Good day, and thank you for standing by. Welcome to the DZS Third Quarter 2022 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, Head of Investor Relations. Please, go ahead..

Thank you, Carmen, and welcome to the DZS third quarter 2022 earnings conference call. Joining us today are DZS President and CEO, Charlie Vogt, and CFO, Misty Kawecki and Chief Product Officer, Miguel Alonso.

After market closed today, we published to the Investor Relations section of the DZS website, our shareholder report and a new investor presentation for the third quarter of 2022 to provide shareholders, prospective shareholders and analysts with market insights, product, business and financial updates, as well as forward-looking information.

Our third quarter investor presentation will be referenced throughout today's earnings call. Thus, we’ll recommend you download it to follow along with Charlie, Miguel and Misty's commentary. 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.

So 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 of forward-looking statements. So 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. During the fourth quarter, we will be participating in investor conferences hosted by Stifel, Needham and Craig-Hallum. I now have the pleasure to turn the call over to Charlie..

Thank you, Ted, and welcome investors, analysts and guests. As Ted shared, today after the market closed, we posted our third quarter shareholder report and an updated investor presentation, which provides an update on our business, financial results, market trends and 2022 outlook.

We continue to make significant progress with our four stated growth pillars during the third quarter. For the first time in company history, we delivered revenue in excess of $100 million, reflecting market share momentum, robust software and service growth and with our core customers who continue to accelerate their fiber and 5G deployments.

A $107 million of revenue during the quarter amplified our execution, navigating a challenging supply chain environment and despite continued foreign currency volatility, resulting from a strong US dollar. A $107 million of revenue represented an increase of 21% year-over-year and on a constant currency basis, an increase of 35% year-over-year.

We remain committed to capturing market share in North America, Europe and the Middle East, with approximately 70% of third quarter orders align with these regions. And we now surpassed $100 million in bookings for the seventh consecutive quarter.

Our go-to-market strategy over the past two years has been laser-focused on large and medium service providers, inclusive of emerging fiber overbuilders, utility cooperatives and wireless Internet service providers, noting that wireless Internet service providers continue to augment their fixed wireless business with fiber-based services.

Our strategic alignment with our customers and prospects have led to numerous product innovations, accretive acquisitions and high-margin software solutions.

Our fixed and mobile broadband portfolio offers service providers and open standards-based next-generation access, optical subscriber and cloud edge software and system solutions designed to disrupt the status quo and enable our service provider partners to differentiate in the markets they serve.

During the quarter, DZS was awarded two cloud software wins, both with large-scale Tier 1 service providers. The first, the profile was a marquee service provider in Western Europe and the second with a large-scale national service provider in Asia. The two cloud software wins represent continued momentum and adoption with our DZS cloud platform.

The Western European ward was for our DZS Extreme orchestration and automation software solution. The service provider will be leveraging our entire DZS cloud platform, enabling orchestration of revenue-generating applications, automation of services, network assurance and in-home WiFi experience management.

This award represents the significant opportunity DZS has to bundle and cross-sell leveraging our differentiated access and optical infrastructure systems and our cloud software platforms, which has been designed for large-scale networks.

The second cloud software win was with our Cloud check in-home WiFi management solution, which enables AI-driven network optimization, automation, real-time data analytics and consumer experience management. Complementing the timing of these 2 software wins last week, DZS received the 2022 excellent Award from Cloud Computing Magazine.

We remain optimistic that we can achieve our stated run rate goal of 40% adjusted gross margins as we exit 2023 and 45% adjusted gross margins by 2025. It's worth noting that on a normalized basis, accounting for foreign exchange and supply chain impacts, our adjusted gross margins during the third quarter would have been 40%.

We continue to invest in advanced and highly differentiated access and optical edge solutions. During the quarter, we unveiled the DZS Velocity V6, the industry's most advanced next-generation optical line termination system.

The V6 uniquely positions DZS to capture new opportunities with service providers, including networks that are transitioning due to Chinese vendor security concerns.

The V6 mirrors the form factor of Huawei's first-generation 6 RULT [ph], though delivers an estimated 10x performance improvement featuring a nonblocking architecture with a market-leading 800 gigabits of capacity per slot.

The V6 and the DZS lineup of next-generation loyalties offers service providers what we believe to be the only true seamless upgrade path to 50 gigabit access technology.

The second innovative milestone introduced during the quarter was the Sabre 4400, an environmentally hardened coherent optic ROADM transport platform designed to address last mile broadband access aggregation at the network edge.

Sabre 4400 delivers significant deployment and operational cost savings as it eliminates the need for climate-controlled environments. Additionally, during the quarter we announced the newly established strategic partnership with Fabrinet one of the world's leading contract manufacturers and a specialist in access and optical technologies.

As we transition internal manufacturing to Fabrinet, it will allow us to free up resources that have been dedicated to supply chain management and manufacturing, allowing us to shift our focus to more strategic growth initiatives.

We expect this partnership and the shift to a contract manufacturing model to deliver enhanced margins in 2023, resulting from improved product and lower-cost operating. Following my opening remarks, Miguel Alonso, Chief Product Officer joins me as we review several product and growth themes from our investor presentation.

