Ditech Networks Inc. (DITC)

F2Q09 Earnings Call

November 20, 2008 4:30 pm ET

Executives

Marie France Nelson – Vice President of Finance

Todd Simpson – President and Chief Executive Officer

Bill Tamblyn – Chief Financial Officer

Analysts

Michael Coady – B. Riley & Co.

Presentation

Operator

Welcome to the Ditech Networks second quarter fiscal year 2009 earnings release. (Operator Instructions) I would now like to turn the conference over to the CFO of Ditech Networks, Mr. Bill Tamblyn. Please go ahead sir.

Bill Tamblyn

Thank you very much, good afternoon everyone this is Bill Tamblyn, the Chief Financial Officer of Ditech Networks. Thank you for joining us for this conference call, which will cover Ditech Network’s announcement of the results of its fiscal quarter second quarter 2009. Today’s conference call will cover our financial results for the quarter and our outlook for the third quarter of fiscal 2009.

Todd Simpson Ditech’s President and CEO will provide the business and strategic analysis and I will provide a more detailed analysis of the financials. Following the update we will open up the call for Q&A.

Before we begin let me state that this conference call is being held on November 20, 2008, any sound recording or republishing of this conference call is expressly forbidden without the written approval of Ditech Networks.

Also we must point out that as with similar presentations the following discussion contains forward-looking statements, and in particular the financial projections of our third quarter of 2009 that involves risks and uncertainties. Our actual results may differ materially from those discussed here. We will attempt to identify such forward-looking statements with qualifying words such as we intend, plan, believe, estimate, or predict or we may, could or will or other comparable language.

Factors that could cause results to differ include factors discussed today in this conference call, in our press release today, as well as those detailed in the section entitled Future Growth and Operating Results subject to risk of Ditech’s Form 10-Q for the quarter ending July 31st, 2008 which was filed on September 8, 2008 with the Securities and Exchange Commission.

We assume no obligation to update these projections or other forward-looking statements. Additionally let me comment on our approach to corporate governance and SEC compliance. Please allow me to mention we have no off balance sheet entities or associations. We believe we have, to the best of our knowledge, disclosed all of our obligations related by transactions as required.

Our auditors do not perform consulting services for such items as system reviews, IT reviews or other forms of consulting services other than tax compliant services. We comply with all effective SEC and NASDAQ requirements related to audit committee compliance and independence. We continue to adhere to Sarbanes-Oxley compliance requirements.

Our discussion today of our operating results will be on a non-GAAP basis. Our press release posted on our website includes the summary information from GAAP and related reconciliation for Q2. The primary adjustments between GAAP and the non-GAAP in Q2 2009 are the elimination of approximately $715,000 related to stock compensation and $875,000 of restructuring charges.

Today’s announcement was released over the wire this afternoon in a press release and you may also read it on Ditech’s web site by going to the investor section of the site at www.ditechnetworks.com. All the non-GAAP financial measures will be disclosed on the call and again, a reconciliation of GAAP and non-GAAP measures is disclosed in our press release as well as our press release of August 21st, 2008 with respect to our fiscal Q1 numbers, again, which is on our web site.

With that I’d like to turn the call over to Todd to comment on the announcement and our strategy going forward.

Todd Simpson

Good afternoon and welcome everyone. Today we are discussing the results of our second quarter and will be commenting more directly on our forward path.

For the quarter ended October 31st, 2008, we had revenues of $4.1 million, slightly below the anticipated level. We expect similar levels for our next quarter. Bill Tamblyn, as he mentioned, will provide more details in his discussion in a few moments.

Our philosophy for the company in the short term is three-fold. First we have a focus on international markets, where the slowdown in spending may have less impact on our carrier customers.

Second, we are actively managing our operating expenses based on a short-term view of the revenue opportunities for our platforms, while at the same time ensuring that our core business carries through the current market down turn.

And third, we are investing at reasonable levels in our diversification strategy including both licensing and software diversification.

This philosophy translates fairly directly to how we are managing our cash and cash equivalents. We are aiming to run the VQA platform business at close to cash breakeven based on a two to three quarter revenue run rate. This includes absorbing much of our fixed overheads including our facilities and public company costs. The incremental money we are spending is on the forward vision.

