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OCZ Technology Group, Inc. (NASDAQ:OCZ)

F2Q 2012 Earnings Call

October 5, 2011 5:00 PM ET

Executives

Bonnie Mott – IR Manager

Ryan Petersen – President and CEO

Arthur Knapp – CFO

Analysts

Alex Kurtz – Sterne Agee

Rich Kugele – Needham & Company

Aaron Rakers – Stifel Nicolaus

Arnab Chanda – ROTH Capital

Gary Mobley – Benchmark

Mitchell Sacks – Grand Slam

Operator

Good day ladies and gentlemen and welcome to the OCZ Technology’s Fiscal 2012 Second Quarter Earnings Conference Call. At this time all participants are in a listen-only mode. Later we’ll conduct a question-and-answer session and instructions will follow at that time. (Operator instructions) As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Ms Bonnie Mott, Investor Relations Manager. Ma’am, you may begin.

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 the information is presented as of October 5, 2011. Please keep in mind that while being made available for replay and listening after today, the information is current only as of today. 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 statement 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 it is now my pleasure to turn the call over to Ryan Petersen.

Ryan Petersen

Thanks, Bonnie and good day to everybody. We’re pleased with our achievements during this quarter. We had record revenue of $78.5 million in the second quarter, an increase of 106% over our second quarter of fiscal 2011.

SSD revenue for the second quarter reached a record $71.1 million, and increased 252% year-over-year. SSD products represented 91% of revenue versus 53% of revenue in the second quarter of 2011. We believe our recent revenue growth suggest significant momentum moving into the second half of the year. As this is our first year with predominantly SSD sales, up the core from normal protocol to give a bit of color on each of our revenue segments.

Enterprise class SSD revenue increased over 60% sequentially and represented almost 20% of our SSD sales during the quarter. This is due to increased enterprise and enterprise OEM activity towards the end of the quarter related to some of the winds we alluded to late last year. Based on our current progress with enterprise clients, our increasing visibility into this segment and keeping in mind the time lapse between design and revenue being generated, we’re confident in continued growth in this segment.

Server and high-performance products class SSD revenue as expected was slightly down sequentially and represented roughly 75% of our SSD sales during the quarter. It’s important to note, we believe that this trend suggests anotable gain in market share in this segment based on ordering patterns in August and September coupled with increasing demand for our server class product, we are confident in continued growth in this segment.

Consumer class SSDs increased about 70% sequentially and represented roughly 5% of our SSD sales during the quarter. We believe that this increase was a result of increased demand, very late in the quarter by laptop manufactures for Indilinx based SSDs and advance in the fall and holiday season in new product releases. We expect continued growth in this segment and higher than historical margins based on our continuing release of next generation Indilinx controllers.

In regards to our non-core power supply and other revenue, this segment increased 58% sequentially and represented about 9% of revenue. This is a result of increased orders for our PSU products exiting the quarter and is a signal of continuing demand in the distribution channel. To briefly explain the dynamic, PSU have long shipping times and are often ordered 8 to 12 weeks in advance of expected and customer demand by both distributors and PSU manufacturers. We have over, the past four quarters enabled to drive meaningful increases in our gross margins and I’d like to take a few moments to discuss our gross margins and the impacts on a go forward basis.

In the second quarter, GAAP gross margins were 21.6% versus 4.3% for the same quarter last year. And gross margins increased about 160 basis points over the 20% we reported in Q1. Though we don’t disclose segment margins, it’s important to note that the margins for SSDs are higher than our reported GAAP margins as the PSU and other categories carries well margins.

The gross margin increases for the quarter were led by a mix shift to higher margin SSD products and improved supply chain dynamics. I’d like to take a few minutes to focus on our margins and our supply chain.

As we previously discussed, we expect to see major improvements in our cost structure as we continue to shift our NAND flash purchasing from the stock market to buying directly from the manufacturer. We had previously reported that by the end of the fiscal year, our goal was to purchase about 75% of our NAND directly from the fab. We exited the quarter achieving that goal and are confident of being able to achieve the same on a quarterly run rate basis going forward.

We reported in the synchronous mode NAND used for our higher margin Vertex 3 high-performance products was in shortage. And it was limiting our ability to fill orders for these products. Exiting the quarter, this situation was fully resolved. And we expect to see reduced cost on synchronous mode NAND, as the cost increased worked their way through our supply chain.

In addition to the cost saving measures we had previously mentioned, in the second quarter we for the first time produced from vapor our own OCZ brands at NAND flash chips were used in our SSDs. This was enabled by a limited vapor purchasing arranged with a NAND flash fab. It’s worth mentioning that arrangements like this are driven by purchasing scale and that as we continue to grow, we expect to able to build similar partnerships. This is another step in our evolution plus vertical integration.

Processing Vapors and NAND flash IC provides a number of notable benefits for OCZ other than the obvious cost reductions including the ability to soar away from at the vapor level for higher performance, for higher endurance and reliability. The ability to build ultrahigh density flash ICs which are otherwise unavailable in the market. And the ability to produce flash ICs with extended temperature and environmental characteristics.

With that, I’d like to take some time to discuss our ongoing R&D efforts. During the quarter, we increased our R&D resources significantly allowing us to introduce major products and much better target enterprise data center and OEM clients. As you read in our earnings release, we incurred a significant increase in R&D expense with non-recurring charges of approximately $2.3 million. These were related primarily to R&D prototyping, intellectual property and other related expenses.

