Network Equipment Technologies F2Q10 (Qtr End 09/25/09) Earnings Call Transcript

Network Equipment Technologies (NWK)

F2Q10 (Qtr End 09/25/09) Earnings Call

October 21, 2009 5:00 pm ET

Executives

Leigh Salvo - IR

John McGrath - VP and CFO

Nick Keating - President and CEO

Presentation

Operator

Welcome to the Second Quarter 2010 Network Equipment Technologies Earnings Conference Call. (Operator Instructions).

At this time, I would like to turn the call over to your host for today's conference, Ms. Leigh Salvo, Investor Relations.

Leigh Salvo

Welcome, everyone, to our call this afternoon during which we will discuss results for Network Equipment Technologies' second fiscal quarter of 2010. With me today are Nick Keating, President and CEO; and John McGrath, CFO.

In keeping with the safe harbor provisions of the Private Securities Litigation Reform Act, I want to remind everyone that we'll be making some forward-looking statements and projections today, including those relating to future revenue, operating results and financial condition. Investors are cautioned that these statements are based on current estimates and assumptions that involve risks and uncertainties that might cause actual results to differ materially from those expressed or implied in forward-looking statements.

These risks and uncertainties include Federal Government budget matters and procurement decisions, the timing of orders, successful and timely completion of product development initiatives, relations with and performance by third-party providers, new competition and technological changes, success in building new sales channels, including with third-party vendors and systems integrators, our ability to convert pilot opportunities into sales, circumstances regarding specific sales that can affect the recognition of revenue, market acceptance for our end products, the progression of patent litigation and other risks, including those identified in the company's filings with the SEC, including Forms 10-K and 10-Q and in other press releases and communications. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Additionally, an audio archive of this call will be available on the company's website for at least 12 months. The statements made on this conference call are only made as of October 21, 2009, and we disclaim any duty or intention to update forward-looking statements.

In addition to financial measures presented in accordance with GAAP, we will also be discussing certain non-GAAP financial measures that are adjusted from results based on GAAP to exclude certain expenses, gains and losses. These non-GAAP measures should not be considered a substitute for or superior to GAAP results. Please refer to the press release issued today for further detail regarding the non-GAAP measures. Reconciliations to GAAP can be found in the press release which is posted on our website.

Our agenda today begins with NET's CFO, John McGrath, who will provide a detailed review of our financial results. Nick Keating, CEO, will then comment on the quarter's financial and operational highlights. John will then offer financial guidance for next quarter and we'll open the call to your questions.

At this time, I will turn the call over to John McGrath.

John McGrath

In the press release issued today and available on our website, we reported that total revenue for the second quarter of fiscal '10 was $19.8 million, up 1.3% from the prior quarter and up 6.7% from Q2 a year ago. For the first half of fiscal 2010, revenue was up 15.2%, which is within our guidance.

Product revenue in the second quarter was $14.4 million, a 9.1% decrease from Q1 and a 1.6% decrease from Q2 last year. Product revenue from our government business was $11.8 million, essentially flat to prior quarter and up $1.5 million from Q2 a year ago.

Our US Federal business improved over the prior quarter. This improvement was offset by a decline in European MoD business, while the customer assesses the status of equipment returned from Iraq and the Balkans in order to determine its exact purchasing requirements for further deployments.

Product revenue from our enterprise business was $2.7 million, a decrease of 38% from Q1 and a decrease of 39% from Q2 last year. The decreases are due largely to our Quintum Tenor product line. We are seeing a decline in sales associated with a basic VoIP applications that were a large part of the traditional Quintum business as we shift our focus to more advanced UC SIP Trunking and other growing VoIP-related markets.

Service and other revenue at $5.3 million, included $1.3 million of funded R&D. Service and other revenue was up from $3.6 million in Q1 and up from $3.9 million in Q2 '09. It should be noted that we are involved in a number of projects with General Dynamics, and in Q2 '10 revenue either earned directly or indirectly from them totaled $9.1 million or 46.2% of total revenue, including $5.7 million related to the WIN-T program.

Gross margins as a percentage of revenue was 39.5%, down from 45.5% in the prior quarter and up from a negative 25% in Q2 last year. Product gross margin was 47.8% compared to 53.6% in Q1 and a negative 31.9% in Q2 last year.

Although our standard margins remained constant, the sequential decrease was due to lower absorption at fixed manufacturing cost or lower product revenue and an increase in inventory reserves related to Promina, as Promina revenue is expected to decline this year. Product margins in Q2 last year were affected by the impairment of intangible assets.

