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Executives

Scott Robinson – VP and Corporate Controller

Mark Lucas – President and CEO

Paul Zeller – SVP and CFO

Analysts

Eric Martinuzzi – Lake Street Capital Markets

Imation Corporation (IMN) Q3 2013 Earnings Call October 30, 2013 10:00 AM ET

Operator

Good morning. My name is Sharon and I will be your conference operator today. At this time I would like to welcome everyone to the Imation Q3 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question-and-answer session. (Operator instructions) Thank you.

Mr. Scott Robinson VP and Corporate Controller, you may begin your conference.

Scott Robinson

Thank you Sharon. Good morning everyone and thank you for joining us today for our third quarter 2013 earnings calls. I’m your host today’s call where you’ll be hearing from our CEO Mark Lucas and our CFO Paul Zeller. On today’s call, we will reveal our third quarter and nine months results.

For that though, I’d like to remind everyone that certain information discussed on the call that does not relate to historical information may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. Such statements are subject to risk and uncertainties that could cost actual results to differ material from any projected results. Risks factors that could cause the results to differ are outlined in the press release issued today as well as our filings with the SEC.

With that, I’d like to turn the call over to Mark Lucas, Imation CEO.

Mark Lucas

Thank you Scott and good morning everyone. On today’s call Paul Zeller and I will cover our financial performance and provide an update on the progress we’ve made in our transformation into a significant provider of data storage solutions and data security products.

Last year this time, I talked about plans to accelerate our transformation because Imation’s traditional media businesses were declining faster than we have anticipated. Because of that industry dynamic, we took a number of actions. We reorganized into two business units, implemented a cost reduction program and said we would explore strategic options for our consumer electronic brands and businesses.

Then earlier this year, we made a strategic acquisition, Nexsan and announced our intent to divest the Memorex and XtremeMac consumer electronics businesses. I’m pleased to say that we completed the sale of the Memorex consumer electronics businesses on October 15 and we’ve entered into an agreement to sell XtremeMac by the end of this year. Selling these lower margin businesses is an important part of moving the company forward and was a key objective for our team in 2013.

We are devoting resources to building our data storage and data security offerings and selling them worldwide to Imation’s two-channel focused business units, both Consumer Storage and Accessories or CSA and Tiered Storage and Security Solutions or TSS.

Given the secular decline in optical media products, the consumer storage and accessory segment performed as we expected in the third quarter. From a sale standpoint both audio and headphone sales reach their highest revenues of the year. Moreover, we saw a distribution growth in TDK wireless products and we continue to leverage our strong position as the optical market leader.

We have also maintained an emphasis on cost cutting and if CSA business is running efficiently with solid margins. Cash generation was particularly strong this quarter as we achieve reductions in inventory levels.

Let me turn now to the Tiered Storage and Security Solutions portfolio, which in addition to tape media encompasses data storage and data security. Sales for the quarter were down slightly as noted in the press release due to several factors. First, we saw reductions in U.S. government spending ahead of the shutdown, during a quarter that is usually our most significant in terms of revenue from the government.

Second, the Nexsan business saw some weakness in OEM revenues due to a short term disruption of one of our major OEMs. And as other storage solutions providers have said, there was some market place sluggishness in Q3 with certain customers delaying their purchasing orders.

Specifics of the accelerated decline in tape media, we believe we are holding our share, but the business has been affected by industry-wide dynamics such as competing formats and continuing improvement and deeded [ph] location technologies. That being said TSS is well positioned and our entire organization is focused on capitalizing on the growth opportunities we face in data storage and data security.

We are aggressively hiring talent to expand our sales footprint globally and at the same time, we continue to enhance our product line. For example, during the quarter we introduced the Nexsan NST6000. This is a fully unified hybrid storage platform to support block and file level data traffic in a single solution without additional software overhead or licenses.

It is ideal for organizations that need highly scalable and high performance storage that supports SAN & NAS enterprise class workloads at the same time. We also announced new channel programs to expand sales marketing and lead generation opportunities for companies and bars [ph] that offers Nexsan storage solutions.

In our mobile security area a highlight for the third quarter was our introduction of the Microsoft Windows To Go IronKey Workspace W500. This product features hardware encryption with enterprise grade deployment and device management options. It is a fast, durable and secure USB drive that allows IT departments to meet the needs of a flexible and mobile workforce while protecting the organization with always on hardware encryption. Mobile security is a growth area and we have technology to address this attractive market.

