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Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q2 2010 Earnings Conference Call

July 21, 2010 5:00 PM ET

Executives

Kirk Misaka – CFO, Corporate Treasurer and Secretary

Mory Ejabat – Chairman, President and CEO

Analysts

Greg Mesniaeff – Needham & Company

Edward Zabitsky – ACI Research

Wayne Linman [ph]

George Tomsey [ph]

Operator

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

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

Kirk Misaka

Thank you, operator. Hello and welcome to the Second 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 second 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 second quarter. Following Mory's comments, I will discuss Zhone's detailed financial results for the second 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 this conference call, we will make forward-looking statements, which reflect management's judgment based on factors currently known. However, these statements involve risks and uncertainties, including those related to projections of financial performance; the anticipated growth and trends in our business; the development of new technologies and market acceptance of new products, and statements that express our plans, objectives, and strategies for future operations.

We 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 and our quarterly report on Form 10-Q for the quarter ended March 31, 2010. We would like to caution you that actual results could differ materially from those contemplated by the forward-looking statements, and you should not place undue reliance on any forward-looking statements. We also undertake no obligations 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 a basis for making operating decisions, because they provide meaningful supplemental information regarding our operational performance and they facilitate management's internal comparisons to the company's historical operating results and comparisons to 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 website at www.zhone.com.

With those comments in mind, I would now like to introduce Mory Ejabat, Zhone's Chairman and Chief Executive Officer.

Mory Ejabat

Thank you, Kirk. Good afternoon, and thank you for joining us today for our second quarter 2010 earnings call. We are proud to announce achieving our revenue and margin guidance for Q2 2010 based on the continued growth of our new MXK and the launch of the new zNID ONT. Second quarter revenue was up 10% as compared to the second quarter 2009 and up 7% as compared to the first quarter of 2010.

We continue to remain confident about the remainder of 2010 based on the strong interest in our new products and our end-to-end multi-service solutions being deployed by service providers in North America and continued strength in the Middle East, Canada [ph] and the new growth in the Nordic Regions. The primary reason for our continued confidence are as follows.

First, service provider demand for our new multi-service solutions remains strong with continued demand anticipated for the foreseeable future. New industry analysts enthusiasm for the new MXK OLT and newly announced zNID 4200 very high speed ONT products. Recent recognition by some of the leading industry analyst firms like Infonetics, Broadband Trends Dittberner, Current Analysis, IDC and others recognized for exceeding our 4500% year-over-year growth for GPON out passing every other vendor in the industry.

Zhone's new flagship MXK product continues to earn strong market recognition and acceptance super passing over 500 MXK system deployed, supporting a total system capacity of over five million subscribers. Additionally, we continued to see a strong response to our solutions globally with continued a strength in the Middle East and the new growth in the Nordics, while we remain confident that US broadband stimulus awards will provide additional domestic growth for the broadband network build out.

We do not foresee award and deployment until Q4 2010 and beyond. That said many of our customers have been awarded second round of stimulus grants. Finally we launched exciting all new ONT zNID 4200 family of products in Q2 2010. The new look line consists of a ten exciting new ONT products featuring Zhone easy touch provisioning, non blocking wirespeed throughput and multiple form factors, making the combination of the MXK and the zNID ONT one of the easiest solutions to deploy, while delivering the highest performance and highest density solutions in the industry today.

Now let me provide you with a few highlights from the past quarter. We are in the final stages of launching the new Zhone brand image and tag line. Bandwidth Changes Everything. This product will new tag line helps to communicate our new goals, objectives and ambition to build the network of the future today. Our new brand is rich and vibrant affecting our ambitions to build the fastest, highest quality all IP networks for our customers while also retaining our Zhone's heritage, coming front [ph] to technology leadership and innovation and multi-service solutions.

