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Executives

Brian Cooper - SVP and Chief Financial Officer

Rick Gilbert - Chairman and Chief Executive Officer

Analysts

Steven Becker - Greenway Capital

Richard Greulich - REG Capital

James Stone - PSK Advisors

Jeff Linroth - Leaving It Better, LLC

Madhu Kodali - Fertilemind Capital

Peter Schneider - Peninsular Capital

Westell Technologies, Inc. (WSTL) F2Q10 (Qtr End 10/30/2009) Earnings Call October 22, 2009 9:30 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to the Westell Technologies' Second Quarter Fiscal Year 2010 Earnings Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. We will not take questions from the media. Please note that this conference is being recorded.

I will now turn the call over to Mr. Brian Cooper, Chief Financial Officer. Mr. Cooper, you may begin.

Brian Cooper

Thank you, Christine. I would like to welcome everyone to our conference call covering the fiscal second quarter results for Westell Technologies. You can find the copy of our earnings release, which we issued last night on our website at westell.com. Today Rick Gilbert and I will discuss the business and our financial results.

Please note that our presentation and discussion contain forward-looking statements about future results, performance or achievements, financial and otherwise. Words, such as believe, expect, estimate, plan and similar expressions are intended to identify such forward-looking statements. These statements reflect management's current expectations, estimates and assumptions. These forward-looking statements are not guarantees of future performance and involve risks and uncertainties that may cause Westell's actual results, performance or achievements to differ materially from those discussed.

A description of factors that may affect our future results is provided in the company's Form 10-K for the fiscal year-ended March 31, 2009 under the section Risk Factors, and in our other SEC filings. The forward-looking statements made in this presentation are being made as of the date and time of this conference call. Westell disclaims any obligation to update or revise any forward-looking statements based on new information, future events or other factors. In addition, this presentation may include certain non-GAAP financial measures. Reconciliations between non-GAAP financial measures and GAAP financial measures are included in our news release.

Now, I'd like to turn the call over to Rick Gilbert, Chairman and Chief Executive Officer of Westell.

Rick Gilbert

Thanks, Brian. Good morning and thank you for joining Westell Technologies second quarter fiscal 2010 earnings conference call. I am Rick Gilbert, Westell's Chairman and CEO. During this call I will briefly discuss the Q2 results and then turn the call over to Brian Cooper, who will discuss the results in more detail. At the end of the call, Brian and I will be happy to answer some of your questions.

During our last earnings call, on July 22, I once again reviewed the two key goals for our fiscal year 2010; returning Westell to profitability and generating positive cash flow. I also described how our first quarter results had certainly moved Westell toward achievement of both goals. I'm happy to say that our results for the second quarter of FY '10 show us squarely on the path to both goals, but during the second quarter, we again recorded solid net income, with an EPS of $0.04 per share on a fully diluted basis. This is very similar to our earnings for the prior quarter.

During Q2 we also increased cash and cash equivalents from $49.2 million to $53.9 million. To put this into perspective, our cash and cash equivalents have improved by more than $10 million or about 23% since the beginning of the calendar year. When we compare the consolidated Q2 FY '10 results to the same quarter last year, we have significantly increased revenue, slightly improved gross margins and dramatically reduced operating costs, thereby yielding a healthy operating profit.

The Q2 results were achieved by good execution in all three divisions, with a deliberate emphasis on bottom line performance versus topline growth. Despite this common approach to our three businesses, we are seeing very different market dynamics affecting each division.

In Customer Networking Solutions we experienced another good quarter, with what we believe to be increased market share with key customers. Order flows have certainly been better than we had reason to expect, especially given the current state of the economy. The annualized revenue outlook for CNS continues to improve and order backlogs for some products now extend nearly six months into the future. While CNS still struggles with painfully slim margins on some product lines, it continues to make progress towards profitability.

In addition, recent changes in accounting rules for software allow us to be much more transparent in discussing the CNS business. For the first time this quarter, we can recognize UltraLine Series3 revenues that were previously deferred, and which we had previously disclosed in non-GAAP reconciliations.

So, what are the primary challenges for CNS? In the short-term it remains difficult to accurately predict the rate of broadband equipment usage by our largest customers. Obviously, it helps to have good order backlogs, but orders can be cancelled or delayed, so we must remain cautious in our outlook until the economy has truly recovered.

In the long-term CNS will remain unprofitable or at best barely profitable until we can find a way to generate a significant portion of revenue from software and software maintenance. Therefore, our best course of action is to fight hard to improve margins, while continuing to push the transition towards software. I am very satisfied with CNS performance on tactical basis, but I do worry about the pace of transition toward more software-based, higher margin CNS products.

