Network Equipment Technologies, F1Q09 Qtr End 27/06/08 Earnings Call Transcript

Network Equipment Technologies (NWK)

F1Q09 Earnings Call Transcript

July 28, 2008 5:30 pm ET

Executives

Leigh Salvo - IR

Nick Keating - President and CEO

John McGrath - VP and CFO

Analysts

Ben Chickrell - Wachovia Securities

Eric Buck - Peak Access

Marc Abizaid - Mohican Financial

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter Network Equipment Technologies Financial Conference Call. My name is Chienell, and I will be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s conference, Ms. Leigh Salvo, Investor Relations. Please proceed.

Leigh Salvo

Welcome everyone to our call this afternoon, during which we will discuss results for Network Equipment Technologies’ first fiscal quarter of 2009. With me today are; Nick Keating, President and CEO; and John McGrath, CFO.

In keeping with the Safe Harbor provisions of the Private Securities Litigation Reform Act, I want to remind everyone that we will be making some forward-looking statements and projections today, including those relating to future revenue, operating results and financial condition. Investors are cautioned that these statements are based on current estimates and assumptions that involve risks and uncertainties that might cause actual results to differ materially from those expressed or implied in the forward-looking statements. These risks and uncertainties include federal government budget matters and procurement decisions, the timing of orders, market acceptance for our new products, timely completion of product development initiatives, relations with and performance by third-party technology providers, new competition and technological changes, the successful integration of Quintum’s operations, success in building new sales channels, circumstances regarding specific sales that can affect the recognition of revenue, and other risks including those identified in the company’s filings with the SEC, including Forms 10-K and 10-Q and in other press releases and communications.

The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Additionally though an audio archive of this call will be available on the company’s website for at least 12 months, the statements made on this conference call are only made as of July 28th, 2008, and we disclaim any duty or intention to update forward-looking statements.

In addition to financial measures presented in accordance with GAAP, we will also be discussing certain non-GAAP financial measures that are adjusted from results based on GAAP to exclude certain expenses, gains and losses. These non-GAAP measures should not be considered a substitute for, or superior to, GAAP results. Please refer to the press release issued today for further detail regarding the non-GAAP measures. Reconciliation to GAAP can be found in the press release which is posted on our website.

Our agenda today begins with NET’s CFO, John McGrath, who will provide a detailed review of our financial results. Nick Keating, CEO, will then comment on the quarter’s financial and operational highlights. John will then offer financial guidance for the remainder of this fiscal year, and we will open the call for your questions.

This time I would like to turn the call over to John McGrath.

John McGrath

Thank you, Leigh. In the press release issued today and available on our website, we reported that total revenue for the first quarter of fiscal ‘09 was $15.6 million, down 53% from the prior quarter, and down 41% from the first quarter of fiscal ‘08. Product revenue was $12 million, a 60% decrease from the prior quarter and a 48% decrease from the same period last year.

As we mentioned in our prerelease in early June we saw a significant decline in government spending resulting from the delay of programs across the board. Government product revenue in Q1 ‘09 was $7 million, down from $24.6 million in the prior quarter, and $21.7 million for the same quarter last year.

Product revenue from our commercial business was $5.1 million in Q1 ‘09, compared to $5.6 million in Q4 ‘08 and $1.2 million in Q1 ‘08. The sequential decrease in commercial product revenue was due primarily to a reduction in Promina upgrades. The decline was partially offset by sequential growth in our commercial VoIP business of $0.5 million, or 12%.

In Q1 ‘09 Promina represented 42.4% of total revenue, compared to 47.3% in Q4 ‘08, and 57.6% in Q1 of the prior year, reflecting decreased government spending for Promina. Service revenue at $3.5 million was 23% of total revenue. Service revenue was up $287,000 from the prior quarter, and up $185,000 from the first quarter year ago.

Gross margin in Q1 ‘09 as a percentage of revenue was 16.3%. This is down from 48.3% in Q4 and 52.9% for Q1 last year. Product margin in Q1 ‘09 as a percentage of revenue was 22.3%. This is down from 53.8% in Q4 and 58.6% for Q1 last year. As a result of our decrease in product revenue, underutilized manufacturing overhead and reserves resulted in approximately a 28.5 percentage point decrease in product margin.

Additionally in Q1 ‘09, the company increased inventory reserves by nearly $2 million, accounting for 17 percentage point decrease in product margin. The largest portion of this reserve relates to our NX5010 product line, which has seen several major programs delayed for more than two quarters.

With the introduction of the next generation of our NX5000 product series expected next year, we believe that some of our demand for our NX5010 product may be replaced by the new technology, thus giving us excess inventory on hand. In the event that federal program delays continue, we will again evaluate our NX5010 inventory.

