Avanex F1Q08 (Qtr End 9/30/07) Earnings Call Transcript

Avanex Corporation (AVNX)

F1Q08 Earnings Call

November 1, 2007 4:30 pm ET

Executives

Maria Riley – Investor Relations

Jo Major - President, Chairman and Chief Executive Officer

Marla Sanchez – Senior Vice President and Chief Financial Officer

Analysts

John Harmon - Needham & Company

Subu Subrahmanyan - Sanders Morris-Harris

Todd Koffman - Raymond James

Sam Dubinsky - CIBC World Markets

Pallavi Madakasira - Piper Jaffray

Hugh Mai - Broadpoint

Presentation

Operator

Welcome to the Avanex Corporation's fiscal first quarter of fiscal year 2008 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.

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 the 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 today's news release, Form 8-K and the risk factor section of our most recent Form 10-K.

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 companies website at www.Avanex.com.

I'd like to take this opportunity to inform you that the company will present at the AEA conference in Monterey, California, November 5^th through 6^th, and at SMH Growth Conference in New York City on November 8. With that I'll turn the call over to Jo Major, Chairman, President, and CEO.

Jo Major

Good afternoon everyone and thank you for joining us today. We're very pleased with the team's outstanding performance this quarter. Our results were reflective of our solid foundation that positions us well for profitable growth and to take advantage of growing bandwidth demand.

We believe that our performance this quarter validates our strategy and our long-term business model. We're optimistic about our market opportunities as the demand for bandwidth intensive services at the consumer level continues to grow.

For the second consecutive quarter, we achieved significant milestones. We have now crossed into GAAP profitability and have achieved breakeven on a per share basis. Our operating model has become very exciting. We are now seeing revenue growth translate into expanded earnings.

As I mentioned on our last conference call approximately one-third of our product revenue flows through to the gross margin line. Our revenue performance was solid and took us to the upper end of our guidance of $54.7 million. Growth this quarter was driven primarily by our modulator and subsystem products and record sales to China and Japan.

Our sales into Nortel, Ericsson, Infinera, Nokia-Siemens, NEC and Tellabs all grew during the quarter. Our greater than 10% customers in the quarter were Alcatel-Lucent at 24% and Tellabs 17%. Nortel was just under the 10% mark.

We're very excited to continue our improvement in gross margin as we move towards our goal of 35%. In the first quarter of fiscal 2008 our gross margin hit 28%, up 4 points from the previous quarter and approximately 17 points over the same quarter in the previous year. We continue to invest in key areas to capitalize on new growth opportunities with differentiated products.

A few highlights. During the quarter we acquired the Telecom piece of Essex. We obtained a strong group of talented engineers who are excited about contributing to a leader committed to developing transceivers and transponders for Telecom applications.

This acquisition has reduced our lead time to market with several key products as evidenced by already securing our first revenue generating design wins. We expect to begin volume shipments of these new transmission products in the March 2008 quarter. As previously stated, we are on the path to having this acquisition be accretive no later than the June 2008 quarter.

Moving on to our one by four ROADM solutions we continue to see increasing market traction. We anticipate completing our first system level testing with a Tier 1 customer in November. As we previously discussed, we expect to begin generating revenue in December and ramping to volume shipments in the March 2008 quarter. We have also shipped samples now to another Tier 1 customer and are preparing to ship samples to yet a third Tier 1 customer.

At the ECOC show in Berlin, we expanded our Tunable Dispersion Compensation product line to include both in-line and terminal 40G products. These enable system integrators to design adaptive 40G transponders with greater reach.

Our amplifier team secured our first Oasis design wins with Tier 1 customers. As you may recall, Oasis is our advanced controlled amplifier platform. It is a flexible configurable platform that delivers efficient and reliable products that are less expensive, and faster to design and build.

These design wins demonstrate that Oasis addresses our customers’ changing needs and continues our tradition of creating value through innovation while reducing the overall costs of our products. Oasis will be ramping in December and we expect the entire amplifier line to switch over to the Oasis platform by the end of the March 2008 quarter.

