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Aviat Networks, Inc. (NASDAQ:AVNW)

F2Q2014 Earnings Call

February 6, 2014 4:30 PM ET

Executives

Michael Pangia – President and CEO

Edward Hayes – SVP and CFO

Analysts

Rich Valera – Needham & Company

Operator

Good day ladies and gentlemen. And thank you for standing by. Welcome to the Aviat Networks’ Second Quarter of Fiscal 2014 Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will be conducting a question-and-answer session and instructions will be given at that time. (Operator Instructions).

I would now like to turn the conference over to our host, Ms. Leslie Phillips. Please go ahead, sir.

Leslie Phillips

Thank you, Taggart. Good afternoon everyone and welcome to Aviat Networks fiscal second quarter 2014 earnings call. I am joined today by Mike Pangia, President and Chief Executive Officer and Ned Hayes, Senior Vice President and Chief Financial Officer.

During today’s call management may make forward-looking statements regarding Aviat’s business, including statements relating to projections of earnings and revenues, business drivers, the timing and capabilities of new products, network expansions by mobile and private network operators and variations of economic recovery in different regions.

These and other forward-looking statements involve assumptions, risks and uncertainties that could cause actual results to differ materially from those statements. Please note that these forward-looking statements reflect the company’s opinions only as of the date of this call and the company undertakes no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events.

For more information, please see the press release and filings made by the company with the SEC. These can be found on the Investor Relations section of Aviat Networks’ website at www.aviatnetworks.com.

In addition, during today’s call, management will be referencing to both GAAP and non-GAAP financial measures. A copy of the press release and financial tables which include the GAAP to non-GAAP reconciliations and other supplemental financial information is available on the Investor Relations section of the company’s website.

Now I will turn the call over to Mike

Michael Pangia

Thanks. Bresley. Today we announced the second quarter of fiscal year 2014 results. Total revenue for the quarter was $85.8 million, resulting in a non-GAAP EPS of $0.15. Revenue for the quarter was in line with our revised guidance issued on January the 14th. Non-GAAP gross margins came in at 25% and book to bill for the quarter was above one.

Our second quarter reported revenue excludes approximately $4.7 million related to the managed services arrangement we entered into with a key customer. While we caution that the fiscal second quarter guidance range of a $100 million to $107 million did not include any impact from the managed services agreement, even when adding back the $4.7 million, the reported revenue results would have fallen short of our original expectations.

Let me talk more about the financial impact of the managed services agreement and provide a detailed financial review in a few minutes. While disappointed by our second quarter performance, a slower than expected investment cycle in Africa where one of our key customers is based was the main contributor to the second quarter shortfall.

Given the current state of our business last week we announced the immediate and significant actions we are taking to address this. The resulting business model better aligns the company’s cost structure with the near term outlook, lowers the company’s revenue breakeven level, moving forward and strengthens the company’s position in the industry.

Given these changes we expect Aviat to return to non-GAAP profitability in the first half of fiscal 2015. We expect to realize a major step towards this goal, exiting the fourth quarter of fiscal 2014 with non-GAAP operating expenses of approximately $27 million.

Cost and expense savings associated with this plan are expected to be in the range of $18 million to $20 million during the remaining portion of fiscal year 2014 and through fiscal year 2015. In addition we are exploring additional actions to further improve the company’s expense to revenue ratio for fiscal 2015.

We are confident that the announced restructuring plan combined with ongoing costs and expense savings initiatives will lower our breakeven level to approximately $90 million in fiscal 2015. Although we believe it’s important to focus on breakeven revenue because operating income is the best proxy for restoring cash generation in the business it also ensures that we have operating leverage under a wider range of revenue scenarios.

During the remainder of my prepared remarks I will provide further details on our efforts to reduce cost and expenses including the restructuring plans. I will follow that with the discussion of the company’s operations, opportunities in our largest geographic segments and then discuss upcoming product launches which are key to Aviat’s future success. I will close my opening remarks by commenting on the strategic direction of Aviat.

The actions we’re taking to reduce cost and expenses affect all areas of our business. First and foremost we remain focused on supporting our customers. Our cost reduction targets have been selected to not impact our high standards of customer service that have been vetted to ensure the pending introduction of our new products will also not be impacted.

On the G&A line we expect to generate savings from our newly installed ERP system. We are also consolidating certain internal functions with headcount reductions aimed at flattening the overall organization.

