Earnings Call Transcript - RBBN Q2 2023

Operator, Operator

Greetings, and welcome to the Ribbon Communications Second Quarter 2023 Financial Results Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joni Roberts, Chief Marketing Officer. Thank you, Joni. You may begin.

Joni Roberts, Chief Marketing Officer

Good afternoon, and welcome to Ribbon's second quarter 2023 financial results conference call. I am Joni Roberts, Chief Marketing Officer at Ribbon Communications. Also on the call today are Bruce McClelland, Ribbon's Chief Executive Officer; and Mick Lopez, Ribbon's Chief Financial Officer. Today's call is being webcast live and archived on the Investor Relations section of our website at rbbn.com, where both our press release and supplemental slides are currently available. Certain matters we will be discussing today, including the business outlook and financial projections for the third quarter of 2023 and beyond, are forward-looking statements. Such statements are subject to the risks and uncertainties that could cause actual results to differ materially from those contained in these forward-looking statements. These risks and uncertainties are discussed in our documents filed with the SEC, including our most recent Form 10-K and Form 10-Q. I refer you to our safe harbor statement included on Slide 2 of the supplemental slides for this conference call. In addition, we will present non-GAAP financial information on this call. Reconciliations to the applicable GAAP measures are included in the earnings press release we issued earlier today, as well as in the supplemental slides we prepared for this conference call, which again are both available on the Investors section of our website. And now I would like to turn the call over to Bruce. Bruce?

Bruce McClelland, Chief Executive Officer

Great. Thanks, Joni. And welcome to the Ribbon team, and thanks to everyone for joining us today. I'm pleased to report a very solid quarter with financial results above the midpoint of our guidance. Our focus on growing enterprise and cross-selling our IP Optical portfolio is working with growth in both sales and earnings. For the first half of the year, sales have increased 5% year-over-year, and earnings have improved 66% or $8 million on an adjusted EBITDA basis. In the second quarter, sales increased 2.3% year-over-year to $211 million with continued growth in India resulting in sales in Asia Pacific increasing 21%, while EMEA sales were up 1%, and overall North American sales were down 2%. In the Optical segment, we continued our trend of double-digit year-over-year growth for the fourth consecutive quarter with sales increasing 24% year-over-year. In the Cloud & Edge segment, as expected, sales were down approximately 9% year-over-year, primarily due to lower sales to Verizon as compared to the record sales a year ago. This was offset by continued strength in our enterprise business with product sales increasing 94% year-over-year, reaching a new high of 44% of overall Cloud & Edge product sales in the quarter. This includes revenue from a very strategic win in the U.S. Federal space, the first of what we believe will be many voice modernization projects. Government agencies need to transform their legacy communication infrastructure to modern, cloud-based, unified communication platforms with high levels of security and survivability. This initial project includes products and services exceeding $10 million, a substantial portion of which was recognized this quarter. As a result of the overall mix in the quarter, gross margins were strong at 52%, above the high point of our guidance. Combined with lower operating expenses, adjusted EBITDA was also towards the high end of guidance at $23 million. Products and service booking to revenue for the first half of the year was 1.05x with the second quarter at 0.9x following strong bookings in the first quarter. Now, a little more detail on each of the operating segments...

Mick Lopez, Chief Financial Officer

Thank you, Bruce. Good afternoon, everyone. For the second quarter of 2023, our financial results showed continued improvement over the prior year, bolstered once again by double-digit revenue growth in our IP Optical Networks business. Please refer to our Investor Relations page on the Ribbon website for supplemental slides summarizing our second quarter 2023 and historical financial performance. Let's begin with consolidated corporate financial results. In the second quarter of 2023, Ribbon generated revenues of $211 million, which is an increase of $5 million or 2% from the prior year, and $24 million or a 13% increase from the first quarter. Non-GAAP gross margin was 52%, which is about 300 basis points lower than prior year, mostly due to the change in business segment revenue mix, and a 400 basis point improvement from the previous quarter, driven by revenue increases and product mix. Non-GAAP operating expenses were $90 million, a decrease of $6 million or 6% year-over-year and down $5 million from the previous quarter. As announced earlier this year, we implemented a strategic restructuring plan to streamline operations, reduce costs, and focus on growth areas. We have optimized real estate, renegotiated supplier terms, and driven headcount synergies. We are definitely on track to exceed our operating expense reduction target of $20 million year-on-year. Our non-GAAP net income was $8 million, which generated a non-GAAP diluted earnings per share of $0.04. Our non-GAAP tax rate for the quarter was 30%. Our interest expense for the quarter was $6.8 million, which is a $2 million increase from the previous year. Non-GAAP EBITDA was $23 million in the quarter, which is a $2 million or 9% improvement year-over-year, and a positive change of $25 million from the previous quarter. Our basic share count was 170 million shares, and our fully diluted share count was 175 million shares for the quarter. Now let's look at the results of our two business segments...

