MRV Communications, Inc. Q3 2009 Earnings Call Transcript

MRV Communications, Inc. (MRVC)

Q3 2009 Earnings Call

November 9, 2009 5:00 pm ET

Executives

Anne-Marie Frisch - IR

Noam Lotan - CEO

Guy Avidan - President of Network Equipment

Near Margalit - CEO of Source Photonics

Chris King - CFO

Analysts

Greg Waters - Investors Asset Management

Jim stone - PSK Advisors

Presentation

Operator

Welcome to the MRV Communications first nine months financial results 2009 conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded today Monday, November 9 of 2009.

And I would now like to turn the conference over to Anne-Marie Frisch, Investor Relations. Please go ahead, ma'am.

Anne-Marie Frisch

Thank you, Britney. Good afternoon, everyone, and thank you for joining today's conference call to discuss MRV's third quarter and nine months of 2009 financial results. I am joined today by Noam Lotan, CEO; Guy Avidan, President of Network Equipment; Near Margalit, CEO of Source Photonics; and Chris King, our CFO.

Noam will provide you an overview of our consolidated results, the state of our markets, our strategy and overview of our Integration business. Guy will provide you with an overview of our Network Equipment business for the first nine months of 2009; and Near will review the performance of our Source Photonics business. Chris will then provide you with a more detailed look at our financial results.

This call is being webcast live on the Investor Relations section of the company's website at mrv.com. A replay of the webcast will be available on the company's website for approximately 90 days.

Additionally, this call is being recorded and a replay of this call can be accessed by phone and will be available approximately two hours after the conclusion of this call. The phone replay will be available for one week.

Earlier this afternoon, the company issued a press release reporting its financial results for its first nine months of 2009 ended September 30, 2009. This release may be found on the company's website at mrv.com or on the Form 8-K we filed today with the SEC. Additionally, there is a presentation on the Investor section of the website that corresponds with today's call.

During the course of today's call, MRV's management may make forward-looking statements about financial and business guidance, product introductions, customer development and the plans and objectives of management for future operations and the company's future economic performance. These statements, which can be identified when they are in the context of words such as may, will, expect, intends, plans, believes, targets, estimates, forecast and variations of these words or use of these words of similar import reflects management's current judgment on those issues.

Because these statements deal with future events, they are subject to risk and uncertainties that could cause the actual results to differ materially. In addition to these factors that may be discussed during the call and those contained in the press release issued earlier today, important factors that could cause actual results to differ materially are contained in the company's Form 10-Qs and 10-Ks which are on file with the SEC and are available on our website. Any future product feature or related specification that may be referenced in today's call are for information purposes only and are not commitments to deliver any technology or enhancements. MRV reserves the right to modify future product plans at any time.

Additional risks not known to us may also impair our business or results of operations, and may prevent us from realizing our current expectations. By discussing the current perception of our markets and making these forward-looking statements, we are not undertaking obligation to provide any updates in the future.

I would now like to turn the call over to Noam Lotan, MRV's CEO.

Noam Lotan

Thank you, Anne-Marie. Good afternoon and thank you for joining us today for our third quarter '09 conference call. I'm very pleased to be on the call to share our results with you and I would like to thank you all for your continued and loyal support. It's great to be back. But I have to warn you, to make-up for lost time today, our prepared remarks will be a bit longer than usual.

On this call, I will highlight the financial and business performance for '09 and make some comments about our future. This will be followed by our two Co-Presidents, Guy and Near, who will discuss their business units and by our recently appointed CFO, Chris King.

But before going into '09, I want to highlight some of 2008 achievements. First, we grew revenue by 20% to a record of $538 million. In fact, revenue nearly doubled in the past four years from $272 million in '04. All three operating segments: Network Equipment, Network Integration and Optical Components demonstrated solid performance resulting in a profitable second quarter.

For the Network Equipment group, '08 was a turnaround year, revenue was up almost 30% for the first nine months, and nearly 20% for the entire year. Net of the $6 million one-time impairment charge for 1998 acquisition, Network Equipment was solidly profitable. But it was too early to celebrate, from mid-2008 and still now, we operate in the shadows of the challenging economic environment.

However, '09 results for the third quarter and year-to-date definitely speak for themselves. In '09, we saw the impacts of the recession in all three segments.

In Network Equipment, revenue declined worldwide, but more so in North America. Still Network Equipment was able to perform well and generate profit in Q3. In Network Integration revenue declined, nevertheless operating income was a record high. Then in Optical Components, multiple challenges forced us to execute the major rebuilding and business transformation at Source Photonics. Near will discuss this in a few minutes.

Consolidated revenue for the first nine months of '09 decreased by 9% from the same period in the prior year. We're certainly not pleased with the decline, but in light of the global economy and relative to our peers, we fair better than many.