In Outside Plant systems we've seen a definite slowdown in purchasing by several customers as they appear to be focused on cash control via targeted inventory reductions. This effect seems to be coupled with a soft market for traditional T1 and DS3 business services, possibly due to current economic conditions. Taken together, these issues made achieving the Outside Plant Q2 revenue goals problematic. However, a tight focus on bottom line performance allowed Outside Plant to record a reasonable quarter, with good operating profits.

The fortuitous combination of solid revenue from CNS and solid profit from Outside Plant was certainly helpful in achieving good consolidated results for the Westell equipment business in the second quarter.

An ongoing challenge for the Outside Plant is that the business tends to be both seasonal and project based, with traditionally small order backlogs that can lead to inventory shortages once a customer finally decides to bite the bullet and place the large order. So far the Outside Plant team has done a great job managing inventory, but we must maintain focus on those product lines that have the potential to generate more predictable order backlogs.

ConferencePlus has also experienced a very challenging second quarter, driven by a clear slowdown in demand for conferencing services from existing customers. Given the fact that most of our competitors have also seen a slowdown we believe that the affect is related to general economic conditions. This issue is compounded by shifts in customer focus toward lower pricing, with less emphasis on quality of service. Like Outside Plant, ConferencePlus had a softer than anticipated topline in Q2, but the team still delivered the expected bottom line by careful management of operating expenses.

Going forward the challenge for ConferencePlus will be to find a way to grow the topline again, while maintaining good profit margin for delivering what many regard to be a commodity service. This is a significant challenge, but certainly nothing new or surprising to team at ConferencePlus.

I would like to conclude with a few remarks about our outlook for the remainder of the fiscal year. We are now halfway through our fiscal year, and halfway through the initial tactical plan on my watch at Westell.

The first two quarters have been very satisfactory, as we've surpassed our initial expectations in both operating profit and cash generation. However, we had expected from the beginning that due to the seasonal nature of our three businesses, the first two quarters of the year would be the strongest. Ordering trends across our business units suggest that we may see some ongoing softness in topline, either as a result of specific customer situations or continuing pressures from the economy.

Our current outlook for the next two quarters predicts less revenue and a lower profit on a consolidated basis. At this time, we expect both quarters to be profitable, but probably less profitable than last the two quarters.

I want to stop and repeat that just to make it clear. At this time, we expect both quarters to be profitable, but probably less profitable than the last quarters. This outlook can be improved by two possibilities, a more rapid economic recovery than we expect or especially good performance from one or more of our divisions. While we may hope for either or both of these possibilities, we do not bank on them. Therefore, our plans in the current environment are exactly as described during our last call; to remain conservative in the use of our cash, to stay on focused on expense reduction, and to maintain solid execution in sales and marketing.

With that I'd like to turn the call back to Brian, who'll discuss our financial results in more detail before we open the call for questions. Brian?

Brian Cooper

Thank you, Rick. I am pleased to be able to talk today about another very good quarter, and I am going to highlight some of our key financial results. I am also happy to report that Westell has adopted very recently approved accounting standards that allow us to recognize revenue along with the related costs, which had previously been deferred. This is the revenue associated with our UltraLine Series3, Gateways, under a particular contract.

With the accounting change, Westell is able to recognize as revenue on a current basis almost of all of the consideration received under this contract. Until this quarter this revenue and the related costs were being deferred, and we had discussed them as non-GAAP adjustments. The accounting now reflects how we interpret our business. So, there should no longer be a need for us to talk about non-GAAP adjustments related to UltraLine Series3 revenue recognition.

You will note from our earnings release that we are an early adopter and that we've elected to apply the new accounting standards retrospectively. This means that we've adjusted prior periods to reflect how we would have reported them if we had been operating under the new accounting rules from the inception of our UltraLine Series3 product shipments.

This is an important distinction and I would like to be as clear as possible on this. The cumulative impact through June 30, 2009 of adopting the changes is $37.8 million of revenue and the $0.5 million of gross profit. The presentation of historical quarters will be adjusted and these amounts will not in effect flow through our current reporting. Out of the $37.8 million of effected revenue, $13 million related to the first quarter of this fiscal year and $24.8 million related to the third and fourth quarter of fiscal year 2009. Each of these amounts is slightly less than the deferred amounts we previously reported for those quarters. This is because a small portion of the revenue relating to the undelivered elements is still deferred.

Our earnings release contains three supplemental tables, which summarize the impact of adopting these new accounting standards.

So moving on to our financial results for the quarter, here are some of the highlights.

