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Ribbon Communications Inc. (NASDAQ:RBBN)
Q3 2020 Earnings Call
Oct 29, 2020, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good afternoon, everyone, and welcome to the Ribbon Communications third-quarter 2020 earnings conference call. [Operator instructions] Please also note, today's event is being recorded. At this time, I'd like to turn the conference call over to Monica Gould, investor relations for Ribbon Communications. Ma'am, please go ahead.

Monica Gould -- Investor Relations

Good afternoon, and welcome to Ribbon's third-quarter 2020 financial results conference call. I'm Monica Gould, investor relations for Ribbon Communications. Also on the call today will be Bruce McClelland, Ribbon's chief executive officer; and Mick Lopez, Ribbon's chief financial officer. Today's call is being webcast live and will be archived on the investor relations section of our website at ribboncommunications.com, where both our press release and our supplemental slides are currently available.

Certain matters we will be discussing today include the business outlook and financial projections for the fourth quarter 2020 and beyond and 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 the 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 this afternoon, as well as the supplemental slides for this conference call, which again, are both available on the investor relations section of our website. As we previously noted, we completed our acquisition of ECI Telecom on March 3, 2020, which impacts comparisons to prior periods. Ribbon operates as a single segment.

However, for the sake of clarity, we are continuing to include additional detail on the former ECI Telecom business performance. As we continue to integrate, we expect to transition to providing business unit performance in Q4 2020 rather than legal entity financials. And now I would like to turn the call over to Bruce.

Bruce McClelland -- Chief Executive Officer

Thanks, Monica. Good afternoon, everyone, and thank you for joining us during this busy earnings week. I hope that you're all healthy and safe. We're very pleased to report strong third quarter results that exceeded our expectations.

We're clearly beginning to see the benefits of our strategy to diversify and broaden our portfolio, combining a strong software business with a higher growth Packet Optical business, resulting in both strong profitability and revenue growth. We achieved a new record level of adjusted EBITDA during the quarter on the strength of increasing software sales in our Cloud & Edge business, and we're very encouraged by the improvement in our Packet Optical business, with sales increasing 22% sequentially and a positive adjusted earnings contribution for the quarter. Our strategy to sell the expanded portfolio to our combined customer footprint is beginning to bear fruit. As noted last quarter, our customers continue to see elevated voice and data traffic levels related to the increased usage of digital and social platforms, as well as broad-based adoption of online collaboration platforms, such as Microsoft Teams and Zoom.

Both service providers and enterprises have responded to this network strain by increasing or accelerating their investment in capacity and capabilities, directly aligning with our portfolio offerings and strategy. Our engagement level with customers remain strong. RFP activity has increased significantly, and we've been able to leverage remote proof-of-concept product demonstrations in place of on-site lab evaluations. Visibility in the business remains solid, and we have no significant supply chain restrictions.

Lower travel and marketing activity have also contributed to the lower operating expenses in 2020. I'd like to start by highlighting a number of recent notable customer accomplishments and activity in the quarter. A key part of our strategy is to strengthen our Packet Optical business and presence in North America, leveraging the position we have with the Cloud & Edge portfolio. In particular, we have a strong focus on cable operators, as well as the regional telco providers.

We're making good progress on this strategy and expect to report meaningful sales in the fourth quarter. More broadly, we've continued our Packet Optical Networks momentum, securing business with eight new critical infrastructure and enterprise customers in the quarter, including a smart city project in Asia; a large European railway deployment; a European car manufacturer; and expansion of a national research and education network in Europe. In India, the long-standing dispute between the telecom service providers and the Department of Telecommunications has been resolved by their Supreme Court. Closure on this issue provides certainty over the operating environment and a path to renewed investment in the country's communications infrastructure.

While we expect it will take several quarters for spending to fully rebound, we're optimistic about the opportunity for growth in 2021. We had very strong sales of our SBC session management portfolio in the third quarter across a variety of applications and regions, contributing to the earnings beat this quarter. As an example, we continued the strong momentum we have in the financials vertical with a large software order from a major U.S.-based multinational bank to support their migration to Microsoft Teams and to increase call center capacity. Our high-performance Enterprise and Service Provider SBC platform sales are up more than 25% year-to-date.