Within that context I will comment on the three areas of our business, mainly the existing platform business, voice quality licensing and our diversification into support for advanced voice applications.

On the platform side we have mature and sustainable platforms for both TDM and Voice over IP networks, providing voice quality and product transcoding. The potential for our TDM products continues to revolve around the widespread deployment in large tier one networks.

This potential exists and is being pursued both in North America and internationally. The mobile industry continues to fluctuate on which strategy to adopt in their move to Voice over IP, so we see revenue potential for our TDM products for at least several more years.

Some carriers have struggled with deploying 3G voice and are thus relying more heavily on their 2G infrastructure for voice calls. And some carriers are looking at bypassing 3G altogether and moving to 4G or long-term evolution. This may leave their voice traffic on the TDM networks for longer than expected.

For our Voice over IP products the short-term potential is within application verticals where voice quality is an acknowledged business driver, namely applications such as conferencing and international peering as well as some web-driven applications. These applications are delivered by a mix of both large and small players. With the large players we are in various levels of testing and certification.

With some of the small players we have had problems positioning our large PVP platform due the cost of entry. With the recent release of a smaller form factor Voice over IP solution, we have a more compelling entry level solution for these smaller players.

I’ll now talk about our investments. And as previously discussed our first diversification effort is on licensing our voice quality algorithms. And we have chosen the Bluetooth space as our first target market for this.

Voice quality is a known differentiator in this market for both headsets and car kits. We have now officially launched VQA in the CSR chipset and are actively positioning our solutions to ODMs and large Bluetooth vendors. Our fully featured solution has excellent voice performance and has a small processing footprint, leading to the potential for longer battery life and integration with other advanced software features.

We are working towards revenue from this licensing initiative in calendar year ’09. Investment is not too large as it utilizes the technology that we have deployed in networks around the world. The design and production market is also consolidated around a small group of ODMs and OEMs making it a fairly efficient sales channel.

Our second and larger investment is in extending our value proposition beyond voice quality. Let me spend a few moments motivating our move into this space. First, we strongly believe that there is significant potential for operators to do more and make more money with voice, particularly as an interface to the Web, to enterprise applications and to personal content. Today voice represents the majority of revenue for many carriers and is in many ways the killer app for mobile devices. It will only become more so as it is used to access data and location based services.

The industry already is starting to see innovation with voice as the interface to rich content both on the Web and within enterprises. Services such as voice to email, voice search and voice notes are starting to gain traction worldwide. The overall potential for these applications is estimated to grow into multi-billion dollar industry over the next five years.

The increase in Smart phone sales and the uptake of the iPhone and the launch of Google’s Android operating system, all point towards much higher utilization of voice applications. Thus, we are investing in voice as it is our core area of expertise.

Second although there is this great potential for voice applications the traditional carriers are at risk of being left out of the opportunity. For example subscribing directly to a voice service through a website may only drive incremental minutes of use to the carrier instead of them participating in the service revenue itself. Voice to email would be a great example of this.

Whereas for traditional services like caller ID that have driven excellent margin and owned by the carrier, carriers may not even be aware of the voice applications that are running on their network. We believe that carriers can and should participate in voice service revenue perhaps more so than pure data services. Voice is a carrier's traditional expertise and by providing Web-based voice applications they can deliver new revenue producing services to their subscribers.

Third much like in the early days of beta applications on the Internet, voice applications are starting to proliferate but it is difficult for individual applications to reach the mass market. Unlike the Internet where search portals now give a single point of access to much of the Web content, voice portals are currently more complex and costly so there is certainly room for innovation in this area.

Our thinking in this space has been shaped through active dialogues with carriers and has led us to a strategy to enable them to provide what we call always-on voice services. An always-on service is one in which the user does not need to remember a phone number or the name of a specific application in order to access services or information. They can simply ask for the service any time they are on the phone. It’s a new approach to a single voice portal and one that can be owned and leveraged by the carrier.

Done successfully this approach requires the powerful and cost effective platform as our existing platforms provide the always-on service and voice quality, evolving into always-on services for voice applications that drive incremental revenue to the carrier is a natural path for Ditech Networks to take.

