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Aviat Networks, Inc. (NASDAQ:AVNW)

F3Q 2014 Earnings Conference Call

May 6, 2014 16:30 ET

Executives

Leslie Phillips - Investor Relations

Mike Pangia - President and Chief Executive Officer

Ned Hayes - Senior Vice President and Chief Financial Officer

Analysts

Richard Valera - Needham & Company

Operator

Good day ladies and gentlemen, and thank you for standing by. Welcome to the Aviat Networks’ Third Quarter of Fiscal 2014 Earnings Conference Call. During today’s presentation all parties will be in a listen-only mode. Following the presentation the conference will be open for questions. (Operator Instructions)

I would now like to turn the conference over to Leslie Phillips of Investor Relations. Please go ahead, ma’am.

Leslie Phillips - Investor Relations

Thank you, operator. Good afternoon everybody and welcome to Aviat Networks fiscal third 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 opinion 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 both GAAP and non-GAAP financial measures. A copy of the press release and financial tables which included GAAP to non-GAAP reconciliation and other supplemental financial information is available on the Investor Relations section of the company’s website.

Now I’ll turn the call over to Mike

Mike Pangia - President and Chief Executive Officer

Thanks. Leslie. Today we announced our third quarter of fiscal year 2014 results. Total revenue for the quarter was $81.4 million resulting in a non-GAAP loss of $0.16 per share. Non-GAAP gross margin came in at 25.8%. We implemented important components of our restructuring plan, the response, this cyclical slowdown that the entire microwave backhaul industries experienced over the past few quarters.

We believe our plan better aligns the company’s cost structure with our near term outlook. We’re on track to exit the fiscal fourth quarter with non-GAAP operating expenses of approximately $27 million. We’re also on track to lower the company’s quarterly breakeven level to approximately $90 million and expect to see gross margin improvements in fiscal year 2015.

Moving forward we’re taking steps beyond our restructuring plan to position the company for profitable growth. While our cash balance is sufficient to run the company, we see room to improve our liquidity position through further improvements in our cost structure and a particular working capital management. Ned will speak to these changes in a few minutes.

As I mentioned our fiscal third quarter results reflect the cyclical nature of the microwave business, where demand differs greatly by region, customer, and vertical market. This cyclicality is currently on display in Africa where revenue declined 42% versus the same quarter of the previous fiscal year and was down 44% during the first nine months of fiscal 2014 versus the same period in 2013. These declines occurred despite the fact that we maintained a very strong position in this market. While operator spending remain weak in Africa we did start to experience an improving pace of business in our other markets.

Our third quarter book-to-bill ratio was substantially above one making a third consecutive quarter in which this ratio was above 1, as a result our backlog is improving. In addition (coating) activity has increased and overall we’re encouraged by the potential new business in the pipeline. Our new products have already opened doors to new customers with orders received for both our CTR 8540 and our new WTM 300 millimeter wave solution.

Looking back on the quarter we just reported I’d now like to provide further details on our customer wins in the respective geographies and how this new business fits into the company’s growth strategy. I’ll also discuss our new product launches and the encouraging signs we see in the market.

Turning to North America, we experienced a sequential uptake in business versus the past couple of quarters. North America revenue included an increase in business within the mobile operator segment as our customers continued with a build-out of what are now the largest global deployments of LTE. In public safety, while sales cycles have lengthened over the past several quarters we’ve seen a growing pipeline of deals. During the quarter we converted one of these deals into an $8 million contract win for a major California county. For this project Aviat will provide its Eclipse IRU600 radio as well as the planning and professional services to replace the county’s microwave backhaul network.

The IRU600 provides the capacity, reliability and security features to integrate into public safety networks like FirstNet, the federal authority charged with deploying the nation’s public safety broadband network. Regarding FirstNet in March we announced the results of an LTE evaluation in the Public Safety Communications Research lab. This lab can be seen as the gatekeeper for products to be used for U.S. public safety broadband rollouts including FirstNet. We’re encouraged by this recent activity and continue to see public safety as a solid and promising market for Aviat.

