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Dot Hill Systems (NASDAQ:HILL)

Q1 2014 Earnings Conference Call

May 8, 2014 11:00 ET

Executives

Jodi Bochert – IR

Dana Kammersgard – President and CEO

Hanif Jamal – CFO

Analysts

Eric Martinuzzi – Lake Street Capital

Glenn Hanus – Needham

Kaushik Roy – Wunderlich Securities

Graham Tanaka – Tanaka Capital

Steve Busch – Southpaw Investments

Thomas Massey – UBS

Operator

Welcome to the Dot Hill First Quarter 2014 Earnings Call. (Operator Instructions). I would now like to turn the conference to our host Ms. Jodi Bochert. Ma'am you may begin.

Jodi Bochert

Thanks, Eric. Good morning. Thank you for joining us today for the Dot Hill conference call and webcast for our first quarter 2014 results.

Before we begin I would like to advise you that we will be referring to slides that can be found in the investor relation section of our website. I encourage you to access them now. I would also 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 we will provide you with the financial results for certain income statement metrics determined on a non-GAAP basis for the quarters ended March 31, 2014, December 31, 2013 and March 31, 2013. 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 Kammersgard

Thanks Jodi. Good morning everyone and thank you for joining us for our first quarter 2014 earnings call. 2014 is off to a solid start. This is in spite of continued economic and secular challenges that have been well documented in many financial results conference calls before us.

In contrast to several in our storage industry peer group was reported revenues had declined year-over-year, our non-GAAP revenues grew by nearly 9% over the same period. Our first quarter non-GAAP revenues were $48.9 million and were above the mid-point of our guidance. Non-GAAP gross margins improved to 33.1%. Operating expenses were well-managed and this yielded non-GAAP earnings per share of $0.02 which is above the high-end of our guidance. As we discussed with you on the last call we have now begun to report our revenues and margins on a segment basis. And Hanif will provide you with a detailed accounting of both in just a moment.

But let me first give you some color on the market at large and on our Vertical Markets and server OEM segments. The macro environment is still tough as much as I hate to continue to say that, by my own estimates I would speculate the year-over-year storage industry revenues were no more than flat in the first quarter and more likely down in aggregate. The economy continues to sputter forward with no real growth evident on a global basis.

Cloud service providers continue to rapidly grow their footprint and consequently have taken some of their storage growth that was historically been found in IT data centers. Well industry pundits suggested at the beginning of the year that IT spending might grow 4% to 5% in 2014 frankly I don’t see it. Perhaps the Intel Grantley launch slated to replace Romley later this year will bring a much delayed refresh to the industry but based on recent history that is a hard call to make.

All I know for sure is that for Dot Hill to grow we need to continue taking share with focus on our Vertical Markets and midrange products. And indeed our results indicate we did just that in the first quarter and I believe we will continue to do so throughout the remainder of the year. Our Vertical Markets revenues grew nearly 60% on a year-over-year basis that’s impressive growth by any measure. Several of our Media and Entertainment and Telco Infrastructure customers who are purchasing various versions of our midrange products fueled the growth.

And it is this customer and product shift that is primarily driving our gross and operating margin improvement. As a result overall gross margins improved a 100 basis points year-over-year. We’re confident in our 2014 goal of 45% growth at the midrange of our guidance range. At the midpoint of our guidance range and Vertical Markets. This anticipated growth primarily comes from existing customers with existing products who are still in the early stages of their revenue ramps and from the same customers with new products that we expect to launch later this year. Our growth is not dependent on revenue from new prospects. New prospects who become customers create incremental opportunities and we expect this to arise especially since our largest competitor continues to demonstrate its intent to exit the OEM focused business.

In fact we have opportunistically already hired a few of their customer facing personnel. As you know we have focused a lot of our product development on the 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. Quite simply we believe our products are substantially faster than any other product at similar price points in the ways that matter most to these markets.

Let me briefly remind you why we’re growing these revenues so much faster than the overall market. First, we believe these market segments are inherently growing faster than the industry at large benefitting in some cases from secular tailwinds such as internet and smartphone growth. By some estimates 90% of all data growth is unstructured data and all of these markets generate unstructured data -- whether raw film footage, live digital broadcast, subsurface seismic logs, satellite images or so-called big data.

Second, we continue to take share. We believe this is not only a function of better, 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. We believe we’re effectively the last man standing in storage focused on OEM routes to market.

And as I mentioned in last call we’re focused on vertical OEM partners who are embedding our storage products not only into their product solutions but into their own revenue streams as well. This is critically important when we think about the economic and secular challenges facing companies selling into the IT data center.

On the other hand our server OEMs underperformed last quarter. As it was more than one of our server OEM customers who fell short of forecast I believe this is symptomatic of the same pressures plaguing our peers that I've already discussed. At the same time I think we have good reason to have renewed confidence with respect to certain of these customers. Together with our largest customer we have launched three major new products over the last three quarters completely refreshing their entry level product line in the process with first to market differentiation and advantage. And as you know may know their competitive landscape has changed dramatically over the last few months, a fact that could potentially lead to upside for this customer and therefore for us.

In summary, our success continues to boil down largely to solid execution primarily by us but supported by our customers performance as well. I believe we executed very well in the first quarter and I’m very proud of our team and its accomplishments.

