Good day and thank you for standing by. Welcome to the DZS Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded.

I would now like to hand the conference over to your speaker today, Ted Moreau, Vice President of Investor Relations. Please go ahead..

Thank you, Catherine, and welcome to the DZS second quarter 2021 earnings conference call. Joining us today are DZS President and CEO, Charlie Vogt; and we are excited to introduce to you our new CFO, Misty Kawecki.

Yesterday after market close, we published to the Investor Relations section of the DZS website, our shareholder report for the second quarter of 2021 to provide shareholders – perspective shareholders and analysts with market insights, product, business and financial updates as well as forward-looking information.

On 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 results – 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 Statements section of the shareholder report that was filed on a Form 8-K as well as being available on the 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 shareholder report referenced earlier. I’d also like to remind you that we will plan to participate in the B. Riley, Jefferies, and Wolfe Research investor conferences during the third quarter. I will now turn the call over to Charlie..

Thank you, Ted. Welcome investors, analysts and guests. As Ted shared, yesterday after market close, we posted our quarterly shareholder report to provide a comprehensive update on our business, including current market trends and dynamics, as well as announcing the appointment of Misty Kawecki as our new Chief Financial Officer.

As highlighted in the news release, Misty and I have worked together for the past seven years during my tenure as CEO of GENBAND, today branded as Ribbon Communications and Imagine Communications. Together, we have acquired and integrated seven companies, including GENBAND’s acquisition of Nortel’s voice over-IP business unit in 2010.

Misty is a rare talent in the field of finance and DZS is fortunate to have her part of our team. Misty, welcome to DZS. Following our opening remarks, I will turn the call over to Misty, who will cover our Q2 financial results as well as provide our outlook and guidance for the remainder of 2021.

As I speak to you today, I am celebrating my one-year anniversary with DZS, and what a year it’s been. We have strengthened the executive leadership team with experienced industry luminaries. We upgraded our global sales organization. We secured 61 new customers. We more than doubled our sales pipeline.

We acquired two technology companies, which are accelerating our innovation in areas of mobile-edge transport and software-defined networking, and we expanded our R&D initiatives driving multiple new product introductions, and we strengthened our balance sheet and are now debt free.

Demand for broadband connectivity, 5G mobile and software defined networking solutions continue to flourish as our industry undergoes a significant upgrade cycle, which has been fueled by the pandemic, geopolitical dynamics, numerous government stimulus funding programs, and a technology movement towards open standards.

The pandemic has exposed a bandwidth limited mobile and fixed wireline network due to the increase of employees working from home large scale applications such as interactive video conferencing, e-sports, remote education and remote healthcare.

In addition, the China specific security threats have opened up numerous 5G and Fiber To The Premises opportunities with Tier 1 service providers. As I shared previously, we were in the early innings of a long-term investment cycle.

Sitting at the convergence of fixed and wireless networks with our mobile-edge transport, broadband connectivity and software-defined networking solutions, we are more aligned with our customers, ecosystem partners and strategic technology partners, such as Broadcom and Jabil than ever before.

In fact, yesterday, DZS and Broadcom publicly announced our intentions to further advance our strategic technology partnership in the areas of broadband connectivity and mobile-edge solutions.

Our focus on North America, Europe, the Middle East, Korea and Japan combined with strong Tier 1 alignment delivered our second consecutive quarter of record orders, increasing 9% sequentially and 65% year-over-year.

Mobile and broadband connectivity demand and exceptional execution has led to record first half orders of $245 million and a record backlog of $160 million as of June 30, 2021.

Our record first half results demonstrates the positive progress the team has made over the past 12 months aligned with our vision and strategy in four growth initiatives, which are; one, our North America and EMEA Take-Share playbook; two, our next generation mobile transport portfolio, which is being fueled by 5G and Open RAN; three, the numerous Huawei and ZTE replacement opportunities; and four, the substantial upgrade cycle that is underway around the world with fiber-based deployments.

During Q2, the current supply chain environment impacted our adjusted gross margins due to longer than normal lead times, elevated semiconductor costs, increased semiconductor – sorry, increased secondary market costs, expedite charges in high freight and logistics cost.

