Good morning, and welcome to the DZS First Quarter 2022 Earnings Conference Call. [Operator Instructions] I'll now hand the call over to Ted Moreau with DZS. Thank you, Ted. You may proceed..

Thank you, Joel, and welcome to the DZS First Quarter 2022 Earnings Conference Call. Joining us today are DZS President and CEO, Charlie Vogt; and CFO, Misty Kawecki.

Yesterday after market closed, we published at the Investor Relations section of the DZS website, our shareholder report for the first quarter of 2022 to provide shareholders, prospective 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 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 a reconciliation to GAAP are contained in the shareholder report referenced earlier. Next week, we will host our Horizons22 Investor Day at our headquarters in Dallas that will simultaneously be webcast. We look forward to your attendance. We will also be participating in the B.

Riley, Cowen, Craig-Hallum and Stifel investor conferences during the second quarter. I now have the pleasure to turn the call over to Charlie..

Thank you, Ted, and welcome investors, analysts and guests. As Ted shared yesterday after market closed, we posted our quarterly shareholder report, which provides a comprehensive update on our business, financial results, market trends and 2022 outlook.

Before providing my comments relative to our first quarter's performance as well as other business and industry dynamics, I'm excited to share real-time news that DZS has signed a definitive agreement to acquire the award-winning consumer experience and service assurance software solutions from ASSIA.

Over the past nearly 2 years, DZS's vision, our go-to-market and strategic playbook have been designed to capitalize on a once-in-a-generation broadband access and consumer experience super cycle.

From high-speed fiber-to-the-home to 5G Open RAN, our industry, which is being fueled by more than $100 million of global broadband government stimulus is in the fast lane, and the consumer experience is front and center.

The specific assets being acquired in an all-cash transaction includes ASSIA's CloudCheck WiFi performance management and Expresse network optimization software solutions, which are deployed by marquee operators around the world with more than 125 million homes connected.

The transaction also adds an elite team of highly skilled cloud and artificial intelligence software engineers, architects and business leaders.

In 2021, we acquired RIFT, a cloud-native software technology innovator, which accelerated our software-defined network orchestration, application slicing and automation solutions, which are now part of our DZS Xtreme software portfolio.

CloudCheck and Expresse will be integrated into the DZS Xperience software suite within the broader DZS cloud platform. These 2 valuable software solutions significantly enhanced DZS Cloud to include service provider and consumer managed WiFi network intelligence, automation, optimization and service assurance.

The acquisition of Expresse and CloudCheck, combined with DZS Xtreme creates a distinguished and differentiated end-to-end access networking and cloud-native service assurance and consumer experience management portfolio.

During the due diligence, I was able to speak to many Tier 1 customers around the world who enthusiastically support DZS and the addition of Expresse and CloudCheck to the DZS Cloud platform. A sample of a few Expresse and CloudCheck customers include Bouygues Telecom, Deutsche Telekom, Liberty Latin America, Lumen, PLDT, TalkTalk, Telefonica, TELUS.

The complete list of customers includes approximately 60 Tier 1 and Tier 2 service providers around the world. Upon closing, we will add Expresse and CloudCheck software extensions to our installed base of home and business connected gateways, representing more than 20 million connected homes around the world.

Today, Expresse and CloudCheck support more than 150 unique consumer WiFi devices, which will significantly expand our reach to Tier 1 service providers, driving new sales synergies and enabling DZS to uniquely offer service providers a comprehensive and differentiated end-to-end broadband experience.

We expect the transaction to close as early as 2 weeks, no later than the end of Q2. The acquired assets will contribute reoccurring Software-as-a-Service revenue that will be accretive to gross margin, EBITDA and earnings per share in 2022. In fact, we expect the transaction to pull forward our 40% target gross margin model by as much as 12 months.

During our upcoming Horizons22 Investor Day, we will be presenting live and in person from Dallas -- from our Dallas headquarters and we'll provide more insights, including demonstrations of our broadband connectivity, mobile and optical edge and new service assurance and consumer experience management software portfolio.

Q1 continued to validate that we are in the early stages of a decade-long dual investment super cycle to include multi-gigabit broadband and consumer experience services. Broadband connectivity, both wireline and wireless is becoming an essential service for consumers and businesses around the world.

