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Meru Networks, Inc. (NASDAQ:MERU)

Q3 2012 Earnings Conference Call

October 24, 2012 05:00 PM ET

Executives

Dr. Bami Bastani - President and CEO

Brett White - CFO

Sarosh Vesuna - General Manager, Education

Steve Pasko - Market Street Partners

Analysts

Jayson Noland - Robert W. Baird & Co.

Jason Willey - Cowen and Company, LLC

Erik Suppiger - JMP Securities

Operator

Good day, ladies and gentlemen, and welcome to Meru Networks’ Q3 2012 Earnings Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator instructions) This conference is being recorded.

I’d like to introduce your host for today’s conference, Mr. Steve Pasko from Market Street Partners. Mr. Pasko, you may begin.

Steve Pasko

Thank you. Thank you for standing by and welcome to the Meru Networks third quarter of fiscal 2012 conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation the conference will be open for questions. On the call today are Dr. Bami Bastani, President and CEO; Sarosh Vesuna, General Manager of Education and Brett White, CFO.

During the course of this call Meru Networks’ management will make forward-looking statements regarding future events and the future financial performance of the Company. Generally these statements are identified by the use of words such as “expect,” “believe,” “anticipate,” “intend” and other words that denote future events. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.

We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption “Risk Factors” in Meru’s most recent quarterly report on Form 10-Q as filed with the SEC on August 8, 2012, and the Company’s other filings with the SEC.

During this call we will present both GAAP and non-GAAP financial measures. Non-GAAP measures exclude stock-based compensation expense, amortization of intangible assets related to the Company’s acquisition of identity networks in the third fiscal quarter of 2011, amortization of a common stock one issued in connection with debt financing and other items outside the ordinary course of business.

These non-GAAP measures are not intended to be considered in isolation from, a substitute for or superior to our GAAP results and we encourage you to consider all measures when analyzing Meru’s performance. For additional information regarding our non-GAAP financial information and the most directly comparable GAAP measures please refer to today’s press release regarding our third quarter 2012 results. The press release has also been furnished to the SEC as part of a Form 8-K.

In addition, please note that any forward-looking statements that we may make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events.

Now I’ll turn the call over to Dr. Bami Bastani, President and CEO of Meru Networks.

Dr. Bami Bastani

Thank you, Steve. Good afternoon everyone and thank you for joining Meru’s third quarter 2012 earnings call. Today I will be discussing the following. One, continued improvement in our financial performance. Two, results of our vertical market focus and best-of-breed solutions in winning new customers and growing our installed base. Three, BYOD on-boarding and our industry leading Identity Manager offering for policy management and authentication and four, our 802.11ac positioning and implementation strategy.

On the financial performance front, I’m pleased to announce that the Company exceeded its revenue, gross margin and bottom line guidance for Q3. The Company’s Q3 total revenues were at $25.4 million, exceeding our guided range of $23 million to $25 million. We also reduced operating expenses sequentially and did an excellent job of managing cash all while maintaining our growth vector.

We continue to remain vigilant in addressing our key markets and improving the efficiency of our business as we optimize our cost structure and drive towards our goals of growth and profitability. We believe results from the last two quarters are solid evidence that our more efficient and focus sales organization has gained traction and it’s delivering improved results. Brett will discuss the numbers in greater detail after my comments.

Our vertical market focus and our best-of-breed solutions are leading to success in winning new customers and growing our installed base. During the third quarter we increased our worldwide number of customers to over 7,000, adding more than 400. These new customers came primarily from our focus verticals of: one, education; two, healthcare and three hospitality and entertainment.

In education, we have horned our compelling value proposition and marketing message. This market is widely interested in leveraging class room management systems to enhance the education process by using the smartphones, tablets and laptops in classrooms. A key challenge is the time wasted in getting all these devices to work reliably under wireless network. Our uninterrupted learning message have obtained partnerships with organizations such as LAN school have all resonated very well with educators.

Sales curve faces the typical BYOD on-boarding issues coming from 100s, if not 1000s of patients, doctors and administrators, all with their own mobile devices which must be authenticated, tracked and managed. Additionally, they face the ever increasing demands of on-boarding electronic medical records, EMR, in a BYOD environment and across both their wired and wireless networks. Our new access points and controllers are designed to handle density and mobility challenges and our Identity Manager products integrate the needed policy enforcement and authentication.

In hospitality we’re making decent growth in this large and complex market. Meru has attracted – Meru has attractive solutions that address key hospitality requirements of density, capacity, throughput and authentication. Our value propositions have easy site planning, which results in lower cost to implement and virtual architecture which solves for co-channel interference resonates well within this vertical.