For those of you who have downloaded the investor presentation, please turn to Page 8. Aligned with DZS growth aspirations, Slide 8 highlights anticipated growth associated with the broadband upgrade supercycle currently underway.

The chart represents a nearly 20% compounded annual growth rate aligned with our access and subscriber edge OLT and ONT illustrated through 2027. The source of the data is Omdia, a highly regarded global market research firm.

Turning to Slide 9, you will see the current global government subsidies during the fiber and 5G broadband market totaling more than $100 billion. The United States is leading the way with more than $70 billion. It's worth noting that award-winning service providers are likely to contribute 50% or more of the required capital investments.

Slide 10 represents the emerging applications that will continue to drive hyper-fast, low latency bandwidth requirements for home, office and mobile devices. To amplify the expected decade long investment cycle, we expect 50 gigabit last mile access to shift from road map discussions to reality by 2024.

Our lineup of OLTs ranging from our V1 to V16, which includes our V2, V14 and newly launched V6 give service providers favorable deployment flexibility and optionality and a seamless upgrade path to 50 gigabit PON and beyond. Miguel will now speak to the next several slides, starting with Slide 11.

Miguel?.

Thank you, Charlie. Slide 11 provides a visual representation of the access network, highlighting the areas where DZS systems and software are deployed by service providers today.

At the top, our Cloud EDGE product portfolio is made up of cloud software that interacts with the physical network to simplify service creation and life cycle management, automated network operations functions and leverage AI to continuously optimize the performance of the access network from the central office to the subscriber devices in the home.

From left to right, the optical EDGE is defined by adopting optical technologies traditionally associated with the optical transfer network to meet the bandwidth environmental and space constrained demands of what is often referred to as the middle mile, which connects the access and transport networks.

Access EDGE is represented by fiber-based optical line termination systems built to deliver today's multi-gig services in any network environment and architected to support 50 and 100-gig access services in the future.

The subscriber EDGE consists of the network termination devices and Wi-Fi service distribution systems that extend the performance of the fiber network in the subscriber premises. Charlie highlighted earlier and turning to Slide 12, our most immediate near-term growth pillar is the GPON to XGS-PON upgrade cycle underway.

As you can see, we have the industry's broadest and most versatile loyalty portfolio. Our loyalties are built on a common hardware and software platform, which provides uniform operations for our customers and a streamlined product development process to introduce new services and applications.

Coming to all of our loyalty systems, our attributes of flexibility like traditional and disaggregated deployment models, architectural headrooms such as horizontal is scalable switching and in-place upgrade to 50 and 100 gig pond and low latency nonblocking deployments at any service fees today and in the future.

Furthermore, the physical characteristics of our royalties are such that any of them can be deployed in data centers, traditional central offices or even in the most demanding outdoor cabinet locations. Slide 13, gives you a view of our recently announced V6 OLT system.

The V6 OLT provides industry-leading performance and service density in a 6-rep unit high environmentally hardened form factor which we define how service providers deploy passive optical networking in high-density locations.

This extraordinary performance is best represented by its service interface capacity, more than 24,000 subscribers in [indiscernible], near terabyte non-blocking switching capacity and the ability to deliver low latency non-blocking 10-gig point class access services.

Additionally, it has the architectural headroom to support in-place upgrades to the 50 and 100-gig point access technologies of the future, while maintaining low latency, non-blocking performance for all service types. This compares with complete system replacements proposed by other vendors to achieve the same goals.

Last but not least, the system's open design facilitates simple insertion into current network environment as well as SDN-based control of the access network to accelerate automated operations.

Slide 14 provides a high-level overview of our GPON and XGS-PON OLT combo card, which best represents the velocity hardware architecture with flexible onboard access interfaces GPON, XGS-PON, combo 1 and 10 gig active different, a high-capacity distributed switch fabric and an onboard network and backplane non-blocking interfaces.

This line card is powered by our modular containerized SBOs embedded operating system that enables software-defined networking, new application deployment agility and increased system reliability and availability. Slide 15 represents our newly released Saber-4400 optical platform.

The Saber-4400 delivers optical transport technologies like 100 and 400 gig coherent optics, transponders, muxponders, amplifiers and ROADM functions in 1RU, telco depth environmentally hardened package.

Personality module-based architecture with service providers never before seen optical, optionality and flexibility to address the optical transport challenges of the middle mile in the multi-gig service area.

These industry-first attributes deliver extremely high value to service providers, since they are now able to deploy 100 and 400-gig coherent optical transfer technologies anywhere in the network, including outdoor remote cabinets without incurring the high cost of constructing and operating telco hubs or controlled environmental box.

To close the product section of this presentation, I will briefly talk about the M4000, which can be found on slide 16.

The M4000 is an SDN-controlled next-generation transport and aggregation switch with the layer 2 and 3 functionality, timing, synchronization and low-latency packet processing capabilities necessary to uniquely address the needs of a broad set of packet transport and aggregation use cases, such as sell-side routing for backhaul and midhaul; fronthaul transport in overland networks; and packet aggregation for the access and optical edge.

