Kirk Misaka - CFO Yung Kim - Co-CEO Jim Norrod - Co-CEO.

Christian Schwab - Craig-Hallum.

Good day and welcome to the Fourth Quarter 2016 DASAN Zhone Solutions Incorporated Conference Call. I'm Karen and I'll be your coordinator for today. At this time, all participants are on a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference.

[Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to introduce Kirk Misaka, DASAN Zhone Solutions Chief Financial Officer. Please proceed..

Thank you operator. Hello and welcome to the fourth quarter 2016 DASAN Zhone Solutions Inc. earnings conference call. I'm here today with Co-CEOs of DASAN Zhone Solutions, Yung Kim and Jim Norrod.

Since Yung is responsible for DZSIs product strategy and technology development, he will begin with comments about DZSI's current product portfolio and future roadmap. Jim will follow with comments about DZSI's markets and the delivery of DZSI's products through our combined sales channels.

Following Jim’s comments, I will discuss DZSI's financial results for the fourth quarter and provide guidance for next quarter. In addition I will provide more details about our 2017 operating model and financial objectives. 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 the replay are available on our press release issued today. An audio webcast replay will also be available online at www.dasanzhone.com following the call.

Before we begin, I'd like to mention that during the course of this call, we may make forward-looking statements, made in reliance on the Safe Harbor provisions of Section 27A of the Securities Act of 1933 as amended, and Section 21E of the Securities Exchange Act of 1934 as amended.

Including forward-looking statements such as the revenue that can be generated by cross selling products after the merger, the amount and timing of cost savings and synergies that maybe achieved in connection with the merger, improvement in gross margins that may result from product cost reductions and economies of scale, the strength of the combined companies balance sheet and financial results following the merger, the degree to which the combined company will alter the competitive landscape and it's industry, and the company's ability to successfully fulfill its customers’ needs.

Actual results could differ materially from those projected in or contemplated by forward-looking statements.

Factors that could cause actual results to differ include the possibility that the intended benefits of the merger may not be fully realized, unanticipated difficulties or expenditures related to the transaction, the response of business partners and competitors to the merger, potential difficulties in employee retention as a result of the merger, legal proceedings that maybe instituted against DZSI and others related to the merger, the failure of the combined company to manage the cost of integrating the businesses, general economic conditions, the pace of spending and timing of economic recovery in the telecommunications industry, the combined company's inability to sufficiently anticipate market needs and develop products and product enhancements that achieve market acceptance and higher than anticipated expenses the combined company may incur in future quarters.

In addition, please refer to the risk factors contained in Zhone's SEC filings including without limitation, its Annual Report on Form 10-K for the year-ended December 31, 2015. We also refer you to the risk factors and disclosures contained in Zhone's definitive proxy on schedule 14A.

Listeners are cautioned not to place undue reliance on any forward-looking statements which speak only as of the date on which they are made. The company undertakes no obligation to update or revise any forward-looking statements. With those comments in mind, I would now like to introduce Yung Kim.

Yung?.

Thanks, Kirk. And greetings to those participating on today's call. On the product side, we continue to focus our efforts on delivering best in class products in five key product areas; broadband access, Ethernet switching, mobile backhaul, passive optical LAN or POLAN and software defined network or SDN.

Let we spend a few minutes discussing each of these areas in more detail. Our current broadband access product offer a variety of options for carriers and service providers to connect residential and business customers.

Our solutions allow carriers and service providers to either use high-speed fiber or leverage their existing copper network to offer broadband services to customer premises.

Once our broadband access products are deployed, the service provider can offer voice, high definition and ultra high definition video, high speed Internet access and business cloud service to their customers.

We develop our broadband to product for all aspects for carrier and service provider access network, customer premise equipment such as DSL modem, Ethernet access demarcation devices, gigabit passive optical network or GPON, and gigabit Ethernet passive optical network or GEPON optical network terminal.

We also develop center office product such as broadband loop carrier for DSL and voice-grade telephone services or POTS, high-speed digital subscriber line access multiplexers or DSLAMs with a very high bit-rate G.fast and the VDSL capability, optical line terminals for passive optical distribution network like a GPON and GEPON as well as point-to-point Ethernet service for one-gigabit to ten-gigabit access.

