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OCZ Technology Group, Inc. (NASDAQ:OCZ)

F1Q13 Results Earnings Call

July 10, 2012 5:00 PM ET

Executives

Bonnie Mott – Senior Manager, Investor Relations

Ryan Petersen – Chief Executive Officer

Art Knapp – Chief Financial Officer

Analysts

Rich Kugele – Needham & Company

Aaron Rakers – Stifel Nicolaus

Andrew Nowinski – Piper Jaffray

Amelia Harris – Sterne Agee

Kulbinder Garcha – Credit Suisse

Mark Kelleher – Dougherty & Company

Operator

Good day, ladies and gentlemen, and thank you for standing by. And welcome to the OCZ Technology to host Fiscal Year 2013 First Quarter Conference Call and Webcast. At this time, all participants are in a listen-only mode. Later, we'll conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions)

As a reminder, today's conference is being recorded. It's now my pleasure to turn the call over to Bonnie Mott, Senior Manager of Investor Relations at OCZ Technology. Please go ahead.

Bonnie Mott

All right. Good afternoon and welcome everyone. On the call today are Ryan Petersen, CEO; and Art 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 July 10, 2012. Please keep in mind that 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 the call are made pursuant to the Safe Harbor provisions of the federal securities laws. Information contained in these forward-looking statements 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 everybody. During the first quarter we again reported record revenue and we saw significantly accelerated bookings of nearly $140 million. Our first quarter revenue increased 54% to $113.6 million, compared with Q1 of '12 revenue of $73.8 million. Our SSD revenue reached $106.5 million for the quarter up 54% year-over-year, compared with $69 million in Q1 '12.

Revenue from our power supply and other category was $7.1 million in the first quarter. It's important to note that our power supply business is experiencing significant headwinds in terms of both revenue and gross margins, as sales of desktop PCs which use these products continue to dwindle. As such, our power supply revenue and gross margin during the quarter were well below our expectations.

Regarding our revenue trajectory overall, we achieved record bookings during the quarter of approximately $140 million and successfully launched the first two families of drives based on the Indilinx Everest 2 platform, Vertex 4 and Agility 4. We shipped over 100,000 units in the first quarter.

I think it's important to note that bookings are normally immaterial and we're reporting bookings this quarter to highlight that we experienced the temporary shortage of power regulators late in the quarter. This also experienced the increase in OpEx in comparison to our previously guided range. These supply chain issues were recently resolved.

Our non-GAAP gross margins increased slightly in the first quarter to 25.2% versus 25% in the fourth quarter, and increased significantly from the 20% reported in Q1 '12.

During the first quarter, we introduced our Indilinx Everest 2 platform and started to ship Vertex 4 mid-quarter and Agility 4 in the last few days of the quarter. The success of these products on a go-forward basis is expected to be impactful to our gross margins.

In regards to the Vertex 4 and Agility 4, on our last call we gave you an early look into initial demand. We continue to receive praise from the industry in terms of performance and feature sets, and are extremely pleased with the improved quality and reliability of these drives in comparison to our previous product generations.

We have since launched firmware and HSDL upgrades that have provided significant performance advantages over the initial release. And we continue to work diligently to increase the price and performance lead in relation to our competitors.

It's key to note that as we had indicated on our last conference call, in anticipation of new products that carry higher margin, we reduced the prices of the last generation of products to well below our average gross margin, while maintaining higher margins on current generation products.

It is our expectation that margins will continue to increase as we transition to our newer generation products and we're confident that our gross margins will see an incremental expansion as a result of increasing purchasing scale and improving product mix.

Moving on, non-GAAP operating expenses in the quarter were $39.8 million. This reflects our expenses at the higher $140 million booking rate. To be specific, this include significantly increased sales and marketing spending from both the growth of our enterprise organization and aggressive advertising programs that were meant to foster increased adoption of our next generation SSDs.

Now, to briefly discuss our SSD revenue by product segment, revenue generated from our hard disk drive format products, which includes our SAS and SATA product lines accounted for $100.3 million in the first quarter, up 5% from $95.1 in the fourth quarter and 45% on a year-on-year basis compared to $69.1 million in the first quarter of '12.

Revenue of our SAN replacement products was $6.1 million and there were no comparable sales in the first quarter of last year. Let me remind you, as we previously mentioned, do we -- we do not expect significant SAN replacement sales until our third fiscal quarter. This is due the long qualification cycles associated with these products.

And we continue to see positive indicators in terms of growth in these product lines. It's worth noting that our gross margin with these products are generally above 50% and any material ramp could significantly increase the company's overall gross margin profile.

I'm very pleased with the developments we have made in building out our enterprise sales platform and recent activity with a number of significant clients. During the quarter, we continued to expand our sales force and build our enterprise technical support organization. We continue to progress on schedule and are extremely optimistic about the opportunity for growth in our enterprise product segments.

Now, as it seems to be a hot topic, I'd like to cover the market environment in regards to NAND flash pricing briefly. NAND flash prices declined significantly in Q1 and as a result we have seen a material increase in sales of our higher capacity products.

Now, while this is an early trend, we expect that the demand shift to higher capacity drives could produce materially increased revenue in our hard disk drive replacement segment if this trend holds.

