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Hutchinson Technology Incorporated (NASDAQ:HTCH)

Q2 2013 Earnings Conference Call

April 30, 2013 17:00 ET

Executives

Charles Ives - Director, Investor Relations

Richard Penn - President and Chief Executive Officer

David Radloff - Vice President and Chief Financial Officer

Analysts

Brian Yurinich - Craig-Hallum Capital Group

Mark Miller - Noble Financial Capital Market

Rich Kugele - Needham & Company

Tom Lewis - High Road Value Research

Operator

Good day, ladies and gentlemen and thank you for standing by. Welcome to the Hutchinson Technology Second Quarter Results Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference is being recorded today April 30, 2013.

I would now like to turn the conference over to Chuck Ives. Please go ahead sir.

Chuck Ives

Good afternoon, everyone. Welcome to our second quarter results conference call. On the call with me today are Rick Penn, our Chief Executive Officer; and Dave Radloff, our Chief Financial Officer.

As a reminder, we will be providing forward-looking information on demand for and shipments of disk drives and the company’s products, product adoption, program ramps, product mix, pricing, production capabilities and volumes, product cost, our operations in Thailand and the United States, capital spending and financing, operating expenses, and the company’s business model, operating performance and financial results.

These forward-looking statements involve risks and uncertainties as they are based on our current expectations. Our actual results could differ materially as a result of several factors that are described in our periodic reports on file with the SEC. In connection with the adoption of SEC rules governing fair disclosure, the company provides financial information and projections only through means that are designed to provide broad distribution of the information to the public. The company will not make projections or provide material non-public information through any other means.

We issued our second quarter results announcement just after the market closed this afternoon and it is now posted on our website at www.htch.com.

I’ll turn the call over to Rick now.

Rick Penn

Thanks, Chuck. Good afternoon everyone and thank you for joining us today. Overall we are pleased with our second quarter performance making further progress toward return to operating profitability and positive cash generation. Industry sources estimate that second quarter disk drive shipments were above flat with the preceding quarter, but our own estimate -- by our own estimate, worldwide suspension assembly shipments were down slightly and we believe our overall market share was unchanged.

While overall demand has been below the expectations that we had six months ago, our position and momentum on new customer programs is even stronger now than a quarter ago. The ramps to higher volumes on each programs should begin to increase our volume in the fourth quarter of this year.

Our strong position on new customer programs is a result of continued adoption of our dual stage dual-stage actuated or DSA suspension assembly, coupled with our ongoing effort to be the industry’s lowest cost producer. With our DSA products, we are delivering the component level innovations customers need to advance the performance and cost effectiveness of their upcoming disk drive products.

While customer ramps on certain programs that use DSA suspensions have been slower than expected, we still project DSA to account for a steadily increasing proportion of our total shipments. Our DSA shipments increased in the later part of the second quarter and we currently expect DSA suspensions to increase from 12% of our shipments in the second quarter to about 20% in the third quarter.

TSA+ suspensions had accounted for 87% of our second quarter shipments, up from 85% in the preceding quarter. Our TSA+ team has worked hard to improve our process efficiencies and their efforts paid off this past quarter with some excellent gains in our TSA+ luxury yield and output, which is further reducing our cost and will help establish us as the lowest cost producer of suspensions.

Also we continue to improve our cost structure by transitioning more of our assembly production to our Thailand operation and by continuing with the previously announced consolidation of our U.S. operations. Our Thailand operation accounted for 27% of assembly production in our second quarter, compared with 18% in the preceding quarter.

By the end of the current quarter, we expect our Thailand operation to account for approximately 40 of our assembly output, including increased production of DSA suspensions. One year from now, we expect above 80% of our assembly output to come from our Thailand operation.

On a separate note, our unique and broad spectrum of precision manufacturing capabilities is also valuable in applications outside of the disk drive industry. The new business development initiative that we started a few years ago continues to focus on leveraging our process technologies and manufacturing strengths for component opportunities in new markets. We will keep you updated on our new business development progress in future calls as these opportunities become material to our overall results.

So in summary, we remain focused on exceeding customer expectations for supply assurance, new product development and costs and will continue to be laser focused on improving our program positions, increasing our volume and improving our free cash flow and profitability.

I will turn the call over to Dave now for a discussion of our financial results.

Dave Radloff

Thanks Rick. The second quarter suspension assembly shipments were $98.9 million, down 5% from the preceding quarter and in light with guidance we provided at the time of our first quarter results announcement. Our mix of products shipped in the quarter was as follows; suspension shipments for 3.5-inch ATA applications decreased 1% sequentially and accounted for 42% of our shipments compared with 40% of shipments in the preceding quarter.