Moving to the emerging markets. Several customer wins came in during the quarter in the Asia-Pacific market. Aviat was selected by Telikom Papua New Guinea to provide the microwave backbone for the country’s first major broadband network rollout. This is the contract that we mentioned a couple of quarters ago that retuned to rebid due to a customer procurement change. In both the initial bid and after the contract was rebid Aviat successfully secured the business with this new customer, which will be worth around $20 million in the initial phases. The date we’ve received most but not all of these orders and have recognized approximately $6 million in revenue.

Having been in Papua New Guinea only a few weeks back I can confirm firsthand that the deployment conditions which involve mountains, big jungles and large structures of water are quite challenging. Our work with TPNG demonstrates two competitive strengths, first, the reliability and resilience of our equipment in the most strenuous environments and second our end-to-end capabilities which provide the customer with the lowest total cost of ownership and highest return on their investment.

Now looking at Africa. While the third quarter performance was impacted by cyclical downward trend of CapEx spending by mobile operators in this region particularly MTN. During the quarter we reveal that the expanded services contract which we referenced previously is with MTN Nigeria. We’re confident that this contract creates an even stronger foundation to expand our footprint with MTN in the longer term. In addition to strengthening our relationship with our biggest customer we’re taking steps to diversify and grow our business in Africa.

During the quarter we announced a joint venture agreement with Ubuntu Technologies to form a co-branded telecom solutions provider in South Africa. The JV will serve state-owned enterprises and public companies by offering Aviat’s microwave networking solutions in particular the newly launched CTR 8540. We see this as an avenue to expand our services to all four South African telecom providers and also help them evolve their infrastructure towards next generation, mobile broadband and enterprise services.

Now switching to product launches and updates. During the quarter our successful launch of this CTR platform was accompanied by two important customer wins. The CTR is the industry’s first purpose-built microwave router. The CTR fits a land and expand strategy where hardware sales lead to software upgrades over time. The first customer utilized this CTR is Intel, the largest telecommunications company in Chile.

We’ve also received CTR orders from Osnova, a new customer in Russia and area of the world where we see a substantial opportunity to grow market share. Existing customers are also recognizing the improved capabilities of this CTR platform and we’re reflecting this in their requirement specifications. This CTR enables mobile backhaul enterprise applications without the additional deployment of router devices.

As previously stated we anticipate this to be the most prevalent and emerging markets where customers seek new revenue opportunities by leveraging existing infrastructure to serve enterprise customers, simply put gearboxes mean a more efficient network and a greater savings for our customers. This CTR is receiving high marks from independent analysts. Infonetics, Richard Webb described the CTR as not just innovative but potentially disruptive recognizing the opportunity for mobile operators to reposition their cell side as a services hub.

Meanwhile Emmy Johnson, Founder of Skylight Research names Aviat a mainstay in the microwave market and validates the CTR’s utility by helping customers scale as new applications push network performance. In addition to this CTR we recently announced that the WTM 330 radio has reached general availability status. The WTM 3300 is a smallest and lightest 70 to 80 gigahertz radio on the market. It is designed – its design has been optimized for densified city environments where we expect small cell deployments will fill critical connectivity and capacity needs.

With the product stay view, we also announced that three customers of our replaced WTM 300 orders including new mobile operator customers in Central and Western Europe and an existing full line telecom provider in South America. We believe these initial orders speak to the WTM 3300 global applicability and appeal. With microwave’s small cell predicted to grow at the fastest rate in the overall market we’re very optimistic about adoption of the WTM 3300 product. These new products are innovated yet competitively priced leaving the customer with little doubt that they offer the lowest total cost of ownership as we continue to actively bid the CTR and WTM platforms we’re drawing an audience of new customers and customers that we haven’t worked with in sometime.

While we’re aware of our near term challenges we’re cautiously optimistic about our long-term opportunities given the recent booking strength, the increased RFP activity and the enhanced capabilities of our refresh product portfolio. As we remain steadfast in our current accounts by providing top rate equipment and services we’re also confident in our ability to strengthen our position in markets where we currently do not have a large presence.

With that I’d like to turn the call over to Ned. Ned?

Ned Hayes - Senior Vice President and Chief Financial Officer

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

The key figures were company’s book-to-bill ratio in the first third quarter was substantially above 1, for the consequent improvement in our backlog for the coming quarters. Revenue for fiscal Q3 came in at $81.4 million down sequentially from $85.8 million in fiscal Q2 of this fiscal year, as we continue to absorb weakness in both bookings and revenue in our Africa region.

