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Dot Hill Systems Corp. (NASDAQ:HILL)

Q4 2007 Earnings Call

March 13, 2008 4:30 pm ET

Executives

Kirsten Garvin - Director of IR

Dana Kammersgard - President and CEO

Hanif Jamal - CFO

Analysts

David Cahill - RBC Capital Markets

Glenn Hanus - Needham and Company

Clay Sumner - FBR

Michael Brown - ICM Asset Management

Operator

Greetings and welcome to the Dot Hill Systems Corporation fourth quarter 2007 earnings call. (Operator Instructions)

It is now my pleasure to introduce your host, Ms. Kirsten Garvin, Director of Investor Relations. Thank you, Ms. Garvin, you may begin.

Kirsten Garvin

Thank you. Hello, everyone, my name is Kirsten Garvin, and I'm Dot Hill's Director of Investor Relations. I would like to welcome everyone joining us on the phone and through our webcast to Dot Hill's conference call for the fourth quarter of 2007. A press release detailing our fourth quarter and full year 2007 financial results was issued earlier today and can be viewed on the Dot Hill website at investors.dothill.com.

With me today are Dot Hill's President And Chief Executive officer Dana Kammersgard; and Chief Financial Officer, Hanif Jamal.

Before we begin, I would like to inform everyone that certain statements made during this call regarding matters that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Because such statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the statements. To learn more about such risks and uncertainties, you should read the risk factors set forth in the Forms 8-K, 10-K and 10-Q most recently filed by Dot Hill. All forward-looking statements made during this call speak only as of the time they are made. Dot Hill undertakes no obligation to update such statements to reflect events that occur or circumstances that exist after they are made.

And at this time, I would like to turn the call over the Dot Hill's CFO Hanif Jamal.

Hanif Jamal

Thank you, Kirsten, and thank you all for joining us on the call. Today, I will be providing details on the company's fourth quarter and full year 2007 financial results, as well as earnings guidance for the first quarter of 2008. Let me start with Q4 net revenue and earnings. For the fourth quarter of 2007, Dot Hill posted net revenue of $51.8 million, which compares to $59.4 million for the fourth quarter of 2006, and $45.7 million for the third quarter of 2007. The net revenue figures for the fourth quarter of ’07 were above the guidance range of $44 million to $48 million that the company provided on November the 8th, 2007, and were in line with the revised guidance issued on January 7th, 2008 and February 8th, 2008.

The year-over-year decline in net revenue was due primarily to a decline in revenue from our largest OEM customer, Sun Microsystems. This decline was partially offset by increase in Series 2000 product revenues and sales to NetApp. The sequential increase in net revenue was largely due to greater than expected revenue contributions from Sun and NetApp.

Net loss was $46.4 million for the fourth quarter of 2007, or $1.01 per fully diluted share, including a non-cash goodwill impairment charge of $40.7 million. This compares to $9.1 million for the fourth quarter of 2006, or $0.20 per fully diluted share, including a foreign income tax expense of $0.5 million, related to a legal settlement, and $4.1 million for the third quarter of 2007, or $0.09 per fully diluted share. Excluding the goodwill impairment charge, net loss was $5.7 million for the fourth quarter of 2007, or $0.12 per fully diluted share. Excluding the foreign income tax expense, related to a legal settlement, net loss was $8.6 million for the fourth quarter of 2006, or $0.19 per fully diluted share, and net loss was $4.1 million for the third quarter of 2007, or $0.09 per fully diluted share.

Net revenue for the full year 2007 was $207.1 million, as compared to $239.2 million for the full year 2006. The year-over-year decline in net revenue was due primarily to an expected decline in revenue contribution from Sun that was partially offset by increased revenue from our Series 2000 product sales and from sales to NetApp.

Moving on to 2007 earnings, the company realized a net loss of $60.2 million for the full year 2007, or $1.32 per fully diluted share, including a non-cash goodwill impairment charge of $40.7 million, compared to $80.8 million for the full year 2006, or $1.80 per fully diluted share, including $3.4 million associated with the legal settlement, $1.4 million in foreign income tax expenses related to the legal settlement, $47.1 million in a tax valuation allowance, and $1.3 million in one-time compensation and consulting-related expenses associated with the retirement of the company's prior CEO.

