DZS Inc (DZSI) 2006 Q2 法說會逐字稿

Good day and welcome to the second quarter 2006 Zhone Technologies Inc. conference call. I'm Eric and I will be your coordinator for today. [OPERATOR INSTRUCTIONS]

I would now like to introduce [Sylvia Choi], Director of Investor Relations. Please proceed.

Thank you operator. Hello and welcome to the second quarter 2006 Zhone Technologies Inc. conference call. I'm [Susie Coisoms] Director of Investors Relations. The purpose of this call is to discuss Zhone's second quarter 2006 financial results as reported in our earnings release, which is distributed over Business Wire 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, as well as Kirk Misaka, Zhone's Chief Financial Officer. Mory will begin by discussing the key highlights of the second quarter after which Kirk will discuss Zhone's financial results for the second quarter and provide guidance for the next quarter. 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 about investors for approximately one week following the call.

As you know, during the course of the discussion today we will make forward looking statements. In this context, forward looking statements often address our expected future business and financial performance and often contain words such as expects, anticipates, intends, plans, believes, seeks or will. 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 10K for the year ended December 31st, 2005.

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 EBITDA, an additional nonGAAP measure we believe is 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 nonGAAP 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 to 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 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.

Thank you Susie. Good afternoon and thank you for joining us today for our second quarter 2006 earnings call. Despite growth in SLMS on [inaudible] revenues for the second quarter of 2006, the second quarter financial result were disappointing due to the larger than expected drop in legacy revenue, reduced margin and increased operating expense. We also wrote off a substantial portion of our inventory due to the reduced amount for our legacy products.

Our primary product line of single line multiservice products grew sequentially by 6.4% quarter-over-quarter. Fueled by increased adoption IPTV of VoIP and broadband services. Our Optical business also had good sequential growth of 28.7% due to the [ployment] of multiple [inaudible] products. Sales of our legacy product continue to decline and experienced 13.5% sequential drop as we focus our effort on our SLMS product line.

Financially we had a pro forma [EBITDA loss] of 10.1 million for the second quarter of the year. Even though we increased our cash balance and further reduced our long-term debt. Kirk will provide more details on our financials later.

We maintain our broad base of service provided customers with sales into each of our worldwide sales region and with no singular country presenting over 10% of revenue. Service providers are moving to the next generation IP-based network. Installing Zhone's innovative solution to enhance their service offering with IPTV, VoIP and broadband. As a result, during the second quarter of 2006, Zhone lost significant new business for its products.

With shipment to 13 new customers. Newly announced customers during the quarter include Telecom Egypt, Premisys Telecommunications Canada, Mikkelin Puhelin Oyi and [Vintelo]. Also of note America, be a significant customer deployment in the Middle East and Latin America. We're focusing on growth [presence] internationally. We have realized 10% growth in our international business in the second quarter 2006.

To give some details regarding some of our recent customer announcements. During the second quarter we announced a major project with Telecom Egypt. Telecom Egypt it deploys Zhone's [inaudible] broadband Loop Carrier technology to provide VoIP and data services for various parts of their network. The project combines Zhone [inaudible] with [inaudible] off switch aligned circuit switch [inaudible] to move onto pure packet network transparently to end users in terms of serviceability, call quality and billing.

This will allow Telecom Egypt to provide its customers with voice services, including both parts and VoIP services. Telecom Egypt has a fixed line customer base in access of 10.6 million subscribers,which makes it one of the largest fixed line provider in the Middle East and Africa.

Last quarter, we announced that Zhone was the third largest North American supplier of DSL access [porter] according to analysts from broadband trends. We are pleased to announce this quarter that the demand for our DSL products remains strong and that our shipment increased to over 400,000 ports in the second quarter. That is an increase over 35% over last quarter, which had previously been our biggest quarter ever for DSL shipments and a good indicator of the growing adoption of our [inaudible] SLMS products.

