DZS Inc (DZSI) 2006 Q4 法說會逐字稿

Good day ladies and gentlemen and welcome to the fourth-quarter 2006 Zhone Technologies conference call. I am Tammy and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session toward the end of the conference. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded for replay purposes. I would now like to introduce Susie Choy, Director of Investor Relations. Please proceed.

Hello and welcome to the fourth quarter 2006 Zhone Technologies Inc. conference call. I'm Susie Choy, Zhone's Director of Investor Relations. The purpose of this call is to discuss Zhone's fourth quarter 2006 financial results as reported in our earnings release, which was distributed over Business Wire at the close of market today and has been posted on our web site 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 results of the fourth quarter and providing some insights into the future for the Company. Following Mory's comments, Kirk will discuss Zhone's financial results for the fourth 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 web cast replay will also be available online at www.zhone.com following the call.

As you know, during the course of the discussion today, we will make forward-looking statements, including those relating to projections of profitability, earnings, revenue, margins, operating expenses or other financial items; the anticipated to growth in trends in our business, product lines or key markets; the capital spending environment and the migration of customers to newer technologies; Zhone's market position and focus; Zhone's recovery, turnaround and other future economic and other future economic conditions and performance and statements that express our plans, objectives and strategies for future operations, including R&D and M&A activities. 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 10-K for the year ended December 31, 2005, and our quarterly reports for Form 10-Q for the quarters ended March 31, 2006; June 30, 2006 and September 30, 2006.

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 were 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 and operating expenses, excluding impairment charges, which are additional 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 the intent of providing greater transparency to supplemental information used by management in its financial and operating 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 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 for pro forma EBITDA within the press release, which as previously mentioned, has been posted on our web site 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 fourth quarter 2006 earnings call.

As compared to the third quarter, [our] revenues grew 3% to $44.3 million, and (indiscernible) revenue grew by over 11%, but was offset by legacy business declines. Margins improved to 36% and operating expenses were reduced by 10% as (indiscernible) $113.7 million of non-cash impairment charge taken in the third quarter.

Improvements on all three fronts resulted in pro forma EBITDA loss of $2.3 million, which was on the low end of our anticipated range of $2 to $5 million pro forma EBITDA loss. Kirk will provide more details on our financial results later, so let me spend a few minutes discussing the business and our progress during the quarter in executing on our strategy.

During our last earnings call, we mentioned that our third quarter's results were affected by several of our large international customers who delayed orders as they evaluated alternative network architectures and technology paths, as well as the effect of mergers and acquisitions among our service provider customers worldwide. Other telecom equipment providers experienced this pause in CapEx spending by carriers during the fourth quarter as evidenced by negative pre-announcement by several companies within the industry. However, while the whole industry remains uncertain about the effect of mergers within the customer base, during our fourth quarter, we began to see our customers getting closer to choosing their technology direction and expect that process to continue over the next few quarters.

In the meantime, we responded to market conditions by quickly right-sizing the Company and streamlining our operations. As mentioned, [reduce] our total operating expenses, excluding the goodwill impairment charge by 10% largely in selling, general and administrative expenses. We also improved gross margin by outsourcing certain manufacturing to CTDI in Hungary and further reducing our internal manufacturing costs.

Even though we streamlined our business, we did not reduce our investment in research and development. During the fourth quarter, we continued to develop enhancement to our existing products, as well as new next-generation technologies. We will continue investment in our product lines during 2007 and we will introduce new products for broadband services over fiber and copper during the entire year.

Focusing on growing our SLMS business, we will continue to complete customer and technology migrations of acquired businesses. During the past year, we migrated our optical technology into SLMS product (inaudible). Late in the first quarter or early Q2, we will introduce our first SLMS product based on our optical technology. To that end, we will report our existing optical transport business with our legacy services and other businesses beginning with the first quarter of 2007.

We will continue to divest non-strategic portion of our company to focus on our SLMS business. For example, we've entered into an agreement to divest our IMARK product line at the end of December, 2006. We are encouraged by the level of customer activity and interest in evaluating these and others of our next-generation technologies. During the fourth quarter, we had shipment to 19 new customers to add to our customer base of over 600 companies. Having built our business to its current level, we no longer plan to rely to acquisition to grow further. And as said, we plan to grow as our current customers begin migrating to next-generation technologies. We anticipate that our customers will increase their spending as they search for ways to increase bandwidth.

These customers will also convert their TDM and ATM networks to capitalize on benefits of more flexible IP-based architecture. They will also be expanding their networks to provide multi-service offerings of voice, video and data. Although much of our growth will come from existing customers, we will also grow as other telephone carriers and cable [operators] (indiscernible) their benefits of our solutions.

