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Netlist, Inc. (NASDAQ:NLST)

Q1 2014 Earnings Conference Call

May 13, 2014 17:00 ET

Executives

Mike Smargiassi - Investor Relations, Brainerd Communicators, Inc.

Chuck Hong - Chief Executive Officer

Gail Sasaki - Chief Financial Officer

Analysts

Richard Kugele - Needham & Company

Richard Shannon - Craig-Hallum

Madhu Kodali - Yaksha Capital

Operator

Good afternoon and welcome to the Netlist First Quarter 2014 Earnings Call and Webcast. All participants will be in listen-only mode. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Mike Smargiassi of Brainerd. Please go ahead.

Mike Smargiassi - Investor Relations, Brainerd Communicators, Inc.

Thank you, Laura, and good afternoon, ladies and gentlemen. Welcome to Netlist’s first quarter 2014 conference call. On today’s call will be Chuck Hong, Chief Executive Officer of Netlist; and Gail Sasaki, Chief Financial Officer. As a reminder, our earnings release and a replay of today’s call can be accessed on the Investor Relations section of the Netlist website at netlist.com.

Before we start the call, I would note that today’s presentation of Netlist’s results and the answers to questions may include forward-looking statements, which are based on current expectations. The actual results could differ materially from those projected in the forward-looking statements, because of a number of risks and uncertainties that are expressed in the call, annual and current SEC filings, and the cautionary statements contained in the press release today. We assume no obligation to update forward-looking statements.

During this call, non-GAAP financial measures will be discussed. Reconciliations for those directly comparable GAAP financial measures are included in the press release, which was filed on Form 8-K.

I would now like to turn the call over to Chuck.

Chuck Hong - Chief Executive Officer

Thanks, Mike and afternoon everyone. And we were pleased with our first quarter financial results as we delivered year-over-year improvement in our revenues and gross profit with no increase in operating expenses year-over-year. We also significantly improved our cash position by effectively executing our public offering during the quarter. Gail will provide details shortly.

During the first quarter, we made further progress in broadening our target market opportunity and expanding our portfolio of flagship products, specifically our Vault family of products. We invented the first hybrid memory product over five years ago. And our NVvault family of products were primarily used for data backup, but are now increasingly being used as data accelerators much like a turbocharger for storage. Our products operated at DRAM speeds to store critical right data for indexes and logs to read hot data, the most commonly accessed data from storage, and to provide persistence in the event of power interruption.

During the quarter, we continued our work with Intel to make the next logical step of taking NVvault from the PCIe channel to enabling it in the fastest bus available, the memory channel. As a result of years of collaboration with Intel in this area, Netlist may be the only NVDIMM vendor with seamless integration into leading storage platform motherboards. This in turn has increased our sales funnel significantly, including qualification efforts with some of the world’s largest Hyperscale customers that plan to adopt NVDIMM hybrid memory to accelerate their infrastructure. We expect deployment on this expanded and diverse customer base over the next six to nine months.

We also took important steps to strengthen our IP position, including securing additional highly favorable victories at the United States Patent and Trademark Office. That reads on both enterprise server memory solutions like LRDIMM and hybrid memory storage solutions like UltraDIMM. Each of these patent wins increases our ability to capitalize on the explosive market dynamic of merging memory and storage into one product. We believe that memory storage will fundamentally change computing as we have known it. Our Vault family of products is the first step toward that future for both enterprise and Hyperscale customers. We continue to work with IBM and HP on our HyperCloud family of products and expect to capture some portion of the rapidly growing LRDIMM market estimated at $1.3 billion this year. The industry has recognized the benefits of our technology and their adoption of HyperCloud’s distributed architecture for their next generation of DDR4 LRDIMM.

In a moment, I will discuss the progress we are making on our licensing strategy including our recent victories at the USPTO, but first let me turn the call over to Gail for the financial review of the quarter and the year’s results.

Gail Sasaki - Chief Financial Officer

Thanks Chuck. Revenues for the first quarter ended March 29, 2014 were $7 million compared to $6 million for the first quarter of 2013 representing a 17% increase year-over-year. Gross profit for the first quarter of 2014 was $2 million compared to a gross profit $566,000 in the first quarter of 2013, a 250% increase due to a combination of improvements including product mix, decreased audit costs of new alliance and improved inventory management. Net loss for the first quarter was $2 million or $0.05 loss per share compared to a net loss of $3.2 million or $0.10 loss per share in the first quarter of last year. These results include stock based compensation in the first quarter of $531,000 compared with $434,000 in the prior year period and depreciation and amortization expense of $282,000 compared with $418,000 in the prior year’s first quarter period.