It's always been our belief that SSD prices do not need to match those of hard disk drives on a per gigabyte basis in order to drive large scale adoption of SSDs. As such, it’s becoming evident that SSDs are increasingly competing with hard disk drives in cost conscious market segment, a trend that’s clearly positive for the SSD industry.

Given that, we believe that pricing on 25-nanometer NAND flash has reached its bottom and in order to drive continued price decreases on a per gigabyte basis, SSD companies need to continue to introduce support for new NAND flash nodes and new technologies, such as the upcoming 20 and 19-nanometer nodes and TLC.

It's further our expectation that as a limited number of our competitors will be able to quickly make this transition. Our controller app roadmap gives us a clear competitive benefit on a go-forward basis.

We will continue to aggressively spend to maintain our technology lead and drive adoption of lower cost drives as it’s our belief that this spending is key to the future success of the company.

In regards to sourcing NAND, we continue to work with key suppliers and industry relationships to ensure timely and cost effective supply of flash. We have successfully made the transition to purchasing wafers and our focus has moved toward reducing our wafer processing time.

I think it's important to point out that we expect our NAND inventory turnover will reach normalized level over the next two quarters and we're glad to note that our wafer inventory has already begun to drop in relation to expected sales, as we become more efficient at processing wafer.

This point’s specifically to our balance sheet metrics, most notably the high inventory to sales ratio. In short, we expect to see considerable improvements in these metrics, which will in turn lead to a healthier balance sheet over the next few quarters.

We're sure that you're aware of the significant benefits to the formalized arrangement with the NAND flash manufacturer. And we’d like to highlight that we're evaluating several potential options for a deeper purchasing relationship with NAND manufacturers. It's worth noting that we intend to aggressively pursue this strategy and are optimistic about its potential outcome in the near to medium-term.

Now, moving on, let me take a short -- give you a short update on our product development front. I think it's important to point out that we’ve recently gave out our next generation Barefoot 3 controller and expect to receive sample silicon back from our foundry partner TSMC in coming weeks.

And as such, we expect to begin sampling SSDs on this controller in the August to September timeframe. We expect to have SSD sales related to Barefoot 3 in the third fiscal quarter.

Initial specifications indicate that Barefoot 3 will support a significant performance increase over our current products and as its primary IP blocks are not licensed from a third party, it provides additional incremental cost benefits to OCZ. The Barefoot 3 controller utilizes our internally designed Aragon 400 megahertz 32-bit processor, which for Barefoot 3 was implemented in TSMC's 65-nanometer GP process.

The Aragon core is the world's first SSD optimized processor and supports an SSD specific risk instruction set, allowing most instructions and branches to be executed in a single cycle.

When implemented in SSD controller, this gives the core a much higher performance than when using an off-the-shelf embedded safety field. And this design opens a world of new possibilities for game changing SSD solutions as it supports unprecedented levels of processing power.

Moving on to cover our SAN replacement business, we continue to see increased interest in our Z-Drive series of products and seen our sales pipeline for these products continue to grow. We believe that the available market for PCIe based SAN replacement products and the associated software continues to develop at an astounding pace and we're optimistic about the opportunity.

It's our belief that our SAN replacement products offer a superior feature set and performance over the SAN replacement products over other SAN replacement products, and that over the few -- coming few quarters this business will blossom, making a clear and significant impact on OCZ.

As previously stated, we expect to see sales growth in this segment begin to ramp in the third quarter. And we continue to expand our enterprise sales force in order to ensure that we address this greenfield opportunity adequately.

We're excited that we have recently received VMware Ready status for our Z-Drive R4 and we expect this to be key to future growth in the segment. As far as our VXL virtualization software goes, we released a mass production version during the quarter and already have begun to see initial deployments. The general availability of VXL and the recent VMware certification of our Z-Drive R4 represent material progress for our enterprise efforts.

In regards to growth of our customer base, I'll simply state this time that we're extremely pleased with the continuing development. From consumers to OEMs and enterprises, we continue to gain meaningful traction. Our transition into the OEM and enterprise arenas continues to go well as we add numerous clients each quarter.

In regards to significant customer news, I'd like to confirm that we are expecting Microsoft deployments across a number of discrete opportunities around our Deneva 2 SATA products, our Talos SAS drives and our Z-Drive R4 PCIe SSD. And this could be material to our business in the near-term and we believe that Microsoft could grow to become one of our most significant clients.

Please note, while we've begun shipping our Z-Drive products to Microsoft during the first quarter, our aggregate sales to distributors and OEMs for Microsoft were less than $1.5 million and therefore not impactful in the first quarter.

With that, I will hand the call over to Art for a financial overview.

Art Knapp

Thanks, Ryan. I'll also point out that our 10-Q for the first quarter is now on file with the typical additional details and disclosures. As Ryan mentioned, we are very pleased with the continued record revenues that we reported for the first quarter and the demand we are seeing for our new products. We thank all of our employees for their dedication and commitment to our success.

Ryan covered revenue by our product groups, so looking at the first quarter revenue by major geographies based on shipping destination. North America grew 120% year-over-year, representing 40% of revenue. EMEA grew 27%, accounting for 46% of revenue, and rest of world grew 33%, representing 14% of revenue. The increase in growth in North America is generally associated with the growth of some of our OEM clients, both server and PC.

