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Executives

Mitch Gellman - Investor Relations

Manouch Moshayedi - Chairman and Chief Executive Officer

Dan Moses - Chief Financial Officer and Director

Analysts

Gordon Johnson - Lehman Brothers

Bob Gujavarty - Deutsche Bank

Daniel Gelbtuch - CIBC

Salomon Kamalodine - Analyst

Richard Shannon - Northland Securities

STEC, Inc. (STEC) Q3 2007 Earnings Call November 13, 2007 4:30 PM ET

Operator

Good afternoon. My name is Erica, and I will be your conference operator today. At this time I would like to welcome everyone to the STEC Q3 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remark there will be a question-and-answer session (Operator Instructions).

Thank you. Mr. Gellman, you may begin your conference.

Mitch Gellman

Thanks, Erica. Welcome, everyone. Good afternoon. Thanks again for joining us today for our Q3 2007 earnings conference call. First of all, I would just like to update you on our upcoming analyst day and our conference presentation schedule. On Thursday, November 29 we will hold our second analyst and portfolio manager half-day event at the NASDAQ market site in New York City.

If you have not RSVPed, please do so by e-mail at IR@stec-inc.com. That will go directly to me. Thank you very much. As far as conferences, on Wednesday, November 28, the day before our analyst day, we will be presenting at the CIBC World Markets Third Annual Mid and Small Cap Best Ideas Conference. That is also in New York City. In December, Thursday, December 6 we will be presenting at the Lehman Brothers, the Global Tech Conference in San Francisco.

And to kick off 2008 we present at the Needham & Companies 10th Annual Growth Stock Conference also in New York City. With me today for today's discussion and Q&A session are Chairman and CEO Manouch Moshayedi and Chief Financial Officer and Director, Dan Moses.

Various comments about the company's future expectations, plans, prospects made during today's earnings conference call, including the question-and-answer session, constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Act of 1934 as amended and are based on management's current expectations.

These forward-looking statements entail various significant risks and uncertainties that could cost actual results to differ materially from those expressed in such forward-looking statements.

The risks and uncertainties are detailed under Risk Factors in filings with the Securities and Exchange Commission made from time to time by us, including our annual report on Form 10-K, our quarterly reports on Form 10-Q and our currently reports on Form 8-K, including the Form 8-K filed earlier today for this news release.

The filings are available under the category SEC filings in the Investor Relations section at our website, which is www.stec-inc.com. Forward-looking statements in this teleconference are generally identified by words such as believes, anticipates, expects, intend, may, will and other similar expressions.

However, these words are not the only way we identify forward-looking statements. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances are forward-looking statements. Listeners are cautioned not to place undue reliance on these forward-looking statements, which represents our views only as of today.

While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change, and therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

Thanks again for joining us, and now I would like to turn the call over to our CFO Dan Moses. Dan?

Dan Moses

Thank you, Mitch, and welcome, everyone. We continue to make significant strides towards completing our strategic plans to add significant low-cost manufacturing capacity in Malaysia, introduce and ramp to substantial revenue levels or new high-growth high-margin SSD product lines and significantly lower our effective income tax rate.

The construction of our Malaysia facility will be completed this month. We plan to transfer production equipment from our interim facility in Malaysia to our permanent facility in January of 2008 and begin producing SSD products in the facility during the second quarter of 2008. And then ramp to significant production volumes by the third quarter of 2008.

Further, we expect several significant customers of our ZeusIOPS product line to transition from the current qualification stage to full-scale production during the next two to three quarters. In addition, we expect to begin sampling our MACH8 and Mach8IOPS SSD product lines before year-end.

Our global tax structure is nearly in place, and we expect to see our effected income tax rate begin to decline in the second half of 2008. For the third quarter of 2007, on a continuing operations basis, revenues by product line were as follows.

Flash memory was $27.9 million or 63% of total revenues, DRAM memory was $14.0 million or 31% of total revenues, and service revenue and other was $2.8 million or 6% of total revenues. International sales comprised 19% of our total revenue in the third quarter of 2007.

Our average sale price for non-service revenue decreased from $33 per unit in the second quarter of 2007 to $30 per unit in the third quarter. Average shipment density for our memory products increased from 1.0 Gigabyte in the second quarter of 2007 to 1.1 Gigabyte in the third quarter.

We ship 1.4 million total non-service units in the third quarter of 2007, up from 1.3 million units in the second quarter of 2007.

GAAP results include several expense items that we do not expect to recur in our long-term operating model. These items are detailed in our third quarter of 2007 earnings release that was issued earlier today.

