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Procera Networks (NASDAQ:PKT)

Q2 2012 Earnings Call

August 02, 2012 4:30 pm ET

Executives

Todd Kehrli - Co-founder and Executive Vice President

James F. Brear - Chief Executive Officer, President and Director

Charles Constanti - Chief Financial Officer, Principal Accounting Officer, Vice President, Secretary and Treasurer

Analysts

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Jason Ader - William Blair & Company L.L.C., Research Division

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Victor Chiu

Daniel T. Cummins - ThinkEquity LLC, Research Division

Catharine Anne Trebnick - Northland Capital Markets, Research Division

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Scott D. Dawes

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Procera Networks Second Quarter 2012 Financial Results Conference Call. [Operator Instructions] This conference is being recorded today, Thursday, August 2, 2012. And I'd now like to turn the conference over to Todd Kehrli of the MKR Group. Please go ahead.

Todd Kehrli

Thank you, operator. Good afternoon, and welcome to Procera Networks' Second Quarter 2012 Financial Results Conference Call. On the call today from Procera are Jim Brear, Chief Executive Officer; and Charles Constanti, Chief Financial Officer.

Before we begin, let me note that the information about to be discussed contains forward-looking statements, including statements relating to the expected demand for Procera's products and Procera's expectations for growth in 2012. These forward-looking statements involve risks and uncertainties, as well as assumptions that if they do not fully materialize or prove incorrect, could cause the actual results to differ materially from those expressed or implied by such forward-looking statements. These risk factors include risks related to the acceptance and adoption of Procera's products; the company's ability to service and update its products; lengthy sales cycles and lab and field trial delays by service providers; the company's dependence on a limited product line or dependence on key employees; its ability to compete in its industry with companies that are significantly larger and have greater resources; its ability to protect its intellectual property rights in the global market; its ability to manufacture product quickly enough to meet potential demand; and other risks and uncertainties described fully in the company's documents filed with, or furnished to, the Securities and Exchange Commission.

More information about these and other risks that may impact its business are set forth in the company's Form 10-Q filed for the first quarter ended March 31, 2012, and Form 10-K, filed for the year ended December 31, 2011. All forward-looking statements in this presentation are based on information available to us as of today, and we assume no obligation to update these forward-looking statements.

I'll turn the call over to Procera's CEO, Jim Brear. Go ahead, Jim.

James F. Brear

.

Thanks, and welcome, everyone. We are pleased to report another very strong quarter reflecting consistent execution, continued positive traction across all customer segments and geographies and a steady investment in positioning Procera for continued growth. Revenue for the second quarter was $14.7 million, a 52% increase over Q2 of last year, while revenue for the first 6 months was $27 million, a 63% increase year-over-year. For Q2, we were profitable and generated $2.4 million of cash from operations.

Our strong performance reflects the increased demand for our products across all our customer segments, including wireless, wireline and cable. With our realtime subscriber-aware traffic analysis and reporting capabilities, service providers are able to improve their subscriber satisfaction, while using detailed analytics to generate additional revenue opportunities via personalized service plans.

Our revenue in the second quarter was spread across all service provider segments, with 40% fixed line, 34% cable, 14% wireless and 12% higher education and enterprise. We had 16 new service provider wins during the quarter, including 3 cable, 5 fixed and 8 mobile. These included 1 new cable Tier-1 customer and 2 new fixed mobile Tier-1 customers in Asia and Western Europe.

As we announced last week, we were selected by a large U.S. Fixed Line service provider who recently deployed more than 100 of our PacketLogic Intelligent Policy Enforcement systems across their network, fully replacing a competing solution. The initial order was worth over $4 million. This service provider selected Procera for detailed analytics and reporting capabilities, as well as the option to deploy carrier-grade NAP as its network expands and it experiences IPv4 address shortages.

Service providers across all segments are recognizing the value of our systems to improve the quality and longevity of their networks, while better monetizing their network infrastructure investments by creating new personalized services for their subscribers.