Revenue for the third quarter of '09 was $129 million, up 8% sequentially by the small 1% year-over-year decrease. Growth in Q3 was driven by Network Equipment and by Source Photonics.

On the bottom line, Q3 was near breakeven or a loss of approximately $0.5 million. Bear in mind, that it includes restatement related expenses of $1.4 million incurred during the quarter. The achievement that I am most proud of in '09 are the following: Despite the challenging environment, which brought Network Equipment revenue down by 22%, gross margin was up by two points, OpEx was reduced 11%, and operating loss for the nine months was $1.4 million, and Network Equipment returned to profitability in Q3.

Network Integration executed extremely well and produced a record of $12.2 million in operating profit year-to-date, up from $7.5 million last year. Successful results in Network Integration came from the multiple actions that managements undertook. These include introducing new product with higher margins, obtaining concessions from existing suppliers. But perhaps the most important thing is the expansion of services, which account for a larger percentage of revenue, in some cases one-third of revenue.

Optical Components have truly engineered much of the turnaround by the real business transformation in spite of an incredibly challenging situation. Throughout 2009, like most of our peers, we made efforts to control expenses and reduce costs. We've taken action with a dual purpose; a) to make certain we make it through the recession, and b) to assure that we emerge from it with the ability to grow and regain momentum. We are determined to continue to do so in order to align the company to be consistently profitable, self-funding and relevant to our customers.

For the third quarter, consolidated results we report today show that we're able to keep revenue from declining, improved gross margin by nearly four points and reduced operating expenses by $10 million or 23% for the quarter.

Year-to-date operating expense was reduced by $20 million or 16%. Expense reduction and gross margin improvements were realized in each of the three business unit, resulting in a near breakeven of consolidated bottom line for the quarter, including restatement related expenses.

While we're still in the recession, especially in the U.S., we're encouraged by our performance and the sequential growth from Q2 to Q3, which is also leading into the fourth quarter. Although, we are by no mean out of the woods, there are reasons to believe that the worst is behind us. We see positive signs of growth across all our operating segments.

That being said, our markets is yet to fully recover and so we remain very cautiously optimistic about our growth prospects for 2010. More importantly, profitability will remain our main focus.

Sometimes shareholders ask me, how this three business units connect? How they fit in the overall division? I'm happy to elaborate during Q&A, but suffice to say that the Network Equipment segment has high margins and high growth potential. The Network Integration segment provides access to Tier 1 carriers in Europe, while it also self-support and services as well as third-party equipment. This segment has demonstrated slower growth over the years, but has been consistently profitable and performed well in the current recession.

Source Photonics, our Optical Components reporting segment is an independent wholly-owned subsidiary, which was in the process of going public in June of '08. When MRV announced the need to restate its past financial results, the IPO had to be withdrawn.

Looking at the future, the market we serve will continue to expand as demand for higher bandwidth and user mobility dictate ongoing investment in carrier infrastructure.

Success depends on three key factors: first, our first-rate management team and our dedicated employees worldwide. Second, our ability to connect technologies to market and deliver value to customers. Third, a relentless focus on profitability.

Sustained profitability is also key to our return to NASDAQ, as we will need to satisfy all the requirements for new listing, including a $4 share price. To ensure solid execution and sustained profitability, I recently mentioned in my 2008 annual letter to stockholders that, "the Board of Directors believe that a strong independent leadership is important to drive the company's business and support our ongoing initiatives, improving the company's corporate governance has been a key focus for 2009."

Accordingly, we have taken major steps to enhance our management team and add diversity and talent to our Board. Here are the important changes. Number one, we increased the size of the Board to 10 and nominated experienced members to improve corporate governance and oversight. We also proposed an independent chairperson.

Number two, we separated the CEO and President position and appointed two Co-Presidents. Number three, we promoted several capable individuals from within the organization, including Chris King, our new CFO; Blima Tuller, Vice President of Finance; and Joel Freedenberg, our new Vice President of Human Resources.

Number four, we appointed Jennifer Painter, as General Counsel; and Donna Boswell, as Director of Internal Audit. Donna reports directly to the Audit Committee.

Additionally, later this week, following our annual meeting on November 11, the majority of the Board will be new and an independent chairperson of the Board will be elected. We believe this [realignment] of management Board and Board structure will more effectively leverage each member's expertise and strong experience, as well as bring new insight and perspective.

Before I address the make-up of the new Board, I would like to take this opportunity to thank outgoing Directors, Harold Furchtgott-Roth, Guenter Jaensch and Dan Tsui will not stand-in for the reelection. These outstanding individuals have made significant contributions to the company over years of dedicated service.

Our new Board will now consist of 10 Directors, two of which have recently joined and four will join on Wednesday. I've met with each new Director and I'm excited for the opportunity to work closely with them. The new additions have carefully researched MRV, including reaching out the customers and shareholders. Their basic conclusion is that MRV has tremendous potential for delivering value to customers and value to shareholders.

