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Netlist, Inc. (NASDAQ:NLST)

Q3 2012 Earnings Call

November 13, 2012 5:00 p.m. ET

Executives

Corey Kinger - Brainerd Communicators

Chuck Hong – Chairman and CEO

Gail Sasaki – CFO

Analysts

Rich Kugele – Needham & Co.

Mark Kelleher – Dougherty & Co.

Operator

Good afternoon and welcome to the Netlist third quarter 2012 earnings call and webcast. (Operator instructions) I would now like to turn the conference over to Ms. Corey Kinger. Please go ahead.

Corey Kinger

Thank you, Laura, and good afternoon everyone. Welcome to Netlist’s third quarter 2012 conference call. On today’s call will be Chuck Hong, chief executive officer of Netlist; and Gail Sasaki, chief financial officer.

As a reminder, our earnings release and a replay of today’s call can be accessed on the Investors section of the Netlist website at www.netlist.com.

Before we start the call, I would note that today’s presentation of Netlist’s results and the answers to questions may include forward-looking statements, which are based on current expectations. The actual results could differ materially from those projected in the forward-looking statements because of a number of risks and uncertainties that are expressed in the call, annual and current SEC filings, and the cautionary statements contained in the press release today. We assume no obligation to update forward-looking statements.

During this call, non-GAAP financial measures will be discussed. Reconciliations for those directly comparable GAAP financial measures are included in the press release which was filed on Form 8-K.

I would now like to turn the call over to Chuck.

Chuck Hong

Thanks Corey. Our third quarter results reflect the continued transitional period for our business as we made progress in launching our new products while the contribution from our more mature products attached to prior generation servers continues to decrease. The quarter was marked by a sharp decline of PERC which have been the single largest portion of our revenues and gross profit over the past two years. The decrease in the demand for this product has occurred much faster than we had anticipated.

However in its place, we shipped more new products than ever before recording revenues of over $1 million for HyperCloud and close to $1 million for NV3 and VLP. We also shipped more new speciality and flash products than in prior quarters. Despite this growth of new product sales, we were not able to make up for the steep decline in PERC revenue in the third quarter. Nevertheless we expect continued momentum for the new products this quarter and into 2013 as additional OEM qualifications are achieved and the sales ramp accelerates for HyperCloud and the NV family.

Netlist has been historically an engineering projects company doing one project at a time for a single customer. For the past several years, we have undertaken efforts to move away from our dependence on customized one-off projects and evolve into a products company that can serve a broader market with our technologies. So despite the anticipated short-term impact to our financial performance, we have been working diligently towards this transition over the past few years to a more diversified business and we believe we are making solid progress in this process.

While PERC was a high volume product, it was a custom, single customer project which was limited to a single generation of Dell servers. In contrast, the new products which we have introduced to the market this year are fundamentally different in every respect. HyperCloud and NVvault, EXPRESSvault are all breakthrough technologies which came out of five years of development work costing approximately $40 million in R&D investment.

HyperCloud is based on silicon level IP which is backed by important patents. The Vault family is based on DRAM to Flash hybrid memory technology, also backed by important intellectual property. These are high performance products that can be sold to a multitude of customers in the server and storage space. Finally, HyperCloud and NV are multi-generational products that can scale to higher speed and higher densities at DDR4 and beyond.

While it has been a sharp transition in our business, we’re very excited about the way our product line and the new customer base are fundamentally reshaping our business and setting us up for stable long term growth over the next decade.

Now let me turn the call over to Gail for the financial review.

Gail Sasaki

Thanks Chuck. As Chuck mentioned, our third quarter results reflect the continued transitional period for our organization as we move forward in launching our new products while the contribution from our more mature products connected to prior generation servers declined more rapidly than we had predicted. Although demand for these products will mostly likely continue through the end of 2013, while ODM is more aggressively managing their inventory level and current and future ordering has been and will be based on maintaining a very limited supply.

Our revenue for the third quarter ended September 29, 2012 was $6.4 million, down 61% compared to $16.3 million for the third quarter of 2011, and down sequentially due to the product line transition just mentioned. HyperCloud shipped during the third quarter was just slightly better than the previous quarter. However HyperCloud booked was 30% higher and included a small initial order of a newly qualified 32 GB HyperCloud.