With that said, we believe the current supply chain environment represents near-term headwinds and are not indicative of our long-term operating model in margin targets.

Over the past six months, we have initiated a number of go-to-market product and operational work streams that we anticipate will increase our gross margins to 40% within calendar year 2023. These margin expansion initiatives are detailed in our shareholder report.

I would also like to highlight that during the second quarter, we reached a favorable agreement with the German works council that aligns with our plans to consolidate our German and Florida manufacturing facilities, giving us one of the largest access networking manufacturing facilities in the United States.

The consolidation is expected to deliver annual cost savings of approximately $7 million. I want to briefly touch on our innovation and product design initiatives, which are the growth engines of our business.

Over the past nine months, we have initiated numerous technology work streams that are yielding differentiated mobile and broadband connectivity solutions that will be orchestrated and automated by DZS Cloud. Two weeks ago, we announced XCelerate, our next-generation 10-gig XGS-PON portfolio and our expanded Helix edge access portfolio.

Our XCelerate portfolio includes the first of our ultra-high performance, any service, any port line cards with a high density 100-gig interfaces.

In addition, we announced that Consolidated Communications, one of the Top 10 service providers in the United States will deploy XCelerate and Helix as part of their initiatives to offer multi-gigabit services to 1.6 million households. We believe this is the largest announced 10-gig XGS-PON deployment in North America.

XCelerate can be deployed in a traditional edge office design port as fully-distributed software defined networking architecture. Our Helix and DZS Cloud solutions together will provide differentiated access orchestration, intelligent service management, service assurance and data analytics capabilities.

XCelerate, Helix and DZS Cloud combined with Velocity, our core optical line termination portfolio and Cronos, our mobile edge transport portfolio, will serve as the foundation for revenue growth and margin expansion. With that as a business update, I’ll now turn the call over to Misty for our financial highlights..

Thank you, Charlie and good morning everyone. As mentioned, I’ve had the opportunity to work with Charlie for nearly seven years, spanning two companies, which combined had revenues exceeding $1 billion. Charlie is a dynamic technology and operational leader with extensive relationships around the world.

I am thrilled to reunite with him and join the impressive leadership team he has assembled over the past year.

As Charlie highlighted demand for our 5G mobile and broadband connectivity solution set remains strong, as reflected in our 65% year-over-year growth in orders to $128 million and 17% year-over-year growth in revenue to $82.7 million above the top end of our guidance range.

Execution of the vision and strategy that was established when Charlie joined the company a year ago has resulted in revenue from the combined Americas and EMEA region exceeding 52% of the total, the highest percentage since the beginning of 2018.

Over the past 12 months, revenue has increased approximately 30% compared to the preceding 12 months period. Growth over this period can be attributed to our participation in 5G and Open RAN network deployment, numerous new customer and design wins, and the global fiber to the premises upgrade cycle that is underway.

With these trends continuing into the second half of 2021, we anticipate Q3 revenue in the range of $85 million to $90 million. And we are raising – excuse me, raising our full-year revenue guidance to $330 million to $350 million from a previous range of $320 million to $340 million.

Our adjusted gross margin for the second quarter was 33.1%, reflecting shipments of lower margin products to a certain customers in Asia and higher supply chain, freight and logistics costs that Charlie highlighted in his opening remarks.

As profiled in our shareholder report, we have implemented seven margin expansion work streams that will begin during the second half of 2021 and will be reflected in our financials by 2022. For the second half of 2021, we anticipate gross margin, improving from Q2 levels based on known backlog in a more favorable geographic and product mix.

Looking ahead, we anticipate the consolidation of our Germany manufacturing operations to Florida will yield a modest contribution in Q4 prior to the full-year contribution for 2022. We anticipate our full-year 2021 gross margins to be in the 33.5% to 35% range.

As Charlie highlighted earlier, we expect the manufacturing consolidation will represent approximately 7 million of annualized cost savings. Approximately half of which will be reflected in gross margin and remainder in operating expenses. We have been thoughtful about our investments throughout the first half of the year and plan for the second half.