Integrating our low-cost controlled amplifier with our TVC platform is a powerful combination for 40G transmission. When combining these two products, it is possible to fix both dispersion on the fly and obtain unparalleled transit control. The Oasis platform has the ability to control both the amplification and the dynamic dispersion functions with no added footprint. Customer response to this integrated product has been uniform and quite strong.

Earlier this week we announced we signed a new supply agreement with Alcatel-Lucent. The terms of this agreement include a commitment from Alcatel-Lucent to purchase 50% of their optical Telecom requirements from Avanex through October 2010.

As you're aware we have a history of success at Alcatel, but had a smaller market position at Lucent. It is important to note that the 50% share agreement that we reached now extends to products that trace our legacy back to both Alcatel and Lucent.

Also, this week, it was announced that Pirelli entered the capital structure of the company by purchasing Alcatel Lucent's 12.4% interest. We welcome Pirelli to our shareholder base and look forward to future collaborations in the development of exciting optical technologies.

In summary, Avanex is now profitable with an efficient infrastructure that translates future growth into expanding earnings. We're very proud of our team's continued execution and our progress to date.

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

Marla Sanchez

Our first quarter revenue was $54.7 million up from $51.1 million in the previous quarter and $50.9 million in the same quarter of the previous year. Growth this quarter was driven by our modulator and subsystem products and a growth in sales at Nortel, Ericsson, Infinera, Nokia-Siemens, Tellabs, and NEC.

As Jo mentioned, we had record sales in China and Japan. The geographic revenue break up for the quarter of total sales was 44% in the Americas, 31% in Europe and 25% in the Asia-Pacific region.

Our gross margin performance this quarter was 28% compared with 24% in the previous quarter, and 10% in the first quarter of the previous fiscal year. The sequential improvement in gross margin was attributed to the divestiture of our facility in France, a decrease in E&O expense, an improvement in direct margin and additional benefits realized from our 5 ongoing programs.

We expect our margins to gradually trend up as new product families are introduced into our revenue stream. Initiatives to improve our gross margin to the 35% range include continued benefits from operational improvements particularly in E&O provisions and our new product introduction.

Operating expenses in the first quarter were $15.4 million or 28% of revenue compared with $18.1 million in the previous quarter or 36% of revenue. If we exclude expenses of approximately 3.2 for the divestiture of a facility in France, operating expenses in the previous quarter of fiscal 2000 would have been 29% of revenue.

When first quarter operating expenses are adjusted to exclude stock-based compensation expense of $1.9 million, they represent 25% of revenue. We expect sales and marketing spending to remain relatively flat, and to increase our investments in R&D as a result of our continued development efforts in new optical technologies and the growing transmission market.

Operating profit on a GAAP basis improved from a $6 million loss in the fourth quarter to approximately breakeven this quarter. After accounting for net interest and other income and expenses of $500,000 and a provision for international taxes of $300,000, GAAP net profit was $45,000 or breakeven on a fully diluted per share basis. This compares with a loss of $5.7 million or $0.03 per share in the previous quarter. On a non-GAAP basis we generated operating profit of $2.1 million, marking our second sequential quarter of non-GAAP operating profit.

Another milestone for the company was the generation of cash for the second quarter in a row, net of a one-time transaction of approximately $2.2 million paid for Essex. We've performed better than expected this quarter despite continuing to invest significantly in R&D and capital equipment.

Our total headcount at the end of the quarter was 545 with approximately 309 employees in North America and Europe, and 236 in Asia. With our continued financial execution and a strong foundational base, we are excited about the opportunities ahead of us. With that I tell turn it back to Jo who will discuss our outlook for the second quarter fiscal 2008.

Jo Major

In summary, the first quarter of fiscal 2008 was a strong quarter for the company. We achieved profitability, grew revenue to the high end of our guidance, exceeded our gross margin expectation, and continued to keep our operating costs in line.

Our efficient operating model combined with our new product pipeline should allow us to expand earnings as we capitalize on growing demand. For the second fiscal quarter of 2008, we are forecasting revenue to be in the range of $56 million to $58 million with gross margin approximately flat to slightly up.

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

Question-and-Answer Session

Operator

Your first question comes from John Harmon - Needham & Co.

