Good morning. My name is Demitras, and I will be your conference operator today. At this time, I would like to welcome everyone to the SeaChange International Second Quarter Fiscal Year 2013 Conference Call. [Operator Instructions] Ms. Schaefer, you may begin your conference

Thank you, Demitras. Good morning, everyone, and thank you for joining us. SeaChange released results for the second quarter of fiscal year 2013 ended July 31, 2012, yesterday after the market close. Attached to the press release were our prepared remarks regarding the financials. If you do not have this material, please go to www.schange.comir to download the document. These prepared remarks will not be read on our call today. Raghu Rau, CEO; and Mike Bornak, CFO, are joining me today. Raghu has a short introduction and a few comments. Following his remarks, we'll be happy to take your questions. This call is being webcast and will be archived on our website in the Investor Relations section. Before Raghu begins, I'd like to remind you that the information we're about to discuss today may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations that are subject to a number of risks and uncertainties that may cause actual results to differ materially from expectations. These risks are outlined in our SEC filings, including our annual report on Form 10-K, which was filed April 5, 2012. Any forward-looking statements should be considered in light of these factors. Additionally, this presentation contains certain non-GAAP or adjusted financial measures as defined by the SEC. Per SEC requirements, we have provided a reconciliation of these measures to the most directly comparable GAAP measures in tables attached to the press release. Any redistribution, retransmission or rebroadcast of this presentation in any form without the express written consent of SeaChange International is prohibited. And with that, I'd like to turn the call over to Raghu.

Thank you, Martha. Good morning, and welcome all of you to our second quarter earnings call. On the last earnings call, I communicated to you that SeaChange had the opportunity to demonstrate our next-generation software for back office, advertising and gateways at the National Cable Show in Boston in May. Since then, we have made important progress and recently announced that 2 major U.S. cable MSOs have selected SeaChange Adrenalin multiscreen back office software and services. We expect further design wins in North America over the next 2 quarters. We have also announced design wins for our Infusion Advanced Advertising Platform. In North America, 2 of the largest MSOs have selected SeaChange for multiscreen ad delivery. Additionally, the company's linear local advertising has been selected by 2 of the region's largest telecommunications operators, including a planned deployment for arguably the largest video advertising insertion operation in the world. In Europe, 2 of the region's largest cable operators that serve multiple countries have chosen SeaChange software for video-on-demand, Ad Insertion and ad decision-making tools. We also continue to make progress on our In-Home Gateway software solutions and successfully featured our Nucleus software only, Headless Gateway, at the CableLabs Summer Conference in August. This groundbreaking solution seamlessly blends the cable set-top with Internet standards to deliver whole-home DVR and linear video via DLNA and MoCA to multiple screens throughout the home, including Smart TVs, game consoles and IP-client set-top boxes. Over the next 2 quarters, we will continue our current level of investments in R&D in order to ensure the timely launch of these next-generation products in the fourth quarter. We expect revenue to ramp into the fourth quarter of this year and position us well to demonstrate sustainable revenue growth as we enter 2013. Revenue growth matched with expenses remaining flat or down should result in a meaningful improvement in profitability as we look forward to next year. Our overall cash position increased from $93.8 million on January 31, 2012, to $107.1 million on July 31, 2012. The increase in cash was primarily due to the proceeds from the sale of our Broadcast and Storage business and Media Services business, offset by capital expenditures of $1.1 million, earn-out payments of $4.5 million and use of cash from continuing operations of $6.5 million. The cash balance was lower than expectations partly because certain amounts held in escrow tied to specific indemnity matters related to our divestitures are now expected to be released in the fourth quarter of this year. A question I have frequently been asked is, what does SeaChange intend to do with this cash? As stated in the press release, I am pleased to let you know that the Board of Directors has decided to institute a 10b5-1 plan to buy back stock up to the level of the $25 million previously authorized, and we intend to institute the plan by mid-September. As you will have observed from our prepared remarks, revenue for the second quarter FY '13 were at $36.7 million and were at the high end of our guidance, and non-GAAP operating earnings were $0.04 per share. Our gross margins, as a percentage of sales this quarter, were lower than the corresponding period in the previous year due to the $1.8 million inventory write-down of our legacy hardware product and lower service margins. Also our margins were lower due to the addition of headcount primarily from the Flashlight acquisition, as these engineering costs associated with our statement of work business are classified as cost of sales due to the direct correlation with revenues recognized. We expect gross margins to come to a more normalized range of 54% to 56% by Q4. We also anticipate our full year fiscal 2013 revenues to be in the range of $152 million to $158 million, which is within our previously announced guidance, and non-GAAP earnings per share to be in the range of $0.31 to $0.37. With that, I thank you for your interest in SeaChange and will now turn it back to Martha.

