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Avanex Corporation (AVNX)

Q2 2006 Earnings Conference Call

February 8th 2006, 4:30 PM.

Executives:

Maria Riley, Stapleton Communications, Director of Investor Relations

Jo Major, President and Chief Executive Officer

Tony Florence, Chief Financial Officer

Analysts:

John Harmon, Needham & Co

Todd Koffman, Raymond James

David Fore, Sur Terre Research

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Operator

Welcome to the Avanex Corporation Second Quarter Fiscal Year 2006 Conference Call. At the request of Avanex Corporation, this conference is being recorded for replay purposes. Please note that all lines will be in a listen-only mode until the question-and-answer session of today’s call. With us on today's conference are Jo Major, President and Chief Executive Officer and Tony Riley, Chief Financial Officer. I would like to turn the call over to Maria Riley of Stapleton Communications. Ma'am, you may begin when you are ready.

Maria Riley, Stapleton Communications, Director of Investor Relations

Good afternoon and thank you for joining us today. To begin, I'd like to remind you that this call contains forward-looking statements, including statements regarding cost reduction and restructuring measures, transfer of manufacturing operations to lower cost regions. Third fiscal quarter revenue in operating performance projections, improvements in gross margins, cost savings and liquidity, market trends in our competitive position, and our product development and manufacturing strategy changes in the market for our products.

Actual results could differ materially from those projected and/or contemplated by the forward-looking statement. Factors that could cause actual results to differ include general economic conditions, the pace of spending and timing of economic recovery in the telecommunications industry and in particular, the optical networks industry. The Company's inability to sufficiently anticipate market need and develop product and product enhancements that achieve market acceptance, problems or delays on our restructuring activities, or in integrating the business acquired from Alcatel, Corning, Vitesse Semiconductor or in reduced cost structure of the combined company. The Company's inability to achieve the anticipated benefits of the acquired businesses or successfully transfer manufacturing operations to lower-cost region in a slowdown or deferral of new products or acquired products, the future cost savings that are an improvement in gross margins higher than anticipated expenses the Company may occur in future quarters, or the inability to identify expenses which can be eliminated.

Avanex renegotiated some leases at the Company's French subsidiary that will reduce the Company's future cash obligations. Avanex is reviewing the accounting for these leases and to date the accounting has not been finalized. The accounting for these leases will not impact the Company's current or future cash flow, revenue, or results of operations. Please refer to the risk factors contained in the Company's SEC filings, including the annual report on form 10-K filed with the SEC in September of 2005 and the quarterly report form 10-Q filed with the SEC in November of 2005. Avanex sends no obligation and does not intend to update any forward-looking statement, whether as a result of new information, future events or otherwise. In addition, because non-GAAP information is being presented, in order to comply with regulation G, please note Avanex has provided a reconciliation table under the investor section of the Company's web site under the presentations tab at www.avanex.com. With that, I'll turn the call over to Jo Major, President and CEO.

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Jo Major, President and Chief Executive Officer

Thank you, Maria. Good afternoon, everyone. And thank you for attending today's call. I'll start with the review of our December quarter financial performance followed by an update on our restructuring initiatives and operational overview. Tony will then provide you with details on the financials and our balance sheet. I'll conclude with the business outlook and guidance for the up coming quarter before we take questions.

The December quarter was our heaviest transition quarter to date. Within this quarter, many functions were transferred to our low-cost operation center. Specifically, all operational control of our New York Group, which is responsible for our market leading amplification and dispersion compensation businesses was transferred. In addition, we transferred much of the assembly operations of our French and Italian operations during the quarter. We also worked through the difficult process of parting with approximately one quarter of our North American and European employees during the December quarter. While these transitions did not go perfectly, I am very proud of the team for the progress that we achieved in reorganizing Avanex.

Now, under the review of our financial performance, revenue in the second fiscal quarter was $36.1 million compared with $41.2 million in the prior quarter and $41.9 million in Q2 of the prior year. The shortfall is revenue was due to transitional issues that arose primarily as a result of expensive transfer activity in the quarter.