As Misty will highlight in our financial commentary, Q1 represented our fifth consecutive $100 million-plus for this quarter, increasing our backlog to $243 million, yielding year-over-year backlog growth of 129%. During the quarter, we also added 16 new customers.

During the first quarter, our industry continued to be challenged with supply chain disruptions, especially related to the manufacturing and shipping port shutdowns throughout China, which interrupted development, manufacturing and transportation logistics.

These factors limited our ability to ship complete systems, resulting in first quarter revenue of $77 million within guidance, though at the low end of our $75 million to $90 million range. Keep in mind that a single semiconductor chip or subsystem component shortage can hold up an entire shipment of a deployable system.

I also appreciate that based on customer request ship dates and the elimination of supply chain constraints, DZS would have shipped more than half of our existing backlog, well above our $90 million top end guidance. Despite the first quarter's revenue conversion circumstances, we remain bullish and confident in our full year outlook.

Just as fiber-to-the-home and in home connected experience solutions remain a growth driver for DZS, Open RAN is gaining momentum around the world.

During the second half of 2021 and into 2022, many of the world's premier mobile service providers, market-leading technology suppliers and government entities have been profiling and referencing 5G Open RAN as the preferred architecture of the future.

With our early involvement with Open RAN and a strategic technology partner to Rakuten Mobile, we expect the numerous RFP and mobile transport trials to convert to incremental growth opportunities for DZS during the second half of 2022 and into 2023.

As we enable the deployment of hyper fast broadband connectivity across our expanding customer base, we are creating new opportunities in the communities our customers reach and enhancing the value-added solutions in the homes and businesses they serve.

With that, I'd now like to turn the call over to Misty to walk through our Q1 financial highlights in our Q2 and 2022 outlook..

revenue of $380 million to $410 million, gross margin in a range from 34% to 36%, operating expenses in a range from $112 million to $117 million, and our full year adjusted EBITDA guidance between $17 million and $31 million. As the acquisition has not yet closed, this guidance does not incorporate any contributions from the acquisition.

That completes our prepared remarks. I'd now like to hand the call over to the operator to facilitate the Q&A session..

[Operator Instructions]. The first question is from the line of Paul Essi with William K. Woodruff..

Yes. I want to -- Charlie, your comment about the pulling forward the 40% 12 months. I did a little digging on the Internet. And it looks like the CA does a little over $10 million in revenue. And I could see how you could swap in the 80% and 90% margin on that, back out your 240 basis points of the supply chain and get to your 40% by the year-end.

Does that mean that we can be looking at 42% by the year-end 2023?.

Well, first of all, the $10 million that you're referencing is way off. So the revenue that we'll profile once we close is significantly higher than $10 million. The margin profile with an all software portfolio that we're acquiring, as you can appreciate, is pretty significant.

And so the margin pull-through based on the expected consolidated software and services revenue in a range of likely 15-plus percent of our total revenue. We'll help you appreciate and get to what the new margin model will look like for the remainder of this year and into next year.

But to your point about exceeding 40%, certainly as a company, we're laser-focused on generating margins well north of 40%. But we have been communicating our target margin model of 40%. And as it relates to a path to get there, this certainly helps us accelerate the time line..

Okay. Good. Other question is, again, on the Internet, they -- it look like ASSIA had put $81 million in investments, and you pulled out some, but the lot of the IP was left.

You hazard to guess at how much of that was spent on trying to promote and develop the products that you guys acquired?.

Yes. So I think the $80 million of raised capital over the years is relatively accurate. We haven't disclosed how much intellectual property will stay with ASSIA versus how much intellectual property will come with us.

But rest assured that when we do articulate the details of the transaction once we close, DZS will have a full cross license for any of the licenses that stays with ASSIA..

Okay. You also made a comment that they have a wide footprint and deep penetration in about 50 service providers.

Can you give us an idea of how many subscribers you have? How long that they've been pushing this product and kind of where you are on the supply on this curve? And also how this would fit in with two?.

