OCZ Technology CEO Discusses F2Q11 Results - Earnings Call Transcript

Oct.14.10 | About: OCZ Technology (OCZ)

OCZ Technology Group Inc. (NASDAQ:OCZ)

F2Q11 (Qtr End 08/31/2010) Earnings Call

October 11, 2010 1:00 pm ET

Executives

Ryan Petersen - CEO

Arthur Knapp - CFO

Analysts

Alex Kurtz - Merriman and Company

Rich Kugele - Needham and Company

Operator

Good afternoon and welcome to the OCZ Technology Group's fiscal 2011 second quarter financial results conference call. (Operator Instructions)

On the call today from OCZ are Ryan Petersen, CEO; and Arthur Knapp, CFO. Ryan will provide a company overview. Art will review the firm's financial results. Following that, we will open the floor to a few questions.

Before I turn the call over to them, I need to remind our listeners that remarks made during this call may contain forward-looking statements that involve risks and uncertainties. Forward-looking statements on this call are made pursuant to the Safe Harbor provisions of the federal securities laws. Information contained in the forward-looking statements is based on current expectations and is subject to change, and actual results may differ materially from those forward-looking statements. Some of the factors that could cause actual results to differ are discussed in the reports filed with the SEC. These documents are available on OCZ's website, www.ocztechnology.com.

With that said, it is now my pleasure to introduce Ryan Petersen.

Ryan Petersen

Thanks and good day to everybody. As you know from our prior two earnings calls, we are in the midst of a strategic transformation away from our historical DRAM memory module products and into the rapidly expanding market for solid-state drives.

In late August, we announced that we were discontinuing the sale of certain commodity-level DRAM products, and this change has allowed us to focus on building our position in the high-performance SSD market. These products are used commonly in enterprise storage arrays and servers as well as consumer and industrial applications.

During the quarter, SSDs represented nearly 70% of our ongoing business and achieved record results with sales of $20.2 million, up 81% year-over-year and 51% sequentially.

At a detailed level, it's important to note that August was not only a record month for OCZ with respect to net revenue, but SSD unit volumes in August were more than triple the average SSD unit volumes during Q1. To be clear, it will not be a practice at OCZ to discuss monthly performance metrics going forward. That said, in this particular instance, we feel that it's helpful conveying the growth in our SSD product lines.

I'd like to take a few minutes to speak more specifically about our various SSD products and their respective markets. Our SSD products are now gaining traction in the enterprise space as enterprise-class products now comprise nearly 20% of our SSD sales compared to only a percent or two a year ago. High-performance and server SSD sales were approximately 75% of our SSD revenue, and consumer grade SSDs continue to be around 5% of our revenue.

During the quarter, we announced that our enterprise-class standard MLC products have been selected by SGI for use across SGI and Rackable product lines. We expect our sales to SGI to ramp to production levels during our fiscal second half.

In addition, we have commenced shipments of our standard MLC SAS and SATA Deneva products to several new enterprise and server OEMs during the quarter, and we expect our enterprise and server OEM business for standard MLC products will continue to ramp.

During the quarter, we commenced mass production shipments of our Deneva Series eMLC-based drives to our current OEM clients and have received evaluation orders from two major OEMs as well as a number of other new OEM clients. We expect the eMLC and eMLC-wide technology will be disruptive to SLC across application categories in enterprise storage segments due primarily to the lower costs and enhanced durability provided by this technology.

Our High Speed Data Link interface and IBIS series of High Speed Data Link-equipped SSDs were launched during the quarter. The HSDL interface currently operates at more than double the speed of fiber channel and SAS interfaces. And next-generation HSDL devices are expected to scale well beyond that of any known future storage interface.

We expect to begin shipping our IBIS drives, which feature 125,000 random write IOPS at a $3 per gigabyte price point versus about $5 per gigabyte for similar performing drives to selected partners late in the third quarter.

On the PCI-E front, our award-winning RevoDrive entered mass production during the quarter. And while it was launched primarily as a solution for high-performance prosumer type desktop PC applications such as video and audio editing, it has seen substantially higher than expected adoption in the server and workstation market, which drove demand in excess of supply during the quarter. We intend to move aggressively to capitalize on these trends, and we're in plan to increase the supply for RevoDrive SSDs in the third quarter.

Due to the continued advancement of SSD technology, we believe that SSDs are now the most important component in the enterprise and server storage offerings. Both premium performance and unmatched reliability are critical. The value proposition offered by SSDs is getting more compelling over time, and that is the key reason why industry analysts project a traffic growth.