Both DNS and Legacy Zhone were market leaders in the broadband access market prior to the merger and the combination of the DNS and Legacy Zhone is expected to enhance our leadership position for both carrier and enterprise solutions in this market going forward.

Our Ethernet switching product provides a high performance manageable solution that bridges the gap from carrier access technologies to the core network. Over the past ten years, carriers have migrated access infrastructure to Ethernet. Our products can also be deployed in data centers luring the line between central office and the data center.

Our product supports pure Ethernet switching as well as layer 3 IP and MPLS capabilities and are currently being developed for interfacing with SDN. Legacy Zhone did not offer a comparable Ethernet switching product prior to the merger. And therefore the Ethernet switching market is expected to provide an opportunity for growth.

We are already seeing some Legacy Zhone customer traction in the market that Jim will discuss further. Our mobile backhaul product provides a robust manageable and scalable solution for mobile operators that enable them to upgrade their mobile backhaul system and migrate from 3G network to LTE and beyond.

We provide our mobile backhaul product to mobile operators or carriers who provide the transport for mobile operators. Our mobile backhaul product may be collocated at the radio access node base station and can aggregate multiple base stations into a single backhaul for the delivery of a mobile traffic to the RAN network controller.

We provide standard Ethernet IP or multiprotocol label switching MPLS interfaces and interoperate with other vendors in this network.

With the mobile backhaul network providing carriers with significant revenue growth in recent years, mobile backhaul has become one of the most important parts of their network due to the explosive growth of mobile data traffic.

DNS has invested over $7 million in the past two years to launch a portfolio of mobile backhaul products to meet the needs of these networks. We expect this area to also provide strong revenue growth in the coming years. Our FiberLAN portfolio of POLAN products are designed for enterprise, campus, hospitality and entertainment arena uses.

Our FiberLAN portfolio includes our high performance, high bandwidth GPON OLTs connected to the industry's most diverse ONT product line which include units with integrated power over Ethernet to provide a wide range of devices such as point-of-sale terminal, CCTV and our full range of WiFi access points.

Our environmentally friendly FiberLAN POLAN solutions are one of the most cost effective LAN technologies that can be deployed allowing network managers to deploy a future proof, low maintenance, manageable solution that requires less space, air-conditioning, copper and electricity than other alternatives.

Our FiberLAN portfolio relates primarily to Legacy Zhone products while WiFi access point and wide variety of terminals are from DNS product line. We expect the combination of Legacy Zhone and DNS products in this market to enhance the functionality of our product offering and lead to continued revenue growth.

Our SDN and network function virtualization or NFV tools and building blocks to allow service providers to migrate their networks’ full complement of legacy control plane and data plane devices to a centralized intelligent controller that can reconfigure the services of the hundreds of network element in real-time for more controlled and efficient provision of bandwidth and latency across the network.

This move to SDN and NFV provides better service for end customers and a more efficient and cost effective use of hardware resources for service providers.

We leverage our broadband access, mobile backhaul and Ethernet switching expertise to extract and virtualize many of the traditional legacy control and data plane functions to allow them to be run from the cloud. The latest evolution of our hardware-based solution was designed to support SDN and NFV.

As we have said before the combination of DNS and Zhone resulted in a robust and complimentary product portfolio that will help service providers and enterprises manage their networks more efficiently and effectively while allowing them to migrate to the latest technology to satisfy the exploding demand for bandwidth.

With that said, I will turn the call over to Jim Norrod to talk about our markets and our customers genuine interest in our product and solutions..

Thank you Yung, and thank all of you on the call for joining us today. As I mentioned on our last call, we are very excited about the market opportunity in front of us.

The fourth quarter was our first full quarter of combined operations and while we are still working on a seamless integration of the businesses of the Dasan Network Solutions and Zhone, we are already seeing the benefits of the combination.

As a leading provider of broadband access, Ethernet switching, mobile backhaul and passive optical end products, demand for these solutions is high and we have already begun to cross sell to each company's loyal customer base with a unified sales and support team in every major geographic region.

