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Sonus Networks, Inc. (NASDAQ:SONS)

Q2 2009 Earnings Call

July 30, 2009 at 10:00 am ET

Executives

Richard N. Nottenburg, Ph.D - President & Chief Executive Officer

Richard J. Gaynor - Chief Financial Officer

Gurudutt U. Pai - Senior VP of Sales and Services, Business Development & Strategy

David Roy - Vice President of Investor Relations

Analysts

Paul Silverstein - Credit Suisse

George Notter - Jefferies & Co.

Natarajan Subrahmanyan - Sanders Morris Harris

Steven O’Brien - JP Morgan

Kenneth Muth - Robert Baird & Co.

Todd Koffman - Raymond James & Associates

Edward Jackson - Cantor Fitzgerald

Greg Mesniaeff - Needham & Co, Inc.

Catharine Trebnick - Avian Securities, LLC

Operator

Good morning and thank you for standing by. Welcome to the Sonus Networks second quarter 2009 financial results conference call. At this time, I would like to remind everybody that today’s call is being recorded and all participants are currently in a listen-only mode. Afterwards, we will conduct a question-and-answer session. (Operator Instructions)

I would now like to turn the conference over to David Roy at Sonus. Please go ahead Mr. Roy.

David Roy

Thank you and good morning everyone. My name is David Roy and I handle Investor Relations for Sonus. And with me on the call this morning are Richard Nottenburg, our President and Chief Executive Officer and Rick Gaynor, our Chief Financial Officer, who will both address you shortly.

And also with us today is Guru Pai, our Senior Vice President and General Manager whom some of you have met. Guru will be available after the comments to help answer your questions.

Earlier this morning, we issued a press release announcing our results for the second quarter of 2009. The text of this release, along with the accompanying income statement, balance sheet, and operating statistics, as well as a reconciliation of the most directly comparable GAAP financial measures to any non-GAAP financial measures used during this call, and for certain prior periods, are available on the Investor Relations section of our website.

And before Richard offers his opening remarks, I would like to remind you that during this call, we will make projections or forward-looking statements regarding items such as future market opportunities and the Company’s financial performance. These remarks about the Company’s future expectations, plans, and prospects constitute forward-looking statements for purposes of the Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995.

These projections or statements are just predictions, and involve risks and uncertainties, such that the actual events or financial results may differ materially from those we have forecasted.

As a result, we can make no assurances that any projections or future events or financial performance will be achieved. For a discussion of important risk factors that could cause actual events or financial results to vary from these forward-looking statements please refer to the risk factors section of our most recent annual report on Form 10-K, at our quarterly report on Form 10-Q for the first quarter, which is on file with the SEC. The second quarter Form 10-Q scheduled to be filed later today.

Any forward-looking statements represent our views only as of today, and should not be relied upon as representing our views as of any subsequent date. While we may elect to update forward-looking statements at some point, we specifically disclaim any obligation to do so, unless required by law.

During this call, we will be referring to non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the Investor Relations section of our website.

I would now like to turn the call over to our CEO, Richard Nottenburg. Rich?

Richard N. Nottenburg

Thank you David and good morning everyone. Thank you for joining us on the call today.

The operating environment remains challenging but we have made significant progress towards right-sizing and realigning our business to the market, reducing overall operating expenses and investing for future growth. In addition, we want new markets customers generating a meaningful sequential increase in revenue, continued to invest in our product roadmap and realized a profitable quarter.

As we discussed on our last call in May, the macroeconomic environment makes replacing legacy infrastructure with next generation equipment less attractive than it was a year ago. The slowdown in consumer spending coupled with the lower ROI environment continues to drive many of our customers to reallocate capital toward revenue generating activities.

We see this trend their strongest in the second half of 2008 continuing for many of our customers through the remainder of 2009. However, against this operating environment, our core value proposition is compelling and competitive as we have demonstrated by stronger operating results and ongoing activities. We believe that the investments we are making this year will better position Sonus for profitable growth by the end of 2009.

The magnitude of the downturn notwithstanding a year ago that Sonus needs to be managed, more efficiently with a much lower cost structure, accordingly, we started to restructure the business towards the end of 2008. This restructuring coupled with a strong operating discipline has enabled us to deliver a profitable quarter. This has been accomplished while making important R&D investments for our future and maintaining a robust and differentiated product roadmap.

As part of our 2009 plan, we have leveraged a nearly double the size of our world class facility in Bangalore. This center will now support existing Sonus products and customers that will drive innovation and new product offerings. With the restructuring nearly complete we will continue to rigorously manage our cost structure in order to create a more efficient and market driven Sonus overtime.

