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SeaChange International (NASDAQ:SEAC)

Q3 2014 Earnings Call

December 05, 2013 5:00 pm ET

Executives

Monica Gould

Raghavendra Rau - Chief Executive Officer and Director

Anthony C. Dias - Chief Financial Officer, Chief Accounting Officer, Senior Vice President of Finance & Administration and Treasurer

Martha Schaefer - Director of Investor Relations

Analysts

Todd T. Mitchell - Brean Capital LLC, Research Division

Steven B. Frankel - Dougherty & Company LLC, Research Division

Michael A. Kupinski - Noble Financial Group, Inc., Research Division

Hamed Khorsand - BWS Financial Inc.

Russell Anmuth

Operator

Greetings, and welcome to the SeaChange Fiscal 2014 Third Quarter Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Monica Gould, Investor Relations for SeaChange International. Thank you, Ms. Gould. You may begin.

Monica Gould

Thank you, Doug. Good afternoon, everyone, and thank you for joining us. SeaChange released results for the third quarter of fiscal 2014, ended October 31, 2013, today after the market closed. If you would like a copy of the release, you can access it on the IR section of our website at www.schange.com/ir.

With me on today's call are Raghu Rau, Chief Executive Officer; and Tony Dias, Chief Financial Officer. This call is being webcast and will be archived on the Investor Relations section of our website.

Before Raghu begins, I'd like to remind you that the information we're about to discuss today may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations that are subject to a number of risks and uncertainties that may cause actual results to differ materially from expectations. These risks are outlined in our SEC filings, including our annual report on Form 10-K, which was filed on April 10, 2013. Any forward-looking statement should be considered in light of these factors. Additionally, this presentation contains certain non-GAAP or adjusted financial measures as defined by the SEC. Per SEC requirements, we have provided reconciliation of these measures to the most directly comparable GAAP measures in tables attached to the press release.

Any redistribution, retransmission or rebroadcast of this presentation in any form without the expressed written consent of SeaChange International is prohibited.

And with that, I'd like to turn the call over to Raghu.

Raghavendra Rau

Thank you, Monica, and good afternoon, everyone. Welcome to the SeaChange earnings call for the third quarter of fiscal 2014. On today's call, we will cover our third quarter performance, provide an update on the company's strategic plan and discuss our outlook for the remainder of fiscal 2014.

During the third quarter, SeaChange recorded revenue of $37.8 million, which was sequentially higher than the second fiscal quarter, led by a 13% increase, and service revenue from the fiscal second quarter. Non-GAAP operating earnings of $0.09 per diluted share declined slightly sequentially, reflecting the higher mix of lower margin service revenues.

I will now provide an update on some of our strategic initiatives. We continue to execute on our strategy of transitioning SeaChange to a best-in-class provider of software and services to the cable and telco segments. We have made great progress on this font over the past year and have grown our next-generation product revenue from 25% of total product revenue a year ago to 45% in the third quarter of fiscal 2014. Moreover, we remain on track to reach our goal of exiting the year with approximately half of product revenue from our new products.

Some examples of our recent successes include: our early involvement and close collaboration with the industry Reference Design Kit, or RDK as it's commonly known, has provided us strategic and time-to-market advantage for our Nucleus gateway software in the global marketplace. We are pleased that our Nucleus software was selected by NETGEAR for its first-ever headless multimedia gateway offering. In addition, during the quarter, we signed an agreement for Nucleus with a Latin American cable operator.

In the third quarter, a large European telco commercially launched our Adrenalin multiscreen platform. In addition, a large Scandinavian cable operator launched an IPTV service using Adrenalin. Our Infusion Advanced Advertising Platform went into live commercial service with a large European service provider, integrated with Adrenalin just last week. We believe that the VOD-advertising market is finally coming of age, both in Europe and North America. And as a proven vendor, we are well-positioned for this growth.

We continue to introduce new innovations, such as AdFlow Core, an extension to our content management solutions line up, and Cloud Adrenalin software-as-a-service. Both of these provide SeaChange's technological advantages to a broader segment of the market.

We maintain our strength and quality in customer satisfaction as we brought new products to market. And during the quarter, I'm very pleased to announce that we won Liberty Global's prestigious vendor award for Best Product & Service Quality.