We have been adding 13 to 24 new customers every quarter over the last year and expect to continue to increase market share with our next-generation technologies. With that growth, our primary near-term goal is to get to quarterly profitability, which we expect to accomplish by the end of 2007.

From a customer perspective, we will continue our focus on international growth markets, such as Middle East, South Asia, Eastern Europe and Central Latin America. Domestically, we will continue to expand our customer base of Tier 2 and Tier 3 telephone carriers.

In summary, we will continue to focus on [having] grow our base of products to address current and future customer needs. Our single-line multi-service architecture continues to be the right strategy as carriers migrate from a TDM network to an IP packet-based network as copper lines are replaced by fiber lines, and single services are being replaced by bundled multiple services. We are well-positioned to take advantage of our market growth in VoIP, IPTV and broadband.

Now I would now like to turn the call to Kirk to take you through our financial performance. Kirk?

Thanks, Mory. Today, Zhone announced financial results for the fourth quarter of 2006. In our press release, the traditional comparison of financial results for the fourth quarters 2006 and 2005 is presented alongside a comparison to the third quarter of 2006. Since the third quarter results are more comparable to this quarter, we will spend most of our discussion today focusing on this sequential comparison.

Let's start with an overview of revenue. Our revenue for the fourth quarter of 2006 was $44.3 million, which was up 3% sequentially and within our guidance range of $43 to $45 million. Our single-line multi-service product lines increased from $23.6 million in the third quarter $26.2 million in the fourth quarter of 2006. This 11% sequential quarterly increase in our SLMS product revenue reflects the anticipated we rebound from order delays in the previous quarter. Also as Mory mentioned, we added 19 new customers this quarter, confirming the continued interest in our products.

By contrast, legacy product and service revenue experienced a 3% decline during the quarter, decreasing from $15.1 million in the third quarter of 2006 to $14.7 million in this quarter. And as Mory mentioned, we entered into an agreement to divest our IMARK legacy product line at the end of the quarter. For 2006, total IMARK revenue was approximately $7.8 million with an average quarterly revenue of just under $2 million per quarter. As we've said in the past, we expect our overall legacy business to decline by 5% to 10% year-over-year. That overall decline will likely be somewhat uneven going forward as that part of our business becomes smaller, and therefore, more concentrated.

Nonetheless, we expect the first quarter of 2007 to experience a greater than average decline with the normal seasonal weakness and the impact from the sale of the IMARK product line.

Optical transport revenue continued to fluctuate and was $3.5 million this quarter, down from $4.4 million in the previous quarter. As Mory mentioned earlier, beginning with the first quarter in 2007, we will no longer separately report the optical transport revenues. Instead, we will report our optical transport business with our legacy service and other businesses as the optical transport business is becoming a smaller portion of our overall revenues.

Overall, we did not have any customers comprising greater than 10% of our total revenues during the quarter. Our top five customers represented approximately 25% of our quarterly revenue as compared to 33% in the third quarter. For the 2006 year, our top five customers represented approximately 25% of total revenues as well.

As previously mentioned, we continued to enjoy a diversified customer base with approximately 600 active customers.

International revenue was approximately 37% of total revenue in the fourth quarter of 2006, basically the same as that of the third quarter. For the 2006 year, our total international revenue was approximately 40% of total revenues, as compared to 34% for the year ended December 31, 2005. We expect our percentage of international revenue to grow over 2007 as we continue to focus on emerging global markets and our largest international customers increase their spending during the year.

For the fourth quarter of 2006, our SLMS revenue represents 59% of our business, which is up from 55% in the third quarter. At the same time, our legacy and service revenue decreased to 33% of our business from 35% in the third quarter. Going forward, we expect our SLMS business to continue this trend as legacy customers migrate to a next-generation solution.

For the first quarter of 2007, we expect our total revenues to be slightly lower. Our estimate of total revenues is between $40 million and $42 million during Q1 of 2007 due to normal seasonal weakness in the first quarter, coupled with the short-term effect of selling the IMARK product line. We expect revenues for the remainder of 2007 to grow from these levels.

Now let's turn to gross margins. Gross margins were 36% for the fourth quarter of 2006, which was within the 35% to 37% guidance we previously provided, and up from 35% in the third quarter. Margins increased as a result of outsourcing certain manufacturing to CDTI in Hungary and other manufacturing cost reductions. We expect our margins for the first quarter of 2007 to remain between 35% and 37% because of volume, but begin improving slightly during the second quarter of 2007.

