Kirk Misaka - CFO Jim Norrod - CEO.

Alan Davis - L.A. Davis & Associates Jim Lenobel - Haywood Securities.

Good day and welcome to the Second Quarter 2015 Zhone Technologies, Inc. Conference Call. My name is Latoya [ph] and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Kirk Misaka, Zhone's Chief Financial Officer. Please proceed..

Thank you, operator. Hello and welcome to the second quarter 2015 Zhone Technologies, Inc. conference call. I'm Kirk Misaka, Zhone's Chief Financial Officer.

The purpose of this call is to discuss Zhone's second quarter 2015 financial results as reported in our earnings release that was 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 Jim Norrod, Zhone's Chief Executive Officer.

Jim will begin by discussing the key financial results and business developments of the second quarter. Following Jim's comments, I will discuss Zhone's detailed financial results for the second quarter and provide guidance for next quarter. After our prepared remarks, we will conclude with questions and answers.

This conference is being recorded for replay purposes and will be available for approximately one week. The dial-in instructions for replay are available on our press release issued today. An audio webcast replay will also be available online at www.zhone.com following the call.

During the course of the conference call, we will make forward-looking statements which reflect management's judgment based on factors currently known.

However, these statements involve risks and uncertainties, including those related to projections of financial performance, anticipated growth, and trends in our business, the development of new technologies and market acceptance of new products, and statements that express our plans, objectives, and strategies for future operations.

We refer you to the risk factors contained in our SEC filings available at www.sec.gov, including our annual report on Form 10-K for the year ended December 31, 2014, and our quarterly report on Form 10-Q for the quarter ended March 31, 2015.

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

During the course of this call, we'll also make reference to adjusted EBITDA and adjusted operating expenses. Non-GAAP measures we believe are appropriate to enhance an overall understanding of our 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 the management in its financial and operational decision-making.

These non-GAAP results are among the primary indicators that management uses as a basis for making operating decisions because they provide meaningful supplemental information regarding our operational performance and they facilitate management's internal comparisons to the company's historical operating results and comparisons to competitor's operating results.

The presentation of this additional information is not meant to be considered in isolation or as a substitute for measures of financial performance prepared in accordance with GAAP.

We have provided GAAP reconciliation information for adjusted EBITDA within the press release, which as previously mentioned, had been posted on our website at www.zhone.com. With those comments in mind, I would now like to introduce Jim Norrod, Zhone's Chief Executive Officer..

being a global leader in fiber access transformation for service providers and providing the most cost-effective, efficient, and environmentally-friendly alternatives to existing copper-based Ethernet line infrastructure to businesses in other enterprises using our industry-leading FiberLAN technology.

As I discussed last quarter, we have a strong, well-established service provider business, serving the most innovative carriers around the world. In order to continue being a global leader in that business, we maintain the course of investing heavily in R&D, to continue providing the cutting-edge technologies that our customers expect and demand.

This included the launch of our new MXK-F which is the fiber-only evolution of our current MXK product line, offering ten times the switching capacity and two times the port capacity, while giving our customers the migration to new high-speed fiber services and access to network functions like software-defined networks, deep packet inspection, and other network virtualization functions.

At the same time, we began building sales and marketing infrastructure to develop the passive optical LAN market for the enterprise.

We embarked on an intensive campaign to educate businesses and other enterprises about the tremendous value proposition associated with our FiberLAN solution, a solution that helps businesses increase the revenue through increased occupancy, decrease power consumption, increase security, increase network life span, reduce CapEx, solve space utilization, and most importantly lower overall expenses.

Today, both our service providers and enterprise businesses are positioned for growth and are gaining momentum. And as you know, growth leads to increased profitability for us because we can leverage our operating expenses and our manufacturing capacity.

Profitability continues to be our number one management goal, and we fully expect to return to profitability for the year as a whole. Revenues are already rebounding from our management and product transitions. Gross margins have similarly rebounded, and operating expenses are back at the levels of a year ago. Kirk will talk more about those specifics.

