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Executives

Jim Fanucchi - Darrow Associates

Greg Dougherty - CEO

Pete Mangan - CFO

Analysts

Subu Subrahmanyan - The Juda Group

Rob Richardson - Stifel Nicolaus

Dave Kang - B. Riley & Company

Oclaro, Inc. (OCLR) F2Q 2014 Earnings Conference Call February 4, 2014 5:00 PM ET

Operator

Good afternoon and welcome to the Oclaro Second Quarter Fiscal Year 2014 Financial Results Conference Call. As a reminder, this conference call is being recorded for replay purposes through February 11, 2014.

At this time, I'd like to turn the call over to Jim Fanucchi of Darrow Associates. Please go ahead, sir.

Jim Fanucchi

Thank you, operator, and thanks to all of you for joining us. Our speakers today are CEO, Greg Dougherty; CFO, Pete Mangan.

Before we begin, statements about management’s future expectations, plans or prospects of Oclaro and its business, including statements about future financial targets and financial guidance, Oclaro's plans for future operations, together with the assumptions underlying these statements constitute forward-looking statements for the purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements concerning financial targets and expectations and progress toward our target business model, including financial guidance for the third quarter of fiscal 2014 ending March 29, 2014 regarding revenue, non-GAAP gross margin and adjusted EBITDA, expectations related to the restructuring of our business, and our market position, economic conditions, product development and future operating prospects and our ongoing customer relationships.

There are a number of important factors that could cause actual results or events to differ materially from those indicated by such forward-looking statements including the risk factors described in Oclaro's most recent Annual Report on Form 10-K, most recent quarterly report on Form 10-Q, recent Form 8-Ks and other documents we periodically file with the SEC.

The forward-looking statements discussed today represent Oclaro's current views as of the date of this conference call and subsequent events and developments may cause Oclaro's views to change. Accordingly, actual results may differ materially from those indicated by these forward-looking statements. Oclaro does not intend and is not required to update any forward-looking statement as a result of future developments.

In addition, today, we will be discussing non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP and should not be considered as a substitute for or superior to measures of financial performance prepared in accordance with GAAP. A table that outlines the reconciliation between the non-GAAP financial measures to GAAP financial measures together with a discussion of their usefulness and limitation is included in today's earnings release, which we have filed with the SEC, and I refer investors to this release.

Finally, as we have previously announced, the company is scheduled to present at the Stifel Technology Internet and Media Conference in San Francisco next Monday and we look forward to seeing some of you at that event.

I would now like to turn the call over to Greg.

Greg Dougherty

Thanks, Jim, and thank you everyone for joining this call. Today, I'm pleased to report that we're making significant progress towards achieving the goals of our turnaround plan. As you can tell from our press release, we delivered a solid quarter with much improved results. While we still have substantial work ahead of us our financial results in the second quarter of fiscal 2014 demonstrate that our restructuring efforts are starting to pay off and that we are on the right strategic path.

As we just reported, our revenue, gross margin and adjusted EBITDA all exceeded our expectations. We improved our execution, we delivered on our restructuring plan, and we significantly cleaned up our balance sheet. All of this progress has been made possible by the hard work and determination of our dedicated employees who have stayed focused amidst the myriad changes and difficult decisions that we have made. While the workload as well as the number of activities and moving parts here remain high, our team is finding renewed energy as we begin to turn Oclaro around.

On the numbers, our revenues came in at $103 million showing over 6% growth from previous quarter. This result shows that our customers continue to value our products, technology, and differentiated solutions. We continue to have strong customer engagement and I believe that our traction is improving.

Aided by strong revenues, improved execution and a favorable product mix, our gross margin improved significantly this quarter. We believe that the decision to continue to manufacture our high performance indium phosphide components in Shenzhen was the right call. It has allowed us to ramp up our contract manufacturing partners in a more controlled way and to do a better job of product transitioning. All in all, this decision has provided a level of stability to our manufacturing plants.

Finally, our adjusted EBITDA came in at approximately negative $11 million representing almost 50% improvement over last quarter. We also substantially improved our balance sheet. During the quarter, we completed the sale of our fiber amplifier business leaving us with $144 million cash at the end of Q2. We also eliminated the last of our expensive debt as our convertible noteholders converted from debt to equity leaving us now virtually debt free.

Despite all of the progress that we have made, we still recognize the challenges in front of us as we continue to stay focused on our main objective to generate cash. Pete will walk you through the details of the numbers but I feel that the financial results today are a clear indicator that we are on a path to financial health. As you can tell from our results, our restructuring efforts are progressing ahead of schedule as are the previously announced headcount reduction plans.