Well, as I've mentioned in my remarks and what was highlighted in the shareholder report, and again, we're trying to be very careful and thoughtful because we're not closed. During our Investor Day in 10 days, John Coffee will be part of the venue now. And together, he and I will articulate, I think, much more about the combined businesses.

But there is approximately 60 ASSIA Tier 1 and Tier 2 customers, primarily in North America and Europe. There are several customers in Asia. There are several large customers in Latin America.

And when you look at how CloudCheck and Expresse dovetails into what we refer to as DZS experience, which is our consumer-facing WiFi optimization and consumer experience solutions, complementing what we're now referring to as DZS Xtreme, which is a lot of what comprised of what we acquired from RIFT and the development over the last year, which is really focused on fixed and mobile network orchestration and service automation and service creation, we think that the new DZS Cloud portfolio puts us in a very unique and differentiated place, especially when you look at the complementary nature of our broadband connectivity, OLTs and ONTs and in-home WiFi devices as well as our mobile and optical transport product.

So we couldn't be more elated about where we're at and what we've been able to accomplish here over the last year. And as we enter the second half of this year, we think there's a tremendous amount of sales synergies that the teams will be able to realize..

The next question is from the line of Tore Svanberg with Stifel..

This is Jeremy calling for Tore. Maybe just digging a little bit more on the acquisition. Can you help us understand what the potential impact to OpEx might be? I do understand that it's accretive to gross margin and earnings.

But what kind of OpEx overhead can we expect?.

Well, we're not highlighting any of the financials today, but I think we did highlight that there's approximately 110 employees that are coming over, most of which are software engineers and architects. So you can -- there's 2 primary facilities, Redwood City just in the heart of Silicon Valley and in Madrid, Spain.

So that's where the majority of the employees are. So you can put pen to paper and kind of assess what you believe the OpEx profile is for those employees, until such time that we give everyone the granular details..

Great.

And forgive me if this is something that you might have broken out in the past, but with this acquisition, can you give us a sense of where -- how much software revenue that you currently enjoy [indiscernible] all this might?.

Are you talking about today with -- are you speaking today without CloudCheck and Expresse?.

Yes. Yes..

Yes. So we've never given that number out. We've never given that number out. I will tell you that we are of the mindset that once we close, we're going to start reporting on software and services revenue, something we haven't previously done.

But because that part of our total percentage of revenue will become pretty substantial, we feel it's important that analysts and investors have that information. And so upon closing, we will begin to report out on our systems business as well as our software and services business..

Great.

And maybe if we look out into your calendar '22, the reaffirmation of the guidance, can you help us maybe just rank order some of the key drivers there? Which ones -- which areas you feel whether geographically or segment-wise are going to be the key drivers of that outlook?.

Yes. I would tell you that we're pretty bullish on the 3 fundamental regions that we're focused on. I mean despite some of the revenue conversion, which we understand as a public company, it certainly gets scrutinized.

But when I look at the fact that backlog is nearly $250 million and when we look at just the demands that are being placed on the business and the opportunities that we're pursuing, the number of RFPs that we're responding to and influencing both on the fixed side as well as the mobile side, we're very encouraged.

There's a pretty healthy balance across all of our regions. We dovetail into the specific country. So Korea continues to be a very strong region for us. We have a lot of exciting opportunities that are unfolding in the Pan-Asia region.

I mean this is a region that historically we've done relatively well, but with some new additions of resources in the region, you can expect some exciting results that are coming out of that region. North America continues to be exciting for us as is Europe.

I mean Europe is one of the most exciting regions for the region right now just because of all the opportunities to cap some of the Chinese vendors in that region where they've been very successful. Similarly with Canada. So we're pretty bullish on all the markets that we're focused on.

As we continue to layer in more intelligence and more software-based solutions, we certainly see the unique opportunity to create end-to-end solutions, which I think in the end customers are really looking for. They're certainly focused on doing business with companies that are focused on open standards.

But I think in the end, service providers are looking to select technology and solutions that can help them from an end-to-end perspective, and that's what we've been really focused on here over the last 18 months.

And I think the transaction that we announced last night and talking about this morning with Expresse and CloudCheck really helps to solidify a lot of the plans that we have..

The next question is from the line of Ryan Koontz with Needham..