I continue to believe 2014 revenues will be more heavily weighted to the back half than typical and I am confident in our ability to execute to achieve our 2014 and longer term goals. With that let me turn it over to Hanif. Hanif?

Hanif Jamal

Thank you Dana. Good morning everyone. Before I discuss the details of our Q1, 2014 financial results I would like to invite you to attend or listen to the webcast on the B. Riley conference in Santa Monica on May 19th, the SeeThruEquity conference in New York City on May the 28th, the Marcum conference in New York City, as well, on May the 29th and the LD Invitational in Los Angeles on June the 4th. In addition, later today at 3 PM Eastern Time Dana will be interviewed live on Clear Channel Business Talk Radio’s The Traders Network Show that will be streamed on iHeartRadio's station DFW1198AM KFXR.

In summary, we had a strong start to 2014. Total Q1, ’14 revenue grew 9% on the year-over-year basis and was within our guidance range while EPS exceeded our guidance. More importantly we continue to demonstrate strong traction in Vertical Markets which grew almost 60% on a year-over-year basis. Significantly and for the very first time gross and contribution margin dollars from our Vertical Markets business exceeded those from our server OEM business.

Before I dwell into the details of our results I encourage you to refer to the first quarter financial results presentation that hopefully you have downloaded by now. As we mentioned during our last earnings call we will now present our financials across three segments. The two primary segments are our server OEM and Vertical Markets lines of business which included the service revenues from customers within each respective segment. The third segment which we call Corporate, contains expenses common to both segments such as research and development, G&A and Corporate Marketing.

Slide 4 of the presentation depicts our go to market models with the server OEMs and Vertical Markets. As you can see our server OEM customers include Hewlett Packard, Lenovo and Stratus as well as our AssuredVRA customers Dell, AMD and Supermicro. Our Vertical Markets customers includes Teradata, Tektronix, Quantum, Autodesk, Motorola, Nokia Siemens, Technicolor, and Concurrent amongst many others.

On slide 5 of the presentation we have summarized a relative characteristics of our server OEM and Vertical Markets business. Perhaps the most critical difference between these two revenue streams is that in general products distributed through our server OEM customers are typically sold with servers into the IT infrastructure of small, medium and large businesses. And when faced with financial constraints my CFO counter-parts tend to force their IT departments to swipe [ph] their assets a little longer.

On the other hand the products we sell to our Vertical Markets are typically embedded into solutions for end users such as into and data probe for network monitoring and management or an appliance for final editing or finishing of box office movies. Since these solutions are integral part of revenue generation for our end customers these expenditures tend to be less scrutinized in challenging times. Thus, one segment tends to act as somewhat of a hedge for the other.

Now let me provide you with the details of our non-GAAP financial performance for the first quarter of 2014 which are depicted on slide 6 and 7. For our GAAP results please refer to this morning’s press release or to our first quarter 2014 10Q that we plan to file tomorrow. In addition we had posted our historical segment non-GAAP financial metrics from 2011 onwards in the investor relation section on our website and in an 8K that we filed with the SEC this morning.

First quarter 2014 non-GAAP revenues were $48.9 million compared to $59.7 million in the prior quarter and $44.9 million in Q1, 2013. This result was above the midpoint of our guidance range issued in early March and represents almost 9% year-over-year growth.

Our Vertical Markets business grew to $22.4 million in Q1, ’14 or 18% sequentially and 59% year-over-year. While there are several customers who contributed to this growth, much of the sequential and year-over-year growth came from Tektronix, which accounted for 15% of our total revenue in the first quarter with sequential and year-over-year growth of a 102% and 43% respectively. Revenue from this customer tends to be lumpy and not always linear nor seasonal.

Our first quarter 2014 server OEM revenues of $26.5 million were down 35% sequentially and 14% year-over-year primarily due to 36% and 16% sequential and year-over-year declines respectively and revenues from our largest customer. It is worth noting, in the first quarter this customer represented a little over 48% of total revenue compared to 61% and 62% in Q4, ’13 and Q1, ’13.

Non-GAAP gross margin for the first quarter of 2014 was 33.1% up from 31.7% in the prior quarter and 32.1% in Q1, ’13. The increase in sequential and year-over-year gross margin was primarily attributable to the increased mix of revenues from our higher gross margin Vertical Markets business.

In addition the year-over-year improvement in gross margin also reflects the impact of component cost reductions. Non-GAAP Vertical Markets gross margins for the first quarter of 2014 were 43.4% compared to 38.7% in the fourth quarter of 2013 and 43.9% in Q1, ’13.

Q4, 2013 non-GAAP gross margins for this segment was slightly lower than recently historical levels due to several factors including a non-recurring product transition charge associated with a Vertical Markets customers in Q4, ’13 and the customer and product mix within Vertical Markets.

First quarter 2014 gross margin percent on the other hand also benefited slightly from a fixed allocation of supply chain overhead that was spread over a higher Vertical Markets revenues. Now-GAAP server OEM gross margins in the first quarter of 2014 were 24.4%, compared to 28.4% in prior quarters and 26.7% in Q1, 2013. Gross margin percent in this segment was down largely due to a higher allocation of fixed supply chain overhead cost over a smaller revenue base.