John Harmon - Needham & Co.

I was curious, what turned out positive on the gross margin line that led you to beat your guidance by so much?

Marla Sanchez

One of the main factors that we had on there was continued improvement on our E&O line. We also had better direct margins and lower manufacturing overhead in general. Most of our variances, a lot of the programs that we've talked about in the past, are really starting to kick in. The other thing to remember is that this was the first quarter that we did not have France on the books at all for the entire quarter.

John Harmon - Needham & Co.

Is there any way to quantify the progress you've made towards reaching your targets on variances?

Marla Sanchez

I think on our target towards variances, what we've really been doing is trying, for example, to get to our E&O to end up being closer to $2 million per quarter which was what we've talked about in the past. We were a little bit better this quarter but I think we had a very good quarter. I'm not sure that I would continue counting on it always being as good as it was quite this quarter.

John Harmon - Needham & Co.

And did you have a say in Pirelli taking over Alcatel-Lucent investment in your company or what do you think their motivation was for taking on the investment?

Jo Major

I think a few things should be said. First, we had a lot of discussions with Pirelli and it's a very core relationship that we've got between the two companies, so there's a very nice relationship that we're looking to develop there, John.

The question of why did Pirelli buy the stake in Avanex, I think is very straightforward: they want to make money in telecommunications. We view Pirelli as a very market savvy investor in optical telecoms and we're quite happy that they selected us as a vehicle to make some investments. We're also in the process right now of exploring how we can collaborate with them.

They've made a lot of investments in some advanced R&D ideas, and Avanex has a really good platform for taking technology to market so there's two pieces of it. One is I think there's a pure financial play that they saw, and we are very happy about that, and the second part of that is that we're quite excited about looking about how we might be able to get the two companies to behave collaboratively and delivering some exciting new products to the market.

John Harmon - Needham & Co.

Just finally, you talked about several products launching and being more in volume production in the March quarter. Any way to quantify the new products; how much a percentage of sales they could be six months from now or so?

Jo Major

Well, it's kind of interesting. Of course, we have quantified some of that already for you, John. On the amplifier side, by the time we exit March, almost all of it is going to be moved over to new product plans that give both some really nice new features to our customers but also give really nice cost structure advantages to both us and our customers.

Some of the other things on the transmission side, for us there’s a big move now as we move from fixed wavelengths to tunable products and that's a really exciting change that will happen over the next three- six- nine months.

You'll see most of our product revenue coming from new generation products, so if you look where we are now compared to where we are going to be in the Summertime, the majority of our transmission products will have moved from fixed wavelength into more interesting tunable products and products that have some more interesting feature sets, like more advanced modulation schemes, or if we go out and look at 40G, it will have integrated things like tunable dispersion compensation and amplification built in.

Operator

Your next question comes from Subu Subrahmanyan - Sanders Morris-Harris.

Subu Subrahmanyan - Sanders Morris-Harris

I had two questions. First, on Pirelli, if I could just ask on kind of product that you can collaborate on, my understanding is they do have a tunable laser product, so that relationship you're exploring and also does this create an opportunity to be a supplier on the Pirelli systems side? And then on the operating expense side, I wanted to a little bit better understanding of the higher G&A expense sequentially and just the trend for OpEx and absolute numbers.

Jo Major

Okay, so I'll let Marla answer the second one. I'll just quickly get into Pirelli. On the Pirelli side, Pirelli invested a lot in some nanotechnology, particularly with silicon-silicon, and glass on silicon, so there's a series of integrated products there that they might be able to put multiplexing functionality on to a chip, or they might be able to put a really interesting low cost component together to enable us to provide next generation WSS componentry.

It’s a little bit early, but if you think about making a lot of the functions that exist in wavelength management, if you think about integrating those, or you think about putting those forward into a smaller and more compact, more feature-rich sort of product, that's what our thinking is with them and right now, it's very early in those explorations but it's also a pretty exciting time as we're getting to know the technologies that the companies have.

