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TranSwitch Corporation

Q4 2009 Earnings Call

February 11, 2010 5:30 pm ET

Executives

Theodore Chung – Vice President Corporate Development

Ali Khatibzadeh – President, Chief Executive Officer

Robert Bosi – Chief Financial Officer

Analysts

Blake Harper – Signal Hill

Sandy Harrison – Signal Hill

[Walter Chenker – Titan Capital]

[Shepherd Davis – Private Investor]

Operator

Welcome to TranSwitch fourth quarter 2009 earnings release conference. Today’s conference is being recorded. At this time I would like to turn the conference over to Mr. Ted Chung, Vice President of Corporate Development.

Ted Chung

With me here today are Dr. Ali Khatibzadeh our President and CEO and Mr. Bob Bosi, our CFO. Before I begin, I want to remind listeners that forward-looking statements made during the call including statements regarding management’s expectations for future financial results and the markets for TranSwitch products are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Investors are cautioned that these forward-looking statements regarding TranSwitch, its operations and its financial results involve risks and uncertainties including risks associated with TranSwitch’s businesses including without limitation risks associated with downturn and economic conditions generally and in our market specifically, risks in product development, risk in market acceptance and demand for TranSwitch products as well as products developed by TranSwitch customers, risk relating to TranSwitch indebtedness, risks of failing to attract and retain key managerial and technical personnel, risks associated with foreign sales and high customer concentration, risks associated with competition and pricing pressures, risks associated with investing in new businesses, risk of dependence on third party application facilities, risks associated with acquiring new businesses, risks relating to intellectuals property rights, risks in technology development and commercialization and other risks detailed in our filings with the Securities and Exchange Commission.

With that out of the way, I will talk briefly about the fourth quarter 2009. For the fiscal fourth quarter net revenues were approximately $12.1 million roughly at the mid point of the revised guidance provided on December 15. Our non-GAAP operating expenses for the quarter were roughly $8.6 million, roughly in line with our guidance.

Going forward, we expect operating expenses to go down based on that fact there are one time expenses that were incurred in the fourth quarter as well as the restructuring actions that were announced last week. Bob will provide on the expense guidance later.

Based on the lowered operating expense level as well as the resumption of growth as we move forward, we believe TranSwitch should achieve profitability in 2010.

In December, we announced a transaction with Seaside 88, an investment partnership that has agreed to invest in TranSwitch by purchasing shares directly from the company every two weeks. We believe this arrangement should take care of the bulk of our obligations for our convertible debt holders who are being paid interest and principal each month.

With respect to the shortfall related to the large Korean customer that we discussed in December, as I indicated this will continue to impact our business in the first quarter.

Finally, the excess inventory of our infrastructure products at a key distributor that was described on December 15, appears to be correcting itself as we move through the first quarter. We expect to have a normalized sell through as we move to the second quarter.

I will now hand it over to Ali so that he can share with you some of these thoughts on the fourth quarter and what he is looking forward to in this quarter.

Ali Khatibzadeh

Good afternoon ladies and gentlemen. It’s been a little over two months since I joined the company and it’s certainly been an eventful two months. During this time I’ve visited many of our key customers and I am reassured by the opportunities we have ahead in the broadband communications space.

I’ve also spent a fair amount of time with the executive team and our employees around the world reviewing our plans for 2010 and beyond. Let me say a few words about the methodology we used for our 2010 planning process.

First, we completed a bottoms up view of the 2010 revenue forecast based on products currently in production. In this base line plan we did not include new design wins or expectations of upside from existing businesses.

Second, we aligned our expenses to the base line plan to ensure operating profitability in 2010 and to base line revenue.

Third, we identified upside opportunities based on design wins that have not commenced production and new design wins in 2010. We have aligned the sales incentive plan to this upside revenue opportunity. There is also a fundamental change to our sales incentive approach in 2010. I will talk more about that later.

Lastly, we have kicked off a strategic planning process to be completed by second quarter. The objective of this process is to one; identify market segments that present the best possible growth opportunities for TranSwitch over the next five years, two, to determine the strengths and weaknesses of our product roadmaps; three, to develop a plan that closes the gaps we currently have and build on TranSwitch differentiators; and fourth, to identify partnership strategies in the market segments that we plan to focus on.

Our strategic planning process involves participation by all company employees, some current customers as well as potential future customers.

With respect to the alignment of operating expenses to the base line revenue, we implemented expense reduction measures of roughly $4 million on an annualized basis. This was already announced and the reductions were done after a careful review of projects and expenses.

We eliminated costs associated with non essential outside programs that did not fit with our growth strategy. We implemented a company wide reduction in cash compensation of roughly 10% across the board for salaried employees including the executive team and myself and the Board of Directors.

