Tollgrade Communications, Inc. Q2 2008 Earnings Conference Call Transcript

Tollgrade Communications, Inc. (TLGD)

Q2 2008 Earnings Call Transcript

July 24, 2008 9:00 am ET

Executives

Joe Ferrara – President and CEO

Sam Knoch – CFO

Grant Cushny – VP of Sales and Professional Services

Christie Tillapaugh – Corporate Attorney

Analysts

Jeffrey Myers – Cobia Capital

Presentation

Operator

Good morning and welcome to Tollgrade Communications' second quarter 2008 earnings results conference call. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today's presentation. An operator will give instructions on how to ask your questions at that time. If you should need assistance during the conference, please signal an operator by pressing star then zero on your touchtone phone. This conference is being recorded. If you have any objections, please let us know by pressing star then zero now. Hearing no objections, I would like to turn the conference over to Joe Ferrara, President and CEO of Tollgrade Communications. Mr. Ferrara.

Joe Ferrara

Thanks Andrew. Good morning and thank you for joining us to review Tollgrade's second quarter 2008 results. This morning, I'll share with you the highlights of our second quarter and, as well as our revenue outlook for the third quarter of 2008, and then we'll take any questions you may have. With me today are Sam Knoch, our CFO and Grant Cushny, our Vice President of Sales and Professional Services. They would join me and answer any questions you may have. Also with us is Christie Tillapaugh, one of our staff attorneys. Christie will provide us with forward-looking statements before we start. Christie.

Christie Tillapaugh

Good morning. During this conference call, we will be making some statements regarding future events to resolve including our revenue guidelines for the third quarter of 2008 which are forward-looking statements within the meeting of section 27A of the Securities Act of 1933, as amended and section 21E of the Securities and Exchange Act of 1934, as amended. Such statements are based on assumptions that involved risks and uncertainties and actual events or results may differ materially from the forward-looking statements that we are making.

In addition to the factors that we mentioned today, additional risk factors that could cause actual events or results to differ materially are included in our filings with the SEC specifically in our annual report on Form 10-K for the year ended December 31, 2007 and in our reports from Form10Q. We expressly disclaim any intention to update our forward-looking statements and the estimates and assumptions associated with them at any time or for any reasons. Thank you.

Joe Ferrara

Thanks, Christie, and again, good morning. I am going to jump right in and start with the review of some of the highlights since our last conference call. We made some significant progress across our business in the –.

Operator

Just one moment there has been an interruption in the call, just one moment please.

Joe Ferrara

Andrew?

Operator

Thank you, we can now hear you please continue.

Joe Ferrara

Okay. So I'm going to jump right in and start with the review of the highlights since our last conference call. We made some significant progress across our business in the past few months which we are very proud of. First, we reached general availability of the first release of our DigiTest ICE product line in June. We also planned additional releases of the product to be generally available by the end of Q3. Second, for the second consecutive year, we received an award from AT&T for being one of it's outstanding suppliers in the area of products and service performance. Third, our operational expenses have significantly declined as compared to the previous quarters based on the restructuring activities in Q1 and actively controlling cost across the business. We have seen declines of 14% in operating expenses in Q2 versus Q1. Lastly, we had a $3.4 million in cash and short-term investments through our balance sheet during the second quarter and now I have over 59 million in cash and short-term investments.

In our last earnings conference call in May 1, I commented about our strategic review process as part of our commitment to take the actions necessary to enhance the value of Tollgrade for our shareholders. We continue to work through the potential opportunities and I have already begun to realize some of the benefits from implementing the internal programs to address the challenges in our business.

Results from our second quarter of 2008 underscored the current condition of our business. We saw increases in revenue year-over-year from our most recent acquisition but the increase is only served to offset declines in other products in our portfolio. This is a challenge that we are striving to address with the introduction of new products throughout the year. Specifically, the first release of the Digitest ICE became commercially available to customers in June.

