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Dot Hill Systems (NASDAQ:HILL)

Q4 2013 Earnings Call

March 06, 2014 11:00 am ET

Executives

Jodi Bochert

Dana W. Kammersgard - Chief Executive Officer, President and Director

Hanif I. Jamal - Chief Financial Officer, Principal Accounting Officer, Senior Vice President, Corporate Secretary and Treasurer

Analysts

Eric Martinuzzi - Lake Street Capital Markets, LLC, Research Division

Glenn Hanus - Needham & Company, LLC, Research Division

Kaushik Roy

Nehal Sushil Chokshi - Technology Insights Research LLC

Aaron C. Rakers - Stifel, Nicolaus & Company, Incorporated, Research Division

Dominic Marshall - Pacific Ridge Capital Partners, LLC

Operator

Good day, ladies and gentlemen, and welcome to the Dot Hill Fourth Quarter and Full Year 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

I would now like to introduce your host for today's conference, Jodi Bochert. You may begin.

Jodi Bochert

Thanks, Tom. Good morning. Thank you for joining us today for the Dot Hill conference call and webcast for our fourth quarter and full year 2013 results.

I would like to remind everyone that certain statements made during this call regarding matters that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Because such statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the statements. To learn more about such risks and uncertainties, you should read the risk factors set forth in Dot Hill's most recent annual and quarterly filings with the Securities and Exchange Commission. All forward-looking statements made during this call speak only as of the time they are made. Dot Hill undertakes no obligation to update such statements to reflect events that occur or circumstances that exist after they are made.

Today's call will provide you with the financial results for certain income statement metrics determined on a non-GAAP basis for the quarters ended December 31, 2013, September 30, 2013 and December 31, 2012, as well as the full year's 2013 and 2012. In addition to these non-GAAP financial results, there are reconciliations from the company's comparable GAAP financial measures to the reported non-GAAP amounts. This information is also contained in today's financial results press release and Form 8-K, which are posted on the Dot Hill website at www.dothill.com, in the Investor Relations section, and filed with the Securities and Exchange Commission.

Joining us today are President and CEO, Dana Kammersgard; and CFO, Hanif Jamal. I will now turn the call over to Dana.

Dana W. Kammersgard

Thanks, Jodi. Good morning, everyone, and thank you for joining us for our fourth quarter and full year 2013 earnings call. All things considered, I think it is fair to characterize 2013 as a good year for Dot Hill. In fact, I think you could call it a very good year in spite of the macroeconomic challenges and secular headwinds already documented and described and reported by many in the storage industry.

For the fourth quarter, we achieved non-GAAP revenues of $59.7 million, representing growth of 29% year-over-year and our highest quarterly revenue in over 3 years. For the full year, we grew non-GAAP revenues to $208.7 million or over 6% growth compared to 2012, while revenues of many of our peers declined annually, and the storage industry at large appears to have grown by less than 1%. And equally importantly, we achieved full year GAAP profitability for the first time since 2005, and we did so at 3x the midpoint of our original April 2013 non-GAAP EPS guidance of $0.02 to $0.10 per share, posting full year non-GAAP EPS of $0.18 per share. Moreover, we are projecting increasing revenue growth for 2014, which said our guidance midpoint would be about triple the storage industry analyst projections for storage as a whole. Hanif will cover all the financial details in just a moment. So let me provide you with some industry and Dot Hill color first.

The macro environment is still tough, especially as it applies to traditional data center purchases and federal spending. Cloud service providers are taking over some of the applications, and therefore, some of the storage growth that has historically been found in IT data centers. While the economy may rebound slightly in 2014, the secular headwind of the cloud that challenges many of our peers and certain of our customers is not going away. That notwithstanding, we expect to grow based on the company's specific growth catalysts and the result of our strategic focus.

Indeed, against this backdrop, our results and our growth are strong evidence that our vertical markets and midrange product efforts are beginning to pay off. Our year-over-year non-GAAP gross margin appreciation of 490 basis points is the primary driver of our earnings growth and can be directly correlated to both product and customer mix shifts stemming from our strategic initiatives.

As you know, we have focused a lot of our product development and sales and marketing on strategically selected vertical markets. We have tuned and enhanced our products to create significant randomized sequential performance differentiation for these markets, which include media and entertainment, telecommunications infrastructure, oil and gas, big data analytics and digital imaging, among others. Non-GAAP vertical markets revenue growth grew a very impressive 42% in 2013 as compared to 2012. Going forward, we're going to start reporting the financial performance of our vertical markets with greater granularity, and Hanif will discuss that in just a bit.

So why are we growing these revenues faster than the overall market? We believe there are a number of contributing factors. First, we believe these markets are inherently growing faster than the industry at large. This was one of the reasons we selected these verticals in the first place. Whether it is the advent of 3D movies, the drive towards energy independence based on newly available exploration technologies or the desire to understand customers' buying patterns better through big data analytics, the data growth in these industries is outpacing the growth in traditional IT data centers. By some estimates, 90% of all data growth is unstructured data. And all of these markets generate unstructured data, whether raw film footage, subsurface seismic logs, satellite images or so-called big data. And several of these customers are deploying and developing cloud optimized applications and solutions based on our storage.

Second, quite simply, we are taking share. We believe this is not only a function of better and faster products with significant feature differentiation but also an OEM-focused culture of flexibility, responsiveness and crisp execution designed to deliver first-to-market advantages with quality.

Perhaps most importantly, however, we are focused on vertical market partners who are embedding our storage products not only into their solutions but into their own revenue streams as well. Generally speaking, our revenues from these customers are not coming from traditional IT data center projects that might be curtailed when budgets are tight or migrated to the cloud for greater efficiency. But rather, our revenues are coming from their line of business revenue generation operations that our customers are intent on growing regardless of macroeconomic or secular conditions.