Looking at our Q3 vertical deployments geographically, in North America some of our key wins during the quarter include A: a large Midwestern University purchased 15,000 Identity Manager licenses plus 10,000 Smart Connect licenses, edging out [CISCO] for this important policy enforcement and authentication implementation. I will be discussing this important and success of Identity Manager in more detail later in my remarks.

Major big 10 university purchased 1,300 new access points to continue to extend their 3,500 APs already in place. The top 50 public school district in Virginia purchased several 1000 APs, 50 controllers and ECR network manager. We have placed a major emphasis this year on promoting our excellent business critical services offering, an example of this effort is a leading futures and commodity exchange that purchased these services. Their Meru wireless LAN handles trillions of dollars of transactions routinely.

One of the worlds largest cruise line continued their aggressive expansion of Meru wireless services in the fleet of passengers use M cruise management and they have been promoting this bow-to-stern Wi-Fi availability as a competitive edge in their recent communication. And their marketing materials have stated “in order to create pervasive wireless across an entire ship the CIO is wiring vessels with a network that utilizes single channel to avoid interference issues”.

We continue to expand our presence in education sector in Europe with several wins at the primary, secondary and university levels. We had many hospitality and sports venue wins, including several stadiums, a major sports arena, and one of the largest convention centers in Europe due to our ability in solving tough density issues. Also in hospitality a well known worldwide hotel brand in Germany installed a large Meru wireless LAN network.

In APAC, a very high profile college in Japan and a Korean high-tech company purchased the wide array of APs and controllers along with ECR of network management tools. A premier convention center in India deployed Meru Wi-Fi network, further demonstrating our penetration in the worldwide hospitality sector.

Next I want to highlight our new products. We announced the availability of industries highest capacity wireless controller the MC6000, the high performance access point the AP332 designed to meet BYOD density and capacity challenges and innovative 802.11ac investment protection plan that protects current wireless infrastructure investments as the current standards moves to 802.11ac. Please see our website for more details on this.

The Meru MC6000 ultra-high capacity 802.11ac ready controller is designed to effectively serve 5,000 access points and 50,000 clients with 200 gigabits per second wireless capacity. Such high capacity controllers we believe are essential for large institutions and enterprises that cannot be served by controller less wireless LAN, more suitable for small installations. Powered by System Director, the industries leading virtualized wireless LAN operating system, the new controller delivers capacity and performance for very high density network environments.

The versatile System Director software can run virtually on any x86 server alongside with other application. That means Meru has a physical or virtual controller solution for a small to large sized operation whether centrally located or distributed to the remote site. We have started the deployment of the MC6000 at a major well known healthcare system in Michigan. This is a prime example of Meru’s ability to serve the multi faceted healthcare environment critical demand.

Our new APs 332 with its unique RFU visualization – virtualization technology can deliver nearly twice the capacity of traditional multi channel installations with same number of access points in dense environment such as lecture halls, conference rooms, stadiums and enterprise campuses. When coupled with the Identity Manager Meru’s market leading solution for automating BYOD on-boarding, we believe Meru offers the best end-to-end solution to manage the BYOD capacity crunch today. Our recently launched products [round] about one of the most complete wireless LAN offerings in the industry and pave the way to a smooth transition to 802.11ac.

Now I’d like to take a minute to discuss what we see as to major inflection points for Meru at the entire Wi-Fi industry. One, BYOD on-boarding policy enforcement and authentication and two, bringing 802.11ac into use without causing disruptions to the current infrastructure and IT budgets.

On the first inflection point as Wi-Fi becomes the dominant network architecture in enterprises and institutions, it must have a robust network management tool that works on a policy enforcement and authentication capability in order to be secure and manageable. Our Identity Manager product suite with the Smart Connect and Guest Connect is the industries leading policy enforcement product, clearly already in use in 1000s of companies and institutions. No one offers a more pervasive, flexible and proven solution.

Identity Manager enables easy self provisioning of client devices for secure connectivity. The IT staff is free from the task of provisioning devices in support of BYOD can easily control access with grown and policy based provisioning, all while protecting the network with authentication and encryption. And this is accomplished leveraging existing network infrastructure with support from access points, controllers and wired switches from any vendor.

Identity Manager works with any OS and any wireless LAN or wired solution, whether it is from Meru or not. Regarding second inflection point, as 802.11ac compliant devices became available PCs, tablets, phones; etcetera will be unveiling our enterprise 802.11ac enterprise grade, 802.11ac solutions to support this new standard. Though this new standard is not expected to be widely adopted until late 2014 into 2015, we’re addressing IT managers concerns about their timing of implementation with products and programs by the investment protection program mentioned earlier.