We reduced budgets company wide for non essential contractors and consultants and overhead expenses and overall we’re creating a more cost conscious culture here at TranSwitch.

Based on these actions taken, we should achieve operating profitability on a quarterly revenue level of roughly $13 million.

With regards to the sales strategy, we put some new initiatives in place. For 2010 we have modified our internal sales incentive plan to align with the upside opportunities that we see in our customers. I’ve also instituted a new and restricted definition of design win which should reflect a better correlation between design wins and revenue in the future.

In 2010 cash bonuses will now be paid out based not on design wins, but based on actual upside revenue relative to our baseline plane. If the company does not deliver revenue at or above the baseline plan, no cash bonuses will be paid out.

We’re also planning to increase the focus of our sales and sales support organization on opportunities in Asia where we believe we have better opportunities.

Moving on to our business, going forward we plan to report on our businesses in two product categories, infrastructure products which contain all of our products the wide area networks including our Ethernet over SONET, our SONET PDH.

The second product category will be CPE or customer premise equipment which includes our Atlanta products, Mustang products as well as high speed interface products.

Infrastructure product revenue for the fourth quarter was roughly $8.5 million. Moving forward in 2010 we see growth opportunities in our infrastructure business based on a recovering global telecom spending.

Additionally, we’re optimistic that we will see further growth from China later this year based on their carriers three year plan to build out both 2G and 3G wireless infrastructure networks as well as wire line access in metro transport systems.

CPE product revenue for the fourth quarter of 2009 was roughly $3.6 million. This is where we saw the setback relating to our key Korean customer. We expect to see a resumption of this customer’s demand in the second half although at a lower run rate.

That said, I believe we have many upside opportunities for our CPE customers and for CPE products and I expect much of the TranSwitch growth in the future to come from this area.

So in summary, we see a stabilization of our business in first quarter with potential for growth as we move forward in 2010. Based on our current backlog and visibility we are projecting our revenue in Q1 to be between $12.5 million and $13 million and we are currently booked more than 90% of the low end of that guidance.

Going forward we are working with our customers to improve our lead time on orders and backlog coverage. I would like to have more confidence in terms of our guidance that we provide in our quarterly earnings.

I will now hand it over to Bob Bosi our CFO who will discuss our financials in more detail and provide complete guidance for the first quarter.

Robert Bosi

Thank you Ali and good evening to everyone on the call. I’ll review the fourth quarter results and provide guidance for the first quarter of 2010.

Net revenues for the fourth quarter of 2009 were approximately $12.1 million as compared to net revenues of $15.2 in the third quarter 2009 and $15 million in the fourth quarter of 2008. The company’s fourth quarter results included a non cash charge of $10.1 million for goodwill impairment charge relating to acquisitions made by the company in 2006 and 2007.

The GAAP net loss for the fourth quarter of 2009 was $12.7 million or $0.64 per basic and diluted common share as compared to a net loss of $1.5 million or $0.08 per basis and diluted common share during the third quarter of 2009 and a net loss of $4.3 million or $0.22 per basic and diluted common share for the fourth quarter 2008. All period per share amounts have been adjusted to company’s reverse in November of 2009.

With respect to the impairment, U.S. generally accepted accounting principals require the companies to perform an annual test of goodwill impairment. As a result of this analysis it was determined that the current valuation did not support goodwill of approximately $10.1 million. Accordingly, we concluded that the goodwill resulting from these acquisitions were impaired.

I would like to emphasis that the charge is non cash and does not affect any of our business plans or any of our product lines. Product revenue in the quarters that were approximately $10.7 million compared to product revenue in the Q3 of $13.5 million. Net service for the quarter was $1.5 million compared to service revenue of $1.7 million.

Our service revenue includes NRE related to activities for some telecom customers as well as revenue related to royalties, intellectual property licensing and our HDMI technology.

The geographic breakdown of our third quarter total revenue was as follows: Asia Pacific 62%, Americas 25%, and Europe 13%. The top countries for our fourth quarter revenues were Japan, Korea, China and the U.S.

For the fourth quarter 2009 our top customers continue to be Alcatel Lucent and Opi in Japan. The GAAP gross margin for the fourth quarter was 54%. This compares to the company’s GAAP gross margin of 54% in the third quarter 2009 and 54% in the fourth quarter of 2008. Non-GAAP gross margin in the quarter was not materially different.

Research and development expenses were $4.8 million for the quarter excluding stock based compensation expense, amortization of purchased intangibles. Research and R&D expenses non GAAP basis were $4.5 million.

Sales, general and administrative expenses were roughly $4.6 million. Excluding stock based compensation expense and amortization of purchased intangibles, SG&A on a non-GAAP basis was $4.1 million.

