SMART Modular Technologies, Inc. F3Q09 (Qtr End 5/31/09) Earnings Call Transcript

Executives

Suzanne Craig – The Blueshirt Group

Iain MacKenzie – President, Chief Executive Officer & Director

Barry Zwarenstein – Chief Financial Officer & Senior Vice President Finance

Analysts

Gary Hsueh – Oppenheimer & Co.

Tim Luke – Barclays Capital

Jim Suva – Citigroup

Kevin Cassidy – Thomas Weisel Partners

Edwin Mok – Needham & Company

SMART Modular Technologies, Inc. (SMOD) F3Q09 Earnings Call June 25, 2009 5:30 PM ET

Operator

Welcome to the SMART Modular Technologies Q3 FY ’09 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 June 25, 2009. I would now like to turn the conference over to Suzanne Craig.

Suzanne Craig

Thanks to everyone for joining us on today’s earnings conference call to discuss SMART Modular Technologies’ third quarter fiscal 2009 financial results. Iain MacKenzie, President and Chief Executive Officer and Barry Zwarenstein, Senior Vice President and Chief Financial Officer join me on today’s call.

Before we begin I’d like to make the following Safe Harbor statements, during the course of this conference call Iain or Barry may make projections or other forward-looking statements regarding future conditions or events concerning our future business, our current and new products and services and/or performance, the size and strength of our market and/or the future financial performance and outlook of the company.

These statements are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities & Exchange Act of 1934. You should review the managements’ discussion and analysis and related risk factors affecting future results contained in the forms and reports filed with the Securities & Exchange Commission. We caution you that such statements are just projections. Accordingly, our future results may differ materially from such projections.

These forward-looking statements are made as of today and SMART does not currently intend and has no obligation to update or revise any forward-looking statements. The third quarter of fiscal 2009 earnings press release is available on the company’s website at SMARTM.com or you may call our investor relations office at 415-217-7722 and we will fax you a copy. Please note that non-GAAP financial results presented excludes certain charges such as those related to stock-based compensation, restructuring costs, goodwill impairment charges and other one-time charges. Please refer to the non-GAAP information section of our earnings press release for further details.

Our agenda for the call today is as follows, Iain MacKenzie will discuss key highlights from the quarter and then Barry Zwarenstein will review the quarter from a financial perspective and provide the forward-looking guidance. Our live Q&A session will follow. An audio replay of this call will be available for two weeks by accessing the investor relations page at SMARTM.com or by dialing 1-800-406-7325 and using the pass code 4094900. Now, I would like to introduce Iain MacKenzie, President and CEO of SMART.

Iain MacKenzie

In the third quarter of fiscal 2009 we once again achieved solid financial results with gross profit, an important financial metric, at $19 million and non-GAAP EPS of $0.01 for the quarter. We also generated positive operating cash flow of $20 million for the quarter bringing our year-to-date of operating cash flow to $45 million. During the quarter we continued to face pressure on the revenue side as a result of lower than anticipated ASPs and demand in SMART Brazil as well as lower global server demand.

These factors affected net sales which came in at approximately $92 million just slightly below our guidance. More importantly however, our revenue profile shifted towards higher margin business which generated gross profit dollars that came in at the top end of our guidance range. On the balance sheet side, our cash position is solid with cash and equivalents increasing by over $10 to $139 million at quarter end compared with $125 million at the end of last quarter and long term debt unchanged at $81.3 million.

For the quarter DRAM related business represented 86% of total sales. While demand for DRAM modules remains primarily in the 2 gigabyte and 4 gigabyte space, we’re seeing increasing qualification activities for 8 gigabyte and 16 gigabyte versions which suggests growing demand for higher density modules. As we indicated in the press release the DDR3 ramp is underway assisted by the adoption of Intel’s Nehalem process architecture across multiple platforms. This ramp however is somewhat impacted by the availability of DDR3.