Turning to the detailed financials, non-GAAP gross margins increased to 25.2% for the first quarter versus 25% in the fourth quarter and gross margins of 20% a year ago.

We started to ship new products based on our Indilinx Everest 2 controller during the second half of the quarter and expect to see positive impact to gross margin in the second quarter, as the mix shifts to our higher margin products.

Our operating expenses in Q1 were $41.4 million on a GAAP basis and $39.8 on a non-GAAP basis after adjustments for costs associated with stock-based compensation and amortization of acquisition related intangibles. The $39.8 million of non-GAAP expenses in Q1 was slightly over the $39 million top end of the expense range we had guided to in last call.

As you recall, on our last earnings call, we stated that the accelerated launch of the Everest 2 platform and the release of the related Vertex 4 and Agility 4 products in Q1 increased certain expense levels in the fourth quarter that would continue into the first.

In addition to expenses related to these products in the first quarter, we also incurred some of the design costs related to two unannounced controller platforms, which we have yet to include in our revenue guidance. As Ryan mentioned, we are also very excited about these new platforms and expect that we will begin to see additional revenue opportunities develop as soon as the third quarter.

Within OpEx, non-GAAP R&D costs were up 41% sequentially and increased by $5.3 million. Overall, R&D costs as a percent of total spending was 46%. The sequential increase reflects the additional expenses for the new platforms and products along with increased R&D headcount.

Non-GAAP sales and marketing costs increased by 25% or $2.6 million on a sequential basis, as we continued to build up our sales and marketing efforts. Our customer marketing and advertising expenses increased significantly due to the launch of our new products, but we expect these expenses in general terms to moderate in the second half.

Non-GAAP G&A and operations decreased by 15%, a decline of $1.4 million sequentially. As you recall, during Q4, we incurred a one-time expense of approximately $1 million as we consolidated our manufacturing operations in Taiwan and moved into our larger facility. If you factor out that one-time expense, non-GAAP G&A and operations expense declined about 5% from the fourth quarter.

At quarter end our headcount was 754, an increase from 708 at the end of February. During Q1, we added 46 people, roughly half of the new hires for sales and marketing in order to pursue the greenfield opportunity that our SAN replacement products represent and roughly half in R&D.

In the first quarter, interest and financing costs decreased by approximately $229,000 from the fourth quarter. On May 10th we signed an agreement with Wells Capital Finance for a $35 million secured credit facility to replace the prior Silicon Valley Agreement.

The Wells facility has a five-year term and provides for committed expansion up to $60 million of cumulative borrowings and a potential further expansion to $100 million of total borrowings. In each case, if certain conditions are met. This new credit line provides us with increased debt capacity at lower financing cost.

The fair value adjustment for warrants issued from our initial equity financing in March 2010 resulted in a $7 million gain due to the lower stock price. This theoretical non-cash adjustment is removed as part of the non-GAAP presentation.

GAAP net loss for the quarter was $6.3 million or $0.09 per share compared to a net loss of $9.1 million or a loss of $0.20 in last year's first quarter. On a non-GAAP basis, we incurred a net loss of $11.5 million or $0.17 per share versus net income of $501,000 or $0.01 per share last year. Included in today's financial release is a table which shows the reconciliation of GAAP to non-GAAP measures as well as the related calculations.

Turning to the Q1 balance sheet, our cash was approximately $43 million, a decrease of $49 million from Q4. Inventory levels increased by $17 million to $126 million, due principally to a quarter end NAND purchase of $14 million, consistent with our prior comments that we will strategically build inventory to prepare for future businesses levels.

To follow up on Ryan's comment on NAND relationships and to make it clear, we expect that our average inventory turns which were 2.9 this quarter versus 3.6 in Q4 will increase starting with Q2. This will be the result of faster wafer processing, less bulk purchases and increased operational efficiency.

During the quarter, our accounts payable decreased by $8.4 million, while our payable days were 89 in Q1 versus 84 in Q4.

Due to the higher sales levels in the latter part of Q1, accounts receivable increased by $16.6 million, and our average receivable days increased to 64 from 56 in Q4. Thus, our cash conversion days were 99 versus 73 in Q4, but again, consistent with our working capital usage strategy discussed in the recent public offering. And to be abundantly clear, we fully expect that our balance sheet metrics will improve as we move forward.

As I've stated before, I'm targeting inventory turns to be in the range of 4.5 to 5.0 for Q4. This and the expected operating results will result in positive cash flow from operations for Q4 and into fiscal 2014.

Our CapEx for Q1 was $1.5 million as we added to our SMT lines and test equipment. As we stated in our last quarter's call, we expect CapEx in fiscal 2013 will be approximately $6 million to $7 million, as we continue to expand our manufacturing capability along with building our internal infrastructure as we scale the business level.

For taxes, we have $56 million of federal NOLs to use against future profits. With the impact of California's s suspension of NOL usage and the minimum AMT tax level, we think a 10% tax rate is appropriate to use for modeling while the NOLs are being utilized.

Meanwhile, we are also engaged in a 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 67.7 million shares outstanding, and 11.3 million shares subject to options and warrants.

