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Quantum Corporation (NYSE:QTM)

F3Q09 Earnings Call

January 29, 2009 5:00 pm ET

Executives

Shawn D. Hall – Vice President, Secretary & General Counsel

Richard E. Belluzzo – Chief Executive Officer

John W. Gacek – Chief Financial Officer

William C. Britts – Executive Vice President of Worldwide Sales, Marketing & Service

Analysts

Brian Freed – Morgan Keegan & Company

James Bash – Dialectic Capital

Unidentified Analyst

Jason Bernstein – Quattro Global

Chris Cook – Unidentified Firm

Presentation

Operator

Welcome to the third quarter of fiscal 2009 teleconference conference call. (Operator Instructions). I would now like to turn the conference over to Shawn Hall, General Counsel.

Shawn D. Hall

Good afternoon and welcome. Here with me today are Rick Belluzzo, CEO; John Gacek, CFO and Bill Britts, Executive Vice President of Worldwide Sales, Marketing and Service. The webcast of this call, our earnings release, and a quantitative reconciliation of any GAAP and non-GAAP financial measures discussed today can be accessed at the investor relations section of our website at www.quantum.com and will be archived for one year.

During the course of today’s discussion, we will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements include our business prospects, priorities, performance, and opportunities; including our anticipated fiscal fourth quarter financial results, trends in the markets in which we compete, the expected timing of new product launches, and our expectations regarding future debt covenant compliance, and estimated third quarter goodwill impairment charge.

We’d like to caution you that our statements are based on current expectations and involve risks and uncertainties that could cause actual results to differ materially. We refer you to risk factors and cautionary language contained in our reports filed with the SEC from time to time, including our most recent 10-K filed on June 13, 2008, and our 10-Q filed on November 7, 2008.

Such reports contain and identify important factors that could cause actual results to differ materially from those contained in our forward-looking statements. All such risk factors identified in our press release and in our filings with the SEC are incorporated by reference into today’s discussion. We undertake no obligation to update these forward-looking statements in the future.

With that I’ll turn the call over to John Gacek.

John W. Gacek

Good afternoon and thank you for joining us. Today, we are reporting our results for the third quarter of fiscal 2009. This quarter’s financial results are the most important that Quantum has reported since the acquisition of ADIC. Results include the highest non-GAAP gross margin, operating profit, and earnings levels in 8 years achieved in a very tough economic environment. These results demonstrate that we are on the right strategic path. The company has a unique market opportunity, and we have the ability to create significant value for shareholders.

At the same time, our third quarter results included initial estimated non-cash impairment charge to Quantum’s goodwill that was triggered by the significant decline in our stock price due to the economic climate and our capital structure. The irony of it is these events happened in the same quarterly period. Here are the key financial results for the quarter:

First, this systems and software revenue including related service revenue was $31.3 million compared to $15.5 million a year ago, an increase of 100%. Second, our non-GAAP gross margin was 44.9% compared to 37.7% for the same quarter last year. Third, our non-GAAP operating profit was 15.3%, including total non-GAAP operating expenses of approximately $60 million, compared to 9.9% and $70 million in the same quarter last year. Fourth, we generated cash from operations of $19.3 million and EBITDA of $40.6 million.

We made our regularly required quarterly payment of $1 million on our acquisition debt and our ending cash balance increased to $51.2 million on December 31, 2008. We also reduced head count and expense during the quarter and as a result incurred a restructuring charge of $4.1 million and finally, we recorded an initial estimated goodwill impairment charge of $350 million against our approximately $390 million of goodwill. I would like to refer everyone to the financial statements and supporting schedule including the press release. It will be helpful for you to refer to those documents as I make my comments.

I am going to start with the goodwill impairment charge. As required by GAAP, during the quarter, we performed an analysis of fair value and concluded it is likely that the fair value of our goodwill is lower than its carrying value based on a combination of factors including the current economic environment and it’s impact on our business and the continued stock market decline which has affected our trading price. Therefore, we are now conducting a detailed impairment analysis of our goodwill in accordance with FASB Standard 142.