With regards to our sales and marketing efforts we plan to focus more attention on areas where we see new opportunities with existing customers and leveraging our new product lines to target new customers where we see lend and expand opportunities. There will be a focus on back office and sales support improvements to increase productivity. Overall, we are still well positioned with the resources intact for future growth.

We have extended considerable efforts to further improvement of our supply chain and we are in the process of consolidating our contract manufacturing partnerships. In addition to improved products and operations overhead cost we expect our new arrangements to improve our inventory turns and working capital efficiencies with benefit to our cash conversion cycle.

Given where we are in our new product introduction cycle we have the opportunity to accelerate the transformation of our R&D organization. As a result we intend to implement a significant realignment of the product development process towards the center of excellence model. We plan to lead project at a single site rather than across sites resulting in both project and resource consolidation.

Additionally we plan to increase use of outsourcing to promote flexibility and implement greater efficiencies in R&D as we approach the completion of our portfolio refresh. With these actions we believe we can also improve productivity and accountability resulting in faster times to market for new products and lower fixed cost while keeping our product roadmap intact.

Notwithstanding the actions to improve the company’s business model the Board is reviewing strategic initiatives to improve the company’s ability to compete for business in existing and new markets, better positioning Aviat Networks for top line growth, consistent positive cash flow generation and better shareholder returns.

I would like to take a couple of minutes to discuss the current market for microwave backhaul Overall the market has been weaker than expected. The microwave business is cyclical with demand deferring greatly by region, customer and vertical markets. Allow me to speak to some examples in our two largest markets.

In North America, during the previous calendar year Verizon completed a major roll-out of LTE. Aviat provided products and services to the largest rollout of LTE in the United States to-date. Compared to this period orders have been lower over the past two quarters. However Verizon continues to be a key customer contributing steady business to Aviat. Given this mobile operator’s focus on adding capacity and recent CapEx projections we believe the steady business will continue.

In North America on the non-mobile side, sales cycles have lengthened especially public safety with the evaluation period lasting up to two years for multiyear contracts. However we are seeing a growing pipeline of deals. We expect to see improvements moving forward first in bookings and then revenue. As an example Aviat and Motorola Solutions were recently selected for a public safety radio systems overhaul for a major California County. Also in non-mobile we have strengthened our position as a leading solutions provider for a low latency networks.

In the fiscal second quarter we announced the Eclipse Adaptive Intelligent Repeater. Soon after McKay Brothers, a leading telecom provider for latency sensitive applications installed this product in its critical network between Chicago and New Jersey.

In Africa our performance has been impacted by a cyclical downward trend of CapEx spending. Despite this low spending Aviat continues to serve the largest Tier 1 mobile operator in the region, MTN. During the fiscal second quarter we announced that MTN Ghana selected Aviat to upgrade its mobile backhaul with full IP capacity. We are focused on attracting additional operators across the continent into the Aviat family.

We also believe we are better positioned to grow our share based on our strategic managed services arrangement with the Tier 1 customer in which Aviat is the only independent microwave provider with this relationship. In fiscal year 2013 Aviat benefited directly from increased spending in Africa and North America. This fiscal year we have seen moderate spending in comparison. Although we do not anticipate an immediate surge to migrate backhaul demand we do anticipate moderate recovery in the near term.

Notwithstanding these cyclical trends the backhaul market is launched, in Africa bandwidth demand is expected to grow at 50% CAGR, faster than anywhere in the world. Thus when the cycle improves we are well positioned to benefit.

Now moving on to Asia and Latin America our business remained steady with new wins in both geographical areas. As you may recall our fiscal first quarter results were impacted by the rebidding of a large contract with a new customer in Asia. I am pleased to report that even after the rebid Aviat has secured this business.

We also won a contract in one of the South Asian countries to deploy our all outdoor WTM 3200 radio to help this mobile operator rollout its 3G mobile data services. In addition we added a new non-mobile customer in Latin America to assist in the build out of a statewide communications network to provide voice, data and broadband services to several state government agencies.

I would now like to update everyone on our product portfolio refresh. Our investments to overhaul our product portfolio are essential for solidifying our long term position with existing customers that will afford us the ability to better compete for new customers in all of our markets. In the next few quarters we will reach general availability status on a number of new products that have been nearing production readiness and are undergoing customer evaluation and initial deployments in recent months.