So let me provide just a few comments about the two businesses. As I've said before, our service provider business continues to anchor our Company. So we are encouraged that our largest service provider customers continue to test the MXK-F in their labs, and we expect them to begin operationalizing the MXK-F in their networks later this year.

They're uniformly excited about the game-changing nature of this platform and we look forward to helping you migrate to it as soon as possible. We assume that the industry-leading platform will also catch the attention of other service providers around the world, creating an opportunity for us to develop and expand that customer base.

Meanwhile, we continue to support and enhance our MXK classic platforms on top of fiber access deployments for those service providers on a slower migration path over different network requirements.

An example is Convergenze S.p.A., a customer based in Southern Italy, who uses our MXK classic to perform and deploy ConFibra, the first fiber-to-the-home solution available in the region of Campania [ph].

Convergenze has completed the deployments of our MXK Gigabit Passive Optical Network, GPON, fiber access technology in the city of Capaccio-Paestum in Italy. This FTTH application allows the residents to have access to reliable triple-play services, including voice, video, and Wi-Fi.

By utilizing our market-leading hardware, Convergenze has increased network bandwidth and reach, while lowering service delivery costs and providing advanced services to its customers.

Convergenze began migrating to fiber-based services in January 2015 after realizing that their DSL technology is diminishing, and there was a customer demand for increased connection speed and bandwidth.

Our MXK 19 OLT serves as the backbone for the network, while our 2400 Series ONTs are installed at residents' homes, enabling them to access the internet at speeds of upto 100 megabits per second.

As for our enterprise business, revenue for the first half of 2015 has more than doubled over the first half of last year, continuing to demonstrate that FiberLAN can be a $100 million annual revenue business in five years.

In addition to growing at a rate which exceeds doubling on an annual basis, we are seeing the total pipeline of opportunity growing even faster as the market learns about the FiberLAN value proposition.

Also we are just beginning to tap the international markets where our world-class sales teams and partners have driven our Company's greatest growth, and where we currently do over two-thirds of our business.

We previously announced a non-exclusive agreement with Corning to co-market an all-fiber-network solution capable of deploying passive optical LAN networks and cellular distributed antenna systems on a common infrastructure.

This quarter, we announced another partnership with TE Connectivity to co-market passive optical LAN solutions to customers in a wide variety of sectors including government, healthcare, hospitality, education, and claims.

Together, we plan to partner on marketing programs and to further promote the adoption of passive optical LAN across multiple industries and raising the awareness about the benefits of the technologies [inaudible]. Robust centralized security makes passive optical LAN solutions highly attractive to the government and finance sectors.

By joining forces with TE Connectivity, the industry-specific applications and benefits of our respective technologies and how they work together could be more quickly and fully appreciated.

Now, let me turn the call back to Kirk to provide more details about returning to profitability, our financial results for the last quarter, and to discuss our financial guidance for next quarter.

Kirk?.

Thanks, Jim. Today, Zhone announced financial results for the second quarter of 2015. Second quarter revenue of $27.5 million grew 1.4% sequentially from first quarter revenue of $27.1 million.

Global economic uncertainties needed to grow somewhat, particularly in our European business, and could continue to influence growth going into the third quarter. Third quarter revenue can also be impacted by seasonal weakness attributable to extended holidays and vacations in some of our international markets.

As Jim mentioned, however, we continue to expect overall revenue growth for 2015, which will be driven by the launch of our MXK-F and continued strong growth in fiber net revenue.

We experienced slightly less customer concentration this quarter with the top five customers representing approximately 38% of revenue for the second quarter as compared to 42% for the first quarter.

We also didn't have any 10% customers in the second quarter as compared to one 10% customer in the first quarter and three 10% customers in the fourth quarter of 2014.