Frankly, the cross sell interest has exceeded our expectation demonstrated by the level of requests for demo equipment by our customers that want to begin lab testing product offerings that were not previously available to them.

In addition to testing of these new product offerings, we have already received cross sell orders that we did not expect until later in the year. At the same time, backlog is increasing for recurring business and the pipeline of opportunities is growing which is increased our visibility for future revenue.

Based on these factors, we believe 2017 revenue will grow more than we previously forecasted and Kirk will give you those details in just a few minutes.

As a reminder, Dasan has been a leading telecom equipment provider in Asia Pacific to some of the largest carriers in the region including three large carriers in Korea and tier-1 carriers in Japan and Vietnam.

Dasan generated about 85% of its revenue from the Asia Pacific region, Zhone on the other hand generated less than 5% of its revenue from that region, but had been and still is a leading player with alternative carriers in the Americas, Europe and the Middle East, in addition to several tier-1 carriers in the Middle East.

Going forward, revenue growth will be driven by three major catalysts. First, we will cross-sell Dasan’s Ethernet switching and mobile backhaul products to historic Zhone customers. As Yung mentioned, Zhone never had these type of products and as I said, many Zhone customers have requested demo equipment to begin testing these products in their labs.

Second, we will grow revenue in the passive optical LAN business which I continue to believe can be a $100 million dollar business in five years with an appropriate increase in the sales and marketing efforts in this area. And our third major growth catalyst comes from the merger itself.

By taking the best people, the best processes and the best products of both companies, I am convinced that we can and will grow revenue, even if we encounter difficult market conditions. Let me spend a minute on the business integration process. Although complex with many moving parts, the integration is going smoothly and is mostly complete.

As I said, we've taken the best people, the best processes and the best products of both companies and moving forward as a stronger, more efficient combined company. Most of the heavy lifting is behind us and the difficult task of squeezing cost efficiencies out of the merger were mostly completed in the fourth quarter.

And although I say that most of the cost cutting effort is behind us, cost efficiency will always be a priority. Revenue growth and cost efficiency will be the major contributors to reaching profitability in 2017.

Longer term, we are also focused on improving gross margins and expect to see the benefits of our integration efforts to reduce the cost of our products and to put to use the excess manufacturing capacity in our Florida facility.

On the customer side, I’ve spent much of the fourth quarter meeting with our largest customers around the world, assuring them that DASAN Zhone Solutions will continue to provide them with best-in-class products and best-in-class service and support.

For them, the uncertainty of the merger has been lifted and I'm very pleased to see them moving forward with their carrying purchases and with the testing of the new product offerings. My tours in visiting our customers demonstrated to me that we have the best customers in their respective areas and that our future is very bright as a result.

With that brief overview, let me turn the call back to Kirk to provide more details about our financial results for the fourth quarter and our financial guidance for the future..

Thanks, Jim. Before proceeding with a discussion of the DZSI financial results for the fourth quarter, let me provide some background concerning what these financial results represent. As discussed on our last earnings conference call, we completed the merger on September 9, 2016.

And pursuant to the mergers, Zhone Technologies issued approximately 47.5 million shares of its common stock, representing 58% of the merged company to DASAN Networks, Inc., the former sole shareholder of DASAN Network Solutions.

At the same time, Zhone Technologies changed its name to DASAN Zhone Solutions Inc., and commenced trading on the NASDAQ capital market under the new symbol DZSI on Monday, September 12, 2016. In this transaction, Zhone was the legal acquirer because it issued shares to acquire the stock of DASAN Network Solutions.

However, for accounting purposes, DASAN Network Solutions was treated as the accounting acquirer, based on a variety of factors governed by GAAP. Accordingly, the financial operations of Zhone are reflected only from September 9 forward and Zhone’s assets and liabilities were recorded at fair value as of the merger date.

Those assets included the value of acquired intangible assets and goodwill and subsequent financial results reflect the amortization of the acquired intangible asset. For these reasons, our fourth quarter financial results are different in several ways from the historical financial results.

