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Executives

Kirk Misaka - Chief Financial Officer

Mory Ejabat - Chairman and CEO

Analysts

Christian Schwab - Craig-Hallum Capital Group

Alan Davis - L.A. Davis & Associates

Zhone Technologies, Inc. (ZHNE) Q4 2013 Earnings Conference Call January 22, 2014 5:00 PM ET

Operator

Good day and welcome to the Fourth Quarter 2013 Zhone Technologies Incorporated Conference Call. I am Kim and I will be your coordinator for today. At this time all participants are on a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to introduce Kirk Misaka, Zhone’s Chief Financial Officer. Please proceed.

Kirk Misaka

Thank you, operator. Hello and welcome to the fourth quarter 2013 Zhone Technologies, Inc. conference call. I am Kirk Misaka Zhone’s, Chief Financial Officer. The purpose of this call is to discuss Zhone’s fourth quarter 2013 financial results as reported in our earnings release that was distributed over Business Wire at the close of market today and has been posted on our website 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 of 2013 and provide guidance for next quarter. After our prepared remarks, we will conclude with questions and answers.

This conference is being recorded for replay purposes and will be available for approximately one week. The dial-in instructions for 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 will 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, 2012 and our quarterly reports on Form 10-Q for the quarters ended March 31, 2013, June 30, 2013 and September 30, 2013.

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 also undertake no obligation to update any forward-looking statements.

During the course of the call, we will also make reference to adjusted EBITDA and adjusted 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 comparisons to competitor’s 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 adjusted EBITDA within the press release, which as previously mentioned, has been posted on our website 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 2013 earnings call. For the fifth quarter in a row, we are pleased to announce that we generated positive net income and free cash flow from operations, which further strengthen our financial position. We expect that every quarter of 2014 will add to that strength.

Fourth quarter revenue of $32.2 million, increased by [3%] quarter-over-quarter and 14% year-over-year. During the quarter our FiberLAN Passive Optical LAN Solution products revenue exceeded our expectation, while the U.S. carriers revenue were below our expectation and international carriers met the revenue goal.

Gross margins continued to exceed historical level due to an improved pricing environment and concentrated efforts on reducing the cost of our products. Most importantly, net income of $1.4 million or $0.04 a share continued to add of five consecutive quarters of profitability and strengthening the balance sheet. Our cash balance improved to $15.7 million on top of it our Wells Fargo debt facility, we make in a comfortable cushion of liquidity to affectively run the business.

Kirk will give you more details on the financial side. So let me talk about the things happening on the business side that are driving this strong financial performance. Enthusiasm continues to grow for our FiberLANs Passive Optical LAN solution. We are working with a rapidly growing number of new enterprise customer opportunities. We continue to ship our FiberLAN solutions in each of our served markets and we are experiencing broad acceptance of GPON at the need for enterprise deployments.

We made several significant announcements this quarter, plus we announced our membership in the Open Networking Foundation ONF is an organization dedicated to accelerating the adoption of open Software-Defined Network or SDN. Zhone will work alongside 90 plus member companies including global giants and [startups] with a variety of expertise, bringing together diverse perspectives from silicon to systems and software to computing for a variety of users.

Second we were awarded JTAG certification for our FiberLAN Passive Optical LAN solutions. This important certification allows us the opportunity to get on military and government contracts.

We are quickly gaining momentum in this important new vertical and remain highly optimistic about the exciting opportunities it provides for us. We also completed several new product launches, one is specifically develop for our core service provider business. We announced a very small form factor VDSL2 DSLAN, the [MX160LT8P] is a compact eight port DSLAN providing next generation features in a very compact form factor ideal for fiber-to-the-home curb building and basement deployments.

In addition we’ve made significant advances, we got FiberLAN Solution launching a new Zhone 2800 series fiber-jacked ONT supporting both active Ethernet and GPON. This new product offers the rich functional field or highly successful zNID 2400 and 2600 ONTs in a new very low profile, (inaudible) that keeps program fiber connections hidden within the walls. (Inaudible) ideal for FiberLAN deployment while reducing special requirements by more than 50%. MXK shipments were very strong in Q4. Zhone shipped 399 MXK in the quarter bringing a total units shipped to 5,772 units and approximately 38 million ports of MXK GPON subscriber capacity.