At the top we reported consolidated revenue for this fiscal second quarter of $47.4 million. This is up $4.2 million or 9.8% compared with last year's second quarter. Sales for Customer Networking Solutions were up $6.9 million or up full 40% year-over-year, while sales for Outside Plant systems and ConferencePlus both declined. Rick has already talked about the specific drivers of these results.

Next, gross margins improved against prior year for both CNS and ConferencePlus, and Outside Plant held relatively constant. Product mix is a large driver of the change in CNS margins. In ConferencePlus price changes and cost management are the main contributors. With our emphasis on the bottom line, pricing and product cost remain a key focus across the board.

Another bottom line focus, of course, is operating expense. We continue to hold the line in expenses of $11.6 million or $6.8 million lower than in the same quarter last year. They were also lower than in our fiscal first quarter. We are seeing the fuller impact of our restructuring as well as the effects of our ongoing cost control efforts.

On the bottom line itself, Westell reported net income of $2.9 million. That compares with the loss of $5.8 million in Q2 a year ago. It also effectively matches the non-GAAP results, which we discussed for our fiscal first quarter, and it represents our second consecutive profitable quarter. On a fully diluted basis, our net income per share translates to $0.04 in the latest quarter, compared with the quarterly loss of $0.07 per share a year ago.

Finally, I want to continue to highlight our cash balances. Our September 30 cash and equivalents totaled $53.9 million, up $4.7 million during the quarter. As we have discussed before, we are remaining conservative with our cash. We include a balance sheet and cash flow in our news release that should help address cash flow questions.

That concludes my prepared remarks and I believe we are ready to open the lines for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Steven Becker from Greenway Capital. Please go ahead.

Steven Becker - Greenway Capital

Good morning, guys. How much money did you lose in the CNS business this quarter?

Brian Cooper

You are talking, as a bottom line?

Steven Becker - Greenway Capital

Well, on operating basis or how we want to break it out.

Brian Cooper

All right. We haven't broken it out that way and the numbers we're putting our here, we're going to that in more detail in our Q. The gross profit was $4.2 million on net sales of 24 million for the quarter.

Steven Becker - Greenway Capital

Can you give us the sense of what the operating profit was?

Brian Cooper

Yes. Well, it was negative. We do allocations of our costs and there a lot direct costs associated with that business in our operating expenses

Rick Gilbert

Steven, this is Rick, It was a lot less negative than we had expected in our planning, beginning the year.

Steven Becker - Greenway Capital

It appears you are going to break it out in the Q. I mean can you give us a sense of the magnitude of how negative it was?

Brian Cooper

I'm not really prepared to do that right now, but it's an improving trend, as Rick said.

Steven Becker - Greenway Capital

Well, Brian in the next call I think it would be important to not have a conference call until you are prepared to give all your investors the information that they need, because how can we discuss this if we have to wait for these numbers to come out in the Q.

And I guess the second question would be, why would you continue to operate a business, I mean, if you have to make a transition to software and that transition is going to take some period of time, obviously, between here and there you stand to loss quite a bit of money in it? I guess the question, why run a business that loses money or why not cut it down to a size where it doesn't loss money?

Rick Gilbert

Steve that's an interesting question, but I guess my philosophy on it is, we have two fantastic channels to the two largest ILECs in the United States, Verizon and AT&T. And as we said in the call, we are picking up market share at CNS. So, it's true that at best it's going to be marginally profitable or still lose money on some of the equipment side of the business, but those channels represent a large opportunity on the software side and we don't want to walk away from those. So, we're going to continue operating the business and meeting the requirements of our customers who we value very highly.

Steven Becker - Greenway Capital

Just back to the question, I think this has been asked on previous conference calls and I think it's a pretty reasonable question. I mean picking up market share in a business where you are losing money strikes me as somewhat of a curious concept. Do you have any sense when you can be making money in that business?

Rick Gilbert

Well, as I said, I think it's depended on getting more business on the software side, with a little higher margin. And we have been working on that since the certainly day one that I've been here. I also said early on Steve that it was our intention not to walk away from any of the three businesses. We said that first call, okay. And in this economy we think it's a very bad time to be looking to divest any of the three businesses. So we are running them in as efficient manner as we possibly can, while working on the strategies that we've discussed in our previous call of July 22.

Steven Becker - Greenway Capital

Well, obviously you guys are close to the business, you can make those decisions, but the idea of selling more product at a time when you are losing money on each product that you sell, obviously, is concerning to investors. So I think from an investor standpoint the sooner we can get clarity on when that business can at least be breakeven, the better and in future conference calls it would be really helpful if you guys could disclose that data so the investors have an opportunity to question you publicly on.