This last statement is important for us. This new initiative enhances our value proposition to one in which our customers can generate incremental revenue. Voice quality, our traditional offering, is often considered a cost savings value proposition. We believe that the combination of these value propositions will allow us to pull more platforms into the network and augment our platform revenue with recurring revenue from applications.

Our investment in these always-on services is twofold. First, we are investing in the software and platform evolution consistent with our history of delivering tier one solutions. Second, we are showcasing a lead application that demonstrates the potential of always-on services and that can be offered via software as a service.

The platform sales cycle is not expected to change. It takes up to 18 months to get a new platform adopted into a large carrier. However with software the service we can accelerate the potential for revenue as early adopters can be hosted on the service. Further early adoption of the hosted service can drive carrier interest and carrier acceleration.

In summary we have now turned the corner internally from a focus on voice quality to a more targeted focus on licensing and always-on voice solutions. The time to market for these solutions is typical of the industry, so this is not an overnight panacea for our current challenges. However this approach gives Ditech the potential to participate in the coming explosion of voice-enabled applications and to enhance our overall value proposition.

We are certainly cognizant of the balancing act between conserving cash and investing in the figure. We believe our current judicious investment strikes the correct balance in this regard. We are also actively watching the marketplace for opportunities to accelerate our business primarily from an accretive revenue generating angle.

With that I will hand the phone back to Bill Tamblyn to discuss our Q2 results in more detail.

Bill Tamblyn

I’d like to now share with you the final results for our second quarter of fiscal 2009, as well as our outlook for third quarter of fiscal 2009. The key points of the second quarter results are on a non-GAAP basis as noted in our press release and are as follows.

Revenues were $4.1 million. Non-GAAP gross margin was 50.5%. Non-GAAP loss from operations was $5 million. The non-GAAP loss was $5.3 million. The non-GAAP loss per share from continuing operations was $0.20 per share.

The second quarter non-GAAP details are as follows. The total revenue for the quarter was $4.1 million down 9% from the prior quarter of $4.5 million and down from $6.6 million for the same quarter in fiscal 2008.

International revenues were $2.2 million or 54% of total revenue. We had three greater than 10% customers in Q2, and they approximated 58% of the revenues. The non-GAAP gross profit for the quarter was $2.1 million or approximately 50.5% of revenues, down from the $2.3 million in the prior quarter.

Gross profit is affected by our graphic, geographic mix and absorption of overheads based on smaller revenues. The non-GAAP operating expenses were approximately $7.1 million for the quarter at the low end of our projection from the August conference call.

The details of the operating expenses for each area are as follows. Non-GAAP sales and marketing expense was $2.6 million. This was a decrease of $800,000 from the prior quarter due to reduced trade shows internationally, lower commissions and overall lower headcount and marketing activities.

The non-GAAP R&D expense was $3 million supporting our sustaining and new activities. This was marginally down from the Q1 level by $200,000. The non-GAAP G&A was $1.4 million, down from the prior quarters $1.8 million and approximately at the levels expected based primarily on lower accounting costs and headcount.

Other income expenses approximated an expense of $253,000 due to the Q2 write-down of two of our auction rate securities by $760,000 which was offset by interest income of approximately $500,000. The non-GAAP pretax operating loss approximated $5.2 million versus the non-GAAP loss of $6.3 million last quarter.

Non-GAAP income taxes and the expenses primarily tied to alternative minimum tax and foreign taxes, is nominal in the period. Our non-GAAP net loss was $5.3 million which is $0.20 per share compared with $6.3 million or $0.24 per share in the prior quarter.

To reiterate all the operating results that I have provided are on the non-GAAP basis, please refer to our press releases for the first quarter fiscal 2009 and the second quarter of fiscal 2008 comparative GAAP as well as the reconciliations of the non-GAAP results to our GAAP results.

Moving onto the balance sheet and cash flows, which are on a GAAP basis, cash equivalents, short-term and long-term investments at quarter end totaled $56.5 million. This was a $3.6 million reduction from the prior quarter. The cash level is consistent with our prior projections even with the inclusion of $760,000 write-down on two auction rate securities.

Cash used in operations was approximately $3.8 million for the quarter; this was as expected. At quarter end accounts receivables were approximately $1.9 million. This was a $2 million decrease from the prior quarter.

