Zhone Technologies' (ZHNE) CEO Jim Norrod on Q1 2016 Results - Earnings Call Transcript

| About: DASAN Zhone (DZSI)

Zhone Technologies, Inc. (ZHNE) Q1 2016 Earnings Conference Call April 20, 2016 5:00 PM ET

Executives

Kirk Misaka - CFO

Jim Norrod - CEO

Analysts

Christian Schwab - Craig-Hallum

Operator

Good day and welcome to the First Quarter 2016 Zhone Technologies' Inc. Conference Call. I am Karen and I'll be your coordinator for today. At this time, all participants are in 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 2016 Zhone Technologies, Inc. conference call. I'm Kirk Misaka, Zhone's Chief Financial Officer. The purpose of this call is to discuss Zhone's first quarter 2016 financial results as reported in our earnings release that 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 Jim Norrod, Zhone's Chief Executive Officer. Jim will begin by discussing the key financial results and business developments of the first quarter. Following Jim's comments, I will discuss Zhone's detailed financial results for the first quarter and provide guidance for next quarter. After our prepared remarks, we will conclude with questions and answers.

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 will 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, 2015.

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 to the company's historical operating results and comparisons to competitor's 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 Jim Norrod, Zhone's Chief Executive Officer.

Jim Norrod

Thanks, Kirk. Good afternoon and thanks for joining us today for our first quarter 2016 earnings call. As you know, on April 12 we announced the signing of an agreement to merge with DASAN Network Solutions and although that has been the focus of most we remain committed to improving our standalone financial performance so that we can carry those successful habits to the combined company. So before talking about the merger let me spend a few minutes to reflect on our standalone company.

2015 was a year of change for us as we positioned ourselves to be successful in our two key businesses; being a global leader in fiber access transformation for communication service providers and providing the most cost effective, energy efficient and secure alternative to existing copper-based Ethernet LAN infrastructure to businesses and other enterprises. We fully expect that the changes we made in 2015 will begin to bear fruit in 2016 and will create sustainable revenue growth and profitability for the future.

We began to see some of those benefits in the fourth quarter with nearly 9% sequential revenue growth and GAAP profitability. Our first quarter results were undermined by normal seasonal weakness, but the fundamentals continued to improve despite very tough global economic conditions.

For 2016 we have four growth catalysts. First, the official launch of our MXK-F should begin to be deployed by our largest customers. Second, the global economic conditions that caused the downturn in 2015 should improve or at least stabilize enough to create and improve spending environment for international service provider customers. Third, the second round of Connect America funding should provide some stimulus for our US service provider customers although the impact of the captive funding will not be felt until the latter part of the year. Fourth, our enterprise business continues to grow rapidly. Kirk will provide more financial details of the first quarter later, so let me say a few words about our two businesses.

First and foremost, we continue to support our strong and well-established service provider business serving the most innovative carriers around the world. In order to continue being a global leader in that business, we will maintain the course of investing heavily in R&D to provide the cutting edge technologies that our customers expect and deserve. In the fourth quarter, we officially launched the MXK-F, a new aggregation platform that can supply fiber based triple play service from one chassis for large city of up to a 0.25 million users.

Innovations like the MXK-F are what made us a global leader in fiber access transformation. As I've said before, our service provider business continues to anchor our company so we are encouraged that our largest service provider customers continue to test the MXK-F in their labs and we expect them to begin operationalizing the MXK-F in their networks soon. Meanwhile, we continue to support and enhance our MXK classic platforms for copper and fiber access deployments for those service providers on a slower migration path or with different network requirements.

As for our enterprise business, it is growing rapidly due to the compelling value proposition of our FiberLAN products. As I've said before, it is easily the most cost effective, energy efficient and secure alternative to traditional copper LAN infrastructure. Although FiberLAN revenue is relatively small, 2015 FiberLAN revenue more than doubled over 2014 demonstrating that FiberLAN can still be a $100 million annual revenue business in another four to five years. In addition to growing at a rate which exceeds doubling on an annual basis, we continue to see the total pipeline of opportunities growing even faster than that. Key reference wins in numerous market verticals are leading the follow through success in those verticals.

With those comments in mind let’s turn to the merger of Zhone and DASAN Network Solutions. As previously announced the current stockholders of Zhone will receive 42% of the combined companies outstanding shares and 58% will be held by DASAN Networks. Upon completion of the merger, the combined company will be named DASAN Zhone Solutions and we expect to trade under the symbol DZSI on the NASDAQ Capital Markets.

After the acquisition, DASAN Zhone Solutions will have two co-CEOs. I will run sales, marketing and G&A while Yung Kim will manage engineering, support and operations. Yung has over 30 years of experience in telecommunications and has held high-level executive positions at both British Telecom and Korea Telecom. His background and wealth of experience will help lead our combined companies’ product strategy.