Excluding the goodwill impairment charge, net loss for the full year 2007 was $19.5 million, or $0.43 per fully diluted share. Excluding the legal settlement, foreign income tax expenses related to the legal settlement, tax valuation allowance, and one-time compensation and consulting-related expense associated with the retirement of the company's prior CEO, net loss for the full year 2006 was $27.6 million, or $0.62 per fully diluted share.

We are presenting our financial information in this manner, as it provides management and shareholders with the more comparable and recurring measurement of revenues and earnings. For the GAAP versus non-GAAP comparison, please refer to the reconciliation table of non-GAAP measures, included in Dot Hill's press release issued earlier today. Also contained in the press release is an explanation of non-GAAP financial measures, as well as at detailed explanation of the company's valuation of goodwill practices.

Okay, turning now to gross margin. Gross margin as a percentage of net revenues for the fourth quarter of 2007 was 12.2%, as compared to Q4 '06 gross margin of 7.9%, and Q3 '07 gross margin of 14.3%.

The improvement in gross margin percentage on a year-over-year basis was largely due to the improved margin structure on the Series 2000 products, the reduction of manufacturing overhead, and variances and continued cost benefits as a result of the migrations of our offshore manufacturing partner.

This was partially offset by an increase in lower margin product sales to NetApp. On a sequential basis, as we've stated in our previous conference call, we anticipated gross margin percentages to be lower for the fourth quarter of 2007, due to the continued ramp of lower margin products that we are shipping to NetApp.

Going forward, we expect margin trends to continue to be relatively volatile, and will be highly dependent on our component cost reduction efforts and on the mix of customer and product sales.

On a full year basis, gross margin was 12.8%, compared to full year 2006 gross margin of 15.3%. The decline in gross margin percentage on an annual basis is attributed to the reduction in higher margin revenue from Sun, compounded by the effect of several new product introductions during the course of 2007.

Finally, with respect to operating expenses, for the fourth quarter of 2007, research and development cost were $5.9 million, as compared to $6.5 million for the fourth quarter of 2006, and $5.7 million for the third quarter of 2007.

The year-over-year decrease in R&D expenses was due to a higher level of investment in prototypes and project material in the fourth quarter of 2006, as we continued the launch of our Series 2000 products, as well as products for NetApp. The slight increase in R&D expenses on a sequential basis was due largely to costs associated with introduction of our new Series 5000 mid-range products. It is worth noting the small incremental expense we incurred in launching these new mid-range products, as compared to some of our previous product launches.

We attribute that to the leverage by our R/Evolution Architecture, which provides us with the ability to create new product iterations in a shorter period of time, and at relatively smaller expense. Sales and marketing expenses for the fourth quarter of 2007 were $4.5 million, compared to Q4 ’06 of $4.1 million, and $3.7 million for the third quarter of 2007.

The increase in sales and marketing expenses for the fourth quarter of 2007 was due primarily to severance expenses of approximately $0.6 million, associated with the restructuring of our office in the Netherlands. General and administrative expenses for the fourth quarter of 2007 were $3.2 million, compared to $3.8 million in Q4 ’06, and $2.4 million in Q3 ’07. Included in G&A expenses for Q4 ’07, Q4 ’06, and Q3 ’07 were $0.6 million, $0.3 million, and $1.3 million, respectively, in foreign currency gain. The year-over-year decline in G&A expenses was primarily due to a greater foreign currency gain in Q4 ’07 relative to Q4 ’06, and higher legal costs in Q4 '06.

Sequentially, G&A expenses increased due to the higher foreign currency gain Q3 '07 versus Q4 '07. Revenue from Sun contributed 52% of our total net revenue for the fourth quarter of 2007, as compared to 75% in the fourth quarter of 2006, and 58% for the third quarter of 2007.

Revenue from NetApp contributed 25.2% of our total revenue for Q4 '07, as compared to 15.7% in the third quarter of 2007. The company recognized productively insignificant revenues from NetApp in Q4 '06 for comparison purposes. We expect to generate an increase in percentage of revenues from our non-Sun sources in 2008, including NetApp, HP, and more than 24 other OEM customers that we have won as a result of our innovative R/Evolution products.

Broken down by products, SANnet II Fiber Channel accounted for 25.1% of net revenue, SANnet II SCSI was 19.8%, SANnet II SATA was 0.5%, and SANnet II Blade was 12.1% of net revenue in the fourth quarter of 2007. Our Series 2000 products accounted for 13.8% of Q4 '07 net revenue, and the [JY] products we are shipping to NetApp accounted for 25.2%. All other products and services accounted for approximately 3.5% of Q4 '07 net revenue.