Service and other margins increased to 17.1% from 10% in the prior quarter and 1.4% in the second quarter of the prior year. The increase was due to cost reductions in the service organization and from $1.3 million of funded R&D, which add a margin of approximately 30%.

Second quarter operating expenses were $12.1 million, down $800,000 sequentially and down from $49.1 million in Q2 last year, which included charges of $34.2 million related to the impairment of goodwill and other intangible assets.

Total company headcount of 251 employees at the end of Q2 was flat compared to Q1 and down 44 from Q2 last year. On a temporary basis, most of our domestic employees have taken a 7.5% pay reduction with the executives taking a 10% to 15% pay cut.

To compensate for this, we granted restricted stock to the affected employees. This resulted in stock compensation charges in Q2 of nearly $0.25 million in addition to other stock compensation charges in the quarter. We took this action both to conserve cash during this difficult economic period as well as to incentivize our employees to increase shareholder value.

As we discussed previously, we streamlined our operations in fiscal 2009, as well as completed the integration of Quintum. We consolidated many of our back office functions, which now leverage a single ERP system for the company. We also continue to focus on a common converged platform, which has enabled us to consolidate overlapping R&D functions.

Q2 '09 results included the amortization on intangible assists acquired from Quintum of $537,000 of which $300,000 was related to operating expense and all of which was fully written-off in Q2 '09.

Sales and marketing expense was $4.6 million in Q2, down $764,000 compared to the prior quarter, which included executive employee separation cost of approximately $700,000 and down $1.1 million from the second quarter a year ago mostly due to the integration efforts and other cost reduction initiative. R&D expense at $4.8 million was up $158,000 from Q1 and down $1 million from Q2 '09.

The year-over-year decrease is due to reduced headcount and other savings as we consolidated our R&D plans into a single company-wide strategy. G&A expense was $2.7 million compared to $2.9 million in Q1 and $3.2 million in Q2 '09. This sequential decrease resulted from lower compensation-related expenses from the timing of stock compensation costs related to salary reductions. The year-over-year decrease was in large part due to consolidation of the back offices at Quintum and NET and other cost reduction initiatives.

Other income in the second quarter was $300,000 attributable mainly to gains on foreign exchange compared to $483,000 in Q1 and $6.3 million in Q2 '09. Other income in Q1 of this year and Q2 last year is attributable to gains from the early retirement of our convertible debt at a discount, which amounted to $555,000 in Q1 and $6.4 million in Q2 '09.

Net interest expense for Q2 was $186,000 compared to $88,000 in the prior quarter and $142,000 in Q2 last year. With the low interest rates, we continue to see smaller returns on our portfolio, which is in large part invested in securities backed by the US government.

The second quarter had a tax benefit of $14,000 as compared to tax expense of $58,000 in the prior quarter and a benefit of $63,000 in the second quarter a year ago. Although we are not profitable on a consolidated basis and also have significant NOLs, we will need to make payments of required minimum taxes, but we do not expect this to be significant this fiscal year.

Turning to net income, the company reported a net loss of $4.2 million or $0.14 per share compared to a net loss of $3.7 million or $0.13 per share in the prior quarter and a net loss of $47.5 million or $1.63 per share in the second quarter of fiscal '09.

On a non-GAAP basis, the net loss was $3.1 million compared to $2 million in Q1 and $8.1 million in Q2 '09. Non-GAAP income adjusted for stock-based compensation, amortization and impairment of acquired intangibles, restructure charges, gains from the earlier extinguishment of debt, and other significant non-recurring items, including executive employee separation charges.

Cash and investment balances at the end of Q2 were $90.8 million, down from $94.7 million at the end of the prior quarter. Cash and investments decreased by $40.8 million from the prior year due in large part to the retirement of $45.7 million of convertible debt as well as cash used in operations.

During Q4 '08, our Board of Directors approved the stock buyback of up to $20 million based upon market conditions. As the company is committed to a long-term growth and acquisition strategy, the company will balance its buyback program with its cash needs. To-date, we have repurchased approximately $1 million or 258,000 shares, none of which was in last quarter.

Accounts receivable were $13.6 million, up $4.million from Q1 and up $2 million from Q2 '09. The increase in accounts receivable is primarily due to timing of shipments in the quarter. DSOs at 62 days increased 17 days sequential and increased 5 days year-over-year and are within our targeted range.

Net inventory was $6.1 million in the second quarter, representing a decrease of approximately $400,000 as compared to the prior quarter. Net inventory decreased $2.2 million compared to the second quarter a year ago.

Now, I'll turn the discussion over to Nick Keating, our CEO.