Our strategic investments have been focused on upgrading key positions throughout the company, timely product innovation, geographic and customer expansion, acquisitions, the numerous Huawei and ZTE cap and grow initiative, and an aggressive sales and marketing campaign pursuing the investment cycle underway in broadband connectivity and 5G.

As a result, Q2 operating expenses were slightly above our guidance range and we are now profiling our full-year operating expenses to be in the range from $106 million to $108 million. Adjusted EBITDA during the quarter represented a slight loss of $400,000, which was at the midpoint of our guidance range.

We anticipate Q3 adjusted EBITDA to be in the range from breakeven to $4 million. For the full-year, we anticipate our adjusted EBITDA to be in the range from $6 million to $14 million. I would now like to turn the call back to Charlie for his closing comments..

Thank you, Misty and again welcome to DZS. I would like to provide some additional commentary regarding Misty’s remarks pertaining to the slight increase in spending for the full-year 2021. Our investment thesis and strategy is centered around capturing market share over the next 12 to 24 months.

There is a wave of opportunity that we are pursuing and while we are being thoughtful about what customers and specifically what countries we’re investing in, our planned incremental R&D, sales and services investments are required to ensure that we have the best opportunity to capture market share.

Our sales pipeline has more than doubled over the past 12 months. Orders, revenue and backlog for the first half of 2021 exceeded our expectations, delivering a book-to-bill ratio of 1.5 and we’re responding to an increasing number of RFP spanning our entire portfolio.

As shared during our Investor Day in May, we are in the early innings of a breakout investment cycle. We continue to effectively manage the near-term headwinds associated with our overall supply chain environment and we are in the final phase of our corporate transformation and integration of former Zhone, DASAN and Keymile.

The results are yielding, a stronger and more sustainable foundation led by innovation and a world-class leadership team. Thank you. And that concludes our remarks for this morning. I will now turn the call over to the operator to facilitate questions..

Thank you. [Operator Instructions] And our first question comes from Christian Schwab with Craig-Hallum. Your line is open..

Hi, guys. This is Tyler on for Christian. Thanks for letting us ask a couple of questions. First, I was wondering, Charlie, if you could maybe expand or give some more detail on your view of the current tight supply chain environment.

I think it’s pretty clear consensus that the channels are going to persist for a while, but was just wondering, do you think the worst is now behind you? Is it going to improve? From here we can kind of remain at this low trough level for a while yet? Any color on your view there would be great..

Yes. I mean, look, and I think we’ve been consistent, I think with our peers that the supply chain environment is challenging. Although, I’ve gone out of my way to make sure that we haven’t used supply chain as a crutch on our inability to deliver on Q1 and Q2.

I don’t think that supply chain is going to hinder our ability to deliver on the second half of the year. Having spent a lot of time with Broadcom and other key technology partners, we feel good about where we sit. We certainly believe that the supply chain constraints are going to continue into 2022.

And for us, I feel like the balance that we have across the various supply chain partners is allowing us to manage the business effectively..

Thanks. That’s great. And then the second question, we really appreciate the color on your financial target models there, and in particular, the gross margin improvements.

I was just wondering, if you maybe could provide the number of drivers, you gave the targeted gross margin improvements, getting to 40% at some point in 2023, you broke it out go-to-market with geo and product mix improvements and the number of operational execution improvements.

I was wondering if you could rank them to some degree or outline maybe some of that’s lower hanging fruit than others and what might be some of the most challenging of those processes to improve gross margins. Thanks..

Yes. Well, we tried to do which it sounds like you understand is to categorize our margin improvement model in sort of two categories, one that we feel like is more within our control, which we dubbed operational execution. And as you could see, we’ve got target ranges somewhere between 450 and 600 basis points.

Obviously, one of the shoe has already dropped with our ability to consolidate our German facility into Florida. And that’s going to – the $7 million that we represented on the call and then in the shareholder report, about half of that will be represented in margin improvement.

There’s other strategic initiatives that we are working on from an operation standpoint, consolidating some of our contract manufacturers, which is allowing us to create a little bit more scale and create a little bit more momentum with those particular partners. The product rationalization that for the most part is behind us.