We also continue to see the gap narrow in price premium of DDR3 and DDR2. The combination of these two factors is positive for us as we are well positioned with a comprehensive suite of [JEDEX] standard and derivative high density DDR3 registered DIMMs at the 1066 and 1333 speed grade. Additionally, AMD recently announced the availability of its next generation Opteron platform they have code named Istanbul. This six core CPU will extend demand for DDR2 RDIMMs and will likely increase the demand for higher density and performance [inaudible] such as 8 and 16 gigabyte DDR2 800s.

These higher density solutions were enabled in part by our advanced stacking technology and processes where we have made excellent progress. As you may know, there are two primary types of stacking processes TSOP and BGA. TSOP is a legacy process and BGA is used primarily for DDR2. Our TSOP stacking and our proprietary BGA stacking technologies have both been qualified by several tier-1 OEMs in both networking and computing and our [inaudible] which is another form of density enhancing technology has been qualified for several OEMs for both DDR2 and DDR3 module configurations.

These capabilities are important to our success because they can be used to create high density modules that help solve constraints important to our customers such as costs, space, power and lead time. Looking ahead, the industry is working on the introduction of the next generation DDR3 modules for servers called load resistors or LR Dimms. We expect to be ahead of the curve and be fully engaged in those qualifications which are currently targeted for calendar Q4 2009 and calendar Q1 2010.

The LR Dimm will provide enhanced memory performance and capacity in server systems. We also see the proliferation of a small form factor in specialty modules for embedded networking and telecom applications with the introduction of DDR3 versions. These versions are co-existing with previous technology generations that are still in production which generally increases our unique product mix and the need for legacy support in these long lived systems.

Now, I want to update you on SMART Brazil. We had a challenging quarter in Brazil mainly as a result of the deteriorating ASPs and to a lesser extent, lower than anticipated volumes. The Brazilian economy though is recovering and along with it so are ASPs and volumes. We are reasonably confident that the third quarter marked the low point and that the current quarter is showing improvement. Longer term we continue to believe we are very well positioned for success in this part of the world as we capitalized on our extensive history and investment in the region.

Turning now to non DRAM businesses, I will first address our solid state drive business as that seems to be of most interest lately. We’re very excited about our partnership with Marvell and our PCI Express SSD product we announced earlier this month. We believe that PCI Express based SSDs are ideally suited for high end enterprise applications because the PCI interface is four times faster than 4 gigabyte fiber channel and five times faster than SATA 3.0. Consequently, [inaudible] PCIe SSD provides performance equivalent to 280 [inaudible] of 15K RPM enterprise class hard drives or four high performance fiber channel SSDs.

The product also provides about a 200 time reduction in overall power consumption compared to a typical hard drive implementation of a high IOPS enterprise storage array. The potential for these products in the enterprise space is tremendous and we’re well positioned to capture a meaningful part of this opportunity.

Now, let me update you on our display and embedded group. As we indicated last quarter one of our embedded programs transitioned to be manufactured in house by the OEM which impacted the quarterly sales and the gross profit contribution from this group. Looking ahead, we’re expanding our display product offerings, in the third fiscal quarter we announced the release of the 22 inch TouchScape E Series and innovative TouchScape I Series displays. The 22 inch E Series is the latest in our Elo compatible display family and is targeted at the next generation gaming and kiosk platforms.

The TouchScape I Series integrates a smart designed [AD] board and a lower-cost solution to provide our customer with a high performance yet lower cost display for applications requiring either 19 or 22 inch displays. SMART now has one of the broadest product offerings available to address embedded display requirements in kiosks, gaming and ATM platforms. In addition, during the third fiscal quarter we began the consolidation of our display manufacturing in to SMART Korea to achieve further cost reduction and enhance profitability for this product line moving forward.

Now, I’ll turn the call over to Barry Zwarenstein, our CFO for a review of the financials and our forward guidance.

