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ModusLink Global Solutions, Inc. (NASDAQ:MLNK)

F2Q10 (01/31/10) Earnings Call

March 8, 2010 5:00 pm ET

Executives

Steve Crane – CFO

Joe Lawler – Chairman, President & CEO

Analysts

Allan Young – Raging Capital

Jeff Osher – Harvest Capital

Operator

Hello and welcome to the ModusLink Global Solutions second quarter 2010 operating results conference call. At the Company’s request, this conference is being recorded. Please note that all lines will be in a listen only mode until the question-and-answer portion of today’s conference call. (Operator instructions)

Now, I would like to turn the call over to Mr. Joseph Lawler, Chairman, President, and CEO and to Mr. Steven Crane, Chief Financial Officer. Please go ahead, Mr. Crane.

Steve Crane

Thanks, Tracy. Good afternoon, everyone, and thank you for joining us for ModusLink Global Solutions fiscal 2010 second quarter Conference Call. I’m Steve Crane, CFO, and I’m joined today by Joe Lawler, Chairman, President and CEO.

In just a few moments, Joe will share his thoughts on the Company’s financial performance and the market environment over the past quarter and provide an update on our strategic initiatives. After Joe’s comments I will review in more detail our fiscal 2010 second quarter results which we released earlier today.

Before we start, I want to remind you this call is being broadcast as a live webcast from our Web site at www.moduslink.com.

Please also note that the information we’re about to discuss includes forward-looking statements for purposes of the Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties. The Company’s actual results could differ materially from those discussed herein.

Factors that could contribute to such differences include but are not limited to, those items noted and included in the Company’s SEC filings including our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.

The forward-looking information that is provided by the Company in this call represents the Company’s outlook as of today and we do not undertake any obligation to update forward-looking statements made by us. Subsequent events and developments may cause the company’s outlook to change.

During this call we’ll be referring to non-GAAP measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP measure can be found in our earnings release issued earlier today. A copy of which is posted in the investor section of our Web site.

I’d now like to turn this call over to Joe Lawler. After our formal remarks we’ll be happy to take your questions. Joe?

Joe Lawler

Thank you, Steve, and good afternoon. We continued to operate in a difficult economic environment in the second quarter while demonstrating sound execution of our business plan and improved profitability, which benefited from a more efficient cost structure.

A few of the main points that you’ll hear Steve and I talk about today are as follows

First, we remain cautious about client volumes and the timing of the start-up of new engagements in the context of the economic environment. However, we continue to see bright spots in our business with improved volumes from certain clients and a generally improving tone for the future.

Second, we continue to be pleased with our revenue mix, which included new engagements utilizing our after market and e-business solutions. These solutions are typically higher margin services with strong prospects for growth.

Our focus on these solutions and the recently completed acquisition of Tech for Less is contributing to a more favorable work mix.

Third, the cost reduction initiatives implemented last fiscal year continue to have a positive impact on our business. Despite having 9.6% lower revenues compared with the second quarter last fiscal year our non-GAAP operating income increased by more than 6% and we generated significant free cash flow from operations.

Before handing the call back to Steve for a more detailed financial review, I’ll share a few observations regarding our operating results for the second quarter.

Overall, we continue to operate in a fairly weak economic environment, which has a direct impact on our clients’ product volumes and the start-up of new engagements. Clients especially those in the Americas and Europe are being very cautious about inventory levels and we see many clients waiting until there is a clear demand signal before adding volumes into the supply chain.

However, revenues from base business in the second quarter were relatively flat compared to the same quarter last fiscal year and we view that as a sign that volumes in our base business are stabilizing.

Revenues from new engagements were slightly better than we expected in the second quarter, which we view as another positive sign. The size of the opportunities recently closed as well as those in our pipeline look good. And we continue to expect new business to make a greater contribution to our revenue performance in the second half of this fiscal year compared to the first half.

Compared to the same period last year, gross margin for the second quarter increased 100 basis points to 13.4% driven by favorable work mix and cost reduction actions taken in fiscal 2009.

