Zhone Technologies, Inc. Q4 2009 Earnings Call Transcript

Jan.27.10 | About: Zhone Technologies, (ZHNE)

Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q4 2009 Earnings Call Transcript

January 27, 2010 5:00 pm ET

Executives

Kirk Misaka – CFO, Corporate Treasurer and Secretary

Mory Ejabat – Chairman, President and CEO

Analysts

Greg Mesniaeff – Needham & Company, LLC

Buz Heikki [ph] – Midsouth Investor Fund

Donna Jaegers – D.A. Davidson

James Johnson – Comcast

Mark Gomes – Pipeline

Edward Zabitsky – ACI Research

Martin Landry [ph]

Operator

Good day and welcome to the fourth quarter 2009 Zhone Technologies, Inc. conference call. I am Izet and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session toward the end of the conference. (Operator instructions)

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

Kirk Misaka

Thank you, operator. Hello and welcome to the Fourth Quarter 2009 Zhone Technologies, Inc. conference call. I'm Kirk Misaka, Zhone's Chief Financial Officer.

The purpose of this call is to discuss Zhone's fourth quarter 2009 financial results as reported in our earnings release, which was distributed over Business Wire at the close of market today and has been posted on our web site at www.zhone.com.

I am here today with Mory Ejabat, Zhone's Chairman and Chief Executive Officer. Mory will begin by discussing the key financial results and business developments of the fourth quarter. Following Mory's comments, I will discuss Zhone's detailed financial results for the fourth quarter and provide guidance for next quarter. After our prepared remarks, we will conclude with questions and answers.

As a reminder, this conference is being recorded for replay purposes, and will be available for approximately one week. The dial-in instructions for the replay are available on our press release issued today. An audio webcast replay will also be available online at www.zhone.com following the call.

During the course of the conference call, we will make forward-looking statements, which reflect management's judgment based on factors currently known. However, these statements involve risks and uncertainties, including those related to projections of financial performance; the anticipated growth and trends in our business; the development of new technologies and market acceptance of new products, and statements that express our plans, objectives, and strategies for future operations.

We refer you to the risk factors contained in our SEC filings, available at www.sec.gov, including our Annual Report on Form 10-K for the year ended December 31, 2008 and our quarterly reports on Form 10-Q for the quarter ended September 30, 2009.

We would like to caution you that actual results could differ materially from those contemplated by the forward-looking statements and you should not place undue reliance on any forward-looking statements. We undertake no obligation to update any forward-looking statements.

During the course of this call, we will also make reference to pro forma EBITDA and pro forma operating expenses, non-GAAP measures we believe are appropriate to enhance an overall understanding of past financial performance and prospects for the future. These adjustments to our GAAP results are made with the intent of providing greater transparency to supplemental information used by management in its financial and operational decision making. These non-GAAP results are among the primary indicators that management uses as a basis for making operating decisions, because they provide meaningful supplemental information regarding our operational performance and they facilitate management's internal comparisons to the company's historical operating results and comparison to competitors' operating results.

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

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

Mory Ejabat

Thank you, Kirk. Good afternoon and thank you for joining us today for our fourth quarter 2009 earnings call.

The fourth-quarter earnings of was up 16% as compared to the fourth quarter of 2008, and remained basically flat as compared to the third quarter. On another positive, we substantially improved pro forma EBITDA profitability, which was our top priority and were also slightly profitable on a GAAP basis during the fourth quarter. Profitability improved largely as a result of improved margins on our newer products and continued expense control.

We expect continued revenue growth in 2010 based on the strong interest in our product solutions, both in the US and abroad. We see the major forces driving revenue growth in 2010 as follows

First, our customers have been focused on delivering new services with higher bandwidth due to competitive pressure, requiring network upgrades and transition to IP-based network. Second, we introduced our MXK product line, which provides an interim solution to meet those customer needs. Third, our global reach allows us to focus on providing solutions in emerging growth markets. And finally, the US broadband stimulus package should provide additional domestic financing for broadband network field outs during the second half of 2010. Kirk will give you more details on our financial performance and guidance later.

So let me give you a brief update on the status of our NASDAQ listing at this price. On our last earnings call, we had until March 29, 2010 to comply with the $1 minimum bid price required for continued inclusion on the NASDAQ capital market. Accordingly, we have postponed plans to move forward with the reverse stock split approved by our shareholders in October 2008. We continue to evaluate the alternatives to maintain our NASDAQ listing. We will issue a press release prior to taking any action that may be required.