It is worth noting that several of these customers have not fully ramped yet. And while some will no doubt take longer to hit their stride than we would like, we do believe that much of the growth in our vertical markets is still ahead of us, both in 2014 and beyond. Furthermore, we believe there are a lot more vertical OEM and embedded solution prospects out there than those that we have already turned into customers, and our marketing and sales efforts are intently focused on these opportunities.

At the same time, in 2013, we launched several products designed to move us up the value stack with higher average selling prices and product margins. Many, if not most, of these vertical market customers are taking our newer, higher-end products rather than our traditional entry-level arrays. And of course, these faster-growing vertical markets embedding these higher margin products are yielding highly accretive operating results since our overall business model remains very leverageable.

With respect to our server OEMs, which form the foundation of our business, we saw good sequential growth again from our largest customer, derived, we believe, primarily from the first-to-market advantage that we provided the company with our 16-gigabit Fiber Channel and 12-gigabit SAS products. While revenues from this customer did decline in 2013 relative to 2012, we think that this could stabilize in the current year. Frankly, given challenges facing in some of the other larger server OEMs, I believe they are well positioned to capture market share in both servers and entry-level storage in 2014. And we will continue to work with their teams to maintain and extend the product differentiation and advantage that they now enjoy. Moreover, we are excited by the longer-term potential of certain of our other server OEMs given recent industry announcements.

In summary, our success continues to boil down largely to solid execution, primarily by us but by our customers as well. I believe we executed very well in 2013, and I'm really proud of our team and our accomplishments. At this point, I believe our 2013 financial results speak for themselves as validation of the success of our strategic initiatives. Yes, market conditions and secular headwinds will be a factor, but I believe our company-specific catalysts set the stage for continued and increased growth, particularly in the back half of 2014.

Going forward, we have decided to discontinue the use of the pipeline charts of which some of you have grow fond. Rest assured, there are several new and significant deals in the pipeline. But I believe the tool has served its purpose, both in terms of exposing you to the OEM sales cycle and providing you with indications of growth before the financial returns became evident. With financial returns now at hand, we believe there are better ways to keep you apprised of our progress. And so rather than the bubble chart, we will begin providing you with focused financials on both our server OEM and our vertical market segments. And having returned to profitability, we will also now discuss with you our target financial model for the business as a whole.

But rather than steal Hanif's thunder, I will turn it over to him now. Hanif?

Hanif I. Jamal

Thank you, Dana, and good morning. Before I discuss the details of our financial results, I would like to invite you to attend or listen to the webcast from the ROTH Conference in Laguna Niguel, California, next Monday, March 10, or attend the Piper Jaffray Conference in New York on March 12.

In summary, we made great progress in 2013. Total non-GAAP revenues were up over 6%, while the storage industry at large was flat. More importantly, we demonstrated the operating leverage and financial benefits of the vertical markets business that we have talked about over the past couple of years as we increase non-GAAP net income by $13.5 million on just $12 million more revenue compared to 2012. Much of these improvement stems from the 42% growth in our higher-margin vertical markets business, which was partially offset by about a 6% decline in our lower-margin server OEM business.

Now let me provide you with the details of our non-GAAP financial performance for the fourth quarter of 2013, and I will then summarize the total year 2013 non-GAAP financial results.

For our GAAP results, please refer to this morning's press release or to our 10-K that we plan to file on Monday. Fourth quarter non-GAAP revenues were $59.7 million compared to $52.9 million in the prior quarter and $46.2 million in Q4 '12 and were slightly above our revised guidance range issued in early January of $59 million to $59.5 million. This represents 13% sequential and almost 30% year-over-year growth.

Our vertical markets business grew to $18.2 million or 8.5% sequentially and over 64% year-over-year. Our fourth quarter 2013 server OEM revenues of $39.8 million were up 15% sequentially and 18% year-over-year, primarily due to 16% and 19% sequential and year-over-year growth, respectively, in sales to our largest customer. We enabled some of this strong growth as we started shipping our fourth generation of products to them in June 2013, giving them a first and only to market advantage in the entry-level space in the second half of 2013 with both 16-gigabit Fiber Channel and 12-gigabit SAS products.

In the fourth quarter, sales to this customer represented a little under 60% of total revenue compared to 58% and 65% in Q3 '13 and Q2 of '12, respectively. Non-GAAP gross margin for the fourth quarter of 2013 was 31.7%, slightly down from 32.8% in the prior quarter, but up 340 basis points from 28.3% in Q4 2012.

Sequential gross margin was down a little, primarily due to cost increases in certain commodities, which we had anticipated, along with product and customer mix. The main contributors to the year-over-year increase in gross margin were certain nonrecurring charges to manufacturing overhead in Q4 '12, year-over-year component cost reductions and the increase in higher-margin vertical markets revenue over the same period last year.

Our vertical markets revenue contribution was 30% in Q4 '13 compared to 24% in Q4 '12. Total non-GAAP operating expenses for the fourth quarter of 2013 were $14.8 million as compared to $14.5 million for the third quarter of 2013 and $14.7 million for the fourth quarter of 2012. Our non-GAAP net income for the fourth quarter of 2013 was $4.2 million or $0.07 per share and was at the high end of our revised guidance issued in early January. This compares to third quarter 2013 non-GAAP net income of $2.8 million or $0.05 per share and fourth quarter 2012 non-GAAP net loss of $2 million or $0.03 per share.

Our non-GAAP EBITDA for the fourth quarter of 2013 was $4.9 million compared to $3.7 million for Q3 '13 and a negative $1 million for Q4 '12. Cash flow from operations for the fourth quarter of 2013 was a negative $1.1 million due to increased receivables from our largest customer compared to a positive $2.1 million for the third quarter of 2013 and a positive $0.7 million for the fourth quarter of 2012.

