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Zhone Technologies, Inc. (NASDAQ:ZHNE)

2Q08 Earnings Call

July 22, 2008 5:00 pm ET

Executives

Susie Choy – Director of Investor Relations

Mory Ejabat – Chairman and Chief Executive Officer

Kirk Misaka – Chief Financial Officer

Analysts

Eric Caner – Analyst

Greg Mesniaeff – Needham & Company

Operator

Good day, and welcome to the second quarter 2008 Zhone Technologies Inc. conference call. (Operator Instructions) I would now like to introduce Susie Choy, Director of Investor Relations. Please proceed.

Susie Choy

Thank you operator. Hello, and welcome to the Q2 2008 Zhone Technologies, Inc. conference call. I am Susie Choy, Zhone’s Director of Investor Relations. The purpose of this call is to discuss Zhone’s second quarter 2008 financial results, as reported in our earnings release, which was distributed over business wire at the close of market today and has been posted on our website at www.zhone.com.

I am here today with Mory Ejabat, Zhone’s Chairman and Chief Executive Officer, as well as Kirk Misaka, Zhone’s Chief Financial Officer. Mory will begin by discussing the key financial results and business developments of the second quarter. Following Mory’s comments, Kirk will discuss Zhone’s detailed financial results for the second quarter and provide guidance for the next quarter. After our prepared remarks we will conclude with questions and answers.

As a reminder, this conference is being recorded for replay purposes and will be available for approximately one week. The dial in instructions for the replay are available on our press release issued today. And audio webcast replay will also be available online at www.zhone.com following the call.

As you know, during the course of the discussion today, we will make forward looking statements, including those relating to projections of profitability, earnings, revenue, margins, operating expenses or other financial items, the anticipated growth or trends in our business, product lines, key markets, new product introductions and the migration of customers to newer technologies, Zhone’s market position and focus, and statements that express our plans, objectives and strategies for future operations. We would like to caution you that actual results could differ materially from those contemplated by the forward looking statements. We refer you to the risk factors contained in our SEC filings available at www.sec.gov, including our annual report on Form 10-K for the year ended December 31, 2007 and our quarterly report on Form 10-Q for the quarter ended March 31, 2008.

We would like to caution you not to place undue reliance on any forward looking statements, which speak only as of the date on which they are made, and we undertake no obligation to update any forward looking statements. During the course of this call, we will also make reference to pro-forma EBIDA and pro-forma operating expenses, non-GAAP measures which we believe are appropriate to enhance an overall understanding of past financial performance and prospects for the future. These adjustments to our GAAP results are made with the intent of providing greater transparency to supplemental information used by management in its financial and operational decision making. These non-GAAP results are among the primary indicators that management uses as a basis for making operating decisions, because they provide meaningful supplemental information regarding our operational performance, and may facilitate management’s internal comparisons to the company’s historical operating results and comparisons to competitor’s operating results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for measures of financial performance prepared in accordance with GAAP. We have provided GAAP reconciliation information for pro-forma EBIDA within the press release, which, as previously mentioned, has been posted on our website at www.zhone.com.

With those comments in mind, I would now like to introduce Mory Ejabat, Zhone’s Chairman and Chief Executive Officer. Mory.

Mory Ejabat

Thank you, Susie. Good afternoon and thank you for joining us today for our Q2 2008 earnings call.

Let me briefly discuss the financial results before providing an update on the business. After two consecutive quarters of exceeding our revenue guidance, this quarter proved to be challenging. Revenue was $40.1 million, equal to our recently updated guidance of approximately $40 million, but below our earlier financial guidance of between $44 million and $45 million. As announced, our largest customer in Latin America requested aggressive price reduction for a multi million dollar expansion that we had to refuse, because it would have been unprofitable at those prices. This loss was not to any larger or Asian manufacturer, but to a European company looking for a new customer. The pricing offered by them was for an inferior product with many service affecting limitations, that wasn’t comparable to Zhone’s product. However, new customer agreements, additional projects with our existing customers, and new product offerings give us the confidence to recover from this loss and get back to our anticipated growth. This loss resulted in the majority of the revenue shortfall in our international market.

