Zhone Technologies, Inc. Q3 2009 Earnings Call Transcript

Oct.21.09 | About: Zhone Technologies, (ZHNE)

Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q3 2009 Earnings Call

October 20, 2009 5:00 Pm ET

Executives

Kirk Misaka - Chief Financial Officer

Morteza Ejabat - Chairman and Chief Executive Officer

Analysts

Analyst for Greg Mesniaeff - Needham & Company

[Inaudible] Kumar – Midsouth Investor Fund

Chad Smith - Smith Capital, LLC

Operator

Good day and welcome to the Third Quarter 2009 Zhone Technologies, Inc. conference call. I'm Shanika 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 toward the end of the conference. (Operator Instructions)

As a reminder, this conference is being recorded for replay purposes. I would now like to introduce Kirk Misaka, Zhone's Chief Financial Officer. Please proceed.

Kirk Misaka

Thank you, operator. Hello and welcome to the Third Quarter 2009 Zhone Technologies, Inc. conference call. I'm Kirk Misaka, Zhone's Chief Financial Officer. The purpose of this call is to discuss Zhone's third quarter 2009 financial results as recorded in our earnings release which was distributed over Business Wire at the close of market today and has been posted on our web site 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 in business development through the third quarter. Following Mory's comments I will discuss Zhone's detailed financial results from the third quarter and provide guidance for 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'll make forward-looking statements including those related to projections of 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 focus and statements that express our planned objectives and strategies for future operations.

We would like to caution you that actual results may differ materially from those contemplated by the forward-looking statements. We will 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 this year ended December 31, 2008 and our quarterly reports on Form 10-Q for the quarters ended March 31, 2009 and June 30, 2009.

We would like to caution you not to place undo reliance on any forward-looking statements which speak only as of the day in 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 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 a 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 and comparison to competitors' operating results.

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

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

Morteza Ejabat

Thank you, Kirk. Good afternoon and thank you for joining us today for our third quarter 2009 earnings call. A strong sequential revenue growth for the second straight quarter led to better-than-expected earnings. As a result, we generated a slightly positive pro forma EBITDA ahead of scheduled and are on track to include pro forma EBITDA profitability in the fourth quarter and potentially achieve GAAP profitability as well.

The strong interest in our new technologies has driven impressive revenue growth of 26% and 19% in the past two quarters. The revenue increased from $30.3 million in the second quarter to $36 million in the third quarter which far exceeded our previous guidance of revenue between $32 million and $33 million. This revenue growth was driven by broad based deployment of our new products in the US and abroad. I will give you more details on the new products and market data.

For now let me just say that we are very encouraged by the growing interest in our new products and hope to continue to build on this momentum to increase profitability. Kirk will give you more details on our financial performance and guidance later on. So let me give you a brief update on the status of our NASDAQ.

We recently announced that Zhone [inaudible] an application to transfer from NASDAQ Global Market to NASDAQ Capital Market. Our petition was approved on September 28, 2009 so we began trading on the NASDAQ capital market.

From an external perspective, we continue to trade under the ticker symbol ZHNE and have the same trading and market access as any other NASDAQ listed company. However, from an administrative perspective, the transfer provided us with an additional 180 days until March 29, 2010 to comply with their $1.00 minimum bid price requirement to continue the inclusion on NASDAQ Capital Market. Accordingly, the corresponding plans to move forward with the reverse stock split were approved by our shareholders in October 2008.

Now let me give you an update on our products and customers. This quarter we announced a very large expansion of our portfolio of customer [inaudible] equipment or FTTx applications, our zNID ONT products. We have been receiving a lot of operator feedback on requirements for FTTx applications from a quickly growing number of [inaudible] all over the world.

Because ONTs represent a big part of the costs of any GPON and Active Ethernet in our network design, it is important that ONTs match precisely in operators in specific network and service requirements.

Our development and integration networks and ONTs have created the industry’s most comprehensive portfolio with now 27 different models covering a wide range of functionality both in indoor and outdoor applications, from simple low cost devices to basic residential service to sophisticated multi service devices for business application and mobile backhaul.

Our customer base for both [MALC] and [MXK] platforms continue to grow. This past quarter we announced a new [MALC] deployment for ADSL2+ and EFM with AccessCom expanding its territory in Louisiana.

The new MXK wins include a large network in Italy with Estracom and a high profile installation in El Gouna. A [inaudible] created by property development [inaudible].