In summary, our recently announced products across our access and optical edge portfolio exemplify our thought leadership and innovation in support of our growth pillars and our aim to help our customers successfully deploy their next-generation access networks. Charlie, I will now turn things back to you..

Thank you, Miguel. Slide 17 through 27 capture our remaining three growth pillars, which I highlighted in my opening remarks, and slide 21 introduces our fifth growth pillar, DZS Cloud. As we look ahead to 2023, we will focus on smart profitable growth.

Over the past two years, DZS has successfully operated its leadership team; upgraded and expanding our sales, marketing, and customer success resources aligned with a growing sales pipeline; and a backlog that has increased more than four times since 2020.

We integrated three disparate ERP systems into one, we also exited two high-cost manufacturing facilities shifting to a low cost and a highly flexible contract manufacturing model.

We have added more than 200 new customers, most of which are North America and European service providers, and we acquired two cloud software companies and an optical transport innovator.

We are encouraged with our global sales pipeline, our current active fiber broadband OLT, mobile and optical transport, and cloud software trials and are now $329 million of remaining performance obligations, specifically our product and software backlog, including deferred revenue.

As we enter 2023, we expect supply chain to improve and the current purchase price variations inclusive of subcomponent, logistics, and expedite costs to improve. We also anticipate foreign exchange, adjusted gross margin, and profitability to improve in 2023.

With that, I'd like to turn the call over to Misty to walk through our Q3 financial highlights in our Q4 and 2022 outlook.

Misty?.

Thank you, Charlie, and good afternoon, everyone. If you are following along in the investor deck, I will start on slide 29. With strong execution across all of our growth pillars during the third quarter, we continued to navigate foreign currency headwinds primarily tied to the Japanese yen and Korean won.

Turning to slide 30, orders remained strong at $125 million, surpassing $100 million for the seventh consecutive quarter. On a constant currency basis, orders grew 8%. We reported record quarterly revenue of $107 million, an increase of 21% year-over-year and above the midpoint of guidance.

Revenue growth would have increased 35% on a constant currency basis. Now, that the new Express and CloudJack software products have been with DZS for a full quarter, we are reporting our revenue mix by product type, including access and optical networking which was 85% of total revenue and software and services at 15% of revenue.

Our unique end-to-end software portfolio is resonating with customers and prospects as demonstrated by our two cloud software wins with Tier 1 service providers. Turning to geographic mix. During the third quarter, revenue from the Americas region increased slightly year-over-year to $28 million.

Customer capture in the region positions us to benefit from government stimulus programs that we expect to materialize in 2023 and beyond. Revenue from EMEA increased 29% year-over-year to $27 million, a recent Tier 1 win in the region, along with a full quarter of Cloud Check and Express revenue contributed to the growth.

Revenue from Asia increased 31% year-over-year to $53 million. Revenue growth was driven by a more diversified customer base adopting our subscriber and optical edge products. Our Q3 adjusted gross margin of 35% was impacted year-over-year by foreign currency headwinds and elevated supply chain costs.

Excluding these headwinds and costs, our adjusted gross margin would have been 40% and in line with our target gross margin level.

We'd like to point out that sequentially, we improved gross margins by 670 basis points as we benefited from a higher mix of revenue from North America and EMEA and incurred fewer expedite fees and had greater software and services as a percentage of total revenue.

At the end of the quarter, we entered into an outsourced manufacturing partnership with Fabrinet to manage the manufacturing of our products shipped to the North America and EMEA regions.

The expected savings from this initial scope with the Fabrinet falls within the operational execution margin improvement category of our target gross margin model that we shared during our Q2 2021 earnings report. This category is expected to provide 450 to 600 basis points improvement.

In the third quarter, adjusted operating expenses were $33 million compared with $27 million in Q3 of 2021. The year-over-year increase reflects our recently acquired assets from Asia ASSIA and continued investments in sales and marketing to fuel growth.

Our adjusted EBITDA was $4 million during Q3 of 2022 compared to $5 million in Q3 2021 and our non-GAAP EPS was $0.05 compared to $0.16 in Q3 2021, with the year-over-year decline, the result of lower gross margin related to foreign currency headwinds, supply chain costs and sales and marketing investments.

Excluding the supply chain headwinds and foreign currency fluctuations, our non-GAAP EPS would have been $0.30 higher or $0.35 per share in Q3. We ended the quarter with $21 million in cash and $7 million drawn on our revolving credit facility, with $24 million of debt as part of the five-year term loan to fund the ASSIA acquisition.

Day's sales outstanding were 106 days in Q3 compared with 90 days in the year ago period. Growth in Tier 1 accounts contributed to the increased DSO's in Q3. We Inventory increased $26 million year-over-year to $85 million to meet growing customer demand.

Annualized inventory turns were 3.5 times, during the third quarter compared with 4 times a year ago. Our Q4 guidance reflects the continued strengthening of the US dollar relative to the Euro, Won, and Yen over the past 90 days.

For the fourth quarter, we are guiding revenue to a range of $110 million to $120 million, gross margin in a range from 33% to 35% and operating expenses between $32 million and $34 million and our EBITDA between $4 million and $8 million.