During the second quarter, we continued to expand our business within all of our customer base, receiving 23 follow-on orders, including 12 fixed, 5 cable and 6 mobile operators. These follow-on orders represented about 50% of second quarter revenue and included 7 follow-on orders from existing Tier-1 customers. We continue to expect about 50% of our total revenue in 2012 to come from follow-on orders and 50% to come from new business.

We received 27 new higher education orders in the second quarter, with higher education enterprise contributing approximately 12% of our total second quarter revenue. Trial activity remains strong and is balanced across all customer types and regions. We currently have 19 direct trials of Tier-1 service providers that are underway or plan to begin over the next 60 days. As we've previously discussed, we continue to be actively involved with a number of large mega carriers and remain quite optimistic. We're also beginning to see increased activity and interest from our -- for our solutions from some of the largest carriers in the U.S. with potential procurement starting in 2013 if our solution is selected.

Now let me touch briefly on our new product development. During the quarter, we launched 2 exciting new product offerings that marked the entry into a $2.6 billion application delivery market. Our carrier-grade NAP and advanced traffic steering products are designed to simplify large-scale subscriber deployments for network and cloud service providers. With our industry-leading application identification technology, we believe we can deliver superior performance and scalability compared to our competing routing application delivery controller solutions.

Carriers derive significant additional benefits from where our products are situated in the packet core, which is why the carriers themselves ask us to develop these capabilities. These new products are starting data trials this month with several Tier-1 carriers, and we expect to see revenue contribution from them in the first quarter of 2013.

We began shipping our new 7810 and 8920 appliances to customers last quarter, and we expect to see revenue contributions beginning in the third quarter. Lastly, we believe we will see opportunities for strategic partnerships going forward, which would include systems integrators, technology and OEM partnerships.

Earlier this week, we announced the hiring of a new VP of Business Development to lead this effort. Mike Lee comes to us from F5 Networks, where he played a central role in orchestration and execution of their entry into the service provider market. With Mike's industry knowledge and experience, we are better positioned to support our partners, expand our footprint and excel in serving customer requirements.

Before I talk about expectations for the remainder of 2012, let me turn the call over to Charles to review the Q2 financials in more detail. Charles?

Charles Constanti

Thank you, Jim. The financial results reported today include both GAAP and non-GAAP financial measures. Our non-GAAP measures exclude the impact of stock-based compensation and business development expenses. A reconciliation of GAAP to non-GAAP measures is part of the financial tables posted with our earnings release. This is available in the Investor Relations section of our website, www.proceranetworks.com.

Total revenue for the second quarter was $14.7 million, up 52% from $9.7 million in the second quarter of last year and up 19% from $12.3 million in the preceding quarter. Bookings for the second quarter of 2011 were $14.2 million, up 47% from Q2 of last year. Product revenue for the second quarter was $11.9 million, up 44% from Q2 of last year. This growth reflects productivity from a number of the salespeople that we added in the second half of last year, with growth driven by sales into the Americas and Europe. This reflects wireline customer success and demand for our PL8000 series products with sales balanced between new and existing customers.

Support revenue continued to grow and is an important source of recurring revenue. Support revenue for the second quarter was $2.8 million, a year-over-year increase of 101% from Q2 of last year and up 12% sequentially. The increase reflects continued expansion of the installed base of our products with ongoing support services.

By geography, North America was 57% of revenue, EMEA was 31% and APAC was 12% of revenue. The gross margin for the second quarter was 63% compared to 62% for the second quarter of last year. As we noted on our last call, we are modeling gross margins in the low 60s for the remainder of 2012.

Non-GAAP operating expenses in the second quarter were $7.7 million compared to $6.7 million in the preceding quarter and $5.3 million in the second quarter of 2011. The year-over-year increase in R&D expense reflects the cost of increased headcount and more costs related to testing and testing equipment for new product introductions.