In addition, selling, general and administrative expense was down 10% for the second quarter compared to the same period last year supporting strong improvement in operating income on a GAAP and non-GAAP basis.

We’ll continue to keep a sharp focus on effectively controlling costs, essentially managing what we can control so as the market environment improves, ModusLink can grow more profitably.

Our continued focus on cost management and working capital efficiency has resulted in the generation of $29 million of free cash flow from operations in the quarter, an increase of 33% compared to last year’s second quarter.

As we move into the second half of the year, our organization is operating efficiently and is focused on opportunities with the greatest potential for revenue and profit growth that will drive improving shareholder value for the future.

I’ll make a few comments about our ongoing strategy in just a few minutes but before I do, Steve will give you a more complete financial review.

Steve Crane

Thank you, Joe. For the second quarter of fiscal 2010, ModusLink Global Solutions reported net revenue of $235.5 million, a decrease of 9.6% compared to net revenue of $260.5 million for the same period, one year ago.

Base business revenue was $219.1 million, an increase of $3.3 million or 1.5% compared to the second quarter of last year. Within base business revenue, our contributions of $4.8 million from Tech for Less, which was acquired on December 4, 2009.

As Joe mentioned, even when excluding revenues from Tech for Less, base business revenues were relatively flat compared to the second quarter of last year, which provides us with some optimism that our base business is stabilizing.

When comparing sequentially to the first quarter of fiscal 2010, base business for the second quarter was lower by 3.9%. Typically base business in our second quarter is seasonally lower than the first quarter.

Revenue from new engagements was $16.4 million, a decline of 28.2 million or 63.2% when compared to the second quarter of last year. This decline is a direct result of our clients delayed decision-making due to the economic headwinds in the spring and summer of 2009. As Joe noted, we expect new business will make a greater contribution to our revenue and performance in the second half of the fiscal year.

Geographically, each of our primary regions was impacted by the continued economic uncertainty. In Asia, revenues decreased to $70.1 million from $74.1 million in a prior year period primarily due to lower volumes.

The Americas and Europe were particularly affected by the economic slowdown with lower volumes of consumer products moving through our facilities in those regions.

As a result, revenue in the Americas decreased to $79 million from $88.6 million in the second quarter fiscal 2009 and revenue in Europe decreased 16% from $94.1 million in the second quarter last year to $79 million in the second quarter this year.

Despite the lower revenue levels, profitability improved in each of our primary regions due to favorable work mix and the positive impact of our cost reduction initiatives.

ModusLink’s gross margin decreased 2.1% in dollar terms to $31.5 million in the second quarter of fiscal 2010 from $32.2 million in the second quarter of fiscal 2009. However, as a percentage of revenue, gross margin increased 100 basis points to 13.4% in the second quarter of fiscal 2010 from 12.4% in the second quarter of fiscal 2009.

Gross margin percentage for the quarter was primarily driven by favorable work mix and benefits from our cost reduction initiatives. Gross margin for the second quarter was lower than first quarter gross margin of 14.6%, which we indicated that exceeded our expectations.

Operating expenses decreased to $25.6 million in the second quarter of fiscal 2010 from $192.7 million in the same quarter last year. The year ago quarter included a non-cash goodwill impairment charge of $164.7 million, which was not present in the second quarter of fiscal 2010. The lower operating expenses also reflect a $2.7 million or 10.2% reduction in SG&A, which was primarily due to our ongoing cost reduction initiatives.

Please note also that the prior year period did not include operating costs related to Tech for Less which accounted for $1.7 million with a $25.6 million in operating expenses in the current year quarter.

Our restructuring expense was reduced to just $36,000 in the second quarter. In line with our cost reduction initiatives, restructuring costs are substantially lower than in fiscal 20009.

For the first half of fiscal 2010, restructuring charges were $165,000 compared with $7.1 million in the first half of fiscal 2009. In a normalized environment, our expectation is that annual restructuring expenses would be in the range of $2 million to $4 million.

For the second quarter of fiscal 2010 and as a result of all of what I discussed, the Company reported operating income of $6 million, a significant improvement compared to an operating loss of $160.5 million in the second quarter of fiscal 2009.