Overall, the Tiered Storage and Security Solution segments saw a gross margin increase one percentage point in the quarter to 19.3% as we added higher margin storage and security solutions products.

We expect this to continue as our mix shifts to higher margin Nexsan and IronKey products. We said that margins would improve and they are, but you know that we are striving for further gains going forward.

Over the past few quarters, I talked about how we are continuously examining Imation’s expenses and making adjustments where necessary as part of our transformation. During the third quarter, we continue to cut staffing levels in legacy Imation businesses and administrative areas due to the secular decline in optical and tape media.

But we have added investment in priority initiatives to address higher growth as higher margins primarily in the TSS area. I said before that we are committed to long term success by becoming a key global player in data storage and data security. With our exit from none core operations and a keen focus on targeted growth sectors, we are on the right tract.

So with that, I now turn the call over to Paul to provide a more in-depth look at our financials. Paul.

Paul Zeller

Thanks Mark. Good morning everyone. Before I get into the details on Q3, I’d like to reinforce a couple of points that Mark just mentioned. With the completion of the Memorex CE transaction and the signed LOI associated with XtremeMac, these are important accomplishments for our transformation.

One of the most important subtext of our strategy is focus. We need to focus on fewer and better opportunities and through these divestitures of these none core categories and through the establishment of the separate autonomous business units, we have a much more refined focus in two key areas.

NSA, we’re focused on consumer media and accessories with a clear directive to manage for cash. And we made excellent progress in the quarter with improved inventory levels and strong cash flows as a result. It was the main driver behind our $14 million increase in cash during the quarter.

In TSS, we’ll laser focus on high margin growth. And while we experienced some headwinds in the quarter primarily around tape products in the government sector more generally, we continue to see exciting opportunities in both storage as well as security solutions as Mark laid out. We believe we’re taking the right actions in each of these segments in laying the groundwork for our continued transformation.

So our revenue in the quarter was a $191.9 million, that’s down 15.6% from last year. Q3 does tend to be our weakest quarter of the year driven especially by seasonal slowness in Europe. In addition, currency translation was also a negative factor lowering revenues in dollar terms by approximately 4%.

Our revenues in consumer storage and accessories represented 56% of the total and may decrease 23.8% in the quarter. This was driven by consumer storage media primary optical, the over category declining 27%. Audio and accessory revenues under the TDK brand were up 26% to $11 million driven by increased sales really in all product categories.

Tier Storage and Security Solutions revenues represented about 44% of total and decreased 2% in the quarter. The main driver was a particularly soft quarter in commercial storage media, primarily magnetic tape which was down 25% as Mark discussed earlier.

Our storage and security solutions revenues were up significantly as expected with the addition of Nexsan revenues from the acquisition. Both our Nexsan business as well as mobile security were impacted by general softness most notably in the government sector as we have discussed.

Gross margins were 18.8% in the quarter, roughly equal to last year’s 19% margin in 3rd quarter. Improvements in TSS margins driven by the addition of higher margin Nexsan revenue was about offset by declines in CSA margins primarily in the flash category as well as hard disk. Optical margins remain solid up from last year and about equal to last quarter.

Operating expenses totals $50.9 million in the third quarter. That was about flat with last year and it reflects two offsetting factors. First, we reduced OpEx significantly by $11 million or 22% driven by our restructuring actions. Offsetting that is a combination of the OpEx we added with the Nexsan acquisition which was not in our base last year, plus incremental investments we’re making in these growth categories.

We’ve recorded $11.7 million of restructuring and other charges in Q3. The most significant item was a $10.6 million dollar non-cash charge associated with the windup of a legacy defined benefit plan in the U.K.

We’ve been evaluating this transaction for quite some time and with the general improvement in financial markets which has increased the trust assets and a modest increase in long term interest rates which has helped lower the liability calculation, this was an opportune time to trigger the transaction and were pleased with the results.

We have previously anticipated this transaction could require from $5 million to $10 million of cash and an actuality was accomplished for almost no cash. So we were pleased with the outcome.