Charles, I just wonder if you can update us on where we are in some of the Chinese displacement opportunities in Europe.

I know it's something you've talked about a lot, and maybe you have some more commentary planned for your Analyst Day next week, but it would be good to hear your kind of current view of the number of opportunities and kind of how they're progressing in total..

Yes. So we are trying to save some excitement for Investor Day. We -- I would tell you that to your point, there's a tremendous amount of activity across the EMEA region, specifically in Western Europe. And there's nothing that we are going to highlight this morning that we didn't include in the shareholder report.

But I would tell you that we're pleased with the progress that we're making.

As I sort of highlighted, Ryan, on the -- in my opening comments, one of the probably more encouraging aspects of the final diligence aspects in working with John and the ASSIA team was getting an opportunity to speak to a lot of Tier 1 customers, many of which were in Europe.

And I certainly feel like this transaction, coupled with our existing broadband and mobile products gives us a much stronger position within a lot of the European and North American customers that we've been focused on.

But as it relates to the Chinese cap-and-replacement opportunities, I think it does give us strength that we didn't have previously..

Okay. And on the -- as far as the quarter goes in terms of the broadband access, it sounds like that was held back by a lot of the supply chain impacts. But I wonder if you could comment at all on any kind of product mix shifts you're seeing within the business that you can share in terms of shift to 10G.

Where are we in that cycle? Is copper pretty much at 0 now? And any kind of mix shifts in terms of CPE versus the networking platforms would be helpful..

Yes. I think the industry as a whole, including what has historically been a lag across Europe is moving at a pretty accelerated rate towards XGS-PON. We rolled out what we believe is the industry's only true GPON, XGS-PON, combo card that can deliver any service on any port in our new XCelerate launch late last year.

And I think customers are looking for flexibility to support their existing GPON as well as the evolution towards XGS-PON. But certainly, I think from small customers to very large customers, there's an amplification towards 10 gigabit and beyond. And most of what we're seeing in new orders is representative of that.

And also, by the way, as we start shipping more and more of our -- what we refer to as our XCelerate combo cards, the margin profile is significantly higher just because of the functionality that's there and the flexibility that it gives our customers.

And for our service provider customers, it's certainly a higher ARPU and a higher margin service product for them as well..

Got it.

And would you say the supply chain impacts were higher on the CPE side? Are they pretty equal across both sides, both network and CPE?.

It's frustrating. I mean the CPE products don't have as much complexity to them as it relates to the BOM level makeup. Most of our ONTs and WiFi devices are driven by semiconductor chips. And so the other attributes of a lot of the CPE products are not the bottleneck.

It's usually the semiconductor chip, of which, for us, most of it is Broadcom and Avago. But on the OLT and mobile and optical core switching products, they're a lot more complex. And the frustrating part, you can see in the $68 million in inventory level that we had at the end of the quarter.

I mean, if we're missing one filter, if we're missing one memory chip, we can't complete the shipment. And so it's a frustrating place to be, but I do feel like we have more visibility into our order flow just because of the backlog that we have.

I mean the difference today than I think historically, is our supply chain team knows exactly what components at the BOM level that they need to fulfill just based on the backlog that we have and the pretty detailed forecast that we have going forward.

So we just got to get our arms around the gap in the subcomponents that make up the complete systems. And hopefully, that dam will break here over the next 3, 4, 5, 6 months. If it does, I think for us, it will be good..

The next question is from the line of Dave Kang with B. Riley..

My first question is regarding your mobile business. You mentioned about project delays.

Were they related to pandemic?.

Well, I think it's two things. One, we certainly -- I mean, I think I'm speaking for the broader industry. I mean, there's still a lot of products at the component level that are coming out of China. And the manufacturing and the shipment ports that were shut down during the quarter certainly had an impact on timing.

And it wasn't just on the mobile side, Dave, it was certainly on the fixed side as well. But we're not having deployment and service installation delays. I mean it's really just availability of subcomponent products that are really impacting our ability to convert our backlog to revenue today..

Got it. And then when you talk about Asia, you also mentioned about customers, lower spending.

What caused that slowdown? Is it just a temporary situation? Or is it more of a trend? Any more color on that?.