In addition, we saw R&D expense increases we invested in additional R&D resources, specifically the added headcount we commented in our last earnings call, along with a full quarter of expenses related to the Indilinx acquisition. Our experience identifying market trends and combined with these engineering resources, allow us to develop and bring high demand products to market on a short development cycle. This has been especially helpful in meeting the needs of OEM clients, many of whom require specialized products that are otherwise unavailable.

We plan to continue to invest in technology development and we believe our ability to deliver advanced technology has benefited OCZ thus far in the form of increasing margins and revenue growth. Further, we believe that our ongoing investments will continue to provide significant long term benefits in the form of risk reduction by increasing barrier centric and margin enhancements as we produce higher value products with a higher level of vertical integration. This has been clearly demonstrated as we have continued to deliver NexGen solutions to market well than advance of our competitors.

We’ve undertaken highly focused cost effective approaches to technology investment. And to that end, today we announced the acquisition of the UK based design team from TLX Technologies, along with access to substantial IT. We believe that this acquisition provides significant cost savings, specifically in regards to IP licensing which we would have otherwise incurred in the next 12 months.

More importantly, their important storage SOC and software teams can have an immediate impact on a roadmap by speeding our time to market with next generation PCIe and SATA based SSD controller solutions.

Moving on, some of our recent investments in controller technology are beginning to bear fruit. On our last earnings call, I said, we were on schedule for delivery of our next generation of our Indilinx controllers. And in July, we unveiled our Indilinx Everest SSD platform. Our success with this product is the evidence by its rapid adoption by laptop OEMs such as LG Electronics who we recently announced. We plan to implement Everest in our high-performance server and enterprise SSDs over the next year fiscal quarters. And we’ve already seen a considerable increase in sales of Indilinx based SSDs. We expect it overtime, Indilinx based SSDs will increase as a percentage of our total SSD sales.

In regards to our increased focus on OEMs and the enterprise segment, we’ve made significant strides in the past quarter to increase our competitive lead. Not just in terms of technology, but with an increased focus on sales and marketing to at least the same customer groups. With that, I’d like to describe some of the critical ongoing activities in this regards.

As we continue to target the enterprise and increase our sales into OEM clients, it’s key that we build an extensive deal sales and support network. To that end, we’ve expanded our field sales and field engineering teams in North America to include regional sales and support teams in areas where we have considerable concentration of activity, including places like Houston, Austin, Seattle, Minneapolis, Los Angeles, Boston, Washington DC and New York City. We continue to make substantial marketing efforts with our new products, which are clearly more enterprise focused and have increased our presence at industry trade shows, such as storage for networking, world and flash memory summits.

For example, at recent trade shows we displayed, NexGen, the next generation of OCZ power servers and storage rays with a few of our OEM partners such as Quanta Computers, Cloud Computing Division, ZT Systems, SGI, CR Attack, Colfax and Supermicro. It’s important to note that the launch of OCZ equipped products denotes the beginning of the products adoption cycle by their customers.

Additionally, due to our growing direct sales force during the quarter, we were able to increase our outbound sales at jeopardy and target a widening group of customers. We received initial orders from more than four times the number of new clients than we received in our first quarter this year. It’s worth noting that our recent increase in enterprise sales is related to our efforts over the last three quarters. And we continue to see positive momentum both with OEMs and with direct enterprise accounts, which is evidenced by our 60% plus sequential revenue growth in our enterprise SSD category.

With that said, I’d like to take a moment to cover our product expansion into the enterprise. In August, we launched our answer to the promise facing with the data center today in the form of Z-Drive R4 PCIe storage solutions. They provide the highest performance of any PCIe based mass storage device with about 500,000 4k random IOPS per logical unit. I’ll spare you the full technical details instead focus on what their parties have to say about the R4.

As background information OCZ provided the Z-Drive R4 to a number of third party independent product reviewers for side by side comparisons with competing PCIe SSD solutions. I’d like to read a few quotes from those comparisons. Storage review, “No other enterprise PCIe SSD can hold the candles in the OCZ Z-Drive R4. OCZ has redefined the art of blending hardware with software for a masterful enterprise SSD.”

Part Hardware commented “OCZ has designed yet another ground breaking SSD product with the Z-Drive R4. It’s the kind of product that you’ll leave some of the players like Fusion-IO, Micron and LSI rather uncomfortable.”

And SSD review commented, “The Fusion-IO Drive was in fact the only comparable product that we thought could offer competition to the Z-Drive R4, which shows our reasoning behind such a comparison review. As for our final call, it has to be the OCZ’s Z-Drive R4 by KO.”

Given the accolades, we believe we’re well positioned to capitalize on increased demand for high-performance PCIe based storage. We’ve had unprecedented demand for evaluation of samples. And based on initial feedback, we’re confident this will become a substantial product for OCZ, over probably the next 6 to 18 months.

Outside PCIe, SATA is also noted as one of the fasted growing interfaces for market researchers. During the quarter, we released a refresh of our Talos SAS 6 gigabyte SSD with our proprietary – delivers even greater performance than before for SAS based storage infrastructures. It’s designed for enterprise applications with mixed workloads. Now we continue to see increased demand for SAS based products specifically in the higher densities such as 1 and 2 Terabytes per drive.