As of December 31, 2008, prior to the impact of this non-cash impairment charge, our goodwill was approximately $390 million. Our initial estimated impairment which is included in a separate line in our operating expenses is $350 million. It is important to note that while this charge is required by GAAP, it does not impact our cash balances, our liquidity, our ability to generate cash flow from operations going forward, or our debt covenants. We expect the amount of the impairment charge to be finalized between now and the filing of our Form 10-Q with the SEC which we expect to occur no later than February 9, 2009.

As a result, the amount recorded in our Form 10-Q may differ from the estimate we have recorded today. Please note that the $350 million impairment charge is excluded from the non-GAAP results which I will describe through the rest of the earnings call.

With that, I will move to revenue. Revenue for the third quarter ended December 31, 2008, was $203.7 million compared to $252.5 million a year ago. Royalty revenue was approximately $19 million for Q3 compared to $26.8 million in the same quarter a year ago. The decline is primarily attributable to the decline in the DLT media royalty. Our Q3 royalty revenue did not include amounts related to our intellectual property from our disk and software patents as it did in prior quarter results.

For the quarter, non-royalty revenue totaled $184.6 million, of which 65% was branded and 35% was OEM. That compares to non-royalty revenue of $225.8 million a year ago, of which 62% was branded and 38% was OEM. Looking further at various revenue classifications, devices in media totaled $29.7 million compared to $58.2 million in Q3 a year ago. The decline is primarily attributable to our anticipated decrease in OEM device revenue and an $11.4 million decline in branded media. We continue to manage our media business opportunistically to generate gross profit dollars. This quarter’s media market pricing resulted in us pulling back on media revenue opportunities.

Tape automation systems revenue was $85 million compared to $112.8 million in Q3 of fiscal 2008. Two-thirds of this decline was related to OEM products and one-third was related to branded automation. The decline in branded automation was primarily related to declines in volumes across entry, midrange, and enterprise automation compared to the same quarter last year where we had a very strong quarter.

This systems and software product and related service revenue was $31.3 million, up from $15.5 million a year ago, a 100% increase. Our year-over-year growth was largely driven by license revenue from EMC and the addition of the DXi7500 to our product portfolio.

Moving to gross margins, non-GAAP gross margin in Q3 was 44.9% compared to 37.7% in the prior period. This improvement is driven by the increase in our disk systems and software revenue, an increase in branded service revenue, declines in our lower margin tape drive and media products, and a reduction in manufacturing expenses and product cost. Our gross margin improvement occurred despite a year-over-year decline of $50 million in total revenue including a $7.7 million decline in media royalty revenue. The method here is we have made significant progress in improving the mix of our revenue towards higher margin, higher value products, and we have reduced our overall manufacturing costs as well.

Moving to expenses, non-GAAP operating expense totaled $60.2 million compared to $70.2 million a year earlier. For the quarter, R&D was $15.4 million, sales and marketing was $29.2 million, and general and administrative expenses were $15.7 million. The significant changes here relate to headcount reductions and associated employee cost, decreases in travel expenditure, and lower marketing and R&D projects spend. In addition, we closed our North American facilities Thanksgiving week and the week between Christmas and New Years.

Moving beyond expenses, non-GAAP operating profit for the quarter was $31.3 or 15.3% of revenue, compared to $25 million or 9.9% of revenue in the same quarter a year ago. This is an exceptional result and shows both the power of our model and the opportunity the company has to create value. Net other expense of $600,000 was primarily comprised of a non-cash charge related to our interest rate caller which we are required to mark-to-mark at each quarter and that is required by our debt agreement.

Interest expense for the quarter was $7.3 million compared to $11 million a year earlier. This included cash interest expense of $6.8 million and amortization of debt issue cost of $500,000. The coupon interest rate for our remaining acquisition debt of $249 million on December 31, 2008, will be approximately 4.958% for the quarter ending March 31, 2009, under 5%. For the quarter, we recognize a net tax benefit of $2.3 million related to the release of a tax reserve involving the expiration of the statute of limitations of the tax position taken in a prior year. However, we still believe for those who do models, it is reasonable to model a million dollars per quarter of tax expense.

Summing it up for Q3, we had non-GAAP income of $25.6 million with non-GAAP EPS of $0.12 compared to non-GAAP income of $13.8 million and non-GAAP EPS of $0.7 in Q3 of fiscal 2008.