Weighted diluted shares are estimated to be approximately 69.3 million at the $6 price level, and 71.8 million at the $9 recent public offering price.

I'll now turn the call back to Ryan for some further comments on our guidance. Ryan?

Ryan Petersen

Thanks, Art. Moving to guidance, we expect our net revenue in Q2 to be in the range of $130 million to $140 million, and $630 million to $700 million for the year. To add clarity here, as in years past, we expect 60% to 65% of our revenue will occur in the second half of the year.

We expect sequential gross margins, I'm sorry, we expect sequential gross margin increases with typical increases in the 100 to 250 basis points per quarter range throughout the remainder of the fiscal year and to exit the year in excess of 30%. This is, of course, subject to any changes in product mix as the SSD landscape continues to evolve.

We expect non-GAAP operating expenses to be in the range of $38 million to $41 million for Q2 and to exit the year between $43 million and $47 million as we continue to aggressively invest in building out the business and strengthening our leadership position.

With that, I'll conclude my formal remarks and I think we're ready to open up the call for any Q&A. Operator?

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first questioner in queue is Rich Kugele with Needham and Company. Please go ahead. Your line is now open.

Rich Kugele – Needham & Company

Thanks. Good afternoon. A few questions from me. So first, on the bookings, how do you actually define the bookings, like what timeframe are you looking at and then of the $140 million, how much of that is tied to Vertex 4 and Agility 4? Is that all of it? And I have some follow-ups.

Ryan Petersen

I think that it's not -- the question is, is typically what do our bookings look like is the first part of that, correct?

Rich Kugele – Needham & Company

Well, or are you defining this as one quarter worth of bookings or is this over the next 12 months you expect to ship it?

Ryan Petersen

I'm sorry, that's one quarter worth of bookings. We typically don't have any material bookings usually the gap is fairly minimal. We'll carry over single-digit millions of dollars. So I think it is -- it's clearly important to understand that the bookings were that much higher level and the OpEx really relates to that.

The reason we didn't ship all of that product is obviously the supply chain shortage that I brought out or brought up during the call. And then I'm not sure that I exactly answered the second part of your question, so if you could ask that again, please.

Rich Kugele – Needham & Company

Well, just is it all tied to Vertex 4 and Agility 4?

Ryan Petersen

I think the answer on that is though the shortage affected those products, I can't say that it was all tied to those products.

Rich Kugele – Needham & Company

Okay. And so you basically you make a sale, you have to pay the salesperson because they made a sale but you can't ship it so you can't generate the revenue, so shouldn't sales and marketing be down sequentially?

Ryan Petersen

No. I mean generally the marketing expense -- the increases in expenses are related to marketing expenses. So those unfortunately were committed to regardless and they're incurred. The commission portion of the expense was not incurred.

Rich Kugele – Needham & Company

Okay. And then from a cash flow perspective, Art, you're talking about being able to be cash flow positive in Q4. So does that also then imply you probably be slightly negative in Q3?

Art Knapp

Yeah. With -- when I was at various conferences at the end of May, I was telling people that with the expected ramp in the second half, the working capital cycle will probably require us to dip into the bank line but then it becomes cash flow positive in Q4. Its -- that’s typical cycle, any time you have a spike in sales, it's going to put pressure on the working capital model. So that's why we do have the bank line in place.

Rich Kugele – Needham & Company

And in terms of the discounting of older products, can you talk a little bit about that. Are you done discounting as all the older product that you wanted gone and -- or will there be any effect here in the second quarter?

Ryan Petersen

I think that there will be a -- there will continue to be an effect. Obviously, we're not going to be limited on how much Vertex or Agility 4 we ship. So our objective going into the first quarter and managing really the product transition was based on the fact that we’d be able to really target a certain level of shipments on the new products. Obviously, they're very popular.

When we ran into essentially a brick wall as in terms of how many of those we could ship, the margins -- they did not average out at the level we expected them to. Obviously, with no shortage and we don't have a shortage anymore of the voltage regulators that are in question. With no shortage there, we're able to manage it on a go forward basis, but we're continuing to discount the old products.

Though we expect to -- at 100,000 units and a higher than average ASP, we would expect to see the transition happen a little more quickly than originally expected, which is positive news. So I think it was -- on a go-forward basis, we'll be able to see the margins going up at a more rapid or at a higher growth level.

Rich Kugele – Needham & Company

Okay. Then my last question…

Ryan Petersen

I’m trying to make sure I answered the question fully.

Rich Kugele – Needham & Company

Yeah. Yeah. I think so. Right. And then, the last question is just on Microsoft, now that you're talking about it publicly. Can you just talk about just on -- let's just take the R4 for example, how would you expect it to be deployed? What type of average capacity? How do you expect it to look? And are they taking your software as well?

Ryan Petersen

They are -- so I'll start with the easy question. They're not currently taking our VSL software. We weren’t in GA or we didn't even, I believe, have a software we believe bought, say, in February. So we did not have a software arm at that time other than the normal management tools like our Z verse series of management tools.