The video service provider industry is at a significant inflection point, given new tech chip technologies that can support multiple tuners in excess of 16. The eminence of 4K technology and the availability of an industry-disrupting open RDK-based set-top box software, such as Nucleus, that also enables the subscriber interface to be hosted in the cloud. These developments provide operators an opportunity to rethink the long-term video strategy, enable them to better address the OTT threat and decide on new features and functionality. This also provides operators with a greater choice of vendors for the chips, set-top box, conditional access, user interface, user experience, besides the back office platform and open RDK-based gateway software. Though SeaChange is a prime contender for many of these operators, due to the complex nature of this decision-making progress, which involves a customer selecting multiple vendors simultaneously, some agreements that we were expecting in the third and fourth quarter are being pushed out. As a result, although we project good sequential growth in revenues and margins in the fourth quarter, our outlook is lower than we had previously expected.

We are pleased at the pace of our transition to a software and services company and believe we are at the end of the second year of a 3-year transition, after which, legacy declines will be minimal and new products will fuel growth. Based on the market acceptance of our next-generation products and the progress on execution, we are optimistic that we will experience good growth next year. Further, we are on track to achieve our long-term objective of double-digit growth in future years. We will provide specific guidance for next year, during our fourth quarter conference call, as usual.

In conclusion, we continue to strengthen our market position and make good progress on positioning the company for long-term, highly profitable growth.

Tony will now walk you through some of the financial details of the third quarter and provide our guidance for the fourth quarter. Tony, please go ahead.

Anthony C. Dias

Thank you, Raghu, and I'll start by reviewing our third quarter results before providing our outlook for the fourth quarter. For the third quarter fiscal 2014, revenues grow sequentially but lower than we anticipated due to delays in new product acceptance and signing new agreements that Raghu just mentioned earlier. New product revenue accounted for 45% of total product revenue in the quarter, up 64% from the same period a year ago. We continue to expect this revenue base to increase to nearly 50% by the end of the fiscal year. Our third quarter results were driven by a very strong performance in our service revenues, which rose 13% sequentially, driven largely by the Nucleus-related services in support of upcoming deployments. The strong performance was offset by a 15% decline in product revenue, from the second quarter revenues, to $13.8 million or 37% of total revenue. This decrease was led by lower revenue for some of our legacy software platforms, primarily due to the legacy middleware and back office products. During the third quarter, international sales rose 14% year-over-year and accounted for 51% of total revenues, up from 43% a year ago.

Our blended gross margins were 66% on a non-GAAP basis, up from 52% a year ago, reflecting the higher mix of product licensing revenues. As a result, we achieved non-GAAP operating margins of 8%, up from 7% in the year-ago quarter. Non-GAAP operating earnings per share was $0.09 per diluted share, in line with the same period 1 year ago. Our balance sheet continues to be very strong. We ended the quarter with a cash balance of $126.4 million.

Now I'd like to turn to our outlook for the fourth quarter of fiscal 2014. We expect fourth quarter revenues to be in the range of $40 million to $45 million and non-GAAP operating income on a fully diluted share basis in the range of $0.15 to $0.20 per share. Although our third quarter performance and fourth quarter outlook each reflect quarter-over-quarter growth, the pace of that growth is more moderate than prior expectations, owing to the continued uncertainty in the timing of the customer acceptance of new products, as long as with delays in signing new agreements that we expected in the second half of this year.

Thank you. With that, I'd like to hand the call back to Monica.

Martha Schaefer

Thank you, Tony. Doug, could you please provide instructions for the Q&A session?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Todd Mitchell from Brean Capital.

Todd T. Mitchell - Brean Capital LLC, Research Division

In light of tonight's news, I was wondering if you could walk us through the new business-generating process for SeaChange, for both Adrenalin and Nucleus and kind of the steps of how this happens, I mean, not how this happens, but like, there is a RFP process, how long does that take? There's a professional service engagement, how long does that typically take? And then there's sort of a licensing arrangement. And kind of what is the typical process for each of these going and what are the key junctures for sort of acceptance? And where, particularly, if you're pitching an operator of more than one product, or they're dealing for more than 1 vendor, where does it get delayed or where is the bottleneck in the process, I guess?

Raghavendra Rau

Great. Okay, let me answer that. Over the last 5 weeks, I've traveled to 3 continents and met the CXOs of about 4 very large cable operators, combined subscribers, probably greater than 20 million. And each of those are at varying stages of making final decisions on an RDK-based Nucleus kind of software. We have been told that we are the frontrunners for all of those 4 customers. However, what the operators are looking at is looking at leapfrogging technology. They're waiting for some new chips from Broadcom and Intel, which will support multiple tuners, which will provide whole-home networking capabilities. They're looking for set-top boxes with about 16 tuners in them. They're looking for, potentially, a new conditional access when the -- if they're dissatisfied with the present one. They have a choice. They have a choice of going to a new set-top box vendor. So what's happening is, even though we are prime and very likely to be selected for both Adrenalin, as well as Nucleus, because of the nature of the decision-making process, we have -- where we have to discuss who will be there, a set-top box vendor, that our Nucleus Gateway will -- a software we'll have to work with. That has been causing some delays and pushouts and some agreements which we were hoping would happen this last quarter and in the fourth quarter, have been pushed out and we're hopeful that they will be in place in the first half of next year.