Now turning over to full year 2013. Non-GAAP net revenues were up 6.1% at $208.7 billion (sic) [million] compared to $196.7 million in the prior year. Perhaps most pleasing about our full year revenue results was that our vertical markets revenue increased over 42% to $68.8 million from $48.4 million in 2012. This growth was offset by a 6% decline in our server OEM business with revenues from our largest customer declining by 9% despite sequential growth of 20% and 16% in Q3 and Q4, respectively.

Non-GAAP gross margin for 2013 increased 490 basis points to 32.8% from 27.9% the prior year, due primarily to the growth in our higher-margin vertical markets business and the fact that the 2012 comparer had certain nonrecurring charges to manufacturing overhead. Non-GAAP gross margin dollars increased $13.6 million or almost 25% to $68.4 million in 2013 from $54.9 million in 2012 on just 6% or $12 million growth in revenue, which once again demonstrates the operating leverage inherent in our business model.

At the same time, non-GAAP operating expenses for 2013 were well managed and were flat at $57.8 million compared to 2012 due to continued spending discipline throughout the year. This resulted in non-GAAP net income of $10.5 million or $0.18 per fully diluted share for the full year 2013 compared to a net loss in 2012 of $3.7 million or $0.06 per share.

Non-GAAP EBITDA for 2013 was $13.7 million compared to a negative $0.4 million the prior year. Cash flow from operations for 2013 was $4.1 million compared to a negative $4 million in 2012. We exited the fourth quarter of 2013 with cash and cash equivalents of $40.4 million and borrowed $2 million from our working capital line. This compares to the end of Q3 '13 balance of $40.4 million with no borrowings and $40.3 million at the end of 2012 with $2.8 million in borrowings.

Net cash declined sequentially, largely due to an increase in receivables. Networking capital at the end of 2013 was $43.8 million, up $4.4 million from $39.4 million as of September 30, 2013, and up $9.5 million from $34.3 million at the end of 2012.

Before I provide you with guidance for 2014 and the first quarter, I want to describe some of the changes in how we'll be reporting future non-GAAP financial results. As Dana indicated earlier, starting with the first quarter 2014 earnings call, we will begin reporting our financials across 3 segments. The 2 primary segments are our server OEM and vertical markets lines of businesses. We've been distinguishing between these revenue streams now for quite some time and believe that our vertical markets revenues are now significant enough to be discussed separately. We also believe this will give you a clearer picture of the growth rates and margins of both our server OEM and vertical market segments and therefore allow you to better assess the value of the overall business potentially on a sum of parts basis.

The third segment that we will call corporate other, which contains expenses common to both segments such as research and development and G&A. Thus, in future earnings calls, we will present revenues, gross margins and contribution margins for server OEM and vertical markets, as well as a full income statement for the entire business.

With that in mind, let me now turn to guidance. For 2014, we expect revenues to be between $220 million and $255 million, which is at the midpoint represents growth of about 14% compared to 2013. We are projecting continued strong vertical markets growth and expect non-GAAP revenues from this segment to be between $90 million and $115 million, while our server OEM business is likely to remain relatively flat between $130 million and $140 million.

Non-GAAP gross margin percentage is expected to remain around 2013 levels or between 32% and 33%. Operating expenses are likely to increase somewhat to $61 million to $63 million. Net-net, we expect non-GAAP EPS for 2014 to be between $0.18 and $0.29 per fully diluted share.

For those of you updating or building financial models, I encourage you to consider the impact of the recent increase in stock price on reducing the option overhang, and hence, increasing our fully diluted share count for the purposes of calculating EPS. We estimate that if the stock price remains at current levels, our fully diluted share count will be about 65 million shares, up from around 60 million shares more recently.

Now turning to guidance for Q1. For the first quarter of 2014, non-GAAP revenues are expected to be between $47 million and $50 million, with non-GAAP EPS of $0.00 to $0.01. Seasonally, the first quarter is our weakest quarter, but our guidance represents 8% growth at the midpoint compared to Q1 2013. We do expect a bit more than historical back-end loading to this year based on the projected ramp of some of our newer customers.

Now that we have returned to sustainable profitability, we are more comfortable in sharing our target financial model with you. As we look at over our planning horizon, we expect that our compounded annual growth rate average in total for non-GAAP revenue from a 2013 baseline should be in the 14% to 18% range, with vertical markets business growing in the 40% to 50% range and the server OEM business being flattish or plus or minus 5%.

Gross margin is also likely to be flattish and perhaps plus or minus 2% as we expect that a fair bit of this growth could come from one or more large customers to whom we also supply the hard disk drives. Non-GAAP operating expenses will likely grow 4% to 8% annually. The net is we are targeting between 8% to 12% of non-GAAP operating profit exiting our planning horizon.

I will now turn the call back to Tom for a question-and-answer session. After which, Dana will make some concluding remarks. Tom?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Eric Martinuzzi from Lake Street Capital.

Eric Martinuzzi - Lake Street Capital Markets, LLC, Research Division

I'm going to gear my questions more towards Q1 and 2014. I think if the -- the difference between where I'm projecting and sort of where you guys are guiding, for me, it comes down to the server OEM side of the house. And I'm hoping you can take a moment to explain a little bit more because I think what I was anticipating, certainly with the HP business, is that, at this point, in the product cycle, that, that would be a double-digit grower, kind of like it was in Q4 and that, that would sustain through 2014.

