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Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q2 2011 Earnings Call

July 20, 2011 5:00 PM ET

Executives

Kirk Misaka – CFO

Mory Ejabat –Chairman and CEO

Analysts

George Tomsey – Scott Macon

David Lamond – Artis Capital

Ronald Mullins – Segmar

Joseph Beaulieu – Morningstar

Operator

Good day and welcome to the second quarter 2011 Zhone Technologies Inc. conference call. I am Stacy 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 second 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 second 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 second quarter. Following Mory’s comments, I will discuss Zhone’s detailed financial results for the second quarter of 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, and our quarterly reports on Form 10-Q for the quarter ended March 31st, 2011.

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.

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 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 second quarter 2011 earnings call. The second quarter revenue increased by 6% to $31.3 million versus $29.6 million for the previous quarter. The increase was driven primarily by increase in international customer acquisition and a significant MXK competitive advantages overall competition.

Domestic growth remain on target largely delivered by MXK expansion by new and existing customer base and increased stimulus activity in the region. Some of our domestic customers experienced fiber storages which resulted in lower than expected results in North America.

Nonetheless as expected the MXK continued to drive new organic customer growth, sustained industry leadership and a strong customer acceptance. Kirk will give you more detail on our financial results later. I am also proud to announce that Zhone Technologies has been once again recognized by the industry leading technology analysts including the Infonetics Research, Dittberner Associates, Ovum Research and IDC acknowledging Zhone’s growing momentum in the GPON and Ethernet FTTx markets in Q1, 2011.

Our last report reflected that the following results for Zhone, top three leadership for GPON in Caribbean and Latin America; top three leadership for GPON in Europe, Middle East and Africa, Top four market positions for GPON in North America. Top five market positions for GPON globally.

Zhone was also recognized as the number two market leader in North America for Ethernet FTTx. This is a significant milestone for Zhone as we establish ourselves in leadership position in both GPON and Ethernet FTTx technologies around the globe.

Furthermore, Zhone established early market leadership in the fast paced VDSL2 market segment for instance in Latin America Zhone was rated as the number three player for DSL connectivity in Q1 2011 for Infonetics Research and Dittberner Associates.

During the quarter, we announced several new customers; we also have gone many stimulus projects and continued to compete for other projects. The size of these projects can vary dividedly (ph) depending on which type of network the Telco decides to deploy, GPON versus active Ethernet. We have received orders from several of these projects in the second quarter. Now I would like to share a few of them with you. At Doylestown Telephone the MXK was selected to support FTTH Triple-Play and ADSL deployment providing thousands of their subscribers’ access to their new Triple-Play services in Ohio.

At Alhambra-Grantfork Telephone the MXK platform was selected for FTTH and multi-service deployment. Illinois residents gained access to higher speed, higher quality voice and data service and all new fiber networks.

In the Midwest Pulaski-White Rural telephone cooperative expanded their broadband services. The Indiana operator leverage new fiber network using the MXK platform to deliver high speed internet, voice and video offers.

At Hickory Telephone Company, Zhone helped with their deployment of an all new copper and fiber based RF Triple-Play deployment in Western Pennsylvania. So the subscribers benefit from 10 times greater bandwidth, increased after being integration of MXK platform.

Regarding new products and solutions Zhone R&D in June worked diligently to develop and launch several new products targeting the mobile backhaul market signal. But specifically we expanded the MXK portfolio with a new offering cost for mobile backhaul. Our new mobile backhaul solution Zhone FiberCell allows a multiple step transition from copper to fiber.

In conjunction with the offering card, we also developed a comprehensive new line of zNID for the deployment at the mobile progress tower locations. Now our customers have their benefit to use MXK for multiservice copper and FTTx convergence while also accommodating complex mobile backhaul over copper or fiber within the same solution.

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 next quarter. Kirk?

Kirk Misaka

Today, I will announce financial results for the second quarter of 2011. Second quarter revenue of $31.3 million increased 6% from first quarter revenue of $29.6 million driven by strong demand for our products especially in our international markets which represents 59% of revenue for the second quarter versus 55% for the first quarter.

For next quarter that strength in global markets such as the Middle East and Europe which is likely to create some seasonal weakness due to the holidays as it have in other years. Also continued fiber shortages could push out some of our customer deployments domestically. As a result, we are forecasting third quarter revenue may be flat to slightly up as compared to this quarter before stronger growth returns in the fourth quarter.

We continue to serve over 750 active customers and experience less customer concentration this quarter with the top five customers representing approximately 37% of revenue for the second quarter of 2011 as compared to 44% of revenue for the first quarter of 2011.