Non-GAAP gross profit dollars for the Vertical Markets and server OEM segments for the first quarter of 2014 were $9.7 million and $6.5 million respectively compared to $7.3 million and $11.6 million in Q4, ’13 and $6.2 million and $8.2 million in Q1, ’13. This represents the first quarter in which gross margin dollars from our Vertical Markets exceeded those from the server OEM business. Non-GAAP sales and marketing expenses were $3.2 million in the first quarter of 2014 compared to $3.6 million in Q4, ’13 and $3 million in Q1, ’13. These sequential decline in sales and marketing expenses were due to higher variable compensation charges in Q4, 2013 resulting from higher revenues in that quarter as well as higher marketing expenses in Q4 due to the timing of marketing events and programs.

Vertical Markets sales and marketing expenses for the Q1, ’14 were $2.2 million compared to $2.3 million in the prior quarter and $2 million in Q1, 2013. Server OEM sales and marketing expenses in Q1, 2014 were $0.5 million compared to $0.6 million in the prior quarter and $0.4 million in Q1, ’13. As was indicated in the past our investment in sales and marketing for the server OEM business is much smaller relative to revenues as compared to the Vertical Markets business largely because we have a small sales team supporting our largest customer who accounted for almost 90% of the server OEM revenues in 2013.

Total Corporate sales and marketing expenses for Q1, ’14 were $0.5 million compared to $0.8 million in the prior quarter and $0.6 million in Q1, 2013. First quarter non-GAAP contribution margin which excludes R&D and G&A expenses was 26.6% compared to 25.7% in the prior quarter and 25.4% in Q1, ’13. Non-GAAP contribution margin percent for the Vertical Markets and server OEM segments for the first quarter of 2014 was 33.6% and 22.7% respectively compared to 26.7% and 27.1% for Q4, ’13 and 29.4% and 25.4% in Q1, ’13.

More importantly in Q1, ’13 we generated $7.5 million in contribution margin in Vertical Markets compared to a $6 million in the server OEM segment. This represents the very first time that the vertical market segment contributed more margin that of sales and marketing expenses than the server OEM business.

Non-GAAP research and development expenses for Q1, ’14 were $9.2 million compared to $8.6 million in the prior quarter and $8.7 million in Q1, ’13. Most of the increased R&D expenses were due to the timing of project related expenses associated with new products and customer launches. Our non-GAAP net income for the first quarter of 2014 was $1 million or $0.02 per share and was above our guidance range of $0.00 to $0.01.

This compares to fourth quarter 2013 non-GAAP net income of $4.2 million or $0.07 per share and first quarter 2013 non-GAAP net income of $37,000 or $0.00 per share.

Non-GAAP EBITDA for the first quarter of 2014 was $2 million compared to $4.9 million for Q4, ’13 and $0.8 million for Q1, ’13. Cash flow from operations for the first quarter of 2014 was a positive $1.1 million compared to a negative $1.1 million for the fourth quarter of 2013 and a positive $0.8 million for the first quarter of 2013.

We exited the first quarter of 2014 with cash and cash equivalents of $40.3 million with no borrowing from our working capital line. This compares to an end of Q4, ’13 balance of $40.4 million with $2 million of borrowings and $40.3 million with $2.8 million in borrowings as of March 31, 2013.

Net working capital at the end of Q1, 2014 was $45 million up from $43.8 million as of December 31, 2013 and $33.9 million at March 31, 2013. Before I provide you with guidance for the second quarter of 2014 I want to share with you our approach to guidance going forward.

On a quarterly basis we will provide only total non-GAAP guidance for revenue and EPS. During our March earnings call we provided full year 2014 non-GAAP guidance for revenue, gross margin percent, operating expenses and non-GAAP EPS. We have also provided non-GAAP Vertical Markets and server OEM revenue goals for 2014. With that in mind let me now turn to guidance. For the second quarter of 2014 we expect non-GAAP revenues to be between $49 million and $54 million and non-GAAP EPS to be between $0.01 and $0.04. As we stated on our last earnings call in March, we expect revenue this year to be little more back-end loaded compared to prior year’s based on our understanding of our customers product launch plans and sales cycle.

In summary, we had a solid start to 2014 with revenue -- within guidance and EPS above guidance during the first quarter and almost 60% year-over-year growth in our Vertical Markets business. More importantly we crossed a critical milestone in our transformation that started in 2010 with the launch of our vertical market strategy and gross and contribution margin dollars from our Vertical Markets segment exceeded those from our core and legacy server OEM business for the very first time.

I will now turn the call back to Eric for a question and answer session after which Dana will make some concluding remarks. Eric?

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from Eric Martinuzzi from Lake Street Capital. Please go ahead.

Eric Martinuzzi – Lake Street Capital

Thanks and congratulations on the good execution in Q1. I think probably what's got the stocks spooked a little bit here this morning, though, is the Q2 outlook. And I want to dive into slide five. Slide five is the comparison of your server OEM and Vertical Markets. And in there, you talk about the server OEM -- it looks like you're reiterating the commentary there about flat plus or minus 5%. And I'd just like to hear your thoughts. Given the first quarter out of the gate, we put up about a minus 14% comp in server OEM. Where's the confidence coming that we can get back into that plus or minus 5%?