Shipments for mobile applications decreased 4% sequentially and accounted for 40% of our shipments, the same as in the preceding quarter and shipments for enterprise applications decreased 12% sequentially and accounted for 18% of our shipments compared with 20% of our shipments in the preceding quarter.

DSA suspensions accounted for 12% of our shipments in the second quarter, up from 9% in the preceding quarter. Our average selling price in the second quarter was $0.60, flat with preceding quarter. Net sales for the fiscal 2013 second quarter were $60.9 million, down 4% from $63.7 in the preceding quarter.

The revenue percentages for our top customers in the quarter were as follows; Western Digital 53%, SAE/TDK 24%, Seagate 12%, and Hitachi GST 9%. Gross profit in the second quarter improved to $8 million of 13.1% of net sales compared with $7.4 million or 11.6% of net sales in the preceding quarter.

The improvement was contrary to our expectation, which was for a slight decline in gross profit based on lower shipment volumes in the absence of our some unusual items that benefitted our first quarter gross profit. The second quarter improvement resulted primarily from better fixed cost leverage on higher levels of flexure and assembly production.

We built more inventory than we initially planned in order to adjust to a change in product mix and to meet expected demand while we continue to transfer more production capacity to Thailand. We estimate to building more suspension and flexures than we shipped at a favorable gross margin impact of approximately $2 million in the quarter. We expect to see an unfavorable gross profit margin impact of a similar magnitude as we use that inventory in manufacturing less in the next couple of quarters, resulting in lower fixed cost leverage. For this reason we expect to see a decline in gross profit in our third quarter.

We expect that the incremental cost associated with manufacturing more volume in the U.S. than we had planned prior to the 2011 Thailand flooding was $2 million in the second quarter, down from $2.3 million in the preceding quarter. As we ship more assembly production volume to Thailand, these costs will continue to diminish.

Second quarter depreciation and amortization totaled $10.2 million compared with $9.6 million in the preceding quarter. R&D expenses in the second quarter were $3.5 million compared with $3.3 million in the preceding quarter. SG&A expenses totaled $6.2 million flat with the preceding quarter. Our second quarter results included $330,000 in severance and site consolidation expenses.

Our operating loss totaled $2.1 million, compared with $3.1 million in the preceding quarter. Included in the prior quarter operating loss was severance cost of $1 million. Interest expense in the second quarter was $3.8 million down from $4 million in the first quarter. Second quarter interest expense excluded -- included $800,000 of non-cash interest expense, down from $1 million in the preceding quarter.

Other income in the second income totaled $2.5 million, up $2 million compared with the preceding quarter as a result of a $2 million increase in foreign currency gains. The gains were primarily due to the strengthening of the Thai Baht against the U.S. dollar.

During the second quarter, we also realized a $5 million gain on debt extinguishment related to the 8.5% convertible senior notes that we repurchased in January to 62% of par value.

Net income for the 2013 second quarter totaled $1.9 million or $0.07 per diluted share compared with a net loss of $6.5 million or $0.27 per share in the preceding quarter. Excluding the $5 million gain on debt extinguishment, the $2 million gain on foreign currencies, $800,000 of non-cash interest expense and the $330,000 of severance and site consolidation costs, our non-GAAP net loss was $4 million or $0.16 per share. In the preceding quarter, our non-GAAP net loss was $4.6 million or $0.19 per share.

Our share count at the end of the second quarter was approximately 26.2 million shares, resulting in book value per share of $6.26. Our share count increased during the quarter as a result of 2.2 million warrants that were exercised. Subsequent to the end of the quarter, an additional 1.1 million shares were issued in connection with the exercise of warrants. This increased our share count to approximately 27.3 million shares and leased only 175,000 warrants outstanding.

Cash generated by operations in the fiscal 2013 second quarter totaled $3.7 million and our capital spending in the quarter totaled $7.6 million. Free cash flow in the second quarter was negative $3.9 million influenced by $4.2 million of unfavorable changes in inventories, payables and receivables.

Our first consecutive quarter results demonstrates that with the adjustments we have made to our cost structure our business discreet cash flow neutral had volume of about 8 million parts per week assuming no changes in our working capital. As shipments grow to more than 8 million per week; we expect to generate positive free cash flow.

Cash and investments at quarter end totaled $41.1 million, compared with $57.5 million at the end of the preceding quarter. In addition to the negative free cash flow that I mentioned, we used $11.9 million of cash to redeem in the remainder of our 3.25% convertible subordinated notes.