The team has done a phenomenal job rationalizing the portfolio over the last 9 to 12 months. And that certainly going to yield some product margin enhancements in the second half of this year and certainly in the next year. So I think those are our easy ones that we see a lot of clarity to.

Certainly, the tariff mitigations, our ops team has done a great job mitigating a lot of the mismanaged tariffs over the last couple of years. So I feel like that margin expansion is well underway. And then, from a new product introduction perspective, I mean, we just have a new philosophy.

I mean, our new products are going to come to market with a different margin profile in considering where we’re selling products around the world. So I feel like the operational execution, we’ve put a lot of time and energy into it, lots of detail into those work streams. I feel like are very well-represented in what we shared.

The go-to-market is really about our ability to continue to execute. And I think, as everyone saw, we’ve had a phenomenal six to nine months in growing our market share in North America and EMEA. And as we continue to grow in North America and Western Europe, the margin profiles are much better there.

And so we feel like what we’re representing is something that’s very manageable..

That’s great. Thanks for the color. That’s all for us, guys. Thanks..

Thank you..

Thank you. Our next question comes from Tim Savageaux with Northland Capital. Your line is open..

Hi, good morning. A couple of questions. First, on the – and congrats on the order book, by the way. First, kind of along those lines, you mentioned that significant deployment with the consolidated being the largest at least tending upon deployment in North America.

And it seems like you’re stepping up OpEx investment in bit too perhaps chase some other opportunities.

I wonder if you – as you look around the landscape or look around your pipeline, relative to what you’ve discussed here with consolidated, what sort of opportunities do you see out there in terms of magnitude and timing relative to that either in North America or globally? And how has that changed, I’d say in the last quarter or so?.

No, that’s a great question. And I appreciate you teeing it up because we did highlight that we have – I mean, look, at the beginning of the year, we can see that we were going to book almost $250 million in the first half of the year.

We certainly expected a robust 2021, but I think the first half and the opportunities we’re seeing are exceeding the expectations that we had. And as I sort of highlighted, Tim, I mean, look, I mean, to me, we’ve got this massive opportunity over the next 12 to 24 months.

And in the access space specifically in the mobile transport space specifically, I mean, you have these design win windows of opportunity. And for us right now our view based on what we’re seeing from just a sales pipeline and the opportunity is being represented to us in North America and Western Europe is an opportunity for us to invest in.

So we certainly have increased the number of sales personnel in North America and Western Europe. We’ve actually added some sales personnel in the Pan Asia region. So outside of Korea and Japan, we’ve hired some very talented salespeople that are helping to expand some of the opportunities there.

But when you look at RDOF, as you pointed out consolidated certainly very exciting opportunity for us, I mean, they’re a long-time customer, but we feel like consolidated is as aligned with us as anyone. And that’s going to continue to be an exciting and growing customer opportunity for us.

But if you look at the $65 billion bipartisan infrastructure bill that’s nearing passage, I mean, that’s three times the size of RDOF, and it’s different in the fact that we believe that the $65 billion infrastructure bill, assuming it gets passed, is going to be doled out to a lot of the municipality and local governments that will know be aggressively deploying fiber-based solutions to their communities.

And that’s an area that frankly we’re doubling down on right now and trying to get ahead of those opportunities. So I think our increase in spend on the sales side specifically has been attributed to adding more salespeople where we see the opportunity for us to continue to grow..

I mean, would you say that’s more oriented toward capturing the rural broadband opportunity, which has seemingly begun to do, or pursuing Tier 1s? I assume there’s a number of opportunities perhaps even larger than consolidated working around out there, both in North America and Europe?.

Yes. So for those who have been following my career, I mean, most of my career has been focused on the Tier 1s, and at DZS we are laser-focused on the Tier 1s. And so you can assume that some of the sales resources that we’ve added in North America has been investing more in our ability to capture the Tier 1s in North America.

We have invested recently in new sales force resources in Western Europe to focus on the Tier 1s in Western Europe. It doesn’t mean that we’re not supporting Meggin’s team, who are focused on the Tier 2s and Tier 3s, we are.

