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Executives

Patti Leahy - Vice President of Investor Relations

Raymond P. Dolan - Chief Executive Officer, President, Director and Member of Corporate Development & Investment Committee

Maurice L. Castonguay - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Todd A. Abbott - Executive Vice President of Strategy & Go-To-Market

Analysts

Natarajan Subrahmanyan - The Juda Group, Research Division

Catharine Anne Trebnick - Northland Capital Markets, Research Division

James M. Kisner - Jefferies & Company, Inc., Research Division

Sonus Networks (SONS) Q1 2013 Earnings Call April 30, 2013 4:45 PM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the First Quarter 2013 Financial Results Conference Call. [Operator Instructions] And as a reminder, this conference is being recorded, Tuesday, April 30, 2013. And it's now my pleasure to turn the conference over to Ms. Patti Leahy, Vice President, Investor Relations. Please go ahead.

Patti Leahy

Thank you, and good afternoon, everyone. Welcome to Sonus Networks First Quarter 2013 Operating Results Conference Call. Thank you for joining us today. As a reminder, a recording of this call will be available on our website at sonus.net. Also, for your convenience, we will post today’s prepared remarks on the Investor Relations section of our website shortly after the call. Also posted on our website is supplementary financial and operational data.

Speakers on the call today are Ray Dolan, President and Chief Executive Officer; and Moe Castonguay, Senior Vice President and Chief Financial Officer. Todd Abbott, Executive Vice President of Strategy & Go-to-Market, is also here to address questions at the end of our prepared remarks.

Please note for purposes of Safe Harbor provisions that during this call, we will make projections and forward-looking statements regarding items such as future market opportunities and the company’s financial outlook. Actual events or financial results may differ materially from these projections or forward-looking statements, and are subject to various risks and uncertainties including, without limitation, economic conditions, market acceptance of our products and services, the timing of revenue recognition, difficulties leveraging market opportunities, the impact of restructuring activities and our ability to realize benefits from the NET acquisition. A discussion of these and other factors that may affect future results is contained in our most recent Form 10-K filed with the SEC and in today’s earnings release, both of which are available on our website. While we may elect to update or revise forward-looking statements at some point, we specifically disclaim any obligation to do so, unless required by law.

During our call, we will be referring to certain GAAP and non-GAAP financial measures. A reconciliation of the non-GAAP to comparable GAAP financial measures is included in our press release issued today, as well as in the Investor Relations section of our website.

It’s now my pleasure to introduce the President and Chief Executive Officer of Sonus, Ray Dolan. Please go ahead, Ray.

Raymond P. Dolan

Thank you, Patti, and good afternoon, everyone. Today, Sonus announced solid first quarter results, which reflect a strong start to the year and position us very well for the full year. Revenue, OpEx, EPS and cash were all better than our expectations and gross margin was in line with our expectation. We continue to make significant progress toward our core goal to transform Sonus to an SBC-centric, profitable company. Our results today reflect crisp execution of our strategy that is resonating with our customers and partners around the world. Moe will review our results and outlook in a moment, but I'd first like to highlight some of the progress we're making against the key operational milestones we laid out for you last quarter.

Before doing so, I would also like to mention, as previously committed to you, that we are providing new disclosures beginning today and expect to do so going forward each quarter. These are the important indicators of our continued success and include: one, our product revenue contribution from enterprise customers; and two, our product revenue contribution from the channel, also referred to as indirect sales. Our goal is to provide you with more transparency into the key performance indicators underpinning our strategy. I would like to point out, and Moe will speak to this issue later on linearity, that these metrics should provide a good perspective of our strategic progress in generating revenue from the channel and the enterprise segment when viewed on an annual basis.

Let me turn to the first key operational metric of SBC growth. We delivered $30 million of total SBC revenue this quarter, which is up 77% from the first quarter of last year. We delivered $23.5 million of SBC product revenue this quarter, up 79% from Q1 of last year. Both SBC product and SBC total revenue marked a record quarterly high for Sonus.

The second key operational metric I will discuss is new customer growth. We secured 163 new customers in Q1, 138 of which are new SBC customers. We believe that securing new customers is an important indication that we are winning in the marketplace and our solutions are attracting an increasing number of new customers from both the service provider and enterprise segments.

