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OCZ Technology Group, Inc. (NASDAQ:OCZ)

F2Q 2014 Earnings Call

October 15, 2013 5:00 PM ET

Executives

Bonnie Mott – Senior Manager, IR

Ralph Schmitt – Chief Executive Officer

Rafael Torres – Chief Financial Officer

Analysts

Andrew Nowinski – Piper Jaffray

Joe Wittine – Longbow Research

Krishna Shankar – Roth Capital

David Rold – Needham & Company

Aaron Rakers – Stifel, Nicolaus

Operator

Good day, ladies and gentlemen and welcome to the OCZ Technology Fiscal 2014 Second Quarter Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today’s conference, Ms. Bonnie Mott, Investor Relations Senior Manager at OCZ Technology. Ms. Mott, you may begin your conference.

Bonnie Mott

Good afternoon and welcome everyone. On the call today are Ralph Schmitt, our CEO; and Rafael Torres, our CFO. Ralph will provide the business overview and then Rafael will review the financial results for our second quarter of 2014. Following their formal remarks we will open the call for questions.

Before I turn the call over to them, I need to remind our listeners that the information is presented as of October 15, 2013. Please keep in mind that while being made available for listening after today, the information is current only as of today.

Remarks made during this call may contain forward-looking statements that involve risks and uncertainties. Forward-looking statements on this call are made pursuant to the Safe Harbor provisions of the federal securities laws.

Information contained in the forward-looking statements based on current expectations and are subject to change and actual results may differ materially from forward-looking statements. Some of these factors that could cause actual results to differ are discussed in the reports filed with the SEC. These documents are available on OCZ’s website www.ocztechnology.com.

With that, it is now my pleasure to turn the call over to Ralph.

Ralph Schmitt

Thank you, Bonnie and good afternoon everyone. We’ve been on quite a challenging journey over the past few quarters. Our fiscal second quarter 2014 which ended on August 31 has been the most difficult quarter to-date.

During this quarter we were still struggling to secure flash allocation and certain of our vendors started restricting our credit limits. This primarily affected our client business as we were unable to get enough products and the flash we did procure was at uncompetitive prices.

Our Enterprise business has not been material impacted by the flash availability. The revenues for the second quarter of 2014 was $33.5 million, down 39% sequentially compared to revenue of $55.3 million for the first quarter of 2014, primarily due to the previously mentioned issues surrounding our client business.

As flash has become more readily available in the market, the pricing environment in the client business has also become more challenging which is impacting our ability to compete based on our costs. Our enterprise business also declined, but still accounted for half of our SSD revenues.

This decline was primarily due to the completion of a datacenter installation with one of our major customers. The rest of our enterprise business through the channel grew in the quarter as we continue to get further traction with our products.

Taking a look at the second quarter revenue by geographies based on shipping destination. The U.S. accounted for 55% of the total versus 64% in Q1. EMEA was 35% of revenue versus 22% in Q1 and the rest of the world was 10% compared to 14% in Q1.

We had only one greater 10% customer which is our largest international distributor.

Turning to our R&D efforts, our product development team continues to execute well in delivering products. They are highly focused on migrating the company to a state where we are delivering industry-leading solutions for the enterprise. We are one integrated team that developed everything from the IP in silicon-based controllers to SSD board level platforms to application-based software and tools.

The team works across borders and time zones and deliver leading performance products. We took all these capabilities and launched the vertical focused product called ZD-XL which targets Microsoft’s SQL database installations. It is a new way to go to market that works well for our channel partners.

We did some software releases this past quarter for our Z-Drive R4 which greatly enhanced the performance of this PCIe product. It was recently benchmarked against other leading solutions in this space to again being the top two in all performance categories.

And last month at the Intel Developers Forum, we unveiled the upcoming smaller form factor Z-Drive R4 PCIe SSD featuring the same exceptional performance but with the ability to ploy in a much greater range of platforms including the support for the open compute projects. This PCIe solution should be available to the market as the Z-drive 4500 in the current quarter.

To round out our enterprise offerings, we’ve also released in the market our new enterprise class SATA drive called DENEVA 2 with improved performance based on our enhancements to a very successful product in this category. It is critical that we continue to lead these product categories in order to capture key hyper scale datacenter opportunities.