Our management team agrees and we're encouraged by their belief in MRV's future. We look forward to working with them.

We intend to file Form 10-Q for the three quarters year-to-date shortly. We view it as a fresh start for MRV after a long and arduous process. While the past year-and-a-half has certainly been challenging, it also has provided us with the opportunity to closely evaluate the company and identify ways to become a stronger organization.

I will now turn the call over to Guy Avidan for a short look at our Network Equipment business. Guy?

Guy Avidan

Thank you, Noam. I'd like to begin with my discussion by reviewing the progress that the Network Equipment group has made over the past three years. Fiscal year 2007 was the low point for the Network Equipment. We lost $8.3 million for the year on a $105 million in revenue.

In response, we reevaluated our business and operating structure, and put a plan in place to address this. The plan included: one, invest in our sales team and training the step-up effort to increase our top line. Two, improve margin by focusing on high margin product in our offering and manufacturing cost reductions. Three, reduce our operating expenses as a percentage of revenue, primarily by growing sales while keeping OpEx constant.

In 2008, we started to see the results of our efforts delivering an operating profit for both Q2 and Q3 on record revenue. It is important to note that while revenue grew during those two quarters, operating expenses as a percentage of revenue decreased significantly from the same quarter in the prior year.

I mentioned this as we view these two quarters as milestones for the Network Equipment group, demonstrating that we are on the right track with our model. Unfortunately, 2008 through the industry (inaudible).

The impact of the recession hit us in Q4 driven by reduced demand in North America, resulting in lower investment in carrier network infrastructure, labor commission and WDM infrastructure. The demand for our legacy product held strong. The Q4 '08 challenges lead us into loss for the quarter and the year, but reduce our 2007 loss from $8.3 million to $1.4 million in fiscal 2008.

Although the depressed demand for Network Equipment product in North America continued into 2009 and our top line suffered, we identified ways to reduce cost without compromising innovation. As a result, we maintained margins for the most parts, reduced operating expenses, minimize our operating losses, and managed to deliver a profit in the third quarter.

We're very proud of the improvements that have been made and have confidence in the strength and resiliency of our operating structure.

Although we're encouraged by the modest sequential growth from Q2 to Q3 and by the positive signs for growth that we see for Q4, we will continue to identify ways to build resiliency and flexibility to create robust operating structure.

What has changed from 2007 to 2009 that enable us to deliver profitability on the same revenue? Focus. We're much more disciplined in targeting our efforts with zeal.

We're focused on strategic investment and product launches mindfully connecting our technology to the right market and leveraging our diversified product line. We realign our R&D and marketing dollars to focus on our strategic market, optical transport and metro Ethernet.

One of the fast-growing segment on those market is the wireless backhaul. The wireless backhaul help to grow and grow quickly to provide sufficient connectivity to the rapid growth in cellular traffic. Fixed mobile bandwidth fees and new technologies are driving growth and expansion of bandwidth-intensive mobile applications like video content download and sharing.

The current infrastructure is rapidly becoming saturated due to bandwidth capacity demand. In some markets, most of new demand for bandwidth is driven by mobile backhaul. The mobile backhaul can already observe 25% OpEx for mobile operators and any increasing costs such as for lease line is not tolerable. Many wireless carrier are now in process of building there own backhaul network or moving their lease line from TDM to packet, i.e. [net] through Ethernet, which can reduce cost up to one-third.

We believe MRV is well positioned and has the right product to address these needs. Migrating from TDM to packet usually generate dimension saving, except where a high quality of service is required. The end cost may hardly change because of the extra network engineering required. Our new series of product enables smooth migration from TDM to packet technology, ease of use in service provisioning and high efficiencies of quality of service and traffic engineering.

Last month, we announced a new provisioning and management software platform for our OptiSwitch product family to Maximize Intelligent Carrier Ethernet Demarcation Deployment. The Pro-Vision platform is a potential game changer for forward-thinking carrier who can leverage these provisioning flexibility to streamline network management and deployment, and position themselves for the next generation of advance service demarcation by their customers.

The Pro-Vision platform is a service provisioning, monitoring and troubleshooting task to be performed from an easy to use, centrally located network management application. We are excited about this new platform and the value it brings to our OptiSwitch customers.

With that, I will turn the call over to Near, for his review of our optical components.

Near Margalit

Thank you, Guy. I'd like to start by taking the time out today to outline the Source strategy and business model, and then I'll get into the review of some of our current performance. So let me start, our primary business is currently in two areas. These are PON transceivers for Fiber-to-the-Home and telecom transceivers for carrier networks.

To our best knowledge, we're the sixth largest supplier of transceivers, while being number one in some key segments such as Fiber-to-the-Home. In these markets, we compete along three main accesses. These are operational efficiency, technical innovation, and Tier 1 customer relationships. To have a successful profitable business, excellence in all three areas is required.