I will discuss these issues in a moment. The second quarter marked our fourth sequential improvement gross margins. Second quarter gross margins were 7%, up 2 points from the prior quarter, up 13 points from the second quarter of fiscal 2005 and up 34 points from the second quarter in fiscal 2004. Net loss for the Company was $0.09 per share, our lowest net loss since we have been a public company. This compares with the net loss of $0.12 per share in the previous quarter. We have decreased our net loss by 44% and 60% from the second quarter in fiscal 2005 and 2004 respectively. I am also pleased to say we reduced our cash burn by $14 million in the second quarter. This reduction in cash burn was a result of teamwork in a variety of areas.

A significant reduction of our cash burn was the result of negotiated one-time event within the quarter, which totaled $6.6 million, offset by the one-time settlement payment and fees to resolve our debt issue of $4 million. Tony will provide details on our cash usage, including further information on one-time events specific to our second fiscal quarter. He will also give guidance on additional liquidity events that will be coming in the next three quarter. Next we will review our restructuring activities and operational performance. We continue to make progress executing our global restructuring plan and achieve several important milestones throughout the quarter including the termination of all manufacturing operations at our Erwin Park New York facility.

In addition, heavy transfer activities again for France and Italy also occurred in this quarter. We have completed the transfer of all manufacturing and related operations for all product lines previously manufactured in California and New York, including subsystem products, micro-optic module, amplification dispersion compensation and small form factor transceiver. The assembly operation for Italy and France, including active componentry, 10-gig transponders and lithium niobate modulator we'll complete within this quarter. Following the closure of our manufacturing line in New York we moved our development and support staff into a significantly smaller facility in the area.

During the December quarter, we encountered operational issues ranging in scope and degree of complexity, including capacity issues, material shortages, yield issues for new products and logistical issues. Together with our contract manufacturers, we have implemented several measures to resolve these issues. These actions include, adding development support on-site to the contract manufacturers to aid in the new product introduction process. Implementing proactive measures, including daily meeting with our contract manufacturers and the hiring of dedicated coordinators for each of our product lines and hiring a very strong individual to lead a dedicated new product introduction team focused on smoother transitions of technically advance products into the manufacturing environment.

In addition, our primary contract manufacturer has hired a high-level executive to lead a team fully dedicated to Avanex. To help you understand our path to revenue growth, we will now share some internal operational metrics for our business. We will not refer to these metrics in the future, but felt that sharing at this time would provide you with insight into our manufacturing process. The efforts of our team and a contract manufacturer that support us is improving our manufacturing performance. Onetime shipment performance in January has improved 10 percentage points over our performance in the second quarter. Several product lines have now stabilized following the transition with lead times decreasing and again becoming competitive with the industry. Our shipment performance in January has also improved, with January shipments approximately 25% higher than revenue shipments in October.

While our key operational metrics are improving, our third quarter of fiscal 2006 does include the closure of our French and Italian assembly operations as key milestones in our cost reduction activities. In addition, this quarter we will be consolidating our SAP infrastructure into an integrated platform to allow further reductions of both G&A and operational spending. Finally, this quarter has a strong focus on completion of activities to achieve environmental compliance with European ROHS standards. We are on schedule with the real estate restructuring in France and still expect it to be completed in April 2006. As a reminder, our goal is to relocate people and equipment from an extended campus of four buildings into the equivalent of a single building on the Nozay Campus.

As we have moved through this painful period of restructuring we have reduced head count further worldwide to 605 employees, as of December 31, down from 702 at the end of last quarter. Our North American and European head count went from 585 to 448 a 23% reduction within a single quarter, while head count in Asia increased from 117 to 157. We have been working very closely with our customers and appreciate their patience as we work through this transition. Since the first of the New Year, we have been holding executive meetings with all of our key customers to show them the preliminary results of our corrective actions for operations and to reinforce our position with respect to new product introductions. As we complete this restructuring, development resources are becoming available for substantial new market opportunities.

Although our second quarter was challenging from the revenue perspective, it was another strong design win quarter for Avanex, including key design wins into major OEMs for RBOC deployments. Giving us the potential for healthy revenue growth in coming quarters. In March, Avanex will participate in a optical fiber communications conference. We will use OFC to showcase strong product capabilities in areas such as low-cost compact amplifiers, low-cost optical filters for fiber to the home deployments, submarine componentry, new subsystem protection switch module and high performance 10-gig NSA transponders. I'll now turn the call over to Tony for details on the financials.