Nick Keating

Our second quarter revenue was affected by several factors. On the enterprise side, our Quintum business has declined as revenues for that product line tapered down. Early in the unified communication trials we used Quintum Tenors for the initial pilots in order to support Microsoft's free gateway promotion program. Today, with the focus on larger enterprise customers, we are using the VX series products, leveraging its advanced features for successful pilots in growth markets.

We are also working with global equipment vendors to make the Quintum product more of a bundled solution by those global equipment vendors. On the government side, a key order was pushed out due to Federal Budget allocation delays. Revenue in the quarter was also affected by seasonality in certain international markets as well as a continuation of purchasing and deployment delays due to the general worldwide economy.

Despite these challenges, revenues during the quarter were within our original guidance as we saw higher Federal Government revenues aided by the recognition of funded development dollars. Moreover, in the second quarter, nearly 75% of our product revenue came from sales of IP-based solutions to commercial enterprises and government entities worldwide.

Sales of our NX1000 switches represented the largest majority of product sales followed by VoIP products. However, given our broad family of IP-based products, our product mix could change in given quarter.

Communication environments are growing more complex even as enterprises attempt to simplify the experience for end users. IT and network managers are continuously seeking ways to eliminate such complexity, improve reliability and support increasingly critical branch locations, while ensuring that critical voice services are available at all times.

This challenging shift among the large enterprises is what will drive our enterprise growth. As we consider the obvious magnitude of these opportunities, we recognize that we must make specific event-driven investments now in order to grow our market share.

I'd like to take the next few minutes to provide some detail on some of the factors that will most likely have an effect on our business for the balance of the year.

With regard to our commercial business, the total number of unified communication pilots remained relatively constant quarter-over-quarter, though the customers of the pilot programs represent significantly larger enterprise opportunities. The shift is in line with what was expected as we see the focus of our partners move to larger enterprise opportunities.

Pilot conversions during the second quarter were slightly ahead of the previous quarter. We are now seeing a number of new opportunities move directly from customer briefing to initial purchase, thus bypassing the pilot phase.

We continue to strengthen our relationships with many of the leading global vendors in the enterprise market including Microsoft, Hewlett-Packard, Avaya, NEC, IBM and Polycom, positioning NET to be a strong and reliable partner-focused company.

With that in mind, I'd like to highlight our new partnership with Tango Networks as announced earlier today. The partnership has two major components. Under the first component, NET will offer Tango's Abrazo fixed mobile convergence solution to its enterprise and government customers, channel partners and carriers globally as a reseller.

The second component enabled NET to integrate the Tango Abrazo FMC solution in the future NET products to provide a single-box solution supporting mobility for unified communications and voice systems. The fully integrated solution will offer customers a cost effective, easy-to-manage solution that integrates mobile phones with enterprise unified communication networks, such as Microsoft's Office Communication Server, IBM Sametime Unified Telephony and IP PBX or TDM PBX based voice networks.

The partnership provides another key element to NET's emerging market strategy, providing the company with an enterprise mobility solution that is complementary to the unified communications market. Tango's award-winning Abrazo fixed mobile convergence platform integrates mobile phones into the corporate enterprise to deliver a truly mobile extension for unified communications and enterprise voice systems.

With respect to Polycom, we recently completed interoperability testing with Polycom's KIRK wireless systems. The combined solution enables Polycom's handsets to act as SIP clients and register directly with a VX switch instead of a SIP softswitch. Systems integrators can now deliver a solution to small enterprises in branch offices, office locations seeking the benefits of IP-based network telephony.

NET's worldwide sales reach has enabled us to pursue geographic markets where early adopters have embraced the benefits of unified communications and resellers and systems integrator partners are using our VX as their primary switch for legacy PBX integration and Microsoft OCS deployment.

In the US, we deployed our VX switch to HarborOne Credit Union, the largest state-chartered credit union in New England and one of the top 100 in the country. NET's VX series is providing integration between HarborOne's Nortel PBX and its Microsoft OCS environment. Their VoIP and UC implementation is part of the company's broader strategy to create a collaborative environment throughout all of its branch locations.

HarborOne represents a typical customer rollout. Recognized as a Microsoft Lighthouse account, NET was brought into the pilot, and within a few months, the pilot was accepted. Soon after we moved ahead to deploy a complete system to two branches, the credit union expects to roll out our VX Series through there 16 regional branches and headquarters over the course of the next year.

In Europe over the past 12 months, we have grown our specialized voice partner network from 9 to 62 organizations. International highlights during the quarter included the successful unified communication deployment of our VX Series at Quick France, part of the Belgian-French fast food restaurant chain. Quick's staff is now able to share skills and work collaboratively online, which has resulted in significant productivity gains and lower communication cost.