As adoption and usage of cloud-based communications and collaboration platforms accelerate, we have expanded our offerings to include multiple cloud-native deployment and usage models. We also announced additional Zoom phone certifications this quarter. Finally, we secured several new contracts for our Call Trust platform, that addresses the growing security challenges related to fraud and robocalling. Bookings for this solution in the quarter were three times the level of the previous quarter.

Despite operating in the midst of the COVID pandemic, we've made great progress on the integration of Ribbon and ECI and implementing organizational efficiencies across the company. Last month, we announced that Sam Bucci has joined Ribbon to lead our Packet Optical Networks business unit. Sam was previously with Nokia, responsible for their multibillion-dollar optical division. I couldn't be more excited to have Sam join the team and supercharge our efforts to expand our presence and share of this massive multibillion-dollar packet and optical market.

Also last quarter, we announced that we've signed an agreement to sell our Kandy Cloud Communications business to American Virtual Cloud Technologies. We continue to make progress on the deal, which remains contingent on successful completion of their capital raise. Year-to-date, Kandy has contributed $10 million in sales with a $12 million EBITDA loss. I'll now ask Mick to comment in more detail on our Q3 performance, and we'll then come back on to talk about our outlook for the business.

Mick?

Mick Lopez -- Chief Financial Officer

Thanks, Bruce. We had exceptional third-quarter financial performance that exceeded our expectations. Please refer to our investor relations website for supplemental slides with graphs and tables summarizing our third-quarter performance. Total revenue of $231 million in the third quarter was comprised of $154 million for Cloud & Edge and $78 million for Packet and Optical.

As Bruce mentioned, we continue to make great traction in our integration efforts. We plan to transition to providing business unit performance rather than legal entity financials, commencing in our fourth quarter of 2020. Given the ECI acquisition, all year-on-year comparisons are against Ribbon's stand-alone unless otherwise noted. The third quarter 2020 GAAP financial results were as follows: total company revenue was $231 million; income per share was $0.04, which included a benefit of $0.03 from the release of a tax valuation allowance from our Ireland legal entity.

For Ribbon, as a total company, our non-GAAP third quarter performance was total revenue of $231 million versus $210 million last quarter, and guidance range of $210 million to $220 million. Non-GAAP gross margin was 59%. Non-GAAP operating expenses were $98 million. Non-GAAP adjusted EBITDA was $43 million compared to $23 million last year, and was above the guidance range of $25 million to $29 million.

The improvement in adjusted EBITDA was due to both higher sales and better gross margins in both Cloud & Edge and Packet Optical Networks. Non-GAAP diluted earnings per share was $0.16. Our diluted share count for the third quarter was 152 million shares compared to 111 million shares in the prior year, with the increase primarily driven by the ECI acquisition. In the Cloud & Edge business, third quarter revenue was $154 million, reflecting growth of 12% from the previous year, driven by strong demand from our service providers.

Our largest customer, Verizon, had some major projects this past quarter and accounted for 16% of our total revenue. Software revenue grew significantly and was 69% of overall product sales in the quarter, resulting in better non-GAAP gross margins for Cloud & Edge of 66% versus 64% in the third quarter of the previous year. Our non-GAAP operating expenses of $63 million decreased 8% from the prior year period, driven by restructuring savings, temporary employee salary reductions and minimum travel and other discretionary expenses. Cloud & Edge non-GAAP operating margin was 25%, which is 11 percentage points higher than last year.

Non-GAAP adjusted EBITDA for Cloud & Edge was $42 million, which is $19 million higher than last year and reflects an exceptional adjusted EBITDA margin of 27%. Now some additional perspective on Cloud & Edge. We recorded $75 million of product revenue and $79 million of services revenue. In the third quarter of 2020, Cloud & Edge software product revenue increased by $21 million or 39% compared to the same period last year.