On the go-to market side we expanded our direct enterprise sales team and the design opportunity pipeline grew 47% in the quarter. The capability of our go-to market team has also improved dramatically as we have the winning designs even during our time of uncertainty.

We’ve had design wins with SATA STAT NPCIe solutions this quarter at large aircraft companies, online shopping networks, online gaming corporations, transportation organizations, universities, hospitals and government agencies.

On the client side, we are not sitting still either, looking for new ways to engage in the market in a profitable manner. We’ve closed on an OEM arrangement in order to enable a large consumer product company to enter a portion of the client SSD market. More details on this and other opportunities in this market are going to be coming out in the coming months.

Before I turn the call over to Rafael, one item I do want to address is the tactical issue that occurred on October 7. We rely on a third-party financial printer to file our SEC filings on our behalf.

Similar to what happened to Google not long ago, our printer erroneously filed the draft of our Form 10-Q for our second fiscal quarter with the SEC. This filing was not authorized by the company and investors should not rely on that information. The printer took ownership of the misfile and has assured us that appropriate corrective actions have been put in place in order to prevent this happening in the future.

This afternoon we filed the Form 10-Q A which amends that filing which is the form that investors should rely on. So with that, it’s now my pleasure to turn over the call to Rafael to discuss further details of the quarter.

Rafael Torres

Thank you, Ralph and good afternoon everyone. On this call, I intend to limit my remarks to key financial metrics relative to our second quarter financial results and key items that are affecting our business today.

Ralph discussed our revenue, so turning to our detailed financials. Non-GAAP gross margins for the second quarter of 2014 were 5.6%, compared to non-GAAP gross margins of 15.5% for the first quarter of 2014.

On a sequential basis, gross margins decreased significantly as there was a shift back towards our client SSDs which are delivering lower margins, primarily due to higher cost than expected and higher price erosion in our consumer-oriented end-markets coupled with the margin impact from sales, our refurbished drives had negative gross margins which we sold in order to turn inventory into cash.

Lastly, we had a higher allocation of labor and overhead cost associated with our Taiwan manufacturing facility as shipments in revenues declined; margins are impacted as manufacturing costs are absorbed by fewer unit volumes.

In regards to expenses, non-GAAP operating expenses for the second quarter of 2014 increased by $1 million and were $18.7 million compared to $17.7 million for the first quarter of 2014. Included in non-GAAP operating expenses, are restatement and other non-recurring legal costs.

In the quarter, these costs increased by $1.7 million as compared to the first quarter and accounted for $3.4 million. This increase is primarily attributed to one-time legal consulting and R&D expenses incurred in order to complete the restatement and subsequent audit periods in order to become current in our SEC filings.

On a run rate basis, non-GAAP operating expenses excluding restatement and other non-recurring legal expenses are running slightly above $15 million a quarter. We expect to have further reductions in OpEx during the fiscal third quarter.

Cash and cash equivalents at the end of the quarter of 2014 were $10.6 million, compared to $5 million at the end of the first quarter. The increase in cash was primarily driven by our recent financing, partially offset by usage of cash for operating activities.

On August 13, we closed a round of financing for $13.1 million of convertible debentures. As part of this financing we issued notes that are convertible into 7.7 million shares of common stock at a conversion price of $1.70. We also issued 5.8 million warrants that are convertible into common stock at a strike price of $0.75.

Since the warrants contain reset provisions and the debentures contain embedded derivatives, GAAP requires that we use the liability method of accounting for the common stock and derivatives.

This has resulted in the recording of non-cash financing charges of approximately $1.8 million for an excess debt discount and 600K of amortization of the debt discount. There is a remaining $12.5 million of debt discount that will be amortized over the remaining life of the debentures or about a year.

In conjunction with this financing, we amended our loan agreement with Hercules and canceled approximately 4.1 million warrants. In exchange for canceling these warrants, a loan fee of 6.5 million was added to the outstanding debt of $10 million, which is now payable on June 1, 2014. This exchange results have been charged to our profit and loss statement.

Our inventory on hand at the end of the second quarter was approximately $24 million with inventory in the channel at an all-time low at about $10 million.

