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Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q1 2011 Earnings Call

April 20, 2011 05:00 pm ET

Executives

Mory Ejabat -- Chairman and Chief Executive Officer

Kirk Misaka – Chief Financial Officer

Analysts

David Buirstein -- DSL Prime Name

David Lamond -- Artis Capital

[Alack Amuna]

Operator

Good day and welcome to the Q1 2011 Zhone Technologies Incorporated Conference Call.

I am Jeremy, and I will be your coordinator for today. At this time, all participants are on a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference.

(Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to introduce Kirk Misaka, Zhone's Chief Financial Officer. Please proceed.

Kirk Misaka

Thank you, operator. Hello and welcome to the first quarter 2011 Zhone Technologies, Inc. conference call. I am Kirk Misaka, Zhone's Chief Financial Officer.

The purpose of this call is to discuss Zhone's first quarter 2011 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 website at www.Zhone.com.

I am here today with Mory Ejabat, Zhone's Chairman and Chief Executive Officer. Mory will begin by discussing the key financial results and business developments of the first quarter. Following Mory's comments, I will discuss Zhone's detailed financial results for the first quarter 2011, and provide guidance for next quarter. After our prepared remarks, we will conclude with questions and answers.

As a reminder, this conference is being recorded for replay purposes and will be available for approximately one week. The dial-in instructions for the replay are available on our press release issued today. An audio webcast replay will also be available online at www.Zhone.com following the call.

During the course of the conference call, we will make forward-looking statements, which reflect management's judgment based on factors currently known. However, these statements involve risks and uncertainties, including those 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 31st, 2010.

We'd 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 obligation to update any forward-looking statements.

During the course of this call, we will also make reference to adjusted EBITDA and adjusted 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 of 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.

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 adjusted 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 first quarter 2011 earnings call. Let me provide a few updates regarding the recent quarter. Despite a (inaudible) of substantial performance attributes in Q1 2011, we experienced material shortages and significant operational disruption due to the storm and tornadoes very close to our manufacturing plant, which resulted in an extended (inaudible) occasion pattern of manufacturing output on the critical last day of the quarter. Due to these factors, revenue for the quarter was $29.6 million, and below our expectations, but led to a substantial growth in our backlog of approximately $2 million, positioning us for a stronger Q2.

Kirk will give you more detail on our financial results later. Now, let me provide a few details about this past quarter. Subscriber system capacity for MXK has now officially surpassed 10 million subscribers. Furthermore, the number of MXK platforms employment has more than quadrupled since March 2010, one year ago, expanding from approximately 320 system deployments in 24 countries, more than 1,350 deployments in over 40 countries today.

In addition, we are proud of our in-depth (inaudible) efforts in continuing to expand and grow our already robust product family. Specifically, we enhanced our fiber (inaudible) and fiber portfolios, introducing Fiber Cell and Zhone Fiber Home brand, and corresponding solutions for FTTc, FTTb, FTTp, and FTTn, and a new mobile backlog solution. The combined solutions include nine new (inaudible) compromised of four new YU SLMS based products, UCP warranties, media cell and (inaudible) cost, all providing enhanced functionality to an already robust and excellent solution.

In terms of industry recognition and analyst ranking, we continue to deliver a solid performance with respect to GPON deployment on global basis, number one in Caller ID. Number three in MEO, deep burner IDC; top five GPON globally deep burner. Additionally, we announced a multitude of solid new customer range during the quarter. Harvey Telecom, recipient of $34 million broadband for the stimulus award. Rochester Telephone Company, FTTX deployment in Indiana, that further expands Zhone’s US and specifically mid west broadband footprint. Florida-based Myakka Corporation advanced fiber access offered to subscribers in rural areas of Sarasota and Manatee counties for the first time, via $7.8 million broadband system project.

Guyana based Guyana Telephone and Telegraph company, nationwide deployment of MXK in the Latin American country. (inaudible) traction in the (inaudible) fiber project. All of these customers are part of our growing global customer base for Zhone as Zhone expands both in Greenfield and opportunities continue for fiber overlay for enhanced copper deployments. This quarter completed the product transition for customer base from the older map product line to MXK product line.

We also started shipping and recognizing the new customers who have received broadband stimulus award, resulting in creating a domestic revenue. During the quarter, we also strengthened our Board of Directors, with the announcement of Mr. Lawrence Briscoe joining the Board. Now I will turn the call over to 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

Thank you, Mory. Today Zhone announced financial results for Q1 2011. Q1 revenue of $29.6 million declined from Q4 revenue of $31 million, due to a variety of factors. As Mory mentioned, these factors included certain material shortages and the power outage due to the storm and tornadoes close to our manufacturing plant on the last day of the quarter. As a result, backlog grew by over $2 million, and we should see strong sequential revenue growth in the upper single digit percentage range for Q2 2011.