During the second quarter of 2006, Zhone announced its [inter expand] products to deliver cost effective highband Internet services over existing copper loops. This copper-based solution provides a compelling fast and inexpensive alternative to [burying] and dedicating fiber. As an early leader in the emerging Internet first [inaudible] industry, Zhone is well positioned to catch a substantial share of this margin. We will continue to enhance our product offerings with more new products and additional functionality that better allow our customers to offer highband rate IPTV, VoIP, broadband and Gigawatt Internet services.

From a customer perspective, we will continue our focus on growth markets such as Middle East, South Asia, Eastern Europe and the Caribbean. While we focus on alternative carriers in Western Europe and South America. Comparatively we will focus on increasing our lead with new products, increased functionality and reduce costs.

To help reduce costs and improve our margins, we selected a Hungary manufacturing facility of communication test, Design Inc., also known as CTDI to perform manufacturing assembly for some of the Zhone's single line multiservice products. This enables Zhone to offshore it's manufacturing of high volume products be done award winning world class manufacturer. As a result, Zhone achieves immediate cost benefit and Zhone's growing international customer base enjoys accelerated delivery tools. Now, I would like to turn the call to Kirk to take you through our financial performance and guidance. Kirk?

Thanks, Mory. Today Zhone announced financial results for the second quarter of 2006. In our press release, [inaudible] comparison of financial results for the second quarters of 2006 and 2005 is presented alongside a comparison to the first quarter of 2006. As you will recall, the fourth quarter of 2005 was the first full quarter reflecting the impact of our acquisition of Paradyne which closed on September 1st. Since the first quarter results are more comparable to this quarter, we'll spend most of our discussion today focusing on the sequential comparison. All though any comparison to the second quarter of 2005 has limited value, we will be glad to answer any specific questions about the Q2 2005 results during the Q-and-A session.

With that background, let's begin with an overview of revenue. Our revenue for the second quarter of 2006 was 54.2 million, which was slightly below our previously provided guidance range of 55 to 57 million. Our single line multiservice product line continued to show significant strength growing from 33.2 million in the first quarter to 35.3 million in the second quarter of 2006. The 6.4% sequential quarterly growth in our SLMS product revenue puts us on track to achieve the 30 to 40% annual growth rate that we've experienced over the past two years. We also added 13 new customers this quarter as a large number of carriers recognize the benefits of our Access technology solution.

By contrast legacy products and service revenue experienced unexpected continuing weakness during the quarter declining from 14.7 million in the first quarter of 2006 to 12.7 million in this quarter. Meanwhile, Optical Transport revenue continued to rebound, 6.3 million this quarter, from 4.9 million in the previous quarter.

Once again, we did not have any 10% customers during the quarter reflecting our diversified customer base and reduced dependence on certain key customers. Our top five customers represented approximately 26% of our quarterly revenue, consistent with 26% in the first quarter. The other 74% of quarterly revenue was distributable to approximately 600 active customers. International revenue was approximately 45% of total revenue in the second quarter of 2006, as compared to 42% in the first quarter. International revenue as a percentage of total revenue has now increased in every quarter for the last six quarters led by successes in the Middle East, Eastern Europe and Central and Latin America.

For the second quarter of 2006, our SLMS revenue represented 65% of our business, which is up from 63% in the first quarter. At the same time, our legacy and service revenue declined to 23% of our business, from 28% in the first quarter. This trend shows continuing shift in our alliance on legacy technologies. As our rapidly growing SLMS business continues to overtake it. We expect this trend to continue during the third quarter of 2006 with strong growth in our SLMS business offset by a declining legacy business. Therefore we expect total revenues to remain roughly flat for the third quarter of 2006.

Now, let's turn to gross margins. Gross margins were 22% for the second quarter of 2006, which was below the 39 to 40% range of guidance we previously provided. [inaudible] declined largely because we wrote off 7.2 million of our inventory, due to reduced demand on our legacy projects that Mory previously discussed. Otherwise margins would have been approximately 35%, which was still below expectations primarily as a result of lower pricing on two large strategic international customers. Going forward we expect cost reductions from outsourcing some of our manufacturing to CTDI as well as stabilizing international pricing pressures to help improve our gross margins to approximately 38% in the next quarter.