And in fact, we’ve completely upgraded that entire team and the pipeline that team has brought into DZS over the last six months has been very impressive. But as you can appreciate, if you’re going to go after AT&T – excuse me, Verizon, Deutsche Telekom and others, you’ve got multiple resources, those are large, large-scale companies.

And we’re making the investment and we feel like aligns with the momentum that we have in those types of accounts..

Great. And maybe last question for me is for the time being focusing in on Q2 order performance. Obviously, you saw a pretty big increase on in APAC.

Should we assume that that’s principally driven by your existing major customers, kind of the usual suspects in terms of Korea and Japan that might normally hit your 10% customer list as well, any commentary there would be welcome.

Or is the sort of tenor of the APAC business any different than it has been?.

Yes. So I think your commentary is spot on with one exception. I mean, I think Asia as a region was up over 100% in orders year-over-year. We did receive a pretty significant size order from a large Tier 1 in India which is our first, and we’re pretty excited about that and so that certainly added to the Asia bookings.

North America, I think was up a 100% year-over-year, so we saw a big uptake in North America. We saw strong orders from Japan and from Korea but we did have a pretty sizable order that we received from India, which as I think everyone knows India is one of the countries that has aggressively been on the pursuit of anti-Huawei and ZTE supplier.

So there’s a very, very large-scale opportunity for us in India. We’re being thoughtful and careful about it, but the big difference between selling into India today versus when I was at GENBAND is we were competing with Huawei in low prices and margins. And it was challenging here.

We’ve got an opportunity now where we’re not competing with the Chinese suppliers which makes it little bit more advantageous for us. And we feel like the tier ones are having a completely different sort of value proposition with suppliers like us today..

Great. I’ll pass it on. Thanks very much. And welcome to Misty..

Thank you, Tim..

Our next question comes from John Marchetti with Stifel. Your line is open..

Thanks very much. Charlie, I was wondering if we could just kind of hit it on the mobile segment here, obviously you cited some strong order growth, particularly around 5G in your prepared remarks. But when I look at that segment, it’s come off that high from about the September quarter, a year ago for four straight quarters.

And just as I’m looking at the back half of this year and into next, do you expect that to get back to at least sequential growth? I know we faced some tough year-over-year comps, but should that mobile business start to grow as we see some of these first half orders start to actually come into revenue there or is that more of a 2022 event?.

I think a lot of the Open RAN initiatives that we’re working on is a 2022 initiative, I mean, we obviously have three very large anchor customers for our 5G mobile solutions. We are hopeful that one of the larger tier ones here in North America kicks in the second half of the year.

We’ve been, I think conservative in forecasting that particular customer for the second half of the year and into next year, but you know – what I will tell you is we are seeing a pretty significant amount of momentum around Open RAN, I don’t know if you saw, but I joined ATIS the Next G Alliance executive board, which AT&T and others are on.

And that board is really focused on accelerating 5G as well as the evolution of 6G. So, I think we’re going to continue to invest in that area. We certainly see the momentum around Open RAN, and we certainly are seeing opportunity for us around the world.

And I know, you all know this and appreciate it, but when you make the decision to invest in tier ones, the sales cycle is a bit longer, it’s a bit more comprehensive but the rewards are much greater in my view. And so we are making the investments that are necessary in the tier ones.

The process takes a little longer, but we, we certainly are seeing the momentum that we want to see and look, I mean, I’ve been spending some quality time with Broadcom, which is one of our most strategic semiconductor partners for both fixed and mobile.

And some of the innovation that two companies are working on, I think helps us differentiate our products and allows us to participate in that – in both the fixed and mobile networks in a unique way as we go forward..

Got it.

And then maybe just a little bit on the newly launched DZS Cloud, just curious what kind of feedback you’re seeing sort of to-date? And again, maybe how we should think about that in 2022 or again, am I being a little too aggressive and should be thinking about that more as an even a 2023 contributor?.

I’m glad that you brought that up because I think we could have done more to sort of highlight the excitement and momentum that we’re seeing right now on DZS Cloud. I mean, DZS Cloud for us is bifurcated two sort of different segments, one on the mobile side.

So specifically around network orchestration, application management, we call that 5G slicing. We did receive our first orders from Telus in July. So we were very excited about that. And there’s number of wireless initiatives that we’re working on with that side of the portfolio.