Dana W. Kammersgard

Eric, this is Dana. Thanks for the question. So there's a lot of moving parts in the business that we do with our foundational customers. And it will probably take me a little while to walk through this. So bear with me. We call them our foundational customers, first and foremost, because they are our foundation, the server OEMs, whether it's HP, Lenovo, Dell, AMD, ACER, Stratus, et cetera. And we're not projecting nor have we projected necessarily strong growth from that group. They are confronted with economic headwinds, whether it be federal spending, whether it be a slowdown in the economy in various parts of the world and secular headwind such as cloud, flash, whatever it may be. Our revenue strategy, if you will, and the reason we're now providing granularity into the 2 segments is that the growth is designed to come from the vertical markets. The foundational customers give us very good economies of scale, lower bills of materials than we would otherwise be able to realize. They give us technology validation. They give us quality validation. They give us great voice of customer insight, et cetera, et cetera, et cetera. So you should focus your thinking with respect to growth, particularly into the vertical markets. Now having said all of that, I think that there certainly is upside within our server OEMs. And anticipating another question that's likely to come, let me get into that now. Yes, we have provided Hewlett-Packard with brand-new products, first-to-market advantage, and we expect that they will capitalize on that. Is that, in and of itself, going to outweigh the secular and economic headwinds? Hard to tell. At the same time, we're all aware of the IBM divestiture or the pending divestiture to Lenovo. We're all aware of the Dell leverage buyout. We think that HP is particularly well positioned these days to take advantage of other turmoil going on with certain of the other server OEMs. At the same time, IDC and Gartner are projecting only 4% to 5% growth at large for storage. And the server OEMs tend to reflect whatever the industry growth rates are. So a lot of moving parts. We think that we are being appropriately prudent with respect to our guidance, and I would focus your growth interest in the vertical markets in particular.

Eric Martinuzzi - Lake Street Capital Markets, LLC, Research Division

Okay, that's helpful. As I look to -- I mean, it just seems like the HP business was so promising, and we sort of have this one quarter and now it's -- we're kind of pulling in our bullish horns. And I understand. I get the secular -- I get the economic headwinds commentary. I just thought there was a longer runway. Having said that, the vertical side of the house, obviously, terrific growth there. As I'm modeling my 2014, you guys have already said, hey, it's going to be a back half skewing to that good growth in the vertical, OEM side of the house. Is that -- are we talking kind of a Q4 skewing? Is this the last 6 months? What indicators do you have that, that's the case? And which quarters do we see the impact?

Dana W. Kammersgard

Yes. I think we'll see progressive growth across the course of the year. It's a little bit tough to call because we've got different OEMs ramping at different times at different magnitudes with different velocities. I think we'll see incremental growth. I'll think you'll start to see a greater impact in the back half of the year as certain OEMs hit their stride.

Eric Martinuzzi - Lake Street Capital Markets, LLC, Research Division

Okay. And then I know you gave an outlook on the OpEx. I think you said $61 million to $63 million on the OpEx. Just curious, that seems like a big step-up here. You were flat, your OpEx in 2013 versus your OpEx in 2012. And now we're up. Kind of at the midpoint, that will be an incremental $4 million. What's the explanation there?

Hanif I. Jamal

Eric, this is Hanif. Thanks for the question. So as you know, we actually held off OpEx flat in 2013. Some of that was that we actually curtailed on what I call structural expenses like salary increases, et cetera, for the employee base. The other part of it is we're anticipating increasing health care costs in 2014. And then the last bit of it, which is really sort of, I suppose, a variable piece of the OpEx, is we're anticipating making some additional investments on the engineering side, a little bit on the sale side.

Operator

And our next question comes from the line of Glenn Hanus from Needham & Company.

Glenn Hanus - Needham & Company, LLC, Research Division

Hanif, I know you were taking some time here to -- as you contemplated your first quarter guidance to kind look over the inventory situation at various OEMs. Is the soft first quarter guide indicative of certain inventory builds? Can you give some color around that?

Hanif I. Jamal

So Glenn, we have talked a little bit because you asked us questions around this the last time. It's always very hard to gauge our customer's inventory because we don't get specific numbers. But one would -- I would assume that there could be some of that in our overall guide because there's a couple of things going on here. Clearly, there was perhaps the year-end build-up. The other piece is we've also got -- there's been a little bit of a -- we're doing a transition certainly with our largest customer between our G3 [ph] and our G4 [ph] products, okay? And it's sometimes hard to gauge the demand you are going to get for a new product right off the shute. And so you tend to perhaps carry a little bit more inventory because certainly when you have a first-to-market advantage, you don't want to sort of give that up right off the bat because you don't have supply to meet it. So there's probably some of that, and some of it is just seasonal, Glenn. We're still up 8% relative to our Q1 '13 number. And as you know that in the vertical markets, the business can also be a little bit lumpy. We saw that last year when we had a terrific Q2 in vertical markets on the back of one customer and we had that lumpiness in Q1 of 2012. So we factor all of these things into it when we put together our guidance.

Glenn Hanus - Needham & Company, LLC, Research Division

So in terms of the first quarter vertical markets, might that be more in line with your September quarter, sort of in the 16 kind of range? Is that maybe where to think about it?

Hanif I. Jamal

Well, yes. You could think about it in that range. Certainly, a piece of what we're expecting is that the server business would go down, if you believe the comments I made on the inventory situation. I'm not trying to project anything. But certainly, you would expect there to be some decline right there. But to be looking at the September quarter, it wouldn't be an unreasonable place to look at in terms of overall revenue there.

Glenn Hanus - Needham & Company, LLC, Research Division

I mean, for the vertical piece?

Hanif I. Jamal

Yes, yes.

Glenn Hanus - Needham & Company, LLC, Research Division

You want to comment maybe more on your non-HP server business as we look at this for 2014, for the first quarter and for 2014. Should we think about that business growing in 2014? And should we think of the first quarter as having sort of normal seasonality down?

Hanif I. Jamal

I would say yes to both. Certainly, if you look at where that revenue is coming from, I think we've stated previously that Lenovo is a part of that. We're doing business with Lenovo in China. Certainly, Lenovo would not be looking to acquire IBM server business if that was not a business that they wanted to grow. So certainly, we're very bullish about Lenovo in terms of one of our prospects for this year. So I'd expect a little bit of growth in the non-HP server business. That's a big piece of it. The other customers that's in there that really hasn't started to wrap for us is Acer. So there's a couple of customers that can give you some upside in that segment. But remember, it's relatively a small business. In 2013, it was $14.5 million. And so it's not going to grow. I wouldn't be looking at it -- a vertical market type of growth in that business.

