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OCZ Technology Group, Inc. (NASDAQ:OCZ)

F4Q12 Earnings Call

May 1, 2012 5:00 PM ET

Executives

Bonnie Mott – Senior Manager, IR

Ryan Petersen – President and CEO

Arthur Knapp – CFO

Analysts

Aaron Rakers – Stifel Nicolaus

Rich Kugele – Needham & Company

Andrew Nowinski – Piper Jaffray

Alex Kurtz – Sterne Agee

Christian Schwab – Craig-Hallum Capital

Operator

Good day ladies and gentlemen and welcome to the OCZ Technology fiscal 2012 fourth quarter and fiscal year financial results conference call. At this time, all participants are in a listen-only mode. (Operator instructions) As a reminder, this conference maybe recorded. I would like to turn it over to your host today, Ms. Bonnie Mott, Senior Manager of Investor Relations. Ma’am you may begin.

Bonnie Mott

Good afternoon and welcome everyone. On the call today are Ryan Peterson, 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 May 1, 2012. Please keep in mind that while being made available for 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

Thank you Bonnie, and welcome to everybody joining in the conference call. 2012 has been an incredible year for OCZ. Against the backdrop of a rapidly growing, constantly evolving market, we executed on our internal goals which were simple, to achieve rapid revenue growth with increasing gross margins and to solidify our position with our OEM clients and in the enterprise.

We are proud to report that recent data from industry analysts indicate that we’re now the world’s largest independent manufacturer of SSDs. As we look forward to fiscal ‘13, it’s interesting to know that IDC expects the amount of storage capacity shipped will more than double by 2015 from about 760 exabytes in 2012. While hard drive based storage continues to be the dominant technology, we expect that the recent NAND flash cost reductions coupled with new technology introductions will significantly drive continued adoption of SSD technology as a percent of shipments, in the short-term as well as over the longer horizon.

Given our recent financing, our progress in operations, supply chain management, and technology, we feel that we’re better positioned than ever to take advantage of the growing SSD opportunity. In short, we’ve earned ourselves the position of the starting line. And in the coming year, we expect SSDs, the NAND flash based storage technologies to become increasingly important. We’re prepared to aggressively address the opportunity before us, as I am sure you’ve all have heard before the old saying, fortune favors the bold.

Now moving on, let me briefly discuss our results. Our fiscal ‘12 revenues increased 92% to $365.8 million compared to fiscal ‘11 net revenue of $190.1 million. Revenue in the fourth quarter was a record of $110.4 million, an increase of 71% compared with net revenue of $64.6 million reported in Q4 ‘11. Our SSD revenue was $338.9 million for the year, up 154% year-over-year compared with a $133.2 million.

I think it’s interesting to note that our Q4 SSD revenues were approximately 80% of the entire fiscal ‘11 revenues, and that during the year, our second half represented about 60% of our annual revenue. Our gross margins increased in the fourth quarter to 25%, up both sequential and year-over-year, as we continued to see the benefits of our scale and improved product mix. We’ve begun to see the results of our key initiatives to purchase the majority of our NAND flash from the past directly as opposed to through brokers and we expect that our gross margins will continue to expand as we move forward.

We’ve recorded a non-GAAP loss in Q4 of roughly $6 million as we continued to invest heavily in building out the business. It’s important to note that we announced an increase in our R&D and sales and marketing spending in the fourth quarter in relation to our acceleration of the product roadmap. This spending approximated $6 million and will let Art go into more detail and resulted in the early launch of our Vertex 4 and Everest 2 products.

It is our expectation that these products will have a major positive impact on revenue and gross margins during fiscal ‘13. In addition, this quarter we began breaking out our PCIe products or SAN replacement product revenues. So that investors can clearly see the progress we’re making with our Z-Drive Series and PCIe SSDs, which were launched in August. As previously stated, we expect sales of these products to gain traction in the second half of our fiscal ‘13 due primarily to the long design cycles prevalent with enterprise storage products.

That being said, sales for our SAN replacement products in the roughly six months post launch have pushed $20 million. This indicates a high level of interest in our SAN replacement products and we feel we’re well positioned to see this product category span at a rate well in excess of our core growth. During the year, we made several key acquisitions including Indilinx early in the year and most recently SANRAD in the fourth fiscal quarter.

These acquisitions have positioned us well from a technology and a competitive standpoint. And we expect them to add considerably to our operating leverage as we move forward. I’d like to move on and update everyone briefly on a few key operational areas before giving you some color on the market segments. In terms of manufacturing operations, during the year, we expanded our manufacturing capabilities on a number of occasions, and after a series of rapid expansions, we consolidated test to manufacturing into a single facility capable of meeting our needs as we move forward.

We kept this move off with the recent hire of our Senior Vice President of Operations, Jason Ruppert, who joined us from his role in a Senior VP of ops at Harmonic. Jason has about 25 years of experience in senior operations roles and he is an excellent addition to our management team.

Moving on to our supply chain. We’ve been successful in shipping from the model of purchasing NAND flash primarily from the spot market to primarily from NAND flash fabs such as Micron, Toshiba, and SK Hynix. NAND flash can account for between 60% to 90% of our cost of goods. And as such this move recently began to positively impact our gross margins as the purchasing structure not only provides lower cost, but decreases price volatility.