To briefly cover our other products, demand for our continuing DRAM module products continues to be strong and our PSU products have benefited from strong demand despite industry-wide capacitor shortages that limited our PSU sales during the quarter.

Now, as you've noticed by today's press release, we've made a change in our financial management with the resignation of Kerry Smith, the CFO and Director. I'd like to take this opportunity to thank Kerry for his years of service to OCZ. He was our outside legal counsel from late 2004 until he joined us full time in January of '09. Kerry will continue to provide some legal services for us in the near term in order to ensure a smooth transition.

I'm pleased that we've appointed Arthur Knapp as our Interim CFO while we decide on the permanent replacement. Art has been with us since mid-2004 and was our CFO for five years of dramatic revenue growth. As we discussed in the press release, he has 15 years experience as CFO of NASDAQ listed companies.

So at this point, I'll turn things over to Art for a financial overview. Art?

Arthur Knapp

Thanks Ryan, and hello to everyone. I'd also like to thank Kerry for his contributions in the past few years. When I initially consulted for OCZ in 2004, I recommended Kerry for the task of handling various corporate legal organizational matters, which have laid the foundation for our public company status today.

So we've worked together for six years and I know we'll have a smooth effective transition. Since the earnings release has the standard financial statement details, I'll focus on some of the analytical highlights for Q2 which ended August 31, 2010.

For the second quarter, OCZ had GAAP revenues of $38 million, essentially equal to the $37.8 million in the prior year second quarter, but up 11% sequentially from Q1. Q2 had record SSD revenues and a 51% sequential growth, as Ryan mentioned. Our product mix was 53% SSD, 33% memory and 14% for PSU and other.

A year ago, nearly half of our revenues were memory. So the SSD mix growth to 53% from 30% last year shows significant progress. This mix shift trend is even more revealing when you use the non-GAAP revenue chart in the release, which removes the discontinued commodity DRAM module products for the past four quarters.

This chart shows that SSDs were nearly 70% of pro forma revenues in Q2, which is up from the 50% to 60% mix in the prior three quarters.

With that product discontinuance, the Q2 GAAP financials have been negatively impacted by inventory reserves and some other non-recurring and non-operational items. Thus the table, which reconciles the GAAP financials to a non-GAAP presentation is particularly relevant this quarter.

This non-GAAP table removes the sales, cost of sales, inventory reserves, along with the direct operating and financing costs related to those discontinued products. It also removes the impact of non-cash items such as stock compensations, warrant valuation gains and deferred tax asset reserves.

The resulting pro forma financial presentation for Q2 of this year shows continuing revenues of $29.5 million, gross margins of 18%, and operating loss of just under $2 million, a net loss of about $2.5 million and a loss per share of $0.09. This is slightly better than the $0.11 non-GAAP loss in the analyst forecast and is roughly the same as the non-GAAP loss of $0.08 in last year's Q2.

This table shows that our operating expenses were $10.2 million on a GAAP basis. Non-GAAP adjustments to OpEx then consist of about $2.9 million of costs related to discontinued products, including $200,000 of stock-based compensation cost. These bring the total non-GAAP OpEx to $7.3 million, which was equal to last year's Q2.

Our GAAP financing costs were higher than last year due to the factoring arrangements, which had just started in Q2 last year, but they were in effect for a full quarter this year. For non-GAAP, we allocated the proportionate share of financing attributed to the discontinued memory.

We then had a $2.4 million non-cash gain for the fair value adjustment of warrants issued with our Q1 equity financing. This gain was removed as part of the non-GAAP presentation.

The last adjustment item was an $836,000 non-cash tax expense for an increase in the valuation allowance on our deferred tax asset. With the additional losses from the discontinued memory, we thought it was appropriate to fully reserve that asset, which showed as part of the non-GAAP presentation.

So putting this all together, and with our higher share count in the Q1 equity offering, the GAAP net loss for this year's second quarter was approximately $7.6 million versus a loss of $1.7 million in the prior year. This represented a loss per share of $0.29 this year and a loss of $0.08 last year.

On a non-GAAP basis, the current year net loss was approximately $2.5 million versus $1.5 million last year. The non-GAAP EPS was a loss of $0.09 this year versus $0.07 last year.

On the balance sheet, with the full quarter impact of the Q1 financing and some skewing from the strong August which Ryan mentioned, we showed large sequential increases in several of the working capital components. The increases in receivables of $6.9 million and inventory of $4.6 million before reserves were offset by an $11.7 million increase in payables.