As expected, the new MXK and zNID continued to be selected and deployed by new customers around the globe solidifying our leadership position in the delivering of all IP multi-service and end to end solutions. A few examples include incumbent operator B.A.S.E. Technologies and Telecom Bonaire selected Zhone's MXK and zNID platform to deliver Fiber To The Home or FTTH services to Greenfield locations throughout the island territories. Telefonia Bonairiano N.V. or Telbo cited platform performance, capacity and flexibility to add future services in the winning selection criteria. The Telbo win further expands Zhone's strong presence in the Caribbean.

BH Telecom selected Zhone's flagship MXK multi-service access platform to deliver GPON and mobile backhaul services to its customers in Sarajevo. BH Telecom is the largest telecom operator in Bosnia, Herzegovina, and we would be the first in the region to deliver high performance GPON providing one gigabit per second service to enterprise customers and 100 megabyte service for residential tripe play. For residential customers, this amounts to more than 25 times increase in broadband speeds and sets the stage for sophisticated IP-TV services and a smaller home networking using Zhone's zNID ONTs.

Du, an integrated telecom service provider in the UAE has opted for Zhone's multi-service access now to deliver a broad suite of sophisticated IP access services to its increasing fixed access customers. Du selected Zhone's end-to-end solution to provide voice, Ethernet in the First Mile, ADSL2+ and ISDN BRI over IP to its residential and business customers as part of its IP network initiatives.

As mentioned previously Zhone received a strong industry analyst endorsement from some of the leading industry analysts ranking us amongst the largest equipment vendors in the industry, results show Zhone's GPON port shipment year-over-year growth at 4580% from Q1 2009 to Q1 2010, thereby outpacing the industry average. The company saw a rapid adoption of its MXK and zNID FTTx system in (inaudible). Since announcing the MXK, Zhone has continued to increase traction in key growth markets including the Americas and the Middle East said Jeff Heynen Directing Analyst, Broadband & Video for Infonetics Research. Subscriber density expanded throughput performance of the MXK and a broad range of zNID ONTs have helped Zhone expand its FTTx market presence worldwide.

Beside the inherent product trends of the MXK and the zNID launch some benefits (inaudible) from its ability to address global markets. We remain highly optimistic about 2010 and we see considerable momentum from our customers and enthusiasm for the MXK and our powerful ONT solutions. With the addition of the new zNID ONTs alongside the MXK, our portfolio product becomes a powerful compared to enabling Zhone to deliver the network of the future today.

Furthermore, we continued to strength the company from multiple perspectives, one with the launch of our new OSP [ph] ONT solutions we rely less on the third-party offshore manufacturing and increase our US base manufacturing capabilities to be continued to improve our overall business and financial performance, increasing both our cash flow position and gross margins.

Now I will turn the call over the Kirk to provide more details about our financial results for the last quarter and to discuss our financial guidance for the next quarter, Kirk?

Kirk Misaka

Thanks Mory. Today Zhone announced financial results for the second quarter of 2010. As Mory mentioned, the second quarter revenue of $33.3 million grew by 10% year-over-year as compared to the second quarter of 2009 and increased by 7% sequentially as compared to the first quarter of 2010, due to increased demand for MXK product family.

Looking forward to the third, quarter we expect another quarter of single-digit percentage sequential revenue growth as domestic customers get more stimulus funding and network expansion continues in emerging international markets. We continue to serve over 750 active customers worldwide with 62% of revenue year-to-date being attributable to international customers.

We experienced slightly less customer concentration this quarter with the top five customers representing approximately 42% of revenue for the second quarter as compared to 50% of revenue for the first quarter. We continued to have just one 10% customer. As expected gross margins of 36.1% for the second quarter of 2010 remained approximately the same on a sequential and year-over-year basis.

We also expect gross margins to remain close to 36% for the third quarter. Pro forma operating expenses for the second quarter came in at the low end of our expectations at $12.9 million as a result of continued expense control. We expect pro forma operating expenses to increase only minimally for the third quarter attributable to the anticipated revenue growth.