A third key metric for 2013 is the percent of revenue we generate from the channel, as well as in the enterprise segment. These are the additional new disclosures I mentioned earlier.

Let me first talk about the channel. The channel is measured by the indirect revenue as a percentage of total product revenue, which in Q1 was 17%. As we continue to scale the deployment of the Sonus partner select program, we expect the channel to contribute 20% to 25% of our total product revenue in 2013. We believe that our first quarter results demonstrate good early progress on our channel initiatives.

Enterprise customers comprised 45% of our total product revenue this quarter and 57% of our SBC product revenue. These numbers include a large SBC deployment with the U.S. federal government. For the full year of 2012, we expect the enterprise segment to contribute $35 million to $40 million of our total product revenue or between 22% and 25%.

The last and arguably the most important metric which I will mention today is our progress toward profitability. As we have repeatedly stated, we expect to be at least breakeven to slightly positive on a non-GAAP basis for the full year, and we expect to begin generating cash from operations from the full year as well. We took a solid step in the right direction this quarter, and we will continue to work hard towards this important milestone by growing revenue, expanding margins and demonstrating disciplined cost controls. Each of these 4 key operational milestones have been strengthened by NET, which has now been fully integrated into our business and is proving to be highly strategic. Our SBC revenue, new customer growth, channel and enterprise revenue are all enhanced this year as a result of the complementary products and services we acquired through NET. The Sonus SBC portfolio now provides the industry's broadest end-to-end SBC solutions, delivering SIP-enabled applications for customers ranging from large, regional and branch offices for both the enterprise and service provider segments.

I'll conclude my prepared remarks in a moment, but first, I'll turn it over to Moe to discuss our results and our outlook in more detail. Moe?

Maurice L. Castonguay

Thank you, Ray, and good afternoon, everyone. Total revenue for the first quarter was $63.3 million compared to $75.1 million in the fourth quarter and $64.3 million in the first quarter of 2012. Total SBC revenue, including products and services, was $30 million in the first quarter, $26.1 million in the fourth quarter and $17 million in the first quarter of 2012. Our top 5 revenue customers represented 50% of revenue this quarter, up from 45% in the fourth quarter of 2012, and down from 66% in the first quarter of last year. We reported revenue from 541 customers in the first quarter. This compares to 504 customers in the fourth quarter.

Looking at revenue geographically, domestic revenue accounted for 69% in Q1 compared to 51% in Q4 and 75% in Q1 of 2012.

Before I go into further details on our financials, I'd like to point out that the following are non-GAAP numbers that exclude: stock-based compensation, write-down of prepaid royalties, acquisition costs, restructuring charges, amortization of intangible assets and depreciation resulting from the write-up of NET assets under purchase accounting.

Total gross margin for the first quarter was 61% compared to 59% in the fourth quarter and 65.3% in Q1 of 2012. Product gross margin for the first quarter was 64.9% compared to 61.4% in the fourth quarter and 77.9% in Q1 of last year. Product gross margin fluctuate quarter-over-quarter based on software content and product mix.

Service gross margin for the first quarter was 55.4% compared to 55.3% in Q4 and 42.4% in Q1 of last year. Total operating expenses for the first quarter were $44.7 million, compared to $42 million in the fourth quarter of 2012 and $46 million in Q1 of last year. Our non-GAAP expenses, which compare favorably to the first quarter of last year, also fully absorbed costs from NET and point to greater operating leverage for the consolidated business.

Consolidated headcount at the end of the quarter was 1,042 compared to 1,093 at the end of December. This reflects the streamlining efforts which commenced last year.

Net loss for the quarter was $6.4 million compared to a net profit of $1.8 million in the fourth quarter, and a net loss of $4.2 million in Q1 of 2012. We ended the quarter with total cash and investments of $284 million, which is slightly better than forecasted and a good indication that we are making progress towards our goal of generating cash from operations for the full year.

Our DSO for the quarter was 71 days as compared to 82 days in the fourth quarter. The improved DSO in the first quarter is more in line with expected norm moving forward.

Now I'd like to provide more details for our outlook for the second quarter ending Friday, June 28, and fiscal year 2013. I will remind you that the outlook is provided in the press release and on our web page.