Other income or loss improved by $3.7 million to a loss of $1.2 million in the second quarter of fiscal 2010 from a loss of $4.9 million in the second quarter of fiscal 2009. Other income or loss in the second quarter of 2010 is primarily comprised of an $800,000 loss from equity and affiliates.

In the second quarter of fiscal 2009, other income including the impairment of several investments in the @Ventures Portfolio, which was not repeated in the second quarter of fiscal 2010.

The Company recorded a tax expense of $2.2 million for the quarter compared to tax expense of $3.5 million in the second quarter of fiscal 2009. We continued to evolve and drive our tax strategy to both support our business strategy and to maximize the use of our U.S. NOLs.

With all the above factors for the second quarter of fiscal 2010, ModusLink recorded net income of $2.6 million or $0.06 per share compared to a net loss of $168.8 million or $3.73 per share in the second quarter of fiscal 2009.

Non-GAAP operating income represents total operating income excluding net charges related to depreciation, restructuring and amortization of intangibles, stock-based compensation and non-cash charges.

ModusLink’s non-GAAP operating income for the second quarter of fiscal 2010 was $13.2 million versus non-GAAP operating income of $12.4 million for the same period in fiscal 2009. As a percentage of revenue, non-GAAP operating income was 5.6% in the second quarter, an improvement compared to 4.7% in the same period last year.

The Company believes that non-GAAP operating income or loss provides investors with a useful supplemental measure of the Company’s operating performance by excluding the impact of non-cash charges and restructuring activities.

Each of the excluded items was excluded because they may be considered to be of a non-operational or non-cash nature. Historically, the Company’s recorded significant impairment and restructuring charges.

Non-GAAP operating income or loss does not have any standardized definition and therefore is unlikely to be comparable to similar measures presented by other reporting companies. Non-GAAP operating income and loss should not be evaluated in isolation of, or as a substitute for the Company’s financial results prepared in accordance with Generally Accepted Accounting Principles of the United States.

We continue to maintain a strong balance sheet. At January 31st 2010, the Company had working capital of approximately $222.8 million compared to $237 million at July 31, 2009 and $217.4 million at January 31, 2009.

Including in working capital as of January 31, 2010, were cash, cash equivalents, short-term investments and marketable securities, totaling $164.3 million compared to $179.2 million in July 31, 2009 and a $135.7 million at January 31, 2009.

Cash, cash equivalents and marketable securities at January 31, 2010 reflects a payment of $29 million net of acquired cash for the acquisition of Tech for Less. The Company concluded the quarter with no outstanding bank debt.

Regarding cash flow, for the second quarter fiscal 2010, free cash flow from operations was $29.5 million, an increase of 33.5% compared to $22.1 million in the same period in 2009.

As investors have been following us know, fiscal second quarter tends to be our strongest for generating cash flow as we and our clients reduce inventories following a seasonally higher demand around the holidays. As we’ve said in the past, given the normal seasonality in our business, we encourage our investors to look at our free cash flow on an annual basis.

Given our expectations for the timing of new business activity, we expect that free cash flow from operations for the full fiscal Year will be similar to what we achieved in fiscal 2009.

During the second quarter, we repurchased approximately $6.5 million worth of shares of ModusLink common stock. Our repurchase program is up to $15 million and through the second quarter we have spent a total of $12.8 million.

Looking forward, we are updating our outlook based on current forecasts from our clients and expect revenue for the third quarter of fiscal 2010 to be flat to lower compared to the second quarter of fiscal 2010.

The Company expects sequential improvement in revenue for the fourth quarter of fiscal 2010 compared to the third quarter of fiscal 2010 as a result of increased contributions from new engagements. Thank you.

And I’ll now turn it back to Joe.

Joe Lawler

Thanks, Steve. Looking forward, we are optimistic that continued execution of our business plan and an improving tone in the market will translate into further improved financial performance for ModusLink.

We expect that the difficult economic environment will continue to be a source of caution among clients. However, we are confident that we have the right strategy in place to achieve long-term growth and increase shareholder value as the economic environment improves.

