Allot Communications' (ALLT) CEO Andrei Elefant on Q2 2016 Results - Earnings Call Transcript

| About: Allot Communications (ALLT)

Allot Communications Ltd. (NASDAQ:ALLT)

Q2 2016 Earnings Conference Call

August 2, 2016 8:30 AM ET

Executives

Gavriel Frohwein - Director of Corporate Communications

Andrei Elefant - President and Chief Executive Officer

Shmuel Arvatz - Chief Financial Officer

Analysts

Timur Ivannikov - Jefferies

George Iwanyc - Oppenheimer

Joseph Wolf - Barclays

Alex Henderson - Needham

Operator

Good day and welcome to the Q2 2016 Allot Communications Limited Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Gavriel Frohwein. Please go ahead sir.

Gavriel Frohwein

Thank you very much and thank you all of you for joining us on our second quarter 2016 conference call. My name is Gavriel Frohwein, and joining me today are Allot’s President and CEO, Andrei Elefant, as well as our Chief Financial Officer, Shmuel Arvatz. The press release announcing our second quarter results is available on the Investor Relations section of our website at www.allot.com.

All results and expectations we review on the call are on a non-GAAP basis, unless otherwise described as GAAP. Non-GAAP net income defined as GAAP net income after including deferred revenues related to the fair value adjustment resulting from our purchase accounting and excluding stock-based compensation expenses, amortization of our provision related to intangible assets, deferred tax assets update and acquisition-related expenses. Please note that all earnings per share amounts are on a fully diluted basis. A reconciliation of each non-GAAP measure to its nearest GAAP equivalent is available in the press release containing our second quarter results.

Before we begin, let me remind you that certain statements made during the call today may be considered forward-looking statements, which reflect management’s best judgment based on currently available information. I refer specifically to the discussion of our expectations and beliefs regarding our pipeline and final potential future business. Our actual results may differ materially from those projected in these forward-looking statements. Certain material factors or assumptions are also applied in drawing the conclusion or making the forecast or projections as reflected in such forward-looking information. I direct your attention to the Risk Factors contained in the Annual Report on Form 20-F filed by Allot with the United States Securities and Exchange Commission and those referenced in today’s press release, most of which detail factors which could cause our actual results to be materially different from those projected in the forward-looking statements.

With that, I will now like to turn the call on to Andrei. Andrei?

Andrei Elefant

Thank you, Gavriel, and thank you all for joining us today. In today’s call, I will highlight Allot’s results and share with you some of the achievements for the second quarter of 2016. After my summary, I will hand over the call to our CFO, Shmuel Arvatz for a review of our financial performance for the quarter.

Q2 financial performance was below expectations on the top-line with the bottom-line above expectations. Though the top-line is not where we would like it to be, improvements in the bottom-line reflects the cost-efficiency measures that we instituted since the beginning of the year.

Going into Q3 and Q4, we will see the results of the reorganization and additional efficiency measures we began implementing at the beginning of this quarter to further improve profitability. I will discuss this in greater details a bit later.

Before drilling down into the quarter, I would like to review with you our ongoing strategy and plan which remains on track got with confidence based on the traction we are seeing.

We continue to execute on our long-term plan leveraging our growth engines, security and monetization, which continues to be fascinated by our customers as a highly valued service.

Inline with our strategy, I am proud to report that we signed a strategic partnership agreement with Intel McAfee, a leading security endpoint player to provide a comprehensive security offering to the consumer and small business markets. This solution is called McAfee Unified Security powered by Allot and would be marketed by both companies.

With this collaboration, we would be able to leverage faster on the market opportunity and it also validates the significant value that Allot provides as a player in the security as a service domain protecting users anywhere anytime.

We also recently announced that e are continuing to expand our security as a service used by CSPs and have already surpassed the 15 million subscriber milestone. This represents a growth rate of 50% in less than six months.

Another important customer win that we announced this quarter is VOO, a European broadband cable service provider, which deploys our Service Gateway Tera, with our DDoS solutions to service protector and CMTS congestion management solution.

As part of our engagement with VOO, they shared with us a challenge to protect the network against DDoS effect, which was negatively impacted the user experience and their customers.

Once the service protection sensor was activated, we will saw that network often sustains 20 to 40 cyber attacks per day with volumes reaching 60 gigabits per second per attack and completely saturating network resources.

Using the service protector to mitigate the effects, we have freed up bandwidth and more importantly they have eliminated service outages. Today, recent alerts notify VOO when the threat is affected and when it has been mitigated.

