SeaChange is providing a copy of these prepared remarks in combination with its press release. This process and these remarks are offered to provide investors and analysts with additional time and detail for analyzing our financial results in advance of our quarterly conference call. As previously scheduled, the conference call will begin today, Sept. 2, 2010, at 5:00 p.m. E.T. and will include only brief comments followed by questions and answers. These prepared remarks will not be read on the call.
Fiscal 2011 Second Quarter Financial Discussion
Revenues for the second quarter of fiscal 2011 amounted to $51.6 million which was $5.1 million or 11% higher than revenue of $46.5 million recorded in the second quarter of last year. From an operating segment perspective, revenue from our Software segment for the quarter was $34.2 million, which was $4.1 million or 14% higher than revenue of $30.1 million for the second quarter of fiscal 2010. The inclusion of revenues from eventIS, which was acquired in last year’s third quarter, and VividLogic, which was acquired in this year’s first quarter, were the main contributors. In addition, higher Broadcast software revenue in connection with a large U.S. Broadcast customer shipment and increased VOD services revenue was mainly offset by lower VOD software subscription revenue due to the timing of revenue recognized in last year’s second quarter compared to the second quarter of this year. During this year’s second quarter, the Company completed a new master purchase agreement with a large U.S.-based cable television provider that extends through December 31, 2011, that follows up an earlier agreement with this customer. As part of the new agreement, this customer extended its VOD software subscription participation over the same time frame.
Servers and Storage segment revenue of $10.3 million for the second quarter of fiscal 2011 was $1.5 million lower than revenue of $11.8 million included in the second quarter of last year. The decrease in Servers and Storage revenue between years was due primarily to lower VOD server shipments to North American and Latin American service providers that was partially offset by revenue recognized for a large Broadcast server order for the Broadcast customer previously mentioned.
The Media Services segment generated revenue for the second quarter of $7.1 million, which was $2.5 million or 54% higher than revenue of $4.6 million in the second quarter of fiscal 2010. The increase in Media Services revenue between the second quarter of fiscal 2011 and last year’s second quarter was the result of revenue from recent content processing contracts with customers in France, Cyprus and Dubai. In addition, increased content processing revenue from customers in Greece and Turkey contributed to the revenue increase between years. For the third consecutive quarter, the Media Services segment reported an operating margin in excess of 10%.
Geographically, revenue for the second quarter of fiscal 2011 included 56% in North America, 32% in Europe, Middle East and Africa, 7% in Asia Pacific and 5% in Latin America. Comcast and Virgin Media were 10% or greater customers in the second quarter of fiscal 2011.
Revenue for the first six months of fiscal 2011 amounted to $106.2 million, which was $10.8 million or 11% higher than the $95.4 million of revenue generated in the first half of fiscal 2010. Increased Software segment revenue from the eventIS and VividLogic acquisitions combined with higher Broadcast software and Media Services revenue were partially offset by lower VOD server revenue.
Total gross margin of 48.1% for the second quarter was 2.9 points lower than total gross margin of 51.1% for the second quarter of fiscal 2010. Reviewing gross margin by operating segment, Software segment gross margin for this year’s second quarter of 53.8% was 6.8 points lower than gross margin of 60.6% for the second quarter of last year. The decrease in Software gross margin was due to lower VOD back office, software subscription and VividLogic software service margins that were partially offset by higher middleware and Advertising Insertion margins.
Servers and Storage gross margin of 47.1% for the second quarter of fiscal 2011 was 2.7 points higher than gross margin of 44.4% for the second quarter of fiscal 2010. The increase in gross margin for the Servers and Storage segment between years was due primarily to a greater mix of higher margin VOD server shipments in this year’s second quarter compared to the earlier version and lower margin flash memory servers that began shipping in the second quarter of last year.
Media Services gross margin of 22.6% for the second quarter was 17.2 points higher than gross margin of 5.4% for the second quarter of last year. This substantial improvement in gross margin between years was due mainly to increased absorption of service headcount-related costs resulting from the significant year over year increase in revenue. In addition, reported gross margin benefited from the absence of duplicative costs incurred in the second quarter of last year related to the segment’s transition of content processing activities in-house from a contracted third party.
