Oclaro's Management Presents at Morgan Stanley Technology, Media and Telecom Conference (Transcript)

| About: Oclaro, Inc. (OCLR)

Oclaro, Inc. (NASDAQ:OCLR)

Morgan Stanley Technology, Media and Telecom Conference Transcript

February 25, 2013 7:00 PM ET

Executives

Jerry Turin - Chief Financial Officer

Analysts

Kim Watkins - Morgan Stanley

Kim Watkins - Morgan Stanley

Okay. We are ready to go. Great. Okay. Thank you. Welcome everyone here today for presentation with Oclaro. I’ve Jerry Turin, the CFO with me here. My name is Kim Watkins. I’m on the Communications Equipment Research team here at Morgan Stanley headed up by Ehud Gelblum, who is unable to be with us here today due to a death in his family. So I have the great pleasure of sitting down and talking with Jerry.

Before we get started I just wanted to read a quick disclosure sheet, please note that all important disclosures including personal holdings disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures or are available at the registration desk.

And with that, let get started. I just wanted to dig in first to more than macro comment.

Jerry Turin

Sure.

Kim Watkins - Morgan Stanley

And you had made some, what I would characterize is kind of qualified statements about demand picking up on your last call? What are you seeing by geography in terms demand, you talked about orders picking up in the first four weeks of the quarter, as that continued? And then, given the more optimistic commentary, putting that together with your guidance, little surprised is down 8% sequentially? So can you just provide us some context?

Jerry Turin

Sure. So, by way of context, first of all, the March quarter tends to be seasonal and optical. Price reduction kicking in early in the quarter. Capital budgets coming out the New Year, tend to come out a little late. Chinese New Year, and again, the Chinese customers tend to -- carriers tend to regroup after Chinese New Year.

So, March, it’s not unusual to expect the softer March than December. At the same time with the market conditions have been softer quite sometime in optical and in the network. So, we are looking for some upside. But, again, within the March quarter, the guidance is fairly typical with what you tend to see seasonally and I guess, fairly typical across the peers as well.

In terms of the order flow in the first few weeks of the quarter. We put that out as a quantitative measure consistent with some other peers that have announced earlier and we put the similar metric.

We caution at the time that four weeks on the back of the fairly extended slow period this space isn’t something that people should take to the bank or assume signals anything other than that data point in time. Today, I don’t really have an update that were, to present in terms of updated order flow information.

Kim Watkins - Morgan Stanley

Okay. Okay. So [taken].

Jerry Turin

[Taken].

Kim Watkins - Morgan Stanley

See once you said on the call that I thought I actually pretty interesting was related to pricing?

Jerry Turin

Yeah.

Kim Watkins - Morgan Stanley

Last quarter you had expected pricing to be at the low end or high end, I guess, the high end of the typical annual price decline 15% and this time you indicated that it was coming at the lower end, what change in the quarter?

Jerry Turin

Well, I’m not sure of anything changed in the quarter per se. We entered the pricing season seeing again that we’ve been in pretty soft markets conditions for over a year and our expectation of more challenging versus less challenging pricing environment was based on that sort of macro view point. It wasn’t based on a particularly product area or a particular customer set, or even anything from a particular quantification point of view, just more from our own expectations given the environment we are facing.

So as we came out of it, there wasn’t any particular area that was stronger than expected or more favorable than expected. If anything can be drawn from it and this might be a stretch as our credit owner, few of our peers become more significant within this space through consolidation.

Over the long period of time we expect that those strategic relationships with customers start paying off in terms of design wins, in terms of roadmap access, in terms of customers wanting to work with a more defined smaller number of suppliers, is there something in the price negotiations that suddenly reflected some progress in that front perhaps, I wouldn’t go so far as to attributed to that though.

Kim Watkins - Morgan Stanley

Interesting. Okay. Let’s change gears a little bit and talk about your balance sheet, you’ve taken some actions last quarter issuing guidance you completed an assets sales, now you have net debt of about $10 million, I believe, almost $100 million in cash, you have a drawdown on your credit line?

Can you walk us through what you did in December the actions that you took? And now why are you -- why you drawn on the credit line given the amount of cash you have? And I guess, in other word ask that question is, what are you feeling on the balance sheet to conduct business?

Jerry Turin

Sure. So as we approach, as we are well into the second half of the year and had expectations coming out of our merger, and coming out of our flood recovery that we’ve start seeing some market recovery, but now wasn’t coming about and when we realized that, while expecting to exceed our merger cost synergy target in December quarter, which in fact we did exceed.