Now let me give you an update on our products and customers. As you know, last June, we announced the introduction of our MXK intelligent terabit multi-service access platform that features a two-time bandwidth improvement over the next competitor. Service providers across the globe quickly deployed the MXK in every major market where we do business.

Following the introduction of the MXK, we added a powerful suite of optical network terminals that assist carriers in reducing time, cost and complexity of delivering FTTx services. Our ONTs include the following key features: ability to deliver any service over any cord, auto-provisioning a smart (inaudible) and simplified management through Zhone’s SLMS operating system. Because ONTs represent a big part of the cost of any GPON or Active Ethernet network design, it is important that ONTs match precisely and operators a specific network and service requirement.

Our development and integration efforts on ONTs have created the industry’s most comprehensive portfolio, with now over 30 different models, covering a wide range of functionality in both indoor and outdoor applications, from simple low cost devices for basic residential service to sophisticated multi-service devices for business applications and mobile backup.

Our customer base for the new MXK platforms continues to grow. This past quarter, we announced a new high-profile installation in El Gouna, a luxury resort town on the Red Sea created by cooperative development along with global telecom operator Orascom.

More importantly, we announced that our MXK platform was selected by Etisalat for a major rollout of the next generation GPON services throughout the UAE. As you may know, Etisalat has been the primary telecommunications provider in the UAE since 1976 and is known for their technological excellence, innovation, and reliability. Being selected by them for this major multi-year deployment is an important acknowledgement that MHK provides superior, innovative carrier class solution. In making the selection of our FTTx solution, they cited the MXk’s unprecedented scalable bandwidth, robust network control, and the ability to service customers with greater efficiency. We are very excited about being selected by Etisalat for this nationwide GPON deployment and believe it will be a measured catalyst in helping us grow revenue in 2010 and beyond.

Last quarter, we also added the ETHX 3100 series with Pseudo-Wire to our EFM product portfolio, which enables operators to migrate TDM applications onto a converged packet network for simple network management and immediate OpEx saving in the delivery of voice, video, and mobile backup.

Last quarter, Updata in the United Kingdom selected our EFM platform to provide carrier class networks for UK public sector and institutions, including government, healthcare, and education.

Finally, in the US market, we supported a number of our customers and prospective customers in their efforts to obtain a portion of the $7.2 billion broadband stimulus grant. In December of 2009 and January 25, 2010, the government announced a portion of the investment and awarded some of our customers the funds needed to build out their broadband infrastructure. We will continue supporting our consumers with their projects and anticipate seeing the effects of the broadband stimulus grant in the second half of 2010.

In the meantime, we continue to have success domestically. This past quarter, Hardy Telecommunications selected our platforms to provide high-speed data and VoIP services, with sophisticated call features to their customers over a wide and dispersed geographical area. Hardy cited that our high value, reliability, and limited maintenance as a reason for continuing to leverage Zhone’s product portfolio.

We also announced today that the city of Salisbury, North Carolina, has selected Zhone’s MXK and zNID fiber to the home solution to serve them and there is a quality broadband initiative now underway. Salisbury cited Zhone’s FTTx system as the most powerful solution with twice the capacity over other platforms, resulting in a lower bandwidth cost, while providing the freedom to grow network services with the growth of the city.

As you can see, we finished 2009 with considerable momentum with improved profitability and increase gross margins. We also introduced a strong product portfolio for FTTx and EFM, targeting broadband products for GPON, Active Ethernet, and Ethernet over Copper that gives us a strong competitive advantage.

The rapid economic recovery in our global emerging markets and expansion of the broadband networks in these markets combined with the US broadband stimulus grants should translate into continued improvement in our financial performance for 2010.

Now, I would turn the call over to Kirk to provide more details about our financial results for last quarter and to discuss our financial guidance for next quarter. Kirk?

Kirk Misaka

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

As Mory mentioned, the fourth quarter revenue $36 million remained basically flat as compared to the third quarter, but was up 16% as compared to the fourth quarter of 2008. Fourth-quarter revenue fell short of our previous guidance of revenue between $37 million and $38 million, largely due to reduced demand by smaller rural carriers in the US that were waiting for broadband seamless bundling. Looking forward, we are forecasting a normal seasonal slowdown in the first quarter, and expect revenue to be flat or slightly down in the mid-single digit percentage range. After that, we expect revenue to grow sequentially each quarter throughout 2010. We also expect quarter revenue in 2010 to exceed that of the corresponding quarters in 2009.