We also still expect revenue for 2011 as a whole to grow over that of 2010. We continue to serve over 750 active customers worldwide, with 55% of revenue for Q1 being attributable to international customers. We had one 10% customer, and experienced slightly more customer concentration for this quarter, with the top five customers representing approximately 44% of revenue for Q1 2011, as compared to 42% of revenue for Q4 2010.

Gross margins at 35.8% for Q1 were at the upper end of our previously provided guidance range of between 34% and 36%. In our long term model, we could see some margin expansion associated with the benefits of the extensive hardware re-engineering we’ve undertaken to cost reduce our products. And from additional manufacturing cost leverage at higher future anticipated revenue levels. For now, we are continuing to forecast between 34% and 36% gross margins for Q2 2011. OPEX of $13.1 million for Q1 was at the low end of our guidance range of $13 to $14 million. We expect OPEX for Q2 2011 to continue at this reduced level, and our drop down guidance range to between $12.5 and $13.5 million.

OPEX for Q1 included depreciation of approximately $400,000 and stock based compensation of approximately $300,000. Going forward, we expect approximately the same amount of depreciation and stock based compensation. Finally, our adjusted EBITDA loss for Q1 2011 was approximately $1.8 million, due to the lower revenue level, partially offset by strong gross margins and tight expense control. With sequential quarterly revenue growth during 2011, we expect to return to profitability on an adjusted EBITDA basis in the second half of 2011.

The revenue growth will also allow us to exit 2011 with more cash than we started the year with. While we’re on that topic, cash and short term investments at March 31, 2011 were $19.2 million, which decreased from $21.2 million at December 31, 2010, mainly due to the adjusted EBITDA loss. As for other balance sheet changes, other working capital changes largely netted out, but a decrease in inventory being offset by a corresponding decrease in accounts payable and accrued and other liabilities. Although accounts receivable remained basically flat, number of day sales outstanding on accounts receivable for the first quarter increased to 90 days as compared to 86 days for the fourth quarter. As mentioned on our last few earnings calls, we anticipate DSOs will continue to be affected by the shipment and payment cycle with our largest customer, but hopefully we’ll be trending downward for the remainder of the year.

Our total debt obligations associated with our working capital with the Silicon Valley Bank remained at $10 million at March 31, 2011 and December 31, 2010. As previously announced, we renewed this facility in Q1, as we’ve done for many years. Lastly, the weighted average basic and diluted shares outstanding were $30.6 million for Q1 2011 and $30.5 million for Q4 2010. With that financial overview, I’ll 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 remain optimistic about our industry momentum. New customer base, market growth, and continued recognition MXK continues to achieve. Also for passing over 1,350 chassis deployed across a diverse range of new and existing customers. Additionally, with the addition of the two new solutions, long fiber home and long fiber cell, both complementing and fortifying an already powerful MXK solution, enabling new revenue opportunities for its customers. The new launch of long fiber home and long fiber cell product suites enable service providers to offer a more robust solution for the customers, while driving additional ROI from their new or existing MXK deployments, and fortifying FTTb, FTTm, FTTc, and mobile backlog deployments.

Zhone’s continued investment in the best in class engineering and solution design, combined with its innovation and technology leadership have contributed to the recent expansion of the customer base in some of the fastest growing economies in the world. 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.)

Our first question comes from the line of David Buirstein, with DSL Prime. Please proceed.

David Buirstein -- DSL Prime

Hi, Mory. You’ve had some success in the US Stimulus, how do you think in the next few years your volume is going to compare in the United States to overseas? Is the stimulus enough to change the trend?

Mory Ejabat

Well, I’m hoping so, because margins are better in the United States than in the international markets, but there are several countries internationally that their economies are very solid, and they’re growing very rapidly. For example, in Brazil or some of the Middle Eastern countries, they are putting money into the economy. So I don’t see us catching up in a couple of years, but our hope is to keep it around 65% international.

David Buirstein -- DSL Prime

Thank you.

Operator

Our next question comes from David Lamond, with Artis Capital. Please proceed.

David Lamond -- Artis Capital

Hey Mory. I saw that you guys have a substantial increase in order backlog. I was wondering if you could be a little bit more specific in how the book to bill shook out.

Mory Ejabat

Normally we don’t publish that, but I can tell you the book to bill was positive.

David Lamond -- Artis Capital

Okay, and while I have you, anything else in the new product pipeline that you’re excited about?

Mory Ejabat

We are excited about the fiber cell, which is going to be used for fiber backcall solution, we’re in trial in a couple of different places, and also we are seeing some momentum in our other home software sales, so even though it’s a new product, we have some momentum in that, it is a very competitive product.

David Lamond -- Artis Capital

Okay, thanks.