As a result, our full year guidance for 2022, is revenue narrowed to a range of $386 million to $396 million, gross margins of 32.5% to 34%, and operating expenses between $121 million and $123 million and EBITDA between $4 million and $8 million. That completes our prepared remarks.

I'd now like to hand the call over to Karmman to facilitate the Q&A session..

Thank you so much. [Operator Instructions] One moment for our first question. Our first question is from Mr. Svanberg with Stifel. Please go ahead..

Yes. Thank you very much and congratulations on the record quarter.

Could you just talk a little bit more about Velocity V6 as far as timing, you know, when you expect some more material revenue? And also perhaps what reason do you expect that particular product to ramp first?.

Yes, we are -- we will be, I guess, investors and analysts should expect announcements soon on customer adoption. As it relates to product availability, we plan to start shipping that product in the first quarter of next year..

Very good. And as my follow-up, Charlie, I was also hoping you could elaborate a little bit more on the Fabrinet partnership, especially, as far as when you expect to see some accretion. It sounded like you were all expecting next year, but I also wasn't sure if this was sort of already incorporated into the gross margin thinking.

So anything else you can add on that, that would be great?.

Yes, there's no gross margin improvement this year. I mean, we are -- if you can appreciate it, we almost have a dual sourced manufacturing capacity in Q4 because we have our existing team that is transitioning and handing over, while at the same time, we have the new Fabrinet team that's coming up to speed.

And so we're -- I think, we've done a really good job accelerating the time line. The cooperation and collaboration with our team in Seminole has been very impressive. And our goal is to completely hand everything off to Fabrinet by the end of this year.

And so we expect to see the margin improvements with a lower BOM cost as well as just a lower labor cost starting in Q1 of next year..

Can I -- just one last question for Misty.

So when I look at your gross margin guidance, is it safe to say that all these headwinds that this is pretty much it, the second half of the calendar year, this is both as for headwinds, both from currency and also from the supply chain issues?.

So, yes. So our guidance for Q4 certainly reflects the additional headwinds we've experienced in Q3 and expect to incur in Q4 as well as just the timing of flushing out the remaining backlog associated with our higher product costs..

Okay. I guess my question was, obviously, that would be the second half comment between this quarter and next quarter. As we move into 2022, how -- what's your view, especially, on some of the currency headwinds.

I know it's hard to predict, but any visibility that you have would be really helpful?.

Tore, I would be paid big box if I had my golden crystal ball for 2023, but we do expect foreign currency to stabilize at a minimum and possibly produce tailwinds in the latter half of 2023 that based on the inputs that we're receiving from various sources..

I mean, I think, there's three main drivers for gross margin improving next year. Obviously, the shift from an in-source to an outsource manufacturing, specifically with our Americas and European. Remember, we're still doing some of our own handholding with our CMs in Asia. That's Phase 2 and how we increase margins.

So there's certainly the improvement that we'll see in our product cost and our labor cost in 2023 with Fabrinet.

We also, as I think everyone appreciates, I think our entire sector incurred significant price increases that began last year and that affected a lot of our backlog that we weren't able to from a timing perspective, increase the prices appropriately. And so we'll see that improve in 2023.

And then you have a significant contribution from software and services that we didn't have this year that we'll have next year. So when you layer those three things in, we feel pretty confident that we can get to an exit velocity and a run rate of 40% margins.

As I highlighted, had we had not had the foreign exchange and supply chain headwinds that weren't expected in Q3, we would have been at 40% gross margins this quarter..

Great perspective, and congrats again. Thank you..

Thank you. One moment for our next question please. Our next question comes from Ryan Koontz with Needham & Company. Please go ahead..

Thanks for the question. Congrats on the quarter there. With your two software wins you mentioned there, it sounds like in the letter, they contributed to revenue in 3Q.

Like how should we think about the opportunity for those customers? Is this just initial deployments, I assume this is a license and maintenance type pricing model for CloudJack and your orchestration platform. Maybe just walk us through little more insights there would be helpful. Thank you..

Thanks, Ryan. No, these are -- obviously, is just an initial deployment. These are designed to be long-term contracts and long-term software contributing clients. I mean, they're both large Tier 1s. And so we're not going to speak specifically to our commercial structure.

But certainly, we expect the contribution from both of these two and others to continue to contribute well into 2023 and beyond. And I also highlighted the one large Tier 1 Western European win has a really exciting and new attribute to it in the sense that they're now going to be utilizing the entire DZS cloud platform.

So we'll be using Xtreme, which is our access and 5G orchestration platform. They'll also be using Express and CloudJack for in-home Wi-Fi. So that's really where we're trying to take our entire customer base. There's a great end-to-end software value proposition there.

There's also a very interesting and unique ability for us to begin to bundle our orchestration and service assurance software with our OLTs to really help differentiate the deployment and the onboarding of new services and the management of new services for our fiber-based customers as well.

I don't know, Miguel, if you want to add anything there?.

I think you covered it very well. Hello Ryan, this is Miguel. Maybe to add to that, I think what we're seeing is our customers realizing the synergy that occurs when they have this end-to-end software that is not just protecting the access network overall, including the orchestration of all the services. So that's a validation of that.