Our new products serve to expand our presence into the enterprise segment. We recently have seen initial shipments directly or through OEMs into more than 10 major data centers. These are for the last generation of enterprise SSDs including products like Velo-Drive Drive PCIe SSD and the Deneva series of SAS and SATA drives. As our customers continue building out their deployments, we expect sales into the data center will ramp significantly. It’s worth reminding everyone. These NANDs are being deployed off and after 6 to 12 months of extensive enterprise testing and qualification, they often take multiple quarters to deploy into substantial quantity. To put our progress in perspective, just nine months ago, our only major data center client was Yahoo!

In addition to our enterprise products, this quarter, we did introduce several products to the high-performance and server markets. We launched for example the RevoDrive 3 and the RevoDrive 3X tube line of PCIe’s deals. They’re designed to deliver maximum throughput and extensive multithreaded workstation applications. And the incorporate and advanced data management feature sets providing both the performance and the features required for high-performance computing and content creation.

Of particular importance this quarter, we released the RevoDrive Hybrid PCIe storage solution utilizing a combination of SSD and Hard Disk Drive technology in partnership with Toshiba. This product is a revolutionary step forward in Hybrid technology, enabling performance in SMT applications of over 100,000 IOPS per LUN at a price of less than $0.50 per gigabyte, the lowest price per gigabyte of any high-performance storage solution in the market.

The RevoDrive Hybrid is expected to begin shipping in the third fiscal quarter. Now, it’s key to understand the Revo Hybrid reaches a new client group for OCZ, the small to medium enterprise. This market has yet to see any significant penetration from SSDs primarily due to their high cost. The Revo Hybrid offers true server clients at these speeds on a PCIe based device at a fraction of the cost of a typical SSD or even a fraction of the cost of a high-performance hard drive based direct.

Now, to move on to manufacturing and operations, in July we discussed our plans to continue our manufacturing expansion. We’re on track to double our manufacturing capacity during the third quarter to about $140 million per quarter in revenue at an average utilization rate of below 60%. We expect the manufacturing capacity will no longer be a constraint for us these days.

In conclusion, we would like to reiterate our commitment to the design and manufacture of innovative solicited drive solutions that address the storage challenges facing our customers. And we continue to deliver the best and brief products with the highest performance, reliability and the most robust feature sets to the whole of our customer group.

Now, prior to turning the call over to Art, for a financial overview, I’d like to make a few comments, really on where we’ve come from and where we’re going.

First, unlike our publicly traded SSD peers, OCZ was not a purpose built enterprise SSD company. Last year we set out to do what might have seemed improbable if not impossible, transition completely away from our 9-digit D-Ram business to focus on SSDs while simultaneously growing revenue. Now, we’re proud of our progress. And we thank our shareholders for supporting this transition. Today, we sell more SSDs than just about any other company in the world. And we’re undertaking the transition to becoming a predominantly enterprise focused company, exactly as we told investors we’re going to do.

Second, after closing the PLX asset purchase and hiring their team, we’ll have about 200 people in R&D, that’s roughly one third of our workforce. If I remove the headcount related to manufacturing operations, I believe, it’s over half of our workforce. OCZ’s commitment to expanding on its technology leadership could not be clearer.

Third, when thinking about the future of OCZ, investors should be most – that server enterprise OEM qualification cycles average between 6 months and well, over a year. We’re for example, just now beginning to deliver enterprise growth based on some initial OEM and enterprise order for our Deneva and Beulah Drives which we sampled in 2010. Given the orders we’re now receiving, the recent demand for samples of our new products and the products that we have in our development pipeline, we feel highly confident about our position and about the value that we can create for shareholders going forward.

Last, because there is a considerable amount of misinformation about our customer winds in the market. I’m going to depart from our normal operating procedure and set the record straight. In the absence of this type of misinformation in the future, this isn’t something we’re going to be doing. Now, either directly or through OEMs, OCZ SSDs have recently been deployed to enterprise and data center clients such as AOL, eBay, SAP, Prudential, Marketwire, EdgeCast, ASK.Com, NTT DOCOMO, South Korean Telecom, Boxel, Boeing, Chevron, Carbonite, Honda, Bloomberg.

In regards to our OEM partners, we’ve grown the list substantially in recent months. Our partners include companies such as Dell and HP, SGI, Quanta Cloud Computing, Supermicro, Panzura, Tegile, Astute Networks, Penguin Computing, Wistron, JVL, Flextronics. Now, these are not intended to be and are not at all inclusive list, it’s simply an example of some of our early deployments. It’s worth noting that the majority of these customers are at the very beginning of their deployment in sales cycles, which often takes several quarters to ramp. But over a period of time, they could result in pretty significant growth.

Now, we’re proud of our achievements so far. But mostly, we’re focused on our future. And we’re going to continue to pursue the opportunity before us as aggressively as we have in the past.

Now, I’m going to turn things over to Art I guess for a financial overview. Art, please?

Arthur Knapp

Thanks Ryan, great job. As Ryan mentioned, we’re very pleased with the continued business progress this quarter. Ryan covered the segment revenues, so I will just add a little additional information regarding revenue by geographies and detailed financials and guidance.

