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Executives

Mory Ejabat – Chairman, CEO

Kirk Misaka – CFO

Analysts

Zhone Technologies, Inc. (ZHNE) Q3 2012 Earnings Call October 17, 2012 5:00 PM ET

Operator

Good day and welcome to the third quarter 2012 Zhone Technologies Incorporated Conference Call. I’m Regina and I will be your coordinator for today. At this time all participants are on a listen-only monde. [Operator Instructions]

I would now like to introduce Kirk Misaka, Zhone’s Chief Financial Officer. Please proceed.

Kirk Misaka

Thank you operator. Hello and welcome to the third quarter 2012 Zhone Technologies Inc. conference call. I’m Kirk Misaka, Zhone’s Chief Financial Officer. The purpose of this call is to discuss our third quarter 2012 financial results as reported in our earnings release, which was distributed over BusinessWire at the close of market today and has been posted on our website at www.zhone.com.

I’m here today with Mory Ejabat, Zhone’s Chairman and Chief Executive Officer. Mory will begin by discussing the key financial results and business developments in the third quarter. Following Mory’s comments I will discuss Zhone’s detailed financial results for the third quarter of 2012 and provide guidance for 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. An audio webcast replay will also be available online at www.zhone.com following the call.

During the course of the conference call we will make forward-looking statements which reflect management’s judgment based on factors currently known. However, these statements involve risks and uncertainties including those related to projections of financial performance, the anticipated growth and trends in our business, the development of new technologies and market acceptance of new products, and statements that express our plans, objectives, and strategies for future operations.

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, 2011, and our quarterly reports on form 10-Q for the quarters ended March 31, 2012 and June 30, 2012.

We would like to caution you that actual results could differ materially from those contemplated by the forward-looking statements and you should not place undue reliance on any forward-looking statements. We also undertake no obligation to update any forward-looking statements.

During the course of this call, we will also make reference to adjusted EBITDA and adjusted operating expenses, non-GAAP measures 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 an 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 they facilitate management’s internal comparisons with the company’s historical operating results and comparisons to competitors’ 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 adjusted EBITDA 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 Ejabat

Thank you, Kirk. Good afternoon and thank you for joining us today for our third quarter 2012 earnings call. This quarter revenue decreased slightly to $29.2 million due to the difficult economic conditions in our served markets and deferred deployments of a few domestic customers related to the changes in Connect America funding.

Nonetheless, as expected, our MXK continue to drive new organic customer growth, sustaining the industry leadership and a strong customer acceptance. Coupled with the launch of our new FiberLAN product line last quarter, which position us in a new market segment that is growing rapidly, we expect to be able to get back to the revenue growth in the near future.

During the third quarter we also restructured the business to only focus on the existing and new copper and fiber based product lines with a major emphasis on FiberLAN and the next generation broadband products. As you know capital spending by telecom companies has been substantially reduced for a prolonged period due to tight budgets and difficult economic conditions.

Accordingly, we suspended the product and market development related to non-broadband product line until capital spending in these sectors resumes over the next few years.

Since this new product line is already substantially developed, we anticipate being able to react quickly to any upturn in capital spending by these organizations. In the meantime, we will incur substantially lower operating expenses and that will lower our breakeven point for profitability, which as I have said before remains our primary financial goal.

After my comments, Kirk will give you more details about the impact of this restructuring as well as our financial results for the quarter and guidance for the next quarter.

The last financial matter I would like to briefly mention is that we continue to evaluate our core alternative to regain compliance with the NASDAQ $1 minimum bet price requirement before the December 18th deadlock. We are also developing contingency plans in the event that we do not regain compliance by then and will announce more detailed information as we move forward.

Now let me turn your attention to exciting things happening on the business side. As I mentioned, last quarter we launched Zhone FiberLAN, an innovative and exciting new product line. We believe FiberLAN represents an exciting new opportunity for Zhone. Thus far, the excitement and new customer interest has been exceptional.

After completing a comparative analysis comparing FiberLAN optical LAN service to that of the copper switch Ethernet LAN, the savings are optimal [ph], providing compelling short and long term savings for our customer, initial analysis reflect 73% reduction in capital expenditure, 92% saving in operational recurring costs, 84.7% green efficiency. We are excited to share these new results with our customers.