Now for the quarter’s results. Revenues for the second quarter of 2016 came in at $23 million at 6% year-over-year and flat on a sequential basis. As I mentioned, top-line this time was below expectations, however we were profitable with net income reaching $0.4 million.

The backlog is greater than last year with book-to-bill for the last 12 months above one, the book-to-bill for the quarter was below one. It is important to remember that we are dependent on large projects.

Now yearly planning we expected a number of large orders from two specific agent customers to land in mid-year. It now appears that these projects will be postponed to next year.

Based on the backlog, the specific large orders and the general business environment, we have updated our revenue guidance for 2016 and expect it now to be in the range of $90 million to $94 million.

Since we have been executing on our strategy to streamline expenses, even though we are lowering our guidance, we expect minimal impact on the bottom-line. As I mentioned earlier, and inline with our strategy, we went through a reorganization and implemented additional efficiency measures this quarter to further improve profitability.

We consolidated various units, specifically in R&D increasing the ability to focus on security and monetization, our growth engine and to leverage synergies on the infrastructure.

On the sales side, we identified and reduced expenses in regions that were not profitable. We also made specific regions to take better advantage of local resources.

These changes might slightly impact our top-line revenue level, but will contribute to increasing profitability. In addition, as our growth engine becomes a more significant portion of our overall business, we will see greater leverage. So stressing what we have done into numbers, we expect to achieve an OpEx of $15 million to $16 million runrate by year end.

This new OpEx level to seek in fully by Q4 though we will see a one-time restructuring fee in Q3. Shmuel will go into further details in a few moments. Looking at the P&L, gross margin improved and came in at 73% bringing it back from 70% last quarter. Operating income was $0.8 million and net income was $0.4 million on a non-GAAP basis.

Cash receipts at the end of the quarter totaled $116.6 million with negative cash flow of $1.2 million from operations. In the value-added services business, value-added services were 27% of bookings during Q2 with security representing about 50% of the total VAS and increasing year-over-year.

In dollar value, for the first half of the year, we grew security VAS by 39% year-over-year. Based on our product booking classification breakdown, security bookings for the quarter were about 30% of total product bookings.

As security represents our target growth opportunity, we continue to invest in this segment both in R&D and sales leveraging up our core technology and enhancing our offering.

Large deals reached 14 in total, eight of which came from mobile operators, five from fixed line service providers and one from cloud operator.

Before summing up, I will turn the call over to Shmuel for a review of our financial results. Shmuel, please.

Shmuel Arvatz

Thank you, Andrei. As Andrei mentioned, revenue came in below our expectation. However, we are happy with the fact that we generated operating and net income on a non-GAAP basis which is, as a result of the cost reduction measures that were implemented in the past quarters, better aligning our cost base with our top-line level, I will elaborate on this later in my script.

Before I begin reviewing the financial results for this quarter, I would like to inform everyone that on this call, unless otherwise noted, I will refer entirely to the non-GAAP financial measures when discussing operational results which is what we use internally to judge the performance of our business.

Non-GAAP financial measures differ in certain respects from the Generally Accepted Accounting Principles and excludes share-based compensation expenses, revenue adjustment due to acquisitions, expenses related to M&A activity, amortization of certain intangible assets and changes in deferred tax.

Turning to our second quarter results. Revenue for the quarter was $23 million, up 6% year-over-year in the same level as in the previous quarter. The geographic breakdown of revenues was as follows: Americas, $4.4 million or 19% of revenues, EMEA $10.4 million or 46% of revenues and Asia-Pacific with $8.2 million or 35% of revenues.

Product revenues for the quarter accounted for 61% of revenues, while service revenues were 39%. This is compared to 56% and 44% split in the second quarter of 2015. The higher percentage of product revenue this quarter was as a result of recognition of revenues from a large project that was booked last year.

Book-to-bill ratio in the quarter was below one. During the quarter, we had two customers with booking greater than $1 million.

Moving on, gross margin for the quarter was 73% of revenues, down 1% compared to the second quarter of last year and up 3% sequentially. Gross margin can fluctuate on a quarterly basis, however, this is inline with our expectation to improve the gross margin from the level of Q1 2016.

Operating expenses for the quarter were $16 million, down 15% year-over-year and down 12% sequentially. The sequential reduction in operating expenses was mostly due to low labor and related costs resulting from cost reduction measure implemented since the beginning of the year as well as lower sales and marketing expenses.

As Andrei mentioned, at the beginning of Q3 2016, we implemented a reorganization plan which included among other measures an additional reduction in our headcount. These measures are aimed at streamlining our operations and alignment of our cost base with our top-line in order to improve profitability.