In addition, other products are expected to become generally available later in the year including our LightHouse power utility solution [ph] and our cable [ph] end-of-line monitoring solution. These few introductions will help begin to address this issue. We are making all attempts to ensure that these new product introductions will be successful but in the meantime we need to manage between declining revenue on some of our older product lines while the new products are introduced to the market. While we saw the continuing effects of the general weakness in the economy and its impact on customer budgets and timing of the equipment purchases during the second quarter. We did see a small increase in our sales from Q1.

Yesterday, we reported second quarter 2008 revenue of 14.6 million which on a sequential basis was up by more than 10% compared to the first quarter of 2008 which was 13.2 million. Our Q2 revenue was also higher than the second quarter of 2007 which was 14.2 million. We exceeded our revenue expectations for the second quarter of this year which ranged from 11 million to 14 million, largely [ph] due to the contribution from our most recent acquisition. For the first half of 2008, revenue was 27.8 million compared to revenue of 27.2 million for the first half of 2007. A small year-over-year increase but clearly we need to do better, given the addition of acquisition revenues. The declines and demands for some of our core products has been challenging for our top line revenue.

In our earnings release, we report a loss per share of $0.02 on a GAAP basis for the second quarter of 2008 which included the effects of non-cash charges for restructuring and stock-based compensation expenses which amounted to $0.02. Excluding these non-cash charges are non-GAAP earnings performance in the quarter was break-even.

On a GAAP basis, earnings per share results for the second quarter of 2007 were $0.03 per share while a non-GAAP earnings per share on the second quarter of 2007 was $0.06 per share. That’s a brief summary of our second quarter 2008 results.

Now I want to share with you a few key trends from the second quarter. Our services results have become a significant source of revenue since the BTD acquisition last year which has a large service oriented revenue base. In the second quarter of 2008, revenue from our services offerings comprised 42% of overall revenue for the quarter. This compares to the 23% contribution from the quarter a year ago. Also, product sales from the BTD acquisition represented approximately 16% of second quarter of 2008 revenue, primarily driven by shipments to European telecom customers.

International sales, in general, made up nearly one-half of the quarter’s overall revenue contribution. That’s an increased of almost 70% international revenue compared to the quarter a year ago. Our traditional product lines, MCUs, DigiTest, and Cheetah, have all expense double-digit declines in revenues since the second quarter of this year compared to the second quarter of 2007. However, on a sequential basis versus the first quarter of 2008, MCU and Cheetah products made reasonable recoveries from multiyear loss [ph] in Q1. And again, our balance sheet remains very healthy. Since Q1, we have returned to our year-end levels of cash and short-term investments.

That’s a review of general business trends. Now I’ll provide a more detailed financial review of the quarter and a brief review by product line. Margins for the second quarter on a non-GAAP basis were 50.3%, slightly better on the sequential basis but down compared to the second quarter of 2007 results with gross margin with nearly 55%. The year-over-year of decline is primarily due to three factors. First, a change in product mix, shifting to a larger mix of lower margin products. Second, lower manufacturing volumes which is impacting overhead absorption rates. And finally, higher certification fees and other cost related to our new product introductions.

We continue to work on reducing our overall cost structure during the second quarter of this year on a sequential basis compared to the first quarter of this year with lowered expenses and selling and marketing, G&A and R&D by approximately 11%, 13%, and 11%, respectively. These cost reductions are the results of the restructuring efforts that begun during the first quarter of this year. The completion of the BTD acquisition integration cost that carried into 2008 and our continued efforts to reduce spending in company wide.

On a year-over-year basis, only R&D costs were up slightly reflecting the additional engineering cost from the BTD acquisition which took place in last year’s third quarter.

Overall, expenses for the second quarter of 2008 were down on both the sequential and year-over-year basis. Expenses for the second quarter of 2008 on a non-GAAP basis excluding special charges were 7.6 million compared to 7.7 million in the quarter a year ago. On a GAAP basis, overall operating expenses were 7.7 million in the second quarter compared to 7.9 million in the second quarter of 2007.

