Zhone Technologies' (ZHNE) CEO Jim Norrod on Q2 2016 Results - Earnings Call Transcript

| About: DASAN Zhone (DZSI)

Zhone Technologies, Inc. (ZHNE) Q2 2016 Earnings Conference Call July 21, 2016 5:00 PM ET

Executives

Kirk Misaka - CFO

Jim Norrod - CEO

Analysts

William Morrison - National Securities

Operator

Good day and welcome to the Second Quarter 2016 Zhone Technologies Incorporated Conference Call. My name is 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 second 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 second 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 second quarter. Following Jim's comments, I will discuss Zhone's detailed financial results for the second 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 made 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, statements that express our plans, objectives and strategies for future operations, the completion and timing of the closing of the merger with DASAN Network Solutions, and the timing and amount of financial benefits that maybe achieved in connection with the merger.

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 and our quarterly report on Form 10-Q for the quarter ended March 31, 2016. 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 second quarter 2016 earnings call. As you know, on April 12, we announced signing an agreement to merge with DASAN Network Solutions. Since that time, we have been working to complete the transaction while remaining focused on improving our standalone financial performance so that we can carry those successful practices to the combined company.

So before talking about the merger, let me spend a few minutes to reflect on our standalone financial performance for the second quarter. Revenue grew by nearly 10% over the first quarter from normal seasonal strengthening and focus by our sales team to avoid the possible business distractions that can accompany a merger announcement. Gross margins also continued showing strength at nearly 39%, while adjusted operating expenses, excluding transaction costs associated with the merger, were also better than expected. The net result of revenue growth continued strong gross margins and lower operating expenses reduced the adjusted EDITBA loss by nearly $600,000. And we nearly finished the quarter at breakeven, which was our goal.

Meanwhile, our balance sheet continues to be strong, and we have adequate liquidity with our Wells Fargo Debt Facility to adequately manage the business. So, while the second quarter had significant challenges, specifically with the merger announcement, we performed well, and I'm proud of the effort of our team and the progress that we are making toward becoming a growing, profitable company.

As I've mentioned before, we have four growth catalysts. First, the official launch of our MXK-F is being deployed by our largest customers. Second, the global economic conditions that caused the downturn in 2015 are stabilizing enough to create an improved spending environment for international service provider customers. And we are seeing more business from those customers in our third and fourth quarter forecasts. Third, the second round of Connect America funding should begin to provide some stimulus for our U.S. service provider customers in the second half of the year. Fourth, our enterprise business continues to grow rapidly. Kirk will provide more financial details of the second 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 demand.

In the fourth quarter of 2015, we officially launched the MXK-F, a new aggregation platform that can support fiber-based triple-play service from one chassis for a large city of up to a quarter 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 continues to grow rapidly because of the compelling value proposition of our FiberLAN product. As I've said many times, it is easily the most cost-effective, energy-efficient and secure alternative to traditional copper LAN infrastructure. Although FiberLAN revenue is still relatively small, 2015 FiberLAN revenue more than doubled over 2014, and we saw the same growth rate in the first half of 2016. In addition to growing at a rate which exceeds doubling on an annual basis, we continue to see the total pipeline of opportunities filling up, leading to continued strong growth in the enterprise business as key reference wins in numerous market verticals are leading to follow-through successes in those verticals.

As you can see, our two businesses continue to thrive as we approach the merger with DASAN Network Solutions. So let's talk about what we believe will be an exciting new opportunity for Zhone. As previously announced, the current stockholders of Zhone will own 42% of the combined company's 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 Market. After the acquisition, DASAN Zhone Solutions will have two co-CEOs, as I will run Sales, Marketing and G&A and Yung Kim will manage Engineering, Support and Operations. Yung has over 30 years of experience in telecommunications and has held executive positions at British Telecom and Korea Telecom. His background and wealth of experience will help lead our combined company's 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. As I've stated before, there are three compelling reasons for this merger, and we continue to be excited about the benefits of the combination. The first reason is a near-perfect complimentary product line. Zhone is world class in broadband access and Passive Optical LAN and DASAN Network Solutions is world class in mobile backhaul and ether network switching. We believe that combining the products and talents of DASAN Network Solutions and Zhone; we will deliver the most complete, competitive solution in the market.