Dana Kammersgard

So I think our server OEM business performed plus or minus in line with the industry in Q1. You certainly follow our peer growth and there weren’t too many guys selling storage into the IT data center that improved their revenues and in fact most of them didn’t even remain flat on a year-over-year basis. There are several developing tailwinds in our opinion with respect to our server OEM group in general and I will try and refrain from getting too terribly specific but in the case of our largest customer over the last three quarters we have done three major product launches with them, entirely refreshing their entry level product line in bands two, three and that part of band four that we participate in and we think that’s very, very important. There remain certain of their competitors that haven't even delivered on 16 gig fiber channel yet.

There remains certain of their competitors that haven't delivered on 12 gig SaaS yet and certainly certain competitors that haven't delivered on a hybrid 16 gig fiber, 10 gig iSCSI. We think being first to market and thereby giving them a differentiated first to market advantage that has a potential to be very meaningful from a tailwind point of view. At the same time you’re well aware what’s going on with respects to the divesture of certain server assets by a certain large company and I believe that there are two and only two competitors of that company that are likely to benefit from that. Their results in Q1 which was a quarter in which they announced the divesture, I believe, if I recall correctly suggest that their server market share has already started to deteriorate significantly.

And they had a market share in the 13% to 15% range with respect to servers somewhere in that range. And not all of that business is going to go to the cloud. The Fortune 1000, Fortune 5000 traditional data center that buys traditional servers is not moving wholesale to the cloud, just not going to happen. As with most things in our industry there is a certain overemphasize and the certain overrating of new fads, new buzz words, new phenomena which include things like cloud, like software defined storage, like pure flash arrays where great deal of the interest and fascination is focused and a great deal of today’s spending is not focused.

So we think that as IBM specifically begins to see server market share decline there is more than likely an equal and equivalent storage market share decline because in this space particularly our space it is a server led storage sale. And there are likely two and only two server companies that are likely to benefit, maybe three if you count Cisco that are likely to benefit from the pending market share decline there and whether or not happens or not I don’t know, I have only been in a storage business for 32 years. So we will see whether or not it happens or not, but companies likely to benefit from that are HP and Dell and perhaps Cisco.

On top of that you have the Intel Grantley refresh slated for later this year. If immediately recent history is a profit of what’s to come then there may not be a refresh of HBAs in a correlating refresh of storage. If on the other hand more historical precedence follow, then there should be a refresh that will also serve as a tailwind for our server customers at large.

Eric Martinuzzi – Lake Street Capital

The pressures that we saw in Q1, again, I'm talking about your 90% server OEM customer -- do you feel that that was across their product line or was that particular to where you sit in their portfolio?

Dana Kammersgard

I think we will have to wait for their own results with respect to that Eric. I’m not expert in their business nor their other product lines or if I’m, I’m certainly not willing to say either way and they report later this month as you know. So we will have to wait and see. But again I think from our perspective there are some tailwinds developing with respect to that customer in particular and I would be remiss if I didn’t point out that we overachieved on not only our Vertical Markets revenue growth of 60% and I think we overachieved the market at large with a 9% growth in the first quarter. I don’t know too many companies posted storage revenue growth in the first quarter and certainly even fewer that did it with growing profitability.

Eric Martinuzzi – Lake Street Capital

And you talk about you've got even more good stuff coming with Vertical OEMs. You said key to that, really, is the timing of launches. Could you be more specific?

Dana Kammersgard

I would love to be more specific Eric. But I’m not going to be, but I will say that if we think about what it takes to be an OEM provider first of all what that means is that we’re working very collaboratively with numerous of our customers both server OEM and verticals and we’re working well in advance because of the customization and qualification requirements that we collaboratively agreed to on the features, on the parameters, on the performance et cetera of new products. So what we said in the prepared remarks is number one that we have certain customers that have not yet hit anywhere near stride with respect to products that they are already selling that they have already announced and that we jointly already begun to ramp.

At the same time because it can take 6, 9, 12 months of development and test before a product is announced and launched by certain of our customers we know what their announcement days are, we know what their launch dates are, we know what the features are, we know what their plans are, we have forecast from them and in that case we have our higher degree of confidence perhaps than a typical end user focused storage company in our ability, their ability to ramp.

We know what the launch dates and announcement dates are. We know what’s coming. I can’t be more specific because we will not preempt our customers with respect to their announcements. At the same time it's important to know that what we also said in the prepared and that is we are not waiting for a miracle to occur. We’re not hoping and praying that something happens, we’re not dependent on new prospects that we have not yet won and they are out there in part because our largest competitor continues to provide ample evidence that they are refocusing, realigning their own efforts away from OEMs and those aren’t in any forecast or projection or anything that we provided to anybody externally. So we’re fairly confident in numbers we have provided in that regard.

Operator

Our next question comes from Glenn Hanus from Needham. Please go ahead.

Glenn Hanus – Needham

So, I'm also wondering whether Teradata's report this morning with the guidance -- I mean, I haven't read the transcript yet, but I guess they gave guidance towards the low-end of their annual range going forward. And I'm just wondering if you could reconcile their, I guess, lower outlook with your reiteration of your Vertical Market forecast. And I think Teradata is probably one of the larger new things ramping, and perhaps there's some concern out there that that ramp may be slower and later rather than more and sooner. And perhaps maybe there's less Teradata in your mix and more of something else in your mix. Could you kind of address those issues?

