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Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q1 2010 Earnings Call Transcript

April 28, 2010 5:00 pm ET

Executives

Mory Ejabat – Chairman, President and CEO

Kirk Misaka – CFO, Corporate Treasurer and Secretary

Analysts

Greg Mesniaeff – Needham & Company

Martin Laney [ph]

Karl Laconte [ph]

Operator

Good day and welcome to the first quarter 2010 Zhone Technologies, Inc. conference call. I am Jonathan and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session toward the end of this conference. (Operator Instructions)

As a reminder, this conference is being recorded for replay purposes. I would now like to introduce Mr. Kirk Misaka, Zhone's Chief Financial Officer. Please proceed, sir.

Kirk Misaka

Thank you, operator. Hello and welcome to the First Quarter 2010 Zhone Technologies, Inc. conference call. I am Kirk Misaka, Zhone's Chief Financial Officer.

The purpose of this call is to discuss Zhone's first quarter 2010 financial results as reported in our earnings release, which was distributed over Business Wire at the close of market today and has been posted on our web site 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 first quarter. Following Mory's comments, I will discuss Zhone's detailed financial results for the first quarter and provide guidance for next quarter. After our prepared remarks, we will conclude with questions and answers.

As a reminder, this conference is being recorded for replay purposes, and will be available for approximately one week. The dial-in instructions for the 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 relating 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 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, 2009. 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 undertake no obligation to update any forward-looking statements.

During the course of this call, we will also make reference to pro forma EBITDA and pro forma 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 the basis for making operating decisions, because they provide meaningful supplemental information regarding our operational performance and they facilitate management's internal comparison to the company's historical operating results and comparisons to competitors' 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 pro forma EBITDA within the press release, which as previously mentioned, has been posted on our web site 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 first quarter 2010 earnings call. With a strong year over year revenue growth in the first quarter and improving market conditions, we anticipate revenue growth for 2010. The first quarter revenue was up 29% as compared to the first quarter of 2009. On another positive note, we substantially reduced our pro forma EBITDA loss on a year-over-year basis, which was our top priority. This reduction was achieved by a strong review growth, improved gross margins on our newer products, and continued expense control. The momentum from our MXK product and the anticipated revenue growth keep us on track to achieve our financial goal of positive pro forma EBITDA for the year as a whole.

We expect revenue growth in 2010, both in the U.S. and abroad. In particular, in the U.S., we have started to see the effect of a stimulus program and some of our customers have started placing orders with us. Also, other carriers, who are not using Zhone's products, and have been awarded a stimulus phones are issuing RFPs for FTTx projects. Our MXK product line is well positioned against our competitors.

The impact of the stimulus program, combined with the improved economic conditions in emerging countries and our strength in the international markets, especially in the Middle East, Western Europe, and South America, will be the major forces driving revenue growth and profitability for Zhone in 2010.

Kirk will give you more details on our financial performance and guidance. So let me briefly mention two other financial matters that happened during the quarter. First, we successfully completed the $1.45 reverse bid, which brought us back in compliance with the NASDAQ's $1 minimum bid price requirement.

The second matter is the addition of Ms. Nancy Pierce to our Board and other committee. Nancy brings both industry experience and financial expertise to Zhone's Board. We are looking forward to her input in helping our continued growth. Her addition also then goes back in compliance with NASDAQ's requirement that we maintain an audit committee without (inaudible). In summary, we are now in full compliance with NASDAQ's requirements.

Now, looking back to some of highlights of the Q1. On the customer front, we added 11 new customers during the quarter, of which one is a good example of winning new customers domestically. KanOkla published an RFP for FTTx systems. During Q1, Zhone received an exciting new contract with KanOkla for fiber-to-the-home. KanOkla intends to deliver a 1 Gbps wireless speed connectivity to all subscribers via Active Ethernet with the MXK and zNID-based ONT solution with this 100% VAS-funded project.

KanOkla had many reasons for selecting Zhone. However, a key reason was Zhone's EMS management system. KanOkla was highly pleased with the overall performance of our network management system. Its ease of use, its user friendly blue interface, and our ability to auto-provision the OLTs to derive optimal occurring cost savings.

As a result of our focus in emerging markets and the strength of our product line, our MXK was selected by multiple customers around the world, solidifying our leadership position and delivering of all IP-multiservice entrance solution. A few examples include desktop for comprehensive GPON rollout in state of Sao Paulo, Brazil. They sub-selected zones, MXK multi-service access platform and zNID optical metro terminals were a stupendous expansion into Sao Paulo. Desktops chose to deploy GPON using direct response to customer demand for higher speed premium services (inaudible) maintain comparative service tiers, but achieving faster return on investment over lower capacity platforms.

The new MXK and zNID platforms were also selected by Sigmanet to deliver FTTx services toward Campinas, Brazil. The MXK will deliver voice high speed data on HDTV Entertainment Services for Sigmanet. Sigmanet currently provides wireless services to Campinas, a city with a population of 1.1 million and a major telecommunication hub for the state of Sao Paulo. Sigmanet will now be able to provide Voice over IP, HDTV, and (inaudible) higher speed down to the corporate, residential, and multi-tenant unit customers throughout the city.