In Q3 2016, we expect to record approximately $1 million in one-time restructuring cost representing mostly severance and other employee-related costs. We expect our OpEx to continue to decrease throughout the remainder of the year.

Operating income for the quarter was $785,000 or 3% of revenues, compared to operating loss of $3 million in the second quarter of 2015. Net income for the quarter was $431,000 or $0.01 per diluted share compared to net loss of $3 million or $0.09 per diluted share in the same quarter last year.

Turning to the balance sheet, our cash reserves comprise of cash, cash equivalents and investments total $116.6 million, down $4.1 million compared to the previous quarter. During the quarter, we recorded negative operating cash flow of $1.2 million. DSO was 92 days up one day from the previous quarter.

We continue to execute on our buyback program. During the second quarter, we acquired approximately 466,000 shares for a total of $2.3 million. In total, we have bought back $3.5 million in shares. We plan to continue with the $15 million buyback program inline with our initial plan.

To conclude, while 2016 is shaping up to be a weaker year for us, we have taken steps which we believe position us well in the coming years. We have realigned our business to focus on the security and monetization growth engine. Our expenses level in the second half of the year and going into next year is significantly below that of last year.

All these steps we believe will enable us to profit from the traction we expect to see from our growth engines over the coming years.

With that, I will turn the call back to Andrei.

Andrei Elefant

Thank you, Shmuel. To wrap up, regarding guidance, we updated our guidance based on visibility going forward and remain confident in our ability to improve efficiencies which should positively impact our bottom-line. We have implemented the wide ranging reorganization of our business both in R&D and in sales.

We believe these changes will go long way for us in streamlining operations and enabling us to improve execution of our strategy. And lastly, the partnership we announced today leverages our market opportunity and positions us as a significant player in the security service domain.

With that, I will open the call for Q&A. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We will now take our first question from James Kisner of Jefferies. Please go ahead.

Timur Ivannikov

Hi, this is Timur Ivannikov asking for James Kisner today. So the first question we have is regarding the APAC customer orders push out. So were you giving any reason for the delay of orders? Was it the same reasons for each customer and can you talk about the kinds of applications that were associated with those orders and why you think they will come back next year?

Andrei Elefant

Each case, - James, each case of these two customers is a little bit different. One of them has originally was supposed to allocate by this for this year, Eventually, this budget was not allocated to this project and it was decided that the budget will be allocated for next year.

So we expect to continue to get orders from this customer, but not this year, probably we will get the large order we expected sometime next year. We will know better by the end of the year.

The other big order is a project we are working on. This is a new customer. We are positioned there and they expected to initiate the project at the middle of this year. Now it seems that the project was postponed towards the end of the year. So, we believe that either will get the order around end of the year or beginning of next year.

Overall, this is a typical situation that we see today in the market that operators sometimes postpone their projects or projects may shift from quarter-to-quarter and on the other hand, we do see that these projects will continue to happen as we continue to work with both customers. So we do expect to get the orders, but in a different timeframe.

Timur Ivannikov

And what about the types of applications those orders were for?

Andrei Elefant

Again, two different cases. One of them is focusing on visibility and DDoS protection and this should have been an expansion to an existing deployment that we had. This is a customer that we have for few years.

Typically, they place large orders, almost every year and we were supposed to – together another expansion that was postponed to next year. This is visibility and the DDoS protection. The other project is on traffic management and with some additions to security capabilities and this is the used case for the new customer.

Timur Ivannikov

All right. Thanks, and then, I’ll ask one more question. And then, so the – your guidance, now it implies another year of revenue decline and so should we be thinking of this Allot’s business to declining – secular decline.

So, I don’t know if you can give us any indication for 2017 should we be modeling revenues flat declining. Any thoughts will be appreciated or any theories as to why revenue has been declining? Thank you.

Andrei Elefant

Regarding 2017, I think it’s too early now to give guidance for 2017. However, as we said in previous calls, we are focusing our efforts on our areas where we see the growth opportunities which is a security monetization that, as I said in my script are growing. We do see the decline in some other areas, mainly on the optimization areas.

I believe that the growth on the security and going forward, the growth in the security monetization will compensate. However saying exactly when it will balance. It’s too early to say. We see a healthy pipeline and believe that we will be back to growth in 2017, but it’s too early to give very accurate guidelines for next year.

Timur Ivannikov

All right. Thanks, Andrei. I’ll let other people ask. Thanks.

Andrei Elefant

Thank you, James.