As for operating expenses, total operating expenses for the second quarter of 2006 were 24.7 million, which was slightly above our forecasted range of 22.5 and 24.5 million. Operating expenses included depreciation of approximately 0.5 million. Amortization of 0.6 million. And stock-based compensation of 1.2 million. Overall OpEx increased by 1.1 million as compared to operating expenses for the first quarter which were 23.6 million. This increase in expenses was primarily attributable to specific new product development efforts for potential major carrier customer. The results of which we should know during the third quarter.

Going forward, we anticipate total operating expenses for the third quarter of 2006 to continue to range between 22.5 and 24.5 million. Our expense guidance includes approximately 2 million of expenses for depreciation, amortization of intangibles and stock-based compensation.

Finally, pro forma EBITDA for the second quarter was a loss of 10.1 million and below the anticipated range of between 2 and 4 million positive EBITDA, due to the previously mentioned legacy revenue and margin shortfalls, as well as the 7.2 million write off of inventory. Our estimated pro forma EBITDA for the third quarter is roughly break-even.

Turning to the balance sheet, our cash and short term investment at June 30, 2006, were 71.8 million, up from 71.5 million at March 31st, 2006. Our total debt obligations decreased by approximately 500,000, from 43.6 million at March 31st, 2006, to 43.1 million, at June 30, 2006. As a result of additional principal payments during the quarter. On a combined basis our net cash balance or cash net of debt obligations, increased by a total of approximately 800,000 during the quarter. So for the third quarter in a row, we generated positive net cash.

As for other balance sheet changes, accounts receivable levels increased as a result of increased international activity, which resulted in the number of days sales outstanding on accounts receivable to increase to 65 days for Q2 2006, as compared to 64 days for Q1 2006. Inventory levels decreased for in the quarter as we fulfill several large orders for which materials were purchased in Q1. As we previously mentioned, we wrote off 7.2 million of inventory primarily related to our legacy business. Finally the average basic and diluted EPS shares were 148.7 million for the second quarter.

Before I turn the call back to Mory, let me summarize the financial results for the second quarter and recap our guidance for next quarter. SLMS revenue continued to grow at more than a 30% annual growth rate. As broadbased deployment of our market leading DLC products continues. Greater than expected declines in our legacy products resulted in the short falls in revenue, even though Optical Transport revenue continued to rebound. All in our disappointing second quarter, we have revised our estimates and expect the third quarter revenue levels to be approximately flat in comparison to those of the second quarter.

As for the other financial metrics for the third quarter of 2006, we expect gross margins to be approximately 38% and operating expenses to range between 22.5 and 24.5 million, including 2 million of expenses for depreciation, amortization of intangibles, stock-based compensation. These results should drive roughly break-even pro forma EBITDA for the quarter. With that overview, I'll turn the call back to Mory.

Thank you, Kirk. Our financial results for the quarter reflect the final [inaudible] of the transition of our legacy to SLMS business. Although we are disappointed with the short-term result, we are encouraged with the continued significant [option] of our SLMS and Optical Transport Solutions. As I mentioned before, we believe our ability to continue [inaudible] will be a significant driver of our future success. Our next generation SLMS architecture is the cornerstone of our product innovations.

And we intend to continue to develop advanced technologies that provide our customers with seamless migration from legacy circuit-based technology to converge Packet-based IP networks, by simultaneously reducing operating costs. We are confident that we have the right strategy, the right solution, and the right leadership to take advantage of tremendous opportunities that lay ahead. We appreciate your continued support in that effort. Thank you for joining us today. Now I would like to open the call to questions. Operator please begin the q-and-a portion of the call.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Hasan Imam. Please proceed.

Hi, guys.

Hi, Hasan.

I have two questions. My first question is, the legacy drop off, are you seeing something in terms of like a long term trend which is -- that's why you're taking restructuring steps. It is not just a quarter issue, where some customer pushed out?

No. Hasan we are seeing a long term drop in our legacy business. That's why we decided to take the inventory down. And also that's why we said the next quarter is going to be flat, because we assume our legacy business is going to be down again.

Okay. And is that legacy part of the Paradyne business that you are planning to restructure down anyway, or is it also from the Zhone site?