Gross profit for the third quarter ended September 29, 2012 was $0.4 million, or 6% of revenues, compared to a gross profit of $5.5 million or 34% of revenues, for the third quarter of 2011 mainly due to unabsorbed capacity from these lower revenues, a transition in the product mix as noted above and start-up costs of our new product lines.

We currently expect our gross profit margins to come in at a range of between 15% to 20% during the fourth quarter and as production volume ramps, the initial investment in capital equipment that we need in China becomes fully depreciated at the end of this year and incremental investments in manufacturing quality and capacity for HyperCloud and VLP normalize, we fully anticipate a return to margins in the 30% range and above.

Adjusted EBITDA loss, after adding back net interest expense, income taxes, depreciation, stock based compensation, and net non-operating expense was approximately $3.7 million for the third quarter of 2012, compared to positive adjusted EBITDA of $32,000 for the prior year period.

Net loss in the third quarter was $4.8 million, or $0.17 loss per share, compared to a net loss in the prior year period of $1 million, or $0.04 loss per share. These results include stock based compensation in the third quarter of $515,000, compared with $464,000 in the prior year period and depreciation and amortization expense of $471,000 compared with $534,000 in the prior year third quarter period.

Total operating expenses were $5.1 million in the third quarter of 2012 compared to $6.5 million in the previous year. Operating expenses were also down by 23% sequentially. As Chuck mentioned earlier and we had on earlier calls, we are aggressively streamlining the business and continue to anticipate the benefits of this optimization to reduce operating expenses to the $4 million level as we enter 2013.

As noted in previous calls, during the first half of the year, we accelerated our product rollout and made early progress on key areas of our roadmap, specifically in regard to our 32 GB product suite. As a result, we will see a decrease in research and development expenses for the remainder of the year, but do plan to invest further during 2013 as we continue development on next-generation DDR4 products.

We ended the third quarter with net cash, cash equivalents, and investments in marketable securities totaling $8.1 million, a gross cash number of $10.9 million compared to $11.7 million at the end of the second quarter. Our cash cycle continues to increase significantly as we ramp the OEM supply chain and that has led to decline in order generation products as noted earlier. We have capacity on our receivables base line of credit for working capital needs but also actively looking at a number of alternatives to supplement that capacity and will balance capital raising with unnecessary dilution.

During the third quarter, capital expenditures totaled $559,000 compared to $326,000 in the previous year’s third quarter. The increase was for planned investments in equipment to support increased capacity and large-scale production volume of HyperCloud and VLP. We anticipate minimal investment during the fourth quarter.

As we previously noted, we recently refinanced our current debt to provide us with additional flexibility as we execute to our business plan. Through December 2012, we will pay interest only on our term loans, plus we have extended the term, which will decrease our quarterly debt service payments by 40% going forward as principal payments resume. Nevertheless we may continue to be a net user of cash for the next couple of quarters.

On the IP front, we continue to enlarge and strengthen our patent portfolio. The U.S. Patent and Trademark Office recently granted us a new patent on hybrid memory technology U.S. patents No. 8301833 entitled non-volatile memory module. This patent covers fundamentals of our hybrid memory sub-systems that combine flash and DRAM and the technology that prevents loss of critical data by transferring data from volatile to non-volatile memory.

We remain the only supplier to have shipped high volumes of such memory sub-systems to major server and storage customers through our NVvault and EXPRESSvault product line. This patent once again validates our historical market leadership and technology solutions that protect critical data and enterprise systems. Today as many companies’ server and storage systems need to be brought back online after power outages, our technology is helping to facilitate the recovery of mission critical data in these enterprise systems.

We continue to vigorously defend our patents against any validity challenges by way of re-examination proceeding at the U.S. PTO. Recently we must also defend our technology leadership position against the patent infringement lawsuit filed by SMART modular technology. We believe that the lawsuit is baseless and we will aggressively fight against it. We filed an answer to the complaint denying any infringement and claiming that the patents being brought against us is invalid and unenforceable and in addition, asserted a set of counter claims.

