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Imation Corp. (NYSE:IMN)

Q2 2010 Earnings Call

July 27, 2010 10:00 am ET

Executives

Tim Gallaher - IR

Mark Lucas - CEO

Paul Zeller - CFO

Analysts

Blaine Marder - Loeb Capital Management

Mark Miller - Noble Financial

Chuck Murphy - Sidoti & Company

Jeff Hershey - Columbia Management

Operator

Good day, ladies and gentlemen, and welcome to your Imation announces Q2 earnings conference call. (Operator Instructions)

I would now like to introduce your host for today’s conference call, Mr. Tim Gallaher.

Tim Gallaher

Thank you, Kevin. Good morning, everyone, and welcome to our quarter 2, 2010 earnings conference call. On today’s call, you will be hearing from our CEO, Mark Lucas and our CFO, Paul Zeller.

Before I turn the call over to them for their comments followed by your questions, I want to remind everyone that certain information discussed on this call that does not relate to historical information may be deemed to constitute forward-looking statements. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from any projected results.

Risk factors that could cause results to differ are outlined in both the press release as well as our filings with the SEC.

With that, I’d like to turn the call over to Mark. Mark?

Mark Lucas

Thank you, Tim, and good morning everyone. First let me comment on the quarter. While we continue to make progress in the evolution of our business model, we clearly need to drive for improved revenue and earnings. While getting better, our results are simply not strong enough.

And having said that, we have been able to continue our return to solid cash flow, and we have improved gross margins and costs across our businesses. I believe these improvements are sustainable over the longer term, and I think Imation has strong, fundamental business practices in place.

As we leverage our data storage technology legacy into our strategy of storing, protecting, and connecting the digital world, I have every confidence we will demonstrate improved financial performance.

I was able to meet several of you during May when Paul Zeller and I were out on the road, and I want to thank you for the time you spent with us. I appreciate the dialogue we had, and I look forward to continuing that with you. I'm excited to be leading Imation, and we have great confidence we can leverage our core capabilities.

Now let me turn the call over to our CFO, Paul Zeller, who will review the financial details of the quarter. Following his summary, I will rejoin the call with Paul to answer any questions you have.

Paul Zeller

Thanks Mark, and good morning everyone. Our Q2 results were much like our first quarter as we continue to build momentum in several important parts of the business. We continue to grow significantly in our emerging storage category. That was up 31% in the quarter, and 37% so far this year.

Our gross margins were still below the wall with some continuing improvement in our growth categories, both in emerging storage as well as electronics and accessories. Operating expenses were well controlled. Working capital indices continued to improve, and cash flows were again very strong in the quarter with our cash balances now over $250 million, and that's up over $160 million from the year-ago quarter.

That said, we need further improvements before our overall results start coming in line with our long term financial goals. While the decline rates in our core optical and tape markets were consistent with the first quarter, we need further growth elsewhere to offset these double digit declines and to deliver total company growth.

And the level of operating earnings, while encouraging relative to last year, is clearly not sufficient yet to provide a fair return to our shareholders. We remain very focused on strategies and actions to bring our current results in line with our long term financial goals.

Now before I get into the details on our Q2 results, I'd like to cover some reporting changes we implemented in the quarter. Based on how we're now managing the business around the world, we realigned our corporate segments and our reporting structure. Essentially we've combined the electronic product segment with our Americas segment. In addition, we've separated the Asia-Pacific segment into North Asia and South Asia regions. Each of these segments has responsibility for selling all of our product lines.

Along with this realignment, we have also changed our product revenue disclosures, which are now first, traditional storage products which includes magnetic and optical and other traditional storage media; second, emerging storage products which includes Flash and hard disk related storage products, and then finally electronics and accessories.

In addition to the change in our product reporting structure, we have also added product gross margin disclosures. These disclosures are aligned with how we're managing the business today, and the addition of gross margins by product category will help investors better understand the underlying trends in the business.

We have provided the financial history of these new disclosures in Table Six attached to our earnings release we issued this morning.

Now let me get into the Q2 results. Our revenues were at $354.4 million. That was down 11.4% versus the same quarter last year. This rate of decline was moderated from the decline rates we experienced last year, which were as high as 20%. We did however see a modest increase from the 8% decline rate we saw in Q1 this year.

