Elizabeth Parker - IR Shabtai Adlersberg - President and CEO Niran Baruch - VP, Finance and CFO

Rich Valera - Needham & Company Dmitry Netis - William Blair

Greetings and welcome to AudioCodes’ Third Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Elizabeth Parker, Director of Investor Relations for AudioCodes. Thank you. You may begin.

Thank you, Melissa. I would like to welcome everyone to the AudioCodes third quarter 2017 earnings conference call. Hosting the call today are Shabtai Adlersberg, President and Chief Executive Officer; and Niran Baruch, Vice President, Finance and Chief Financial Officer. Before beginning, we’d like to remind you that the information provided during this call may contain forward-looking statements relating to AudioCodes’ business outlook, future economic performance, product introductions, and plans and objectives related thereto. And statements concerning assumptions made or expectations as to any future event, conditions, performance or other matters are forward-looking statements as the term is defined under US Federal Securities Law. Forward-looking statements are subject to various risks, uncertainties, and other factors that could cause actual results to differ materially from those stated in such statements. These risks, uncertainties and factors include, but are not limited to, the effects of current global economic conditions and conditions in general and in AudioCodes’ industry and target markets, in particular, shifts in supply and demand, market acceptance of new products and the demand for existing products, the impact of competitive products and pricing on AudioCodes and its customers’ products and markets, timely product and technology developments, upgrade, and ability to manage changes in market conditions as needed, possible need for additional financing, the ability to satisfy covenants in the company’s loan agreements, possible disruptions from acquisitions, the ability of AudioCodes to successfully integrate the products and operations from acquired companies into AudioCodes’ business and other factors detailed in AudioCodes’ filings with the SEC, the US Securities and Exchange Commission. AudioCodes assumes no obligation to update information. In addition, during the call, AudioCodes will refer to non-GAAP net income and net income per share. AudioCodes has provided a reconciliation of non-GAAP net income and net income per share to its net income and net income per share according to GAAP in its press release and on its website. Before I turn the call over to management, I would like to remind everyone that the call is being recorded and an archived webcast will be made available on the Investor Relations section of the company’s website at the conclusion of this call. The call will also be archived on our Investor Relations app, which is available for free from the iTunes App Store and the Google Play market. With that said, I would now like to turn the call over to Shabtai Adlersberg. Shabtai, please go ahead.

Thank you, operator. Good morning and good afternoon, everybody. I would like to welcome all to our third quarter 2017 conference call. With me this morning is Niran Baruch, Chief Financial Officer and Vice President of Finance for AudioCodes. Niran will start off by presenting a financial overview of the quarter. I will then review the business highlights and summary for the quarter, discuss trends and developments in our industry and business and the outlook for the rest of the year. We will turn in to the Q&A session. Niran?

Thank you Shabtai and hello everyone. As usual, we will be referring to both GAAP and non-GAAP numbers on the call, the non-GAAP P&L metrics exclude recurring non-cash items. Today’s earnings press release contains a reconciliation of supplemental non-GAAP financial information. Revenues for the third quarter were 39.2 million, up 1.2% from the prior quarter and up 5.4% compared to the third quarter in 2016. Services revenue for the third quarter was 12.7 million accounting for 32.4% of total revenue. Deferred revenues balance as of September 30, 2017 was 34.8 million compared to 33.8 million as of June 30, 2017. Revenues by geographical reason for the quarter were split as follows: North America 47%, Central and Latin America 8%, EMEA 30%, and Asia-Pacific 15%. Our top 15 customers in aggregate represented 57% of revenues in the quarter of which 44% are attributed to our 10 largest distributors. Gross margin for the quarter was 62.8% compared to 61% in Q3 2016. Non-GAAP gross margin for the quarter 63.2% compared to 61.7% in Q3 2016. Operating income for the quarter was 2.6 million compared to an operating income of 2 million in Q3 2016. On a non-GAAP basis, quarterly operating income was 3.4 million or 8.8% of revenues, compared to an operating income of 3.1 million in Q3 2016. Net income for the quarter 1 million or $0.03 per share. On a non-GAAP basis, quarterly net income was 3.4 million or $0.10, compared to net income of 2.9 million or $0.08 per share in Q3 2016. Our balance sheet remained strong. At the end of September 2017, cash, cash equivalents, bank deposits and marketable securities totaled 60.1 million. Day sales outstanding as of September 30 were 57 days. Operating cash flow generated during the quarter was 6.2 million. During the quarter, we…