In closing, since joining about six months ago, it became very apparent that in order to continue building a strong SSD business, we needed to complete the restatement in order to give our shareholders, vendors and customers, the confidence to continue supporting us.

While we are delighted that we have completed the restatement, our business has been impacted by the delay in restating. We believe our biggest challenge today is securing flash at acceptable prices. This challenge is somewhat dependent on our ability to raise capital and strengthen our balance sheet which in turn gives our suppliers the confidence to invest in us.

We did raise money in the quarter to help bridge us to the point where we could act upon our strategic options. These activities include everything from full acquisition to joint ventures to infusion of strategic money, to strict fund raising and restructuring. While we have narrowed our activities, we had not yet come to a closure.

We plan on updating investors as our strategic alternatives play out. Based on our current uncertainty with credit and supply, we feel that it’s not appropriate to provide guidance for our third fiscal quarter of 2014 at this point.

Once again, thank you for your support throughout this challenging period. That concludes our formal remarks and at this point, we would like to open up the call for questions. Operator:

Question-and-Answer-Session

Operator

(Operator Instructions) The first question comes from Andrew Nowinski from Piper Jaffray.

Andrew Nowinski – Piper Jaffray

Okay, good afternoon. Is there anything- any color you can provide in terms of breakeven points at what revenue and operating margin as your breakeven point?

Ralph Schmitt

Yes, Andrew. So, I guess to answer that is where Rafael described that is our OpEx is dropping to about $15 million a quarter. We believe that as we start addressing the flash situation and cost, we should be operating somewhere near the 20% gross margin level making a breakeven somewhere around $75 million a quarter.

And we have certain OpEx reductions that are happening in this quarter that get us to that point in order to get the breakeven to near that point.

Andrew Nowinski – Piper Jaffray

Okay, and then, in terms of I guess the NAND supply issues that you’ve got, assuming you go forward with one of the strategic activities you had mentioned and in selling of some of your consumer grade products which likely consume a vast majority of the NAND supply.

I guess, would a sale actually resolve your NAND supply issues going forward? Or would you still need to do something in terms of getting a long-term supply agreement, so?

Ralph Schmitt

In essence, we do need to get a long-term supply agreement and we’ve been working towards that with a few different vendors and again, it was all predicated on the fact that was getting current on our filings as the first step.

I do think we’ll be able to do that. As I mentioned in my comments, we’ve had really no issues per se around getting product to support our enterprise customers. So that’s a place where we clearly already have supply.

Then depending on, again which strategic option we go take, it will depend on how much supply we need on the client side if any and that would also impact obviously our OpEx. So the OpEx I talked about just to your previous question was really on a continual basis the way we are structured today.

Andrew Nowinski – Piper Jaffray

Okay, last question for me then, looks like you burned about $7.1 million in cash from operations this quarter I guess, do you expect to have another cash burn next quarter?

Rafael Torres

Yes, cash burns continue at roughly the same level that we’ve seen over the past quarters. So, that’s in the ballpark for the coming quarter.

Andrew Nowinski – Piper Jaffray

Okay, thank you.

Operator

The next question comes from Joe Wittine from Longbow Research.

Joe Wittine – Longbow Research

Hi, thank you. Congratulations on getting all the filings out.

Rafael Torres

Thanks, Joe.

Joe Wittine – Longbow Research

I was hoping you could provide maybe just some color on bookings if you can, just to give us some idea of which way things are trending, if you could do it by enterprise client that would be helpful too. Really just trying to get an idea of how much could you be shipping right if supply weren’t a bottleneck?

Ralph Schmitt

Yes, so, that’s a difficult question to answer, I’ll tell you, because our business is heavily turns. So if you look at clients, it’s almost, I’d say very close to 100% turns based.

So our backlog there is relatively small, especially because we’ve now gone through some extended periods, I would say couple a few months in which it’s been difficult to ship products. So we are not taking on backlog that we know we can’t ship basically.

And then on the enterprise side, there too, backlog is low. It’s a few millions of dollars, but we are shipping on a pretty regular basis and there too because there is inventory in the channels we’ve staged products in the channel for our enterprise customers. And today, approximately almost 90% of our enterprise business is being funneled through the channel.