Adjusted EBITDA loss after adding back net interest expense, income taxes, depreciation, stock based compensation and net non-operating expense was approximately a negative $800,000 for the first quarter of 2014 compared to an adjusted EBITDA loss of negative $2.2 million for the prior year period. Operating expenses were $3.6 million in the first quarter which was flattish as compared with last year’s first quarter as well as the fourth quarter of 2013. However, without patent legal costs from both periods operating expenses decreased by $700,000 compared to last year’s first quarter.

Gross profit over the next few quarters will continue to be dependent on a number of factors including revenue, unabsorbed manufacturing capacity, change in product mix as well as higher cost of materials some of which we may not be able to pass through in the form of higher ASPs. We will continue to focus on managing our quarterly operating expenses while targeting product execution including strengthening our patent portfolios for both our HyperCloud and NVvault product families.

During the first quarter we closed on our registered firm commitment underwritten public offering of $8.7 million common shares raising net proceeds of approximately $10.3 million. These funds have further bolstered our balance sheet and strengthened our liquidity as we move forward in executing on our plan. We ended the first quarter with cash and cash equivalents and restricted cash totaling $19.1 million, as compared to $7.8 million at the end of the fourth quarter, reflecting our successful offerings and a no cash burn during the first quarter. Year-over-year our cash cycle improved by 74 days, mainly from improved inventory turns. We do anticipate to be a net user of cash during the second quarter as our cash cycle returns to a more normal 45 days from the 15 days we experienced in Q1.

First quarter capital expenditures were minimal and we continued to anticipate not spending more than $200,000 in CapEx over the next few quarters. At the end of Q1 we also had untapped capacity of $3 million on our receivables bank line of credit from Silicon Valley Bank for working capital needs and access to $9 million of available funds under our IP bank loan agreement with Fortress Investment Group.

I will now turn it back over to Chuck.

Chuck Hong - Chief Executive Officer

Thanks Gail. As I noted, we have continued to add to our record of wins at the USPTO, most recently the examiner and the consolidated reexamination of our 912 patent issued and action closing prosecution confirming the patent’s ability of 92 claims related to LRDIMM. The reexaminations were brought by Google N5 and Smart Modular Technologies. The 92 patentable claims are generally directed to the fundamental concept of rank multiplication, which is integral to the design of LRDIMMs. The ACP marks the end of the prosecution stage of the consolidated reexamination that has lasted nearly 4 years and amassed a written record of over 10,000 pages. This represents a significant step towards confirming these fundamental LRDIMM claims within the USPTO.

The parties will next have the opportunity to appeal the Examiner’s findings to the Patent Trial and Appeal Board later this year. The 912 patent is also the subject of litigation between Netlist and Inphi in the Central District of California and between Netlist and Google in the Northern District of California. Both litigations have been stayed pending the outcome of this and other reexamination proceedings. This positive decision comes on the heels of the Appeals Board’s decision earlier this year upholding the validity of all 60 claims and the related reexamination of our 537 patent brought by Inphi. In that decision the Appeals Board dismissed every single validity challenge raised by Inphi over three years and affirmed the Examiner’s decision to allow the claims of our patent. These claims are also generally related to rank multiplication as well as load reduction, another fundamental concept integral to the design of LRDIMMs for both DDR3 and DDR4. Netlist innovations have efficiently – have effectively created two major product categories LRDIMM and Hybrid DIMMs and our IP reflects the groundbreaking we have done in both areas.

Our LRDIMM portfolio grew out of the early HyperCloud development, which took place years ahead of LRDIMM that can fit elements from the HyperCloud architecture and design have been incorporated in DDR3 and DDR4 LRDIMM. Now with claims having survived a rigorous review by the PTAB, we believe our portfolio is without parallel in terms of coverage of many core features of the LRDIMM architecture. Our hybrid memory portfolio appears to be on a similar trajectory. Our early innovations arose in part out of the NVDIMM product development years ahead of the industry. We have already been successful in getting patents issued at former strong core of protection in the space.

For example, we reported in March of this year, the issuance of two patents covering core aspects of hybrid memory systems that combined DRAM and Flash Memory technologies. The claims contained in these new patents cover innovations critical to facilitating the movement of data between a host system and DRAM memory and between DRAM and Flash memory subsystems. The rapidly expanding market for the fusion of memory and storage is an important area for our company. Enterprise flash tips – enterprise flash solutions of which hybrid memory modules and memory channel interface SSDs are part of are projected to be an $8 billion market by 2017. We are proud to be a technology leader in this transformation and we see significant opportunities for current and future products as well as patent monetization.