Todd T. Mitchell - Brean Capital LLC, Research Division

Okay. So when this happens, you have, presumably you've been engaged with these people for a while, so they've sort of taken a look at your technology and said, "How can you customize it to meet what I'm looking to do specifically? In that initial -- I guess the first part of the question is in that initial upfront question, is there any revenue that ever changes hands as part of a professional services or is that basically just part of pitching businesses? And then, secondly, once you get past the stage and they have accepted you, is that when a professional service arrangement becomes -- or is that when a licensing agreement -- it's just -- walk me through kind of how the staging of the different revenue streams that are generated by getting a Nucleus deal, I guess. And, I mean, do you ever walk through a professional stage services agreement with somebody and then get delayed before the licensing happens because you've done all the work but they say, "We're not quite ready because we haven't decided on another component." I guess, I'm just trying to figure out some of those -- sort of the logistics of how this happens.

Raghavendra Rau

Right. Yes. Let me give you the process. It varies a bit between an existing customer versus a new customer. Of the 4 companies I mentioned, 3 of them are existing customers who want to make the transition. One is a completely new customer. With the new customer, we've been working with, probably, for the last 7 to 8 months, and we've been told that we are 1 of the very few that have been shortlisted for this solution in both the back office, as well as in the Nucleus gateway software. However, the process of getting approval from the board for total expenditure, that has not happened as yet and is expected to happen probably in the January time frame and then revenue starts. What we typically do is we start with a mobilization period, which is professional services and which generates revenue for each deployment. We also do some proof of concepts for which we charge. And by the way, we've already demonstrated the proof of concepts in each of these 4 prospective customers. And yes, there is some revenue associated with that, but not a very significant amount. The royalties are typically prepaid for -- to a certain extent. Let's say an operator decides they will prepay about 1 million licenses, and only when they go to the next 1.1 million does -- do they have to pay additional royalties. And that would depend on the rollout of the new boxes, whether existing boxes or the next-generation boxes, which many of these operators are now considering.

Todd T. Mitchell - Brean Capital LLC, Research Division

Okay. So last part of the question then. So, in each of these instances, it involves the Nucleus, but was there also a delay in the back office? And can you tell us if this was -- there's 1 over at the back office and -- 4 where there were Nucleus delays? Or I guess, sort of how we can think about that as well? Because, I guess, what I'm asking is can 1 component muck up the other component?

Raghavendra Rau

Not the Nucleus and Adrenalin, because, as you know, Todd, I mean, it's proven that they work together. So that's not the issue, as much as they have to choose potentially a new set-top box vendor, a new conditional-access vendor. They know who we already have worked with. We have worked with a certain set-top box which Liberty Global has chosen, certain conditional-access vendor that Liberty Global has chosen. And so that -- the particular operator may decide to, for time-to-market reasons and lower the risk, they might decide to change their conditional-access vendor. Some of those discussions are ongoing and that's one of the reasons for the delay. It's not between Adrenalin and Nucleus, but between the rest of the ecosystem. And to the second part of your question, in terms of which of these operators have delayed for both -- 3 of the operators are going with both -- are looking at both Nucleus, as well as Adrenalin. One is already an Adrenalin customer and will expand their system, but are now looking at Nucleus for their next-generation Gateway software.

Operator

Our next question comes from the line of Steven Frankel from Dougherty & Company.

Steven B. Frankel - Dougherty & Company LLC, Research Division

I'd like to start by addressing the revenue recognition delays around the deals that you were looking for in Q3 and Q4. You saw a little bit of that earlier in the year, but you felt pretty comfortable, at least as of last quarter, that you could get the deals slated for Q4 to revenue. What's changed to push those particular deals out?

Raghavendra Rau

Thank you, Steve. As I mentioned in the last quarter, we are managing several large implementations that involve multiple vendors and new custom integrations, the Adrenalin. These include different VOD servers, different UIs, different conditional access and different encoding solutions. And although our product is already proven and works in the field, unless these customers see the full ecosystem working in harmony, they tend not to give us acceptance. We did receive acceptance of something that was delayed in Q2 and Q3, and this was the large telco we mentioned, which happened in Q3, which was supposed to have happened in Q2. We have other systems for which we accept -- expecting acceptance and that we are hopeful will happen over the next couple of quarters.