Service margin in Q1 ‘09 decreased to a negative 3.9%. This is down from negative 3.3% in the prior quarter and down from 13.3% in the first quarter of the prior year. Our service organization continues to support the sale and education effort of our new unified communication voice partners, which generally does not results in initial revenue. As the partners begin to ramp sales, we should see service margin begin to increase. First quarter ‘09 operating expense was $16.1 million. This is up from $15.6 million in the prior quarter, and up from $13.3 million in the first quarter last year.

Total headcount at the end of Q1 was 300 employees, a decrease of 8 from the end of the prior quarter. Sales and marketing expense in Q1 was down $151,000 compared to the prior quarter, and up $1.2 million from the first quarter a year ago. The sequential decrease was primarily the result of decrease in sales commission, offset by additional costs related to investment in our commercial sales force. The increase from the prior year was in large part due to the acquisition of Quintum in December 2007.

R&D expense in Q1 was down $221,000 from the prior quarter, and up $257,000 from the first quarter a year ago. The decrease over the prior year was due primarily to lower headcount-related costs. The increase over the prior year is due to the acquisition of Quintum. Q1 ‘09 R&D expense was offset by approximately $314,000 of externally funded R&D costs, which will be recognized together with the revenue once we have reached the milestones.

G&A expense in Q1 was up $718,000 compared to the prior quarter, and up $1.1 million compared to the first quarter a year ago. The sequential increase is in large part due to increased accounting and tax costs related to the acquisition of Quintum, a patent lawsuit settlement, and increased stock compensation costs. The year-over-year increase is also impacted by the acquisition of Quintum.

Included in our Q1 ‘09 results are charges related to stock compensation of $1.2 million. Stock compensation charges totaled $977,000 in Q4 ‘08 and $454,000 in the first quarter last year. Other income in the first quarter was $3.8 million compared to income of $157,000 in the prior quarter, and expense of $21,000 in Q1 of the prior year. The other income in the first quarter was primarily attributable to the repurchase of $12.5 million of convertible debt.

Net interest expense for Q1 was $105,000 compared to income of $165,000 in the prior quarter, and income of $692,000 in Q1 of the prior year. The sequential and annual decrease is primarily due to lower yields on our investment portfolio.

The first quarter of fiscal ‘09 had a tax expense of $17,000 as compared to a tax benefit of $1.9 million in Q4 ‘08, and a tax expense of $58,000 in Q1 ‘08. The benefit in Q4 ‘08 related to the reversal of evaluation reserve on a deferred tax asset for an international subsidiary.

Turning to net income. The company reported a net loss of $9.8 million for Q1 ‘09, or $0.34 per share, compared to net income of $2.8 million, or $0.09 per share in the prior quarter, and net income of $1.3 million, or $0.05 per share in Q1 last year. Non-GAAP net loss was $11.2 million, or $0.39 per share in Q1 ‘09 compared to net income of $2.6 million, or $0.09 per share in the prior quarter, and net income of $1.8 million, or $0.06 per share in Q1 last year.

Cash balances at the end of Q1 ‘09 were $150.9 million, down $14.8 million from the end of Q4. Cash and investments decreased by approximately $8.3 million related to the buyback of convertible bonds, and approximately $858,000 related to the repurchase of our stock in Q1 '09. The remaining sequential decrease in cash was primarily due to deposits made to our contract manufacturer for aged inventory, reflecting lower shipments to NET.

Accounts Receivable was $8.3 million, a decrease of $14.9 million from Q4 '08, and a decrease of $3.1 million compared to Q1 '08. The sequential and annual decreases were primarily from decreased revenues. DSOs at 49 days decreased from 63 days sequentially, and increased from 39 days year-over-year. Our target DSOs remain between 60 and 70 days.

Net inventory was $8.6 million in the first quarter, a decrease of approximately $1.4 million as compared to the prior quarter, and a decrease of $4.9 million from the prior year. Although there was a decrease in inventory owned by NET, we were required to put a deposit on inventory owned by our contract manufacturer of approximately $5 million related to inventory not consumed during the quarter. This amount is shown in other current assets on the balance sheet.

Now I'll turn the discussion over to Nick Keating, our CEO.

Nick Keating

Thank you, John. The predominant factor impacting NET's revenue in fiscal Q1 was a slowdown in government program spending. The federal government supplemental defense and communications budgets continued to get pushed out last quarter, and other program funding projects were delayed. I do not expect that program funding will return to normal levels until at least the end of NET's current fiscal year. After the election, when more is known about the timing and size of ongoing defense spending.