Beyond Tier-1, they expanded the MXK product suite by adding EFM capabilities to an already powerful MXK solution. EFM allows service providers to commence multi-service access with more wide backhaul in the Senegal end-to-end solution providing the investors, only building a migration path from copper to traverse the scale buybacks.

We also are excited to launch the all new OLTZ net family of products in Q2. These exciting ONT solutions ensure each interfaces' dynamic new software chip polarities and non-blocking wire speed throughput, providing a perfect match to the MXK.

In January, we have strengthened our management team by naming Brian Caskey as Chief Marketing Officer. Brian brings a 25-year track record in global management, strategic marketing, and a topline revenue growth for Zhone. We intend to make a strategic push in marketing and plan to initiate an aggressive funding backed awareness campaign immediately.

We are highly optimistic about 2010, and we see considerable momentum from our customers and their enthusiasm for the MXK and our powerful GPON Active Ethernet and FTTx solution. With the addition of the new zNID royalties alongside the MXK, our portfolio becomes fully strong, enabling Zhone to deliver the network of the future today.

Furthermore, we remain confident that our customers will continue to receive a stimulus grant throughout the later part of 2010 and they will revitalize our RAW-certified solutions for their network deals.

Now, I would turn the call over to Kirk to provide more details on what our financial results for last quarter and to discuss our financial guidance for the next quarter. Kirk?

Kirk Misaka

Thanks, Mory. Today, Zhone announced financial results for the first quarter of 2010. As Mory mentioned, the first quarter revenue was $31.3 million, grew by 29% as compared to the first quarter of 2009, due to the increased demand for our MXK product family, despite declining by 14% as compared to the fourth quarter of 2009, due to normal seasonal weakness. Looking forward, we are forecasting seasonal improvement in the second quarter, and expect revenue to grow by a single digit percentage range. We also expect revenue to grow sequentially each quarter throughout 2010 and exceed that of the corresponding quarter in the prior year.

We continue to serve over 750 active customers worldwide, with 65% of revenue for the first quarter being attributable to international customers. We have experienced more customer concentration over the last three quarters, with one 10% customer each quarter and the top five customers representing approximately 50% of revenue for the first quarter, and 48% of revenue for the fourth quarter.

Gross margins increased substantially from 32.4% for the first quarter of 2009 to 36.4% for the first quarter of 2010, largely due to product cost improvements in our newer MXK product family. Gross margins should remain close to 36% for the second quarter.

Pro forma operating expenses for the first quarter came in at the low end of our expectations at $12.5 million, as a result of continued expense control. We expect pro forma operating expenses to increase only minimally for the second quarter, attributable to the anticipated revenue growth. Pro forma operating expenses for the first quarter excluded depreciation of approximately $400,000 and stock-based compensation of approximately $1.4 million. The stock-based compensation was higher this quarter due to the accelerated vesting on certain stock options held by senior management, as previously disclosed in our Form 8-K filed on March 31, 2010. Going forward, we expect operating expenses to include about $400,000 of expense for stock-based compensation, as well as the normal expense for depreciation of approximately $400,000.

Finally and most important, our pro forma EBITDA loss for the first quarter of 2010 was approximately $1 million, which is a significant improvement over the $5.5 million pro forma EBITDA loss reported for the same quarter last year. As Mory mentioned, this improvement year-over-year was achieved by the strong revenue growth, improved gross margins on our newer products, and continued expense control. We expect to continue to reduce or eliminate the pro forma EBITDA loss for the second quarter of 2010 and also expect to report positive quarterly pro forma EBITDA in the back half of 2010. As Mory mentioned, we remain on track of achieving our primary financial goal of having positive pro forma EBITDA for the year as a whole.

Now let us take a look at the balance sheet. Cash and short-term investments at March 31, 2010 were $20.9 million, which declined only slightly from the $21.8 million at December 31, largely as a result of the pro forma EBITDA loss for the quarter. Other working capital changes in the balance sheet, net of that, were slight increases in accounts receivable and inventory levels, being offset by similar increases in accounts payable and accrued and other liabilities.

The number of days sales outstanding on accounts receivable for the first quarter increased to 109 days, as compared to 93 days for the fourth quarter. The increase in accounts receivable and DSOs is largely attributable to the growth in business with our 10% customer. We anticipate DSOs will gradually decline over the year as the payment cycle with this customer catches up with and eventually see to additional revenue shipments. With this decline in DSOs, operating cash flow will begin to turn from negative to positive, along with pro forma EBITDA. For the year, we still anticipate net neutral cash flow from operations, which will help us stabilize our liquidity resources. As for other balance sheet changes, our total debt obligations remained basically the same as last quarter at $28.7 million.

Finally, the weighted average basic and diluted shares outstanding were 30.3 million for the first quarter of 2010. The weighted average basic shares outstanding for the fourth quarter of 2009 were also 30.3 million, as reflected on a post reverse split basis.