Looking at the second quarter revenue by major geographic areas based on shipping destination, North America grew 36% year-over-year representing 33% of revenue. EMEA grew 189% and accounted for 53% of revenue, the rest of world grew 139% representing 14% of revenue. On a sequential basis, revenue from North America grew to 24% primarily due to 20% higher SSD revenues. EMEA grew 2% and the rest of the world declined 10%.

Turning to the detailed financials GAAP gross margins were 21.6% for the second quarter versus GAAP gross margins of 4.3% a year ago and 20% in Q1. As Ryan mentioned, this improvement was driven by the mixed shift to our enterprise products and purchasing efficiencies. You heard Ryan describe that we achieved our goal of a 75% mix of direct purchases, so this will help our margins on a go-forward basis.

Our operating expenses were $18.9 million on a GAAP basis and $18.1 million on a non-GAAP basis, after adjustments for costs associated with stock based compensation. This $18.1 million compared to $10 million of non-GAAP operating expenses in Q2 last year and $13.7 million in Q1.

Within OpEx, non-GAAP R&D cost increased 71% sequentially and 319 % from last year. As stated on our last call, we have doubled our engineering staff in the end of our fiscal year and we continue to hire detail in the second quarter. In addition Q2 includes a significant increase in R&D expense including approximately $2.3 million related primarily to R&D prototyping, intellectual property and other specific engineering projects which are not reflected as R&D expense on a run rate basis. Also Q2 represented a full quarter of expenses related to the March Indilinx acquisition.

Sales and marketing costs increased 30% on a sequential basis and 58% from last year, reflecting our comments last quarter on increasing these efforts to address enterprise sales opportunities and the increased revenue levels.

G&A and operations increased by only 4% sequentially, reflecting some economies of scale as the sequential cost increases noted above represented key investments in our business areas of technology and sales. With the acquisition of the UK Design team, we will see additional operating cost of approximately $2.2 million to $2.4 million per quarter. This will mostly be R&D cost as about 40 of the nearly 45 people we expect to add are engineering related. But these costs will offset plan future expenditures over the next year or so plus we gain the market advantage of an assembled workforce and IP access. We are very excited about the addition of this experienced team to the existing OCZ technical resources.

Our financing costs decreased by 65% from last year and 57% from Q1. During the first six months of fiscal 2012, we’ve repaid a total of $25 million of debt for our loans and those assumed by the Indilinx acquisition.

The fair value adjustment of warrants issued with our initial equity financing in Q1 last year resulted in a $5.4 million non-cash gain, principally due to a lower stock price, which of course makes the warrants less valuable. This theoretical non-cash adjustment is removed as part of the non-GAAP presentation.

GAAP net income for the quarter was $3.2 million or $0.06 per share compared to a net loss of $7.6 million or a loss of $0.29 per share in last year’s second quarter. On a non-GAAP basis, we showed a net loss of $1.4 million or $0.03 per share versus a net loss of $9.7 million or $0.36 per share last year.

Included in today’s financial release is a table, which shows the reconciliation of the GAAP to non-GAAP measures as well as related calculations. Turning to the Q2 balance sheet, our cash was approximately $46 million, a decrease of $19 million from Q1 as we invested in growing our inventory levels which increased by $24 million to $59 million compared to $35 million in Q1 and only $15 million a year ago. This is a strategic move for us to have available levels to support the future business.

That’s further evidence of improved vendor relations our prior $1.3 million of LCs granted to vendors were returned during the quarter, so the current restricted cash of $62,000 nearly represents the Letter of Credit in connection with our August lease renewal at our corporate headquarters in San Jose, providing the additional floor space needed to house our expansion.

Our receivable days increased slightly to 51 versus 46 in Q1. Inventory days were 76 versus 52 with a strategic inventory increase above and payable days were 75 versus 67 in Q1, and 85 in the year ago quarter.

Our CapEx for Q2 was $600,000, making a total of approximately $1.8 million invested in the past three quarters, mostly related to factory expansion with SMT machines and other related items. We expect that our equipment-related CapEx investment will continue at these levels as we invest in continued expansion through fiscal ‘12.

For our shares outstanding, we now have approximately 51.7 million shares outstanding and 9 million shares subject to warrants and options. Diluted shares are estimated to be approximately 55 million for Q3 at the current price levels.

Turning to guidance, we previously raised our revenue guidance for fiscal year ‘12 to be in the range of $310 million to $345 million. We are now raising that guidance to a range of 320 million to 350 million. Since the first six months accounted for about 152 million, the second half of the year would be in the range of 168 million to 198 million.

Last quarter, we raised our long-term gross margin target from between 28% and 32% to between 30% and 40%. We believe due to recent developments, we expect gross margins to reach the target model during the latter part of the next fiscal year.

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

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Alex Kurtz from Sterne Agee.

Alex Kurtz – Sterne Agee

Yeah, thanks for taking the question guys. You know, Ryan, congratulations on the quarter. If I look back to last quarter, you talked about 60% to 70% of your revenue coming in the second quarter. If I just do the math, it looks like you know, you’re going to be north of 380, yet you guide below that. How should we think about how you guys are guiding in the next two quarters, is that just a conservative estimate?

Ryan Petersen

You know, Alex, you’re very good in maths and I’m not exactly sure how I’m supposed to comment. I do believe that we talked about on a historical basis, the majority of our revenue of course occurring in the second half of the year. You know, that’s about all I can think.