During the last quarter, we completed the last step of our announced workforce restructuring by launching programs in China, Japan and Thailand. All regions where Oclaro operates have now shared the pain of these adjustments. As I said on our last call, on July 1, 2013, we had a workforce of approximately 3,000 with plans to cut that number in half in one year.

As of early January, we were down to approximately 2,000 employees compared to our plan of 2200 and we remain on track to be under 1500 people by July of this year. It is important to note that our downsizing has been staged, so the associated expense reductions will not always materialize in the period when the actions are taken. Therefore, we expect the cost benefits to be realized over the next few quarters.

We are also continuing to reduce the number of our global sites as part of our plan to streamline and simplify the company. We have gone from 20 sites to 14 and still expect to be at 10 by July. The smaller footprint is allowing us to begin building better business practices and processes. I expect that being simpler with better processes will make us more efficient in all areas.

Despite our restructuring and resizing, we continue to invest strongly in R&D. As we said before, Oclaro's strategic choice is product leadership via technology differentiation. We remain focused on the concept of photonic integration, laser innovation and advanced packaging to enable the emerging needs for higher speeds, lower power consumption, higher port counts and density and lower cost for both telecom and datacom applications. These emerging market trends played very well to our core strength.

We have targeted development activity in the high growth areas of components and modules for 100G coherent application, indium phosphide integrated circuits, 100G client interfaces, 40G and 100G modules for datacenters as well as tunable SFP+. As evidenced with some of our progress and focus at OFC next month we will present two exciting papers on our photonic integrated circuits for use in 100G coherent networks.

One paper discusses a highly integrated balance receiver and the other an integrated tunable laser plus modulator in a small package. Both of these papers highlight our ability to provide photonic integrated circuits in indium phosphide with world class performance. In addition to our papers and presentations, one of our key customers will actually present a paper demonstrating the performance that they achieved by using our integrated indium phosphide optical components with their proprietary DSP in a 100G coherent system.

I would now like to talk a bit about our markets, customers and products. Our datacom business represented 44% of sales for the quarter growing nicely by 10%. This was fueled primarily by our 100G client CFP and CFP2 products and by our 40G pluggable transceivers. Telecom represented 49% of sales and grew by almost 4%. It was driven by strong demand for our 40G line cards. These line cards are used in North American telecom networks which continue to build out 40G capacity.

We are now expecting the 40G business to last longer than we thought and continue to be healthy with modest reductions over the rest of this calendar year. We also saw strength in demand for our 100G coherent products such as lithium niobate modulators and narrow line width tunable lasers.

Our Q2 business in China grew by over 10% sequentially, driven in part by demand from our customers that are preparing to participate in China Telecom’s 100G program. We expect our business in China to remain at about this level as we anticipate seeing continued business from some of the same customers once China Mobile's 100G tender is awarded, which we understand to be sometime in the first half of this year.

And finally, our industrial and consumer business remain steady at 7% of sales.

One of our challenges as we look forward is the phasing out of some of our legacy and discontinued products such as previous generations of 10G pluggable transceivers, 40G 2PSK modules as well as our WSS product line. While I am confident that we have many promising developments in our R&D pipeline, we will need to continue to improve our execution in introducing new products into volume manufacturing to address this challenge.

As you are well aware, last quarter was a typical time for annual price negotiations with many of our key customers. In terms of the price adjustments, the outcome of the negotiations was pretty well in line with both our expectations and the average range for industry in prior years. We will see the impact of these price adjustments in our current quarter.

In summary, we are starting to see the results of our efforts to right-size the company and align with our more focused and simplified strategy. We believe we are still on track to achieve breakeven adjusted EBITDA by the December quarter based on the model that we previously outlined. Pete will walk you through the model in his section. The targets in that model are not reflective of a long term model from the company. However, they are intended to set realistic milestones for us to achieve breakeven.

With that I'd like to turn the call over to Pete to go through the details of our financials for the quarter. Pete?

Pete Mangan

Thanks, Greg. Before I start I want to apologize in advance to the folks on the call as I'm battling a cold and my voice is a little rough. That said, I will start by summarizing the results from the December quarter and then I will provide guidance for our fiscal third quarter ending in March.

For Q2, net revenues for $102.9 million grew 6.5% compared to $96.6 million in the prior quarter. As shown on the revenue table that we have posted today on our website we had another quarter of strong performance for our 40 and 100G transmission products that grew approximately 20% for the second consecutive quarter and represented 44% of the company revenue. Also, our 10G and lower business remained our largest product group with 48% share.