To our company, FiberLAN Optical LAN Solution, we launched an impressive new line of ZNID-26XXs of indoor desk ONTs specifically designed for the FiberLAN Optical LAN Solution. Zhone products continue to drive new customer growth while sustaining GPON industry leadership in each of our served markets for a company record, 11th consecutive quarter.

New analysis report also reflect that Zhone Technologies is the number one GPON provider in the Middle East. During the quarter we won several new customers and expanded our customer base globally with customers such as Pend Oreille County Public Utility, Washington State; iTV-3, Central Illinois; Cherokee Communication, Southeast Oklahoma; York Data Services, the United Kingdom; Communication partner, SRL Argentina; Access Media 3 Chicago, Georgia, Minnesota, Florida, Tennessee, Virginia and Washington D.C.

MXK shipments remain strong. We shipped close to 350 units in the quarter, bringing the total units shipped to 4000 units and well over 28.7 million close of GPON service provider capacity. Additionally, we experienced a strong ONT shipments of nearly 100,000 units of the popular ZNID 2400 ONT series.

With those brief comments, let me turn the call over to Kirk to provide more details about the financial results for last quarter and to discuss our financial guidance for the next quarter, Kirk.

Kirk Misaka

Thanks Mory. Today Zhone announced financial results for the third quarter of 2012. Third quarter revenue of $29.2 million decreased from second quarter revenue of $30.8 million, due to the difficult economic conditions in our international markets and deferred deployments for some of our domestic customers.

As Mory mentioned, we expect to be able to replace much of the revenue being lost due to the difficult economic conditions and changes caused by Connect America funding.

Our international markets continue to produce the majority of our business and represented 58% of revenue for the third quarter versus 57% of revenue for the second quarter. We experienced slightly less customer concentration this quarter with the top five customers representing approximately 38% of revenue for the third quarter as compared to 43% of revenue for the second quarter. We also had only one 10% customer for the third quarter as compared to the two 10% customers in the second quarter.

Gross margins declined to 28% for the third quarter as compared to 30% for the second quarter. Margins continued to be under pressure from aggressive competitive pricing, especially in our international markets. On the positive side, we see prices beginning to bottom out. When coupled with continued product cost reductions we believe gross margins will begin to improve next quarter.

Operating expenses are $12.4 million for the third quarter, were slightly higher than our previous guidance range of between $11.5 and $12 million and the $11.4 million for the second quarter.

As Mory mentioned, we restructured the business to only focus on existing and new copper and fiber based product lines with a major emphasis on FiberLAN and next generation broadband products. As a result of the restructuring, we incurred approximately $700,000 of additional operating expenses this quarter for severance, termination of certain leased office space and write-off of certain assets related to that restructuring.

In addition, operating expenses for the third quarter included depreciation of approximately $100,000 and stock based compensation of approximately $800,000. Stock based compensation included $650,000 related to the accelerated divestment in certain stock options for senior management and employees.

For the fourth quarter we expect approximately the same amount of depreciation or about a $100,000 and anticipate that stock based compensation would drop to about $50,000.

We expect overall operating expenses for the fourth quarter to drop substantially to between $9.5 million and $10 million largely as a result of restructuring, as over $2 million per quarter lower when compared to the third quarter operating expenses and $1.5 million per quarter lower when compared to the second quarter.

Finally, our adjusted EBIDTA loss for the third quarter 2012 was approximately $3.2 million as compared to a $1.7 million dollar adjusted EBITDA loss for the second quarter. However, we expect to generate positive adjusted EBITDA for the fourth quarter with approximately same amount of revenue because margin should improve and operating expenses will be substantially lower.

Now turning to balance sheet. Cash and short term investment for September 30, 2012 declined to $10.3 million from $13.1 million at June 30 2012, primarily due to the adjusted EBITDA loss. The net effect of other balance sheet changes had a positive effect of about $500,000. Accounts receivable grew to $26.1 million at September 30, 2012 from $25.5 million at June 30, 2012, increasing the number of days-sales-outstanding on accounts receivables for the third quarter to 80 days as compared to 74 days in the second quarter.

The growth in receivables and DSO was largely attributable to our largest customers. As we stated before the shipment and payment cycle with our largest customers continue to create these large fluctuations.

Our total debt obligations associated with our working capital facility with Wells Fargo remained at $10 million at September 30, 2012 and June 30, 2012. You may recall that we entered into this new working capital facility during the first quarter of this year and anticipate that it will provide adequate liquidity to continue to run the business during this entire three year term.

