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Procera Networks (NASDAQ:PKT)

Q4 2013 Earnings Call

February 27, 2014 4:30 pm ET

Executives

Nicole Noutsios

James F. Brear - Chief Executive Officer, President and Director

Charles Constanti - Chief Financial Officer, Principal Accounting Officer, Vice President, Secretary and Treasurer

Analysts

Vijay Bhagavath - Deutsche Bank AG, Research Division

Victor Chiu

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Operator

Good afternoon. My name is Latisha, and I would like to welcome everyone to the Procera Earnings Release Conference Call. [Operator Instructions] Ms. Nicole Noutsios, you may begin your conference call.

Nicole Noutsios

Thank you, operator. Good afternoon, and welcome to Procera Networks' Fourth Quarter 2013 Financial Results Conference Call. On the call today, from Procera, are James Brear, Chief Executive Officer; and Charles Constanti, Chief Financial Officer.

On today's call, James will start with an update on Procera's performance and growth strategy. Charles will review the fourth quarter results and provide an outlook for 2014 before opening the call for questions.

Please note that the financial results reported today include both GAAP and non-GAAP financial measures. Procera's non-GAAP measures exclude the impact of stock-based compensation, business development expenses, as well as acquisition-related amortization and deferred compensation, amortization of intangible assets and related tax effects. A reconciliation of GAAP to non-GAAP measures is part of the financial tables posted on Procera's news release on the fourth quarter results, which is available at the IR section of the company's website.

Before we begin, let me also note that, today, this call contains forward-looking statements, including statements relating to the expected demand of Procera's products and the company's financial and other expectations for 2014. These forward-looking statements are subject to risks and uncertainties that can cause actual results to differ materially from those projected, including the risks set forth in Procera's most recent annual report on Form 10-K and quarterly reports on Form 10-Q filed with the Securities and Exchange Commission, as well as specific risks and uncertainties noted in Procera's news release on fourth quarter 2013 financial results.

These forward-looking statements represent the company's judgment as of today, and the company disclaims any intent or obligation to update these forward-looking statements whether as a result of new information or otherwise.

I will now turn the call over to James.

James F. Brear

Thank you, all, for joining us. Our Q4 revenue was $21.3 million, up 29% from last year, and full year 2013 revenue was $74.7 million, up 25% for the year. As we announced, while we continue to gain share in the market, we were disappointed to be short of our 30% growth we expected in 2013. There are a number of dynamics we saw in the quarter that impacted our Q4 results. The shortfall relates to lower-than-expected orders from U.S. cable market and we believe this reflected uncertainty and potential consolidation in the market.

There were a number of new and existing cable customers that we were targeting that were impacted by these market dynamics. While we continue to aggressively seek new orders from U.S. cable operators, we are taking a more cautious view to that market in our future outlook that Charles will be discussing in the call.

Despite our revenue shortfall in the fourth quarter, as we reflect back on 2013, we executed on the key initiatives and achieved important accomplishments that strengthened Procera's competitiveness in the market. We invested in sales, support and R&D, and now have a significant global presence and reach. As a result of our expanded worldwide sales team, we reported strong growth internationally in the quarter, posting a 74% EMEA growth year-over-year, and a 16% growth in APAC.

Second, we invested in our support organization, which allows us to support large customers and positions us for future growth.

Third, the company invested in R&D to enhance existing offerings and drive innovation for our customers.

As we move forward into 2014, stay tuned for new technology offerings and expanded strategic partnerships.

In the fourth quarter, we won a 2013 Broadband Traffic Management Award for the "Most Innovative Tool for Driving Real-Time Intelligence." The award recognizes Procera technology as the most innovative tool for operators to gain real-time intelligence into network traffic and subscriber behavior.

We also ranked among the top 10 fastest-growing network companies for the fourth year in a row in Deloitte 2013 Technology Fast 500.

We are focused on customer experience, and we've made some important announcements that highlight Procera's 2014 product and technology investments in enhancing the customer experience.

First, we announced the Service Plan Assurance solution, which is a comprehensive offering that operators can use to manage network congestion, while maintaining both network quality and service transparency. Service Plan Assurance is unique because we can provide detailed information on the impact of congestion on the operator's network and their subscribers, including how many subscribers were affected by congestion, what applications were impacted, and how much latency was added to the traffic during congestion.