By definition the 802.11ac [stay] calls for fewer channels for accommodating increased coverage with greater bandwidth and throughput. Our micro cell competitors will depend on a multiple channel approach will likely need to make significant adjustments to their architectures to get the most from this new spec and their customers will similarly need to do major planning revision in their current deployments to get a smooth transition.

We are very excited about the 802.11ac standard because we along some key industry analysts believe our single channel architecture is best suited to deliver on its promise of greater coverage and bandwidth. On an organizational note, Carl Gustin, our Chief Marketing Officer will be transitioning from Meru. I want to thank Carl for all of his contributions. Carl’s departure is very amicable and we wish him well for the future. Carl will continue to assist the team and is committed to an orderly transition. Going forward our VP of vertical marketing, Manish Rai will lead the Company’s marketing function.

To close, Q3 was another great quarter for us providing, proving we can deliver on our vision and that we’re on course for 2012 and for the future. Our category is projected to keep growing in double-digits through 2015 for IDC. We believe our best-of-breeds and highly differentiated technology, we show its priority to competitive offering in handling BYOD on-boarding and policy enforcement as well as getting the most from 802.11ac as it migrate into the enterprise over the next few years.

Now I will turn the call over to our CFO, Brett White to further detail our financial results.

Brett White

Thank you, Bami. Please note that the following discussions of our operating results will be on a non-GAAP basis, which excludes stock-based compensation expense, amortization of acquisition-related intangibles, and amortization of a common stock warrant issued in connection with debt financing. For a reconciliation of GAAP to non-GAAP results, please refer to the press release issued today and the supplemental financial information which is posted on our investor relations website.

As Bami mentioned, we’re very pleased with our financial performance for the quarter, exceeding our prior guidance for revenue, gross margin, operating expenses, and cash.

Total revenue for the third quarter was $25.4 million with products and services revenue of $25.3 million. This represents growth and products and services revenue excluding ratable revenue of 9% from Q3 last year. Products revenue was $20.9 million up 4% year-over-year. Support and services revenue was $4.4 million up 40% year-over-year.

Approximately 59% of Q3 revenues were from the Americas, 33% were from EMEA and 8% were from Asia Pacific. Excluding the impact of ratable revenues the Americas grew 11%, EMEA grew 22% and Asia Pacific declined 29% from Q3 last year. 94% of our shipments were through indirect channels, the remaining 6% direct.

Total non-GAAP gross margins in Q3 were 65.1% above our guided range of 63.5% to 64.5% and representing 150 basis point improvement from last year. Product margins were 65.8% up 80 basis points from last quarter and up 170 basis points from Q3 last year.

Total non-GAAP operating expenses were $19.7 million down $0.4 million from last quarter. As we stated in our earnings call last quarter, our objective is to rationalize our operating expenses to our near-term revenue expectations and we have been able to reduce operating expenses sequentially again in this quarter.

Total non-GAAP operating loss decreased to $3.1 million from $4.2 million last quarter and $3.6 million from Q3 last year. Non-GAAP net loss decreased to $3.9 million compared to $4.6 million last quarter and $3.7 million in Q3 last year. Non-GAAP loss per share for the quarter was $0.22 using a basis and diluted share count of approximately $18 million.

We ended the quarter with $31.1 million in cash, cash equivalents and short-term investments and $10.4 million of debt on the balance sheet. We generated $2.6 million in cash from operations and total cash increased $0.7 million from last quarter after the $1.1 million loan payment driven by favorable sales linearity in the quarter and record collections.

DSO improved in Q2 to 20 days compared to 46 days in Q2. We do not expect this type of linearity in Q4 and continue to expect future DSO will fall around 45 to 50 days. We added over 400 new customers in the quarter bringing total customer count to over 7,000. We continue to perform well in our key verticals with additional strength this quarter in the hospitality sector.

Deferred revenue was $17.5 million, an increase of 19% from Q3 last year excluding the ratable revenue element. Our full-time equivalent headcount at the end of the quarter was 399 compared to 430 at the end of last quarter.

Now on to guidance. We’re currently estimating that total Q4, 2012 revenues will be between $25 million and $27 million. We expect non-GAAP gross margins to be in the 61% to 63% range. The reduction from Q2 relates primarily to our product mix expectations for the quarter. Our current view is that this mix shift is unique to Q4 and we continue to maintain our long-term gross margin target of 65% to 68%.