The year-over-year increase in sales and marketing reflects the cost of new hires in 2011 and in the first half of 2012 and higher commissions on increased revenue. The year-over-year increase in G&A expense reflects higher variable compensation with performance exceeding expectations and a greater use of contractors and professionals as we implement the new accounting system and scale our business for growth.

Non-GAAP operating expenses are expected to grow in Q3 and Q4 of 2012, mainly in R&D and sales and marketing, with operating expenses going above $8 million in Q3 and above $9 million in Q4 as we accelerate our investment for growth. GAAP net income for the second quarter was $766,000 compared to net income of $181,000 in the second quarter of 2011.

On a non-GAAP basis, net income for the second quarter was $1.4 million compared to non-GAAP net income of $595,000 in the second quarter of last year. We generated $2.4 million of cash from operations in Q2. We ended the quarter with $132 million of cash and short-term investments. We are pleased with the leverage of our business model and the progress that we made in scaling for growth.

With that, I'll turn the call back to Jim.

James F. Brear

Thank you, Charles. Now let's talk about what we expect for the remainder of 2012. With our strong revenue performance year-to-date, we are raising our 2012 annual revenue guidance to a full year growth of 40% or approximately $62 million of revenue for the year, up from a previously provided guidance of 30% annual revenue growth.

In closing, we are seeing strong global demand for our products across all customer segments and regions, and we continue to have good visibility into our pipeline giving us confidence that we can achieve our increased revenue guidance. The Procera team continue to do a fantastic job of creating and delivering the best technology in industry. We have a highly competitive set of products, and we are expanding the team to position ourselves for growth in 2012 and '13 and beyond.

With that, we will now turn the call over to the operator to start the question-and-answer section of the call.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Sanjiv Wadhwani with Stifel, Nicolaus.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

A couple of questions. Jim, this is, I think, the first time you've mentioned the U.S. large customer base looking at these types of solutions. Can you just elaborate on that, to the extent that you can, just would be helpful putting into context as to what's the time frame and what are they thinking about doing with the products?

James F. Brear

Sure. I want to be sensitive, extremely sensitive to confidentiality, so I'm going to be pretty crisp. But we are seeing interest and activity with a few very, very large carriers in the U.S. And we're looking forward to building that relationship and potentially executing on that in 2013.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Got it. All right then. And I know those are standards [ph] , so I appreciate your giving some clarity there. But also, your largest competitor talked about maybe elongated sales cycle, carriers getting a little more price-sensitive. I'm curious, are you seeing any of that, or maybe that was just particular to them?

James F. Brear

Yes. At this point, no. I don't see price sensitivity or elongation of sale cycles from Procera's standpoint.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Got it. And one last question, Charles, 10% customers, I'm guessing at least one, given the large order of $4.5 million, and any clarity on that or was there more than one?

Charles Constanti

There's 2. Two were 10% customers. One new, one existing.

Operator

And our next question comes from the line of Jason Ader with William Blair & Company.

Jason Ader - William Blair & Company L.L.C., Research Division

Just before we get going with my question, I just had a clarification. Jim, could you remind us of the definition that you guys use for a Tier-1 carrier?

James F. Brear

Tier 1 in Procera's definition is any carrier that either has at least 1 million subscribers or is the top 3 carrier in a given country.

Jason Ader - William Blair & Company L.L.C., Research Division

Okay. And the last question, Sanjiv's question, asked about a lot. One thing I wanted to ask you was [indiscernible] just made 2 acquisitions recently in sort of video optimization and caching, do you think that, that is a capability that you guys will need to move in-house? How strategic do you think that capability is, and do you think that it puts them on a potentially stronger competitive footing?

James F. Brear

I would say that, as you can expect, we are knowledgeable about the market, and we knew and are aware of those acquisitions. We did not make any effort to participate. I think that's a decision that the competitor thought is strategic, and I think time will tell.