The following comparisons are based on non-GAAP operating expenses from continuing operations for the second and third quarters of 2007. Non-GAAP sales and marketing spending decreased from $4.3 million in the second quarter of 2007 to $4.0 million in the third quarter of 2007.

Non-GAAP general and administrative spending was relatively flat at $3.5 million in the third quarter of 2007 compared to $3.4 million in the second quarter. Non-GAAP research and development spending was also relatively flat at $3.1 million in the third quarter of 2007 compared to $3.2 million in the second quarter.

Capital expenditures were $10.7 million during the third quarter of 2007, and depreciation expense was approximately $1.2 million during the quarter. The capital expenditures related primarily to construction costs and new production equipment purchased for our Malaysian facility.

We're projecting third quarter of 2007 results to range from revenue of $48 to $51 million with diluted non-GAAP EPS of $0.07 to $0.09 per share.

Thank you again for joining us today. This concludes our prepared remarks, and now Manouch, Mitch and I would like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Gordon Johnson with Lehman Brothers.

Gordon Johnson - Lehman Brothers

Hello, guys. Can you hear me?

Manouch Moshayedi

Yes.

Gordon Johnson - Lehman Brothers

Congratulations on a good quarter and guidance.

Manouch Moshayedi

Thank you.

Gordon Johnson - Lehman Brothers

I just wanted to ask a question on the expected revenue from ZeusIOPS next year. Is there any potential given what you guys have seen since the last call that we could see potentially higher revenue or a higher estimate there?

Manouch Moshayedi

Right now we are still projecting $50 million, and we think that that is a conservative view. But we will have to wait and see. That is based on the few customers who have already qualified or are in the later stages of qualification of ZeusIOPS into their systems.

Gordon Johnson - Lehman Brothers

Okay. Thank you.

Manouch Moshayedi

I think given what, I think $50 million is a good number still to go with.

Gordon Johnson - Lehman Brothers

Okay. Thank you.

Operator

Your next question comes from line of Bob Gujavarty with Deutsche Bank.

Bob Gujavarty - Deutsche Bank

Okay. Thanks guys. Did you purchase any shares in the quarter?

Manouch Moshayedi

Yes, you mean the Company or…?

Bob Gujavarty - Deutsche Bank

Yes, the Company I mean.

Manouch Moshayedi

The Company did not buy any shares in the quarter.

Bob Gujavarty - Deutsche Bank

Did not? Okay. And could you go through some CapEx expectations for next quarter and then maybe just some inkling of what you think you can, 2008 could look like?

Dan Moses

Sure. For Q4, and again this is primarily being driven by the finalization of the building in Malaysia, we are expecting about $8 to $10 million of final construction payments and some equipment. We expect that should wrap up, the construction costs in Q4.

Next year we will be buying a little bit more equipment, mainly testing equipment, that type of thing. But it should be markedly lower than what we saw in 2007. So if I had to estimate it, I would say maybe somewhere between $4 and $6 million of equipment fixed assets for next year. It should come way down.

Bob Gujavarty - Deutsche Bank

Okay. Great. And then just one final question. As the ZeusIOPS product becomes a bigger portion of your mix, how should I think about that from a margin perspective? Is it pretty much in line with your other Flash segments, the rest of the Flash segment, or do you think it moves it one way or the other?

Manouch Moshayedi

At this point we're projecting a 50% plus margin growth.

Bob Gujavarty - Deutsche Bank

Okay. Great. Thanks, guys, and congratulations.

Manouch Moshayedi

Thank you.

Operator

Your next question comes from the line of Daniel Gelbtuch with CIBC.

Daniel Gelbtuch - CIBC

Hello, Congratulations on an excellent quarter and pretty good guidance. As far as the tax rate is concerned, you mentioned that you expect it to start declining in the second half of next year. Where should we be looking for it to shake out towards the end of the year?

Dan Moses

It is very difficult to project exactly at a point in time because there's a lot of variables. I think once everything settles and we are out a couple of two years or so, we're hoping to get it down as low as 20% if not even lower than that.

The variables are what is eligible for low or no taxes are products that are built in Malaysia that are shipped internationally either to international subs of U.S. companies or to international companies, and using IP that was co-developed by Cayman.

The Cayman entity that we have actually owns the foreign rights to all the ZeusIOPS product. Because when we did the acquisition last year, we were able to buy the foreign rights to our Cayman entity.

So, ZeusIOPS is technology, the foreign rights of which are owned by Cayman and then anything we have been building since April this year, all the new products based on new controllers will be owned by Cayman.