Rick Gilbert

Good point and I do want to make the point that we do not lose money on each product that we sell.

Brian Cooper

Incrementally, we are making money when we sell more product. We just have a lot of costs that are needed to be covered and the business has improved a great deal.

Rick Gilbert

Your point is well taken and we will look at that for future calls.

Operator

The next question comes from Richard Greulich from REG Capital. Please go ahead.

Richard Greulich - REG Capital

Good morning. Am I correct in looking at the CNS business and saying that the non-Verizon business grew sequentially quarter-to-quarter?

Brian Cooper

Yes. It did.

Richard Greulich - REG Capital

And that that business has obviously a higher gross margin, so the non-Verizon business in the CNS business gross margin was over 30%?

Brian Cooper

That's sounds high, but it is significantly better. Yes.

Richard Greulich - REG Capital

Why was that stronger quarter-to-quarter?

Brian Cooper

We had a number of factors working in our favor. It's what our customers ordered and we had some opportunities to fill-in in the marketplace and pick up some business and we did that.

Richard Greulich - REG Capital

And as you've indicated in your prepared remarks that the order pattern was strong and backlog was higher there now is that correct?

Brian Cooper

That's correct.

Richard Greulich - REG Capital

Why would backlog extend out like six months or so? Is that due to, you are not having it in inventory or just due to the taking schedule of the customer?

Rick Gilbert

That's a good question and that's not the case at. These customers typically order months and months in advance, first of all, and they have to, because the lead times for building the product, in some cases lead times for components can be almost six months. So, we buy to forecast and we buy to orders. Right? And the good news is that we have a very healthy flow, backlog of orders from our largest customers and we've been very good at delivering the equipment on the dates requested by our customers. In fact, I think we've been almost perfect.

Richard Greulich - REG Capital

It looks to me like the sales to Verizon are significantly lower what the actual usage or the placement of the product would be?

Rick Gilbert

Well, I think the thing you have to be careful of is, we don't do anything artificial to try to force orders into one quarter or another. We take orders when they come and we ship when people want the shipments. And so, periodically you have a quarter that looks artificially lower than the real [flow] and I think you have to look at it over a multi-quarter timeframe to really get the numbers.

Richard Greulich - REG Capital

But, I guess, my question that is, I mean certainly Verizon's expansion of the their FiOS business was not down 70% quarter-over-quarter, so is it likely that that business will actually pick up at a more steady state basis then?

Rick Gilbert

Well, again I am not speaking for the Verizon, but I suspect the situation is that they had enough inventory to meet the needs they had on a instantaneous basis. And again, we haven't been talking about orders that we've received for this current quarter, but you can get orders that come in on the quarter boundary or something, that make things look artificially low, and that's the right answer.

Operator

And our next question comes from Jim Stone from PSK Advisors. Please go ahead.

James Stone - PSK Advisors

I used to follow Westell years ago, and catching up because it looks like you are doing a good job to me, turning the company profitable. My question is really related to what's happening? What are you looking forward to, say you have recovered probably out of the woods now. Is it actual sales, is it stimulus money coming through somewhere, what sort of events will really help you to say, we're really out of trouble?

Rick Gilbert

Well, Jim, I think we've looked at it as a two-stage process, since Brian and I have been here. Stage one was making sure that we are riding the tactical plan, which we see as about a year long plan, as well as we possibly could in terms of the basic blocking and tackling of the business. And so focusing, especially, in this economy on the bottom line, making sure that we are turning the business to be profitable on a consolidated basis, generating enough free cash flow, so that we're increasing in our cash reserves.

All those things are important. I think we've been executing well on those things, but the real thing that turns the business at an inflection point is execution of some of the strategies that we talked about in the July 22nd meeting and just briefly reiterate those strategies. In CNS, as I've said, it's very important for CNS to start generating software business, because it's higher margin, it allows us to offset lower margin hardware, it allows us to exploit the hardware and the channels. And if we can start generating software-based business into reasonable number, we can turn that business to be profitable and I think that's our primary goal as a separate business unit.

In terms of Outside Plant, I mean they have essentially this old T1, DS3 base business that's still going along, but their real focus has been on new types of customers and new businesses, in wireless backhaul, and smart grid applications and those things take time, as we've said, to develop, but that's where they are focused. And so, that needs to come along.

And then finally, in ConferencePlus, because of the scale that ConferencePlus has, their asset is the quality of their conferencing services, which is better than anyone. And what they needed to do is find those customers that value the quality and find those vertical markets, exploit those vertical markets, like healthcare and legal for instance that require the kind of quality of service that ConferencePlus provides. And those are the three strategies and each division needs to execute well to really change the whole picture from just running the company on a good cost basis.