With that in mind, we will discuss the fourth quarter financial results of DZSI, but won't be making comparisons to prior operating results.

To better understand our fourth quarter results as it relates to future financial performance, we will provide supplemental financial guidance for the first quarter of 2017 and a revised view of our 2017 financial model. Revenue for the fourth quarter of 2016 was $59.2 million.

In addition, approximately $2 million of product shipments for the quarter did not meet our revenue recognition criteria and we expect those shipments to increase our revenue forecast for next quarter, which I'll discuss here in a minute. But first, let me remind you of our previous financial guidance.

On our last earnings call, we forecast revenue to increase from approximately 45 million in the first quarter of 2017 to about $60 million in the fourth quarter of 2017 due to seasonality.

We also indicated that we expected total revenue to be about $210 million for 2017, which represented low single digit percentage revenue growth over the 2016 pro-forma combined revenue of the merged companies.

As Jim mentioned, several indicators suggest that revenue growth in 2017 will be stronger than previously expected, including the lab test activity and cross-sell orders of new product offering coming from legacy Zhone customers as well as the growing backlog and pipeline of opportunities for existing product offerings.

Based on these indicators and after a full quarter of combined operations behind us, we feel more confident about top line growth and now expect annual revenue to grow to about $220 million, which represents more than 6% growth over the 2016 pro forma combined revenue of the merged companies.

With the additional growth and the approximately $2 million of deferred revenue shipments from the fourth quarter, we expect first quarter revenue to be approximately $50 million instead of our previous guidance of about $45 million. Gross margins for the fourth quarter of 2017 were 30.3% and were consistent with our 30% financial guidance.

As we discussed last quarter, combined gross margins for 2017 should continue to be about 30%, the longer term gross margin expansion coming from product cost reductions and manufacturing economies of scale.

We will provide further details regarding that potential on subsequent earnings calls after we have fully integrated the manufacturing operations of both businesses. However, we do not expect much gross margin expansion until the latter half of 2017 at the earliest.

Operating expenses for the fourth quarter of 2017 totaled $20.5 million and included depreciation and amortization of approximately $2 million and stock-based compensation of approximately $200,000.

Adjusted operating expenses, excluding depreciation, amortization and stock-based compensation, was approximately $18.4 million and slightly below our previous $19 million forecast.

For the first quarter of 2017, we expect adjusted operating expenses to remain roughly the same as in the fourth quarter of 2016, but then expect to see increasing benefits from merger cost synergies over the remaining three quarters of 2017.

By the fourth quarter of 2017, we expect adjusted operating expenses to be about $2 million per quarter lower. Depreciation and amortization should be about $1.2 million in the first quarter and decline to about $700,000 in the fourth quarter.

Stock-based compensation should be about $400,000 per quarter and remain at that level for the remaining quarters of 2017. Our non-GAAP adjusted EBITDA loss for the fourth quarter was $500,000 and our GAAP net loss was $5.3 million.

Based on our revised financial guidance, we expect that we will be generating positive adjusted even EBITDA by the third quarter of 2017, which is our immediate and primary financial goal.

Improved earnings performance will be driven primarily by revenue growth from cross-selling opportunities and new growing markets in mobile backhaul and passive optical LAN and operating expense reductions from cost synergies associated with the merger.

Longer term, our primary financial goal will be to increase adjusted operating margins to 10% before making any other major structural changes to our operating model.

We plan to accomplish that long term objective through continued revenue growth, expanding gross margins through cost reductions and manufacturing economies of scale and leveraging operating cost efficiencies. Now, let's take a look at balance sheet.

Cash and cash equivalents at December 31, 2016 were $17.9 million, reflecting the additional liquidity created by the merger. Also debt of $22.6 million at December 31, 2016 is only partially indicative of the much larger borrowing capacity of the combined companies.

As previously mentioned, the increase in intangible assets and goodwill reflects the purchase accounting associated with the acquisition of Zhone. All other balance sheet increases primarily reflect the impact of merging the two companies.