Our priorities are centered on generating growth from base business and driving new engagements while supporting our efforts with strategic acquisitions. As investors that have been following us know, our client base is comprised of some of the world’s largest and strongest technology and consumer brands with more than 70% of our revenues are from Fortune 1000 companies.

We touch a diverse set of product categories such as notebook computers, microprocessors, flash memory and many others, with no one category representing more than 15% of our revenues.

Providing strong client service has been a key part of developing our client base. Even during the lowest point of the economic recession, we maintained the highest levels of customer service. And as a result, client satisfaction has never been higher. We are also supporting clients with innovative new services.

For example, ModusLink recently announced ModusLink Rebate, a web-based customer loyalty solution and a component of our e-business suite of solutions.

ModusLink Rebate provides online and offline rebate processing to accelerate fulfillment and automate the complete rebate process to help clients increase sales, reduce costs, and enhance their customers experience.

Lowering our clients costs, shortening their time to market and executing reliably across our global footprint continues to set us apart from competitors.

Solutions such as e-business entitlement management and aftermarket services represent particularly strong opportunities for ModusLink. We are developing these solutions both organically such as with the rebate program I just described as well as through acquisitions.

For example, Tech For Less, which we acquired in December strengthens ModusLink’s existing capabilities for remarketing, returned and repaired technology products by extending our solutions to the B2B and B2C markets.

The integration is going well and having had the opportunity to work with Tech for Less team over the past couple of months we are enthusiastic about the contributions the business will make to ModusLink. We will continue to consider acquisition opportunities that fit our business model and contribute to growth in revenue and profitability.

In addition, securing new engagements is important for driving future growth. As I mentioned earlier, we’re pleased with the size and quality of our pipeline and we see opportunities to increase revenue and market share by winning new engagements with both existing and new clients. I’d like to provide you with two examples.

We are pleased to have added a new engagement with Sony Ericsson, whereby Sony Ericsson is leveraging our forward supply chain services for its accessories, kitting, and spare parts management. This further streamlines Sony Ericsson’s supply base network and provides a closed loop supply chain solution.

Our work with Sony Ericsson is a great example of the value of our integrated solutions and the value for Sony Ericsson working with a single partner to support its end-to-end supply chain processes while enhancing customer service for their customers.

Another good example is our work with Provo Craft, an innovative maker of consumer electronics. Provo Craft previously insourced the execution of their supply chain. And as you heard us talk about last quarter they engaged ModusLink for e-business services. After proving the strength of our e-business capabilities, Provo Craft recognizes the value of the trusting its configuration and fulfillment processes to ModusLink as well.

We will now provide Provo Craft with an end-to-end supply chain management solution in the United States including order management configuration fulfillment and returns management in addition to contact center support and customer service for its direct response programs.

Provo Craft is a particularly good example of the opportunity we see to work with companies that have not outsourced their supply chain previously. Industry estimates suggest that more than 70% of the supply chain costs are not yet outsourced.

We’ve been preparing for the start-up of both the Sony Ericsson and Provo Craft engagements in our fiscal Q2 and Q3 and expect to generate revenues beginning in Q4.

In summary, we continue to operate in a difficult economic environment. ModusLink’s results will be largely driven by unit demand from our clients as well as the timing of new programs starting up. We see bright spots within our client base and a generally improving tone, which makes us optimistic for the future.

We continue to focus on managing expenses. The positive effects of the cost reduction and restructuring activities executed last year are reflected in our results, contributing to year-over-year improvements in gross margin, GAAP, and non-GAAP operating income as well as free cash flow. And importantly, we continue to maintain a strong balance sheet providing a solid foundation for our business model.

With that said I look forward to speaking with you again on our next earnings call. Now, Steve and I are happy to answer any questions you may have. So Tracy, if you’d open it up for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Allan Young with Raging Capital.

Allan Young – Raging Capital

Good afternoon. We saw in fiscal Q4 a number of companies benefited from inventory restocking had the strong quarters. And I’m curious to the extent you saw that or did not see that in that quarter?

