Network Equipment Technologies, Inc. F4Q09 (Qtr End 3/27/09) Earnings Call Transcript

Network Equipment Technologies, Inc. (NWK)

F4Q09 Earnings Call

May 11, 2009 5:00 pm ET

Executives

Leigh Salvo - Investor Relations

John McGrath - Vice President and Chief Financial Officer

Nick Keating - President and Chief Executive Officer

Analysts

Greg Mesniaeff - Needham & Company

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the fourth quarter fiscal 2009 Network Equipment Technologies earnings conference call. My name is [Eric] and I'll be your audio coordinator for today. (Operator Instructions)

I would now like to turn your presentation over Leigh Salvo. Please proceed.

Leigh Salvo

Welcome, everyone, to our call this afternoon, during which we'll discuss results for Network Equipment Technologies' fourth fiscal quarter and fiscal year 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'll 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 forward-looking statements.

These risks and uncertainties include federal government budget matters and procurement decisions, the timing of orders, market acceptance for new orders, and the 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, the progression of patent litigation and other risks, including those identified in the company's filings with the SEC, including Form 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, although 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 May 11, 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 include 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 measure. Reconciliations 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 the comment on the quarter's financial and operational highlights. John will then discuss the financial outlook and we'll open the call to your questions.

At this time I'd like to turn the call over to John McGrath.

John McGrath

Thank you, Leigh.

In the press release issued today and available on our website we reported that total revenue for the fourth quarter of fiscal 2009 was $12.7 million, down 33% from the prior quarter and down 62% from the fourth quarter of 2008. For the entire fiscal year revenue was down 43% to $65.8 million.

Product revenue was $9.2 million, a 40% decrease of Q3 and a 70% decrease from Q4 last year. Produce revenue from our government business was $6 million compared to $12.2 million in the prior quarter and $24.6 million for Q4 a year ago.

Our government business was impacted by the lack of federal budget and funding delays in programs that contain our products such that our government orders fell to a minimal level in January and February. In March we started to see an increase in government purchasing activity but too late in the quarter to turn into revenue.

Product revenue for our enterprise business of $3.2 million was essentially unchanged from the third quarter and was down 43% from Q4 last year. The decrease from last year was related in declines in our legacy Promina business and in Quintum revenue, which was impacted by the global recession.

Service and other revenue of $3.5 million was down $142,000 sequentially and up $278,000 from the fourth quarter last year.

Gross margin in Q4 as a percentage of revenue was 31.5%, down from 45.3% in Q3 and 48.3% for Q4 last year. In Q4 '09 we determined that we would likely not use licensed technology and associated prepaid royalties which we acquired from Quintum. As such we took an additional charge of $320,000 for the impairment of this asset.

Product gross margin in Q4 excluding the impairment charge was 45.8%, down from 55.3% in Q3 and 53.8% for Q4 last year. Product gross margin was affected by reduced product revenue, which meant a higher proportion of fixed costs were allocated to product cost of goods sold. Additionally, there was a decline in legacy Promina revenue, which typically has higher margins. Service and other margin in Q4 decreased slightly to 3.3% from 3.8% in the prior quarter, but increased from a negative 3.3% in the fourth quarter of the prior year.

Fourth quarter operating expenses were $13 million, down $1.6 million sequentially and down $2.6 million for the same quarter last year. Total company headcount was down to 254 employees at the end of Q4, a decrease of 23 from the end of the prior quarter and a decrease of 54 from Q4 last year.

As Nick will discuss in more detail, we continued to streamline our operations in fiscal 2009 as well as completed the integration of Quintum. We consolidated many of our back office functions, which now leverage a single ERP system for the company. We also continue to focus on a single product direction, which has enabled us to consolidate overlapping R&D functions.

Q4 2008's results included the amortization of intangible assets acquired from Quintum of $883,000, of which $555,000 was related to operating expense and all of which was fully written off in Q2 '09.

Sales and marketing expense was $4.6 million in Q4, down $597,000 compared to the prior quarter and down $1.3 million from the fourth quarter a year ago. The sequential and year-over-year decreases were largely due to lower travel, marketing and compensation expense. Q4 '08 expense also included $502,000 related to intangibles acquired from Quintum.