I want to share a few key takeaways from the second quarter. Revenue was $61.6 million for the quarter compared to $87.8 million for the same period last year and up approximately 50% from Q1 2009. Non-GAAP operating expenses have been reduced from $45.9 million in Q2 2008 to $34.8 million this quarter. Non-GAAP operating income was $6 million for the quarter compared with non-GAAP operating income of $13.2 million in Q2 2008 and a loss of $12.6 million in the prior quarter. Our book-to-bill ratio was below one and we ended the quarter with a strong cash and investment position of $387 million with no debt.

Now, I would like to highlight from significant customer wins, wins that demonstrate the ongoing demand for our market leading products and services and validate our current product strategy.

Cox Communications, the third largest cable television company in United States has selected a Sonus IP based network as part of its next generation network transformation. The Sonus solution includes capabilities such as centralized call routing, media transcoding and IP pairing.

We can also report significant progress in Asia. CITIC 1616 one of Hong Kong’s fastest growing voice network wholesalers connecting 350 operators in 60 countries has chosen Sonus for its network migration. CITIC 1616 undertook a rigorous selection process of global vendors before choosing Sonus due to our robust centralized routing capabilities and ability to provide session voice security and media gateway capabilities with the same infrastructure.

Additionally, by leveraging our market success in Japan and through a new partner Next Gen, we have won new business with one of Japan’s largest network operators to undertake nationwide deployment of its Trunking and Switching network.

In addition to this, we have announced that due to our longstanding relationship with KDDI in Japan, we were chosen to provide the IP Voice Network infrastructure to KDDI Global, which expands KDDI’s rich in Asia, Europe, and the United States.

Our relationship with BT Conferencing continues on a solid footing with a further significant platform expansion in the second quarter. BT Conferencing now has two locations in the US, Denver and Boston. This expansion includes deployment of equipment in the US and UK and allows integrations with this 21C Network and the rollout of new services.

Guru and I spend a lot of time meeting both current and potential customers. There is no doubt that Sonus enjoys a robust reputation for carried rate solutions and the professional services team will get its customers into service quickly. While our customers are not standing still and neither were we, innovation has always been at the heart of Sonus and we have aligned the organization around the current and future market needs maximizing the intellectual capital we have across the world.

By working directly with market leading network operators and carriers worldwide, we have developed a comprehensive view of what is needed to evolve our product roadmap to support their future requirements. With our latest software release, we have enhanced our Network Border Switch solution with key features which focus on making large scale deployments for both IP access and Trunking simpler and more cost effective. We have introduced features that enable flexible network deployments, simplifying provisioning and significantly enhanced network security.

The introduction of local policy management means that for the first time, the Sonus Network Border Switch will be able to act as a standalone network element with built in call routing functionality, a key differentiator of our architecture.

The majority of our proposals now includes the Sonus Network Border Switch, either hyper TDM-to- IP or IP-to-IP configurations and provides significantly differentiable alternatives to point solutions.

Our solutions provide increased efficiency and improved the liability and scalability, helping to lower network operating costs for our customers. This latest software release is the first step towards the disaggregation of certain elements of our solution to enable flexibility and a simpler, faster deployment for a wider range of network environments.

At the beginning of the year, I referenced that Sonus could realize more value from its intellectual property and domain expertise. Shortly, we will announce a new product that provides advanced network performance analysis at the individual co-level and is based on one of our professional service offerings. This is the first of a new family of products in Sonus networks which leveraged our many years of Voice over IP network design and deployment expertise.

I came into Sonus with a set of priorities and I am encouraged with the operational progress we have made to date to have been substantial challenges over the last 12 months and we still have work to do but I now feel more confident in our ability to drive the strategic agenda of the Company forward.

As I enter my second year as CEO, we will continue to adhere to our three guiding principles of creating a more efficient and market driven Sonus, carefully managing our balance sheet and investing in new products and service offerings for our future. Many of the elements of our strategy have proven successful as we continue to win new business, bring new offerings to our customers and remain on a stable financial footing with $387 million in cash and investments and no debt.

I will now hand the call over to Rick to review the financial results in more detail, then I will come back to take your questions with Rick and Guru. Over to you, Rick.

Richard J. Gaynor

Thank you, Rich, and good morning everyone. Please note that throughout my discussion I will reference both [broken audio]. Please also note [broken audio] our product as always, we encourage you to evaluate us on the longer term basis.

Please be reminded that due to the sale of our Zynetix subsidiary in the fourth quarter of last year, the results of Zynetix have been classified as discontinued operations in our statements of operations for 2008. So they will be excluded from my discussion of our operating results for the fiscal 2008 periods.

There is one more thing I want to cover before I get into the numbers.

During the second quarter, we updated the third party equity software applications that we used for stock option administration and accounting. In so doing, we discovered through our internal control procedures that the prior version of the third party software had a logic error that impacted the timing of stock compensation expense recognition. The result was an immaterial understatement of our non-cash stock based compensation expense with the corresponding understatement of additional paid in capital in the amounts of $2.5 million in 2008 and $700,000 in 2007.