Domestically, we met our revenue targets and are encouraged that moderate growth may once again be possible. With the revenue shortfall, gross margins, pro-forma EBIDA, and cash flow were also negatively impacted on the short term basis. Going forward, we will focus on deals that meet our gross margin goals and profitability objectives.

We have restructured our manufacturing operations and have reduced operating expenses to achieve pro-forma EBIDA profitability in Q4 08. These actions will have a one time negative effect on our operating expenses during Q3 08, but will have a positive impact going forward. Kirk will give you more details on our financial performance and guidance later.

Before turning to the business side, let me say a few things about the status of our NASDAQ listing. As announced in our recent press release, we received a letter from the NASDAQ stock market on June 11, 2008. In their letter, the NASDAQ notified us that for 30 consecutive grading days, the best price for our stock had closed below the $1.00 per share price required for inclusion on the NASDAQ global market. The NASDAQ has given us until December 8 to regain compliance, appeal the listing, or apply to transfer the company stock to NASDAQ Capital Market subject to those requirements. Since receiving the letter, we have been actively consulting with our advisors and board to fully evaluate all of the alternatives. We expect to make a formal announcement prior to the deadline, when our evaluation process is complete.

So, with a brief financial update, let me talk about our business and the positive signs that give us confidence that we can overcome the short term financial challenges. Turning to a view of the market, we see continued progress on the fundamentals that sustain our confidence about the business. From continually strong market share position to customer agreements and enthusiastic response to our new product innovations, our market share position remains strong.

In the multi service access platform, or MSAP , a segment that is core of our business, Infonetic research reports, in their latest available market share statistics, that core shipments remain an essentially even heat for leadership between Zone, Alcatel, Lucent, Walway, Nokia Siemens, and VT, each with roughly 7 % to 10% market share in the category. Customers with forward looking multi service and network conversions initiatives continue to respond very well to the value of our product portfolio. The initiation of the customer agreements that we have announced over the past quarter proves the point.

On communications – a competitive carrier covering 16 states in the Eastern United States selected MALC as the platform to support voice and EFM services to over 160,000 small and medium enterprises. In Canada, MTS Allstream, a leading incumbent telecom provider and Maskatel, a comparative carrier, both selected the MALC platform to support converge voice and data services that will be delivered throughout the country.

On telecoms – an innovative alternative carrier in Greece selected the MALC to provide business services using our Ethernet in the First Mile, or EFM, solution, targeting leased line replacement and improve the economies for more than 70,000 small and medium enterprises in their territory.

Growing support for a multi service access region across every region we serve became tangible in a new way in May, our annual customer event, Zhone Tech. We had operators from a record 30 different countries together for a spirited discussion of the road ahead for access, previews of our next product releases, and productive networking with their peers.

Our R&D efforts continue to create greater depth in our multi service offerings. Our latest public launch – the SkyZone metro Wi-Fi product, received rave reviews from the industry critics and the product innovation award judges at NXTcomm, one of the industry’s key annual events. We are addressing the metro wireless opportunity as a national extension of a multi service wire line access network. We have created a solution in SkyZone that dramatically improved the economics of metro Wi-Fi by delivering much higher capacity and reliability with very low increment of cost. We continued our first deployment with www.acd.net, a US site that has implemented their solution in model private/public partnership with two cities. We also have several deployments in progress with other telcos that see SkyZone as an attractive opportunity to extend their service model and capture new revenue services within their markets.

Our R&D team has also made substantial progress on a number of next generation aggregation platforms that are in early customer deployments now. Customer experiences with these early deployments have been very positive, and we expect to launch these solutions to the broader market over the course of Q3 and into Q4.