That is actually from Zhone site. These are the product that we acquired in the last two or three years. Paradyne legacy business was kind of tailed off. And it was insignificant in their business.

Okay. And I guess I was hinting at, I mean is there something fundamental going on in terms of your customer base, that they suddenly decided to push -- I mean not to buy the legacy stuff anymore?

Well, you've got to look at our customer base. We have two customer base. They wanted to buy our legacy business are not really the same customer base that are buying our new SLMS and Optical base. There's a very, very small overlap between the two. So our customer base is growing in SLMS and Optical. And some of the legacy business customers have converted their net worth to SLMS. And obviously some drop off in the legacy business.

Okay. So this is essentially because of the move to the Next-Gen. Because I thought, as you pointed out Mory, that your customers with legacy are somewhat different from the SLMS. So wouldn't that mean that the legacy customers in terms of capacity needs continue to need to deploy the legacy?

Well not as much anymore because we have --they have [captive] legacy business and they are moving to the Packet product base. With the exception of one customer, one or two customers that are using the legacy business majority around are either [captive] business or moving to the Packet business, which is SLMS and Optical business.

Okay, thanks. And one last question for Kirk. In terms of next quarter guidance, how does seasonality play into that?

Well the top line, as Mory said, we expect flat revenues. And normally revenues would be up sequentially quarter-over-quarter. Flat revenues is based on the decline of roughly $2 million in our legacy business and an increase in our SLMS business by a similar amount.

To just add comment on that, even though we trade on one of our major part of our business is international and we do see international being European and our Middle East customers being on vacation this quarter, third quarter, we are not seeing that much aside in that area in our business.

Got you. Thank you.

Your next question comes from the line of Greg [Mesiness] with Needham. Please proceed.

Yes thank you. I have two quick questions. The 35% gross margin that you alluded to, if you assume without the inventory write-down, that decline sequentially, is that really a function more of the Paradyne acquisition and the integration issues? Or does it reflect any other pricing issues or give us some color there.

Well actually, it doesn't have anything to do with the Paradyne issue. We ended up that we were in a competitive situation with two large customers internationally that decided to forward price some of our product for future business, when we couldn't take advantage of the offshore facilities. Now, we are in the offshore facility and taking advantage of that. And we assume that our gross margins are going to increase.

But now that you've got your manufacturing moved, the sequential effect should be one of a rebound.

Correct.

Okay. And my other question is, as far as the softness and the falloff in the legacy business, besides just the age of the products, are you seeing any secular or longer term shift in market share that you could share with us?

In the past, we were looking at the decline in this product line by about 5 or 6% year-over-year. This year we are seeing more softness in that area because of the legacy business has [capped] up a lot of net work providers. And they are moving to a Packet [inaudible] network at this point. So we're going to continue seeing that.

Okay, but is it fair to say that overall the pricing environment is--continues to soften?

Not in the legacy. Not in the legacy environment. The legacy environment is pretty solid.

Okay. Got you. Okay, I'll stop right there. Thanks.

Your next question comes from the line of [Bob Poole] with [Wachovia] Capital. Please proceed.

Hi, guys. At what point do you think you just have to make this a profitable business at 50 some million in revenues per quarter? I mean obviously you can't continue to bounce around here, around break-even and have that be an acceptable outcome for shareholders. And if you don't for some reason think that you can do -- you don't think you can adjust the business model yourself, for whatever reasons, at some point, don't you have to take what somebody would think would be $80 million of potential annual contribution and fold that into another business, where that 80 million can be valued? Whereas we're really getting no value for your efforts in the current --

We are continuously evaluating our business. And we're looking at areas to grow and increase shareholder values. Our business that we set to do, that was our SLMS and Optical business are growing at a rapid pace. We are focusing on those areas. We are moving some of our legacy customers to our new platform to increase business. Unfortunately, the legacy business got under pressure last quarter, the last two quarters. That was unforeseen with us. But in any event, we are looking at our business on a daily basis. And we are planning to be profitable and provide some shareholder value [as much as possible].