Both Zhone and DASAN Network Solutions are market leaders in the broadband access sector with strong and loyal customers around the world. The combination of DASAN Network Solutions and Zhone will enhance this leadership position in both carrier and enterprise solutions for the broadband market. There are three compelling reasons for this merger.

The first is a near perfect complementary product line. Zhone is world-class in broadband access and passive optical LAN and DASAN Network Solutions is world class in mobile backhaul and Ethernet switching. We believe that combining the products and talents of DASAN Network Solutions and Zhone will deliver the most complete competitive solution in the market.

The second reason is near perfect complementary markets and marketing teams; our customers just do not overlap. Where we are strong DASAN is not active and where DASAN is strong, Zhone is not active. Jointly we have a stronger sales and support organization. This transaction also expands our customer base worldwide. The combined company will have a strong presence in every geographic region of the world for growth of sales, service and support. This complementary customer base and market opportunity will also create operational efficiencies which will flow to improved financial results.

The third compelling reason is financial strength. The merger will more than double the revenue stream, the balance sheet and operating income. In addition, the combined company will have access to significant lines of credit and/or committed loans. The merger will also facilitate operational efficiencies which are expected to significantly improve EBITDA and GAAP net income performance. The transaction will be immediately accretive.

To summarize, there are three compelling reasons for the merger; complementary products, complementary markets and of course financial strength. This combination will expand the product portfolios of both companies and grow our substantial carrier and enterprise customer base. We will have a strong position as a leading provider in four key areas: Broadband Access, mobile backhaul, Ethernet Switching and Passive Optical LAN. We will provide customers, both enterprise and service providers, with the best solutions for converged packet based voice data and video services. The transaction will bring cost savings from reduction of operating expenses and as I mentioned, will be immediately accretive excluding the acquisition and integration related charges, and it will provide a stronger balance sheet with better liquidity.

With that brief overview of our business, let me turn the call back to Kirk to provide more details about returning to profitability, our financial results for last quarter and to discuss our financial guidance for next quarter. Kirk?

Kirk Misaka

Thanks, Jim. Today, Zhone announced financial results for the first quarter of 2016. First quarter revenue of $20.6 million declined 14% sequentially from fourth quarter revenue of $24 million and slightly more than the normal seasonal weakness that we expected. As we discussed last quarter, global economic uncertainties continue to cause many of our service provider customers to cautiously approach new network investments and as a result, many of our international customers have reduced their network expansion. Although we expect higher sequential revenue next quarter, in line with typical seasonal improvements, that growth may continue to be subdued until uncertainties subside.

For 2016, as a whole, we still expect mid-single digit percentage revenue growth on a standalone basis over 2015, driven by the four growth catalysts that Jim previously mentioned, namely the official launch and deployment of our MXK-F platform by our large service providers and improved spending environment for our international service providers, some CAF 2 stimulus in the latter half of the year for our US service providers and continued strength in our fiber LAN business. Since the global economic slowdown impacted many of our international markets, revenue from our international customers who typically produced the vast majority of our business represented just 54% of revenue for the first quarter as compared to 60% of revenue for 2015 and as a whole and 68% for 2014.

With the lower revenue, we also experienced more customer concentration this quarter with the top five customers representing approximately 46% of revenue for the first quarter as compared to just 31% of revenue for the fourth quarter of 2015 and we had three 10% customers in the first quarter as compared to none in the fourth quarter of 2015. Gross margins of 40.1% exceeded our guidance range of between 36% and 38% due to stronger domestic margins, stronger enterprise margins and continued manufacturing efficiencies. We expect our domestic international mix to begin normalizing next quarter. As a result, we expect gross margins for the second quarter of 2016 to return to historical norms of between 36% and 38%.

Total operating expenses of $11.6 million for the first quarter included additional stock-based compensation of $640,000 related to Mory Ejabat’s stock grant, pursuant to his transition services agreement and $1.6 million related to the cancellation of Jim Norrod’s stock options, which triggered the recognition of his remaining unamortized stock-based compensation associated with those stock options. Adjusted operating expenses, excluding this additional stock-based compensation, were approximately $9.4 million and within our original guidance expectations of between $9 million and $9.5 million. Total operating expenses for the first quarter also included depreciation of approximately $200,000.