Steven B. Frankel - Dougherty & Company LLC, Research Division

But -- so are these new combinations of third-party products that you hadn't seen before that are causing these delays or this is the same -- it's a limited set of components and you're still having issues getting the whole system to work?

Raghavendra Rau

Right. We have responsibility for getting the whole system to work only if we are the system integrator for the entire system. I mean, it's not necessarily a case that, that is the case for all of these deployments. However, the operator wants to be sure that it's not the back office or -- that's the problem and, therefore, they wait till they see the whole system working together. And yes, for the second part of your question, it is true that, yes, we are working on a number of new custom integrations for Adrenalin, with new VOD servers, with new conditional-access vendors and new set-top boxes, as well.

Steven B. Frankel - Dougherty & Company LLC, Research Division

So given the significant revenue shortfall for Q4, are you contemplating any reduction in expenses? Or are you just going to kind of maintain your current run rates of expenses and hope that the revenue comes in, in the next couple of quarters?

Raghavendra Rau

We don't anticipate any significant reduction in expenses in the fourth quarter. However, we have spent very significantly, I mean, almost 20% of our revenues on R&D in the last year, as well as this year, so very significant amounts. And we had to increase the R&D expenditure because we were building 3 new products. Most of that is going to be quote "complete" and so the incremental investments that we had made using our flexible workforce, we may be able to reduce and get some reductions in R&D in the next year.

Steven B. Frankel - Dougherty & Company LLC, Research Division

Okay. And why did we see a reduction in product gross margins in the quarter? You've been making good progress over the last couple of quarters and then you've slipped back.

Raghavendra Rau

Right. If you looked at what the product gross margin was a year ago, same quarter a year ago, it was 60.7%. If you look at what it was in the third quarter, it was 74%. So it was significant year-on-year growth. The difference between the product margins last quarter and this quarter were primarily because we sold more hardware along with -- and third-party products, along with the Adrenalin software, to a major customer in Europe.

Steven B. Frankel - Dougherty & Company LLC, Research Division

Okay. And I noticed you didn't buy any stock back during the quarter, okay. What's your posture towards the stock repurchase plan today?

Raghavendra Rau

We will establish a 10b5 plan. We have the board authorization for up to $25 million, and we expect we will implement that plan this quarter.

Operator

Our next question comes from the line of Michael Kupinski from Noble Financial.

Michael A. Kupinski - Noble Financial Group, Inc., Research Division

My question relates to Adrenalin. I understand that some of the cable operators, particularly Comcast, has developed software that writes on the Axiom platform. And my -- I'm curious why would Comcast decide to develop their own software to write on Axiom rather than to upgrade to the Adrenalin product? Secondly, is there, or are there, product -- I guess, are there product enhancements or things that you offer in terms of Adrenalin and that there might be a shelf life to the Comcast patchwork, I guess, of developing that software that writes on an Axiom and that there is a better functionality in Adrenalin. I was just wondering if you could just score for me the opportunity that you will have with Comcast and how far into the future that it might be that they upgrade to the Adrenalin platform?

Raghavendra Rau

Thank you, Mike. Comcast, when they decided that they wanted a next-generation VOD platform, SeaChange was not ready with the Adrenalin platform, unfortunately. And so that's why Comcast went their own way. They still continue to use Axiom and we believe they will continue to use Axiom in the foreseeable future. However, considering the immense success that Adrenalin has received, we're hopeful that at some point of time, Comcast will want to go with the world's best enterprise-class back office platform, which is Adrenalin, and we have not planned for any Comcast revenues for the next year, but we are not giving up hope that we will be able to enter Comcast with Adrenalin at some point of time.

Michael A. Kupinski - Noble Financial Group, Inc., Research Division

And what is the increased functionality that they would have by kind of migrating to the Adrenalin platform versus with what they might have now?

Raghavendra Rau

We believe there'll be significant reductions in OpEx costs, which will be a big driver. And Adrenalin is an integrated linear, as well as a VOD system, and that's another big advantage. And it supports both IP and HFC and is already proven with the Nucleus gateway software.

Michael A. Kupinski - Noble Financial Group, Inc., Research Division

And also just a quick question, what type of -- I know that part of your hope is to introduce and get people to buy the Infusion, the Ad Infusion product, advertising insertion product, here in the United States. It seems like you're more successful in Europe. Are you -- what are the discussions about -- on your Ad Insertion product and how -- what are your thoughts about that in -- as you try to penetrate here in the United States?