Pro forma operating expenses for the second quarter excluding depreciation will account $400,000 and stock-based compensation of approximately $300,000. Going forward, we expect pro forma operating expenses to exclude approximately the same amount of depreciation and stock-based compensation. Finally and most important, our pro forma EBITDA loss for the second quarter of 2010 was approximately $800,000 which met our goal of reducing the pro forma EBITDA loss from the $1 million loss in the first quarter.

We expect to achieve breakeven pro forma EBITDA for the third quarter of 2010 keeping us on track of achieving our primary financial goal of having positive pro forma EBITDA for the year as a whole.

Now let's take a quick look at the balance sheet. Cash and short-term investments at June 30, 2010 were $20.3 million, which declined only slightly from the $20.9 million at March 31, largely as a result of the pro forma EBITDA loss for the quarter. Other working capital changes in the balance sheet, netted out with the large decrease in accounts receivable being offset by a similar decrease in accounts payable, with a large decrease in accounts receivable the number of days sales outstanding on accounts receivable for the second quarter decreased to 75 days, as compared to 109 days for the first quarter.

As mentioned on our last few earnings calls, we expect the DSOs would decline as the payment cycle with our 10% customer caught up with and eventually exceeded 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 remainder of the year, we anticipate roughly net neutral cash flow from operations, which will help stabilize our liquidity requirements. As for other balance sheet changes, our total debt obligations remained basically the same as last quarter at $28.5 million.

Total debt obligations are now classified as current since our campus loan is due in April 2011 and our working capital facility renews annually in March. We are currently working on a restructuring our campus loan and are targeting completion of that restructuring by the end of the third quarter but no later than the end of the year. In any case we'll make an announcement when the restructuring is completed.

As for our working capital facility we anticipate being able to renew it again as we've done for many years. That renewal would occur in the first quarter of 2011. Finally the weighted average basic and diluted shares outstanding were $30.3 million for the second quarter of 2010. The weighted average basic shares outstanding for the first quarter of 2010 were also $30.3 million as reflected on our 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. We are pleased with the 10% year-over-year and 7% sequential quarterly revenue growth which builds on the momentum from the first quarter. Market interest in our new products and improving overall environment may cost domestic that we can continue growing quarterly revenue for the remainder of the year which will lead to achieving our primary financial goal of generating positive fairly pro forma EBITDA.

This year we will sustain our investment in research and development focused to ensure we widen our window of opportunity in high growth markets including multi-service, FTTx and mobile backhaul solutions. We intent to leverage our market leadership in Middle East and (inaudible) and surrounding Greenfield regions. As an organization we will continue to maintain close attention to operational expenses and exercise discipline to maintain maximum efficiencies across the board.

We have taken a proactive role in helping our US customers navigate broadband stimulus funding and we will continue to provide support throughout all phases of the deployment. We plan to have strength our relationships with our partners and channels, working to have our current and future customers deliver a profitable services. We have our new commitment to building the fastest and highest quality all IP multi-service solutions for our customers.

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

Question-and-Answer Session

Operator

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

Greg Mesniaeff – Needham & Company

Yes, thank you. Couple of questions, first for you Kirk. Looking at the OpEx results for the quarter, it seems G&A was down after unusually high Q1. Could you kind of refresh my memory on what that was all about?

Kirk Misaka

Greg, we had the acceleration of some of the stock option vesting recorded in G&A in the first quarter, that's about $800,000 of stock-based compensation that no longer exists in the second quarter.

Greg Mesniaeff – Needham & Company

Got you, so for modeling purposes, the current G&A number is a more normalized kind of a benchmark number?

Kirk Misaka

Yes, that should be – going forward that should be pretty close.

Greg Mesniaeff – Needham & Company

Okay. And for you Mory I was hoping you can give us a little bit more of a kind of product roadmap on the zNID ONT product and where you see that product being deployed in terms of current market geographies?