The vendor is aware with the problems with prior version of the software and has fixed this problem in the current version and we have verified this fix independently. The amounts in error were immaterial to their respective periods, so as an immaterial restatement corrected historical amounts are reflected in our second quarter earnings release issue this morning and will be reflected in our Q2 2009 10-Q and other financial reports going forward. Of course stock compensation is not included in our non-GAAP numbers so there is no impact on our non-GAAP results.

Revenue for the second quarter was $61.6 million, up approximately 50% from $41 million in Q1 2009 and down approximately 30% from $87.8 million in Q2 2008. Our book-to-bill in the quarter was below one. There was one customer that contributed greater than 10% of total revenue in the second quarter and that was Global Crossing.

Looking at revenue geographically, domestic revenue accounted for 78% of revenue versus 71% in Q1 and 80% in Q2 2008. Our top five customers represented approximately 42% of revenue in Q2 in line with Q1 and compared with 69% in Q2 of last year. We reported revenue from 89 customers including four the new customers in the second quarter compared to 82 in the first quarter this year and 80 in the second quarter of 2008. This state reflects the fact that our improvement this quarter was broad based and not dependent on any single customer.

Capital spending in the second quarter was $2.6 million, bringing our first half total to $3.4 million. The increase in Q2 CapEx is primarily related to capital investments in engineering and the ramp up in our Bangalore facility.

Before I go into further details, I would like to point out that these are non-GAAP numbers that exclude stock based compensation and amortization of intangible assets in both 2008 and 2009. These non-GAAP numbers also exclude restructuring expense to 2009 and the reduction of a loss contingency related to an employment tax audit in 2008.

Non-GAAP gross margins for the second quarter were 66.3% of revenue compared to 58.3% in Q1 and just below the 67.3% recorded in Q2 2008. Product gross margin for the second quarter was 70.9%, compared to 69.5% in Q1 and 71.3% in the same period last year.

Favorable product mix in the quarter contributed in improved margin versus the prior quarter.

Service gross margins were 59.7% compared to 48.2% in Q1 and 57.6% in Q2 of last year. Increased professional services volume related to new customer deployments and improved service delivery efficiencies where the primary drivers of improved service margin relative to the first quarter.

Deployment in both product and the service margins I just described resulted in a very solid 66.3% overall gross margin in Q2, well above our long term gross margin target range of 58% to 62%.

Total operating expenses for the second quarter were $34.8 million, down from $36.5 million in the first quarter and down from $45.9 million in the second quarter of last year, primarily reflecting cost reductions from the right-sizing and realignment actions we have taken.

We are able to post lower costs of our previous quarters in every functional area. We expect third quarter operating expenses to increase from the second quarter, due to such factors as employee costs and recruiting fees related to our ramp up in India, increase deployment of eval units over the second quarter and the step up in new product development efforts.

I will provide guidance on third quarter operating expense a little later.

Rather than going through all of the expense line items for the quarter please find that detailed information in the Investor Relations section of our website, where we reconcile our GAAP to non-GAAP information, I encourage you to visit that site.

Now, looking at our headcount, we ended the quarter with 933 employees compared to 910 employees at the end of Q1. While Sonus has reduced headcount in some locations, we continue to hire in all locations as needed and at lower cost geography specifically to support future business plans.

Some of the increase from Q1 to Q2 comes about because as we conditioned activities from higher costs to lower costs geographies there are some temporary duplication to avoid GAAPs and R&D schedules as Rich says double dipping. Once the transition is substantially complete, that duplication will cease.

At the end of Q2, we had 213 employees, nearly 22% of our total headcount in lower cost geographies supporting our drive for lower overall expense level. This is up from 19% in the prior quarter and 13% in the same period last year. We anticipate the headcount and low cost geographies will approximate 25% of total headcount by the end of Q3.

We ended the quarter with cash and marketable securities of $387.4 million, well above our guided range of between $370 million and $380 million. The main reason for cash coming in above guidance was continued strong cash collection performance, including some accelerating collections against maintenance contracts.

On our last few calls, we have talked about the timing of our AT&T revenue. As a result of a two-year maintenance contract renewal and the applicable accounting revenue recognition rules, revenue we book and ship with AT&T each quarter gets deferred and subsequently recognized on a prorated basis from the point of sales through year end 2010.

Our deployments with AT&T are an integral part of their existing network infrastructure and we continue to enjoy a good relationship. We remain actively involve and pursuing additional opportunities with them.

As an additional data point, we said we will provide you with a portion of deferred revenue that is from AT&T. At the end of the second quarter, total deferred revenue was $82.5 million. Of that total, AT&T deferred revenue was $33.5 million compared to $28.9 million at the end of last quarter. While the second quarter showed considerable improvement over the first quarter, we still expect the second half of the year to remain constrained demand wise.