As for operating expenses, total operating expenses for the fourth quarter of 2006 were $20.2 million, which was below the low end of our $20.5 million to $22.5 million guidance. For the third quarter of 2006, total operating expenses, excluding the $113.7 million non-cash impairment charge, was $22.6 million. The $2.4 million sequential quarterly improvement in operating expenses primarily resulted from eliminating selling, general and administrative expenses associated with the revenue decline.

Operating expenses included depreciation of approximately $500,000 and stock-based compensation of $1.1 million. Going forward, we anticipate total operating expenses for the first quarter of 2007 to remain at this reduced level, between $20 million and $21 million, including approximately $1.5 million of expenses for depreciation and stock-based compensation.

Finally, pro forma EBITDA for the fourth quarter was a loss of $2.3 million and at the low end of the anticipated range of a loss between $2 million and $5 million. Our estimated pro forma EBITDA for the first quarter of 2007 is a loss of between $2 million and $4 million. Nonetheless, as stated previously, our goal is to achieve positive pro forma EBITDA on a quarterly basis by the end of 2007.

Turning to the balance sheet, our cash and short-term investments at December 31, 2006 were $64.3 million, which is down from the $65.8 million at September 30, 2006. Cash balance declined during the quarter, primarily as a result of the pro forma EBITDA loss of $2.3 million. Our total debt obligations decreased slightly from $41.6 million at September 30, 2006 to $41.5 million at December 31, 2006 as a result of normal debt amortization on our campus loan. On a combined basis, our net cash balance, or cash net of debt obligations, decreased by a total of $1.4 million during the quarter. As mentioned, we expect to grow revenues, improve margins and reduce our operating expenses throughout 2007. The combined effect of those efforts will minimize net cash burn.

As for other balance sheet changes, accounts receivable levels decreased as a result of improved collection efforts. The number of days sales outstanding on accounts receivable improved to 65 days from Q4, 2006 as compared to 74 days for Q3 2006. Inventory levels decreased to $45 million at December 31, 2006 from $48.4 million at September 30, 2006 as a result of improvements in our order fulfillment processes.

Finally, the average basic and diluted EPS shares were $149.1 million for the fourth quarter, changing only slightly from the $148.9 million in the third quarter due to stock option exercises by management and employees.

Before I turn the call back to Mory, let me summarize the financial results for the fourth quarter and recap our guidance for next quarter. As compared to the third quarter, revenues grew 3% to $44.3 million, margins improved to 36% and we reduced expenses by 10%, excluding the third quarter goodwill impairment charge. Improvements on all three fronts resulted in a pro forma EBITDA loss of $2.3 million, which was on the low end of our anticipated range of a $2 to $5 million pro forma EBITDA loss.

Overall, revenue was within our expectations with SLMS revenue showing strong growth over the prior quarter. We expect the first quarter 2007 [revenues] to be slightly down to between $40 to $42 million as a result of normal seasonal weakness and a short-term effect of our IMARK divestiture. Gross margin should remain between 35% and 37% for the first quarter with a slight improvement for the remainder of 2007 resulting from higher volume. Operating expenses should remain at a lower level between $20 million and 21 million, including $1.5 million of expenses for depreciation and stock-based compensation.

Overall, we anticipate a pro forma EBITDA loss for the first quarter 2007 of between $2 million and $4 million and pro forma EBITDA losses and negative cash flow should be reduced throughout the year as a result of growing revenues, improving gross margin and lower operating expenses. These efforts should produce positive EBITDA and cash flow on a quarterly basis by the end of 2007.

With that overview, I will turn the call back to Mory.

Thank you, Kirk. We view the fourth quarter as the first step in our recovery process and are excited about the prospect for 2007. The continued customer wins and level of customer interest in our next-generation products is extremely encouraging. During the fourth quarter, we took the opportunity to streamline our operations, which resulted in increasing gross margin, as well as reduction in operating expenses. As I mentioned, at the beginning of the call, our primary goal is to achieve quarterly pro forma EBITDA profitability by the end of 2007.

We're all fully engaged in the business of this Company and absolutely believing the long-term strategy and vision for the Company. We're confident that we have the right strategy, the right solution and the right [industry] to take advantage of tremendous opportunities that lie ahead. As always, we appreciate your continued support in that effort.

Thank you for joining us today. Now, I would like to open the call to your questions. Operator, please begin the q-and-a portion of the call.

(OPERATOR INSTRUCTIONS). Greg Mesniaeff, Needham & Co.

This question is either for either Mory or Kirk. I was wondering if, assuming we see some modest or slight sequential increase in revenues in '07 from the base guidance you gave us for the first quarter, I am wondering how much more OpEx percent reductions you can deliver without -- and still maintain that year-end goal of EBITDA profitability. In other words, how much wiggle room do you have in any continued OpEx reductions?