Dana Kammersgard

So what you will know with respect to our prepared remarks is that we identified Tektronix as a greater than 10% customer and it didn’t meant Tektronix, not Teradata and I will get to Teradata in a moment. If we do have a greater than 10% customer we are going to identify them to the extent that we can and certainly Tektronix was that in Q1. Teradata notably was not identified as a 10% customer in Q1, right? So, with respect to their product announcements and timing thereof, again, I’m not going to get into that but we think that the total available market within that particular customer is very significant and where we’re going to grow predominantly especially in the next couple of years is by taking share from generally speaking our largest competitor but there are others out there as well.

We believe that Teradata happens to be a fairly significant customer of our largest competitor and to the extent that we can execute to their satisfaction and to the extent that if there are future programs that we’re launching with them that we do it confidently and on time with good quality. We think that there is plenty of opportunity to continue to grow that customer perhaps at the expense of our competition, I really don’t focus too terribly much on that. I focus intently on executing to our customers, our requirements, dates, performance, price et cetera and if my competition struggles that only has a tendency to accelerate our opportunity as opposed to decelerate. So I don’t really think that at the end of the day that you can reconcile those in the manner that you suggested. We think that there is a whole lot of opportunity not only there but with other customers that and prospects by the way that are current customers of our largest competitor.

Glenn Hanus – Needham

As you look at your anticipated ramp of Teradata over the next year, 18 months, over the last 90 days, have you sort of changed your internal outlook for that customer downward based on, you know, the forecast you're getting from them?

Dana Kammersgard

I will give you a short answer to that one. No.

Glenn Hanus – Needham

Just to be clear, when you said earlier more backend-loaded year, that was the comment you made last quarter. Are you suggesting anything more incrementally backend-loaded this quarter, going forward, than what you said last quarter? Or are you just sort of reconfirming the backend-loadedness, if you will, from last quarter?

Dana Kammersgard

The backend-loadedness, I think that’s a new word but short answer on that is no as well. And the only caveat I would give you is that as with last quarter we need to continue to execute. Our future is dependent on our ability to execute for the customers that we have already won and to some degree it is also dependent of course on their execution. But no we’re saying exactly the same thing in that regard that we said last quarter.

Glenn Hanus – Needham

And your upside and your Vertical Market, I'm at least -- I think you'd beat my estimate on the Vertical Markets. Where did your upside in Q1 come from on the Vertical? Was the Tektronix business coming [ph]?

Hanif Jamal

So Glenn, I think we -- in my prepared remarks I commented that we had a very strong quarter, it was Tektronix and have actually Tektronix grew 102% and 43% on a sequential and a year-over-year basis. So that was a big piece of it. If you remember we have actually done -- we have business with Tektronix in the past. It's a very lumpy business, Q2 last year was a big quarter, Q1 of ’12 was a big quarter. So this business tends to be a little bit lumpy and not linear nor seasonal.

Dana Kammersgard

We get a good quarters with a number of our Media and Entertainment and Telco Infrastructure, other Telco Infrastructure customers as well on the verticals.

Glenn Hanus – Needham

Are you reiterating your multi-year target model from last quarter?

Hanif Jamal

Let me answer that, so we’re not changing it which means yes we’re reiterating it. Yes, if we felt that that was not a viable we would certainly have updated it.

Glenn Hanus – Needham

Okay. And you made some comment about -- well, I think you addressed this, the renewed confidence there at HP, okay. I think you kind of addressed that. So, the cloud -- the comment you made about the cloud footprint growing faster, taking growth -- can you just flesh that out where what types of cloud guys you think are taking and what workloads you think there -- are you suggesting some of the more some of the hyperscale types of guys or more service provider types of guys? And what workloads are you kind of seeing going in that direction more?

Dana Kammersgard

Really we haven't seen any change in that regard at all. So we think about the hyperscale guys, our view is that that vast majority of data moving in their direction continues to be consumer and/or very small businesses. The core data that is proprietary to any customer of substance, any company of substance is not moving anytime soon. I can tell you as a personal anecdote that we would never consider putting our financial data as a public company on a public cloud and the oil and gas guys aren’t going to put their proprietary exploration data out there and the Media and Entertainment guys, the studios are not going to put their pending movies out there and the financial institutions are not going to put their trading algorithms and their customer client databases out there either. So from that point of view there is certainly a migration of non-critical data, largely in our view from small companies and/or consumers moving in that direction and I don’t see that changing in the near future where you will see growth in cloud infrastructure that is not in the hyperscales like either hybrids and private clouds.

I think they will continue with relatively traditional storage purchases aggregated in the form of an internal or a hybrid cloud that they have confidence that they have complete control over from a security point of view.

Operator

Our next question comes from Kaushik Roy from Wunderlich Securities. Please go ahead.

Kaushik Roy – Wunderlich Securities

So, Hanif, just to clarify, are you reiterating the full-year 2014 revenue guidance of $220 million to $255 million and $0.18 to $0.29?

Hanif Jamal

Yes Kaushik, it hasn’t changed that at all.