Looking forward, we reiterate that we expect revenue for 2009 to be substantially lower than the revenue we realized in 2008. Our 2009 gross margin percentage is expected to be within our longer-term target range of 58% to 62%, a target range, which we also reconfirm again today.

In the past, we had suggested that we may be at the lower end of that range in 2009. Despite good gross margin performance in the first half, we do not currently expect to see mix as favorable in the second half of the year. So, gross margin in the second half should be near at the low end of our 58% to 62% long term target range.

Total operating expenses are expected to be in the range of $144 million to $153 million for the year. We expect operating expenses in Q3 will increase to between $37 million and $39 million. We expect third quarter ending cash and marketable securities to be between $370 million and $380 million. Again, based on our first half performance and current outlook, we still believe we will be able to report a cash balance above $350 million at year end.

Basic share count for Q3 should be approximately 275 million shares. One of the areas for improvement we indicated to you on the previous call was that we wanted to improve the timeliness of our financial reporting. In reporting our results and filing our quarterly 10-Q later today, we have cut 12 days off of our Q2 reporting schedule of last year. The ability to close earlier reflects the progress we have made operationally and I would like to thank the entire Company, in my finance team in particular for this achievement. This progress will now allow us to turn more attentions to other important matters, including our investor outreach.

I think you should expect more participation from the Company at conferences going forward, as well as a possible Analyst Day in the first half of 2010.

Before we go to your questions, I would like to comment on our execution against the operating plan for the first half of 2009. We knew going in that this will be a challenging year. With that in mind, we were committed to impacting those things over which we had some control. We continue to meaningfully lower our operating expense. We reorganized and realigned the Company around our business opportunities and we focused our R&D resources toward projects that can generate future growth for us.

In conclusion, let me summarize on some of the important points Rich made with respect to what we have accomplished so far through the second quarter.

We have made substantial progress in right-sizing and realigning our business in the market. We won important new customers and engaged new partners and we enhanced our product and service offerings and here is my path, we realized a profitable quarter.

We plan to attack the second half the same way we did the first half. Continuing to manage the business according to our guiding principles, execute just as well and list Sonus well positioned for 2010.

Now with that let me turn it back to Dave so we can start your questions. Dave?

David Roy

Thank you, Rick. Operator, could you please provide our callers with the instructions on how to ask a question?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is coming from the line of Paul Silverstein - Credit Suisse.

Paul Silverstein - Credit Suisse

Rich, I think you mentioned when you got a win at Cox for deployment, can you give a little bit more insight on that?

Richard N. Nottenburg

Paul, I would like to talk a lot more about that Paul and to be honest, you probably noticed that we have had a limited amount of information we have been able to release there. We are just not in a position we can release more information right now and we would love to and we will do so when we are able to.

Paul Silverstein - Credit Suisse

On your top line customers given that they were 42%, I assume Global Crossing was greater than 10% wasn’t traumatically greater?

Richard J. Gaynor

I would say this. It was somewhere between 10% and 20%.

Paul Silverstein - Credit Suisse

Okay. And AT&T on the deferred revenue, I know you guys walked through that last around. If you could just revisit that Rick in terms of looking for minus 10 years to get the stuff with each quarter because it keeps building out.

Richard J. Gaynor

Correct, correct, yes.

Paul Silverstein - Credit Suisse

In terms of the recognition, as we go forward to the next two years, we should see the recognized portion from each pricing your quarter gets build in and therefore there is going to be natural increase. Is that correct?

Richard J. Gaynor

That is absolutely correct.

Paul Silverstein - Credit Suisse

Okay. Can you talk a little bit beyond the deferred revenue number? Can you talk about the quality of trend, at AT&T what you are seeing there and I recognized it is only so much you can give on any customer?

Richard N. Nottenburg

Let me just give you a little color on that. There is some interest here. I think we would like to say that AT&T is the stronger [31.52] and we have a very good relationship with them and we continue to see a lot more opportunities while providing excellent service and value given the size of our install base. We feel really good about AT&T but we really cannot comment on a lot of more specifics on new projects and what is going on there.

Paul Silverstein - Credit Suisse

And one last question if I may, OpEx Richard has done a very good job, historically I know you are projecting and increasing Q3. What the [growth] here is, are you going start growing OpEx modestly or is Q3 an anomaly and you are going to hold the line and keep reducing as we go forward?

Gurudutt U. Pai

I think it is a mix of we are going to continue to look for opportunities to reduce over head where you can also continue to leverage out low cost footprint. But we are also making significant investments in the business, Paul and those investments do not come in a linear fashion. So, I think you should see we made significant amount of progress we intend to make but quarters will fluctuate up a bit and down a bit just based on what investments we are making in particularly in engineering.

