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RadiSys Corporation (NASDAQ:RSYS)

Q3 2010 Earnings Call

October 26, 2010 5:00 p.m. ET

Executives

Holly Stephens - IR

Scott Grout - President & CEO

Brian Bronson - CFO

Analysts

Rich Valera - Needham & Co

George Notter - Jefferies

Operator

Welcome to RadiSys Corporation Third Quarter Earnings Conference Call with Scott Grout, President, CEO of RadiSys. As a reminder today October 26, 2010, this call is being recorded. Later we will conduct a question and answer session. (Operator Instructions). Mr. Grout please go ahead.

Scott Grout

Thank you very much Tiffany. Good afternoon and thank you for participating in our third quarter conference call. In this call, we will review our results for the third quarter as well as our outlook for the fourth quarter and full year and then we will open the call up for questions as usual.

Participating on the call today are Holly Stephens, Finance and Investor Relations Manager, Brian Bronson, our Chief Financial Officer and again myself, Scott Grout, President and CEO.

Before we get the call started, I’d like to turn it over to Holly for a caution about forward-looking statements.

Holly Stephens

Thank you, Scott.

Any statements in this call regarding future expectations for the business of RadiSys constitute forward-looking statements that involve a number of risks and uncertainties. We caution you not to place undue reliance on these statements. Factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in our earnings release today and in our SEC filings most recently in our 2009 annual report on Form 10-K.

All information provided in this call is as of today. RadiSys undertakes no duty to update any forward-looking statement to conform the statement to actual results or changes in the company’s expectations. In addition, during the call we will refer to some non-GAAP measures. We’ve provided a GAAP to non-GAAP reconciliation for these measures in our earnings release issued today.

Now, I’ll turn the call back over to Scott.

Scott Grout

Thanks Holly. So our third quarter revenues were $75.2 million with NexGen revenues of 30.9 million up 42.5% year-over-year. On a year-to-date basis our NexGen revenues have been 90.1 million up 22.5% over the last year as more of our customer programs ramped production and deployment.

Gross margins for media server ATCA platforms application solutions continued to be strong while margins for our legacy and larger volume ATCA Blade only business continues to be under pressure.

You will continue to see as more of our investment and growth focus are of more valuable software and system level solutions. For example, in the quarter we announced our new LTE Security Gateway or SEG product targeted at providing security solutions for new all IP wireless networks.

Our LTE SEG is built upon our industries leading ATCA carrier grade platform with five times the performance of existing enterprise focus solutions. The SEG provides authentication, data integrity and encryption for IP based wireless networks and can be deployed as standalone solution or integrated into other wireless network elements.

Our security gateway is now under evaluation by a Tier 1 equipment maker and will be available for trials in the fourth quarter and commercially available in the first half of next year. Other key developments for us in the quarter included in our media server business, we released our new Interactive Mobile Media Server or IMMS solution to a Tier 1 China based equipment maker to begin trials. IMMS as you might recall is built upon our industry leading IP Media Server and is targeted at innovative new revenue generating services in the wireless arena.

In addition another global Tier 1 equipment went live with our RadiSys CMS-9000 with China Mobile. We were also awarded other new business for our IP Media Server product in Color Ring Back Tone, conferencing and network announcement applications.

Moving to our ATCA products, we won new business of notable size in a military application for unmanned vehicle reconnaissance. In this application ATCA will be used for high performance computer control and image display. This win is meaningful for us in that it validates our strategy of bringing robust high capacity ATCA systems into military applications.

Other new ATCA application wins in the quarter include LTE, Evolved Packet Core, IPTV and wireless access location. A number of these program awards were in China as this geography continues to grow for us.

In our commercial business we were awarded new COM Express business across all three geographies in medical imaging, defense and networking applications. In addition a Tier 1 enterprise infrastructure provider in North America began production of a new network switching and routing solution using RadiSys high performance COM Express products.

Returning to our results for the quarter, our top five customers in the third quarter in alphabetical order were Cisco, GE Healthcare, NEI, Nokia Siemens Networks and Phillips Healthcare. Collectively these five customers represented 64% of our revenue in the quarter with 42% from Nokia Siemens Networks.

NSN continues to be a very strategic customer for us with revenues diversifying nicely beyond legacy products to include meaningful new business in ATCA and IP Media Servers. Again this quarter over 25% of our NSN business is coming from our NexGen products and we expect this percentage to continue to increase over time.

Finally, before I turn the call over to Brian, I wanted to highlight a new addition to our Board of Directors. Niel Ransom joined as board member in August and brings extensive background and communications networking including serving as the past CTO of Alcatel Networks as well as serving the boards of a number of highly successful public and private technology companies.