With each of these wins the value and importance of our patent portfolio is becoming increasingly clear. As a result we believe we are well positioned to accelerate our patent monetization efforts with a wide range of industry participants as the market for LRDIMMs and hybrid memory grow at a rapid phase. In this regard, we have continued to follow through on our patent and trade secrets lawsuits against SanDisk and Diablo Technologies, one of Netlist’s former design contractors for HyperCloud.

To recap our complaints allege that the UltraDIMM product infringes on a total of seven Netlist patents and as described in our most recent amended complaint and trade secret action, we believe Diablo exploited it’s position as a trusted vendor to steal Netlist’s most valuable intellectual property and incorporate the stolen technology in it’s UltraDIMM product. We intend to bring Diablo’s long course of unlawful conduct to light and to vigorously pursue every available remedy for its theft. Mostly recently served – most recently we served an Amended Trade Secrets Disclosure describing in detail approximately 60 technology trade secrets taught and disclosed by Netlist to Diablo and believe to reside in the UltraDIMM. Among others these trade secrets include our LRD/DxD chipset architecture, our ASIC controller architecture, our isolation switch device architecture, and novel features in Netlist’s architecture for memory module self-test.

We are seeking among other things and in junction against the UltraDIMM product as well as damages, royalties and restitution for Diablo’s misappropriation of Netlist’s trade secrets. The patent and trade secret lawsuits are proceeding and discovery is now underway. In early April, the court denied Diablo’s motion to strike our infringement contention and granted our motion compelling the defendants to produce certain documents. The Court also recently granted our motion to request the Canadian Courts to issue summons for the two former Diablo’s employees named in the whistleblower letter we received last year. Depositions of these individuals will likely occur in the next few months. We have remained confident of prevailing in both the patent and trade secret counts.

So, in summary, we are continuing to move forward and transitioning our business model and taking the necessary steps to unlock the value of our industry leading products and IP assets. Thank you all very much for listening today and we are now ready for questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question is from Richard Kugele of Needham & Company.

Richard Kugele - Needham & Company

Thank you. Good afternoon.

Gail Sasaki

Hi, Rich.

Richard Kugele - Needham & Company

Hi. Couple of questions. Gail, obviously let’s start with my usual question of can you breakdown the revenue a little bit and then I have a couple of follow-ups?

Gail Sasaki

Okay. So, as usual, the usual categories are our Vault family, EV and NV was 55% of revenue, HyperCloud 5%, Flash 15%, and other 25%.

Richard Kugele - Needham & Company

25%, okay. And included in other is what again?

Gail Sasaki

Industrial (indiscernible) or VLP products.

Richard Kugele - Needham & Company

Okay, yes. Okay. And then Chuck, can you remind us just I know that the Fortress funds are tied to certain patents, I believe on the HyperCloud side, but can you just refresh us on what’s tied to that and that should you receive funds, because of a settlement based on those patents, how much of that would go to you versus go to them? Can you just clarify that?

Chuck Hong

Well, I think, yes, some of this is already in public filings, but I think I’ll let Gail address that.

Gail Sasaki

Okay. Yes, the Fortress agreement is backed by our HyperCloud patents, not the Vault patents.

Richard Kugele - Needham & Company

Okay.

Gail Sasaki

So, any monetization related to either one of two HyperCloud would be on shares with Fortress and the way that would work is the first $30 million is approximately 28%. It’s a waterfall sliding scale and then after that, 15%.

Richard Kugele - Needham & Company

Any amounts over $30 million?

Gail Sasaki

Correct.

Richard Kugele - Needham & Company

Okay. And then in terms of HyperCloud being at 5%, Chuck you were talking about some hope still that you can generate a little bit better revenue with HP, can you just talk about what you are seeing there from a market acceptance rate average capacity perhaps demanded?

Chuck Hong

The 16-gigabyte HyperCloud demand appears to be winding down, but we are seeing some ordering out of IBM and HP on 32-gigabyte. So, we are hopeful that, that will continue to ramp in the second half of the year.

Richard Kugele - Needham & Company

Okay. So, was 32% a meaningful percentage then of the 5% of revenue?

Gail Sasaki

Yes. It was the lion share.

Richard Kugele - Needham & Company

The lion share. Okay. So we are at that point now. Okay. Alright, I will go back in the queue. Thank you.