We are also in the process of opposing a motion for preliminary injunction also brought by Smart modular and are confident that the court will rule in our favor regarding the motion.

In summary, despite the near term reduction in our revenues resulting from the transition in our business, we remain in our ability to expand our revenue streams over the next several quarters through product diversification as well as increased volumes given the superiority and proven performance of our new product lines, additionally supported by the exponential growth anticipated in the market for high performance memory.

I will now turn it over to Chuck for more details on our progress on the product front.

Chuck Hong

Okay. Thanks Gail. Since the beginning of this year, we have received multiple qualifications from the world’s top server and storage manufacturers for several of our new products, including our flagship products 16 gig and 32 GB HyperCloud. During the third quarter, we announced that our 32 GB HyperCloud became qualified on IBM system x3650 M4 servers. The 32 GB HCDIMM is the highest performing highest density server memory in the world. It allows IBM systems to be fully populated with 768 GB of main memory and simultaneously deliver high performance bandwidth with the lowest latency.

The qualification of our 32 GB HyperCloud product at IBM expands the availability of this breakthrough technology on one of the top selling servers in the world. Independent benchmarks as well as OEM testing confirmed that 32 GB HyperCloud dramatically outperforms the competing 32 GB LRDIMM on fully populated Intel-based servers. This faster performance and lower latency combined for an overall memory throughput advantage that is equivalent to two memory speed grades above LRDIMM. There is simply no other product on the market that can generate results at this level.

At this week’s supercomputing conference we are conducting a memory shootout where we test HCDIMMs side by side against LRDIMMs running an industry standard memory benchmark SANDRA. The results once again greatly favor HyperCloud showing a 39% throughput advantage for servers using HyperCloud over those using the same density of LRDIMM. We expect to showcase our technology to hundreds of end market users who are attending the conference.

The 32 GB HCDIMM and 32 GB 4 Rank Planar-X RDIMM were launched during the third quarter. They joined 16 GB HCDIMM, 16 gig and 32GB VLP NV, and EV3 as new products all launch this calendar year. Taken together, these high performance memory sub-systems provide our customers in the cloud computing virtualization and high performance computing markets with the most advanced and cost effective memory solution in the industry. As these new products begin to take hold, we continue to believe we will see a more diversified and higher quality stream of revenues with more attractive margins, reflecting their high performance attributes and IP content.

Our products are targeted at the entire server and storage space giving us the larger and more diverse addressable market going forward. These are also multi-generational products based on ground-breaking IP. As a result, we continue to expect the business to scale over many years as these products gain traction in the marketplace. In the near term, we will continue to focus on maintaining a disciplined approach to managing our expenses with the goal of maintaining adequate liquidity and positioning our business for profitability as revenues begin to expand with the ramp up of our new products.

We remain committed to taking full advantage of our emerging leadership position while laying out the ground work to generate returns from our investments to the benefit of our shareholders. Thank you all very much for listening today. And we are now ready for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) And our first question will be from Rich Kugele of Needham & Co.

Rich Kugele – Needham & Co.

I have a few questions that probably everyone is asking. I guess first, would you expect this quarter to represent the trough for revenues, overall revenues? And then secondly, when you look at the product mix that you now have especially the 32 gig, would you expect HyperCloud to materially increase in the fourth quarter and now that we are already well into, if you could give us a sense on how much you think it might increase sequentially?

Chuck Hong

Rich, yeah, we expect this to be the trough, Q3. We saw that the HyperCloud volumes have increased, we are seeing bigger demand this quarter over the last quarter. We saw a slight increase in Q3 from Q2. So we expect HyperCloud to start selling in greater volumes today, it is pretty much all 16 GB HyperCloud being sold by IBM. In the coming months, 32 GB became a SKU offering really starting in October. So that will start to get marketed and we will see some traction on that, we believe, starting at the end of this year and growing through next year.

Rich Kugele – Needham & Co.

Okay. In terms of the cash balance, $10.9 million obviously a material downtick but can you just – what do you expect for cash burn over the next one to two quarters, how much availability do you have on your credit lines and when you go and look deeper into those credit lines, are there any toughness that we should be aware of.

