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Executives

Chris Farrell - CFO

Bob Howard-Anderson - CEO

Analysts

George Notter - Jefferies & Co

Jason Ader - Thomas Weisel Partners

David Titus

Justin Shore

Jason Kim - Thomas Weisel Partners

Occam Networks Inc. (OCNW) Q4 2007 Earnings Call February 20, 2008 4:30 PM ET

Operator

Good afternoon. My name is Cara and I will be your conference operator today. At this time, I would like to welcome everyone to the Occam Networks Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you. Mr. Farrell, you may begin your conference.

Chris Farrell

Thank you Cara and thank you all for joining today's conference call. I'll begin with the Safe Harbor. This conference call contains forward-looking statements within the meaning of Section 27A of Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934 as amended.

Among these forward-looking statements will be comments about the outlook for our business during 2008. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual company or industry results, levels of activity, performance or achievements to differ from those expressed or implied by these forward-looking statements.

In particular, we operate in a highly competitive market for communications networking equipment that is undergoing consolidation and rapid technological change. Our ability to increase our revenues and achieve profitability in future periods will depend among other things on increased market acceptance of our products and our ability to continue to enhance and improve our existing products and introduce new products to meet customer requirements. It also depending part on macroeconomics factors including capital investment trends in the telecommunications industry.

You should also specifically consider the various additional risk factors detailed in Occam's Securities and Exchange Commission filings and reports including the company's most recently filed annual report on Form 10-K and quarterly reports on Form 10-Q. These factors may cause the company's results to differ materially from the forward-looking statements made in this conference call.

Although the company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guaranty future results, levels of activity, performance or achievements. These forward-looking statements are made only as of today's date and Occam expressly disclaims any obligation to update or revise information contained in the forward-looking statements. This concludes the Safe Harbor statement.

Now, I'll turn it over to Bob Howard-Anderson our CEO to discuss our quarterly and annual results.

Bob Howard-Anderson

Thanks, Chris and thank you all for attending. Welcome to Occam Network's 2007 year end earnings call. We are pleased to announce that Occam closed the year with a good deal of momentum in customer growth, products and technologies and operating results.

As we mentioned last quarter, one of the keys to our long-term success is the integration of the GPON technology that we acquired through the purchase of Terawave asset into our BLC 6000 product line. We have made good progress in this area with our first integrated products currently scheduled to be released next quarter.

Upon completion of the integration, we'll be able to provide our customers with the GPON OLT that will seamlessly integrate into our existing BLC 6000 platform and several versions of GPON ONTs. Combined with our existing copper and point-to-point fiber access solutions, we expect this release to significantly extend our technological market advantage and drive revenue growth in the second half of this year.

Clearly this progress is a testament to the capabilities that our teams and technologies poses. We expect that the increased technical talent of our new combined teams will be utilized to enhance our product breadth and provide us with a sustainable competitive advantage in the all Ethernet IP access equipment market.

We also mentioned last quartet that we would be focusing on the expansion of our markets. To accomplish this, we have made several additions to our Canadian sales team, which has lead to the expansion of our Canadian customer base. We were also able to secure a key win at GTA TeleGuam in the Pacific.

Additionally, we are exploring ways in which we can expand into the EMEA o r European Middle East and African Market leveraging some of the sales relationships that Terawave have brought us and we expect the product international adaptation efforts will be made in accordance with our sales progress.

Returning now to 2007 result, we added 68 new customers for the year and extended our streak of adding more than ten new customers in a quarter to 13 consecutive quarters. We ended the year with 273 service provider customers. The majority of the customer growth was in our core tier 2 and tier 3 IOC market and we are pleased with the continued growth and opportunity that these markets represent for Occam.

We also announced a tier 1 account win in North America. Recently, we were selected by FairPoint Communications to be the lead access equipment provider for a major broadband initiative for the network they are acquiring from Verizon in northern New England. This should take place after the proposed acquisition of Verizon's wireline business in Maine, New Hampshire and Vermont is completed.

FairPoint's acquisition of this network is currently contingent upon regulatory approval in all three states involved. This deal represents a significant opportunity for Occam, as FairPoint would become one of the largest IOCs in the nation, as a result of the acquisition of approximately $1.6 million additional access lines. Their selection of Occam as the best choice for their network validates our technology in the large IOC arena and should give us an important boost and key reference account for other large IOC opportunities.

