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Executives

Ryan Petersen - CEO

Arthur Knapp - CFO

Analysts

Alex Kurtz - Merriman Capital

Rich Kugele - Needham and Company

Steve Glass - STG Capital

OCZ Technology (OCZ) F3Q11 Earnings Call January 10, 2011 5:00 PM ET

Operator

Good day and welcome to the OCZ Technology Group's fiscal 2011 third quarter conference call. [Operator Instructions.] And now I'll turn the program over to Bonnie Mott, investor relations manager of OCZ. Please go ahead.

Bonnie Mott

Good afternoon and welcome everyone. On the call today are Ryan Petersen, CEO, and Arthur Knapp, CFO. Ryan will provide a business overview and then Art will review the firm's financial results. Following their formal remarks, 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 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 turn the call over to Ryan Petersen.

Ryan Petersen

Thanks, and good day to all of you. As you know from our prior earnings calls, OCZ has spent the last year focused on transforming the company from being a niche provider of DRAM modules into being a leading SSD provider.

We are very pleased with the financial results we achieved during the third quarter. Net revenue totaled a record $53.2 million, of which $41.5 million, or approximately 78%, was generated from our SSD products. Our focus on SSDs has proven successful, as our third quarter SSD growth rate more than quadrupled to 325%, compared to second quarter year-over-year growth of 81%. On a sequential basis, revenue generated from our SSD products grew 105% over second quarter SSD revenue of $20.2 million.

During the third quarter, we saw our non-GAAP gross margins increase to 19.4% and achieved a key milestone by posting positive non-GAAP EBITDA. These increases were driven primarily by the success of our SSD segment.

Due to our strong SSD growth, coupled with our recent successful financing and the continued weakness of the DRAM market in general, we are happy to announce that we've accelerated our plans to exit completely from the DRAM module business by the end of this fiscal year. It's important to note that we expect our DRAM products will have minimal, if any, sales in the next fiscal year.

With that, I'd like to take a few minutes and speak more specifically about some recent key developments in our business. Our OEM and enterprise and server segments are continuing to gain traction. In December we announced that we've received our first mass production orders from a tier-one OEM for our Deneva MLC-based enterprise class SSDs. As previously announced, these customized Deneva MLC-based SSDs are being deployed as an enterprise storage solution for use in data center applications. We began shipping those orders in the current quarter.

We have continued to expand our OEM client base, and expect our sales of enterprise-class SSDs to ramp as recent design wins finally reach mass production levels over the next fiscal year. We continue to see growth indicators with our current OEM clients across all product categories, as they release new SSD-equipped storage array servers and workstations.

And, as current SSD-equipped products continue to gain traction in the marketplace, we believe that the enterprise server and storage markets are the primary driver for SSD sales growth in the short to medium term.

We noted at the recent CES trade show that a number of major laptop OEMs have added new SSD-equipped laptops and tablet PCs to their roadmaps for the second half of calendar 2011, and while this is not representative of current demand, we believe that the PC and laptop segments will become a driver of SSD growth, specifically versus rotational media, in the medium term.

Just as SSDs are disruptive to traditional hard drives, MLC and EMLC SSDs are disruptive to SLC in the enterprise storage and server segments, due primarily to the lower cost provided by those technologies. We believe we're well-positioned to continue to take advantage of the move from SLC to EMLC- and MLC-based technologies in those segments in the coming fiscal year.

We also believe that as the smaller process nodes of MLC flash become mature, and we see improvements in 3 and 4 bit per cell technologies, that we'll see increased adoption of SSDs in network attached, PC, laptop, and tablet markets due to a lower delta between SSD and hard disk pricing in these segments.

Our IBIS series of HSDL-equipped enterprise MLC SSDs began shipping to clients during the quarter. The HSDL interface, which was developed at OCZ, operates at more than double the speed of fiber channel and SAS interfaces.

Our award-winning RevoDrive PCI-Express SSD continued to ramp as we widened our marketing strategy for PCIE-based SSDs in servers and workstations. Specifically, we introduced our higher-performance RevoDrive X2 series SSDs, which feature two times the speed of standard RevoDrive products, producing up to 150K, 4K random write IOPS. The Revo X2 began shipping to key strategic OEMs during the third quarter for early calendar 2011 product releases, and revenue is expected to ramp throughout the year.

In terms of enterprise PCIE products, we began sampling our revision 3 Z-Drive, which provides read-write speeds in excess of 2 GB/s and 250,000 random write IOPS as well as mission-critical data reliability supported by state-of-the-art supercapacitor technology, to a number of major enterprise OEMs and direct data center clients. These products are slated for mass production in our fiscal first quarter.