In February, we raised a $110 million, in part to support the move to NAND flash wafer purchasing which really requires a company to carry a 12 weeks of inventory and that’s a significantly lower price for NAND flash. This again is expected to contribute to increase gross margins and lessen risk associated with NAND price volatility.

In terms of technology developments, while we continue to significantly understand our competitors, we’ve increased our technology lead not only by investing in the SANRAD and Indilinx acquisitions but increasing our organic R&D spending. Our investments in R&D have increased significantly for good reason. These investments are critical in enhancing our strengths across the various SSD segment as we continue to pursue technological dominance across all product segments.

I will for once, spare the listeners the long list of technological advances, we have made over the past year as our revenue and margin really speaks for itself. To encapsulate things in short, we feel we now have a sustainable reason in terms of SSD technologies and that this will help ensure our success as we move forward. In recapping our R&D strength, it’s worth bringing up that we’ve recently accelerated our product roadmap across the board.

It perhaps goes without saying that the early release of that Everest 2, will have a major impact on our business as sales ramp for this product. Now I’d like to call out that we’ve recently achieved a tape-out of two unannounced SSD controller platforms. That these products we believe be released mid-year well ahead of schedule and should provide considerable revenue upside. It’s worth mentioning, that while the cost related to these two new platforms are in fact reflected our operating expense guidance we have not reflected any additional revenue or margin upside, and we will update guidance to reflect the benefits of these products post product release.

In regards to sales and marketing, we’ve continued to invest heavily in expanding our platform resulting in increased sales of account and a number of customers wins in key customer groups, including PC OEMs, server manufacturers, and data centers. It’s worth noting that a year-ago we had no material revenue of tier one OEMs. And while we’ve now established ourselves with these OEM clients, historical growth notwithstanding, we have yet to fully exploit most of these relationships. It is critical as we move forward that we continue to build out the appropriate sales and marketing structure to support our ongoing OEM growth initiatives. Now with that I’d like to move on to give a little bit of color around our two major product areas.

In regards to the hard disc drive format business which includes our SAS and SATA product lines, we continue to see strength and we expect that our early launch of our Everest 2 Controller will positively impact margins and revenue, particularly as we rollout the various derivative products. These subsequent products include the mass market and enterprise variance, for example, the Agility 4, and the Intrepid 3 which we’ll launch in coming weeks.

Simply put, we now have superior technology and a substantially lower cost versus our SandForce-based products. Our price and performance offering clearly illustrates the benefit of our new technology introductions. As an example with recent NAND flash price decreases, we have been able to introduce market leading products with price points of approximately $0.65 per gigabyte without negatively impacting our gross margins.

These cost reductions continue to drive SSD adoption and we feel it is critical to continue to drive cost down. With that we planned to launch both 1x nanometer and TLC support during the year subject to NAND availability. In short, we expect recent declines in NAND flash pricing to make SSDs more attractive to mainstream applications such as SANs, network appliances, Ultrabooks and mainstream serves.

And further it’s our intent to continue to bring low cost technologies to market such as our TLC-based products, enabling this trend. Now moving on its been to get to the Vertex 4 product had the margins approaching 40% compared to SandForce-based predecessor product since Vertex 3 as an example with gross margin in the 20% range.

While these margin estimates are broadly accurate, I’d like point out that in line with our strategy of market share expansion, we will over the longer term be pricing the Vertex 4 and its derivative in line with market expectations. This pricing strategy enabled by lower cost of goods on the Everest 2 Controller and the enhanced performance specs should shift sales away from our Vertex 3 line and could provide additional significant margin upside as well as drive significant in-market demand.

Let me be as clear as possible. We are targeting increased margins and simultaneous market share growth. These goals are supported by a proprietary technology that allows us to use low-cost flash in high performance applications. I think it’s important to note that while we continue to focus on SSD products, we’ve historically sold our controller platform to a number of companies including OEMs such as Juniper and Cisco and to our competitors including well known enterprise SSD manufacturers who sell SSDs and an SSD Controllers under their own brand names utilizing our controller platforms.

Given the recent launch of our Everest 2 platform, we intend to continue to support serving strategic partners with our controllers. And we have recently finished qualification with the number of SSD manufacturers. Now sales of our controller products were less than a $1 million in the fourth quarter, but carried gross product margins in the 60% to 75%.

As we only recently released the current generation platform, we are now providing guidance on the revenue ramp for SSD controllers. We do expect considerable growth of revenue in these products and we will update to markup when appropriate. Moving on to enterprise storage, the market for enterprise storage continues to go through a period of innovation which is impacting how enterprise storage solutions are adopted as system architecture level.

And we believe that we’re positioned at a cross roads or a shift in the storage environment and then our SAN replacement products are unique with the vision to take advantage with that shift. We continue to provide our SAN replacement solutions such as the Z-Drive R4 to independent media for analysis. In March independent product reviewers of storage review redeveloped their testing platform to better accommodate the burdening PCIe SSD space and tested the R4 side-by-side with competing products.