Focusing on cash flow for the quarter in the balance sheet on December 31, 2008, I want to highlight several key points. Cash flows from operations for the quarter were $19.3 million. We paid down $1 million of our ADIC acquisition related debt during the quarter which totaled to $249 million at the end of the period. As we stated at the beginning of the year, we intended to aggressively pay down our debt in the first two fiscal quarters to ensure covenant compliance until our EBITDA improved. We now have paid down $91 million during the first 9 months of fiscal 2009. Non-GAAP EBITDA for the quarter was $40.6 million. We are in compliance with all debt covenants on December 31, 2009, and we expect to be in compliance with our debt covenants during the next 12 months. For purposes of calculating our debt covenants for EBITDA for the last 12 months, was $106.7 million.

Sequentially, inventory decreased $10.9 million and accounts receivable decreased to $2.8 million. We had an accelerated payment of $14.6 million from one customer. CapEx was $1.3 million. Purchases of service parts for maintenance were approximately $1.2 million, and depreciation and amortization totaled $17.8 million for the quarter.

Looking forward for the fourth quarter, we have taken into account both seasonality and the macroeconomic environment, and our plan anticipates a sequential decline in branded and revenue and a slight increase in expenses. Specifically in Q4, we expect revenue of $175 million to $195 million, non-GAAP gross margins of approximately 40% to 42%, non -GAAP OpEx between $60 and $63 million, and non-GAAP operating income of $10 to $20 million.

With that, let me turn the call over to Rick.

Richard E. Belluzzo

Well Thank you John. We were very pleased with our Q3 performance especially in terms of our process on our key strategic priority, i.e., transitioning Quantum and our business model from a device-centric to a more system-centric focus. This has included shifting our revenue content to a mix that favors higher gross margin businesses with a primary focus on our branded business and disk systems and software business.

In addition to shifting our revenue, we have also aggressively aligned our investments around new opportunities in these areas while reducing investments in some other more mature parts of our overall business. All of these actions are key to improving the value of Quantum in terms of profitability and our market position. In Q3, several elements of our results point to the effectiveness of our strategic focus. Our record non-GAAP gross margin of 44.9% represents an increase of more than 13 percentage points from the combined Quantum and ADIC level when we merged the companies 2-1/2 years ago.

The 100% year-over-year growth in our disk systems and software revenue reflects the progress we are making in building this business through both our branded sales efforts and OEM partnerships.

Next, the 14% year-over-year reduction in our non-GAAP operating expense is a result of the aggressive work we have been doing over the last 6 months to reduce spending and to improve our operating performance while ensuring that we can continue to deliver on our strategic opportunity. All of this contributed to our non-GAAP operating profit of 15.3% and the $41 million in EBITDA that we delivered, even in the face of a clearly challenging macroeconomic environment. It is also worth noting if we had not taken the goodwill impairment, our GAAP net profit would have been the highest it has been in 4 years.

In summary, we are very pleased with our operating results but at the same time, we recognized that there are still a few critical areas that require focus in order to improve our execution or capitalize more effectively on our opportunities. The first of these is the return on investment from our branded sales and marketing effort. With EMC and Dell licensing our de-duplication replication software, we must do a better job aligning our efforts to drive our branded DXi sales with the support that we will provide to these partners in selling products with our technology.

Because we have not been sufficiently aligned in these areas, we have seen a somewhat weaker disk revenue and certainly higher costs than should be the case. Fixing this is a primary focus, as we work to capitalize on our large installed-based OEM Partnerships and channel relationships. To improve here, we will need to more effectively align our product portfolio, our sales model, and our marketing programs.

Next, we have an exciting opportunity in the de-duplication replication market. We are a leader in the early phases of this market and have strong OEM partners in Dell and EMC. However, the market is evolving at a very fast pace and therefore, we must also move quickly to take full advantage of this opportunity. This means, continuing to enhance our technology and product offerings and accelerating time to market while still managing our overall investment levels, and then finally, we must continue to work on our overall OpEx reduction.

The current environment is very challenging, and we need to make sure that we drive our competitiveness in all aspects of the business, and as I have said in previous earnings calls, and what we demonstrated in Q3, is that we are confident that we can continue to reduce our expense levels while still delivering on our strategic priorities.