So, the mix of products and how quickly we can get customers to contract with us internationally are kind of the variables, but we do expect to increase in ZeusIOPS sales second half of next year. We should be able to build that product out of Malaysia.

So, we know that there will be some part of the mix that will be subject to the low tax rate. So, I cannot really give you a good number at this early stage.

Daniel Gelbtuch - CIBC

I understand, but as far as the, it should peak out probably in the second quarter, is that what you are saying, the tax rate?

Dan Moses

Yes, well, yes, I would say so. I would say pretty much this quarter, next quarter, all the way through Q2. It is going to probably be higher than our normal because we're actually co-funding R&D expenses through Cayman and they really are not collecting any IP royalties yet.

So, yes, I would say it would peak out in Q2, and then we should start to get some revenue into Cayman Q3 of next year.

Daniel Gelbtuch - CIBC

All right. Now switching gears to, let's say, ZeusIOPS, obviously you have a whole bunch of testing going on. How many customers and is there any you could give us some number of how many customers you have in, let's say, beta testing right now or beta testing and beyond and are already customer testing?

Manouch Moshayedi

I would say in total, people who can use ZeusIOPS, there are probably about four to five major companies that would use ZeusIOPS in the right application and then there are probably about 20 companies below them that would use ZeusIOPS, but not in the majority of the work.

We are qualifying parts at all 25. We are I would say way ahead of the rest of the 20 with the five first, so the top five are I would say in the later stages of qualifications at this point. So, there are no customers in the world that can use ZeusIOPS that we have not approached already.

Daniel Gelbtuch - CIBC

I have got you, when you say that they are well underway in the qualification stage, you are saying they are already at beta testing and beyond?

Manouch Moshayedi

Yes.

Daniel Gelbtuch - CIBC

They are already directly some of them theoretically could have products that are in the hands of potential customers?

Manouch Moshayedi

We would think that sometime around first of or late first quarter of next year, you will see announcements from the big storage enterprise storage companies about using ZeusIOPS in their systems.

Daniel Gelbtuch - CIBC

Okay. Now, as far as Zeus MACH products, can you just update us on what you see the timeline for adoption and obviously, that's a very large potential market, but it might have different economics triggers than obviously, the ZeusIOPS, but what do you see as the timeline for that market's adoption?

Manouch Moshayedi

But, the MACH8 and MACH8IOPS will be sampling at the end of this month to the biggest customers who would be able to use this product. Everyone is extremely anxious about it because this is the highest technology product that is out there.

There is no eight-channel controller SSD out there at this point, no one has announced it and I would say everybody who would be in it is at least two or three quarters behind. So most of the major PC and server companies, who could use SSDs are waiting for us to sample them the product. I think it will have a shorter qualification time span than the ZeusIOPS.

I think it will probably start the qualification would end in about six months rather than the 12 months that has taken the ZeusIOPS. So, I think we should be able to start getting good revenue out of the MACH8 and MACH8IOPS somewhere around third quarter of next year.

Daniel Gelbtuch - CIBC

Okay. And as far as competition in that space and I guess maybe touch on what competition for ZeusIOPS, Mach8IOPS or Zeus MACH8, how would you characterize the competitive landscape for all three?

Manouch Moshayedi

Okay. I think, there is a paragraph in our press release today just trying to set aside all the misinterpretations, misunderstandings that's out there about announcements from different companies who have come out and said, we're going to get into SATA SSDs and oh, we have SATA SSDs or other types of SSDs that are out there or people are thinking about coming out, none of which are going to be even comparable to what we offer in our ZeusIOPS. So people have to put that out of their mind that there is a competition on ZeusIOPS product line.

And based on the complexity of this product, we don't see anyone, if they all decided that they wanted to get into it, it will take at least a year, a year and a half for people to actually come up with this type of product. So since we have not seen any press releases from anyone, we don’t think that anyone is even thinking about coming out with a ZeusIOPS compatible product.

Daniel Gelbtuch - CIBC

What is the distinguishing Factor? Is it the eight-channel configuration? Is it the IOPS per second performance?

Manouch Moshayedi

Right. So the ZeusIOPS is a 16-channel controller that is much faster than anything that’s out there. It is specifically built for the enterprise server and storage applications. It replaces 30 actual hard drives when it’s applied into those markets.

So it is a completely different product than just a regular SSD. Because the IOPS that it has is so much higher than anything that is out there or anyone is even imagining of coming out with. Then we get into MACH8 and Mach8IOPS.