But you don't foresee Mory, I mean you're not questioning in your mind whether we're just--there needs to be a total Paradyne shift in the way you think about the business to restore profitability sooner rather than later? I don't sense from you or your discussion today that there's any sense of urgency to get this Company on a consistently profitable basis. Which it seems that $200 million and something of revenue, you ought to be able to do. And how do you -- and in light of a quarter that's not going so well, how do you overshoot on R&D spending and sales and marketing spending?

There are things that you're not aware that we have spent money on, some project in the hopes of winnings a large project that major carriers that last quarter that was a risk that we take to make a big move to one large carriers. On the other hand, we are looking at our business at every given day and every given hour. Now, if you have any other ideas that you want to explore with me, please call me in my office later on.

Okay and then just finally, given that there was a big sort of bubble of spending on a major piece of business that you were able -- that you were looking to win--I mean it looks like it was a fairly large-- can you characterize how much money you spend on that and why?

There was a large potential. And all the expenses that we incurred during the quarter in the OpEx was R&D in that project.

Right. Okay. Well, thanks. I just encourage you to recognize that you've got to get to profitability-- this is not six or seven years ago. We've got to get to profitability.

I appreciate your talk.

Thanks.

Your next question comes from the line of Peter Schleider with Peninsula capital. Please proceed.

Yes, I'm wondering first if the forecast for cash in the quarter is positive sequentially or negatively, you're going to burn some cash in the third quarter? And secondly, what was the legacy revenue in the fourth quarter?

Pete, this is Kirk. With regard to the cash for the third quarter, we expect it to roughly break-even on a net basis. We do have some principal payments that we plan to make during the third quarter on our debt obligation. But otherwise as you know, EBITDA and cash flow are approximately the same for us. And we've projected a break-even EBITDA number. As far as the legacy revenue for Q4, it was 19.0 million.

And then how-- where do you think you can get your inventory levels down to -- they seem, even with the 7 million write off, it seems like you can get them down maybe another 5 million. Is that reasonable?

Our plan is to reduce our inventory in the next, this coming quarter by about 2 to $3 million. And just -- not as a write-off, but as a usage.

Thank you.

Sure.

Your next question comes from the line of Anton Wahlman with ThinkEquities.

Hi Mory and Kirk, can you hear me well?

Sure.

I have a few questions on random subjects here. Let's just start with [six] expenses. If I understood your comments correctly, you basically, this R&D and [S&M] in particular went up because you are developing a new type of product line that you intend to announce in the next 60 to 90 days or so?

That's a part of that. But the other part was, we were doing a specific product that a carrier wanted. We are looking at a carrier to deploy that product. So we were developing that product for them.

And that is a -- from a time line perspective, if you separate out new product line from kind of lets call custom-made products, which of those would hit first in terms of the revenue line? And the approximately when?

Let's put it this way. Under custom product, it's a comparative situation, two or three companies are doing that. We don't know whose going to be the winner on that and how soon that's going to get deployed. If it gets deployed, it would be probably in 2007. And with respect to product announcement, we will do some announcement within the next five to six weeks. And we hope to see revenue out of that in Q4.

Okay. So but for the then the overhead expenses -- if I understood Kirk's guidance correctly -- to sort of strap out all of the other stuff. Then basically it seems like the fixed expenses would decline by about $1 million into the September quarter. Is that approximately the correct interpretation, Kirk?

[Hoping] to decrease by at least 1 million, yes.

I wanted that--I have to mention that that expenditure that went off, it was based on purchasing some equipment and software to be able to deal with that product. It's not--we didn't add additional head count or anything like that.

Okay, so it was really your project driven, a little capital equipment and specialized stuff?

Specialized stuff. Correct.

Okay, now if I look at the margins, and I'm trying to understand your margin commentary. On the one hand, you said that it is the legacy product line that was the drag. On the other hand, you're talking about a couple of these new international opportunities which I presume were really SLMS focused. Correct?

Correct.

So are you saying that the margin impact then therefore came in both of those areas, or was it more in one as opposed to the other?

It was more in SLMS in a couple international areas.

