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Zhone Technologies, Inc. (NASDAQ:ZHNE)

Q4 2011 Earnings Call

January 25, 2011 5:00 p.m. EST

Executives

Kirk Misaka – CFO, Corporate Treasurer, Secretary

Morteza Ejabat – Chairman and CEO

Analysts

Greg Mesniaeff – Kaufman Brothers

Donna Jaegers – D.A. Davidson

Mark Gomes – Pipeline Data

Operator

Good day and welcome to the fourth quarter 2011 Zhone Technologies, Inc. conference call. I’m Melanie and I will be your coordinator for today.

(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

Welcome to the fourth quarter 2011 Zhone Technologies, Inc. earnings conference call. I'm Kirk Misaka, Zhone’s Chief Financial Officer.

The purpose of this call is to discuss Zhone’s fourth 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'm here today with Mori Ejabat, Zhone’s Chairman and Chief Executive Officer. Mori will begin by discussing the key financial results and business developments for the fourth quarter. Following Mori’s comments, I’ll discuss Zhone’s detailed financial results for the fourth 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, 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 reports on Form 10-Q for the quarters ended March 31, 2011, June 30, 2011 and September 30, 2011.

We would 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’ll 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 for making operating decisions because they provide meaningful supplemental information regarding our operational performance and they facilitate management’s internal comparisons with 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, has been posted on our website at www.zhone.com.

With those comments in mind, I would now like to introduce Mori Ejabat, Zhone’s Chairman and Chief Executive Officer.

Morteza Ejabat

Thanks, Kirk. Good afternoon and thank you for joining us for our fourth quarter 2011 earnings call. We are pleased to announce a strong revenue growth across all regions during the quarter.

Fourth quarter revenue of $33.4 million grew 11% sequentially over third quarter revenue of $30.2 million and 8% year over year as compared to last year’s fourth quarter revenue of $31 million. With this strong top line growth, we also achieved our other major financial objectives for the quarter and generated positive adjusted EBITDA. As expected, the MXK continued to drive new organic customer growth while sustaining industry leadership and a strong customer acceptance. We expect to continue this momentum into 2012. Kirk will discuss our financial results and guidance in greater detail later.

In late October, we announced the immediate availability of the new zNID 2400 GP optical network terminals, ONTs. The new active ethernet indoor ONTs, part of the zNID 2400 series indoor ONTs, provide a cost-efficient, high personalized solution for delivering high bandwidth services. As you’ll much recall, last quarter we announced the GPON version of the 2400 series zNID ONT. The 2400 has been a very successful line of ONTs for Zhone Technologies.

Also in October, we announced the expansion of our next-generation broadband access solution portfolio, Zhone FiberHome, with the immediate availability of the MXP-160/260 and MXP-180/280 1U SLMS platform. The new offering provides advanced multiplayer connectivity to global voice, data and video services, further expanding the reach of our global fiber base access solutions.

As we turned the corner into 2012, Zhone has experienced rapid FTTx customer growth at over 460% since inception. We continue to renew customers in each of our served markets. Now I would like to share a few examples of our exciting wins announced in the quarter.

We announced a new MXK deployment with Central Oklahoma Telephone Company, an independent local exchange company headquartered in Devonport, Oklahoma. We also announced the Mark Twain Telephone Company is deploying Zhone’s industry leading MXK Intelligent Terabit Access Concentrator to enable digital subscriber line xDSL connectivity to its access lines in northern Missouri. MXK also help to provide differentiated services as multi-service access [nodes] and will serve as the core enabler of Novosco’s deployment of ethernet in the First Mile EFM solution in Northern Ireland.

In November, we announced working with Grand River Mutual Telephone Corporation, Missouri’s second largest independent operator. We’ll build a new fiber network that will support delivery of more affordable and reliable high-speed internet access, VOIP and video services to residential and business subscribers. Lastly, we announced the addition of Green Hills Telephone Corporation as a new customer for its industry-leading FTTx solutions. Green Hills Telephone Corporation, an independent Missouri-based service provider since 1952.

Reflecting on 2011, the year was challenging as well as rewarding. The record MXK growth resulted in shipping over 2,200 units in 2011 with total unit ships in excess of 3,000 units since inception. We have now shipped over 20 million [ports] of MXK subscriber capacity. The record shipment of MXK will complete our product transition from [nodes] to MXK.

During the year we announced several new products, including 1U SLMS-based products and several new models of ONTs. Zhone ONT portfolio is now one of the most comprehensive and diversified portfolio in the industry. The combination of MXK growth and the new product launches during the year has placed Zhone into a position of leadership in the fiber-to-the-home (inaudible) building market verticals.

During the year (inaudible) massive price reduction in our products mainly due to international price competition that limited Zhone growth during the year. We believe the price reduction has stabilized, and going into 2012, we will maintain pricing and increase gross margin as it was evidenced in our Q4 2011 results.

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

Kirk Misaka

Thanks, Mori.