Arthur Knapp

If you still stand by, I’m sorry.

Alex Kurtz – Sterne Agee

If you still standby that 60% to 70% range.

Arthur Knapp

It builds with the historical numbers so those are factual numbers.

Alex Kurtz – Sterne Agee

And then, my second question. You know, you guys put an K-K last Friday evening about a change of control provisions about the company with the senior executive. I know that was somewhat timed around the shareholder vote. But you didn’t have one before. So, what’s the board thinking has something changed along those lines, if you can comment at all?

Arthur Knapp

No, I really can’t comment on that.

Alex Kurtz – Sterne Agee

All right. And then, last question from me here. Can you just talk about how we should think about OpEx on a normalized basis, I know there is this 2.3 onetime charge and also you just acquired some new engineers. Can you give us some guidance on OpEx going forward?

Arthur Knapp

You know, we haven’t really officially adopted that. But what I was trying to do was, you know, put some parameters around. And we think we had some, you know, unusual R&D expenses even, you know, despite our focus on increasing R&D. But then, we’re also, you know, almost offsetting that with the PLX design team acquisition. You know, we said we had 2.3 of maybe unusual but I’m guiding 2.2 to 2.4 of additional expenses coming in with the PLX. We didn’t see anything unusual for our sales and marketing or the G&A line.

Alex Kurtz – Sterne Agee

The 2.2 to 2.4 for PLX going forward on a quarterly basis?

Arthur Knapp

Correct, correct.

Alex Kurtz – Sterne Agee

Okay.

Ryan Petersen

I expect that acquisition to close some time in October. So, you know, you have a partial quarter something like, at the Indilinx acquisition earlier in the year.

Alex Kurtz – Sterne Agee

All right, thanks guys. I’ll jump in the queue.

Operator

Thank you. Our next question comes from Rich Kugele from Needham & Company.

Rich Kugele – Needham & Company

Thank you, good afternoon and well done. Just a couple of questions, I guess first PLX. Can you just talk about where PLX has been successful that drew you to this design team, what IP if you can be specific, are you getting access? And then, I’ve got a follow-up.

Ryan Petersen

So, I guess they’ll take that one. I mean, to be specific, we plan typically as part of our basic design strategy to license things like CPU cores, SATA cores, rate cores, things along those lines, AES, scramblers, compression cores from third parties. And because of the design teams experience and the amount of IP that they’ve built up historically, you know, obviously we’re attracted to them. I would guess that the IP that we’ve picked up is worth substantially more to OCZ given what we have to license it out for. And you know, it’s a win-win situation I think in both sides of the idea.

Rich Kugele – Needham & Company

So, you’ve dealt with PLX in the past?

Ryan Petersen

Well, we do use some PLX ICs and some of our PCIe products.

Rich Kugele – Needham & Company

Okay. And can you talk about how much this is costing?

Arthur Knapp

I don’t know if we’re going to comment on that. But I think we said it was immaterial.

Ryan Petersen

Okay, yeah, we said it was relatively immaterial amount, its several million dollars. We’re trying to deferring with PLX as they’re appearing in an investor conference tomorrow. And we want to let them describe it first.

Rich Kugele – Needham & Company

Okay. And then, you know, as your mix does change towards different types of enterprise solutions and then even consumer solutions that are high margin. What do you think is the best way to look at the business in the future? Do you think it’s better on the interface basis between, you know, PCIe, SAS, SATA? And then, can you give any color on maybe as you’ve been increasing your full year guidance twice now. Where would you expect the greatest difference in revenue to come from, you know, is it primarily PCIe based, is it primarily SAS or SATA data center, any color there?

Ryan Petersen

I think that there is a lot of inputs so it’s hard to give specific guidance. You know, often, not that we would give specific guidance on items like that. But you have to keep in mind that with the Indilinx acquisition, with our historically strong market share or historically strong position in the high-performance and server markets, it’s hard to tell that any specific market is going to grow faster than another, given that our overall which is going in all markets so quickly. And so we end up with those kind of three input areas. If you really want to look at detail, you’d want to maybe focus in on our successful PCIe and how that affects our enterprise margins on a standalone basis.

But again we’re not going to comment specifically, I think we told everybody that we expect our PCIe margin in the enterprise segment to be in the 50 plus percent range or I’m not sure what the exact comment is but at least. And obviously SAS and SATA enterprise drives are much lower. So, you know, there is a lot of moving parts I guess what I’m trying to say. We do have some – we have some clarity, we’re just not guiding on it.

Rich Kugele – Needham & Company

Okay. The last is, you did talk about, on the server and data center side that you felt that you were gaining share. Do you think that that’s against other SSD companies or you’re just talking about gaining, you know, slot share, how are you referring to that?

Ryan Petersen

Well, I mean, yes. Again, it’s hard to give you an answer. A number of the enterprise that we’re selling to now have only deployed up to the SSDs. So, you’re moving from the hard drive segment with these new products though. And you have to keep in mind, this cycle started a long time ago. Some of these clients starting demoting products as early as 2008 and they’re just buying now. So, and you know, most in 2010, so it’s typically you know, six months to a year, between when we first sample and then they buy the product. So, a year ago, there just wasn’t a whole bunch of data center business to be had. And now, we’re deploying all the new products in sample form to these clients. And obviously, we think that we are well positioned to win business from our competitors for those who already have I guess deployed at this stage. So, I’m trying to give you the answer but it’s a little difficult given the number of clients.