Let me now discuss the balance sheet. Dot Hill finished the fourth quarter of 2007 with cash and cash equivalents of $82.4 million, with no outstanding debt. This compares to the Q3 '07 balance of $90.2 million. The sequential decrease in cash and cash equivalents was due primarily to operating losses, and the creation of hub inventory for certain of our large OEM customers. The Q4 ’07 cash figures equate to approximately $1.80 per share of cash and cash equivalent.

I will now turn to guidance. For 2008, the company will continue with its practice of providing quarterly guidance or projections. We’ll, however, provide these projections on a non-GAAP or adjusted basis only. For the first quarter of 2008, we will exclude the impact of an estimated $2 million reduction in revenue, associated with the issuance of warrants to HP, share-based compensation expense, foreign currency gains or losses, severance and restructuring charges, and other one-time items that may occur or be projected to occur.

For the first quarter of 2008, the company is targeting net revenue in the range of $48 million to $52 million, and a net loss in the range of $0.15 to $0.19 per fully diluted share on a non-GAAP basis, as discussed earlier. We have, however, factored into our earnings guidance the potential impact for additional engineering expenses associated with the development and launch of products for HP, as well as a potentially lower gross margin percent due to product and customer sales mix, and additional manufacturing overhead expenses related to the HP revenue ramp.

As in 2007 and prior years, we are not providing full year guidance in 2008. However, I do want to share with you a few of the more important constructs regarding our business model. As we have stated in prior public forums, it is our goal to return to profitability sometime in 2008. In order for us to achieve this, we must create operating leverage on a number of different fronts. If we are unable to accomplish these objectives; we could compromise our ability to return to profitability.

First, we must aggressively focus on further reducing product and manufacturing costs from our suppliers.

Second, we must leverage our existing investment in our Series 2000 and 5000 products, and drive revenue growth with these products to existing and new OEM partners.

Third, we must continue to focus on leveraging our R/Evolution Architecture to launch new products, at reduced incremental launch cost.

Fourth, we must try to maintain 2008 operating expenses on a non-GAAP basis at substantially the same level or slightly higher than 2007 level. While we have made significant progress in reducing our operating expenses from $70.6 million in 2006, excluding a one time legal settlement charges $3.4 million, to $51.1 million in 2007, excluding the goodwill impairment charge of $40.7 million, we do not expect continued improvement in 2008, in light of our anticipated investments to execute on our expanded relationship with HP.

Fifth, our ability to return to profitability on a non-GAAP basis will depend on our mix of product and customer sales, and overall gross profit and gross margin percentages versus our operating plan. From a margin standpoint, we expect higher margin revenues from Sun to continue to decline. We further expect that this revenue loss could be replaced by lower margin NetApp sales and sales of our Series 2000 products. These new products carry lower margins, but have continued to improve somewhat over time.

These factors that negatively impact gross margin percentage could be offset by sales of higher margin Series 500 product and Data Management Services, as well as the product cost reduction initiatives that I have already mentioned.

While we are aggressively focused on improving overall product margins, we do not expect overall gross margins in 2008 to be substantially different from 2007 levels, due to product and customer sales mix transitions.

Finally, with respect to cash, we expect a further reduction of cash, until we reach breakeven. In addition, we will be investing in hub inventory at HP, NetApp and Fujitsu Siemens. While it is difficult to forecast revenue at hub inventory levels at these customers, we expect that inventory at the end of 2008 could conceivably more than double from 2007 year end levels. Consequently, we expect additional cash to be tied up in the supply chains for these customers.

At this time, I would like to turn the call over to Dana.

Dana Kammersgard

Thanks, Hanif, and hello everyone. As I have indicated several times during the last two years, we have been undertaking an intense transformation of the company, to lay the foundation for us to return to profitability in 2008. We have frequently referred to this as our Quiet R/Evolution. During the fourth quarter of 2007, and into the beginning of 2008, we took the following steps that we believe will be the final elements of our transformation.

During the fourth quarter of 2007, we saw virtually all of the remaining inventory of our Series 2000 products supplied by Flextronics, and concluded the manufacturing transition of these products to MiTAC in Phoenix. From now on, all of our Series 2000 and 5000 products will be sourced from these partners. At the Storage Networking World event back in October 2007, we announced two new products based on our R/Evolution Architecture, the 2330i SCSI rate product, targeted as the fastest growing segment of the volume storage market, and the 5730, the first in a series of products targeted at the mid-range market.