Tony Florence, Chief Financial Officer

Thank you, Jo. Revenues were $ 36.1 million in the second fiscal quarter compared with $41.2 million in the prior quarter and $ 41.9 million in the second fiscal quarter of the prior year. As Jo mentioned, the revenue declined in the second quarter was primarily due to transitional operational issues that arose as a result of the closure of our Erwin Park, New York fashion facility in early December and the transform to a low cost contract manufacturers. I would like to note that the second quarter was our heaviest period of the manufacturing transition process.

Gross margins in the quarter improved to 7% compared to 5% in the prior quarter and negative 6% in the second quarter of the previous year. Gross margin percentages have increased four sequential quarters primarily due to the reduction in our manufacturing overhead. These sequential improvements are a validation of our strategy to shift manufacturing to contract manufacturers in low cost areas. We expect continued improvements in our gross margins.

Also, we are pleased with the improvements we have made in our cost structure during the second quarter as well as over the past year. We have achieved sequential improvements in our operating costs, total GAAP operating expenses in the quarter were $16.3 million compared with $18 million from the prior quarter and $21.8 million in the second quarter of the prior year. Non-GAAP operating expenses, which exclude our amortization of intangibles, restructuring cost, share base payments, a gain on the restructuring of our leases in France and other one-time events where $11.4 million or 31% of revenue, compared with $15.million or 38% of revenue in the prior quarter and $15 million or 36% of revenue in the second quarter of the prior year. The improvement in non-GAAP operating expenses was driven by the reduction in head count and the continued streamlining of our operations.

Our GAAP net loss continues to improve and as Joe mentioned, we achieved the Company's best ever GAAP net loss results since the Company's IPO in 2000. In the second quarter, GAAP net loss was $13.5 million or a net loss of $0.09 per share compared to a net loss of $16.9 million or a net loss of $0.12 per share in the prior quarter and a net loss of $24.4 million or a net loss of $0.17 per share in the second quarter of the prior year. The improvements of net loss were driven by improved gross margins, reduced operating expenses and a gain on the restructuring of our leases in France being partially offset by the settlement costs associated with our convertible note holders. The recurring portion of our cost structure has been substantially reduced as a result of our restructuring initiatives. The interest payments on the Company's convertible note have been prepaid for two years, so although the interest does hit the net loss line, it is a non-cash expense. Our non-GAAP net loss, which excludes amortization of intangibles, restructuring cost, shared base payments and a gain on the restructuring of our leases in France and other one-time events was $9.3 million or a net loss of $0.06 per share. Non-GAAP net loss with the same adjustments in the prior quarter was $14.7 million or a net loss of $0.10 per share compared with a net loss of $17.5 million or a net loss of $0.12 a share in the same quarter a year ago.

The restructuring charge of $2.9 million recorded in the second fiscal quarter is primarily due to changes in accounting estimates. The cash outlay from restructuring in the second quarter was approximately $8 million. We expect a similar cash outlay for restructuring in the third fiscal quarter. We expect cash outlays for restructuring to decrease to $3 million in the fourth quarter.

I would like to now spend time discussing our balance sheet and more importantly, our liquidity. Managing cash is one of our top priorities. Our cash and investment balances as of December 31 was $48 million compared with $54 million at the end of the prior quarter. The sharp reduction in Q2 cash burn to $6 million from $20 million in the previous quarter was driven by actively managing our working capsule, the various agreements Alcatel and Vitesse and improved operating results. These were offset by settlement payments to our convertible note holders, which totaled $ 4 million including legal fees. More specifically, the agreements with Telus was a purchase agreement for high-powered lasers and some associated equipment. We collected the full amount of these purchase agreements totaling $1.8 million in the second fiscal quarter.

