Avanex F4Q06 (Qtr End 6/30/06) Earnings Call Transcript (AVNX)

Avanex (AVNX)
F4Q06 Earnings Call
September 5, 2006 8:30 am ET Executives March 1, 0000 ET

Analysts

John Harmon - Needham & Co.
Todd Koffman - Raymond James
John Anthony - Cowen & Co.

[Portion not webcast]

Jo Major

Thank you for attending today's call. Today we'll provide you with a brief review of our accomplishments for fiscal 2006 and then discuss our performance in the fourth quarter. Cal will then give you a detailed look at our financial performance and then I will give you our outlook for the first quarter of 2007. At that point we'll open up the call for questions.

Let's start by reviewing what the team accomplished this year. Fiscal 2006 was about reducing our fixed costs. We executed our restructuring plan with milestones and consistently delivered cost reductions. I'm very proud of our team and the fact that we delivered a $54.4 million year-over-year reduction in net loss. While we continue toward lowering our fixed cost base, in fiscal 2007 we will focus on revenue growth and increasing our direct margins through several initiatives that I will explain further in a few minutes.

Our revenue in the year was $163 million, up modestly from the previous year's revenue of $161 million, despite the rapid transition in our operating structure. Our growth after restructuring has been strong, with sequential double-digit revenue growth in the past two quarters. We reduced the North American and European headcount from 770 employees at the end of fiscal 2005 to 407 employees, a 47% reduction, while we grew our Asian presence to over 200 strong. Bangkok is now our largest site by headcount.

Productivity increased rapidly throughout fiscal 2006. Looking at the fourth quarter of fiscal 2006 and comparing it to the fourth quarter of the prior year, on an annualized basis revenue per employee is up 48% to $299,000 per employee per year. The amount of annualized revenue being generated by an employee in North America and Europe has doubled over the year to $447,000 per employee per year.

It's critical following a dramatic restructuring to get product development generating future revenue streams. The team has done a great job here, focusing our North American and European sides on developing innovative solutions and introducing a low-cost development center in Shanghai to produce an impressive set of product introductions in the second half of our fiscal year 2006.

These products offer our customers increased functionality with very attractive price points. We're focused on products that address the needs of future networks, including pluggable amplifiers, optical monitors for reconfigurable systems, and integrated products. These products have been very well received by our customers as indicated by the strong bookings for them. Several of these products are already shipping to tier one OEMs for large scale, next generation carrier deployments.

Our product strategy is actually very simple, and it is clear with these introductions. First, we are primarily a modules and subsystems company with the vast majority of our revenue coming from sales at these levels of integration. We will continue to focus at that level of sale.

At the module and subsystem level, we will focus on reduction of size, the integration of multiple advanced functions within a common footprint and ease of use; attributes that our customers need for ease of use are things like plugability, hot swapability and optical connections that are free of the expensive and cumbersome act of fiber slicing. Our pluggable amplifier and the newly introduced integration of a high performance amplifier with low cost optical performance monitoring built-in are key examples of this strategy.

We believe in having only a few key technologies at the component level. These technologies will have several attributes. They will contribute solutions to the problems of implementing flexible, optical communication networks. They will be provided by only a relatively small number of competitors, and they will be strongly differentiated in terms of the value that they provide to our customers.

We believe that having lots of different component technologies, particularly component technologies that compete for the same end market just does not make sense within our company. It would be economically very expensive and would lead to unhealthy technological competition within our company. The advanced modulators that we've recently introduced are excellent examples of differentiated component technology that is critical to next generation systems.

This corporate strategy clearly stresses the reinforcement of a broad range of module and subsystem products through the continual focus on software, firmware, and optical integration. On the component side, we'll continue to source the majority of our components externally and focus on growing or acquiring only those component technologies that we view as strategic from an economic standpoint.

