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Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q3 2011 Earnings Conference Call

October 19, 2011 17:00 ET

Executives

Kirk Misaka – Chief Financial Officer

Mory Ejabat – Chairman and Chief Executive Officer

Analysts

(Wayne Linman)

Operator

Good day and welcome to the Third Quarter 2011 Zhone Technologies Incorporated Conference Call. I am Jennifer 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 – Chief Financial Officer

Thank you, operator. Hello and welcome to the third 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 third 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 third quarter. Following Mory’s comments, I will discuss Zhone’s detailed financial results for the third 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 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 31, 2010 and our quarterly report on Form 10-Q for the quarters ended March 31, 2011 and June 30, 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 the basis for making operating decisions, because they provide meaningful supplemental information regarding our operational performance and they facilitate management 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 – Chairman and Chief Executive Officer

Thank you, Kirk. Good afternoon and thank you for joining us today for our third quarter 2011 earnings call.

The third quarter revenue decreased slightly to $30.2 million due to the seasonal slowdown in our international markets and some deferred deployment for a few domestic customers that continued to wait for broadband stimulus funding. More or less as expected, the MXK continued to drive new organic customer growth, sustained industry leadership, and a strong customer acceptance. As a result, we expect revenue growth in the fourth quarter accompanied by adjusted EBITDA profitability. Kirk will start our financial results and guidance in greater detail later.

I am proud to announce that Zhone Technologies has been recognized by the industry’s leading technology analysts like IDC and Infonetics Research for sixth consecutive quarter of GPON leadership. Zhone is the only American GPON supplier among the top five global GPON vendors.

We have significant number of new product launches in the quarter helping to further increase our investing years and technology differentiation. In September 2011, we announced immediate availability of the MXK 194/198 1U GPON OLT platforms. The new 194/198 1U GPON OLTs provide an expanding addition to the industry leading MXK and some portfolio.

To complement the new MXK 1U GPON OLTs, Zhone also introduced a new portfolio of zNID GPON ONTs targeted for indoor residential use. As part of ongoing effort to increase cost efficiency and service differentiation, the new indoor zNID 2400 series of GPON ONTs offer a rich area features and functionality optimal for both Greenfield or expansion FTTx networks globally, and leverage features and best-in-class performance delivered by Zhone’s widely deployed 4200 series outdoor zNID ONTs. These new products help to complement an already powerful solution suite and we are confident of these new products targeting both the central office and customer premise of Zhone to better serve our new and existing customer in all the markets globally. Zhone continues to be new customers in all of our said markets including new international, domestic, and stimulus customers throughout the quarter.

Now, let me share a few customer announcements we made during the quarter. These are just a handful of customers during this period. Velocity Network deployed Zhone’s industry leading MXK as its multi-service access solution for business VoIP and higher speed Ethernet-over-copper services in Erie, Pennsylvania. The MXK multi-service access node was selected by SRT Communications in combination with Microsoft Mediaroom to deliver a new IPTV and video services via ADSL2+ and fiber-to-the-home networks in North Dakota. In addition, we also work with SRT communication on a disaster recovery project, where in the MXK, multi-service access node was used during and after the disaster relief in Minot, North Dakota through Venus Telephone, an internet service to nearly 2,100 non-evacuated customers.

Venus Telephone, the 100-year-old local telephone provider in Venus, Pennsylvania currently offers triple-play services to customers and then deploy Zhone’s industry MXK as its primary Gigabit Passive Optical Network access platform for the new fiber-to-the home, FTTH network in its building.

Cornerstone Telephone deployed Zhone’s industry leading MXK as its multi-service access solution for business VoIP and higher speed Ethernet-over-copper services for area businesses in Syracuse; Oneonta; New York City; Poughkeepsie; and Richmond. Cornerstone chose the MXK to provide both copper and fiber services on a single platform based on their rewarding experience with the deployment of Zhone’s MALC multi-service platform within their network.

And finally, we announced that (indiscernible) Zhone’s flagship MXK solution and Zhone fiber cell portfolio as part of its effort to enable a 1-gigabit link through each LTE mobile radio base station, as it completes a major network expansion to transition to advanced 4G wireless throughout the United Arab Emirates. As fiber is getting deployed in base station, Zhone continues to provide a cost effective upgrade path for operators Etisalat transition from circuit to fiber based connectivity in their mobile backhaul networks.

Lastly, Zhone also expanded the current MXK shipping over 600 units in Q3. We talked in excess of total 600 system, deployed since inception. And it’s not working 80 million coupon subscriber system capacity for proving that MXK is the multi-service platform of choice for the future, or placing the industry average for coupon.