Niel will also chair our new technology and market developing committee of the board that will focus on organic and inorganic growth opportunities for the company. We are very pleased to have Niel join as a member of our team.

With that I’d now like to turn the call over to Brian to talk a bit more about third quarter results and projection for the fourth quarter.

Brian Bronson

Thanks Scott. As Scott previously mentioned, our third quarter revenue was $75.2 million and our NexGen revenue was $30.9 million, up 42.5% year-over-year. On a year-to-date basis, our NexGen revenues were $90.1 million and up 22.5% year-over-year. We deliver non-GAAP EPS of $0.16, which was in line with our previous expectations and on a GAAP basis we had earnings of $0.09 per diluted share.

Our Q3 non-GAAP gross margin rate was 32.8% and up from the second quarter. The sequential increase is mainly due to lower manufacturing cost related to the outsourcing of production. We expect our fourth quarter non-GAAP gross margin to be up nicely to between 34% and 35%; this range is sequentially higher than the gross margin rate in the third quarter due to expected growth in our NexGen products as well as favorable product mix inside of NexGen.

In addition, our legacy communications networking revenues are declining sequentially which have much lower gross margin rates. So while Q4 is a very real example of what is possible long term for corporate gross margins, I do expect Q1, 2011 gross margins to be lower i.e. 32% to 33% due to meaningful ongoing declines in our legacy gross margins and overall product mix.

I also expect medium term gross margins to continue to fluctuate between 32% and 35%. But to be clear we continue to target long term corporate gross margins of between 35% and 40%. Our NexGen business continues to command gross margins of 40% to 50% but again it can fluctuate up or down inside that range depending on the mix media server versus solutions versus ATCA systems as well as ATCA blades.

We expect that our legacy communications business will have gross margins in the low 20s in the fourth quarter down from the high 20s earlier this year and we expect that it will most likely in the teens in 2011.

And our commercial business gross margins have been operating in the mid-20s during 2010 and we anticipate they will drop to the low 20s in 2011. So, you can see that strategically we are marching towards the higher gross margin rate but in the medium term our overall gross margins will go up and down and be sub-optimized while we try and effectively manage the glide path down on our legacy businesses.

Moving over to operating expenses, non-GAAP, R&D and SG&A expenses totaled 19.8 million which is around the same level as the prior quarter. We currently expect that our fourth quarter non-GAAP and R&D and SG&A expenses will be up around 300,000 from the prior quarter at the mid-point of our guidance range.

The increase is mainly related to the sales and marketing expenses tied to our annual sales meeting that will occur in November. Non-GAAP operating income was 4.8 million or 6.4% revenues in the third quarter. This compares to 5.9% in the second quarter and a 4.8% in the same quarter last year.

We expect our fourth quarter non-GAAP operating income percent to be around the same level as Q3 again at the mid-point of our guidance range. Net non-operating expense which includes interest income, interest expense and other non-operating items was $458,000 in the third quarter. We currently expect our non-operating expense to be around $450,000 again in the fourth quarter.

Our non-GAAP tax rate was 3.6% in the third quarter. We continued to project a low rate as all of our taxable earnings are being generated in foreign jurisdictions with lower tax rates. We currently expect our fourth quarter non-GAAP tax rate to be around 5% and our using an assumption of 25% for our GAAP tax rate.

We did have two tax items that resulted in a net favorable tax benefit of approximately $1 million that were excluded from non-GAAP results in the third quarter. Specifically we reversed approximately 1.4 million of income tax liability that was previously accrued for uncertain tax positions and partially offsetting this we accrued 400,000 of income tax liability related to a different uncertain tax position.

Both of these are non-cash items and they only affect the levels of our deferred tax assets. Our non-GAAP diluted weighted average shares were 28.5 million which includes 3.8 million shares related to our convertible notes. Our third quarter GAAP diluted shares were 24.4 million.

We project our diluted shares to be 20.6 for non-GAAP results and 24.5 million for GAAP results in the fourth quarter. When calculating EPS for net income over 2.9 million, the convert shares and in the interest income add back a $456,000 in net income should be included in the calculation.

Moving to the balance sheet DSO was 53 days in the third quarter, which is about the same DSO that we had in the second quarter. Given the timing of shipments this quarter, specifically 15% shipped to date versus 21% shipped at the same time quarter, I do expect DSO to increase in the low 60s in the fourth quarter.

Our fourth quarter is more backend loaded due to some supply constraints. Our inventory balance was $18.4 million at the end of the third quarter, which is down from $28.3 million at the end of the third quarter last year and up from $17.1 million in the second quarter.

As we have discussed previously, the industry supply shortages required us to build a few million dollars of buffer inventory. I expect our inventory to go up another couple of million in the fourth quarter to support ongoing buffer levels and then begin to decline in the first half of 2011.