So no acceleration software which is the VXL software included on the PCIe win there. The ASPs vary quite a bit from opportunity to opportunity. So there are opportunities on the low end. And I'm doing this from memory, with an ASP in the $300 to $400 range, I think $312 is probably our lowest in-bound sell price on a SATA product and obviously the ASPs on the PCIe product I believe are in the $4,000 to $5,000 per unit range.

There are numerous opportunities at Microsoft. I do believe that we're currently engaged in six sizable for us opportunities, probably four to five of which we expect to win in the short term, hopefully as a sole source. And some of them we've won already.

Rich Kugele – Needham & Company

Okay. But none of this was included in the 630 to 700 guidance?

Ryan Petersen

That's right.

Rich Kugele – Needham & Company

Okay. Great. Thank you very much.

Operator

Thank you, sir. Our next questioner in queue is Aaron Rakers with Stifel Nicolaus. Please go ahead. Your line is open.

Aaron Rakers – Stifel Nicolaus

Yeah. Thanks guys for taking the questions. A couple as well. I want to go back to the voltage regulator issue that you guys are referencing. I guess, just the first question there is when did that develop in the quarter -- in the May quarter?

Ryan Petersen

It was fairly late in the quarter. Basically, the parts didn't arrive for the last few weeks of the quarter.

Aaron Rakers – Stifel Nicolaus

And is the message, Ryan, I'm trying to understand, is that you're given a 140 number, would you have been above your 110 to 120 guide, if they weren't for that?

Ryan Petersen

I'm sorry. So the 140 is immediately shippable backlog. So we would have been at -- it's actually 139 point -- and change, it's close to 140, its slightly under. So that would have been our expected shipping level had we not had the shortage.

Aaron Rakers – Stifel Nicolaus

So that would have been the number for the quarter, just to be clear.

Ryan Petersen

Yeah. Absolutely.

Aaron Rakers – Stifel Nicolaus

Basically. And can you help us -- I guess I'm trying to understand, your OpEx was higher than your original guide and you had given that guidance with one month left in the quarter.

Ryan Petersen

Sure, so we guided…

Aaron Rakers – Stifel Nicolaus

I'm trying to understand that.

Ryan Petersen

Very simple. So and Art can butt in if he would like to. So we were at -- we guided the top end of our guidance range, our range was 110 to 120. We guided $37 million to $39 million in OpEx. We came in at 39, and about $1 million over on OpEx. That additional $1 million of cost is associated with customer based marketing programs to promote the new products and it worked.

I mean, obviously those promotions worked. But we were unable to ship the difference in sales, so we ran the 39.9 which is -- and our expenses might have been slightly more than that, had we actually shipped it, shipping related expenses and so on. But we think that that's roughly in line as a percentage of the actual sales level which is why I brought up bookings in the first place.

Aaron Rakers – Stifel Nicolaus

And kind of completing that notion of what we're talking about, gross margin would have been 100 basis points higher similar to where we're at? Just trying to understand how the normalized model would look?

Ryan Petersen

You know, it wasn't all Vertex 4 and Agility 4, but those were running over 30% gross margin.

Aaron Rakers – Stifel Nicolaus

Okay.

Ryan Petersen

Slightly over 30, not substantially over. So you look at that and I guess you can average it in and kind of come up with a number, though the whole revenue shortage was not related to those products, the majority was.

Aaron Rakers – Stifel Nicolaus

Okay. Final question, I'll get back in queue. In the comments on the inventory and I guess as it relates to the cash position, I'm confused. You expect inventory to go up, down, flat from here. And where do you expect to exit let's say the August and possibly even if you're willing to take a stab, the November quarter in terms of cash?

I think one of the questions we get a lot of is just where you stand on the cash position and whether or not you might obviously go -- need to have to go beyond just the bank line of credit.

Ryan Petersen

I think that the answer to that is pretty simple. And then I'll let Art expand a little bit. So just from a starting point, we expect our inventory to drop, though significantly as a percentage of sales and absolutely on a dollar basis. That's simply -- and I'll remind everybody we have just begun purchasing wafer.

Our processing time on wafer purchasing was, in fact, very long. And so we made a conscious decision to spend that capital on purchasing wafer, build up our ability to process that wafer so we can enjoy the cost benefits over time.

As our ability to process the wafer has improved and as it continues to improve in those processing times become shorter, we expect to carry significantly less inventory, especially as a percentage of revenue. If that makes any sense at all.

So that speaks to much better overall inventory efficiency. And I think that that's why we believe we're going to be able to generate cash in the fourth quarter, giving you a stab at where inventory is. I mean, I would just keep it general but I would say that we expect it to be down sequentially quarter-over-quarter. Is that right, Art? I don't know if you have a number.

Art Knapp

Yeah. I think that's exactly right because it would have been not as high as it was if we hadn't taken that 14 million right at quarter end. So one of our tactics is to not have that sort of bulk purchase, that's what I have mentioned as one of our improvement tools and we're going to be taking things in every two or three weeks which works out operationally much, much better for us.

I mentioned that inventory turn target of 4.5 to 5 in the fourth quarter, our new VP of ops has a higher target than that. And again, in my recent investor visits, we carried about the steak dinner incentive. But we're both very serious about getting inventory levels down.

As far as cash levels, I've also indicated to people that with the build in sales levels in Q3, we may have to dip into the bank line because I'd like to keep about $40 million on the balance sheet for cash just optically to help with sales situations but we fully expect cash flow positive from operations in Q4.