James Stone - PSK Advisors

What I'm reading into this then that you say we are really depending more on the economy than your new product or a particular customer working through their inventory, these sorts of things?

Rick Gilbert

No, I mean, let's say the exact opposite. I think these strategies do depend on fundamental changes in the way that we do business in the three divisions. We do recognize, however, and I think you bring up an interesting point that I would like to focus on, that we believe the economy is still far from recovered, at least in our business areas. All right? And we have seen effects from the current economy, without any doubt whatsoever at least in Outside Plant and ConferencePlus. And so, in those timeframes, we need to run the company very, very carefully to meet our goals of profitability on a consolidated basis and generating cash. Should like to see the economy change around, but we're not counting on it, so.

Operator

The next question comes from Jeff Linroth from Leaving It Better, LLC. Please go ahead.

Jeff Linroth - Leaving It Better, LLC

My question is about credit markets and the availability of credit. Obviously, you are not really relying on that in any great measure, but some of your important customers might be relying on that. Would you talk about, if we have a significant increase in cost of borrowing in a short period of time how that might affect your customer's ability and willingness to order it from you. and I am not thinking about consumables, I am thinking more about large scale ordering.

Rick Gilbert

I can take a shot at that Jeff, I think first of all you are right, the credit markets don't have as direct a bearing on us because of our cash position. The second thing I would say is, we have some very, very strong, very large customers. So, they are very financially sound and I think the credit markets are less likely to impact them. That said, I guess the cost of money change that could change willingness to invest in capital and so forth. So I could see an indirect effect there. There are some of our customers that probably have a greater credit exposure, but I don't think it will have a material impact on our business in any kind of direct linkage

at least.

Jeff Linroth - Leaving It Better, LLC

Okay. Good. Thanks for that. Independent of credit and it's availability and cost, do you think the economy, do you see a slowdown in some of your significant customers as a result of them, more a result of them a, trying to really optimize inventory or do you sense that they are experiencing a softening in demand alongside that or which of those factors would you assign that, your comments that you anticipate softness, how would you characterize that among those two scenarios?

Rick Gilbert

Jeff, that's a great. I think that there is no doubt and I'll use example of Outside Plant that we have seen customers trying to optimize their inventory right down to the truck level, right. They are really trying to maintain the smallest inventories they require. And I think that's almost been a lagging thing for our area versus the economy. I think these companies moved slowly and they finally got into the point of reacting to the economy, saying, "Okay. Let's use all the inventory we have." Okay. And that can lead to exactly the kind of thing that Outside Plant saw in the second quarter, which is a slowdown from some customers in restocking orders. And the good news about that is, once everything is gone the restocking orders tend to be pretty nice. So we have to watch for that effect coming along.

The other aspect of your question, the place I would expect that to happen most would be in CNS, on consumers actually buying broadband services, or premier broadband services. Okay. And I think that that is a risk and we certainly watch things going forward, but as I said, we have a good solid order pipeline right now for CNS. And so, so far so good.

Brian Cooper

Yes. And then, obviously, ConferencePlus is a services business, so there isn't the inventory impact, but they are experiencing lower demand and you can see the link to the economy there. There is less travel, so little more demand for conferencing services, but that's offset by fewer people in the marketplace and companies really trying to tighten down on their expenses.

Operator

Next question comes from [Madhu Kodali] from Fertilemind Capital. Please go ahead.

Madhu Kodali - Fertilemind Capital

Got a few questions, little new to story and learn a little more about the UltraLine Series3. I see that pressure on the margins, and I am trying to understand, you have looks like Verizon as a major customer and probably AT&T and others. I am trying to understand, what's you percentage of revenue that you get in CNS from UltraLine, Gateway is question number one? And the second question is whether Verizon or AT&T do they exclusively use your product on their service segment or do they use you and others, and do you compete with in that market?

Rick Gilbert

Yes. And I will answer the second question first. In fact all our large customers, we sell to most of the copper based broadband suppliers in the U.S. not just the ILECs that you mentioned, but also the large IOCs, which some of them are quite large. None of them have single source for broadband equipment, it's too dangerous for them, so they at least have two sources, sometimes three. Okay. And we have very strong market shares in several of those large customers, but they aren't exclusive. Okay. In the other area that you asked, I mean I am not sure we breakdown individual percentage of specific products for specific customers. I don't think our customers will be too wild about that, and I think what you will see in the Q is the percentage that we get from a specific large customers, and Verizon is...