We also increased our bank debt by $2.6 million to $13 million. Our existing bank facility limit is $17.5 million, and we are negotiating for higher limits so we can continue to expand our SSD sales as we exit the current fiscal year.

The cash balance was $2.6 million, while the warrant liability decreased to about $500,000, reflecting the non-cash gain of $2.5 million.

For guidance, in late August with the announcement of the discontinued DRAM products, we indicated that we expected fiscal 2011 revenues to be in the range of $165 million to $180 million, and we're reaffirming that guidance. We also expect to achieve positive adjusted non-GAAP EBITDA during the second half of this year.

So with the financial overview completed, I'll turn the call back to Ryan. Ryan?

Ryan Petersen

Thanks, Art. Our strategic transformation into a pure-play SSD provider is proceeding very well. And we appreciate our investors' support as we make this happen.

At this point operator, I think we can now take a few questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of (Anthony Calisso of Caissa Capital)

Unidentified Analyst

Just a quick question on Kerry. I see that he has resigned and is going to be providing legal services to OCZ. Does this mean that the transition is going to be back to its original role as the attorney, and that Art is going to be taking over as CFO from here on now?

Ryan Petersen

Well, clearly we mentioned that Kerry will still be providing services on the legal front to OCZ as well as any transitional needs that we may have on the financial side. Art has a wealth of experience with NASDAQ listed companies, and has been appointed as interim CFO. And the Board, of course, will make a decision on the full-time CFO in the near future. I do have to add that we're extremely confident in the team that we've put together on the financial side. And then, Art has been our VP of Finance for the last few years; post him operating as our CFO for five years.

Unidentified Analyst

Can you talk to your record monthly revenue in August, specifically that your volume was about 50,000 I believe for a month. How is it looking right now, since we're about halfway through the quarter?

Ryan Petersen

Well, demand has continued to be at these levels into the current quarter. Though we don't intend, as I mentioned before, to provide this level of granularity in the future.

Operator

Our next question comes from the line of Alex Kurtz of Merriman and Company.

Alex Kurtz - Merriman and Company

Ryan, a competitor published a note this morning talking about you guys getting qualified at EMC. Do you care to comment on that?

Ryan Petersen

I can neither confirm nor deny any current qualifications of tier-1 OEMs.

Alex Kurtz - Merriman and Company

So you can't even say that you are getting qualified there?

Ryan Petersen

That's correct.

Alex Kurtz - Merriman and Company

Could you just give us a little color on ASPs during the quarter, Ryan? And maybe what's more important that what the total gigabytes that were shipped during the quarter, was that up sequentially because obviously you did a lot more units than I was expecting?

Ryan Petersen

Well, our ASPs were around $215 when you look at all SSD categories for the quarter. In terms of gigabytes, we certainly shipped a lot more in terms of gigabytes, part of that is driven by the fact that MLC is getting a lot of adoptions in the space right now. At the end of the day, we're not going to comment on the exact amount of gigabytes shipped.

Alex Kurtz - Merriman and Company

Suffice to say, what's going on is, even though the ASPs came down, the customers are buying the same amount of storage or more than you expected, but just at different foreign factors, right?

Ryan Petersen

Yes. What we've seen is really adoption of a larger number of SSDs with a larger gigabyte number obviously, but at lower prices in general. This is something that we would expect to continue as a trend, and it really doesn't affect us either way.

Alex Kurtz - Merriman and Company

Right. They're just buying it in different kinds of ASP units, but the overall capacity is going up. Could you just talk about the memory business to close that out? Going forward in November quarter, will that just be a pure number on the go-forward memory business or will it be some flow-through from the discontinued stuff into the November quarter?

Ryan Petersen - President and CEO

I believe that we've taken sufficient write-offs associated with the discontinued memory business. So really on a GAAP basis or on a forward basis what we will see is what the normal businesses or the ongoing businesses.

Alex Kurtz - Merriman and Company

So there won't be any kind of GAAP to non-GAAP revenue reconciliation next quarter, right?

Arthur Knapp

We think not. Like Ryan said, we think we have adequate reserves for the discontinued memory.

Alex Kurtz - Merriman and Company

Ryan and Art, can you guys just comment on sort of the gross margin target that you've talked about in the past and so where you see yourselves getting to? Obviously, changing the memory mix helps. Do you think you can get into the high-teens, low-20s exiting the fiscal year? Is that a reasonable goal at this point?

Arthur Knapp

Well, you're of course doing your own numbers, Alex. I think that it's a fair target to be in the low twenties, high-teens.