Both products were available for shipment to our customers during the fourth quarter. As I mentioned during our Q3 earnings call, I’m especially excited about the introduction of the 5730 because it is the first in its series of the products targeted at the mid-range.

In addition the 5730, in combination with the Series 2000, represents the first truly and fully unified experience in terms of hardware, software and data for customers requiring both entry level and mid-range storage products. We do not believe that any of our competitors can currently offer this unified experience and the early feedback from our customers on the 5730 has been quite positive.

Initially, we have targeted our existing customer base with this product, while also going after other potential mid-range customers. This should allow us to gradually increase our foot print in that market segment. As with our Series 2000, we are targeting OEM customers, and as you likely know, the sales cycle can be quite lengthy. However, we believe we now have the products to begin to penetrate this incremental market.

During our last earnings call, I mentioned that NetApp had announced general availability of two products based on our technology in September 2007, and that we had agreed to supply follow-on products to their product line. During the fourth quarter, we released these follow-on products, and began to ramp revenue from NetApp representing roughly a quarter of our total net revenue in Q4.

However, we still do not yet have a good handle on the slope of the revenue ramp with them, and there could well be continued volatility in the short to medium-term. We are, at this time, contemplating moving the manufacturing of this product to MiTAC, as we did with our Series 2000 products. On January 7, 2008, we were pleased to announce that we had amended our agreement with Hewlett Packard. The original agreement covered great storage rates for the HP Storage Works 9000 virtual tape library system. Under the amended agreement, we would be providing private branded entry level rate storage [rated] to HP across a variety of applications. For a number of reasons, we believe this win is one of the most strategic and important wins in the history of the company.

Let me enumerate. First, it provides for a potentially long-term relationship with one of the premier server storage and networking companies in the world. Clearly, this is highly dependent on the number of things, including, most importantly, our ability to execute well for HP. You can be assured that there is a lot of energy focused on this at this time. Second, this agreement clearly validates the RAID storage products and technology represented by our R/Evolution Architecture. HP has the potential to be our largest customer based entirely on our own intellectual property, and we believe it speaks volumes about our innovative products and technology.

In addition, this agreement affords us the opportunity to sell incremental high margin data management services, software, such as our sure-to-happen or [sure-to-copy] offerings. And third, the potential volume of this business could allow us to further reduce component costs with our suppliers. We are aggressively pursuing this, and we will continue to do so throughout 2008.

As I look back on 2007, my first full year as CEO, I am pleased with the transformational progress we have made with the company’s customers, products and supply chain. As I look forward now to 2008, we will continue to build on the foundation that we have laid and drive this company towards a return to profitability. We are striving for a sustainable profitability that is based on diverse revenue steams, a great set of products incorporating our own IT, and a streamlined and more cost efficient supply chain. During the last earnings call, I identified the key strategic elements for 2008 and beyond.

Let me briefly remind you of what those are once again. First we will continue to focus on securing our position in the entry level storage market. [Brokering] the entry level segment continues to outpace the rest of the storage market, and we believe we are strategically positioned to capitalize on this growth. We grew our Series 2000 revenue nearly 114% year-over-year, and of course HP is great evidence in validation of this aspect of our strategic plan.

Second, we intend to venture and pursue a meaningful share of the mid-range market. This is important, because this market is larger in scope, and typically affords higher margins in the entry level market we currently serve.

Third, we will continue to focus on organic development of our unified RAID architecture and data management services software. As we establish a significant installed base of R/Evolution RAID systems in the field, our DMS software products become more important and significant potential margin enhancers.

And finally, we will continue to develop alternate engagement models to serve a greater universe of customers. We have done higher work on all facets of our strategic plan, and I believe we have begun to demonstrate tangible progress on all fronts. However, there is still a tremendous amount of work to do.

In addition to the operational objectives that Hanif has outlined, the keys for us getting back to sustainable profitability in 2008, are these. We must execute well on our expanded relationship with HP. This means aggressively driving the supply chain to meet HP's demand, meeting and exceeding their quality standards, and developing new products and derivatives of current products on schedule. We also must focus intensely on leveraging our larger forecast volumes to reduce product manufacturing costs, across all of our product lines.