Raghavendra Rau

We have not been very successful in penetrating the U.S. market, specifically. However, as you rightly point out, we already have 2 very large deployments in Western Europe. One of them has been there for over 1 year and generating almost 1.5 million VOD ad placements per day, and we're going to be expanding the capacity of that system soon. We also have interest from North America, particularly Canada, and in -- from Latin America. However, the U.S. operators, we haven't really seen them embrace VOD advertising as we see happening in Europe.

Michael A. Kupinski - Noble Financial Group, Inc., Research Division

And do you see that changing, Raghu? I mean, what is going to be the dynamic that makes that change?

Raghavendra Rau

Yes, we're hopeful that it will be changed. I mean, they're doing it. They use 1 proportion of our product, which is called the ADR. And so -- but it's not really taken off. They don't use the full system.

Operator

Our next question comes from the line of Hamed Khorsand from BWS Financial.

Hamed Khorsand - BWS Financial Inc.

I would just, first, want to get a little bit clarification from your earlier comments. Are you saying the delays are really related to the implementation of third-party technology and not really what you guys are providing?

Raghavendra Rau

No, I wouldn't say it's black and white in those terms. What I would say is, our product, working with some new third-party products is taking time to get accepted. Our product, we believe, works well and works -- and is already proven in multiple deployments. However, when you go with a new integration, with a new vendor, new encoding vendor, either it's -- whether it's in video or RGB or harmonic or anyone, then you have acceptance issues.

Hamed Khorsand - BWS Financial Inc.

Okay. Is there a risk that maybe some of these service providers decide to go with a competing product instead of SeaChange?

Raghavendra Rau

No, we don't believe there's any such risk. These are fairly normal delays. It's just for a brand-new product. So, the systems performed well, it performs well in other -- with other customers already. It's already been commercially launched. As I said, we've launched 2 major systems in Europe in the last quarter, in third quarter, so it's just a matter of time.

Hamed Khorsand - BWS Financial Inc.

Okay. And then in your guidance, are you assuming any kind of increase as far as licenses or a new license from Liberty Global?

Raghavendra Rau

There is some revenue associated with Liberty Global. Yes.

Hamed Khorsand - BWS Financial Inc.

Okay. And then, what kind of assumptions are you making as far as the M&A environment is going? And how that might slow the process of deployment?

Raghavendra Rau

We haven't noticed that very much. But we, like you, read what's happening in the papers about potential acquisitions of some of the large cable operators. So far, we haven't felt any impact. And one thing I want like to clarify for you, Hamed, is that we have not lost any business. Even though some of this has been deferred, we have not lost any business that we had planned to win to any of our competitors.

Operator

[Operator Instructions] Our next question comes from the line of Russell Anmuth from Gotham Holdings.

Russell Anmuth

Could you speak to the SaaS offering? And, in particular, how it's aimed at large IPTV carriers and telcos and the mobile operators? And when you think you might start to see revenue drop in?

Raghavendra Rau

Right. We're really excited about this product. We had demonstrated it at IBC. It's now ready to launch on a trial basis with select customers. In terms of generating revenue, this is more of a mid-next-year scenario. Essentially, what this does is takes Adrenalin, rather than having it be premise-based, is hosted by SeaChange in the cloud. And what this does is enables some of the smaller operators to be able to provide the most advanced multiscreen services without having, necessarily, to have the CapEx costs associated with that. It also enables them to go to a more OpEx model and, therefore, helps with their cash flow. And so that's the value proposition for the cloud Adrenalin service.

Russell Anmuth

Does it work for the large operators who are multi-country in geography, so they can roll out geography by geography?

Raghavendra Rau

No, that's going to be much more difficult because of -- one is, it's a content rights and ability to do that, number one; and, two, the larger operators would prefer to be able to manage their own system on their premises.

Russell Anmuth

Okay. If you could just hit back on Infusion a bit. So how many Infusion customers do you have at the moment? How many adopters at this point?

Raghavendra Rau

It's not a very large number. It's about 4.

Russell Anmuth

Okay, okay. And then, can you speak to mobile operators, in particular, and how the mobile operators can implement your solutions to enable them to get into the game?

Raghavendra Rau

Yes. We have been working with a major mobile operator for -- to use Adrenalin. Unfortunately, we're experiencing some delays there in terms of getting them to finalize an agreement, even though they've decided that, that's what they want to do because this operator has been involved in some major M&A activity and so they're slightly distracted, and that's why we have not been able to close, but they tell us that they still want to go ahead and do that.

Operator

There are no further questions at this time. I'd like to hand the call back over to management for closing comments.

Raghavendra Rau

Okay. Thank you very much. We really appreciate you participating in this call, and we look forward to continuing to work with you.

Operator

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.

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