As usual, we continued to have just one 10% customer. Gross margins at 35.4% for the second quarter were at the upper end of our previously provided guidance range of between 34% and 36% and approximately the same in the first quarter gross margins of 35.8%. In our long term model, we continue to see some margin expansion associated with the benefits of the extensive hardware reengineering that we have undertaken to cost reduce our products and from additional manufacturing cost leverage at higher future anticipated revenue levels.

For now however, we are continuing to forecast between 34% and 36% gross margins for the third quarter of 2011. Operating expenses of $12.9 million for the second quarter was in the middle of our lowered guidance range of between $12.5 million and $13.5 million and consistent with our $13.1 million for the first quarter.

We expect operating expenses for the third quarter of 2011 to continue at this reduced level. Operating expenses for the second quarter 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 the second quarter of 2011 improved as it was approximately $1.1 million as compared to $1.8 million for the first quarter due to growth in revenue and stable gross margins in operating expenses. Despite the EBITDA loss, cash and short-term investments at June 30, 2011 improves slightly to $19.3 million from $19.2 million at March 31, 2011 due to improved working capital balance changes during the quarter.

Also notably, accounts receivables declined by $2.6 million to $26.8 million at June 30th from $29.4 million at March 31st. improving the number of days sales outstanding on accounts receivable for the second quarter to 77 days as compared to 90 days for the first quarter.

DSOs continue to be affected by the shipment and payment cycle with our largest customer which improved during the quarter. Our total debt obligations associated with our working capitals facility with Silicon Valley Bank remained $10 million at June 30, 2011 and March 31, 2011.

As previously announced, we renew this facility annually in the first quarter as we have done for many years. Lastly the weighted average basic and diluted shares outstanding remained at $30.6 million for the second quarter of 2011.

With that financial overview, I will turn the call back to Mory for a few final comments before we open the call to questions and answers. Mory?

Mory Ejabat

Thank you, Kirk. Reflecting on Q2, we had a good quarter achieving 6% growth and increased revenue globally. Once again we were recognized as a leader in both GPON and Ethernet FTTx solutions in the leading emerging markets globally. We experienced organic growth internationally, domestically and from new stimulus wins. We launched a compelling line of new mobile backhaul products at leverages or industry leading MXK as the cornerstone of this solution.

As ever growing demand for bandwidth continues to rapidly increase Zhone has timed the market with the right solution at the right time. Thank you for joining us today. We would now like to open up the call to questions. Operator, please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of George Tomsey with Scott Macon. Please proceed.

George Tomsey – Scott Macon

Can you give us any flavor on what impact what’s happened in Egypt and Mid East is having if anyone of your Mid East business and in particular (inaudible)?

Mory Ejabat

Definitely we have some drawbacks in Egypt but it’s coming back again in the last couple of weeks. But in the other areas in that region that we actively are involved, we haven’t seen any pressure of any kind irrespective to our customers and their orders.

George Tomsey – Scott Macon

You mentioned new products in particularly backhaul I was under the impression that had been introduced last quarter?

Mory Ejabat

Yes, unfortunately that was introduced last quarter, unfortunate that introduced this quarter and you got to have both end of that product was offered in mobile backhaul and we are just getting new to some trials with that.

George Tomsey – Scott Macon

Right, but I thought there were some trials for what was introduced last quarter either had started or about to start?

Mory Ejabat

Right. We had some trial on that as well, normally this was has taken about six to nine months to accommodate.

George Tomsey – Scott Macon

Is that potentially a big area?

Mory Ejabat

Mobile backhaul is a growing market, I don’t have numbers about how weak the market is but its growing and a conversion of TDM (ph) to fiber is becoming or to the IP is becoming more and more prevalent right now.

George Tomsey – Scott Macon

And can you give us share any light on what revenue you lost this quarter due to the shortage of fiber what you referred to and as some of your competitors have referred to that as well?

Mory Ejabat

We don’t disclose those numbers at this point because I don’t think my customers will be really happy with that.

George Tomsey – Scott Macon

Okay. In a report that Jefferies recently released they estimated that Calix was going to do $65 million of revenue this year from stimulus products and $200 million next year and they estimated further that the combination of Calix and Occam had 70% to 80% of the market? If you assume that you had 10% of the market, the domestic market or at least got 10% of the stimulus projects that would yield something like $16 million to you this year and $15 million to you next year and is that reasonable way to look at that?