Aaron Rakers – Stifel Nicolaus

Okay. Thank you. I'll get back in queue.

Operator

Thank you, sir. Our next questioner in queue is Andrew Nowinski with Piper Jaffray. Please go ahead. Your line is open.

Andrew Nowinski – Piper Jaffray

Okay. Thanks, guys. Thanks for the color on Microsoft. And just as a quick follow-up on that, you said, you expect PCIe revenue to ramp in Q3, but Microsoft does not included in the annual guidance. Just wondering if you could provide any color with regard to what is driving your confidence that PCIe revenue will ramp in Q3?

Ryan Petersen

Well, Andrew, it is very simple. These -- we've launched the product last August. We've had numerous PCIe wins. It's not all about Microsoft. Clearly, we wouldn't have been counting on a single customer to drive our sales on a go-forward basis. So, -- and certainly most of the customers are not the size of Microsoft, as I'm sure you know and I think you've actually have seen it in your research, those opportunities could be massive.

There are a number of clients that are massive that we've been winning and those include OEMs. Those include some of the wins like, that we've been announcing or we've been publishing white papers on.

So we're seeing traction, in general on PCIe. It's just a long cycle. And so we know what our discrete opportunities are. We have a fairly good beat on the size of that business on a go-forward basis. But we’re also trying to remember that it is a new business for us and we don't have a history. So it's less predictable maybe than the other business, which is why we're cautious on the guidance.

Andrew Nowinski – Piper Jaffray

Okay. Got it. Thanks. And then, Art mentioned that you had two unannounced controller platforms that could start ramping also in Q3, but there are also not included in guidance. Just wondering if you could provide an estimated range of how big those might be and what could potentially prevent those projects from materializing in Q3?

Ryan Petersen

Well, a number of things could, obviously. They're new products. So I think the question is really what's the commercial acceptance of those products. Though they're not final products, they are late stage and so -- and the real product we're talking about here, one of the unannounced products is Barefoot 3, so we've begun to show that product.

It will be sampling in August or September. So on the Q2 call, I would expect that we're going to be able to give an update, moreover, a better beat on really what the upside opportunity is surrounding Barefoot 3. The other expenses relate to the next generation controller, which will not be out in the third quarter.

Andrew Nowinski – Piper Jaffray

Okay. Got it. And then just last question from me, regarding your discussions or comments about discussions with potential near-term NAND flash manufacturer, just wondering if you could provide any sort of color in terms of the impact for what your gross margin profile might look like if a deal is established and is that guidance that's currently out there predicated on finalizing a deal?

Ryan Petersen

No. Well, first off, and great question, by the way. The first, I mean I think this in reverse order. The first thing, I'd like to get out of the way is there's no way that we would predicate our margin guidance on that type of relationship.

And to answer the second part of your question, really give you the why, is because it's clearly a game changer for us. If we're to establish the type of relationship we're talking to. In regards to color given the stage we're at, it's really going to be hard for me to comment in detail.

Andrew Nowinski – Piper Jaffray

Okay. Understood. Thanks.

Operator

Thank you, sir. Our next questioner in queue is Alex Kurtz with Sterne Agee. Please go ahead. Your line is now open.

Amelia Harris – Sterne Agee

Hi, this is Amelia in for Alex today. Thanks for taking the question. Going back to the Microsoft conversation, obviously when do you see the timing of the majority of this revenue? I know you mentioned under $1.5 million this quarter. When do you see the majority of that hitting? And also you said a range from SATA to PCIe, where should we expect the margin range for the majority of that revenue to lie?

Ryan Petersen

Sure. So I think it's hard to answer exactly on that, Amelia, and it's a great question. Looking at the SATA and the SAS business, those are obviously margins that are in the more normalized range for those product categories. And I'm not sure we've commented specifically on SAS margins but it is higher than SATA.

In terms of ramp, we have stayed away from giving specifics on that, mainly because of the situation we've had, we've entered the enterprise, it's quite hard to predict and enterprises can buy in a relatively lumpy fashion. So again, it goes back to -- we don't have the history with the clients to know. Microsoft is brand new for us.

In regards to the $1.5 million of revenue on PCIe that we had in the first quarter, I believe that that business is going to continue to grow and we'll see kind of slow increase over the next few quarters.

I think that all of these opportunities could materialize in size as early as the fourth quarter and possibly not until first quarter of next year. But the key thing to remember when looking at opportunities like that is they are in fact, they're Greenfield for us.

We don't have considerable PCIe sales now. So, the growth in the interim period between when they're fully ramped and where we're at today really is all very beneficial to us, whether or not it's full size or full size deployments is notwithstanding. Keeping in mind, and I think what's important to keep in mind here is the Microsoft runs maybe five out of the world's top 10 data centers by size and some of these deployments are quite large.

Amelia Harris – Sterne Agee

Understood. Thank you for that. And one last question. Going back to your 10-K, you called out Memoryworld as a significant customer. And obviously, you guys had some growth in EMEA this quarter, which is great. Are those because of large customers and large data center deployments or are you seeing that organic channel growth? Thanks.