The total revenue outlook for the second quarter is anticipated to be between $66 million and $68 million. Our fiscal year 2013 revenue outlook remains unchanged and is expected to be between $267 million and $271 million. Included in our second quarter outlook is anticipated total SBC revenue of $27 million to $29 million. Our first half SBC revenue remains in line with our expectations and we remain confident in our annual guidance provided on our last call and reiterated today.

The full year revenue outlook remains unchanged and includes total SBC revenue of $120 million to $124 million, reflecting year-over-year growth of approximately 40%.

I'd like to pause here for a moment to discuss the matter of SBC linearity and help you with your modeling assumptions. In 2012, we realized approximately 40% of our SBC product revenue in the first half of the year and 60% in the second half. This year, based on the midpoint of our guidance, we expect to realize approximately 46% of our SBC product revenue in the first half and 54% in the second half. With regards to the second half of the year, we continue to expect fourth quarter to be our strongest quarter, representing approximately 30% of our SBC product revenue, as was the case in the fourth quarter of 2012.

Turning to our legacy product revenue outlook. While we believe there could be upside to our outlook, we maintain our assumption for an annual decline of 30% in our media gateway product revenue, which implies roughly $60 million of legacy product revenue in 2013.

Turning to gross margins. For the second quarter, we expect total non-GAAP gross margins to range between 62% to 63%. For the full year, we continue to expect non-GAAP gross margins of between 64% to 65%, reflecting continued streamlining of manufacturing and service operations and lower component and subassembly costs.

For the second quarter, we expect non-GAAP operating expenses to be between $42.5 million and $43.5 million. Total non-GAAP operating expense outlook for fiscal year 2013 remains in the range of $171 million to $172 million. For the second quarter, we expect a non-GAAP loss per share of $0.01 to breakeven. And for the full year, we continue to expect non-GAAP earnings per diluted share of breakeven to $0.01.

Basic share count for the second quarter is anticipated to be approximately 282 million. Full year diluted shares are expected to be approximately 285 million. We expect to be cash flow positive from operations in 2013, with the second quarter ending cash and investments of $282 million to $285 million. We expect year-end cash and investments of $283 million to $287 million.

With that said, I'll now turn the call back over to Ray to provide his concluding remarks.

Raymond P. Dolan

Thanks, Moe. We believe the proof of our transformation toward a profitable, SBC-centric company is becoming increasingly clear. This quarter, 62% of our total product revenue was derived from SBC solutions. This is a record high for Sonus. We are pleased that our most important drivers of value, including SBC revenue growth, new customer growth, revenue growth from the channel and the enterprise and the progress towards improved profitability are all tracking consistent with our expectations.

Turning to profitability. I want to make it clear that our crisp focus on profitability is not limiting our growth potential. We believe we are already uniquely competitive with the industry's most comprehensive SBC portfolio. And I am confident that the continued investments we are making will ensure that we are increasingly relevant and strategic to our customers and partners.

Infonetics expects the total SBC market to grow in the mid-teens in 2013. We continue to expect to grow our SBC product revenue by approximately 50% this year, implying continued share gain. In short, Sonus is playing an important leadership role in the evolution of our industry and I'm thrilled to be part of this journey. I'd like to thank our team for their continued hard work and for the continued support from our shareholders.

And with that, I'll now turn the call over to our operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Subu Subrahmanyan.

Natarajan Subrahmanyan - The Juda Group, Research Division

First, a question on the enterprise revenue, Ray. Can you talk about -- if repeat some of the numbers you had mentioned and gave some context, are those as percentage of product revenue and 57% of SBC I thought I heard, was that weighted -- or was it higher because of the government business? What should more of the steady-state be for the company?

Raymond P. Dolan

Okay. So the enterprise revenue, as a percentage of -- and same with the channel, as a percentage of its total, Subu.

Patti Leahy

Total product revenue.

Raymond P. Dolan

The channel is 17% and it should normalize on an annualized basis in the 20% to 25%. The enterprise was unusually high this quarter at 45% of total product and 56% of SBC product. And it will normalize in the 22% to 25% range of our total product revenue. And we gave you the dollar value of that so you can just do some of the math of $35 million to $40 million. So that's a restatement of what -- or a repeat, I should say, of what we just discussed. So if you have a question on that, I'm happy to take it.

Natarajan Subrahmanyan - The Juda Group, Research Division

Is there any 2012 number that you can give us just for context, what percentage of product revenue it represented?

