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Imation Corp. (NYSE:IMN)

Q1 2014 Earnings Conference Call

April 30 2014 10:00 AM ET

Executives

Scott Robinson - Vice President, Corporate Controller and Chief Accounting Officer

Mark Lucas - President and Chief Executive Officer

Paul Zeller - Senior Vice President and Chief Financial Officer

Analysts

Eric Martinuzzi - Lake Street Capital Markets

Mark Miller - Noble Financial Group

Stan Berenshteyn - Sidoti & Company

Operator

Good morning. My name is Phoenix and I will be your conference operator today. At this time, I would like to welcome everyone to the Imation Corp. Q1 Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers', there will be a question-and-answer session (Operator Instructions).Thank you.

Scott Robinson, Vice President, Corporate Controller, you may begin your conference.

Scott Robinson

Thank you, Phoenix. Good morning everyone and thank you for joining us today for our first quarter 2014 earnings call. I'm host for today's call. So you'll be hearing from our CEO, Mark Lucas and our CFO, Paul Zeller. We will review our first quarter results and progress on our strategic transformation.

Before that though, I'd like to remind everyone that certain information discussed on the call that does not relate to historical information may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Act of 1995.

Such statements are subject to risks and uncertainties that could cause actual results to differ materially from any projected results. Risks factors that could cause the results to differ are outlined in the press release issued today as well as our filings with the SEC.

With that, I'll turn the call over to Mark Lucas, Imation's CEO.

Mark Lucas

Thank you, Scott, and good morning everyone. As usual on today's call, Paul Zeller and I will cover our financial results and discuss the important progress we have made recently in our strategic transformation. We started this transformation several years ago. We set out to leverage our Imation's deep roots in data storage to become a major player in higher growth, higher margin industry segment. Let me recap what we have done so far to reposition Imation.

First, we reorganize the company into two nimble and customer centric business unit. We've also existed two low margin consumer electronics businesses. We made acquisition of Nexsan and we built the mobile security platform. Throughout this process we've taken a hard look at our cost structure and reduced expenses significantly. While at the same time increasing our investment in targeted growth areas of data storage and mobile security.

Our team has worked very hard and with urgency because of approximately 65% of Imation's current volume is in declining businesses. We are focused on new revenue streams in growing markets.

With that overview, let's talk specifically about the 2014 first quarter. While Paul will give you an in-depth analysis of our financials, let me comment from a revenue perspective. We came in about where we expected in total. We are pleased with our initiatives in the areas of working capital and cash management especially. I mentioned our on going cost control efforts in my overview. During Q1, we reduced SG&A by almost $6 million and rigorous cost management is now part of our everyday stated operating procedure and it will continue. As you know, it was the key objective of our team to divest our lower margin non-core consumer electronic businesses. After selling a Memorex consumer electronics business in the fourth quarter of last year, we have now completed the sale of XtremeMac business in January. These transactions are strategically important because they allow us to narrow our focus and concentrate our resources and intentions on the opportunities offering the greatest potential for long- term growth and profitability.

Now let's turn to an update on our two business units. I'll start with Consumer Storage and Accessories or CSA. Our gross margin rose 1.6 percentage point year-over-year and margins improved in all major product categories. As expected, we continue to experience revenue decline at the optical media market progresses to its lifecycle. Our strategic transformation is all about reducing our dependence on Imation's legacy media businesses. We are introducing differentiated new products during 2014 into the retail channel. And we have some successes I would like to share with you.

First, we had a solid growth in our TDK Life on Record audio and accessories portfolio. This resulted in 38% overall growth in that product category compared to a year ago. Additionally, in January in consumer electronic show we launched our 2-in-1 Micro USB Flash Drive. This build on Imation's core position in personnel storage and meets the storage and data transferring need of Android users. And is off to fast start

Again our mandate is differentiated higher margin products and that's exactly what both our TDK Life on Record and our 2-in-1 Micro USB Flash Drive products are. While we don't anticipate CSA returning to growth in a near term, we have made some very good progress in improving the profitability of the product line and this segment will remain an important contributor to our earnings and cash flow.

In Tiered Storage and Security Solutions, revenues and gross margins were down. We anticipated this in our magnetic tape category and this format continues its secular decline. We are managing this legacy business very well and it continues to be in an important contributor to us in many ways. While our storage solutions and mobile security businesses also fell short on our revenue expectations. While this is not acceptable I believe it is the short term issue and I am confident we are investing properly and these businesses truly are our growth engines.