Today Zhone announced financial results for the fourth quarter of 2011. As Mori mentioned, fourth quarter revenue of $33.4 million increased by 11% from a quarter-over-quarter basis as compared to third quarter revenue of $30.2 million, and 8% on a year-over-year basis as compared to fourth quarter revenue in 2010 of $31 million. For the first quarter of 2012, we expect the normal seasonal slowdown similar to what we’ve experienced over the past few years.

Our international markets continued to produce the majority of our business and represented 60% of revenue for the fourth quarter versus 57% of revenue for the third quarter. We also continued to serve over 750 active customers and experienced more customer concentration this quarter with the top five customers representing approximately 46% of revenue for the fourth quarter as compared to 37% for the third quarter. The majority of the additional customer concentration was due to the growth in our business with our largest Caribbean and Latin American customers, creating another 10% customer in addition to our other 10% customer in the Middle East. Our success in these two geographic regions continued to produce strong revenue growth and we expect that trend to continue in 2012.

Gross margins improved to 36% for the fourth quarter 2011 as compared to 34% for the third quarter of 2011, coming in at the upper end of our previously provided guidance range of between 34% and 36%. Margins improved this quarter due to better manufacturing economies of scale coupled with continued product cost reductions. Going forward, we expect gross margins to range between 34% and 36% for the first quarter of 2012 before improving during the second half of the year as we get better manufacturing economies of scales with higher revenue in the later quarters.

Adjusted operating expenses were $12.4 million for the fourth quarter of 2011, excluding the impairment of long-lived assets of $4.2 million. We review long-lived assets including intangible assets for impairment annually, or whenever changes in circumstances indicate that the carrying value of an asset may not be recoverable. Due to the significant decrease in our market capitalization recently, we determined that the indicators of impairment existed similar to the conditions that existed during the second quarter of 2008 when we last impaired assets. Since we do not anticipate material impairment going forward, we believe adjusted operating expenses is a better reflection of the future.

Adjusted operating expenses were slightly below the low end of our guidance range of between $12.5 million to $13.5 million, and lower than the $13 million for the third quarter. We expect operating expenses for the first quarter of 2012 to continue at this lower level, around $12.5 million. Operating expenses for the fourth quarter included depreciation of approximately $400,000 and stock-based compensation of approximately $200,000. Going forward, we expect depreciation to drop to less than $100,000 due to the impairment of long-lived assets, and anticipate that stock-based compensation will remain about the same, around $200,000.

Finally, our adjusted EBITDA profit for the fourth quarter of 2011 was approximately $300,000, as compared to the $1.3 million adjusted EBITDA loss for the third quarter. With the anticipated revenue growth, gross margin improvement and stable operating expenses, we expect to generate positive adjusted EBITDA for 2012 as a whole.

Now turning to the balance sheet, cash and short-term investments at December 31, 2011 increased to $18.2 million from $17.8 million at September 30, 2011, approximately equal the adjusted EBITDA profit. The net effect of other balance sheet changes was minimal except for the additional $5 million use of our credit facility with Silicon Valley Bank to finance the large growth in receivables.

Accounts receivable grew $4.7 million to $31.6 million at December 31, 2011, largely due to the shipment and payment cycle with our largest customer. As you know, we have experienced these fluctuations periodically in the past and expect that the majority of the current buildup in receivables will reverse over the next two quarters. As you would expect, the number of days sales outstanding on accounts receivable also increased during the fourth quarter to 85 days as compared to 80 days for the third quarter.

As mentioned, our total debt obligations associated with our working capital facility with Silicon Valley Bank increased to $15 million at December 31, 2011 from $10 million at September 30, 2011. We will reduce our draw in this facility in connection with the reversal of the buildup in receivables just mentioned. As for the debt facility itself, we anticipate renewing this facility in the first quarter of 2012, as we’ve done for many years. Initial discussions with Silicon Valley Bank are underway and are progressing in a manner consistent with the past.

Lastly, the weighted average basic and diluted shares outstanding was 30.8 million for the fourth quarter 2011 and 30.7 million for the third quarter of 2011.

And with that financial overview, I’ll turn the call back to Mori for a few final comments before we open the call up to questions and answers. Mori?

Morteza Ejabat

Thank you, Kirk. Q4 was a strong quarter for Zhone, especially in our international markets where we have experienced sustained success. We hope to carry that momentum into 2012 to generate revenue growth and profitability for the year as a whole.

We are happy that our financial performance is beginning to reflect what leading industry analysts have recognized for the previous eight quarters, that Zhone Technologies have [carrier] class industry-leading products which allow service providers the flexible solution needed to meet the rapidly growing demands of the customers, with sustained growth rate at over 8,500% for our zNID ONTs and over 9,800% for MXK OLTs since inception. We continue to be highly optimistic that we have the right solution for our growing customer base around the world.

We would now like to open the call up for the questions. Operator, please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions).

And our first question comes from the line of Greg Mesniaeff with Kaufman Brothers. Go ahead.

Greg Mesniaeff – Kaufman Brothers

Hi, guys.