In addition, we must accelerate the momentum of sales of our 2000 and 5000 Series products to new customers, as well as to more than 24 other OEMs which purchase these products from us. This will allow us to continue to drive towards a more balanced customer portfolio than we have had historically.

And finally, as Hanif mentioned, we cannot lose focus on the improvements in operating efficiencies we achieved in 2007, in terms of operating expense management, as well as process and infrastructure improvements.

The last two years have been challenging ones for Dot Hill. However, I am confident that we have laid a strong foundation in our drive towards returning to sustainable profitability. The Quiet R/Evolution is over. We know there is still a lot of work to be done, along the lines of what I have just outlined above. And our success is far from a slam dunk. But I believe we now have the customers, the products, and the supply chain, to not only achieve sustainable profitability, but to grow this company once more.

I thank you for joining us on this call and I look forward to speaking to you next quarter. Operator, we will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from David Cahill with RBC Capital Markets. Please proceed with your question.

David Cahill - RBC Capital Markets

Hi guys, just a few questions regarding Sun; that seems to have declined, I think, slower than the business that's declining, anyway slower than expected. Have you reached that expectation there, or do you continue to be, I guess, conservative, or maybe the word is aggressive, on the revenue declines in the forward outlook? And then, I have two other questions.

Hanif Jamal

We've not really reached that expectation, externally. I think that our forecasts are dependant upon the forecasts we've historically got from Sun. Yes, relative to our original thoughts a couple of years ago, the business has declined a little bit slower than we originally anticipated. But our own internal forecasts today are not that far off than what our actual results are.

David Cahill - RBC Capital Markets

Okay. So, there hasn’t been that much of adjustment relative to, I guess, or you may have anticipated originally?

Hanif Jamal

There has been an adjustment from what we had anticipated a couple of years ago, but on a quarter-to-quarter basis, we are not being surprised materially.

David Cahill - RBC Capital Markets

Yeah.

Dana Kammersgard

Hey, Dave this is Dana. Historical facts are not necessarily indicative of future performance, so we are taking what we think to be a prudent outlook towards the projection. It's a hard slope to call. As we've said numerous times in the past, this is the slope on the NetApp volume, and now the slope on the HP volume is hard to call, as well. We've been relatively surprised that the revenue stream has not tailed off as quickly as some might have projected. But that doesn't necessarily mean that we are opening ourselves up for short falls in the future by being too aggressive with respect to our projections.

David Cahill - RBC Capital Markets

Okay. All right, thank you. With respect to HP, are there any other warrants there? Are there any other contingent claims associated with those warrants, or are they fairly mainly awarded?

Hanif Jamal

They are fairly cleanly awarded. I mean, bottom line is that the exercise price is above $2.40, they [vested] immediately. They are pretty straight forward. They are pretty standard terms and conditions.

David Cahill - RBC Capital Markets

Okay. And then finally, stock base comp expense, give an estimate for that for Q1, just so we can look apples-to-apples versus prior years?

Hanif Jamal

Yeah. In fact, it's going to be roughly to same as Q4 '07.

David Cahill - RBC Capital Markets

Okay.

Hanif Jamal

Those numbers will be in our K, but you could look it around $700,000.

David Cahill - RBC Capital Markets

Got it, all right. Thank you very much.

Hanif Jamal

You are welcome.

Operator

Thank you. Our next question comes from Glenn Hanus with Needham and Company, please proceed with your question.

Glenn Hanus - Needham and Company

Good afternoon.

Hanif Jamal

Hi ,Glenn.

Glenn Hanus - Needham and Company

Hi. I don't know if you can give us any more color around the NetApp ramp. I assume it’s favorably surprised you. You guys sounded like you are not sure whether it will -- do you expect it to continue on a fairly steep ramp from here, or you are expecting it to flatten out pretty dramatically, or any color there whatsoever would be helpful?

Hanif Jamal

Well, you know you have to keep in mind, Glenn, that Q4 of ’07 was our first full quarter, and technically it wasn’t even a full quarter, because, as I recall, the products were launched September 18th, or announced September 18th, from NetApp, I almost said Network Appliance, but they don't call themselves that anymore.

Glenn Hanus - Needham and Company

Right.

Hanif Jamal

And so, it's just difficult, we have a data point of one, right? And the data point of one does not project a trend. We would like to have two or three data points to be able to then begin to extrapolate a curve, so…

Glenn Hanus - Needham and Company

So, with some of this storage, the backing and filling of the whole channel, if you will, and then perhaps there is the little trail off, and then you figure out what is your ramp is, is that it?