Now let me turn the call back to Kirk to provide more details about our financial results for the 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 2013. Fourth quarter revenue was $32.3 million, grew 3% sequentially from third quarter revenue of $31.5 million and grew 14% year-over-year from fourth quarter of 2012 revenue of $28.3 million. For the first quarter 2014 we expect revenue to increase in a single-digit percentage range on a year-over-year basis the decline on a sequential basis due to normal seasonality.

Our international markets continued to produce the majority of our business and represented 69% of revenue for the fourth quarter as compared to 66% of revenue for the third quarter. We experienced about the same level of customer concentration this quarter with the top five customers representing approximately 42% of revenue for the fourth quarter and third quarter.

We also had only one 10% customer in the fourth quarter compared to two 10% customers in the third quarter. Gross margins of 37.5% exceeded our guidance range of 35% to 37% and continued the trend of higher gross margins when compared to historical norms.

As Mory mentioned the gross expansion is the result of an improved pricing environment and product cost reductions. For the first quarter of 2014 we are leaving our gross margin guidance between 35% and 37%, but are hopeful that gross margins will continue to surprise to the upside.

Operating expenses of $10.7 million for the fourth quarter were slightly higher than the third quarter of $10.3 million and our previous guidance of about $10.5 million, primarily due to the additional sales and marketing efforts related to the expansion of our FiberLAN sales channel.

As we have mentioned before we anticipate that operating expenses will continue to fluctuate around $10.5 million and can be leveraged to support future revenue growth thereby leading to improved profitability in 2014.

In addition operating expenses for the fourth quarter included depreciation of approximately $100,000 and stock based compensation of approximately $50,000, both of which we expect to continue at the same level into the first quarter of 2014.

Finally, our adjusted EBITDA profit for the fourth quarter of 2013 was $1.6 million and net income on a GAAP basis was $1.4 million or $0.04 per fully diluted share.

Now, turning to balance sheet, cash and short-term investments at December 31, 2013 increased to $15.7 million from $14.3 million at September 30, 2013 primarily due to net income. The net effect of other balance sheet changes was very minor, although specific balance sheet accounts fluctuated to a larger extent.

Accounts receivable increased to $33.3 million at December 31, 2013 from $29.4 million at September 30, 2013, causing a slight increase in the number of days sales outstanding on accounts receivable for the fourth quarter to 93 days as compared to 84 days for the third quarter. Our total debt obligations associated with our working capital facility with Wells Fargo was $10 million at December 31, 2013 and September 30, 2013.

Lastly, the weighted average basic shares outstanding were $31.9 million and the diluted shares outstanding were $34.3 million for the fourth quarter of 2013.

And with that financial overview, let me 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. When we entered 2013, our primary financial goal was to generate profitability for the year as a whole. Having achieved both top-line growth and profitability, we enter 2014 with two primary financial objectives, generating continued revenue growth and improved profitability. Our industry leading MXK and new FiberLAN Optical LAN Solution make us optimistic that we can continue on that path adding momentum as we move forward.

We would now like to open up the call for questions. Operator, please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of Christian Schwab from Craig-Hallum Capital Group. Please proceed.

Christian Schwab - Craig-Hallum Capital Group

Great, thank you. Mory, can you quantify the FiberLAN revenue in the quarter?

Mory Ejabat

Christian, as I have mentioned several times we don’t -- we are not in the position to quantify the numbers. What I can tell you is that we had a goal in mind and we exceeded that goal. And that was a good indication that we see our FiberLAN is picking momentum at this one.

Christian Schwab - Craig-Hallum Capital Group

Great. And then regarding the opportunity in FiberLAN for 2014, I know in previous calls you’ve suggested the opportunity to do $20 million or better potentially as you highlighted a lot of positive activity in FiberLAN. Can you give us an update on what we should be thinking for the year would be great?

Mory Ejabat

Well, as you know, this is early in the year. We still believe we are close to the goal and we can achieve that given that we have recognized that the sales cycle in this product has increased and it’s more than what we’ve thought it’s going to be and that may affect our numbers. But at this point, it’s early in the year and we are [extending] those numbers.