Kirk Misaka

Hi, Greg.

Morteza Ejabat

Hi, Greg.

Greg Mesniaeff – Kaufman Brothers

First of all, congratulations on the encouraging results. I have a question on the US market for your products. I know you’ve been very active in the tier 2 and tier 3 carrier space. And my question is, when you look at the competitive landscape, recently ADTRAN on their conference call said that they were -- while they were experiencing weakness in the tier 1 space, with AT&T and Verizon, their traction in the tier 2 and tier 3 carrier markets increased. And they even alluded to the fact that they may have captured some market share. I was wondering if you can comment on that, and how you see your competitive positioning in the tier 2 and tier 3 domestic carrier markets. Thanks.

Morteza Ejabat

As you heard in this announcement today or discussion today, we announced four new customers, three of them were domestic, and tier 2 to tier 5 overseas. We see that we are gaining momentum in this area and taking market share as well. And our performance has been fairly well-received by all of our customers, and increasingly declined more and more product into the [IFCs] domestic. Given that, we are increasing our international presence as well.

Greg Mesniaeff – Kaufman Brothers

In the domestic tier 2 and tier 3 markets, are you finding that the strongest competitive position is price or is feature set or is it the domestic manufacturing that you’ve been promoting? Which of those variables is it?

Morteza Ejabat

In the domestic market, our strength is our product functionality and performance, in addition with pricing and our US manufacturing. We definitely have a good position in this area. When we go into competitive situation, most of the time we win.

In areas that we have difficulty is when our competitors are incumbent in those areas. Normally it takes a couple, two or three quarters to actually move that (inaudible) put our products in there.

Greg Mesniaeff – Kaufman Brothers

And Mori, can you comment on the broadband stimulus funds that may be made available for some of your opportunities?

Morteza Ejabat

Yeah, we see that -- we’ve seen that slowly coming down. There were two issues in the past. One was the availability of the fiber and the other one was the slowness of getting the stimulus funds into our customers. I believe fiber shortages are beyond us, and we are seeing that our customers are getting the fund and things are happening in the more rapid fashion than it was in the last couple of quarters.

Greg Mesniaeff – Kaufman Brothers

Thank you for that. And just one final question for you, guys, I know majority of your business is outside the US, which partially would explain your high DSOs, but I'm wondering what, if anything, you can do to maybe try to bring that number down a little.

Morteza Ejabat

Greg, this is typical of international business, and especially in the fourth quarter, that people, some of our customers were looking at their own balance sheet and they don’t want to release funds till the new year. We have seen that happen and actually we went through a good collection period in the last couple of days.

Greg Mesniaeff – Kaufman Brothers

Okay. So I guess it’s fair to assume that the DSOs will quite likely come down as the year unfolds.

Morteza Ejabat

That’s our goal.

Greg Mesniaeff – Kaufman Brothers

Great. Thank you.

Morteza Ejabat

Thanks.

Operator

Our next question comes from the line of Donna Jaegers with D.A. Davidson. Go ahead.

Donna Jaegers – D.A. Davidson

Hi, guys. Thanks for taking the question.

I was just curious, given the FCC reform changes on universal service fund and their push to link any future subsidies more to broadband, if you saw any changes in interest from your customers or your pipeline in the fourth quarter because of the SEC regulatory change?

Morteza Ejabat

To answer your question, Donna, the first one, we haven’t seen any changes in their behavior, but we definitely have noticed that they are preaching about what’s going to happen and how it’s going to affect them. And most likely may affect the smaller ones a lot more than the larger ones. But that bill hasn’t been ratified yet, so there’s lots of opposition about that.

Donna Jaegers – D.A. Davidson

Actually, it’s an SEC regulation, it’s not a bill.

Morteza Ejabat

Regulation, yes.

Donna Jaegers – D.A. Davidson

Yeah. Okay. Thanks.

Morteza Ejabat

Sure.

Operator

(Operator Instructions).

Our next question comes from the line of Mark Gomes with Pipeline Data. Go ahead.

Mark Gomes – Pipeline Data

Hi, gentlemen. Nice quarter. Most of my questions have actually been answered, but can you elaborate a little bit with regard to your US manufacturing and whether or not that provides any benefit with regard to any US legislative requirements for stimulus?

Morteza Ejabat

Well, to answer your question, Mark, no, it hasn’t done anything for us domestically with respect to any stimulus money or any funds. But it has definitely helped us in competitive areas domestically and also internationally. Domestically, people are very proud to buy our products because we have manufactured it here, and internationally, they believe it is a good product to buy and the quality is higher from any other manufacturers in the world.

Mark Gomes – Pipeline Data

Great. Thank you very much.

Operator

And ladies and gentlemen, I'm showing no further questions at this time. I’d like to turn the call back over to management for any closing remarks. Please proceed, gentlemen.

Morteza Ejabat

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

Ladies and gentlemen, thank you for your participation in today’s conference. That does conclude the presentation. You may disconnect. Have a wonderful day.

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