The previously announced supply agreement with Alcatel supplies Alcatel with 70% of its fiber optic component requirements through October 2007. As part of that agreement Alcatel agreed to prepay 5 million euros approximately $6 million. We have already received $2.4 million of the prepayment, all of which will be applied to shipments in the third quarter. We expect to receive the remaining $3.6 million in cash in the third fiscal quarter, which will be a applied to products shipped in the third fiscal quarter of fiscal 2007. We are reducing our footprint in France by consolidating our Nozay facilities. The Alcatel agreements included rent credit totaling $7 million over 18 months. In addition, the reduction of our footprint reduces our future lease liability. The renegotiation of these leases at the Company's French subsidiary will reduce the Company's future cash obligation. Avanex is reviewing the accounting for these leases and for the to date the accounting has not been finalized. The accounting will not impact the Company's current or future cash flow, revenue or result of operations.

We previously announced we expected to receive $10 million in cash for tax credits from the French Government and receivables in the second half of fiscal 2006. In Q2, we received $2 million and expect to receive the remaining $8 million by the end of fiscal 2004. In Q1 of fiscal 2007, we now expect a further $1.1 million with French tax credits. With that, I would like to turn it back over to Jo.

Jo Major, President and Chief Executive Officer

Thank you, Tony. We have been working hard to build a cost-competitive and successful company and as we've discussed today, we have achieved several important objectives, completing our restructuring activities, managing our working capital and growing our revenue base will be our focus areas over the next few quarters. This restructuring program has substantially improved our company over the past year . Our gross margins have improved over 13 points. Or GAAP net loss has improved from $0.17 to $0.09 per share the best result that Avanex has achieved as a public company. Our GAAP OpEx has decreased from $21.8 million to $16.3 million and our cash burn has been substantially reduced. For the third fiscal quarter of 2006, we are forecasting revenues to be in the range of $36 to $40 million. We expect gross margins to further increase in our third fiscal quarter. With that, we now welcome your questions, I'll turn it to you operator,.

Questions-and-Answer Session

Operator

Thank you, sir. At this time, we are ready to begin the question-and-answer session. If you would like to ask a question please press '*' '1', you may need to lift your handsets before pressing '*' '1'. You will be announced prior to asking your question. If you would like to withdraw your question press '*' '2'. Once again, to ask a question please press '*' '1'. And our first question comes from John Harmon with Needham & Co.

Q - John Harmon

Good afternoon.

A - Jo Major

Hey, John, how are you?

Q - John Harmon

Good, good. Thank you. Just a few questions, please. What was cash flow from operations, if you've got it handy?

A - Tony Florence

That we haven't disclosed on quarterly basis, but it will be disclosed in our 10Q, which we hope to file shortly.

A - Jo Major

When we file the Q, we can sit with you and walk you through those numbers and help you understand the relevant pieces to it. I guess there's a couple of things that kind of are worth talking about. On the one-time side, as you're looking at cash, which is probably where the question gets at, on the cash side, we've negotiated sort of a series of transactions that are bringing cash into the Company. In Q2, those transactions that we negotiated brought $6.6 million of cash to the Company. That was kind of offset by the fact that we had a payout of roughly $4 million to settle the convertible note issue. Beyond that, there's changes that you can see in the working capital part of the business and we'll walk you through that in the Q and then you can kind of figure it out from that, how the money moves on the operating side.

Q - John Harmon

Okay. I think we've got about all the parts, but speaking of working capital. It looks like you reduced working capital by about $10 million, is that something that's sustainable, are there further reductions that you can do?

A - Jo Major

We really haven't given guidance on working capital improvements. We have been working very, very hard at, there's some things we can't say. We have worked very hard at accounts receivable and we will continue to do that this quarter. I think the second thing is that one of the beliefs we have about the contract manufacturing model is that over time, we'll be able to move our inventory exposure down, and you can see a gradual improvement of inventory that we've already achieved as we do this. Those are a couple of places where we will really focus on working, John.

Q - John Harmon

Okay. Thanks. If you could help me understand the other expense line, it's certainly a combination of interest expense plus it sounds like you had a one-time gain on your lease adjustments, and is that offset by the $4 million payment to your creditors?

A - Jo Major

That's correct, John. So, essentially if you look at our pro forma net loss table, you'll see a one-time gain for the restructuring of our French leases and that was recorded in other income below the OpEx line. That was partially offset by the $3.5 million cash payments to convertible bond holders. So it's really two rather large numbers offsetting each other.