We realize that we are going to continue to have negative bottom line and negative EBITDA burn beyond that. So we thought that was important to exist the year strengthening the balance sheet. We saw that what we call a non-core business, a non-strategic business with thin film filter and interleaver business for $27 million. We did a small convertible debt offering and we increased our line of ability -- line of credit availability with our bank and in fact, after the year and brought in another bank to increase the syndicate availability.

Our guidance for March shows negative EBITDA range in the double digits and while we continue to have more synergies from the deal that are going to have an effect over the course of the year. And while we have a lot of positive operating leverage in our model, as revenues grow, we drop 40% to the gross margin line and at this point in time early in the merger, we’ll probably dropped 40% to the bottom line, when you have that sort of negative EBITDA, you can’t sit still and so we are looking at how to take cost out, how to realign aspects of the business in order break down -- bring down the break-even level and not just rely on revenues alone is the answer to that.

So having a sufficient balance sheet to create a runway to execute that and also to potentially pay for part of that, while experiencing a negative EBITDA it all comes together and it’s important to be in a position to take that challenge on.

Kim Watkins - Morgan Stanley

So back to the cash level, is there minimum that you need to have on your balance sheet to conduct business.?

Jerry Turin

I would say, there is a minimum, I wouldn’t put out a number because our quarter end number is a little bit misleading because you do have abs and flows within a quarter. So there certainly are minimum cash resources you have to maintain and manage yourself above those levels to support the business.

Kim Watkins - Morgan Stanley

Okay. But you got quite a few different puts and takes on the cash front coming in the next several months. You’ve got some money coming in from Venture, some insurance lending? Could you just talk us through the different sources the need of the cash burn for us?

Jerry Turin

Sure. Early last year we executed a transaction to transition our internal manufacturing, our internal assembly and tested some in Shenzhen, China, to Venture a contract manufacturing in Malaysia. Over a two-year period, in the series of product line transitions, we’ll be moving that manufacturing to Malaysia.

As we move that manufacturing, Venture will be buying portions of the equipment base and portions of the inventory. So over a two-year period there will some significant cash generated from that, probably not in the next six months to a significant degree, but over two years, there is probably still in excess of $15 million to $20 million net of restructuring costs potentially available as we execute that transition.

We have $23 million in insurance claims outstanding going back to the flood. We expect the ultimate settlement number to the less than that, but we are actively working to resolve that, and move forward and I think the insurance company is in a position where they would like to resolve claims and move forward as well, but we are working activity on that as well.

Kim Watkins - Morgan Stanley

And what do you think in terms of potential for type of timing on that?

Jerry Turin

Well, it’s potential that portion of that could be in the relative near-term, hard to say exactly what that portion is, but something short of a settlement of the full amount might be something we maybe able to execute in the relative short-term, it would be nice to resolve the entire claim in a similar timeframe, but I want to be cautious in terms of people’s expectations of when some of these cash sources come in.

We’ll drive them as quick as we can and as soon as we can, but again, I don’t want to put overly aggressive expectations out there. But I do think we are making very positive progress on those fronts.

Kim Watkins - Morgan Stanley

Okay. Great. And then, you mentioned EBITDA guidance was again negative for next quarter and back to the break-even guidance is about, the break-even levels about 20% higher than current guidance, if I’m doing my math correctly?

You mentioned on the last earnings call that one other ways that would look to raise the funds to restructure would perhaps selling non-core assets. Just had a curiosity how much do you think that you need to restructure effectively and how much you think you could raise from asset sales and how are you evaluating what assets or opportunities?

Jerry Turin

Sure. Well, it’s a fairly complicated metric, because in a perfect world an asset sale divestiture may also reduce your overhead base and be structured in a way to retain the core strategic value of that particular product area and generate cash at the same time.

So in the sense, if you find the ideal sort of approach, maybe a pace where the restructuring by virtue of substraction and lease them residual cash as well to finance the business another way.

But alternatively it could, an asset sale could also generate cash to allow you to take cost reductions in certain parts of the world that are more expensive. In the meantime, we are taking it hard to revise looks at how to drive costs out of the product that are direct material and labor level that might be somewhere well over last 12 to 18 months with flood recovery, with tsunami on the Opnext side, with merger, merger integration and some of the other things we’ve been up to, a lot of that takes engineering resources, a lot of that supply chain resources and a lot of those resources in a normal day-to-day basis should be focus on driving cost out of the products and that maybe somewhere where didn’t have as much attraction in the last year.

So we are trying to get an updated grasp of exactly what short-term leverage we have. Looking at what incremental cost savings just by looking at cutting costs we can drive, looking at these different opportunities and putting it together as a comprehensive plan and those things are interrelated and there are dependencies, so we’ll sort of those out and come up with something we hope execute towards bringing down that break-even significantly, so we don’t rely just on the revenue growth.