Now let me say a few words about the market. The overall IT market has clearly tightening over the last 6 months. Storage has not been immune, although activity levels have not weakened as much as one would think. In particularly the market for de-duplication replication continues to show momentum and back-up redesign remains a high priority according to many IT surveys. In general, however, deals do take longer to close, channel partners have been reducing inventory levels, and pricing is clearly more aggressive. We expect the market to remain challenging though calendar year 2009.

Quantum’s position in the de-duplication replication market is clearly getting stronger. Our software platform is currently shifting in Quantum branded products and in EMC disk libraries. In the first half of this year, Dell will also offer storage systems with this software enabling replication compatibility across products from all 3 suppliers. This will further enhance our market presence, continue to be at a higher margin license revenue, and begin to establish and ecosystem to deliver on our extended edge-to-core strategy at providing multi-site, multi-tier data protection.

As a result of our partnerships with Dell and EMC, and continued momentum in our branded EXI business, we expect deployments of our de-duplication replication software will surpass those of the market leader this calendar year.

As for the recently completed quarter, we introduced the Quantum DXi7500 Express De-duplication appliance optimized for small and medium-sized enterprise environments and Quick-Fit configuration program designed to make it easier for channel partners to size, order, and install Quantum de-duplication solutions. Although it only shipped for less than half the quarter, the DXi7500 Express showed strong sales over this period, re-enforcing the growing adoption of our de-duplication and replication technology.

Based on shipments through the December quarter, this technology is being used now to protect more than 400 petabytes of data. We are continuing to build on this momentum as illustrated by the hardware and software enhancements to the DXi7500 announced earlier this week. Besides increasing usable capacity by 22%, we provided more granular replication capabilities, expanded the range of options for direct tape creation from disk, and added support for a number of ISD applications.

Also this week, the DXI 7500 was named as a finalist in the backup hardware category for the storage magazine, Searchstorage.com 2008 Product of the Year Awards that will be announced in February.

While all of this speaks to our progress and future opportunity, we clearly face a significant amount of pressure as a result of the tightening credit markets. We believe that this factor has put the most significant pressure on our stock price, and we obviously need to address this risk factor aggressively.

We have worked on four approaches to the problem. First, we have been focused on raising the level of EBITDA in order to avoid any dead covenant issues and to improve the financing capacity of the company. Second, we have taken the cash generated and used it to reduce our debts significantly, but starting in this quarter, Q3, we have transitioned to holding more cash in order to give us further flexibility. Third, we are monitoring the debt markets and will pursue viable options to re-finance as they develop.

There is some progress here, but the overall market remains very constraint. Then finally, we are exploring a range of strategic options ranging from strategic investment after sales and other solutions. It will take some combination of these efforts to transition into a more desirable capital structure. The key principle is that we must continue to make the business more valuable in terms of both profitability and market position, and as I said, we believe we are making notable progress in both of these areas.

In summary, Q3 was a good quarter in terms of driving stronger operational performance. In the coming quarters, we will work to make significant progress on our three execution priorities, improving the return of our branded sales and marketing investments, continuing to enhance our technology and product offering while accelerating time to market, and finally continuing to drive further OpEx reduction. At the same time, we have a very strong sense of urgency to make fundamental improvement in our capital structure.

Again, thank you for joining us and let me turn the call over to operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Brian Freed with Morgan Keegan & Company

Brian Freed – Morgan Keegan & Company

On the de-duplication side of things, can you give us any more color into the mix between the branded DXi product and the EMC royalty contribution in the quarter?

John W. Gacek

No, but both were up. Again, our position there, Brian, as you know well, we don’t want to talk about our partners’ products, so we are not going to break those up separately, but both were up and we both are having success in the marketplace.

Brian Freed – Morgan Keegan & Company

As you guys talked about the go forward strategy in leveraging more from your branded sales force, does that to some extent imply a more singular focus on the mid-range to avoid channel conflict with say EMC, and then with Dell forthcoming being kind of a low end fulfilling solution for de-duplication?

