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Qualstar Corporation (NASDAQ:QBAK)

F1Q08 Earnings Call

November 13, 2007 5:00 pm ET


Lasse Glassen - IR

Bill Gervais - President, CEO

Andrew Farina - CFO


Patrick O’Bryant - Needham& Co.

Sam Bergman - Bayberry Capital Management


Welcome to the Qualstar first quarter 2008 conference call.(Operator Instructions) I would now like to turn the conference over to Mr.Lasse Glassen of Financial Relations Board. Please go ahead.

Lasse Glassen

Thank you, and welcome, everybody. This afternoon we'll bediscussing Qualstar's fiscal 2008 first quarter results for the period ended September 30, 2007. If you do nothave a copy of our press release from earlier today, you can find one posted onthe investor relations section of our website at Click on investors,and then on press releases.

Providing comments on Qualstar's results and businessoutlook today is Bill Gervais, Founder, President and CEO of Qualstar. He isjoined by Andy Farina, Qualstar's Chief Financial Officer.

Before we begin, I would like to preface the discussion withour Safe Harborstatement. Statements made in this presentation concerning the future business,operating results, and financial condition of the company are forward-lookingstatements as defined in the Private Securities Litigation Reform Act of 1995.Such statements are based on management's current expectations and are subjectto a number of uncertainties that could cause actual performance and results todiffer materially from the results discussed in the forward-looking statements.

Factors that could affect the company's actual resultsinclude our ability to increase sales of tape libraries which incorporate LTOtape drives; our ability to increase sales of our N2Power supply business;whether the company's initiatives to maintain sales of its tape libraries thatutilize AIT tape technology will be successful; whether the company's XLSEnterprise class tape libraries will achieve customer acceptance; reschedulingor cancellation of customer orders; unexpected shortages of critical components;unexpected product designs or quality problems; and adverse changes in marketdemand for tape libraries, or other Qualstar products.

The company undertakes no obligation to publicly update anyforward-looking statements, whether as a result of new information, futureevents, or otherwise. Further information on these and other potential factorsthat could affect the company's financial results or conditions are included inQualstar's filing with the Securities and Exchange Commission; in particular,references made to the risk factor section of the company's annual report onForm 10-K for the period ended June 30, 2007 and to management's discussion andanalysis of financial condition and results of operation section of its Form10-K and its most recent quarterly report on Form 10-Q.

With that, I would now like to turn the call over to BillGervais.

Bill Gervais

Thank you, and thanks to everyone for joining us thisafternoon. On today's call, I'll begin by highlighting our fiscal 2008 firstquarter operating results. Then, I'll provide an update on our recent businessactivities. Andy will provide detailed comments on our first quarterfinancials, along with remarks on our outlook and guidance for the secondquarter of fiscal 2008. After that, we'll open the floor for questions.

With the exception of a small shortfall in XLS unitshipments, our operating results from this past quarter were generally withinour expectations. Revenues in the first quarter totaled $5.3 million, anincrease of about 14% from $4.7 million in the same quarter last year. Thegrowth in revenues in this period were driven by contributions of $4.6 millionfrom tape automation, up more than $700,000 or 19% from $3.9 million in thesame quarter last year, while revenues from power supplies at $0.7 million wereup on a sequential quarter basis, but lower by about 8% from $0.8 million inthe same period last year.

Gross profit in the first quarter increased to $1.6 millionor 30.5% of revenue compared to $1.3 million or 27.9% of revenue in the samequarter last year. Through the remainder of the year, gross profit dollars andgross profit percentage are expected to be influenced by the proportion ofrevenues derived from our XLS Enterprise class library shipments. Gross marginson cumulative XLS shipments over the last five quarters continued to hold atbetter than 50%.

During the first quarter, we delivered eight XLS units,somewhat short of our goal of 12 units. On a comparison basis, this was up fromthe same quarter last year where we shipped three units, but down sequentiallyfrom 14 units in the strong June quarter. The sales cycle for our XLS librariescontinues to be six months or more in duration, and we believe this will notchange any time soon. It's worth noting that three additional XLS units that wehad originally planned to ship in Q1 were actually shipped seven working daysinto Q2 and will be included in our second quarter results.