R&D expense was $4.6 million in Q4 '09, down $557,000 from the prior quarter and down $2 million from the fourth quarter a year ago. The decreases are due to lower headcount and expense reductions as we consolidated our R&D plans into a single company wide strategy.

G&A expense was $3.2 million in Q4 '09 compared to $2.9 million in Q3 '09 and $3.1 million in Q4 '08. This sequential increase resulted from legal costs related to the defense of a patent lawsuit.

Other expense in the fourth quarter of fiscal 2009 was $282,000 compared to income of $19.1 million for Q3 '09 and income of $157,000 in Q4 of the prior year. This sequential decrease is due to gains in Q3 from the early retirement of our convertible debt at a discount. The decrease over the prior year was due mainly to translation gains, of which a significant amount was related to the closure of a European subsidiary.

Net interest income for Q4 '09 was $10,000 compared to $35,000 in the prior quarter and $165,000 in Q4 of the prior year. With the low interest rates, we continue to see smaller returns on our portfolio, which is in large part invested in securities backed by the U.S. government.

The fourth quarter of fiscal 2009 had a tax provision of $52,000 as compared to a tax provision of $61,000 in the prior quarter and a tax benefit of $1.9 million in the fourth quarter a year ago. The benefit in Q4 of fiscal 2008 related to the reversal of a reserve for deferred tax assets for the United Kingdom as they have begun to earn tax profits and realize their NOLs. Although we are not profitable on a consolidated basis and also have significant NOLs, we expect to continue to see tax expense due to required minimum taxes.

Turning to net income, the company reported a net loss of $9.3 million for Q4 '09 or $0.32 per share compared to net income of $13.1 million or $0.42 per share in the prior quarter and net income of $2.8 million or $0.09 per share in the fourth quarter of fiscal 2008. On a non-GAAP basis the net loss was $7.3 million in Q4 '09 compared to $3.2 million in Q3 '09 and net income of $2.6 million in Q4 '08 non-GAAP income adjusted for non-cash compensation, amortization of acquired intangibles, restructure charges, gains from the early extinguishment of debt and other significant nonrecurring items.

Cash balances at the end of Q4 '09 were $98.2 million, down from $101.6 million at the end of Q3. Cash and investments decreased by $67.5 million in the prior year due in large part to the use of $41.8 million to repurchase our convertible debt along with $21 million used in operations.

During Q4 '08 our Board of Directors approved a stock buyback of up to $20 million based upon market conditions. As the company is committed to a long-term growth and acquisition strategy, the company will balance its cash needs with this buyback strategy. To date we have purchased approximately $1 million or 258,000 shares.

Accounts receivable were $7.1 million, down $4.9 million from Q3 '09 and down $16.1 million year-over-year. The decrease in accounts receivable is primarily due to decreased revenues. DSOs at 51 days increased 7 sequentially and decreased 12 days year-over-year.

Net inventory was $7.4 million in the fourth quarter of 2009, representing a decrease of approximately $600,000 as compared to the prior quarter. Net inventory decreased $2.6 million compared with the same quarter a year ago.

Now I'd like to turn the discussion over to Nick Keating, our CEO.

Nick Keating

Thank you, John.

Overall, fiscal year 2009, while financially disappointing, was a year of transition and structural accomplishment for NET that strengthened the company and positions us for recovery. Throughout this economic downturn we have carefully leveraged our existing resources and continued to reduce costs while introducing new products targeted at the emerging unified communications and secure voice markets.

Before discussing our outlook for this year I think it is important to take a few moments to highlight what was accomplished this past year, a year where our development investment shifted from legacy products to a full range of IP-based platforms.

Let me start with our traction in the unified communications market. Increasingly, we are being brought into large opportunities within government entities, universities and other educational institutions, health care providers and other large enterprise customers. NET is recognized by industry leaders such as AT&T, IBM, Avanade, and Microsoft as a provider of a broad range of UC solutions that are complementary to their applications initiatives. This recognition reflects the early and continued investment we have made in delivering the best product for the unified communications and secure voice markets.