Africa and the Middle East region revenues declined sequentially from $26 million in fiscal Q2 to $21.7 million in this fiscal quarter. This region’s revenues have declined from $150.6 million in the first nine months of the last fiscal year to $84.7 million in the first nine months of this fiscal year demonstrating a cyclicality we’re facing in the region. Still MTN our key account in Africa was once again a 10% plus customer in the quarter. It should be noted that reported revenue in the quarter was not impacted by any changes in revenue recognition timing arising out of our recently announced managed services agreement with MTN Nigeria.

Having said that North America was relatively strong in both orders and revenue with new wins in the non-mobile space and continued expansion of our mobile operator customers LTE networks. Non-GAAP gross margin for the fiscal third quarter was 25.8% of sales. Gross margin in the quarter was negatively impacted by an increase in our customer services inventory excess and obsolete reserve of approximately $1.5 million compared with last quarter reflecting lower returns of legacy products as our customers are transitioning faster than we expected to our new generation of products. We also had an unusually large freight expenses overall in the quarter as we dealt with the carrier customer facing continuing political appeal in an African country. Without these anomalies non-GAAP gross margins would have been closer to 28% of revenues in the quarter.

As we observed in our last fiscal quarter lower revenue volumes had a significant margin rate impact caused by lower absorption of fixed cost on the product margin side and certain fixed cost on the services margin side. For the fiscal third quarter non-GAAP operating expenses totaled $30.9 million which compares to $30.4 million spent on OpEx in the previous sequential fiscal quarter. The quarter over sequential quarter increase was almost entirely attributable to a sizable increase in bad debt expense in writing off the carrier account in Africa of approximately $600,000.

It should be noted the actions undertaken on the announced 2014, 2015 restructuring plan did not significantly impact the quarter’s results as headcounts were carried into additional month or two due to notification period requirements especially here in the United States. But the majority of planned headcount reductions were completed by the end of the quarter.

Non-GAAP loss from continuing operations for the quarter was a negative $10.2 million or a loss of $0.16 per share. Fiscal third quarter adjusted EBITDA was a negative $7.8 million. The company ended the fiscal third quarter with a cash and equivalence balance of $47.5 million. We ended the quarter with net cash which is cash less debt of approximately $41.5 million. In addition to the operating losses absorbed in the quarter and shifts in working capital cash was impacted by payments on restructuring liabilities of $2.3 million in the quarter mostly related again to our recently announced 2014, 2015 restructuring plan.

Cash used by operating activities was $14.5 million in the fiscal third quarter. CapEx was approximately $2.4 million. Going forward we expect CapEx to settle back down to historical norms now that we’ve completed our ERP implementation and much of the capital activity around new product development. Free cash flow in the quarter came in at a negative $16.9 million.

Now on the working capital front our inventory turns rate was 5.1 turns, DSOs were 89 days of sales, and days payable stood at 59 days. We understand that we have to address our liquidity position. Even though our current cash balance remains strong we’re not depending on a growing top-line to improve things. We’re vigorously taking steps to reduce operating losses and we already have taken the steps to get quarterly non-GAAP OpEx below $27 million in fiscal year 2015.

Indeed we’ll be exiting this fiscal year at that level with further expense reductions contemplated for the next fiscal year. Additionally to further optimize and improve our cost structure above the gross margin line we have a number of focused efforts that we believe will bare significant returns. First, our new product platforms have been designed at lower costs with volume ramp cost reductions yet to come.

Second, we’re well underway in consolidating our contract manufacturing or CM and warehousing facilities worldwide. And lastly we have strengthened our procurement team to focus on product cost reductions on a wide variety of materials we use into deployment of our new and legacy products. The consolidation of our outsourced manufacturing to single CM will benefit us with a much simplified supply chain, volume discount product pricing and allow to do higher levels of product integration with our CM.

Beyond these expense and cost improvement initiatives we also have significant opportunities to improve our working capital management by transitioning to abide the order model given significant improvements in our lead times, deploying a merge and transit supply chain model here in North America, substantially extending payment terms through re-negotiation of supplier agreements and continuing to be diligent with respect to the quality of revenue in terms of expected (Ts and Cs).