Moving on to our financial results: for the fourth quarter of fiscal 2006, revenue grew to $45.5 million, up 13% from $40.1 million in the prior quarter. This strong growth in revenue, including record revenue levels across multiple product lines, validates the operational strength of our contract manufacturing model. In addition, a significant portion of our revenue is now coming from design wins achieved in the last six months that were achieved directly into a contract manufacturing site.

On a quarterly basis, we evaluate the usability of our inventory and determined this quarter that it was appropriate to increase our inventory reserves based upon recent experiences in the contract manufacturing environment. We also noted a decrease in warranty costs following our manufacturing transitions and therefore adjusted those provisions. Finally, our collections experience has been strong and we adjusted our bad debt allowance by $2 million which favorably affected G&A costs in the quarter.

Overall, we're very pleased with the manufacturing model that we've chosen and its impact upon our financials.

Gross margin in the quarter was essentially flat from the prior quarter. Cal will provide details on our gross margin and the reserves that affected it. GAAP net loss in the quarter was $0.04 per share, an improvement of $0.02 per share when compared to the prior quarter and an improvement of $0.26 when compared to the fourth quarter of fiscal 2005.

Non-GAAP net loss in the fourth quarter was also $0.04 per share, an improvement of $0.02 over the non-GAAP net loss of $0.06 per share in the prior quarter and an improvement of $0.06 per share when compared with the non-GAAP net loss of $0.10 in the fourth quarter of fiscal 2005.

I'm really proud of the actions the team took to preserve cash this quarter, including finding buyers for excess machinery and subleasing some of our office space in the Silicon Valley area. These actions were positive contributions to the quarter's performance.

Customers that represented more than 10% of our revenues this quarter were Alcatel, Nortel and Infinera. We're very pleased to add Infinera, an innovative system manufacturer, to this list and are excited about being able to help them grow.

At the end of quarter four worldwide headcount was 608 employees compared with 604 at March 31, 2006. During the quarter, North American and European headcount decreased from 414 to 407 and headcount in Asia increased from 190 to 201. On a year-over-year basis, headcount decreased from 846 at the end of fiscal 2005 to 608 at the end of fiscal 2006. Also in the fourth quarter, the operations center in Bangkok achieved TL9000 compliance.

In early August, the European Union funded a multi-year project called Wisdom with EUR2 million of funding to develop a photonic firewall on a chip. Avanex is a participating partner on this project with several other vendors, including British Telecom.

At this point, I'd like to speak now about our view of the markets. We see the long haul and metro markets growing in the 15% to 20% range this year with metro growth modestly stronger than that of long haul. We now see substantial opportunities in the sub-marine market firming up for calendar year 2007. In particular, the Trans-Pacific Express, or TPE, will represent a total available market for optical components of $30 million to $40 million in revenue in the first half of calendar '07. We believe that the timeframe of this project is reasonably solid. Other exciting projects such as the Asia-American Gateway, or AAG, have also been announced but do not appear to be happening within our 2007 fiscal year.

We have traditionally been one of two premier vendors in this market. We've continued to invest in this market and we believe that we are well positioned to be the number one or number two player in this component market as it re-emerges at the component level.

In general, we are optimistic about our markets and the overall trends that we are seeing. While we've previously stated that we would look into adjacent markets for expansion, based on the current strength of the optical hardware telecom market, both in the near-term and long-term, we currently believe that the best strategy for our company's growth is to capitalize on the current trends in our existing markets. Therefore, in fiscal 2008, we will focus on optical hardware for the telecommunications industry.

At this point, I'd like to touch on our plans for the coming fiscal year. Throughout our transitions, our direct margins, which we define as revenue minus variable costs, decreased by about 10 points. This is largely due to the fact that a lot of our teams focused on transitions as opposed to working on direct margin. We have targeted several programs to improve direct margins this year. These programs touch various aspects of the Company such as supply chain management, product portfolio management, new product introduction, and manufacturing improvements.