Finally, in the US market, we turn the rest of the communications [inaudible] here and eagerly await the outcomes from the first round of broadband stimulus grant proposals. [inaudible] a number of our customers are providing their proposals and based on their quality are expectant to have done well in the proposal reviews. We understand that [inaudible] are nearing their decision on finalizing and we look forward to seeing this important program turn into real growth and employment activity early next year.

As you can see, many exciting thing are happening in our business that should translate into a stronger financial performance in the future.

Now I’ll turn the call over to Kirk to provide more details on our financial results for last quarter and to discuss our financial guidance for next quarter.

Kirk Misaka

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

As Mory mentioned, revenue for the third quarter of 2009 increased by 19% of $30.3 million in the second quarter to $36 million in the third quarter which exceeded our previous guidance of revenue between $32 million and $33 million. Looking forward we see continued revenue growth in the fourth quarter but at a moderating rate. Any economic recovery is expected to be slow. The broadband stimulus funding isn’t expected to have any effect until the first quarter of 2010 at the earliest, and many carriers are expected to continue to be cautious about moving forward with major capital expenditure plans at this time.

Nevertheless, we are forecasting continued revenue growth of 3% to 6% for the fourth quarter resulting in revenue between $37 million and $38 million. We continue to serve approximately 700 active customers worldwide, with 62% of revenue for the third quarter being attributed to international customers. We experienced more customer concentration this quarter with one 10% customer and the top 5 customers representing approximately 42% of revenue for the third quarter as compared to 34% for the second quarter.

As expected, gross margins dropped from 36.4% for the second quarter to 33.5% for the third quarter which was within our previous guidance range of between 32% and 35%. As mentioned on our last conference call, the second quarter margins reflected in inventory earn-out proceeds from previously divested product lines that didn’t exist in the third quarter.

Going forward, we expect margins for the fourth quarter to improve to between 33% and 36% with opportunities for slight margin expansion in areas of improved new product costs and manufacturing [inaudible] to scale.

Operating expenses for the third quarter came in at $13 million versus guidance of between $13 million and $14 million. Operating expenses included depreciation of approximately $400,000 and stock-based compensation of approximately $500,000.

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

Finally and most importantly, pro forma EBITDA for the third quarter of 2009 was a $79,000 profit, a better than expected loss of between $1 million and $2 million. With continued revenue growth and slightly better margins offset by slightly higher operating expenses, we expect that pro forma EBITDA profit for the fourth quarter will improve to approximately $1 million which would also lead to break even GAAP earnings.

Our primary financial objective continues to be generating GAAP profitability and we’re looking forward to achieving that objective in the fourth quarter.

Now let’s take a quick look at the balance sheet. Cash and short-term investments at September 30, 2009 were $22 million, which declined from $26.8 million at June 30, 2009 largely due to working capital changes occurring in the third quarter. Our total debt obligations remain basically the same as last quarter at $28.8 million.

As for other balance sheet changes, inventory levels decreased again from $33.6 million as of June 30 to $30.5 million as of September 30. However, accounts receivable levels increased nearly $13 million to $32 million at September 30 and the number of days sales outstanding on accounts receivable for the third quarter increased to 80 days as compared to 57 days for the second quarter.

The increase in accounts receivable and DSOs is largely attributable to the growth in business with our 10% customer. We anticipate DSOs will return to around 70 days for the fourth quarter.

Finally, the average basic and diluted EPS shares were $151.1 million for the third quarter, increasing only slightly from the $150.9 million in the second quarter. Once again, the slight increase resulted from stock option exercises by management and employees.

With that financial overview, let’s turn the call back to Mory for a few final comments before we open the call up to questions and answers.

Morteza Ejabat

Thank you, Kirk. We are excited by stronger than expected revenue growth associated with the beginning of a new product cycle for the company. The initial positive reaction to our new products is very encouraging and we hope to build on that momentum going forward.

In the third quarter we achieved our primary financial goal of generating positive quarterly pro forma EBITDA ahead of schedule and put our focus on improving that profitability in the fourth quarter.

Thank you for joining us. We will now open the call for questions.

Question-and-Answer Session

Operator

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

Analyst for Greg Mesniaeff - Needham & Company

Hey guys, this is Connor Irvine calling in for Greg. I just wanted to ask first off about the timing of the broadband stimulus funds. It seems like funding has been pushed out a little bit into next year and I guess I’m just trying to get a sense of when you think that might really start to benefit your business next year.

Morteza Ejabat

We believe the benefit will have started in January and we are going to continue to see that through Q1 and Q2.

Analyst for Greg Mesniaeff - Needham & Company

Okay, that’s Q1 into Q2, great. And then my next question is in regards to your gross margin. I know you said that in Q3 it was down lower as a result of lower inventory earn out. Was that the majority of the decline? Are you guys still seeing favorable pricing and just a little more color there would be great.