I don't know if lower spending is a fair assessment. I mean what I think Misty was trying to highlight is the challenges associated to our ability to convert backlog to revenue. I wouldn't necessarily say that, that has lower spending attributes to it. I mean we did book our fifth consecutive $100 million plus quarter in a row.

So demand from an order flow perspective, which to me is spend is still pretty robust. I mean what we were challenged with is our ability to convert that backlog in quarter to revenue. So I kind of separate spend from revenue conversion..

Got it.

And then regarding your second quarter revenue outlook, can you share some of your assumptions, especially on the supply chain situation? And should we expect orders to be up sequentially?.

Yes. I'll take that. I mean, the first one is, it's a very difficult environment to predict revenue, probably in my entire career. I mean, the projections that we gave of $85 million to $100 million is in line with the best view of where we are and just simple backlog conversion.

I mean if the timing of the component deltas from what we currently have in inventory doesn't increase, we certainly have an opportunity to hit the high end of the range, but it's certainly predicated on our ability to get 100% of the subsystems to be able to fulfill the backlog.

As it relates to orders, I mean, we continue to be very bullish on our ability to attract new business. As I highlighted, we had 16 new customers in the quarter. We had 105 new customers last year. So there's a lot of activity that the sales team is pursuing with that call it, 125 customers last 12 months.

And there's just timing with regards to a lot of large projects that have an impact on when we receive orders. So we're still very bullish on order flow. My #1 priority right now, frankly, is just keeping customers happy.

And again, while we're on an earnings call and everybody is focused on the business, our #1 priority right now is making sure that we keep our customers happy and we put them in a position where they can deliver services and keep their end-user consumers happy. And I think if we can address that recipe, then everything else will fall in place..

The next question is from the line of Christian Schwab with Craig-Hallum..

Great. So first, I guess, congrats on gross margins and OpEx, gross margins being a little bit higher in OpEx, a little bit lower than guidance given the manufacturing and transportation issues in the quarter. But my question has to do with the tax rate and the assumption for taxes on a go-forward basis.

Can you tell us about the benefit that you received and why and what we should be thinking about as far as the tax expense on a go-forward basis?.

Yes, I can take that one. So from a tax perspective, right, we have annualized and forecasted our full year. We are shifting to a more profitable level in 2022 as a company, and therefore, have an effective tax rate that was applied to Q1.

Given we had a loss, we actually had a $1 million tax benefit in Q1, but we expect that to course correct as we become profitable and shifted tax expense for the full year 2022..

Do you have an idea -- should we assume like $0.5 million a quarter?.

Well, it depends on our profitability levels of each quarter, of course, but our effective tax rate for?.

And where..

Right. And where. I would say, a very high level effective tax rate is around 33% to 36%. We do have a certain new tax laws that went into effect in 2022 associated to the CARES Act, where R&D costs are expected to be capitalized. And so we are closely monitoring the progress of how that tax law will be impacted in 2022.

But for now, have assumed that we will be leveraging some of our NOLs to offset some of that R&D capitalization expected in 2022..

Yes. We do have, Christian, as Misty said, I mean, we do have a significant amount of NOLs from the various acquisitions and the combination of what's resulted in today's DZS. And so when we look at our tax exposure, we look at it based on the profitability of each specific region, which varies..

No, that's fair.

I guess broadly speaking, on a non-GAAP basis, would the tax rate be anything different than the effective tax rates depending on jurisdiction that Misty just highlighted?.

It will vary by jurisdiction. Some will be slightly higher, some will be lower. But overall, our total tax rate for the year is expected to be 33% to 36%..

All right. Great. Now after the nitpicky stuff. So congrats on what Charlie, what appears to be a very exciting acquisition, not only from a revenue contribution, but a gross margin contribution. Look forward to next week hearing about the growth profile may be expected.

But I guess my quick question regarding that, since there's limited details, do we have enough cash on hand to pay for it?.

That's a loaded question. Especially since we haven't talked about what we're paying for the assets coming over. I think the most important thing for everybody sort of take away is we're not using any equity to pay for the transaction. I mean between the cash that we have and the relationship that we've fostered with J.P.