We continue to serve approximately 700 active customers worldwide, with 65% of revenue for the fourth quarter being attributable to international customers. We have experienced more customer concentration over the last two quarters, with one 10% customer each quarter and the top five customers representing approximately 48% of revenue for the fourth quarter, and 42% of revenue for the third quarter.

Gross margins increased substantially from 33.5% for the third quarter to 40.1% for the fourth quarter, which exceeded our previous guidance range of margins between 33% and 36%. As mentioned on our last conference call, we expected margins to improve with the introduction of our new technologies that have been designed with maximum cost efficiency in mind. Fourth-quarter results prove those expectations to be somewhat conservative.

So for the first quarter of 2010, we are increasing our margin guidance once again to between 36% and 40%, with the potential for additional margin expansion throughout 2010, as the department of our new higher-margin technologies increases and higher volumes allow us to take advantage of manufacturing economies to scale.

As we begin this new product cycle however, we will be carefully balancing revenue growth and increase market share with profitability and higher margins.

Operating expenses for the fourth quarter came in at $13.7 million versus guidance of between $13 million and $14 million. Operating expenses included depreciation of approximately $400,000 and stock-based compensation of approximately $700,000. With additional sales and marketing activity around our new product launches, we still anticipate total operating expenses for the first quarter of 2010 to increase slightly to between $13.5 million and $14.5 million, including approximately $1 million of expenses for depreciation and stock-based compensation.

Finally and most important, pro forma EBITDA for the fourth quarter of 2009 was a $1.9 million profit, and better than the expected profit of approximately $1 million. We also reported net income on a GAAP basis of just over $300,000 for the fourth quarter. As mentioned, substantially stronger margins associated with our new products lead to improved profitability. However, due to normal seasonal weakness in the first quarter and a slight decline in revenue, we anticipate a slight pro forma EBITDA loss for the first quarter of 2010. We expect the first quarter to be a normal and temporary seasonal downturn and thus anticipate returning to profitability in the second quarter as well as improving on that profitability for the remaining quarters of 2010.

Now let us take a quick look at the balance sheet. Cash and short-term investments at December 31, 2009 were $21.8 million, which declined only slightly from the $22 million at September 30, 2009. The positive cash flow associated with the $1.9 million pro forma EBITDA was largely offset by working capital changes in the balance sheet, dominantly Accounts Receivable. Accounts Receivable levels continued to increase and grew by $5.1 million to $37.1 million at December 31. Correspondingly, the number of days sales outstanding on accounts receivable for the fourth quarter increased to 93 days as compared to 80 days for the third quarter.

The increase in accounts receivable and DSOs is largely attributable to the growth in business with our 10% customer. We anticipate DSO will gradually decline beginning in the first quarter as the payment cycle with this customer begins. With this decline in DSOs, operating cash flow will begin to turn from negative to positive along with pro forma EBITDA. For the year, we anticipate net neutral cash flow from operations, which will help us stabilize our liquidity resources.

As for other balance sheet changes, inventory declined slightly to $30.2 million as of December 31 and $30.5 million as of September 30. Our total debt obligations remain basically the same as last quarter at $28.7 million.

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

Mory Ejabat

Thank you, Kirk. We are excited by a stronger-than-expected profitability associated with the beginning of a new major product cycle for the company. The initial positive reaction to our new products is very encouraging and we hope to build on that momentum in 2010. In the fourth quarter, we achieved our primary financial goal of generating positive quarterly pro forma EBITDA and GAAP net income and now focus on improving that profitability for 2010 and beyond.

Thank you for joining us today. We will now open the call to questions. Operator, please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Greg Mesniaeff from Needham & Company. Please proceed.

Greg Mesniaeff – Needham & Company, LLC

Yes, thank you. Two quick questions. First, on the gross margin improvement, obviously new product cost profile. Is that product still internally manufactured or is that outsourced?

Kirk Misaka

Yes, it is manufactured in our Largo facility.

Greg Mesniaeff – Needham & Company, LLC

So that has not changed, it is really a function of just the design, correct?

Kirk Misaka

That is correct.

Greg Mesniaeff – Needham & Company, LLC

And the other question is one the DSOs. Did I hear you right, there were 93 days in the fourth quarter?

Kirk Misaka

Yes, 93 days for the fourth quarter.

Greg Mesniaeff – Needham & Company, LLC

And is that attributable to linearity, you know, back-end loaded revenue pattern or is that more just a function of the nature of the customer?