Marla Sanchez

On the operating expense side, for Q4, from the prior quarter to this quarter, part of what we have is on Q4, this is the second year we've had a history of actually having the expenses be a little bit lower in the fourth quarter than the first quarter. Most of that is usually due to a lot of the readjustment of the final year allocations that we do for all of the facilities and IT charges where we end up with a little bit lower expenses.

Going forward, we actually expect our G&A expenses to be in about the 7% range of revenues. We would eventually like to get that closer to the 6% range but for the next quarter we would still be shooting to have them closer to the 7%.

Subu Subrahmanyan - Sanders Morris-Harris

And OpEx as a percentage of revenue, 25%, is that what you're modeling?

Marla Sanchez

That's our goal overall, yes.

Subu Subrahmanyan - Sanders Morris-Harris

I had a question on the new products and year-over-year growth trends. We had like 8% year-over-year growth quarter, our next quarter or mid-point would be a low single digit number, as we come out of this spending pause. When do we get back to double digit year-over-year growth and what is your view for the overall year? I understand you're not giving fiscal '08 guidance, but when do we get back to double digit year-over-year growth and how would that impact fiscal '08 do you think?

Jo Major

We had pretty decent bookings last quarter we talked about. We had a pretty decent booking quarter last quarter, so that gives us some encouragement. I wouldn't say that we've got multiple quarter visibility looking out, Subu, so I think we should be pretty consistent in our view.

We think that the market dynamics are pretty good. We think that the spending is coming back, and when we're looking at 8% sequential growth guiding up in the single digits, I think when we start to see those growth rates for several quarters in a row, everybody will start to feel better about the underlying growth of the industry; but in general, most of the trends that we're seeing from our customers tend to be, I wouldn't call them irrationally exuberant to quote Mr. Greenspan, but they do seem to have a pretty confident look that the market is going to be continuing to rise.

Subu Subrahmanyan - Sanders Morris-Harris

Yes, and the new products should be incremental to the current revenue base. That's the other part of my question is, if you look at margins during the last two quarters in the fiscal year, you should have some incremental revenue over the current base and I was wondering if that creates an acceleration in second half versus first half?

Jo Major

Certainly, you should always view new products as having two functions in a technology company. One function is to making sure that you're replacing legacy products that are falling off the revenue stream. Fixed wavelength products are migrating to tunable. We're moving from static configurations to reconfigurable optical add-drops or ROADMs so one of the biggest things that you have to do is you have to keep your product portfolio migrating with that so you can grow with the market.

We do think that we have additional opportunities to grow above the market if we can execute crisply on some of the products that Essex is bringing to the market. Certainly, we have a lot of ROADM slots that are becoming very, very interesting to us and we've got a next wave of development projects launching in the ROADM world. That's really exciting to us.

40G, we have a lot of the componentry in 40G so it's interesting, in 40G transmission, it's not just a laser and receiver anymore; it's a laser and a receiver and tunable dispersion compensation and an amplifier that really helps keep the receiver in a good position for received power, and a really exceptional modulator that can do the 40G work, a lot of those pieces are now within Avanex and we're really excited about where 40G is going to take the company.

And to answer your question, some of it is replacing revenue going away but we do have a lot of new opportunities that the company hasn't been able to address before that we're quite excited about over the next say 6 to 12 months.

Operator

Your next question comes from Todd Koffman - Raymond James.

Todd Koffman - Raymond James

Congratulations, great progress on the margin side. On this new Alcatel-Lucent agreement, my recollection was that the old agreement, maybe I was wrong on this, but it was you were supplying 70% of the requirements to Alcatel and now, it's 50% to the combination Alcatel-Lucent, is that correct or no?

Jo Major

Yes, that's correct.

Todd Koffman - Raymond James

So net-net, given Lucent's position in the market, is this new arrangement as about the same opportunity, less, more, or you just have no idea?

Jo Major

No, we have some pretty good ideas here, Todd. I think you should view it as a really nice positive supply agreement for a couple of reasons. One, the general scope of this thing is very similar to what we've had before and it's been cast forward three years. I think the other thing is there's a lot built into the supply agreement between the two companies that we don't describe here and that's very supportive of the company.