Okay so the margin impact on legacy and service was more directly -- the volume there went from 14.7 million last quarter to 12.7 million this quarter. So just as a result of volumes coming down a shade, gross margins went down just by a shade as well. Will that be the correct way of looking at it?

I think if you were to read into what I was commenting about the margins, I said that the overall margins are 22%. And the result of the legacy inventory write-off of 17.2 million is roughly 13%.

No. That's all crystal clear. But in terms of the decline sequentially in overall corporate gross margins by about 3 points, from 38.3 to 35.3, that really comes from the then the SLMS side, if I understand it correctly.

Not totally. You're correct by saying when the legacy business came down, obviously the margin gross -- it would affect the margin. But by shifting the SLMS product to Hungary, a small portion of that, we believe we are going to increase our gross margin to the point that we can maintain 38% gross margin for next quarter.

Okay, all right. That's a little bit clearer then. Well, those are-- and also, if you see yourselves at some point -- let's say that you are positive EBITDA by $1 next quarter, not $0.01, but just positive by the smallest amount that you will have to report a fully diluted share account, which you would have to do even if you were positive by the smallest possible amount. I mean would you say that it's about 2 million shares that would be the differential there, at about a $2 share price for you? Or is it less than 2 million number of shares?

On the treasury share method basis, at $1.90 [inaudible], it would be about 1.3 million shares.

1.3, perfect. All right. And in terms of just interest expense and income, are you paying down your debt a little bit? And the net impact, interest rates have been moving up here or whatever, how could you just characterize that--?

Actually, net interest expense for next quarter is expected to be only slightly negative. So roughly 100,000 of net interest expense.

Okay. So darn close to zero, anyway.

Right.

Okay, well that's all I had. Thank you.

Sure.

Your next question comes from the line of [Eric Buck] with [Green Murray]. Please proceed.

Thank you. I just wanted to touch on the expense side again. When you look at what could be as much as 2 million or even over 2 million, when looking at the low end of your guidance range on operating expenses, is the delta solely related to not working on these carrier specific initiatives? Or is there, in fact, an effort to otherwise lower operating expenses?

What we mentioned are operating expenses regardless of this one time development, stayed flat from the quarter before, with a slight upside. So we believe we can get back to the operating expense of what we had in Q1.

All right. But if you're at the low end of that 22.5 to 24.5, that's implying taking out better than 2 million of expenses. And that sounds-- that 2 million number sounds like it's larger than what you spend incrementally for these programs. Is that not correct?

Well, roughly 1 million as compared to the prior quarter relates to this major carrier initiative. And a little bit less than 1 million relates to additional sales and marketing that occurred this quarter, largely around the conferences and a customer event that we hosted.

We have several marketing events that happened during the quarter that we don't see happening in this quarter.

Okay, so all of the reduction comes from the absence of events as opposed to a concerted effort to specifically reduce costs?

Our plan in respect to cost reduction is increasing the gross margin not [inaudible].

Okay. Thank you.

Your next question comes from the line of [Steven Board]. Please proceed.

Yes. I was curious as to the percentage of inventory legacy versus the SLMS. Can you comment on that?

Will you give us a minute to look at that?

Steve, I don't have that detailed between legacy and SLMS. Especially after the write-down. Most of the legacy inventory that Mory was mentioning that we wrote off as a result of a decline in the legacy business took us to about 20% of what we were holding before. So we wrote off about 80% of that legacy inventory.

And so you're being very conservative then in your write-off?

We substantially reduced the inventory carrying value associated with the legacy product line that had declined significantly.

You don't really anticipate any future declines in the write-offs in this area, in the future, would you say?

We took it down to the level that we thought would be sold or could be liquidated in the next year.

Okay. Within the next year. Okay, thank you. Also, the operating expense, I was looking at the total operating expenses. And I know -- to some extent, this is noncomparative because you-- because of your acquisition. But to the second quarter of last year, to the second quarter of this year, operating expenses basically increased 81%. Do you have any comments related to a need to cut back on some of that? Or that -- that those expenses are actually required and necessary for your operations going forward?