Total gross margin for the first six months of fiscal 2011 was 49.2%, which was 1.9 points lower than gross margin of 51.1% for the first half of last year. The decrease in gross margin year over year was due primarily to lower VOD software subscription and back office margins that were partially offset by higher Advertising Insertion and Media Services margins.
Operating expenses for the second quarter, excluding restructuring costs, of $24.4 million were $0.2 million higher than the $24.2 million of operating expenses incurred in the second quarter of last year. The increase in operating expenses in this year’s second quarter compared to last year was primarily due to the inclusion of operating expenses for eventIS and VividLogic combined with increased Philippine engineering expenses that were partially offset by lower middleware engineering and corporate general and administrative expenses.
For the first six months of fiscal 2011, operating expenses, excluding restructuring costs, of $52.0 million were $4.1 million higher than operating expenses of $47.9 million for the first half of last year. The increase in operating expenses between periods was due mainly to the impact of the eventIS and VividLogic acquisitions, transaction costs related to the VividLogic acquisition and increased Philippine engineering costs offset partially by lower domestic headcount-related engineering and general and administrative expenses.
GAAP net income for the second quarter of fiscal 2011 was $3.5 million compared to a GAAP net loss of $0.4 million for the second quarter of last year. The GAAP net income for this year’s second quarter included an income tax benefit of $3.3 million related to lower than previously forecasted taxable income for this fiscal year and the ability to utilize this benefit to reduce previously recorded taxes related to the gain on the divestiture of Casa in this year’s first quarter. The corresponding GAAP earnings per share for the second quarter of fiscal 2011 was $0.11 per share compared to a $0.01 loss per share for the same period last year.
Non-GAAP net income for this year’s second quarter of $3.2 million was $1.6 million higher than non-GAAP net income of $1.6 million for last year’s second quarter. The corresponding non-GAAP earnings per share for the second quarter of this year was $0.10 per share compared to $0.05 per share for the same period last year.
For the first six months of fiscal 2011, GAAP net income and earnings per share of $23.8 million and $0.75 per share, respectively, were significantly higher than GAAP net income and earnings per share of $0.6 million and $0.02 per share, for last year’s second quarter.
For the first half of fiscal 2011, non-GAAP net income and earnings per share of $6.5 million and $0.21 per share, were higher than non-GAAP net income and earnings per share of $3.9 million and $0.13 per share, for the first six months of fiscal 2010.
From a balance sheet perspective, the Company ended the second quarter with cash and investments of $76.3 million and no debt compared to $85.6 million and no debt at April 30, 2010. The $9.3 million decrease in cash and investments in this year’s second quarter was driven by lower payables, tax payments related to the gain on the Casa divestiture, VividLogic acquisition payments and capital expenditures that collectively were partially offset by non-cash depreciation, amortization and stock compensation expense as well as lower inventory. In addition, during the second quarter, the Company repurchased 178,000 shares of its common stock at a cost of $1.4 million.
The Company had a strong quarter in broadcast, media services, and servers/storage and it continues to be the world’s leader in cable back office software. The quarter ended with 65% recurring revenue, and several new and expansion sites. This quarter’s results are at the low end of the guidance provided, primarily because of three unexpected delays – one product deployment delay from Q2 to Q4, one product acceptance, which was moved into Q3, and one revenue recognition delay in which the deliverables were moved between quarters. In each of these cases, the revenue is still planned and moved to different quarters, although meeting the revenue recognition criteria for software remains an ongoing challenge.
Americas – SeaChange completed two large master purchase agreements with top tier operators in Q2. One of these is specific to Video on Demand and is the largest purchase commitment in the history of SeaChange. The other is specific to advertising products for a large U.S. Telco. Several other master purchase agreements were finalized with smaller operators. VOD systems expanded in several countries throughout Latin America. The SeaChange-TiVo partnership has created key interest throughout the United States and the company continues to expand its TiVo customers. The TiVo partnership enables operators to utilize TiVo set-tops and access SeaChange video on demand to those customers. The Company also closed a significant software subscription customer in Q2, providing further recurring revenue for the Company.