Ryan Petersen

I would believe that Memoryworld generally is not selling a large amount and this is just color that I have. I guess you'd want to do a channel check with them. So I'm sure you've talked to those guys. That being said, I think that in general, Memoryworld is not a big mover for enterprise products. So generally, those deployments are going into PCs and servers, SATA based.

Amelia Harris – Sterne Agee

Okay. Great. Thank you.

Operator

Thank you, ma'am. Our next questioner in queue is Kulbinder Garcha with Credit Suisse. Please go ahead. Your line is now open.

Kulbinder Garcha – Credit Suisse

Thanks. Many of my questions have been answered. I've got a few clarifications. I guess just on the bookings point, see are you -- just to be clear, you guys saying that hard disk component shortage not happened. Your revenue for the quarter just gone would have been closer to $140 million, is that what you're trying to say? And if that is, what you’re trying to say, why isn't your guidance for the next quarter higher, so I'm not really understanding, can you guys please clarify that for me first?

Ryan Petersen

I am sure. So I can answer it in two parts. I think the answer to the first part of your question is that you're right. So our revenue would have been closer to $140 million. And I think to answer the second part of your question, 60% to 65% of our revenue is in the first half of the year or I'm sorry, in the second half of the year. So I don't see how it behooves us to push very hard or to try to guide massively up on the annual guidance, given the ramp that we already have in the second half of the year.

Kulbinder Garcha – Credit Suisse

I appreciate the conservatism. I guess, Ryan, I'm trying to think about if you guys have $27 million worth of almost firm orders that would actually -- that should have been this quarter, they are going to come next quarter, plus you got the underlying business you should be at 140 anyway, right?

And then so, I can kind of think plus your underlying business is growing, PCIe is going to grow a little bit you're saying and then do you just got growth in the end market. So it just seems a $130 million to $140 million is significantly conservative just in the very near-term or am I missing something?

Ryan Petersen

You know, I don’t -- I really don't think you're missing anything.

Kulbinder Garcha – Credit Suisse

Yeah. Right.

Ryan Petersen

I don't. I think, obviously we had an operational execution issue last quarter, in regards to the shortage. And so those are risks that we need to manage there. As regards to them being almost by the way, those are absolutely confirmed sales. So they're not almost solid. Those are sales that have shipped in the interim period.

Kulbinder Garcha – Credit Suisse

Okay. And they…

Ryan Petersen

Let's say we're off to a good start this quarter.

Kulbinder Garcha – Credit Suisse

Okay. Good. And then on the issue of just -- on the PCIe ramp, I know it's a small business and it's ramping quickly. I'm just surprised it actually even declined in the near-term. I know it's a very small number, so only a couple of million dollars of revenue. But I'm surprised it did decline. I was kind of always in the impression it would build then significantly ramp, maybe towards the back half of the year.

Just to be crystal clear, has anything changed in the confluence that you or the management team have in the ramp of PCIe revenues from here, where will we see simultaneous sequential growth or will we see this quarter-to-quarter volatility and that’s just what we should get used to and how we’re forecasting it?

Ryan Petersen

So I think in general what you saw in -- within the last quarter, where PCIe increase significantly was related to sample orders to a large extent as opposed to actual deployments. There is a certain amount of volatility, I think as we all know, in enterprise deployments when they occur. For us, we're still learning really and again, we don't have a lot of history there. That being said, our confidence level is pretty high, I mean especially given the Microsoft PCIe win.

Kulbinder Garcha – Credit Suisse

Okay. Okay. And then finally, on the cash flow just to be clear, your cash flow potentially is going to be negative next quarter. So are -- you're saying you're going to potentially have to use a debt facility. I'm just kind of curious or concerned I guess that what happens in the event that your inventory management doesn't, under the wafer processing improvements, you want to put through, don't come through.

And is there any scenario which that debt facility gets compromised and you can't access it. Or any -- is there any scenario that is worth sharing with. Because I concerned, I guess, how is that, if you can't do that then you guys are going to probably have to come back to the market for more under some point.

Ryan Petersen

I think the answer there is nothing that would jeopardize that, the debt facility, in the next few quarter, outside of act of God type stuff. Art seems pretty confident. He's smiling at me in the background here. So I don't know if you had any comments, Art?

Art Knapp

Only that the intention on the bank facility is really Q3 with the ramp in working capital. I don't anticipate drawing down on it right now. It is receivable based, so it's going to be funded by the receivables that we have and we're booking through the business levels. So I'm not worried that it's in jeopardy at all. And the nice thing is we have the ability to scale it as the business grows.

Kulbinder Garcha – Credit Suisse

Okay. And then on the -- on the -- but just to be clear, free cash flow is negative next quarter slightly and then hopefully positive as we exit the year, that's the way you guys see it right now.

Ryan Petersen

Well, next quarter meaning Q3 is when I think I might have to draw it down in Q2. I'm not anticipating having to draw it down.

Kulbinder Garcha – Credit Suisse

Okay.

Ryan Petersen

On the bank line.

Kulbinder Garcha – Credit Suisse

Okay. Okay. And…

Ryan Petersen

Until -- and if it gives you any comfort, I should also point out that’s the improved wafer processing times. We've already seen some progress there which I thought I -- and I know it's confusing. There are a lot of items going on. But I thought, I had been specific about it earlier.