Kim Watkins - Morgan Stanley

And what is the timing that we should expect to hear something in the next three, six months kind of timeframe?

Jerry Turin

Rather expect sooner than that and I wouldn’t expect us to be reporting back on weekly basis at conference updates and so forth. But I certainly expect something well within -- latter into that timeframe to be sure. It’s something we are very actively working.

Kim Watkins - Morgan Stanley

Okay. What are the things that you mentioned and you’ve talked about this quite extensively is the fact that you exceeded your target, synergy target for the next integration. But it sounds like there is still quite a few more synergies to come as it relates to gross margins. So can you just talk about the process there? Where are the opportunities specifically? How does it flow through the financials?

Jerry Turin

There continues to be significant opportunities from a synergy point of view. It’s a little bit more difficult to capture in terms of a precise estimate and in terms of something we can report back on in the future and educate what the precise results were.

And the reasons are one of the categories as what we referred to as inseeds or product inseeds where one part of Oclaro produces or supplies a particular component, that another part of Oclaro or formal part of Opnext, curious from competitors on the open market.

As you transition that to internal supply that can represent pretty significant cost savings to the product level. In some of those areas, there might be an area where Oclaro, well established supplier of the part into a formal Opnext product.

In summary, it might be where Oclaro is a fairly stabilized supplier but needs a fairly straightforward re-qualification for particular application. And it can be laser being applied into a new application all together. For example, our VCSEL lasers, on the Oclaro side that we use for different consumer devices, laser mice, finger navigation, optical interconnectivity, can play very well into some short reach data comp pluggable products in the Opnext side.

That will actually require a little bit of redesign, a little bit of R&D effort because we don’t deploy those in communications right now. So if you think about those sorts of different opportunities, then the qualification cycles will end up with something that’s probably over the next six to 12 to 18 months, the exact savings become a function of the revenues.

The revenues become a function of how quickly the qualifications are done, how quickly existing inventories are burnt through. And exactly what the market demand is in terms of the topline. So significant opportunity there and then at some point that transitions from being a synergy to being the part of the strategic value proposition of been a vertical integrated company. And where do you cut off between synergy and doing good business in the future.

We are also do some back-end activity in Western parts of the western world in Japan. Some of that is a legacy and we are on existing time lines over a period of time to gradually move that to lower cost Asian sourcing. Some on that on Optnex side with short-term responsiveness to the flood recovery and now we turn around and we move that back to South East Asian as well.

And again that can -- some of that can help fairly quickly, some of that can take a longer period of time. And some of that depends on exactly where you’re at in terms of customer requirements. Or perhaps some of that is newer products that are ramping in the early stages customers perhaps you reach out more stable point in time before you transition it.

So a lot of moving piece but a lot of opportunity but not some thing that we can cease and go forward into the current quarter and say this is exactly the synergy we are going to drive in the next quarter. And it alone is going to close that break-even gap. It’ more long-term sustained upside over a period of time but slightly different than what we’re working on today in terms of closing that gap.

Kim Watkins - Morgan Stanley

Now, can all these activities -- kind of, towards next quarter, gross margin is 10% to 14%. Can all these activities, a lot of them on the COG side get your gross margin back to the former peak, say mid to high 20s or is that primarily a function of revenue leverage?

Jerry Turin

Well, certainly it requires revenue leverage. Cost improvements alone are not going to have that sort of impact. We view a part of our core value proposition being in our wafer fabs and our wafer and chip level technology. And we think that becomes even more relevant in the future as customers look for different ways to create differentiation within their own products.

The flipside is you have a fairly significant cost based which we’re nearing very soft market conditions like we’ve experienced, had a very significant impact on the margin but with revenue growth -- again that’s the source of why we generate 40% incremental gross margin.

How do you get back up to the high 20s? It really requires a combination of both, walking, tapping cost improvements, vertical integration of our components into our own products, growth in new product areas and certainly growth in revenues overall across the fixed cost base.

Kim Watkins - Morgan Stanley

And that fixed cost base, the fabs that not anything you would ever outsource or during down the cost base?

Jerry Turin

Well, there is not -- there is not -- we don’t’ se a real viable outsource model in optical. And we don’t see an easy way to go from an existing fab print to substantially smaller footprint, without creating either more short-term cost or a long-term transition.

So if we think about some of our key fabs that could be a two year of more transition. And you start paying the cost of that transition immediately in terms of rotating people in terms of concerned with customers or in terms of any risk during the transition. And over the long term that’s something that can make sense. It’s not a short term answer. It’s close to break-even quickly though.

