Ladies and gentlemen, thank you for standing by, and welcome to DZS Third Quarter 2020 Earnings Conference Call. At this time, all participant lines are in listen-only mode. [Operator Instructions] After the speakers' presentation, there will be a question-and-answer session.

[Operator Instructions] Please be advised that today's conference may be recorded. I would now like to hand the conference over to your host today, Mr. Ted Moreau, Vice President, Investor Relations. Please go ahead..

Thank you, Liz. Welcome to DZS's third quarter 2020 earnings conference call. Before beginning, I would like to comment, it has been fun working with the management team since I joined DZS two months ago.

This is an exciting time for the Company as we position the business to take advantage of a number of growth opportunities we see in the coming years. This is all outlined in our stockholder letter published last night in the Investor Relations section of our website, @dzsi.com.

I look forward to interacting with our analysts, shareholders and prospective shareholders. Joining me today are President and CEO, Charlie Vogt, CFO, Tom Cancro; and CTO, Andrew Bender. I would now like to provide the DZS safe harbor statement.

During this call, we will provide projections and other forward-looking statements regarding future events or the future financial performance of the Company. The Company cautions you that such statements are only current expectations and actual events or results may differ materially.

Please refer to documents that the Company files with the SEC, including its most recent 10-Q and 10-K reports in the forward-looking statement section of the letter to stockholders that was filed on a Form 8-K, as well as being available on our Investor Relations section of our website.

These documents identify important risk factors that could cause actual results to differ materially from those contained in the Company's projections or forward-looking statements. Please note that unless otherwise indicated, the financial metrics being provided to you on this call are determined on a non-GAAP basis.

These items together with corresponding GAAP numbers and the reconciliation to GAAP are contained in the letter to stockholders. So, with that, I will now turn the call over to Charlie..

Thanks, Ted. And welcome investors and guests, and especially our West Coast attendees for getting up early with us this morning. Following the market close yesterday we released our inaugural quarterly stockholder letter, highlighting our performance for the quarter ending September 30th.

Our quarterly stockholder letter provided an overview of our alignment with today's market trends, as well as our regional expansion plans, government sponsored programs such as the United States Secure and Trusted Communications Act and the Rural Digital Opportunity Fund.

We also profile the enhancements we've made regarding our new leadership team, as well as the broader overview of where our products and solutions are being deployed within fixed mobile and enterprise networks.

As Ted mentioned, our Chief Financial Officer, Ted Cancro, (sic) [Tom Cancro] and our Chief Technology Officer, Andrew Bender, who recently joined DZS from VMware, are here today with me to expand on topics of interest, as well as answer any questions you may have that was represented in our stockholder letter.

Closing out my first quarter, I'm thrilled to report all-time record revenue for the quarter, which was led by growing demand for our next generation mobile transport solutions, as well as continued demand for our fiber-based broadband access and customer premise solutions.

We had an exceptional top-line quarter, delivering 33% revenue growth when compared to Q2, and 31%, compared to the same period a year ago.

I want to recognize and applaud our employees and partners for achieving this outstanding milestone, especially in light of the ongoing global pandemic, which has impacted component shortages, customer valuation trials and deployments. Before I open the call to questions, I want to amplify three key themes represented in the stockholder letter.

First is our expansion in the North America, Latin America, EMEA and India, leveraging our fiber-rich portfolio, broadband access solutions and next generation mobile network, transport solutions which are being deployed in volume in the world's first Open RAN network.

Second is our skilled and agile research and development team that spans both fixed and mobile domains, and our follow DASAN geographic capabilities across the United States, Germany, South Korea, Vietnam and India.

And finally, the more than 30 new employees, including executive management team members, as well as key leaders spanning product, engineering, supply chain, sales, marketing and finance that have joined DZS since my appointment in early August.

Over the past three months, we have made significant progress integrating former DASAN and Zhone a key mile, creating a one DZS brand and culture.

We have rationalized and accelerated our commitment towards unified technology roadmaps and aligned our employees and partners with a vision and strategy to capture market share in the burgeoning 5G fiber-to-the-premise, and connected home and enterprise market segments. With that, I'll turn the things back over to moderator for questions..