During the quarter, we announced the opening of our new state-of-the-art SSD manufacturing facility in Taiwan, increasing our manufacturing capacity by almost 3x, and allowing us to support not only current demand, but to support key OEMs with a facility dedicated to producing OEM SSD products.

Since this announcement, we have increased our manufacturing capacity in the new facility by about 50%. It is instructive to note that within our current facility footprint, with minimal additional capital expenditure, we are able to ramp production considerably in a short period of time if needed.

While we have historically developed SSD controller and firmware related technology organically, we are of course cognizant that speed to market is a key driving factor to our success. Accordingly, during the quarter we acquired certain fiber channel, SAS, and DRAM-based SSD controller technology assets from Solid Data Systems Inc., which further facilitates our expansion into the fiber channel and low-latency SSD markets. This asset acquisition simultaneously speeds the development of our hybrid DRAM flash controller as well as SAS and fiber channel demand controllers, which we expect to launch during fiscal 2012.

We recently launched and demoed a number of new products at last week's Storage Visions and CES conferences. Notably, our Helios fiber channel/SAS 6 GB enterprise SSD architecture set, which features about 550 MB/s read-to-write speeds with from 80-125,000 IOPS, is powered by our proprietary virtualized controller architecture.

The Helios creates a pooled resource of two or more NAND Flash controllers, managed by our newest data management firmware, to enable speeds which maximize the available interfaced bandwidth. Helios SAS versions are expected to begin sampling to select OEMs during the present quarter, followed by FC fiber channel 800 versions in fiscal Q1. We received numerous additional evaluation order requests from major OEMs of our SAS 6 GB versions of Helios during the CES show.

Our Vertex 3 SATA 6 GB architecture, which features read-write speeds around 500 MB/s and up to 80,000 random write IOPS, utilizes the latest 2x nanometer [inaudible] high speed synchronous mode flash. And OCZ is among the first to support the technology. We expect to begin shipping evaluation orders to tier one OEMs in the current quarter and to begin shipping mass production quantities in our fiscal Q1.

Our IBIS XL ultra-high density SSD, based on our HSDL interface, with speeds in excess of 1.8 GB/s and 200,000 IOPS, is expected to sample in capacities of 4 and 8 TB/s to selected data center clients in the fourth quarter. And our new optical interface version of HSDL technology was launched, which has theoretically unlimited upper transfer speeds.

We were pleased with both trade shows. We received a great deal of trade press and customer reactions to our new products were encouraging. Further, we noted no substantial product launches from any of our key competitors.

Turning to our most recent financing, in late October the company raised an additional $22 million in the private placement of common stock to several institutional shareholders. This was priced at a premium to the then market price, allowing the company to build balance sheet strength and continue to support demand for our SSD products.

We are very pleased with our progress during the quarter, and I'd like to take the opportunity to emphasize that SSD revenue growth and continued development of cutting-edge SSD technology remains our primary focus and is key to long-term profitability. To that end, we plan to continue to increase our investments in both R&D and sales and marketing, enabling us to strengthen our leadership position.

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

Arthur Knapp

Thank you Ryan. We are very pleased with our third quarter results, as we reported record revenues led by a sequential doubling of SSD revenues and positive results for both non-GAAP operating income and adjusted EBITDA. Our record Q3 GAAP revenue of $53.2 million was an increase 40%, both on a sequential and year-over-year basis from the $38 million reported in both the second quarter and in last year's third quarter.

From a product mix standpoint, our transition into SSD products was clearly evident as it represented 78% of revenue, compared to 53% in the second quarter and only 26% a year ago. SSD revenue was $41.5 million, more than double the $20.2 million from the second quarter and an increase of 325% from last year's third quarter.

Enterprise-class products grew by about 110% from Q2, and accounted for 18% of our SSD revenue, a similar mix to Q2. High performance and server products were approximately 80% mix, versus 77% in the second quarter, and consumer-grade SSDs were about 2% compared to 5% in the second quarter.

As expected, revenue from our memory products declined based on our August announcement to transition away from certain unprofitable commodity DRAM module products. Memory revenue in the third quarter was 12% of our revenue, compared to 33% in the second quarter. Revenue from power supply and other products increased 5% sequentially and accounted for 10% of our revenue in the third quarter.

As Ryan mentioned, we are planning to completely discontinue our DRAM module products by the end of this fiscal year, so revenue generated from these products will be weak in Q4 and insignificant in fiscal 2012.