Kaushik Roy – Wunderlich Securities

And R&D went up a little bit compared to last year or last quarter.

Hanif Jamal

Yes.

Kaushik Roy – Wunderlich Securities

And where you are spending? What are the expectations going forward?

Hanif Jamal

So you know the big piece of the variability, research and R&D really has to do with the timing of when you have to purchase project materials that will be associated with either new products or new customer launches or existing customer launches but for new products with them. So it was not that much, if you think of it was a $600,000 difference between Q4 of ’13 and Q1 of ’14 and that is on a base of $8.6 million. So it's not significant but those are the timing differences. We are not going to go into details as to exactly which customer and what program we’re working on.

Kaushik Roy – Wunderlich Securities

So, in terms of modeling, we should model around that 9.2 for Q2?

Hanif Jamal

I would be modeling, yes I would just model take -- it’s a bit like a variable take what you think we’re going to spend for the year. We spent, we were at the last year we were I think 35 million in change. So it was roughly $9 million a quarter and then whatever you feel you want to add on that. $9 million seems to be a reasonable run-rate for us right now in that.

Kaushik Roy – Wunderlich Securities

Okay. And then on gross margins for the server business, it came down. Was it primarily because of the volume impact or was there something else?

Hanif Jamal

Yes there is a couple of things going on here Kaushik but the biggest driver was the volume impact because there is a fixed overhead that we allocate out to the two segments and when your revenues are a little bit lower you’re going to take a big hit of it relative to your revenues and that was a big piece of it.

Kaushik Roy – Wunderlich Securities

So, if Q2 revenues are going to be up, so, is it fair to assume that gross margins are going to be, too?

Hanif Jamal

It would be and it also depends on the mix of products Kaushik, we sell to the OEMs. That’s also another driver there as the mix of products we actually sell to them. These are not all the same, there is a wide amount of variability.

Kaushik Roy – Wunderlich Securities

Okay. But overall, can you comment overall gross margins for Q2? I mean, do you think --

Hanif Jamal

We provided guidance of 32% to 33% for the year. I would say to you I’m so confident in that number. Yes we had a good quarter in Q1, it was 33.1% and so we’re sort of in the higher end of that range but I wouldn’t make assumptions right now that that would necessarily accelerate because our goal for 2014 is that 32% to 33% range.

Kaushik Roy – Wunderlich Securities

Dana, one industrial market question. You're still expecting significant growth in the Vertical Market and I know you talked about the shift to the cloud. But all the other big legacy vendors, they're getting hit by this shift to the cloud. So, why won't your customers have the same impact? Some of their parts of their non-mission critical workload can move to the cloud.

Dana Kammersgard

That’s true Kaushik and the difference we covered a couple of times in the prepared is a really important distinction. If people are moving their, HR or CRM or marketing data bases into the cloud, HR I don’t think they would that’s a bad example but there are others. That’s an internal IT data center function and application that they are willing to commit to a public cloud. They are not turning their products, all of our Vertical Market customers for the most part sell products. In all cases we’re part of their product line up, we’re embedded in their product portfolios, we’re embedded in their revenue generation. To the extent that the cloud represents a significant diminishment of their ability to sell product because they now become a software only or a service only or et cetera I can tell you that they will be exceptionally reluctant to migrate in the direction of cloud and so yes you will find people running there light weight, non-proprietary, IT data center applications in a cloud context.

You don’t find too many companies that are moving their appliance based products into a cloud service because that would have a severe effect on their revenue stream. So the fact that we’re in the embedded solutions of our Vertical Markets is a phenomenal hedge if you will with respect to any of the headwinds and/or secular changes that are affecting IT data shops itself. That would notwithstanding, we’re going to figure out how to sell into these cloud environments as well.

But the Vertical Market growth is coming from the revenue generating portions of the lines of businesses of these customers not by selling into their data center.

Operator

Our next question comes from Graham Tanaka from Tanaka Capital. Please go ahead.

Graham Tanaka – Tanaka Capital

So real quick about the top, working capital is down a lot despite the revenue growth. So, why and what’s the --

Hanif Jamal

Actually working capital is up.

Graham Tanaka – Tanaka Capital

Sorry accounts receivable is down.

Hanif Jamal

Accounts receivable is totally tied to the levels of revenue and so since we were 59.7 million in revenue last quarter versus 48.9 million that’s the biggest delta. So you will see a huge difference.

Graham Tanaka – Tanaka Capital

But your accounts receivable went down from 42 to 33, despite the growth in revenues.

Hanif Jamal

And part of that is the intra-quarter timing of when we ship products to our customers.

Graham Tanaka – Tanaka Capital

Okay so it's just a timing thing. Okay.

Hanif Jamal

Yes it's whole timing. For your FYI, our accounts receivable is very clean. We have no -- there is really no charges against that for bad debts.

Graham Tanaka – Tanaka Capital

Okay, the other is gross margins for vertical markets. It did not go up, it actually went down marginally. So I’m just wondering with such rapid growth normally there is, they opted more revenue to spread over -- to spread the fixed cost over. So, why didn’t the gross margins go up, is there a reason for that?

Hanif Jamal

So it really depends on the product mix and the customer mix, Graham. If we’re selling brand new products into a new customer typically the margins can be a little bit lighter in the early going as we vet out cost of goods in the product but it really has more to do with the customer mix and the product mix with respect to that.