Q - John Harmon

Okay, got it, thank you. Just a couple more, please. I noticed the item restructuring accruals went up. Is that number going to go up as you reduce your head count in France and Italy, or is it something else in that?

A - Jo Major

Well, we really haven't, oh, so this number. Let's separate the question into two. I'll get to the future stuff first. I think it's fair to say that you've been around us to know that we're really looking at how the Company performs and the cost structure. We're always looking at ways to improve the productivity of the Company and improve the general cost structure. That means we typically don't give guidance, actually legally can't give you any guidance to restructure in the European theater. Tony, maybe you can comment about the…..

A - Tony Florence

Yes, so John, essentially, that restructuring expense was really a change in accounting estimates for preexisting restructuring plans. So it's not an indication of any new previously unannounced restructuring plans.

Q - John Harmon

Okay. Thank you. Just finally, looking at your guidance, clearly in Q2, you were unable to ship some product because of capacity constraints and other issues that you mentioned, are you still, and your Q3 guidance is really kind of a round trip back to roughly the revenue level you did in Q1. Are you still dealing with capacity issues and yield issues in Q3?

A - Jo Major

This is still, let's see. So Q2 we had a lot of this issues, I think we worked through a fair amount of them. I understand on this call that there is some data that may be a little bit confusing to people. As an example, our January shipment, we really are doing a better job in shipping, we're really getting a lot more product out there. Our revenue compared to a similar time in Q2 is up 25%. But it does look like we're settling down and getting better performance out of our manufacturing team. We do have significant transfers that tie off in this quarter. And because of that, we've put the guidance where it is. I think there are some things to be said. One is, we are working very closely with our customers, we do believe that there's demand that lets this company grow and we've also seen some pretty rich results on the design win side. We do have some nice design wins that as we get our manufacturing online, we think that there's some quite nice growth that's potentially there for us. We did want to take a somewhat conservative stance, given what we think is the risk that the various product lines have.

The other thing I said, and I'll reiterate is, these transfer programs really go off product line by product line. And we do have quite a few products now that the return the lead times are returning to where they need to be. We're getting the materials flowing through the factory, we're really getting a lot of material moving through and the logistics are working a lot cleaner. So for a lot of our product lines, we're actually starting to see a return to normalcy. But, we saw some jitter last quarter and I think given the transitions we have this quarter, we felt it was better to take a bit more conservative stance on the revenue projections.

Q - John Harmon

Okay. Thank you.

Operator

Our next question comes from Todd Koffman with Raymond James.

Q - Todd Koffman

A follow up on that last question. It sounds like your January performance is up 25%, from, I guess you're comparing it to some month in the December quarter, but your guidance really doesn't reflect any meaningful progress. Is there just a tremendous amount of conservativism baked in, given that you have to execute in February and March and we could see a sort of a $44 - $45 million number or there's not that much demand for you to capture in the current quarter were you to execute successfully?

A - Jo Major

Just for clarification and we did provide you some insight into sort of manufacturing metrics that we don't typically do and won't going forward. When I compared January to October, basically that's the first month of our third quarter as compared to the first month of our second quarter. So we've started this quarter shipping much more strongly than we did last quarter. That's, we really wanted to give people an understanding of the fact that we have resolved some issues and we're out there moving along. I think the guidance is an accurate reflection of what we see the business to be. It's clear that there's demand for our products and that we can grow. I think everybody, at that point in the quarter, every CEO you talk to would like to blow away his guidance. But I think it's prudent just to say our guidance is 36 to 40 and we'll do everything we can to finish tying off these problems and grow the Company as quickly as we can.

Q - Todd Koffman

If I could just have a follow up on the same line of conversation. If you look back over the last six or seven quarters, excluding this December quarter, you've been doing 40, 41, 42 million a quarter, and you've given indications that the demand environment has gotten better. So where is the disconnect between what the level of business you were previously doing and the demand environment versus your sort of, the commentary on the guidance.