APAC – SeaChange launched its first multi-screen offering with StarHub in Singapore, which is a commitment for a full three-screen (television, PC, and mobile) offering. The Company also won a large Chinese cable operator for both software and streaming servers and had expansion business in Japan.
EMEA – SeaChange launched second screen (PC streaming) software including a managed service offering at a tier one MSO in the region. The Company expanded flash streaming solutions in the Middle East and expanded software solutions in Hungary, the Netherlands, Germany, and the U.K.
Servers and Storage Business
As specified on previous earnings calls, SeaChange continues to see itself as a software company. The Company has been assessing the decreasing market opportunity of the server and storage business. Over the past few quarters SeaChange has gone through the strategic options for the server business including the evaluation of a potential sale or merging of the business, keeping in mind that a key goal is to ensure ongoing high quality support and upgradeability of its customer base. As of now, the Company has received several offers; however none are consistent with external analysis of the value of the business. Although the server business unit performed fairly well in the quarter, the Company continues to see a weakening demand for streaming systems in the coming quarters and it has concerns about demand going forward. As a result, SeaChange has decided to greatly reduce the operational investment in the server business unit. It is expected that this reduction will be welcomed by SeaChange investors. Consequently, the revenue target for FY11 has been reduced.
SeaChange expects gross margins for the software business at 60%, which has been achieved in the past. Software margins for Q2 were at 53.8%. Looking towards the end of FY11, the margin is expected to be close to the planned 60% mark for Q4. However, software margins in the short term will be impacted by several factors described below. The Company still maintains a clear expectation of a long term 60% gross margin, although it is seeing the commercialization time for certain products taking longer than expected. Software margins for the year as a whole are expected to be around 55%, taking into account the Q4 margin increase. Given the operating margin target of 10% for FY11, SeaChange will work to partially offset the margin shortfall with lower than planned R&D expenses in order to optimize the operating margin this year.
As SeaChange continues to transition to a software company, there are several additional factors that need to be considered related to revenue recognition and that SeaChange feels are important for its investors to understand. The software products remain a very attractive business in that these products provide high recurring revenue opportunities and the opportunity to become very embedded into accounts. There are, however, new business factors, and for SeaChange the five discussed here comprise the most short term factors that have financial impacts: (1) projects being pushed out by customers; as software is an early planning factor for our customers, it is sometimes difficult to assess the exact quarter in which the order(s) will be granted/completed, (2) revenue recognition issues specific to complex software transactions, (3) the timing of converting VividLogic professional services work into licensed software revenue, (4) the slower than expected stream expansion in Europe, and (5) product acceptance timing. To address these business issues and improve margins SeaChange will focus on (1) structuring customer agreements with revenue recognition in mind, especially as it relates to the integration of new software entities, (2) managing acceptance criteria to ensure timely product acceptance, and (3) charging appropriately for custom work that’s not licensed revenue.
Research and Development Spending
In the first half of this year the Company has achieved its 26% R&D goal and will continue to try to improve on that for the balance of the year. The Company continues to make progress on the creation of a single architecture that allows it to more rapidly, and at a lower development cost, adjust to new requirements. The Company continues to leverage its offshore resources to achieve this goal.
Given the decision to restructure the Servers and Storage business, the non-GAAP FY11 full year revenue forecast is in the range of $215M to $220M. This takes into account the adjustment for the server business as well as the software business factors. The non-GAAP earnings guidance for Q3 is in range of $0.07 to $0.10 per share, equating to non-GAAP revenue guidance of $50M to $53M. SeaChange will provide more detail on the Server and Storage business restructuring throughout Q3 and on the next earnings call, and the Company will continue to provide transparency in the details of its transition to a software company. The market and recurring revenue remain strong, and SeaChange has earned a well established leadership position in VOD back office software in the Americas, EMEA, and China cable markets.