DSOs in Q2 equaled our long-term expectations at approximately 42 days compared with 77 days in the last quarter. As we have referred to many times, we would expect our long-term target to be between 45 and 55 days. Let me emphasize that our DSO numbers are subject to change; the timing of sales and shipments in any given quarter is always subject to fluctuations.

Net inventory was $13.7 million at quarter end up approximately $200,000 from the prior quarter of $13.5 million which reduced revenues. We did not utilize greater amounts of inventory in the period. At quarter end we believe the remaining inventory is still usable based on our forecasts.

Gross deferred revenues at October 31st were approximated $3 million up approximately $800,000 from the prior quarter. Capital spending was less than $100,000 in the quarter. Additionally we had bookings in excess of $6 million in the quarter, some of which will be shipped and/or recognized in subsequent periods; depreciation and amortization approximately $700,000.

We ended the quarter with approximately 118 employees, down from 143 in the last quarter. We continued to look at headcount and operating expense efficiencies as we move forward.

I will now review with you GAAP projections for the third quarter of fiscal 2009. In this regard please note the cautionary statements regarding these forward-looking statements that we gave at the beginning of the call. Our Q3 revenue outlook is derived from existing backlog, deferred revenues and our bookings forecast. Therefore we project them to be similar to the first half quarterly levels that we achieved.

We believe gross margins will be similar to Q2 levels at approximately 50%. This may vary based on product, customer mix and revenue levels. Regarding operating expense, we are continuing to maintain our TDM and packet platform businesses, but are moving staff to new initiatives. Operating expense in the third quarter will be tied to customer and channel mix as well as restructuring expense variability.

Overall we would expect our GAAP operating expenses, which includes an estimated $300,000 of stock-based compensation and approximately $600,000 in restructuring and severance cost at approximately $6.9 to $7.2 million. This would be an approximate $1.4 to $1.7 million decrease from the second quarter level. Our tax rate should approximate a range of 2% to 3% due to the loss situation. Deferred revenues at the end of Q3 are expected to approximate the $3 million level, similar to the quarter we just experienced.

Additionally a couple of other data points for you. Weighted average shares should continue to be calculated on a basic basis due to our losses and therefore approximate 26 million shares. Based on projected revenue and operating expenses we believe that operations will consume approximately $2 to $2.5 million in cash before working capital charges.

Looking at Q2 as a whole we are watching our cash flows, addressing opportunities and investing judiciously in our future product offering. We had reasonable booking activities and have a number of opportunities in the legacy business. Additionally, we are encouraged on the licensing activities; small yet minimal investing at software margins.

Lastly, we look to commence hosting our new applications in the new calendar quarter of 2009. In looking at Q3 we still have short-term concerns on transaction timing but will control our costs.

With these comments I'll turn it back over to Todd.

Todd Simpson

Thanks, Bill. [Art], we would be happy to open for Q&A at this point.

Operator

(Operator Instructions) Your first question comes from Michael Coady – B. Riley & Co.

Michael Coady – B. Riley & Co.

Todd, you commented, I think either you or Bill commented earlier that you expect your annum to run VQA at cash breakeven; you mentioned I think at a revenue level the last few quarters. The last few quarters you've seen variability from 77 to 41 so I've got to say it, what quarterly run rate would you expect VQA to be about cash breakeven?

Todd Simpson

Yes, so we're kind of looking at averaging over the last few quarters so, as you well know, doing exact projections going forward on a quarter by quarter basis is pretty tough but, so this is not a definitive number but cash flow breakeven based on looking back two or three quarters.

Michael Coady – B. Riley & Co.

So it's somewhere in the kind of 5.2, 5.3, in that ball park?

Bill Tamblyn

Yes.

Todd Simpson

That would be an approximate rate.

Michael Coady – B. Riley & Co.

You mentioned the cash burn from operations, or cash consumed in operations was 2 to 2.5 for working capital changes. The receivables look like they're down pretty low, yet the payables and accrued expenses were actually up. So I'm wondering will those reverse and consume cash in the quarter? Bill, do you want to provide a projection of cash balance at January 31st?

