Violin Memory: Stranger Things Have Happened... Right?

| About: Violin Memory, (VMEM)


VMEM's Q1 didn't show much progress in terms of revenue, but CEO commentary implied some hope.

But an unexplained, and substantial, miss relative to gross margin guidance doesn't help confidence.

The company is down to about three quarters' worth of cash, so a turnaround needs to take hold quickly.

All told, I still think the impact of Violin's condition on the sales process will be too big an obstacle to overcome.

I was curious as to how the market would react to Violin Memory's (NYSE:VMEM) fiscal first quarter results because there was a bit of a good news/bad news split in both the numbers and the commentary on the Q1 conference call. Shares had gained 15.3% during the day on Tuesday, ahead of the after-hours release, as traders continue to pile into questionably solvent stocks ahead of earnings. (Aeropostale (NYSE:ARO), bebe stores (NASDAQ:BEBE) and Thompson Creek Metals (OTCQX:TCPTF) have all seen similar moves in the last few months - and I'm sure there are others I'm forgetting.)

On Wednesday, the market basically unwound those gains, taking shares down 9.5%. VMEM has slid another ~1% as of this writing Thursday, back to $0.33, and back near all-time lows. And that seems about right. I didn't see much in the way of good news in the quarter - but there was just enough for VMEM to keep being seen as a potential lottery ticket.

Still Some Hope

Don't get me wrong: I still believe strongly that Violin will wind up in some sort of restructuring that wipes out the equity. Of course, that doesn't necessarily imply a zero share price at the moment - the equity can't drop below zero, which is part of the fun here. Even a 10% chance of VMEM surviving and reaching $4 theoretically should support the current share price, and then some. As long as upside is material, a narrow chance of survival supports some value in the stock.

It appeared Violin CEO Kevin DeNuccio was trying to nurse that bull case, particularly on the Q1 call. If bulls were looking for something on which to base their hopes, it was probably this quote:

The nature of our enterprise base and the size of the rollout by definition is a forecasting challenge and also most likely means we won't build our revenue growth incrementally, but we will break out in a given quarter.

That is the bull case right now: that Violin's Flash Storage Platform can drive enough adoption to create a hockey-stick-type recovery in revenue. And to drive that type of rebound, Violin is focusing on major accounts. DeNuccio said Violin had 10 members of the Fortune 100 as customers and cited a major Q1 win with an insurance company in that group - which drove over 10% of revenue in the quarter - as an example of what Violin hoped to achieve going forward.

Meanwhile, Violin continues to work on the partnerships announced as a happy byproduct of its "strategic alternatives" review in fiscal Q4. A tie-up with a software maker will deliver a VDI (virtual desktop infrastructure) solution built on Violin arrays. Another OEM relationship "continues to move forward," per DeNuccio. The CEO also gave a bit of an "I feel your pain" talk to shareholders, pointing out that executives and board members were themselves impacted by the sliding share price and arguing forcefully that Violin would turn itself around.

So there is a plan here, at least, and revenue is guided up sequentially: $11-$13 million in Q2 (against $9.7 million in Q1), with another $6-8 million in opportunities from current major clients. Meanwhile, DeNuccio said Q2 (which started May 1) was "one of our best a year." Getting the trajectory here back to growth alone is a necessary first step, and Violin management, at least, appears to believe the company is taking that step.

Yeah, But...

For some time, my argument against chasing VMEM has been that an investor can't simply disentangle the company's ever-worsening financial situation from the future prospects of the business or its ability to sell FSP, in particular. The fact that Violin is struggling financially - and the fact that those struggles are well-understood by potential customers - is itself a major obstacle to sales.

If a shopper bought a T-shirt from Aeropostale in December, she likely didn't know the company was in financial trouble, and likely didn't care if she did. Violin is different. Customers are going to be wary of building a storage solution if Violin might go under and/or be taken over by another company - perhaps a provider the customer doesn't trust or like. The risk of even a minor disruption in maintenance or support from a change in control is substantial given the critical importance of storage in the overall IT ecosystem. And DeNuccio implicitly acknowledged this problem on the Q1 call (emphasis mine):

Customers who have been willing to invest the time to be involved in the detail of how we are managing the company have found the disclosures refreshing and supportive of their decision to select Violin as their storage solution partner.

The mention of customers who have been "willing to invest the time" naturally means there are potential customers who haven't. All told, I just didn't see enough in Q1 to change my opinion that the solvency problem itself is enough to keep Violin on a path to a restructuring. Revenue was down sequentially, and product revenue basically flat q/q. And for all DeNuccio's talk about large customer success, it's important to note his phrasing in the Q1 release (emphasis mine): "Violin Memory supports the storage foundation of 10 Fortune 100 accounts."

That's not the same thing as being the "primary storage provider" or "having multi-million-dollar deals with 10 Fortune 100 customers." Indeed, only five of the deals are related to FSP; the other five likely are legacy deals that don't really relate to Violin's strategy going forward. And the phrasing goes to a larger point: much of the commentary seemed intent on implying a perception of strength that simply isn't here. DeNuccio cited 60 FSP wins as an "important barometer" of progress at Violin, pointing out that the average was one a week. But Violin added just 7 customers in both Q1 and Q4, an average of barely 0.5 per week. That recent performance seems a more important barometer - and it's not something that looks particularly impressive.