Our international markets continued to produce the vast majority of our business and represented 67% of revenue for the second quarter, as compared to 63% of revenue for the first quarter.

For the second consecutive quarter, gross margins of 37.2% exceeded our guidance range of 34% to 36%, largely due to stronger domestic margins and continued manufacturing efficiencies. We expect gross margins for the third quarter to return to more normal levels, estimated at between 34% and 36%.

Operating expenses of $10.5 million for the second quarter were at the low end of our guidance expectations of between $10.5 million and $11 million.

With the completion of our restructuring in the first quarter, we anticipate that operating expenses will continue to range between $10.5 million and $11 million for the remainder of the year, with only slight increases for the additional sales commissions on the anticipated revenue growth.

Operating expenses for the second quarter included depreciation of approximately $200,000 and stock-based compensation of approximately $300,000, both of which we expect to continue at roughly the same level into the third quarter of 2015.

Finally, our adjusted EBITDA profit for the second quarter of 2015 was $148,000, as compared to an adjusted EBITDA loss of $142,000 for the first quarter. Our net loss on a GAAP basis declined to $366,000 and $0.01 per basic and diluted share in the second quarter of 2015, from $602,000 and $0.02 per basic and diluted share in the first quarter.

Improved performance was driven by revenue growth, continued strong gross margins, and reduced expenses. As Jim mentioned, we continue to expect to be profitable for the year as a whole, which remains our number one financial objective. Now let's take a look at the balance sheet.

Cash and short-term investments at June 30, 2015 declined to $11.1 million from $11.3 million at March 31st, 2015, primarily due to minor net balance sheet changes, offset by the adjusted EBITDA profit. Although the net effect of balance sheet changes was minor, specific balance sheet accounts fluctuated to a larger extent.

Accounts receivable decreased slightly to $31.6 million at June 30, 2015 from $31.9 million at March 31st, 2015, decreasing the number of days sales outstanding on accounts receivable to 103 days, as compared to 106 days for the first quarter.

DSOs have been elevated over the last two quarters largely due to the pattern of shipments to and collections from our largest customers. We expect those patterns to normalize and DSOs to continue declining over the coming quarters.

We continue to focus on reducing net [ph] inventories, which were $15.4 million at June 30, 2015, as compared to $17.3 million at March 31st, 2015 and $20 million at December 31st, 2014. As for our total debt obligations associated with our Wells Fargo working capital facility, they remain $10 million at both June 30, 2015 and March 31st, 2015.

Lastly, the weighted average basic and diluted shares outstanding were $32.7 million for the second quarter of 2015. With that financial overview, let me turn the call back to Jim for a few final comments before we open the call up to questions and answers..

Thank you, Kirk. We continue to believe that we can grow revenue for the year in both our service provider and enterprise businesses. As I mentioned, the growth drivers stem from the launch of our highly anticipated MXK-F and the execution of our sales and marketing strategy for FiberLAN.

Our second quarter results illustrate that we are on track in our focused business structure lean profitability, which remains our primary financial objective. We are very excited about the opportunity because we know that revenue growth, coupled with operating expense leverage, leads to improve profitability.

Now we'd like to open up the call to questions. So, operator, please begin with the Q&A portion of the call..

[Operator Instructions] Your first question comes from Alan Davis with L.A. Davis. Please proceed..

Hi guys. Just a couple of questions. First, in regards to the service provider business.

As you look at your pipeline in the second half of the year, any significant shift in product mix or geography? And then on the MXK-F, when that starts shipping, will we see any positive gross margin implications there?.

Hey, Alan, this is Jim. Thanks for the questions. Yeah, we do watch that funnel very closely. And I've not seen a major shift on the service provider business. It seems to be pretty well-stable both on international and domestic. So we, again, we do about two-thirds of our business outside the U.S.

That really -- it moves around a point or two, but it stays pretty close to being two-thirds. So I don't see a big shift. We had a little better domestic this last quarter and maybe a little less in the Middle East due to the seasonality, but it doesn't shift but a point or two off.