Now, I would like to turn the call to Kirk to provide more details about our financial results for last quarter, and to discuss our financial guidance for next quarter. Kirk.

Kirk Misaka

Thanks, Mory. Today’s Zhone announcement entered results from the second quarter of 2008. In our press release, traditional comparison of financial results for the second quarters of 2008 and 2007 is presented alongside a comparison to the first quarter of 2008.

As we have done on previous earning’s calls, most of our discussion today will focus on the sequential comparison to the first quarter results. With that in mind, let’s start with revenue. As Mory mentioned, revenue for the second quarter of 2008 was $40.1 million, which met our revised guidance but fell short of our original financial guidance of between $44 million - $45 million. Weakness in the Latin American market caused international revenue to decline to 55% of total revenue in the second quarter, as compared to 59% of total revenue for the first quarter.

Domestic revenue, however, increased by 3.7% over the prior quarter, showing signs of an improving domestic environment, and increased interest in our technologies.

We continued to serve approximately 700 active customers worldwide, but experienced slightly more customer concentration over the last two quarters as compared to the past. We had one 10% customer, with the two slots representing about 17% of second quarter revenue and our top 5 customers represented approximately 37% of revenue for the second quarter, as compared to 38% for the first quarter.

Second quarter revenue of $40.1 million declined by 6.9% when compared to first quarter revenue of $43 million. Since the third quarter is a seasonally weak quarter, particularly in our international market, we expect revenue to continue to decline and expect it to range between $36 million and $37 million for the third quarter. We expect revenue growth to return in the fourth quarter.

Now let’s turn to gross margins. Gross margins fell to 29% for the second quarter of 2008, largely due to the lower revenue level in manufacturing operations that were prepared to produce much higher volume. Going forward, we’ve adjusted our variable manufacturing labor and other costs to the new revenue forecast, and therefore, expect margins to improve to between 32% and 34% for the third quarter.

As for operating expenses, total pro-forma operating expenses for the second quarter of 2008 were $18 million, excluding the impairment of intangible assets of $70.4 million and the increase in our estimate of the lease liability associated with excess space in our Largo facility of $3.3 million. Pro-forma operating expenses were within our $17 million to $18 million guidance range. Operating expenses include depreciation of approximately $400,000 and stock based compensation of approximately $600,000. As Mory mentioned, we have also reduced our operating expenses to reflect a lower revenue level and we anticipate total pro-forma operating expenses for the third quarter of 2008 to drop to between $15 million and $16 million, including approximately $1 million of expenses for depreciation and stock based compensation, but excluding about $500,000 for severance and other restructuring charges attributable to reducing operating expenses by approximately $2 million per quarter.

Finally, pro-forma EBIDA for the second quarter of 2008 was a $5.2 million loss, and larger than our anticipated estimate of EBIDA loss of approximately $2 million. We expect to substantially reduce the pro-forma EBIDA loss for the third quarter to between $2 million and $3 million with the goal of returning to break even quarterly pro-forma EBIDA in the fourth quarter.

As for the balance sheet, cash and short term investments at June 30, 2008 were $50.1 million, which declined from $57.3 million at March 31, 2008, mostly attributable to the EBIDA loss and other working capital changes occurring during the second quarter. Our total debt obligations declined slightly to $34.2 million at June 30, 2008, as compared to $34.3 million at March 31, 2008. On a combined basis, our net cash balance, or cash net of debt obligations, decreased from $23 million to $15.8 million at the end of the second quarter, again, as a result of the EBIDA loss, and other working capital changes occurring in the second quarter.

As for other balance sheet changes, inventory levels stayed basically the same at $37.2 million as of June 30, 2008, while accounts receivable decreased by $1.9 million to $30.2 million at June 30, 2008. The number of day sales outstanding on accounts receivable for the second quarter coming in at 58 days, as compared to 67 days for the first quarter. Finally, the average basic and diluted EPS shares were $150.3 million for the second quarter, increasing only slightly from $150.1 million in the first quarter. The slight increase resulted primarily from stock option exercises by management and employees.