Their conclusion was simple, the Z-Drive R4 is nearly impossible to beat in performance, price, or flexibility. Its key to note that we launched our Z-Drive R4 in August of last year and have only recently with the acquisition of SANRAD, build out a fully featured virtualization software offering. With that in mind and despite the fact that we have a considerable growth in a short period of time, we don’t expect sales of those products to ramp until the third fiscal quarter.

Now since the acquisition of SANRAD, we’ve launched our VXL software offering, which has given us access to a broader array of opportunities than were previously addressable. We are very pleased with the momentum we’re seeing. As we’ve noted and also our competitors have noted, that customers continually indicate that vMotion support, ease of installation and support for cache sharing among servers are prerequisites for our customers’ virtual environments.

Our VXL software is unique in its ability not only to reduce installation complexity with an exiguous approach but to share a single Z-Drive over a multiple servers and to support vMotion with no loss of cache. The value of this differentiation is a measurable. VXL was designed from the start with a simple rule, to empower virtualization with flash rather than to hamper virtualization whenever the flash is used by a virtual machine. VXL is a catalyst opening the door for flash, bringing flash’s full benefit to the virtual environment even under the most demanding workloads.

Now I’d like to take a moment to characterize the large Greenfield opportunities that our SAN replacement products address. In reviewing our business pipeline for these products, we see our top 50 opportunities have an estimated deployment value of approximately $1 billion. Now while we may not be able to win each discrete opportunity at this level, it’s an encouraging trend. Given the limited competitions we see in these accounts, further eyeing up the opinion that we have yet to scrap the surface in the SAN replacement opportunity.

Moving on, in addition to the bundled PCIe plus VXL offering, we are seeing early signs of interest in our VXL software as a standalone sale both to OEMs for integration into their flash storage arrays and directly to large data centers. Now we’re not currently forecasting the opportunity but we’re pleased with the early success of the product and are optimistic in regards to future sales success with this standalone software.

So moving onto our sales opportunities going forward, in speaking to our growing enterprise customer base, we begun to generate revenue with initial orders from several major data centers. Now though they represent a small portion of our revenue, historically speaking, these wins showcase OCZ’s transformation in 2012 and give insight into our future opportunities. Some of our largest new data center clients recently began to point or finish qualification during fiscal ‘12. These included a leading social media website, a leading cloud and content delivery provider, a global software-as-a-service provider, the world’s leading online auction site, the world’s leading web-based content management system, the world’s second largest telecommunications provider and three of the world’s top 10 data centers by size.

Further it’s worth noting that our largest current data center client, an American multinational internet company, headquartered in Sunnyvale has recently provided increased forecast of over three times their current run rate. That being said, growth in data centers is expected to drive sales for OCZ as we move forward. Now moving onto our OEM relationships, we’ve been able to secure our relationships with the majority of the tier-one OEMs exiting the year.

And we expect that these relationships will continue to grow as we expand our product offering and as we grow our sales and support organization to provide on the ground support at the manufacture site. Now moving on and before turning it over to Art, I want to take a moment to comment on our annual and quarterly revenue guidance. Art will provide a little bit more detail in regards to expense guidance during his commentary and we are guiding – so to move on, we’re guiding our net revenues for the fiscal quarter to be in a range of $110 million to $120 million and annual revenues to $630 million to $700 million for our fiscal ‘13.

It’s key to note that we expect about 60% to 65% of our revenues to occur in the second half of the year. This is in line with our normal seasonality. As a midpoint, growth is approximately 80%. In regards to our visibility on annual revenues, I wanted to take the time to remind our audience that our initial guidance at the beginning of fiscal ‘12 was $300 million to $330 million and we closed the year at $366 million. For fiscal ‘13, the increase in OEM and data center opportunities has helped us to increase our visibility into our client base.

So with that, I will hand it over to Art for a financial overview. Art?

Arthur Knapp

Thanks Ryan. As Ryan mentioned, we are very pleased with the continued business progress this quarter and for what has truly been a transformative year for OCZ. We are very appreciative of the dedication, talent, and determination of the people here at OCZ. Ryan covered product area revenues, so looking at the fourth quarter revenues by major geographies based on shipping destination, North America grew 94% year-over-year representing 38% of revenue. EMEA grew 51% accounting for 47% of revenue and rest of world grew 92% representing 15% of revenue.

Turning to the detailed financials, gross margins were at record 25% for the fourth quarter versus gross margins of 16.6% a year ago and 22.5% in Q3. We expect that going forward, gross margin should grow 100 to 250 basis points per quarter. To reiterate Ryan’s earlier comments, we are starting to see the benefits to our financial model from the combination of a mix shift towards the enterprise, the vertical integration of our technology and stronger more effective purchasing power.

Our operating expenses in Q4 was $35.6 million on a GAAP basis and $33.2 million on a non-GAAP basis after adjustments for cost associated with stock-based compensation, amortization of acquisition related intangibles and acquisition related charges. This is $33.2 million as compared to $19.9 million of non-GAAP expenses in Q3.