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

Kirk Misaka – Chief Financial Officer

Thanks, Mory. Today, Zhone announced financial results for the third quarter of 2011. Third quarter revenue of $30.2 million decreased widely from second quarter revenue of $31.3 million due to normal seasonality in our international markets and differed deployments for some of our domestic customers waiting for delayed broadband stimulus funding. Going forward, we are forecasting single-digit percentage revenue growth for the fourth quarter especially as the demand in our international markets returns and broadband spending increases in the domestic market.

Our international markets continue to produce the majority of our business and represented 57% of revenue for the third quarter versus 59% of revenue for the second quarter. We also continue to serve over 750 active customers and have experienced less customer concentration over the past two quarters with top five customers representing approximately 37% of revenue for the second and third quarter of 2011. As in prior quarters we had 110% customers.

Gross margins were 34% for the third quarter and within our previously provided guidance range of between 34% and 36% but lower than the second quarter gross margins of 35.4%. With the anticipated revenue growth in the fourth quarter, we will have better manufacturing economies to scale which when coupled with continued product cost reductions could lead to improved gross margins next quarter. Nevertheless we still would expect gross margins to range between 34% and 36% which it has for every quarter this year.

Operating expenses of $13 million for the third quarter was in the middle of our guidance range of $12.5 million to $13.5 million and consistent with a $12.9 million for the second quarter. We expect operating expenses for the fourth quarter 2011 to continue to be in the same range. Operating expenses for the third quarter included depreciation of $400,000 and stock-based compensation of approximately $900,000.

Stock-based compensation included $600,000 related to the accelerated investing of certain management stock options to partially offset previous reductions in their cash compensation as already disclosed in our Form 10-K filed on August 29, 2011. Going forward we expect approximately the same amount of depreciation, and anticipate the stock-based compensation will return to previous levels around $300,000.

Finally, our adjusted EBITDA loss for the third quarter 2011 was approximately $1.3 million as compared to $1.1 million adjusted EBITDA loss for the second quarter. With the anticipated revenue growth gross margin improvement and stable operating expenses, we expect to generate positive adjusted EBITDA for the fourth quarter.

Now turning to balance sheet, cash and short-term investments at September 30, 2011 declined $17.8 million from $19.3 million at June 30, 2011, primarily due to the adjusted EBITDA loss. The net effect of other balance sheet changes was only about $200,000. Account receivable remained basically flat at $26.9 million at September 30, 2011 while the number of days sales outstanding on account receivable for the third quarter increased slightly to 80 days as compared to 77 days for the second quarter.

Our total debt obligations associated with our working capital facility with Silicon Valley Bank remained at $10 million at September 30, 2011 and June 30, 2011. As discussed on previous calls we anticipate renewing this facility in the first quarter 2012 as we’ve done for many years. We will provide a more detailed update regarding the renewal of this facility on next quarter’s conference call.

Lastly, the weighted average basic and diluted shares outstanding was $30.7 million for the third quarter of 2011 and $30.6 million for the second quarter of 2011.

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

Mory Ejabat – Chairman and Chief Executive Officer

Thank you, Kirk. We believe Q4 will be a positive quarter for Zhone, the international market will resume it’s growth and domestic market will go regardless of any delays in the similar response. Thank you for joining us today. We will now like to open up the call to the questions. Operator will you please begin the Q&A portion of the call

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from line of (Wayne Linman). Please proceed.

Wayne Linman

Hi, Kirk good morning. I had a question about the MXK product, we keep hearing how good it is but we don’t see an increase in revenue or share price. Can you comment on that?

Kirk Misaka

Yes, Wayne as we ship more MXK, as we wanted to mention we have shipped over 2,600 of that. Majority of the product shipped is (indiscernible), that why you see no revenue increase. And also there has been some price reduction in the last two or three quarters that hasn’t shown any increase in the revenue. We should see some revenue increase this quarter based on MXK as we go forward.

Wayne Linman

Can you comment on the stock price, I am a little concerned, the company already did a reverse split and the stock price is under $1 once again?

Kirk Misaka

Yeah, I cannot comment on the price of this stock and I don’t know – we don’t have any plans for any split reverse or anything like that. So, hopefully with our performance, the stock prices will go up again.

Wayne Linman

Last question, if a private equity investment group or another company offered to buy you guys out, would you consider it?

Kirk Misaka

We would consider new offer depends on the offer. I have always said that it has to be an offer that the Board and the stockholders, then employees would like that offer.

Wayne Linman

Thank you.

Kirk Misaka

Yes.

Operator

(Operator Instructions) There are no further questions at this time and we will turn the call over to Mory Ejabat.

Mory Ejabat – Chairman and Chief Executive Officer

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

Operator

That concludes today’s conference. Thank you for your participation.

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