Whether 70% of the smaller pie or 50% of the bigger pie is a bigger pie, maybe that's up in the air, but the truth of the matter is we're going to go in and we're going to try and make great products, we're going to try and get those great products there at a compelling price and if we're doing that we're going to be in great shape and we'll get 50% share or we'll even get more if we've got compelling differentiated products.

Todd Koffman - Raymond James

Just as a follow-on to that, in the just reported September quarter, I think your business level with Alcatel-Lucent was down a few million dollars sequentially. Was there any dynamic associated with that as it related to the finishing up of the agreement or it just is how it played out quarter-to-quarter and you can't read too much into that?

Jo Major

Yes, I wouldn't read too much into that, Todd. Last quarter was pretty strong for us in North America. It was a good quarter for us in Asia. Europe for us was a little bit weaker in this quarter than previous quarters. We do want to note that August is for Europe as a customer base, August is a bit of a slow month, so that may not be all that surprising to any of us that it's a little bit slower there. But yes, I don't think that I'd read too much into that.

Todd Koffman - Raymond James

Okay, just last question. Un-related. On the ROADM, I think you said that you'd start to shift for revenue in the December quarter and then you get into volume in March and then did you say that you have another top tier customer target or win, or what was the commentary about that that I missed?

Jo Major

Yes, we have two other Tier 1 customers that we're engaged with now. One of the things that we've said in the past is we can pick up one or two large engagements per quarter. I think it's really important to our shareholders to let them know whether we're getting the subsequent engagements going.

So the first engagement we had is finishing up this Fall in November and if everything goes according to plan, and we hustle, we'll be shipping a little bit of revenue in December and we'll have a nice ramp in the March quarter.

Then Todd, we've got two more Tier 1 customers that we talked about engaging this quarter. The first one we've already shipped samples; they're already testing; we're with our third round of sampling now. The first sample got them going and the second one is full spec compliant. The third one which we're getting ready to ship actually meets their pin out, so it actually will go right into their equipment and off and running they go. So that's where we are with our second customer.

Our third customer receives their samples in a couple weeks and we'll start to get that customer up and running, and then hopefully in the next quarter we'll talk to you about how those customers are going and further customers that we're bringing on board with the ROADM product suite.

Operator

Your next question comes from Sam Dubinsky - CIBC World Markets.

Sam Dubinsky - CIBC World Markets

Not to harp on this too much but just as the new supply agreement with Lucent-Alcatel, just so I'm reading it correctly, can this business still grow at the same rate it has historically or is there any lumpiness, as a gap maybe, as Lucent products, new designs ramp up and maybe some older Alcatel stuff ramp down a little bit or can this just sort of grow as it has in the past? And I have a couple of follow-up questions.

Jo Major

Okay, so the first, there's always the possibility that any individual customer will go up and down. I understand that Alcatel-Lucent is well under way with their restructuring and the structure of their product lines, so that's something that we've gotten a lot of work done already.

We don't anticipate that there's going to be huge fall off in revenue as we transfer from one to the next, and remember, Alcatel was the larger of the companies in the optical world, which is where we do our business, so for us, it's not as big a deal as it is if you're traditionally supplying a lot of stuff into Lucent. It's more of a smooth transition and quite honestly we really haven't given our supply base any big surprises due to the Alcatel-Lucent integration.

Sam Dubinsky - CIBC World Markets

And then a unrelated follow-up, do you have any benefit or risk to margins of currency, change in FX regarding weakening U.S. dollar? Has that hit you at all or do you see any benefits or negatives from those?

Marla Sanchez

It does affect us a little bit but not a great deal. We do end up taking some charges that has gone both against us and in our favor in the past. It usually is relatively small.

Sam Dubinsky - CIBC World Markets

Just one last question on the state of inventories across the customers. Is there any particular pockets of strength or any particular pockets of weakness or is it just everything looks pretty lean?

Jo Major

Inventories, I don't think there's anything all that unusual to report right now. The several companies that have taken their inventory positions down which we think is healthy and helps us respond faster to their needs we haven't seen any big pockets of inventory develop nor have we had any customers come to us and say they need to launch big lean initiatives that would be negative to our revenue in the coming quarters.

Operator

Your next question comes from Pallavi Madakasira - Piper Jaffray.