So let me discuss that with you. First, Storage Solution which is our Nexsan business. As we said previously since we purchased Nexsan just a year ago we have started investing in sales and channel initiatives. Specifically in this first quarter, we hired over 30 new sales engineering and support professionals including new sales management in key geographies. We are also significantly upgrading our product offerings. We've expanded our footprint within high capacity storage markets and has successfully entered the hybrid storage market which is growing at more than 20% growth rate and is on pace to capture 45% of the external storage market by 2017. Our NST line of hybrids storage solutions uses an architecture that optimizes flash technologies for caching and storage performance. NST is broadening our market reaching to data center by addressing mixed application workloads, cost effectively and in a scalable way. Imation's spreads of hybrid storage solutions and the new capabilities we have on the drawing board position us well for growth in this segment.

Another part of Nexsan is the Assureon Data Archive Storage Systems. This business has a solid first quarter and we are in the process of building our Assureon sales team globally for further gains. Our systems are ideal for primary storage optimization, regulatory and corporate compliance and secured long -term retention of files. Security features complied with HIPAA, SOx, and SEC 17, making Assureon systems attractive for usage requiring privacy and confidentiality such as human resources and medical records. Assureon systems can reside on premise or the in the cloud or both.

You may have also seen our press release and some of the upgrades we made this quarter to our E series system. The E Series is the successful and established line that Nexsan is well known for. We introduced several new E Series advanced same storage system designed to help mid market organizations add capacity while lowering overall power, space and cost requirements.

Let's move on to mobile security. You heard me speak before about PC on Stick which has whole Window 8 operating system on a secure flash drive along with central management services for IT departments to control and manage access. This product is more formally known as our Iron Key Workspace or Microsoft Window Certified -- Microsoft Certified Windows to Go line. It net expectations in the first quarter and we grow more excited about its potential everyday. We have learned recently that due to the security package, durability and speed of the storage device, we have been named the approved provider for our Fortune 100 manufacture. Moreover, PC on a Stick is in the product evaluation stage with many large, recognizable companies, governmental agencies and more around the world. In fact, over 100 of them. While a sale cycle is never as fast as we like we expect to continue gain traction in this market place as the evaluation process is completed at these global organizations.

As a further testament to Windows to Go benefits, we were delighted that it was recently named the hardware finalist for Best of Tech Ad which is Microsoft's premier technology conference for IT professional and enterprise developers. Our partnership with Microsoft on this endeavor has been excellent.

So we have a lot going on to build for the future Imation. So I hope you take away from today's call as that we are 100% committed to the growth areas we have identified data storage and mobile security. We are making sales, channel and product development investments in all of these segments. We fully expected to transform the company to a value provider of higher margin products in growth markets.

I look forward to sharing more of our progress with you in July after we announced our second quarter results.

Now let me turn it over to Paul.

Paul Zeller

Thanks Mark. Good morning, everyone. The overall results we released today, as noted in our release we are essentially in line with our expectations showing similar trends to those we have seen over the last couple of quarters. We experienced continued broad based strength in our consumer storage and accessory segment but some weakness in Tiered Storage and Security Solutions with continued decline in cap storage and a soft marketing and commercial storage in general. We manage the balance sheet well during the quarter with cash ending at $126.2 million in a seasonally soft quarter from the cash flow perspective.

Now let me get into the details on our start for the year. Our quarter one revenue totaled $178.9 million, that's down about 20% from the same quarter last year and includes a 3% penalty from currency translation. Our defined rate was driven primarily by the expected and the continuing decreases in our legacy optical and tape businesses. Revenues in our Consumer Storage and Accessory or CSA segment were down 17.9% in the quarter which is the lowest level of declined we have seen in over year. Revenue trends improved in all major product categories. Consumer storage media primarily optical declined 21.6% compared to recent declined rate in the upper 20% range.

Our optical business benefited from some business brought forward ahead of the Japan VAT increase that became effective at the start of the second quarter. Audio and accessories revenues under the TDK brand were particularly strong as well with the 38% year-over-year growth rate as Mark mentioned.