Brian Cooper

I think you are asking about the UltraLine Series3 in particular. That's effectively what we break out because of the accounting issues that we've experienced on revenue recognition. And of course, that has fluctuated a fair amount, so that percentage of CNS's revenue would also fluctuate. But I think you can look at CNS's revenue this quarter of 24 million and we've shown you the portion that's revenue recognition, that's lion share of the UltraLine Series3 sales that we have this quarter.

Madhu Kodali - Fertilemind Capital

What's ASP UltraLine Series3, if you can give some indication on that and probably if you can tell us, if you did 24 million, at 17.5% gross margin and you are losing some money, at what revenue run rate do you think that business unit will become profitable?

Rick Gilbert

Well, depends on the mix of the products obviously. And so, to your second question, impossible to answer, that actually going into various mix metrics. And the first question, I am sorry, but ASPs are something that we simply can't disclose due to contractual agreements with our customers.

Madhu Kodali - Fertilemind Capital

Let me ask you in a different way. Could you tell us how many units have you shipped this quarter?

Brian Cooper

(Inaudible) with the same thing, so we really don't go to that detail. I mean...

Rick Gilbert

I can tell you that Westell shipped over its history something like 20 million broadband units, so we ship a lot, but yes, we don't go down to unit shipments in per quarter.

Brian Cooper

And I understand what you are trying to get at here. Certainly, one of the reasons we don't look at the topline that's required to get CNS profitable is because it could probably be profitable with the current topline if we are selling the right way, the right things, with the right margins and we are working on that. And we are steadily cutting the losses that we were taking there. After we do our allocations for this quarter, I think you'll end up (inaudible) when we put it together in our Q that, the loss for CNS is probably under $400,000 for the quarter. I mean it's a dramatic improvement from where it had been. So, if (inaudible) that gives you a little sense for where we are going with it.

Madhu Kodali - Fertilemind Capital

May be can you throw some light on the market itself, what is the market in terms of number of units being shipped from third party analyst report and what sort of market share do you guys have?

Rick Gilbert

Actually I think, I would refer it for you to the third party analyst reports. I mean I guess it's dangerous to share what we consider internal information on market shares and such and the analysts talked to the customers and a wider group of people and probably have as accurate information as anyone.

Madhu Kodali - Fertilemind Capital

I think one thing you missed is, I was also trying to find out who do you directly compete in that particular space?

Rick Gilbert

That depends on the customer and it depends on the type of product, but big competitors for us are people like Motorola, 2Wire, Actiontec those are probably our biggest three competitors depending on customer.

Madhu Kodali - Fertilemind Capital

Thank you. One last question. I see the strategy to add software and improve margins, what gives you confidence that customers are going to one, buy your software, and two, pay higher prices for that?

Rick Gilbert

Well, I think we look at the kinds of products that we are providing for these networks, which are essentially very capable home gateways, that have line speed routers, that are connected to all the equipment in the home over the cable or Ethernet, and have enough processing power, and with enough memory added can have very sophisticated home-based applications. We see that as an opportunity and we see a market amongst the consumers that could be quite interesting in that area. And whether we supply it or somebody else does, I think it's going to happen. So we are focused on that.

Madhu Kodali - Fertilemind Capital

Is it (inaudible) to compete with the other players in the market that have additional software already or is there something new that you're trying to achieve?

Rick Gilbert

Well, we're trying to achieve software applications on the gateways themselves. I think a lot of the other players in the market to have very specific brands, and they are trying to defend, and we see it more as device independent, brand independent, which is another thing that I think consumers are interested in. So there's a big differentiating factor there.

Madhu Kodali - Fertilemind Capital

I'm sorry. I couldn't quite get what the differentiating factor from your product...

Rick Gilbert

For instance, Apple has a lot of software, right? Apple's goal is that you use everything in the home is Apple, right?

Madhu Kodali - Fertilemind Capital

Right.

Rick Gilbert

And consumers don't necessarily do that. They have got PCs, they've got Apples, they've got picture frames and all, they've got thermostats, they've lights, they've got nanny cams. And the point is, that if you have a very capable home gateway, the ability to integrate those things into a single user experience, we are in a better position to do it than somebody who's trying to defend a specific brand of in-home equipment.

Madhu Kodali - Fertilemind Capital

So these software features, are they (inaudible) help user experience or is it more for carriers to control and manage the modem?

Rick Gilbert

Well, I think from the carrier perspective, they would like to control and manage as much in the home as they possibly can through the broadband connection. From the user's perspective, I mean put yourself in that position, do you want to be able to control a lot of the equipment in your home through a common portal and a common user experience. And that's what we see as an emerging market. It's almost like cloud-based computing in the home. Okay. And we find that quite interesting and an area that we think that there is going to be a very good market in the future. And I think we need to move on. Thank you for your questions, however.

