M-Systems Q3 2006 Earnings Call Transcript

| About: M Systems (FLSH)

M-Systems Ltd (FLSH)

Q3 2006 Earnings Call

October 23, 2006 10:00 am ET


Lee Ross – KCSA Worldwide, Investor Relations

Dov Moran – President, Chief Executive Officer

Ronen Faier – Interim Chief Financial Officer


Good day. My name is Jackie and I’ll be your conference operator today. At this time I would like to welcome everyone to the M-Systems Q3 2006 earnings conference call. All lines have been placed on mute for the duration of the conference. Thank you. It is now my pleasure to turn the floor over to Lee Ross. Sir, you may begin your conference.

Lee Ross – KCSA Worldwide, Investor Relations

Thank you and good morning everyone. This is Lee Ross of KCSA Worldwide, investor relations consultants for M-Systems. With me on the call are Dov Moran, President and Chief Executive Officer; and Ronen Faier – Interim Chief Financial Officer. At this point, you should have all received a copy of the press release which was issued earlier this morning. If you have not received this release, please refer to our corporate website at www.msystems.com.

Before we begin, I would like to mention that the matters discussed on this conference call include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, including statements about our business outlook for the year 2006 that are based on our current expectations and may involve a number of risks and uncertainties. In addition, any statement that refers to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. We caution you not to place undue reliance on these forward-looking statements, as they are subject to significant risks and uncertainties that could cause our actual results to differ materially from those expressed in these forward-looking statements.

These risks include, but are not limited to, the risk factors detailed in the Company’s most recent Form 20-F filed with the SEC and the risk factors detailed in the Company’s proxy statement filed with the SEC on October 11, 2006 on Form 6-K in conjunction with the pending transaction with SanDisk, and on all of its other filings or furnishings with the SEC, including Form 6-K.

Listeners are cautioned not to place undue reliance on those forward-looking statements which speak only as of the date hereof. M-Systems assumes no obligation to update such forward-looking statements, and disclaims any obligation to publicly revise any such statements to reflect any change in expectations, or in events, conditions or circumstances on which any such statements may be based. Also, as we already stated in this morning’s press release, in light of the pending transaction with SanDisk, there will be no question-and-answer session following management’s prepared comments on the call. With that said, I would now like to turn the call over to Dov and Ronen. Gentlemen, go ahead please.

Dov Moran – President, Chief Executive Officer

Thanks. Good morning everyone. Thank you for joining us for our Q3 earnings conference call. Ronen Faier, our Interim CFO, will open our call this morning with a discussion of our Q3 financial results. After Ronen’s comments, I will conclude with some background and forecasts. Ronen?

Ronen Faier – Interim Chief Financial Officer

Thank you, Dov and good morning, everyone. Before beginning, I would like to emphasize that the following discussions will include GAAP and non-GAAP numbers. Our Q3 non-GAAP results reflect adjustments for the following items:

1)Equity-based compensation expenses, which totaled in Q3 $4.3 million, and withholding taxes related to prior stock option grants in the amount of $126,000.
2)Amortization costs related to the acquisition of Microelectronica, which totaled in Q3 $426,000 net of taxes.
3)Certain G&A expenses which include expenses that are attributable primarily to the merger with SanDisk, as well as to the review of prior stock options granted, which totaled in Q3 $3 million.

A full reconciliation of the non-GAAP results to GAAP results discussed on this call is currently available for review on our website at www.M-Systems.com and in the press release issued today.

Going back to the numbers and starting with revenues. Q3 revenues totaled $217 million. Q3 revenues reflect a slight increase of 4% compared with the previous quarter, and a 41% increase compared with Q3 2005. Q3 revenues include $3.4 million resulting from the consolidation of our venture with a flash partner. In terms of where our revenues came from, the geographical breakdown of revenues is as follows. Please note that the following breakdown does not include revenues attributable to our venture with the flash partner. Q3 revenues in the U.S. totaled 38% of our revenues, compared with 33% in Q2 2006. Q3 revenues in the Far East, excluding Japan and the rest of the world, totaled 36% of revenues compared with 41% in Q2. Q3 revenues in Europe totaled 17% of revenues compared with 16% in Q2 and Q2 revenues in Japan totaled 9% compared with 10% in Q2.

Revenue breakdown by market for Q3 was as follows: revenue from the USB flash drive market totaled $133 million, which represents 61% of revenues in Q3. As already indicated, this amount includes $30.4 million resulting from the consolidation of the venture with our flash partner. Revenues from the USB flash drive market in creased 18% compared with the previous quarter and 24% compared with Q3 2005, mainly as a result of the increase in the number of units sold. The prices per megabyte continues to go down this quarter, and was offset by an increase in average capacity per unit.