Hanif Jamal

Yes. It's certainly possible, I would be -- I would certainly not speculate personally on that. There is an awful lot of dynamics going on at the macro level in the economy right now. The product has been received very well and I believe it was InfoWorld's the [fast] 2020, was it, Kirsten? I think it was InfoWorld's product of the year for 2007, so kudos to NetApp on that. We're proud to be the basis of that at least in part, but it's just a little too early to call all the ramp.

Glenn Hanus - Needham and Company

And then on HP, I guess they formally released in March. Have you started some shipments there, and should we think about that having a steep ramp like Network Appliance or not, or now or later or…?

Hanif Jamal

So I am not going to comment too much with respect to their plans they have stated publicly, and that is my policy. Frankly, I haven't commented on anybody's [GA] dates, et cetera. But they have stated publicly that they intend to start shipping in March, and we obviously were very excited and very pleased to be their new entry level storage product. It will be interesting to see how fast they do ramp. It's a little early to call. Again, we do have forecasts from them.

Obviously, for them to start shipping in March, it would be reasonable to conclude that we've already begun shipments to them, because there are hubs to build and channels to prime and that sort of thing. But other than that, I really can't give you any color yet. We certainly can give you a data point of one next quarter, very similar to what we've done now with NetApp in the Q4 of '07 timeframe. So Q2 of '08 will be our first real data point with respect to forecast accuracy and that sort of thing, and you'll ask the same question and I'll give you the same answer that I did with respect to NetApp, and that is we have a data point of one. It's very encouraging, but we really can't project from that yet.

Glenn Hanus - Needham and Company

And on cash, can you give us some sense of where that might bottom through the year. I guess this is another quarter of cash usage. You have a rough sense of where that may kind of bottom out during the year?

Hanif Jamal

Yeah. So I am not going to sort of provide specific guidance out. So to share with you what the drivers are going to be, clearly the two primary drivers are going to be operating loss and inventory. Inventory one is, I have already indicated in our prepared comments. We could easily see inventory more than double -- conceivably more than double from where we ended up in 2007, that’s primarily building inventory at HP, NetApp, and Fujitsu Siemens. In terms of the inventory footer, they do [exhort]. While we would love for the inventory to build up because it means we are selling more products, with these guys it does tie up cash in their supply chain.

And the other side is operating losses, and we are not providing any guidance in terms of what we expect our losses to be and when we expect to breakeven. I doubt that probably doesn’t answer the question to the level of depth that you are looking for, but I think those are the major drivers.

Glenn Hanus - Needham and Company

Thank you.

Operator

Thank you. Our next question comes from Clay Sumner with FBR. Please proceed with your question.

Clay Sumner - FBR

Yes, thanks very much and I really would like to apologize with you all as I took on the call late, so you may have gone over these already. But if not, or if you don’t mind readdressing, some people believe you had to really agree to low gross margins on the HP program in order to win it, and then it might be even actually profitable for you. I don’t believe that, but if you could please go over the kind of the main clips and takes for gross margin when a program like that ramps, and what should the gross margin trajectory look like in that kind of a program?

Dana Kammersgard

Hi, Clay, this is Dana. I will take a crack at that and Hanif can as well. Every deal and every OEM that I have ever done or that I have seen anyone else do, in the early going, it generally started at lower margins, then you realize over time for several reasons. One is that every program I have ever done is competitive, and you are always competing against someone, usually more than some one, and it can involve internal competition and external competition.

Number two, products that you are typically awarded in the new deals, certainly of this scope, are generally early in their lifecycles, and early in their lifecycle means that you haven't ramped too wide. This is true about drives too, by the way, hard disc drives start out and they follow a price erosion curve and the margin appreciation curve. So, there really is no difference, then, in the nature of the business in general, particularly as it applies to OEMs.

And the third one is operating leverage, and the ability to take costs down, because the volumes go up substantially. Now, we believe that HP has the potential to help us drive significant volume. I also believe that, as result, we have the potential to lower our cost differentially. And yeah, we are very excited about opportunity. We have, I think, indicated that the margins are low going in, but this is based on our intellectual property. We have great operating leverage in our supply chain now. HP's name means a lot to a lot of folks. And we also have the potential to add new products that we don't have to competitively end. And data management services software, which we've already indicated that they are very interested in adopting and taking and selling as well. So, I can't give you or won't give you any projection in terms of the margin curve, we are pretty excited about this from a variety of points of view.