Barry Zwarenstein

Let me walk you through our income statement and balance sheet and then review our guidance. For the quarter, net sales totaled $91.6 million down 16% from last quarter’s $109.1 million and down 45% from the year ago quarter. This decline is attributable to the continued depressed economic climate and the associated weaker demand as well as an embedded program that transitioned to be manufactured in house by the OEM.

Taking a look at our net sales by geography for the third quarter, the breakdown is as follows: US 47%; other Americas 24%; Asia 22%; and Europe 7%. In terms of our sales by end market the breakdown is as follows: servers 30%; desktop PC 29%; network and telecom 18%; logistics, 8%; storage 7%; industrial 5%; and printers 3%. Sequentially the biggest changes in dollar terms occurred in two end markets, networking telecom and servers. The decline in both of these end markets was primarily due to the weak macroeconomic environment in general and to an embedded program now being manufactured in house by the OEM.

Desktop PC grew in the quarter on an absolute basis and was 29% of sales up from 20% of sales last quarter due to strong PC channel sales in the US. HP continues to be our largest customer representing 23% of revenues this quarter which is down from 30% last quarter. On a dollar basis sales to HP were lower by approximately 34% compared to last quarter due primarily to a combination of softness in the server and PC end markets and the lower level of DRAM ASPs for mainstream DDR2. CISCO remained our second largest customer during the quarter representing 13% of our revenues essentially flat on a percentage basis with last quarter.

Moving to the rest of our income statement, gross profit for the third quarter was $18.6 million, down 23% from last quarter’s $24.1 million. Third quarter non-GAAP operating expenses of $15.9 million were down from the $17.3 million we reported in the prior quarter and included R&D expenses of $4.1 million and SG&A of $11.8 million. Non-GAAP adjustments net of tax for the third quarter of fiscal 2009 included $0.9 million of restructuring charges, $0.8 million of one-time expenses related to the relocation of our corporate headquarters and $1.5 million of stock-based compensation expense.

GAAP net loss for the third quarter of fiscal 2009 was $2.4 million or $0.04 per share compared to a GAAP net loss of $1.8 million or $0.03 per share for the second quarter fiscal 2009 and a GAAP net loss of $11 million or $0.18 per share for the third quarter of fiscal 2008. Non-GAAP net income for the third quarter of fiscal 2009 was $0.9 million or $0.01 per diluted share compared to $4.1 million or $0.06 per diluted share in the second quarter fiscal 2009 and $4.9 million or $0.08 per diluted share for the third quarter of fiscal 2008.

Turning now to the balance sheet, our net accounts receivable increased by $6.3 million to $121.9 million despite the lower sales. Days sales outstanding were 29 days compared to 42 days in the prior quarter. More than all the DSO increase was due to a major logistics deal. Inventory was $54 million at the end of the quarter down from $84.6 million at the end of last quarter. Inventory turns increased to 16 times for the third quarter versus 11 times in the prior quarter. Excluding inventory associated with major logistics deals in both periods, inventory turns would have been approximately 19 times compared to 17 times last quarter.

As a reminder, as part of our logistics programs, we are compensated for holding inventory and generally have no liability. As we move forward, we expect our inventory turnover will be in the mid to high teens. Consistent with past practice, accounts receivable and inventory turnover are calculated on a gross sales and cost of goods sold basis which totaled $227.7 million and $209.1 million respectively for the third quarter of fiscal 2009.

Cash and cash equivalents totaled $139.2 million at the end of May up from $125.4 million at the end of the second fiscal quarter. Cash flow from operations were $20 million for the third quarter fiscal 2009 mainly due to changes in working capital. Year-to-date we have generated$44.6 million in operating cash flow. Depreciation and amortization totaled $3.1 million for the third quarter, capital expenditures during the third quarter totaled approximately $3.5 million bringing the year-to-date total to $12.6 million. We expect full year capital expenditures to range from between $13 to $16 million.