A portion of our revenue stream is legacy products, where the direct margin is unacceptably low. Our customers are typically quite willing to work with us to transition over to significantly more cost-effective products and as such, we have targeted our lowest margin legacy products for redesign into more cost-effective solutions.

This is our product portfolio management program. Our supply chain in Bangkok is now focused on product cost reduction as opposed to transfers. This program has already resulted in dramatic cost reductions and we are excited about the prospects of future cost reductions that have already been identified. We are localizing our supply base into Asia where possible, consolidating our purchasing into a smaller number of suppliers, stressing the need for second sources of materials through outer build materials and inserting into our product development program strict rules for direct margin achievement.

Finally, we're aggressively working on yield both to reduce cost, but really equally importantly to increase capacity to meet our customers' need for product. Taken together, these operational programs form the heart of our annual operating plan for this fiscal year with our focus now moving away from transitions to a focus on expansion of revenue and margin improvement throughout this year.

I'll now turn the call over to Cal for details on the financials.

Cal Hoagland

Thank you, Jo. I will first review our cash and yearly performance and then our fourth quarter on a GAAP and non-GAAP basis. At June 30, 2006 cash and investment balances were $74.3 million compared with $82.1 million at March 31, 2006 and $73.9 million at June 30, 2005.

In Q4, 2006 we used $7.6 million, a decrease from the $10.6 million in the prior quarter after consideration of $44.6 million net proceeds raised in the March 2006 equity stock offering.

In the past our cash usage was influenced by several factors including tax credits and restructuring payments. We spent $6.8 million of cash in the third quarter and $3.5 million in the fourth quarter on restructuring. In the coming quarter we anticipate the cash outlay for restructuring to be approximately $2 million.

On the income statement for this quarter we had a restructuring credit of $1.2 million, which includes a benefit from our ability to sublease excess facility space and the improving real estate market going forward. During the quarter our current restructuring accrual decreased to $6.3 million at the end of fiscal Q4.

We continue to see our debt trend down as our investors convert debt into equity. At June 30, 2006 the outstanding principal carrying amount of our long-term convertible notes was $4.6 million, down from $6.1 million at the end of the prior quarter.

In fiscal 2006 revenue totaled $162.9 million compared with $160.7 million in the previous year. GAAP operating expenses were $55.2 million compared with $108 million in the previous year. GAAP net loss in fiscal 2006 was $54 million, or a net loss of $0.33 per share compared with a net loss of $108.4 million, or a net loss of $0.75 per share in fiscal 2005.

On a non-GAAP basis the net loss was $41.9 million, or a net loss of $0.26 a share in fiscal 2006 compared with a net loss of $70.5 million, or a net loss of $0.49 per share in fiscal 2005.

Revenue in the fourth quarter was up 13% to $45.5 million compared with $40.1 million in the prior quarter and up 7% when compared with revenue of $42.7 million in the fourth fiscal quarter of the prior year. The increase in revenue is principally driven by higher demand.

Gross margin in the quarter was 4.4% compared with 4.1% in the prior quarter and a negative 0.3% in the fourth quarter of the previous year. As Jo briefly mentioned, gross margin in the quarter was negatively impacted by a net increase to our reserves of approximately $6.2 million.

In the fourth quarter of fiscal 2006 on a GAAP basis, operating expenses were $10.1 million, a decrease of $1.4 million from the prior quarter and a $29.4 million decrease from the fourth fiscal quarter of the prior year. The net sequential decrease includes an increase in G&A spending for the implementation of SAP and SOX related expenses offset by a reduction in our accounts receivable allowance because of favorable collection history.

Included in the fourth quarter's operating expense are share-based payments of $1.9 million, up quarter-over-quarter by $1.1 million. Combined R&D, sales and marketing and G&A operating expenses, including share-based payments, were 27% of revenue in the fourth fiscal quarter and that compares with 31% in the prior fiscal quarter and 38% of revenue in the fourth fiscal quarter of the prior year.