Clay Sumner - FBR

So Dana, I guess just to speculate if it got to anything like the level of a Sun program, if you got to that level, would margins be similar to the margins you guys earned on Sun program.

Dana Kammersgard

I don’t understand it, if the margins got to anything like the Sun program?

Clay Sumner - FBR

No, it's the volume.

Dana Kammersgard

Yeah, absolutely, I would say so.

Hanif Jamal

We believe there is certainly that potential.

Clay Sumner - FBR

Okay. And then, also again in [quality], if you covered it, but, could you give us an update on the Sun business, and it is clearly in decline, how should we model that decline? And do you guys expect that to maybe level off at the $15 million at quarter level or so?

Dana Kammersgard

No, we didn't talk about that one, Clay, but I am happy to readdress it. As we projected in 2007, and even in 2006, if you go back early, in the 2005 time frame, I predicted that it would have a negligible or minimal impact on 2006 and a moderate impact on 2007. And I believe that projection has come true. In fact, the tail has been longer than we thought. The slope has been shallower than we expected, and they still have reasonably robust product sales, and no public announcement of end of life of the products, yet. We think, we don’t know, or we think that may be because we have significant penetration into their OEMs and into their government accounts that don't turn product as fast as high-technology, end user customers or financial end user customers. So, I can't forecast an equilibrium point, yet. It's too early to do that. As you may recall, we have, I don't know what, I mean, 150,000 units in the field, all of which will at some point in time will go out of warranty, so we fully expect the service side of this to ramp up, as, or when, or if the product sales ramped down. So, we do expect to hit a steady state, but I don't know what exactly that is, at this point

Clay Sumner - FBR

Okay and then lastly.

Hanif Jamal

And, Clay I just want to reiterate something on your question around HP. I think we have said publicly in the past, and I want to reiterate, that the HP business in '08, it could be dilutive or it could be accretive. And I just want to reemphasize some of the factors that Dana talked about, what’s going to drive the profitability is a number of different things. It's our ability to reduce costs, that's the operating leverage piece that we talked about. But that's not only just on the HP business, but it's also our ability to accomplish that on the non-HP business. It’s value engineering the product, it’s ability to sell higher margin products, the mid-range products, data management services, those are going to be the key drivers that will determine what the gross margins structure of the business with HP will look like.

Dana Kammersgard

And there are other things, just to put a finer point on that. We are not saying at this point in time that we expect to be accretive for the year with respect to the HP program. We are not saying that we expect to be dilutive either. We don't know at this point, yet. It's too early to tell. We do expect, we believe it’s a very significant program, obviously we wouldn’t have gone after it if we didn’t think that it could have a material impact on our bottom line. Their forecast accuracy, how well the product is adopted in the market, how their sales force reacts to it, along with the other things that Hanif just identified, costs, etcetera are going to determine whether or not it's an aggregate accretive or an aggregate dilutive this year.

Clay Sumner - FBR

Okay. And then lastly from me, you guys have talked about before, your goals to be profitable, a quarter during 2008, I presume 4Q, ’08. That’s still the goal?

Dana Kammersgard

Sure.

Hanif Jamal

So, let me take that one, Clay. Certainly, we are planning to strive to be profitable sometime in 2008. But as I have indicated, there is a lot of hurdles, there are a lot of bumps in the road for us to get there. Some of the ones we have already talked, our ability to reduce the costs, the ramp of the business with HP, the ramp of the business at Sun, how the Sun declines, how quickly NetApp increases. Our ability to get operating leverage in terms of rolling out new products. Our ability to sell higher margin products. There are a lot of factors that are going to go into whether or not we will get there this year. But is that our goal? Is that what the company is focused on? Absolutely, the company is focused on trying to get to be profitable some quarter this year.

Clay Sumner - FBR

Well, I guess anybody would say. Have you guys gotten more or less confident in that goal in the last 90 days.

Hanif Jamal

I would say to you that we have seen, personally I think I have seen, probably with the HP business coming along, we are seeing some additional risks that we think we can manage. But we believe there are additional risks, on our paths to getting profitable.

Dana Kammersgard

We are pretty convinced, Clay, in laying the foundation that gives us opportunity to do that.