We expect that the cost reductions that we have been driving will continue and that Q4 non-GAAP operating expenses will be at or below Q3 levels. Based on these estimates, we expect Q4 non-GAAP net loss of $3.2 million to $4.6 million or $0.17 to $0.25 per share based on the share count of approximately 18.3 million shares.

In our last earnings call we said that we expected to use less than $10 million of cash in the second half of 2012, which is a 50% improvement from the first half of the year and we're still comfortable with that number.

This concludes our prepared remarks. Operator, can you please open up the call for questions?

Question-and-Answer Session

Operator

Sure, Mr. White. (Operator Instructions) The first question comes from Jayson Noland with Robert W. Baird.

Jayson Noland - Robert W. Baird & Co.

Thank you. Congratulations on a good quarter and guiding a tough macro, gentlemen.

Bami Bastani

Okay. Thank you.

Brett White

Thank you.

Jayson Noland - Robert W. Baird & Co.

Brett maybe some more color first on the gross margin guidance, you said of mix is it – is there a one large deal that’s driving that?

Brett White

It’s primarily a mix along product lines. So, we get different profitability from [eight] access points versus controllers versus software, and this is going to be an AP heavy quarter that’s kind of view right now. And those are lower margins, so that’s why we’re comfortable to say it’s – we think it’s unique and we’re comfortable. We’ve been clipping along at 65% gross margin here for a while and we’re comfortable with that number. We just got a lot of APs in the hopper this quarter.

Jayson Noland - Robert W. Baird & Co.

Okay. And what drove DSOs down so shortly, you said record collections?

Brett White

Right, so we had great linearity. First off this was the most linear quarter I think that I’ve ever experienced and I’ve been here almost five years. And then second, we had great collections at the end of the quarter are actually – if you look at our receivables its pretty low and that’s -- we just had fantastic quarters – collections especially the last day of the quarter.

Jayson Noland - Robert W. Baird & Co.

Any color you can provide on where you expect the cash or net cash balance to be at the end of this year?

Brett White

Well last quarter we said we thought we used less than $10 million in the second half and we’re still comfortable with that number.

Jayson Noland - Robert W. Baird & Co.

Okay. Last question for me and I'll [exit] the floor, just to ask about performance by vertical across the three major verticals. I think you said you had strength in healthcare. Any more color you can add across those three maybe growth rates year-on-year if possible.

Dr. Bami Bastani

Yeah. This is Bami, and I’ll double team with Brett on this one. Q3 specifically we saw great momentum in all three sectors; in education, which is traditionally our strongest sector. We’re coming with solution-based offerings and in the right partnership. In the area of healthcare we’re coming with what I call world class products that deals with the major catalysts which is the EMR, introduction into this equation and in hospitality we started shipping to one of the major cruise lines that we cited. And we’re also gaining very good traction through certain ISP that we have partnered with in Europe and we have seen good activity in the Middle East. So, I was very pleased that the three areas that we have focused we are producing good momentum.

Jayson Noland - Robert W. Baird & Co.

Bami, is it fair to say there was growth – year-on-year growth in all three verticals?

Dr. Bami Bastani

Yes.

Brett White

Yes.

Dr. Bami Bastani

The answer is yes.

Jayson Noland - Robert W. Baird & Co.

Thank you gentlemen.

Brett White

Sure.

Operator

Next question comes from Jason Willey with Cowan.

Jason Willey - Cowen and Company, LLC

I just wonder if you could talk a little bit about the competitive environment and kind of any changes you’re seeing, I think particularly that relates to some of the controller-less offerings out there.

Brett White

So I would say, the competitive landscape is pretty consistent both from who we see in the different opportunities and from a pricing perspective. One of our product announcements was the MC6000 which is kind of the highest performing controller in the market. And that’s really focused on really high-end implementation where you’re running 1000s of APs and 10s of 1000s of devices, clients and so you mentioned controller-less. We see the controller-less option in kind of the lower end, lower less demanding environment is kind of more ease of use convenience type applications, but you still need controllers for these big campus wide deployments.

Dr. Bami Bastani

Sarosh.

Sarosh Vesuna

Yeah, I can just add to that. What's happening is that the funding especially in higher education for technology has become more strategic which means the deployments are going from what we call Wi-Fi hot zones to actually ubiquitous deployment across the entire campus, and controller-less pollutions are really only about 5% of market right now. The large deployments still require a controller and as they expand the entire university, the controller is what gives them manageability and ease of deployment et cetera.

Jason Willey - Cowen and Company, LLC

What about in the K-12 market?