A - Jo Major

Again, Todd, I want to, let's see, I want everybody to, and we've tried to be very clear about the last quarter, and you're looking for several quarters back, we've been pulling a hundred people off roll each and every quarter. And as these people come off roll, I need to make a very clear statement that these are talented people, they understand what they're job and their contributing to the Company and when we take them off roll, typically we are asking that work to be shared or transferring that work many time zones away to somebody to pick up that ball and run. And if you look at our bottom line performance, if you look at growth margin performance, we have done what I consider to be a very strong job at radically changing the cost structure of this company over the period of a year. That causes, it's not just last quarter where our transitional issues were impedient from revenue growth. We have removed a lot of cost structure and basically kept a flat revenue profile with the exception of last quarter. There is demand out there. And there is a growing industry on a long off side and the metro-side, things are coming back. We're getting penetration into metro. Submarine is potentially coming back. In the middle of that, we are in the unfortunate situation of really changing our cost structure very quickly at the same time that the market is growing. Because of that, we've tended to be a flat revenue company for the past year.

Q - Todd Koffman

Thank you. Very helpful.

A - Jo Major

No problem.

Operator

Our next question comes from David Fore with Sur Terre Research

Q - David Fore

Hi, guys.

A - Tony Florence

Hi, David.

Q - David Fore

Jo, can you talk a little bit about what you might see as you go into this optical conference in March. Particularly in your regard to, I guess you mentioned a little bit on the lower cost side, the RBOC talk deployments?

A - Jo Major

So David for reason I don't know we lost the first part of your comment. I didn't hear the first part of your question.

Q - David Fore

Oh, sorry. You mentioned on the conference call, the upcoming optical industry conference for optical in general. Maybe if you can extend in that in terms of opportunities you might see there beyond your contribution constraints, particularly in regard to things like RBOC fiber the home deployments.

A - Jo Major

So the primary, actually in the call, we mentioned a few things. We are getting some products that we're looking to sell into some associated markets. We've got a really nice low-cost passive device that's essentially an optical monitor, if you will. That we're selling into certain fiber to the home applications. That's not a North American fiber to the home configuration, but the general idea and technology could be applicable to a lot of fiber to home applications. That's a real exciting thing for us. Obviously at OFC, there'll probably be a fair amount of focus on the fact that the submarine market is showing a lot of signs of life. There have been a number of cables that have been put in place and we're starting to see the inventory of that industry be depleted so that as the next cables come, we'll be many companies in the supply base will be blessed with submarine componentary demand, which is a real exciting thing that will probable be talked about at OFC. My guess on some other areas that will be real interesting that will come out of OFC is as these networks become more flexible, things like tunable dispersion compensations, low cost dispersion compensation, things like routums (phonetics) and different configurations of routums that are aiming at lower cost points. Those times of products I think at OFC will really be on the center stage and you'll see some exciting things there.

Q - David Fore

Great. Thanks, guys.

A - Jo Major

Sure, thanks, David.

Operator

Once again to ask a question, please press '*' '1'. One moment, please.

A - Jo Major

Okay. If there's no other questions, I'd like to thank you all for coming here and giving us the opportunity to talk about our business. We'll be happy to arrange calls and meetings throughout the quarter. Please contact Maria Riley, at maria@stapleton.com, if you're interested in seeing or talking with us. Thank you very much.

Operator

Thank you. That concludes today's Avanex teleconference call. At this time, all sites may disconnect.

TRANSCRIPT SPONSOR

Xponent Logo

Want to understand the future of optical components?

Xponent is the technology leader in the rapidly expanding market for FTTx optical devices. Our patented Surface Mount Photonics technology eliminates the high costs and complexity that have plagued single-mode optical components since their inception. Optical components can be assembled in a similar fashion to semiconductor electronics resulting in devices that are simpler, smaller and far less costly.

Surface Mount Photonics provides unequaled cost-advantages for building high-quality optical components.

Our products include a range of triplexers and diplexers for single-fiber applications including PON, point-to-point and bidirectional RF systems. Customers include optical systems vendors, transceiver suppliers and optical subsystem suppliers.

View our products, read more about our technology, read our press releases, and view our job openings.

To sponsor a Seeking Alpha transcript click here.

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Source: Avanex Corporation F2Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (AVNX)
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