During the past quarter, we recorded and additional $1.1 million of goodwill in respect of the Adtron acquisition finalizing this matter. In summary, the Adtron acquisition agreement called for a maximum of $15 million in earn outs. $6.6 million of the $15 million maximum was earned and we paid out $5.1 million of the earned amount in the third quarter.

Now, let me turn to our guidance, for the fourth quarter fiscal 2009 we estimate net sales will be in the range of $90 million to $100 million, gross profit in the range of $17 million to $19 million and GAAP net loss per share will be in the range of $0.02 to $0.01. On a non-GAAP basis excluding charges related to stock-based compensation, we expect net income per diluted share will be between $0 and $0.01. Please refer to the non-GAAP information section of our earnings press release for further details.

The share count used in computing EPS is estimated to be approximately 61.8 million shares for GAAP and on a diluted basis 63.5 million shares for non-GAAP. That concludes my remarks. I’ll now turn the call back to Iain.

Iain MacKenzie

We’re once again proud to have achieved our primary objectives this quarter in the face of continued challenges in the overall markets. Our business model and focused execution have served us well in these difficult times. Looking ahead we’re optimistic about the future as the decline in DRAM ASPs seems to have at least bottomed out and may have turned the corner. Demand is slowly returning.

For me and for this organization the main focus however is SSD for enterprise customers. We’ve been increasing our resources dedicated to SSD development for the fast growing PCI Express and [SAS] based applications. We’re confident that we’ll take total advantage of the tremendous opportunities ahead.

Operator we’re now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Gary Hsueh – Oppenheimer & Co.

Gary Hsueh – Oppenheimer & Co.

Just a quick question, I popped on the call a little late but obviously you talked about one OEM taking in house an integrated kind of module assembly that might have hurt your business in either the networking and telecom business or the server business. Can you just help me out and elaborate a little bit more on that?

Iain MacKenzie

Sure, we announced it last quarter, it’s actually a program that’s been running and building since 2001 or 2002 and has gone through an acquisition of the company in the meantime. We group it in to networking telecom classification and it’s around about $24 million annualized.

Gary Hsueh – Oppenheimer & Co.

So basically the step down in the May quarter reflected 100% of that dynamic?

Iain MacKenzie

That’s correct.

Gary Hsueh – Oppenheimer & Co.

I was just on the Micron call and I think they talked about a little bit of a recovery here on the enterprise sector particularly with DDR3, are you guys seeing that yet or where are you in terms of the cycle in your exposure on the DDR3 module side to the enterprise server market?

Iain MacKenzie

Yes, we’re certainly starting to see that with qualifications done in good timing and seeing it now I think more so you’ll see that in our current or new Q4 quarter as opposed to last Q3 which finished in May. So yes, certainly seeing it and feeling it strengthen right now.

Gary Hsueh – Oppenheimer & Co.

Okay, so would that be the primary driver for sequential revenue growth in Q4 then?

Iain MacKenzie

It will certainly be one of the drivers and then we’ll have the AMD DDR2 Istanbul that’s going to kind of push the reverse for DDR2 perhaps a little bit better price point than the Intel Nehalem. So that new six core coming out is good timing, I think it was five months early by AMD so, DDR2 will be pushed. Then Brazil is certainly seeing some strength and recovery of both the economy, the market and hence demand along with ASPs as DDR3 tends to be feeling as if it’s a shortage. So, I’m thinking AMD may very well benefit from some of that too.

Gary Hsueh – Oppenheimer & Co.

Just another kind of question here on the top line, last question just on the storage and the announcement with Marvell, where are you guys in terms of commercial qualification on OEM platforms with this product number one? Then, what’s in the marketplace I guess that’s a differentiator between your PCI Express interface solution and maybe a competitors like Fusion-IOs?