Jason Ader - William Blair & Company L.L.C., Research Division

Okay. Fair enough. And then, Charles, on the gross margin, just remind us, what are the kind of key drivers up and down for the gross margin going forward? I know the longer-term guidance is higher than low 60s, correct?

Charles Constanti

Yes. So the key drivers are, I would say, as we grow our installed base, we're seeing a shift towards more mix of software versus hardware, particularly on the appliance series products, as those continue to grow and as the percentage of our sales will grow in absolute dollar amount, we will get a margin leverage from that. The installed base, as support growing, we also get leverage from. And I think as our installed base customers mature, customers tend to drive the better gross margin.

Jason Ader - William Blair & Company L.L.C., Research Division

Okay. So you think in 2013 there's a big probability that gross margins will be higher than in 2012?

Charles Constanti

Yes. And I just want to correct one thing on Sanjiv's question. He asked about 10% customers, there's actually 3. And I'll give a little bit more color. One with 22% of revenue, that's a new customer. One is 16% of revenue and one was 11% of revenue. Those are both existing.

Operator

And our next question comes from the line of Alex Kurtz with Sterne Agee.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Just a couple of housekeeping items first for Charles. Can you give us the appliance versus chassis breakout and also the stock-based comp on the OpEx line?

Charles Constanti

Stock-based comp for OpEx line, these are in thousands, 30 for COGS; R&D, 124; sales and marketing, 323; G&A 184. And appliances are about 75% of the product sales.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

So if I look at 75% that was up from last quarter, do you think we're sort of at that 70% directional for the rest of the year, Charles?

Charles Constanti

I think it will move around. I think we'll continue to see strength in the appliances, but I think it's safe to think of it as maybe being in the 70-30, but it could go -- it could move around.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

And for you, Jim, as we start to get closer to 2013, I was wondering maybe you could give us initial indication on what you think the market can grow and maybe in relation what Procera can grow looking into maybe next year, just an early look.

James F. Brear

Gosh, that's a tough question. I mean, I can only speak to Procera. We're quite bullish on the growth opportunity as we've just raised guidance. And we look in at our funnel and activities, and it's the best -- we're in the best position we've been in the history of the company.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

So just to clarify, would you say that given your 40% growth rate for this year and that it's a new market, you have new sales guys coming on right now, is 40% a little bit aggressive for next year and maybe a little bit below that, or you think that's a potential target you're thinking about?

James F. Brear

That I don't know, Alex. I guess I would look to the industry. The industry right now is growing slight -- I think right around 30%.

Operator

And we have a question from the line of Victor Chiu with Raymond James.

Victor Chiu

This is Victor Chiu in for Simon Leopold. Last quarter, you mentioned some visibility into some incremental Tier-1 opportunities that you were pursuing that weren't fully baked into your guidance. Can you give us an update on what your expectations are, where they stand now for those and coming contributions to 2012? Is it kind of where the upside that we're seeing from your updated forecast?

James F. Brear

It could be, yes. Those are maturing. And as I mentioned, we're positive about the maturity. And that does give us a little more confidence around increasing our guidance.

Victor Chiu

Okay. So that's -- okay, that's helpful. I think most of my questions have been answered. I just have one more technical one. What portion of your deployments occur adjacent to a load balancer, and what portion sits elsewhere such as a central office?

James F. Brear

We don't necessarily sit that close to the load-balancing technology. They are a little further up in the network. I would think most of the carriers have load-balancing in it, so -- but we don't really see or sit that close to it.

Operator

And we have a question from the line of Dan Cummins with ThinkEquity.

Daniel T. Cummins - ThinkEquity LLC, Research Division

Let's see. I first wanted to ask about book to bill and your -- I guess your view on whether that's kind of the #1 indicator.

Charles Constanti

Well, bookings are clearly relevant. We tend to ship the majority of our bookings for the quarter and taking out support, which can play out over 12 months. So I think it's -- the way we operate our business is not really driving a lot of backlog. Usually as trials mature, that's when we get the orders. User acceptance is fairly rapid, and the revenue is -- we ship and we plan around these orders so that we'll have the inventory to fulfill them.