We continue to see XLS appealing to a broad mix of endusers. We're not reliant on any single business segment or application. As anexample, eight units shipped during the first quarter were deployed at atelevision station for archival storage of broadcast content, two with researchuniversities, a radio station and a major aerospace company.

For most of fiscal 2007 -- our first year of XLS sales -- welimited shipments primarily to domestic customers in order to reduce our riskand ensure that we could carefully manage the installation and field supportprocesses on these early units. With more than a year of experience now behindus, we recently expanded the availability of the XLS to the rest of the world,with particular emphasis on Western Europe, which webelieve will be an important market for this product. Our field experience thusfar has been excellent from both a reliability and from a customer satisfactionstandpoint. Since launching the product line in July of 2006, we have deployeda total of 38 units. End users have told us that our XLS price proposalsconsistently offer very cost effective solutions.

Of the three different library resource modules availablefor shipment, 50% have been the large 700 tape units, 30% the 500 tape units,and 20% the relatively new 300 tape units, giving us a good product mix in thefield, albeit biased in favor of the higher margin 700. The largest systemsshipped to date have been in the 2600 tape area. We've shipped three suchsystems.

Our business model provides for library deliveries within acouple of days of an order receipt therefore, as usual, there is no orderbacklog to report to you. Our order pipeline is about the same as it was duringour last call two months ago on September 6.

Turning to our other tape library products, in the quarterour TLS and RLS series unit shipments held up fairly well. We shipped 144 unitscompared to 142 units in the same quarter last year, and up sequentially from137 units in the June quarter. We continue to anticipate a slow decline in theolder TLS and RLS product lines and have phased out production on Sony's SuperAIT libraries and Quantum's Super DLT tape models.

LTO appears to be the market favorite at the present timeand all new library R&D activities are focused on the LTO format. We are,however, providing an upgrade path for customers who may be using Super AIT andSuper DLT tapes by offering to convert robotic units over to the LTO format,thereby preserving the customer's investment in Qualstar hardware.

We recently commenced shipments of IBM's LTO 4 tape drivesutilizing the recently introduced SCSI LVD low voltage differential interface.These will be primarily used as upgrades for customers using LTO 3 and downtechnology.

Moving to the N2Power business segment, revenues were$724,000, down slightly from $787,000 in the same period last year. Powersupplies accounted for 13.6% of our overall revenues in the quarter.

During the quarter, we announced the expansion of ourdistribution agreement with New Horizons, an important N2Power stockingdistributor to resell our entire product line on a worldwide basis. NewHorizons previously distributed our power supplies only in the United Kingdom and in Ireland.This new agreement significantly enhances the exposure of our products to NewHorizons' worldwide customer base.

During the last quarter, we secured design wins on sevendifferent networking systems, including products made by Emulex and Comtech EFData. The combined business potential of the seven projects is between $1.2million and $1.5 million per year, and it's for a broad mix of power supplymodels. These products will be shipped to OEMs and their contract designatedmanufacturers. N2's business model is built upon the emerging importance ofminimizing wasted energy in all types of electronic and communicationsequipment. High efficiency units cost more to produce, but command higherselling prices in what is normally a commodity market.

Usually, when space is at a premium, designers must specifyhigh efficiency components to minimize heating and air flow requirements. Anadditional advantage is the savings in power costs over the life of theinstallation, along with reduced air conditioning loads. With energy pricesincreasing worldwide, we expect that these factors will help continue to drivedemand for N2 products going forward.

While N2 unit volumes picked up in the period compared tothe previous quarter, we are aware of some customers who continued to delayordering during our transition from the 250-watt units to the new 275-wattproduct line. The 275 packs more power in a smaller package than virtually anyother competing product on the market and we are anticipating healthy demandfor this unit in applications such as industrial automation, telecom, securitysystems and network gear. We expect the 275-watt unit to come online late inthe current or second quarter of fiscal 2008 with unit volumes ramping up afterthat in Q3 and Q4.