Iain MacKenzie

First of all, that was the product announcement so going through to launch and availability in calendar Q4 and certainly supply from our third quarter next year or March starting quarter. In competitive landscape certainly, we’ll continue to have products coming out and at this moment in time as a new product newly announced just manages to beat the other PCI Express the Fusion-IO products and certainly at this moment in time a lower cost. But, I’m sure there are many products to come to market. The good news is we already have the scale and the customers. Now, this is a new product offering to the customers in the high end enterprise solutions.

Operator

Your next question comes from Tim Luke – Barclays Capital.

Tim Luke – Barclays Capital

Just in terms of the gross profit dynamic, can you give us an outline of what some of the variables are? It looks like it could be somewhat lower sequentially. Then maybe just give us some granularity on how you see R&D and SG&A and sort of op ex trending going in this coming quarter?

Iain MacKenzie

Tim, I’ll do the income piece and I’ll let Barry talk to the cost side. But, the gross profit dynamic is looking fairly strong, I think you’ll see a gross margin percentage uptick as some of the ASPs were lower but GP dollars we’ve forecast to be essentially the same this quarter to last, $17 to $19 million. But, certainly feeling the strength and the bottoming that this indeed is a more solid basin in the business so GP dollar income I think is strengthening overall.

Barry Zwarenstein

Tim, with respect to the R&D and SG&A expenses, you should see it decline very moderately. Part of the reason for that is one of the tailwinds we obviously had this past quarter was the salary reductions and they were not implemented until the second quarter. Offsetting that partially in R&D is we are stepping up as Iain alluded to in his concluding remarks is a little bit in research and development with respect to enterprise SSD.

Tim Luke – Barclays Capital

Just to be clear the revenue, the midpoint is slightly up but the gross profit, the midpoint is sequentially lower from the $18.6 in the May quarter right and therefore I guess my question is, if that’s the case what was edging that lower?

Barry Zwarenstein

Variability quarter-to-quarter is very heavily dependent up on the mix. Within that degree of forecasting precision it’s simply how the numbers roll out in the various segments. In other words, a slightly less favorable mix in terms of high margins versus lower margins sequentially.

Tim Luke – Barclays Capital

Do you expect the industrial and the networking and telecom to start to show some improvement in the coming quarters or do you think that the overall mix by end market will be fairly similar?

Barry Zwarenstein

I think what you’ll see is a fairly similar profile. I think recent strength, the Brazil strength will offset some Q3 US desktop channel strength and I think it will come up to compensate that and hence we’ll end up at pretty much this mix. It’s actually a fairly good mix with 30% servers, 30% desktop PC, 20% network and telecom and a good diversified balance. It’s been one of our goals to get that diversification across end markets.

Operator

Your next question comes from Jim Suva – Citigroup.

Jim Suva – Citigroup

Iain can you discuss a little bit about given your current mix, even though the economy at this level is very challenging, are you seeing normal seasonality for the August quarter or is that kind of lagging as far as just normal seasonality given your mix and where you see your orders coming in?

Iain MacKenzie

I think any previous notion of any seasonality is disrupted in the current climate. All I can say is we’re given a fairly good feeling right now that that Q3 that we just reported really feels like a bottom and certainly feeling some solid ground right now. So, hopefully that does take us through in to a stronger Q4 and Q1 season. Then, I’ve seen lots of reports about DDR3, DDR2 mix back-to-school US consumer and then in particular PC demand in China and emerging markets. So, I think it just feels like it’s the bottom and slightly coming.

Jim Suva – Citigroup

As a follow up, your bookings for the August quarter, are you seeing actually the bookings coming back to normal or just no longer of a decline?

Iain MacKenzie

We’re not a good bookings number company, Jim. Our flexibility in turnaround and inventory turns at 20 turns we tend to be the fast responsive version. We have seen some recovery of inventories in the channels which were driven to a really, really all time low in the last quarter so I think some inventory recovery and looking good as we go forward.

Jim Suva – Citigroup

Then as a follow up would we expect still kind of your strongest quarter even though you’ve been diversifying more, still strongest quarter to be the November quarter?