Software accounted for 69% of total product revenue in the third quarter compared to 51% in the third quarter of the previous year. The Packet Optical Network business recorded third quarter revenue of $78 million, an increase of $14 million or 22% from the previous quarter. From a profitability perspective, we are pleased to report a positive adjusted EBITDA of $1 million for our ECI entity, driven by exceptionally strong gross margins of 46%, an increase of 700 basis points sequentially and continued expense controls. We would like to provide some consolidated metrics for the third quarter.

Our book to revenue ratio excluding maintenance, was 0.93 times as compared to 1.12 times in the second quarter of 2020. We continue to have a solid pipeline, providing us with good visibility into sales in the upcoming quarter. Software revenue accounted for 43% of total product revenue across the company. Maintenance represented 32% of total revenue.

Our top 10 customers accounted for 49% of total revenues, which compares to 47% in the second quarter of 2020. Service providers accounted for 71% of revenue in the quarter, and Enterprise customers represented 29%. International customers represented a greater percentage of revenue with 55% of revenue in the third quarter of 2020 as compared to 52% in the second quarter of 2020. Turning to the balance sheet.

We ended the quarter with cash and cash equivalents of $111 million, including restricted cash of $7 million. This is an increase of $17 million from the previous quarter. The principal balance of our term loan was $395 million as of September 30, which is down $2.2 million, reflecting a quarterly scheduled principal payment. Our revolver of $100 million remained undrawn.

The effective interest rate on our term loan was 4.4% in the third quarter of 2020, as compared to 3.9% for the second quarter of 2020. The rate increase was driven by the higher interest rate percentage for the $75 million tranche of our Term Loan B that was assigned on August 18. For details, please refer to our 8-K filed in August or in our 10-Q to be filed in the next business days. Once again, we comfortably met our quarterly financial covenants.

As per our credit facility calculations in Q3 2020, our leverage ratio was 2.6 times versus a maximum of four times, and our fixed charge coverage ratio of 3.9 times versus a minimum of 1.25 times. From a cash perspective, the company generated $29 million of cash from operations which included an accelerated final payment receipt of $16.75 million from the Metaswitch legal settlement. We anticipate approximately $4 million for restructuring and acquisition-related expenses in the fourth quarter of 2020. Capital expenditures were $4 million for the quarter, which included $2 million of real estate leasehold improvements for our North Dallas offices facility.

Now let's turn the call back to Bruce.

Bruce McClelland -- Chief Executive Officer

Great. Thanks, Mick. As we look to the fourth quarter and into 2021, we expect many of the key trends supporting our business to continue. In our Cloud & Edge portfolio, adoption of cloud collaboration platforms, such as Microsoft Teams and Zoom Phone will continue to create demand for our growing portfolio of SBC products from both service providers and enterprise customers.

A significant portion of this business is now transitioned to enterprise software solutions, as well as capacity growth via license activation on existing infrastructure. In 2021, we expect the consumption model to begin to shift to recurring revenue, leveraging our new cloud-native service offerings. Overall, we expect continued profitable growth in the SBC product category. Our network transformation business has seen a burst of activity this year to adjust to traffic growth related to the work from home transition.

We expect the investment in digital transformation to continue, but a slower pace in 2021. However, we're seeing adjacent alternatives in areas such as service assurance, machine learning and analytics, and fraud and robocall mitigation that leverage our installed base with high-margin software applications. And we expect the associated technical support revenue stream to continue given the lifeline critical nature of the service deployed on these platforms. We'll further benefit from the portfolio adjustments and operational efficiencies we've made in 2020 that will lower our overall operating costs and improve the earnings power of the company.