Raymond P. Dolan

No, there really isn't.

Natarajan Subrahmanyan - The Juda Group, Research Division

Okay. And then, on gross margin, Moe, can you talk about the progressions through the course of the year? Obviously, given your full year numbers and the second quarter guidance, should expect some fairly sharp increases. How much of that is related to mix versus cost? Can you talk about that?

Raymond P. Dolan

It's those 2 things, Subu, mix and cost. And Moe referred to the way our margins move based on software content and mix, that's definitely some of it. You'll see some of it also coming from our cost structure as we're designing for manufacturing and improving our cost structure from the standpoint of our overhead. And I would say it's probably an even balance between the 2 throughout the rest of the year.

Natarajan Subrahmanyan - The Juda Group, Research Division

And the final question on just capital spending environment. First of all, how do you view that for 2013 and how relevant is it to Sonus in terms of -- with some of the growth calls that you have?

Raymond P. Dolan

So I've always felt that we need to take it down to the sector level because we're not a big enough company to be a call in the capital spend, if you will, of the total environment. But if you look at our sector, we think that the mid-teens growth rate for the SBC category in general, is a solid forecast. We can underpin that based on what we see as trends in the marketplace and we like our opportunity to gain share there, all right? So I think a lot of the trends in the SBC category, specifically at the subset of the total CapEx spend, are very favorable to us.

Operator

Our next question comes from the line of Catharine Trebnick with Northland Securities.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

My question has to do more on the carrier side and the enterprise. You really pulled it together. Are there other types of technology, like, there's a big discussion on WebRTC and certain types of that technology. Do you see that impacting any SBC growth or do you see it enabling SBC capabilities? And do you have any comments on that technology and where it's headed?

Raymond P. Dolan

Sure. I'll give it a shot, and I also welcome Todd to join me answer toward -- when I give it. So here's how I look at that, Catharine. One, it is an enabler in the enterprise, for sure, on the SBC space in general. It will be a driver of UC, and it will be a driver -- it'll be a complementary driver with SIP trunking of UC, all of which will drive the SBC growth. So I think we're in good shape there. Remember, our heritage is as real-time as you can get. Even though there's a lot of perception that Sonus was a voice company, there is no more rigorous real-time app than voice. So we've got all the skills to port those real-time capabilities into a broader suite of UC applications as WebRTC takes off. So we see it as a real net positive.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

Okay. And then, my follow-on question is just in general on the enterprise partnership, I mean, is there a way to extrapolate how well you are doing with Microsoft Lync or Aero or some of the other partners that you have, I mean, out of the 25 or 30 Gold Partners? Are there maybe a few of them that have been able to deploy more of your SBC technology into the enterprise, sort of a general commentary on how well you're doing with your partners that seems to be picking up?

Raymond P. Dolan

So we are picking up with our partners, just some really healthy signs there. And both of them and others are important partners to us, but we don't plan to report out our revenue based on any one or group of partners there, Catharine. All of them will be strategic to us, and they'll come in and out of our revenue profiles based on their own business strategies.

Operator

Our next question comes from the line of James Kisner with Jefferies LLC.

James M. Kisner - Jefferies & Company, Inc., Research Division

I guess, my first question -- I'm just really kind of surprised to see government pop up as a 10% customer. Obviously, that would mean it was up sequentially, I think. So we just some -- a couple of companies in our space have very negative things to say about the federal government, and I'm just curious if you could try to provide any texture there? Is it a broader initiative you're benefiting from to save on voice expenses or what's really kind of driving the streak there?

Raymond P. Dolan

It's Ray. I wouldn't put it in any broader context there. This is an important project for us and for the U.S. federal government, driving SBC and a number of UC applications in their network. But I would not connect it, if you will, to any macro sequestration, positive or negative. So I think it just stands on its own merit. It's really outside the context of the major government shifts that are going on right now. It's a net positive for us, it's certainly a good strategic component of the outcome of our NET acquisition, and it's a good way for us to leverage the entire breadth of our portfolio in the SBC space with the federal government.

James M. Kisner - Jefferies & Company, Inc., Research Division

Could they become a 10% customer again? Do you think this is sort of a one-time large project or a big piece of a larger project? Could you give us any color there?