Since we accelerated the launch of the Everest 2 platform, and Vertex 4 product in Q1, we incurred increased expense levels in the fourth quarter which will continue into the first quarter. Within OpEx non-GAAP R&D costs were up over 450% and nearly doubled sequentially and they increased by $6.5 million. This sequential increase reflects approximately $2 million related to the acquisition run rates which I described on the Q3 call plus NRE and IP charges, licenses, prototype, and mass costs associated with the platform launches along with higher infrastructure costs for the R&D department such as design tools, staff levels, and specialized outside contractors.

Overall R&D cost as a percent of total spending was within the top end of the 36% to 40% mixed range which I described in Q3. Sales and marketing costs increased by a 160% from Q4 last year and by 50% or $3.6 million on a sequential basis, as we continued to build up our sales and marketing efforts to support increasing amount of OEM enterprise sales. It’s probably worth noting at this point that OCZ historically has carried sales and marketing expenses at a level much lower than comparable U.S. based storage companies. And we in fact do expect to see considerable cost leverage as we move forward.

As Ryan mentioned, when we look at our data center opportunities, we see the potential for dramatic shift in sales towards higher margin products over the next 12 months. G&A and operations increased by 120% in Q4 last year and by 53% or $3.3 million sequentially. During Q4, we incurred a onetime expense of approximately $1.2 million as we consolidated our manufacturing operations in Taiwan and moved into a larger facility allowing for an increase in both production capacity and efficiency. The recent factory consolidation will allow OCZ to drive reduce production costs on a unit basis, increasing operating leverage as we move forward.

In the fourth quarter, interest and financing costs increased by approximately $270,000 from the third quarter as we had incurred bank debt in Q3 which wasn’t paid off until mid February using the proceeds from the public offering which netted us approximately $110 million including the issue which was exercised in March. On our last earnings call, we announced that we’ve signed a proposal letter with Wells Fargo Capital Finance for a $50 million credit facility that can expand to $75 million if certain conditions are met. Given the additional public offering, this facility has now been modified to include a $60 million committed portion, than it can expand to $100 million.

We expect to conclude this agreement next week when the Silicon Valley Agreement expires. This new credit line will provide us with increased debt capacity at lower financing costs in our present facility. The fair value adjustment in the fourth quarter of warrants issued with our initial equity financings in Q1 last year resulted in a $2.4 million non-cash loss. This theoretical non-cash adjustment is removed as part of the non-GAAP presentation.

GAAP net loss for the quarter was $10.9 million or $0.19 per share compared to a net loss of $9.3 million or a loss of $0.27 in last year’s fourth quarter. On a non-GAAP basis, we incurred net loss of $6.1 million or $0.11 per share versus a net loss of $800,000 or $0.02 per share last year. Included in today’s financial release, there is a table which shows the reconciliation of GAAP to non-GAAP measures as well as the related calculations.

Turing to the Q4 balance sheet, our cash was approximately $92 million, an increase of $54 million from Q3. This increase principally reflects the net proceeds from our follow-on offering and the repayment of our $23 million Silicon Valley Bank loan. Inventory levels increased by $31 million to $109 million which is consistent with our comments during the offering that we will strategically build inventory to prepare for future business levels based on the purchase and processing wafers in the completed NAND flash devices.

As Ryan discussed, the cost savings, and decreased price volatility are pretty good to our success in increasing gross margins. Accounts payable increased by $21 million reflecting higher levels of purchasing activity after the public offering. With this late quarter activity, our average inventory days were a 101 versus 77 which is 3.6 turns versus 4.7. And payable days were 84 in Q4 versus 70 in Q3. As we move forward, we expect our inventory turns to generally remain in the 3.5 to 4.0 range.

Then due to the higher sales levels in the later part of Q4, accounts receivables increased by $7 million and our average receivable days increased to 56 versus 48 in Q3. This made our cash converting base 73 versus 56 in Q3, but again consistent with our working capital usage strategy discussed during the recent public offering. At year-end, our headcount was 708, up from 422 last year. During Q4, we added 74 people, 14 of which were part of the SANRAD acquisition and 60 were new hires, mostly in R&D and operations.

Since Q4 last year, we have tripled the R&D department with nearly half of the growth from acquisitions and the rest from organic hiring. Our sales headcount increased by about 75% from last year and since year-end, we have added a dozen people to our sales and marketing efforts. It is worth noting that while our R&D headcount expense should grow at a much lower rate moving forward, we are expecting to continue to ramp sales and marketing headcount aggressively in order to pursue the Greenfield opportunity that our SAN replacement products represent.

Our CapEx for Q4 was a little over $1.2 million making a total of approximately $3.5 million invested in fiscal 2012 related to factory expansion, SMT machines and other related items. We expect that CapEx in fiscal 2013 will be approximately $6 million to $7 million as we continue to expand our manufacturing capability.

For taxes, we have nearly $50 million of federal NOLs to use against future profits. With the impact of California suspension of NOL usage and the minimum AMT tax level, a 10% tax rate is appropriate to use for modeling while the NOLs are being utilized. Meanwhile, we are also engaged in the tax planning strategy to significantly reduce our future overall rate from the typical 35% to 40% range. For our share count, we currently have approximately 67.6 million shares outstanding and a 11.5 million shares subject to warrants and options. Weighted basic shares are estimated to be 67.4 million in Q1 and weighted diluted shares are estimated to be approximately 69 million at the current price levels and approximately $71.5 million at the $9 recent offering price.