Mory Ejabat

Yes, the zNID product right now actually it has been deployed on the globe, where we do sell our product, but majority of the sales has been in Middle East, South America and United States. And majority of our new IOC customers are using our new zNID and the roadmap on that right now is the residential and multi-dwelling units that are being deployed and we're going to follow that up by mobile backhauling product line.

Greg Mesniaeff – Needham & Company

Thank you.

Mory Ejabat

Yes.

Operator

And next question comes from the line of Edward Zabitsky. Please proceed.

Edward Zabitsky – ACI Research

Edward Zabitsky, ACI Research. Just wanted to ask you about the MKX or MXK and you had mentioned of course that it continues to grow, so could you define what percentage of overall revenue it was this quarter just so we understand where we are in this process?

Mory Ejabat

We haven't published that information at this point what percentage it is, but if you look at the whole FTTx or FTTH area, the majority of the sales come from ONTs. They are the CPs or remote site devices that go with these product line, but our MXK enables the sales of the ONTs and we do have right now over 500 units deployed of the MXK.

Edward Zabitsky – ACI Research

Okay. And as far as I mean typically in the markets I've heard a number of about around $100 per line quoted, is that about right for you, are you above the market, below market?

Mory Ejabat

Yes, $100 per line, it depends what you're describing. If you're talking about GPON product line, it's way too low at $100. We haven't even seen that from very, very aggressive Chinese manufacturers. Yes, you can talk about between 150 to $250 per line depending on the features and functionality.

Edward Zabitsky – ACI Research

Is that both sides?

Mory Ejabat

It's both sides.

Edward Zabitsky – ACI Research

I was talking about per side. Okay, so that's in the ball park?

Mory Ejabat

Yes, it’s $100 per OLT side, it could be correct.

Edward Zabitsky – ACI Research

Okay. And you mentioned new customer in your press release? Can you tell us a little more?

Mory Ejabat

New customers, we talk about several customers, new customers that we talked about in the call today, there was four or five of them that we discussed. But we do have lots of new customers but we don't talk about them until we do a press release. The major, the two major customers that we had in this call that we mentioned, one of them is BH Telecom, which is Bosnia Telecom, which is the incumbent in Bosnia, that's a large telephone incumbent and we have got the first order from them which was minimal but we anticipate two larger orders from them.

The second large one is du, which is the largest wireless and wire line telecom provider in UAE after Etisalat. So with Etisalat and du being our customers, we have a total coverage of a majority of gulf regions and UAE.

Edward Zabitsky – ACI Research

Okay, actually the quote from the press release was new growth in the Nordic regions.

Mory Ejabat

Nordic region, yes. We bought 20 some odd of customers in Nordic region that have started deploying our products in a trial and freshed up its [ph] application right now.

Edward Zabitsky – ACI Research

Okay, now there has been, so I'm just going back to the UAE, there has been some press about their broadband plans. Are we talking about an Emirates wide deployment, how big are these plan deployments?

Mory Ejabat

Well if you look at the total Emirates which includes eight Emirates, they decided that they are going to go fiber to all Emirates, to every home on every building and from every building to every condominium or any complex. So they are in initial deployment on that.

Edward Zabitsky – ACI Research

And over how many years…

Mory Ejabat

Their plan is to -- I would guess that what their plan is to do it in couple of years.

Edward Zabitsky – ACI Research

Well, so you expect this to be a continued driver for you?

Mory Ejabat

Definitely.

Edward Zabitsky – ACI Research

Okay, very good. I'll let someone else ask questions. Thank you.

Mory Ejabat

Thank you.

Operator

Your next question comes from the line of Wayne Linman [ph]. Please proceed.

Wayne Linman

Hi Kirk, I have two questions for you. Number one, can you give me your thoughts on why the stock price is trading so low for a company which is projected to be profitable by the end of the year?

Kirk Misaka

Wayne, we typically don't comment with regard to the market activity around our shares. Certainly we're disappointed that we don't have similar valuations as our competition given our performance.