I think one of the exciting initiatives and one of the core investment thesis to acquiring RIFT was this unique ability for us to accelerate what we were doing already with DZS Cloud to be able to bring to the market, what we believe will be the most robust fixed wireline access orchestration, service assurance, data analytics portfolio from any fixed wire line operator.

And if you think about the fact that we’ve got 20 million products deployed around the world, there’s this unique and significant opportunity for us to unlock the value there. So to answer your question, I think it’s a 2022 opportunity.

You know, we see the back half of this year and really into the first half of next year as an opportunity for us to anchor a lot of those products into some of the networks that we’re pursuing..

Great. Thank you very much..

It’s part of, I mean, if you –I think the question that was raised at the beginning by Craig-Hallum on margins. I mean, when you think about our go-to market, when you think about our margin expansions into the second half of 2022 and 2023, I think, that’s where we see DZS Cloud making a big impact..

Thanks, Charlie..

Thank you..

Thank you. Our next question comes from Dave King with B. Riley. Your line is open..

Hi guys. Good morning. I was wondering if you can quantify the supply chain impact on your revenue and gross margin for second quarter, and what’s baked into third quarter outlook..

I think if you look at Misty’s commentary and what’s in the shareholder report Dave, we attributed supply chain to be about 500 basis points in the quarter..

Got it.

And then regarding your backlog, which was up quite nicely, I was wondering if you can break out between broadband versus mobile?.

I don’t have that in front of me. And I don’t think we’ve ever broken out our backlog, so I’ve got people in the room shaking their head. So I mean, I want to be careful and thoughtful about providing something that I haven’t done. I mean, should we expect that – to the extent I would tell you, roughly speaking because we did talk about that last week.

I want to say it’s about 50:50, but I’d have to get back with you on that..

Got it.

And my last question is regarding going back to the supply chain situation, I was wondering if you can raise prices as some of your peers are starting to do to pass-through some of the elevated costs?.

You sound like one of my board members. We have – as long as I’ve been in this industry, the one thing that has been very difficult is raising prices to end-users.

Having said that I – being able to provide software attributes and different functionality to differentiate the products is obviously the best way to be able to enhance margins, it’s hard when you have contracts, and we have a lot of long-term contracts that are in place for some of our tier ones. So it’s a hard discussion.

It is something that we have been spending a lot of time discussing internally, as you guys can appreciate. I don’t want to promise our shareholders and analysts that we’re going to be able to go out and increase prices.

It’s a delicate – it’s delicate, when you’re a company that is in one particular area, have nothing else to sell, it might be an easier thing to do specifically if you’ve got a lot of market share, but when you’re trying to sell a portfolio of products it sometimes makes it challenging..

Got it. Thank you..

Thanks Dave..

Thank you. Our next question comes from Ryan Koontz with Needham & Company. Your line is open..

Hey thanks for question. Most of mine have been answered. May be I can ask a little different way.

Charlie, how would you characterize the RFP activity in the tier ones and tier twos? Obviously, lots of tier three are coming your way with the stimulus and subsidies, but are we starting to see an influx of XGS PON RFPs yet, the Consolidated one obviously a result of that? And the follow-up there on Consolidated, can we assume that you’re a prime supplier there or a dominant supplier there in Consolidated? Thank you..

The answer to Consolidated is yes. Two, I would tell you that, the RFP activity is dominated right now by 10-gig XGS PON and our software portfolio, our network orchestration products, not that we’re not receiving and pursuing a lot of the Open RAN. I think the Open RAN market is at a different phase right now.

I think, we’re engaged with like numerous mobile operators from a network architecture perspective that hasn’t moved from the network design and architecture to the RFP.

But I would tell you that we’re overwhelmed right now with RFP responses, some of which we’ve had a hand-in influencing those projects, but between North America, Latin America and Europe, we are reaching more RFP activity and since I’ve been here, I think that the company is seeing in a very, very long time, if not ever..

Helpful. Thanks, Charlie..

Thank you..

Thank you. And there are no other questions in the queue. This does conclude today’s conference call. Thank you for participating. You may now disconnect..