We are seeing larger pilots from Fortune 1000 global companies. The vast majority of our pilots are ending up in successful adoption of a UC program, but few represent large rollouts at this early stage. In total, by the end of our last fiscal year we had 69 pilots that converted to adoption status, including multiple opportunities in every major geographic region where we have a presence. It is still early in the business cycles for many customers to have commenced full deployment within their organizations, but we continue to grow pilot programs and are keeping the pipeline strong through a direct touch sales organization and an expanding network of partners. At the end of the fiscal year we had 120 pilots under way with 100 more in the sales pipeline.

Most recently applications driving new pilot growth include on-premise voice and video conferencing to reduce employee travel costs and SIP trunking services to reduce traditional telephony costs. Other catalysts driving pilots include the push for adopting green policies and the recent H1N1 virus, highlighting the need for companies to implement a strategic business continuity plan.

Enterprises are realizing real savings from the deployment of UC solutions. For example, according to commentary by an executive of Avanade during a recent webinar we hosted, implementation of UC is providing organizations with significant transformational business value through more secure access and better management of information with employees, customers, business partners and other constituents. This translates into an estimated 20% reduction in communications and related expenses.

We are seeing an increasing number of VX opportunities. We expanded both our domestic enterprise and international sales organizations throughout the past year. During fiscal 2009 we added 154 new UC-focused partners globally, including new partners in the U.S., Australia, Japan, France, the Middle East, where we opened a sales office in Dubai and have already completed our first UC sale. I expect this global partner initiative to continue.

Our relationship with Microsoft continues to broaden as we are supporting more of their product initiatives. Today we have business activities under way with all 10 Microsoft global systems integrators and over half of the Microsoft global voice partners. We were selected as a TAP partner - that's Microsoft's Technology Adoption Program - which allows us to participate in the beta testing for their next major OCS release. Following on from our initial unified communications qualification, we delivered VX and Tenor certifications in time for Microsoft's OCS R2 launch.

Other notable milestones this year included receipt of the Microsoft Customer Excellence Award for manufacturing and verification of NET as an federal OCS R2 voice-specialized partner. Last year we launched an outbound marketing initiative focused on webinar speaking engagements that position NET as a thought leader in the UC market.

We were included in a number of Microsoft events throughout the past year. Later this month our Chief Development Officer has been invited to speak at AEA's Tech America event on the Microsoft Silicon Valley campus. Executives from Intel, Plantronics and Avanade will join NET on a panel to discuss unified communications in the telenetworking environment. In addition, NET was awarded Avaya Gold Partner status and is one of the only 8 vendors among Microsoft, Intel and Nortel chosen to participate in Avanade's Global Technology Summit later this month. These and other strategic recognitions position NET among the leaders in the enterprise UC marketplace.

Turning to our government business, this is where we saw the greatest decline in sales last year, largely due to a lack of major new programs for our products and a transition away from new deployments of our legacy products. We were further impacted by the federal government's budgeting delays during the change in administration. Now that the new budget has been improved and funding is becoming available again we are seeing some signs of a return in this market, including orders for our NX1000 and VX series products. The WIN-T program continues, but at a pace slower than we had anticipated. This business will most likely remain lumpy, with orders in the $2 to $3 million range in a couple increments per year.

We also saw a decline in our secure voice revenue last year as we wrapped up a couple of major programs. We have now commenced new initiatives and new VX opportunities have been identified in the federal government. While I don't believe that we will see the return of major government programs in the late fiscal year, I do expect to see increasing stabilization in this market.

We continue to make significant investments in research and development for our new IP-based products. During the past year we made a number of enhancements to our VX series product portfolio, including our Microsoft active directory integration feature. This feature has proven to be a strategic differentiator for the UC market and has been instrumental in pilot wins.

We also delivered Release 4.7 with several major secure voice features, including support for MLPP and V.150 universal modem relay. V.150, combined with our product support for STE equipment, which is S-T-E or secure telephone equipment, enables instant interoperability between old and new secure voice technologies and assures that STE phones will be able to interoperate with new IP-secure phones. NET's V.150 solution is currently being evaluated and demonstrated to a number of PBX vendors to provide IP-based secure voice interoperability for their federal customer base.