Total GAAP operating expenses for the fourth quarter were $19.1 million which included $10.1 million of goodwill impairment and other non-GAAP items. Total non-GAAP operating expenses in Q4 were $8.6 million compared to our guidance for the fourth quarter of $8.4 million, $8 million in Q3 of 2009 and $12 million in Q4 2008.

Non-GAAP operating loss for the fourth quarter of 2009 was approximately $2.1 million compared to non-GAAP operating income of $4.2 million in the third quarter of fiscal 2009 and non-GAAP operating loss of $3.3 million in the fourth quarter 2008.

On a GAAP basis the operating loss in the fourth quarter of fiscal 2009 was $12.6 million compared to an operating loss of $.6 million in the third quarter of fiscal 2009 and operating loss of $8.4 million in the fourth quarter of 2008.

Excluding items I mentioned, which are detailed on the last page of our press release, non-GAAP net loss of $2.2 million or $0.11 per share. There were approximately 20 million basic and diluted average shares outstanding for the quarter.

Our balance sheet shows cash and cash equivalents position of $5.1 million. Our accounts receivable at December 31 was $11.7 million which was down from September accounts receivable of $13.5 million.

Inventory at December 31 was $4.2 million which is down from September 30 inventory of $5 million.

In the second and third quarters of 2009 we achieved our objective of profitability on a non-GAAP basis. Our fourth quarter of 2009 was a set back from a revenue perspective and we have taken the necessary actions to align our costs to the revenue at hand.

As Ali mentioned, we guide first quarter net revenues to be between $12.5 million and $13 million. As of December our backlog for Q1 was around $9.5 million. Through today, our current billed backlog is roughly $12 million.

Based on our current revenue outlook, product mix and our blended gross margin, it is approximately between $6.6 million and $6.9 million at a 53% margin assumption. Our first quarter guidance is for non-GAAP R&D expenses to be roughly $3.9 million. Our first quarter guidance is for non-GAAP SG&A expenses to be roughly $3.7 million.

These forecasts reflect the beginning of our cost reduction savings that we recently announced. Our cost reduction program will have full effect in Q2.

In the first quarter we expect our non-GAAP operating loss to be approximately between $.7 million and $1 million. In addition, as we previously announced we plan to record a restructuring charge of $1.4 million specifically for severance costs.

With respect to cash and liquidity, we are entering Q1 with approximately $1.5 million of cash and marketable securities. During the previous quarter we paid down $1.2 million of our debt under Ali’s leadership. In addition to the OpEx reduction that we previously discussed, we are beginning a number of initiatives to mitigate our working capital required for our supply chain.

We have taken steps to reduce our inventory, reducing our restricted cash balances and service collateral for some supplier LC’s. To further shore up our balance sheet, we expect to establish a line of credit for working capital purposes. We currently have a number of proposals at hand that we are considering and we believe we will put a facility in place by the end of the quarter.

I would like to conclude by saying that the management team, our Board of Directors, and all of our employees worldwide are focusing on achieving our goals to sustain profitability. We thank you for your patience and your support and we will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Blake Harper – Signal Hill.

Blake Harper – Signal Hill

You talked earlier about some areas that you wanted to focus on with a bit more of a smaller focus on a smaller number of markets and you laid out your two product lines that you have right now. Could you talk about which areas you see initially that maybe you focused on with your RDF versus where you see some opportunities.

Ali Khatibzadeh

Obviously we’re in the middle of that process and we expect to have a better visibility at the end of that process which will be early Q2. When we look at the markets, really CPE is an area where we see significant growth ahead and it has the right characteristics in terms of some of the differentiators that we have. We believe we’ll find that market will do well.

On the infrastructure side we also see opportunities in areas such as media gateway for example. We see that as an area that’s growing. It’s driven by demand for broadband triple play services and we do have differentiators in that market as well.

So those are areas where we see clearly our technology and our product performance seem to be validated by our customers and we see potential for growth in those areas.

Blake Harper – Signal Hill

As far as the gross margins you had laid out, you targeted before in the higher 50’s range, but do you still think that’s something you can move towards and how do you see that evolving given the product focus that you’re going to have going forward?

Robert Bosi

I think it’s obviously a function of mix. We have our product ranges, our margins range form 90% to the high 30’s so right now the current mix is at 53%.

Theodore Chung

I think Bob’s right. It does depend on mix. I think we certainly can get back to a gross margin in the higher 50’s as opposed to the mid 50’s. I think we’re working to do that in a number of respects but on any given quarter you can see that continue to be the range, the 53% to 57% range.

Operator

Your next question comes from Sandy Harrison – Signal Hill.

Sandy Harrison – Signal Hill

You talked about your cost cuts and you think they will be in full effect in Q2, based upon Q1 with some true ups for the typical beginning of the year payroll and other taxes, what do you think is a good place to start modeling the numbers going forward from an OpEx perspective following the first quarter true up and others.