With respect to operational efficiency, many of our products have life cycles that are similar in nature to consumer electronics, with unrelenting price pressure and products quickly being replaced by newer generations, lower cost versions with more features.

To compete in such an environment, there are several key areas that need to be addressed. These include excellence in supply chain management, and operating structure that allows for solid profitability at modest gross margin and a cost down-oriented culture.

Many of our competitors in the Fiber-to-the-Home space are native Chinese or Taiwanese companies, well versed in low cost product development. As such, scale is a critical factor to effectively compete. To this end, we are the largest supplier of PON transceivers and telecom access transceivers.

For supply chain management, we have invested considerable time and money in developing and implementing best-in-class planning and operation systems. The results of some of these efforts are demonstrated in parameters such as inventory, access in obsolete inventory write-offs and customer satisfaction levels.

As an example, we experienced a 90% or $9 million drop in inventory from the end of last year, while at the same time increasing revenue.

Even more important, we are on track to meet below 1% excess in obsolete expense in 2009. We believe excess in obsolete write-offs are a major source of losses in the fiber optic industry. It is common to see two to 4% of revenue written-off as excess on obsolete industry, and such amounts are often not included in pro forma numbers.

Our efforts to [combat] are done through our sophisticated combination of off-the-shelf software planning system and in-house developed proprietary systems. Our Global VP of Supply Chain and Operational Planning, Dr. Amit Nagra, recently presented an Invited Talk at Oracle Open World, outlining some of these techniques. Because of the rapid nature of demand turnover and rapid cost down product introductions, we believe that our system will continue to be a competitive advantage for sometime to come.

This is true specifically when competing against some of our smaller Asia-based rivals that did not have the scale to invest in development of such systems. We've also executed our plans to consolidate and optimize our manufacturing operations. At the time of the Fiberxon acquisition, manufacturing for the combined the company was spread across close to a dozen contract manufacturers and in-house facilities. In the second half of 2008, our new Chengdu factory went online as scheduled. We shut down manufacturing at our [Schengen] location as well as many of our contract manufacturers.

Our operational model focused just on two main factories; one in Taiwan, where we have our advanced indium phosphide optoelectronic fab and packaging, and one in Chengdu, where we execute all other aspects of transceiver manufacturing.

Product manufacturing cycle times have dropped from several weeks down to less than a week. Finally, production volumes continue to contribute to operational efficiency. In the last quarter, we produced more than 1.5 million transceivers. Operational efficiency is obviously a never-ending task, but we believe we have been effectively executing and see it as one of our sustainable competitive advantage.

Now, let me address our progress in technical innovation. At our current run rates, we spend five to 6% of revenue on research and development or approximately $3.2 million a quarter. Although, this is quite a bit lower than many of our publicly-traded competitors, we believe that we generate significant leverages from this spend. We rely heavily on a real-time collaborative environment between our R&D centers. We have a small but focused and very advanced team in the U.S. collaborating on a daily basis with their Taiwanese and Mainland China counterparts. This allows for near around-the-clock development cycles and also best leverages the talents of each team.

Our R&D efforts focus on three functional areas of transceiver design. These are optoelectronic chips, optical sub assemblies and transceiver design. Our internal optoelectronics fab in Taiwan has made several important developments over the last year. We are now fully internally sourced on our DFB and APD chips for GPON market space.

We are also internally sourced on 10-gigabit per second lasers and receivers. Our fab is near 100% utilization and we've been making modest upgrades in capital equipment as volumes justify.

We've also active development projects on chips for higher speed and longer distance applications. For optical sub assembly, we've developed cooled XMD packaging technology for 40 and 80 kilometer 10-gigabit per second transceivers. We continue to put significant development into 10 and 40-gig technologies as they represent significant potential for future revenue streams for Source.

We've also developed a unique low cost packaging technology for 40-gigabit per second [CSP] type transceivers.

Finally for transceiver design, we recently announced several products using 10-gigabit per second technology. These are the 300 pin small form factor tunable transponder, and both ONT and OLT transceivers for next generation 10-gigabit per second Fiber-to-the-Home. Both these projects will be expected to generate revenue in 2010.

We also have active development in 40-gigabit technology transceivers as well it is expect to provide announcements on that shortly.

We are committed to having technical innovation as a core principle in the Source culture. As our gross margins percent improved above the 20% level, we expect to increase spending to the seven to 8% of revenue on R&D as a long-term model.

Now moving on to customers and markets; there has been a substantial shift in our product sales towards the China system providers. In 2007, China represented less than one quarter of our product sales. In 2009, we expect close to half of our product sales to be made to China domestic customers.

Our 10% customers for this first nine months of 2009 are as follows; Huawei at 20%, ZTE at 19%, Alcatel-Lucent at 15%, Motorola at 11% and Tellabs at 10%. The China customer base had 135% revenue growth, while the rest of the world shrank by 37%.