Christian Schwab - Craig-Hallum Capital Group

Great. And then, can you walk us through any potential expansion of sales distribution partnerships that you may have for that type of product to help bring that to market and create new generation, is that something that we should expect to hear about throughout the course of 2014?

Mory Ejabat

Yeah. As you know, we have partnership with Corning, TE Data, 3M and IBM and they have started promoting their FiberLAN type of product or per se Optical LAN solutions. We have partnership with Graybar, Anixter and other distributors plus with some integrators such as (inaudible) and others and they are moving their product as an integrator. Also we have some -- the other partnership with SAIC for the government contract.

Christian Schwab - Craig-Hallum Capital Group

Great. And then on the core business are you seeing -- you guys heard typical seasonality next quarter, so the expectations in North America that were little bit less than expectations, you don’t expect that continue into Q1, we just experienced that some others have talked about in particular North America that there just was not any meaningful budget flush?

Mory Ejabat

Well, I cannot say budget flush, I really haven’t seen budget flush for so many, several years, but tier 2 to tier 5 traders were very slow in Q4 and we see that happening in Q1 as well, but in the international, our international business met its expectation. And we believe in Q1 international traders will do the same, but Q1 is always a budget cycle for everyone. So we believe that's going to be the seasonality that we have seen year-over-years that's going to happen.

Christian Schwab - Craig-Hallum Capital Group

Fabulous, no other questions. Thank you.

Mory Ejabat

Thank you.

Operator

Your next question comes from the line of Alan Davis from L.A. Davis & Associates. Please proceed.

Alan Davis - L.A. Davis & Associates

Hi guys. Kirk, could you repeat your guidance for the first quarter?

Kirk Misaka

Sure. We said, the revenue growth would be single-digit percentage; gross margins were 35% to 37%; OpEx, approximately $10.5 million for the quarter.

Alan Davis - L.A. Davis & Associates

Okay. And given I think the one thing was up a little bit this quarter, obviously sales and marketing, it sounds like given your guidance that's just going to be up and down, the fourth quarter isn’t necessarily the level you are going to stay at going forward?

Kirk Misaka

That's correct. We think it will be closer to $10.5 million next quarter, which we beat down finally from this quarter.

Alan Davis - L.A. Davis & Associates

Okay. And I guess looking to FiberLAN, obviously I know you won’t speak in terms of specific guidance forward, but do you think by the second half of the year, you will be able to break that out what are kind of the plans there and then I know you won’t break up sales for the quarter, but you can talk about progress or your level of optimism changing in terms of deal sizes or things of that nature over the course of the last three months?

Mory Ejabat

Alan, our options hasn’t changed. We believe that's a product that is very cost effective; it’s green product; its high performance for enterprise business and it’s a no-brainer for new size or you have -- having buildings to use fiber and FiberLAN type product or our product. So this is a no-brainer. And we are still enthusiastic about this product. And we believe second half of this year would be -- we will see some good penetration on this. So given that, we are now building our pipeline for this product.

Alan Davis - L.A. Davis & Associates

Okay. And then lastly and just in terms of the domestic carrier business being a bit weak, I guess in terms of your expectations, they just look out or as far as you can see I would imagine is just as you mentioned is into the first quarter and you expect it to be slow as well, is that about as much as you have into that market?

Mory Ejabat

We see that Q1 is going to be as slow, which has been like this for years as the budgets are not decided on and not approved.

Alan Davis - L.A. Davis & Associates

Okay. That’s it from me. Thank you guys.

Mory Ejabat

Thank you.

Operator

(Operator Instructions). Your next question comes from the line of Chris Coney. Please proceed.

Unidentified Analyst

Hello, can you hear me okay?

Mory Ejabat

Yes, we can hear you.

Unidentified Analyst

Yes. I was just going to ask if you have any idea how it happened that after hours, the stock dropped by $1, if you have any new speculation on that?

Kirk Misaka

You know what; your guess is as good as mine. I have no idea why the stats behave the way it does.