To our guidance. Continuing the quarterly outlook we started last quarter, we are now also providing some commentary on expenses. Ryan mentioned that we expect net revenue for Q1 to be in the range of $110 million to $120 million and $630 million and $700 million for the year with a heavier weighting to the last half of the year. Our non-GAAP gross margins are expected to be slightly up from Q1 and to exit the year in excess of 30%. We have typical sequential gross margin increases of 100 to 250 basis points per quarter throughout the remainder of the fiscal year subject to changes in product mix as the SSD landscape continues to evolve.

We expect non-GAAP operating expenses to be in the range of $37 million to $39 million for Q1 and then exiting the year at between $43 million and $47 million for a quarter, as we continue to aggressively invest in R&D and sales and marketing to help achieve our ongoing growth objectives. In regards to our operating expense guidance, Ryan mentioned that in Q1 we have cost related to two unannounced controller platforms, which we have yet to include in our revenue guidance.

On our April 5th call, we indicated that controller platform related expenses can range from $5 million to $10 million, which can result in some lumpiness in our R&D costs as we expense rather than defer various IP, mass and NRE charges. For example based on current schedules, we estimate that R&D expense will decrease by several million dollars in the second quarter and then increase back to levels around Q1 in the later part of the year.

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

Question-and-Answer Session

Operator

Thank you sir. (Operator Instructions) Our first question comes from Aaron Rakers from Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

Yes, thanks guys. A couple of questions for me, first of all, I’d just like to ask, when you guys look at the guidance that you’ve laid out for the full-year, how do you think about that trajectory from a visibility standpoint, how do you get comfortable or how do you really go about laying out guidance looking out that far and what seems to still be a fairly dynamic – market dynamic?

Ryan Petersen

So I’ll take that one if you don’t mind, Aaron. Thanks by the way for the question. I think it’s important to note that our customer base has changed substantially over the year. So some of that questions historically for us about, are visibility into revenue guidance have kind of melted away as we go in a multi-quarter or year long forecast from some of our OEM customers.

Obviously any time you’re looking out a year, there is some variability. And you deal with that typically by looking at what you think it locked in and adjusting accordingly in terms of your range. As I kind of mentioned on the call, at the beginning [ph] of last year, that we ended up guiding quite a bit lower than we actually did. I would suspect that if I were just coming out and saying I mean I think we’ll take a relatively conservative view of what the future hopes for us.

You’ll also notice I do not mentioned or speak about really any controller sales, we’ve not really thought about what the Ultrabook opportunity is, we’re really focusing on the business the same way we have done looking at servers, looking at PCIe is a big opportunity and based our guidance on that. So there could be some additional upside or not, but the range is also 10% so I think that’s safe range.

Aaron Rakers – Stifel Nicolaus

And then two other questions if I can real quickly. So looking at this guidance and looking at the operating expense and gross margin that you’ve laid out, first of all, how do you think – when do we think that you guys would be bottom line profitable from a non-GAAP basis and then second to that is, how are we thinking about that long-term operating model that you’ve laid out in the past?

Ryan Petersen

So if you look at the – I know you probably didn’t have had time to do your model yet, but if you were to look at your model with the numbers we’ve given, presumably you would show a profit in Q2.

Aaron Rakers – Stifel Nicolaus

Okay, and then the long-term model?

Ryan Petersen

I think, we kind of get there towards the end of the year.

Aaron Rakers – Stifel Nicolaus

So when you say get there, do you mean operating margin in that – what’s your operating margin target long-term?

Ryan Petersen

I do think we’ve said before like 7% to 10% of that ‘12.

Arthur Knapp

15%.

Ryan Petersen

I am sorry.

Aaron Rakers – Stifel Nicolaus

Over the long-term model.

Ryan Petersen

Our long-term model.

Arthur Knapp

Yes, so that would be a return like 15% to 20%.

Aaron Rakers – Stifel Nicolaus

15% to 20%. Okay, thank you very much. I’ll get back in queue.

Operator

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

Rich Kugele – Needham & Company

Thank you. Good afternoon, gentlemen. Can you hear me alright?

Ryan Petersen

Yes sir.

Rich Kugele – Needham & Company

Hi, just a couple of question I guess, first, we got a lot of inbound questions over the course of the quarter just about the proprietary elements of some of your drives like the Vertex 4. Can you just talk about the extent of enterprise inclusion in that and to the extend you’re working with partners and how that compares maybe sort of players in this space?

Ryan Petersen

So the confusion – there is a lot of confusion around that, but I think the question is, is generally to answer in a pretty simple terms. Our controllers are at least any controller that’s sold under the Indilinx brand name or under an OCZ brand name, not one we’re using us, our real third-party controller like something from SandForce. Typically the things you need to know about them is that they are proprietary. Nobody else can duplicate that product. We do in fact sell those controllers or plan to sell to those controllers aggressively to other SSD makers. And they cost us a lot less, hence the fairly large NRE is associated with making those controllers?

So there is always – and I understand that we are covered by storage analysts, but there is always some cross licensing or something going on with every controller. So it’s not – there is not like there is not going to be an ARM license forever that as much as I’d like to do everything in-house, we’re not a semiconductor company, we make SSDs.