If you look at the pro forma, you can see that we've clearly removed a significant amount of very, very low margin memory business on an ongoing basis. So the impact is clearly going to be increased gross profit margins.

Alex Kurtz - Merriman and Company

Can you talk about RevoDrive during the quarter? That's a high ASP item. Are you able to ship as much that you saw from the demand side or is there backlog there?

Ryan Petersen

As I mentioned a little bit earlier, we did expect the sales of RevoDrives will be limited to specialty applications. We really did undershoot supply quite significantly based on what we believe to be higher than expected demand in the server market. Our reaction to this, of course, is to increase supply of RevoDrives and begin targeting the product towards more server applications on a go-forward basis.

That answers your question?

Alex Kurtz - Merriman and Company

Yes, it does. So RevoDrive will increase as a mix next quarter?

Ryan Petersen

That would be fair to say.

Alex Kurtz - Merriman and Company

So going into Q3 here, just what are you guys thinking about OpEx levels and profitability? Obviously you guys expect to be positive EBITDA in the second half-year, but is it fair to say you're going to grow the OpEx levels $1 million or so off of that non-GAAP number, Art?

Arthur Knapp

Yes, because as we mentioned in the press release, we're trying to build additional capacity with our sales channel to take advantage of the opportunity. And on the technical front, there's a lot of exciting opportunity. So we're going to try to put investments into those areas.

Alex Kurtz - Merriman and Company

But I should be building my OpEx growth off of the non-GAAP number, right? Just trying to understand the sequential growth; not off of the GAAP OpEx number because that includes items that you're not working with anymore?

Ryan Petersen

Correct.

Alex Kurtz - Merriman and Company

Let's talk about the credit line for a second here. Art, can you just repeat what's the total amount of availability on that credit line now?

Ryan Petersen

So at the end of the quarter we had $13 million borrowed against the $17.5 million line. So there's $4.5 million available, and we are currently in negotiations to increase that.

Alex Kurtz - Merriman and Company

So what's the timeline on that negotiation? I mean, when should you expect to have an answer? Just to have a rough idea, is that a month from now or is that two months from now?

Ryan Petersen

I think it's within the month. Obviously the lenders wanted to see the impact of the quarter. The discontinued memory they were aware of. So for any loan committees, they want to make sure they're presenting the full picture. So we have that information now and we can go forward.

Alex Kurtz - Merriman and Company

Are you going to restructure the factoring that has been going on, because obviously that was a big chunk of your interest expense? How should we think about interest expense in the next couple of quarters then?

Ryan Petersen

Well, we are trying to restructure the factoring either in the interim by making some changes to the rates which they've alluded to. Now that we've been there a year, we can renegotiate some things. But the line that we are trying to negotiate would significantly reduce the financing cost. So on two fronts we are trying to reduce the financing cost and increase the availability of capital or debt.

Alex Kurtz - Merriman and Company

So I should model the interest expense going up because you're going to be probably using more of your credit line this quarter, right?

Ryan Petersen

Correct.

Alex Kurtz - Merriman and Company

Maybe at some point in Q4 you restructure in that the rate improves, right?

Ryan Petersen

That's our goal.

Operator

And our next question comes from the line of (Jim Burke of Lucas Capital).

Unidentified Analyst

This is a two-part question. STEC spent seven times what you did in the last six months in R&D and has much more cash. How could you compete with that? And do you have a percentage target in mind for what R&D spend will be as a percentage of revenue?

Ryan Petersen

I think in general we do believe we're able to compete very well across the board by making the right R&D investments, by being efficient. Focusing on Firmware has really allowed us to bring meaningful products to market with a low R&D investment or lower than our competitors. Of course, some of this has been built into our R&D in the memory space over the years.

That noted, we expect to see quite an increase in R&D expenditure as we continue to develop our own controller solutions, though we don't ultimately tie our R&D budget to any specific revenue level where it is product-based. I hope that answers your question.

Unidentified Analyst

That does. Actually, have you flushed all the write-offs associated with the discontinued DRAM products through in Q2 or will there be more going forward?

Ryan Petersen

Yes, I do believe we've taken sufficient write-offs.

Operator

And our next question comes from the line of Rich Kugele of Needham and Company.

Rich Kugele - Needham and Company

If we're going to dig a little deeper into just the SSD side of the business, is there any other detail you might be willing to provide on either the OEM versus retail, or maybe even just to look at the interfaces. And then how you would expect those categories to trend over the next couple of years?

