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Zhone Technologies Inc. (NASDAQ:ZHNE)

Q2 2009 Earnings Call Transcript

July 22, 2009 at 5:00 pm ET

Executives

Mory Ejabat - Chairman and Chief Executive Officer

Kirk Misaka - Chief Financial Officer

Analysts

Greg Mesniaeff - Needham & Company, LLC

Donna Jaegers - D.A. Davidson

Marty Albam - Verizon Network

Operator

Good day, and welcome to the second quarter 2009 Zhone Technologies Inc. conference call. I am Anita and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session at the end of the conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the call over to Kirk Misaka, Zhone’s Chief Financial Officer. Please proceed.

Kirk Misaka

Thank you, operator. Hello and welcome to the second quarter 2009 Zhone Technologies Inc. conference call. I am Kirk Misaka, Zhone’s Chief Financial Officer. The purpose of this call is to discuss Zhone’s second quarter 2009 financial results as reported in our earnings release, which was distributed over Business Wire at the close of market today and has been posted on our website at www.zhone.com.

I am here today with Mory Ejabat, Zhone’s Chairman and Chief Executive Officer. Mory will begin by discussing the key financial results and business developments of the second quarter. Following Mory’s comments, I will discuss Zhone’s detailed financial results for the second quarter and provide guidance for the next quarter.

After our prepared remarks, we will conclude with questions and answers. As a reminder, this conference is being recorded for replay purposes and will be available for approximately one week. The dial-in instructions for the replay are available on our press release issued today. An audio webcast replay will also be available online at www.zhone.com following the call.

As you know, during the course of the discussion today we will make forward-looking statements including those relating to projections and profitability, earnings, revenue, margins, operating expenses or other financial items. The anticipated growth and trends in our business, product lines or key markets, new product introductions and the migration of customers to newer technologies, Zhone’s market position and focus and statements that express our plans, objectives and strategies for future operations.

We would like to caution you that actual results could differ materially from those contemplated by the forward-looking statements. We refer you to the risk factors contained in our SEC filings available at www.sec.gov, including our annual report on Form 10-K for the year ended December 31st, 2008 and our quarterly report on Form 10-Q for the quarter ended March 31st, 2009.

We would like to caution you not to place undue reliance on any forward-looking statements which speak only as of the date on which they are made and we undertake no obligation to update any forward-looking statements.

During the course of this call, we will also make reference to pro forma EBITDA and pro forma operating expenses. Non-GAAP measures that we believe are appropriate to enhance an overall understanding of past financial performance and prospects for the future. These adjustments to our GAAP results are made with the intent of providing greater transparency to supplemental information used by management in its financial and operational decision making.

These non-GAAP results are among the primary indicators that management uses as the basis for making operating decisions because they provide meaningful supplemental information regarding our operational performance and they facilitate management’s internal comparisons to the Company’s historical operating results in comparisons to competitors operating results.

The presentation of this additional information is not meant to be considered in isolation or as a substitute for measures of financial performance prepared in accordance with GAAP. We have provided GAAP reconciliation information for pro forma EBITDA within the press release, which as previously mentioned has been posted on our website at www.zhone.com.

With those comments in mind, I would now like to introduce Mory Ejabat, Zhone’s Chairman and Chief Executive Officer.

Mory Ejabat

Thank you, Kirk. Good afternoon and thank you for joining us today for our second quarter 2009 earnings call. The Zhone's sequential revenue growth through gross margins and continued expense control contributed to weather the unexpected earnings for the quarter.

As we discussed on our last conference call, we were beginning to see signs of an improved environment and a strong interest in our new technology. Both signs prove to be accurate as we meet our previous guidance for revenue, gross margins, operating expense and pro forma EBITDA. Most important, revenue growth by 26% from $24.1 million in the first quarter to $30.3 million in the second quarter, we far exceeded our previous guidance of revenue between $27 million and $28 million. This revenue growth was driven by broad base deployment of our new products in the US and abroad.