Iain MacKenzie

We still think so but in this disruptive economy it’s tough to say but it certainly feels that way at the moment.

Jim Suva – Citigroup

The inventory level, the inventory came down quite a bit. Obviously, a function of that is ASPs as well as mix. With the OEM in sourcing more are we at a level now where the inventory level you expect to sustain or with the OEM pulling in inventory production should we start to see inventory come down a little bit more? How should we think about inventory going forward?

Barry Zwarenstein

Jim, for the respect of this quarter, our forecast is showing that inventories will increase. They’ll increase for a number of reasons, first of all our Brazil inventories, partly due to shortages, were lower than we really would have liked them to be in the just completed quarter and we are expecting a stronger quarter in Brazil so inventories will go up there. We’re also seeing receptivity in terms of our logistics programs, we’re holding more inventory for longer periods of times and that’s going to cause that aspect of it to grow. Frankly, thirdly and finally, we are seeing as Iain mentioned shortages in different spots and we’d like to position inventory wherever we can in that environment.

Jim Suva – Citigroup

Then Iain likes to spend the cash and Barry you want to make sure you are a good steward of the cash, how should we think about your cash usages? Are you going to look at some acquisitions or Barry how do you and Iain balance that?

Barry Zwarenstein

Well, fair enough. Obviously, we are on record in the past saying that we are looking for acquisitions. We have a very active program on that score but we also at the same time are working very closely with the board, extremely prudent. It’s difficult to forecast, it’s like forecasting when you’ll eventually find a spouse. On the day-to-day capital spending we have expansions in Brazil that we are contemplating and we will use some of the cash we have for that. But, the normal run rate on cap ex for this year we said was $12 to $16 million, that’s the type of level we’re talking about for the future absent any acquisitions.

Operator

Your next question comes from Kevin Cassidy – Thomas Weisel Partners.

Kevin Cassidy – Thomas Weisel Partners

You mentioned on the enterprise side the strength you’re seeing, it sounds mostly like product refresh with new products on the Nehalem side and AMD’s Istanbul. Is that the only growth you’re seeing or is there any growth I guess in the older systems?

Iain MacKenzie

That’s certainly our area of focus, the mid to high end and certainly on the new systems overall year-over-year on mid to high range systems we’ve seen an overall reduction of around 29% to 30% of which 50% was between our Q2 and Q3 sequentially. So, I would say the core server business, the mid to high range serve business has been low and so we’re happy to see these new products. And also, the complexity between DDR3 and DDR2 and people having to choose their system and choose the density typically works well for our delayed build to order type model.

Kevin Cassidy – Thomas Weisel Partners

You alluded to possible shortage in DDR3, can you expand on that a little?

Iain MacKenzie

I think the only expansion is that at this moment in time we are aware of and seeing and aware of our own trying to increase the forecast in DDR3 and we’ve seen some people being declined. So, it’s being well controlled for the right use. I don’t see any DDR3 available at all for the spot market or white box market which typically means we have tier-1 OEM demand for the product.

Kevin Cassidy – Thomas Weisel Partners

If I could ask again maybe on the SSD, the timeline for that if you build a product I guess how long of a qualification cycle is it at your customers?

Iain MacKenzie

I think overall through to meaningful production volumes it’s six to nine months. We already released the product, we’ll have good samples available end of calendar this year and expect to be having volume backlog by March.

Kevin Cassidy – Thomas Weisel Partners

Are you limited on who’s flash you use or do you have quite a few sources qualified?

Iain MacKenzie

At this moment I’m only qualified over two sources. We’re finding that the product is still fairly sensitive to end application and to the controllers and to the structure we use. So, with really heavy qualification time then we need to focus on the idiosyncrasies of the applications and the flash and the controller and the product design all in one so only two supplies at the moment which is find. They are two very large suppliers.

Operator

Your next question comes from Edwin Mok – Needham & Company.