Joe Lawler

Yes, Alan, I think just as reflected by Q4 you’re talking about calendar Q4?

Allan Young – Raging Capital

Yes, yes, we really are, and I understand, obviously, January 31, but we did see that across the number of industries.

Joe Lawler

Typically, when you look at our business model we would be anywhere from one month to three months ahead of a lot of the inventory stocking levels that you’re talking about. So we’re a little further upstream in the supply chain. One of the jobs that we’ve got is to help our clients make those supply chains more efficient, reduce the levels of inventory in those supply chains. And so there’s no question we saw some spikes here and there with some clients increasing inventory levels, but overall, I think a very cautious tone that we were seeing really at the beginning of the fall.

Allan Young – Raging Capital

Number of your clients, some of the big ones had pretty good Q4. Did you benefit from that previous to that fiscal quarter?

Joe Lawler

Yes, some of our clients absolutely did have good quarters. It’s one of the reasons we wanted to comment this time on just how our product portfolio breaks down. We work with 100 clients around the world. We have a very diverse product set with them. So there’s really no one single product category that represents more than 15% of our business and a lot, in fact, most obviously well under 10%.

And so, yes, we did experienced some upticks in business, but generally speaking, the softness with our base business coupled with delayed decision making in new business start-up and I think that was clearly the biggest driver to the results we saw in our fiscal Q2 results, calendar Q4 is just the delayed decision-making that really we started to see at the beginning of last calendar year and didn’t start to pick-up until we were getting into the fall of this past year and as I indicate, we’re confident is on the uptick as we move into latter parts of fiscal 10.

Allan Young – Raging Capital

Okay. Just want to comment on the sequential increase in SG&A. We’re starting to get towards a more sustainable rate or do you expect further increases?

Joe Lawler

Yes, I think we feel as though we’re at a pretty good level. We indicated to you how much was a function of the acquisition that would not have been in there in a previous quarter and yes, we think that we’re operating at pretty good and pretty efficient levels right now.

Steve Crane

I think that’s right, Alan. This is Steve Crane. I’d just add to point out that TFL was in for about two months of the quarter –

Allan Young – Raging Capital

Right.

Steve Crane

But I think we both feel comfortable that this SG&A level was about the right level.

Allan Young – Raging Capital

All right. And then lastly, I just want to touch on why the restructuring costs were as low as they were.

Steve Crane

I’ll answer that. If you go back into fiscal Year '09 when we started to see the economic headwinds, that’s when we went through our big cost reduction initiatives. So you would have seen that for fiscal Year '09, we spent close to $20 million on restructuring expenses. So as we said, we had a good first half from that perspective. Our expectation in a more normalized environment is that we would see kind of $2 million to $4 million a year in restructuring expenses.

Allan Young – Raging Capital

Great. And actually can you just comment on thoughts on the gross margin? I know at the end of last quarter you suggested it wasn’t quite sustainable. Are you more comfortable with this level?

Steve Crane

Yes, I would say that the gross margin level in Q1 did exceed our expectations of that 14.6%. We are absolutely pleased with the gross margin uplift and when we compare Q2 to Q2. It’s also interesting when you look over the last four quarters we’ve actually generated net of about a 13.8% gross margin, but our long-term business model and we’re not changing that is consistent and sustainable 12% to 14% gross margin for this business and I think we feel very comfortable with that.

Allan Young – Raging Capital

Right, great, thanks very much.

Operator

Your next question comes from Jeff Osher with Harvest Capital.

Jeff Osher – Harvest Capital

Yes, hi guys. Just a few questions. One housekeeping question. What should we be thinking about, I think I heard you say think about operating cash flow for fiscal '10 similar to fiscal '09. Should we think about CapEx in a similar light too?

Steve Crane

CapEx, I think we’d see a little bit of an uptick when we compare second half of '10 to the second half of '09.

Jeff Osher – Harvest Capital

Okay. And what have you done in the first half?

Steve Crane

The first half, let me get that to you, let me just look.

Jeff Osher – Harvest Capital

I mean that $2 million in Q2.

Steve Crane

Overall, Jeff, we did $3.4 million.