Richard N. Nottenburg

Yes. Paul, I think the takeaway from that is as follows and I would like to redirect you on the last call. What we said in last call was, we will exit 2009 with the right cost structure for the business. But in addition, we will exit 2009 in a more competitive position that we entered 2009 and so given that these investments have to be made and maybe some more and even we are all committed here as we exit the year as we said we would and we will continue to be posting on progress.

Operator

Your next question comes from the line of George Notter - Jefferies & Co.

George Notter - Jefferies & Co.

I also wanted to ask about AT&T. I understand how the revenue recognition worked certainly from a deferred revenue perspective. If I go back far enough in the model and, I looked at your progression with AT&T there are a lot of quarters here that were $20 million, $25 million and $30 million quarters from the revenue recognition perspective. And then obviously stepped down quite in December, in March and then here in June and again I understand the deferred revenue model but you have got $33 million and it gives that deferred revenue, you recognize over the next six quarters. You see here $5 million, $6 million, $7 million a quarter certainly there could be new deferred revenue coming in there but it feels like there has been a big step function down in your business level with AT&T and even looking through the new revenue recognition model. Am I reading that correctly? And then if that is right, could you kind of walk me through what exactly has happened with AT&T?

Richard J. Gaynor

Clearly on the temporal basis, I am not going to give a lot of specific color on AT&T because this is really not something. We are not really in a position to talk about the detail about the specifics of network deployments in any one year.

There are a lot of puts and takes on a quarter-by-quarter basis and even annual basis and clearly in the current operating environment all large operators have to make decisions about where they want to deploy capital and I think that we do have a relatively, I mean we are in an issue which functions with a relatively uneven type of business. Clearly networks get build out. They get build out in spurts they slowdown. They build up.

I am not in a position to predict when, if, how we would return our actual revenue levels. What I would like to say is our relation with AT&T is very good. We are very significant install based to continue to service them and we continue to pursue opportunities with them. We will keep you posted of these if we can.

George Notter - Jefferies & Co.

It is fair to say then that your market share is the same as it was back then or better or have you lost share or opportunity?

Richard N. Nottenburg

We do not believe we have a market share problem here.

George Notter - Jefferies & Co.

I got it. Okay, great. And then just shifting gears very quickly, I know the deferred revenues were down I think $9 million or $10 million or so sequentially. They look like the AT&T deferred revenue was up a tad Can you talk about what the mechanics of that? What is going on with deferred revenue? Why is it turning down? Was there some pent up revenue recognition that you had run through here this quarter, any thoughts? Thanks.

Richard N. Nottenburg

I actually got it on the money. a couple of projects that we are in. deferred revenue that have built up over several prior quarters and they got released in the second quarter probably the contribution to revenue we saw in the quarter but offset a little bit by down tick in deferred revenue.

Operator

Your next question comes from the line of Subrahmanyan - Sanders Morris.

Natarajan Subrahmanyan - Sanders Morris Harris

Two questions. I know you are not highlighting specific quarter-to-quarter guidance but we are at the midpoint of the year talking about significant down tick and I am just trying to understand just trend wise if you are thinking September gets weaker and then we have any improvement in December or kind of a stronger end of the year. That was one more question.

And then on Asia, you talked about contract expansion with KDDI and I think you also referred to a partner about one business as one of their largest Japanese there, I wanted to make sure these are two separate things and if you can talk a little about revenue that started to be recognized for many of those opportunities or what the timeframe could be?

Richard J. Gaynor

I will take the first part of question and then hand it over to Guru and to Rich for the second part.

In terms of Q3 and Q4, we obviously have not given any guidance on revenue in the second half of this year other than saying that we do expect revenue to be lower than we were last year. I think we have also said in the past that we can project it to be below $250 million for the entire year.

The second half of the year is traditionally stronger for us in the first half, with that being said, last year changed that fairly dramatically given the economic decline. We are not on the business of predicting the economy here. So hence while we think visibility is difficult for us and we are not prepared to give real guidance or detailed guidance for the quarterly basis for the second half of the year as of the guidance with KDDI.

Guru, do you want to comment?

Gurudutt U. Pai

Sure. To answer your question, there are two separate and distinct projects. They are not the same and I think the second part of your question was - Did they contribute to the revenue this quarter? The answer is no.

Natarajan Subrahmanyan - Sanders Morris Harris

Alright. And any color in terms of what the scope of the extension of the two customers kind of timing scope, give us a sense because these are too fairly large areas, just trying to understand how significant it could be?

Richard N. Nottenburg

Yes. Unfortunately, Subrah this time, we cannot give you customer-by-customer views.

Operator

Your next question comes from the line of Steven O’Brien - JP Morgan.