On a geographic basis, North America SSD shipments grew 45% sequentially and represented about 35% of all SSD sales in Q3 versus the 50% mix the prior two quarters. This was due to a strong 160% sequential growth in international markets and shows that the SSD adoption is truly becoming a worldwide event. As shown in this quarter, our strong international distribution channels are poised to take advantage of this trend. Meanwhile, the enterprise-class products are strongest in North America and as our tier one and tier two customer initiatives take hold, these can fuel future growth in North America.

Turning to the details of our financial results, our GAAP net loss per share for the third quarter was $0.29 compared to a loss of $0.05 in last year's third quarter. Included in today's financial release is a table which shows a reconciliation of GAAP to non-GAAP measures as well as a calculation of EBITDA and adjusted EBITDA.

With the memory product discontinuances, the third quarter GAAP financials have been negatively impacted by $1.5 million of inventory reserves taken for that discontinuance. The reconciliation also reflects non-cash charges and infrequent or unusual adjustments that are not representative of our normal ongoing operations.

GAAP gross margins were 14.4% for the third quarter, but after adjustments for the impact of unusual rebates and inventory reserves, non-GAAP gross margins were 19.4% versus 17% a year ago. Our operating expenses were $12.2 million on a GAAP basis and $10.6 million on a non-GAAP basis after adjustments for costs associated with a technology acquisition, executive severance, other nonrecurring costs, and stock-based compensation. This $10.6 million compared to $7.4 million of non-GAAP costs in the year ago quarter.

With these adjustments, we reported a non-GAAP operating profit of $81,000 in the third quarter, compared to a loss of $947,000 in the year-ago third quarter. That $81,000 non-GAAP profit was net of an estimated $1 million loss on the memory business due to low margins, direct costs, and an allocation of non-overhead costs.

In the third quarter, we also had a $2.8 million noncash loss related to the fair value adjustments of warrants issued with our first quarter equity financing, principally due to a higher stock price, which makes these warrants more valuable. As you'll recall, we had a $2 million noncash gain in the second quarter, so these theoretical noncash adjustments are removed as part of the non-GAAP presentation.

GAAP net loss for the quarter was $8.3 million, or a loss of $0.29 per share compared to a loss of $1 million, or $0.05 per share in last year's third quarter. On a non-GAAP basis, net loss was about $900,000, or $0.03 per share compared to a loss of $1.5 million or $0.07 per share last year. Our adjusted non-GAAP EBITDA was a positive $369,000 versus a loss of $658,000 last year.

Turning to the Q3 balance sheet, all of our key metrics improved. Cash was $20.1 million, reflecting additional capital raised in the late October private placement. Calculating on a quarterly average basis and factoring out the role of non-GAAP adjustments, our receivable days decreased to 48 versus 59 last quarter. Inventory days decreased to 40, versus 43, and table days decreased to 77 versus 85, which helps our vendor relations as we seek higher credit limits due to our revenue growth rates.

To help finance these key working capital components, our bank debt rose to $15.4 million from $13.1 million in Q2. I mentioned on the last call that we were working on restructuring the existing $17.5 million debt facility to expand our borrowing capacity while decreasing the cost.

With our memory product discontinuance, several of the terms in that agreement are being revised to better accommodate the SSD traction we are seeing. A new structure is being presented to the loan committee this week, and once approved will be updated in the existing new loan agreement draft. I expect to have it signed and in place by month-end.

Turning to guidance, on November 1 we raised our revenue guidance for the fiscal year 2011 to the range of $170 million to $190 million. Notwithstanding the discontinuance of the company's historically significant DRAM products, we are still guiding to the middle of this range due to the continuing growth in the company's SSD products.

Finally, I'm very pleased to formally announce a couple of additions to our Investor Relations efforts. Bonnie Mott joined us a month ago as our IR manager, and she brings over a dozen years of experience with several Silicon Valley technology companies. A number of you already know her, and I'm really pleased to have her aboard.

We also have engaged ICR to be our external investor relations firm starting this month. They came highly recommended by several of our key investors, and we look forward to working with them in 2011.

That concludes our formal remarks. At this point we would like to open the call up for your questions. Operator?

Question-and-Answer Session

Operator

Yes sir. [Operator Instructions.] Our first questioner in queue is Alex Kurtz with Merriman Capital. Please go ahead.

Alex Kurtz - Merriman Capital

Ryan, can you just talk about the Helios product, what the margins look like, and will this become sort of the lead OEM product going forward? Is this what's going to be sold into the enterprise space? I think it could be a higher margin product than you guys have had in the past, right?