Jeff Osher – Harvest Capital

Okay, so $3.4 million in the first half and could that double in the second half?

Steve Crane

As I said I think you’ve got to look at it second half of '10 compared to the second half of '09 so. As we start to build up, one of the things we’ve been guiding you to is new engagements are coming on board and typically there’s going to be an investment associated with that so expectation is you’ll see the CapEx pick-up in the second half of the year.

Jeff Osher – Harvest Capital

Okay. And what I’m trying to get a sense of is should we expect a similar free cash flow number for fiscal '10 as you throw off in fiscal '09?

Steve Crane

That is our guidance that we would expect the free cash flow from operations to be consistent and similar to what we saw in FY 2009.

Jeff Osher – Harvest Capital

Okay, good. 10% customers?

Joe Lawler

Say that again?

Jeff Osher – Harvest Capital

10% customers?

Joe Lawler

Yes.

Steve Crane

Yes, we have like two in the quarter, so it’s similar to what we’ve had in the past, Jeff.

Jeff Osher – Harvest Capital

Okay. Without naming them specifically what did the two accounts for?

Steve Crane

We’ll keep talking and I’ll come back to that one.

Jeff Osher – Harvest Capital

Okay. And then one final one. Obviously, you’re doing a really good job and you have flow goes over the next six months to 12 months that should reaccelerate growth assuming the base business continues to stabilize. What changed though with regard to expectations in your customer engagements, specifically, on the new customer side over the last three months. I know it’s semantics.

You guys again are doing a good job, but when you initially had expected Q2 to be flattish with Q1 and then a gradual uptick in Q3 and Q4 to now a down Q2 versus Q1 and the subsequent down Q3 versus Q2 before we see a resumption of sequential growth. Maybe if you can just provide a little more color around what changed in the last three months?

Joe Lawler

Yes. Jeff, I think a couple things. One, we were expecting to see a little stronger base business activity in Q2 than we actually saw. Last year’s Q2 really slowed down, particularly, as we got into the quarter and we didn’t see an uplift. We saw as we indicated about the same activity so we were expecting to see a little more volumes. Didn’t think it could be quite as soft as it was last year, but there is just tremendous reluctance to build inventory levels into the supply chains.

And secondly is it really is a shift in new business start-up. Some of the start-up activity that we’ve got is taking a little longer. We were very active in the second quarter, preparing for new business start-up that’s going to happen later in Q3 and will benefit us in late Q3 and Q4. I would say that our new business activity is as strong as we have seen it in the past couple of years. Our close rate is increasing, our cycle time is improving.

And what happened is literally a year ago, there was a freeze in decision-making at our clients and because it takes us, it can take six months to close a transaction and then sometime after that to get it on boarded, we’ve seen the effects of that. So we expect it to see a little stronger new business in the second quarter, but it was not bad. And I think the trend is going to be up as we go through the second half.

Jeff Osher – Harvest Capital

Okay. I’ll follow-up more offline, but maybe if you can just refresh my memory. If it typically takes six months to close a transaction then the business you would have been guiding to for fiscal Q2 would represent a business that had already closed. So that would suggest the on-boarding times have just been lengthened, is that fair?

Joe Lawler

Yes, that’s very fair. I just give you a couple of examples of transactions. One of which we had expected to start-up at the beginning of Q3, but the complexity and the size of the opportunity has just required more on-boarding time than we thought three months ago.

Jeff Osher – Harvest Capital

Okay, thanks guys.

Steve Crane

Jeff, just to answer that question so HP accounted for 28% of our revenues in this quarter.

Jeff Osher – Harvest Capital

HP was 28%?

Steve Crane

(inaudible) one over 10%.

Jeff Osher – Harvest Capital

Okay, thanks for the color.

Steve Crane

All right.

Operator

At this time, gentlemen, there are no further questions. Are there any closing remarks?

Joe Lawler

Thanks very much for the questions. We’ll look forward to updating you on the next earnings call. Thanks, Tracy.

Operator

Thank you, and thank you for participating in today’s conference call. You may now disconnect.

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