Our cash flow from operations was $4 million during the third quarter and our year-to-date cash flow was $19.3 million compared to $14.9 million for the same period last year. We ended the third quarter with $133.3 million of cash and this is up from $92.1 million in the same quarter last quarter and up from $122 million in the prior quarter.

This reflects the paid off line credit to UBS and the re-class of the restricted cash to simply cash. We currently expect an operating cash flow in the fourth quarter of up to $5 million. This is solely attributable to the timing of quarterly shipments mentioned previously and the ongoing inventory buffer requirements to ensure continuity of customers supply as certain component shortages continue to be a challenge.

I also want to let you know that we filed an S-3 registration statement today or will today for $100 million of common stock or other securities. This is simply refresh on extension to our current shelf which is $95 million that will expire on November 7th of this year.

With that I’ll turn the call back over to Scott to talk about the revenue and per share outlook for the fourth quarter.

Scott Grout

Thanks Brian. So regarding our outlook for the fourth quarter, please note that this is our view as of today and it is a forward looking statement subject to risks and uncertainties as discussed previously and in our press release made available earlier today.

We currently expect our fourth quarter revenues to be between $68 million and $72 million. We expect our NexGen product revenues to grow to around $33 million. At this level we predict our next 2010 NexGen revenues to be up 20% over 2009.

While we have market demand to support this projection, our fourth quarter NexGen revenues could be a few million higher or lower as we continue to experience stock shortages or delays on some components.

Our legacy or traditional communications networks product revenues are expected to be between $17 million and $20 million in the fourth quarter, which represents a decline for the full year of 33% to 3% over 2009 and down over 19% sequentially. We currently expect our fourth quarter non-GAAP EPS to be between $0.12 and $0.17 and our GAAP EPS to be between breakeven and $0.05.

So overall, we continue to see strong growth in our next generation business as customer deployments expand across a wide range of applications. While our next generation platform deployments continue to advance, we are also adding new solutions such as IMMS and LTE Security Gateway on top of our platforms to give customers an even more complete set of solutions. We believe we are poised to see longer term gross margin expansion and operating leverage as our new products and solutions grow while our older legacy business continues to roll off.

So, with that I would like to thank you for participating and open the call up for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is from the line of Rich Valera of Needham & Co.

Rich Valera - Needham & Co

Thanks. Good afternoon gentlemen. A question on the gross margin, you guided for pretty impressive ramp in gross margin in the fourth quarter and that sounds like you expected drop back down in the first quarter. But I am wondering on a year-over-year basis, it looks like you will do about 33% for a pro-forma gross margin in 2010. How should we think about 2011 relative to that level for a gross margin?

Brian Bronson

No it's a good question, so I and the reason I feel to compel to signal in the Q1 visibility is limited. We don’t prefer to get into really in the February and talk about the full year but I do think its similar levels to 2010 around 33%. I think again the opportunity to expand as we go through the year as we have been talking about the last couple of quarters we just have this ongoing sequential declines in the gross margin rate where our legacy business is particularly and despite ongoing growth in our NexGen business in forty or fifty points.

All its doing is sort of offsetting the legacy gross margin decline right now.

Rich Valera - Needham & Co

Got you and in terms of the top-line trajectory, obviously you have got the same conflicting trends on the top-line. Can you at this point say anything about where you think overall revenue might be in 2011 relative to 2010?

Brian Bronson

Nothing specific other than for me no change, we have been talking about the NexGen growth of 20% plus a year still feel good about that and I think really in many ways no change on the legacy side 20% plus decline there right? So, the good news is about 2011 is that NexGen should overtake legacy and so that for us has been inflection point. I know for many investors have been waiting for that inflection point to come and in 2011 that will happen.

Rich Valera - Needham & Co

And I guess just related to the gross margin, I think a lot of folks had thought that as this transition was taking place you would see some nice gross margin improvement and it sounds like at least over the medium term we are not really looking for that. Has the legacy gross margin kind of decelerated or declined faster than maybe you would thought always back.

Brian Bronson

Definitely.

Scott Grout

Yes.

Brian Bronson

Definitely, I mean I would have never called a bunch of reasons for but the bottom line just think about our legacy comps business went from again high 20s earlier this year. It will be in the teens a year later. I would have never called that a year or two ago. But I want to make sure it's crystal clear and then I would like to line in thanking because our NexGen business again just to be to a pole is operating as expected and planning the gross margins are 40 to 50 as we have been calling it.

Scott Grout

So, growth looks like it should for NexGen and margins looks like it should be for NexGen.

Rich Valera - Needham & Co

Right, okay.

Brian Bronson

And get to the full reconciliation Rich, just sorry to interrupt. The legacy revenue actually doing about as expected in some cases even a little bit better but the gross margin again surprise.