Having a large majority of our support and R&D staff in China has made engagement with these fast-growing China customers very successful. The service demands of global large-scale system manufacturers continue to increase. We continue to see these service and support requirements as significant barriers to our smaller competitors.

There is room for improvement, but we are on the right track. Improvement of our relationship with the other four or five major global Tier 1 telecom system providers is a growth opportunity for us.

To summarize, our strategy relies on sustainable competitive advantages along three primary competitive accesses. Rely on the unique blend of U.S. and Asia development for technical innovation. We have the scales and systems to provide best-in-class operational efficiency. Finally, we have deeply engaged with the fastest growing system manufacturers in the world.

Now let me go over some history and context before reviewing the Q3 results.

As many of our competitors, when the recession hit last year, our business performance degraded significantly. As revenue began to shrink in the industry, smaller companies were very aggressive in trying to maintain the revenue levels and dump excess inventory. This resulted in severe price competition during this period. At the same time, we were incurring higher than usual manufacturing overhead costs as we incurred both cost for contract manufacturers, and the full costs of integrating our own facilities. The results of which was three quarters, starting in Q3 of 2008, a really depressed gross margins at subsequent operating losses.

This was an unfortunate confluence of a market decline at a critical point where Source Photonics was realigning its manufacturing strategy to maximize efficiency in the future.

Given that background, we believe we have made significant progress in the second half of 2009. The factory transfer costs and management bandwidth associated with it are no longer issues. The problems associated with the former Fiberxon management team have been cleaned up. We're back focused on cost down and new product introductions. We have a stable and unified complete management team that does not include any of the original Fiberxon management team members.

We are meeting our operating cost target of 15% excluding non-cash related to amortization and goodwill write-off. Our primary challenges now are to continue to drive growth and bring gross margins into the 25% range.

To this end, recently we also pushed back very hard on customers with products that had gross margins below 15%. In some cases, this meant losing unprofitable business. In some cases, there were some compromise made with our customers to get levels above 15% gross margin level.

We are carefully now balancing the revenue loss or gain versus the gross margin impact in competing end market segments with very aggressive pricing. This will be an ongoing trade-off between revenue growth and gross margins percentage. As many product segments have irrational pricing by small companies trying to compete with larger, more established competitors.

Now specifically in Q3, revenue for the quarter was $55.9 million, a 14% growth over the same period last year, or 12% growth over the previous quarter. This growth was positively contributed by a large deployment by 3G wireless carrier in China that was using 2.5-gigabit per second metro transceivers.

Operating expenses were $8.4 million in the third quarter and gross margin came in at $9.6 million, or 17% of revenue. Operating income was a profit of $1.2 million, which includes $1.8 million of depreciation, amortization, and also includes stock-based compensation expense of $188,000.

We expect the long-term average spending on capital equipment to be in the two to 3% range of revenue.

Now let me turn the call back over to Chris for our financial performance.

Chris King

Thank you, Near. As many of you know, I have spent much of my time since joining MRV working on the restatement. I am very happy to be putting that period behind us, and excited to be joining the earnings call for the first time as CFO.

More importantly, I'm happy that we are able to resume regular calls with our investors. I'm also excited to have more time to focus on the business, especially at this point in the company's history, and to have the opportunity to lead our finance team through our next stage.

Now moving onto our third quarter and year-to-date 2009 financial review; I will first provide you with a brief summary of our consolidated results, then give you a more detailed look into Network Equipment, Network Integration and Optical Components operating segments, which I believe is a better way to evaluate our performance as the operating performance characteristics of each segment are very different.

Since I will be covering three quarters of 2009, as well as the year-to-date period, I would encourage you to follow along with the slides available on our Investor Relations website. This is our first financial results call since the recession began to impact our business. Our results were impacted first in the latter part of last year, but we felt the biggest impact of the recession in Q1.

Since the first quarter, we have seen our revenue stabilize and then grow. Although the sequential growth is off a substantially lower Q1 and our markets have not yet recovered to their 2008 levels, we are encouraged by the improvement in revenues during the year. We've also reduced our operating expenses in response to the decreased revenue.

Consolidated results are shown on slide five. Consolidated revenue for the third quarter was $128.9 million, an 8% sequential increase compared with revenue of $119.6 million in the preceding quarter, and 1% year-over-year decrease compared with revenue of $130.6 million in the third quarter of the prior year.

Revenue for the nine months ended September 30, 2009 was $366.8 million, which is a 9% decrease from $403.8 million for the same period in the prior year. Gross margin declined for the nine-month period ended September 30, 2009 to 26%, compared with 29% in the same period of the prior year. This decline was due primarily to the first quarter when we experienced an overall gross margin of 20% due to the challenges of Source Photonics, which Near discussed earlier.