Glenn Hanus - Needham & Company, LLC, Research Division

And could you maybe comment on what changed since? I mean, maybe I put out a first quarter number that was a little too high or something, but what has shifted over the last month or 2 for you to put out the softer guidance for the first quarter? Is it more back-end loading of certain vertical markets, customers? I know you're not going to name names or something. Is it more related to that? Or is it more related to HP and the other side of the business?

Dana W. Kammersgard

Yes. There's a couple of things, Glenn. And we haven't put out our fourth quarter guidance before. And maybe softer compared to your numbers, but there's a few things going on. There is the transition at HP going on from G3 to G4. And that makes it difficult to call from the standpoint of unit volume run rate. So there could be some volatility there. Certainly, as I indicated in my prepared remarks, we have a difficult time calling the ramp of some of our OEM customers. And it generally takes a little longer than we would like, like most things in life. So, and then you've got the seasonality effect. We had a very strong fourth quarter. We have what we believe to be a seasonally down first quarter and perhaps a little bit more back-end loaded year than we historically have. But if I go back to the last question briefly and talk about the server OEMs at large, if you think about their performance over the last couple of years, and I'm not talking about HP specifically, I'm talking about all the server OEMs, they've been down, generally 10% year-over-year, for at least the last couple of years. And in the last couple of years, the industry analysts have forecast 4% to 5% growth, generally speaking, in storage on an annual basis. And generally speaking, the industry analysts have been wrong the last couple of years with their 4% to 5% growth. So for us to be indicating that server OEMs are plus or minus 5%, this year, possibly next, I think it's a very reasonable approach. And I think you're seeing some of that reflected in our first quarter guidance as well.

Operator

Our next question comes from the line of Kaushik Roy from Wunderlich.

Kaushik Roy

Hanif, I may have missed this. Did you give a non-GAAP gross margin guidance for 2014?

Hanif I. Jamal

Yes, we did, Kaushik. We gave a guidance of 32% to 33%.

Kaushik Roy

Okay. Dana, so can you comment on some of the new emerging hybrid companies such as Nimble? They seem to be growing very fast. And can you comment how different you are in terms of technology, as well as your business model?

Dana W. Kammersgard

Yes, sure, certainly, Kaushik. That's certainly a long -- that's a short question with a long answer. So I don't necessarily want to do a direct compare to any private or newly minted public. But I would, at the same time, ask you to consider what public storage companies are out there growing at a midpoint projected of 16% per year that are profitable. And we're very mindful, of course, of the need for sustainable profitability, and our guidance reflects that. We're not in a position where we can spend 50% of our operating -- 50% of our revenue on sales and marketing. We're not interested in non-profitable growth at this point in time. But there's a major and very important distinction between the markets that any of these newly minted or soon to be minted storage companies are going after and ours. All of them are targeting the IT data center, whether it be in a managed service provider or in a traditional Fortune 1000 or SMB company. Most of them are going after that predominantly through a reseller network. As such, they are going to go head to head eventually with NetApp or EMC or one of the traditional server OEMs who sell into that IT data center market. And the day that NetApp or EMC decides to compete on the basis of price will be the day that their growth is cut short, regardless of who we're talking about. That's just my personal opinion. You can take it for what it's worth. We are not typically selling into the traditional data center. We are selling our products into the revenue generating lines of business of our customers. Whether it's the production of major motion pictures like Iron Man 3 or Gravity or The Hobbit or some forthcoming movies, whether it's oil and gas exploration, whether it's companies selling big data analytics, whatever it may be, we're on the revenue generation side. As such, I think it's much easier for us to project our growth, and our growth is not tied to significant incremental sales and marketing expense. And that's because we are selling to embedded solution providers and OEMs. Our business is really relationship and road map based as opposed to the transaction-oriented sales. For our customers, we're always going to get revenue quarter-over-quarter over quarter-over-quarter because they're generating revenue on their own on the basis of our products. On the context of these others we're selling into the data center, it's a transaction-oriented model, and they have got to go every quarter and find a new end-user customer through a reseller to sell a Microsoft Exchange solution to or an Oracle database solution to or what have you. With respect to the technology, I think that the one that you mentioned in particular has but done a phenomenal job of marketing a value proposition. I will stand by our technology, our patented technology against anybody, whether it be performance, whether it be reliability, what have you. One of the value props that they have recently mentioned is Five 9's worth of availability based on something in the neighborhood of 5,000 systems in the field over the last 18 months. By comparison, we measure and monitor 150,000 arrays every single week, and we have been doing that for 5 years. And I would ask you -- and we can demonstrate weekly Five 9's worth of availability. So I would ask you whose data might be a little more robust in that regard than in the other. But I've taken up enough time answering your question. Hopefully, I got to some of the salient points that you were looking for.

Kaushik Roy

All good points. Last question for me, and it's market related. I mean, you are growing, but EMC, NetApp, they're not growing. One of the reasons probably is the shift to the cloud. So can you comment, where do you think the impact is more with this shift to the cloud? Is it more of the high-end storage in the IT data center? Or is it impacting the entry-level storage that SMBs are using?

Dana W. Kammersgard

That's a good question, Kaushik, and I can speculate along with you and the other analysts on the phone. I think what we're seeing is, let's call it, initially -- let's talk specifically about the public cloud for a moment as opposed to the private or the community or the hybrid or all the other different mutants, if you will, of the cloud notion. What we're seeing in the beginning, in the early going, are relatively ancillary applications moved into the cloud. Ancillary applications could be marketing programs, could be CRM, customer relationship management programs, could be HR functions, et cetera, et cetera, et cetera. And I think we're seeing that occur both in larger companies and also in SMBs, small and medium business side companies. As such, what we are seeing is the absorption of some of the storage growth into the cloud for those that are selling into the traditional data center, probably faster in the SMB space than it is in the large-scale enterprise space. And as such, it's probably more midrange-type storage product than high-end storage product. But virtually, every Fortune 100 out there, no doubt, has at least a study, if not a prototype, going on with the cloud experiment, largely private when it comes to their proprietary or high-security applications and potentially public when it comes to some of their ancillary applications. We think, in our context, by selling into the revenue side of our customers, we are a little bit more resilient because they're not going to move their major motion picture or their oil and glass -- oil and gas proprietary analytic software into a public cloud. They're going to keep that on the revenue generation side, at least a whole lot longer than somebody wanting to move their Microsoft Exchange Server or their CRM system over into a cloud.