Morteza Ejabat

The decline was based on the inventory earn out but we don’t see any more price erosion any place with respect to our business. Actually when it comes to pricing I believe we are a leader in the price setting at this point including domestically and internationally.

Analyst for Greg Mesniaeff - Needham & Company

And do you still see cost reductions in the quarter?

Morteza Ejabat

We are continually looking at cost reduction. Of course we are going to see some more.

Analyst for Greg Mesniaeff - Needham & Company

My last question for you is in regards to sort of your long term operating targets. Again, you did a great job in the quarter. I was wondering how you expect that to trend into Q4 and if you have any insight yet into next year and basically how you see your sales and marketing activity tied to your new product cycle?

Morteza Ejabat

Our plan is to continue improving our profitability during every quarter. We haven’t set the major target about what we are going to see but if I look at the industry as a whole, the majority of them are said to have about 10% profitable to margin. So our goal is to continuously improve our profitability.

Analyst for Greg Mesniaeff - Needham & Company

Did you provide a dollar amount for OpEx in Q4? I might have missed that.

Morteza Ejabat

OpEx amount is between $13 million to $14 million.

Operator

Your next question comes from [Inaudible] Kumar – Midsouth Investor Fund.

[Inaudible] Kumar – Midsouth Investor Fund

Got a question about your R&D spending. Are you going to spend the $5 million for the next couple of quarters or are you going to reduce that or what’s the plan on that?

Morteza Ejabat

We are spending about the same amount you mentioned in R&D and it’s about $5.3 million and we are going to continue keeping that [inaudible] increase it a bit during the quarters.

[Inaudible] Kumar – Midsouth Investor Fund

Are you guys thinking of doing reverse stock split or anything in the near future?

Morteza Ejabat

We announced an approval of our shareholders reverse stock split [inaudible] 5 for 1 or 10 for 1 but we are still looking at that. We haven’t made a decision on when we are going to do that, if we are going to do that.

Operator

Your next question comes from Chad Smith - Smith Capital, LLC.

Chad Smith - Smith Capital, LLC

Couple questions and to whatever extent you can provide some color, that would be great. If you can’t, that’s fine. Can you give me a breakdown of growth by geographic region? Obviously I know you already gave the breakdown of percentage of revenues that are coming from international, but just based on your various regions, can you give me a feel for where you’re seeing the most growth?

Morteza Ejabat

I can tell you that we had growth both domestically and internationally and also within international we saw a majority of the growth to be in Italy.

Chad Smith - Smith Capital, LLC

So broadly speaking the majority of your international growth, not majority of revenues, but majority of growth is coming from more emerging markets? Would that be correct?

Morteza Ejabat

Correct.

Chad Smith - Smith Capital, LLC

Are you seeing any signs of pick up in developed international markets?

Morteza Ejabat

Yes we do. We [inaudible] United States. We see some of that is improving.

Chad Smith - Smith Capital, LLC

Can you give us a breakdown of percentage of revenues that are still coming from I guess what I would describe as legacy products but what you guys would describe or put into that category?

Morteza Ejabat

Actually we have stopped at doing any legacy business. I don’t know how long ago you’ve been following us but we sold all of our legacy business in 2008 I believe and what you’re seeing is all about our what we call SLMS product line.

Chad Smith - Smith Capital, LLC

I knew that, I didn’t know if there’s any residual or if it’s all coming from SLMS.

Morteza Ejabat

And if there is some, it’s very neglible.

Chad Smith - Smith Capital, LLC

Kirk, I’m sorry, I missed when you indicated on the balance sheet, you gave a comparison on the cash line. I apologize, I don’t have it in front of me. What was the – you’ve got $22 million in cash now, what was it last quarter? I just don't have it in front of me.

Kirk Misaka

It was $26.8 million at the end of June.

Chad Smith - Smith Capital, LLC

So even with EBITDA positive, can you get a feel for at what point we’re going to reach that kind of cash neutral maybe even transitioning into cash flow positive mark?

Kirk Misaka

There was a substantial buildup in the accounts receivable this quarter so that relates to this 10% customer that we have that we’re expecting payments from next quarter so with a little over $12 million increase in accounts receivable alone, as I said, largely from that customer that we would expect to be collecting next quarter.

Operator

There are no further questions in the queue. I would now like to turn the call over to Mr. Mory Ejabat.

Morteza 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

That concludes today’s conference. Thank you for your participation.

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