Our operating loss from continuing operations excluding the charges I just mentioned was $14.8 million and adjusted EBITDA on that same basis was a loss of $8.9 million. Non-operating cost were $1.7 million in Q3, that was up from $100,000 in last year’s third quarter and that quarter was benefited by a one-time investment gain.

We’ve recorded a $2 million income tax benefit in the third quarter that was driven by a discreet tax benefit associated with the UK pension buyout. That all led to a loss per share of $0.42 from continuing operations ex charges. And beyond that, a loss of $0.21 from discontinued operations.

In our discontinued operations, we recorded a $5.5 million asset write-off in anticipation of the domestic [ph] transactions. And that rolled the majority of that $0.21 loss.

On that topic, as Mark mentioned, we completed the sale of the Memorex Consumer Electronic business in mid-October and signed a letter of intent to sell the XtremeMac Consumer Electronic business shortly thereafter. And this transaction is anticipated to close by the end of the year.

We expect to receive approximately $19 million of total proceeds from discontinuing these businesses overtime. We expect about $10 million of that spread between fourth quarter of this year and early 2014, and the balance over the next several years.

Cash ended the quarter at $108.4 million with net cash at $88.4 million after deducting the $20 million outstanding on our credit facility. This represents an increase of $14 million during the quarter driven by strong working capital performances especially in our CSA business.

We achieved this outcome despite spending $5 million in cash on restructuring during the quarter. Our inventory days of supply were down six days during the quarter to 66 and that’s the lowest level we’ve seen in years.

So in summary, our Q2 results reflect the continuing execution of our strategic transformation. We’re investing in growth in both our tiered storage and security solutions businesses. And though we saw some softness, we remain optimistic about the prospects in both of these areas.

Gross margins remain solid and should improve as our mix moves towards higher margin TSS categories. OpEx reductions are on track, and delivered $11 million of year-over-year reductions which shall fund incremental growth investments in tiered storage and security solutions. And our cash performance was especially strong during the quarter with cash up $14 million to $108 million.

We remain focused on the important initiatives we’ve outlined, and on driving improvements in our financial results over time. So with that, we’re pleased to take your questions. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Eric Martinuzzi from Lake Street Capital. Your line is open.

Eric Martinuzzi – Lake Street Capital Markets

Thanks and congratulations on the progress on the discontinued op sales. That’s good to hear.

Mark Lucas

Thank you, Eric.

Eric Martinuzzi – Lake Street Capital Markets

Just curious to know, the legacy business here, you guys had a pretty good quarter on the optical side. When you talked about the a little bit worse than expected in the TSS, could you give us a layer deeper there between the tape and the kind of SNS side? What’s your expectation would be for whether or not that continues in tape into next quarter and whether or not that continues for Nexsan and IMS into next quarter?

Mark Lucas

Yes, sure, Eric, it’s Mark. The tape had actually a very, very challenging quarter. And we’ve been doing a lot of research with all of our – both our suppliers, our distributors around the world, and it’s pretty consistent.

All our independent market research says that we’re maintaining our market share. But the market is going down. All of a sudden, we were seeing historical rates of cost, high single digit declines in tape. In the third quarter, we saw over 20% declines. And be it IBM, Oracle, Quantum, all these guys that we’re talking to as well as suppliers in Japan – Fuji, Maxell, everybody have seen the same thing.

Nobody is really sure exactly what’s going on because the whole data storage markets seem to get a little bit sluggish near the end especially in terms of the decision making. So to be honest with you, the jury is out right now. We’re taking a look at that.

The same thing is also, I would say true with both IMS and Nexsan, is that they got off to a really strong quarter and then it just seemed decisions kind of stalled out at the end. Federal Government was a chunk of it, but even beyond that it’s not that orders were lost. It’s just that everything got kind of put on hold [indiscernible] the close.

So they’re still in the system, and we’re still really optimistic. But it just kind of everything slowed down in September.

Eric Martinuzzi – Lake Street Capital Markets

You had talked last quarter that the kind of that the SNS business on a six-month basis had actually shown growth. I’m assuming on a nine-month basis, it did not. If we had had a kind of normalized federal business, do you think that would have changed that calculation?

Mark Lucas

Yes, absolutely. Both Federal Government, and again, I don’t have clear visibility to as why some of the corporate enterprise customers that’s kind of delayed their decision. I think it’s this all total uncertainty about the economic situation and what’s going on.