It's also a validation of our thesis that and history, which is we have built these products to be deployed at scale by national large Tier 1 service providers, globally..

That's great. It's great to come for you guys. If I can shift gears real quick and talk about the middle mile opportunity, certainly sounds promising as you look at kind of the bigger optical players trying to push their way into the Access Edge where they don't have the experience.

But for DZS selling stand-alone optical platforms into the Western wireless and wireline operators, that's a new endeavor for you? And how should we think about the sales cycles there and customer adoption opportunity for you in this new market opportunity. Thanks..

Yeah. I mean -- I mean, we have no plans to go upstream and compete in the high-density DWDM market. Our strategy has always been -- when we acquired Optelian, the game plan all along was as more-and-more capacity is being deployed in last mile, there's a big gap from high-density DWDM platforms to last mile aggregation.

And so our -- the introduction of the 4,400 is really uniquely designed, Ryan, to really couple what we're doing with a very flexible 100 to 400 gigabit ROADM-based, cooking and optics platform with our OLTs. And so we don't see it as it relates to last mile access, we actually don't see it as a stand-alone sale opportunity.

Certainly, there's an opportunity for us to go into networks where our peers are deploying OLTs and be able to elegantly provide that platform. But think about the unique ability we're going to have now to bundle the Sabre-4400 with our OLTs doing something very unique in the way we're going to aggregate last mile OLT and last mile aggregation.

Separate and apart from that, there is a huge opportunity for us to enter the data center market, the hyperscaler market with a very cost-effective platform. And again, remember, we believe this is the first of its kind in that it's environmentally hardened and the modular design of it and the cost structure of it, we think hits the sweet spot.

And as you said, there's -- just here in the United States, there's over $5 billion of middle mile requirements. And we think that of the 235 applications that have already been filed, that we're in a really good place to begin to participate there. Again, Miguel, if you want to touch on anything..

I think you covered this well, Charlie. I think the question about, how do we compete in the transport space.

As you said, this is our vision all along has been the fact that there is a gap that exists today, between the traditional transport network and access network, both fix and wireless that is producing an incredible amount of bandwidth from subscribers.

Now, to fill that gap, you need the bandwidth capacity of the traditional transform network, but you need the physical attributes of the access network in terms of size, environmental hardening, et cetera. And that's how we have uniquely built our products and uniquely because nobody else in the industry..

You've got state rings, you got electric co-ops that are ideal customers for this platform. And when you just look at the ROI that we've mapped out, I mean there's -- and this has been with engineering firms, this has been with customers we're saving somewhere between $20,000 and $200,000 per deployment based on the TCO on the Sabre 4,400..

That's great, guys. I appreciate the insights. I'll pass it on..

Thanks, Ryan..

Thank you. One moment for our next question, please. Our next question comes from the line of Paul Essi with William K. Woodruff and Company. Please go ahead..

Thanks for taking my question and ccongrats on a good quarter. I wanted to follow-on a little more on what Ryan had talked about. Going into the Sabre and the V6 is a little bit different than selling your traditional products.

And I was wondering, what steps you were taking, what resources, what training , what additional steps have you been taking to try to get your sales force up and running in this area? And then secondly, I noticed that the head of sales is no longer on your website.

And I was wondering if you can give a little color on the transition and if this was part of this this change in strategy..

Well, first of all, the -- and thanks, Paul. I mean the V6 is an extension to our existing OLT portfolio. So there's nothing new from a product or sales training. It's really an extension to the portfolio we have.

And it really -- it really introduces a completely new type of platform into the market, not only designed to try to form fit a lot of the deployments that Huawei has historically deployed with their 6 lot platform across Western Europe, Middle East, India and Canada.

But it provides a new architecture from a non-blocking and capacity that we haven't seen in the industry. So we've been working on that platform for quite a long time. The attributes of that platform span across the rest of the portfolio.

So as I think Miguel, did a good job highlighting in his in his commentary that it is a common architecture from hardware to software to the service modules that we're utilizing across all the different chassis, sizes and scales.

And I appreciate it, if you're going into medium and large size markets with large and medium-sized service providers, I mean, it's density requirements is a big deal.

And our concept is if you think about a 7-foot rack, and you've got a Huawei 6 RU chassis that's in that rack, I mean we're now able to take that out and replace it with the exact form factor, but with 10x the capacity. So lots of improvements there. We think it significantly differentiates us from anyone else in the industry.

From a sales and training perspective, there's really very little on the V6. I mean the sales team knows how to sell OLTs very well. You mentioned the Sabre 4,400. We acquired upselling almost two years ago. There's a lot of DNA inside the company.

The sales team has been coming up to speed here over the last year, really waiting for the 4,400 to be announced. I mean it's something that we've been training the sales team on for six, nine months, knowing that this was coming. So I think it's a natural extension to the OLT portfolio and will be relatively easy for the team to position.

Miguel, I don't know if you want to touch on anything..

As you said, right, Charlie..

I'll touch on Jay and the change with Jay in a second..