The acquisition of N2Power in July of 2002 was based on ourbelief that energy costs and energy concerns would become more important overtime, thus creating an opportunity to capitalize on the trend, which now hasthe name Green Movement. We've noted that many large manufacturers are nowcatching on, at least superficially, if not factually. We intend to continuedeveloping high efficiency power supplies that these manufacturers will requirein order to reduce energy waste in their products.

I believe that Europe is now leadingthe way and is heavily promoting the Green Movement, thus the importance wehave placed on the New Horizon relationship should be a value to us goingforward. Initial stocking orders to New Horizon are presently underway.

Now moving on to other product areas, we enjoyed good tapemedia revenues in the first quarter at $922,000, up 63% from $566,000 in thefirst quarter last year. Some of this increase was associated with end of lifeshipments on Super AIT and thus will not be a continuing trend. We havetraditionally done well in what I will call specialty media and not done wellin media that is broadly or over distributed, such as DLT tape has been.

Service revenue was $656,000 in the first quarter, down 10%from $725,000 in the same period last year. You may recall that we have chosento bundle first year onsite service at no cost with our XLS products. As aresult, service revenues from XLS shipments will not be recorded until thesecond and subsequent years after any individual unit is shipped. We believethat variations in both media and service revenues reflect normalquarter-to-quarter business fluctuations.

On the product development front, we're continuing toenhance the XLS product line with additional models and features that will be announcedduring Q3. Also, N2Power's continuing to invest in the development ofadditional power supply designs, beyond the 125-watt to 275-watt range that isnow available.

Our sales and marketing initiatives continue to placeemphasis on our large libraries. During the first quarter, we participated inthe European IDC show in Amsterdam,and in October we displayed at the Storage Expo conference in London.Storage Expo culminated a three-week XLS promotion tour in Europethat by all accounts was the introduction of the XLS to that market. I believethat we have some significant competitive advantages in Europe,with our high storage density, low power consumption, and cost effectiveapproaches.

In December, we will be exhibiting at the Storage Decision showin San Francisco, followed by theCeBIT Show in Hanover, Germany.

In the near term, we expect to continue our pace of productdevelopments, drive hard at our initiatives to penetrate the enterprise tapestorage market and hold the line on spending in the expense categories in orderto return the company to a healthy level of profitability. Additionally overthe next six months, we'll be devoting considerable effort to internal controlsand issues related to the required Sarbanes-Oxley Section 404 certifications.

Now, I'll turn the call over to Andy, who will go over someof the additional details on the financial results with you.

Andrew Farina

Thank you, Bill. I hope everyone can hear me. I will addressthe comparison of the operating expense line items in the income statement.Research and development expenses for the first quarter of fiscal 2008 were$728,000, or 13.7% of revenues compared to $750,000 or 16.1% of revenue in thefirst quarter of fiscal 2007. Lower wage and related costs along with lowerconsulting costs account for the reduction in the R&D expenses in thelatest period.

Sales and marketing expenses for the first quarter of 2008were $759,000 or 14.2% of revenues compared with $786,000 or 16.5% of revenuein the first quarter of fiscal 2007. The decrease in the sales and marketingexpense was primarily due to the closure of the sales office in the United Kingdom.

General and administrative expenses were $739,000 or 13.9%of sales in the first quarter, and were down from $744,000 or 16% of sales inthe first quarter of fiscal 2007. The decrease is primarily due to lower legaland accounting costs during the most recent quarter.

The loss from operations for the first quarter was $602,000compared with the loss from operations of $906,000 in the prior year period.

Investment income for the first quarter was $413,000 up from$381,000 in the first quarter of fiscal 2007. The increase was due to higheryields in interest rates earned on the company's cash, cash equivalents andmarketable securities compared to the same period last year. Our cash and cashequivalents and marketable securities balance of $33.7 million in the firstquarter of 2008 was up from a balance of $33.3 million as of the end of thelast quarter of fiscal 2007.