So we've actually seen the wafer processing time shrink by several weeks. So the hope is that, that will continue to shrink. Hopefully in excess of the time we need it to start generating so capital turns that Art needs really to make the cash flow model work.

Kulbinder Garcha – Credit Suisse

Okay. So, just although is clear, cash flow in fiscal Q2 is negative, potentially negative in Q3 but positive as we exit the year?

Art Knapp

Correct.

Kulbinder Garcha – Credit Suisse

Okay. Okay. Good. And one final question I just had on the inventory. There's been lots of discussion and speculation just on the risk of you guys having to do a write-down. I prepared you would like to comment as to how recoverable all the inventory you guys have is, how it's marked, what risks there may or may not be around that.

Ryan Petersen

I don't think there's booked. I mean just to be frank, the NAND flash prices on the majority of the NAND flash inventory have bottomed. We've been reducing our inventory reselling. So I think the answer is that there's really no impact in regards to our inventory buildup now. I mean as it regards to -- in regards to how we manage that on an ongoing basis.

I think it's key to keep in mind that we've been in commodity markets with the DRAM market for our entire existence, way back to 2002. So we're relatively adapted at managing our inventory levels. We -- those big NAND flash purchases, we bought several months ago were fairly low priced. I think any price declines were priced in at the time and in fact in looking back in hindsight that seems to be the case.

Kulbinder Garcha – Credit Suisse

Okay.

Ryan Petersen

So, and this is based on of course what we did at the beginning -- at the end of last quarter and the previous quarter. So we've done this several times. Though, there is always risk.

Kulbinder Garcha – Credit Suisse

Okay. Okay.

Art Knapp

And this is Art. Just to add to that, we were pretty much at a relatively flattish inventory level until that end of quarter purchase, when you look at the 10-Q you'll see raw materials are up $13 million basically, reflecting that quarter end purchase which we're not going to be doing anymore. So we had a pretty good inventory tracking until we decided to make that purchase.

And then we're going to go from there and be reducing inventory. Our new VP of ops I told people in May, give him some time. He just had come aboard and we will have reductions in Q2 and Q3, and Q4. It will go down.

Kulbinder Garcha – Credit Suisse

Okay. Great. Thank you.

Operator

Thank you, sir. Next questioner in queue is with Mark Kelleher with Dougherty & Company. Please go ahead. Your line is now open.

Mark Kelleher – Dougherty & Company

Great. Thanks for taking the question. Art, could you break out the NRE charge, is it possible to do that in the quarter?

Art Knapp

I'm thinking back in the Q, I think we talked about $6 million of project costs, which are a large portion. We did have what we talk about typically a couple of million dollars of NREs that lumpy charges as we've described. So those are the kind of the big components of that, in addition like we said the salaries, et cetera.

Mark Kelleher – Dougherty & Company

Okay. And you touched a little bit on Memoryworld in Europe. But could you just sort of give us your macro opinion of what you're expecting over there, you're pretty exposed over there, how's it looking?

Ryan Petersen

So, I'll take that one if you don't mind, Mark. I think that and by the way, I appreciate you bring up this question. I think it's something on a lot of people's minds. The macro environment in Europe despite the noise that we hear in the U.S. regarding the macro environment or the general economy in Europe, we continuing and you'll also note the U.S. is growing faster now.

But in terms of SSDs, it's our feeling that the SSD market has not been affected by macro -- by the macro probably or I'm going to go out on a limb here a bit, but probably because SSDs are really taking market share away from incumbent technology. So the SSD market is growing at a rate in general so far in excess of anything else that the general economic here.

And I do believe there is one, has not affected and I still believe it’s been ongoing for some time. It's not affected the overall sales of SSDs. Of course, we are heavily exposed in Europe.

We do believe that our exposure to Europe will be less as we go forward and as we grow our OEM relationships. Typically, OEMs or the larger Tier 1 OEMs are based in the U.S., or we're shipping to manufacturing centers in Asia for those. So as we continue their transition, we think that we will see a shift in our geographic sales to those regions, if that makes any sense at all.

Mark Kelleher – Dougherty & Company

That’s great. That's all I've got. Thanks.

Ryan Petersen

All right. Thank you.

Operator

Thank you, sir. And with that, ladies and gentlemen, this does conclude our time for questions-and-answers. I'd like to turn the program back over to management for any additional or closing remarks.

Ryan Petersen

Thank you. In closing, I just want to take a minute to remind our shareholders that OCZ is committed to developing and introducing industry-leading products. We continue to focus on building scale and building our technological foundation that will allow us to gain market share over time and will deliver the maximum value to our shareholders over the long-term as SSDs continue to gain prominence as a primary storage medium.

We continue to see accelerated adoption of SSD Technology and I believe we're on the cusp in an industry that is beginning to take meaningful market share from incumbents. As this transition continues, we're pleased with the progress that we continue to make from both a product offering and an execution standpoint.

With that, I will bid you adieu and thank you for attending.

Operator

Thank you, presenters. Again, ladies and gentlemen, this does conclude today's conference. Thank you for your participation and have a wonderful day. Attendees, you may disconnect at this time.

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