Operator

And your next question comes on the line of Nehal Chokshi from Technology Insights and Research.

Nehal Sushil Chokshi - Technology Insights Research LLC

So there's a 2-quarter period before the next wave of vertical market growth driver starts to take hold. Is the bulk of that stuff function increase driven by the addition of Teradata? I know there are multiple vertical market OEMs that you're working with, but it seems like Teradata is the biggest mover there. Can you first verify that, if that is indeed the case?

Dana W. Kammersgard

So let me start with that, Nehal. This is Dana. And I'm sure Hanif will add on. I don't know that you should make an assumption that there's a 2-quarter hiatus or pause in vertical market growth. We did indicate that we thought that there would be an acceleration of growth in the back half, and we think that comes from a variety of customers who are either just ramping or just launching or about to launch products based on our storage. I'd rather not comment on any one individual. We've indicated before where we thought Teradata revenues could be in 2014. But there's a number of customers. And frankly, there's a number of prospects, prospects being those that we haven't turned into customers yet that we think that turn into revenue-producing opportunity for us this year. Did you want to add...

Hanif I. Jamal

Yes, Nehal, let me add a little bit of color to that. So if you look at our business, in fact, in 2013, the revenues we got from Teradata were really not meaningful. And so yet that business still grew 42% year-over-year. There's another of other customers who are also ramping, who started ramping in the latter half of 2013, going -- and hopefully, we'll continue to see some of that ramp in 2014. So I think that there's -- just the vertical markets business, when you think of it, is that in many cases, what we're doing is we're replacing -- when we're replacing a competitor, the revenue -- or the ramps tend to be fairly steep because there's already an established installed base of business. we're just a new supplier. Hence, the reason for showing this pipeline chart in the past kind of gives you a sense for the new customers that we're able to bring in and then ramp up. And as Dana indicated, the pipeline has not dried up. We continue to fill the pipeline, and there's still a lot of opportunity out there for us.

Nehal Sushil Chokshi - Technology Insights Research LLC

Right, okay. by the way, when I said 2-quarter period before the next wave of vertical market growth, I was talking about on a sequential basis, not on a year-over-year basis. So just for clarity, when you're saying that you expect continued growth on the vertical markets, was that on a year-over-year basis or a Q-over-Q basis?

Hanif I. Jamal

I would say to you both, that you would expect there to be some growth in that business. It did that last year. With that said, remember, there is lumpiness in our business. So Q2, for example, of 2013 was a big quarter for us. It was actually the largest quarter we've ever had in vertical markets. It was -- we're over $20 million that quarter, $20.6 million. We've never been over $20 million for the rest -- since we started the program -- the initiative here. So it is lumpy. It's hard to do a compare from that standpoint. But I would say generally speaking, the momentum is positive in the vertical markets business. And aside from timing differences and lumpiness, we are seeing that business grow, and we're seeing this to grow on a sequential basis as well.

Nehal Sushil Chokshi - Technology Insights Research LLC

Okay, great. And then within the major vertical wins that you have with the pipeline, what do you see is the probability and timing of adding new product lines within those large vertical OEMs that you have bought initial ones with? [ph]

Dana W. Kammersgard

So new products, new programs with existing vertical market customers. Is that the question?

Nehal Sushil Chokshi - Technology Insights Research LLC

Yes.

Dana W. Kammersgard

That happens every day. That happens every month. That happens every quarter. We are -- as I indicated earlier, the OEM, whether it's vertical or server, transaction, the OEM sale is a relationship and road map-based conversation, right, or sale. And in that context, we are constantly working jointly with our customers on road maps, on near-term products, on near-term feature enhancements, on midterm and longer-term products and technologies. And we're doing that with virtually every single one of them all the time. In some cases, we have monthly technology reviews. In some cases, we have quarterly technology reviews. And in some cases, we have weekly interlock meetings. And in that context, we're talking about new products, future developments, new features, et cetera, et cetera, et cetera. Generally speaking, the better we execute, the better we listen to our customer -- customers, particularly compared to our competition, the more likely they are going to design us into, either incremental products and products within their line up or into future durations [ph] as they turn the crank on their own product life cycles.

Nehal Sushil Chokshi - Technology Insights Research LLC

Okay. And then finally for me is that with Lenovo buying IBM, what do you see is a probability of them becoming a foundational customer? And what do you see as the main risk to them not becoming a foundational customer?

Dana W. Kammersgard

That's a great question,Nehal. And I think we're very bullish on Lenovo. As Hanif mentioned, we are currently their entry-level storage supplier, private branded Lenovo in China. So let's set aside the IBM divestiture for just a moment. To the extent that Lenovo has aspirations to become a major player in the server space, outside of the IBM divestiture, or acquisition as the case may be, they would likely deploy worldwide. And as long -- again, as with any of our customers, as long as we execute well, we execute with the time-to-market advantage, we execute with great performance, good pricing, good features, et cetera, et cetera, we would expect to continue that relationship. They have done some great organic growth in smartphones, for example, in China, where they are now #2. They've done some great acquisitive growth in the ThinkPad product line -- lineup that they acquired from IBM 5 or so years ago. In the context of the IBM server acquisition, I think in the short term, quite frankly, it benefits other than IBM and potentially other than Lenovo. I think Lenovo benefits in China, but I think people are going to wait to see with respect to whether or not this transaction goes forward. And CIO, Chief Information Officers, are likely going to go with the more certain partner in the short term. I think that Lenovo has demonstrated a very formidable capability to execute on market share growth when they put their mind to it. And I think certainly in the mid to long term, they could do that very capably with this asset should this transaction go forward. So we're excited with them as a partner. We're excited about the near-term ramifications of this prospective transaction. We're certainly excited about the longer-term ramifications of this potential transaction as well.