Operator

The next question comes from Peter Schneider from Peninsular Capital. Please go ahead.

Peter Schneider - Peninsular Capital

Yes, I'm wondering that both AT&T and Verizon, if you have idea how often if they roll a truck every time they replace a product, and the reason for my question is that Actiontec from the FAQ's that are out there seems to be getting a lot of rejects within the Verizon account and I am just wondering if the truck rolls when they replace it with a Westell product?

Rick Gilbert

It depends on the exact product, but a lot of the products are installed by users without truck rolls. Okay. I think you call or you can go talk to the individual carriers, but I'd say the large portion of products that are installed are installed without truck rolls

Brian Cooper

That said, there is a real cost obviously to having to replace a product.

Rick Gilbert

Yes. Not necessarily, just the truck.

Peter Schneider - Peninsular Capital

I understand. Secondly, what is the length of term of the Verizon contract? How long does that contract last?

Rick Gilbert

The original contract was of three-year term, with a one year extension option, okay, and on the UltraLine Series 3. All right.

Operator

The next question comes from Richard Greulich from REG Capital. Please go ahead.

Richard Greulich - REG Capital

Thank you. If you introduce the use of software features are you able to go into units that are already field deployed and utilize them?

Rick Gilbert

Yes, to the extent that there is enough memory in the units to run the particular features and there is enough memory to run a lot of the applications, but some of the applications will require additional memory, which would be different, either a supplementary unit or a different unit would be installed.

Richard Greulich - REG Capital

Are the current units that are being shipped incorporating more memory than ones just a couple of quarters ago?

Rick Gilbert

I don't believe so, actually, I mean, by the way these things aren't memory stripped. I mean they have plenty of memory in them, it's just that for some of the applications you'd might want lot more and we recognize that for some of the premier users there, there may be the opportunity for something that has more memory in it.

Richard Greulich - REG Capital

What would be the software applications that would be most likely to be near term?

Rick Gilbert

Well, the applications that we've done some demo applications that we've been working on, that are in the area of security, in the area of control of devices like lights, thermostats and such, in the area of monitoring staff, and we are also working on somewhere, much more ambitious stuff which has to do with storage of data in the common formats, from different, different devices different brands. So think of the type of things you do in the cloud computing and then think of the applications of those things in home environments.

Brian Cooper

I think we're also doing some sort of behind the scenes applications that just help the network product customer to be a little more efficient.

Richard Greulich - REG Capital

Then likely would we see announcements if people begin to utilize what you want to have offered or would that not be announced?

Rick Gilbert

Well. I assume when such things are made available they will be announced, but the point is, I don't want to give you the impression that they are going to be announced next week. I mean this is a long-term development program that's focused on a very sophisticated set of software. And we've gotten to the point where we've demos essentially. And we know we can do it, but we are long way away from I think products and really significant product revenue in that area.

Richard Greulich - REG Capital

And just to ask clarify, you said that the company would likely be profitable unless you get a significant deterioration from here. Is that correct in the next couple of quarters?

Rick Gilbert

Well, I said that we expect the next two quarters to be profitable, okay, at this time. We do expect them to be perhaps less profitable than the last two quarters, which were surprisingly good for us.

Operator

The next question comes from (inaudible). Please go ahead.

Unidentified Analyst

Hi. Couple of questions. I think your words were a little bit worried about the pace at which software revenue in the CNS business might develop and that sounded like its' perhaps on the margin little bit more pessimistic view of that. I am just wondering if there any particular a, whether I am reading that right, and b, are there any particular influences that make you feel that way, is that a tender issue, is it a product capability, is it the difficulty you getting the software to behave as you wish? Just a more color.

Rick Gilbert

To be honest Brian it perhaps comes from the last 25 years of producing products and realizing that everything takes longer than you initially think. The reality is, as Steven said earlier in his question, I mean, we are sitting with a division that has a lot of revenue that's bearing barely profitable, if profitable. And what I was really saying is that I would like to see us move to software as fast as we possibly can. And that said, I know how hard it is to transition businesses from hardware to software. It's possible, and we are working on it, but it's non instantaneous. And so, all things being equal, I wish the pace were even faster.

Unidentified Analyst

Then to follow-up on USP part of the business. The weakness in the E1or the T1, DS3 demand, are you able to kind of have a sense as to how much of that is truly cyclical versus may be a secular preference for fiber or other kinds of connectivity?