Ryan Petersen

Sure. Let me try to cover that. To what degree, we don't really haven't given out that level of granularity in the past, but our primary focus is OEM. In terms of SSDs 75% of our business, as I mentioned, I believe, in the call, has been in the server segment or server and high-performance segment. Enterprise is growing specifically. What we see in those markets is PCIs are higher-end interfaces.

PCI-E SAS based products, not a lot of fiber channel for us. It's been limited really to fiber channel. Market has been limited to clients like EMC or Sun which we are not currently selling to. What we do see though is a lot of growth in the server space, which is really the middle segment of the market. Those have been PCI-E based SATA and SAS based products, which I guess covers the range in terms of interfaces. Does that answer your question?

Rich Kugele - Needham and Company

Yes, it does. And I guess I was just wondering, with you already being 75% plus OEM, you said earlier you still expect the gross margin profile to increase based on the new products and eMLC going up the door. Is that still the case? Is it a mix issue that's going to drive that?

Arthur Knapp

Well, in general, our SSD margins are, of course, much higher. So if we're looking at the GAAP presentation or historical financials, what you'll see is the gross profit has been very, very negatively affected by the historical DRAM business. We do expect, obviously, enterprise and server SSDs, specifically the enterprise or the ultra-high end of this segment have significantly higher margins than as you get down in the product range. So I hope that gives it some color for you without commenting specifically on what our margins will be.

Rich Kugele - Needham and Company

Sure. And then secondly, when it comes to manufacturing, what are your greatest gates to manufacturing today? You talked about having maybe even some less, some demand on the table because of how strong it was. Was that more of a back-end loaded issue, and you just didn't have time or could you not get the components in time, their burn-in times or what was the factor on the manufacturing side?

Ryan Petersen

Yes. Specifically, on the RevoDrive, where we severely undershot the supply was a planning issue for us. We did not plan for that sort of demand. It was considerably higher than we expected. Going forward, we intend to solve that by planning appropriately for those levels. That demand was very much towards the end of August. So you know it is a timing issue to some degree to have that occurred in September that would have been called it in the quarter. Our manufacturing capacity is at roughly 85,000 to 90,000 SSDs per month currently, so that's our maximum capacity today.

Rich Kugele - Needham and Company

And then just lastly an accounting question. How do you expect your warranty reserve to change over time, especially given the higher-end products that you're going to be making?

Ryan Petersen

I think our warranty reserves have been colored by the DRAM business, but I'll let Art comment on that specifically.

Arthur Knapp

I think on a go forward basis there'll be the normal historical levels that they're increased in this quarter, because of discontinued product lines. So with the quality of the products going forward, I wouldn't see any deterioration if that is what you're looking at.

Operator

(Operator Instructions) And our next question comes from the line of (Greg Lever of Investa Capital).

Unidentified Analyst

What should we think about in terms of receivables and inventory going forward in terms of absolute dollar level?

Ryan Petersen

Well, as you know I think August was a record month for us, which caused us to increase. And I'll turn it over to Art for specifics here.

Arthur Knapp

Well, we actually would obviously relate to the level of sales you have, so our targets on the DSOs that was skewed this quarter was probably in the 58-day range, will be to try to keep receivables into the low 50s. And then have our inventory returns increase by negative nine or 10, and then payable days we'll probably see a decrease in those.

Ryan Petersen

But our strategy is to try to turn the inventory quicker, collect the cash quicker from customers and not have to try to stretch vendors, because we want to have good vendor relations.

Unidentified Analyst

Could you give us a sense of kind of where you are in light of after restructuring the business in terms of a rough breakeven on an EBITDA basis revenue?

Ryan Petersen

I think we've said in the second half we expect to achieve positive. So in the second half as we've jettison the businesses and the SSD ramp continues, we expect that will result in a positive adjusted EBITDA.

Unidentified Analyst

For the entire second half combined or is this just you're heading the fourth quarter kind of thing?

Ryan Petersen

During the second half. That's not for the entire, but it's growing. And I think the key in our business is the exit rate, the trajectory that we're doing, because this is such an enormous opportunity, it's really a ramp that's key and that's why we had disclosed the August results, because we know we think that shows the kind of trajectory that's out there.

Operator

It appears we have no further questions in the queue. I would like to turn the conference back to Mr. Peterson for any further remarks.

Ryan Petersen

Well, thank you everybody for your questions. And I just will close with that we feel very strong about our transformation into SSDs. We were glad to have been able to dispose of the DRAM business this quarter. And thanks everybody for attending the call.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may now disconnect.

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