As the Source Photonics gross margins have improved since the first quarter, so have the consolidated margins. Third quarter 2009 gross margin was 29%, compared with 28% in the second quarter and 26% reported in the third quarter of 2008.

The company has also reduced operating expenses during 2009. In the first quarter, operating expenses dropped about 10%, compared to 2008 levels, to $38.1 million. In the second quarter, operating expenses dropped an additional 9% to $34.5 million. In the third quarter, operating expenses were $34.9 million.

So the good news is that revenues are increasing, gross margins are improving and operating expenses have come down. All of that translates to improved operating income.

In the third quarter, the company had operating income of $2.9 million, which is a significant improvement from where we were at the beginning of the year with the first quarter operating loss of $14.4 million.

The company reported a net loss attributable to MRV stockholders of 0.5 million in the third quarter of 2009, or $0.00 per common share, which included share-based compensation charges of 0.6 million and 1.4 million in expenses related to the restatement and proxy solicitation.

This compares with the net loss of 9.9 million or a loss of $0.06 per common share in the comparable period of 2008, which included share-based compensation charges of one million and 6.5 million in expenses related to the restatement.

For the nine months ending September 30, 2009, MRV reported a net loss attributable to MRV stockholders of 21.6 million, or a loss of $0.14 per common share, and a net loss of 12.8 million or a loss of $0.08 per common share in the comparable period of 2008, including 1.6 million and 3.5 million in share-based compensation charges respectively.

As I mentioned before, I believe that to really understand MRV, you have to look at each of the three segments individually. So let me turn now to the segment results.

The Network Equipment results are shown on slide six. The trend in the Network Equipment segment is similar to the overall results. Revenues dropped in the third quarter to $24.9 million, which was 19% below the same period of 2008. In the second quarter, revenues dropped further to $23.3 million, which was 31% below the second quarter of 2008.

The Network Equipment group reported revenue of $26.6 million in the third quarter of 2009, which was 16% below the third quarter of 2008 and represented a 14% improvement over the second quarter of 2009. This growth was primarily driven by sales in Europe, including our aerospace and defense business in Switzerland.

The Network Equipment group reported revenue of $74.8 million for the nine months ending September 30, 2009, compared with $95.7 million in the same period of the prior year. The Network Equipment group has a higher gross margin profile than our Network Integration or Optical Components groups. Despite the recession, we were able to maintain our gross margin above 50%, and actually improve gross margins by 159 basis points for the nine-month period 2009 compared with 2008.

Gross margin for the third quarter of 2009 was 55% compared with 57% in the second quarter of 2009 and 52% in the third quarter of the prior year.

Gross margin decreased 124 basis points from Q2 to Q3, primarily as a result of a change in product mix. Over the year-to-date nine-month period, gross margin increased to 54% compared with 53% in the same period of 2008.

In the Network Equipment segment, we expect revenue growth to be moderate in the near term and have made adjustments to our operating expenses to lower the breakeven point. After the revenue decrease in the first quarter, which led to an operating loss of $2.2 million for the segment, we made adjustments which led to a quarter-over-quarter decrease in operating expenses of 6% in the second quarter, and a further quarter-over-quarter decrease of 4% in the third quarter.

We are cautiously optimistic about our top line recovery and our ability to hold margins, and we expect that this, coupled with our recent efforts to reduce operating expenses, will allow the Network Equipment segment to deliver operating income.

In the third quarter of 2009, Network Equipment reported operating income of $1.4 million, compared with an operating loss of $0.7 million in the second quarter, and an operating income of $1.1 million in the third quarter of the prior year.

For the nine-month period ended September 30th, the Network Equipment group reported an operating loss of $1.4 million for 2009, compared with an operating profit of $3.1 million in the same period of the prior year.

The Network Integration results are shown on slide seven. Our Network Integration group is consistently profitable and has done relatively well through the recession, although changes in foreign currency exchange rates have had an adverse effect on the reported results.

For example, the Network Integration group reported revenue of $145.8 million for the nine months ending September 30, 2009, compared with $164.3 million in the same period of the prior year, which represents a decrease of 11%. However, on a constant dollar basis, revenues were flat.

For the third quarter, the Network Integration group reported revenue of $49.3 million, a small increase over the $48.8 million of revenue in the second quarter and a decrease of 8% compared to 53.6 million in the third quarter of 2008.

Gross margin improved for the nine-month period in 2009 to 27%, from 25% for the same period of 2008. Gross profit was down 3% due to the decrease in revenues on a US dollar basis, but up 10% on a constant dollar basis.

Gross margin for the third quarter of 2009 was stable at 27%, compared with 27% and 26% in the second quarter of 2009 and the third quarter of the prior year respectively. Once again operating expenses were down 18% for the nine months of 2009, compared to 2008 or 5% on a constant dollar basis.