Ryan Petersen

That's accurate. So the Helios is going to be primarily positioned as a product that will sell into storage arrays. It was in fact designed with feature sets that specifically address ultimately enterprise end users' or data centers' requirements, things such as [inaudible] pass through, consolidated smart reporting, which are ultimately required in those enterprise storage arrays and obviously products in that category have significantly higher margins.

Alex Kurtz - Merriman Capital

Ryan, when you look at the strength of the results this quarter for SSD was some of it attributed to seasonality? Should we expect that in the February quarter? Where was the broad-based strength from? Was it just across all channels, or was there one specific technology segment that went after the product?

Ryan Petersen

Again, we really believe that servers and enterprise storage have been the drivers for the market, workstations to some degree. The only thing I would comment in terms of seasonality is that during February Chinese New Year falls this year, so ultimately our factory is open for just two and a half weeks during February. So it's a short quarter in terms of shipping days for us. We have obviously two different types of seasonality going on depending on the PT segment or the server segment and how those really overlie each other is unknown to us as enterprise server and storage has not been such a high percentage of our business in the past.

Alex Kurtz - Merriman Capital

Last quarter I think you gave us a run rate exiting the month of August. Can you give us that flavor again and maybe what the monthly run rates were in the SSD business?

Ryan Petersen

Well we really aren't going to comment in the future on our total unit growth unfortunately, so that was a one-time affair really to allow people to know how much progress we'd seen in units previously.

Alex Kurtz - Merriman Capital

Okay, and just moving on to some other items, it sounds like if you exclude this million dollar charge in memory that you guys were $1.1 million of non-GAAP operating income. Is that right?

Arthur Knapp

That's correct, yes.

Alex Kurtz - Merriman Capital

How should we think about the Q4 outlook here? If you were to exclude your assumptions on SSD, how should we think about power supply and memory as far as a total revenue projection for the fourth quarter?

Arthur Knapp

I'll take this one. In general, Alex, I would feel that the memory business is really, and to maybe give you some flavor there we are literally trying to discontinue all memory revenue by the end of fourth quarter. So we will simply sell what our inventory position was during the quarter and then no longer be in the memory business. Obviously we've taken some prudent reserves against selling that at a discount. In terms of revenue, I don't really have what the inventory position was, but we obviously began this late in the last quarter and would expect to close it out in the very near future.

Alex Kurtz - Merriman Capital

On the power supply business, Ryan, I know there were some constraints on capacitors the last couple quarters, did that impact you again this quarter? Do you think you can make up some revenue and can there be sequential growth in power supply in Q4?

Ryan Petersen

I would say yes, there can be sequential growth in power supply in Q4.

Alex Kurtz - Merriman Capital

And you expect to retain that business in fiscal 2012?

Ryan Petersen

We have no plans to do otherwise currently.

Alex Kurtz - Merriman Capital

And last question from me, if you're exiting the memory business, I think there would be an assumption that there would be some associated op ex that you could glean from that, but it also sounds like you're making a greater commitment to spend on the R&D and sales and marketing front to sort of build the franchise value. So is one going to outweigh the other? On a net-net basis, is it sort of a push? Or should we see some op ex incremental growth next year because you're spending again on sales and marketing and R&D?

Ryan Petersen

Let me take this one though I'd normally let Art answer on the op ex. Ultimately, again, our primary focus of the business is to gain as much market share as we can in the SSD segment. We're uniquely positioned due to our technology to take advantage of what's probably the fastest-growing market I can remember seeing. We think that making investments in R&D are critical to our success in the long-term, and we're focused on delivering long-term shareholder value, which really requires a substantial effort. Now, to that end, we will continue to invest in R&D as opportunities present themselves. Obviously, as an example the Solid Data acquisition was unplanned for, things along those lines. Technology investment just in terms of our R&D is a big focus area for us. And as opportunities come to us, we will not turn down opportunities based on additional costs. For example, selling to tier one OEMs you may need to station engineers within their factories, you may need to station sales people local to them. Those are investments in the future for us and obviously making those investments has provided an enormous ramp in not only revenue but in the revenue growth rate. So it would be unwise to do anything at this point other to just invest where necessary. Sorry to give you such a soft answer, but -

Alex Kurtz - Merriman Capital

I appreciate that Ryan, but is it safe to say that there's a little bit of op ex savings from shutting down memory but not to be offset by what you guys are talking about as far as op ex growth next year?

Arthur Knapp

That's correct, As I just stated on the product line P&L, some of those are allocated costs, so as we have memory sales, we have a sales rep that's selling there, those costs aren't going away because now that sales rep will be selling SSD type products. We do have some operating costs in Taiwan that are higher with memory products than with SSDs, which tend to be more automated. You saw announcements of expanding our factory in the SMT lines, so we'll have some labor cost savings there, but generally we're putting muscle back into the business.