Kirk Misaka

There is some of that that was in the back end of the quarter, but 20-plus days related to the increase in DSOs related to this one 10% customer that we referred to.

Greg Mesniaeff – Needham & Company, LLC

So what you are saying is this customer tends to pen lay it anyway, but on top of that, a big chunk of business came at the very end, right?

Kirk Misaka

That is right.

Greg Mesniaeff – Needham & Company, LLC

Okay, thank you.

Operator

Your next question comes from the line of Heidi Heikki [ph] with Vone Technology [ph]. Please proceed.

Kirk Misaka

It is from Buz Heikki maybe?

Buz Heikki – Midsouth Investor Fund

She said Judy, I thought that I – I didn't know whether it was me or not. This is Buz Heikki [ph] with Midsouth Investor Fund. A couple of questions. What is your debt count?

Kirk Misaka

We were on about $300,000 per quarter as our net interest cost.

Buz Heikki – Midsouth Investor Fund

At what rate?

Kirk Misaka

It varies. We have two facilities, one with Silicon Valley Bank and it is at prime plus 2.5%, and we also have a mortgage that runs on a six month LIBOR plus 300 basis points.

Buz Heikki – Midsouth Investor Fund

What about your R&D counter? Are they going to stay where they are?

Mory Ejabat

Yes, we anticipate our R&D to remain the same.

Buz Heikki – Midsouth Investor Fund

Okay. Your inventory went down a lot. Does that have to go back up or what was the reason that is so?

Mory Ejabat

No, we anticipate our inventory to stay at this level or go down.

Kirk Misaka

When you refer to that it down a lot, it went down a lot compared to December of 2008 to now, but from the third quarter to the fourth quarter, it was relatively stable. It went from $30.5 million to $30.2 million and as Mory said, we are anticipating that it will level out somewhere in this range.

Buz Heikki – Midsouth Investor Fund

Okay. And then, this contract Salisbury municipality was that bid on or did they come to you, how did you get that contract?

Mory Ejabat

Well, you know, there was an RFP and we answered the RFP. There were many competitors that were invited to that RFP, and we won that RFP.

Buz Heikki – Midsouth Investor Fund

And why did they select you all?

Mory Ejabat

Because of our product and performance and quality of the product.

Buz Heikki – Midsouth Investor Fund

Okay then. And will you be getting some larger municipalities, do you think, or is that about the average size you will be getting in the future?

Mory Ejabat

We are working on all the fronts, so any RFPs that come onto our desk, we will go after that.

Buz Heikki – Midsouth Investor Fund

Okay, and what would about the approximate dollar size of this one?

Mory Ejabat

We don’t share.

Buz Heikki – Midsouth Investor Fund

Okay, then. And your margins are going to be getting better I guess to the end of the year as your revenues start going up higher.

Kirk Misaka

That is our plan.

Buz Heikki – Midsouth Investor Fund

Okay, then. Thank you very much.

Kirk Misaka

You are welcome.

Operator

Your next question comes from the line of Donna Jaegers with D.A. Davidson. Please proceed.

Donna Jaegers – D.A. Davidson

Hi, thanks for taking my questions. Just two quick questions, I guess on the pipeline. Can you give us a little more color as far as what the – are the number of RFPs out there increasing, any sort of color that you can give on the pipeline.

Mory Ejabat

In respect to our pipeline, what we are seeing is a lot more activities this year from the same quarter last year or actually from the last quarter. We are seeing lots of RFPs and RFIs. And internationally, we are seeing a lot more activity than we are seeing domestically.

Donna Jaegers – D.A. Davidson

Okay. And then, where you respond to RFPs, but you don’t end up winning, is there one specific reason why you don’t win those contracts?

Mory Ejabat

Yes, it is different in the different areas, and some of the areas internationally, we might walk away from the RFP because of the low pricing from Chinese manufacturers, and domestically, we haven't lost any in the RFPs that have come out. I don't know if they come, what we would lose them, I don’t know. We are going forward with a new product as we are.

Donna Jaegers – D.A. Davidson

And obviously, you have leapfrogged your competition with this new product, being able to carry twice the bandwidth. How long of a lead do you think you have versus say ADTRAN and some of your other domestic competition?

Mory Ejabat

Well obviously, we are not going to stop our development. We are going to continue enhancing this platform. Our intention is to stay ahead of competitors for a year. Year-by-year, we are going to enhance this product.