Robert Bosi

Our objective is to be about $7 million in OpEx in Q2.

Sandy Harrison – Signal Hill

You talked about some of the other areas you thought didn’t necessarily make sense or as you looked and thought your position wasn’t ideal for whatever reason, what do you plan to do with those products? Is there any revenue or cash to be garnered from that or how do you expect to wind down some of these areas.

Ali Khatibzadeh

We have what we call core business, legacy business that we believe will continue to generate cash for us for the foreseeable future and obviously that is a high margin piece of business that we have today and it is we believe fairly stable.

We did have some downturn last year due to the slowdown in the world wide economy which resulted in lower infrastructure spending. But what I refer to in terms of programs that we cancelled were some programs that were still related to our core business activities that we felt did not align with the vectors that we see are going in our strategic planning process.

There were some one time projects that were more of a custom nature that we felt we didn’t want to continue because they really don’t serve the strategic direction of the company.

Operator

Your next question comes from [Walter Chenker – Titan Capital]

[Walter Chenker – Titan Capital]

First is just a statement which is continuing on my issue, but there’s a company and a text book example of why the current design win is not relationship to economic benefit and maybe the company should stop even thinking in the terms of design wins, continually think in terms of revenue which might have an impact on profitability. It’s just a comment in passing and 500 design wins later revenues have shrunk to $12 million to $13 million. It doesn’t require a comment on your end. It’s just a statement of fact.

On a question basis just to make sure given what you just said about OpEx, this means that going forward the company needs $14 million plus of revenue to be profitable. Is that in the right ball park?

Robert Bosi

What we said was $13 million with a gross margin model of about 50% to 54%. We believe that is consistent with the OpEx guidance of about $7 million. We plan to be under $7 million.

Ali Khatibzadeh

To your comment, I just want to add I totally agree that you’ll not be hearing design wins from us unless it’s a significant design win and we believe it’s worth noting. First of all the definition I put in place is much more restrictive than we had in place before. It basically involves a purchase order from the customer for pre-production quantities.

Having said that, the reason I brought up the design win is for our internal incentive plan. We have two sets of measures. One obviously the revenue which as I highlighted, our cash bonuses will be aligned to upside revenue relative to our base line every quarter. Second, in terms of what we obviously need to measure and reward our sales team for is a meaningful design wins that will generate revenue in the future.

We don’t want to just focus on revenue in the quarter. A lot of activities of our sales team and our R&D team are involved to generate new design wins for the future growth. In that sense we have tightened up the definition of design wins significantly and those design wins will not be rewarded by cash but rather restricted stock that will have value aligned to our future revenue.

I agree with you that the company, we will not be talking too much about design wins unless they are major and very significant.

[Walter Chenker – Titan Capital]

Going back to cash bonuses and your statement of how the company is going to reward its people, first related question, that is just for your sales force or for everybody starting from the top on down and the second related question just to make sure I understand it is, those cash bonuses only kick in for sales which are in excess of the base case and the base case is roughly break even for the company?

Robert Bosi

Correct. I think may have stated there might be cash bonuses or implied there might be cash bonuses for other people outside of the sales force and that’s not the case. There are no cash bonus program for anyone in the organization but for the salesmen who have a relatively low base salary and that’s part of their overall compensation program.

It’s standard practice in the industry that for sales people their compensation is more skewed towards bonuses than base salary and therefore that’s why we have cash bonus for our sales people. But the R&D and other organizations in the company we do not issue cash bonuses.

Operator

Your next question comes from [Shepherd Davis – Private Investor]

[Shepherd Davis – Private Investor]

I’m just wondering about what appears to be a lot of R&D spending in relation to revenues. It appears to be something around 30% to 40%. I know we have to do some R&D but do you feel that’s high the way I do or am I off base?

Ali Khatibzadeh

Part of our strategic planning process is to understand the markets that we’re going to focus, the products roadmap that we need and that to a large extent determines our capital needs and our operating expense needs going forward. I do not believe that our operating expenses are high.

I’d argue that our R&D expenses are not enough, but we don’t anticipate to be at this revenue run rate in the future. We have expectations of growth and that involves investing in new products that will generate that growth in the future and so we have to manage that. Of course that’s part of our task in the management team to identify what level of R&D and my job to make sure that they align to our top line correctly and of course our Board of Directors reviews that very frequently.

I should say that we need to be more effective in converting our R&D to revenue and that’s something that we’re working very hard and we hope to show the results in the future and our R&D do translate into significant revenue.

Operator

There are no further questions.

Theodore Chung

Thank you all for joining us today and we’ll visit with you again in the future.

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