[Operator Instructions] Our first question comes from the line of Dave Kang with B. Riley..

Yes. Good morning.

First of all, regarding gross margin, can you just provide more color on the gross margin decline and how should we think about gross margin going forward?.

Sure. Margins this quarter were impacted by some significant orders for fiber access infrastructure. Certain customers where we have won the business few quarters ago competing against Huawei and just delivered now.

The margins take a hit sometimes to capture share, expand the footprint, particularly we're taking it from an incumbent that can be competitive and then hard one. So, it impacts our gross margins, but it was a contributor to gross profit dollars overall, right, drive up EBITDA.

The point is going forward as we globalize these products, we sell into less price driven markets and markets Huawei doesn't compete. Also, as product go for the longer lifecycle, margin improves..

Got it. And then, you talked about some demand that was pulled in from fourth quarter.

Can you kind of quantify how much of that was pulled in?.

We're not going to quantify -- I think, as you may have recalled on our Q2 earnings call, I had mentioned that we started to quarter out with about $50 million of scheduled backlog.

And based on the guidance that we had provided, we had somewhere in the $30 million, $35 million go-get for the quarter, and we were able to one, pull some things; and two, I think, demand for our mobile products, as well as our fixed wireline products exceeded our expectations that we had in our original outlook..

And then, regarding fourth quarter outlook, clearly, there was some pull-in in the third quarter.

But, what about rising COVID cases and increasing restrictions? What are your assumptions on that regarding the outlook?.

Well, I think, you're exactly correct, and I think, that’s part of the reason why we guided, the way we guided. We certainly see the new cases, not only across the EMEA region, but also in Asia. And you look at not only the customers are potentially affected, but you look at supply chain and components.

And we feel like the guidance that we have provided aligns with that. I think, the reality is, is that when you still take a look at Q3’s actual of nearly $94 million and the mid-range of what we're getting at 77, the second half of this year represents the best sequential combined half that Company's ever had.

So, we're not necessarily looking at our revenue on a quarter-by-quarter basis, but looking at it more on a longer term totality basis..

And my last question is on, can you just go over other 5G pipeline? Previous management, they talked about two Korean and two Japanese customers.

And, are there any opportunities outside of Asian countries?.

Well, look, I mean, I would tell you and Andrew can certainly chime in. It's probably one of the most exciting segments within the Company right now. I mean, our base business has been traditionally our fixed wireline core as well as connected premises products.

But, with the introduction of our really first market product into the mobile space with Rakuten and a couple of other customers in Asia, it certainly gives us a tremendous opportunity in other markets. And there's a lot of sales activity underway. We certainly aren't going to represent our pipeline in either segments.

But, I can tell you that there's a lot of excitement on both the customer as well as the sales side..

Our next question comes from Christian Schwab with Craig-Hallum. Your line is now open..

Hey. Congratulations on a strong second half of the year. As we look forward, a couple of different questions about the different growth drivers and how they may play out in the future.

Could you give us some idea of how much you think you'll be shipping roughly to Rakuten, and how much you could be selling to them next year? If you don't want to talk about that, maybe just incrementally how much better that customer could be '21 than '20?.

Yes. I mean, obviously, we're not going to share that that data. But, certainly, we expect Rakuten to continue to have a strong 2021 with us as they continue to deploy their 5G network. They've certainly been a great advocate for DZS and a champion for us, helping us as a reference with other key accounts that we've been marketing to around the globe.

So, our outlook for Rakuten in 2021 is strong..

Okay, great. And when you guys think about the Rural Digital Opportunity Fund, did you expect that to drive meaningful revenue in '21, or would you expect that to be more a '22 event? Typically, there's been a lag between awards and real true aggregate spending.

Just wondering and the government programs -- just wondering how you guys are thinking about that over the next few years..

Yes. No, I mean, you know that the auction began yesterday. I think, there was approximately 400 of the 500 recipients that were awarded some of element of the program yesterday. The reality is, and I think you said it very well, we anticipate that a lot of the RFI and RFP activity will happen in the first half of next year.