With that financial overview, I’ll turn the call back over to Mory for a few final comments before we open the call up to questions and answers. Mory.

Mory Ejabat

Thank you, Kirk. The second quarter proved to be challenging, but our business shows positive signs that indicate that we can overcome the short term financial challenges. We remain focused on quickly making the necessary adjustments to our business so that we can get back to break even pro-forma EBIDA by the fourth quarter. We expect future results to confirm that the service providers around the world are adapting our market leading access technologies at an increasing rate.

As a global company focused on pure player access technologies, we are positioned to benefit from the extension of our access networks in emerging markets around the world.

Thank you very much for joining us today. We will now open up the call to questions.

Operator, please begin the Q&A portion of the call. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Erik Caner. Please proceed.

Eric Caner - Analyst

Thank you very much. I wonder if you could talk to us a little bit about how much of your business came from existing contracts, and how much came from new contracts, and maybe how did that compare to the past?

Mory Ejabat

Eric, let me comment on that. In comparison to the past, as you remember, we had some negative business in Q2 of last year. If we take a direct picture of Q2 last year, year over year our business grew about 4% even though we had a shortfall this quarter. So, that means we attracted new customers and new product to sell to these new customers to achieve that 4% year over year achievement. We normally don’t keep track of how much of our business comes from new businesses, but in the past quarter we had several new customers that we announced and several of them that we haven’t announced. So, I would say a good portion of our business came from our existing customers, but there was some that came from the new customers.

Eric Caner - Analyst

Okay. As far as the new bids that you are part of, are you seeing an increase in the number of competitors in those new bids?

Mory Ejabat

Actually, no, we are seeing a decrease in the amount of customers in the new bids. As you know, one of our largest competitors dropped the Gcom business, that was well publicized. And also, people are looking for more and more multi access concentration or NSAT byproduct and there are not as many people in that sea that can provide all that functionality.

Eric Caner - Analyst

Okay. One last question is about the SkyZone product. I wonder if you can tell us about the kind of interest that you’re seeing there, and how quickly that product may ramp.

Mory Ejabat

Actually, what I can tell you – we were at NXTcomm trade show and the majority of the show was centered around this product. We have seen lots of people looking at the SkyZone really interested. We have several trials going on right now. The majority of the interest comes from telcos that have a relationship with a municipality, as well as international carriers. And we believe the product is going to start ramping up, more likely in Q4 and Q1 of this year.

Eric Caner - Analyst

Okay. Great, good luck.

Mory Ejabat

Thank you.

Operator

Our next question comes from the line of Greg Mesniaeff with Needham & Company. Please proceed.

Greg Mesniaeff – Needham & Company

Yes, I have a question for Kirk. If you could just tell us where the concentration of the goodwill impairment was focused on. Was it the Paradyne part of the business?

Kirk Misaka

Greg, the impairment eliminated all of our goodwill that still remained on the books.

Greg Mesniaeff – Needham & Company

Okay, okay, so it’s everything then at this point?

Kirk Misaka

Yes, that’s correct. So there’s no remaining goodwill to be impaired.

Greg Mesniaeff – Needham & Company

Got you

Kirk Misaka

We previously impaired about $165 million of goodwill, and Premises and Paradyne were the majority of that amount.

Greg Mesniaeff – Needham & Company

Got you. Thank you.

Operator

This is all the time we have for questions. I would now like to turn the call back over to Mory for closing remarks.

Mory Ejabat

Thank you again for joining us today. We appreciate your continued support and are looking forward to speaking with you in our next conference call, when we hope to report improved financial performance. Operator?

Operator

That concludes today’s presentation. Everyone have a great evening. You may now disconnect.

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Source: Zhone Technologies, Inc. 2Q08 (Qtr End 06/30/08) Earnings Call Transcript
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