For fiscal Q2, we had three customers with greater than 10% of revenues. Coriant became our number one customer with 15% of total revenues and drove much of our 40G business. Cisco contributed 13% and Huawei represented 10% of total revenue. Now that Marlin Equity Partners has completed its acquisition Tellabs and the companies have combined the new Coriant would have represented 18% of our sales for the quarter.

As a few final comments on revenue, our top 10 customers contributed 75% of our revenues and regional sales showed Europe with 32%, China with 25%, America 18%, Southeast Asia 16% and Japan 9%.

Our non-GAAP gross margin improved to 17.1% in Q2 compared to 12.6% in the prior quarter. The improvement was driven by a richer mix of 100G, product cost improvement in our high volume business and higher sales leveraging fixed overhead. Each category contributed one plus point of improvement. Non-GAAP operating expenses of $34.4 million decreased by $4.4 million in the quarter.

In the September quarter, there were additional costs from year-end audit fess of $2.2 million. When factoring out these year-end expenses the normalized decrease was 6% as we saw $1.3 million of initial benefit from restructuring plus had a favorable Yen saving in the quarter of $0.4 million.

As a result of improved gross margin and reduced operating expenses, our non-GAAP operating loss was $16.8 million. Also, our adjusted EBITDA was a negative $10.7 million which improved significantly by $8.9 million or 45% from the prior quarter.

Overall, net loss on a non-GAAP base was $27 million or $0.29 per share essentially flat with the prior quarter. The $10 million delta between non-GAAP operating loss and net loss was primarily the result of interest expense of $8.5 million in the quarter. The interest expense included a make-whole provision associated with the convertible note exercised in December. I will provide a few more comments on the debt to equity conversion in a moment.

On a GAAP base for the December quarter, total GAAP adjustments were negative $11.1 million. This primarily included $6.7 million of restructuring, professional fees and severance cost and $2.8 million of Yen-based FX loss. Also, we recorded a $69.7 million gain on the sale of our amplifier business; the details are shown on Slide 5 of the presentation for your reference. Bottom-line, in Q2 '14, we recorded a GAAP net profit of $31.5 million or $0.34 per share. The profit is the result of the amplifier gain on sale.

Now turning to the balance sheet, cash including restricted of $144 million increased approximately $50 million. The increase was driven by the net cash received from the amplifier sale f $79.6 million and was offset by adjusted EBITDA of negative $10.7 million, interest expense of $8.5 million, restructuring of $6.7 million, and deal cost of $2.7 million.

Other significant balance sheet items included accounts receivable of $77.7 million or 69 days of sales which decreased $23 million in the quarter as the pump and amplifier AR left behind was collected.

Inventory of $89.5 million or 95 days remained relatively flat in the quarter.

Accounts payable and accrued expenses decreased by 10% in the quarter to $159.1 million, but still remain high at 141 days of payable.

As previously announced we exchanged our convertible debt on December 19th. In exchange for $25 million of notes, we issued 13.5 million shares of common stock and paid a make-whole provision of $8.3 million for the remaining four plus years of interests. As a result of the exchange at the end of the quarter, we had shares outstanding of $107.7 million.

In summary, the second quarter came in better than expected, as revenue, gross margins, and adjusted EBITDA, were favorable to our guidance and we start calendar year 2014 virtually debt free with a much stronger balance sheet. This concludes the financial review of the second quarter of fiscal 2014.

Let me now comment on our outlook. Today we announced the following guidance for the third quarter ending March 29, 2014. Revenues are expected in the range of $93 million to $103 million, non-GAAP gross margins in the range of 13% to 17%, adjusted EBITDA in the range of negative $13 million to negative $9 million. As additional comments, non-GAAP operating expenses are expected to further decline by about $3 million in Q3 and depreciation is expected to be approximately $5 million.

Also this quarter, we expect to establish a $40 million working capital line of credit, but do not plan to utilize the facility this year.

In closing, I would like to reconfirm our plans provided last quarter for adjusted EBITDA breakeven and what I view as some key financial requirements for this year. Regarding restructuring, in Q2, we spent $7 million of the $20 million to $25 million plan and expect this level to continue for the next two quarters and then tail off to $1 million to $2 million per quarter in the second half of this calendar year.

Regarding our cash, we expect further cash usage this calendar year in the following four areas. One, to fund our remaining restructuring; two, to fund negative adjusted EBITDA; three, to normalize our AP post-divestiture, which we expect we will require $25 million to $30 million in cash; and four, to fund normal CapEx and capital lease payments of approximately $4 million to $5 million per quarter.

Following the completion of the restructuring, we continue to expect that on revenues of approximately $110 million per quarter, non-GAAP gross margins of 20%, and operating expenses of 25% of sales we will achieve adjusted EBITDA breakeven.