In the fiscal second quarter we made initial shipments of our E-Band millimeterwave solution the WTM3300. The high throughput and tiny form factor of this product make it very attractive for all forms of dense urban backhaul for both macro cell and small cell deployments. Our formal launch of this product will take place in the coming weeks.

We are also nearing the formal launch of Aviat’s CTR 8000 platform. We have completed trial and demonstrations with our principal customer targets. We are on schedule for a general release. As previously stated we expect shipments of the first CTR products before the end of this fiscal with further releases creating more significant revenue and margin opportunities in fiscal year 2015.

CTR is a powerful microwave platform and a router all-in-one. As a microwave platform CTR will be the most compact integrated solution on the market. As a router CTR will enable the differentiation of services for mobile backhaul in enterprise applications without the additional deployment of expensive router devices.

We anticipate this to be more prevalent in emerging markets where customers seek to grow revenue by leveraging existing network infrastructure to provide fixed services to enterprise customers. CTR is fully comparable with our installed base guaranteeing our operator customers the lower cost for upgrading capacity and running capability. We are very excited about the imminent launch of the much anticipated CTR product and recognize the capabilities it brings to our product portfolio.

With that I would now like to turn the call over to Ned. Ned?

Edward Hayes

Thanks, Mike. Aviat’s GAAP financial statements, along with the reconciliation of non-GAAP financial measures are included in the company’s press release issued today following the markets close. I would like to take a few minutes to summarize our non-GAAP financial performance at a high level.

The key figures were; the company’s book-to-bill ratio in the fiscal second quarter was above one; revenue for FQ2 came in at $85.8 million, in line with revised guidance range provided on January 14.

During our fiscal second quarter we saw a significant quarter-over-quarter revenue decline in our Africa region. Our reported revenue was impacted by a change in revenue recognition timing that occurred in the quarter. As Mike previously mentioned Aviat is entering into a managed-services agreement with a key customer in Africa. While this agreement solidifies a more robust commercial relationship in which Aviat can provide network planning and design services, inventory management and warehousing services, elements of the agreement led to approximately $4.7 million of product revenue not being recognized in the quarter.

As part of the agreement’s warehousing services component during the time equipment temporarily resides in our Aviat control facility the revenue associated with that equipment is not recognized until the equipment is shipped out of the facility upon the operator’s direction. We expect equipment to be released across a period of one to three quarters after entering the facility. We expect the value of inventory entering the Aviat control facility to essentially match the value inventory exiting the facility and roughly equate to a [wash] over the next three to four quarters.

It should be noted that the commercial terms with this customers remain exactly the same as in the past, with the customer invoicing and cash collection occurring when the equipment is shipped from our factory to our warehouse. Moving forward, we believe the agreement categorically opens the door to further strengthen our relationship, expand our footprint and we’re moving into adjacent areas across the continent with this key customer.

Africa and Middle East region revenues declined sequentially from $37 million in fiscal Q1 to $26 million in fiscal Q2, driven primarily by cyclical buying patterns by our biggest customer in Africa and the revenue delay noted earlier. MTM our key account in Africa was once again a 10% plus customer in the quarter. We saw a slight revenue uptick quarter-over-sequential quarter in Europe and Asia Pacific region.

Non-GAAP gross margin for the fiscal second quarter was approximately 25% of sales, significantly below what we have observed historically. As we observed in our previous fiscal quarter the lower than anticipated revenue lines have significant margin rate impact caused by a lower absorption of fixed period cost on the product margin side and certain fixed cost on the services margin side.

In addition, the negative impact on margins, caused by the low absorption of fixed period cost on the project margin side was further exacerbated by the revenue that was not recognized in the quarter due to the managed services agreement.

For the fiscal second quarter, non-GAAP OpEx totaled $30.4 million, which compares to $30.5 million spent on OpEx in the previous sequential quarter. Non-GAAP loss from continuing operations for the quarter was a negative $9.4 million or a loss of $0.15 per share.

Fiscal second quarter adjusted EBITDA was a negative $6.8 million. The company ended the quarter with cash and equivalents balance of $64.7 million. As previously disclosed our company had a $13.2 million tax payment to a foreign tax jurisdiction in advance of the final settlement that contributed significantly to the overall use of cash in the quarter. The company continues to vigorously defend its position in the appeal process.

We ended the fiscal second quarter with net cash which is cash less debt of approximately $59 million or nearly a $1 per share. Including the cash we expect to use for the aforementioned restructuring plan we do not expect to require any financing other than perhaps some short term use of our credit facility.