Gail Sasaki

For the cash balance, we do believe we have positioned capacity, our working capital line is based on accounts receivable and it can go up to $15 million as we have discussed earlier. We do anticipate needing to renegotiate our covenants with the bank. And we believe that, that won’t be an issue. As covenants are just – are based on estimates that we made a while ago, so the decreased revenue did impact that estimate obviously. So we will be working through that. And in terms of the cash balance, otherwise we are looking to supplement that through the appropriate partnership with investors and we have been actively working on that. We feel very positive about that potential outcome.

Rich Kugele – Needham & Co.

Just one last question, can you just refresh us on how much of the company management owns in aggregate?

Gail Sasaki

It’s approximately 20%.

Operator

And our next question is from Mark Kelleher of Dougherty & Co.

Mark Kelleher – Dougherty & Co.

Can you tell us what percentage of revenue in the quarter was PERC revenue?

Gail Sasaki

So we have the flash back PERC as well as the battery free or battery backed. And the battery backed was zero during Q3. So we did ship the newer product and it was about a 10% of revenue.

Mark Kelleher – Dougherty & Co.

So if that PERC revenue goes away entirely from down, would that happen this quarter? That’s another 600,000 would go away this quarter before?

Gail Sasaki

As I mentioned earlier, we are just watching the ODM got an over-inventory position because of the steep decline. I think everybody was surprised, Dell is normally pretty good in terms of predicting their demand. So it will depend on how, they’re trying to be very conservative about how much inventory they keep. So we are not quite sure yet what that number will be. We expect some revenue but not more than a million.

Mark Kelleher – Dougherty & Co.

And I noticed that SG&A was kind of flat quarter to quarter despite a downtick in revenue. Is there anything you do it be more aggressive on that side, are there any plans for headcount reductions and things like that to bring it more in line with revenue?

Gail Sasaki

Yeah actually the operating expenses came down by about 23% between quarters and—

Mark Kelleher – Dougherty & Co.

Right, but the SG&A line was kind of flat, 22.6 to 2.5.

Gail Sasaki

We have taken some actions on continuing to transfer some headcount over to our lower cost operation in China. And some of that, the benefit of that will start to show up as we exit Q4. So we are looking at about a $4 million OpEx by the end of the year. And some of that is in SG&A.

Mark Kelleher – Dougherty & Co

And just kind of on a higher view of the HyperCloud ramp, what things do you think are affecting the slower ramp than you had been expected, and particularly over at HP, why are things taking longer to ramp than originally thought?

Chuck Hong

I think HP the lack of traction there has been probably the biggest contributor to the slow ramp of HyperCloud. HP historically is the largest consumer of high density memory, server memory. In fact, two to three times the volume of IBM, for example. They qualify 16 GB a little bit later and they are not promoting the product as much as IBM. IBM has done bulk of the sales of 16 GB HyperCloud and they’ve actively promote it. We’ve worked together to do that. I think HP, we’re in qualification of a 32 GB with HP and that is their target product. I think HP has offered up this 16 GB standard register DIMM – standard RDIMM as an offering that is equivalent to HyperCloud unlike IBM. IBM made it very clear that the 16 GB HyperCloud outperforms the industry standard 16 gig.

So I think moving forward, the 32 GB will be the focus at HP and that should generate significant volume because the dollars, the ASPs on that is much higher. And at IBM we will continue to make progress on the 16 GB and then they will layer in the 32 GB on top that, starting -- that product was made available last month. So they will start to market that. Now that will add to the volumes of HyperCloud at IBM.

Mark Kelleher – Dougherty & Co

And do you have any sense when HP might qualify for 32 GB?

Chuck Hong

We’re in the middle of that process today. So it’s been in qualification now for a couple months.

Operator

And this concludes our question and answer session. I would like to turn the conference back over to management for any closing remarks.

Chuck Hong

Well, thank you for listening and thank you for your continuing interest in Netlist. We’ll talk to you and report back next quarter on our progress. Thank you.

Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.

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