Thank you, Raghu. Demitras, can you please give instructions for our question and answer queue?

[Operator Instructions] And your first question comes from the line of Christopher Ferris with Noble Financial.

Raghu, previously on the last couple calls, you'd stated that the OpEx cuts for this year were expected to be in excess of $15 million. Is that number changed? I understand you've had some additional -- you've continued with the cost cuts, but I'm just trying to understand what's changed in the expense outlook compared to where you were in the prior quarter? And was that the main emphasis to lower the OpEx guidance despite hitting the revenue plan? Just trying to kind of understand what's happening below the revenue line.

No. The OpEx does not change. I mean, we will have achieved the $15 million reductions that we said we would achieve.

But the difference between -- I mean, your prior guidance was I think $17 million to $20 million non-GAAP operating income, and now you're sort of implying a number that's more like $13 million to $15 million. Can you talk about just what's changed to cause that number to come down?

Right. What's changed is partly the cost of goods sold has increased in Q2, and we expect that to continue to Q3. Partly, it's also due to the fact that the high-margin software license product is not -- because of revenue recognition reasons, not going to hit significantly as we previously thought in Q3, and it's moved over to Q4.

Okay. That sort of led into my next question, which was exactly what you just said there about the high software revenue. The other question I have is that you made a number of customer announcements just in the past month or so, and I would have thought that given those deployments, might be surprising to some that you left your revenue forecast unchanged. Were the recent wins you announce baked into your previous guidance? Were you just being conservative? Or is some of this revenue simply being pushed out into 2014 and beyond? Or is there an issue where some of this new revenue on the service side is just compensating for legacy revenue that's declining faster than you might have expected?

The legacy revenue is declining faster. Not sure that it's faster than we expected. We certainly expected the decline to happen. What has not happened is that the revenue from new software licensing has not happened in Q3, and it's moved to Q4 and 2014. And what we have in Q2, while we are still able to meet out revenue guidance is that we have taken on lower margin product sales, primarily the soft -- statement of work subscription, sales which are at lower margins than the product licensing margins.

Given seeing that revenue being pushed out to 2014, I know you're not giving guidance for '14, but can you give us a little bit of flavor for what kind of revenue growth you might expect next year?

Yes, we would expect, based on our current expectations, would expect double-digit revenue growth next year.

Your next question comes from the line of Rich Ingrassia with Roth Capital Partners.

Raghu, can you say a little bit more about gross margins in Q2? And you mentioned in the press release, of course, it was due to the mix. But then maybe give us some sort of profile for gross margins by segment going out into 2014 or FY '14?

Right. If you look at Q2, if you eliminate the inventory write-down, the gross margins were about 51.2%. Now that is not a normalized margin. What I have said in my opening remarks that we, in Q4, we expect gross margins to come into the more normalized range of 54% to 56%. The reason for the 51% is with the acquisition of Flashlight and the increase in the cost of goods sold and not enough product licensing revenues, the mix is what has caused the gross margin to decline in Q2 and that will continue in Q3, even though the gross margins may be slightly higher in Q3 because we are launching some of our next generation solutions towards the end of Q3. And so it's a question of the mix between product licensing and services margins.