We are continuously looking at opportunities to reduce our OpEx. At this point, we think we are in the level of OpEx that we can maintain our R&D and sales activity and be able to increase our top line and deliver the numbers that we are expected to deliver throughout the year.

Thank you. I'll come back later with some more questions. Thanks.

Anton Wahlman, Think Equity.

So you mentioned that you would be coming out with your first SLMS-based optical product soon. Correct me here if I'm wrong, but I was sort of under the impression that you had already been shipping something in that area in '06 from the standpoint of -- you had some fiber-to-the-home, albeit it very small, but in the Czech Republic and Japan and in rural America here and there. Could you straighten that out? I obviously understand the difference between your sort of metro area separately reported optical product line, but what is new here?

You are correct, Anton. We've been selling optical products as a [BCON] product line throughout 2006. The product that we are talking about is a product that has our SLMS technology, or DWDM/CWDM technology, that we haven't discussed that in the past, nor do we intend to discuss it at this point.

Okay. So, DWM/DWDM, and --.

Our SLMS code base, yes.

And this differs from [Zpon] or some sort of [ZEpon] or --?

Yes, that differs from all of those. It's targeted really for up to about 10-G kind of a transport kind of a stuff. So it's not something that we're ready to discuss publicly.

10-G, wow, to the home?

I cannot say that, no.

Alright. In terms of the other existing optical business that used to be down in San Diego, is that a business in which you are continuing to invest, or is that going to be a -- or do you view that as something that you -- in terms of folding it into reporting with the other legacy businesses, it seems like it sounds like you're just not going to try to enhance that with new generations, but rather just milk that for as long as it goes. Is that correct?

The product that we acquired from San Diego, we will continue to enhance it and offer it to our existing customers. But that technology, plus our SLMS technology, is the one that we talk about that would be called the next-generation product that offers CWDM/DWDM.

Okay, alright. And would you say that in terms of enhancing the overall SLMS portfolio, very broadly speaking, are you going to stick to serving the "traditional telecom access," or are you also pondering other things, be it wireless or something else, that -- do you think you have the capacity to broaden that exposure at this point, or are you going to simply use the resources that you have to go after the existing focus more?

Our focus is going to be definitely on access, mainly on wireline, and we have several products under development that we will be announcing throughout the year that enhances our product line for wireline, broadband applications. And those applications can be either voice-over IP, IPTV or true high-speed broadband.

And final question on VoIP certification. I remember you, back several months ago, there was an issue with certification with the Nortel 2K, which led to some delays, but I believe if I remember correctly, you passed that subsequently. Does that mean that you can now start selling in volume into places like Egypt and other places, or is there anything else going on in that type of area?

No. Actually, that certification has helped us very much so with (indiscernible) .com in addition to Telecom Egypt. The Telecom Egypt started deployment and installation of the product after we made the certification. So that certification with the CS2K of Nortel has helped us very much in getting into several new accounts. Some of that that we mentioned was part of that 19 accounts that we mentioned. Some, they were using Nortel sub switch.

Thank you very much.

(OPERATOR INSTRUCTIONS). Greg Mesniaeff, Needham & Co.

I have a quick follow-up. At the Needham Growth Conference, I think I may have heard you say in the breakout that you guys either have or are working on a pseudowire product offering. And I was wondering if that would be part of the SLMS line or how that would come to market, if it's not already in the market.

Number one, it's not in the market. When it comes to the market, it would be part of the SLMS line.

Would that be primarily for -- I assume that's primarily for wireline use, not for wireless backhaul.

It's for wireline use, but it does not have any limitation that would not allow wireless backhaul.

That's all I have. Thank you.

Ben Shamsian, Canaccord Adams.

The upside on the quarter, was that -- how much of that was from a recovery of the last quarter, with regards to Middle East and Latin America?

You know, honestly, we're not breaking that down. We cannot tell you exactly what that is, but we do know that international business was 37% of our business, which is equivalent to last quarter.

Great. And when I look at the gross margins, if I back out the FAS-123, I look at 36.3% this quarter, 36.3% last quarter. I guess, where do you see the upside from looking at a pure number here?

As we develop our new products and we take costs out of the product line and improve our manufacturing processes, I also think our goal is to grow our gross margins to probably 38%. That's where we can get to that -- that's how we can get to those numbers.

Alright, great. Thank you.

At this time -- this is all the time we have for questions today. I would now like to turn the call over to Mory Ejabat for closing remarks. Please proceed.

Thank you again for joining us today. We appreciate your support and I'm looking forward to speaking with you at our next conference call. Operator?

That concludes today's conference. Thank you for your participation you may now disconnect.