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Avanex Corporation (AVNX)
F4Q07 Earnings Call
September 4, 2007 4:30 pm ET

Executives

Maria Riley - Director of Communications
Jo Major - Chairman and President & CEO
Marla Sanchez - SVP and CFO

Analysts

John Harmon - Needham & Co.
Todd Koffman - Raymond James
Natarajan "Subu" Subrahmanyan - Sanders Morris Harris
Hamed Khorsand - BWS Financial
Jagjit Sahota - Wedge Partners

Presentation

Welcome to the Avanex Corporation fiscal fourth quarter and fiscal year 2007 financial results conference call. (Operator Instructions) With us on today's call are Jo Major, Chairman, President and CEO; and Marla Sanchez, Senior Vice President and CFO.

I would now like to turn the call over to Maria Riley. Ms. Riley, you may begin.

Maria Riley

Good afternoon and thank you for joining us today. I'd like to remind you that this call contains forward-looking statements about future events and future performance of the company. Forward-looking statements are subject to risks and uncertainties and actual results could differ materially from those projected or contemplated by the forward-looking statements. We encourage you to look at the company's most recent SEC filings, particularly in today's news release, Form 8-K and the risk factors section of our most recent Form 10-Q. Avanex assumes no obligation and does not intend to update any forward-looking statement, including guidance, as a result of new developments or otherwise.

In addition, because non-GAAP information is being presented on today's call and in order to comply with SEC regulations, please note that Avanex has provided a reconciliation table and other information attached in today's press release which can be found on the company's website at www.avanex.com.

I'd like to take this opportunity to inform you that the company will present at the Jefferies’ technology conference in New York City on October 1 and 2, 2007.

With that, I'll turn the call over to Jo Major, Chairman, President and CEO.

Jo Major

Thanks, Maria. Good afternoon everyone and thank you for joining us today. The key points of our discussion today will be: that at a revenue level of $51 million, Avanex is approximately at non- GAAP breakeven; that we believe our operating structure is sufficient to handle substantially higher levels of revenue; and, that we are now focused on investing in profitable growth.

To get to this point, the Avanex team has streamlined our operational infrastructure, resulting in a 67-point increase in our gross margins since the first quarter of fiscal 2004. We've grown our revenue without acquisitions by almost 300% over the same time period, transformed our development infrastructure into a cost effective 24/7 global team to provide great new products and strong technical support to our customers, and restructured our G&A functions to provide better oversight of the company as we move forward. Taken as a whole, the team has created a company poised for profitable growth in a large and growing marketplace. Prior to telling you about our next growth phase, I'd like to thank all of the members of the Avanex team that have worked so hard to transform this company and to lay such a solid foundation for future growth and prosperity.

Now we'll walk through some of the highlights of the quarter. Revenue for the quarter was toward the upper end of our guidance at $51 million. Revenue for fiscal 2007 was a record $213 million, up 31% over the previous year. Growth this year was driven by our integrated amplifier developed for next generation network deployments, dispersion compensation products and solid growth from our transmission products at both the module and component level. We are also very excited to achieve the gross margin goal we set three quarters ago. Our gross margin now stands at about 24%, an increase of approximately 20 points over the same quarter in the previous year.

The team achieved two milestones this quarter: first the company is now at breakeven on a non-GAAP basis. This is very exciting as we look forward to a return to revenue growth since approximately one-third of our product revenue flows through to the gross margin line. Second, net of the French divestiture payout we generated cash. We have succeeded in evolving our operating structure into a low cost, flexible model to give us a solid foundation for vigorous and profitable growth.

On the customer side, Alcatel Lucent and Tellabs were both greater than 10% of our revenue in the quarter, with other strong customers in the quarter including Cisco, Sienna and Huawei.

I'd like to move now to our investment and growth strategy for fiscal 2008. Our objective for 2008 is to leverage our market position and increase our investment levels in key areas to capitalize on new growth opportunities. We will intensely focus on expanding new technologies, products and design wins in critical growth areas. One of the steps we have taken in this new fiscal year has been to acquire the telecom piece of Essex Corporation, a division of Northrop Grumman, a teaming of a group of talented engineers and technology to meet our customer needs for 10 G and 40 G transmission gear. The Essex acquisition will reduce our time to market with several key products. More specifically, we currently have several tunable transponders in various stages of development. We are encouraged by the reception of our expanded product portfolio and the opportunities we see on the horizon with tier 1 customers. We expect to gradually ramp production of these transponders in the December quarter with volume production beginning in the March quarter. We will be announcing this product suite September 17 through 20 at ECOC in Berlin, Germany.