On the MXK-F, yes, by the way, we've got several customers that are using that product live as we speak. We've not yet announced it formally but we will later this year. And yes, the gross margins are higher on that product, so we're very excited to get it out to the general population as soon as possible..

Okay, great. And then on FiberLAN, it sounds like there were comments kind of sticking with your long-term guidance.

Anything else you'd like to add there in terms of the expectations for that product, anything that’s changed over the last three months?.

Yeah. Get me started and I'll stay on the phone for a long time with you on this. This is where I spend, as you know, a lot of my time here. As everyone knows, we're in really the two markets, service provider business and then the enterprise business with FiberLAN.

We have continued to be a strong believer in that business opportunity where our business has more than doubled in the first half of this year versus the first half of last year, again, more than doubled.

We've more than doubled the number of resellers that we have that we're working with, and more than doubled the number of customers that have bought the products.

So yes, I and the Company continue to be very, very bullish on FiberLAN and we still believe that the goal that we stated to be -- that business be a $100 million business in five years is right on. So again we're bullish about the opportunity. I spend a lot of time on the road for this Company, almost more than half of my time I'm out with customers.

As an example, I'll be in Israel this weekend working with one of our very large opportunities in Israel, that is the largest opportunity identified to us in the FiberLAN area. So again we're very bullish as to what we see. And again, we're sticking to our guns that we think it's a $100 million business in five years..

Okay, great.

And last thing is, I wanted to gain some perspective here and just see how your first year at Zhone kind of compared to maybe your expectations going in, any challenges or successes that stand out?.

Yes. Again good question. I think we're exactly where we want to be. The thing that, as I said, I spend a lot of time visiting our customers early on to understand what products they want, and we directed our R&D team to focus on those requirements.

So I think we're exactly where we want to be in both the markets, and we will continue to focus on the service provider and the FiberLAN business. Again, where I thought we would be is where we are. We have really done a good job getting our expenses lined up. You see the numbers there. We continue to manage those expenses very carefully.

And I will say that, when I came into the Company, I said we wanted to be a profitable business, and our goal is still to be profitable this year. We think we got a great shot at doing that.

But more importantly than just the short-term goal, we've set the foundation for the future, 2016 and beyond, of both the service provider technology with the MXK-F, which is just a phenomenal product, there's nothing like it in the industry today, and so we set the foundation there.

And we've used the same technology that we've developed for the service provider business for the FiberLAN enterprise business. And again, I will just reiterate that, when I say more than doubled, we're on track to do very well both with revenue, with customers, and with resellers. I mean, it's right where we want it to be.

So I am not disappointed at all on that..

Great, Jim. Thanks. That's all for me..

[Operator Instructions] We have a question from Jim Lenobel from Haywood Securities. Please proceed..

Yes.

Could you provide some background of detail on what if any the dollar strength has had on your financial results?.

Sure. This is Kirk Misaka, Jim. Most of our customers are international customers, are in countries where the currency at the foreign country is pegged to the U.S. dollar, so there's a little impact. There have been some impact with regard to Europe, and that may be some other reason why Europe experienced some weakness.

But I wouldn't say that there's a major macro trend with regard to the strength of the dollar that's influencing our business. We're not completely resilient from that, but we have less impact in other companies..

Great. Thank you very much..

I would now turn the call over to Mr. Jim Norrod for closing remarks..

All right, folks. As always, we want to thank you for joining us today and your continued support. We are very excited about the growth opportunities that position us for this year and beyond.

And again, I want to remind you, our number one goal is, Kirk has mentioned and I mentioned, is to be profitable this year, and build the correct foundation going forward. And we think we're on track to do both of those. So again we're committed to making this a successful business. We're making great progress.

And again we appreciate all your support throughout the year and look forward to building this into a valuable company going forward. So again, thanks for attending..

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