For the second quarter, we expect total operating expenses to range between $9.5 million and $10 million, excluding expenses related to the potential merger, which will be expensed when incurred. Finally, our adjusted EBITDA loss for the first quarter of 2016 was $668,000 as compared to an adjusted EBITDA profit of $990,000 for the fourth quarter of 2015. Our net loss on a GAAP basis was $3,432,000 and $0.10 per basic and diluted share in the first quarter of 2016 as compared to net income of $403,000 and $0.01 per basic and diluted share in the fourth quarter of 2015. Our goal for the second quarter is to breakeven on an adjusted EBITDA basis, excluding any expenses related to the potential merger.

Now, let’s take a look at the balance sheet. Cash and short term investments at March 31, 2016 decreased to $9.3 million from $10.1 million at December 31, 2015, while net cash increased to $7.3 million from $5.1 million over the same period largely due to a reduction in accounts receivable. Accounts receivable decreased to $24.8 million at March 31, 2016 from $28.2 million at December 31, 2015, but the number of days sales outstanding on accounts receivable increased slightly to 108 days as compared to 106 days for the fourth quarter. DSOs have been elevated over the past few quarters, largely due to the pattern of shipments to and collections from our largest customers. We expect those patterns to normalize and DSOs to continue improving in 2016.

Net inventories remained relatively flat at $14.6 million as of March 31, 2016, as compared to $14.8 million as of December 31, 2015, while total debt obligations associated with our Wells Fargo working capital facility declined to $2 million at March 31, 2016 from $5 million at December 31, 2015. While total debt obligations associated with our Wells Fargo working capital facility declined to $2 million at March 31, 2016 from $5 million at December 31, 2015. As reported last month, we renewed our credit facility with Wells Fargo for another three years to March of 2019 and anticipate that the credit facility will continue to provide ample working capital for our growth needs. Lastly, the weighted average basic and diluted shares outstanding were 33.8 million for the first quarter of 2016.

And with that financial overview let me turn the call back to Jim for a few final comments before we open the call up to questions and answers.

Jim Norrod

Thank you, Kirk. As I said, we fully expect that the changes made in 2015 will begin to bear fruit in 2016 and will create sustainable revenue growth and profitability for the future. Despite the impending transaction, we continue to maintain focus on our standalone financial performance and are driving the initiatives that will create revenue growth and margin expansion while maintaining cost efficiencies. And so our merger with DASAN Network Solutions, the combination will expand the product portfolios of both companies and grow our substantial carrier enterprise customer base. We will have a strong position as a leading provider in the four key areas of broadband access, mobile backhaul, Ethernet switching and of course passive optical LAN. We will provide customers both enterprise and service providers with the most and the best solution for converged packet-based voice data and video services. The transaction will bring cost savings from the elimination of duplicate operating expenses and will be immediately accretive excluding acquisition and integration related charges providing a stronger balance-sheet with better liquidity.

Now I would like to open it up for questions. So 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 Christian Schwab from Craig Hallum.

Christian Schwab

Hey, guys, now that we've had a little bit of opportunity to look into the company you’re merging with, can you talk to me about how you guys are addressing any potential cultural challenges there may be and how long do you expect sales integration to take and what is your plan and strategy regarding enhanced product portfolio and training of the sales force to sell products they haven't sold before?

Jim Norrod

Yeah, Christian, good questions. First of all culture is - certainly the cultures are different in the two companies. Yeah it's one of the reasons that we chose a co-CEO approach to have both the Korean culture and our culture. We certainly don't want to change the culture and their success that they've had in Asia nor are they trying to change the success that we've had in the Americas and Middle East and Europe. Again the goal is to try to take the product strengths from each company and get it into those customers. So as an example, I think, we've talked about is that their two areas of strength are mobile backhaul and Ethernet switching, our areas of strength are broadband access and passive optical LAN, we're very anxious to take our strengths in what we do and get them into the Asian markets. They are very anxious or we are very anxious to take the strengths of their product areas like mobile backhaul and get it into our market. We're very excited about doing that as soon as possible. I'm headed over to Dubai this weekend to meet some of our largest customers and I'm sure they're going to ask when they're going to get those products because I know they want them. And so that's - so cultural will come together but again you’re going to have two CEOs from the two different cultures and I think it will some time to merge the cultures, which of course it will.

On the sales integration side, I'll be running that, they have some outstanding sales executives in Asia. As I think I said before there are three top customers in Korea, Korea Telecom, SK Telecom and LG Uplus and the executives that runs those three is an outstanding sales executive and he'll be reporting to me along with a couple other of their sales managers and along with our sales managers. So we have a pretty aggressive plan to do some cross training but all that has to - this has to be done after the merger is completed. We are tempted, really tempted to jump all over this and start as quickly as we can to integrate, to train, to bring others up to speed but we can't do it. We have to operate as two separate companies until the date of the merger. So what we're trying to do is get us prepared with as much that we can do ahead of time. So at merger date, we immediately go into execution mode of training, of customer visits, of dual product presentations, we're doing all that work in the background but it's being done in the background. It's being done by the individual companies because we have to operate separately. So lot to be done, we're going to really set up as much as we can prior to the merger and then when the merger is announced, we're going to take off as fast we can.