Bill Tamblyn

That's one of our difficulties right now. The receivables is down and it may go back up in Q3. The issues is as we have done more international activity the international payment timelines are difficult to project. There is the potential that the receivables will grow in Q3 based on those international activities. I don't know exactly where they'll end up because there are some that are on the edge of being collected in Q3 or potentially in Q4.

But the basics of the businesses will burn the 2 to 2.5 on operations before working capital, but if working capital does increase in Q3 it probably is flat to beneficial in Q4, so it's a tough one to project.

Michael Coady – B. Riley & Co.

And then I guess most importantly, you spent some time doing it but I still didn't get my arms around it, what new applications will you be hosting in the first quarter? I don’t understand what you're investing in in terms of the always-on voice solutions.

Todd Simpson

Okay. Well maybe I can try to come at it from a slightly different angle. There are a number of companies in the telecom space today that are taking sort of the traditional signaling capabilities and opening those up into the Web world where many more different developers can create innovative applications because the API's been opened up and exposed to the development community.

We're looking at doing much the same thing for capabilities in the media stream itself, in the voice stream itself, by giving access to increased functionality in the media stream. So traditionally we've done that for voice quality and I can give you a couple other examples that will maybe bring some applications to mind.

So elements such as keyword spotting or finding certain words in real time in voice conversations could trigger a lot of different types of applications. Understanding what language is being spoken by both participants on a call could bring in translation services or potentially maybe some legal intercept courses of action. And so there's a number of these media functions that we will open up and allow our customers to build applications around.

And so we have come up with these in discussions with the customers on the applications that they could drive and so they are actually now having a big influence in how we're developing and they see everything from consumer-centric applications that would extend the [inaudible] functionality to you and enterprise applications. So we're taking some of the voice-enabled enterprise applications and making them more accessible and more ubiquitous to the enterprise community, all the way through to more government or legal applications.

So although we are going to lead with a sample application, which is consumer-oriented, our customers are actually going to utilize the platform capabilities to build the applications they envision. Does that help?

Michael Coady – B. Riley & Co.

Absolutely. That helps very much, thanks. And how far along – could you potentially name any of your potential customers who use your application, like Web 2.0, application developers, some of the private yet some of the relatively well-known companies that might be your customers?

Todd Simpson

Well certainly in the long run we're targeting the traditional market that we have sold to and enabling the carriers to do some of these applications because as I said in the prepared comments, we believe that carriers can do an excellent job on voice applications and should participate in that. And so we have definitely been talking to some of our traditional customers and potential customers on how they could utilize this technology.

We are still a platform company at the base, right? And we see that as a huge differentiator. We don't intend to become up here a software application company because we believe that a hugely competitive market and it's hard to differentiate yourself. So we are leveraging the fact that you can do a lot of innovative things with a high performance platform, but moving beyond voice quality into applications where our customers see the potential to generate revenue.

Michael Coady – B. Riley & Co.

And then just lastly and then I'll jump off, you mentioned doing this initially in the first quarter of '09 and without getting too specific, how far along are you in terms of targeting customers? What do you expect? What impact could this have on the first quarter? And then a short question.

Todd Simpson

Yes, so I think it's going to have minimal impact in the first quarter so we have a version of the system running and it's demonstratable and we are showing it now to some customers but first quarter I think is optimistic for it to have an impact. We expect to be able to host it and start actively into the sales process maybe towards the end of the first quarter and into the second quarter and then look for actual update on the revenue side mid or later in the calendar year.

Operator

(Operator Instructions) Please go ahead Mr. Coady.

Michael Coady – B. Riley & Co.

I missed what you said about the international before? I was trying to do two goals at once; 52% did you say, Bill?

Bill Tamblyn

Let me just double check. It was $2.2 million or 54%.

Operator

And there's no one else in queue. Please continue with any closing remarks.

Todd Simpson

Thanks [Art] and thanks everyone. Let me just close reiterating quickly our current operating philosophy. So over the last year we have sized and organized the existing voice quality platform business to run at essentially breakeven based on our current revenue run rates. We're investing $1.5 to $2 million a quarter in the licensing and always-on initiative that I've just outlined that we think have great potential.

So we believe this is a prudent course of action given both the upside potential and the downside risks of the current markets. We look forward to updating you further in about three months. Thanks again.

Operator

And ladies and gentlemen that does conclude your conference for today. Thank you for your participation.

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