Our G-cup modulators are in full production with revenue projected to be in excess of $1 million in the December quarter. Market traction is increasing for our 1X4 ROADM solution. We are in system level qualification with a tier 1 customer and see several additional opportunities. Our WSS easily integrates with other technologies in the Avanex portfolio such as optical monitoring, tunable dispersion compensation and optical amplification. These differentiated combinations, which very few of our competitors can offer, are the foundation for integrated solutions of the future. We expect to begin generating significant revenue from this product line in early calendar 2008.

In summary, Avanex is approximately at breakeven with a stable infrastructure capable of translating future growth into healthy profitability. We are very proud of the progress we've made in 2007 and are committed to achieve our goal to be the leading telecom optical solution provider.

At this point I'll let Marla walk you through the details of our financials.

Marla Sanchez

Thank you, Jo. Our fourth quarter revenue was $51.1 million with revenue for the fiscal year being $212.8 million, up 31% from the $152.9 million of our previous year. The year-over-year growth was primarily driven by demand for modules and subsystems such as amplification, dispersion management and transponders. On the components side, we had quite significant modulator growth. For the quarter just ended, Alcatel Lucent and Tellabs represented 31% and 17% respectively of our total sales. We continue to maintain strong partnerships with these two customers. Other strong customers in the quarter included Cisco, Sienna , and Huawei. This strong customer base has remained stable year over year.

Geographically, revenue for our fiscal year in the Americas is 45% of total sales. Europe accounted for 40% and Asia Pacific for 15%. Our gross margin performance this quarter was 24% with gross margin for the entire fiscal year coming in at 18%, compared to 5% for the previous year. We expect to continue seeing benefits from programs we put in place several quarters ago; however, going forward these benefits will result in smaller incremental improvement to our gross margin. We expect our margins to remain roughly flat in the near term, but gradually trending up as new product families are introduced into our revenue stream.

Operating expenses for the fourth quarter, net of a one-time loss for the divestiture of our French subsidiary’s operating expenses were $14.9 million, or 29% of revenue. When operating expenses are adjusted to exclude stock-based compensation expense of $1.1 million, they represent 27% of revenue. We will continue reducing G & A expenses. We expect sales and marketing spending to remain relatively flat and we anticipate slightly increasing our investment in R&D as a result of our Essex acquisition. Overall, we continue driving to reduce total operating expenses as a percent relative to revenue.

Operating loss on a GAAP basis, which includes a loss on the divestiture of our French subsidiary, improved quarter over quarter by $0.7 million from $6.8 million loss to $6 million loss. After accounting for net interest and other income and expenses of $0.8 million and a provision for international taxes of $0.5 million, GAAP net loss of $5.7 million or a loss of $0.03 per diluted share.

On a non-GAAP basis, we had an operating profit of $49,000 marking a significant milestone for us. Non-GAAP financials exclude the loss on the divestiture, the operating expenses incurred for our French subsidiary until the transaction closed, stock-based compensation expense, restructuring, and amortization.

Another milestone for the company was the generation of cash. $24.9 million was paid for the divestiture of our French subsidiary and for the operating expenses incurred in the fourth quarter until the transaction closed. If you net this amount against our cash position change of $19.7 million quarter over quarter, the company generated $5.2 million of cash. In the near term, cash generation by operations will be offset by spending on the Essex acquisition and capital investment for new products. As Jo mentioned, we acquired Essex in the first quarter of 2008 for $2 million in cash. We expect modest revenue from this investment in the December quarter with the acquisition to become accretive in the March and June quarter.

This quarter saw the achievement of two significant milestones by the company: non-GAAP breakeven profitability and operational cash generation. As Jo mentioned, we are very proud of the team’s accomplishments and excited about the opportunities that lie ahead of us. With that, I will turn it back to Jo who will discuss our outlook and guidance.

Jo Major

Thanks, Marla. We see the market returning to growth in the second half of calendar 2008, led by increasing strength in Asia and robust bookings in North America. For the first fiscal quarter of 2008, we are forecasting revenue to be in the range of $52 million to $55 million with gross margin approximately flat.

With that, we now welcome your questions and we'll turn the call back over to the operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Harmon - Needham & Co.

John Harmon - Needham & Co.

Congratulations on hitting breakeven. A couple questions. First of all, I was wondering which product you're targeting for growth in Fiscal ‘08? You talked about transponders and amplifiers. I wonder if you're expecting high growth in any other products?