Kim Watkins - Morgan Stanley

Got it. Okay. Just on -- to change gears here and talk a little bit other product set as a business. You were particularly hard hit in Thailand in a flood a year ago now. It seems like you lost some share in that process, particularly perhaps on the Opnext side of the business. How do you regain that share and what timing could that occur?

Jerry Turin

So I go back in time or clear all the time, lost about 30% of its revenue. And often next laws something in the order of 40%. We expect that it will hope to kind of exit the June quarter with most of that back and we need to have most of that back and with some market upside across the market upside didn’t transpire.

If I think about it’s a fairly wider ray of products, I think there is some legacy data com products where there is some share picked up by competition, that’s going to take a little bit longer to recover. And that’s not a going area regardless.

And in fact, maybe a decline in market, as we move forward anyways. So achieving three revenue levels is probably unlikely in a reasonable period of time. But again you’re going to win in this phase by being a leader in the new product segment and our legacy products are important to support your cost base and continue to benefit from the R&D of the past. It is a legacy product area that is transitioned to other form factors but we expect to be a leader and have strong play.

We also -- I don’t if I class this last market share, last timing or loss share opportunity and 40 gig and 100 gig modulators, which we’re just ramping when the flood hits. So we have to pull some of the prototyping back to the fab in Europe and then when we actually did the flood and started revamping the products, it took a lot longer to get yields up to a reasonable level. And into that intervening time, additional players entered the space.

So we probably would have had a stronger leadership position if we had it ramped on time. Now, we have to kind of get back into the slot and catch up a little bit net product area.

Kim Watkins - Morgan Stanley

Okay. So time to market….

Jerry Turin

Otherwise, I think we really held share really well and a lot of the core product areas where weather was impacted and we recovered fairly quickly. But I think those are two areas that are reasonable to point out?

Kim Watkins - Morgan Stanley

Okay. Clear -- recently, we started talking about tunable XFPs. I think revenue levels had hit around $5 million still relatively small. That market is currently dominated by JDSU, Finisar entering the market about the same time as you. They are roughly about the same size based on their reported revenue. How do you gain traction in this market. Do you expect JDUC customers to add another source of supply and if they do, does that mean that those contracts would have lower volumes for you. So then you would continue to be relegated as a smaller player with opportunities to go and is primary in some customers?

Jerry Turin

There is a lot of opportunity in the space. We’ve got 17 design wins. Finisar probably speaks about similar numbers themselves. I’m not sure the latest tally. We expected to be a significant growing market for some time. And there are more and more customers with requirements in that space.

And there are technical hour special, we’re focusing on maybe more of the longer distant segment. So there is clearly -- this is not an area where it’s coming in second to JDS with the existing slots and that’s for some of the world.

Ideally, when I do have to say recent quarters, the total volume of tunable XFP totals’ revenue, anyway tunable XFP have been fairly steady, fairly flat. But we do believe that’s still a significant growth area and ideally with an up growth that well we take some share of JDS, while we take some new slots that overall are going to see the market growing up, that’s arising side effect as well.

Kim Watkins - Morgan Stanley

Okay. That sounds definitely like an area of opportunity for you next year?

Jerry Turin

I would hope that again it’s been like most of the market fairly flat for last couple of few quarters.

Kim Watkins - Morgan Stanley

Okay. And how large is the Oclaro’s 300-Pin thickness. And to what extent is that cannibalize -- there is a risk that could cannibalize?

Jerry Turin

So I don’t think there is a direct cannibalization. But I do think that if we think in terms of long-term product evolution, larger form factors or the small form factors, the different data rates. And so over time, the 300 -- existing 300-Pin Transponder slot will grab our legacy and will gradually go away. But a long turn on a dime because tomorrow a lot of sudden customers are able to put a transponder and put in bunch of pluggables.

There will be some thing similar to actually, we gained our fairly strong leadership position in small form factor, 10-gig transponders, by taking share from people with larger form factors. And that’s just kind of path of the natural evolution of form factors to form factor.

So tunable XFP over time will be what transitioned to but I don’t expect that a quip in a legacy product. I just expect no growth and a gradual decline.

Kim Watkins - Morgan Stanley

Okay. I’m going to ask one more question and then open it up to the audience. So open if you have questions, start thinking about those. I want to talk to you to about 100 gig, you start, just started shipping 100 gig coherent module. What are your expectations for the product line and 100 gig in general. Do you expect it to be larger or smaller, and what point in time then the 40 gig business that you have?

Jerry Turin

Well, that’s a good question. In 40 gig the combination of Opnext and Oclaro the clear leaders and really have a very strong almost dominant position with, if I look at the peak revenue of the different modulations stems quite substantial revenues.