We certainly are cautiously optimistic the second half of next year will certainly provide an uptick for us, especially since that's a market that we haven't aggressively pursued that market as we are today. But, I think it's more of a 2022 acceleration than it is in 2021..

And then, just trying to better understand your highlight in the stockholder letter of opportunities versus Nokia and Huawei, I certainly, I think, understand the political environment and opportunities in Huawei.

But, is there any geographies where you think people might be more receptive to hearing from DZS than they have over the last few years ago?.

I think, one of the things that we get excited about and certainly investors should get excited about with DZS is, especially when you compare us to others. Most network, most large scale, even medium to large scale network providers are selecting at least two suppliers.

And one of the things that we have found across all of EMEA, obviously, a lot of the APAC regions, Latin America over the last 10 years, Huawei has made significant inroads in those markets.

And just the calls that I've had with dozens and dozens of customers, as I joined the Company, there's certainly an appetite to look at someone like DZS that has the resources, the products and the scale in those particular regions to augment, as they deemphasize Huawei, in those particular networks.

And even here in the United States, I think a lot of people are appreciating that there's $2 billion worth of rip and replace of Huawei that the U.S. government is sponsoring that we're certainly involved with. So, I certainly see us as an ideal suitor to be able to participate alongside Nokia.

I mean, Nokia is with a combination of Lucent, Alcatel and Ascend, they're in a lot of accounts, just because of the combined nature of those three companies.

But, when you look at where the [indiscernible] is and you look where Huawei was, we certainly see DZS as a natural company to be able to participate in a lot of the markets, including U.S., but certainly where they were strong outside of the U.S..

Great. Thank you. And then, my last question has to do with FiberLAN. Previous management teams have significantly talked up the opportunity of that as a new product category. And now that you've been there for a while, Charlie, I'm just wondering, what is your thoughts on that product line and its potential over the next few years.

Is it realistically -- have an opportunity to be a material contributor to the top-line of DZS?.

So, first of all, FiberLAN is a solution brand. And the way I want you guys to look at this is, FiberLAN represents existing products that we sell into the core, as well as customer premise network solutions in the traditional service providers, but is intended for the enterprise verticals.

And I think, the reality is, is that the products and solutions have always been there, it's really been the focus and the go-to-market and systems integrator alignment that was required. And I can tell you that I'm very passionate about this market. I think it's a significant opportunity for us.

We've recently hired several enterprise lead salespeople to help us accelerate the pace. But, I think, it's a great question. Because when you look at the market, we think it's a $10 billion market that the copper and traditional coax infrastructure with a lot of the enterprise verticals is going to be completely transformed.

And I think, it's a significant opportunity for us. So, we're aggressively planning on going after that market. And we'll do it through the service provider channel, as well as through a lot of systems integrators who are focused on that market..

Okay. No other questions. Thank you, guys..

Andrew, do you want to comment on anything?.

Yes. A quick comment about FiberLAN. I think, one of the exciting things that we see with that solution set is also the adjacencies to the licensed and unlicensed mobile market.

As Charlie correctly said that we see networks transforming, and that includes in the premises and in enterprise customers, so as they embrace more wireless technologies in buildings and across campus, FiberLAN is well-positioned to enable that transformation..

It's a natural for us to extend into this fixed wireline part of the market as well, right?.

That’s right..

Our next question comes from Tim Savageaux with Northland..

Hi. Good morning, and congrats on the strong Q3 results. Obviously, it looks like Asia Pacific, from a geographic standpoint, was a big driver there.

I wonder if you could speak to -- any more specific color around geographic markets perhaps in Korea and Japan, and also any 10% customer concentration in the quarter? And then, should we assume that to the extent you saw some of this business come sooner than expected that that’s the Asia Pacific region and the deployment patterns of specific carriers are what’s driving that pulling from Q3 to Q4? And I have follow-up..

First of all, Tim, I appreciate the congrats. As I think you probably saw in the stockholder letter, Asia represented 60% of the revenue. North America was also up.