Bruce McClelland, Chief Executive Officer

Great. Thanks, Mick. As I look into the second half of the year, it's clear that our strategy to diversify the company has become increasingly important and is working. From an industry perspective, enterprise has become a significant new growth vector for the company that counterbalances variances in service provider spending. From a portfolio perspective, the addition of IP routing and optical transport has opened major new opportunities such as the U.S. Rural Broadband segment. And from a geography perspective, the company is very well positioned in high-growth areas such as India and Africa. Our financial projections for the second half of the year benefit from this strategy and are based on four key assumptions. First, in the North American service provider market, we expect the elevated spending by U.S. rural broadband providers to continue, and likely increase over the next several years, as new funding sources become available. Our portfolio is a great fit, and we're taking share. We expect the rural broadband opportunity to offset more constrained spending by Tier 1 U.S. service providers in 2023 with increased spending anticipated in 2024 for voice network modernization, given the compelling business case that reduces operating costs. As I mentioned earlier, we've also seen increased activity in this area across multiple regions with service providers who have not made this a priority in the past. Second, we will continue to gain share in the enterprise market vertical as investment in communication and collaboration platforms enables companies to improve their efficiency and effectiveness. This includes several major U.S. Federal opportunities that we anticipate being awarded in the second half where we are very well positioned and expect to generate significant revenue. Where it makes sense, we're transitioning the business model with enterprise customers away from perpetual licenses to subscription models that will create a more predictable recurring revenue stream for the business...

Christian Schwab, Analyst

Hey. Congratulations on the strong results.

Bruce McClelland, Chief Executive Officer

Hey, Christian, I apologize. You're breaking up, I think.

Christian Schwab, Analyst

Hello?

Bruce McClelland, Chief Executive Officer

Yes, try again, Christian.

Christian Schwab, Analyst

I'm sorry about that. I was asking on rural broadband, could you tell us how big that could be over a multi-year timeframe?

Bruce McClelland, Chief Executive Officer

Yes, so thanks, Christian. Good to connect again. So obviously we've seen that grow substantially here this year. I think we're up about 3x from what we were doing last year. I think there are some upper bounds just from a construction resource perspective in the whole industry. So it's hard to predict exactly what the growth looks like next year. It's not a lack of funding at this point, particularly as BEAD funding starts to flow in into the second half of next year. I think the limitations are going to be more at the pace that they can do construction and drive fiber. But as the funding envelope increases the amount of addressable market, for us it certainly is going to expand. So I expect it to grow pretty well going into next year.

Christian Schwab, Analyst

And then on the IP Optical business, can you tell us how many customers that you're selling to currently, and what we should anticipate that number of customers to expand to say by the end of '24 as new introductions come up?

Bruce McClelland, Chief Executive Officer

Yes, so that's a good question. I don't have a number off the top of my head. In a particular quarter, the majority of the revenue will come from several dozen customers within the quarter, let's say. And we are definitely adding customers every quarter. A number of our projects are with critical infrastructure projects or operators. And so, every quarter there's somebody new being added. We do try and kind of keep up a good cadence of press releases every quarter on some of the more strategic adds we've had within a quarter. So I think that gives you an indication of kind of the velocity every quarter of new names being added. And of course, some are smaller projects and some can account for much larger revenue stream in the future.

Christian Schwab, Analyst

Great. And then my last question, I know you guys have talked about for some time, landing material business on the optical side with the top Tier 1 carriers. Do you have any updates for us on how that's going or is that something you're enthusiastic for over the next 12 months?