We’re digging into the Federal Government stuff here too. What’s a little bit concerning is that some of the government contracts are still pending because they’re concerned that the January 15th, the government might shutdown again. So there are some now talk about delaying decisions till post-January 15th.

Now we again have not had clear visibility to that, but we’re hearing some of that rumbling right now.

Paul Zeller

Eric, this is Paul. One other thing that was specific to the quarter is at the end of the quarter, we did see some softness in the particular OEM, as they were going through some issues at the end of the quarter and we saw some order disruption that we think was more almost logistical and procedural than from a business standpoint.

That also mixes us a bit in the kind of storage solutions category.

Eric Martinuzzi – Lake Street Capital Markets

And back to the kind of follow on question to that, I understand that what happened in September, the expectation for December, is it kind of more the same, can’t really tell or is there a seasonal balance here? Are we sequentially up in Q4 versus Q3 on SNS?

Mark Lucas

Right now, our sales force are telling us that they’re pretty optimistic about Q4. I think the wildcard again is the Federal Government. But I think the other factors that we’re looking at are pretty positive.

Paul Zeller

Yes, all things being equal, we clearly should normally have a sequential month [ph] between Q3 and Q4.

Eric Martinuzzi – Lake Street Capital Markets

Okay. And then lastly for me, you had some progress there on the cash balance rising. I guess given that both the Memorex and the XtremeMac didn’t – the progress there didn’t happen until after the quarter closed, what’s the pro forma cash I guess for Memorex? And then what would it be assuming this incremental or maybe you can’t comment on the XtremeMac until that one closes.

But I’m just trying to get a feel for where is our cash right now.

Paul Zeller

Yes, so let’s talk a little bit about third quarter and then I’ll try to address some of your go-forward questions. We know that we have incentive programs that really are broad based. And one of the critical factors in our program is that we include cash and working capital days as a part of the metrics our business units have especially in our CSA business.

And Greg and his team did a really good job in third quarter in driving our inventories down to really levels we haven’t seen in a very long time. And I think it’s just better supply and demand planning. It’s the whole gamut, skew control, all of that.

And so I think we had a very good result. Some of that being in taking some inventory that maybe should have been out in the past and just getting more efficient.

If you look forward – and we talked a little bit about the impacts from the sales of the businesses. As we said, we discontinue those businesses, we think there’s about $19 million of total cash proceeds we will deliver over time. About $10 million that, we’re going to see spread between fourth quarter in early 2014.

But some of that also depends on the realities of XtremeMac and the timing of the closure and the likes. So yes, I can’t talk with specifics because one of the transactions isn’t closed. But that is certainly a positive.

And it’s a positive, yes, because we’re monetizing the businesses and we can redeploy that cash, but it’s also a big positive because we’re doing this for a reason which is to really focus on our growth categories. And I think that intangible benefit is really important.

I guess the final thing I’ll say is in – we referred to it in your report, about some of the hidden value elements that exist on the balance sheet. And let me speak to the real estate side of things.

We continue to work on the Camarillo property sale. We’ve been disclosing that in the 10k and such. And we still anticipate that should close in 2013, roughly a $10 million benefit.

There’s always the chance to slip in to ‘14, but we feel good about the transaction. We’re at the very tail end of it. So we’re just through some final governmental approvals and things at the local level. But things look good.

And we have kicked off the process we’ve been talking about related to the headquarters facility in terms of looking at options for monetizing and getting cash out of the significant infrastructures here in Oakdale. And so I think we’re doing the right things in that regard as well.

Eric Martinuzzi – Lake Street Capital Markets

Got it. Thanks for taking my question.

Paul Zeller

Thanks, Eric.

Operator

(Operator instructions) And we have not further questions at this time. I’ll turn the call over to the presenters.

Mark Lucas

Let me close by saying that while we’ve seen significant declines in the legacy optical and magnetic tape businesses, we are focused on higher growth, higher margin data storage and information security solutions.

We are taking the right actions and with urgency to build the company for a long-term success, and we are confident in our strategy. I look forward to update you again when we release our fourth quarter and full year results in early 2014. Thank you.

Operator

This concludes today’s conference call. You may now disconnect.

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