Gail Sasaki

Thanks Rich.

Operator

And our next question will come from Richard Shannon of Craig-Hallum.

Richard Shannon - Craig-Hallum

Hi, Chuck and Gail how are you?

Chuck Hong

Hi, Richard.

Gail Sasaki

Hi, Richard.

Richard Shannon - Craig-Hallum

Once again congratulation on another solid quarter after a great first quarter here a few questions from me, let’s see here Google Vault’s products would take you another solid quarter there, can you give us a sense of the breadth of customers there. And then I think also if you have mentioned that you had (signed one) with typical WHIPTAIL that’s been subsequently purchased by Cisco, wondering if those guys have entered into – started generating revenues for you yet?

Chuck Hong

Yes. Richard, the Vault products are being sold to a number of customers today, Nimble Storage being one of the larger customers. And then we are starting to see orders out of Cisco from the WHIPTAIL acquisition. We are hopeful that they will take the NV or the EV the Express Vault and apply it more generally across their UCS platforms, which would translate to higher volumes. We have customers like Tintri which is a up and coming exciting storage box vendor who is planning to go IPO, companies like Avere another storage appliance vendor. So there is a number of customers that we are shipping to today. I think as I alluded to earlier we are hopeful that the transition of this product into cloud datacenter applications would lead to a significant increasing demand from a different segment of the market.

Richard Shannon - Craig-Hallum

Okay. I appreciate that’s going down. Chuck I want to focus one of your comments on the color regarding your work with Intel and alluding to some potential Hyperscale customers within six months to nine months, if you could share some more details on that any sense of size relative to customers and your hybrid memory products area so far and to what extent does your relationship with Intel different or special exclusive that helps you gain these customers that will be great to hear?

Chuck Hong

We have been working with their storage group out of Arizona for the last three years. We have been the only company that they have worked with in terms of enabling the NVDIMM taking it from where it resides today in a PCIe and putting it into the DRAM channel. So as a result of that work we believe we are the only supplier of NVDIMM today that has complete compatibility with some of the storage platforms that Intel is a introducing into the market. So that’s – I think that’s a good position to be. We are working with a couple of major Hyperscale customers or integration of the NVDIMM into the DRAM channel and their storage flash server access. These are customers that have up to 1 million servers installed worldwide in their datacenters. And we are starting out with the first 100,000 units of their servers to retrofit the NV for their indexing and caching applications. So we think there is maybe anywhere between one to four units part of these servers for units of NV so it could represent quite a significant increase in volume for our business.

Richard Shannon - Craig-Hallum

Okay. Chuck, are you saying or implying that they had a (keep) relationship or even a contractual relationship related to either one of these Hyperscale customers or is this still in the design-in phase?

Chuck Hong

Products are being designed in and we’ve been doing that work now for the last four to five months.

Richard Shannon - Craig-Hallum

Okay.

Chuck Hong

Yes, over the next couple of months that, we will finish that design-in work and qualification and then rollout.

Richard Shannon - Craig-Hallum

Okay, perfect. That sounds very exciting. My last questions or two probably for Gail, Gail, could you give us a sense of what we should look at for OpEx going forward especially since it sounds like your case related to SanDisk and Diablo, maybe it looks like it’s entering the discovery phase which I understand to be relatively expensive part of the – of legal cases. Can you give us a sense of what we should expect for this quarter and maybe going forward for the rest of the year related to that (case)?

Gail Sasaki

Sure. Well I think you’ll see it staying relatively flattish without the legal cost, with the legal cost maybe as much as a 10% increase.

Richard Shannon - Craig-Hallum

Okay.

Gail Sasaki

Depending on one quarter, I don’t think it’s going to – it will just kind of fluctuate.

Richard Shannon - Craig-Hallum

Okay.

Gail Sasaki

Okay.

Richard Shannon - Craig-Hallum

Okay. So that is helpful. I think that’s my questions for the time-being. I’ll jump.

Gail Sasaki

Okay. Thanks, Richard.

Operator

Next we have a question from Madhu Kodali of Yaksha Capital.

Madhu Kodali - Yaksha Capital

Hi, thank you. I have a couple of questions. The first one is I was wondering if you can give us some color on units and ASPs of the product, I’m relatively new to the story, trying to get an handle on the market and what you have in terms of the market share, you talk about quite a few billion dollars in terms of opportunity, so I’m trying to get a handle on that?