Operator

Thank you. We will now take our next question from George Iwanyc. Please go ahead sir.

George Iwanyc

Thank you for taking my questions. So, just following up on the regional question or the regional comments, can you give us some color on the weakness that you are seeing in the Americas as well? And then what gives you confidence that Europe will hold up in a stronger position like it has been?

Andrei Elefant

So, as we said, the weaker regions were Americas and APAC on our booking side and we do see a stable business from Europe. We believe that in the Americas, we believe that we will be able to grow our business with our security offering.

We also signed today, as I mentioned an important partnership with Intel McAfee that are very strong in the region and we believe that we thought security offering will be able to expand our business in the Americas.

Regarding APAC, I would say that this is a temporary issue related to a specific project and I believe that we will be able to recover in APAC on the longer-term. We do see the opportunities there. We have won some significant customers last year. So, I believe that we will be able to recover in APAC.

George Iwanyc

And expanding on the opportunity with Intel, how long do you think it would take for that partnership to start to contribute to the top-line?

Andrei Elefant

I believe that we will see this partnership starting contributing at 2017. We already going together to customers. So we already started the process, but the process with the carriers takes typically six to nine months to materialize. So I believe that more significant business will be there in 2017.

George Iwanyc

And is that primarily an Americas-driven opportunity? Or is there opportunities outside of the Americas as well?

Andrei Elefant

It’s global. The partnership is a global one and we are working with all the teams globally. But for us, it’s a good opportunity to increase the potential that we are seeing in Americas, mainly North America and we are confident that this partnership will yield results and improve our Americas operations.

George Iwanyc

Okay and now one last area. Security has been about 30% product bookings for the last couple of quarters. When do you expect that to start tick up? And can you give us some color on the good security as a service traction that you are seeing?

Andrei Elefant

So security on the product analysis in this quarter was 30%, previous quarter to remind you, it was 48%. So we will see improvement versus last year. This quarter was less than what we saw in the first quarter. But overall, we do see that security is taking bigger part of our business.

We believe that with the security as a service, we identified an important market opportunity or significant market opportunity. We see also some strategic players that are also looking in this space and this is how the partnership with Intel McAfee formed up.

We believe that with this partnership and also by our standalone operation, we will be able to penetrate into new customers with this service. Again, with – in the telco market, the processes may take six to nine months to materialize. But we do see the interest from our customers.

George Iwanyc

Thank you.

Andrei Elefant

Thank you, George.

Operator

Thank you. Our next question comes from Joseph Wolf of Barclays. Please go ahead.

Joseph Wolf

Thank you. Just couple of questions that I think are related to questions that were just asked. But if I think about the peak revenues and where the revenue runrate is right now, can you give us just an update on what you think the natural growth rate is for the businesses that you are investing in? I don’t expect you to get back to $117 million any time soon, but I am just wondering how you are thinking about natural growth rates?

Andrei Elefant

We believe that security has a potential to grow 15% to 20% year-over-year. We saw even greater increase as I said in the script of 39% increase. This is – I think 20% to 30% increase on the security side. It’s something that we should see going forward. But it will take time until it will become the majority part of our business and by then, I think it will start contributing more significantly to our top-line.

Joseph Wolf

Okay. As I look at the OpEx levels right now, you talked about – or have you done the – I don’t know – I don’t want to call it the easy part, but if you look at the amount of dollars that have to be spent to remain competitive in an area like security, and you talk about the target of $15 million to $16 million in OpEx by the end of the year, where does that comes from on a percentage basis going forward? Does the G&A come down further? Where there is a little bit more flexibility that doesn’t influence the long-term opportunity for the company?

Andrei Elefant

All the savings that we did are coming from areas that we have – that are not part of the growth engine. So we haven’t touched the security product lines. We haven’t increased the investments there and we are investing also in monetization and on the sales cycle, we reduced investments in areas that were not producing.

So these are the areas where we did the cuts. We believe that with some – with the partnership that I mentioned and other ways to address the markets, we will have a greater return on the investment and therefore we decided to reduce investments in areas that were not producing for a long time. This is on the sales side.

Joseph Wolf

Okay. And then just finally on the Intel, McAfee opportunity, is you are going to sell that through the service providers and they are going to offer a package to customers? Is that sort of an add-on package? What’s the pricing mechanism? How are you splitting that? What is their - Intel investment there and what kind of agreement do you have going forward?

Andrei Elefant

Okay, so from what I can share with you, the agreement is about subscription that when we are selling it to our customers, we are sharing the revenues with the CSPs and then we have a split between McAfee and Allot in different ratios depend on the scenario. But in general, the project or the modeling should be a subscription type of arrangement.