In our Packet Optical business, we're very pleased to see the recovery take shape after a slow start to the year. While the operating environment remains challenging, we're clearly making progress on our strategy and are well positioned to gain share as the spending environment improves. Several factors contribute to our optimism, including resolution of the India AGR dispute, paving the way to clear capital allocation plans and investment in this large important market; growing negative sentiment toward Chinese manufacturers, unlocking significant market share growth opportunity; the investment shift toward 5G capable transport platforms and recognition of Ribbon's technology leadership; and the potential for cross-selling the entire Ribbon portfolio and in particular, gaining momentum in the critical North American market with our Packet Optical portfolio. We believe the combination of these factors will result in a major transformation for Ribbon, which in fact, is already well under way, strengthening our balance sheet and creating significant shareholder value.

In the near term, for the fourth quarter, we anticipate further revenue growth with sales in the range of $235 million to $245 million, primarily related to the continued improvement in the Packet Optical business. We expect profitability to be in the range of $36 million to $40 million of adjusted EBITDA, reflecting the higher mix of Packet Optical sales, as well as slightly higher opex of approximately $105 million as we eliminate temporary salary reductions. Non-GAAP earnings are projected to be in the range of $0.12 to $0.14 per diluted share. This guidance excludes any potential effects of the proposed sale of Kandy and assumes existing COVID-19 conditions.

In summary, we just had a great third quarter with exceptional performance by Cloud & Edge and improved results in our Packet Optical Network business. We expect this trend to continue in the fourth quarter. Operator, that concludes our prepared remarks, and we can now take a few questions.

Questions & Answers:


Operator

[Operator instructions] And our first question today comes from Paul Silverstein from Cowen and Company. Please go ahead with your question.

Paul Silverstein -- Cowen and Company -- Analyst

Thanks. Good evening Bruce. Thanks for taking the question. First off, that particular banking deal you referenced, the large deal, can you give us any sense for how large that is?

Bruce McClelland -- Chief Executive Officer

Multimillion, Paul. Not eight digits, but well in the sevens. So...

Paul Silverstein -- Cowen and Company -- Analyst

And that's just the one quarter or that extends over time?

Bruce McClelland -- Chief Executive Officer

No, just in the one quarter. And this is expansion of both call center capacity, as well as helping with the migration to broader deployment of Microsoft Teams. So as you recall, there's a variety of deployment models for that. But in their case, they're deploying the SBC capacity within their infrastructure.

Paul Silverstein -- Cowen and Company -- Analyst

Understood. And then, Bruce, on the Packet Optical business, I think you cited eight new customers. Can you give us any sense that's relative to what? How large is that customer base today and the nature of those customers that you're winning? Any signs of progress in North America with the service providers you're targeting?

Bruce McClelland -- Chief Executive Officer

Yes, that's a good question. I don't have the exact number in the back of my head, Paul, trying to look that up for you offline. But obviously, we have a variety of customers that would contribute to get to the $78 million or so in sales and some are sub-million dollar transactions and some multimillion. So it's a pretty broad, diversified customer base.

But I'll try and get the number for you off-line. As I mentioned in the remarks, we are definitely making progress here in North America and hope to have a couple of notable things to announce here in the fourth quarter even. So making some pretty good progress.

Paul Silverstein -- Cowen and Company -- Analyst

One last, if I may. I recognize we're all in uncertain times, visibility is challenging but sometimes, even more so now. That said, any visibility into next year?

Bruce McClelland -- Chief Executive Officer

Well, clearly, we expect the Packet Optical momentum to continue and grow. If you look at as an example, one of our larger markets in India, year-to-date, we're down about 50% from last year, primarily due to the dispute we talked about. But every quarter is getting a little better, clearly. And as the spending environment improves there, we definitely expect considerable growth in '21 for that portion of the business.

And I think there's room for us to still grow around the Cloud & Edge business. And particularly, this transition to software just continues to be a real strong platform base for the company. So we're pretty excited as we kind of get through COVID here and get into a more normalized environment. But even with the world we're living in now, clearly, the business has continued to improve this year for us.

Paul Silverstein -- Cowen and Company -- Analyst

Thank you.

Bruce McClelland -- Chief Executive Officer

Thanks.