Joe Wittine – Longbow Research

On the enterprise business, can you give an idea of what the rough mix is going forward, the split between pure SSDs and PCIe-based solutions? Any additional color you can give there?

Ralph Schmitt

Yes, so, currently, when you look at it, our volume is still dominated by SATA. Again, rough numbers, I don’t have exact numbers in front of me. Seems like I have every breakout, but that breakout, it’s about 70% SATA and then split evenly 15% and 15% between SAS and PCIe.

We continue to see, I’d say PCIe is growing again, because we definitely we are on a decline for a few of the quarters, fact that we had not reported and we are starting to see an increase over the last two quarters again as we rebuild with new opportunities in those areas.

Joe Wittine – Longbow Research

The hyper scale customer, so was that SATA SSDs?

Ralph Schmitt

Yes, primarily, not entirely, but it’s almost the same mix.

Joe Wittine – Longbow Research

Okay, and then as far as you are competing in PCIe going forward, your aim is to target the small mid-sized enterprises in the channel, is that right?

Ralph Schmitt

No, that’s where we’ve been successful. We are – I’ll say more targeting larger OEMs and enterprise customers and we are making traction there but clearly they have all been hesitant to engage with us more deeply because of our uncertainties, I would say.

But from a technological perspective, we have a number of large OEMs that are very interested in moving forward and we are hoping we can start breaking those down as we get out of these issues.

Joe Wittine – Longbow Research

Okay, got it. And then maybe just one real quick one if I could, the power supply business that had pretty healthy declines sequentially, I wouldn’t think that’s impacted by NAND, what was the driver there?

Ralph Schmitt

I’d say the biggest driver there for us is, there are two things is, we are going through a product transition and it doesn’t have the focus that our SSD business has. Essentially, those are really the two issues. I do expect that to start going back to a growth phase.

We let our products get, I’d say behind some of our competitors there and we’ve really made an impact this past quarter with a bunch of new products which I think you probably have seen some of the releases.

Joe Wittine – Longbow Research

Okay got it. I’ll cede the floor. Thanks a lot.

Operator

The next question comes from Krishna Shankar from Roth Capital.

Krishna Shankar – Roth Capital

Yes, Ralph. Can you elaborate a little more on your supply arrangements and whether you are talking to any other flash memory suppliers or things that you are doing to broaden your supply for NAND flash?

Ralph Schmitt

Sure, Krishna. We have two primary suppliers today. We had three and one of those suppliers has decided to only supply itself internally. And it’s spread relatively equally if you take it across all products. We have one supplier in particularly that dominates our enterprise business.

And we’ve gotten a good amount of support, but clearly as time went on, our credit limits started to go down and we started using distribution as a way for us to gain products which obviously added cost to our products in some cases making us uncompetitive.

So those are the things that we are trying to reverse. I do believe we will get support from those two suppliers to help us as we move forward.

Krishna Shankar – Roth Capital

Okay, so you are in kind of a better position for your enterprise flash requirements versus the consumer flash requirements?

Ralph Schmitt

That’s correct. I mean, obviously we are also prioritizing that over the consumer in essence because we are getting good gross margins in that area; it’s a better business to build off of and then commitments to customers there are highly binding. So it’s important for us to ensure supply.

Krishna Shankar – Roth Capital

Okay and then can you talk about any new design win activity for your PCI express accelerator and also SSD solutions?

Ralph Schmitt

I don’t know that I want to get into too many details, but only to say that the launch of ZD-XL which is more of a vertical product category using PCIe is being adopted pretty widely amongst smaller customers because it’s an ease of use.

It’s - somebody can plug and play that into a small datacenter very easily and so a lot of our additional VARs [value added reseller] and some of the people we signed on like TechData for instance in the quarter have been able to find great opportunities in some of the smaller places.

Now I tried to list out for you in the quarter some of the type of wins that we’ve received, it is obviously customers are a little bit sensitive into releasing information about them, but it is a pretty broad base of customers and we are doing quite well with getting that product off the ground.

Krishna Shankar – Roth Capital

Great, thank you.