Rich Kugele – Needham & Company

It’s okay. Thank you very much and congratulations.

Ryan Petersen

Thanks.

Operator

Thank you. Our next question comes from Aaron Rakers from Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

Yeah, thanks guys, sorry about the background noise. You know, first question, I know that you guys have commented on gross margin attaining you target model in the second half of fiscal 2013. You’ve also provided in the past the 15% to 20% operating margin target. Given the puts and takes in the operating expense line with the acquisition of PLX and R&D. Are you also telling us that you expect to be operating at that level on operating margin basis, if not, when do you expect to attain that target?

Ryan Petersen

I think if we mention the segment of the target model, the only things we’ve changed are the segments that we talked about. So, obviously there is some offsetting going. So, I don’t know that we’re updating the operating margin, the operating profit guidance.

Aaron Rakers – Stifel Nicolaus

So, that’s still a two to three year target?

Arthur Knapp

Right. This is Art, yes, that’s correct. Ryan mentioned that the extra PLX spending that we will have basically offsets future planned expenditures that we have. And we think there’ll be some cost savings related to some of the IP access we have. So, longer term, you know, those targets still hold.

Aaron Rakers – Stifel Nicolaus

Okay. And then, other question on, you know, two on the PCIe market opportunity. You had noted, you know, 10 major data centers, you know, now deploying products or looking to deploy products. You know, at what stage would you say that deployments are at, you know, in those customers. Are we just kind of towing the water right now and if so how do we think about that ramp? And I think in the past you have talked about very large opportunities in the market, can you update us on what you’re seeing today?

Ryan Petersen

I gave you, I did give a list of all the guidance we would basically. I went through the list of data centers, who have recently deployed. And by recently we mean in maybe the last 60 to 90 days. And those are beginning, its’ to the beginning of the cycle as I think I stated. What we mean is that we should expect obviously to grow rapidly, that is not the 10 new clients, those are very early in this stage, those are our 10 additional clients themselves.

Aaron Rakers – Stifel Nicolaus

In your sense Ryan, on the side of the opportunities that you see in the market. I know you’ve talked about very large, you know, $100 million plus if not larger than that opportunities that you see in the pipeline?

Ryan Petersen

Yeah, I think there opportunities, they’re not changing in ties. And in fact there are more opportunities today. The question comes down to when do they start buying and how quickly do they ramp and more –

Arthur Knapp

But yes.

Ryan Petersen

But obviously we’re starting now, keep in mind, a year ago we had, I’m sorry the 10 data center plans which I talked about, I’m looking back on my notes here. World clients who are currently deployed, it’s not the same as the list that I listed the names. So, obviously we think that there are, even if there are small deployments or they’re ramping slowing or if there is a significant amount of business to be had in the data center for us.

Aaron Rakers – Stifel Nicolaus

Right, right. And then, the final question. Ryan, you had alluded the expansion of your direct sales force. And I think you made the comment for that increase in the amount of, correct me if I’m wrong, I think the amount of business that you’re doing on a direct basis or opportunities out there. Can you update us on what is the size of your direct sales force now is and how we should expect or look to see that expand going forward?

Ryan Petersen

I think we probably, you can look at we built probably close to 20 kind of direct sales or because some of them are in the San Francisco Bay area by about 20 additional direct sales, not including the support staff.

Aaron Rakers – Stifel Nicolaus

And the growth in that has been what?

Ryan Petersen

The growth in the probably 70% 80% year-on-year just in the direct reps.

Aaron Rakers – Stifel Nicolaus

Okay, thanks a lot.

Ryan Petersen

You know, obviously we’ve guys got the whole sales force that represented us.

Arthur Knapp

That’s actually during the year.

Ryan Petersen

Yeah, I’m sorry, it’s our last fiscal year.

Arthur Knapp

You know, the February fiscal year end it’s up about 75%.

Aaron Rakers – Stifel Nicolaus

Okay, thanks and congratulations.

Operator

Thank you. Our next question comes from Arnab Chanda from ROTH Capital.

Arnab Chanda – ROTH Capital

Thank you, couple of questions, maybe one for Ryan and one for Art. First Ryan, if you could talk a little bit about your PCI Express product that you just announced, it’s been getting some pretty good reviews. What do you think is the ramp of that product? Do you think there is, you know, do you think it’s going to go straight to retail or are you getting enterprise engagements and what kind of time frame could we see that being a significant part of your revenues?

Ryan Petersen

I mean, so the enterprise products are not available in retail nor would we be foolish enough to try to sell those in retails. They do find their way they’re often through some of our distribution clients. So, what you generally see in terms of new product through ramp, it can be really expressed by looking at the Velo-Drive. We started to ship to major enterprises, the Velo-Drive really at the very end of second quarter. The Velo-Drive, the version that we shipped OEMs that would be low, the name is known under for channel. The original Velo-Drive started sampling I believe, November-ish of last year.

So, you see kind of sample revenue come in and we see very small clients deploying through the channel. And then you tend to see the big enterprise deployments you know, 9 months later typically. So that’s generally what we’d expect to see with these Z-Drive R4. And then, you know, if you want to look at. Go ahead, sorry.