Unidentified Analyst

Okay. Because it was definitely making progress in the upward motion. And all of a sudden after hours it just made drastic change, so I just thought maybe someone would have some idea in that regard. And I guess (inaudible).

Mory Ejabat

No clue. Thank you very much.

Unidentified Analyst

Okay.

Operator

Your next question comes from the line of George Tomsey. Please proceed.

Unidentified Analyst

Yes. Can you give us any other insights into the competitive environment, both domestically and internationally? And in particular, I believe there have been a few articles that the Chinese company Huawei is trying to make a push in Tier 3 area?

Mory Ejabat

Okay. So in the special core business our competitors are Huawei, ZTE and Alcatel-Lucent. We’ve been competing with these companies for at least 10 years in a global scene. We have been able to win majority of their deals that we go against them, but lose some. Huawei has tried to conquer the U.S. for many years, they haven't been successful and I don't think they will be successful in this quarter as well.

Unidentified Analyst

Okay. Thank you.

Operator

Your next question comes from the line of Greg [Haynes]. Please proceed.

Unidentified Analyst

I had a question about how we should be thinking about revenues in 2014 specifically when we're thinking of FiberLAN in 2014. Should we be thinking of that as additive to the non-FiberLAN business as it transpired in 2013 or is there going to be some overlap in accounts where the 2013 revenue is not necessarily a base from which to work [of us]?

Mory Ejabat

Well, there might be some overlap in the account because some of our international carriers offer a whole solution. They provide business services as well, so they may deploy FiberLAN into their customers. They do not disclose that to us. So, we would not know how to account for that.

Unidentified Analyst

Okay. So there hasn’t been any specific guidance then been given to revenue growth in 2014 over 2013, has there?

Mory Ejabat

Typically we don’t give any guidance; our guidance is quarter-over-quarter.

Kirk Misaka

The only guidance we provided was for the third quarter which was single-digit percentage growth year-over-year, down sequentially, but year-over-year we expect in the first quarter single-digit percentage growth.

Unidentified Analyst

Okay. So are you not comfortable to mention that overall you’re expecting 2014 should be at a certain percentage above 2013 for example?

Mory Ejabat

What we said today is that we believe 2014 is going to be a profitable year for us and that’s what we’re going to stop at.

Unidentified Analyst

Okay. I just was referring back to the guidance on FiberLAN which was somewhere around $20 million to $40 million in previous call. So, I was trying to model whether that should be additive or it was going to overlap substantially where you minimize as far as year-over-year increase in revenues?

Mory Ejabat

As I mentioned, we’re recognizing that FiberLAN sales cycle is increasing. So, we are still optimistic about the FiberLAN sales. And we believe it’s going to do well for us.

Unidentified Analyst

Okay. When you say increasing in sales cycles, I remember back early in 2013, the product was coming to market and it was already known that the sales cycle would be longer than the base equipment. So, has there been a change then that would lead you to say that it’s extended even further or what are we….

Mory Ejabat

Yes. Remember, when we came in with this product, that was a new product and we felt the cycle is going to be long, but now that we are in the deals and reaching out prospect and working with the customers, we understand that the decision making time is larger.

Unidentified Analyst

Okay, very good. Thanks for taking my call.

Mory Ejabat

Sure.

Operator

Your next question comes from the line of [Aaron Martin] from AIGH Investment Partners. Please proceed.

Unidentified Analyst

Hi. This is Aaron Martin from AIGH. So, could you talk a little bit about the pricing environment in your core business? Three to six months ago we’ve seen a little bit of easing up on the pressure coming from competitive pressure on pricing. Have you seen that continuing or are there any changing dynamics in pricing?

Mory Ejabat

No, we see that pricing is the same and nothing has changed, we don’t see our competitors coming to the market with a major cost reduction. So, pricing environment has been stable for the last few months.

Unidentified Analyst

Okay. Thank you.

Mory Ejabat

You’re welcome.

Operator

There are no more questions at this time.

Mory Ejabat

Thank you. Once again, thanks for joining us today and for your continued support. We are looking forward to speaking with you on next quarter’s earnings conference call and we expect to announce continued profitability and improving fundamentals. Operator?

Operator

This concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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