Revenues from the mobile market, which include revenues from the sale of mDOC for handsets and other portable devices, as well as SIM cards to mobile network operators total $66 million, which represents 31% of revenues in the Q3. Mobile revenues increased 13% compared with Q2 2006, but more than doubled compared with Q3 2005. Mobile revenues decreased this quarter as a result of a lower number of units shipped, due in part to a shift of sales from Q3 to Q4. This was partially set off by an increase in ASP per product, higher average capacity per unit and relatively flat ASP per megabyte. Revenues from the embedded systems market totaled $18 million or 8% of revenues in Q3. This represents a 12% decrease compared with Q2 and flat compared with Q3 last year.

Moving to gross margins. Non-GAAP gross margins in Q3 were 26% compared with 23.4% in Q2. This quarter, gross margins were significantly improved by an extraordinary credit for flash components which were purchased in Q3 and in prior periods.

Operating expenses - non-GAAP operating expenses in Q3 totaled $29.5 million, a 4% increase compared with $28.4 million in Q2. Moving to non-operating income and expenses items, financial income decreased from $1.5 million in Q2 to $601,000 in Q3. This decrease resulted from two factors. One is the lower cash value and two, a non-cash item representing the cumulative effect of currency rate fluctuations of inter-company balances with Microelectronica. We recorded a one-time tax benefit of $1.9 million from the projected utilization of losses from prior years in one of our subsidiaries.

Our equity losses in an affiliate subsidiary in the amount of $1.5 million relates to the activities of U3, our joint venture with SanDisk. Our minority interest in the amount of $14.3 million relates to our venture with a flash partner. All of these resulted in the GAAP net income for Q3 of $5.8 million with EPS of $0.14 and non-GAAP net income of $13.6 million with EPS of $0.32.

As for the inventory level, the inventory balance at the end of Q3 was $118 million, a 40% increase compared with Q2 inventory of $84 million. Our on-hand inventory, which consists of our GAAP inventory less $17 million of shipments to customers which have not yet been recognized as revenues, inventory on consignments and inventory held by debenture on behalf of our flash partner totaled $101 million compared to $61 million in Q2, an increase of 68%. Increasing our on-hand inventory resulted almost entirely from an increase in our end dock inventory. We announced the end of life for our monolithic Q3 and Q4 end of devices. In order to accommodate expected purchases from customers for projects in mass production, we are purchasing these devices in advance against commitments from customers and future orders.

Our cash balance at the end of Q3 was $161 million, down from $179 million at the end of Q2. The decrease resulted from negative cash flow from operations of $14.3 million. From the beginning of the year, our cash flow from operations was positive; $23.6 million.

I will now turn this call back to Dov.

Dov Moran

Thank you, Ronen. Q3 2006 was a unique quarter for us at M-Systems, as we announced our planned acquisition with SanDisk on July 30, announcing to Q3. As can be expected, since the acquisition announcement we experienced some level of hesitancy from some of our customers and weakened support from some of our suppliers. Despite these circumstances, we continue to work and support all of our major customers. The demand we continue to experience from our customers is a testament to our OEM business model and the relationships we have built with our customers. Indeed, Indeed, the combined company will need to continue making all of our existing OEM customers as well as new ones, very comfortable. I do believe they will understand very quickly that once we complete the acquisition, SanDisk will be a valuable, reliable and trustworthy supplier to OEMs and should be their main supplier and partner.

In light of these unique circumstances, I am very proud of our Q3 results. We grew our revenues significantly compared with Q3 2005 and we also grew our revenues compared to Q2 2006. M-Systems has demonstrated phenomenal growth over the past five years. Just as an example, it is interesting to compare our results this quarter to our Q3 2001 results. In the comparable quarter five years ago, we sold less than $10 million, compared with $270 million this past quarter. This represents a 20-fold revenue growth and I believe this is a unique achievement. In the first nine months of 2006, we already sold more than our full year 2005 revenues. I believe that had M-Systems presented full Q4 results this year, we would have shown record revenues which would far exceed what we had achieved in prior years. As proud as I am of what we have done and for our accomplishments to date I am also very pleased with the planned acquisition, as I have said on different occasions since we announced the acquisition, I believe that this business combination represents the best opportunity going forward for our investors as well as for our employees, customers and partners.

Since the announcement of the acquisition, we realized that SanDisk and M-Systems are not only a great match, with strong synergies in technology, channels and products, but most importantly we found that SanDisk shares our first and foremost value – people first. I would like to take this opportunity in what is likely to be our last quarterly earnings conference call as an independent company, to thank all of the employees of M-Systems who helped build this company over the past 18 years. It is through their teamwork and commitment to excellence, hard work and loyalty that created this innovation, technology and tremendous success. I also want to pay a special thanks to our long-term shareholders and their faith in me and our employees. Our employees, shareholders, suppliers and customers are all our partners in this great, successful voyage. Thank you again for being with us this morning. This is probably my last conference call as the CEO of M-Systems. I am quite certain this is not my last contact with the financial community, so goodbye and good luck.


Thank you. This concludes today’s M-Systems’ conference call. You may now disconnect.

Question-and-Answer Session

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