Thank you Niran. We’re pleased to report strong financial results and continued momentum for the third quarter of 2017. As mentioned earlier in a press release, we experienced good business momentum for several years now and have build the ground for continuous growth in the coming years. 2017 will be the 5th year in a row that we grow our new business in the UC and SIP telephony. Similar to the first half trends, our two main business lines, UC-SIP and gateways, which together comprise about above 90% of our revenues continued to exhibit healthy business trends. As such, it provides a strong confidence level in our investment in these areas. In the UC-SIP area, we grew above 15% year-over-year and we continue to successfully execute on our enterprise voice strategy to help businesses migrate to a digital work place in all-IP world. Continuing these investments and growing partnerships and collaboration with unified communications and SIP tracking market leaders, should support extending this success over the coming years. We will keep pounding on our key message to the world voice networks are in a ‘forced migration era’. The first major part of it is taking place right now between 2015 to 2025. This is what other players in the market call network transformation projects, transitioning from the old TDM world to an all-IP world. This migration process drives the evolution of unified communication and UC as a service and prosperity among UC solution makers such as Microsoft, Cisco, BroadSoft, Vonage and other over the top players. And the latest announcement by Cisco targeting to acquire BroadSoft close to 2 billion further underlines these trends. But the other side of this ‘prosperity climb’ is the fact that more such unified communication and the unified communication and service solutions need CPE and…

[Operator Instructions] our first question comes from the line of Rich Valera with Needham & Company. Please proceed with your question.

It looks like you took down your growth target for your UC-SIP business. You had been looking for 20% for this year; it looks like now its 15%. In the last quarter you had talked about some softness in the Skype for Business part of that business. Just talk us through what’s behind that moderated expectation? Is it in fact kind of a softer, near-term outlook for the Skype for Business that you guys do?

Naturally, as the business grows, I think everybody should expect that a larger business will demonstrate slow growth. So while we grew 30% and 25% and 20% in the previous years, reaching a level of 65 million and growing to 100 million. We are moderating expectations. We do believe that we will do more than 15% which we did this quarter. You may have a point in that the announcement of things to be provided in combination with Skype for Business may in some areas maybe something that may slow the business a bit, but it’s not really. But when we plan this quarter and the fourth quarter and as we plan next year, I don‘t see much effect to that. Simply because the UC-SIP business is built out of a lot of activities, Microsoft is one of them, BroadSoft is another one, Genesys is another one, the service provider PSN [Shadow] is another one. All-in-all there are so many different factors that affect the success of that line that we simply want to be more realistic and 50% and above is the right growth cycle that we want to assign to that business.

I appreciate the law of large numbers, but I’m just trying to understand kind of what at the margin from what you were expecting only a quarter ago you’d kind of had reiterated the 20% target and now a quarter later, we are talking about 15. So it seems like something changed there, and I’m just trying to get a better handle on what that was.

Again, really there’s not much change I can tell you. I can just provide you more details that I think in the previous quarter we grew around 18.x, this quarter we grew 16.7. So listen it’s a quarter-by-quarter fluctuation, I don’t think we should look at such low details. I think we are very confident in the strong growth that we have of 15%, but that is something that we stick to and that’s how I think we should refer to it.

And it sounds like the gateway business had another quarter that was probably a little better than you were looking for. When you headed in to the year I think you were looking for that business to be down for the year. Starting the year you were positive on the third quarter as well as I think for the first half. Can you kind of give us your updated view on that gateway business for this year and maybe for longer term?

Definitely, as I mentioned contrary Voice over IP history that’s between ‘96 to 2015, the previous let’s say 20 years. When inspecting to the period that’s between 15 and 25, it’s going to be what I mentioned, a forced transition in each country and we expect there was a leading economic country such as the US and Germany and France and the UK to be in front of that. It’s no longer a choice. The service provider and the communication authorities in these countries have set sudden date for inforce transition from the old TDM network to in all-IP. So that continues to drive the gateway business. Just to give you an example, on the British Telecom side, we’re starting with gateways in all that activity, and the gateways do provide an interface to SIP tracking position. In the future, that gateway business will evolve to become also in succession for the controller business. But all those transformation that has to connect tens of thousands and millions of businesses. The element that is needed in most of those transitions side-by-side with the softswitch and/or the UC application is gateways. So we expect gateways to continue to sell very nicely. Actually we are adding features and capability to our gateway line, simply because those are required by customers. So the gateway business is very much alive and we believe that it will maintain a very nice level, either flat, up or down a few percent, but all-in-all very solid, by the way also very profitable because our investment in it is very limited. So that by the way provides cash infusion to be invested by our other activities in the UC-SIP etcetera.

Our next question comes from the line of Dmitry Netis with William Blair. Please proceed with your question.

A couple of questions from me, maybe going back to the gateway question Rich just asked. Can you frame, I think you said it’s going to be flat this year. Do you expect gateways given the project that you on-boarded in the last few quarters. Would you expect gateways to be flat again next year or does that kind of go back to the normal secular decline pattern and I think it was 10% to 15% decline. So if you could help us understand what to expect for gateways going in to the next year.