Dana Kammersgard

Graham just as an FYI we actually -- the Vertical Markets gross margin for certainly for Q4 was quite a bit lower than Q1 and I explained that in my comments. There was some specific non-recurring charges but on a year-over-year basis it's only 50 basis point delta.

Graham Tanaka – Tanaka Capital

Should we expect those margins that now jump a little higher though -- so more direction is more important to me than what happened last quarter.

Dana Kammersgard

I would say to you that directionally I think I have answered this question at a higher level with Kaushik, directionally I was expecting gross margins generally to be flat relative to last year and so we put out a guidance of 32% to 33% in the aggregate and I would just apply that flatness across to both sectors.

Graham Tanaka – Tanaka Capital

How long is the runway? You should us those bubble graphs or whatever which showed that how much you have in the pipeline for developing a Vertical Market. Is that pipeline a potential business still as larger or smaller than say last year?

Dana Kammersgard

Well given the fact that our largest competitor has done something’s that would suggest that they are realigning, rebalancing their workforce towards areas of greater growth for them and have indeed done some headcount reductions in areas that are focused on OEM would be reasonable for you to conclude that that might actually open up incremental opportunity for us.

Graham Tanaka – Tanaka Capital

So the pipeline is just a larger -- is larger than a year ago?

Dana Kammersgard

We’re not going to quantify that for you Graham, because it was never intended to be a quantitative tool that was intended to be a qualitative tool and the fact that people are trying to quantify, it is one of the reasons why we decided to eliminate that particular device.

Graham Tanaka – Tanaka Capital

The other thing is just you’ve done a great job of delivering faster but a cheaper product and I’m just wondering how that sort of longer term technology roadmap is? Are you still adding things to your R&D pipeline at the beginning of the pipeline that will come out in a year, or two or three that will help you maintain your lead? Or is it tougher to find?

Dana Kammersgard

Absolutely. That is our life blood for an OEM focused company. We’re intently focused on continuing to bring very innovative first to market differentiated product to our customers whether they be several OEMs or whether they be vertical market customers and I think we have done an excellent job of that over the last two or three years, we will continue to do that over the next two or three years.

Operator

Our next question comes from Steve Busch of Southpaw Investments. Please go ahead.

Steve Busch – Southpaw Investments

So, the quarter was beyond [ph] my expectations, so kind of two questions that tie into each other from the past. First, Hanif, you used to talk about if revenues got to X then, at some point, you're dropping $0.20 to the bottom line. Can you refresh my memory on that and where we stand?

Hanif Jamal

Yes that is certainly we believe that to be true. In fact if you kind of look at the segment results we have actually put out is spread sheet and you can go look at that, it's on our website but what you will see is that generally speaking we have taken what we do is we sort of allocate our fixed cost which for the most part is engineering and G&A. If you look at the contribution margin in the business that has been running in the mid to high 20s and that’s a reflection of the again that same operating leverage. We certainly believe that that operating leverage carries forward as we continue to grow the top line here. So we feel comfortable in that 20% to 32% number.

Steve Busch – Southpaw Investments

Right. So, in terms of the server OEM side with HP dropping, et cetera, versus the Vertical growing, where are we in having Vertical grow so much that the OEM side gets less and less of a problem when it goes down? I guess that's a roundabout way of saying are we just treading water sometimes, even though we're growing fast in Verticals? If we take a big hit on OEM server, then we're kind of stuck in the zone?

Dana Kammersgard

From my stand point Steve, 9% of year-over-year growth in the market that is probably at best flat and likely down is not treading water but I do understand your point and if you take the compounded annual numbers that we have provided you as an outlook for business that being plus or minus five on the server side and 40% to 50% vertical growth over the next -- what we have described as the planning horizon, which we could fairly say is greater than one year and less than five. I think you could figure out fairly quickly and Hanif just ran some numbers. I think you can fairly figure out that in the 2015 – 2016 time frame that the verticals overtake the business in a fairly significant way and we become less dependent on server OEMs in or around that time frame.

Hanif Jamal

So, this should give you more data here. In 2013 the server business was 34% of total. The midpoint of our guidance for 2014 if you take the midpoints we’re projecting that to be 43% of total revenue.

Steve Busch – Southpaw Investments

Right. No, I understand. I was trying to get a little bit more color.

Hanif Jamal

You will see that trend if you go back historically and our investor decks actually have those percentages.

Steve Busch – Southpaw Investments

So, just kind of on the bubble chart front, have you considered or would you consider, instead of viewing the pipeline qualitativeness of the bubbles, where your current new pipeline stands, in terms of a product launch initiation and to a ramp-up and have bubbles move across in kind of like an actual product launch without naming the customers, of course?

Dana Kammersgard

Yes I think that’s the -- first of all we try to listen very closely to our constituents whether they are customers or investors or whomsoever. And we have to do that with an OEM culture and that same OEM culture rolls over into listening to our investors. We understand that that was a very important, very valued device and as I have indicated before and we saw evidence of this already on this call the moment that people try to turn a qualitative tool into a quantitative modeling tool is the day it has outlived its usefulness. If we can figure out a way that we can give you clarity with respect to these so called bubbles without that happening then I will be happy to consider reinstituting that. But it is being interpreted and used in means that it was never intended to be and the ramification of that is that people spend less time listening to our words and more time trying to quantitatively analyze this chart, come to conclusions that may or may not be right.