Nehal Sushil Chokshi - Technology Insights Research LLC

Okay. Could you just really, real quickly -- what do you see is the risk of them not leveraging Dot Hill's technologies?

Dana W. Kammersgard

Well, I think the one prospective risk is that they choose to take IBM's storage. IBM tends to be more of a midrange play, not an entry-level play. And so I think that the risk relative to that is relatively low. So, but it boils down to the same kinds of risks we always have, which are can we execute with quality, can we deliver a first-to-market advantage, can we give them great service, great price, great performance. And as long as we do that, and we have a history of doing that, I think we'll be fine there.

Operator

And our last question comes from the line of Aaron Rakers from Stifel.

Aaron C. Rakers - Stifel, Nicolaus & Company, Incorporated, Research Division

So I want to -- you outlined several different dynamics at the OEM level, be it Lenovo, Dell, et cetera. But one thing I wanted to ask you about is have you had any discussions or engagements with your partners, your customers on the pending Seagate acquisition of Xyratex? Does that open up any opportunities for you in your mind? And if so, when would you expect to see them?

Dana W. Kammersgard

Aaron, this is Dana. Thanks for the question. That's an interesting one. So for those who do not know, Seagate has agreed to acquire Xyratex for $340 million or $350 million in cash, I believe. Transaction should close fairly soon. Once upon a time, Xyratex could rightfully be considered a competitor of ours, I would say, 5 years ago, that was probably true. Over the course of the time since, they have moved more, at least initially, in the direction of a chassis enclosure company while we have moved more in the direction of a high feature external accelerated RAID storage area network company. And in fact, perhaps, 3 to 4 years ago, when they got out of the external RAID business, we picked up a number of their vertical market OEM customers, including Harris, including Concurrent and including Autodesk, to name a few. More recently as, Aaron, you know, they have gotten into the cluster store business and trying to build a business in the HPC space based on a storage server that runs Linux and a distributed file system. Seagate has acquired them ostensibly and perhaps primarily for the test harness, test infrastructure business where as you recently pointed out, Aaron, they can essentially defray the overall cost with the CapEx savings they will have simply by owning the test harness provider, Xyratex. At the same time, I think you are right in pointing out that they can move up the value chain in terms of providing an enclosure-based storage product in particular to those customers who have begun to move towards a lowest common denominator of value in terms of where they're sourcing their product from., i.e., buying the disk drives directly and specifically the hyper scale or major cloud service providers. In that regard, I don't see a -- certainly, I don't see any near-term detriment to us because that's not a community or a market segment that we are attempting to service directly primarily because it's a very low margin, very competitive space. I'll tell you an anecdote without identifying the particular end user/major cloud service provider. We were over in China recently at our power supply vendor who is a sub-tier supplier to us through Foxconn. And one of the major cloud service providers was there, looking at custom power supplies. So not only did they cut out several layers of traditional supply chain, they're going around the contact [ph] manufacturer in that regard as well. That's not a business that we're interested in. On the other hand, I think it could make sense with the risk of alienating certain of their traditional customers for Seagate to potentially move up the value chain and begin to provide enclosures to those customers as well. So I think frankly, it's pretty similar to the way you see it.

Aaron C. Rakers - Stifel, Nicolaus & Company, Incorporated, Research Division

Okay. You answered a lot of my other questions in that comment. The only other question I have is if you could be a little bit more specific. I think you had referenced some component costs a bit pressuring gross margin. Just curious of what that was and how you expect to see that as we look forward.

Dana W. Kammersgard

Primarily DRAM. And we see that ameliorating as we go through 2014. There was a little bit of NAND pressure as well, as you know, and we see that ameliorating as well.

Operator

And we do have another question from Dominic Marshall from Pacific Ridge Capital.

Dominic Marshall - Pacific Ridge Capital Partners, LLC

I just wanted to -- most of my questions have been asked, but I just wanted to follow up on the guidance, just a little bit more detail. The OpEx range of 61 to 63, does that coincide roughly with the full fairly wide range of revenue guidance?

Hanif I. Jamal

Yes, it does. There will be -- some of the OpEx would be variable based on revenue as well.

Dominic Marshall - Pacific Ridge Capital Partners, LLC

Right. But said another way, $63 million should coincide roughly, not holding anything [ph] exactly, to the high end of the revenue range?

Hanif I. Jamal

I wouldn't get that specific because some of the OpEx investments are going to be investments in R&D. You're not necessarily going to get that -- see the return from that right away. Some of it is in variable compensation.

Dominic Marshall - Pacific Ridge Capital Partners, LLC

Sure, okay. But just using the wide range, especially at the mid to high end of the revenue guidance, just using -- just running the numbers that looks to me like you're still expecting contribution margin for additional revenue dollars to be roughly in the maybe mid-20% operating margin contribution range, which is why you talked about in the past...

Hanif I. Jamal

Yes, that's right.

Dominic Marshall - Pacific Ridge Capital Partners, LLC

I just wanted to make sure that lined up with what you're thinking. And then I appreciate you guys are being -- I understand that and I appreciate that you're being conservative on guidance and certainly hope that it turns out to be conservative. But when the revenue level goes beyond the high end, whether it happens to be this year or going into next year, I'm assuming the contribution margin that you'd be looking for would still be in the same ballpark?

Hanif I. Jamal

Yes. Certainly, that's the model we have spoused to. We've said that in the past, and we believe that, that's -- we can maintain that.