I will give you more detail on the new products and market later on. For now, let me just say that we are very encouraged by the immediate acceptance of our new products and hope to build on this momentum to achieve our primary goal of reaching quarterly EBITDA profitability by yearend. Kirk will give you more details on our financial performance and guidance later on.

Also before turning to the business side, I want to update you on the status of our NASDAQ listing. As we have discussed in the past, the NASDAQ has continued to extend the temporary suspension of the $1 minimum per share bet price required for continued inclusion on NASDAQ global market. Recently, they extended the suspension of the requirement onto July 31st, 2009 and notified us that this will be possibly the final extension. As such, we will have until September 25th, 2009 to regain compliance with the minimum bet price requirement. As you know, we received shareholder approval to do a reverse stock split of between 1.5 and 1.0 in order to regain compliance with the $1 minimum per share bet price.

If we decide to proceed with the process to complete the reverse split, we will make a further announcement well in advance of taking any action. In the meantime, we will continue to evaluate other alternatives to maintain our NASDAQ listing.

Now let me talk about our products and customers. This quarter, we announced the very important new product for Zhone, the MXK intelligent terabit access concentrator. The MXK combines a clean-sheet hardware design for unrivaled bandwidth in GPON and Active return of application with our well proven SLMS access operating system for service intelligence. We have been trying the MXK as the foundation of customers request to fiber access networks for several months.

As we all know, at the product launch in June, several of these customers have moved into implementation for our providing commercial service on the MXK including Edge Telecom in UK, LOS Bynett in Norway, four IOCs in US, Copaco in Paraguay, Tel Sur in Chile and a large project in the Middle East. The NSE has responded well to the announcement with positive coverage from all the leading broadband industry press and now, thousands of web references to product. Most important, the MXK is carrying us and a quickly going number of customer opportunities as momentum in the broader GPON market continues to build.

In support of our GPON initiatives and the interest of one of our largest customers, earlier this year we joined FSAN, the Full Service Access Network organization. FSAN is an operator-led group that sponsored a standard [13.54] and interoperability testing for GPON solution. We brought the MXK to their recent event last month where it performed well in test with several other vendors. The equipment improved the value of FSAN work on the interop standards.

Finally, in the US market, we report last month that both the MXK and SkyZhone are award-winning method Wi-Fi products that are accepted by the USDS roll out utility services administration for use in growth funded projects. This highlights the value of this platform can provide in the US broadband stimulus programs. At the beginning of July, the administration kicked off the application process for the first round of the stimulus grant expected to total nearly $4 billion. We are working with a number of our customers on their proposal and the government suggests that funds should start flowing by the end of this year. We are pleased to see this process moving forward and we anticipate having many opportunities to have the winners fill out their network and new networks.

As you can see, many exciting things are happening in our business that should translate into a strong financial performance. Now, I will turn the call over to Kirk to provide more details about the financial results for last quarter and to discuss our financial guidance for next quarter. Kirk?

Kirk Misaka

Thanks, Mory. Today’s Zhone announced financial results for the second quarter of 2009. In our press release the traditional comparison of financial results for the second quarters of 2009 and 2008 is presented alongside the comparison to the first quarter 2009. As we have done in the past, most of our discussion today will focus on the sequential comparison to first quarter results.

As Mory mentioned, revenue for the second quarter of 2009 increased by 26% from $24.1 million in the first quarter to $30.3 million in the second quarter exceeded our previous guidance of revenue between $27 million and $28 million. Last quarter, we mentioned that we had started to see some signs that revenue levels had hit bottom. Those factors included sales backlogs that increased for the first time in several quarters, increased trial activity, more request for information about our new products and product enhancements and greater visibility under this quarter's pipeline of orders. Those factors continued to exist so even though our third quarter has historically been seasonally weaker, we are forecasting continued revenue growth for the third quarter to between $32 million and $33 million.

We continue to serve approximately 700 active customers worldwide with 52% of revenue for the second quarter being attributable to international customers. We experienced slightly more customer concentration this quarter with one 10% customer and our top five customers represented approximately 34% of revenue for the second quarter as compared to 26% for the first quarter.