Bruce McClelland, Chief Executive Officer

Yes, there is certainly a strong pipeline in three main regions: North America, Europe, and Asia Pacific. We have already announced some expansions, such as our collaboration with Bharti and wins in Africa with MTN, Singtel, and Optus, as well as Rogers in Canada. We are clearly gaining momentum. I mentioned Japan as a new market for us, where Ribbon has a strong presence with our voice infrastructure products. While we haven't disclosed any names in that region yet, I believe there are significant opportunities ahead. As I noted, Japan accounted for about 5% of our revenue in the third quarter. So, stay tuned as we continue to focus on this area alongside building momentum with regional telecoms and critical infrastructure providers.

Timothy Savageaux, Analyst

I have a couple of questions that build on the recent discussion. You mentioned that IP Optical revenue in the U.S. is at 15%, primarily driven by rural areas. Last quarter, U.S. rural accounted for 10% of IP Optical revenue, and it's clear you anticipate growth in that segment. How should we connect this with your insights on Japan in relation to India? You also mentioned growth in India, which I assume is your largest market, possibly exceeding the U.S. in terms of country or regional scale. With the expected growth in rural broadband over the next couple of years, could it surpass some of the larger markets you’re currently discussing? Can you provide some context on India's current position and the margin implications that the growth of U.S. rural broadband might have for this segment?

Bruce McClelland, Chief Executive Officer

Yes, great. All good questions. So, the 15% of sales was a North American number, and rural broadband is a significant portion of that. As you recall, we've got a number of other customers in North America, including Rogers up in Canada, that all contribute to that 15% of sales. But the rural broadband portion was more than half of that certainly in the quarter. As you kind of compare it to India, India is still significantly larger than North America today. I think more than 2x, Mick, right, in that ballpark?

Mick Lopez, Chief Financial Officer

Yes.

Bruce McClelland, Chief Executive Officer

So, of course, we have one large customer in India with Bharti that we've enjoyed good growth here this year. As I mentioned, getting kind of back to maybe where we were a few years ago was our strongest quarter we've had since we merged the companies together. So, back to your final question on how big can rural be? We're in some ways just getting started. I mean, we've had some really good success with customers that know us well, that have other products from us deployed today, and that's allowed us to start to build a good pipeline with new customers. I don't know if it can be bigger than India. I mean, India's 1.2 billion people, three major operators there that I think are going to drive a lot of scale. We're deployed in enterprise markets in India as well with partners like Tata Teleservices and folks like that. So I think that's going to remain a really significant market for us.

Timothy Savageaux, Analyst

And maybe a similar question around Japan. I mean, I think you're implying your production there is likely with Tier 1 carriers, but how significant can that get for you over time?

Bruce McClelland, Chief Executive Officer

Again, we're kind of just entering the market. I mean, it was great to see some of the momentum there with several operators, a number of different use cases, both in optical as well as in IP. So I'm pretty excited about that market. We've got a great infrastructure in place in Japan. It was one of the kind of strategic elements to the combination several years ago and focused on cross-selling. It's taken us a while to go through the vetting process, go through the testing process now into commercial service. So it will add another plank to the operation here for us for sure.

Timothy Savageaux, Analyst

Okay. And last question for me. Obviously after a very strong Q1, IP Optical orders came down pretty significantly in Q2. I guess, how would you characterize that and what are your expectations for orders in IP Optical in the second half?

Bruce McClelland, Chief Executive Officer

Yes, so there were kind of two reasons why the order velocity was lower in the second quarter, all related to the strong first quarter. I'd mention previously that part of the bookings in Q1 was a large multi-year agreement with a defense operation in Europe. A portion of those orders were for the second quarter, so we were shipping those in the second quarter. Normally, we would have gotten those bookings in the second quarter, but they were all accelerated into Q1. And then the other part was around some of the expansion - market share expansion in India with Bharti and some of the larger orders that we're shipping against in the second and third quarter. So I'm not, although - obviously numerically the number is down in the second quarter for the first half, I think we're at 1.15 for IP Optical for the first half or 1.14, some number like that. So, I still feel good. Obviously, for the second half of the year, we're still projecting growth going into the second half. I think to achieve our 15% plus annualized growth number, the second half will grow more than 10% versus last year. So, we're feeling good about the velocity in the second half here.

Dave Kang, Analyst

First question is on the IP Optical. Just wondering if you can talk about their EBITDA trajectory in second half and into next year? I mean, will they be positive? And just wondering if it will dip into negative in first quarter next year before becoming positive in second quarter? Just if you can help us out.