Finally, all historical equity accounts of DNS and its subsidiaries, including par value per share, share and per share numbers have been adjusted to reflect the shares of the company's common stock issued in connection with the merger. Before proceeding with questions, let me provide an update on our NASDAQ listing and planned reverse stock split.

On our last call, we discussed that the DZSI listing was considered a new listing subject to the NASDAQ’s initial listing requirements. Since DZSI did not meet those requirements, we requested and the NASDAQ Hearings Panel granted an extension of time to March 13, 2017 to gain compliance.

Subsequently DZSI’s stock price also fell below the NASDAQ's minimum bid price requirement and the panel granted the company a concurrent extension of time to regain compliance with that requirement.

In order to regain compliance with these requirements, DZSI filed a definitive proxy on January 26, 2017, requesting shareholder approval for a reverse stock split of up to 1 for 5.

The company expects shareholder approval of the reverse stock split at a special meeting of stockholders on February 27, 2017 and if approved, will execute a reverse stock split of one for five shortly thereafter, which will enable the company to regain compliance with these NASDAQ requirements.

Also on or prior to March 13, 2017, the company plans to file the necessary amendments to its Form 10-Q for the period ended September 30, 2016 and being current in its filing obligations as required by NASDAQ. With that overview, we would now like to open up the call to questions. Operator, please begin the Q&A portion of the call..

[Operator Instructions] Our first question comes from the line of Christian Schwab from Craig-Hallum..

Hey, good quarter, guys.

Kirk, on the taxes in the quarter, can you explain why that was so big and what should we be assuming as far as taxes in ’17?.

Yes. The majority of the income tax expense relates to the write up of the deferred tax asset for the DASAN Network Solutions Korean group. Because of the losses, historical losses and the current period losses, we wrote that asset off. In the future, it's possible that those benefits will be realized.

And when it becomes more likely than not, those deferred tax assets will be recognized and the corresponding benefit will be reflected in the income statement.

I think going forward, at least for the next few quarters, we certainly do not expect any recognition of income tax benefits and similarly would not expect to have any write-offs of any deferred tax assets because the deferred tax assets on a net basis are currently zero.

So in the next few quarters, income tax expense would be expected to be close to zero..

Okay.

And then post the merger, can you remind us the size of the NOL?.

The NOL is in excess of $1 billion in gross, but the majority of that is limited under section 382 because of the change of ownership related to this transaction. The actual amount that will be able to be used, we’ll disclose that in the filing of our Form 10-K for the year ended 2016.

It is substantially less than what you would anticipate to be available..

Right, right.

Can you give us a rough idea of what that is or do you just want to wait till it's filed?.

It’s definitely less than $5 million..

Less than 5 million?.

$5 million annually..

Okay. Prefect. And then as we look past 2017, do you believe that the combination of the two companies is a growth company like we talked about before.

And if it is, can you walk us through a three to five year outlook on what we think this company could look like?.

Hi, Christian. This is Jim.

Yes, it is a growth company we believe and we have not done a three to five year plan yet because the merger had its complexities putting the companies together, which we have said, a lot of moving parts which we've been focusing on doing and focusing on getting the right organization in place and the right expense structure.

We haven't done a revenue plan for three to five years out. But I will say that I'm positive about where we're headed and positive that it is a growth company not a shrinking company.

So again, our two goals that we have focused on and actually presented very clear ways to the board yesterday was that our two goals are our growth, number one, and closely followed by profitability, in fact they're I’d say one and two, they're right there together, but it is a growth company.

We expect to be able to hone in on what that's going to look like here over the next couple of quarters..

[Operator Instructions] And with no further questions, I'll turn things back over to Jim Norrod for any closing comments..

Thank you, operator. Appreciate it. And as always folks, thanks for joining us today and for your continued support. We are genuinely excited about the merger as I mentioned earlier about making this a growth company and creating significant value for our customers and our investors.

Our number one financial goal is to return to profitability and generate shareholder value.

So we're excited about our progress on that and we look forward to speaking with you again at next quarter's earnings conference call when we will discuss our progress toward extracting the value associated with the merger that will lead to corresponding financial benefits. So thank you and we wish you a good day..

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