Operator

And our next question comes from [Alack Amuna]. Please proceed.

[Alack Amuna]

Hi guys. How many broadband stimulus projects are you still pursuing in terms of still being in trials?

Mory Ejabat

Actually, unfortunately I don’t have those numbers in front of me, but there are many RFPs for the stimulus account that have been sorted coming through or being published, and we are working with many of the tier 3 to tier 5 customers who have received this stimulus, but we recently saw that after the budget approval in the US, they started coming in and being more productive, and people are planning to use the money to start building.

[Alack Amuna]

Okay, now you have this new counter added to the Zhone website. That appears to give subscriber capacity shipped number. The question I have is how one can make use of that information, in other words, how that number relates to new or something more meaningful and measurable.

Mory Ejabat

Well, if it was really – we are not using that for financial conditioning, we are using that for our customers to know how expanded our capacity is on a daily basis. Now, some of that capacity might be new on the shelf, but some of them may not be; but the chassis has the capacity to do that. So it is realistically not for financial analysis, but more for a marketing campaign.

[Alack Amuna]

Oh, okay. Now to at least – in an effort to make use of that information, is it possible for you to share that on an average or typical basis, when you send out or ship an MXK chassis, how many cards go with that?

Mory Ejabat

Normally it has anywhere between 14 and 17 a slot, our product, maybe eight, but normally the majority of them go out with probably three to eight line cards.

[Alack Amuna]

Okay, and at one time, in one of the conferences, you guys had mentioned that you are below 100% in your factory utilization, and I think there is a potential for you to have more than one shift. What is the current utilization rate, and what is your expectation for the future quarters?

Mory Ejabat

You know, unfortunately, in our business all the orders come in at the end of the quarter, and we get a (inaudible) at the end of the quarter. The beginning of the quarter we are not in a double shift, but we need that capacity at the end of the quarter. Unfortunately, the storm happened, and that taught us a lesson, that you can have three shifts, but if an act of God happens, you cannot do anything about it. So in any case, we are using that capacity to program the volume up and down, but at the end of the day I can say we are at about 50 to 60% of the capacity.

[Alack Amuna]

Another question is on your website, you have in the last couple of months added several new open positions, and the question I have, are these positions open because you have lost people or this is based on your anticipated future needs?

Mory Ejabat

Every quarter, we would look at our people and look at the performance of them, and sometimes we have to shift people from one function to another function, so we take advantage of the attrition in that respect. Right now we have several openings based on some future requests that we are seeing from some of the customers. But as a whole we are not going to increase our OPEX.

[Alack Amuna]

Oh, okay. Now, regarding your guidance, it’s happened for the last several quarters that you ended up missing the guidance, and I would assume that having credibility is important in the marketplace. Are you trying to address by adjusting, or by doing something to your accounting processes to fix that issue so we can be more confident that the guidance that’s provided – that the company would be able to meet it?

Mory Ejabat

Yes, we are looking at all of our backlog, and we are adjusting for that every week, and we know where we are going to go. In the beginning of the quarter, we get a forecast from our sales people, and we adjust that, and that is the number we give you, and the guidance we give you. Sometimes, due to international issues, some orders don’t come, or sometimes we have missed because we don’t finance our customers. They don’t send a letter of credit on time, and things like that will happen. That’s a fluctuation you see in the international business.

[Alack Amuna]

Okay, now your results seem to suggest, and you guys claim, probably fairly, that MXK system is probably one of the best access products out there. The question comes to mind is your generation of revenue and the lack of profitability doesn’t seem to reconcile with that. Can you shed some light, what is the reason for that?

Mory Ejabat

As you will see, we have shipped more than anybody GPON based product line in the last year. We are number one in several areas, we are in the top three or top four in every region. Now, even that, the nature of our business internationally is very competitive, and we have gone to a cellar of cost reduction, but we have to turn that on and provide that cost reduction to our customers because of some of our competitive issues that comes from China and other places.

[Alack Amuna]

Okay, I guess the last question, you know Zhone has been good to its customers, providing great products and has been good to the company employees. I’m an investor, and I want to know when investor will begin to see benefits of their investment.

Mory Ejabat

We definitely want to be on your good side as well, not only the customer and the employees; we want to make sure the investors get a return on their investment as well. As Kirk mentioned, we are targeting to be profitable in the second half of this year, and be able to return some – get some appreciation out of the stock, and you guys can take advantage of that.

[Alack Amuna]

Okay, well thank you and good luck.

Mory Ejabat

Thank you.

Operator

(Operator instructions). At this time there are no more questions. I would like to hand it off to Mr. Mory Ejabat, CEO. Please proceed.

Mory Ejabat

Once again, thank you for joining us today and for your continued support. We are looking forward to speaking with you on our next earnings conference call. Thank you.

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