Clay Sumner - FBR

Okay. All right. Thank you very much.

Hanif Jamal

Thank you.

Operator

(Operation Instructions). Our next question comes form Michael Brown with ICM Asset Management. Please proceed with your questioning.

Michael Brown - ICM Asset Management

Hi guys. Just a couple of quick questions for you. How are you going to manage the inventory at your OEMs. In other words, are you connected at all into their supply chain systems, or is it more of an ad hoc, you get a phone call, orders for more units, how does that all work?

Dana Kammersgard

That’s a good question, Mike. How are you doing, this is Dana.

Michael Brown - ICM Asset Management

Hi, Dana.

Dana Kammersgard

We are going to manage it very carefully, number one, with dedicated logistics personnel, number two ,and Direct DDI connections to our customers that they can do electronic polls, number three.

Michael Brown - ICM Asset Management

Okay, so you feel pretty comfortable that you will be able to manage that inventory commensurate with their in-demand?

Dana Kammersgard

Yes, we have to. I mean this is a critical aspect of our success. It’s something that I can honestly say the Board is even focused on. This is how we decided to use our cash rather than stock buybacks, or other things, and we put a premium on our cash. We are going to have to do a good job of managing it.

Michael Brown - ICM Asset Management

By the way, I want to compliment you on having the vision to do that. I know you were getting some pressure to buy back stock, and it has worked out the way that you called it, so a good job.

Dana Kammersgard

Thank you.

Michael Brown - ICM Asset Management

I had a question for Hanif. I believe that in the press release, where you talked about revising the HP agreement, that you talked about an additional $10 million to $20 million you have to invest primarily in inventory at HP hubs. Did I get that right?

Hanif Jamal

Yes. So basically, in the prior press release I said that we could envision spending as much as much $10 million to $20 million of inventory at HP, as well as in other organizational costs such as engineering and beefing up our supply -- operations organization, et cetera.

Michael Brown - ICM Asset Management

Okay, and then on this call you said that, I believe, that inventory could actually from Q4 levels double which would take us -- would be an additional $9 million.

Hanif Jamal

I think I said more than double.

Michael Brown - ICM Asset Management

More than double. Okay that’s what I was missing. Okay.

Hanif Jamal

It's more than double, absolutely.

Michael Brown - ICM Asset Management

Okay, and then finally, I believe it was in February, you talked about a target operating model that you hoped to achieve in the intermediate term. Are those goals still ones that you think you can get to, or with some of these new OEMs going on are we pushing that out?

Hanif Jamal

I think, Mike, at this stage it’s really hard for us to predict what the operating model is going to look like. We have just layered in a -- just a whole new level -- whole new layer of business with HP. Where the margin structure on the HP business settled and where the margin structure and the volume of the NetApp business settled will, to a large extent, drive what the model is going to look like.

Michael Brown - ICM Asset Management

Okay.

Hanif Jamal

Do we still, do we think -- to go back, we think we can be so this can get profitable? Yeah, absolutely we are focused on getting there. Some of the dynamics of getting there may have changed, or some of the timing may have changed.

Michael Brown - ICM Asset Management

Okay and actually, yes, one more quick question, and I don't imagine you gave my answer as yes, but at some point do you think you could give us a target for days of inventory that we could use for modeling purposes?

Hanif Jamal

Yes. You know something, I’m happy to share something right now. In terms of inventory, the way we go and model our inventory is, if you look at it historically, 2006, beginning of 2007, we used to run $2 million to $3 million -- $3.5 million, and that was sort of a steady state for quite a bit of time. What we have done since then, we have incremented that with hub inventory for our large OEM customers. That inventory should probably be modeled at about five to six weeks of inventory in the pipeline present. Okay, so that's really the best way to model that regardless of the base level, which is as you know, this is an base level inventory in parts and others things in the organization, and then there is all the tough inventory.

Michael Brown - ICM Asset Management

Okay, great, that's very helpful. Thank you very much.

Hanif Jamal

Thanks, Mike.

Operator

There are no further questions in the queue at this time. Would you like to make any closing comments?

Hanif Jamal

No, not really. But thank you all for attending, we look forward to speaking with you soon and if there are any other questions we will follow-up.

Dana Kammersgard

Yes, please follow-up with Kirsten Garvin if you have any additional questions you have with us. Thank you all.

Operator

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Dot Hill Systems Q4 2007 Earnings Call Transcript

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