Richard E. Belluzzo

Yes, Brian, it actually, if you look at the results, with our semi-500 Express, we got a preconfigured very purpose target and product implementation that is really built around our channel partner relationships and being able to leverage those, so it really takes advantage of our historical success in the open systems, kind of mid range and up to the low end of the enterprise.

Brian Freed – Morgan Keegan & Company

Lastly, I might have missed it in the details, but did you given the percentage of DXi that has the right to tape function enabled.

John W. Gacek

We didn’t actually. I am going to oversee if we have it. I don’t have it handy.

Brian Freed – Morgan Keegan & Company

Do you have the sense it has changed materially?

John W. Gacek

I’m looking at Brad. I don’t think we know right now.

Richard E. Belluzzo

I may just add to this whole process. We have been pursuing this market, there is no doubt this de-duplication replication trend is probably one of the most significant, if not, the most significant storage trend that is underway, and we entered the market with our platform, with our product, and as opportunities developed, we added EMC, recently Dell, and that has evolved into this perspective that we have an opportunity to partner and to build this ecosystem where we have multiple suppliers with replication compatibility and that leads us to getting more focused in places where we can deliver more value which is more, we call, the low enterprise, mid-range part of the market. Today, we are not fully aligned there. We have more work to do to get our sales force channeled, marketing program, and product, I would say, as well, all aligned around that opportunity, and we are pretty aggressively focused on that, and we believe we need to do that in order to optimize our results, and today, we are not exactly where we need to be. I often tell our team, it is like a kid’s soccer team where this is great opportunity, everyone is after the ball and we are kind of bunched up on the field, and we have got to spread it out, play our positions, and I think we will get a lot better results in the marketplace with a lot lower cost.

Operator

Our next question is from the line of James Bash with Dialectic. Please go ahead.

James Bash – Dialectic Capital

Guys, really good execution in the December quarter! As far as March goes, revenue is projected to be definitely sequentially down which is more than understandable in this environment. This question, more is on operating expenses, I think you mentioned, John that they are expected to be slightly up this quarter. Why is that the case? Then I have a follow-up question.

John W. Gacek

Sure. There are a couple of one-time events like the two-plants shutdown in Q4 that will not repeat, and then this quarter also has two high-end expense items where you start having FICA again, and then those guys are in their accelerator mode, so we have those factored in. We are going to continue to look at reductions, but from a guidance perspective, we are looking at it from run rate to the things that were one-time in nature on both sides.

James Bash – Dialectic Capital

The follow-up is you guys have stated before, I think, in previous conferences and publicly that in terms of looking at covenants that March would be the toughest covenant quarter to get through and then things should get easier after that, so it is nice to see the large EBITDA number in the December quarter. Can you talk a little more about why you feel that is the case? That should be the hardest hurdle to jump over, and then it should get easier.

John W. Gacek

Yes, so I guess I am going to revise that today with that comment. March does not look as hard as it looked going into Q3, and not that we are only going to just clear the bar, but I think the number is, we roughly need to do $6 million of EBITDA in Q4 to meet the March covenant, and our plan is to do a lot more than that, so now, because this quarter was so strong, we are not really that worried about March. I do not want to say that we are not worried, because we are going to operate, so I don’t want to give the wrong impression, but it has gotten a lot easier in Q4.

Then beginning in Q1, last year, that quarter was just a very weak quarter, I think the number was around $18 million. We had a real poor quarter, and we have got these ramping good things going on inside our business, our DXi, EMC, VL 3-D products, and then Dell comes online as well within all of that and all the rest of the changes that we are doing in the business, so we really feel like our execution is improving and our opportunities are more clear the further out we get.

Operator

Our next question is from the line of [unidentified analyst].

Unidentified Analyst

Congratulations on getting to the turn around here. It is nice to see. Just you have mentioned it, but if you did, I missed it, when you were talking about the March quarter, do you think disk and software can grow off of the strong performance that you put up in December?

John W. Gacek

It’s hard. Seasonally, the quarter is generally down, so we have tried to model it that way, but as I look around the table, we all feel a lot of momentum, so we have tried to model it conservatively for the obvious reason, and it is just hard to predict how the macroeconomic environment is going to impact us, but having said that, we are getting a lot of traction, we think our partner is getting traction, and we feel good about it. The answer is may be, but we are not modeling it that way.