So its unique, it saves us a lot of money, nobody else has the technology, that is important to us, belongs to us. So hopefully I answered your question.

Rich Kugele – Needham & Company

Yes, thanks. And then when you look at rather than maybe give it on a quarterly basis, when you look at the full fiscal year, can you give us a sense in your newly reported categories what you would roughly expect the relative mix to be especially since there is such a gross margin difference between the two categories?

Ryan Petersen

I think we’re not going to comment on that at this point. You know where the starting point is. Generally, we do not bake in an enormous amount of upside regarding the PCIe business, though we do as I mentioned there are probably $1 billion of opportunities just for their top 50 opportunities. Given that massive number I think it would not wise to guide a high hit rate there, so you can presume that we’re not guiding the majority of our business from a segment that is only a little bit less than 10% down. So it’s growing at a faster rate, probably growing at twice the rate of the core business. I think that exactly gives you a color.

Rich Kugele – Needham & Company

Okay.

Ryan Petersen

So there could be some upside.

Rich Kugele – Needham & Company

Or maybe we’ll look at it in another way. A year ago, two years ago, you used to primarily channel baked and now, certainly over the last year you’ve shifted to more OEM. Can you give us a sense on what that mix might be today and what you would expect maybe to exit fiscal ‘13?

Arthur Knapp

Sure. So about 50% of our business exiting the year was system integration OEMs, SANs and enterprise.

Rich Kugele – Needham & Company

Okay. And so…

Arthur Knapp

So that probably is quite a bit now.

Rich Kugele – Needham & Company

And maybe exiting ‘13 what would you expect generally to be?

Arthur Knapp

I think that if you – we want to – or I would really characterize it as, if you look at the hard drive makers, I would assume that 80% of their businesses is OEMs or enterprises. So similar we are attempting to get to a similar ratio. Obviously that would indicate more upside than we’re guiding.

Rich Kugele – Needham & Company

Okay. And then just lastly, do you believe that you have enough NAND in-house today to be able to hit your guidance, what, for the first half or how much runway does that NAND gives you versus having to go and buy more from a Micron or whoever?

Ryan Petersen

Well we buy NAND all the time, so I mean we make pretty regular purchases. And you can tell from a fairly large even with our conservative guide the fairly large revenue guidance that we’re going to be running through lot of NAND. So presumably, we’ll be buying NAND every 30 days or so. I don’t know if that’s – what your questions is.

Rich Kugele – Needham & Company

Well that helps. Thank you.

Ryan Petersen

Okay.

Operator

Thank you. (Operator Instructions) Our next question is from Andrew Nowinski from Piper Jaffray.

Andrew Nowinski – Piper Jaffray

Hi good afternoon. Just wanted to touch base I guess on your annual guidance again. So you said that few tape-out products, the controller revenue and the SANRAD revenue would not get measured into the guidance. So I guess based on your accounts regarding that a lot of data center customer that increased CapEx by 3x, is it fair to assume that your FY13 revenue includes a ramp-up in that large scale [ph] clients and then were there any other specific deals that you are impacted into second half revenue growth?

Ryan Petersen

I am sorry, so which client are you talking about?

Andrew Nowinski – Piper Jaffray

I guess the first one that you mentioned regarding the large…

Ryan Petersen

Is that from networking side?

Andrew Nowinski – Piper Jaffray

Yes, the increase in CapEx about 3s.

Ryan Petersen

So our largest data center client today is – its baked and those are hard forecasts, we have that revenue. The majority of those other clients because really we don’t have the revenue yet, they’re not going to be baked into our forecast. So those will be something we have to update the market on as we really determine how much business they are going to do with us, so that’s not (inaudible).

Andrew Nowinski – Piper Jaffray

Understood, and then I guess, can you give any color on what prompted that large data center customer of yours to select the OCZ products, was the pricing below the competition?

Ryan Petersen

I will – hopefully its performance related. So I am going guess performance related. Right now very seriously that we’re cheaper than anybody else. So obviously you have to divide software enabled drives and the SAN replacement, where you have to really split the folks who just make a PCIe SSD from people who make a storage system. It’s our belief that our performance REs [ph] have used and pretty much everything is better with our products then our single competitors. So hopefully that we do of course sell at a lower price.

Andrew Nowinski – Piper Jaffray

Okay, understood. And then just real quick on the Vertex 4, I know you said still on the first stage [ph] that has demand track. So how is the demand track since then after you got one product back in the channel?

Ryan Petersen

I think demand is growing obviously. It’s not going to take over our sales overnight in that segment, but Vertex 4 is doing very well.

Andrew Nowinski – Piper Jaffray

Last question for me, I know it looks like inventory ramped up, will that for related to specific orders in the back half of the year and while you just to wait for purchasing?

Ryan Petersen

I am sorry?

Andrew Nowinski – Piper Jaffray

It looks the inventory looks like up again this quarter, was that related to specific orders in the back half of the year for FY13 or is that more due to just you’re waiting for purchasing?