Jo Major

Sure. We see our modulator group has done a great job in growing and is continuing to grow. We see some really nice opportunities for amplifiers, so those are product lines that you know pretty well. If you look at new products that we've announced that we're seeing pretty exciting opportunities for, you need to look to our ROADM which we think kicks in, in the second half. You also need to look at tunable dispersion compensation. We didn't mention that on this call, but that's another real exciting play. And then some of the higher performance transmission products at the module level will be kicking in a little bit in December and then more in March and June.

John Harmon - Needham & Co.

Okay, thank you. Secondly, what kind of revenue expectations do you have with the acquisition you made in fiscal ’08?

Jo S. Major

We haven’t broken that out in any detail to the public. What we said on the call, and I think Marla detailed it pretty nicely, was that we see very modest revenue in December and then we start to see it pick up in the March and June quarters. Is there any --

John Harmon - Needham & Co.

Okay, thank you and just finally, what is behind your expectation of flat revenues? It must be product mix. What are you expecting a higher mix of?

Jo S. Major

What, revenue or gross margin, John?

John Harmon - Needham & Co.

I’m sorry, gross margin, excuse me.

Marla Sanchez

Well, we’re in the -- we had been saying we would be in the 20% to 25% range. We are 24% range now. We will end up considering that a lot of the programs that we’ve had, we’ve taken a lot of a -- we will see incremental changes in that going up. We will also end up seeing similar margins over time, not in the short run but over time we do expect them to end up increasing with new product families that we’ve been growing.

John Harmon - Needham & Co.

Okay, thank you very much.

Operator

Your next question comes from the line of Todd Koffman with Raymond James. Sir, your line is open.

Todd Koffman - Raymond James

Thanks very much. Congratulations on hitting effectively break-even results. On the gross margin outlook, you’ve done a lot of the hard work getting into the 20% to 25% range, getting rid of France, et cetera. You are guiding sequentially flat. What is left over the next I don’t know, two to six quarters to get the margins so that you can actually get potentially a reasonably attractive return operating the business now?

Marla Sanchez

I think some of the things that we have is we’ve talked about the programs that we put in place about a year ago. Some of those programs will continue generating improvement and particularly the ones that have to do with a lot of our vendor pricing and improving some of our yields and some of the capacity improvements that we’ve had in place. Those will continue being incrementally additive as we keep seeing the benefits of those.

We also have talked about the programs that we have in place with our new product introduction where we talked about the hurdle rates that we’ve got, where we don’t end up releasing the funds for new product development on the R&D side unless we have a market case that actually shows that there’s a significant enough market size and that we can end up making a gross profit margin that is actually beneficial to us. So in most cases, there will always be a few exceptions to that for strategic placement but we are looking at really seeing the improvement from some of those programs in place. We’ve been much more diligent about that and will continue.

We have design reviews weekly where we go over the development of these projects and we actually have internal reviews even before the funds are released. We make sure that we are comfortable with the business case for these projects.

A lot of these programs will end up improving our gross profit margin over time. I’m just really saying that I don’t think we are going to see the huge jumps in gross margin improvement as we saw in the last year. We went from 4% a year ago in the fourth quarter a year ago to a 24% now -- a 20% improvement. That’s still a pretty big improvement. We’re not going to see that kind of a growth in the next few quarters.

Jo S. Major

A couple of points, Todd. One of them is we are getting our product line shaped up and the flow through that we get on incremental revenue is pretty attractive right now, so one thing that is natural is if we control the cost structure of the company as we grow the company, that is a nice effect that you will see starting to come in to the gross margin line. And again, we have grown the company pretty fast, so that’s a pretty exciting thing that a good structure of the company and good flow through gives you.

Marla did touch on the new products. The last place is we have -- we are very judicious about where we vertically integrate but vertical integration done right can really drive gross margin performance, so if you look at the modulator that we have feeding into a nice transmission module, that’s a place where we have vertical integration. Our ROADM is all internal, so all of the internal componentry there is another place where we see vertical margin. Tunable dispersion compensation is another place where the core componentry itself, we’ve decided that’s really key and can generate a lot of margin.

So making sure you have the right underlying componentry can also fit you in to some margin dollars.

Todd Koffman - Raymond James

Separate and apart from that, just a bigger question on the industry as it relates to the systems vendors. How do you think, if you look out through 2008, Sienna was saying that they think their business could grow 20% in the going forward fiscal, 12-month looking forward period and they said at 20%, they think that they’d probably be growing than the industry at large. What is your view on the overall industry as it relates to the systems vendors?