Similar to our revenue growth, gross margins also improved substantially from 32.4% for the first quarter to 36.4% for the second quarter and exceeded our previous guidance of between 31% and 33%. The margin improvement resulted from a variety of positive factors including new product cost improvement, favorable pricing on a few large transactions, inventory earn-out proceeds from previously listed products, and manufacturing economy's scale.

Going forward, we expect margins for the third quarter to range between 32% and 35%. Operating expenses for the second quarter also came in better than guidance at $13 million versus guidance of between $13.5 million and $14.5 million. Operating expenses included depreciation of approximately $400,000 and stock-based compensation of approximately $500,000.

With additional sales and marketing activity around our new product launches, we anticipate total operating expenses for the third quarter to increase slightly to between $13 million and $14 million including approximately $1 million of expenses for depreciation and stock-based compensation.

Finally and most important, pro forma EBITDA for the second quarter of 2009 was a $900,000 loss and significantly less on our estimate of an EBITDA loss of between $3 million and $4 million. With continued revenue growth with slightly lower margins and slightly higher operating expenses, we expect the pro forma EBITDA loss for the third quarter to range between $1 million and $2 million and hope to return a positive quarterly pro forma EBITDA in the fourth quarter of 2009 assuming revenue continues to grow.

Now, let us take a quick look at the balance sheet. Cash and short-term investments at June 30, 2009, were $26.8 million which declined from $28.9 million at March 31, 2009, largely due to the EBITDA loss and other working capital changes occurring during the second quarter. Our total debt obligations remained basically the same at last quarter at $28.9 million.

As for other balance sheet changes, inventory levels decreased again from $39.8 million as of March 31st to $33.6 million as of June 30th. Also accounts receivable levels increased slightly to $19.1 million at June 30 but with higher revenue in the quarter with the number of days sales outstanding on accounts receivable for the second quarter decreased to 57 days as compared to 70 days for the first quarter. We anticipate DSO will return to around 70 days for the third quarter.

Finally, the average basic and diluted EPS shares were $150.9 million for the second quarter increasing only slightly from the $150.7 million in the first quarter. Once again, the slight increase resulted primarily from stock option exercises by management and employees.

Without financial overview, I will turn the call back to Mory for a few final comments before we open the call up to questions and answers. Mory.

Mory Ejabat

Thank you, Kirk. As we begin the new metric products cycle, we hope that the second quarter of 2009 represent an important turning point for the Company given the initial positive reaction to our new products, the opportunity that we can return to generating a positive quarterly pro forma EBITDA by the end of the 2009. This remains our primary financial goal. Thank you for joining us today. We will now open the call to questions. Operator, please begin the Q-and-A portion of the call.

Question-and-Answer Session

(Operator Instructions) Your first question comes from the line of Greg Mesniaeff - Needham & Company.

Greg Mesniaeff - Needham & Company, LLC

Nice job on the revenue line. I was wondering whether the guidance you had given for gross margins for the third quarter which I believe is up to 35% is kind of a sustainable number assuming the current revenue run rate and what contributed to the even stronger number in the second quarter, the 36.4%?

Kirk Misaka

Well, let me say that we hope to be able to sustain a higher gross margin level going forward. We did provide guidance of 32% to 35% to reflect what we anticipate the third quarter to come in at and Mory will talk a little bit more about the reasons for the margin improvements last quarter.

Mory Ejabat

Okay Greg, a couple of things under revenue growth. The 20% of our revenue was attributed to our new product introduction, the MXK with the associated CPEs. So that was a good win beyond our sell and that product has really taken off and people are really excited about the capabilities of that product and by far, has exceeded any competition in the industry. So, that has been a shining point in our revenue.

Greg Mesniaeff - Needham & Company, LLC

And if I can just ask a follow up question regarding the MXK product, without giving perhaps any kind of concrete backlog numbers, where are you seeing most of the activity, the backlog activity for that product? Is it in the US or what region of the world?

Mory Ejabat

It is really diversified, Greg. We see we have a good backlog on that in domestic as well as internationally. Well, internationally, it is the stronger backlog than domestically.