Rick Gilbert

Boy, that's a really good question. Certainly some of it is seasonal. You can go back and actually look at the quarters that this company has had had in the past and you can see that we are in that season, where there tends to be slowdown anyway. The kinds of people that are buying the equipment from Outside Plant, the big companies have calendar-based budgets in many cases, and as they get toward the end of the year they start shedding down budget spending. So, certainly some of it is seasonal. However, T1 and DS3 are products that we are little less focused on as we've said in the past anyway, because we see those as being legacy harvest type of products, and we do expect them overtime to slowdown anyway. Although, we think that ramp is pretty slow and predictable.

Unidentified Analyst

On the newer business opportunities there in terms of backhaul and smart grid, has that stuff slowed down a little bit more than you thought or can you just comment on or give us some color there on what the demand patterns look like?

Rick Gilbert

The backhaul is going well. The stuff we've have done smart grid has been put in trials, but the trials are taking longer than we were originally told they take. It has nothing to do with products, at least our products, but I think Outside Plant is disappointed in the rate of progress in some of the trials for the smart grid.

Operator

The next question comes from Steven Becker from Greenway Capital. Please go ahead.

Steven Becker - Greenway Capital

I just want to clarify, because I think Brian answered the follow-up question with a specific number on the loss or his estimate of what the loss will look like in the CNS business and I thought I heard 400,000 is that correct?

Brian Cooper

I said, it would be less than that.

Steven Becker - Greenway Capital

So it would be less than 400,000 for that business.

Brian Cooper

Yes.

Steven Becker - Greenway Capital

Today are you selling any products that have a software component in that business?

Brian Cooper

That's actually part of what the cause of our revenue recognition issue is, there is a software component to the UltraLine Series3 and some potentially additional software to go with it.

Steven Becker - Greenway Capital

How would you quantify what percentage of the overall product mix has what you would consider to be acceptable margins?

Rick Gilbert

In CNS only?

Steven Becker - Greenway Capital

If any, yes. In CNS, yes.

Rick Gilbert

Gosh. How you define acceptable margin? I mean broadband equipment business always has slim margins, ridiculously slim margins. I think the test is can you get it profitable, and not on a gross margin basis, but on a fully allocated basis.

Brian Cooper

I'm not sure how to answer it either.

Steven Becker - Greenway Capital

Well I mean I guess it sounds like you're not selling anything today that has high enough margins that it would make you that happy.

Brian Cooper

Nothing that we would dance in the streets about.

Steven Becker - Greenway Capital

On the Outside Plant business, my understanding is, there's a fairly significant amount of that revenue stream that is directly related to the wireless backhaul issue, are you kind of not seeing the effects of that, that other vendors into that space or how should I look at that?

Rick Gilbert

No. I think, there's a portion of that business, a significant portion of the business is wireless backhaul related. I haven't really compared ourselves to other vendors, because I think that when you talk about wireless backhaul, wireless backhaul is made up of the hell of a lot of things and we play in a small piece of it. But I believe the Outside Plant people are feeling good about the wireless backhaul area, it's just a matter of the people they sell to are exactly those of kind of companies that as I said, as come close to the end of the year tend to slow down their purchasing.

Steven Becker - Greenway Capital

Other than the ordinary seasonality, is that a business that we should expect to see growth from in a steady state environment?

Rick Gilbert

Yes, absolutely. And I mean the product is a great product. All right? So there are not many product problems in that product or any of the other Outside Plant products. In fact, they are very popular, it's just a I think they're seeing (inaudible) affects from seasonality and to some extent the economy.

Operator

The next question comes from Jeff Linroth from Leaving It Better, LLC. Please go ahead.

Jeff Linroth - Leaving It Better, LLC

Yes, just one more. Based on the evolution that you are working on CNS to really bring the software and services piece in here, do you imagine and have you had conversations about the retail channel being a greater or a lesser prospect down the road?

Rick Gilbert

The retail channel.

Jeff Linroth - Leaving It Better, LLC

Yes.

Rick Gilbert

I think we'll try to avoid retail channel, because I think it's not something that's one of the core competencies of this Company and I think that the volumes that we would like to do are best done through channels that we already have, the carrier channels. Remember the devices you'd like to run this stuff on are operated by the carriers, right. So they really have to be a part of the distribution solution.

Rick Gilbert

Thank you everyone for joining us on the call and we'll look for you in the next quarter.

Operator

This concludes the Westell Technologies second quarter fiscal year 2010 earning conference call. Thank you for your participation. You may all disconnect at this time.

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Source: Westell Technologies, Inc. F2Q10 (Qtr End 10/30/2009) Earnings Call Transcript
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