Tiered Storage and Security Solutions or TSS has revenues that decreased 23%. The most significant factor was commercial storage media primarily magnetic tape which was down $15.5 million or 23%. Storage and security solutions however also declined by 23% or $8.2 million. Our revenues were impacted by the general softness in IT spending. We have achieved larger deals specially compared to the first quarter of 2013 and saw some continuing softness in Fed business.

Gross margins in the first quarter were 18.8%, flat with the same quarter last year. Gross margin was down sequentially from quarter four driven by the levy benefits we recorded last year. Our best gross margin performance came from CSA where gross margins were up year-over-year in each major product category especially in audio and accessories under the TDK brand where we see -- often seems to 20% gross margin now for several quarters. We are encouraged by our progress here.

TSS gross margin were somewhat soft based on the lower volumes and less advantageous product mix. Operating expenses totaled $47.7 million prior to restructuring and other items which was down $7 million from a year go. We continue to see the benefits of our cost reduction program announced in late 2012 and implemented throughout 2013. We driven this OpEx reduction despite growth investments in our storage solutions business that Mark outlined earlier.

We recorded the structuring related charges of $2.1 million in the first quarter and that related to the cost reduction program I just talked about. Including those charges, our operating loss was $16.1 million in the first quarter and excluding those charges the operating loss would have been $14 million.

Depreciation and amortization was $5.5 million and thus adjusted EBITDA a loss of $8.5 million. Non operating cost was $700,000 similar to what we experienced last year. Tax expense was flat in discontinued operation was a net $700,000 loss and all that brought us to a net loss of $17.5 million or $0.43 per share on a U.S. GAAP basis. Excluding restructuring special charges, our net loss from continuing operations was $14.7 million or $0.36 per share. As Mark mentioned earlier we completed the planned sale of our consumer electronics businesses on the Memorex and XtremeMac brand and this is an important milestone as we steadily execute on our transformation.

Cash ended the quarter at $126.2 million as I mentioned earlier with net cash at $106.4 million after deducting roughly $20 million that remain outstanding on our credit facility. We are very pleased with this result. Seasonally Q1 is when variable compensation in our annual rebate payment are made and despite this cash is only down modestly reflecting cash generated for working capital.

In summary, in our first quarter we saw trends improving our CSA business with solid results across the board. OpEx reductions were on track helping to fund growth investments. And our cash performance continues to solid with cash earnings at $126.2 million. We managed our legacy business as well but our investment results in storage and security solutions need to ramp more quickly. We are investing in growth in both storage solutions and in security especially Windows to Go as Mark mentioned and that will continue. We believe the opportunity is great and our product and channel capabilities position us well for success. We remained focused on our transformation and driving improvements in our results over time.

And with that we will be pleased to take your questions. Thank you.

Question-and-Answer Session

Operator

Your first question comes from the line of Eric Martinuzzi from Lake Street Capital. Your line is open.

Eric Martinuzzi - Lake Street Capital

Thanks. My question has to do with the Storage and Security part of the business. That's something that I've been looking to see recover coming out of Q4, and yet it went the other way. This is now the fourth quarter in a row, based on my organic calcs from some of the acquired businesses, where we are seeing not just the decline year-over-year but acceleration in the decline. So kind of a two part questions. What's your expectation for Q2? Does that trend hold true again or do we see balance here and then you talked about some of the products enhancement you made, ways you can counteract that but I am just wondering I guess what's the timeline for those products getting that traction?

Mark Lucas

Yes, Eric, this is Mark. We pretty much let Nexsan operate independently through the majority of 2013 and towards the end we worked with Philip Black to put in an investment scenario where we were adding lot of people across the organization which we started during the end of Q4 and really got in to heavily in Q1. So when we do that, for example we added approximately 25 sales people in the U.S. alone. So when you do that we had to reorganize our regional boundaries and responsibilities. We have beefed up our internal sales team tremendously and shifted some responsibility from field sales to internal sales. We have focused our go to market strategy a little bit more closely than Nexsan had previously, I think they were trying to be too many things for too many people and Philip would agree with me and Ian Williams agreed. So we went through a lot-- what I would call organizational disruption changes in Q1. I think that you might ordinarily see right after an acquisition. But we delayed quite substantially thereafter to do it. And it's going to take great benefit to us because we are putting lot of feet on the street, we have added engineers, we added a new head of sales in Asia Pacific. We are adding, reorganizing Europe as well. And so what we hit here is I would say just say a slight disruption factor. And you combined that with a little bit softness and on a macro scale in IT storage. And results quite frankly to my perspective were not acceptable and the team knows it and the team is working hard and we expect a pretty quick recovery from that. We are already off to a pretty good April.