Daniel T. Cummins - ThinkEquity LLC, Research Division

Okay. Would you expect to be significantly above 1 book to bill in any of the immediate quarters coming?

James F. Brear

Too hard to say.

Daniel T. Cummins - ThinkEquity LLC, Research Division

Okay. Let's see. Yes, and I also wanted to ask you, I think you detailed about 75% of the bookings for the quarter, I think, in a series of press releases. Should we still expect that kind of visibility from you on current business intra-quarter? And then I have one last question on the U.S. market.

James F. Brear

Yes, I would think so.

Daniel T. Cummins - ThinkEquity LLC, Research Division

Okay. Well, that's great. And then one of your software partners has described the situation in the U.S. market where there seems to be this paralysis that had spread from the opposition, to T&T mobile -- AT&T mobile with respect to clarity on the regulatory environment, et cetera, and how to get spectrum if you can't get it from M&A. Do you share that view to some extent? And it just feels like these U.S. trials seem to be taking a very long time when you consider that AT&T and Verizon are kind of off-and-running with the family bucket plans. I was curious what your comment might be on that.

James F. Brear

I don't -- I'm pretty removed nor do I really get a sense of any regulatory challenges regarding procurement of our technology at this point. And as you know, in the U.S., they are beginning to consider more unique personalized services as you describe the family plans, et cetera. That's what we consider to be kind of step 1 in the evolution, moving to a personalized service and really for the -- to have a unique service suited for the Olympics where they allow you to stream all you want, they're going to have to have technology like ours. So it's one thing to create tiers based on usage for bandwidth, that's another than to vector off of applications or devices, et cetera.

Operator

And we have a question from the line of Catharine Trebnick with Northland Securities.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

The last name is Trebnick. Jim, Charles, a couple of quick questions around the competition and some color. One would be, you had said you had 3 new Tier-1 customers this quarter, could you tell us if they were competitive bids?

James F. Brear

All 3?

Catharine Anne Trebnick - Northland Capital Markets, Research Division

Yes.

James F. Brear

[indiscernible] And 2 were replacements.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

All right. And then my other question happens to be around, is there any region that you're seeing more traction in than others, either because of the -- either due to more competitive weakness or more desire to spend less capital and optimize the networks?

James F. Brear

Catharine, I have no idea. I can only look from my vantage point. And at this point, we're lucky enough that we don't see macro issues really affecting us.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

All right. And then the last question is, you announced 2 new products in June, traction with the new products at this point in time?

James F. Brear

I'd say it's beyond expectations, although we haven't really dug into deep trials. But we're hopeful that they'll turn into substantial [ph] wins, if not late this year, early next year.

Operator

And our next question comes from the line of Brent Bracelin with Pacific Crest.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

First question, obviously, you kind of took your full year guidance up to 40% from 30%. As we kind of think about kind of the Q3, Q4 breakdown, obviously you've had a very strong first half. Growth obviously is expected to slow some in the second half but clearly, a little stronger than what you would've expected. Is there a chance that the Q3 momentum could be down sequentially? How much visibility do you have into kind of Q3 versus Q4? How should we kind of think about the optimism that you kind of have right now and the business as it rolls out from a quarterly basis?

James F. Brear

I think it's a little early to tell. At the end of the day, we've guided up because of confidence. Some of that confidence is due to more opportunities, larger opportunities. I don't know exactly how those, if we win, will play out in terms of [indiscernible] and revenue recognized and all those things. So there's always the chance for lumpiness, and it's -- I just don't know yet.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Okay. Fair enough. And then obviously, a lot talked about some RFP lengthening sale cycles. Again, I think the way that they characterized it was a handful of deals where they start to see that approval process lengthening. Are you guys seeing any sort of lengthening of approval process? I know you're a lot smaller, but what are you seeing out there on kind of the RFP cycle? Are things slowing there, or no change relative to what you're seeing?