In the third quarter of 2009, network integration reported an operating income of $4.2 million, compared to an operating income of $4.6 million in the second quarter and an operating income of $3.4 million in the third quarter of the prior year. For the nine months, operating income in the network integration group was $12.2 million, up $4.7 million or 64% increase over 2008 or 78% increase on a constant dollar basis.

The optical components results are shown on slide 8. The optical components group, or Source Photonics, had a difficult start to the year. In Q1, the group had revenue of $48.1 million, with $1.7 million of negative gross profit and $9.4 million of operating expenses, adding up to an operating loss of $11.1 million. By the third quarter, the results improved considerably, with top-line growth to $55.9 million, gross margin improvements to 17%, and a $1 million or 11% reduction in operating expenses leading to operating income of $1.2 million.

Third quarter revenues represented 14% growth over the same period of 2008 and 12% growth sequentially. Source Photonics reported revenue of $154.0 million for the nine months ending September 30, 2009, compared with $155.2 million in the same period of the prior year.

Gross margin for the third quarter of 2009 was 17%, compared with 13% in the second quarter of 2009 and 7% in the third quarter of the prior year. Gross margin for the nine months 2009 period was 9%, compared with 17% in the same period of 2008.

The optical component group reported an operating loss of $12 million for the nine month of 2009 period, compared with an operating loss of $7.9 million in the same period of the prior year.

I'd also like to spend a minute discussing our balance sheet, beginning with the debt, which is shown on slide nine. The company has no corporate debt. The debt shown on our balance sheet exists in our Italian network integration companies and in Source Photonics. In Italy, we have about $23 million in borrowings against accounts receivable. This level has been pretty consistent over the last several years.

At Source Photonics, the debt has climbed in 2009 from $11.7 million to $55 million. Of this $43.3 million increase, $31.1 million relates to two transactions in China. First, there is about $18.9 million related to the sale with recourse, of commercial drafts from a major customer, which is one of the top two telecom system providers in China.

Our customer has always settled this accounts receivable with Source Photonics by issuing short-term notes receivable, typically maturing in four months. However in the past, Source Photonics would sell this note to its bank without recourse and after the sale would no longer carry the note as an asset.

More recently, this customer modified the type of note issued to Source Photonics and due to this change, the local laws provide a subsequent holder in this case the bank, with recourse to Source Photonics in the event of the customer does not pay the note when due.

Although, we believe the credit risk is very small, our sale with recourse requires different accounting. In this case the $18.9 million of notes remains an asset on the Source Photonics balance sheet, and debt is recorded in the same amount until the note is paid.

The second transaction was $12.3 million loan from the Bank of China that is secured by restricted deposit, which has initiated as part of the Source Photonics longer term financing plans in China.

Remaining $12.1 million of 2009 borrowings were used to increase Source Photonics, cash on hands to by $5.5 million to $17.7 million and fund cash requirements during the first a part of the year.

As of September 30th, 2009, we had total cash and cash equivalent, time deposits and investments of $90.5 million and approximate $8.9 million increase including the $12.3 million in additional time deposits from December 31st, 2008.

Before I turn it back to Noam, I would like the make a couple of closing remarks. MRV is emerging from a difficult period caused by a combination of the economic recession and the need to restate our historical financial statements and the related complications that brought.

As I discussed, we have made some progress in 2009 in restarting revenue growth and controlling operating expenses with the aim of improving profitability. However, I believe we have a lot of work left to do. We have begun developing and implementing a number of initiatives that are intended to improve profitability, strengthen the balance sheet, and improve our system of governance, risk and compliance. We are prioritizing these efforts above our short-term results, and accordingly we will not be providing guidance on future results at this time.

I will now turn the call over to Noam for a summary. Then we will take your questions.

Noam Lotan

Thank you, Chris. In summary, MRV has reached 21 years history of unique innovation and excellence in engineering, as you've just heard in the new product mentioned by our two Co-Presidents. We now have the right leadership team in place. We believe we are headed in the right direction as confidents in our future. While we continue to emphasize innovation and growth as Chris mentioned, we aim for sustained profitability above all.

Now, we will take your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Greg Waters with Investors Asset Management. Please go ahead.

Greg Waters - Investors Asset Management

A question regarding CES, it used to be listed or used to be the majority of what was listed as other on the financial statements, is it now included in network equipment?

Noam Lotan

It always was included in network equipment, Greg.

Greg Waters - Investors Asset Management

Okay. Along those lines, CES seems to be something that doesn't quite fit with the rest of MRV, it's in the aerospace and defense industry and it's really not a networking equipment so to speak or optical components, is that something that the board has looked at potentially spinning off or at any other opportunities with that company that division?

Noam Lotan

Well first of all we have a new board and this issue will probably come up at some point. But let me make a couple of comments on that. When we made the acquisition of CES back in 2001, CES was heavily involved in telecommunication with most relevant to our business. As a matter of fact it was one the units at the time that was potentially an IPO potential. Especially due to the very rapid deployment of NTT DoCoMo, which was the mobile telecom services in Japan.