And I think, what we get excited about going forward, and I'll talk about Q3, but as we think about our business going forward, there's just a tremendous amount of focus and effort that’s being placed right now on expanding into North America, EMEA, Latin American and India.

And I think, these are markets that traditionally have been underserved and under focused. If you appreciate it, the new sales talent that we brought into the Company, especially around these regions, we certainly are optimistic about the prospects for these regions in 2021.

As it relates to third quarter, you can appreciate the fact that our core customers in Korea and Japan continue to deliver strong results, both on the mobile side, as well as on the fixed wireline side. And Rakuten continues to accelerate their deployment, which is very exciting.

And we got to be careful about who we represent in the region, just based on our confidentiality with those customers. But, you can imagine the Tier 1s in both Japan and Korea that make up the lion's share of that 60% of the revenue..

Got it. And last quarter, I mean, you referenced some comments on backlog and shippable backlog.

And as you look into your Q4 guide here, I mean, -- I don't know whether it's accurate to say, you've hit certain numbers, based on some risk factors from potential pandemic impacts, or whether that's really kind of a pull forward dynamic? But, to the extent you have kind of taken some conservatism with regards to uncertainties around pandemics, could you possibly quantify that? And, is there any -- are there any similar metrics that you can offer relative to last quarter, you'd indicated that you had three quarters of your plan in backlog or something like that? Any comments around visibility heading into Q4?.

Yes. So, as we entered Q3, as I articulated last quarter, Q3 was about $50 million of scheduled backlog and so we had a go-get based on our guidance of, as you mentioned, 25% of our original $74 million to $79 million guidance is Q3. We entered Q4 with $45 million of scheduled backlog.

And so, when you look at the current guidance that we have, we get similar metrics. And so, are we being cautiously optimistic? Maybe. But, I think, we're guiding what we think is aligned with where we see the pipeline and the go-get and other dynamics, as I think we've all talked about as it relates to just the spike in COVID.

There's a pretty significant component shortage out there. We did a great job of navigating through that Q3. I expect that we’ll do a good job of navigating through Q4, but it’s there and it’s real in the risk that we all need to be aware of. But, there is some upside in Q4 as well..

And looking into next year, you mentioned North America, which is a relatively small market for you now.

But, at this point, would it be too much to say that you expect North America to perhaps be your fastest growing segment for the Company in '21, given the opportunities? And obviously, we've seen a lot of strength in that rural broadband area, even prior to RDOF taking off? When you consider that market backdrop and your increased sales efforts, what are you thinking about growth in North America in '21?.

I think, there's two very significant growth opportunities for us next year. One, and I think, we're trying to do the best job that we can just to really articulate just how significant the mobile segment opportunity is for us. It's a brand new market segment for us.

And if you look at the historical revenue profile of the Company going back a decade, it's been almost 100% fixed wireline. And so, now you open up a brand new market segment that has probably more investment focus than any segment that is in the mobile space.

And, when you look at the fronthaul -- you look at front haul, middle haul, and backhaul, fronthaulas of magnitude difference in the number of aggregation devices that will be deployed.

So that alone -- I talk to the sales team and management team all time that if we can just secure Rakutens, you can only imagine the size and scale that it has as a multiplication effect to the Company. But to your point, we certainly think that North America represents the single biggest growth opportunity for us over the next several years.

We've invested significantly in a very senior sales organization over the last several months. It is not just about RDOF. I think, it's about the overall dynamics, the focus, the alignment of our products. And I think the consolidations that certainly you continue to hear yourself. And so, I think your assumption is right..

Last question for me. And when you consider -- you mentioned, kind of the Huawei rip and replace program, and also just Nokia being pretty concentrated everywhere. At least that first one with Huawei, you would think that's focused on a large number of small carriers. But, maybe a different opportunity relative to Nokia, maybe not.

I guess, when you talk about opportunities to displace larger vendors, either because of political pressure or carriers looking to diversify vendors, should we think of that as mostly kind of a Tier 2 to Tier 3 carrier focused opportunity for DZS or are there larger Tier 1 opportunities out there that kind of have the same profile?.