Unidentified Analyst

Got it, and John, just to stick on that line, is it possible for you to characterize the gross margin in disk and software compared to the other segments of the business or the corporate average?

John W. Gacek

Sure. I should give you the pieces. Our pure software business is close to 95%. The disk products are in the 60% to 70%, and then the license we get from EMC and when we get it from Dell, that is 100% because we don’t ship any hardware, so it really pushes it up pretty high.

Unidentified Analyst

Yes, so probably 70% to 80% on a blended basis?

John W. Gacek

Yes, or higher.

Unidentified Analyst

And John, just talking about the EBITDA covenants, do you have handy the March number that now you’re going to anniversary from last year, from what you guys did in March EBITDA for covenant purposes?

John W. Gacek

You mean it is from the period?

Unidentified Analyst

Correct.

John W. Gacek

The March period last year was 19.5.

Unidentified Analyst

So 19.5, so you’re going into this quarter with almost 87 of EBITDA that then whatever you do in March is going to add to?

John W. Gacek

Yes, and I think actually I probably made the number too high, I think we have to get to 91 based upon the current data mount, so that is why I said a quarter ago, this looked really hard with a step down, but given such a strong period, it really makes it look out further out from my skis to run with my sports analogy.

Unidentified Analyst

A final question, Rick, when you were talking about what you guys were focused on to kind of deal with the crisis in the credit markets? I think your last initiative was talking about looking at strategic options. Have your guys or has the board formally hired an investment bank to help you with that evaluation?

Richard E. Belluzzo

No. That was a bit of a broad phrase that included a lot of thinking about how we work with our partners in terms of potential investments. It includes other pieces of the business that we can monetize that are on our focus moving forward, I mean it is a variety of things like that. I wouldn’t interpret that to say the company’s for sale. That was not the intent of that statement. It is that there are many options. We feel that finding the right solution to the capital structure is very, very important, and we think doing that, of course, is ultimately the most important thing we are doing in this environment, but we also recognize that underlying that is improving EBITDA and improving the value of the business, and that those options then become available in our IP portfolio, and we have many things to work with, that we are looking at everything possible in order to make sure that we have the best set of options available to us.

Unidentified Analyst

Great, I understand more clearly now. Thanks very much and congratulations again.

Operator

Our next question is from the line of Jason Bernstein with Quattro.

Jason Bernstein – Quattro Global

Okay, let’s see if we can make this work. Congratulations on a great quarter. I just had a question. Was the Riverbed settlement included in the cash number this quarter?

John W. Gacek

Yes. We collected that this quarter.

Jason Bernstein – Quattro Global

What was the D&A number again?

John W. Gacek

17.8.

Operator

(Operator Instructions). Our next question is from the line of Chris Cook with (inaudible).

Chris Cook – Unidentified Firm

I may have missed this. What are your expectations for CapEx for the fourth quarter and going on into fiscal 2010?

John W. Gacek

We have been, if you look at the last three or four quarters, we are below $4 million. Normally, I say, it is about $4 million, but the business is fairly mature, and we really have that clamped pretty far down, so you can put $3 million or $4 million in, and you would be conservative.

Chris Cook – Unidentified Firm

And your expectations are that it would continue into fiscal 2010.

John W. Gacek

Just like this quarter was 2.5, last quarter it was 1.5, and it is kind of a, I would call it a burn rate if you will. We include in that, our service parts that we use for maintaining our products, so that is half of it, so that is a little bit different than some people.

Chris Cook – Unidentified Firm

Thanks.

John W. Gacek

Well thank you for your questions and thank you for joining us to day. I just want to close by reiterating what I said before we started the Q&A and that we feel about the results that we delivered this last quarter and we really believe in the opportunity we have to extend this progress. At the same time, we know that there are a number of very critical areas that we have to take action on. While we are in a very tough economic environment, we still do believe that we have many opportunities to improve execution in order to capitalize on the opportunities that we have before us, and I think we laid those out during this call, and you can be sure that our primary focus over the next few quarters is addressing those areas, so that we can continue the momentum that we delivered in our third quarter.

Again, thanks for joining us, and we look forward to talking to you on the next call.

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