Rich Valera - Needham & Co

Right, okay and then on your new LPE Security Gateway, you mentioned in the release that this was kind of done in response to some of your TEM Customers. Can you give any more color on that? Do you have one or more TEM customers that plan to sell this on an OEM basis? Could you give us more color on that?

Scott Grout

Yep. So intent of the Security Gateway is to be sold on a broad basis to a number of different TEMs. We have a bit Tier 1 TEM that is evaluating the product today and should go to trial in Q4 and deployment beginning of next year assuming that trails go well.

We are talking with a number of other TEMs right now and getting favorable response to the concept of adding security gateway capability on top of the platform. So the real intended market for this is the major equipment providers and seeing good traction thus far with the product announcement.

Rich Valera - Needham & Co

Great. And one final one from me if I could. You mentioned the variability around the fourth quarter NexGen revenue. Is that really – really is it mainly product or I should say supply constrained or is there sort of also issues around timing of your customers deployment which seems to be an issue with that business as well.

Scott Grout

No. Predominantly or exclusively product, our material availability, and I can say just to comment on that; material availability got better in Q3 from Q2 and it is better in Q4. But there still are some spot shortages that we’re working on. So the market demand to support the range is very good and its really going to be above material supply and our Ops team has done just a phenomenal job clearing shortages

Brian Bronson

I think the only difference would be to – and I’m sure everybody heard earlier, potential for a cash burn in the fourth quarter. Again really timing, we’ve been able despite chain shortages to figure out a way to collect enough time in the quarter. This will be a quarter again with X amount shipped in the quarter that we just won’t be able to collect it by 12/31 and the cash flow will spill into Q1.

Rich Valera - Needham & Co

But you would expect then to conserve timing that maybe it would go cash flow positive again then in Q1?

Brian Bronson

Oh even more so. Even more so. Yeah .This has in many ways been the first burn in isolation in years and it’s obviously because of our operating performance. It’s the working capital, right.

Rich Valera - Needham & Co

Sure. Okay. Thanks for taking my questions.

Scott Grout

Thanks Rich.

Operator

(Operator Instructions). Your next question is from the line of Jodie 0:02:46 (inaudible) of Jeffries.

George Notter - Jefferies

Hi, it’s actually George Notter at Jefferies. Hi guys. The question I – just getting back to the gross margin discussion on the legacy products, I’d love to dig in there a little bit more. Is it more than expected – a larger than expected decline in margins? Is that a function of volume? Is it a function of pricing pressure? I’d love some more flavor for what’s going on in there.

Brian Bronson

Well it’s a combination of both. In the Legacy business its simply just pressure by customer and dual source commoditized. We’re – it is a board that can be sourced elsewhere and of course where we have it and willing to supply it and we’re willing to take the gross margins. We’ll obviously do it because it is economically positive. But again it’s – every quarter it’s going to continue to drop until it’s gone.

George Notter - Jefferies

Are there specific programs or projects with customers then that you could point to that are no longer economically positive, pieces of business that you could keel out of. I know certainly there have different programs that you guys have done that with in the past. Could that be a source of improvement in margin structure potentially?

Scott Grout

So that could improve margin structure but as Brian said, it is economically positive to us. So it does deliver OI. It does deliver cash. Imagine as some programs get to very near end of life also making that call at that time would be right thing to do but certainly gross margin cosmetics impact us but it is positive cash flow, positive OI for us and still right business to take.

George Notter - Jefferies

Got it. Okay.

Brian Bronson

And then as you hear from Scott too, as you would expect us to do we do look at product line and customer profitability and [IVA] and all those things and that’s the conundrum. It adds every quarter but you don’t like the gross margin rate.

George Notter - Jefferies

Got it. Okay. Can you talk a little bit about M&A opportunities, I know one point there was a lot of interest in going out looking in another players in the space rolling up some other out there. Is there still a thought to do that, what is your perspective on M&A at this point?

Scott Grout

So absolutely still in area of high interest and high activity for us. So, we have got a team including Brian, myself, the business development, CTOs that are dedicating lots of time to go out and look at target companies. So that continues to be a priority for us. The funnel has been really good and we are working hard to make sure that what we look at is strategic, continues in the direction that we are taking more toward solution and that being careful that what we do is accretive and we have got good sense of being able to turn it into a success. So, kind of a long answer but continuous to be very important and area of focus and like the fun all that we are seeing.

George Notter - Jefferies

Got it. Okay. Thanks very much.

Scott Grout

Thanks George.

Operator

And that was our final question. This concludes our question and answer session. Mr. Grout, are there any closing remarks?

Scott Grout

Just want to thank everybody again for participating in the call and see many of you throughout the quarter. Thank you.

Operator

This concludes today’s conference call. You may now disconnect.

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

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