Donna Jaegers – D.A. Davidson

Great. Thanks a lot, Mory.

Mory Ejabat

You are welcome.

Operator

Your next question comes from the line of James Johnson with Comcast. Please proceed.

James Johnson – Comcast

Hi, just one quick question about the NASDAQ listing. Do you guys – you guys anticipate something happening in the next two months? Is there a plan; is there a potential expanding the deadline, what are you guys – can you guys provide something on that?

Mory Ejabat

Well, right now, the deadline is end of March and we have to comply with that. We are obviously looking at different alternatives onto that. So you should just standby until we come up with a resolution and we will let you know.

James Johnson – Comcast

So there is a plan.

Mory Ejabat

Well, we are always looking at different plans.

James Johnson – Comcast

And reverse is out of the question.

Mory Ejabat

I cannot say that it is out of the question. That might be one of the items in the plan, but we are looking at several alternatives.

James Johnson – Comcast

Okay, thank you for your time.

Mory Ejabat

Sure.

Operator

Your next question comes from the line of Mark Gomes with Pipeline. Please proceed.

Mark Gomes – Pipeline

Hi, folks. I was wondering if you could talk a little bit about any deal slippage that you may have incurred during the quarter as a result of implementation of broadband stimulus funding and along those lines; can you provide some further commentary or updated commentary on how you expect to benefit from the coming broadband stimulus?

Mory Ejabat

Yes, I can say that in the fourth quarter, we saw various slowdowns in our US business because of how our customers were waiting for the stimulus funding or the award on that respect. As I mentioned, there has been two awards that has been published, and some of our customers too have been awarded to this for the funding. But they have to send their project plans and all of that and have to get approved. And I really cannot tell you what the cycle time is for those projects to get approved and the funding to start. So until we get the first indication of how fast the government moves providing this funding, we cannot tell you exactly when this funding is going to be available.

Mark Gomes – Pipeline

Okay. Would it be fair to say that you would have been able to make the published street estimates this quarter if those deal delays did not occur in the fourth quarter?

Kirk Misaka

Most likely, yes.

Mark Gomes – Pipeline

Okay, thank you. And can you name any of the customers that were awarded broadband stimulus funding in the last two rounds?

Mory Ejabat

We cannot do that. And also, there are a lot of customers; they haven't selected anybody that we are targeting as well.

Mark Gomes – Pipeline

Great. Thank you very much.

Operator

Your next question comes from the line of Edward Zabitsky with ACI. Please proceed.

Edward Zabitsky – ACI Research

Ed Zabitsky, ACI Research. I was wondering about the MXK product. Is that – are you bidding larger deals because of the availability of the platform? In other words, are you going after Tier-1 carriers now?

Mory Ejabat

The answer is yes, we are going after Tier-1 carriers. Actually, Etisalat is a Tier-1 carrier. (inaudible), a couple of quarters back, these are Tier-1 carriers. We are going after Tier-1 carriers internationally. Domestically, we haven't seen any RFP from either Verizon or AT&T. They haven't published anything, but we have RFIs from Tier-2s that we are responding to those and I believe we are in a strong position to win some of those.

Edward Zabitsky – ACI Research

That is great. Could you characterize sort of the size, just the rough size of the (inaudible) deals? Are they in the millions; are they above $10 million, what is the scope we are looking at?

Mory Ejabat

I cannot tell you exactly what it is, what I can tell you is we are already in.

Edward Zabitsky – ACI Research

Okay, thanks very much.

Operator

(Operator instructions) Your next question comes from the line of Martin Landry [ph]. Please proceed.

Martin Landry

Good afternoon. I was wondering if you could identify your two 10% customers that you mentioned acquiring in the last two quarters.

Kirk Misaka

It is the same customer and it is our customer in the UAE.

Martin Landry

Thank you.

Operator

You have a follow-up question from the line of Mark Gomes. Please proceed.

Mark Gomes – Pipeline

Do you guys ever comment on backlog at all, qualitatively or quantitatively and can you tell us if your backlog increased or decreased in the quarter eventually.

Mory Ejabat

We had not commented on the backlog in all of our conference calls and we won’t do that. We just give you guidance on the top line and the gross margins.

Mark Gomes – Pipeline

Okay, thanks.

Operator

At this time, you have no further questions.

Mory Ejabat

Thanks again for joining us today. We appreciate your continuous support. I am looking forward to speaking with your on our next earnings conference call. Operator?

Operator

That concludes today’s conference. Thank you for your participation. Have a great day.

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