The most significant driver for this was video electronic products. Our decision to exit the highly volatile TV category in the second half of last year had the most significant impact to our Q2 comparisons.

Traditional storage revenues declined about 14%, driven by both optical media and magnetic tape. This was almost identical to the Q1 decline rates we saw. Our emerging storage revenues increased nicely during the quarter as I had said earlier, up 31% on top of a 42% increase in the first quarter.

The majority of this increase was in the Flash category, but hard disk products were also up year over year. From a segment standpoint, our Americas segment was down 14% in the quarter. That was driven by continuing declines in traditional storage, as well as video products.

Europe is down a disappointing 25% year-over-year, driven by declines in both tape and optical revenues. Our Europe business is more concentrated in our traditional storage category, and thus receives less benefit from emerging storage and electronics and accessories. In addition, currency translation was a penalty during the quarter.

North Asia revenues grew 4% with strong volume growth. This region was also aided by a stronger Yen versus the Dollar. South Asia grew 6%, also aided by positive currency impacts.

Overall, when we look at our roughly 11% decline in total revenues, it came from about a 3 point impact from lower volumes, a 9 point impact from price erosion, offset by a 1 point positive impact from currency translation.

Our gross margins in the quarter were 16.5% to sales; that's up six-tenths versus last year's second quarter, which was at about 15.9%. We improved margins in both emerging storage products as well as electronics and accessories.

In the case of emerging storage, margins were up in both Flash as well as hard disk products. While we're making good progress here, we still have significant room for improvement as our margins remain in the upper single digits in this category.

In electronics and accessories, we continued the gradual improvement we've seen over the last year, almost year and a half. All of the product categories were in the double digit range, and our accessory margins were particularly strong, especially in areas such as headphones.

Our traditional storage margins were very stable year-over-year with gains in optical products offset by declines in magnetic tape. As we look at our margins sequentially, we were down slightly from quarter one, with mix playing a role as expected. I'd like to remind everyone that Q1 does tend to be our highest gross margin percentage quarter due to seasonal mix benefits.

Our operating expenses totaled $55.4 million in the quarter; that's down $8.5 million or 13% from second quarter of last year. This was driven by lower legal costs after having served the Philips litigation in July of last year. Results were benefited by our restructuring and cost control actions.

As a percent of sales, OpEx was 15.6% in the quarter; that's down from 16% last year. We had $3.4 million of restructuring charges during the quarter, those related to our previously reported restructuring program.

In addition, we reported a $23.5 million goodwill impairment charge during the quarter. As I just mentioned, we combined the electronics products reporting unit with the Americas unit as part of our realignment. As a result of doing that, we were required to test goodwill from impairment.

The Americas reported unit had a fair value significantly lower than book value prior to this combination, and therefore once we combined the units, an impairment was triggered. There is no goodwill remaining on our balance sheet after this charge.

Including these non-recurring charges, we had an operating loss of $23.8 million in the second quarter. Excluding those charges, operating income in the quarter was $3.1 million, and that represents a $3.6 million improvement over $0.5 million loss last year, also excluding charges.

Non-operating expenses totaled $2.9 million in the quarter; that's down from both Q2 last year and from the prior quarter this year, driven by lower currency related costs. We recorded an $11 million tax benefit in the quarter associated with our pre-tax loss of $26.7 million, for a tax benefit rate of about 41%.

On a per share basis, we had a loss of $0.42. If we adjust this to exclude the charges I just mentioned, we had earnings per share of about $0.02. That compares to a loss of $0.05 per share last year on the same basis, excluding charges.

Our financial position continues to improve with cash up another $27 million in the quarter and up $88 million since the end of last year. Cash ended the quarter at $251.3 million, and we had no debt outstanding. Our cash flows in the quarter were driven by continued improvements in working capital, as well as cash earnings.

I'd like to remind everyone that our quarterly earnings carry a depreciation and amortization burden of over $10 million, while capital spending was only about $2 million in the quarter.

In summary, we were encouraged by the continuing improvements in our operating trends during the quarter, with stable gross margin performance and operating costs well controlled. Our balance sheet indices continued to improve, and we continue to generate solid cash flows.