So, Tim, it’s Andrew Bender here. I guess, one of the things that we have seen in the market dynamics surrounding this regime that you mentioned, is not just the geopolitical aspects, but the changing landscape of the network, the concept of open, the concept of standardized interfaces. In fact, there's some legislation in the U.S.

is supporting that I think we talked about in our letter to stockholders.

So, part of our success factors in addressing and comments large and small is our ability to be agile, to bring new products to market, and to embrace the open network standards, like the Open RAN Alliance family of standards and similar initiatives in the wireline network, we've seen that being a big reality for us in the product space..

And the other thing I would comment, Andrew is, to Tim's point, most of the success that Huawei has had around the world has been with the Tier 1s. And so, even when you look at North America, which includes Canada, which is where they've had some success, there's significant Tier 1s that they'll be replacing.

And a lot of wireless infrastructures, you would appreciate, and a lot of -- to your point, Andrew, a lot of close and proprietary networks that obviously with the momentum that we have and the architecture that Rakuten and ourselves in the ecosystem that we're forming right now is promoting is really an Open RAN network architecture, which really fosters an opportunity, a unique opportunity for us..

Our next question comes from George Iwanyc with Oppenheimer. .

Charlie, with all the additions that you made, can you give us a sense of the go-to-market changes you're making at the same time with the new sales leadership?.

I appreciate it. I mean, I wish everybody could be a fly on the wall over the last 90 days. Because we've really accomplished a lot. And, first and foremost, we're technology company.

And so, what we've spent a lot of time over the last three months focusing on is really rationalizing the product portfolio and aligning the product portfolio, with our resources around the world and how that aligns with where we believe we have the best chance of winning, looking at the geopolitical landscape as well as the competitive landscape.

And we've -- just calling it like it is, I mean, we’ve put together a very significant Huawei playbook. We've looked at every single Huawei account there is. And we're engaged in all those accounts, as it relates to how we might be able to participate, either at the edge or in the core.

And then, here in North America, we certainly are competing heavily with ADTRAN and Nokia and Calix, and we certainly think there's a growing opportunity for us, especially with the fact that, both ADTRAN and Calix don't really participate on the mobile side, like we do.

I don't think neither of them have the same size and scale of portfolio on the enterprise side and CPE side. And so, there's certainly an opportunity for us to continue to grow there. But, our focus has really been where we feel like we have the best chance of winning, based on our product alignment and the overall competitive landscape..

And as you look at expanding regionally, as well as looking at the product synergies, can you give us a sense of how long the customer engagements are probably likely to take and the timing of ramps in the newer regions in the newer areas?.

Well, on the enterprise side, on the FiberLAN solution portfolio side, the sales cycle can be relatively short. In fact, we just had a very large recent project that came, and the opportunity came pretty quickly. And the opportunity to be able to engage and deploy that was within 90 days.

If you look at participating in the core, especially if you're dealing with Tier 1 or Tier 2, the sales cycle can last anywhere from six months to a year. Having said that, I think that the enterprise, or the CPE, in home or enterprise CPE portfolio seems to be an opportunity that we can get into relatively quickly.

We got a new line of Wi-Fi6 and mesh products that are being very well received around the world. And so our sort of strategy and game plan is, especially on the Huawei side is for us to be -- I mean, one thing we don’t talk enough about that the Company has done a phenomenal job of and that is just having to compete in Asia.

We've had to interop with just about everyone. So, we’ve interoped our CPE products and our core products, and interop with Huawei and ZTE and FiberHome, ADTRAN, Calix.

And so, we sort of look at ourselves as a free, nimble and agile company to where we can deploy our products anywhere in the network and be comparable and complement the existing infrastructure is there.

There's several very large customers in EMEA that have entertained the idea of bringing us in on the in-home and enterprise side with our CPE portfolio, and then giving us an opportunity to then weave our way back into the core, the network over time..