Jo S. Major

It’s kind of funny. Sienna’s comments were actually pretty bullish and they said that there was -- I can’t remember. The guy used a really interesting phrase to describe it, but he basically said look, there’s lots of opportunities and we can be judicious about this and grow good business as we go forward.

In some sense, we’ve got a lot of opportunities that we are chasing and we are very, very bullish about the opportunities and the [inaudible] we can go after and we are feeling more and more compelled that solid execution can really give us excellent growth over the next calendar year, or the next year that we are looking at here.

If we look at the system vendors themselves, it gets a little bit more difficult to forecast for them because some of them are growing a lot faster than others. Currently we see a lot of demand from our North American customers and we are starting to see Asia really take off. We are seeing a little bit less coming out of Europe, if that helps give you a little context.

Todd Koffman - Raymond James

Yeah, and then just a last question as it relates to then the other component and sub-system vendors out there, there still seems to be a lot and JDSU made an interesting comment. They said that the industry can’t consolidate because there are significant barriers to exit. I’d never actually heard a characterization like that. What’s your thoughts on those types of comments and the smaller players at your level?

Jo S. Major

I guess I hadn’t heard barrier to exit. Again, we think that the industry does have too many competitors. We think that a combination of having a good solid sort of consolidation strategy, coupled with a good solid intellectual property strategy and really great execution can go an awful long ways to help gradually clean up the industry.

I guess -- I don’t know. Did you hear Kevin talk to that, Marla?

Marla Sanchez

No, I missed that. It is an interesting phrase. I mean, I think one of the things we have talked about is in terms of putting together the right combinations and making sure combinations actually end up being accretive when you do so. I don’t know if that’s what he was referring to or not.

Todd Koffman - Raymond James

Thank you very much. Good luck and congratulations on effectively operating break-even.

Operator

Your next question comes from the line of Subu Subrahmanyan. Sir, your line is open.

Natarajan "Subu" Subrahmanyan - Sanders Morris Harris

Thank you. I wanted to ask a little bit more of a long-term question, Jo. First, on fiscal 2008, obviously after a strong period in calendar ’06, is a slightly slower start to the first half of calendar ’07 and then coming back. When you look at fiscal ’08, you see kind of breaking out of this $50 million to $55 million band and kind of getting to more of like a $60 million plus kind of quarter level. What are the things that need to happen? Are the end market drivers in place and are any of the inventory issues that have been blamed for some of the slow down in the first half past us in your opinion?

And then on longer term operating margin goals, if you could update us on your longer term operating margin goals and the timeframes you think those are achievable.

Jo S. Major

Sure. We can start with the last question first. That’s the most straightforward. Our, and I don’t know that it’s long-term, because long-term, we’d like margins to push higher than this but we’ve said that we think 35% is a good intermediate goal for this company. We first introduced that probably six months ago and said we’d do that in something like 18 months, so you are probably looking at the timeframe being about a year for us to do that.

We’ve made a lot of progress along the way and that’s our longer term margin objective.

Let’s see, I can’t -- yes, that’s the gross margin objectives.

Marla Sanchez

With a 25% op-ex is what we are trying to get to, so that we can get to an operating profit of about 10%.

Jo S. Major

Turning to the growth question for 2008, I think the company feels like, or we feel as the management team in the company that there are a lot of really good growth opportunities for us, and we’ve kind of walked you through those.

When you talk about breaking out of the $50 million to $55 million revenue range, there’s nothing really mystical about that to us. That’s some good solid demand from our customers, good execution on our team and we’ll push right past those numbers. We haven’t given you guidance that’s multi-quarter but certainly the company has a track record of pretty strong revenue growth and $50 million to $55 million isn’t a magic place for us.

Given the demand that we think we are going to see in the future and given the product sets that we have in place, we are certainly planning on going a lot higher than that in revenue.

Natarajan "Subu" Subrahmanyan - Sanders Morris Harris

And in the past, I know you’ve talked about timing the deployment for some carriers and some of your competitors have talked about lean initiatives from customers and issues like that impacting revenues. More recently we’ve heard of those tailing off. Your perspective -- are we past those issues and now the end market demand the customers face will pull through demand for components?

Jo S. Major

Two of our customers very publicly see Cisco and Nortel, both launched public lean programs that pulled revenue back. Obviously they are bleeding through, or bleeding their revenue down, so as demand comes back you’ll see more of that going directly into their suppliers.