The second reason is near-perfect complimentary markets and marketing teams. Our customers just do not overlap. Where we are strong, DASAN is not active, and where DASAN is strong, Zhone has not been active. Jointly, we will 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 complimentary customer base and market opportunity will also create operational efficiencies, which will flow to improve financial results. The third compelling reason is financial strength. The merger will more than double revenue, strengthen the balance sheet, and provide the scale to become profitable. 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, adjusted to EDITBA and GAAP net income performance. The transaction will be immediately accretive.

To summarize, the three compelling reasons for the merger are: complimentary products, complimentary markets and financial strength. The 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 will be immediately accretive, excluding acquisition- and integration-related charges, providing a stronger balance sheet with better liquidity. We are working diligently to complete the transaction and currently expect to hold our shareholder vote in September, with a close shortly thereafter. The distribution of our shareholder proxy statement will contain much more information about the transaction, and will precede the shareholder vote by about one month, so please stay tuned.

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 the last quarter, and to discuss our financial guides for next quarter. Kirk?

Kirk Misaka

Thanks, Jim. Today Zhone announced financial results for the second quarter of 2016. Second quarter revenue of $22.6 million, grew 10% sequentially from first quarter revenue of $20.6 million and slightly more than the normal seasonal improvement that we expected.

In particular, our domestic business outperformed with 18% sequential revenue growth. Although our international business grew by just 3% since global economic uncertainties are having a greater impact on our international service provider customers making them cautiously approach new network investments. As a result, revenue from our international customers, who typically produce the vast majority of our business, represented just 51% of revenue for the second quarter as compared to 62% of revenue for 2015 as a whole and 68% for 2014. With the revenue growth we also experienced slightly less customer concentration this quarter with a top five customers representing approximately 42% of revenue for the second quarter as compared to 46% of revenue for the first quarter. And we had two 10% customers in the second quarter as compared to three in the first quarter.

As for next quarter, we expect normal seasonal improvement which should result in slight sequential revenue growth into the third quarter on a standalone basis. However, if the merger with DASAN Network Solutions is approved by shareholders and the transaction closes in the third quarter, then all of our forward-looking guidance will not be reflective of the actual results of the combined company which as Jim mentioned will be named DASAN Zhone Solutions. Instead, the financial results of the combined company will reflect those of DASAN Network Solutions for the entire quarter, combined with the financial results of Zhone just for the steep period following the close going forward. The reason for this treatment is that DASAN Network Solutions will be treated as the acquirer for accounting purposes; even those Zhone is the legal acquirer. For more details, please read the forthcoming proxy statement which as Jim mentioned will hopefully be distributed sometime in August.

Gross margins of 38.8% exceeded our guidance range of between 36% and 38% due to a 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 third quarter of 2016 to return to historical norms of between 36% and 38% on a standalone basis but as just mentioned, will not be reflective of the combined company's gross margin percentages.

Total operating expenses of $20.4 million for the second quarter included merger transaction related costs of $1.2 million. Adjusted operating expenses excluding these transaction costs were approximately $9.2 million and below our original guidance expectations of between $9.5 million and $10 million, excluding merger transaction costs. Total operating expenses for the second quarter also included depreciation of $145,000 in stock-based compensation of approximately $100,000. For the third quarter, we expect total operating expenses on a standalone basis 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 second quarter of 2016 was $85,000 as compared to an adjusted EBITDA loss of $668,000 for the first quarter. Our net loss on a GAAP basis was $1.6 million and $0.05 per basic and diluted share in the second quarter 2016 as compared to the net loss of $3.4 million and $0.10 per basic and diluted share in the first quarter. Our goal for the third quarter is to be slightly profitable on an adjusted EBITDA basis excluding any expenses related to the potential merger. And as mentioned, actual results of the combined company will be different if the merger closes.

Now let's take a look at the balance sheet. Cash and short-term investments at June 30, 2016 decreased to $8.3 million from $9.3 million at March 31, 2016, largely due to the adjusted EBITDA loss and merger transaction expenses offset by a slight improvement in our networking capital balances. Accounts receivable increased to $26.5 million at June 30, 2016 from $24.8 million at March 31, 2016.

While the number of days sales outstanding on accounts receivable improves slightly to 106 days as compared to 108 days for the first quarter. DSOs have been elevated over the past few quarters, largely due to the patterns 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 $14.4 million as of June 30, 2016 as compared to $14.6 million as of March 31, 2016. And our total debt obligations associated with our Wells Fargo working capital facility remained at $2 million at June 30, 2016 and March 31, 2016. Net property and equipment increased to $4.4 million at June 30, 2016 from $2.2 million at March 31, 2016, largely due to the leasehold improvements made to relocate our Florida manufacturing and engineering facility. Lastly, the weighted average basic and diluted shares outstanding remained at $33.8 million for the second quarter of 2016.