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We will continue to balance our spending with long-term opportunities as we move forward. Our backlog for a firm customer purchase orders and signs up for a maintenance contracts was 18.5 million at the end of the second quarter of this year compared to the backlog of 19.2 million at the end of 2007. A majority of these backlogs amounts 75% and 71%, respectively, as related to software maintenance contracts. We expect approximately 38% of the current backlog to be recognized as revenue in the third quarter of 2008. Review in our performance by product line our top code test [ph] systems business which includes the product families of DigiTest, LDU, and N(x) Test were evident from this group of products for the second quarter of this year was 5.2million compared to 4.5million in the quarter a year ago, an increase of approximately 15%. This increase is largely due to the addition of the LDU products to our portfolio on Q3 of last year, which offset lower sales of our DigiTest products, specifically the DigiTest DMU products. LDU shipments were strong in both the first and second quarter of 2008 with these significant shipments to European customers.

With regard to DigiTest ICE, our compact service assurance offering, while it has been standardize with one of our large international customers, deployments have been slow a year to date. The initial release of DigiTest ICE became generally available in June. We expect to see initial shipments of ICE into the domestic telecom market during the third quarter of 2008. We remain encouraged by the initial interest in ICE and are hopeful for its success as a lower cost service assurance solution for remote sites and broadband networks.

Revenue from LoopCare software license fees was roughly 550,000 in the second quarter of 2008, compared to 486,000 in Q2 of 2007. Sales of cable hardware and software products during the second quarter of 2008 were 2.1million, which is down from 3.5million in sales on the second quarter of 2007. This decline is primarily due to reduced market demand through OEM channels and two major MSOs. We expect this condition to continue for a number of quarters, but are attempting to replace the revenue through other customer accounts and new product offerings. We believe lower cable operator spending is impacting many other vendors in this market as well.

MCU sales were roughly 1.2million in the second quarter of 2008 compared to 2.9million in a quarter a year ago. Roughly one half of this decline is due to the completion of a major customer testability project in 2007, and the rest can be attributed to overall reduce market demand for MCUs.

Customer budget releases for MCUs early on the year, began to ease and we experienced some recovery in MCU sales in the second quarter, Sales increased by 40% from the Q1 revenue of $850,000 for MCUs. Revenue from services continues to be strong. The addition of recently acquired software maintenance agreements nearly doubled services revenue in the second quarter of 2008, achieving revenue of 6.1million compared to 3.3 million in a quarter a year ago.

As discussed previously, many of these agreements are multi-year commitments with major domestic and international telecom companies.

We continue to invest in our new power utility product line, LightHouse, which is in the midst of important customer trials and also on a development path to general availability. We hope these trials will validate our capabilities in long-term opportunity in this new market segment. Anticipate conducting additional pilots [ph] throughout the bounds of 2008, and also expect the LightHouse solution to be commercially available later in the year.

Looking ahead to the third quarter of 2008, we expect revenue to range from 12 million to 15million, which is slightly higher than the revenue guidance provided for the second quarter of 2008. Included in this revenue is the expectation of a meaningful contribution from initial domestic market shipments of DigiTest ICE, our new low-cost IP Service Assurance Probe to promote (inaudible). This revenue range also reflects our continuing caution about global economic conditions and a general impact on customer capital expenditures.

As I briefly mentioned earlier and as you know, during the second quarter, we expanded our strategic review process by engaging outside the advisers to work with us to undertake a full review of strategic opportunities to leverage Tollgrade’s expertise and reputation in service assurance test and measurement solutions. We’re in the midst of this evaluation process and to date, have not reached any specific conclusions. No deadline has been set for completing the process, but our objective remains to ensure that we've preserved an enhance share holder value.