I’ll try to model it Dmitry. If you take the new accounts, so I’m confident we relied on more accounts for the next year. If you’re talking about previous accounts, they will expand the solution. We think it’s known that we provide to Verizon in this case, we work with Comcast, worked with Deutsche Telekom. Those projects have just begun, so we can very much be assured that the activity will go on. So I will tell you that we will need another 12 months or so to provide a more sound or analytic backed response. But I’ll tell you that in my view next year it could go anywhere between minus two, three points to plus three points or either flat. So it’s in that range.

And then on the SBC side of the business, I think you made a commentary and it kind of made sense that Microsoft is going through a transition and lumping the Skype well killing Skype for Business online and developing its own product within teams’ environment. Would that essentially spark a pickup in your SBC business in support of the premise environment, and have you seen any of the Microsoft Skype for Business server premise environment – premise deals rather spike as a result of this change of this transition that’s going on.

So the way we see it is that at Ignite I think the on-prem solution got a new life. Microsoft announced a new release called vNext to be delivered in the second half of 2018, saying that gave a lot of support for all the larger enterprises, Skype for Business customers, who now have assurance that Skype for Business server for on-prem deployments will be evolved will be supported. So that’s in place. Skype for Business online is really not going to be killed. It’s going to transition and more of the investment will go in to teams. Teams will replace it. But all-in-all when you’re talking about either Skype for Business online and/or you’re talking about teams, when you want to provide PSTN calling you need to connect and usually those are Session Border Controls that help to connect. So Session Border Controls will keep selling in the on-prem solution for the Cloud Connect solution in another new version for the team solutions. So all-in-all in an all-IP world or SBCs are used to connect between location and operators, SBCs will keep growing in to a very strong business. And definitely the announcement of teams gives us a new phase of deployment.

And any evidence yet of the Skype for Business server business being kind of a pickup yet or is that still early?

No. I’m telling you third quarter has been very strong. We see projects, just yesterday we mentioned there’s a large world leading accounting firm that we signed about five years ago, so that the deployment over the past few years is not really reached even 50% of its deployment. So all of these large companies, and I’ve mentioned by the way those four companies in the session that has altogether 630,000 SIP. A very small portion of that has been deployed. So you can assume that these companies will continue now that they have assurance for continuation of the on-prem. And I think to be realistic; guys don’t expect large companies to go fully cloud. Small companies will go cloud immediately. When you’re talking about companies who employ tens of thousands and hundreds of thousands of employees, those companies most of their operation in many cases will remain on-prem when private cloud will be a better solution maybe some of it will move to cloud. But the fact is that cloud really serves today mostly F&Bs and starts to serve also some need market companies. But large companies, majority of them will employ for many years going forward on-prem solutions.

I was just referring to this change that Microsoft just made, that that’s for additional business or not. But we could talk about it offline. What I also wanted to ask real quick is, is there any way to frame DT British Telecom and DT Portugal Telecom opportunities as far as number of lines that are transitioning from TDM to IP? Any sort of guidance you can provide on potentially how big these projects could be or what it means in terms of lines.

Usually they do not or we do not expect a firm number. I’ll just mention that about three years ago we signed with Deutsche Telekom. When we negotiated the contract, the potential discuss was about 10 million supplies. So that gives you kind of an indication for when you’re dealing with a large tier-one service provider in a leading western country. Those are the numbers, you go to smaller service provider you talk about a few million. So we haven’t stretched really yet the potential in that case. The world use different statistics. I think in the US the market is more advanced mainly with the micro business and the 10-20 employees, but when you go worldwide a very small penetration, less than probably 10%. So the potential is huge and it’s going to last for the next 10-15 years.

Okay, so BT is probably similar sized to Deutsche Telekom, so we could expect maybe about a similar size, 10 million lines (inaudible).

Right. Yes. I just wanted to mention also, by the way Dmitry; you just reminded me that we haven’t mentioned it. But we announced this quarter that we won the RSP for a large global service provider, name was not mentioned in that call. But yes, there’s another one, just fine.

One last real quick question on services, it’s done really nicely this year. Do you expect that level of growth maybe high-single digits, low double-digits to continue going forward? And I think part of it as you said maybe predicated on this Microsoft Skype for Business deployments that you’re working through in professional services that are attached to that. So can we expect similar growth next year?

Yes. Right now we predict services growing at about 10% to 12% annually and we do not see any reason that that trend will change.

Thank you. Mr. Adlersberg there are no further questions at this time. I’ll turn the floor back to you for any final remarks.

Thank you operator. I would like to thank everyone who attended our conference call today. Relying on good business momentum in the first three quarters of 2017, we believe we are on track to achieve another year of growth and continue to build the growing profitable business for the coming years. We look forward to your participation in our next quarterly conference call. Thank you. Have a nice day.

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