Steve Busch – Southpaw Investments

I understand. I'm just saying, whether it's a Big Data customer or an Oil and Gas customer -- if you see that bubble going across that's currently in ramp-up, as opposed to something that's in the pipeline of possible getting, as a customer, just to kind of see where they are at any given quarter for any number of reasons. But I understand, I just think you guys are doing a great job. And I look forward to the future.

Operator

Our next question comes from Thomas Massey of UBS. Please go ahead.

Thomas Massey – UBS

As one of your investor constituents, I had a question about if you could tell me a little more about, going forward, the band two and three versus the band four. Is there going to be an expansion of band four that you hope or that you're starting to see?

Dana Kammersgard

The answer is yes, and if you think about our strategic initiatives they include moving up the value chain. In fact in certain instances through our channel we actually sell band five product as well. So there are a couple of somewhat opposing phenomenon here and I’m sorry, I’m struggling for the right word to articulate this clearly. But you have on the one hand our unrelenting trend to move band five, band six, features and performance downstream. Why we do that is because in that regard we’re bringing the market to us, we’re dynamically disrupting the price points of the higher order products, band five, band six, even hopefully band seven by taking that functionality down into a band two, band three, band four product. At the same time we’re investing in moving our products upstream to capture more of that available 10 [ph]. So those two forces if you will are a little bit opposing but they both serve to achieve the same goal which is higher average selling prices at higher margins and a bigger overall available market to us.

So yes, we’re investing upstream just as we have declared from a strategic initiative point of view and at the same time to the extent that it is technically feasible we’re trying to cram as many of those features into our lower order products as we can.

Thomas Massey – UBS

I am glad to hear that you both sound angry and focused this morning. I think the market is reading this wrong. And if you could, that kind of information combined with a little more detail going forward, not only the climb up the ladder through the bands, but an outlook on are there new customers still on the horizon, in addition to expanding the -- are they in the pipeline currently?

Dana Kammersgard

I don’t know about the anger, we’re certainly focused and our outcome as I indicated is absolutely tied to our execution far more so than any economic or secular headwind that might exist out there and I would love to be able to expose to you all the projects we have, all of the roadmap we have but that wouldn’t do us -- it wouldn’t do our customers any favors and at the end of the day they are the ones who pay the bills. Having said that our immediate opportunity and I identify our immediate opportunity as the things that happen now that will have benefit to us over the course of the next couple of years is doing as much as we can, as fast as we can to take share and in taking share there are really two forms of that. We can take share within the context of an existing customer, that means that maybe we’re a small part of their overall storage portfolio or the storage products that go into their embedded solutions and we can take share in terms of incremental companies out there that maybe nervous because their current supplier is not sending the kind of signals that make them feel comfortable with them as a partner for the next two years.

The first one, taking share with an existing customer as I indicated we already know what’s happening there. We know what products they are launching, what next generation stuff they might be doing. We have a reasonable level of ability to predict that and it gets back to, do we hit our milestones? Do we deliver the product on time, can they launch it because we have given them a features they need, with the quality they want, et cetera. And we’re aggressively taking share in that context.

Number two, we’re not putting into any projection or forecast or outlook or any other commentary with respect the numbers that we provide to our investors. So that if there is a new prospect that determines that they need to move through a new supplier i.e. us because their current supplier doesn’t seem to be behaving in a manner that is conducive with their long term business goals, the customers long term business goals. That’s new opportunity too when we’re aggressively working to take share on that front as well.

Thomas Massey – UBS

One follow-up on that -- do you have any new customers in the pipeline currently being qualified?

Dana Kammersgard

Yes.

Thomas Massey – UBS

And on a different topic, who or what is your biggest competitive threat currently?

Dana Kammersgard

So, there are very few and I said in the prepared remarks that we appear to be the last man standing in storage and I should qualify that a little bit. We seem to be the last meaningful or effectively the last man standing in storage but is focused on OEMs and our historically greatest competitor whether they were owned by LSI or whether they are owned by NetApp is a subsidiary called Engenio. And if you go back and read the transcripts or follow the transcripts in the future NetApp reports later this month. You will see how their OEM revenues are doing except that they don’t call them out any more for some strange reason.

Thomas Massey – UBS

And that division is still your biggest concern?

Dana Kammersgard

Still our biggest customer, sorry, still our biggest competitor, still our greatest opportunity.

Operator

And there are no further questions. I would like to turn it back to management for closing remarks.

Dana Kammersgard

Thanks Eric. Thank you all for joining us today on our first quarter 2014 call. Hopefully with respect to the tone of our voices whether it was mad or focused we remain very excited with respect to our prospects for 2014 and beyond. We remain exceptionally focused on our strategic initiatives in terms of Vertical Market execution and moving up the value chain so to speak with respect to higher order products and I can tell you that our future is going to be largely determined as we have said by our execution over the course of this year and beyond. We will talk to you next quarter. Thank you.

Operator

Ladies and gentlemen that does conclude today’s conference. Thank you for your attendance. You may now disconnect. Everyone have a great day.

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