Ryan Petersen

No, so the inventory we have now obviously has just for our normal purchasing and normal usage. So the kind of big ramp in the second half that we’re talking about, we want to buy for that approximately 12 weeks in advance with the orders coming in.

Andrew Nowinski – Piper Jaffray

Okay, got it, thanks.

Operator

Thank you sir. Our next question is from Alex Kurtz from Sterne Agee.

Alex Kurtz – Sterne Agee

Yes, thanks guys for taking the question. Just some clarification points Ryan.

Ryan Petersen

Yes.

Alex Kurtz – Sterne Agee

The difference between the HDD and the SAN replacement. Is SAN replacement just all PCIe or is there some Deneva in there as well?

Ryan Petersen

No, it’s a PCIe with software.

Alex Kurtz – Sterne Agee

Okay. So only PCIe?

Ryan Petersen

That’s correct.

Ryan Petersen

All right. Just back on this social networking win, I assume that’s a PCIe win, right?

Ryan Petersen

Sure. It is – we’re not commenting specifically on the client though.

Alex Kurtz – Sterne Agee

I know, but just from a product perspective that’s a Z-Drive win, right?

Ryan Petersen

That’s correct.

Alex Kurtz – Sterne Agee

Okay. And then can you take us through sort of how the channel works out Vertex 3 out of their inventory. I know you guys recognized and sell in and then how does that Vertex 4, gets layered in through in the next couple of quarters? Is that – is there a certain amount of discounting that has to go on to sort to ease that inventory in the channel or if it’s sort of like an orderly fashion for you guys that you’ve gone through before?

Ryan Petersen

I mean this is not the first time we’ve transitioned to product. So it’s just a matter – we’re talking about the channel which is what’s important to us as the company now. It’s roughly half of our business. And that number will change through the year. With OEMs, we know exactly obviously what they are going to take and when the switchover points are.

With the channel, there is some discounting – of course discount the old product to move through right as you move the new product. And I think I kind of covered that dynamic when I talked about Vertex 4s, people who’ve backed out the way that those margins to be around 40%. So when you launch a product, it does have higher margins, you bring down the margin of the old product and if you plan correctly, there is not a whole lot of inventory out there. And once that inventories run down, we move rolling the new product.

Alex Kurtz – Sterne Agee

So when you say that the February quarter and the May quarter does include a little bit of a burn down in Vertex 3 inventory, then sort of that’s why there is like an acceleration in the second half, is that a fair view of it?

Ryan Petersen

do you mean what’s generating the revenue acceleration in the second half?

Alex Kurtz – Sterne Agee

Well I guess I am saying is, are you waiting for some of the channel just to work through their Vertex 3 inventories as they move into Vertex 4 or is that much faster than?

Ryan Petersen

No, I mean there is not that much. That would be a lot of inventory in the channel. So there is – we typically are working on two weeks of inventory in the channel. So I don’t really – I mean I understand what you’re hitting at.

Alex Kurtz – Sterne Agee

No, that’s fair. There is only two reasons that answers the question. And just on the long-term operating model question and Ryan, so the 15% and 20% is that something that you guys could potentially achieve exiting fiscal ‘14? Is that something that could be a good target for the company or is that two years out now?

Ryan Petersen

Did you say ‘14?

Alex Kurtz – Sterne Agee

Yes, not fiscal ‘13 that we’re right now, but fiscal ‘14, I mean the low end of that range from the 15% to 20% operating margin.

Ryan Petersen

I mean if I would guess with the trajectory sorry, we’re all sitting here nodding at each other but I think the trajectory exiting ‘14 should probably be around that. The original LTM – the original long-term model, we refer to it as our three year model. And so the model you’re working off from was our three year model. Obviously that would be exiting ‘14.

Alex Kurtz – Sterne Agee

Okay. So heading the low – at least hitting the low end of the range Ryan, existing to fiscal ‘14?

Ryan Petersen

Yes.

Alex Kurtz – Sterne Agee

Okay. All right, thanks guys.

Operator

Thank you. Our next question is from Christian Schwab from Craig-Hallum Capital.

Christian Schwab – Craig-Hallum Capital

Congratulations on the strong gross margins and revenue guidance. Just so we’re all on the same page as far as the product groups, can you kind of give us a rough expectation of current gross margins in the HDD format, the SAN replacement, SSD and then tell us where you’re targeting that at the year-end in particular, I guess in the SAN replacement/PCI Express targets?

Ryan Petersen

So I mean I think what you can just do is just apply the PCIe numbers that we’ve given before and then what ends up happening is because of these fabs [ph] mixed dropping into a hard drive replacement, when you see hard drive target margins going up a little bit. So we’re looking at just in general terms our long-term target margins in the PCIe or the SAN replacement sector are in the mid 50s maybe 60% – 55 % to 60%. And the target margins in the hard drive format products are getting to around 30 – 28% to 32% I believe. Art, can correct me if I am wrong.

Christian Schwab – Craig-Hallum Capital

Does that sound right Art?

Arthur Knapp

Yes, those were the old categories we had when we had consumer in Enthusiasts, so now that there is one thing of their controller package depending on how you want to model it, the mid to high, 20s as a base and then 30%, 32% for the top end in that area.

Christian Schwab – Craig-Hallum Capital

Okay. That’s perfect. I don’t have any other questions, thank you.