As mentioned before, I want to emphasize that this breakeven objective is only our first financial milestone. This will be followed by the goals to breakeven on a non-GAAP operating base, which we expect will require further improvements in our gross margins to achieve.

As for our first objective, we continue to expect to achieve adjusted EBITDA breakeven in the December quarter of this year. That concludes my comments on our outlook. I will now turn the call back to Greg for his closing remarks.

Greg Dougherty

Thanks, Pete. In summary, I am proud of our accomplishments so far as we have taken the necessary actions to position ourselves for a brighter future. I would again like to recognize and thank the Oclaro team, whose dedication and consorted efforts are starting to positively impact our financial results.

We have made great progress in a very short period of time and we also realized that we have much more to do. We all clearly understand that from this point forward, our future is in our own hands. I am very excited about the opportunities ahead of us and I know that our team is as well.

With that, I will turn the call back to the operator to begin the Q&A session. Operator?

Question-and-Answer Session

Operator

Thank you, sir. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions) Our first question comes from the line of Subu Subrahmanyan with The Juda Group. Please go ahead.

Subu Subrahmanyan - The Juda Group

First, there is some material constraints that you had last quarter, which were at about a 5% impact. Can you talk about whether that, how that played out, I know you would expect an impact from that in December quarter back and how that played out? And then for datacom and telecom, for datacom, Greg, I wanted to see if your largest customers in this space is having some product transition issues, have you ever seen any impact of that? And for Teleco, I assume it's related to the large U.S. provider that 40 gig uptick you see and can you talk about -- kind of is that bigger than you expected lasting longer from what the trend line you would expect for that to be?

Greg Dougherty

Okay. On the manufacturing or operational execution, we did make a lot of progress in the last quarter and we were much less constrained. We did have some new product ramp issues as we started the quarter, but made up a lot of ground towards the back end of the quarter. So I felt pretty good about the progress we made there.

I think that settling down the transfers to our contract manufacturing partners and getting them more focused and not biting off more than we could chew made a big difference.

On the datacom market, no, I don't think we were impacted much in terms of any product transitions by our largest customers for those products, at least not that I'm aware of, Subu.

On the 40G line cards, yes there is two major service providers with major networks here in the United States that the 40G equipment is going into different product go into each side or into each provider. The line cards that we talked about that demand was as expected, but it looks like it's going to last longer than we thought at just as recently as December, early January. And as we said in the script we expect the business to continue to be strong and just modestly come down quarter-on-quarter through the rest of this calendar year. Before we thought it would roll off a bit quicker towards the back end of this year.

Subu Subrahmanyan - The Juda Group

And Greg, on the datacom side with 100 gig CFP, CFP2 you had mentioned you're helping 40 gig QSFP. How do you see going into next quarter with a kind of a down a few million dollars, what is the mix between telecom and datacom what's going, any piece is going up or down. Can you provide any color on that?

Greg Dougherty

I think we -- the seasonal price movement has an impact in this quarter, as you know, and so it takes a few more parts to sell the same amount of revenue, so we have that going on, Subu. I think the mix is going to be roughly the same. There is some changes again due to the price compression.

Subu Subrahmanyan - The Juda Group

So which impacts primarily telecom, is that right, Greg, so you would expect the decline to be more in telecom than datacom in March?

Greg Dougherty

No, I think it's going to be fairly, I think more in telecom but there is some impact on datacom.

Operator

Thank you. (Operator Instructions) Our next question is from the line of Patrick Newton with Stifel Nicolaus. Please go ahead.

Rob Richardson - Stifel Nicolaus

Hi this is Rob Richardson on for Patrick today. Thanks for taking my question. Just a quick question on guidance. Can you talk a little bit about what scenario is baked into sort of achieving the high end of guidance and in the low end? And then if kind of possible what revenue from discontinued operations was in the quarter?

Pete Mangan

Right. So, Rob, hi, this is Pete.

Rob Richardson - Stifel Nicolaus

Hi.

Pete Mangan

Discontinued operations, all the results we described were for continuing operations. So we had $102.9 million on continuing, you will see in the 10-Q that we filed there is about $7 million worth of discontinued operations revenue and the bottom line on that was essentially neutral, actually we had about a $200,000 loss, but again that was not included in the results except for the discontinued line.

In terms of revenues, $93 million to $103 million, it's still a pretty broad range, it's driven by still a wide range of execution of course from the quarter from a general [sale] [ph] point of view, we are in a similar place to where we were one quarter ago. But as Greg had indicated we had a good second half of the last quarter and it continues to make that broad [a range] [ph]. We do have some impact on the annual price to reductions in the March quarter as well of being a driver.