Cash used by operating activities was $13.6 million in the fiscal second quarter, again significantly impacted by the aforementioned tax payable. Indeed excluding the effect of the tax payment we would have had a positive cash flow from operations of approximately $0.2 million in the quarter. CapEx was $1 million.

Going forward we expect CapEx to settle down to these historical norms now that we’ve completed the ERP implementation and much of the capital activity around new product development. Free cash flow in the quarter came in at a negative $14.6 million.

On the working capital front our inventory turns rate was 5.0; receivables were 81 days of sales and days payable stood at 69 days. At the end of our fiscal second quarter, our book value was $2.09 per share. Now one should note we are going to re-double our efforts at optimizing working capital efficiencies across all accounts here in the very near-term. We believe we have a line of sight to continue to reduce inventories with our supply chain partners and monetize receivables and other balance sheet items all with an eye to increasing and preserving cash.

I would now like to address the impact of the restructuring plan that was announced last week. The Board approved certain cost and expense reduction initiatives that will result in savings in the range of $18 million to $20 million during the remaining portion of fiscal year 2014 through fiscal year 2015. These initiatives will primarily affect operations in the United States. The company expects to incur approximately $6 million to $7 million of restructuring charges in the aggregate in connection with these cost reductions initiatives with severance and employee-related cash charges.

Related cash payments are expected to total approximately $5 million to $6 million in fiscal year 2014 with the remaining amount paid in the first half of fiscal year 2015. With these and other actions we expected our quarterly non-GAAP OpEx to be approximately $27 million exiting this fiscal year. Going forward we see the opportunity to further reduce our OpEx in the next fiscal year and will take those actions required in the short-term to deliver that result.

As we referenced in the last quarter’s earnings call the quarter just closed depicts in stark detail the intense volatility we see in geographic markets, product and services volumes and mix, choppiness of the buying patterns of key customers, lengthening sales cycles and in quarter linearity of bookings.

Given the limited near term visibility and the impact the managed services agreement is going to initially have on our results we will not be providing specific revenue or non-GAAP earnings per share guidance for the third quarter of fiscal 2014.

Having said that I’ll reiterate Mike’s earlier comment that we expect the company to return to non-GAAP profitability in the first half of fiscal 2015 due to the restructuring plan discussed today along with other cost and expense reduction initiatives currently underway. And I’ll repeat that we expect our quarterly non-GAAP OpEx to be approximately $27 million exiting this fiscal year and going forward we see the opportunity to further reduce OpEx in the next fiscal year and we will be taking those actions required in the short-term to deliver that result.

So with that update I’ll turn the call back over to Mike for his executive summary. Mike?

Michael Pangia

Thanks, Ned. As evidenced by our fiscal 2014 first half results the current business environment is challenging. We are experiencing a reduced part of the demand cycle characterized by fluctuating CapEx spending and extended sales decision processes. As a result we are acting quickly to align the company’s cost and expense structure with the expected near-term revenue opportunities while also focusing on the successful launch of new products that will better position the company for growth.

Beyond this the Board is reviewing strategic initiatives to further improve Aviat’s competitive position. With the proliferation of smartphone and need for increased capacity as the back drop we believe the reduced demand the industry is experiencing is short term. We are confident in the recovery for the demand for mobile backhaul most notably in Africa and in the new markets such as more latency.

Ultimately we believe our long term prospects remain positive and the actions that management and the Board are taking should better position the company for profitability and strengthen Aviat’s competitive position in the industry.

Now I would like to turn the call over for questions. Operator you may now proceed with the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Rich Valera with Needham & Company. Please go ahead.

Rich Valera – Needham & Company

Thank you. First a clarification on the book-to-bill can you say if the book-to-bill would have been above one, to one if you included the $5 million of deferred revenue, in other words if you hadn’t started that agreement?

Edward Hayes

That’s great question Rich we still would have been above one.

Rich Valera – Needham & Company

Great so just trying to think of how to think about the baseline revenue level. I understand you are not giving guidance but is $90 million kind of the right baseline to think about here, one to sort of grow from or is there any color at all you can give on kind of a near term revenue base that we can think about?