Operator

Thank you sir. And I do have a follow-up question from Aaron Rakers from Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

Yes, thanks guys. I just want to touch a little bit on the gross margin guidance for the current quarter. This will be the first kind of quarter that we’ve seen Vertex 4 kind of contributions play into effect. You’ve talked about kind of the 40% gross margin target. You also have continuation of kind of the direct wafer engagement flowing through the model. So I guess I am trying to understand why the underpinning of the kind of only slightly up sequentially guide, what kind of tempers that? Is it the burn down of the inventory of the Vertex 3 or is that just a healthy sense of conservatism?

Ryan Petersen

I think that in general our objective is because we’ve had frankly a lot of issues giving analysts some model appropriately, what we think our margin and our operating expense guidance has been. Really we’re concorded to giving a range of 100 to 250 basis points on average per quarter through the year and then executing to that. Some of that is because project transitions do of course affect things, and we don’t know when it’s going to be done and a two week move on a 40% from a 28% margin product can have an effective 50, 60 basis points.

Its small movements, however because we’re under a high level of scrutiny, I think it’s appropriate to kind of guide that way. Does that make sense at all?

Aaron Rakers – Stifel Nicolaus

Yes.

Arthur Knapp

And there is revenue. So we’re also guiding the revenue now in place, that we feel is a very appropriate and gives us enough room to execute above. So I mean…

Aaron Rakers – Stifel Nicolaus

Right. And then also on the OpEx line, just so I understand the puts and takes there, you talked about a sequential decline going into the fiscal second quarter, it seems like the streets going to look at the NREs obviously inclusive in their model assumptions, what’s the anticipated NRE to hit the R&D line that you’re assuming in the – through the course of the year, just so we can have to have that in the back of mind how we should think about that as you kind of flow in and out of these tape-outs?

Arthur Knapp

Well this is Art. I think the guidance I was providing was several million dollars less in Q2 and then Q3 and Q4 coming back up to the Q1 levels.

Aaron Rakers – Stifel Nicolaus

Right, so you…

Arthur Knapp

I said if you kind of work with that parameter, you should be able to get there.

Aaron Rakers – Stifel Nicolaus

So to be clear you said $5 million to $10 million in R&D that’s for the two controllers that you’re taping out this current quarter, correct?

Arthur Knapp

That’s for per controller.

Aaron Rakers – Stifel Nicolaus

That’s $5 million to $10 million per controller.

Arthur Knapp

That’s correct.

Aaron Rakers – Stifel Nicolaus

Okay, so its $10 million to $20 million you’re assuming in the current – that don’t make any sense? So your assumption on the NRE and the R&D line this quarter is what?

Arthur Knapp

This is Art. We don’t break that other than that you see that there is an increase that we’re talking about for OpEx and a good amount of that is going to be on the R&D line. And then in Q2 it will come back down. The $5 million to $10 million is a range – typical range what we actually have can vary based on the platforms. I also spoke to the fact that we’re increasing the infrastructure, so there is higher level of ongoing costs, Ryan, talked about two controller platforms run not certainly in the revenues. So there is a lot of projects that we have. So it’s not like whatever we did in Q4 and Q1 and then we stop. We have a lot of projects that are ongoing.

Ryan Petersen

I think the answer is we pulled in – there is some of the NREs are probably are built in – all of the NREs are built into the OpEx forecast that we’ve given.

Aaron Rakers – Stifel Nicolaus

Okay. And if…

Ryan Petersen

We’re looking at roughly three including the one we’ve just expensed, three new controller platforms this year.

Arthur Knapp

Right.

Aaron Rakers – Stifel Nicolaus

And then finally…

Ryan Petersen

Does that make [ph]?

Aaron Rakers – Stifel Nicolaus

Yes, it does. And then final thing from me is, is inventory to be up or down sequentially this quarter?

Arthur Knapp

Is revenue I am sorry, is revenue going to up or down sequentially? I think we guided up.

Aaron Rakers – Stifel Nicolaus

Inventory.

Ryan Petersen

Inventory.

Arthur Knapp

Inventory up, I am sorry.

Aaron Rakers – Stifel Nicolaus

Up.

Arthur Knapp

Yes.

Aaron Rakers – Stifel Nicolaus

Okay, thank you.

Operator

Thank you sir. And now I would like to turn it back to Ryan Petersen for any closing remarks.

Ryan Petersen

All right, well thank you to everybody. In summary, it was another transformational year for us this year. Just two years ago, we were DRAM manufacturer, we’ve moved into SSDs and we’ve become the world’s largest independent SSD manufacturer. We further our lead over the competition. We continue to introduce new innovative technology and we have successfully executed kernel [ph] of our initiatives. Now I feel confident in our future, in the task that lay ahead for us and fiscal ‘13 and I am very optimistic about the business opportunities and about our enterprise pipeline.

Our goal to continue to hold our position as the world’s largest independent SSD provider, and I think we’re going to be able to do that. So with that, I conclude my remarks and I wish you adieu.

Operator

Thank you. Ladies and gentlemen, this does conclude your call for today. You may now all disconnect. Thank you very much and have a wonderful evening.

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