It's not just the quarterly report: Violin issued a press release last week that highlighted 20 wins in Asia - but the number came over the same period (since February 2015), representing about 1.3 wins per month. To be fair, revenue in the region appears to have increased sequentially based on a geographic breakdown given on the Q1 call - but from $1.3 million to about $1.5 million. Asia as a whole generated just $7.4 million in revenue in 2015, per the 10-K. Highlighting "widespread adoption" in the region, as the press release put it, based on 20 wins in countries across all of Asia seems almost ridiculous. And it's a stretch, at the absolute best, to tout adoption in Asia given that Violin's non-GAAP loss in the first quarter alone was over $16 million. Asia revenue could double tomorrow and Violin's financial situation wouldn't change all that much.

From a top-line standpoint, my internal response to much of the commentary was "it's not enough." The major insurance company win represented about $1 million in sales; that's nice as far as it goes. Violin is on track to lose (again, on a non-GAAP basis) something like $50 million this year. If the company can get some of the "opportunities" cited and change the trajectory within the next 1-2 quarters, maybe there's a chance. But it seems like Violin has spent a lot of time discussing wins that simply aren't that material to its long-term survival.

Below the top line, non-GAAP gross margin guidance missed badly: the company had guided for margins of 50-55% on the Q4 call, but the figure came in at just 42%. What's concerning is that the explanation for the miss was wholly unsatisfactory. CFO Cory Sindelar attributed the lower levels to lower-than-expected service gross margin - per the CFO, an 800 bps sequential decrease in service gross margin was driven by "back maintenance, which led to higher revenue recognition in the fourth quarter." In other words, lower-than-expected revenue and "slightly higher" support costs combined for a ~1000 bps miss. But why Violin didn't anticipate that revenue pressure when giving guidance at the end of Q4 wasn't explained. Clearly, the company should have understood the impact of revenue recognition, given that it already had been recognized. So the fear is that service revenue missed because existing customers are leaving. The other pressure was forward pricing on a "material" transaction - which most likely means that Violin had to discount the heck out of the $1 million-plus deal that it highlighted as an important turning point earlier in the call.

The miss on revenue and margin thus led to cash burn being higher than expected, and that is a huge problem. Violin burned over $26 million in cash in Q1, leaving its quarter-end balance at just $49 million. Q2 guidance is for another $12-14 million in burn - but Sindelar had guided on the Q4 call for "less than $10 million per quarter" in burn post Q1.

The updated figure means Violin basically has three quarters left to execute its turnaround, given it must repay the $5.8 million remaining on its credit facility as well. That assumes Violin - which has made a nasty habit of missing guidance over the past few quarters - is properly projecting its Q2 loss. But there's little else to boost the balance sheet or the P&L. A series of layoffs will have been fully incorporated in the Q2 figure, inventory fell sequentially and sits at just $11.5 million, working capital is tiny, and there only hard assets VMEM has are equipment and software.

Sindelar did admit on the Q1 call that "we may have to look at adding some cash in order to extend the runway," another noted shift from Q4. In the Q4 release, DeNuccio said the layoffs had "reset (Violin's) cost structure to provide a pathway to profitability over the next 18-24 months without the need to raise additional capital." But I'm skeptical that new capital can be raised. The market cap is $33 million, an equity offering that raises $25 million seems difficult to execute and still only adds about two quarters' worth of lifespan. Violin's 2019 convertible senior notes last traded at 25 - getting some sort of subordinated funding seems unlikely, if not impossible, at the moment.

And that only amplifies the problem in Q1: a company in Violin's position simply can't miss on guidance. There's a real chance now that Violin could be finished by the end of this calendar year, with the company's financial position looking much more challenged than it did three months ago, and that appearance likely adding further pressure on sales. Another miss on cash burn in Q2 means Violin could show a balance of $25 million or so by quarter-end ($18-19 million burn, in line with Q1, plus $6 million in debt reduction). That's a few months' worth of cash on a straight-line basis, but as numerous similar examples show, cash burn usually accelerates near the end as suppliers tighten terms and customers stretch out payment.

In the near term, meanwhile, there may be some pressure on the equity even with the stock at $0.33. If an equity offering is coming, it needs to come quickly. Such an offering almost certainly would be highly dilutive and at a price well below current levels. VMEM shares also are facing a delisting in mid-July. To avoid that outcome, Violin probably needs to execute a reverse split, which generally push share prices down. So even if an investor wants to take a shot on VMEM, now doesn't appear to be the time - and the senior bonds, which are now valuing the assets here at about $30 million, seem a far more attractive option.

Longer term, I still think this ends up with VMEM equity being wiped out. An acquisition is off the table. If a buyer was interested, a deal would have been made while Violin was trying to sell itself, and there's no logic to making bondholders whole and paying a premium for the equity. The argument that Violin's technology is good doesn't carry much water at this point - it doesn't take an expert to see that "better" technology routinely loses out (going back to the Betamax/VHS split), and it's only getting harder for Violin to sell its "better" product as the risk of disruption to service and support increases. (The bonds have gone from 60 to 25 since the beginning of the year alone. From a customer standpoint, the risk of Violin being restructured and/or taken over now has to be augmented by the risk of Violin simply disappearing, its product lines being subsumed into another company that may not be interested in servicing 70 or 80 installations with a likely annual revenue base in $2-5 million range.)

Personally, I didn't see enough in the quarter to see much upside, even if investors may have. Much of the optimism - DeNuccio's tone, the projection of a "breakout" quarter - is belied by the actual numbers here. Violin has placed its future prospects on FSP, and specifically its ability to sell FSP to major customers. In Q1, it had seven wins, and one with a major customer. That's not enough. It's not anywhere close to enough - and Violin simply doesn't have much time to change that.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.