Turning to the products and technology front, we continue to add both organically and inorganically to our burgeoning all Ethernet, all IP product portfolio. In 2007, we introduced the BLC 6450, a 10 gigabit Ethernet aggregation blade that enables customers to scale their networks for more HD IPTV and video-on-demand as well as continue the transition to an all packet infrastructure. These blades have been popular with our customers and were a key component of our winning solution for FairPoint.

As we exited the year, we experienced a somewhat better than expected rebound in our business with both revenue and margins increasing sharply after the soft Q3. In particular, we benefited from strong seasonal spending broadly across our customer base, the new customer win in Guam and resurgence in customer confidence, which were attributing in part to completion of our restatement and our SEC filings.

Although, we expect that we may continue to see in the future periods some of the copper to fiber transition issues that we experienced in Q3. We are cautiously optimistic about 2008. We believe the uncertainty surrounding our Audit Committee investigation should be behind us and the FairPoint selection should improve our competitive positioning and credibility with customer prospects. Finally, although much may depend on economic development in the next few quarters, we were pleased with the telco capital spending trends we saw in Q4.

Now, I'm going to turn it back over to Chris Farrell, our CFO to discuss Occam's financial results in more detail.

Chris Farrell

Thank you, Bob. For the fourth quarter of 2007, Occam reported revenues of $21.3 million, a decrease of 4% over the same period a year ago, but up 36% sequentially from the $15.7 million of revenues reported last quarter. For the year, revenues grew from $68.2 million to $75.1 million, an increase of 10%.

Gross margin in the fourth quarter was $9.2 million representing 43% of revenues. Gross margin increased sequentially from the 36% reported in Q3 because of favorable product mix. In the fourth quarter, we saw a rebound in our blade shipments and larger purchases of newer cabinet models both of which have higher than average gross margin.

Overall, we expect our corporate gross margin to continue to be sensitive to mix to the extent that product category such as cabinets or ONTs comprise a larger portion of our revenues than our historical average, we would expect lower margins in those periods.

Now turning to operating expenses. In the fourth quarter of 2007, we incurred an expense of $2.2 million related to in-process R&D purchase from Terawave. This accounting charge pertains to the estimated value of GPON technologies acquired. Excluding this charge R&D expense was $4.3 million up from $3.2 million in the prior quarter.

Majority of the increase is attributable to the hiring of former Terawave personnel and excluding stock based compensation expense and the purchased in-process R&D charge, R&D in the quarter was $4.1 million compared to $3.1 million in the prior quarter. For 2007, R&D expense was about $15.5 million up from $9.6 million in 2006.

Excluding stock based compensation expense and the purchased in-process R&D charge, R&D for the year was $12.6 million up from $8.8 million in the prior year. SG&A expense in the fourth quarter was about $7.7 million down from $7.9 million last quarter. Excluding stock based compensation expense, SG&A in the quarter was $7.4 million down from the $7.7 million in the prior quarter. Sequential decrease is principally attributable to the decrease in professional fees related to the Audit Committee investigation that concluded in October of 2007.

This reduction was partially offset by other professional fees related to the acquisition of Terawave, filing of our restated financials, conducting our annual shareholders meeting and compliance costs related to Sarbanes-Oxley. We also incurred additional staffing costs and increased commission payments.

For 2007, SG&A expense was about $26.5 million up from about $15.3 million in 2006, $4.9 million of the increase was related to Audit Committee investigation cost. Excluding stock based compensation expense SG&A expense for the year was $25.4 million up from $14.5 million in the prior year.

Net loss in the fourth quarter was approximately $4.6 million or $0.23 per share compared to a net loss of $4.9 million or $0.25 per share in the pervious quarter. Excluding the write-off of purchased in-process R&D and non-cash stock based compensation expense; non-GAAP net loss in the fourth quarter of fiscal 2007 was $1.9 million and the non-GAAP loss was $0.09 per share. In the prior quarter, non-GAAP net loss was $4.4 million or $0.22 per share.

Occam incurred a net loss for 2007 of $10.4 million or $0.53 per share compared to a net loss of $2.2 million or $0.24 per share in 2006. Excluding the write-off of purchased in-process R&D and stock based compensation charges; Occam incurred a non-GAAP net loss of $6.1 million or $0.31 per share in 2007. In 2006, Occam generated non-GAAP net income of $3.1 million or $0.18 per diluted share. A reconciliation of the non-GAAP numbers is provided in our press release and is also available on our website.