Steven O’Brien - JP Morgan

I have, first off, a bigger picture question for Richard and then maybe a follow up on the business model. First question, can you help quantify Sonus’ maybe potential for share gains or at least change in the market from Nortel’s positioning and bankruptcy right now? Do you see a potential for footprint grab here and what are you hearing from customers in terms of more activity looking to perhaps transition from Nortel gear or looking for new solutions to sort of extend their work now?

Richard N. Nottenburg

That is a very good question. I think what we said in the past and I think we would like to reiterate right now is if you look at the Sonus solution setting, in fact, if you look at our platform solution set. It is extraordinary compelling and we have done a very good job of replacing not just Nortel but other legacy suppliers in the market.

Clearly, as some of our competitors or some of our legacy suppliers have become more impaired and in this case one actually ended up filing for bankruptcy. It has been, obviously, a significant increase in velocity around making sure that these networks continue to operate properly.

So, we do see a substantial uptick in activity around that but needless to say that, we run the business as we have always wanted, is that continue to replace legacy gear and I think that the overrunning part of the market right now is that it allowed that replacement cycle has been so much muted by the lower ROI environment, so kind of two different forces in the market and then multiple forces in the market playing at the same time.

I am pretty encouraged by the fact that our solution set placed well and I am satisfied, I mean I like the opportunity that we are seeing.

Steven O’Brien - JP Morgan

Okay. I think guess more on the business model, is the breakeven annual revenue level changed from $250 million and can you give us some more color around from this release, from deferred revenue that drove gross margin 66% above the long term target range this quarter?

Richard J. Gaynor

Sorry, trying to answer the first cut, you might have to, probably with second part again, Steve.

In terms of the breakeven, we did say that we felt that our revenue breakeven point would be around $250 million and we have modestly exceeded our expectations a bit in the first of the year. So, we would say we are now modestly better than $250 million, so not significantly because we are tracking pretty closely to our plans for the year or so. I would say that we are just slightly below now $250 million as a breakeven point for us.

What is the second part of the question Steve?

Steven O’Brien - JP Morgan

The gross margin this quarter going above the 58% to 62% target range and then sort of the indication that the full year would fall towards the lower end of that range, is that a function of projects getting released out of the deferred revenue or just something else in the mix?

Richard J. Gaynor

No, I think it was partly a factor of the gross margin profile of deals that are coming out of deferred revenue. I think it is also reflective of the gross margin of just our book ship opportunities coming through the first half of the year.

Net-net, we did have favorable mix in terms of what we are able to score and we do not expect to see that favorable mix in the second half. So I think we are closer to the lower end of our 58% to 62% range, but if you do the math on the map while we indicated prior that we felt we were at the low end of range for the year. I think we are going to be probably closer to the midpoint of our range for the year at this stage based on the strength of the second quarter particularly.

Steven O’Brien - JP Morgan

Great, and then very last, on the cash flow, are you seeing that your cash expectations for the second straight quarter cash and any balance expectations? Can receivables, can they go any lower, it seems like you might have reached the point where they are just doing the normal course of business they might have to trend up in the coming quarters and perhaps the same for inventory. Looking out over the next couple of quarters, how should we think working capital impact cash?

Richard J. Gaynor

Let me break it down. In terms AR, I guess our job is to assume as we grow in sales that I have not collected. So, our goal is to, and actually our AR performance is very good in the Company. We have a great customer base. They do prompt pay and it is not an area of concern for me. So, but yes, our AR has tipped to a lower level recently which puts some pressure on us in terms of the cash collection going forward which is the primary driver of why we think we will see a downturn in cash from $387 million level in between $370 million and $380 million in the third quarter. That is primarily driven by the amount of AR we have coming in to the third quarter.

In terms of inventory, we actually have something of an uptick in inventory but that is driven primarily to two factors. One is we have a need for some last time buys in the first half of this year and just to protect our ability to service our customers and secondly we do have a shift in our contract manufacturer and we are moving from one CM to another and as a result to that transition, we built the certain level of safety stock in the middle part of this year and we stopped working that down. So, I would suggest that yes we would expect that is going up in the second part of this year and inventory we would expect it to tick down a little bit going into the second half of this year as that migration to new CM is completed.

Operator

Your next question comes from the line of Kenneth Muth - Robert Baird.

Kenneth Muth - Robert Baird & Co.

Can you give us any more update on your initiatives then your execution on the session border control market opportunity that you are talking about stressing last quarter? And then how do you see maybe the potential to win the larger enterprise deals within the session border control market?

Richard N. Nottenburg

Let me handle that. No, let Guru handle that question. It would be good.

Gurudutt U. Pai

Sure. Again, we are very confident on our hybrid strategy that we talked about on the last call which is supporting both TDM-to-IP and IP-to-IP architectures of the same platform. One of the things that Rich talked about in this call is going to be the introduction of local policy Network Border Switch, which gives us the ability for the first time to deploy our GSX running our NBS software in a standalone configuration. So, that gives operators and certain segments of the market increased deployment flexibility and giving the same advantages that we had in our larger more complex network deployment included in all our network component.