We had outstanding borrowings of $2.3 million under our revolving line of credit at quarter end, down from $4.1 million at the end of the preceding quarter. Through the transactions completed during the quarter, we have reduced the total principle amount of our long term debt balance from $149 million to $131 million. Of this balance, $39.8 million has a first put date in 2015 and $91.1 million is due in 2017.

Turning now to our outlook, we expect our third quarter shipments to be about flat with the second quarter at 95 million to 105 million. Average selling price in the third quarter should be slightly up on an increase in the mix of higher value DSA suspensions.

As I mentioned previously, our third quarter gross profit is expected to decline compared with the second quarter, primarily because of lower fixed cost leverage as we lower our production volume and work to reduce the inventories or builds in the first half of our fiscal year.

We estimate that our SG&A expenses will be approximately $6 million per quarter and our R&D expenses should be around $2.5 million per quarter. Depreciation and amortization expense is expected to be approximately $10 million per quarter. Our interest expense is expected to be approximately $3.7 million per quarter with the non-cash portion decreasing to about $750,000 per quarter. Our tax rate is expected to be near zero in fiscal 2013.

As we consolidate some of our U.S. operations, we expect to incur external costs to prepare the available space in Hutchinson for operations and to move equipment from our development center and stamping operation to our headquarters building. We estimate that these external costs will be approximately $2 million over the next 18 months.

We expect our fiscal 2013 capital expenditures to be about $20 million. At 2013 capital investments are primarily for customer-specific program tooling and DSA production equipment. For the second quarter, we've obtained about $3.5 million of lease financing for the capital investments in DSA and we expect to obtain more throughout the year.

That concludes our prepared remarks, and George please begin pooling for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Christian Schwab with Craig-Hallum Capital Group. Please go ahead.

Brian Yurinich - Craig-Hallum Capital

Hi guys, this is Brian Yurinich on behalf of Christian.

Rick Penn

Hi Brian.

Brian Yurinich - Craig-Hallum Capital

Hey so can you show the decline in heads shift in the December to March quarter, given a shift to WD using more internally sourced heads? As that continues to accelerate, is that a positive for you from a share gain perspective?

Rick Penn

Brian, we don’t -- you know, we supply the WD either through TDK or directly to WD. So that shift doesn't really affect our position in one way or the other.

Brian Yurinich - Craig-Hallum Capital

Okay. And then both TDK and Nidec talked about double-digit increases in the June quarter due to the completion of an engine to earn HDD inventory correction and should we consider your guidance to be conservative or do you believe your suspensions weren’t over-purchased in the last few quarters?

Rick Penn

Well I think we look at the June quarter -- you know, we are really taking our customers lead primarily Brian I mean, you know, we are seeing things running along at a fairly flat level and if listen to Western Digital, they are talking about flat to down and so, you know, we sort of take our customers lead and that’s how we gauge what -- how we look at it, again depending on what might be happening with specific programs.

So we are looking at our situation as being flat. We don’t see any really disruptive kind of inventory things going on that are affecting us and we think we are being prudent to just look at the business environment that way at this point.

Brian Yurinich - Craig-Hallum Capital

Okay. And then one more question is it appears as Thailand and DSA compete to ramp, you guys are getting closer or kind of breakeven there, you know modest profitably. If at current stage you know, relative flat to modestly increases and you guys kind of gain from the share you’ve talked about previously. How many quarters away do you think we are from making money?

Dave Radloff

Yes, I am a little hesitant to be quarter specific, just because it's so dependent on the volume Brian and when do we get to the levels of volume that allow us to do that, but we certainly would like to think that happens in 2014. I wouldn’t want to predict that it's going to happen in 2013. So it's a matter when do we get to the volumes.

Brian Yurinich - Craig-Hallum Capital

Okay. Thank you.

Operator

Thank you, and our next question is from the line of Mark Miller with Noble Financial Capital Markets, please go ahead.

Mark Miller - Noble Financial Capital Market

Was the inventory build that you spoke about, was that due to what you perceive to be any share shifts among major customers?

Dave Radloff

Mark, that inventory was really -- we had a product mix shift that was significant and so we need to -- we need to build some buffer inventory as we transferred product to Thailand and so that’s really the balancing act that we were playing to make sure that we kept our capital supply lines moving for our customer.

Rick Penn

And so Mark, I don’t think we would say that it was because of change in allocation between us and our competitors.

Dave Radloff

No.

Rick Penn

Strictly managing supply to our customers as we transition to Asia.