Joseph Wolf

Okay. So it will be user acceptance?

Andrei Elefant

It was based on the number of subscribers that are registering to the service and each one of the parties can lead the project. So it might – in some cases, we might lead the selling, in some cases, it will be led by their sales team and then there is a different splitting for each scenario and again, this is in a subscription model type of business.

Joseph Wolf

So those sales cycles right now is getting approved and certified to become a option on a Verizon, Sprint, or AT&T network?

Andrei Elefant

Yes, the solution leverage is the network-based security that we deliver. Together we see endpoint security that is being delivered by Intel McAfee and power of integrating the two is the ability to get faster acquisition of new subscribers into the service.

Joseph Wolf

Okay, thank you.

Operator

[Operator Instructions] Our next question comes from Alex Henderson of Needham. Please go ahead.

Alex Henderson

Thanks. Could you give us the year ending headcount?

Andrei Elefant

Yes, so, about the end of Q2, we had slightly above 500 and towards the end of the year, following the reduction in headcount, we aim at about 450.

Alex Henderson

I see, that’s – that was my second question, thanks. Can you just give us the security as a service percent VAS again? And what the percent of VAS was in the quarter?

Andrei Elefant

So, as I mentioned in the script, the VAS was 27%, 50% out of that was the security licenses.

Alex Henderson

Okay, so, the VAS number is down quite a bit sequentially. What caused that?

Andrei Elefant

It depends on the type of VAS you are looking at. On the security side there, we actually went up and if you look at the breakdown, there are some other VAS that in this quarter were not producing as they were producing last year. But as I mentioned in the script, the security VAS has increased both in this – in Q2 and in Q1 and if I combine Q1 and Q2, compared to last year, we increased by 39%.

Alex Henderson

Right, but your security VAS 50% to 27% has got a long way to go to offsetting the declines in the 75% of your business that’s not VAS. I assume that the predominant piece of your business is the optimization that’s reflected in non-VAS.

How rapidly do you expect the optimization segment to rollover? Is that other 75% is coming down at, say, 5% a year, is that enough – is that what we should be looking at in terms of the rates of decline or is it steeper than that?

Andrei Elefant

Yes.

Alex Henderson

Obviously, two pieces to this, is what’s growing and there is what’s declining?

Andrei Elefant

Yes. So I wouldn’t take from one quarter and we mentioned that also in previous call that one quarter of VAS does not represent a trend. Just to remind you Q4 was – in terms of 50% value-added services, so, and it’s increased quarter-after-quarter over the last year. We had in some value-added services a decline at the beginning of the year.

In general to answer the question, we do see a decline on the optimization part. And as I mentioned, we believe that towards the end of the year of 2017, we will – I believe that we will be able to see that security compensate – full compensates for the decline of the optimization part.

Alex Henderson

So, could you just give a sense what do you think the rate of decline in the optimization part is? Is it in the 5% to 10% range or is it less than that?

Andrei Elefant

Yes, I would assume something in that area, yes.

Alex Henderson

That’s helpful. Thank you. A question on the tax rate, obviously, you are kind of bouncing around near breakeven here. I was a little surprised to how large the tax line was in the quarter. Should we be using 200 to 300 per quarter assuming near breakeven numbers?

Andrei Elefant

Yes, more towards 200. 200 to 300, that’s correct.

Alex Henderson

Okay, and just going out to the gross margin line, you did recover from the 70% in the quarter, but it’s obviously down from 75% last year. Are we expecting the margin on the VAS segment and specifically the securities service deliverables to be able to sustain that 73% level or is the trajectory still a modest downward trajectory on the margins?

Andrei Elefant

Based on the current top-line – reduced top-line, I would now expect lower than last year, 72%, 73%, this is the range that we are now expecting.

Alex Henderson

Is that a reasonable range to project out into 2017 or is the trajectory downwards – slightly downward slope because of the mix?

Andrei Elefant

No. This is the range.

Alex Henderson

Okay, thanks. Great, that’s very helpful. Thank you. Okay I’ll see the form.

Andrei Elefant

Thank you, Alex.

Operator

Thank you ladies and gentlemen. [Operator Instructions] As there are no further questions asked this time, I would now like to turn the call back over to the speakers. Thank you.

Andrei Elefant

Thank you all for joining us today. Thank you very much.

Operator

Thank you. That will conclude today's conference call. Thank you for your participation, ladies and gentlemen, you may now disconnect.

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