Raymond P. Dolan

Well, it's always possible, I wouldn't forecast that. For this year, I wouldn't forecast them being that again, but we'll certainly disclose it if, in fact, it happens, okay?

James M. Kisner - Jefferies & Company, Inc., Research Division

Okay. And here's a sort of separate question on just your revenue guidance for the year. I mean, you've done, obviously, a great job in Q1 and your Q2 guidance is pretty strong. And I'm just curious, why would you not raise the year at this point? And is it -- are you seeing anything about the environment and is the visibility the same as it was a quarter ago or you're just being conservative? Just you got any texture of why you wouldn't, sort of, commit to an additional upside into your annual guidance?

Raymond P. Dolan

This is Ray again. It's really right down the middle. I think it's premature for us after a solid Q1 and a good outlook into Q2 to do anything for the year. We're trying to be as transparent as we possibly can. And so it's as simple as that. As we get greater and greater visibility into the back half of the year, we'll certainly let you know what that looks like on our next call.

Operator

[Operator Instructions] Our next question comes from the line of Steve Cowen [ph] with Bravo Partners.

Unknown Analyst

This quarter -- great job, by the way, this quarter on -- particularly on the SBC side that came in significantly better than what was included in your guidance, which implies that the legacy business came in a little bit soft in the first quarter, yet it seems like you're expecting a pretty good uptick on that in the second quarter and you were adamant that the 30% down for the year on product -- legacy product revenue was sufficiently pessimistic. Is there some sort of a big project on the services side that's getting billed the next quarter or some deferred revenue moving forward -- we have to recognize? What's -- explain the kind of the ups and downs in the legacy revenue business.

Maurice L. Castonguay

With respect to service business, our service business -- or the professional services component of it can be up or down a few millions at any given quarter, tied to specific projects. But that's basically, if there's no really significant movement. We are expecting in our guidance of $66 million to $68 million increases in both product and service revenue.

Unknown Analyst

On the legacy side?

Maurice L. Castonguay

That's correct.

Unknown Analyst

Also, on a different subject, I think it was last quarter you mentioned the win at Verizon for the SIP interconnect project, yet they don't show up as a 10% customer this quarter. I also noticed in the proxy you disclosed that, that was going to be SBC 9000 product. Is that going to -- at Verizon, does that turn out to be new software onto boxes that they had already acquired for a prior application or are there new shipments into -- that Verizon anticipated?.

Maurice L. Castonguay

Yes, I'll go ahead and ask Todd to go and weigh in on pricing in general on your question here, Steve.

Todd A. Abbott

Yes, so what we have previously disclosed is that the 9000 win at Verizon was a new chassis win, 100% dedicated to SBC for interconnect. So it did not relate to software upgrades to existing gateway products. So it was the 9000 competing on its own as a 100% full-fledged SBC. It is a multiyear project, it will be lumpy in different quarters, and we're well into the implementation of that infrastructure for Verizon.

Unknown Analyst

I guess, as a follow-up to that, Todd, does that imply that the 9000 chassis has a longer life to it than I otherwise have thought or was there something special about the Verizon network that made it particularly appropriate for them and is less likely to be replicable at other carriers?

Todd A. Abbott

For any net new carrier, it would be 5000-based. You have to kind of think about the sales cycle of a large infrastructure sale. And at that point in time, the 9000 was a much more natural migration for our legacy customers because of experience base and comfort with the GSX 9000. For any net new customer now, given where we are in the capabilities and the installed base and referenceability of the 5k base, that really becomes the lead with platform for any net new carriers. But the 9000 is going to have a long life. It's very strategic to a lot of our legacy customers and we continue to invest and innovate on that platform.

Operator

[Operator Instructions] And it appears there are no further questions at this time. I'd like to turn the call back to the speakers for your closing remarks.

Raymond P. Dolan

Well, thank you very much. This is Ray Dolan. We appreciate all the support from our shareholder community, as well as the financial analyst community in following the progress that we're making here at Sonus. And on behalf of over 1,000 people that are proud to be part of this journey, I just want to say, we look forward to sharing our results with you each quarter this year as we continue the transformation. So thanks, again. That's all we have for this evening. Have a good night.

Maurice L. Castonguay

Thank you. Good night.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for participation and ask that you please disconnect your line.

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