Combined R&D, sales and marketing, G&A expenses in the quarter were $12.3 million compared with $12.4 million in the prior quarter and $16.4 million in the fourth quarter of last year. The cash outlay from restructuring in the quarter was approximately $3.5 million.

In the fourth fiscal quarter, GAAP net loss is was $8.4 million, or a net loss of $0.04 a share compared with a net loss of $10.2 million, or a net loss of $0.06 a share in the prior quarter and a net loss of $42.8 million, or a net loss of $0.30 a share in the fourth quarter of the prior fiscal year.

On a non-GAAP basis, our net loss continues to decrease. Non-GAAP net loss is $8.4 million, or a net loss of $0.04 a share in the fourth financial quarter of 2006, which compares with non-GAAP net loss of $8.9 million, or $0.06 a share in the third quarter of fiscal 2006 and compares with non-GAAP net loss of $15.1 million, or a net loss of $0.10 a share in the fourth fiscal quarter a year ago.

Non-GAAP net loss excludes share-based payments, amortization of intangibles, restructuring charges, gains and losses on the disposal of property and equipment. In the third quarter of 2006, non-GAAP net loss also excludes an inventory provision related to Restriction of Hazardous Substances compliant product and fourth quarter of 2005 non-GAAP net loss also excludes the write-off of a long-term investment. At this time, we plan on filing our 10-K timely, possibly using an extension beyond the initial filing day of September 13.

With that, I would like to turn it back to Jo for a recap and a look at our guidance for fiscal Q1 of 2007.

Jo Major

Thanks, Cal. We're seeing positive indication in the market that we believe will drive our growth in Q1, including continued strength in bookings, including multiple quarter bookings, increasing demand for our new products that support flexible networks, like our amplifier that has the integrated optical performance monitor and a slight easing in pricing pressure due to this demand. For the first fiscal quarter of 2007, we are forecasting revenue to be in the range of $48 million to $50 million.

With that, we now welcome your question and will turn the call over to the operator.

Question-and-Answer Session

Operator

(Operator Instructions) We have a question from John Harmon - Needham & Co.

John Harmon - Needham & Co.

Hello. Good morning. I think I might have missed some of the initial remarks. Could you talk about the charge that you took to cost of goods sold and what gross margins would have been excluding that charge and then what your expectations would be for Q1 based on your revenue guidance?

Jo Major

We generally don't give gross margin guidance, John, unless we say it's going to rise. Obviously, that is the focal point to the Company right now. If you look in aggregate, we took a net hit to cost of goods sold of $6.2 million this quarter. That's substantially higher than the $2 million or a little bit above that we would normally take. So we don't actually back that out of non-GAAP measures, but you can do the math and look at what our margins would be. Again, we took a net $6.2 million hit this quarter to COGS.

To give you color on this, there's several factors that play into this. One of the things that's happening is, we used to have a lot of engineers on the manufacturing floors. We used to have a lot of ability to use non-standard raw materials, or older raw materials, by having engineers on the line essentially redesigning things on the fly.

In a contract and manufacturing environment, we're really focused on cost, we're really focused on capacity, we're really focused on getting our yields up. We're really focused on using those materials that make the line work smoothly and crisply.

The other thing that is happening on our line is, instead of having a very high percentage of engineers on the line, we now have much more streamlined manufacturing in that there's a lot more workers and a lot fewer engineers supporting that. Because of that, we don't have the same flexibility to use some of the stuff that we've had in the past. That and other factors as we really got to understand what this manufacturing environment meant to us, led to us taking this charge this quarter.

Maria Riley

John, it's Maria. Sorry to interrupt here. I just wanted to clarify that at the beginning of Jo's response I believe what he meant to say is that we do not give a number for gross margin guidance and we did not provide any gross margin guidance this quarter.

Jo Major

Yes, that's right.

John Harmon - Needham & Co.

That includes, you haven't said whether you expect margins to go up or down or given any guidance on that?

Jo Major

That's right.

John Harmon - Needham & Co.