Rob Richardson - Stifel Nicolaus

And then I guess just as far as the gross margin guidance goes, so we've seen kind of a just sequential increase the last two quarters, been above 16%. What's driving sort of the sequential reduction in gross margins? Is that primarily the pricing or is there some kind of mix issues that are driving that?

Pete Mangan

There could be some product mix. We did have a good quarter in the December quarter, so the range I think is driven on product mix as well. Depending on the revenue towards the high side we could pick up even if we had a weaker mix some leverage on manufacturing overheads but it really depends on where we end up in that range.

Operator

Thank you. Our next question is from the line of Dave Kang with B. Riley & Company. Please go ahead.

Dave Kang - B. Riley & Company

First, can you repeat what you said about China, the activities there?

Greg Dougherty

Sure Dave. There are two major 100G programs in China, the first being China Telecom which several of our customers were gearing up for that last quarter, for their deployments of their equipment. There is a follow on program from China Mobile that it's our understanding the contract will be officially released the first half of this year. And so we're expecting to see [inaudible] from China based on the award of that program likely going to many of the usual suspects who are our customers.

Dave Kang - B. Riley & Company

And then regarding datacom certainly was very strong. Were there any new significant customers and do you sell to any Web 2.0 customers?

Greg Dougherty

We have a little bit of business directly with the Web 2.0 customers, but I wouldn't say that we have a - that we’re active enough there. I think at the Needham Conference, I emphasized that we need to do - have a stronger push looking at some of these. A lot of our existing customers serve the Web 2.0 people and so we do indirectly sell into [via their] [ph] equipment. But we are gearing up and have a lot of engagement going on looking at some of these 40G and 100G opportunities.

Dave Kang - B. Riley & Company

So that -- the 10% growth is pretty much all organic, no new customers or anything like that, right?

Greg Dougherty

That's correct.

Dave Kang - B. Riley & Company

And then I was wondering if you can just provide a little bit more color as far as like mix is concerned like what sort of a split between like 40G and 100G and what's the mix between -- between within 40G what's the split between datacom and telecom?

Pete Mangan

Yes, Dave the schedule that we provided on the web there shows how we communicate externally. We don't breakup the 40G and the 100G; it did represent 44% in the quarter.

Dave Kang - B. Riley & Company

Right.

Pete Mangan

It did have a strong quarter backed up by a strong September quarter. We have mentioned the 40G business being the AT&T business as Greg just mentioned, we view it to be stronger for this year and I think those are the key comments. We don't really break them out, but call them as one category.

Dave Kang - B. Riley & Company

But would you say 40G is bigger than 100G? Is that a fair statement or not? Or they come in equal?

Pete Mangan

They're both significant for us.

Dave Kang - B. Riley & Company

And then regarding I'm going back to the guide for the March quarter. Could you just provide little more datacom versus telecom, I'm assuming datacom might be kind of flattish and telecom might be down a little bit. Is that how you get to the midpoint of the guidance?

Pete Mangan

That's probably a good assumption.

Dave Kang - B. Riley & Company

And then lastly, oh actually a couple more. What was the CapEx and what's the budget for the next couple of quarters and then lastly, can you give us an update on the Japan's non-telecom asset?

Pete Mangan

Yes, the CapEx guidance going forward I combine with the lease payments. The lease payments are about little over a million and the CapEx is between $3 million and $4 million a quarter. CapEx for the December quarter was less than $3 million.

Dave Kang - B. Riley & Company

Okay. And then on the Japan assets?

Greg Dougherty

Sure, we are still exploring options with Japan assets for the non-telecom product lines.

Dave Kang - B. Riley & Company

Is there sort of an urgency to sell that or you guys going to kind of?

Greg Dougherty

No, no. You can tell from our cash position and our plans there is zero urgency to take any action like that. If we were to sell it, it I would be for the right buyer at the right price. And basically just to allow us to continue to simplify and emphasize focus, but there is definitely no compelling reason to sell it.

Dave Kang - B. Riley & Company

How is the margin profile? Is it better or worse than the --?

Greg Dougherty

Better.

Dave Kang - B. Riley & Company

Better?

Greg Dougherty

It's better. It's better.

Operator

Thank you, ladies and gentlemen that concludes our question-and-answer session. At this time, I would like to turn the conference back over to Jim Fanucchi.

Jim Fanucchi

Great. Operator, thank you and thanks to everyone today for joining us. We look forward to talking with you again when we report our fiscal Q3 results later this year.

Operator

Thank you, sir. Ladies and gentlemen that concludes our conference for today. Thank you very much for your participation. You may now disconnect.

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