Pallavi Madakasira - Piper Jaffray

I noticed on the operating expense side you have been operating down around the 25% level for the past few quarters which is great and as you move towards that target gross margin, do you have any efforts or expectations to reduce that OpEx line?

Marla Sanchez

Yes, we do actually. We will probably continue for the next couple of quarters to keep R&D a little bit higher at the level that it's running at, at about 12 to 14%. Sales and marketing we will keep most of the expenses about flat. The only part that will end up going up will be that relative to commissions relative to revenue, but we are looking to see if we can bring G&A expenses down a little bit more. Some of our amortization expense will be dropping off as we go forward.

Pallavi Madakasira - Piper Jaffray

Okay, is there any kind of specific long term target you're putting on that then?

Marla Sanchez

We are looking to try and get to 25% including the stock-based compensation.

Jo Major

Yes, and just to echo something that Marla said earlier, we are a high technology company. We do believe that high technology companies need to invest and need to grow pretty robustly based on new products. So one of the things that we really have tried to do is put a structure in place that generates enough margin that we can continue to invest and invest in robust growth and robust margin products and that will keep our R&D in the 12 to 14% range.

Pallavi Madakasira - Piper Jaffray

I'm sorry I missed on your regional revenue, what was the result in Asia and with respect to the customers in Asia, what kind of growth prospects are you seeing there?

Marla Sanchez

What we had for the revenue was we had 44% revenue in the Americas, 31% in Europe, and 25% in Asia. We had good record sales in both China and Japan this quarter. We are looking to continue to try and maintain good growth happening there and good revenue levels there.

Jo Major

We've done a lot in China. We've put in field applications engineers to help solve technical problems in the language that our customers speak and the time zones that our customers reside in. We've taken the next step of putting some other functions into the Asia region so that we can respond very, very quickly to customers needs and be more flexible. Most of those things have paid off 3 to 6 months after we've put them in place so we're pretty excited about the prospects that we have in Asia simply because we're putting a good structure in place to go address that part of the world.

Operator

Your next question comes from Hugh Mai - Broadpoint.

Hugh Mai - Broadpoint

I'm sorry for getting back to the ROADM question, but the customer that you mentioned that you're finishing the qualification, have you received authorization from them to go into mass production? If not, can you qualify your confidence level that it will go into mass production?

Jo Major

I don't know that we get a signal from them to go into mass production other than POs. So the process really is as follows. They have a qualification process; our customers typically have their own qualification process internal and we have a qualification process of our own. Those run in parallel. Both of those processes are ongoing.

The results from both the internal and the external qualification programs look okay, and those things percolate along, when everybody gets a certain amount of confidence we start to see POs come out so we should see POs for small volumes, that test our manufacturing capability, come out in the late November/early December time frame, and then as they gain confidence in us, then you should see significant PO coverage start to happen in January and February time frame.

A couple of things to say, we really have designed this thing to be manufacturable and to be built from the get-go with low cost in mind. Our supply base has been selected so that they can be very responsive to high volumes. Samples that what we're shipping right now are shipping from China, so we've already transferred this into China. We've had a team from our contract manufacturer here several weeks ago. We've sent our team for a few weeks into China to get things to happen, and that means a couple things, Hugh. It means that the ramp should proceed pretty smoothly but it also means that we should come out with really nice attractive cost structure from day one and you're not going to hear us come on and say well, we had lots of revenue but our margins have to be worked up over time. We have a lot of that taken care of upfront.

The third point is a lot of the construction techniques of this have been modified from products that have already been qualified and already built in China, so the real qualification risk for this we think is fairly modest.

Hugh Mai - Broadpoint

Back to the FX issue. I was wondering how much of your revenue is denominated in the dollar and then related to that how much of your COGS as well as operational expenses?

Marla Sanchez

We have some European customers that actually the revenue on them is in euros. I can't give you actually an exact percentage of what we have euros to dollars, but it's not the majority of our revenue. The majority of our revenue is actually in dollars and the majority of our expenses and our COGS are actually in dollars.

Operator

There are no further questions at this time. Thank you for joining today's call.

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