The majority of that difference is, when we acquired Paradyne which had about an equal amount of cost infrastructure and zone, the cost infrastructure doubled. And yet, as you said, it's up 81%. The--we did have significant cost energies associated with Paradyne that we took out in the third and fourth quarter. Those have been largely removed and are reflected in our go forward operating expenses. And as we've been discussing here in the last few minutes, roughly an additional 1.5 million to 2 million of operating expenses this quarter related to specific events or projects.

Your pricing power from -- and you talked about this before with the other analysts. Pricing power legacy versus SLMS, could you address that as being soft, flat or strong in each of those categories?

We believe on the pricing rise legacy is stable. International pricing has stabilized this quarter for all of our product. And domestic pricing has been stabilized.

Okay. Thank you.

Your next question comes from the line of [Howell Patruchi]. Please proceed.

Mory, with all due respect, I understand that there are certain things that are out of your control. And I'm not a [inaudible]. And I'm very concerned about you getting such a large bonus for your performance. We're down right now, we're really [inaudible]. Can you give us your thoughts or comments?

Let Kirk make that comment.

Obviously Mory's compensation is carefully reviewed by our compensation committee of the Board. And the Board has strategic initiatives for Mory, many of which he performed very well against in the second quarter. The acquisition of significant new customers, 13 new customers, in particular Telecom Egypt and his role in Premisys Telecommunications. So those are reasons for the bonus that was paid in the second quarter.

Okay. Thank you.

Next?

Your next question is a follow-up question from Hasan Imam with Thomas Weisel. Please proceed.

Yes, thanks. I had a question in terms of the trajectory of the legacy versus the growth businesses. So right now, you've roughly let's say 20 to 25% of revenue is coming from legacy. And I think you mentioned that the growth or blended growth in the Optical in SLMS business is something on the order of 30%. So could we expect the legacy business to decline to a level low enough where it ceases to be a meaningful drag on the business by the end of the year? Or are we looking at more like first half of '07?

Our expectation would be probably end of this year or end of first quarter of next year.

Okay. Thanks.

[OPERATOR INSTRUCTIONS] Your next question is a follow-up question from [Eric Buck] with [Green Murray]. Please proceed.

Thank you. I guess I'm a little confused on that last comment as it relates to the legacy inventory comment. I mean if you-- if 7 million was 80% of the legacy inventory, that would imply there's only a couple million worth of inventory there left. So that would seem at your legacy rate to be something that would be shipped that much faster than first quarter of '07. And I guess service is in that category as well. Maybe you can give us a sense as to where that split is now and how you reconcile the inventory versus the length of time its going to take you to sell the rest of that off.

Well, it relates primarily to one specific product line, as opposed to the entire legacy and services revenue base. So you've got a couple of pieces that you can't assume that there is a cost of goods sold of half of the legacy and revenue numbers for this quarter.

If the question is is there a potential major write-off on legacy inventory, the way we have it this quarter, if that's the question, there is -- no, there is not. We don't have that much inventory of legacy. Legacy has stopped in our inventories. So when we look at the legacy inventory, we are in the position right now that we can use majority of our inventory for our product.

Okay. Can you give us a sense of how much of the legacy and services business is in fact legacy products versus services that might be associated with the ongoing SLMS and Optical business?

We don't break the service business in that finite. You could assume that service is probably about 25% of our legacy--legacy and service business.

Okay, thank you.

Your next question is a follow-up question from [Greg Mesiness] with Needham. Please proceed.

I actually had a couple of questions. But I boiled them down into one fairly straightforward question. Again, if you assume pro forma gross margin for Q2 of 35% without the inventory burnoff, and you've given Q3 guidance of 38% on gross margins, could you give us some of the rationale behind the 300 basis point increase?

As I mentioned, by shifting our manufacturing to offshore manufacturing, we are reducing majority of labor and material costs. One of the larger product -- larger volume products that we ship.

So it's really a question of shifting to a lower cost manufacturing and logistics?

Correct.

Okay. Thank you.

Sure.

Ladies and gentlemen, we're showing no more questions at this time. I would like to return the call over to Mory.

Thank you for joining us today. And we'll see you in the next conference call. Thank you.

Thank you for your participation in today's conference. This concludes our presentation.