And going forward, how do you expect gross margins to shape up over, say, the next 12 months?

We think a normalized gross margin is in the 55% range, considering that product licensing will generate about almost 70% to 90% gross margins. And services typically is between 45% and 50% gross margins. We have also had a lot of hardware, as you know, and this was unexpected. We have actually, in terms of video service sales, increased compared to last year for the first half of this year. And that is also -- that's primarily hardware at lower margins.

Okay. And the OpEx reduction has obviously been impressive. But talk about what else happens over the next 12 months, say, to complete the transition that you want to make here. Are there other tuck-in acquisitions like Flashlight that you think are important to complete the suite? Are there some upgrades or additions to the sales force that need to occur? Kind of why don't you kind of shape the balance of the transition to the all-software model?

Right. So a few things that we really need to focus on. In terms of tuck-in acquisitions, yes, we are looking at some small acquisitions to fill out our portfolio and to be able to have more robust licensing revenues. And that's one. And the fact that our solution is very modular lends itself to some of these tuck-in acquisitions. The second area that we want to -- in terms of expanding our revenue base, is to go to adjacent markets, the IPTV market as well as the mobile market. We have begun to see early traction here, and we do need to invest some sales, dedicated sales resources to be able to cater to some of these markets. But because most of the wins we are now getting is based on inbound interest rather than us going out to these customers and aggressively marketing our solution because our traditional base has been cable, and so those are the areas. We're also looking at new geographies. We're very strong in Europe. We're very strong in North America and Latin America. Asia-Pacific is again an area where we think we can take our solutions to. And one of the things that we're looking at is because our solutions are now capable of being hosted in the cloud is being able to provide cloud-hosted solutions to some of the Tier 2, Tier 3 operators and other more price-sensitive markets.

Your next question comes from the line of Todd Mitchell with Brean Murray.

I wanted to know if you could talk to us a little bit about your home gateway product. Specifically, it seems to me that this is part of a package sale along with the VOD operating system. And so what I would like to know is, how do you feel that you are positioned in the market that's differentiated from some of the larger competitors in the space, one. And two, can you talk to us a little bit about how the product cycle in terms of get the inbound call, do the RFP, win the deal, spec it out and then ramping. Just generically, how is that going to ramp? What's the timeframe? And kind of what does the cost and revenues look like as this becomes a third sort of product for you guys?

Right. Todd, yes, we're really excited about home gateway side of our business, and this is already growing and expected to grow this year at a double-digit level. What's really interesting about this is that we have a very significant position in the gateway software business because what we do is we provide a layer of software that works across multiple SOCs, including Broadcom, Intel and SD Micro, and also work with a number of different box vendors, including Motorola, Cisco, Pace, ARRIS and several others. And so what we are able to do is take our software and provide the functionality, whole-home DVR functionality, in that gateway. And so the differentiation as far as the cable operator is concerned is that they don't have to depend on the manufacturer of the box to be able to provide the differentiation, but they can work with any manufacturer and get the differentiation from SeaChange software. So that's the value proposition. And a new product that we are now launching, which is attracting a lot of attention in the industry, in the Headless Gateway. And this is a gateway with SeaChange software, which you can tuck into your garage, your basement, your attic, and it can work with Smart TVs, it can work with ordinary TVs, as long as you have any IP client box. And it provides whole-home DVR capability. It also provides you the ability to be able to have application in the cloud and be able to change your UIs very flexibly. So the differentiation is that rather than depend on the manufacturer to create differentiated software in the box and perpetuate that differentiation and making it more difficult for operators to get lower prices for the box, here they can -- the operators are now standardizing on a Comcast-led RBT-based software solution with SeaChange in a Nucleus software product to create a much lower-cost solution. What we get is we do this in a number of ways. We work with these operators, create some customized features for them, and that's typically on a statement of work basis. We also license the gateway software. And so that's a licensing deal. Now in terms of the product cycle, I mean, how it's sold. At present, most of these operators are looking at this alternative versus getting differentiated boxes from the different vendors because for a number of reasons. It makes applications rollout much easier. It reduces the time to put an application and test it out on different boxes, matter of days rather than matter of months as what is the case earlier. So that's what – where the value of the product is, and SeaChange clearly has a leadership position here. We're talking to every major cable operator and also working with a number of the telcos as well.