Arnab Chanda – ROTH Capital

Art or even Ryan, either one. So, you know, just wanted to ask you just a question on your margin structure. So, obviously your gross margins have gone up for three quarters in a row as you had predicted. However your R&D has almost tripled if you look at the run rate. Are we likely to see more step up before you kind of see the, you know, sort of the benefits of the revenues and margins coming through because your operating margin kind of went backwards last quarter. I just wanted to see if this is a onetime kind of opportunity that you saw or should we continue to see ramps in OpEx in the next couple of quarters or so?

Ryan Petersen

So, I’m sorry, I thought we were abundantly clear that we expect to continue to spend fairly focused amount but more on R&D as we try to establish ourselves as the premier enterprise player. Also building a direct sales force on all our competitors where you’re selling directly into the enterprise obviously requires some investment. Now that being said, we can plan the expense but we can’t guarantee any wins based on an OEM past month. So, you know, presumably the margin upside more than makes up for the expense.

Arnab Chanda – ROTH Capital

Yeah, I understand that. But my question was more specific. You know, you’ve basically tripled your R&D expense year-over-year. I’m just wondering, is the rate now where you should see R&D as a percent of revenue to go down as revenues go up or do you think this is – so in other words R&D is going to grow, is it going to grow up faster or slower than revenues in the near future?

Ryan Petersen

Well, there is $2.4 million of what we would call non reoccurring expenses and then we’ve just added a couple of million dollars a quarter of R&D expense of PLX acquisition. So, I would guess that it’s going to start at that point because of the magnitude not really be increasing as a percentage of revenue. And I’ll refer you kind of back to our operating model long term. The only things that have changed in the long-term operating model were we expect our margin to be pulled down. And obviously the revenue guidance has increased. So, on a larger basis, it should be the same, I’m sorry, I don’t have that chart in front of me or might be.

Arthur Knapp

Well, you know, when we talked about this past quarter sequentially, you know, basically G&A obviously were flat. And the $4.5 million of increased spending on a non-GAAP basis, you know, excluding the acquisition charges last quarter. It was basically, you know, two thirds of it was in engineering, $3 million and $1.5 million in our sales and marketing, both positioning us for future growth. As Ryan described on the R&D side, there was some that we though wouldn’t re-occur but then we are building more muscle with the PLX team. And the sales and marketing, as he described with the ramp of our enterprise sales people that that accounted for that kind of increase. But we are trying to have expenses grow slightly less than revenue going forward. Combined that with the margin expansion that we see on the products, and that produces some nice operating leverage for our model.

Arnab Chanda – ROTH Capital

Okay, thank you.

Operator

Thank you. Our next question comes from Gary Mobley from Benchmark.

Gary Mobley – Benchmark

If I read correctly, there is going to be some products associated with the acquisition you’re announcing today. And if that’s true, what kind of revenue contribution that we expect when the deals close in October?

Ryan Petersen

I’m sorry, there are no, there is no, we’re not taking any of the products related to the PLX.

Gary Mobley – Benchmark

Okay.

Ryan Petersen

We’re getting IP.

Gary Mobley – Benchmark

I’m assuming this team that you’re, as you buy 40% team of engineers is coming from the Oxford Semiconductor acquisition PLX made in 2009 at that time that product was described to be in the consumer oriented storage SOC. I’m just wondering if the market focus has changed since then?

Ryan Petersen

Well, I don’t know if you mean ours or theirs. We obviously have no designs on the consumer market. This is something to understand about the nature of the IP that we picked up it’s generally related to things like SATA interfaces and CPUs. And pieces that we have to pay a third party for, for licensing fees, like synopsis, C-Bay Cadence, those are armed. Those are people we’ll license product from all the time. So, the majority that IP just reduces our IP licensing fee when related to all classes of SSD controllers on a go forward basis.

Gary Mobley – Benchmark

Okay.

Ryan Petersen

But, you know, so you can kind of guess, I bought that information, I’m guessing most of the IP was related to Oxford deal.

Arthur Knapp

But the people on the projects will work on.

Ryan Petersen

Yeah, the people obviously on the projects here are going to work on a current what happen, help to speed that along.

Gary Mobley – Benchmark

Okay. And Ralph Schmitt, the CEO of PLX was recently appointed to your board. What can you tell us to assure us that this deal was done in Arms link?

Ryan Petersen

Well, Ralph did recluse himself from the deal on both sides. So, it was a negotiated between of course independent parties versus independent committees on both ends.

Gary Mobley – Benchmark

Okay.

Arthur Knapp

You’ll notice the deal was signed by the two CFOs so we you know, kind of keep the board member involvement to a minimum.

Ryan Petersen

And you know, even to go further it’s also a fairly immaterial amount of money involved.

Gary Mobley – Benchmark

Sure, point taken. Now, on your delta in your R&D expense, in the extraordinary amount as it’s described the $2.3 million. You mentioned that was prototyping and intellectual property related. But I mean, prototyping is got to be, you know, part of your day to day business. So, I’m just hoping that maybe you can.

Ryan Petersen

Unusual, I’m sorry. We may have said more clearly, unusual prototyping. So, specifically, you know, for example, we may enter into high cost production for fast run chips to get a product utterly and things like that so those type of things. You could amortize them, we’ve chosen to expense them.

Gary Mobley – Benchmark

All right, very good, thanks again.