Last but not least our recently amended Silicon Valley Bank credit facility provides us with adequate liquidity and flexibility as we go through our business transition. As we referenced in our last quarter’s earnings call the quarter just closed depicts the volatility we see in geographic markets and product and services, volumes and mix and the choppiness of the buying patterns of key customers and lengthening sales cycles and then quarter non-linearity of bookings. Given this limited near term visibility and the impact that continuing cyclicality in our key (Africa) accounts have on our results we’ll again not be providing specific revenue, margin or non-GAAP earnings per share guidance for the fourth quarter of fiscal quarter 2014.

That said we do expect to see modest sequential top-line improvement for the fiscal fourth quarter of 2014. And we expect the company to return to quarterly positive cash flow generation in the first half of fiscal 2015. Due to the financial benefits of our restructuring plan impacting future results along with other cost and expense reduction and working capital initiatives currently underway.

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

Mike Pangia - President and Chief Executive Officer

Thanks, Ned. Our results demonstrate that we are in a tough market, with Africa continuing to be the most challenging. In this region CapEx spending has been contracting and competition remains fierce. Given with these challenges the global backhaul space remains attractive. To ,maximize our opportunities we’re actively taking steps to position the company to be more agile and efficient and while we’re encouraged by the improving visibility and the traction our new products are receiving we’re very focused on improving our liquidity position to ensure that we can continue with a strong balance sheet and cash position. As we position the company for profitable growth we remain cautiously optimistic about our medium to long-term prospects.

Leslie Phillips - Investor Relations

And now we’ll open the call to questions.

Question-and-Answer Session

Operator

Ladies and gentlemen we will now begin our question-and-answer session (Operator Instructions) And our first question comes from the line of Richard Valera with Needham & Company. Please go ahead.

Richard Valera - Needham & Company

Thank you. Good afternoon gentlemen.

Mike Pangia

Hi, Rich.

Ned Hayes

Hi, Rich.

Richard Valera - Needham & Company

Hi, couple of questions on the cash situation. One, Ned, could you say how much domestic cash you have and how comfortable that position is? Secondarily would you mind sharing the size of the credit line that you discussed and sort of what terms there might be on that, those are my first two things?

Ned Hayes

Sure. So in general Rich the disposition of our cash is about the third of it in the U.S. a third of it in Africa and a third of it in the rest of the world. So given our current working capital and operational cash requirements we feel that we’ve got sufficient balances right now for us to continue to conduct our business. The new terms on our Silicon Valley Bank facility are allowing us the liquidity amount of about $40 million on that line. I think the interesting and important things to focus on are the covenants that we’re looking at certainly the adjusted quick ratio needs to be greater than 1.1 and we report on that monthly.

That calculation is unrestricted cash plus AR, the current liabilities, less deferred revenue advances, whatever debt we have outstanding and outstanding letters of credit so we’ll make sure that we abide by that. We also have created a huge amount of flexibility going forward on our EBITDA covenants. If you take a look at what they are we’re looking at the quarter ending 328 is a negative $17 million, two quarters ending 627 at negative $27 million and two quarters ending 9/26/14 at $12 million certainly those are not our forecasts but we believe we have certainly built up an extraordinary amount of headroom for us to make sure that we’re in compliance with those covenants.

Richard Valera - Needham & Company

Great. That’s helpful. And can you say what your rough expectations are for cash usage if that’s the case in the upcoming quarters?

Ned Hayes

Yes, I think in general we will be – as we described in the past we’ll be using cash once again to pay our restructuring liabilities. I think that number could at be anywhere between $4 million and $5 million and probably another couple of million being used in terms of operating losses and working capital shifts.

Richard Valera - Needham & Company

Okay. Fair enough. I wanted to ask a few questions about some of the new products. So congratulations on the launch of the CTR and WTM products during the quarter. I wanted to see if there is any color you could give on your expectations for a bookings ramp associated maybe with these products combined. And when you think they’d be contributing let’s say materially to revenue and I don’t know how we want to define that, 5% or 10% of revenue – just any color on how you think you re going to ramp. And also you made reference to the fact that the lower cost near existing products it was a sense of where you would expect the initial gross margins for the new products to be ad it sounds like you would expect them to go up over time with volume. So if you can give any color on the gross margin trajectory of them that would be helpful? Thank you.