And just in terms of, say, I am XYZ MSO, and I decide I want to go this sort of infrastructure and I give you a call, how long does it take you to basically spec something out for me? And is there an upfront cost to SeaChange associated with that that's not associated with the revenue? And then once I've decided to pick you, how does the revenues come into SeaChange? Does it come in on as I deploy these boxes or is there sort of another linear relationship between the revenue growth?

Right. That's a good question. What I'll do is give you an example of a very recent case with a major European operator. So obviously, they've heard of our work with some of the major operators here in North America. They approached us and they said, "This is what we intend to do, and can you give us a proof of concept." This was a period of from March to the August timeframe. We did get paid, but obviously it's based on a statement of work. A lot of work went into this. The proof of concept was provided, worked beautifully, and we recognized the revenue for the proof of concept. But the margins on the proof of concept were obviously low even though it was a substantial number of engineers over a period of 4 months. Now we're in the commercial discussions in terms of getting this code implemented in the production model, and they're looking at launching in 2 markets initially, but eventually in several markets that they currently don't serve. And the timeline for that is in the end of January, we are hoping to be able to get the first field trial of code delivered. And by the end of March, we expect to have a field trial. The licensing model will be that they will license the software from SeaChange and pay us a license fee for a certain minimum number of subscribers because we don't want them – we don't want to necessarily wait for several months, maybe even years before they get to, let's say, 0.5 million or 1 million subscribers. So there's a step function here in terms of the license fee that we get. And so that's how this cycle works.

Okay. One last question, I apologize. So last question here would be, so let's say that I am a MSO and I've been a SeaChange customer for a number of years, and I was taking Axiom and perhaps buying some servers at one point. And a year from now, I'm going to have Adrenalin and I'm going to have that home gateway product from you and maybe even some of your Ad Insertions. Do you have any way that you could quantify kind of the value per sub differential between sort of the new product lineup and the old product lineup?

That's a little bit difficult to do because I can take that question back because we sell in different ways. There's some customers, we sold Axiom with a perpetual license. There's some customers we sold on an active subscriber basis. Some customers were sold on a per stream basis. What we're now moving towards is a model where it's more Software-as-a-Service, and what we're looking at is initial upfront license fee for a certain number of subscribers, then based on further active subscribers. And so that's -- and 20% of, typically, of the software is maintenance. So for the new products, it's a different model for the old products. Now which model gets you the higher revenue, it's something I think I'll have to really look into to determine what it is. But intuitively, I can tell you this new generation of products gives us a substantial increased opportunity to generate further revenues.

[Operator Instructions] Your next question comes from the line of John Zaro with Bourgeon Capital.

A couple questions and maybe more clarification. On the cash side, you sort of discussed, is the holdbacks that you're getting in the fourth quarter now bigger than you thought it was going to be?

Yes. We expected some of the holdback earlier. So it's really what we were expecting earlier is now happening towards the end of the year.

Right. And so is that number sort of $10 million to $12 million?

No. It's about half of that.

About half of that, so like $5 million to $6 million? Okay. And then I'm assuming that part of the expenditures is because you've received more orders and are spending more upfront cost to get everything delivered, and you're not getting the revenues as you've discussed, because of the way you book software until really the fourth quarter and into 2014.

Right.

But it's not -- you're not -- in other words, it gets back to the earlier question that I can't remember if it was Ferris after or the guy from Roth, but it doesn't have to do with the fact that your expenses are going up. It has to do with, we have all these new orders, we have to make sure that we get them done. So we're -- it's the reason why you bought Lighthouse or whatever the acquisition was.