That obviously the market at that time crashed after 9/11 and then the IPO did not materialize. Over the years, and even though they continue to do business with such as Intel, Siemens and subsequently led to Nokia Siemens, which we still work on gateways for centerfield, which is part of wireless backhaul, but over the years they have made a transformation into more of aerospace and defense, electronics. Now whether this business

fits within our telecom business or doesn't, it doesn't.

The fact is that aerospace and defense given the current market that they are going out tremendous growth potential for us. They are definitely entrenched in this businesses and I think it's a direction as we are going to take including with our network equipment. So, I don't see currently any contradiction, but again like I said we have a new board and the new board will have to take a closer look at that. Thank you.

Greg Waters - Investors Asset Management

Since you mentioned mobile backhaul will quickly with OptiSwitch products, can you provide some customer names there just to give an idea of the strength of MRV products in the mobile backhaul area?

Noam Lotan

We don't really want to provide customer names at this point, but we have project going on in Asia and United States and in Europe.

Greg Waters - Investors Asset Management

Could you give an idea of percentage of the equipment is in backhaul areas?

Noam Lotan

I think a lot of potential lies in this area, and we've had a significant success in the past with multimillion dollars deployment. Right now we have initial success with our OptiSwitch 900. We've had several announcements including the interoperability trial that we recently made with wireless backhaul conforming to the newest standard. But I don't think we can speculate right now on specific projects at this point.

Operator

(Operator Instructions). Our next question is from the line of Jim stone with PSK Advisors. Please go ahead.

Jim stone - PSK Advisors

What I'm trying to understand is what actually happened in the quarter to drive the revenue. My concern is, is it a bubble or is it symptomatic of good long-term growth.

Noam Lotan

Are you specifically referring to one of our business units or why don't you maybe a little bit specific?

Jim stone - PSK Advisors

You were referring during the presentation that a lot of the growth was due to a order from the second largest customer in China, who is ordering equipment. So, that's what I was referring to.

Near Margalit

Hi, Jim, this is Near. Yes, we did as you see basically there was a pretty strong stimulus package in China to buildup 3G wireless infrastructure. It definitely peaked in the middle of 2009, it's probably taking a little bit of a breather and should resume in 2010.

Jim stone - PSK Advisors

Well, was the order that you were delivering for or the project that you were delivering for, is that a project that is now complete or is it something that's on going?

Near Margalit

If you're familiar with basically there is large scale deployments of 3G cellular infrastructure in China, across all their major carrier including China Unicom. Basically they have phases to their project, so they have a more intense phase in 2009. I think there is pretty good literature out there that it's slowed down a little bit in Q3 and Q4 and expected to resume in 2010.

That's basically 3G wireless, infrastructure, whereas essentially we provide transceivers to

backhaul data from these wireless base stations back this into central offices.

Jim stone - PSK Advisors

Could you share with us, I know you probably don't have precise figures, but an approximation on the quarter that was just finished, very roughly how much of it ended up in equipment in China or what the geographic dispersion of the end equipment was when installed?

Near Margalit

It's hard for us because we don't sell the end equipment. For the fiber optics, we can tell you roughly half of it was sold to China-based Network Equipment manufacturers. We've try to do some estimates, it's a very rough estimate, but we think probably the end unit demand that we have is roughly around 30% in the United States and 70% in the rest of the world. But it's a definitely a rough estimation.

Jim stone - PSK Advisors

That I understand. In the last quarter that 70% rest of world, how was that split China, would you say China versus the rest of the world?

Near Margalit

I think we only have end unit visibility more into the United States and the other stuff. Unfortunately, the China local system manufacturers sell a lot to the rest of the world outside of China, so that it's very difficult for us to breakdown.

Operator

Our next question is from line of Greg Waters, a follow-up question from Investors Asset Management. Please go ahead.

Greg Waters - Investors Asset Management

Just real quickly, what drove the head count to 4000 this year?

Near Margalit

Yes, it's basically the move from contract manufacturers to internal manufacturing in Chengdu. I think these were people that were working for us at contract manufacturers and now are working for us in our own factories, but cost per employee on those employees tends to be on the range of a couple $100 a month.

Operator

(Operator Instructions) There are no further questions in the queue at this time.

I would like to turn the call back to Mr. Noam Lotan for any closing comments.

Noam Lotan

Thank you, Operator. Thank you everyone for being on this call. Since there are no further questions, we want to thank you and hopefully we'll see you all on the next call in the quarter. Thank you very much and have a good afternoon.

Operator

Thank you. Ladies and gentlemen this concludes the MRV Communications first nine months financial results 2009 conference call. If you would like to listen to replay of today's conference, please dial 1-303-590-3030, or 1-800-406-7325 and enter access code 4179751 followed by the pound sign. We thank you for your participation. You may now disconnect.

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