Now, let's review Occam's balance sheet highlights. Occam had $50.7 million of cash at the end of the year, $13.1 million of which was restricted. Inventory days are now about 34, if you exclude the inventory that is at customer sites and is in many cases installed and in use. This inventory is not yet converted to revenue because of the terms of the contracts. These are all U.S government contracts with many rural telcos used to fund our network capital investments.

As Bob mentioned, we closed the year with a good deal of momentum. Our sales force is credited for winning a number of large new deals in a competitive environment. We are currently judging if the improved sales traction marks the beginning of a trend. As compared to the fourth quarter, our leading revenue indicators for the first quarter are mixed.

Q1 is seasonally a slower quarter than Q4 and we expect customer ordering activity decline relatively to Q4. Additionally, the copper to fiber transition is still underway. This may not only delay customer purchasing decisions, but also may impact margin based on sales mix.

Since a significant portion of our reported revenues depended on lumpy cash receipts, forecasting revenues with a high degree of accuracy within a short timeframe is very difficult. Importantly, we'll continue to provide annual guidance rather than next quarter guidance.

For 2008, we confirm our prior guidance and still expect revenues to land in the $85 million to $95 million. This revenue range could possibly improve, if FairPoint's acquisition of approximately $1.6 million Verizon lines passes regulatory approval. Although, we cannot judge when or if they will receive a favorable determination, we'll keep you updated.

We expect gross margin for the full year of 2008 to be in the 38% to 42% range. I'll expect the markets to transition to more fiber based products. We have also identified cost reduction opportunities that should help margin.

Overall our forecast is based on the number of price, cost and mix assumptions and the gross margin percentage at any given quarter may be outside of this range because of the sensitivity of the product mix, customer revenue concentration, accelerated ASP erosion, and failure to cost reduce our products. Overall, we did not see anything that prevents us from eventually achieving our long-term model goal of 42% to 43% gross margin.

As indicated in our last earnings call, we expect operating expenses to increase in 2008. In addition to meaningfully augmenting expanding our engineering team, the Terawave acquisition introduces additional spend related to integrating products, processes and systems. Further, we planned to expand our sales and marketing operations to include new domestic and potentially new international markets. Obviously, we believe that this investment in our business will result in additional sales overtime.

In the general administrative area, we are incurring cost related to improving our internal controls, meeting our remediation plan goals and complying with Sarbanes-Oxley. Given these factors, we expect to reach breakeven profitability at a quarterly revenue run rate of roughly $28 million.

I'm pleased with the business momentum, as we exit 2007. We collected a number of account wins in the fourth quarter and our product development efforts are progressing as planned.

Now, I'll turn it back over to Bob for closing comments.

Bob Howard-Anderson

Thanks, Chris. We also announced today that our CFO, Chris Farrell will be leaving the company to pursue personal career interest, which differs from his current role. Chris will remain on as Occam CFO through our first quarter, the closing of the books for Q1 and the filing of our 10-Q in order to provide the company with enough time to search for the appropriate successor.

In the meantime however, we have also retained the services of a veteran CFO, Steve Cordial to act as an advisor to the company on financial matters through the transition. I would like to thank Chris for his dedication and the immense efforts, he has given to Occam. As CFO over the past two years and as controller before that, Chris has seen us through some major challenges, but also through periods of significant growth and accomplishment and we are grateful for his contributions.

I'm pleased to have exited 2007 with momentum. We had a number of important new account wins and the integration of the former Terawave personnel and technology has been progressing, as planned. In 2008, I expect our business plan to build on these successes. We have a host of new product introductions and plans to bring these technologies into new market. At this point, we'll answer any questions you have about the business. The conference moderator will now coordinate the questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of George Notter.

George Notter - Jefferies & Co

Hi, thanks very much guys. I got a few questions here. I guess I wanted to ask about you mentioned you're going to be shipping GPON, I think you said next quarter. Can you talk about what kind of impact do you think that will have on the P&L from a margin perspective -- how different is our gross margins along the GPON products relative to the existing copper based product? And then also what kinds of ONTs are you guys assuming in terms of the full year guidance and what kind of overall GPON mix are you assuming in the full year guidance?