Operator

The next question comes from Rich Kugele from Needham & Company

David Rold – Needham & Company

Hi there, it’s David Rold in for Rich Kugele. Thanks for taking the call.

Ralph Schmitt

Hi, David.

David Rold – Needham & Company

Just one question from us, wondering if you could just clarify what the undrawn availability is, I guess, in terms of conditions of the Hercules loan that you’ve met today.

Rafael Torres

Yes, currently, I’ll tell you what we haven’t done. We haven’t drawn on the loan, there is $5 million there and we also have a $15 million line of credit with Hercules and it’s really an option at their disposal to be able to fund us accordingly.

David Rold – Needham & Company

The entire $15 million of that revolving facility?

Rafael Torres

That is available.

David Rold – Needham & Company

Okay, got you. Thank you.

Rafael Torres

Let me be clear, that’s really an option available to Hercules, not anybody else.

Ralph Schmitt

Yes, they’ve got the right to grant it to us or not. So just…

David Rold – Needham & Company

Okay.

Operator

The next question comes from Aaron Rakers from Stifel.

Aaron Rakers – Stifel, Nicolaus

Yes, thanks for taking the questions. First question, just so I can understand, $15 million in OpEx, how soon do you think you can get there?

Rafael Torres

We are already there now. Once you ex out all the non-cash type charges, we are slightly above $15 million per quarter in OpEx.

Aaron Rakers – Stifel, Nicolaus

Okay, so that’s the level we should think about on a going forward basis?

Rafael Torres

I think that’s right. Once we get – for the most part they are behind us now, but once we get all the restatement related cost behind us, and you ex out all the stock comp, we are effectively there.

Ralph Schmitt

It’s sort of a transition quarter that we are in right now to get to that state. So I wouldn’t say we got entirely there. We are also going to more of an outsourced manufacturing model and that has an impact to getting it to that $15 million level.

Aaron Rakers – Stifel, Nicolaus

Okay, when you look at the gross margin and hopefully you get past some of these supply constraint issues that you have, remind us again how we’re to think about the enterprise versus client gross margin and where that stands today?

Ralph Schmitt

That kind of has a simple model and I’m trying to stay away from specific numbers but just to give you a sense. You can state that SATA – enterprise SATA is somewhere between 20% and 25% gross margin. The SAS is somewhere between 40% and 45% and PCIe is somewhere between 60% and 65%.

Aaron Rakers – Stifel, Nicolaus

And that’s where we are operating today in that business?

Ralph Schmitt

That’s correct. Yes, that’s where we are operating today.

Aaron Rakers – Stifel, Nicolaus

Okay. So clearly some significant losses, some negative gross margin on the client side. I think in your filings you noted that, and again so I understand Toshiba, Micron and Intel were your strategic suppliers of NAND flash. When did one of those decide to disengage and just fulfill themselves internally in terms of NAND flash?

Ralph Schmitt

I don’t have an exact date, but I’d say from today’s date, it’s probably about a quarter ago.

Aaron Rakers – Stifel, Nicolaus

Okay, and then final question for me, just on the balance sheet, when we look at the Hercules and the debt that currently exists on the balance sheet, remind us again of what the covenants are and what kind of triggers we should be watching or what you are really watching, when you look at the balance sheet with kind of liabilities greater than total assets at this point?

Rafael Torres

Yes, we haven’t disclosed what those covenants are but in a nutshell they are financial metrics that if we don’t meet obviously violates that covenant, but we really haven’t disclosed what those are specifically, but they are financial metric related covenants.

Aaron Rakers – Stifel, Nicolaus

Okay, thank you.

Operator

And at this time, I am showing no further questions. I would now like to turn the call back over to Ralph for his closing remarks.

Ralph Schmitt

Okay, thank you very much. We appreciate the time that you spent with us in order to better understand the current status of OCZ. Clearly there are still challenges in front us. The management team and Board appreciate the support of our investors, employees, customers and vendors. We all believe that OCZ is a valuable asset that matters to solid state disk drive market. It’s our intent to fully realize this value for the OCZ shareholders. Thank you.

Operator

Ladies and gentlemen, that does conclude the conference for today. Again thank you for your participation. You may all disconnect. Have a good day.

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