At this point, Mark and I would be pleased to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Blaine Marder with Loeb Capital Management.

Blaine Marder - Loeb Capital Management

Two questions, Mark. You've been at the company for a little while now. Can you give us your sort of assessment, your review of all the operations, all the segments? I mean, perhaps even justify the existence of some of the segments.

In the electronics segment, what are you looking to do? You continue to exit, are you going to build? I mean, it's not the greatest business in the world. Maybe just help us understand your strategic thinking.

Mark Lucas

Sure. Actually I've been the CEO now for just a little over 60 days, although I have been involved with the company much longer. I would say operationally, we continue to make progress. Since I came in as COO about a year-and-a-half ago, we've done a lot of working capital management programs. We've done a lot of rescaling and sales, marketing, engineering and other areas.

So we continue to evolve the company to be able to address the very dynamic and fast-paced competitive market out there. We just realigned our businesses to look at them and report them the way we will now be managing them going forward. So we have traditional storage; as Paul said, emerging storage, and CE and accessories.

And with our stated strategy of being a global technology company that focuses on storing, protecting and connecting digital data, I think each of those three categories plays a very important role in our future. CE and accessories when acquired a couple of years ago, was a different model, and then in the manner in which we want to operate it, it was a low margin, low differentiated product line.

We have been evolving that to be a highly differentiated, higher margin CE line. And I believe it's got a great future for us as we move forward as long as we continue to develop the products in a selected and differentiated mode, and primarily under the Memorex and TDK brand names.

Blaine Marder - Loeb Capital Management

In that business, who do you emulate as far as best practices?

Mark Lucas

Well, again, we have different models. So the Memorex brand for this is after the modern mom. And quite honestly there's not a real emulation there, because most of the products are not in the c-space model for the modern mom. So that means the user interface changes, the design changes, we use light colors and pass dull colors.

And you can see its great, great reviews on Best Buy and Wal-Mart. For example, both of which are trying to appeal to their female customer. The TDK brand is positioned more towards the male audiophile. So I would say there, you could look at us as the type of JBL type brand.

Blaine Marder - Loeb Capital Management

Now speaking of accessories, in terms of the business differentiating yourself.

Mark Lucas

We view accessories as a high margin opportunistic category that complements the CE and the storage area. So what we try to do there is develop products in the marketplace that our customers, our retailers have said that they want. So for example, some of the gaming, the Wii products that we have, the steering wheels and the pads and so forth are simply superior products that have features in them that moms and families have asked for.

And for example, we've just gotten them placed in Toys"R"Us in a fairly significant manner; Wal-Mart is looking at them as well, simply because again, some of the features and benefits that we have that others don't.

Blaine Marder - Loeb Capital Management

And then bring us into your boardroom in terms of what you are thinking as far as use of cash, you know, reinstating the dividend or acquisitions. I mean what's the strategic plan there?

Mark Lucas

Well, obviously I can't bring you into our boardroom. But I would say to you that we are very pleased that we are building up cash. I mean, if you look back a year ago, just over a year ago, we were much, much lower in our cash build than we are today. So this is not something that we have been sitting on or hoarding for a very long time period.

Given the current economic climate, we, the management team and the Board want to be very cautious in terms of what we do. So we are going to continue to consider all options. But there is no definitive agreement as to what we are going to do at this point.

Blaine Marder - Loeb Capital Management

But do you think any acquisitions you might do would be of the smaller nature, or would you see anything medium or large sized?

Mark Lucas

I would say to you that at this point in time we want to be very judicious and cautious moving forward, and we don't intend to make any big bets.

Operator

Our next question comes from Mark Miller with Noble Financial.

Mark Miller - Noble Financial

You saw a significant decline in Europe, like a lot of firms. But some firms reported that the decline was earlier in the quarter and things seemed to be improving as the quarter ended and they went into July. I was just wondering about the linearity you are seeing in Europe.

Paul Zeller

Europe was disappointing for us, to be honest. It did have a much more negative currency element to it. But beyond that, it was difficult in our core media categories. There were some unique events that we think are more quarter-2 specific. But in general, I think we have some room to improve in Europe.