Michael Pangia

So I guess the complexity around the revenue side Rich, I think again notwithstanding the visibility part of the equation is this whole concept of the new managed service arrangement which you have to estimate, how much is going in versus how much is coming out. That puts a bit of a challenge around the conversion side of the equation. So that’s just one element to be cognizant of. So I would say that we’ve got a growing pipeline that on the bookings front we would definitely expect to see improvement over the first half and then it’s just a matter of what the conversion looks like to revenue.

So second half rather than first half on the top line, difficult to predict the timing of between Q3 and Q4 relative to that. Hopefully that gives you a better sense of what we are doing here.

Rich Valera – Needham & Company

Just want to make sure I understand where things stand, second half of the year, better from a revenue perspective than the first half of the year is that what you’re saying?

Michael Pangia

We would expect that, in particular we would expect the bookings to be better. Again it’s a bit hard to translate that to the revenue side again because of this managed services arrangement. Ned do you want to give a little bit more color to that or…?

Edward Hayes

I think Rich mechanically we’re going to see higher revenues in the second fiscal half of the year only because we’re going to start seeing some of those inventories that are currently in the warehouse being deployed out for the field. Yes, we will enjoy that. And to the extent that these are spread over two to three quarters I am hoping that they normalize almost to a wash in terms of ins and outs in two to three quarters here. So that should help us get a better line of business on the reported revenue.

Rich Valera – Needham & Company

That’s helpful. And then I know this is tough projecting this but assuming you get – you have 25% gross margin this quarter. Assuming you are at, let’s just say $90 million or $95 million do we think we’re – kind of where do we think our current gross margins are, I would assume somewhere between 25% and 30% maybe closer to the mid-20s, I am just trying to get a sense of how anomalous that 25% is or is that kind of level we should think if we’re in the $85 million to $90 million in revenue range?

Michael Pangia

I think we’re seeing some significant impact based upon volume. We talked about under absorption of period cost on a product margin side, under absorption of services cost on the services margin side. Some of the activities that we’re taking are aimed at reducing those fixed cost levels and that’s going to bear some fruit but it really does come down to continued product cost reductions, the introduction of new lower cost products, reducing fixed overheads and really getting our volumes back above $90 million, $95 million is really going to help us improve by a material amount, a number of 100 basis points margin improvement.

Rich Valera – Needham & Company

Okay. That’s helpful. And then this may be cutting a little bit fine but you said $27 million OpEx run rate exiting the year, does that mean that’s the level for the fiscal fourth quarter or that’s really the level we would expect to see in the fiscal first quarter of next year?

Edward Hayes

We would be exiting the fiscal year at $27 million broadly OpEx.

Rich Valera – Needham & Company

Right so the fiscal fourth quarter we should expect $27 million.

Edward Hayes

Right.

Rich Valera – Needham & Company

Okay. That’s helpful.

Michael Pangia

And that shows the sense of urgency, I mean that requires us to be taking actions now so we can deliver that number, in an absolute dollar perspective in this third quarter.

Rich Valera – Needham & Company

Right.

Edward Hayes

Again reiterating we see further opportunities to reduce OpEx in fiscal 2015.

Rich Valera – Needham & Company

And then with respect to cash, understanding you will be working very hard to improve your working capital, anything that you could say about expected – you’ve given the number for the specific cash cost associated with the restructuring. Anything else you would be willing to say about expected cash usage over the next couple of quarters?

Edward Hayes

Again I think the vast majority of the $5 million to $6 million that we talked about being incurred in fiscal 2014 will be in FQ3. We see some positive developments in our supply chain management that are going to be seeing probably $5 million to $6 million with the inventory reductions that will be a source of cash. That will probably start in fiscal quarter four and then continue into 2015, and then again following that we see operating earnings being able to contribute to the cash balances going forward.

Rich Valera – Needham & Company

In fiscal ‘15, basically.

Edward Hayes

Yeah.

Rich Valera – Needham & Company

Right. Okay, that’s helpful color. I will leave the floor, thanks guys.

Michael Pangia

Thanks, Rich, appreciate it.

Edward Hayes

Thanks, Rich.

Operator

(Operator Instructions). Our next question comes from the line of Tim Duchell with – a private investor. Please go ahead. And I am showing no further questions at this time. Please continue.

Leslie Phillips

I want to thank everyone for your participation in today’s earnings call and for your interest in your Aviat Networks. This concludes Aviat Networks fiscal second quarter 2014 earnings call. Have a great day.

Operator

Ladies and gentlemen that does conclude our conference for today. You may now disconnect.

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