Mike Pangia

Yes, first off on the new products in terms of the impact on our business. So we’re positioning CTR very actively now on all new opportunities. It’s intended to be primarily for the international markets. So I would see that over the course of the next fiscal year you will see us transitioning towards the CTR. So I would expect that a fair amount of our business by the end of the next fiscal year will be CTR-driven when it comes to the indoor networking unit for the international markets.

On the 3300 and it’s – before I go into 3300 CTR given us our indoor networking unit that has a significant amount of volume in the business. The 3300 which is the millimeter wave product. That market size is not significant at this point but it’s an important enabler and entry into many customers that are starting to deploy that technology and that will be something that I think over time will be very well-suited to the small cell segment. So the 3300 will be a door opener and I see that being growing over time but numerous significant assets at CTR.

As far as margin impact is concerned I would say that as we discussed in the script the impact of CTR with respect to a land and expand strategy, I think that it’s got a lot of capability from a software upgrade potential not withstanding that, I would expect the CTR to be at least to pull into the current margins we’re getting with some significant upside driven by both the licensing capability as well as the impact on the cost side of the equation as we ramp the volume.

Richard Valera - Needham & Company

I just want to make sure I understand, what you’re saying there, Mike. So initially would we put them a sort of 30% gross margin where your products have been running prior to the dip in revenue here amend with upside potentially to low to mid, I don’t want to put words on that?

Mike Pangia

We don’t – improvement only comparing it to the current margins, we don’t breakdown our margins down to that level, Rich.

Richard Valera - Needham & Company

Sure.

Mike Pangia

We sell obviously the indoor unit gets sold with outdoor radios and it’s much more of a bundled sale. Their services included in several of our offerings. Again relative to our current products that we’re selling I expect it to be neutral to positive from the outset with a improvement of margins clearly over time as a result of the licensing capabilities as well as improvement on product cost.

Richard Valera - Needham & Company

Okay. That’s helpful. And one final one from me. Just on the Africa outlook, obviously you’ve gone through sort of a long slide here following the period of a very high activity. And one could conclude maybe that there was some sort of burn off of inventory if you will taking place here. Do you have any sense of where we are in that process and any view towards when the African business might start recovering?

Mike Pangia

Yes. Clearly the impact of inventory has had in the past and that has comeback down significantly. Having said that our largest customer MTN as they recently provided color on their capital requirements for the next fiscal year they actually identified that their largest market which was Nigeria which you see about 23% CapEx reduction in 2014 calendar year and clearly there is a focus by MTN to better manage their cash, I think they’re optimizing that to be extreme. The rest of Africa and recent reports that we’ve seen., Africa in general most reports has been down calendar year 2013 versus 2012 down into the – around 14% based on what we’ve seen 12% to 14% in that range.

So those are all factors that clearly are working against us. We’re seeing signs of more visibility on projects coming through with MTN that’s a positive sign. We’re seeing budgets being allocated. So I would expect that recovery will happen but we’re not – the timing of it is the most difficult thing at this point to estimate, Rich, we’re taking actions outside of MTN in Africa and I think our – the activities that we got going on is South Africa will help us in terms of diversifying our concentration MTN until such time that they start spending again at a more normal rate.

Richard Valera - Needham & Company

Okay. Good luck with the turnaround, gentlemen. Thank you.

Mike Pangia

Thank you.

Ned Hayes

Thanks, Rich.

Operator

Thank you. (Operator Instructions). And I’m showing we have no further questions in the queue at this time. I would now like to turn it back to Ms. Leslie Phillips for any closing remarks.

Leslie Phillips - Investor Relations

Thanks, operator. Before closing the call I’d like to remind everyone that Mike and Ned will present at the Jefferies Global Technology, Media and Telecom Conference in Miami. Investors are invited to listen to the conference presentation which will take place on May 8, 2014 at 11 A.M. Eastern Standard Time. The presentation webcast will be available live and via replay on the Investor Relations site. I want to thank everyone for your participation today and thank you for your interest in Aviat Networks. This concludes Aviat Networks fiscal third quarter 2014 call. Have a great day.

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