Bob Howard-Anderson

Hi, George, it's Bob. So, yeah, we're confirming that we are on schedule to ship GPON next quarter and yes, there will be some margin impact. Chris gave a range on margins that will vary throughout the year. I'm not going to actually pin it down.

But obviously in the first quarters of shipping about any new product but particularly a product that has fiber ONTs is in. There will be some margin pressure based on the volume ramp up and getting maturity in the product.

So, it will start off being somewhat of a drag on margin and then improving throughout the year. We also have next generations of ONT technology already being planed and underdevelopment that will come out in following years that will address the cost structure and the margins.

To the mix, we actually expect that towards the back half of the year things will stabilize that it's about half-and-half -- point-to-point gig Ethernet fiber to the home and PON to the home shipping from us all in the same platform.

George Notter - Jefferies & Co

Got it, okay. I guess just expanding on that, I guess, I was just trying to figure out can you talk about -- I assume one of the things I -- obviously, we've got some history here looking at companies like Tellabs, Tellabs has been shipping PON and you've granted they are shipping into Verizon, which is certainly exerting internal leverage over Tellabs from a margin perspective.

But I mean, is it fair to assume that do you think you can make money in this business longer-term are the margins longer-term more akin to the corporate average kinds of margins or where do you think you can get this business?

Bob Howard-Anderson

Yeah. We obviously think we can make money on it. Particularly, because we've a blending of ONTs and OLTs and clearly there is a difference in margin there the ONTs being for single home there is not as much margin that you can expect to realize. But certainly the OLT is spread over a large number of subscriber, so we can garner more margin their.

And that is also where we tend to put the highest amount of performance value add in the OLT side. So, we've already baked in these assumptions to our plans and as we've said we've a range for this year and we also see no reason we can't achieve our long-term model of 42% to 43% and that's burnout by already now a year of experience on our active ONTs.

George Notter - Jefferies & Co

Right. For the GPON ONTs, will you develop those ONTs yourself or you outsource that to other companies?

Bob Howard-Anderson

That's an in-house development both the initial generation as well as the next generations I talked about that will address cost structure.

George Notter - Jefferies & Co

Got it, okay. And then just a housekeeping question on you referenced a customer win number for this quarter, I think it's quite roughly 235 customers. But how does that account -- is that include the Terawave customers that come into the mix. How much of the customer growth was organic in your core business?

Chris Farrell

It's always 273. We added 68 for the year and it was all organic, George.

George Notter - Jefferies & Co

Got it, okay. Thanks very much.

Chris Farrell

You're welcome

Operator

Your next question comes from the line of Jason Ader.

Jason Ader - Thomas Weisel Partners

Thank you. Did you guys have any specific revenue from Terawave in the quarter, I was curious? And then secondly, could you -- maybe Bob could you comment on the competitive environment and how that might have changed throughout this year?

Bob Howard-Anderson

Sure, Jason. With regard to revenue from Terawave, we did not recognize any meaningful amount of revenue from Terawave customers in the fourth quarter.

Jason Ader - Thomas Weisel Partners

Okay.

Chris Farrell

And regarding the competitive environment, we really as I said felt a better than expected rebound in our business in Q4. I'd say therefore that we felt less competitive pressure. I think the announcement of eminent GPON products adding to our existing point-to-point and right alongside copper services all out of the same architecture really contributed to that.

We also do all of those services in the same platform back allover 10 gigabit Ethernet, which is pretty unique and the 10 gigabit Ethernet, we've been deploying since June and its quite popular. I think all of that is contributed to giving us once again a significant lead over some of the competitors out there.

Jason Ader - Thomas Weisel Partners

We haven't seen any step up in pressure from guys like Adtran or Calix that's been sort of status quo?

Chris Farrell

Yeah I say that's a fair assessment. I think the FairPoint, when we alluded to was an extremely thorough and rigorous evaluation with very top tier competitors in there and we were announced as the lead vendor. So, I think again that makes us feel good about our competitive positioning.

Jason Ader - Thomas Weisel Partners

Is that a single source type of deal?

Chris Farrell

So far, we've announced that, we were the lead access vendor for that. It is certainly a big enough project that there maybe other vendors. But we feel very comfortable that we'll be the substantially major supplier to that.

Jason Ader - Thomas Weisel Partners

Okay. And then, you're still doing business with FairPoint today, correct?