Flashlight.

Or Flashlight.

That's exactly right, John.

So as these early expenses come in as you discussed for the last 2 calls, if we see higher expenses, it's because you have more orders?

That would be the correct way of putting it, yes.

Okay. So I'm just trying to correct between the headlines of seeing people who say, "Oh my gosh, they missed, and our expenses are up." It's not really -- they don't really know what they're talking about because it really has to do with the fact of the orders that you're getting and the discussion that we've had in the past on these calls, which is expenses go up because we're implementing these things and we need to get them out the door, and we're not going to get the revenues until we do.

Right. We are very pleased with the acceptance of these products and the interest in these products. We are also getting interest and expect design wins from customers who are not Axiom customers. And I'm hoping that is something I can announce in the next 2 quarters. There are at least 2 customers who are not Axiom customers whom we expect to announce design wins with based on the initial level of interest that we've had from them.

That's fantastic. Okay. And again going back to the cash, you're not getting any cash less than you thought you were going to get?

No. We will continue to be cash flow positive.

Okay. And then the buyback, I'm assuming that the reason why you didn't have it already in place, because it's pretty easy to put these in place, is because you just did it at the board meeting last night or the day before?

Yes. I mean there's best practices, and we have to wait for our trading window to open and...

Right, which is in what, couple days?

Yes, in a few days.

Okay. So you can start in a couple of days. Even if you had it in place, you couldn't do it today anyway.

Yes. We already identified the bank and identified the parameters. We need to finalize the plan and execute it after the trading window opens.

Great. And hopefully, it's somebody who's supported you all the way along as opposed to someone who doesn't care about you. And then you have been very upbeat in the last couple calls about all of the -- about the business going forward and the successes and as you just pointed out, the 2 non-Axiom customers who are suddenly very -- who you think might jump on board. Can you just sort of talk about what you're seeing out there and sort of the business climate, and particularly relative to both Europe and the U.S. is about the implementation and the rollout of these products?

Yes. We see a lot of interest in terms of wanting to support multi-screen and have multi-screen in their portfolio. We also see a lot of interest in terms of reducing your overall operating expenses. And then therefore, they're looking at solutions like our Adrenalin product which enables centralization and serious reductions in OpEx. So we're seeing that. However, what we are not yet seeing and all of you know this as well, is how much the multi-screen is going to increase the revenues of our operator customers. I mean, that's something that – where the jury is still going to act, but what we are able to do is to equip these service providers with all of the tools and the capabilities necessary to be able to compete more effectively against the over the top players. And so therefore, I mean, there's a lot of interest in what we're doing.

Okay, great. And then just 2 last short ones. Again, getting back to the sort of rollout of the next generation and the revenues start to ramp up in Q3 that really ramp up in Q4 and into next year. There are no delays or hiccups or problems that you're having. You just got a lot of staff and you got to roll it out. So it…

Right. We have a strong visibility to the revenues. Question is -- but what's tight about this is being able to recognize, get the acceptance and being able to recognize the revenue in the time frames that we're talking about. I mean, that's what we need to achieve in the [indiscernible].

It's not that you're having problems implementing it, it's just that you can't recognize it until everyone's fully signed off on it. So it's the typical software issue.

Right.

Okay. And then the home gateway, just a minor clarification. You said that, when you were talking to Todd that everything was great and that you were going to see -- you expect double-digit growth for next year.

For this year.

I'm assuming -- for this year? I'm assuming it's pretty large double-digit growth because it's off a small base.

It was a double-digit base, and it's double-digit growth.

Your next question comes from the line of Spencer Grimes with Twinleaf Management.

Could you talk a little bit more about the board's thinking of regarding return of capital and why they felt it was apparently necessary to retain so much cash on the balance sheet rather than return it in a tax certain environment of 2012?