In Japan, we established a key new relationship with NTT DoCoMo and just announced certification of our VX product for direct IP PBX connection to NTT DoCoMo's Office Link service. This will provide enterprises with seamless integration among NTT DoCoMo's Office Link, the mobile phone and a traditional IP PBX used with Microsoft's OCS 2007.

NTT DoCoMo Office Link offers fixed mobile convergence service to the enterprise, which enables business users to switch from Microsoft OCS to the FOMA cellular network when they leave their office. This capability allows small to medium-sized businesses to reduce mobile airtime costs and be more productive.

Turning to our government business, during the second quarter we received follow-on orders for our NX1000 product line from General Dynamics and also received an additional order for other WIN-T initiatives that could be rolling out as early as this calendar year. The WIN-T network is using NET's NX1000 tactical switch to interface with the Defense Information Systems Network.

As John noted, our British Ministry of Defense business was affected by the return of previously deployed equipment from Iraq and the Balkans, and that is NET equipment among others. We anticipate that once the MoD has concluded their assessment of returned equipment to determine its future purchasing requirements, normal purchasing should resume in the latter part of our fiscal year. We are encouraged by the expanding opportunities for our equipment that appear to be emerging throughout the MoD, as we are identifying larger programs that are [combing] to a broader range of systems integrators.

On the product development front, we announced today that the general availability of our next-generation voice solutions to the enterprise, the VXe, is the latest software release providing extended unified communication features for our VX Series product line. As I commented last quarter, the majority of our product development over the past year has been concentrating on developing IP-based solutions and further enhancing our own platforms for large-scale deployments, and the introduction of the VXe places us in a unique position.

The availability of extended unified communication features in the VXe will provide real value to Microsoft OCS 2007 R2 enterprise voice customers by reducing the operational and capital cost of OCS R2 deployments. VXe provides branch offices with several key features, including Native DSP support for Microsoft's RT-audio, support for meshed, high availability OCS networks, end to end Quality of Experience monitoring, secure, line speed SRTP and TLS encryption; and automatic codec selection for improved audio quality.

The VX series is a fully integrated multi-service voice switch that provides high performance secure VoIP communications for enterprise OCS deployments interoperating with all the leading PBX and IP PBX vendor protocols while offering rapid deployment, ease at installation and lower maintenance.

Today, our product development is primarily focused on developing the next-generation product family. This will allow us to more quickly enhance our feature functions, as well as integrate third-party applications on to our platform. We believe that this strategy will distinguish us from other players in the marketplace, given the rapidly evolving dynamics of the unified communications market.

I'll now turn the call back to John now for comments on our financial guidance and closing remarks.

John McGrath

In Q2 we had increased revenue from our Federal Government business, while our foreign MoD business was affected by the need to assess the status of equipment returned from the field. We are very cautious about our Federal Government business to support as there is no new Federal budget in place, the lack of which has historically negatively affected our business.

The MoD business could also see another quarter of slower sales as it wraps up the assessment of the returned equipment. As such, our Q3 guidance for the government business assumes only a modest amount of orders beyond those that we have booked to-date.

We do believe that we will see our commercial business pick up in Q3 now that the international holidays are complete. With that said, we believe our Q3 revenue could decline sequentially 10% to 20%. We may realize some upside if there is a swift passage at the Federal budget and programs containing our equipment our funded.

Our cash breakeven revenue level remains at $21 million to $24 million quarterly. We intend to continue to tightly manage our expenses to minimize any cash burn.

Operator, this concludes our remarks. We would like to open up the call now for Q&A.

Question-and-Answer-Session

Operator

(Operator Instructions). Our first question comes from the line of Greg Mesniaeff with Needham and Company.

Unidentified Analyst

This is (inaudible) calling in for Greg. My first question is if you could comment maybe a little bit more on the government business and order push-out you saw during the quarter, you kind of went quickly over that on the call. I'm wondering if you could just kind of maybe say it again what caused the order push-outs and what's factored into your Q3 guidance.

Nick Keating

That order that was pushed out is not factored into our Q3 guidance. As John said, as some of these rollout, then that could change the nature of the guidance that we gave you. That was an order for one of the DoD agencies. It was approved. We had the bill out. We had built the product. The order was put on hold right at the end of the quarter because the customer was concerned about their priorities and their lack of budget for the new fiscal year.

Since then we've had a small release, just a fraction of that order, and we've not been able to determine with the customer that we're selling through a systems integrator whether that will get released this quarter or whether it will be held longer. So that was a direct example of the end user being concerned about their source of funds until they could get better visibility on what their new budget would look like.