After accounting for interest income and income taxes,Qualstar reported a fiscal 2008 first quarter net loss of $206,000 or $0.02 ashare. This compares to last year's first quarter net loss of $579,000 or $0.05a share. Qualstar's financial condition remains very healthy. As I mentioned,the company has cash, cash equivalents and marketable securities of $33.7million or $2.75 a share, which is relatively unchanged from prior quarters.

Day sales outstanding were 55.1 days at September 30, 2007 compared to 41.9 days at September 30, 2006. Inventory turnswere at 2.5 times on an annualized basis for the period ended September 30, 2007. This compares toinventory turns of 1.8 times for the quarter ended September 30, 2006.

Before turning over the call for questions, I will wrap upmy remarks by providing some financial guidance for the second quarter offiscal 2008. We expect the following:

  • Revenues in the range of $5.2 million to $6.1 million.
  • Gross margin percentage in the range of 31% to 36%.
  • R&D expenses in the range of $730,000 to $780,000.
  • Sales and marketing in the range of $770,000 to $830,000.
  • G&A expenses in the range of $750,000 to $830,000.
  • Investment income in the range of $390,000 to $420,000.

This concludes our prepared statement, and we can turn it overfor questions.



Your first question comes from Patrick O’Bryant - Needham.

Patrick O’Bryant - Needham

Hey, guys. Maybe youcould break out how much the XLS product line contributed in the quarter?

Bill Gervais

XLS contributed$349,000.

Patrick O’Bryant - Needham

Going forward, the end ramp in XLS, the pre-shipments, howshould we be thinking about gross margin, given your best visibility nowthroughout fiscal '07?

Bill Gervais

I'm having a littletrouble hearing you. You asked what we thought the gross margin will be goingforward on XLS?

Patrick O’Bryant - Needham

Correct. You know,for fiscal '08 your best visibility on the impact to overall gross margin.

Bill Gervais

Yes, we think that itwill pull up gross margins to the extent it becomes a bigger and biggerpercentage of our shipments. What we have stated publicly is that the grossmargins on XLS A are holding up on cumulative shipments at something betterthan 50%, and exactly where it is in there, I'll tell you it's less than 60%and it's more than 50%. It's just somewhere in that range, and we think thatprices will hold up.

We're offering a very cost effective solution and stillmaking acceptable margins because our manufacturing cost is somewhat lower forour style of library than many competitors, and, of course, the competitors arebigger and they tend to set the prices. So I don't expect to see any erosionthere.

The biggest thing that will affect the gross profit is productmix. If we ship a lot of the 300s and very few of the 700s, then of course,that will pull it down. Also, the expansion units typically command less than alibrary resource module and so that will pull it down. So it's all very much afunction of how the product mix comes out at the end of the day.


Your next question comes from Sam Bergman - Bayberry CapitalManagement.

Sam Bergman -Bayberry Capital Management

First of all, on those three XLS units that were shipped inthe beginning of the second quarter were they the 700 units? What was the delayin shipping it into the next quarter, if any?

Bill Gervais

There was a purchase order snafu on the part of thecustomer, and we were pretty sure we were going to have that one in the quarterand it turned out that it had to go back to the purchasing department again andget the PO reissued and that delayed it about seven working days.

So I just point that out to kind of indicate that we werepretty close to making our 12 units that we were looking for, and of course,those three units are actually being installed with our installer today. Sothey did ship just into the Q2 and that was a three box shipment. It was twoMEMs and an LRM and it was a 700-tape LRM. It was a large one.

Sam Bergman -Bayberry Capital Management

Can you tell us if there's going to be a larger amount ofR&D in the third and fourth quarter when the larger units, the XLS units,that are going to be developed at that point, would there be an increase inR&D for those units, or not?

Bill Gervais

No, we're going to beholding that pretty steady. The crew that is doing this development has notchanged in size in the last six months and I don't anticipate hiring any peoplethere. So the quarterly expenditure on R&D should hold pretty steady, as wecontinue to put out new units. We're going to be expanding the XLS family tothe higher end, in other words, beyond the 700-tape unit into a machine that'smore tailored to the archive market. So I don't expect to see any change inR&D expenditures.