And MACH8 product line would go into low-end servers and PCs, and since that is eight-channel controller, still it works faster than anyone's SSD that is out there. Because the best SSD product that’s out there today is using a four-channel controller. So, therefore, it is not as fast as the MACH8 product.

On those we have the Mach8IOPS, which has got extra circuitry in it and extra components on it that will make this product again in terms of IOPS quite superior to the regular SSDs that are out there that is built specifically for high-end server markets.

So these are the three product types that we're coming out with. And if you think about who is going to be a competitor in this market, I would say on ZeusIOPS we don't expect anyone to come into this market for the 2008. On the MACH8 product line, we will see competition probably in the second half of next year. In the Mach8IOPS we will probably see competition at the end of 2008.

Daniel Gelbtuch - CIBC

Okay. And again for the MACH8 and the Mach8IOPS, who do you peg as the competitor in the second half of next year?

Manouch Moshayedi

I would say the best current candidates to be a competitor in that market will be people who are actually today making Flash components.

Daniel Gelbtuch - CIBC

Okay. Thank you, Manouch.

Manouch Moshayedi

You are welcome.

Operator

Your next question comes from the line of Salomon Kamalodine.

Salomon Kamalodine - Analyst

Hi, I want to get an idea of how much visibility you have into this $50 million projection for next year, Manouch. Is that based on the top five customers in particular where you expect to get bigger design wins, or is that based on having some wins at all 25 customers?

Manouch Moshayedi

This is mostly based on the top five. And if we get design-in and the thing is, if you look at the whole market that would use ZeusIOPS, there is one organization that is about 50% of the whole market, and then there are a couple of other companies who are about 20% of the market. And then all the other companies, all the other 22 or so fall in the 10%, 15% of the market.

So once you get into the top three or four, you have got most of the market wrapped up. So that is where we are today, and we think that the projection of $50 million will come in primarily from a couple of customers.

Salomon Kamalodine - Analyst

Great. And you talked about 50% gross margins on the ZeusIOPS drive. What kind of ASPs do you have in mind with this?

Manouch Moshayedi

What kind of ASPs?

Salomon Kamalodine - Analyst

Great. And you talked about 50% gross margins on the ZeusIOPS drive. What kind of ASPs do you have in mind with this?

Manouch Moshayedi

What kind of ASPs?

Salomon Kamalodine - Analyst

Yes, for at this particular large customer where presumably ASPs would have to be a bit lower than …?

Manouch Moshayedi

Right. Based on the slide that we are projecting for SSD chips during 2008, I would say that our projections are based on a $5000 per unit.

Salomon Kamalodine - Analyst

Got it. Can you just give us an idea of the product mix in the Flash business in the September quarter in terms of TF cards versus they drives and maybe give us the sampling revenue from the Zeus product in the September quarter?

Dan Moses

Sure. So we did about roughly $28 million in the quarter for Flash, let me get the exact number. Yes, we actually did $27.9 million in total Flash for the quarter. Almost 21 of it was based on CompactFlash. We had about 4.5 that was SSD and of that I believe about $3 million of it was ZeusIOPS, $2.5 to $3 million.

Salomon Kamalodine - Analyst

Okay. So there is going to be another $3 million from Zeus?

Dan Moses

Yes, there is a variety of other interfaces and form factors, ATA, MMC, SD, USB. There is a variety of other smaller ones, but there are all under $1 million.

Salomon Kamalodine - Analyst

Okay. And the gross margin in that business?

Dan Moses

The gross margin on Flash, I don't actually have it in front me. Let me grab it and I will say it before the call is over.

Salomon Kamalodine - Analyst

Okay. Thanks. A couple of more, what is going on with HP at this point? Have they come back any DRAM business? Also, I was under the impression that you guys could potentially be shipping some Flash parts to them this year, maybe next year.

Can we get an update on that?

Manouch Moshayedi

Yes, so we are continuing our work in terms of Flash qualifications at all customers, HP included. And we are still in a good; we're shipping a good amount of revenue on a quarterly basis to HP.

As you can see right now, I think this quarter we have got somewhere around $2.5 million of basically service revenue that is taken out of the DRAM, when we shipped it out to HP.

So we don't have the business still at the same levels as we had it in 2006, but it still is I think this year including DRAM into the revenue, I think we would do somewhere around $20 to $22 million.

Dan Moses

Okay. So I'm going to have the gross profit margins by the product categories. So we have got the DRAM memory product category is about 9% and Flash is about 40. A couple of things are happening. These are all GAAP numbers, so there are some Malaysian costs and the onetime inventory write-off that was kind of abnormal in the quarter, so bringing down some of these numbers.