But moving on to operating margins, please. Is the Q4 dollar amount a good basis level for next fiscal year? You were talking about how, I think, bad debt expense affected G&A; sales and marketing expense was up a bit sequentially. Any other comments you could just provide on the level of operating expenses going into fiscal '07?

Jo Major

OpEx really isn't where the focus of the Company is. We're going to be maintaining those levels and not really driving them down. If we grow revenue throughout the year, I suppose you could see OpEx trending down. We did get a positive $2 million pop to OpEx this year. In other words, we got $2 million that made OpEx look smaller that we probably won't get next quarter.

In general, the focus of the Company, John, is really on gross margin and really on top line. I think we've got our operating structure basically in a place that we're happy with it.

John Harmon - Needham & Co.

Thanks. And just one quick kind of housekeeping question. It was purely coincidental that your non-GAAP net loss was exactly equal to your GAAP net loss in the quarter, right?

Jo Major

Yes. It's just the way the things broke out. We got the subleases and we got another nice one-time that was positive on a non-GAAP side and it just turned out to be the same number.

John Harmon - Needham & Co.

Okay. Thank you.

Operator

Thank you. Our next question comes from Todd Koffman - Raymond James.

Todd Koffman - Raymond James

Thank you. Can I just get a clarification? You said that the net hit to the gross margin was $6.2 million. Can you just give the actual dollar value of the inventory write-down in the quarter?

Cal Hoagland

We haven't broken it out that way. The net hit is $6.2 million. There's a couple positives; warranty reserves were positive there, Todd. By the way, good morning and how are you? The warranty reserves were a positive effect, so the overall inventory write-down that we took was a bit bigger than $6.2 million.

Todd Koffman - Raymond James

Assuming the inventory write-off was a little bit bigger than $6.2 million and in the March quarter there was, I think, about $2 million worth of inventory written off. In my recollection something about a facility move out of New York or whatnot. Is the inventory balances today as clean and as correctly valued, or as you've moved through the current quarter, there may be the realization that those inventories might have to be again revalued and reconsidered at the end of the quarter as well?

Cal Hoagland

As we mentioned earlier, that we have a normal run rate of a couple million dollars plus for inventory and warranty on a quarterly basis. Each quarter we evaluate excess and obsoletes take into consideration the most current information we have at the time. So we anticipate that there will be a certain level which goes forward, typical to what we've historically experienced.

Jo Major

Todd, a little bit more color on that. This really is only the second quarter that we've been residing, if you will, in our new manufacturing house and I do find having to change reserves on inventory of how we look at inventory a real irritating thing. We've been driving people in marketing to look at their forecast numbers and really think about what we're doing. We've been driving the manufacturing guys six ways to Sunday to make sure that we understand exactly what's going on in the new environment. So we are working very diligently to make sure that our portrayal of inventory is as accurate as we possibly can.

The other comment that I would make is because this is the press conference associated with our K, it's a little bit later in the quarter, so we have been scrubbing and scrubbing very hard on this for quite some time. So I believe we've done a good job in understanding what the new model does for us.

I think we've taken a really harsh look at what we can use and what we can't and I think we've taken a fair stand on inventory. I can't provide you the forward-going statements that we won't have mishaps in the future, but I think we have done a good job in getting a fair representation of the usability of the inventory we've got.

On last call, when you asked me the same question about is this going to happen again? I said, I don't know, because I didn't feel at that time that we really had a deep understanding of what contract manufacturing was all about. We have worked very hard over the past four months to get a lot better answer to that, and I think we have a lot more coherent understanding of the economics of contract manufacturing, so I believe actually that we've done a good job and we're fairly represented here.

Todd Koffman - Raymond James

Thank you. Very helpful. Good luck.

Jo Major

Todd, thanks.

Operator

Thank you. Our next question comes from John Anthony - Cowen.

John Anthony - Cowen & Co.