With that financial overview, I will 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. Despite the normal seasonal slowdown in our business, we are seeing improvement in the overall environment, as evidenced by the nearly 30% year over year growth in quarterly revenue. No doubt we are matching the compliance with all the NASDAQ listing requirements. Shareholders can focus on these improving business fundamentals. This year, we intend to leverage our market leadership in the Middle East and South America, and (inaudible). We are taking a proactive role in helping our U.S. customers navigate broadband and stimulus funding, and we will continue to provide support to our whole phases of deployment. As on our vision, we will continue to pay close attention to our provisional expenses and exercise discipline to minimize efficiencies across the board.

Thank you for joining us today. We will now open the call to questions. Operator, please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

Ladies and gentlemen, (Operator Instructions) Your first question comes from the line of Greg Mesniaeff with Needham & Company. Please proceed, sir.

Greg Mesniaeff – Needham & Company

Thank you. Good evening, guys. Couple of questions. First of all, congratulations on getting Nancy Pierce on Board. My question is really twofold. You can give us, Kirk, a breakdown of revenues by, you know, a percentage of U.S. versus overseas and perhaps by geographies, that will be helpful. And number two, if you could just give us a little more color as to why stock comp was so high in the J&A area in the first quarter?

Kirk Misaka

Okay. Regarding the first, on the international revenue percentage, it was 65% in the first quarter, which was also the same as it was in the fourth quarter of 2009. That has increased from the 39% and 52% in the first half of 2009. So it has gone up very substantially and it is around 65%. We don't disclose the regional breakdown for international revenues, so I am not prepared to give that.

Greg Mesniaeff – Needham & Company

Okay.

Kirk Misaka

As far as the stock-based compensation, there was approximately an additional $900,000 of stock-based compensation in our operating expense in this quarter related to the accelerated investing that we previously disclosed for the senior managers of the company. So we did this primarily to eliminate the future stock-based compensation that would have been reflected in our GAAP earnings.

Greg Mesniaeff – Needham & Company

So you expect the stock comp to pretty much return to recent historical levels?

Kirk Misaka

Yes. The guidance that I had provided, about $400,000 per quarter.

Greg Mesniaeff – Needham & Company

Got it. And what should we be modeling for tax rate for the rest of the year?

Kirk Misaka

We still anticipate having a zero tax rate.

Greg Mesniaeff – Needham & Company

Got it. That including no minimal tax or anything like that? Okay. Okay, then I have no other questions, thanks.

Operator

Your next question comes from the line of Martin Laney [ph]. Please proceed.

Martin Laney

Thank you. I just had one quick one confirmation, one question. The confirmation being that the 10% customer that you referenced is still Etisalat?

Mory Ejabat

We haven't disclosed who that customer is in the past, but we do have a 10% customer.

Martin Laney

And one of the things that hasn't been mentioned, is this roughly what percentage of your business comes from customer premise equipment?

Mory Ejabat

We don't disclose that at this point, but I should tell you the majority of our revenue comes from the Central side.

Martin Laney

That is what I was expecting, just was hoping for a little granularity.

Kirk Misaka

We don't disclose that. Actually, I don't have those numbers in front of me.

Martin Laney

All right, thank you.

Operator

(Operator Instructions) Your next question comes from the line of Karl Laconte [ph], private investor. Please proceed, sir.

Karl Laconte

Good afternoon. I had two questions. The first is simply who is your major competitor in the United States?

Mory Ejabat

We have two competitors. They are Calix, Occam, and Atman [ph] in the Tier-2 to Tier-3 and the Tier-1 is Alcatel.

Karl Laconte

Okay, thank you. And regarding the one for five stocks a bit earlier, why did you not do a one-for-ten stocks. That would have given you a price of around $5 a share and maybe then eligible for more funds to be able to purchase.

Kirk Misaka

Well, one of the considerations was the number of shares outstanding after the reverse split. We felt that 30 million shares for a company of our size was about the right level. Also, we hope to be able to improve the stock price and get up into that $5 range on our own.

Karl Laconte

Okay, thank you.

Operator

You have a follow-up question with Mr. Greg Mesniaeff with Needham & Company.

Greg Mesniaeff – Needham & Company

Thank you. Just a quick follow-up. Can you guys give us some color as to what you are currently seeing in the area of component pricing? And also in component availability? Thanks.

Mory Ejabat

Greg, in some areas, the component pricing has stayed the same, somewhere else, they have gone down, but the lead time is now in the range of over 20 weeks sometimes with some of the components.

Greg Mesniaeff – Needham & Company

Got you. Okay, thank you.

Operator

(Operator Instructions) At this time, there are no further questions. I would like to hand the call back to Mr. Mory Ejabat for closing remarks, sir.

Mory Ejabat

Thanks again for joining us today. As always, we appreciate your continuous support and look forward to speaking with you on our next earnings conference call. Operator?

Operator

Ladies and gentlemen, thank you for your participation in today's call. The call has ended. You may now disconnect. Good day.

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