In general, I think the industry did have a bit of an inventory correction. Maybe they got a little bit ahead of themselves on the purchasing side in 2006. The demand that we have right now really is driven by deployment needs. We’re on that phone with customers a lot talking about what products they need to get their next shipments up and going, what can we do to make those shipments happen for them, and there’s a real sense of urgency about getting the products in their hands so that they can meet their corporate objectives. And that feels a lot different than the situation where you are buying or the customers are buying and they have a lot of inventory on the shelf.

Natarajan "Subu" Subrahmanyan - Sanders Morris Harris

Got it. Thank you so much.

Operator

Your next question comes from the line of Hamed Khorsand with BWS Financial. Sir, your line is open.

Hamed Khorsand - BWS Financial

Good afternoon. Great quarter. My question was regarding E&O charge during the quarter; what was that figure?

Marla Sanchez

For E&O this quarter, we ended up having a charge of $2.4 million. That compared to about $2.7 million in the prior quarter, and $8 million in the quarter a year ago.

Hamed Khorsand - BWS Financial

Okay, and the headcount for the quarter?

Marla Sanchez

The headcount for the quarter, total headcount was 539. Do you want that broken down by site or by functional area or --

Hamed Khorsand - BWS Financial

By geographic is fine.

Marla Sanchez

Geographic, we had 156 in the U.S., 21 in France, 123 in Italy, 178 in Thailand, and 61 in China.

Hamed Khorsand - BWS Financial

Are those French employees still going to be with the firm?

Marla Sanchez

We have about 20, 21 people in the French that are actually an R&D group. When we divested the French subsidiary, we divested product lines and the people associated with those product lines. There were some product lines that we wanted to keep for strategic reasons and those are the R&D people that are associated with those product lines. They are actually in a site outside of where we used to be. We moved from the site we were at and they are in a brand new location.

Hamed Khorsand - BWS Financial

Okay. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Jagjit Sahota with Wedge Partners. Sir, your line is open.

Jagjit Sahota - Wedge Partners

I had a quick question; you guys briefly mentioned the ROADM and being at the tier one system and -- can you just go into a little bit more detail in terms of what the opportunity is for the ROADMs and what kind of configuration and the timing on that please?

Jo S. Major

Sure. As a lot of you on the call know, the ROADM market is pretty fragmented so we will give you a little bit more information about what our configuration is and what opportunities we see.

First of all, our configuration is, it’s a WSS. It is liquid crystal based, primarily focused at really hitting attractive performance but very, very low cost.

The other configurations out there, which we would evolve to after getting the one-by-four slots that we are looking at, could include things like one-by-nines or one-by-twos. But currently we are really focused on taking the one-by-four and getting several slots that we see.

When we are talking about revenue opportunities for things, we haven’t really spoken about that at great length but certainly most of the opportunities that we have, we see them as being sort of multiple millions of dollars per quarter if we were able to successfully execute and get a nice share, so that gives you sort of a framework for how big they are.

To give you a feeling for where the program is now, the program has shipped fully specification compliant parts into a tier one system house and they will put those on their system testing and go through certification of those parts. That’s a very serious step for them. It takes a long time, it takes a lot of engineering investment. If we get through that successfully, we will have achieved essentially our first design win for that product and head on into production.

As we head into -- about the same time that we head into certification testing, it allows our R&D team to go suit up and go get their next opportunity, so it is really exciting for the team to be where we are and looking at the new opportunities.

Again, we are a one-by-four player. We also have the ability to expand down to lower cross ROADMs at the one-by-two configuration or into higher port count WSSs, like one-by-eights or one-by-nines, but our first product is a one-by-four.

Jagjit Sahota - Wedge Partners

Is that like a six month kind of window where if you could see the first revenues out of this?

Jo S. Major

We said that we, presuming that the certification program goes well, we would see revenue starting in the March quarter, early 2008, to be more specific.

Jagjit Sahota - Wedge Partners

And is that, last question, is that a U.S.-based OEM or an international -- any color on that?

Jo S. Major

We haven’t provided anymore information on that but the places where we see ROADM deployment being strongest right now is really in Japan and in North America, and we think that we will see places like China and Europe following closely after them.

Jagjit Sahota - Wedge Partners

Thank you.

Operator

And there are no further questions. At this time, I would like to thank everyone for attending Avanex Corporation’s fiscal fourth quarter and fiscal year 2007 financial results conference call. You may now disconnect.

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