Lastly, the weighted average basic and diluted shares outstanding were $31.1 million for the third quarter of 2012 and $31 million for the second quarter of 2012. With that financial overview, I’ll turn the call back to Mory for a few final comments before we open the call up to questions and answers. Mory?

Mory Ejabat

Thank you Kirk. In summary, we believe that we can return to profitability in Q4 to better gross margins and substantially lower OpEx. That profitability should also continue for 2013 as a whole and generate positive free cash flow from operations.

Thank you for joining us today. We’d now like to open up the call to questions. Operator please begin the Q&A portion of the call.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question today comes from the line of Lala Muna [ph].

Unidentified Analyst

Hi guys. You know, you guys are not a Chinese company and considering that I think this was a pretty decent quarter because I’ve seen some of your competitors having pretty bad quarters recently. And I’m also encouraged by the fact that you have done some restructuring and hopefully that will bear some fruit in the next quarter and for the next year.

Can you please describe in little more detail your restructuring effort you did Q3? What I want to know is how much of the Q3 losses were attributable to the restructuring cost. You mentioned I think 700,000, was that the total expense of the cost of restructuring?

Kirk Misaka

Yes, that’s right. The 700,000 was incurred for severance, the termination of the leased office that we had and also the write-off of various equipment related to that portion of our operations.

Unidentified Analyst

Okay. As soon as you have completed the renegotiation of your Largo facility lease agreement and – is it fair to assume that you have gotten rid of the excess space you used to have?

Kirk Misaka

Yes, we extended the term through June of 2013 and are currently in negotiations to extend that again. The other space that we had prior to that time has been turned back at the landlord and we are not paying for it.

Unidentified Analyst

So, you know, your operating expense estimate you had provided earlier, does that take full benefit of this renegotiation of your lease or you have maybe some more savings coming down the line?

Kirk Misaka

No, that’s already been reflected in our operating expenses and there aren’t any future savings on the Largo lease.

Unidentified Analyst

Okay. In the last conference call you had mentioned that you are going to focus on improving gross margins. Looking at all the various competitors, Zhone’s gross margins are probably one of the lowest. Also we note that all the other competitors have their manufacturing outside U.S. Are you getting to a point where you may consider doing manufacturing outside U.S. to become competitive as far as the gross margins are concerned?

Mory Ejabat

Lala, first of all, this is Mory Ejabat. Thank you for the earlier compliment. And, let me tell you about our gross margin. Actually our gross margin is better than some of our competitors. A couple of domestic competitors that we have actually only sell domestically and with a small amount of revenue coming from international market, which they have a fair gross margin as a result. Even though a couple of them have acquired companies that do international business, actually there are still some erosion on their gross margin as well.

Now, if you compare our gross margin with ZTE and Huawei and any other international companies actually and Alcatel-Lucent, actually we are higher in the gross margin. Given that, we are continuously trying to improve our gross margin while focusing on cost reduction of our product and actually our efficiencies in manufacturing.

We have done several studies of manufacturing in the U.S versus manufacturing overseas. Considering the fuel costs and the transportation costs of the products shipping from overseas to different areas in the world, we feel our manufacturing is very competitive and it might be in some instances a better efficiency than other companies.

Unidentified Analyst

Thanks, that’s helpful. Another question I had, you know, because of the losses your cash level is declining, one question I have is, you have this revolving credit line with Wells Fargo, are you getting close to where you may be in trouble with their covenants for the credit line?

Kirk Misaka

We looked forward through the term of the credit line and believe will be in compliance. We did the restructuring in order to continue to be in compliance so that that would provide adequate liquidity to continue to run our business through the term which ends in the beginning of 2014.

Unidentified Analyst

Oh okay, well thank you. I have a few more questions but I think I probably would give other people a chance to ask question and go back in line, and if get a chance to ask a few more questions later on.

Mory Ejabat

Now, you can send us an email if you wish to do so.

Unidentified Analyst

Thank you.

Mory Ejabat

Thank you.

Operator

[Operator Instructions] All right. With that we’ll go ahead and conclude our question and answer portion of today’s event. I would like to turn the call back over to Mory for some closing remarks.

Mory Ejabat

Once again, thanks for joining us today and for your continued support. We are looking forward to speaking with you in our next earnings, and we hope to discuss a return to profitability then. Thank you very much.

Operator

Ladies and gentlemen that concludes today’s conference, thank you for your participation, all lines would be disconnected at this time.

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