Operator

Your next question comes from the line of Donna Jaegers - D.A. Davidson.

Donna Jaegers - D.A. Davidson

I follow a number of your customers in the rural area and I was just curious given that the rules have finally been spelled out on the use of the subsidy money for rural broadband. Are you seeing any sort of pick up in testing or any other indications that would indicate that the rural companies are looking more at your product?

Mory Ejabat

Well, one thing that we have seen is the first roll has started providing funding for some of the contract that was signed before this summer. But they did not do that, now they opened up the gate and they are doing that. The other thing that we are seeing, we have seen lots of proposal ready to go with our customers willing to get a proposal to put in there for some other span. We have seen lots of activity in that respect. And also, we have seen lots of interest in our new MXK product for testing. However, there will be lower for other areas in the country.

Donna Jaegers - D.A. Davidson

Can you talk about; I know Consolidated Communications is a large customer of yours. Can you talk about any of the other major [RLX] that are testing your equipment?

Mory Ejabat

Well, we kind of like to keep that confidential since I do not want to give the testing of our products to our competitors.

Donna Jaegers - D.A. Davidson

Okay. Can you talk a little bit about how your product backs up for sort of bandwidth and IPTV versus Adtran's products or any sort of comparable products from our [Alkalu]?

Mory Ejabat

Let me just tell you our product and I am not going to talk about the competitors but I can tell you that we are the first product that can provide terabit bandwidth back line capacity. We have GPON card that has eight ports on that and it can put our 9,000 subscriber on that. With that 9,000 subscriber, they can run IPTV, Voice over IP, traditional voice and also high-speed internet access major higher at 50 to 100.

So, with that kind of combination as we put together, I do not see any competitor anywhere close to what we offer.

Operator

Your next question comes from the line of [Marty Albam] - Verizon Network.

[Marty Albam] - Verizon Network

Guys, congratulations. You did a good job. That is fabulous. I could see return coming. Can you give us, these projections for the next quarter, it seems to me with all the stimulus money that is coming near, do you anticipate us getting a portion of this and how big can it be and when do you expect this?

Mory Ejabat

Well, we do anticipate getting some of the stimulus money. Our customers are getting those monies and in turn, ordering equipment. Those funds are not going to be available until the fourth quarter and the reason we did a 32% to 33% guidance at this point, as you know, majority of our business or good portion of our business is from international customers and Europe is going to be on vacation toward this quarter and Middle East is going to be so hard that people do not work and we have some of the holidays as well in Middle East that is going to affect the quarter. But given that, we have seen a growth in our product and mainly it is going to come domestically.

[Marty Albam] - Verizon Network

I would think that the stimulus package would want American companies to participate in the package so I think we are in a great position on this, I would think.

Mory Ejabat

We sure are and majority of our customers are open to buy product from the company that manufactures in the United States.

[Marty Albam] - Verizon Network

That is wonderful now, have you gotten any new brokerage people following you? Do you have any analyst looking at your Company because I think we got a great story here? If you get the story out, this new exciting product and the return coming and the stimulus package, I also think you do not have to worry about doing a reverse split on this because the stock can go down easily, any coverage at all?

Mory Ejabat

I cannot comment on your last statement but I can tell you we have partnered with several banks and they know our position and our strength in the market and Greg Mesniaeff is doing a great job following us and we are happy with the colors that he put out and we get and hopefully, in the near future, we will have some other analysts to follow.

[Marty Albam] - Verizon Network

That is wonderful. Keep up the great job and wonderful of the turn that is taking place in the Company and I am sure in time, everything will come together there and I appreciate what you have done for the Company.

Operator

(Operator's instruction) There are currently no additional questions in queue. I would now like to turn the call back over for closing remarks.

Mory Ejabat

Thanks again for joining us today. We appreciate your continued support and look forward to speaking with you on our next conference call when we hope to announce another quarter of strong financial performance. Thank you. Operator.

Operator

Thank you for your participation in today's conference. This concludes the presentation.

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