Christian Schwab

So the product sales cycle of all those products except Ethernet switch which is bought as needed if they like that switch, the product cycles are extremely long. So a lot of your customers are still source buyers in the Middle East and so there are certainly would be slow to change backhaul on a moment's notice. So I just want to know why you guys are still confident in the $250 million worth of revenue first. If I look at the public records of DASAN, it looks like they have probably [indiscernible] in how Q4 turned out, probably going to show some very strong growth on a year-over-year basis. I am wondering (a) of that 250 million or over 250 million what percentage of that do you believe is theirs versus yours? And if you have some insight on what is driving that growth for them this year that would be helpful as well?

Jim Norrod

I can’t give you a percentage – I cannot give you percentages as breakdowns now because we haven’t made any of that information public. But let me say that we are quite aware of the major deals that they have – you mentioned the backhaul area. You’re right, customers in the Middle East, they will not stop on a dime and immediately put in the DASAN solutions. But DASAN has been working with some fairly large companies around the world and specifically in United States on the backhaul solution, which they have been – they have spent a year working on and they are very close to success on these. This isn’t the first rodeo for them on backhaul because as you may know, SoftBank is one of their biggest backhaul customers. And SoftBank as you know, is really one of the leading companies in this area in Japan. So they have had great success with their backhaul products in Japan. So that solution [indiscernible] they have installed in Japan is being bid in several large companies around the world that we are aware of. We can’t disclose who they are, but we know intimately the deals that they are working on and we think there is a reasonable chance they’ll get some business pretty quickly from those. But you asked a question about sales cycles and of course, I am as concerned about how quickly we can bring this up to speed but with their momentum that they have I feel comfortable that that number is doable.

Christian Schwab

Great. And then two other quick questions. You guys are very confident in profitability or operational synergies, I assume that means profit on a combined basis of the two companies. However, when you overlap the sales and research and development offices of yours and theirs, there isn’t a significant amount of overlap. So I am trying to figure out where all the OpEx cuts are going to come from?

Jim Norrod

Well, you’re right, there is not geographic overlap, but there is overlap in what’s being done. So as an example, we may take some work that’s being done here in the US and look at doing it over in some of their sites. They may want to take some work that’s being done in their locations and bring it here. So all in all, I think again this work is still being done now. We clearly believe that there are certain management layers involved in these companies that could be redundant. We are looking at those and making sure that we have the most efficient company that we can put together. All that work is being done now. And so I mean, I don’t think the geographic locations are overlapped, I think the functions certainly are. As an example, we both have a management system, right. We have one, they have one. They have looked at our management system and they think it’s an outstanding management system and we should put some additional resource on our management system. So they are working on their own, we are working on our own, let’s just do one as an example that we can use going forward, so there will be some redundancy there as we continue to put more work in our system.

The other thing is certainly from other efficiency standpoint, there are manufacturing efficiencies that clearly could create margin expansion. They outsource basically everything they do, we outsource some stuff and we do significant amount in our Largo facility. As they have looked in that facility, the Largo facility where we do a darn good job. Look what we have done to our margins in the last several quarters. Notice that they have been creeping up, creeping up. They are I think 41% or so. Now, and that’s because of some real efficiencies that we have done in our manufacturing facility. Dasan will certainly be moving some of those products into that facility. There will be some efficiencies we get from that and again, we are working on all of that, but we are convinced that there will be a reasonable amount of expense reductions that we can do to make this work.

Christian Schwab

Okay. And then my last question. In Dasan’s public filing in Korea announcing the acquisition, they have put out a monthly target of what they thought the combined company could do over time of roughly $800 million. Do you have any idea on how they think you could get there?

Jim Norrod

Yes, first of all, I haven’t seen that. And secondly, you will have to ask them about that because we have nothing to do with that side. I really can’t comment on it. I haven’t seen it.

Christian Schwab

Got you. Thanks, no other question.

Operator

[Operator Instructions] And that concludes our question-and-answer session for today. I would like to turn the conference back over to Jim Norrod for any closing comments.

Jim Norrod

Thank you, Karen. As always, we want to thank you for joining us today and for your continued support. We continue to be optimistic that we are positioned for strong growth opportunities that will lead to success in 2016 and beyond. We also remain committed to converting that success in the profitability and shareholder value, especially as it relates to the merger. We look forward to speaking with you again on next quarter’s earnings conference call to talk about our progress on the merger and on achieving sustainable revenue growth and profitability. Thanks.

Operator

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

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