Right. I think we're in the midst of a transformation of the business model of SeaChange here, going into a pure play software company. And during this transition, what we want to do is ensure that we've got all these next-generation products in line, we've got all our cash flows, increases in revenue, profitability all lined up. And while we're certainly open, the board is certainly open to looking at other ways of utilizing the cash, what we have decided to do is just the first step here. We'll continue to see how best to utilize the cash because we know just keeping it in the bank is not the most productive use for the shareholders.

Your next question comes from the line of Blair King with Avondale Partners.

I just have a just sort of a follow-up question, and perhaps in a little bit broader terms than what was trying to be outlined earlier. Raghu, if you could -- hopefully you can -- or perhaps you could explain just in general -- in a general sense, what your picture is for an inflection point in the business versus with next gen product sort of overcoming the legacy component of the business. And then I guess the follow-up to that question would just be relative to pricing on the next gen products with a couple of wins under your belt now. If pricing has held up kind of consistent with your expectations earlier on or if it's been a little bit better or even worse, or just some commentary around that would be really helpful.

Right. To answer your first question about the inflection, we think Q4 is the first quarter where there's substantial launch of our next-generation products. And the acceptance of those, the products, the performance and the acceptance of the new business model in terms of the licensing as I referred to earlier on an active subscriber basis. All of those things I think make that quarter an inflection point going forward into 2014, and giving us the double-digit growth I mentioned earlier and improved profitability because we really have been able to bring our past to a level that any increases in revenues flow substantially to the bottom line. So that, I would say, is the inflection point in Q4. As far as pricing is concerned, it's new to us, to our operator customers, and we've been having some good discussions. And we're trying to make this into a win-win situation and be priced more like a software company would price its products. And that transition is happening, and we're learning as you go, but I'm pleased with where we are today. I wouldn't categorize it as that we're getting much more than what we were expecting or much less than what we were expecting. I think we're getting fairly priced for a software company.

And we have a follow-up question from the line of John Zaro with Bourgeon Capital.

Yes, I have 2 questions. One, might as well start with the pricing. When you've changed some of the pricing just with different customers, and I think like in the case of something like Comcast on how it gets -- how it sort of flows through, are you seeing them take different pricing models from you? In other words, to put some pricing pressure on you or not really?

In any negotiation between customers and vendors, there's always pricing pressures put on us. And the question is, I mean, are we pricing for value, which is what we're doing. We are spending very significant amounts on R&D. It's about $39 million on an annualized basis, very significant for a company of our size, which – where we're doing $150 million to $160 million. But it's really focused in terms of very specific areas, so we're pricing based on value. As long as the customers understand the value, the negotiations become much easier.

So as in the past, where you guys have carried a lot of the costs of doing this, you feel like, unlike maybe historically, you're getting a little bit better value out of it than you have historically? Because in the past, you've done a lot of sort of one-off stuff for different customers, and I'm not sure you always have gotten paid totally for it.

That's true. We also sold a lot of hardware, and when you sell – try and sell hardware, which are different margins, which are more commoditized and you also try and sell software, it's difficult to price one on value and one on cost. And so the fact that we've been able to get away from the hardware business, reduce manufacturing things ourselves, work on commoditized hardware that's out there, it makes it a little easier.

Okay. And then any -- we're still waiting hopefully sometime in the next 2 to 4 weeks that we're going to hear something about the ARRIS lawsuit.

I couldn't predict it's going to be in the next 2 to 4 weeks. But it's going to be 3 months after all the final briefs were submitted in that case, and it could happen next couple of months.

Right. And at that point, you might have a different idea of what you're going to do with your cash?

That's a possibility.

[Operator Instructions] And there are no further questions.

Okay. On behalf of the SeaChange management team, thank you for your time and participation this morning. Over the coming quarters, we will look forward to reporting further progress on our ongoing strategy to transform SeaChange into a pure play software company and deliver increased growth and profitability. Thank you.

Thank you, ladies and gentlemen. This concludes today's conference call. You may now disconnect.