In the first quarter we also experienced some delays related to specific orders, such as a change in a customer's program management organization, and a customer request for product modifications before delivery, which shifted revenue opportunities beyond the quarter. There were several notable accomplishments in the government sector during the quarter. This included a new contract from the UK Ministry of Defense for additional NET product, which was received late in Q1 for revenue shipment in Q2.

We continue to work with General Dynamics on the product rollout for the Army's WIN-T program. The WIN-T network will use NET's NX1000 switch to interface with the Defense Information Systems Network. We expect this program to be a significant contributor to revenue going forward, with new orders expected in the current quarter. We also received an initial order for VX400 and VX900T units to build a system for [Socom].

We completed the certification testing for our Promina and VX Series at the Joint Interoperability Test Command at Fort Huachuca. Once we have received the official approval expected in the current quarter, these products will be listed on the Department of Defense's approved products list.

Obtaining the JITC Certifications is not only essential for potential deployments within the Defense Switched Network, but also for other customers who require certified secured communications solutions.

During the first quarter of this fiscal year we saw growth in our Commercial Voice-over-IP business. And I am encouraged by the number of resellers and systems integrators that are bringing us into sales opportunities. Today we're working with seven large global systems integrators, and expect to add more in the future.

Recent customer wins included Albany International, one of the leading providers of service and equipment for the pulp and paper industry. NET provided a Unified Communications solution of more than 30 offices worldwide.

TOHO Cinemas, the movie entertainment division of TOHO Ltd. NET deployed a VoIP network to 30 cinemas throughout Japan, integrating an Asterisk server with existing PBXs at each site. And a new customer in Australia with partnership with one of our global systems integration partners.

While the first quarter's revenues results saw decline, I see no reason to alter the strategy we have been executing against for the past two years. The government market, both federal and international, presents significant long-term opportunities for NET. At the same time we're gaining traction with US and global enterprise customers and systems integrators worldwide.

Now at this time I would like to turn the call back to John to provide detail on our financial guidance and some closing remarks.

John McGrath

Thank you, Nick. Although we anticipated a slow start to fiscal 2009, we have seen a deferral of government spending that was greater than we had predicted a quarter ago. We expect to see some rebounds in the next two quarters; however, we do not see ourselves returning to fiscal '08 revenue levels until late this fiscal year or early next year. To that end, we believe that our revenues for fiscal 2009 will be in the $80 million to $90 million range.

For the remainder of the year we anticipate gross margins will increase to the mid to upper 40s, exclusive of any further inventory reserves that we may take, and will increase as revenue levels approach prior year levels.

Our current breakeven cash flow level is quarterly revenue of $27 million to $29 million per quarter. As we continue to streamline our manufacturing and realize synergies from the Quintum acquisition, we believe our breakeven could drop to the mid-$20 million quarterly revenue by the end of our fiscal year. As such, it is our goal to enter next fiscal year generating cash.

In the coming quarter our operational cash burn will be impacted by our low beginning receivable balances, and potential additional inventory deposits to our contract manufacturer until their level of inventory has decreased.

Operator, this concludes our prepared remarks. We would like to open the call for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of [Ben Chickrell] of Wachovia Securities.

Ben Chickrell - Wachovia Securities

Hey guys. Hello.

John McGrath

Yes, right here.

Ben Chickrell - Wachovia Securities

Okay. Might be the only one here. Could you guys rationalize the capital structure for me?

John McGrath

In what sense, Ben?

Ben Chickrell - Wachovia Securities

In the sense that right now the stock is basically trading for little or negative enterprise value. I appreciate the fact that you purchased some of the converts and a little stock in the past quarter. But I just want you to explain where you see the capital structure over the next six months to a year. You expect to be at the same share count. You expect to keep the same amount of cash, barring losses on your balance sheet.

John McGrath

I will take that question, Ben. I think what we will do is we will take a look at our share price. We will take a look at our bond price. And together with our Board we will make some decisions as to how we used our cash. At the same time we will evaluate that against other strategic opportunities.

Ben Chickrell - Wachovia Securities

When you say strategic opportunities, could you be a little bit more specific?

Nick Keating

Ben, this is Nick. We continue to use our cash for investment in research and development. We're continuing to look for other partnership opportunities, which could include funding external R&D. There are a number of initiatives that we have right now, but as John said, we have got to balance it off against the revenue forecast. What we expect will happen in terms of the government marketplace, cash requirements that we may have to have relative to continuing to cover more of the inventory at our contract manufacturer. And I think this will be an ongoing day-to-day program in close cooperation and conversations with our Board.

Operator

And your next question comes from the line of [Eric Buck] of [Peak Access].