And then also as we go forward, we're expecting a pretty good size increase in ZeusIOPS in Q4, which is going to be at a higher margin than the normal Flash products that we have. And then as the revenues go up too, we will be able to absorb more of the cost amongst the higher revenues.

So it is actually a little bit lower than normal for the Flash category, but we expect it to start to turn back up beginning this quarter.

Salomon Kamalodine - Analyst

So you allocated the PCB write-off and the Malaysian ramp-up costs to the Flash ..?

Dan Moses

Well, the write-off is actually going to be fully, that is a DRAM write-off. So that would actually go against DRAM. But the Malaysian costs would be spread evenly by revenue.

Salomon Kamalodine - Analyst

And would it be fair to say that because you may have been working through some higher cost inventory bought in the second quarter that may have impacted your margins in the Flash business in Q3?

Dan Moses

You know, I would have to go back and take a look at exactly where the drop came by product category, but it is probably a combination of a variety of factors. The ones I listed that also could be part of the issue as well.

Salomon Kamalodine - Analyst

Okay.

Dan Moses

I would expect that to tick up into Q4.

Salomon Kamalodine - Analyst

Okay, thanks.

Dan Moses

Okay.

Operator

Your next questions come from the line of Richard Shannon with Northland Securities.

Richard Shannon - Northland Securities

Hi guys, how are you?

Manouch Moshayedi

Good. How are you feeling?

Richard Shannon - Northland Securities

Not to bad. The first question following up on one of the questions previously about you are actually takes us $50 million in ZeusIOPS revenues in 2008. How sensitive is that to your expectations of what SOC pricing is going to be?

Manouch Moshayedi

Richard, you are getting completely cut out, so we cannot hear what you are saying.

Dan Moses

I think his question was on the ZeusIOPS, how sensitive is it to the components, Flash component prices changing. Is that right?

Richard Shannon - Northland Securities

Yes, it is. Can you hear me a little better now?

Manouch Moshayedi

Okay.

Richard Shannon - Northland Securities

Sorry about that.

Manouch Moshayedi

I had to guess what your question was. I think Dan's hearing is much better than mine. But ZeusIOPS basically our customers understand a formula that we have given them in terms of margin and how price of Flash affects it.

So, up or down the price of Flash components will definitely be affected ZeusIOPS. So, it definitely makes a difference on that.

Richard Shannon - Northland Securities

Is there any way that you can give us a sense of what level of SOC pricing is required to get to that level of units and ASPs that you are going to see that $50 million?

Dan Moses

To get to our 50 estimate

Richard Shannon - Northland Securities

Okay.

Dan Moses

So, where do we think pricing is going to be?

Richard Shannon - Northland Securities

Yes, how much lower does it need to be than it is today in order to see that as a reasonable estimate?

Manouch Moshayedi

Okay. I do not think that ZeusIOPS is as susceptible to pricing as a regular SSD would be for the PC and low-end servers. So, today we're shipping out our ZeusIOPS somewhere around the $10,000 per unit.

It is even at this price is about 40% of the price of using hard drives. Plus, it can save about 90% of the maintenance cost on a yearly basis. So, there is a significant 60% savings for any of our customers who would use the ZeusIOPS versus a rotating hard drive.

So, the price is not such a big part of the whole deal when you are talking about ZeusIOPS. For the SSDs and when it goes into PCs and laptops and low-end servers, the price would be different. It would be a big number.

However, for the $50 million, we're calculating about 10,000 units shipped in 2008 at $5000 a piece.

Richard Shannon - Northland Securities

Great. A couple of very quick follow-up questions here. Dan, what was the amount of DRAM units you shipped in the third quarter?

Dan Moses

Come again, Richard?

Richard Shannon - Northland Securities

The number of DRAM units you shipped in the third quarter?

Dan Moses

Sure. Third-quarter unit volume for DRAM was 303,000 units. Flash was about 1.1 million.

Richard Shannon - Northland Securities

Okay. Great. And then the last one for me. Can you give us an idea of what your assumptions are for DRAM pricing that is included or embedded in your fourth quarter guidance?

Manouch Moshayedi

I think DRAM pricing is as low as we are going to see them for a while and we actually are predicting pretty stable DRAM prices at this point.

Richard Shannon - Northland Securities

Okay. Great. Thanks a lot guys

Manouch Moshayedi

All right.

Dan Moses

Thanks Richard.

Operator

There are no further questions at this time.

Manouch Moshayedi

Thank you very much for participating today. Talk to you guys later.

Operator

This concludes today's conference call. You may now disconnect.

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