Eric Martinuzzi - Lake Street Capital

So, yes, a little bit more on the timing, though. Is this a situation where it takes say nine months to ramp a salesperson, and that we shouldn't anticipate anything until Q3? Or could we see some progress here in Q2?

Mark Lucas

I would anticipate progress in Q2, Eric. Yes, we haven't-- tha the sales people that were there are still there, so they are still effective. Yes, new sales people typically take nine months in total to ramp up to full speed but each month they start adding incremental volume to us. But the base is still there. Like I said this is more I think disruption. Whenever you change sales, region and quotas and shift responsibility to an internal sales team and so forth and so on. There is a bit of as I say disruption and that should be short term in nature.

Eric Martinuzzi - Lake Street Capital

Okay. And then seasonally I would expect a Q2 to be up from a Q1, given all the disruption in the sales maturation. Is that a safe assumption on my part, that we do see sequential growth?

Mark Lucas

Yes, Eric.

Eric Martinuzzi - Lake Street Capital

Okay. And then shifting over to the cost structure, you are at a point here. I understand that you're trying to drive revenue, which requires investment, and yet the revenue is coming the other way. But at what point do we have to go back to the restructuring well again to get this business to a point where we've got a positive adjusted EBITDA light at the end of the tunnel?

Paul Zeller

So let's first talk about the continuing benefits that we will see from the restructuring actions we already took. Remember, the cumulative cost reduction from the program we kicked off the end of 2012 to $65 million and that happened -- we implemented that through out 2013. So we will continue to see some benefits comparatively but we are also be adding up investment as Mark talked about it especially in the next line arena. I think cost control need to always be a part of our business model especially in our legacy businesses as we maintain efficiency around and what are going to be decline rates in optical and tape and so I think cost reduction, it has to always be a part of what we do. And I think it's frankly is and I think we got a track record of doing what needs to be done to maintain the health of the business.

Mark Lucas

Yes, I would say, Eric, there are no major restructuring programs on the horizon. We will be acting with surgical tools rather than mass restructuring programs.

Eric Martinuzzi - Lake Street Capital

Okay. And then final question for me. The Audio and Accessories, obviously a silver lining to the quarter. Curious to know that 38% growth that you experienced in Q1, any one-timers in there? Is this level of growth sustainable as we look out to the remainder of 2014?

Paul Zeller

I think the couple of things. I don't think -- I wouldn't say there is significant one timer in first quarter of 2014. I would say we have particular challenges in first quarter of 2013 that helped our growth rate. I think we did have some strength in the business in a lot of areas. We had some great wireless headphone business in Japan that helped us a lot in first quarter. I think from a dollars standpoint these businesses are continuing to be really good. We did ramp it up throughout last year just based on that the growth percentage not remained in that kind of range. But we do like this business, we like the fact that it has been prosecuted in a very differentiated margin way and our margins are really good and staying strong. And our focus here is very, very different from the legacy CD businesses we exited, differentiated products and strong brand presence with TDK and markets where that brand really resonates.

Operator

Your next question comes from the line of Mark Miller. Your line is open.

Mark Miller - Noble Financial Group

Good morning, Mark, Paul and Scott. I was just wondering you attributed the weaker -- sluggish IT environment to some of the disappointing sales. And Seagate had some similar sentiment last night in its call where they were talking about their mission-critical near-line storage has been aggressive and fairly soft recently. But they indicated that they thought that was going to rebound. There are some major products going to be coming out from two of their customers. I believe one of them is EMC. I'm just wondering what you're seeing? Do you think that that's going to -- do you agree with Seagate that's going to rebound more strongly second-half of the year?

Mark Lucas

We would anticipate yes similar trends. We have actually also still see some weakness in our Fed government business and especially our security business has a very large percentage that goes to the U.S. government. We see that slowly coming back. We thought actually it would come faster-- come back faster than it has. And actually the overall IT environment, IT vindicate Mark. We do believe to have the stronger than second half of the year.

Mark Miller - Noble Financial Group

Now, I'm assuming this is because you added salespeople. You did pick the $5.9 million off SG&A year-over-year; but as a percentage of sales and increased year-over-year, we actually see addition of 25 people?