From a linearity standpoint, without getting into the details, I would say, it was actually a bit more of a June issue, than it was an April or May, and I think a bit more unique to June rather than longstanding. But clearly, we can't live with the 25% decline rate in any of our regions long term, and we think we are going to moderate from that as we look to the future.

Mark Miller - Noble Financial

Then also give us a little more color on what went wrong with datacenter products?

Mark Lucas

Yes, datacenter was down sequentially as one might expect because we tend to see a little bit bigger datacenter business in first quarter than second. Year-over-year datacenter and the rest of magnetic had a quarter much like we had in first quarter. We were down 14-some percent overall in tape. And datacenter has the same mega-trends that we have been talking about Mark, in terms of the overtime, the move somewhat away from proprietary formats.

But we do like our position with Oracle in terms of the T10000 program, and we like the fact that we are the path to market for both the major OEMs in the market and that we have a major share in datacenter. So it's good business for us.

Mark Miller - Noble Financial

One thing, and I don't know if this would be a thought, any ideas if you could monitorize your IP portfolio or do anything with that?

Mark Lucas

We look at all options, Mark, and I think that we have got time, looked at, you know, do we think we should use some of our IP and move towards a licensing model, especially maybe even some of our brand intellectual property. When it comes to that though, we believe there's more for us to add value to the shareholder by managing those brands ourselves and driving value that way.

In terms of the technology side of things, you know we do license some of our technology, and license other technology as you would I am sure realize in the industry. So we do get some value for our technology and we continue to develop more of it. So it's an important asset to the company.

Operator

Our next question comes from Chuck Murphy with Sidoti & Company.

Chuck Murphy - Sidoti & Company

I guess, first wanted to thank you for the new segment reporting. I think it's going to help with transparency. I was just wondering though if you could help me kind of tie out the new way you report with the old one. Looks like, maybe magnetic, you took something out of there and put it into emerging storage. Is that correct?

Mark Lucas

No, I don't believe so. It there a particular issue that you are trying to tie out? Maybe we can help you with that.

Chuck Murphy - Sidoti & Company

It just looked like, if I took the way you reported magnetic last quarter versus this quarter, looked like a very sharp sequential decline. I didn't know if it was because that had to do with the change in segment reporting.

Mark Lucas

It may be that audio/video products has moved into a different category. Maybe we can check on that and get back to you. Now that is a Magnetic product, but it's not tape specifically. If you look inside of traditional storage products, I know (OEB) is in there. I think though, it's moved from the magnetic to the other storage category within that.

Chuck Murphy - Sidoti & Company

So A/V might be going from the old magnetic to the new other traditional storage?

Mark Lucas

Someone just confirmed that for me. That's exactly what has happened. So there is a bit of a sequential issue. We have recast all the numbers, and if you look at the mean numbers they would reflect it this way back, going back.

Chuck Murphy - Sidoti & Company

And then, is the electronics and accessories category roughly the same as what it was before?

Mark Lucas

Yes.

Operator

Our next question comes from Jeff Hershey with Columbia Management.

Jeff Hershey - Columbia Management

Paul, you've mentioned long-term financial goals a couple of times. Can you just share those with investors here on the call what the long-term financial goals of the company are now?

Paul Zeller

Sure, one of the charts in our investor relations presentation, we were out on the road talking to folks about in our website, I referenced the long term goal we have of bringing our return on invested capital in line with our rated average cost to capital. I've talked about that being somewhere in the low teens, 10% to 15% range.

And in order to do that, with the asset churns that we're generating and we believe we can generate, we need to see our operating margins move significantly beyond the 1% to 2% range, at best we've been experiencing, and we need to be in the 4% plus range. That's clearly a long term financial goal this company has to have.

And then we've been pretty clear over time that the total company revenue has to turn around and start growing at some stage. And so as we look at our long-term goals, clearly it's for some degree of revenue growth at margins that are 4% plus.

Jeff Hershey - Columbia Management

And do you think you can do that internally, or do you need to go out and make acquisitions to achieve those goals?

Mark Lucas

I think we'll look at all of the options, as we talked about. And we were pretty clear about that as well in terms of cash deployment strategies. Clearly, in the near term, organically, growing the total company is going to be a challenge. We're working hard on a lot of those growth categories, and you're seeing some really good results in emerging storage.