Morgan, you should assume that the cash proceeds will be in the form of debt. I think as it relates to our outlook, we are preparing to provide an updated 3-year outlook at Horizons, which will likely include the assets coming over.

I mean, a lot of it just has to do with the timing of when we're closing here, which we think, as I mentioned, I mean, we're optimistic that we can get this done here in the next few weeks, but we're sort of guiding to at least no later than the end of the quarter.

But we're trying to get things done in such a way that we can use the platform that we have at Horizons 2022 Investor Day to share more information..

[Operator Instructions] The next question is from the line of Tim Savageaux with Northland Capital Markets..

I wanted to take another run at the kind of RFP pipeline topic, not with any specificity, but maybe at a high level or in the aggregate, I think we may have talked in the past about a dozen or more RFP opportunities. I don't know if that's worldwide or just across Europe.

And maybe you can give us a sense of the maybe aggregate spend across those opportunities in terms of potential pipeline? And then the question would be, as you look at your guidance for calendar '22, to what extents are there any material assumptions about wins converting into revenue? Or should we think of that more as a 23% growth driver?.

So ironically, Tim, as you were speaking, I wrote the word dozens down on a piece of paper next to me. So we -- just across the Europe, I mean we still are pursuing in the dozens of RFPs. And as you can appreciate, most of those are Tier 1 and Tier 2s. I mean most RFPs are generated by the larger marquee customers versus the smaller regional players.

So it's certainly been a process. I would say that we're very optimistic in our participation in a lot of the RFPs, some are at different stages. We certainly wish that we were at a place where we could be more articulate in wins. But the way these RFPs work, and I know you guys all know this, I mean, you've got a formal response phase.

And then if you make it to the next phase, there could be more paper studies. But ultimately, you want to get to the proof of value and trial phase. And I would tell you that we're in the proof of value and trial phase where our products are actually in the lab with a number of large Tier 1s across Europe and in North America.

So we're cautiously optimistic. Our pipeline in every company sort of manages their pipeline maybe differently, but I would tell you that our pipeline today is reaching close to $1 billion. We're not going to convert 100% of that.

But we have a lot of very detailed forecasting assessment guidelines that go into the way our sales team forecast and business opportunities in our pipeline and then how that pipeline converts into a higher forecast outlook just based on where we're at within those accounts.

So we are encouraged with the way the pipeline has grown over the last year and where we're at with a lot of these RFPs that you pointed out.

And as it relates to our 2022 guidance, we rarely ever go into a year where we have significant upside or significant revenue profile in our guidance that's associated with an RFP project, especially something that has meaningful revenue.

So I think that investors and shareholders should appreciate that our 2022 guidance is focused on primarily existing customers and any new big wins would be something that we would profile as upside for the second half of the year, but more importantly, as you pointed out, into 2023..

Great. And if I could just follow up briefly on the order book with another kind of strong quarter of order intake. I wonder if you could characterize any major differences either geographically or product category between what you saw from an order standpoint and what you saw from a revenue standpoint in Q1 given the supply constraints..

Well, there's a few dynamics here. And so surprised that maybe the question didn't come out, although I think, Tim, you maybe touched on it slightly.

I mean one of the things that I think we were very open and honest about going back to the October-November time frame was our desire and our focus on partnering with service providers around the world on new commercial terms in light of the fact that we were impacted as everyone else is, with a lot of price increases over the last, let's call it, 6 to 9 months.

And so Q1, I would tell you, was somewhat impacted from an orders perspective of just where we're at in new commercial terms with some of those operators. And so our Asia customers specifically, were lagging in the timing of completing those new contracts.

I would tell you that we're pleased to report that the majority of the focus customers where we were partnering on new commercial and pricing terms is now behind us. And so we feel like we're going into the second half of this year with a commercial structure with our existing customers and new customers that aligns with where we need to be.

But that did have, frankly, an impact on timing with orders. I mean we made the conscious decision that we weren't going to take orders in Q1 at the old price because we certainly felt like that wasn't in the best interest for us for certainly the business. And so that certainly had an impact.

And as it relates to the mix of Asia and North America, it was really Asia that we had the biggest challenges with from a revenue mix in Q1..

That concludes today's conference call. Thank you for joining today. You may now disconnect your lines..