There are a number of programs out there that we've identified that if they got released would certainly improve the quarter's performance. At this point, it would be pure speculation on our part to determine when that's going to happen. We've also seen some opportunities for our release of IP secure voice for the BX using the V.150 and MLPP technology. We've seen one customer place some small orders. We know that they have requirements to deploy these throughout their offices around the world.

Again, whether that's budget-related or simply that they need to go through more certifications, but that follow-on release could be a couple million dollars and we have no visibility at this point when it could be released. So we're in kind of a wait-and-hold mode. The same is the case with the MoD. I mentioned earlier this fact that as the UK Ministry of Defense pulled out of the Balkans and Iraq, they had over equipment that had been deployed, they brought it back, they don't know what condition its in, whether it could be upgraded or whether its scrapped. We had new programs that we were expecting this quarter and those were put on hold until they could do their assessment of the over deployed systems.

As I mentioned in the script though, from a long-term standpoint, we've identified some fairly sizable new programs and are working with systems integrators that we haven't worked in the past. From a longer term standpoint, I believe our sales organization is very bullish about the opportunities in the UK MoD.

Unidentified Analyst

My next question relates more to the enterprise type of business and your pilot activity. I am wondering if you are seeing a change in the number of customers actually purchasing the equipment following your initial trial periods as enterprises sort of reprioritized their budgets and if you are starting to see an increase in customer deployments beyond initial CapEx?

Nick Keating

Let me start with the trials themselves. We actually had expected that the trial numbers would go down quarter-over-quarter. As we rolled up those numbers, the number of trials that were ongoing were about the same as they were last quarter, and so that was kind of pleasant surprise.

On the deployment side, let me preface it by saying we don't have full visibility on the deployment. We know about the deployments when we sell equipment to the customer because they've been on consignment. Deployments were slightly higher this quarter than last quarter, although the size of the long-term customer opportunity appeared to be greater.

We don't share the number of new customers, but I would say it's a substantial number of customers last quarter, and again, this quarter that have acquired the equipment, made the initial deployment and we're working with them now to get a better sense for what their deployment will look like over the next 12 months. We used HarborOne today as an example. Initially two different branches, but over the next year we hope to have all of those branches installed in a full company-wide network.

I would call your attention to Albany which we've talked about in the past. That went slow, and then all of a suddenly they made a decision to do it quickly. In a six-month period, I think, they rolled out all 30 of their locations.

The other thing that's happening, which we find kind of interesting, is we've been doing extensive training literally all over the world. We had a training team in Taiwan recently, another one is Australia. We are doing training in the UK. We've got our resellers now to the point where they can do the initial trials and deployments, and only in very complex situations do we have to send our people in to work with them.

We don't know how big it is that there are deployments now, trials and deployments where we have no visibility other than the fact that the reseller is buying equipment from us. We think that both our trials and deployments are even larger than the number or the trend that I gave you indicating they were about the same level as they were last quarter.

Unidentified Analyst

On the last call you mentioned that you guys were focusing on developing improved branch office solutions. I was wondering if you guys could maybe provide us with an update there and if this was maybe tied to an uptick in your R&D during the quarter?

Nick Keating

First of all, I'd like to highlight the press release that we put out today on what we refer to as VXe. These are extended features on the VX platform that are designed for applications, such as branch applications, and other features that are more generic to the VX as a whole. That press release should have hit the wire. I'm looking at Yahoo right now and that's been picked up now by Yahoo.

That's represented a very extensive development over the last 18 months of extended features to be able to offer solutions from the large enterprise headquarters down to the branch office location to integrate encryption capabilities. As a result, that's the first of our branch office solutions. As part of our longer term product development, we are working on a next-generation platform, but that platform is scalable from very large enterprises. It will have capacity beyond that of the VX1800, scalable all the way down to branch office locations with continued advanced features.

The other thing I'd like to point out, you'll see two other announcements that we made today. Obviously, I talked about Tango and I talked about DoCoMo. Both the Tango product and the DoCoMo product implementation are designed to be used both in an office and in a branch and mobile environment.

We've talked in the past about our fixed mobile convergence strategy. I think the Tango relationship and the success in certification with DoCoMo are examples of what we try to accomplish in the FMC space. We would expect to have other initiatives in the future as we broaden our reach out of the large enterprise locations, into the branches and ultimately into the mobility space.

Operator

(Operator Instructions). There are no questions in queue at this time. I would like to turn the call back over to Leigh Salvo for closing remarks.

Leigh Salvo

This concludes the conference call for today. We look forward to talking to you next quarter. We will be in New York for conferences in early November. We hope to see many of you there. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and everyone have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!