Alex Kurtz - Merriman Capital

Last question, Art, I assume that on the higher volume that your SSD margins grew this quarter?

Arthur Knapp

Yes.

Operator

Our next questioner in queue is Rich Kugele with Needham and Company. Please go ahead.

Rich Kugele - Needham and Company

Just a few questions from me. First, on supply, can you talk about your availability for sufficient NAND as you ramp the DSSD business next fiscal year? And then for Art, on the gross margin side, now with DRAM out a little quicker than we expected, can you just talk about generically, for the full year perhaps, what your target gross margin for the blended company might be?

Ryan Petersen

On the supply channel side, because we have been among the few people using 22X or 25 nm NAND Flash, we have pretty good supply chain planned through the first half of the year. Obviously the second half there's been third party forecasts that there'll be oversupply in the second half of the year for NAND Flash, so we feel quite good about our availability of NAND Flash, the continuing price drops of NAND Flash and other drivers to the supply chain and to the SSD market in general. [inaudible] So we're feeling good and that's all based of course on the newest technology, 2X nm coming out, and additionally even 3 bit per cell for the consumer segment later in the year. And with that I'll go to Art on the -

Arthur Knapp

So Rich, I presume you're talking about fiscal '11, because we're not providing guidance at this point on the '12, so that basically means the fourth quarter. I would look for an uptick in our reported margins with the SSD business. We had, as Alex kind of alluded to in his question, we did see increased margins from SSDs this quarter. As always, our answer is it depends on the mix of some of the server products versus the enterprise, the enterprise having a higher margin. So depending on the sales mix, we can get a little bit of a different answer. But we are looking for improvement.

Rich Kugele - Needham and Company

And then just lastly, what were the unusual rebates related to that were excluded?

Ryan Petersen

So I can answer that one. At the end of the day, the unusual rebates that were excluded were essentially a fire sale on DRAM inventory, just to dump the DRAM inventory. I'm sure everybody's familiar that DRAM during the quarter dropped in cost as much as 30% in the market in general, so just reducing our inventory value or reducing our level of inventory was very important at the time, which was the prelude obviously to discontinuing the remaining DRAM business. All related to DRAM, so none of that relates ultimately to the SSD segment.

Operator

[Operator Instructions.] We do have a question from Steve Glass with STG Capital. Please go ahead.

Steve Glass - STG Capital

First of all, you mentioned in the press release that HSDL enabled IBIS is ramping in mass production quantities to select customers. When you say enabled, are those IBIS drives using HSDL? Are those customers using HSDL do we know?

Ryan Petersen

Yes, they are in fact. Unfortunately for us, IBIS only comes in HSDL. I guess that's the benefit of owning the technology behind it. So as IBIS is an HSDL-only product, it is shipping with HSDL, so yes, some strategic OEMs - this is your followup - some strategic OEMs are enabling or using HSDL in their systems, or planning to.

Steve Glass - STG Capital

That's great. And you guys have alluded to OEMs in the past, tier two as well as tier one, some of which I think you guys publically announced. Can you give me a sense of, are those tier twos, are they fully ramped? Are they still in the ramp phase?

Ryan Petersen

A number of tier twos are just beginning to ramp today. We had a lot of wins last year. We continue to get a lot of design wins in the tier two or the smaller, non-major OEM accounts. Many of them have not ramped at this point, and we are seeing increased traction but not near their annual forecast. So in meeting with them for year-end operating reviews on a calendar year basis, we do those, we've seen that a large amount of the ramp is really coming [inaudible] calendar 2011. So we do see significantly increased sales from quarter to quarter from those tier two clients.

Steve Glass - STG Capital

The tier one potential customers, my understanding is generally they do care about the balance sheet and probably the financing helps to expedite those discussions. How about the tier two? Is it also changing the tone of those discussions as well as creating new opportunities there as well?

Ryan Petersen

I think the tier twos are a little - I think the balance sheet itself is a little less important with tier twos, or in some cases it's not important at all to a tier two, depending on the size of the client. So unfortunately, no, but obviously we've had a lot of success with tier twos in the past. I would expect continued success on that front, with those clients.

Operator

And that appears to conclude our time for Q&A. I'd like to turn the program back over to Ryan Petersen for any closing or additional remarks.

Ryan Petersen

Well, thanks everybody for your questions. I just want to close with the fact that we feel very, very strong about our progress. We feel strong about the future. And we thank everybody for attending the call. We'll be presenting this Wednesday at the Needham conference, and I hope to see some of you there. Thank you.

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