Operator

Our next question comes from Mike Latimore from Northland Capital. Please go ahead with your question.

Unknown speaker

Hi. This is [inaudible] on behalf of Mike Latimore. Can you give an idea about how important the 5G backhaul is when it comes to the ECI growth?

Bruce McClelland -- Chief Executive Officer

Well, for the most part, the networks that are migrating to 5G are being used for augmenting capacity for the current network. Some of the advanced capabilities, both on the radio side and on the network side, are still kind of nascent business models. But what we are finding is, as an operator, is looking at upgrading either the capacity or kind of building a broader network and extending fiber. They're clearly looking toward the future.

And why would you spend dollars on infrastructure that's not capable of some of the advanced slicing and timing requirements. So I do think it's pretty important from a future proofless and kind of evolution of the network perspective. But it's not necessarily getting activated and turned on with some of the advanced features yet in the network, if that makes sense.

Unknown speaker

All right. All right. Fine. And perhaps some comment on the pipeline, like where do you see a big chunk of business coming from? Is it from Verizon or AT&T?

Bruce McClelland -- Chief Executive Officer

Well, so a lot of our business in Packet Optical is international. And in fact, our business in Europe and Asia Pacific are actually both up year-to-date. So those remain to be really important markets for us. I've mentioned India already.

And the kind of former Soviet Union countries are obviously highly important as well. In the North American market, where the kind of base of business is around Cloud & Edge, clearly, Verizon, our largest customer, remains highly important to us. But most of the larger carriers are using our technology, either for traditional landline voice networks or for supporting unified communications collaboration platforms.

Unknown speaker

All right, all right.

Operator

[Operator instructions] And our next question comes from Liz Pate from Cowen and Company. Please go ahead with your question.

Liz Pate -- Cowen and Company -- Analyst

Hi guys. Thanks for the question. I just had a quick follow-up. I missed it, Bruce, what you said in terms of the guidance on the opex for the fourth quarter.

Bruce McClelland -- Chief Executive Officer

Yes. So we think it will be up somewhat a little bit from the second and third quarter run rates. Our current estimate is in the $105 million range. We'll see where we finally land.

But there's some incremental spend around just base salaries and then probably some success-based spending based on how we finished the year.

Liz Pate -- Cowen and Company -- Analyst

OK. Thank you. And then looking out to next year. Obviously, this year has been a different story.

But would it be safe to assume that opex will tick up a bit looking out into next year?

Bruce McClelland -- Chief Executive Officer

Yes. I guess there's a couple of factors that played there. There's probably some incremental investment around R&D for a number of programs, offset by lower spending as Kandy -- we successfully complete the Kandy transaction. So if you kind of factor those 2 things in, probably not a big change in opex overall.

Liz Pate -- Cowen and Company -- Analyst

OK. Great. Thank you.

Mick Lopez -- Chief Financial Officer

And in our restructuring effort, which will assist us in whatever incremental expenses we will have, we'll try to mitigate with continuous restructuring on our part.

Bruce McClelland -- Chief Executive Officer

Yes. Good point, Mick.

Mick Lopez -- Chief Financial Officer

I'll say thanks.

Operator

And ladies and gentlemen, I'm showing no additional questions. I'd like to turn the conference call back over to Bruce McClelland for any closing remarks.

Bruce McClelland -- Chief Executive Officer

Thanks, Jamie. Well, thanks again for everyone joining the call and the interest in Ribbon Communications. We're really, again, pleased with the execution and improved results here in the third quarter, excited about our path ahead. So look forward to seeing many of you in the upcoming investor conferences, you'll find the list in our press release.

So with that, thank you, operator. This concludes our call.

Operator

[Operator signoff]

Duration: 28 minutes

Call participants:

Monica Gould -- Investor Relations

Bruce McClelland -- Chief Executive Officer

Mick Lopez -- Chief Financial Officer

Paul Silverstein -- Cowen and Company -- Analyst

Unknown speaker

Liz Pate -- Cowen and Company -- Analyst

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