Mory Ejabat

I really don’t know what Jefferies came up their numbers based on that I cannot really comment where they came in but the way you look at it might be correct but I cannot verify Jefferies numbers.

George Tomsey – Scott Macon

Can you give us any feel I mean you talked about the stimulus projects and stuffs specific customers but can you give us any feel for what kind of revenues that could potentially contribute this year and potentially contribute next year?

Mory Ejabat

Unfortunately I cannot comment on that. I cannot expect because we are still in the process of dealing with RFPs and RFIs for their stimulus projects or many projects that have been awarded for the vendors haven’t been selected. So I cannot comment on any of those I can call be able to win or not.

George Tomsey – Scott Macon

What gives you confidence that you are going to grow and get profitable like you have said that you will in the second half?

Mory Ejabat

Our plans are --- we are on our plans and the forecast that we are seeing has given us a comfortable position to be profitable unless they can have and that’s our plan.

Operator

(Operator Instructions). And your next question comes from the line of David Lamond with Artis Capital. Please proceed.

David Lamond – Artis Capital

I may have missed this part of the call but I was just wondering Kirk could you provide any EBITDA guidance for the second half of this year?

Kirk Misaka

We did not.

David Lamond – Artis Capital

You did not. From a cash balance perspective we are still very solid and no need at all to capital there?

Kirk Misaka

No we had the improvements in DSOs on the balance sheet and with improving EBITDA loss, our reducing EBITDA loss we don’t just paid 18 additional cash this year.

David Lamond – Artis Capital

Okay, great and are there any covenants in the line of credit or anything we need to be aware of that could cause a problem?

Kirk Misaka

There is a EBITDA covenant in the agreement with Silicon Valley and we are in compliance for this quarter and we anticipate being in compliance for next quarter as well.

Operator

Your next question comes from the line of Ronald Mullins with Segmar. Please proceed.

Ronald Mullins – Segmar

I have to comment that this quarter is very discouraging and said many previous quarters been and you talk very positively in some of the conference calls about the products and the possibilities denoting how many encouraging results. I would appreciate it if you say anything and I believe you were asked about the second half didn’t make any comments but I am thinking somewhat longer term for the company from next year. How long do the existing products that you have so much confidence going to last and how much will it contribute to the sales of the company?

Kirk Misaka

The new products that we have at this point I believe competitively is ahead of everybody else within six to eight months or six to nine months and we are going to continue developing this product and enhancing it to be there. And our belief is our new MXK product launch and associated product that goes with MXK contribute about 80% of our revenue next year.

Operator

Your next question comes from the line of (inaudible), private investor. Please proceed.

Unidentified Analyst

First of all, I would like to thank you for giving me the opportunity to ask what appeared to be whole lot of questions and I hope I am not going to take too much time. But I have some questions and as an investor I have been generally disappointed with this stock price performance. So some of the question may be little blunt but I don’t intend them to be rude, I just want to get some insights.

Today’s press release there is a quote we are encouraged by the increase in demand of our innovative product, and when I looked at essentially flat sales for the first three quarter of this year last quarter, this quarter and then your projecting flat possibly next quarter. Where in the financial statement should be look for that sign of increase in demand?

Kirk Misaka

As we mentioned we already have fourth quarter to be better than Q3 and as many of the investors know that when you do international business chiefly above the Europe and Middle East is gone on holiday and also in Middle East there is a holy holiday as well. So that is why we don’t see increase in Q3 but I should mention that from Q1 to Q2 we had an increase of 6% and that was within our guidance of the Q1 conference call.

Unidentified Analyst

Well, I think going back to that 6% sequential increase but please correct me if I am wrong if we take out the $2 million of revenue that you could not ship during the last quarter; your revenue actually has decreased sequentially for this quarter isn’t that correct?

Kirk Misaka

But if you look at it that way yes, but you don’t know our backlog and we don’t report on our backlog.

Operator

Your next question comes from the line of Joseph Beaulieu with Morningstar. Please proceed.

Joseph Beaulieu – Morningstar

Hi, I just wanted to ask about you mentioned that your products primarily have a six to nine month lead over the competition and I wanted to check if you thought that your current R&Ds spending track is enough to maintain?

Mory Ejabat

It is for the size of our company we are spending over 20% in R&D and that makes us very comfortable to enhance the product launch and keep it that way.

Operator

And at this time, I would like to turn the call back over to Mr. Mory for closing remarks.

MoryEjabat

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, operator.

Operator

We thank you for your participation in today’s conference; it thus concludes your presentation. You may now disconnect and have a great day.

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