So as you just said, right, we – we see and our customers see the Sabre 4400 as the necessary extension of the access network.

So from that perspective, the sales teams, as Charlie said, and as part of our new product introduction and product launch, we prepare our teams and our product specialists to be able to articulate the value proposition to our customers. And hope they realize the value that the product brings to them..

Yes. As it relates to Jay, as you mentioned, I mean, Jay was running the Americas and EMEA, and I've known Jay for 25 years. He's done a great job helping us get to this place.

But over the last 18 months, we've actually done a really good job bringing on some fantastic sales leadership talent, and it really gave me an opportunity here to flatten the organization, allow me to get closer to sales. So we've basically gone from two regional sales leaders to three.

So under the new sales organization, I have Drew Finkelstein, who's running the Americas reporting to me, Vincente, who's running EMEA who joined us from ASSIA, and Daniel Won continues to manage Asia.

So from our standpoint, there's really nothing that we've done other than streamline the sales organization and created three regions where before we had two..

Okay. Great. Another question, ASSIA. You -- everybody got really excited about it back in May, we haven't heard a lot about it in some of your releases. You did say in the letter that over time, you're expecting some growth.

Can you give us a flavor for what we might see in the next 12 months as far as what you're going to enroll here and what it might mean for revenues?.

We did highlight two Tier 1 wins in the call and in the shareholder report, one of which was cloud check, which came from ASSIA. We certainly didn't go into details of any other let's call it, smaller and mid-sized wins. We were highlighting the two Tier 1s specifically. We did book $125 million.

We didn't split out the bookings between software and Access and Optical, and we're not going to, but you should assume that there were software wins within the $125 million quarter we posted.

So if we didn't do a very good job there, I apologize, but we're -- software and services revenue as a percentage was 15% in the quarter, which we think was pretty significant.

And on a full-year basis going into 2023, as I've said, going back when we acquired ASSIA, we expect software and service revenue to increase at least 25% a year, and we're sticking to that theme for 2023.

So if you kind of schedule out a run rate of Q3, you should be expecting our software and services revenue to be in that $50 million range next year..

Okay. Good. Thank you. I'll pass it on..

Thank you. One moment for our next question, please. Our next question comes from the line of Tim Savageaux with Northland Capital Markets. Please proceed with your question..

Hi, there. Good afternoon. Question here on some of the customer engagement we discussed, some of the wins. Put a couple of names up there. Some of them look like current customers, some of them look new. I was interested in what you're doing with Airtel in particular, assuming that's India, but it might be something else.

They've been -- a lot of guys getting contracts from those guys. So there are -- obviously, India is getting underway with a big 5G build. I wonder if it's related to that. And secondly, kind of on the Tier 1 front, I understand the software wins.

So do we assume at this point that's with third-party vendor hardware, or do you have any kind of anything on the Tier 1 front in Europe to talk about from an access infrastructure perspective in addition to the software wins. Thanks..

Yes. Thanks, Tim. Airtel, I think we did mention was one of our early Huawei replacement opportunity, so you should assume that it's within our access and subscriber edge portfolio. And we did begin shipping to them during the second half of this year, and we've got a pretty significant schedule to ship to them in 2023.

As it relates to our Tier 1 and Tier 2 activity with our access and subscriber edge portfolio in Europe, we didn't specifically highlight anything, and I don't think we have any prepared remarks to do that.

I can tell you that if analysts and shareholders should take anything away from this call, I don't think that we would have invested the millions of dollars we did in the V6, which was designed to be a Huawei replacement platform, from a form factor perspective, if we weren't highly confident in our ability to participate in the markets where they are at.

And that's considerably Western Europe, Middle East, India, parts of Pan-Asia and Canada. I mean, those are certainly the target markets. There's a lot of activity that we've been working on for the last six to nine months, and we expect some of that to continue to convert as we enter next year..

Yes, let me follow up on that kind of pipeline discussion there, which we've talked about a number of opportunities out there. It sounds like some decisions are starting to get made.

I mean, I don't know if you can quantify anything in terms of what you're pursuing or what -- how many of those decisions we might see, but -- have you seen those opportunities expand, remain stable, or are we just getting closer to the normal cycle of decision-making here?.

Yes. I think the opportunities for DZS on the medium and large-scale operators in North America and Canada, and Europe, Middle East, Pan-Asia has continued to increase. And I think it's increasing because of the things that Miguel and I highlighted.

I mean, one of the reasons why we wanted to takes some time out of this call and highlight what we're doing on the product side is to amplify where we see a lot of the differentiation that a lot of prospective customers are also seeing from a density perspective and just next-generation technology. I apologize, Tim.

I'm not going to get into the details of where we're at in the cycle of decisions, only from a competitive standpoint. I mean, there's only a few of us that are competing in these markets. And we're very confident in where we're at with a number of medium and large-scale Tier 1s around the world with our OLT portfolio..

Great. Thanks. And if I could just follow-up and maybe touch on the Fabrinet deal a little bit, which looks very promising. And I don't know that you've necessarily quantified any incremental impact, but more -- you said that I guess, supports the path to 40% and then 45%.