As we keep investing in the IP-to-IP space, you should expect us to continue to enhance our roadmap in the network border security products and in session border control as a domain.

Kenneth Muth - Robert Baird & Co.

And then just on the enterprise side, do you see that market as opportunity coming up or do you have enterprise customers today?

Richard N. Nottenburg

Yes. I think the only thing I would like to say that is obviously a very interesting vertical. I have always been very intrigued by that market vertical. We are going to keep you posted as time goes on as we start to look at that vertical.

Kenneth Muth - Robert Baird & Co.

Should we think about that as a growth opportunity for the Company or not?

Richard N. Nottenburg

I think you should think about the fact that I like it. I like that vertical than it is on top.

Kenneth Muth - Robert Baird & Co.

And then just a follow up on global crossing, it looks like it has been awhile since there have been 10% customer. Have they changed any initiatives or taking new products or there are just more add on to what they have had historically?

Richard N. Nottenburg

No, I think it is a normal course the business growth for them.

Operator

Your next question comes from the line of Todd Koffman - Raymond James.

Todd Koffman - Raymond James & Associates

Operator

Your next question comes from the line of Edward Jackson - Cantor Fitzgerald.

Edward Jackson - Cantor Fitzgerald

I have a couple of questions. One of them just on geographic front, can you give a little color relative to geographic activity where I think is a strong, weaker in North America, Europe and A-Pac? I have another follow up on that.

Gurudutt U. Pai

Sure. This is Guru. Again, in our two traditionally strongest markets had been North America and Japan with Asia Pacific and I think that continues to be the case right now for us.

Richard N. Nottenburg

Yes. I think the thing we could say about Japan is that we have a very significant footprint in Japan. I have been over there a couple of times. Guru has been over there. Rick has been over there. I think we should be spending a lot more time over there. I think there are a lot of opportunities. So, we are going to continue to focus and leverage. We have a strongest ball base and we have a very strong team. I want to mention that we have a strong team in Japan which has enabled us to manage that base very effectively and grow our business there.

Edward Jackson - Cantor Fitzgerald

Excuse me?

Richard N. Nottenburg

I am sorry, go ahead. But do you want to amplify that question some?

Edward Jackson - Cantor Fitzgerald

No, I just move on to the next one. The other one is more interesting anyway. I just want to go back to something you guys had announced in April which had to do with the Trunking and through, the build with [50.10] with their enterprise and I wanted to touch base on that and have you all talked maybe a bit about the importance of that capability perhaps the need that you might have to do that with other vendors. Is that a situation that is simpler like back in the legacy days when people had to go and get the different interphases for the different [PBXs] to be able to interoperate with them, this kind of simpler type of situation? I mean I guess where I am getting at is - how complex is it, what kind of opportunity to do relative to other vendors and what kind of competitive differentiation that they possibly get?

Richard N. Nottenburg

Okay. Let me try to answer that question vis-à-vis the forum. So the set connect forum is essentially setup to allow interoperability with different translate devices from the network and if we participate in that that is what the press release was about and that advantages play us on both sides to make sure that interconnectivity does not impede deployment for our joint customers.

So, I think the market has changed in that sense. It has progressed so that the anomaly that we talked about. Having said that we have a fairly significant IOP program that our products participate in, again in terms of interoperating with Sonus’ base equipment and I think that is just a sort of the needs and helps us both in development as well as serves the needs of our customers so that they can deploy with the confidence and knowing that has been tested into interoperability with Sonus base equipment.

Operator

Your next question comes from the line of Greg Mesniaeff - Needham & Co.

Greg Mesniaeff - Needham & Co, Inc.

It is Greg Mesniaeff. Question, view at reference to the Bangalore facility expansion, I was wondering if you can give us some color as to what potential for further OpEx reductions you can obtain from leveraging that facility further and which areas?

Richard N. Nottenburg

Yes. Thanks for the question. What I wanted to very clear on the call about is that it is obviously an opportunity to basically transform our R&D cost structure but I think importantly we also recognized that we have hired some pretty phenomenal people there and that we also have the ability to innovate into our new product and service offerings.

So, I think overall, I think they were going to get to a more, you can view it to a more industry normal type of balance between low costs, high costs, type of R&D overtime and I think that by the end of 2009 we will essentially be done with the substantial part of our plan which we ended the year with. I think that you should monitor and I think we are going to give you more information as it calls and we see much how we are making progress there.

Greg Mesniaeff - Needham & Co, Inc.

Great, and besides R&D, are there any other functions such as service and fulfillment that could be off shored as well.