Ryan Petersen

And IP, as IP, we’re just buying at it, so I mean, we’re pretty clear what that is.

Arthur Knapp

Well and the amount of product rollout we had.

Ryan Petersen

Yeah, so keep that, yeah. So, keep in mind we rolled out probably four very, you know, very much next generation products that are fantastic products we think. Those costs are pretty much associated with the products we sell.

Gary Mobley – Benchmark

All right, thank you guys.

Ryan Petersen

No problem.

Operator

Thank you. Our next question comes from Mitchell Sacks from Grand Slam.

Mitchell Sacks – Grand Slam

Hey guys, great quarter. Can you talk a little bit about the Indilinx deal and how that’s helping you in terms of both on the margin side and on the sales growth side?

Ryan Petersen

Sure. I mean, I’m not sure we’re going to specify. I can reiterate that we said as we roll out the products, we’d kind of see a 2% to 4% margin improvement. We obviously control that the Everest product. We’ve got a win very early from LG Electronics laptop market. We’re not a big focus area but we will rule that out through the rest of our product the Everest chips. And we think that you know, clearly it’s higher profit margin when you’re producing your own chips.

Mitchell Sacks – Grand Slam

Yeah, is there anything you can do strategically with it also to help the business or is it you know, it is purely just a margin item?

Ryan Petersen

Strategically, yeah, I mean, we get a control our own firmware, our own SOCs. So it’s supremely important to our business and in terms of doing things like offering customized firmware to large OEMs which they often require. Now, we had some limited ability to do that before. But we couldn’t make special silicon to meet the needs of a huge enterprise for example, now we can.

Mitchell Sacks – Grand Slam

Okay, thanks.

Ryan Petersen

Yep.

Operator

Thank you. Our next question comes from Alex Kurtz from Sterne Agee.

Alex Kurtz – Sterne Agee

Yeah, thanks, just a quick follow up, Art. You’re looking into next year’s tax rate on non-GAAP basis. Can you provide us any kind of, you know, any kind of idea, you know, are you going to pay any taxes at all. Are we potentially going into 20% taxes next year, how should we think about that?

Arthur Knapp

It’s kind of similar to last quarter’s commentary where there is you know, some minimum taxes that we have to pay, the alternative minimum tax and the hiatus in the California tax rate. But you know, those are nominal I think we have some people use 10% as calculations for those until we go through 30 some million of NOLs and we have build up. So, you know, you have to run your own models. So, when you think we hit that level.

Alex Kurtz – Sterne Agee

Right, okay. Thanks guys.

Operator

Thank you. Our next question comes from Rich Kugele from Needham & Company.

Rich Kugele – Needham & Company

Thank you, just a couple of follow-ups for me. Just first, on the micron deal, with the wafer deal, do you expect that to be going forward thing, is that just there were some wafers available now? And then, in terms of your own factory expansion, are you doing this wafer chip packaging or are you doing that yourself in your factor or is it a third party doing it?

Ryan Petersen

Well, it’s a two part I guess question, to give you an idea. So, the wafer and it’s usually a very, very big companies who consume, you know, massive amounts of NAND Flash are able to work themselves into strategic partnerships with fabs like this one. Our rapid growth has kind of got us be interested in early stage for a company like us. I mean I could only think of a few companies, a handful of companies that are able to access their wafers from the fabs. So, this has been limited for us. And we think that we’re going to be able to rule that out across our products, fairly aggressively in the next year.

Now that being said, obviously, we have a lot of technology related to our old D-Ram business where we’re able to do it fairly effectively due to our experience. We however do no handle the actual packaging, we do outsource that. We do all of the kind of process and design related work. Though, given the volume that we’re doing and the volume of flash that we’re consuming, I think on a go forward basis that may not always be the case, just because of the magnitude of our flash purchases. And in here I think I said a bunch of things but I got to reiterate that this is really key to having lower cost in all of our competitors, frankly on an ongoing basis.

Rich Kugele – Needham & Company

So, if you had the rank order, the impacts to or the reasons why the gross margin is able to come, you’re able to hit that target margin so much earlier between mix or between the overall revenue level or procurement. How would you rank them?

Ryan Petersen

Wow, I think mix has always got to be highly important just because, you know, we’re mixing like the R4 but very high margins. And secondarily, wafer kind of processing is a big deal for us. It does substantially lower our price, specifically on high density parts and ultrahigh density parts. And that’s a very substantial impact on our margin. You have to compare it to other people, and I’m sure you know who I’m talking about, who’ll work with fabs in this way. And kind of look at how that’s affected their cost structure, to get an idea. Now, this may roll out over several years obviously. So, it’s not at all going to impact us today. But we feel it sets us up well for the future. The fact that we’re able to have a wafer deals at all, given that you know, our current run rate.

Rich Kugele – Needham & Company

Okay, great. That’s helpful, thank you.

Ryan Petersen

Thank you.

Operator

Thank you. I would now like to hand the conference back over to Mr. Ryan Petersen for any closing remarks.

Ryan Petersen

Well, I’d like to thank everybody for coming on the call today. We’re very happy about the position that we’re in. And we’re very excited about the direction that we’re heading. With that, I’m going to bid everyone adieu. And I hope to see you at our next earnings call. Thanks.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes our program for today. You may all disconnect. And have a wonderful day.

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