Eric Buck - Peak Access

Hi guys, it's Eric Buck. How are you?

John McGrath

I am fine. How are you, Eric?

Eric Buck - Peak Access

Good. I was just kind of curious as to whether you could more specifically identify the government spending slowdowns. Are these things that are specific to your individual programs or is there something you can point to that would give some verification this is a broader kind of government pullback in the general communications area?

Nick Keating

I am not sure I could answer it with respect to a general pullback, because I see companies right now some of which had a down quarter with the government and others had an up quarter with the government. But I can certainly comment with respect to some of our main programs.

We had a program with the Marine Corps that slipped starting in the fall. We were expecting an order at December 15 and in the February timeframe, and we shipped that in Q4. We were expecting then a follow-on in Q1. It looks like that follow-on has been pushed all the way out to Q3.

We had a couple of 5010 customers that -- they had in one case funding issues, in another case they could not get circuits. And in another case their facility was not ready in time, and so that got pushed back. We saw similar slippage in the WIN-T program. Part of that was caused by our customers saying to us that they wanted us to put some additional enhancements in to the product, and we had to go actually develop those enhancements, and then retest with them. We did that. We have now passed the testing, and we are expecting a release for shipment in Q2 and Q3.

We had other programs that just basically got delayed. We have had customers say that they cannot get additional funding until the beginning of the new fiscal year, i.e., October 1. I think a couple of our larger programs, two of the tactical programs with the Marine Corps and the Army, which -- and the Marine Corps is separate from this other Marine Corps program. I think that our integrators are probably absorbing a lot of the work that was shipped to them by ourselves, and by other vendors, and we have engaged with them right now to try to see at what point are they going to resume activities.

So, I think it was across the board. There was probably eight or ten programs that were impacted negatively. Now, there are others that are coming back up again. We have a Navy program, and once a year we receive releases for that. We have got a program coming up with the Air Force that we are also waiting for releases on that one. But, unfortunately, it was almost a perfect storm. There was just a whole series of different reasons that things got pushed out, and it was not anticipated. We had put together our quota program in Q1. The quotas that our Federal guys were carrying bore no resemblance to what actually happened in the quarter from a booking standpoint.

Eric Buck - Peak Access

Okay. So, it was on multiple programs, but that each program had its own individual issue as opposed to any broader issue across all the programs is what I am hearing?

Nick Keating

As I say, we are hearing that in some cases procurements are being pushed back to the new fiscal year. As you probably know, the supplemental defense budget got delayed substantially, and that it was only until the very end of the quarter that it was finally signed, and we had projects in there that got delayed because the supplemental had not been approved. And then this UK Ministry Defense order, which we expected in the quarter -- we expected it earlier in the quarter and we wanted to ship it in the quarter. It didn't come in until the last couple of days of the month, and so that order will ship in Q2.

So, you roll them all up -- and of course for government it is not just Federal government, it is also international government. An that is where the massive -- just across the board and compounded, and was dramatically lower than what we saw three months before.

Eric Buck - Peak Access

Okay. And then in terms of the actual NX and VoIP revenues, can you give those numbers yet or we will have to wait for the 10-Q on this?

John McGrath

The majority of the non-Promina revenue was VX.

Nick Keating

And Quintum.

John McGrath

I am sorry, it was the VoIP revenue. Excuse me.

Operator

And your next question comes from the line of Marc Abizaid of Mohican Financial.

Marc Abizaid - Mohican Financial

Yes, hi guys. John, can you go over your cash flow guidance for the remaining of the year and next year again please?

John McGrath

I didn't give any specific numbers, but our cash flow breakeven is about $27 million to $29 million currently on the revenue per quarter level. We expect to drop that down to the mid-20s as we exit the year because we see some efficiencies as we integrate Quintum, bringing together our R&D strategies, bringing together some of our back office, etc.

So, that is something we will be working towards. As far as this coming quarter, we would see a higher burn than the revenue level might suggest only because we are going in with such low receivables. So there is usually a one-quarter lag in the cash drain. So, for instance, if you took out the stock buyback, the bond buyback and our deposits, we are pretty cash neutral. And we would expect the impact of the $15.6 million of revenue to actually come through our next quarter because of the delay with regards to receivables, etc.

Operator

There are no further questions. I would now like to turn the call back to Ms. Leigh Salvo.

Leigh Salvo

This concludes our remarks for Q1, fiscal year '09. If you have further questions, please feel free to call me at NET. Thank you.

Operator

Ladies and gentlemen, that concludes the presentation. Thank you for your participation in today's conference. You may now disconnect. Have an excellent week.

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