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

Jim Norrod

Thank you, Kirk. The changes we made over the past two years are beginning 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.

As for our merger with DASAN Network Solutions, the combination will expand the product portfolios of both companies, and grow are substantial carrier and enterprise customer base. A complementary product portfolio and complementary customer base will lead to revenue growth. We will have a strong position as a leading provider in four key rare areas of; Broadband Access, mobile backhaul, Ethernet Switching and Passive Optical LAN. We will provide customers, both enterprise and service providers with the most and the best solutions 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 the acquisition and integration related charges, providing a stronger balance sheet with better liquidity.

Now I would like to open up the call to questions, so operator please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from Alan Davis [ph] with LA Davis. Your line is open.

Unidentified Analyst

Hi guys, just a couple of quick questions here. First off, I wonder on FiberLAN could you give us a little more granularity on that in terms of momentum first quarter to second quarter, any change in momentum in sales or in the pipeline?

Jim Norrod

Yes, Alan -- the momentum has continued to advance and grow. We got a couple of fairly large deals which we're very pleased to have gotten and the size of the deals were pretty substantial, so yes, the momentum is continuing and again our goal is to double again this year over last year, and I think we're right on-track to do that or beat it. So yes, I think momentum is continuing.

Unidentified Analyst

Okay, great. And just one on your service provider market and as you looked at the second half of the year, just trying to get a sense for your expectations here. As you look at kind of the three factors you mentioned; the stabilizing economic condition, new MXK platform, and then the connect America funding. If you do rank those in terms of importance to topline, or the effect of having a top line how would you do that?

Kirk Masala

I think the stabilizing environment's probably number one of that. I think we -- and that's kind of translating into some additional international opportunities, so the stabilization, we're really talking more international there than domestic. So I think that that, because of the stabilization, we're seeing some of the customers that we haven't seen business from for a year or so internationally are now starting to come forward and buy. And so I clearly put that as number one and then number two would be the MXK-F, followed by the connectivity, the third one.

Unidentified Analyst

Okay, okay. And then last thing here, if you guys -- if the deal does close in the third quarter, do you guys do a call to discuss it or just wait for the third quarter results call?

Kirk Masala

Alan, we haven't made a decision with regard to that. It really kind of depends on how close it is to the quarter end and whether we'll be reporting third quarter in any event.

Unidentified Analyst

Okay, fair enough. All right, thank you.

Kirk Masala

Thanks, Alan.

Operator

Thank you. And our next question comes from the line of Bill Morrison from National Securities.

William Morrison

Hi guys, just a couple of quick questions. First of all, do you see any RFPs or any trial activity on NG-PON2?

Kirk Masala

Yes, we are seeing some RSPs on NG-PON2. They are longer-term RFPs, but, yes, we are seeing some.

William Morrison

Okay, good. So when would you expect that to start to contribute?

Kirk Masala

Next year Bill, 2017.

William Morrison

Good. Also with DASAN, you're looking for immediately accretive so you must have done some work on a model. I mean, is it going to be accretive to the gross margin? What kind of model would we be looking at?

Jim Norrod

Bill, we have not provided any information to the markets and don't plan on doing that until a transaction is approved by shareholders. What we will do is, as soon as we have formulated an operating plan of the combined company, and it is approved, we will try to get that information out as soon as possible.

William Morrison

Okay, good. And then looking at DASAN's pipeline, how's that shaping up here domestically? Has there been any movement, any wins/losses, that kind of thing?

Jim Norrod

Domestic defined as U.S.?

William Morrison

Right here.

Jim Norrod

Well, you know, we haven't really disclosed any of that information yet, Bill. I know everyone on the phone's interested in getting more details on this, and we just haven't published any information on it specific to their pipeline or their customers. We just haven't disclosed it.

William Morrison

All right, great. Thanks.

Operator

Thank you. And that concludes our question-and-answer session for today. I would like to turn the conference back to Jim Norrod for any closing comments.

Jim Norrod

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

Operator

Thank you. That concludes today's conference. Thank you for your participation and you may now disconnect.

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