On the NX front we released the next version of the NX1000 software, which provide IP trunk capabilities that allow pseudowire applications and multi-service traffic aggregation over IP networks. We have also received key product certifications over the past year for both our VX and Quintum products. This includes our Microsoft UC-related product qualifications as well as other vendor certifications for the UC and SIP trunking market. NET's VX became one of the first products to be validated for interoperability with IBM Sametime Lotus unified telephony, which will be released in the very near future.

SIP trunking is becoming an emerging standard for next generation voice services. SIP trunks have the capability to displace legacy TDM trunks connected to the PFTN network with IP-based public voice network connectivity. We see this as a key market opportunity. Today NET's SIP trunking products have been certified by more than a dozen service providers worldwide, with other certifications under way.

Turning to operations, our IT department successfully implemented Microsoft unified communications throughout our organization, which has improved employee communications and reduced travel expenses.

In fiscal 2008 we transitioned our manufacturing to a new contract manufacturer, Plexus, and throughout 2009 we bolstered that relationship with improved process documentation and information management.

Organizationally we completed the merger of NET and Quintum. We now have a single integrated global sales force, a consolidated back office, and an integrated management and R&D strategy. These combined actions have substantially reduced our operating expenses.

We were fortunate to bring on broad three new senior executives this past year with deep experience in areas critical to our business. This included Pete Patel, our VP of Global Operations, John Fossett, our VP of Manufacturing Operations, and Jim Fitzpatrick, who recently joined us as President of NET Federal.

Clearly this past year was financially challenging for most companies and NET was no exception. In the midst of this, however, we were able to grow our cash position net of debt by $5.5 million. Through the buyback of our convertible debt at a discount, we reduced our total debt by $73 million. Close attention to our balance sheet and our cost structure has enabled us to enter the new fiscal year with more streamlined operations, an advanced product portfolio, and a broader base of global distribution partners.

As a result of early signs of improvement in government purchasing, I am more optimistic about our ability to regain business in this key market. Further, worldwide recognition and adoption of unified communications in the enterprise is becoming more prevalent and we are well positioned as a recognized participant in this growing market.

I'd like to turn the call back to John now for some financial commentary and closing remarks before we open the call for your questions. John?

John McGrath

Thank you, Nick.

As Nick mentioned, we have many exciting things happening related to our enterprise business and much of our revenue growth will be dependent upon not only the timing of acceptance of these new applications but also the economy. We have begun to see some recovery in our government business since the low point in January and February but do not expect major new programs to begin again until later in the fiscal year.

With that said, we expect revenue for the first half of our fiscal year to increase 15% to 20% over the first half of the last fiscal year and to be up around 50% from Q4 '09. We will continue to focus on cost reductions while at the same time investing in sales, marketing and service initiatives to grow our unified communications and voice businesses for both government and commercial applications.

In the first half of fiscal 2010 we have implemented temporary salary and benefit reductions and suspended our bonus plans. It should be noted that we expect to take charges in the current quarter of more than $500,000 primarily related to employee severance for actions taken at the beginning of the quarter. We expect our cash breakeven levels to be in the $21 to $24 million a quarter range and could be lower if we continue to be successful at drawing down our inventory at Plexus. Our goal is to enter the second half of the fiscal year at a cash breakeven to positive level, dependent upon the market conditions and government spending.

As we reflect upon last fiscal year, which was disappointing from a financial perspective, I believe we have taken some important steps to strengthen the company and position us to return to profitability as the economy recovers. We have aligned our product strategies to streamline our business, we have invested in our global sales and marketing capabilities, we have integrated Quintum into our operations, we have lowered our cash breakeven levels by $6 to $8 million a quarter, and our cash net of debt grew by $5.5 million. Later this month we are presenting at the JMP Conference in San Francisco and in June at the RBC Conference, also in San Francisco.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes Greg Mesniaeff - Needham & Company.