Mark Miller - Noble Financial Capital Market

But more specifically I was thinking about one of your customers I mean, Western Digital in the K, they didn’t picked up some share going in the quarter, they didn’t talk that much about it, I was just wondering if that might have played a role that one of your customers might have seen a change in their share for certain programs you serve.

Rick Penn

It could have been possibly -- yes, I don’t know, but I would probably read too much into that.

Mark Miller - Noble Financial Capital Market

Are you seeing -- I assume pricing remains competitive even though you were kind of flat pricing, I guess there was some mix up effect while pricing didn’t change, but I am assuming you are not seeing any change in the pricing environment for suspensions?

Rick Penn

Pricing continues to be competitive and sort of normal competitive kind of an environment Mark and we see that continuing.

Mark Miller - Noble Financial Capital Market

And as you ramp the (inaudible) because you remind me again that the savings that fully ramps up over the next year or so what ultimately means in terms of savings.

Dave Radloff

Yes. There was $2 million this quarter Mark.

Mark Miller - Noble Financial Capital Market

Okay.

Dave Radloff

That we think goes away as we get to that facility operating pool.

Mark Miller - Noble Financial Capital Market

So that especially out of SG&A I assume, or manufacturing cost I am sorry.

Dave Radloff

That’s primarily manufacturing.

Mark Miller - Noble Financial Capital Market

Okay. So improvement of $2 million. All right. Thank you.

Dave Radloff

Yes.

Operator

(Operator Instructions) Our next question is from the line of Rich Kugele with Needham & Company. Please go ahead.

Rich Kugele - Needham & Company

Thank you. Good afternoon.

Rick Penn

Yes hello.

Rich Kugele - Needham & Company

Just a couple of quick questions. Can you give -- break down the fixed and variable cost assumptions or the way it broke down in the second quarter, so that we can figure out what Q3 margin decline might be?

Dave Radloff

Give us a second Rich.

Rich Kugele - Needham & Company

Okay.

Dave Radloff

One of the things -- we want to check a little bit just because we are seeing variable go up as you get more DSA.

Rich Kugele - Needham & Company

Okay.

Dave Radloff

So go ahead Chuck.

Chuck Ives

Yes, it was about 55% of variable during the quarter, 45% fixed and as DSA continues to ramp, we see that moving probably more towards a 60%-40% split.

Dave Radloff

Versus the historically said about 50%-50%.

Rich Kugele - Needham & Company

Okay. That's helpful. And then you talked about in your prepared remarks and in the press release that you had thought I guess DSA would have been a little higher, how much off was it in the second quarter because of the timing of some programs?

Rick Penn

Well, it's may be that fell -- we think will be 20% this quarter Rich and probably 40% DSA by say the end of the calendar year or where allowed back, we would have said that with 50% by the end of the calendar year. So just to kind of give you a sense where the pace changed there.

Rich Kugele - Needham & Company

Okay. That's helpful.

Rick Penn

Yes. Okay.

Rich Kugele - Needham & Company

And then, you know obviously we've seen a big uptick in capacity per drive -- total drive shipments for WD were in terms of the capacity was up significant year-over-year when they reported, what do you think on the average suspension count, because perhaps we should stop looking at them for you as well and instead look at average suspension count figuring and that way when you hit this 8 million per week magic number.

Rick Penn

Yes. You are right and we are watching drives as well as sort of data surfaces that shift to meet the requirements and there is certainly a shift going on to these capacity optimized enterprise drives with higher platter counts that are serving enterprises in the cloud and feel as we hear as we work with the drive guys, they make the shifting, as far as heads per drive and what does it mean for that, I think the right way to look at that is still think about a tenth of head per year increased as we move forward and it might move more rapidly than that Rich, but I think that’s probably a good way to think about the growth heads. Remember a tenth of a head is about a 3% increase in the suspension TAM, so a tenth of a head is significant.

Rich Kugele - Needham & Company

And where is it currently?

Rick Penn

So currently as [we report], we are about 3.2 heads per drive on average or something close to that. So you know, I just -- again I think that probably climbs slightly something like a 10 may be a little better than that each year, we will see.

Rich Kugele - Needham & Company

Okay. Great. That's helpful. Thank you very much.

Rick Penn

You bet.

Operator

(Operator Instructions) Our next question is from the line of Tom Lewis with High Road Value Research. Please go ahead.