Richard N. Nottenburg

The only other function right now if you look at the headcount in Bangalore, the vast majority is engineering talent with a handful of that support infrastructure people but we do have plans moving forward to start trying to move some back office type activities, not so much for the service organization per se but some of the G&A type activities and IT activities that could be reasonably supported out of Bangalore. We obviously would proceed with extreme care there given, yes. We have made a lot of progress here in terms of our operational and competency and we do not want to lose any of that. But we do some thoughts that we are working on that for 2010. It might allow us to get some sort of back office opportunities as well.

Richard J. Gaynor

Yes. And I think the other thing I want to add is that having a facility and having a strong center in Bangalore, I mean I have been over to Mumbai, meeting with customers over there. So I think there is an opportunity to help us regionally deal some of the, what I call customers in that part of the world.

Operator

Your next question comes from the line of Catharine Trebnick - Avian Securities.

Catharine Trebnick - Avian Securities, LLC

My question has to deal with how much of the addressable market you are looking at is really SBC focused versus perhaps maybe a wireless strategy focused? Could you quantify that or give some opportunity? What I am trying to do is to understand your pipeline, how much of your product they are really IP-to-IP versus TDM-to-IP? And then also the last part of it is, what are you doing about LTE?

Gurudutt U. Pai

Okay. Hi Cath. It is Guru. So, majority of our proposals that go out now involved the NBS which is IP-to-IP in the IP-to-IP domain and we think we compete very effectively and we like our product strategy. With regard to LTE, again we are evaluating exactly where and how we participate in that effort. Obviously our products are based on the IMS standard as we have said publicly for a while and to the extent that IMS participates and becomes a predominant deployment [by April], we expect to participate and compete on that area.

Richard N. Nottenburg

The interesting part about again a part of our wireless strategy and then it is a big opportunity not only for our different industry. It is predominant portion of wireless voice is on TDM today and I think as there’s traffic, as there’s more and more voices originate and terminate on mobile networks as that portion of the overall voice full globally starts to migrate to IP. We believe there is an opportunity in the companies like ours which end up with TDM-to-IP state to participate and gain from it.

We do not know when that would happen. We think in the long run. We are pretty confident with that traffic and multi IP but exact timing is clearly one that is impacted by each operator decision but also by I think in some sense by the macroeconomic conditions.

Richard J. Gaynor

Operator, we are getting near the top of the hour. I think we have time for one more question.

Operator

It appears that we have time for only one more question. You have a follow up question comes from the line of Paul Silverstein - Credit Suisse.

Paul Silverstein - Credit Suisse

Rich, I know you have touched on the responses to other questions but in previous calls you have highlighted your investment in your session border control, your border switch and you have spoken about the transition to marketplace to session management away from traditional TDM side to gateways. Can you give a little bit more color on what you are seeing in terms of that transition and where you are positioned? I trust you are still not at a point where you want to disclose the NBS revenue as a percentage.

Richard J. Gaynor

Well, we are not in a position to disclose that as a specific revenue stream but I think you have identified an important change in the market and I think that we recognized that when we came in here. What I kind of believe is as follows is that we made a substantial investment in the space and I am feeling very comfortable. I think it was really a couple with how pickup some traction momentum here. I think overtime which you are going to see here is that the space is going to evolve, just setting session metrics going to do a lot of other things that are currently not done by point solutions in the market and I think that this is going to be an interesting story as these things evolve but I do not really need one, Rich do you have a commentary to add?

Richard N. Nottenburg

Paul, again, just repeating the answer that I said earlier. The majority of our proposals now include NBS or IP-to-IP as part of our responses and proposals to customers. The importance is certainly increasing, it does not mean however that the basic TDM-to-IP value proposition has gone away. In fact I think there was interesting network effect as more IP-to-IP traffics that the partner will interconnect in the world still TDM and most people show that TDM lines. So the need to do the gateway function both for quite sometime. However, there is I think you are correct in saying that the importance of IP-to-IP is significant and having said that I think the hybrid strategy and now our local policy NBS doesn’t give operators increased flexibility in being able to go after IP-to-IP traffic that they want to go out and compete for.

Richard J. Gaynor

Hey Paul I think that we should answer the question about Global Crossing earlier. I think I can be a little bit more precise to my answer. I said it was somewhere between 10 and 20, I will ask TDS hard data point, there was 14%.

Dave?

David Roy

Okay. Thank you, Operator. That does complete this morning's financial results conference call. We would like to thank you all again for joining us and we appreciate your interest in Sonus Networks. Operator, could you please provide our callers with the replay instructions before we sign off.

Operator

Ladies and gentlemen that does conclude today’s conference call. For replay, please dial 1 800-633-8284 and a reservation number 21431767. Once again please 1 800-633-8284 and a reservation number 21431767. Alternatively, you can also dial toll at 142-977-9140 and once again on a reservation number 21431767. Thank you.

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Source: Sonus Networks, Inc. Q2 2009 Earnings Call Transcript
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