Sam Bergman -Bayberry Capital Management

The question about VARs and adding VARs to your businessmodel. I assume over the past six months you have added VARs to handle the XLSproduct, but you did mention that the quotations or the activity for thatparticular product is about the same as what it was in the prior quarter. I'mjust wondering why there's not a greater pickup for the quotations and agreater amount of quotations for that particular line?

Bill Gervais

We have added VARs -- not as many as I would like to haveadded -- but we have added some VARs and actually some of those new VARs havebeen responsible for some of our recent sales. Remember the quoting activityprecedes the actual shipment by as much as six or seven months. So the newVARs, once they come on board, we have to go out and train them and sometimeswe bring them to the factory and train them and then they send their salespeople out into the field to hunt up potential sales. From the time we firstsign up a new VAR until the time we've got some quotes on the table, it couldbe four to six months. So it's happening, not as fast as I would like it tohappen, but it is happening.

Sam Bergman -Bayberry Capital Management

Can you give us anidea of what the activity is in the first six weeks of this quarter for XLS?

Bill Gervais

The pipeline of potential orders is a little bigger than itwas at the beginning of the quarter. The shipments have not gone out the dooryet.

Sam Bergman -Bayberry Capital Management

Okay, and in terms ofthe N2Power business, these design wins are going to add incremental dollars tothe top line when you ramp up and ship product?

Bill Gervais

Yes, actually we'realready shipping some of them and yes, that will be purely incremental sales.It's new OEM business that we didn't have in this quarter last year or even inthe previous quarter. OEM business that I quoted, $1.2 million to $1.5 milliona year tends to go for many, many years. You almost have to really try to loseit if you don't want it anymore. So we see that as a good, solid base on whichto build other deals.

Sam Bergman -Bayberry Capital Management

Was there any revenue this quarter going into the inventoryfor New Horizons or not?

Bill Gervais

Yes. The distributor shipments have already begun to NewHorizons, and each country is a different story and they aren't all going outin one month or in a short period of time. It seems like about every month anew country signs up and orders they're stocking inventory. I would say thatover the current quarter before the end of December, all of the stocking orderswill have been fulfilled. They are about one-third fulfilled at the presenttime.

Sam Bergman -Bayberry Capital Management

How big is the stockingorder in general?

Bill Gervais

$60,000 to $80,000 generally. We have to usually suggestwhat proportion of which models for them to handle, because they are taking ona new line, they have no clue what's really going to sell and what isn't.

We have a model that looks at our recent shipment historyand suggests what portion of which models, what quantities of which models theyought to have for starters. Once it starts moving, of course, then they knowwhat to reorder.

Sam Bergman -Bayberry Capital Management

Last question I haveis in Western Europe, how are you going to sell the XLSproduct and who is going to do the installations for those products?

Bill Gervais

In Western Europe, everything isbeing sold through resellers. There are no distributors involved. This productis really too big for distribution and we do not take sales direct. So thebasic channel is through our resellers. A few of them are new. Most of them areresellers that we've had for many, many years, who we finally allowed to sellthe product.

Sam Bergman -Bayberry Capital Management

Would you say a four to six-month timeframe to start gettingbids on those?

Bill Gervais

Yes, and how are wegoing to install them? Generally, our preferred approach is to have the resellersend his technician here for the maintenance training. When they leave hereafter a week of training, then they are qualified to take a unit and install itthemselves and certainly if we need to we'll walk them through it on thetelephone, but if they have done it once or twice here, which they all do, theypretty much can get through it.

We've had two of them shipped to Italyand they did their own self-install. They had one of them ship to the Czech Republicand they did their self-install, and one to Finland so far, and they did aself-install. But we're not averse to going on site ourselves if we have to, ifthe reseller doesn't want to send somebody here for training. That's workingpretty well.


I would like to turn it back over to management for closingremarks.

Bill Gervais

In closing, I would like to reiterate that we remain veryupbeat about our prospects to return Qualstar to a growing and profitablebusiness model. The key to our success is the XLS product line and results continueto indicate that the XLS has been well received by the market both in the well as Europe. As always, we look forward to sharingour progress with you next quarter.

Thank you once again for joining us this afternoon and foryour continued support.

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