Sarosh Vesuna

In K-12 its well, we are focused on the largest school systems. For example, the Philadelphia school system that’s we focused on, Miami-Dade. These are systems with about half a million students, and these kind of systems require proper control of the end year -- end user and the students and the APs. We aren’t seeing a huge demand for controller-less.

Jason Willey - Cowen and Company, LLC

A question on the balance sheet, inventory levels, the debt fairly substantially, if you can help understand what's going on there?

Brett White

Sure. So, we have got some new products that we just announced very recently plus we’ve got some other new products that we have not announced yet and so that’s really what that is, is we’re bringing onboard new products.

Jason Willey - Cowen and Company, LLC

And is that connected to pipeline that you see or is this just part of the kind of ramping-up process?

Brett White

Yeah, I mean it’s connected to opportunity, to pipeline, transition. As you transition from one product set to another you’re going to have a build, but yeah I mean we have – we manage our inventory against our demand expectations. So that's basically what we’re seeing.

Jason Willey - Cowen and Company, LLC

Okay. And then one last question; can you maybe talk a little bit about how you’re thinking about your need to kind of improve or manage kind of the balance sheet flexibility and available kind of capital. What the options are and how you kind of weigh those and particularly in light of kind of where the share price is?

Dr. Bami Bastani

Yeah, this is Bami. Most important thing is to put your money where your focus is and make sure those verticals are well funded for success. And then that's why we picked up education, healthcare and hospitality and entertainment as the three areas even though our products sell horizontally into many applications and many areas.

So in that regard the marching order is that we have internally the plans that we have internally is keep a lid on OpEx, but frankly the only reason I like to see that our OpEx goes up either we sell more and we’re paying more commission dollars and that’s music to my ear. But we have a very strong tight control in terms of spending and OpEx.

At the same time we are probably spending more money in our verticals from creating solutions while we’re economizing in other places. You also have seen that our headcount now is around 399, let me round it 400. That’s roughly the ballpark that we’re keeping it up from going forward. In terms of financing option, as you know we have filed for a S3 to give the company flexibility. At this point and time with the company cash position and our tight cash management we are – I am comfortable where we are. So we’re not running out today to raise money, if that’s the question. But we have the flexibility when the conditions change favorably.

Jason Willey - Cowen and Company, LLC

Maybe just a quick follow-up and it kind of relates to the comments around the OpEx levels and I’m just wondering if you could talk at all about, how we should kind of view a breakeven revenue level, if there is a level here that we need to get to, I am not necessarily looking for timing here, but what level of revenue do we need to see to kind of reach breakeven?

Brett White

Right. So, I think if you kind of do the math we’re comfortable with our OpEx. We’ve actually taken actions which will further take OpEx down. So, if you kind of do the math on OpEx and gross margin it says we can breakeven probably $28 million to $30 million revenue number and even if you assume a pretty modest growth rate that’s not too far away.

Jason Willey - Cowen and Company, LLC

Okay, great. Thanks a lot guys. I appreciate it.

Brett White

Right. Thank you.

Operator

Next question comes from Erik Suppiger with JMP.

Erik Suppiger - JMP Securities

Hello. Good afternoon.

Brett White

Hey, Erik.

Dr. Bami Bastani

Hi, Erik.

Erik Suppiger - JMP Securities

Just on the competitive front, and I apologize if you had discussed it earlier, but have you seen any pricing trends, have you seen any in light of filings from – walk us through where margins are somewhat lower. Are you seeing any customer push back in terms of pricing?

Brett White

Nothing new, customers push back on pricing everyday. But I wouldn’t say there is anything new major changes in the pricing environment over the last couple of quarters.

Dr. Bami Bastani

Yeah to me actually the potential for upside has the emphasized sale of software, the sale of our new products, with identity (indiscernible) points with Identity Manager. Indeed we have probably one of the best or it’s not the best policy management and authentication and that’s the way the world is going. So we generally think about the company as a hardware, which is APs and controllers, there is a lot more coming to the landscape in terms of support, services, and in terms of provisioning and a network management. So all of those present us with opportunity to increase gross margins and really the challenge and the task for us in our sales team and our engineering team is keep coming up with those world-class products and sell those world-class products.

Erik Suppiger - JMP Securities

Okay very good. Thank you.

Operator

(Operator Instructions) At this time I’m showing no further questions and I’d like to turn the call back over to Dr. Bastani for closing remarks.

Dr. Bami Bastani

I would like to thank everybody for monitoring our progress. We are excited about the Company, our prospects and the progress that we’re making. Looking forward to talking to you as we go forward and in our future earnings call. Thank you very much.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. You may now disconnect.

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