James F. Brear

No change at all.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

No change, okay. And then Charles for you, as we think about the margin levers to the business, I think on average you've had a 56.5% gross margin, product gross margin over the last 6 quarters on average. As we think about kind of leverage in the business, on one hand you have new customer deployments. I think the largest customer in the current quarter was a new customer footprint win where I imagine this can have a slightly lower initial gross margin, but what are the kind of levers to gross margin going forward? And how should we think about product gross margins at the 56 level here that's been relatively stable? At what point and what would be the catalyst for those gross margins to move higher?

Charles Constanti

It's going to be the mix of software, as well as I think geography can play a role. As you mentioned, new versus existing customers. It's going to -- with that said, it's a little hard for us to predict exactly when that number will -- that average that you're pointing out will move north. And I would expect, while we're guiding in the low 60s, kind of balancing it out. There could be lumpiness in that margin number as those factors play out.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Okay. And then my last question, as I think about the software contribution, obviously you announced some new functionality with traffic shaping and a carrier-grade NAP, and data will ship that, it sounds like, the beginning of next year. How meaningful of a margin lever could that be next year? And what's been the initial response to -- since you've announced that product?

James F. Brear

Well, we've been pleasantly surprised by the interest. And again, we kind of knew that based on the fact that a lot of our customers have been asking us to build the capability. So I'd say, overall, we're very encouraged by the interest based on just wanting to test the equipment and move it into a trial phase. But on your question around the impact, I think it's undetermined.

Charles Constanti

Yes. What it will depend on is, is there enough hardware already at the customer site to support the added functionality? If it is there, then it would be much higher. It would be higher margins. If they need hardware, then it would take us more towards our normal model.

Operator

[Operator Instructions] Our next question is a follow-up question from the line of Alex Kurtz with Sterne Agee.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Charles, just a clarification on the appliance business. I know last quarter you announced a large software deal. Did you have anything this quarter that was above $1 million? And do you expect any kind of large software-only deal above $1 million in the remainder of the year?

Charles Constanti

We did not -- in terms of a pure software deal, we did not in Q2. And we don't have a line of sight to a big software-only deal. [indiscernible] sort of in the low 60s in part.

Operator

And our next question comes from the line of Scott Dawes with Hilliard Lyons.

Scott D. Dawes

Last conference call for Q1, you mentioned that you had several mega carriers. And is the sales cycle for a mega carrier about the same as your ordinary or most of your customers, a year plus or minus?

James F. Brear

The answer is actually longer, to be honest. It's not unheard of for that to be multiple years.

Scott D. Dawes

Okay. How many would you classify as mega carriers are there worldwide? In other words, how big is the sea?

James F. Brear

I'd say there's maybe 25.

Scott D. Dawes

Okay. And also you mentioned at that conference call that you had at least one prospect in every phase of your sales cycle. How many phases are there in your sales cycle from the time they knock on the door to the time you recognize sales?

James F. Brear

I guess it would depend on the scale of the carrier. If you go into small, medium, large because...

Scott D. Dawes

I'm talking about megas.

James F. Brear

Yes, the mega, generally it starts with an RFI, Request For Information, general information gathering, that can take a period of time when you move into an RFP phase and process. Then you can move into then a lab trial process that can then turn into a field trial process, which then can lead to a procurement and contract negotiation, that would lead to a master supply agreement and our initial P.O., which leads to initial installation, and then once that's completed, an acceptance.

Operator

And I show no further questions in queue at this time. Management, please continue with closing remarks.

James F. Brear

Thanks again for joining the call. We look forward to speaking with you in the next 90 days. Thank you.

Operator

Ladies and gentlemen, that concludes our call this afternoon. If you would like to listen to a replay of today's conference you may dial 1 (800) 406-7325 or (303) 590-3030 and enter the access code of 4549033. Thank you very much for your participation, and you may now disconnect.

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