Bruce McClelland, Chief Executive Officer

Yes. So I think if you do the modeling on the business here with assumptions on margin and OpEx and whatnot, the target for the second half is to get to EBITDA breakeven and positive. So that's what the whole team is focused on. That's the reason we've done the acquisition. This business needs to contribute. You need to be in the $100 million plus range per quarter with where margins are projected to be there. And that's what the target is for the second half. We do find that the first quarter tends to be a lower quarter every year. So whether we'll be at that level or not in the first quarter is a little too early for me to provide additional commentary on. But the focus here is on the second half and making sure we get to that mark in the third and fourth quarter combined.

Dave Kang, Analyst

And then I believe, regarding the supply chain situation, I think that impacted your revenue by about $10 million in first quarter. Just wondering what that was in second quarter?

Bruce McClelland, Chief Executive Officer

Yes. It was very similar, Dave. Really the same sort of issues as we're ramping in particular our long haul products and our Cell Site Router products. We could have shipped more in the quarter again not unlike others, I'm sure, right? So I didn't comment on it this time. But very, very similar in the second quarter. I do think we get more caught up in the third quarter on some of the longer lead time parts on the new products. So as I mentioned, I think as we get into the second half of the year, the majority of those existing issues are behind us, who knows what new surprises we find in the future.

Dave Kang, Analyst

So should we expect something like maybe $5 million impact in third quarter or is it going to just go to zero?

Bruce McClelland, Chief Executive Officer

It's in that ballpark probably, Dave. There's always something that ends up kind of hanging out to the next quarter. So it's probably in that ballpark, yes.

Dave Kang, Analyst

I'm curious about the breakdown of the growth in IP routing. Can you provide details on the performance of IP compared to optical, and what the margin difference is between the two?

Bruce McClelland, Chief Executive Officer

Yes, we have historically mentioned that the split for IP routing is in the 35% to 40% range. This percentage has been increasing over the past few quarters due to the growth rate in IP. Currently, I believe it's over 40% from a product revenue perspective given the recent growth. Both businesses have shown growth, with optical increasing by about 20% and IP by approximately 40%. Optical is also growing, but the mix is continuing to shift more towards IP routing, and we anticipate this trend will continue over time.

Dave Kang, Analyst

And what's their margin differential? Is it about 5%, 10%, something like that?

Bruce McClelland, Chief Executive Officer

Yes, so we don't break that out. It varies by region and the type of product. If it's a higher volume Cell Site Router type product that tends to be a little lower margin. If it's more a high-performance 4 terabit routing platform, that's much better margin. So it can vary a little bit, Dave, just depending on the mix and the type of products we're shipping in the quarter. In general, the trend is towards higher margin on the IP products.

Dave Kang, Analyst

And my last question is actually a clarification. Did you say C&E will be kind of flat this year or maybe I misheard?

Bruce McClelland, Chief Executive Officer

Yes, so I've characterized the third quarter as being similar to the second quarter with a stronger fourth quarter, and overall in the second half, earnings contribution will be up from last year. So I've kind of given those two data points.

Greg Mesniaeff, Analyst

My question is on the Cloud & Edge segment. You had mentioned in the call that you're in the process of transitioning your revenue model from one of a perpetual license to a subscription-based model, and I totally understand why you're doing that, namely to smooth out the lumpiness that this business has had. Can you kind of give us a little more color as to what the steps are to kind of proceed down that path and where you are in that process? In other words, are you keeping your existing customers on perpetual licenses and starting new ones with the subscription model? Or are you weaning the older customers off the perpetual license to the subscription model? And then I have a quick follow-up. Thanks.

Bruce McClelland, Chief Executive Officer

Yes, hi Greg. That’s a good question. Most of this activity is focused on the enterprise space rather than the service provider or carrier space. The acceptance and interest are primarily on the enterprise side. There are a couple of models to consider. For instance, our Ribbon Connect offering serves as a fully cloud-based multi-UCaaS platform for Microsoft Teams, Zoom, or Cisco Webex, featuring a per subscriber, per seat, per month pricing model. Although this segment is relatively small right now, it represents a typical as-a-service revenue stream that is growing. Another approach involves transitioning from a perpetual license for something like an SBC to a term license, which could be an enterprise-wide license that encompasses software licenses, maintenance, and professional services. This represents a more significant shift that we are currently pursuing. It allows for the renewal of licenses every year or whatever duration is established for the term license. This is likely the most substantial change we are making, involving both new and existing customers. Many of our products, such as session border controllers and analytics platforms that have a high software content, are well-suited to this model. We are observing considerable interest in moving towards this structure.