Greg Mesniaeff - Needham & Company

Actually, I have a two-part question on the government business. You had mentioned that not only did the government business decline in the quarter both year-over-year and second quarter but there was also the continued mix shift away from Promina to next generation products, which contributed to the lower margin. I'm curious as the government business eventually does start to pick up later this year, are you faced with pretty much market share pressure of any kind to competitors such as, say, a Juniper or someone else as the transition from TDM to IP continues for them or is this just a matter of waiting when the business returns?

Nick Keating

Let me start with the transition from legacy, i.e., TDM-based switching over to IP-based switching.

We've clearly seen a trend within DISA that they're buying less and less of our Promina products and they're moving over to all IP-based backbone solutions, and clearly the new backbone being built by DISA is a Cisco and Juniper backbone. So our products continue to be installed, but they're being used for access and aggregation. But that is a long-term trend that I think is irreversible.

On the hand, if you look at our deployed systems - these are the systems that we sell that are put into communications vehicles and vans and ships and aircraft - those are predominantly IP-based solutions. The NX1000 is a hybrid; it supports both TDM and IP and I mentioned in the call today that we've now added pseudowire capability to it, which would allow us to be able to handle other legacy traffic, whether it's [frame] relay or TDM or ATM with an IP trunking capability.

That's a product where we're not seeing competitive solutions from organizations like Juniper and Cisco; I see them less on the deployed side. Likewise, on our VX products, the issues for the VX really related to large programs. We had a contract that wrapped up a year ago with the Marine Corps where we sold nearly 1,000 VXs to the Marine Corps. Now we're seeing new purchasing coming from these agencies, but sometimes they're not of the size as some of the bigger programs have been in the past because there's been a lot of equipment that's been ceded out there.

I will say - and I think both John and I referred to it - in March we saw a pickup in our government business. Orders for some of the products came in toward the end of the quarter; we were unable to build those and ship them and get them to the customers' loading dock in time. But we also said that we see our government business stabilizing and then larger programs probably picking up in the second half of the year. So I think right now we feel a lot better than what we did going into January and February.

I'd also like to point out what John said, just to reiterate it. We expect revenue for the first half of our fiscal year, this new fiscal year, to increase 15% to 20% and the quarter to be up about 50% over Q4. So that clearly shows a rebounding there.

Greg Mesniaeff - Needham & Company

And just a quick follow up. As you explore different adjacent areas of your market as a lot of the other networking companies have done recently, there's two particular areas that I'm kind of interested in getting your perspective on - one is wireless mobility and the other one would be session border control, you know, IP-to-IP gateway type of work that's being done in the carrier space but is now moving into the enterprise space.

Nick Keating

Well, we see a growing opportunity within the VoIP business across the board and I think it's just a matter of the industry maturing and the economy's getting better. Obviously the unified communications, unified messaging is one of the key drivers. Wireless mobility, the emersion of fixed-mobile convergence, will be another driver in that area. Certainly we now see growing opportunities within the SIP trunking market and, as I mentioned, we're in the process of certifying with a number of carriers for their SIP trunking services.

I think from a long-term standpoint we see growth in the government secure communications area. The release of our V.150 and MLPP, which is a preemption protocol, has generated a great deal of additional interest within the federal government. We've demonstrated that last month at the DISA partners conference out in Anaheim. We were running live with an Avaya PBX attached to the General Dynamics vIPer, which is V-I-P-E-R, secure phone.

We expect to be in General Dynamics partners conference later this month in Las Vegas with a number of other defense partners, and the V.150 and the MLPP features should expand our market opportunities within the federal market. Going back on the enterprise, we're starting to see call center opportunities and trading floor opportunities with some of the features that we've put into the VX to address those markets.

So today we have about five or six addressable VoIP markets of which obviously the one we highlight is the UM/UC but we can clearly see these other market opportunities emerging at the same time.

Operator

(Operator Instructions) We're showing no more audio questions in queue at this time. I would like to turn the call over to Leigh Salvo for closing remarks.

Leigh Salvo

Thank you, Operator. This concludes our conference call for Q4. Thank you all for participating.

Operator

Thank you for your participation in today's conference. This concludes our presentation. You may now disconnect. Have a good day.

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