Second, we announced our Internet Intelligence Insight product family that is designed to provide role-based perspectives for executives, marketing and engineering personnel within the network operator. This solution is the foundation for an entirely new solution offering from Procera.

As part of our new insight analytics, we also announced a role-specific insight solution designed for customer care professionals named Customer Care Insights. Customer Care Insights is a real-time web interface that provides in-depth perspectives on subscriber's broadband connections that includes not only the subscriber's plan and historical activity, but also real-time view on the subscriber's traffic.

This solution can help diagnose and resolve customer experience problems far more quickly than existing solutions because of its complete view of the subscriber's location and real-time data activity.

We made several partnership announcements that demonstrate our continued leadership in virtualization. We announced and demonstrated a joint solution with Intel and HP for a virtual customer premise equipment offering that can be used as a managed service, leveraging Procera's rich intelligence as best-in-breed offering for the enterprises. We also announced and demonstrated a virtualized implementation of our Revenue Express solution with Openet. That is the first joint product offering in a virtualized billing and charging market.

We are also investing in the virtualization of our solution, and we strongly believe that this will bring great benefits to operators and will deliver Procera competitive advantage by leveraging our strengths in software versus our competitors.

We continue to expand our customer base. We added 68 new service provider customers in fiscal 2013 and 27 new service providers and customers in Q4 alone. Three of these were Tier-1 wins.

Our revenue mix for Q4 was 34% fixed, 32% mobile, 20% cable and 14% embedded enterprise and higher education. 32% of our fourth quarter revenue is from new customers, with 68% follow-on. Our revenue mix for fiscal 2013 was 33% mobile, 29% fixed, 26% cable and 12% embedded enterprise and higher education. Approximately 45% of our 2013 revenue was from new customers and 55% was follow-on.

As we look at our pipeline, we expect approximately 40% of our 2014 revenue to come from new customers and 60% to come from follow-on orders.

Contributing to our growth, Vineyard's revenue increased 19% sequentially quarter-over-quarter, and we're pleased to report that we added 6 new embedded wins. Trial activity is strong. We have 16 direct trials with Tier-1 global service providers. These trials are underway or planned to begin in the next 60 days.

In the quarter, we announced that we were selected by 2 new LATAM Tier-1 fixed-line operators and received orders from 2 Tier-1 fixed-line operators in the Latin American region, including 1 cable MSO and 1 DSL operator. We also received a first-time multimillion-dollar order from a new Tier-1 operator in EMEA.

With that, I'll turn the call over to Charles for a more detailed look at our financials.

Charles Constanti

Thank you, James. We reported 25% revenue growth for the year. Total revenue in the fourth quarter was $21.3 million, up 29% from last year.

Bookings for the fourth quarter were a record $22.4 million.

Product revenue in the fourth quarter was $16.2 million, up 24% from the prior year, and flat sequentially from the third quarter of 2013.

During the quarter, we had 2 customers that represented over 10% of revenue, one at 10.5%, and the second at 13% of revenue, for a total of 23.5% of revenue for the fourth quarter.

Support revenue continued to grow and is an important source of recurring revenue. Support revenue in the fourth quarter was $5.1 million, up 47% from the prior year, and up 2% sequentially from Q3. Our support revenue reflects ongoing support agreements and growth in professional services as we increase our focus on delivering solutions.

Total deferred revenue was $14.8 million and is comprised of maintenance and support, together with term licenses for the Vineyard -- from the Vineyard acquisition and for that business in January of 2013. We completed that acquisition in January of 2013, and our Q4 revenue for this product was $925,000, up 19% sequentially from Q3.

Looking at fourth quarter revenue by geography. EMEA was 47% of revenue, Americas was 35%, and APAC was 18% of revenue. With the expansion of our global sales force, we expect the contribution of offshore sales to be an important part of our revenue growth in 2014, as international customers continue to deploy advanced solutions for Internet intelligence and policy enforcement in their highly competitive markets.

The non-GAAP gross margin rate for the quarter was 60%. Sequentially, this compares to 50% in Q3. The sequential improvement reflects an increase in our product gross margin from a higher mix of software as compared to hardware. The margin rate in Q4 was consistent with our guidance for gross margin rate in the high-50s to low-60s for the quarter.