But to the extent that you think you might have been around 40x items this quarter and are looking to exit the year there, assuming in large part, I guess, because a lot of those items will moderate or maybe even turn around.

In that context, where do we see the impact of the Fabrinet deal, or are we taking kind of a conservative approach to any upside from a gross margin standpoint? Thanks..

Well, go ahead, Ms. Misty, go ahead..

I was going to say, and I think one of the important things to know about Fabrinet is that we'll take some time to transition. We're rolling it out first in our US manufacturing facilities that supports North America and EMEA, and we will have the ability to expand that in 2023 to other regions.

We did call out that it was within the category and our target margin model that would provide 450 to 600 basis points improvement. We do believe it's within that bucket.

We do believe there's several things in that bucket, right? And so we're not ready to call out anything that's incremental to the target margin model until we see some course correction in some of the headwinds that we've experienced with foreign currencies and supply chain. So we did mention that in our long-range model, we're driving towards 45%.

And I would say we're still consistently driving towards that path..

I think the other thing that's worth noting is when I joined the company 2.5 years ago, the gross margin was around 33%. And if we can get to 40% sustainable margins with a three-year period, especially in light of everything that we've all had done or 700 basis points improvement, pretty significant.

Our goal is to get to a place where we can be in all three regions with a sustainable 40% gross margin exiting next year, to your point, Tim, we certainly would like to meet that goal ahead of ending next year.

I think if we can continue to make progress on the OLT side, with our optical transport side, high-margin products, if we can continue to have success with our software and services, high-margin products, we can certainly get there sooner.

But we are trying to be as prudent as we possibly can to provide the best guidance we possibly can with the most assurance we possibly can. But is there a path to get there sooner? There is.

But at this point, we're not prepared to commit to that until we have proof points that we can sustain ourselves at that level which all the things that we're doing from product innovation to software and services to the outsourced contract manufacturing all lends itself to a path to be able to do that..

Got it. Thanks very much..

Thank you. One moment for our next question, please. Our next question comes from the line of Dave Kang with B. Riley. Please go ahead..

Thank you. Good afternoon. First question is regarding supply chain. So I just wanted to be clear regarding the impact. So it sounds like it's really impacting your margins, but not revenue.

What I mean by that is that higher expedite fees definitely impacting your margins, but leaving any revenue on the table because of, say, chip or component shortages.

Just wanted can you provide additional color on my comments?.

I would say you're partially correct. I mean I would tell you, and I've said this, I think, on the last three calls that if we had all of the components that we needed, we would be shipping more than what we are.

I mean, with more than $300 million in product backlog, we -- and with most of our customer requested ship dates as ship as soon as possible, we certainly would be generating and converting more revenue if we had access to more components. So I would tell you that, we're by no means through the shoot of solving the supply chain challenges.

Is it getting better? It's getting better, but it's not where we want it to be. It's certainly not where it was pre-pandemic. So, there's certainly revenue impacting, but you're right, from a margin perspective, the expedite fees, the logistics costs, they're all getting better. We certainly saw logistic costs coming down.

We certainly saw fewer purchase price variances within the quarter associated with the gouging expedite fees and everything else that we've been dealing with for 18 months. Those were positive signs, but it certainly isn't at a normalized state. It was really FX that impacted order value, revenue value and gross margin.

And I just want to remind everyone that, if you go back 10 years, and this is a company that's been selling into Europe, Korea and Japan for more than a decade. The Korean won and the Japanese yen, even the euro have been favorable to where -- significantly favorable to where the US dollar is today.

So, if we can get anywhere back to some state of normalcy, it will, as Misty said, be a tailwind for us in 2023 and beyond compared to what we're dealing with today..

Got it. So, your revenue is still constrained by supply chain, and it sounds like, it’s getting better.

So how should we think about the seasonality for first quarter, I mean, should we still model a typical sequential decline, meaningful decline, or how should we think about first quarter assuming supply chain continues to get better, and you got over $300 million in RPO?.

Yes. I don't think that there's any traditional seasonality right now with many of us, just because of the backlog that has stair-stepped up over the class of the last three or four quarters. So, I mean, you certainly can make the comment about order flow.

I think it will be interesting to see how service providers continue to support the timing of shipments based on what I hope to be improved delivery times from our key subcomponents and chip manufacturers in 2023.

But I think that Q1 can continue to be or can be a stronger than normal Q1 if we can convert a lot of the backlog in Q4 and Q1 like we're anticipating..

Got it..

I mean, if you go back three years to a traditional eight to 12-week lead time. I mean, you've got -- for most of us in this industry, including some of the large-scale systems companies, I mean your BSR in more than 50% of in-quarter revenue, meaning you're booking and shipping and converting revenue more than 50% in quarter.

I mean, over the course of this year, most of us have been up in BSR in 50% in quarter. I mean we're fortunate we can be BSR 10%. So backlog and the timing of our ability to convert it has a lot to do with just our alignment to components and the ship schedule that we have.

So, if we can we can continue to have a strong – coming off of Q3, we're going to have a strong Q4 and we can deliver the remaining backlog in Q1 and Q2 it may not be as traditionally seasonal as you may think..