Last question for me. Maybe this one's for Tom. Can you give us a sense of -- as you do more on the CPE side and focus with some of those opportunities.

How the product margins work across the portfolio?.

Yes. I mean, I'm not going to get into detail on it. But pretty much as you'd expect and as you see throughout the industry, the CEP network is the highest margin product that you have. Certainly, some of what we're doing on the mobile transport side is some of the higher margin products in our portfolio, and you're seeing a greater growth there.

But, as much of it has to do with geography is product mix, right? And as you start to -- you invest a little bit in R&D this quarter, as you start to globalize some of these products, you can sell them into markets that are less price-focused. That'll impact our margins going forward as well..

Yes. I would just echo the fact that there's several dynamics on the margin mix. One is just what cycle you're in selling chassis-based core systems versus the service module. So, the chassis tend to come with larger -- less margins than the service module.

So, as we deploy a new core chassis into a central office, and we start deploying service modules as more subscribers come on line, the margin profile with that is much higher. And then, as Tom said, where we have an opportunity to truly differentiate, especially with newer disruptive technology, the margin profile is much greater..

Thank you. .

Our next question comes from Jon Gruber with Gruber McBaine. Mr. Gruber, your line may be on mute..

Jon? Liz, maybe move on to next question then..

Our next question comes from Bill [indiscernible]..

How does, what you're doing in 5G and Open RAN, complement and compare with Mavenir’s Open RAN product offerings?.

So, thanks for the question Bill. Andrew Bender here. We are engaged with Mavenir as with a lot of the ecosystem vendors, as Charlie mentioned here. We're not today an end-to-end provider of radio access network in 5G. But, we are providing some key enabling technology with unique products.

And that's what's led to our early wins in the anyhaul or the front and the backhaul space.

So, that's -- I guess, that's probably the best answer I can give about where we're complementary there that we're providing unique networking and transport capabilities in the RAN that are complementary to the BBU functions, the centralized unit, distributed unit that you would see in the Open RAN architectures there..

Yes. We're certainly fostering relationships with the overall mobile ecosystem that complements an Open RAN architecture, as Andrew said. And Mavenir, who’s down the street here in Dallas is certainly an ideal ecosystem partner that complements us and where they're participating in the core versus where we're participating with the mobile edge..

Okay.

Let me ask, if the elections results, if there is a change in administration, do you think there'll be a change in policy regarding Huawei?.

We've actually been pretty engaged with the White House over the last few months. What I would tell you is -- in fact, we were on a call with very large team last week, and I asked the same question to the group.

And I think that the feeling of the current administration is that the current policies as well as some of the programs that have already been approved, like, for example, if you look at the Secure and Trusted Communications Act, that’s a $2 billion rip and replace of Huawei. That program has already been approved. It's just waiting for funding.

So, the question I asked to them is, is there any risk in that program going away? And the answer was no. As it relates to things like Rural Digital Opportunity Fund, is there anything that would impact that particular program? The answer was no. And so, we don't see a change in administration have a change in views as it relates to Huawei.

Go ahead, Andrew, if you want to add..

Yes, sure. One thing I will quickly add there, Bill, is that if you look at some other legislations, in this area, particularly the U.S., you saw there the utilizing strategic alliance Telecommunications Act.

So, that is bipartisan legislation or proposals that support the adoption of Open standards to enable the creation of the ecosystem that we've been talking about on this call. So, one would suspect that that will be enduring.

That concludes today's question-and-answer session. I’d like to turn the call back to Charlie Vogt for closing remarks..

Well, I’d just like to thank everyone for joining our earnings call, and especially our analysts for their questions.

Our industry has experienced transformational change, which is resulting from disruptive technology shifts, accelerate network upgrades fueled by today's work and learn from home dynamics, and certainly the geopolitical security concerns that we were just talking about.

We think DZS is well positioned to capitalize on these opportunities with the clear vision and strategy and with the committed and experienced employee, systems integrator, distributor and technology partner base. So, with that, we'd like to say thank you, and have a great weekend..

Ladies and gentlemen, thank you for your participation in today's conference. Everyone, have a great day..