Chuck Hong

Well at a high level there are two categories of products, the HyperCloud and the NVDIMM or the EV NV or EV what we call. The HyperCloud products depending on the density, there is a 16 gigabyte and 32 gigabyte version. It’s going to be anywhere from $150 to $350 in ASP for HyperCloud products. NVDIMM products are mostly four gigabyte either four gigabyte or eight gigabyte and the ASP’s ballpark is anywhere between $150 to $300 on those products.

Madhu Kodali - Yaksha Capital

Okay. The follow-up question is related to the patent licensing opportunity, so minus that what’s the opportunity for the company with the current products that you are already shipping and is the patent litigation primarily a revenue opportunity from SanDisk and Diablo and if you win those or there are other opportunities that you’re trying to get some sort of contractual agreement with other competitors or vendors or customers at this point?

Chuck Hong

Yes. So I think we have a number of litigations as we’ve talked about. We’ve got three other litigations that are stayed outside of – and the SanDisk and Diablo litigation is live litigation. There are probably two dozen different licensing opportunities that we can discern from patent families that we have that cover LRDIMMs and the hybrid memory. So we’re looking at other opportunities as well but what is in front of us is the SanDisk and Diablo litigation.

Madhu Kodali - Yaksha Capital

What is the status on the two dozen opportunities that you’re referring to?

Chuck Hong

Well those are potential licensing targets that are in the business supplying or consuming or manufacturing LRDIMMs and other hybrid memory devices.

Madhu Kodali - Yaksha Capital

I mean are these companies – sizable companies and what is stopping you now to get those contracts and start generating revenue?

Chuck Hong

Well there is obviously strategy involved given the law, given the – given certain principles around patent extortion. So we need to make sure that the licensing activity takes logical priority. So the LRDIMMs this year are about $1 billion market, $1.3 billion that’s going to grow over the next few years to $3 billion, $4 billion, $5 billion annual market. As I mentioned that our patents are seminal and probably the only patents that have gone through this level of scrutiny in the patent office. So we’re very confident that we have very strong position on the LRDIMMs. So..

Madhu Kodali - Yaksha Capital

So if you do get your way and if you do get licensing opportunity maybe even 20% or 30% of this target market. What can you see in terms of revenue, you’re right now around $28 million, $30 million run rate, what can you think of our dream of over the next two, three years timeframe for this company to become in terms of revenue?

Chuck Hong

I’m not going to speculate on that now. I think you’ll have to infer from the size of the markets and the strength of the patents that we have. These are both LRDIMM market will be a mutli-billion dollar market and then the hybrid memory market covering NVDIMMs and other UltraDIMM like devices will be a multi-billion dollar market. And we have we believe we have seminal and the strongest patent coverage in both of those market segments. The dollars will come from what are going to be the royalty rates that are negotiated with which parties. So it could be various types of different outcomes.

Operator

And our next question is a follow-up from Richard Shannon of Craig-Hallum.

Richard Shannon - Craig-Hallum

Hi, guys. Maybe just one follow-up question from me on HyperCloud, you’ve seen your two suppliers of LRDIMM out there have two good quarters in a row, some very strong growth in that category. It looks like your 32-gig are now just starting – get a start but seem to be maybe trailing to hang a little bit so far. Can you give us a sense of what helps accelerate that and keep in line with what the LRDIMM guys are doing so far in DDR3?

Chuck Hong

Well it’s currently positioned at a high end niche of this market. So in terms of the way HP and IBM are pricing this product it’s higher than LRDIMM. I think as the market for 32 gigabyte growth we will naturally see our volumes pickup and that niche grow. We work with both HP and IBM to market HyperCloud to their customers. If you go and look at the IBM website on their server virtualization application, it leads with HyperCloud as the preferred memory solution. So, there is ongoing work. It is a high end niche part of the server memory market, but as the density – as the 32-gigabyte density grows, we think the volumes will pickup.

Richard Shannon - Craig-Hallum

Okay, fair enough. And my last question, Gail, can you give us any idea of what your expectations are for results in the second quarter top and bottom line if you can please?

Gail Sasaki

Well, Richard, we don’t provide specific guidance, but as you can tell from the call, we are very pleased with the increased activity in our products and our IP. And we are focused now on converting all of that activity to orders and monetization, which should happen in the near-term.

Richard Shannon - Craig-Hallum

Okay, fair enough. That’s all the questions for me. Thanks again once again.

Gail Sasaki

Sure. Thanks.

Operator

Thank you. And with that, we will conclude the question-and-answer session. And the conference is also now concluded. Thank you for attending today’s presentation. You may now disconnect your lines.

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