As a reminder, the Q3 gross margin rate was unusually low, reflecting the impact of a large mega carrier deal in Q3 that had a heavy concentration of hardware and reduced the gross margin rate for that quarter.

Non-GAAP operating expenses in the fourth quarter were $12.7 million, up $1.5 million sequentially from Q3, and up $4.3 million from last year. The increase in operating expenses sequentially from Q3 and from last year was due to investment in R&D, quality control resources and our global sales team.

The year-over-year increase in operating expenses also reflects the impact of assuming the ongoing operating costs from the acquisition of Vineyard Networks at the beginning of 2013.

The GAAP net loss for the fourth quarter was $3.3 million compared to a GAAP net income of $1.2 million in the fourth quarter of 2012. On a non-GAAP basis, our results for the fourth quarter were breakeven compared to non-GAAP net income of $2.4 million in the fourth quarter of 2012.

We ended the quarter with $107 million of cash and short-term investments. This is down approximately $2 million from Q3, primarily from an increase in accounts receivable. DSOs were 108 days, which is high for us and reflects longer-than-typical payment terms for 1 large Tier-1 customer. We expect this receivable to be paid in Q1, and the receivable balance should then reflect a more typical DSO level.

Turning to guidance for 2014. We expect revenue growth of 15% in 2014. This reflects anticipated strong international growth and takes into account our limited visibility into new U.S. cable opportunities, with potential consolidation in that space impacting new orders.

Revenue growth is expected primarily from the international mobile market as that market continues to innovate and address significant growth in mobile data services. The Vineyard revenue is expected to also be a contributor to revenue growth in 2014. We expect Vineyard revenue to increase by over 50% in 2014.

Revenue growth in 2014 is expected to follow a seasonality pattern similar to prior years, down sequentially in Q1 compared to Q4 of 2013, with growth skewed toward the second half of 2014.

We expect Q1 revenue to be flat to a slight increase from our revenue reported in Q1 of 2013. While our pipeline is strong, deployment momentum typically tends to be seasonally low in Q1.

Our gross margin rate is expected to be in the low- to mid-60s. Key drivers for the gross margin are increases in higher gross margin support revenue, increases in Vineyard revenue and the mix of software to hardware in customer orders.

Our gross margin can fluctuate with our product margin impacted by the mix of software and hardware in a given quarter.

Non-GAAP operating expenses in Q4 of 2013 were approximately $12.7 million, and we expect quarterly operating expenses to remain relatively flat with this level in 2014. We plan to increase our investment in innovative product solutions and offset the cost of these investments with cost reduction actions in the other parts of the -- of our business. We are modeling a return to profitability in the second half of 2014 on a non-GAAP basis.

Thank you. I'll turn the call back to James.

James F. Brear

As we look to 2014, we have built the foundation for long-term growth and market leadership. In 2013, we made investments in our global sales expansion, enhancing our customer support and expanding our product portfolio.

Having just returned from Mobile World Congress, where we doubled the quantity of meetings from last year to well over 150 meetings in 4 days, it's clear that we are gaining a leadership position in network virtualization and in network and subscriber analytics.

Our pipeline continues to grow, and we feel well positioned in the market as we head into the year.

With that, we will open up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Okay. And your first question comes from the line of Vijay from Deutsche Bank.

Vijay Bhagavath - Deutsche Bank AG, Research Division

Jim, Vijay, by the way. So yes, a question for you is on -- help us better understand the pricing dynamics between virtual appliances and the hardware platforms. I think where I'm coming from is, as you said, increasingly, you will be selling into an NFV type of virtualization-oriented telco network. So how did it manifest from a pricing point, if you would, in terms of a haircut to unit test these [ph] ? Help us understand that.

James F. Brear

Sure. So the answer is I don't know yet. Obviously, we're still very early in how NFV will be rolled out within carriers and the impact in hardware sales. That's, I'd say, undetermined. So I'm really not sure what to answer you at least for 2014.

Vijay Bhagavath - Deutsche Bank AG, Research Division

Okay. And then the second question is on the cable side, you see the demand environment, in doing, over the next few quarters, so you think this is kind of a semi-structural issue here around a reduced spending from the cable operators? What's your view overall from a demand outlook in cable [indiscernible] ?