Greg Mesniaeff, Analyst

Are customers being receptive to this transition, would you say, especially the legacy larger ones on the carrier side?

Bruce McClelland, Chief Executive Officer

Yes, I wouldn't describe it as we're trying to force it. We'll meet the customer wherever the economics are best to meet their needs. So most of the cases, this is not just a receptive thing. The customer is very interested in that type of approach. Again, it's mostly around enterprise, not so much around the carrier side, although the Ribbon Connect platform, as I mentioned is used by a number of carriers and it supports their managed service offering to enterprises. So it fits that model pretty well.

Erik Suppiger, Analyst

A couple of questions. First off, did you see that Verizon was a 10% customer? Did you notice the adjustments to inventory that were mentioned by companies like Ericsson and Nokia regarding some of these carriers working down their inventories? Or was Verizon within the range that you had anticipated?

Bruce McClelland, Chief Executive Officer

Thank you for your questions, Erik. From Verizon's standpoint, we had an excellent quarter last year in the second quarter of 2022, driven by several voice modernization programs, all contributing to revenue during that period. Therefore, the comparison isn't entirely fair since it was our best quarter ever with Verizon. Consequently, the year-over-year decline is significant. However, if you exclude Verizon from our revenue figures for both periods, the service provider business actually showed year-over-year growth. The situation is mainly influenced by the exceptionally strong quarter we had last year. The challenges you're hearing about, such as inventory builds from others, don't apply here. It’s simply a tough year-over-year comparison, and our results ended up exactly where we had predicted for the quarter, consistent with the previous quarter as well. Once our 10-Q is out, you’ll see the percentage of revenue we report from our 10% plus customer.

Erik Suppiger, Analyst

Yes. From a Q4 margin perspective, we do expect Q4 margins to be stronger in both businesses. As Mick mentioned in detail, the increased margin around IP Optical is largely due to the higher level of revenue and fixed cost absorption driving a higher gross margin percentage in Cloud & Edge. The mix is important, and the velocity at the revenue level also makes a difference. We have a strong pipeline of larger deals, both in enterprise and with service providers for Q4. Additionally, there is a transition towards more annual ELAs that benefit us, along with a stronger software mix overall in Q4. Your model sounds accurate.

Bruce McClelland, Chief Executive Officer

Yes, I think it's similar. Erik, unfortunately, I don't have that number in front of me, so I'm going to have to go do some more research on it. I apologize.

Timothy Savageaux, Analyst

Hi. I wanted to follow up on the profitability in IP Optical. It seems that in Q2, you significantly reduced your cost base related to the breakeven revenue run rate in IP Optical, around $5 million or $6 million. This is also reflected in your overall operating expenses performance. Is that accurate? Is that level where you expect it to remain? It appears you are forecasting your EBITDA loss in IP Optical to be cut by half or perhaps a bit more in Q3, assuming that comes from increased revenues and gross margins as Mick mentioned, along with stable operating expenses in the high 30s range. Is that a reasonable way to view the situation, and are you looking to be EBITDA positive in Q4?

Bruce McClelland, Chief Executive Officer

Yes. I don't want to go into too much detail about the Q3 guidance. What you mentioned is generally accurate. Achieving breakeven in the second half relies on both Q3 and Q4, with Q4 volumes expected to be higher, leading to greater profit. The cost and spending improvements we’ve implemented are ahead of our expectations for the year, benefiting both businesses. In Q2, we were around $3 million better in operational expenses for IP Optical, and we also have some savings beyond the gross margin line in service costs and similar areas. We anticipate this trend will continue at that level, certainly for the company overall. I believe we had $90 million in operational expenses in Q2, and we expect to remain in a similar range, plus or minus $1 million, in Q3 and Q4, which should allow us to exceed $20 million in net savings for the year in operational expenses.

Operator, Operator

Thank you. There are no further questions at this time. I would like to turn the floor back over to Bruce McClelland for any closing comments.

Bruce McClelland, Chief Executive Officer

Okay, great. Well, thanks, Paul. Thanks everyone for being on the call here with us again today, your interest in Ribbon Communications. We have a number of upcoming investor conferences, so we look forward to meeting everyone there and continuing the dialogue. Thanks very much, operator, appreciate your help. And that concludes our call.

Operator, Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.