Dana W. Kammersgard

Yes. And that's exactly right, Dominic. And appreciate you bringing that out. We're forecasting or we're projecting 14% to 18% compounded annual with, what, Hanif, 4% to 6%.

Hanif I. Jamal

4% to 8% of the OpEx.

Dana W. Kammersgard

4% to 8% OpEx. And if you net that out, you're still in that $0.20 to $0.30 per dollar -- per revenue dollar contributing to the bottom line. We're very consistent. We believe that strongly. Whether we execute at the low end of the range or the high end of the range, that still remains true.

Dominic Marshall - Pacific Ridge Capital Partners, LLC

Sounds good. And you said, if I heard it correctly, that the model is 8% to 12% operating margins. I kind of get they're running numbers that you gave, maybe towards the high end of your revenue guidance for this year. But again, looking out beyond, whether it happens to be that you beat the revenue number this year or looking at the growth into next year, I would imagine getting up towards the high end of that 8% to 12% range and maybe potentially even beyond as we go out a year or 2 is what you guys are looking for?

Dana W. Kammersgard

Certainly possible. Our goal is to execute as well as we can, both in terms of spend discipline, as well as in terms of winning new customers. I'll reiterate -- and new programs within existing customers. I'll reiterate something I said earlier. One of the nice things about being in the OEM-embedded solutions provider business is that our projections tend to be more predictable because we have recurring customer revenue streams as opposed to having to get up every morning and go find another transaction-oriented customer that I can sell a $50,000 storage product to. So if we put out a projected guidance growth range of 40% to 50% on the vertical markets, we did that because we have a collection of recurring customers who are motivated to sell their own product in which we are embedded and we have a number customers that have not yet hit their stride. Predicting exactly when they will hit their stride is tough, but what we know is that if we execute along the lines of what I characterized earlier, which is give them what they want, give it to them with quality, give it to them with time-to-market advantage, give them good performance and reasonable pricing, we're going to get loaded into a greater percentage of their road map and their future products. And that allows us to predict with confidence that kind of a compounded annual growth rate, which in our view is just about as good as anybody in the business out there and better than most.

Operator

And the next question comes from the line of Thomas Macy [ph] from UBS.

Unknown Analyst

In the past -- I've been a long-time -- well I am a long-time shareholder. And in the past, the charts that you've provided, the profiles of possible customers and how they're emerging through the pipeline have been very useful. The new scheme of breaking down the vertical and the OEM markets sounds interesting, but what it sounds like is that it's getting rid of any look forward. How will you address that? And is the lack of address -- it leads me to question, is there a deficit somewhere that is being removed?

Dana W. Kammersgard

I'm glad you asked that question, Tom, because I figure there's a lot of people that feel that way. Let me reiterate what I said. Actually, you're going to get a look forward, right. We're actually providing you with, starting with the first quarter earnings conference, with a great deal of granularity in terms of guidance on both of these sectors. What the pipeline or the bubble chart was designed to do, it has accomplished. I think it has accomplished it very well. It has exposed opportunities that were in various stages of our sales cycle with a reasonable degree of granularity, demonstrating the prospect of growth in the vertical markets with certain opportunities before financial returns were evident. That was why we put it in place. We started noodling on this probably late 2012. We put it in place very early in '13. And we refined it, in particular, at the Analyst Day, that we conducted. But it was, a, designed to educate and expose what the process is from a sales pipeline point of view, why it took so long to gestate some of these, where the revenue opportunities were within the verticals, et cetera, et cetera. Some people started getting very -- and it was always intended to be qualitative in nature, not precisely quantitative. Some people became -- tried to use it as an analytic estimating tool where they would measure the progression of a quarter inch across Phase 3 or they would try and estimate the revenue potential on the basis of the low and the high of the size of the bubbles. So it actually started getting used in a way that we didn't anticipate and we didn't think was particularly in line with what we had developed the tool for. Now with financial evidence at hand, sustainable growth, sustainable financial returns, frankly, I think that the tool has served its purpose. You should take absolutely no conclusion that anything other than what I've just stated is the case. In other words, we haven't lost opportunities, or prospects have fallen off the map or anything like that. In fact, we have incrementally more and more interesting opportunities at the left-hand side of that chart that are just now entering the pipeline.

Unknown Analyst

Fantastic. Another question gets back to the accumulation of the shares over the years, that there have not been very many purchases, independent of options or stock ramps since, say, Preston Romm other than August of '12. And I wonder if there's a legal reason or if there's any thought that, that would be a good idea for the board?

Hanif I. Jamal

Tom, so the question regarding insider ownership, right?

Unknown Analyst

Correct.

Hanif I. Jamal

I know there are a few months or maybe about 1.5 years ago, I think all the board members bought a small number of shares. And what we have -- actually, what we have done in the earlier days, and this is kind of going back into the 2007, '08, '09, '10, '11 time frame -- traditionally, compensation packages around here constitute a base salary, an incentive-based cash bonus based on meeting certain milestones, and usually, they are financial milestones or financial targets, and then equity. For several years, we actually -- the management team here took their whatever incentive compensation we were eligible for in the form of stock. Okay, so you could look at that as one way of saying, "Actually, did they invest or not?" We chose to -- we chose to take out our compensation in stocks. So I think it's a little bit -- it's probably not as transparent as it should be. But I think there certainly has been some insider buying when you take that into account.

Operator

And I'm showing no questions at this time. I'd now like to turn the call back over to Dana Kammersgard for closing remarks.

Dana W. Kammersgard

Thank you, Tom. Thanks, everyone, for joining us today. We're all in all pretty well pleased with our 2013 results. I'm really proud of the team for executing on spend discipline, executing on the margin appreciation, executing on the vertical markets growth in spite of a difficult macro. Frankly, we're even more excited about 2014 and beyond. And we look forward to updating you with respect to greater granularity on our first quarter 2014 earnings call. Thank you. Have a great day.

Operator

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a good day.

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