Chris Farrell

Absolutely. They've been a great customer of ours since 2003.

Jason Ader - Thomas Weisel Partners

But it's not in the Verizon, so that's not in the guidance, correct?

Chris Farrell

That's correct. We're leaving that out until we get the determination.

Jason Ader - Thomas Weisel Partners

Okay, thank you.

Chris Farrell

Thank you.

Operator

(Operator Instructions) Your next question comes from the line of [David Titus].

David Titus

Hey Bob, hi Chris. Big question, I think on everyone's mind is how big can the FairPoint contract be overtime and I don't know if you put a [size raged] on that yet or not?

Bob Howard-Anderson

No, we've not and I'd only steer you to FairPoint is doing a great job of keeping people apprised of the progress on the regulatory approvals, but also on their commitments to greatly enhance the broadband services for the subscribers in those three states. So, I'd have to refer you to keep track on FairPoint's releases about both their regulatory process but also the level of investment they are going to be making.

David Titus

Second unrelated question is the restricted cash seems to be growing the last couple of quarters and just curious as to what's causing that?

Bob Howard-Anderson

Sure. Our restricted cash typically applies to contracts that we entered that are U.S. government backed contracts. We allowed our customers to work with the [rural] utility service to get long-term, low interest rate loans and those require us to post in certain cases performance bonds. So, that reflects our growing business with customers, who are using our U.S. funding.

David Titus

Thanks.

Operator

(Operator Instructions) There are no further audio question, sir. It looks like we do have question from the line of George Notter.

George Notter - Jefferies & Co

Hi, thanks. Just one last one, you commented that some of the strength in the quarter came from seasonal strength. I guess, historically I've always thought of the independent telcos as being seasonally stronger in the June and September quarters on the weathers there --is there something unique about your business or something different this quarter than that historical experience?

Bob Howard-Anderson

Yeah, few factors there George. We noted not only strong revenue and ordering activity but we also had very strong margins 43%ish and that reflects that one of the cyclical patterns is that telcos tend to buy a higher degree of blades in the winter or going into the winter for doing more work in central offices or adding incremental blades to slots that are already out in remote terminal cabinets rather than doing the construction for them.

And then there was also a rebound following Q3 of the mix of more towards copper than fiber and again some customers put some buying decisions on hold in Q3 and then when they returned to making their buying decisions did a healthy mix of copper as well as fiber.

George Notter - Jefferies & Co

Got it. Thanks very much.

Operator

Your next question comes from the line of [Justin Shore]?

Justin Shore

Hello, Bob, hello Chris. Given Occam's history in the active Ethernet arena do you have a feeling for where the industry might be going versus active and passive?

Bob Howard-Anderson

The industry -- the markets are broad, right. There is worldwide market. Certainly in our tier 2, tier 3s and I suspect even in some of the largest we're seeing a demand for a mix of both of those technologies and it has to do with the level of service that a provider wants to provide as well as the geographic density of the homes or endpoints they are serving.

And what's unique about our platform is we'll be doing both gigabit point-to-point Ethernet as well as PON out of the same platform alongside, where there are same copper services are being deployed or backhaul over 10 gigabit Ethernet. And we're seeing broad demand from our customers for a hybrid of those constructions.

Justin Shore

Very good. Thank you.

Operator

Your next question comes from the line of Jason Kim.

Jason Kim - Thomas Weisel Partners

Yeah. Hi, just a couple of quick housekeeping questions. First given the cash flows, what was the deprecation and amortization in the quarter?

Chris Farrell

We'll be putting out all that information in our 10-K, which will be forthcoming.

Jason Kim - Thomas Weisel Partners

Okay, all right. So, maybe you can't answer this question about cash flow from ops in the quarter?

Chris Farrell

I'll come out with our K.

Jason Kim - Thomas Weisel Partners

Okay. And then just to confirm you guys had to pay $3.4 million for Terawave as well in the quarter?

Chris Farrell

We've paid it's over $5 million for Terawave.

Jason Kim - Thomas Weisel Partners

Okay, thanks.

Operator

(Operator Instructions) There are no further audio questions.

Bob Howard-Anderson

Okay. Again thank you all for attending and we look forward to hosting future earnings calls with even better results.

Operator

That concludes today's conference call. You may now disconnect.

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