourth quarter of this year of more than $500,000 primarily related to employees severance for actions taken at the beginning at the fourth fiscal quarter.

Operator this concludes our prepared remarks. We would like to open the call now for Q&A.

Operator

(Operator instruction) Your first question comes from Greg Mesniaeff from Needham & Company. Please proceed.

Greg Mesniaeff - Needham & Company

Yes .Thank you. My question is about the pilots that, Nick you have alluded to the fact that they have essentially tripled quarter over quarter. I am kind of wondering if you can give us some guideline as to how to interpret the conversion of these pilots into revenues because even though the metric appears to be impressive it needs to be applied to some formula to convert to sales.

Nick Keating

Yes, Greg. Thank you for the question. There are a number of steps to this process. First, of all we have to get the customer to agree to do the pilot. Typically we are brought in by one of our partners who are really taking the lead in getting the pilots set up. The equipment is then put in place, we need to engineer pilots so that they relate to whatever the voice environments that they have whether it is a IP-PBX or TDM base PBX or soft switch and whether they want to link them into different voice infrastructures within their facility or for that matter across of couple of facilities so that they, at times, are already network and they are not necessary in a stand-alone environment.

The pilots, as I say, are typically 2 to 3 months. We see them shorter. We have also seen customer at 1 or 2 to push them up further. By and large as soon as the pilots are complete the customer is ready to consider some form of deployment. We have seen very different situation. We have seen rapid employments and we have seen timed and cautious employment. I would say the one thing that we see is that every customer has a somewhat different priority. As I mentioned, what we typically expect is it goes from a headquarters location to regional, national and global but we have got one customer right now that is starting to build their global network even at the time that they have not completed their domestic network and this is not Albany, we have obviously announced Albany in the past and that was one that once they architected, they went both nationally and globally at the same time.

The roll-out, frankly is going to be dependent upon the speed that the IT organization is prepared to move and we also expect that it will open up a lot of systems integration opportunities for either the regional system integrators or the global system integrators to the extent that the customer wants to move quickly.

We have seen a number of statements recently and by the way there is a lot more researches coming out right now. There are a lot more articles, a lot more statements by the key suppliers; most of them seem to feel that for medium size customers they are going to be able to roll-out with them within about a 24 months time frame.

So from a modeling stand point, assuming that those pilots are successful and our experience up to now is virtually all of them have been successful, that is the matter of how quickly they are going to deploy. If we can save the customer from having to rip out their existing voice infrastructure, the cost of implementing UC is a fraction as opposed to what would happen if you want to go rip out your TBM and put an IP PBX environment.

So we take in a stressed economy where a capital spending is reduced or spare that we probably have one of the most cost compelling solutions for implementing a UM or UC environment. In some cases we are one tenth of the cost of going with a large systems base solution.

I hope that you just some sense Greg.

Greg Mesniaeff - Needham & Company

It does. I think what I get out of that is that it appears to me that we are looking still at a situation where maybe we are a couple of quarters away from getting a more firm view on the visibility, if you will.

Nick Keating

Yes. The thing I would emphasize again is that we are seeing pilots literally all over the world. Number of pilots going on in Mexico and there is a pilot in Colombia, a fair amount of heavy government pilots outside of the United Sates which I think reflects the fact that there is a lot of seats where you get in the government agencies and as you can appreciate companies like Microsoft are trying to encourage pilots where there is a large number of seats that can be implemented.

One of the statements by the way that we saw just to give you a sense of the market opportunity was a statement by one of the analysts who said, that wherever you find a email seat you should assume that at some point that is going to be a UCC and in a way you look at it as that context the market opportunity is as broad as the email server vendors have experienced in the past.

Greg Mesniaeff - Needham & Company

Got you and as my follow-up, Nick if you could, recently Cisco has been making a lot of waves about entering the data center server market and providing an integrated solution there. How would you characterize that as impacting NET’s business in a competitively or from a potential strategic alliance stand point?

Nick Keating

Whether we expect the Cisco, where Cisco is the dominant vendor in the enterprise, we do not see a lot of opportunity. I think our greatest value proposition is where the customer has a mixed environment easily including Cisco but with other PBX vendors or Soft Switches or IP-PBXs and I think we function best in the mixed environment. We also function best where the customer at this point is not prepared to do something radical and rip out their voice infrastructure. Now, I do think over time that as systems come in particularly for Greenfield locations and for OPBX’s there will be a point of time where the customer simply switches over to full OCS implementation and eliminates the PBX.

The tenth of the cost statement I have made is particularly true when enterprises looking at going to an all Cisco’s solution. So if they have a strong aggressive capital budget in a large Cisco house, that I think many of these enterprises will continue to be Cisco but I do think that the opportunities are great if a customer particularly wants to reduce their dependency on a single vendor. They have the flexibility of all the different solutions and opportunities that are coming out and quite frankly some of these new solutions are very compelling and I speak against using a single vendor for all your solutions.

Operator

(Operator instruction) At this time we have no additional question in the queue. I would now like to hand the call back to Ms. Leigh Salvo for any closing remark. Please proceed.

Leigh Salvo

Thank you and thank you all for joining us this afternoon. This concludes our conference call.

Operator

(Operator instruction)

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