100 gigs is going to be more a substantial cycle. If I think about the peer group that, the large peer group that people are familiar with were clearly the leaders of 100 gig among that group.

At the same time there is a dynamic of supplying 100 gig transponders to customers they were looking for merchant solution versus customers with their own proprietary solutions where folks like us another supply component level products.

We think it is a big market opportunity and important one, one deciding factor that will be the competitiveness of the merchant solution versus the incumbent solution. And I think there will be a lot of battles to be raise at that well and I think that will tell a part of the tale as well.

Kim Watkins - Morgan Stanley

So do you think the component business could be larger for you than the module business?

Jerry Turin

Oh! I think, Kim, again it’s a tough question, I think the component business as we ramp more of our 40 gig and 100 gig products our coherent products, I think we have some significant opportunities there. I would like to think that the transponder leadership is going to translate into a bigger market opportunity.

Kim Watkins - Morgan Stanley

Okay.

Jerry Turin

But they both could be very strong businesses and nice margin.

Kim Watkins - Morgan Stanley

Okay. Let just check in and see if anyone have any questions in the audience. Okay. Right here in the front you. You just wait for the mic it’s coming. Thank you.

Question-and-Answer Session

Unidentified Analyst

Yeah. So my question is regarding the return to profitability and hopefully vitality in the optical industry? And kind of how you see industry evolving in this stage of growth relative to the use of outsourcing companies like FiberNet and Venture, and others that has been used to basically [differ] or leverage CapEx expenses or fab building? Do you see building fabs is a core competency for you and other folks in your part of the value chain or is that something that industry is moving away from more to outsource fabrication?

Jerry Turin

Sure. So if I breakdown the manufacturing process between the wafer fabs and assembly and test, that’s what folks like FiberNet do as the assembly and test side of the optical side, very different from the wafer fab.

Our installed base of our wafer fabs goes back quiet a long time to some very dramatic investment levels over the 80s, 90s into the bubble era, a lot of the predecessor companies of Oclaro that’s been out of Oclaro of Nortel Optical Components investments by Hitachi, by IBM, Nortel, if I look at our peer group, I see, JDS also has a very substantial wafer fab infrastructure and again, a lot of significant investment over those periods of time within their own reality at the time.

There is a lot of know-how, a lot of IP. I don’t see that we are anywhere close to an outsourcing model where some of coming from a foundry point of view and from scratch be able to investment to come up with the fab that they can do those sorts of things. Over a long period of time maybe but in the short-term it’s very proprietary and very much what we view is a differentiator in the short-term and long-term.

On the back-end, we did a very exhaustive review year and half, two years ago before the flood hit on, whether our existing Shenzhen assembly and test facility, we were going to expand some day and build the new factory as our volumes increased. And we really view that we didn’t see a competitive differentiator in the back-end but we did see a lot of capital tight up in equipments and inventories.

And in our case, in Shenzhen we saw very high turn over rates and Chinese inflation, which also combined to make sense to us to develop the partnership with Venture to outsource Shenzhen to Venture over two year period of time and work at least for the time being with that sort of two back-end supplier strategy and then see where it goes from there.

Kim Watkins - Morgan Stanley

Okay. Any other, yeah.

Unidentified Analyst

Two quick questions, the first one on the (inaudible) SFP side, as you’ve tried ramp into that market, have you seen any unusual anticipatory pricing action from your competitors, whether its JDS or just one out there in effort try to gain momentum there and then I have a follow up?

Jerry Turin

Internal SFP, I think that, went back a year ago, you I think, all credit to JDS for coming first to market, I think, my impression is that they have some very favorable pricing and with ourselves and Finisar becoming competitors it’s still a very good margin area and I think the pricing is quite good, but I expect they probably did see our decline for what they’ve seen for the first year or two have been around, but I don’t see anything unusually in that product area at all.

Unidentified Analyst

And then in terms of lead time, what’s your normal lead time to customers at this point and are you seeing those lead times stretch out at all?

Jerry Turin

It varies too much across the product portfolio, we got a very broad set of products across different parts of the network and that the vertical level components versus high level, so it’s really difficult for me to pin -- provide a pinpoint answers on that one.

If the market was able, was picked up dramatically, I think we’ll be able to response very quickly, but again it’s tough for me to articulate a kind of across the board set of data on that.

Kim Watkins - Morgan Stanley

Okay. Unfortunately, we are out of time now. But thank you very much, Jerry, for being here with us.

Jerry Turin

Thank you, Kim. Thank you.

Kim Watkins - Morgan Stanley

Thank you, everyone.

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