Got it. And my last question is regarding your fourth quarter gross margin outlook. It looks like it's going to be kind of flat or down.

Is there any reason for gross margin to decline sequentially when supply chain is improving?.

Yes. I mean, as Misty said, it's really 3 things. It's what we anticipate to be a steady state on FX. I mean, if it remains what it is, then we're on track. If the US dollar weakens in those markets, then it could provide upside for us.

We do anticipate more participation from Asia and more ONT sales in Q4, which puts a little bit more pressure on margins. So, you've got anticipated product and regional mix. And then as we said, you just have the timing of some of the remaining backlog that we had that was associated with higher prices.

So remember that we've all been dealing with a backlog that incurred higher prices that didn't reflect our ability to change the sale price.

And so, we flushed most of that out in the first 3 quarters of this year, we still have a remainder of that that will flush out in Q4, I think those are the contributing factors that are profiling the margin where we have in Q4..

And about higher prices, you mean cost costs, where we haven't been able to adjust the sales price, yes..

That's right. Got it. Thank you..

And one moment for our last question. Our last question comes from the line of Christian Schwab with Craig Hallum. Please proceed. .

Good afternoon guys. So two quick questions, maybe. The first one on the Huawei replacement. Have we configured that product in a way that it could be in line with product gross margins or when that ramp should we assume since the customers that chose Huawei the first place was extremely price sensitive, I assume they still will be.

How should we think about product gross margins there?.

Well, I think – Chris, this is Miguel. I think you should think of gross margins in line with our target margins for OLTs. As we move forward, when service providers are replacing Huawei equipment, they are doing so to deploy new technologies. In this case, we are taking advantage of that situation to evolve towards 10-gig plus services.

So that makes a significant difference. And I wouldn't say that, every service provider that deploy Huawei was – did that because of price sensitivity. It was just a product that was available in the market and competed with the other one. So that's how we look at it and also consider that – it's not just a product for Huawei replacement.

It's just a phenomenal OLT for deployment of PON in high density anywhere in the world, right? So that combination should give you a good sense for PON..

The other thing, I'd just like to add is I appreciate that these OLTs have a significant amount of embedded software. And there are software licenses associated with the OLTs. It's not just a transport platform and access platforming. There's a lot of software there.

We're introducing our next-generation software-defined network operating system, which will add a software contribution element that will add to margin enhancements.

And if you look at just what happened from GPON to XGS-PON, I think I'm speaking for the entire sector that we did see an uptick in revenue and margins that were commensurate with what our service providers were going to be able to charge their customers downstream.

And so I believe that, the V6 is significant because it's the first platform in this industry that you could safely assume as a service provider, that it can stay in the network for 15 to 20 years because we've designed it in such a way that it can support not just XGS-PON but the evolution of 50-gig and eventually 100-gig.

So we think that, that has a significant value to service providers, and we think that they'll pay more for a platform that they don't have to do a forklift upgrade, which most of our peers will have to do to support the higher speeds..

Excellent. And then my last question, just the five pillars of growth that you outlined seem to suggest that growth could be much more robust than greater than 10%. And -- is that conservatives on your part, given some of the unexpected currency.

But if we just think about it just constant currency, am I thinking about that right? There's a lot of potential for success from that outlook?.

Yeah. I mean, we think so. I mean, if you look at – I mean, look, I think Omni does a really good job. They spend a lot of time across the globe with, obviously, large-scale and medium-sized service providers, which is where most of the dollars are.

And if they're anywhere close to that and we can participate and convert some of the trials in pipeline to revenue, sure. There's a lot more upside than what we're probably profiling. It's hard for us to do that when you're not already an incumbent.

It's easy for us, easier for us to forecast anticipated orders and revenue with our existing customer base. But when you're in a trial phase, or you're going to take share phase, it's hard to be too overly ambitious because the swings are significant. You close a new Tier 1 or Tier 2 for OLTs or optical transport.

I mean, you're talking tens of millions of dollars, and it's just hard for us to be in a position to where we can feel confident that we're going to lean in there.

I think the other thing that we haven't talked a lot about that we will talk a lot more about is the evolution of our mobile orchestration and software automation platform to what we believe to be the industry's most comprehensive access orchestration of software automation for fixed wireline networks, we don't think anyone's doing this, especially not what we're doing.

And as we begin to bundle Xtreme with our OLTs that's going to give us a significant differentiation, it's certainly going to give us an opportunity to enhance margins with our OLTs. So there's a recipe there that we're laser-focused on.

I'm not going to share all of our competitive secrets on an analyst call, but I appreciate there is margin opportunity, margin expansion opportunity and compete with some of the more challenging, as you pointed out, Christian, on the more challenging, while we're replacement opportunities where maybe some of the larger Tier 1 and Tier 2s have pricing expectations that they got from Huawei.

I think they're looking at a completely different today than they did when they originally brought Huawei into compete with -- for the most part, at the time, Nokia..

Excellent. No other questions. Thanks guys..

End of Q&A:.

Thank you. And with that, ladies and gentlemen, we conclude our Q&A session and conference for today. Thank you for participating. You may now disconnect..