And if you pulled out the TV issue out of video, you'd see a much better picture there in electronics area as well. But when 70%-plus of your revenues are in traditional storage in some level of legacy decline, that's been difficult to offset in the near term. And for the near-term future that will also be true. We're working hard at it, and we clearly believe over time we can get this company to grow. And we'll look at both organic and inorganic actions to do that.

Jeff Hershey - Columbia Management

On the electronics and accessories, the business is still in decline. And you referenced the TV products. When do we fully lap those issues, and when should we start to see that category growing?

Mark Lucas

Yes, it takes till about fourth quarter of this year when we're comparing. Well, fourth quarter of last year, we still had some TV revenues as they're selling through some of our excess inventories. It was high in second and third quarter last year, but there were still TV revenues in fourth quarter of last year. So it really will take till 2011, until we have a totally clean comparison in terms of that rationalization.

Jeff Hershey - Columbia Management

And then finally, when do you think the Board will come to a conclusion regarding the cash balances? I mean, Imation as a company needs to have a nice healthy dividend. There's no dividend now. We didn't buy back any stock during the quarter. I know you're deliberating and thinking about options, but can you lay out a timeframe for when you might be able to articulate that to shareholders?

Mark Lucas

I guess I can't be really specific on timeframe, but what I will say is, looking at our track record historically, and when we have excess cash that we don't have in appropriate and accretive use for, either organically or inorganically, we've recognized that the cash on our balance sheet is not getting the return our shareholders want. And we've looked at other strategies, including bulk share repurchase and dividends.

That's not promising what we're going to do or when we're going to do it, except that we understand, we get the math, we understand that you don't want a lot of cash just sitting on the balance sheet and not deployed. And we get that math.

Jeff Hershey - Columbia Management

I didn't know whether you're going to be deploying the majority of that cash going forward through acquisitions, or it's going to be a more balanced approach. And that would helpful. It sounds like it's going to be a more balanced approach with reference to a question cited earlier, but will appreciate your comments on that.

Mark Lucas

We're looking at all the options, and I think we're going to have more to say as time goes on.

Operator

Our next question is a follow-up from Mark Miller with Noble Financial.

Mark Miller - Noble Financial

I was just wondering, number of storage; and Intel and some other PC firms are seeing kind of differentiated demand. In the consumer area, there's weakening there. But at the same time business buying has stepped up and is expected to be strong going forward. I'm just wondering what you're seeing in your storage products.

Mark Lucas

As you know Mark, one of the benefits that we have is our breadth. We are in all of the regions of the world. We're in a lot of different channels, and we carry a number of important brands to market. So the good thing is, we have a nice exposure across consumer and commercial channels.

And I think we're not seeing a significant difference in one part of the business or another. I think one of the benefits, as I said, is that we have a bit of a diversification that helps moderate any changes one way or another. But I don't think there is anything dramatically different between the businesses as we see it.

Paul Zeller

One area, Mark that we shared with you when we saw you, and made us had very, very good response to, is our flash security devices that are FIPS-certified. Under the Defender series, we launched those a couple of months ago, and they are getting rave reviews and a lot of interest on that commercial side. So that's one area of commercial business that we are very bullish on.

Mark Miller - Noble Financial

You've already been impacted by the very strong demand right now for Flash. Is that having any effect on your business there? Flash chips, I should say.

Mark Lucas

We're really not into the commodity USB flash business. What we're very focusing on here is differentiated security products, of which flash is one of them. So I'm referring probably more to the interest on the data security side.

Paul Zeller

Mark, as you know, we do have more broad business in USB flash in certain parts of the world. And clearly, we need to buy right and maintain minimal amounts of inventory so that as there's changes in the whole cost side of it we're matching that with our sell-through. And so, we try to manage inventories very tightly in flash, and we understand that volatility can be very high in this category and we need to be very tightly managed because of that.

Operator

(Operator Instructions) We have no further questions at this time.

Mark Lucas

I'd like to thank you all for participating in today's call. And as I stated earlier, I really am excited about leading Imation and I'm very confident in our opportunities ahead. I look forward to talking with you again next quarter to discuss our progress. Thank you.

Operator

Well, ladies and gentlemen, this does conclude today's presentation. You may now disconnect.

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