Tom Lewis - High Road Value Research

Yes. Good afternoon. First question, you referenced to volumes ramping up. In the fourth quarter it was a little atypical, going out there for time, is that about just the way that new product ramps normally do or is that seasonal or is that some of these things that you also referred to some -- it sounds like the slower than expected ramps in some of the DSA program, can you kind of flush that out for us, why you were willing to point out -- speak to volume more than a quarter out or volume prospects I should say?

Rick Penn

Sure Tom. As we've said the -- the programs that we thought that eight or nine programs would ramp sort of steadily through our quarter of our fiscal '13 and that pushed out so that more are ramping at the back end. We are ramping some now and then there is some that ramp very -- at the very end of the calendar year of Q4 and so when you net all that out, we see that this push out causes us to view quarter four relatively favorably and as we move through time, we are getting a little better visibility on allocations that we think we are lining up for on each programs, but becoming a little fair what our allocation is going to be.

So when we look at those push-outs, look at the weight of that program ramps in the fourth quarter and look at a little bit of visibility on where our allocations could look like, that’s what gives us some confidence in the fourth quarter numbers being stronger.

Tom Lewis - High Road Value Research

Okay and speaking of (inaudible) with respect to allocations as this wave of new products continues to build, market share and how that might look. It was -- we've been talking for as long as quarters, many quarters now in terms of 20% and some of us have a recollection of it being may be twice that high, can you speak to given this picture that we are getting that you are well positioned to gain market share, are there any impediments to you -- what would be the impediments to you regain eventually or over the course of a couple of years seeing your market share return to where it's been in the past?

Dave Radloff

Well we are -- we are gaining some position and we are winning these qualifications across segments and across customers because we now have a company that we've shaped that has cost structure that is on a path probably to be the best cost or lowest cost structure of their suppliers.

In doing that, we kept our technical core in place. So we performed very well in the products that we've been supplying on these new programs. The products perform well. The reliability is good. We might have a bit of an edge over some competitors and some programs. So the confidence in the company is growing and the qualification progress therefore is stronger than it's been in a long time and so as those new programs ramp, those new programs are really the window of opportunity to gain some position and even though we've been pushed out and our share growth has been slow in coming, we see that starting to get some traction as we look ahead now.

I think the impediments really would be poor execution. I think it's really all about executing at this point. We've got the process technologies, we've got product performance, reliability, the suspension requirements are being pushed and I think we will see that environment continue for a few years in front of us as the drive guys keep working to advance their performance and their capacity point.

So we think we are -- when the drive requirements like resonance control, flat-head control, contamination control, tighter lines and spaces down the flexure as there is more lead going out to the head, all of those kinds of pressures are on us now.

Tom Lewis - High Road Value Research

Okay.

Dave Radloff

And they are going to stay on us for a while and you know in that environment we do pretty well and it gives us a shot at perhaps getting an edge over our competitors in some cases. So I think I am just trying to sort of clarify how we see ourselves and how are positioned and now it's about execution and we are going to have to keep working real hard to make sure we drive those costs where they need to be and real hard to make sure we've got the best value proposition for our customers and that’s what we are all about.

Tom Lewis - High Road Value Research

Yes. Okay. Well thanks to that answer.

Dave Radloff

Okay. Yes. Long winded.

Operator

Thank you. And our next question is a follow-up from Mark Miller with Noble Financial. Please go ahead.

Mark Miller - Noble Financial Capital Market

I just wanted to check your free cash flow. You said it was may be $2.9 million for the quarter.

Dave Radloff

I think $3.9 million Mark.

Mark Miller - Noble Financial Capital Market

$3.9 million and just wondering about -- is there somewhere you paid the lower interest rate and what was the rational for that rather just paying off some more of the higher interest rate debt.

Dave Radloff

It could be -- that will be put to us in mid January and so we more or less last January, yes and so it was going to be put to us Mark and so we just called it an effect.

Mark Miller - Noble Financial Capital Market

Okay so it was going to be put to you well before the other two.

Dave Radloff

They had the right to be and all reasonable expectation was that it would be put to us yes.

Mark Miller - Noble Financial Capital Market

Okay. Thank you.

Operator

Thank you. And I am showing no further questions. I will turn the call back to Rick Penn for closing remarks.

Rick Penn

Thanks George. Thanks everyone for joining us on the call today. We truly appreciate your questions and your interest in the company and we look forward to talking with you soon. Thank you.

Operator

Ladies and gentlemen, this concludes our conference for today. If you would like to listen to a replay of today’s call, it will be available until midnight May 3rd by dialling 303-590-3030 or 1-800-406-7325 with the access code of 4614669. We thank you for your participation. You may now disconnect.

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