James F. Brear

Yes. I don't see this is as a structural long-term issue. I'd say it's going to be more of a near-term issue as the mobile operators go through potential consolidation and strategy...

Charles Constanti

Cable.

James F. Brear

Right. Excuse me, cable.

Operator

[Operator Instructions] There is a question from the line of Simon Leopold.

Victor Chiu

This is Victor Chiu in for Simon Leopold. I just wanted to ask -- dig a little deeper on the cable side, given the contribution from cable operators in recent quarters, I was wondering if the miss was strictly related to cable? Or if there were other factors that contributed? Or was it strictly related to cable?

James F. Brear

Yes. It was cable.

Victor Chiu

Okay. I guess, just trying to reconcile the commentary because Comcast and Time Warner both forecast significantly higher plans for spending in 2014, so that just seems to be -- yes, it just seems to contradict what you're seeing, I guess. I'm just trying to reconcile that and how -- why that might be.

James F. Brear

Yes, I mean, that -- they may be. The question is, is that -- any of that CapEx budget going to go to technology that we provide? So that would be a question. And secondarily is, who's going to make the decisions? What organization -- there's a lot of, obviously, flux in terms of how and when they make any more decisions.

Victor Chiu

Okay. Sure. On the back of the Netflix announcement on your agreement with Comcast, does this have any impact done directly? And on a broader note, do you envision similar agreements like this down the line with telcos such as AT&T, Verizon? And how does that impact the deployment of DPI?

James F. Brear

Yes, I would -- again, I'd say that announcement, from my perspective, is not a real issue. It really was a peering agreement issue, where they were using third parties. There was spending money. Netflix is spending money. Now they're just -- that same dollars go in direct to Comcast versus through different CDNs. So I don't really see it having an impact for our business, negatively or positively.

Operator

And your next question comes from the line of Alex Kurtz.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Jim, I have a few questions. First, on the 4Q this year, was any of this related to competitive losses that you were expecting to win? Or are they all related to timing with the M&A background?

James F. Brear

There were no competitive losses in Q4.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

In cable?

James F. Brear

That's correct.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

So this is strictly a timing issue with some deal flow that was expected? And is that receivable the Charles mentioned, was that part of this whole cable M&A issue?

Charles Constanti

No, it has nothing to do with that. It was an operator in EMEA.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Okay. And then my second question, Jim, is I think over the last -- and, of course, I'm only getting it from investors here. I mean, in the last couple of years, you guys sort of forecasting this big 4Q and providing annual guidance has proven very challenging, and what gives you -- what's different this time? What gives you the confidence to go out after 2 consecutive 4Q misses to provide guidances, just like a completely derisked kind of number versus what we'd gone through for the last couple of years here?

James F. Brear

Yes. No question, I made a mistake. We missed both Q4s, so we're, obviously, being more cautious.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Yes, but I guess, the follow-on question is what are you taking out of that number for 15%? I mean, does that assume minimal returns then from existing customers? Does that x out any kind of return in cable? So can you give us the market here an understanding of what you have taken out of the 15% growth number, so we can sort of figure out where the upside could come from during the year?

James F. Brear

Yes. I think you're right, Alex. I'd say we're very cautious on the U.S. cable spend. That could change. It could change relatively quickly or it could take a while, but that's where we are being conservative in the guidance.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

So not in EMEA telco or U.S. telco or Asia? The conservatism is really on U.S. cable?

James F. Brear

Yes. Not us. It's not Americas. It's specific to U.S., and it's specific to cable. As we said...

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

And just as a last follow-up -- just a last follow-up question on what the last person was asking about the M&A space. I mean, Time Warner and Comcast have not been 10%-customers for you, historically. So I'm trying to reconcile why this M&A situation here between these 2 companies is impacting your business because, obviously, other cable companies have been bigger contributors.

James F. Brear

I think it's broader than just that M&A, Alex. There's a lot of activity that you may or may not be aware of inside of the cable MSO market in the U.S. that has created pause in some CapEx spend.

Operator

And there are no more questions at this time from the phone line.

James F. Brear

Okay. Thank you, everyone, for joining the call, and we'll talk to you next quarter.

Operator

This does conclude today's conference call. You may now disconnect.

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