Paul Zeller

And the continuing decline in the legacy business frankly.

Mark Miller - Noble Financial Group

Okay. So, sales people. Just final thing. Inventories ticked up this quarter. I just was wondering why?

Paul Zeller

Well, I think that is probably more function of how far we brought in down in first quarter and I think given the strength and frankly unexpected strong finished to the year, we got little bit lower inventory and actually had to come back a little bit. I don't think we are uncomfortable with inventory levels still I think we still can incrementally improve quarter-to-quarter.

Operator

Your next question comes from the line of Stan Berenshteyn from Sidoti & Company. Your line is open.

Stan Berenshteyn - Sidoti & Company

Good morning, thanks for taking my call. I want to look at the inventory levels a bit closer. Is there a particular segment that's contributing to the increase in inventory? Is it Nexsan or --?

Paul Zeller

Yes, I would say it was low less across the board. We did have some unique issues in the quarter as we looking at our sources apply relative to our tape business. We did increased our tape business as we bought ahead a bit in our -- from our TDK source of supply, that was also a factor in the quarter that we will moderate as you move throughout the year. Certainly, it was a little bit in optical; it was a little bit in storage solutions. It wasn't in one place otherwise.

Stan Berenshteyn - Sidoti & Company

Okay. And I want to I guess jump over to the slack in the Nexsan business. I just want to understand the rationale behind increasing the sales force while there appears to be a continued slack in demand. Are you finding that this is more of an external problem? Or are the sales weak primarily from lack of capacity in the sales force?

Mark Lucas

There is actually not a lack of demand in the market place for hybrid solutions and secure solutions like Assureon. Those markets actually growing quite rapidly. We, our go to market resources were quite-- they have been quite frankly stretched. One of the things we required Nexsan, the management said to us and one thing they need is more resources and feet on the street and we worked with them in latter half of last year to figure out exactly how to do that and where to do that and how do we leverage our global footprint and so we did most of that in the first quarter and added these people and that's kind of disruption factor I talked about. But the market place itself is strong in general. You get some IT market sluggishness and weakness. So what's happening is that IT department taking longer to make their decisions, projects are getting pushed so the sales cycle getting dragged out a little bit more but the market demand is still there especially in a hybrid storage market. So I would say to you that we are very bullish and very aggressive as we had resources to go to market and fulfill customer demand.

Paul Zeller

And Stan you talked about something, there are several markets that we play and within storage appliances and kind of stand market place where our E series plays, it still, the majority of revenues, where we are focusing most intensely in terms of new product work and focus in terms of marketing. And hybrid storage with the NST platform as well as compliance related storage with Assureon those are the markets that are really interesting and that's where we really focusing so I think there is also a bit of mix change over time that you will see as we become more and more focused on how we are growing segment to the market.

Stan Berenshteyn - Sidoti & Company

Okay. And how does the sales team get their lead generation? Are there marketing initiatives that are being implemented? What's the exact process?

Mark Lucas

Yes, it is a combination of different areas, Stan, we use, we do have degeneration activities going on in direct marketing campaigns. But we also-- we worked through channel partners so we have our model has to go through VARs and distribution partners and so we channel leads to VARs, VARs channel lead back to us and we worked with them to qualify them and pursue them. We also have promotional programs; we have steps for VARs and everything else for lead generation. So the combination of working with the local VARs of which we have very good relationships with both in U.S. and outside the U.S. Along with our own internal marketing campaigns and regeneration activities.

Stan Berenshteyn - Sidoti & Company

Is there going to be any increase in allocation towards internal marketing initiatives?

Mark Lucas

Well, yes, there has been, we expanded our inside sales force for example, so these are the people who man the telephones and call both new leads and customers. We have expanded that group by almost a third in the last couple of months. We've expanded our activities on our website advertising as well as internet and direct digital advertising as well. So, yes, there has been expansion there as well. So when I say we are investing here. The primary area that we have done in the first quarter is sales headcount but we have also doubled our marketing budget. We've increased our engineering budget and we are leveraging our footprint outside the U.S. globally as well.

Operator

There are no further questions at this time. I will turn the call back over to the presenters.

Scott Robinson

I want to thank everybody for their time today and if you have any questions or follow up, please contact us otherwise we'll talk to you at the end of Q2. Thank you very much.

Operator

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

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