We continue to challenge ourselves to execute on our plans and drive for a sustainable and dependable position in the market that can provide long term profitable growth. The market for our traditional products continues to be challenging, which means that we have to execute on our new product introduction activities to impact the results of our top line revenue. This is a key activity for the Tollgrade team while we examine potential opportunities to enhance short-share holder value in our strategic review process. We remained actively engage with customers and prospects.

During the second quarter, we are pleased with our activities at two trade show industry events. Last month, our sales and marketing teams were busy at our two largest trade shows of the year. At MAXCOM in Las Vegas, we featured the recently released DigiTest ICE solution to telecom customers, and the LDU 50 made its debut as part of Tollgrade’s product offering. The following week in Philadelphia was the SCTE Cable Tech Expo where we featured our Cheetah End-of-Line Monitoring Solution and our Call Quality Manager, IP Test Element. Also, we have several trade show events on the near term horizon.

Our LightHouse team will be exhibiting next week in Ohio at a national power utility conference on advanced distribution automation. And later in the third quarter, we will exhibit at Broadband World Forum in Brussels, as we continue to target international telecom customers.

Lastly, as I mentioned earlier, we are very pleased that for the second consecutive year, AT&T honored Tollgrade as one of its outstanding suppliers in the area of product and service performance. We are only one of 27 suppliers named by AT&T as a tribute to the people in our organization and the interaction with customers like AT&T.

Thanks must go out to our AT&T sales and services team, and the engineering team supporting them. This is a tremendous recognition from a long-standing industry-leading customer.

Another, some of you may have questions for Sam Knoch, Grant Cushny, or myself, so this time I’ll turn the call over our conference coordinator, Andrew, who will remind you how to signal for any questions or comments you may have for us.

Andrew?

Question-and-Answer Session

Operator

Thank you sir. (Operator instructions) We have a question from Jeffrey Myers of Cobia Capital. Please go ahead.

Joe Ferrara

Hi Jeffrey.

Jeffrey Myers – Cobia Capital

Hey, how are you?

Joe Ferrara

Good. How are you?

Jeffrey Myers – Cobia Capital

Good. Well, so my question for you is with DigiTest ICE growing out this quarter, first question on that is do you think this is going to cannibalize sales of your other products or is this like focused on the new area that you guys have not addressed before?

Joe Ferrara

Primarily, most of the other products were focused on the central office and DigiTest ICE is focused more on remote sites, so we don’t expect a whole lot of cannibalization. There is a possibility that you would have some customers that would place ICE [ph] at smaller COs, but for the most part we expect it to be placed in remote sites.

Jeffrey Myers – Cobia Capital

Now, the second question is the first release of ICE, what functionality does it have? Does it have – does it – can you do IPTV on it? Can you do voice over IP, and, if not, when are those functionalities [ph] going to be coming up?

Joe Ferrara

So, the first release is metallic testing only, and that release is out. The other releases are coming out this quarter. We have two different releases. One that’s based on a G-Version of the DSL, and then we also have another broadband version that is coming out. The broadband version is the version where we would develop IPTV and additional functionality that you were referring to.

Jeffrey Myers – Cobia Capital

I see. And, of those three versions, do you expect higher sales levels for any of those in particular, or is it tough to tell at this point?

Joe Ferrara

Tough to tell at this point.

Jeffrey Myers – Cobia Capital

Got you [ph]. Okay, great day, thank you.

Joe Ferrara

Alright, thank you very much.

Operator

(Operator instructions) Mr. Ferrara, there appeared to be no further questions. I’d like to turn the call back over to you for any closing comments, sir.

Joe Ferrara

Okay, thanks Andrew. Now if there are no further questions, you can always contact the company directly if you have questions in the future. I want to thank everybody for joining us for this update today, and we appreciate your interest in Tollgrade and looking forward to our next quarterly update. Thanks and have a great day.

Operator

The conference has ended; you may now disconnect your lines. Thank you.

Joe Ferrara

Thank you.

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