Good morning, guys. A couple questions. Just want to focus on the top line a bit here. Jo, what gives you the conviction that your bookings are going to continue to increase through the end of the year?

Jo Major

Hi, John. I actually didn't say that our bookings would continue to increase throughout the rest of the year. I'll just make sure that I'm clear about what I did say. I did say that we see the markets growing and we’re not unusual in that regard. Most of the analysts out there that are looking at this market see growth on the 15% to 20% range this year so I think we're simply in line with people there.

Our bookings have been strong historically so I'll reiterate what I said. For a couple quarters now I've said that what limits our ability to get revenue is our capacity, that there's lots of demands for the product and our big challenge is gearing up our supply chain and gearing up our factories to go get that revenue, but I did stop short of saying that we'll see bookings increase throughout the rest of the year.

The other thing that I said on this call was, you know, we want to go publicly on record that the sub-marine market has been coming back, but those programs have primarily pulled out of inventory as opposed to new product for us. We believe that the supply chain, that the inventory levels of our customers are now deleted and we see real signs that there are programs that will turn the sub-marine program on in the coming year and we will absolutely positively do everything possible to be the number one or number two player in that market.

John Anthony - Cowen & Co.

Okay. Let me turn that question on its ear a little bit then. Would you be surprised if you saw a contraction in demand? I apologize, when I say the rest of the year, I mean the rest of the calendar year. So based on your guidance for the current quarter, would you be surprised if you saw a contraction after that through the remainder of the calendar year?

Jo Major

It's kind of funny because in essence, it feels to me like I'm giving multiple quarter guidance and I don't want to do that because this market has done crazy things on the upside and crazy things on the downside throughout my career. In general, our customers are talking to us right now about getting capacity in place, we're talking pretty methodically about supply chain stuff. So right now, we don't see indications that our customers are backing away.

The supply chains turn on their ear in a heartbeat, and I don't want to oversell a situation. But right now, the discussions that we're having with customers are, where's your capacity, where do you need the capacity to go, how do we get the capacity there, what are the log jams in the supply chain, and we don't see the cautionary flags of debookings or those kind of things on the horizon right now.

John Anthony - Cowen & Co.

Past the 10% customers you mentioned, could you talk about any other significant contributors either to the quarter just passed or the current quarter and do you see any new customers or new programs coming online that particularly stand out?

Jo Major

Yes, if you look at the top tiers of our customers, you get the normal cast of characters. Alcatel's always been a very supportive and wonderful customer. The big names for us are Nortel, Siemens, Cisco, Ciena, Ericsson, Fujitsu. Lucent is and other great customer, WRI's a great customer that are out there and they've got programs that are turning on.

I think the place that excites me most in the customer base is that some of the integrated products that we're putting together now are actually shipping into the large next generation carrier deployment. So those deployments are just getting started and I think we're real encouraged next quarter, we're going to really start to see revenue taken in the deployments that everybody's excited about.

John Anthony - Cowen & Co.

When you say next quarter, do you actually mean next quarter or the current quarter?

Jo Major

It's kind of funny because we're announcing so doggone late. It would be the September quarter.

John Anthony - Cowen & Co.

Not to belabor the point, but could you be a little more precise when you say some of the next generation carrier networks? Are you referring to some of the dynamic optical transport networks that had been announced at carriers like Verizon?

Jo Major

Sometimes we have agreements with our customer that we can't exactly say who our end customers would be, but the big carrier deployments like Verizon and BT and things like that are the kinds of programs we're selling into now.

John Anthony - Cowen & Co.

Okay. Great. Thanks, guys.

Jo Major

Maria, if it doesn't seem like we have any more questions floating in, I'd suggest that we thank everybody for listening. Again, the technical issues I think were frustrating for us as well you and we apologize for that. Welcome you to the call and wish you all a great day today. Thank you very much for attending and I think we should end the call now. Bye all.

Operator

Thank you. That does conclude today's conference call. We thank you all for participating and have a great day.