Wayne Linman

Okay, the second question, if a private entity wished to purchase the company, would you consider a buyout?

Mory Ejabat

Well, you know we always look at the – we always consider any buyout, it depends how big your check is?

Wayne Linman

Okay, thank you, Mory and Kirk. I appreciate it.

Mory Ejabat

You're welcome.

Operator

And your next question is a follow-up question from Greg Mesniaeff. Please proceed.

Greg Mesniaeff – Needham & Company

… for the quarter, how does that compare to the first quarter?

Mory Ejabat

We are sorry, Greg, we can't hear you.

Greg Mesniaeff – Needham & Company

I'm sorry, what was the days sales outstanding, the DSO, for the second quarter versus the first quarter?

Mory Ejabat

Second quarter was 75, first quarter was 109.

Greg Mesniaeff – Needham & Company

Got you, okay. Any color or commentary about that?

Kirk Misaka

Well, as we talked about on the last few earnings calls, our 10% customer had a payment cycle that was just beginning and we received very large payment this quarter which exceeded the revenue shipments and therefore we've had a significant reduction in accounts receivable related to that 10% customer.

Mory Ejabat

In addition to that, Greg, there was a performance criteria that we had to meet and get acceptance. We did that and passed that.

Greg Mesniaeff – Needham & Company

Thank you.

Mory Ejabat

You're welcome.

Operator

And your next question comes from the line of George Tomsey [ph]. Please proceed.

George Tomsey

Yes, can you shed any light on whether a stimulus revenue is staring to hit your P&L yet and also what you see in the next couple of quarters regarding the stimulus revenue because you mentioned it.

Mory Ejabat

Sure. We that had – that stimulus revenue hasn't hit our numbers yet but we have the several customers probably more than what you would anticipate that have awarded a stimulus money and right now they are in the last contract negotiation withdraws for getting the money awarded to them or released. They have been awarded but the money hasn't been released to them and we anticipate to seeing some of that release after September. And then at that point they would place orders with us.

George Tomsey

Okay. And how long do you expect that to continue for, is that going to continue to for a order or two or for a year?

Mory Ejabat

I think it's going to continue until the end of 2011.

George Tomsey

End of 2011?

Mory Ejabat

Right.

George Tomsey

And then I noticed that one of your directors who was just recently appointed resigned from one of your (inaudible).

Mory Ejabat

Right. That was an unfortunate misinterpretation of the regulatory requirement. We us and (inaudible) we interpreted the regulations the period of time that we asked to wait for approval was wrong for our interpretation. The regulatory, since she was from a different industry is, she has to wait 60 days for regulatory approval but we thought its immediate and that was caused some issues. So we have to wait 60 days.

George Tomsey

Okay. Thank you.

Mory Ejabat

You're welcome.

Operator

(Operator Instructions). Your next question comes from the line of Edward Zabitsky. Please proceed.

Edward Zabitsky – ACI Research

Thank you very much. So I wanted go back to the MXK, obviously over time you've gone back to targeting larger really the tier one carriers across the world. Has it entailed the change in your sales force toward people that are more familiar with some of these larger accounts?

Mory Ejabat

Yes, actually majority of our sales force are trained for that type of account and the area that we are changing is in our service area to make it more conducive to the type of requirement that larger customers have.

Edward Zabitsky – ACI Research

Okay. So you've been able since the big merger a few years ago, you have been able to retain some of these people who have the big carrier experience?

Mory Ejabat

Definitely.

Edward Zabitsky – ACI Research

Okay, very good. Thank you very much. Lots of luck.

Mory Ejabat

Thank you.

Operator

There are no further questions. I would like to turn the call over back over to Mory Ejabat. Please proceed.

Mory Ejabat

Once again thank you for joining us today for your continuous support. We are looking forward to speaking with you on our next earnings conference call when we hope to report another (inaudible) improving financial results. Operator?

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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