Netlist's CEO Discusses Q2 2012 Results - Earnings Call Transcript

| About: Netlist, Inc. (NLST)

Netlist (NASDAQ:NLST)

Q2 2012 Earnings Call

August 14, 2012 5:00 p.m. ET

Executives

Mike Smargiassi – IR, Brainerd Communicators

Chuck Hong – Chairman and CEO

Gail Sasaki – CFO

Chris Lopes – VP, Sales

Analysts

Rich Kugele – Needham & Co.

Mark Kelleher – Dougherty & Co.

George Santana - Ascendiant

Richard Shannon – Craig-Hallum Capital Group

Operator

Good day everyone and welcome to the Netlist second quarter 2012 earnings conference call and webcast. [Operator instructions.] I would now like to turn the conference call over to Mr. Mike Smargiassi. Mr. Smargiassi, the floor is yours, sir.

Mike Smargiassi

Thank you, operator, and good afternoon ladies and gentlemen. Welcome to Netlist’s second quarter 2012 conference call. I'm here today with Chuck Hong, chief executive officer of Netlist; and Gail Sasaki, chief financial officer; and Chris Lopes, vice president, sales.

As a reminder, our earnings release and a replay of today’s call can be accessed on the Investors section of the Netlist website at www.netlist.com.

Before we start the call, I would note that today’s presentation of Netlist’s results and the answers to questions may include forward-looking statements, which are based on current expectations. The actual results could differ materially from those projected in the forward-looking statements because of a number of risks and uncertainties that are expressed in the call, annual and current SEC filings, and the cautionary statements contained in the press release today. We assume no obligation to update forward-looking statements.

During this call, non-GAAP financial measures will be discussed. Reconciliations for those directly comparable GAAP financial measures are included in the press release which was filed on Form 8-K.

I would now like to turn the call over to Chuck.

Chuck Hong

Thanks, Mike. During the second quarter, we saw an initial and steady stream of ordering of our two new flagship products, 16 GB HyperCloud, and 16 GB VLP and our OEM customers IBM and HP.

With the qualification of 16 GB HyperCloud at HP on the day of our last call, HyperCloud became available to ship with the three highest-volume enterprise servers in the world, just a few months ago. We have the only 16 GB density load-reduced memory currently offered by IBM and HP on these highest-volume servers.

Recent third party benchmarking from industry thought leaders like Deopli, and key vertical markets, provides insight as to why the OEMs have selected HyperCloud over LRDIMM, as HyperCloud delivers a huge gain of 54% in memory bandwidth improvement. HP benchmarking has also shown a significant benefit to using HyperCloud when running 3DPC 1333, which basically equates to a two speed grade advantage over LRDIMM in comparison to equivalent products. I’d like to note that this benchmarking result is available on the HP website on their white paper.

In a moment, I will provide an update on how we’re expanding our footprint for our 16 GB HyperCloud along with our progress in launching 32 GB HyperCloud, 32 GB VLP, 32 GB Planar-X, as well as our next-generation of NVvault systems.

But first, before turning the call over to Gail, I would like to comment on our financial results. As we noted on our last call, our business is undergoing a major transition, which is marked by a reduction in the shipment of our products associated with previous server generations, primarily PERC and NV2 and a ramp up in our new product line, including HyperCloud, NV3, and VLP. We remain confident in the market potential of these three products and believe our operations are well-positioned to grow over the long term.

During this transition phase, we have focused on maintaining a disciplined approach to managing our expenses with the goal of maintaining adequate liquidity and positioning our business for sustainable profitability as our revenues begin to expand with the ramp up of our new products. To that end, we are aggressively streamlining our business through various strategies including SKU optimization and increasingly shifting a larger portion of our operations to China.

We plan to reduce operating expenses by 30% before the end of the year. These initiatives will have no impact on our new product rollout strategy, and in fact we have continued to prudently invest in our resources and successfully bring our flagship products to market. The reduction in our second quarter revenue reflects this transition and the early-stage nature of the HyperCloud and NV launch.

We are optimistic as we begin to gradually gain traction with HyperCloud and the launch of our other new products. We currently have seven new high-density high ASP products in some stage of evaluation or qualification at the three major OEMs.

Now, let me turn the call over to Gail for the financial review.

Gail Sasaki

Thanks, Chuck. As Chuck mentioned, our second quarter results reflect a transitional period for our organization as we move forward in launching our new products while the contribution from our more mature products attached to prior generation servers continues to decrease.

Our revenue for the second quarter ended June 30, 2012 was $10.6 million, down 34% compared to $16 million for the second quarter of 2011, and down sequentially due to the product line transition just mentioned.

Gross profit for the second quarter ended June 30, 2012 was $2.7 million, or 26% of revenues, compared to a gross profit of $4.9 million, or 31% of revenues, for the second quarter of 2011, due to lower revenues and a transition in the product mix.

On a sequential basis, gross profit dollars also declined due to lower revenues, the startup cost of our new product lines, and higher than anticipated DRAM prices for the initial phase of HyperCloud and VLP.

We currently expect our gross profit margin to come in at a range of between 20% to 25% during the third quarter, and as production volume ramps, our DRAM costs naturally decline, the initial investments in capital equipment in China become fully depreciated at the end of the year, and recent incremental investments in manufacturing capacity for HyperCloud and VLP normalize, we fully anticipate a return to margins in the 30% range and above.

Adjusted EBITDA loss, after adding back net interest expense, income taxes, depreciation, stock based compensation, and net non-operating expense was approximately $2.9 million for the second quarter of 2012, compared to an adjusted EBITDA loss of $393,000 for the prior year period.

Net loss in the second quarter was $4 million, or $0.14 lost per share, compared to a net loss in the prior year period of $1.5 million, or $0.06 lost per share. These results include stock based compensation in the second quarter of $482,000, compared with $406,000 in the prior year period and depreciation and amortization expense of $535,000 compared with $602,000 in the prior year second quarter period.

Total operating expenses were $6.6 million in the second quarter of 2012 compared to $6.3 million in the previous year. Operating expenses were also flattish sequentially. As Chuck mentioned earlier, we are aggressively streamlining the business and anticipate the benefits of this optimization to reduce operating expenses to the $4 million level as we exit the second half.

During the first half of ’12, we accelerated our product rollout, and made early progress on key areas of our product roadmap for the year, specifically in regard to our 32 GB product suite. As a result, we will see a decrease in research and development expenses for the remainder of the year, but plan to invest further during 2013 as we accelerate development on the next-generation products.

We ended the second quarter with cash, cash equivalents, and investments in marketable securities totaling $12 million, compared to $14 million at the end of the first quarter. Although our cash cycle has increased as we ramp the OEM supply chain for both IBM and HP, we continue to believe we have sufficient capacity on our currently untapped $15 million line of credit for working capital needs to supplement our current cash balance.

During the second quarter, capital expenditures totaled $772,000 compared to $134,000 in the previous year’s second quarter. The increase was for planned investments in equipment to support increased capacity and large-scale production volume of HyperCloud and VLP. We anticipate approximately $200,000 of additional investment during the rest of the year.

As we previously noted, we recently refinanced our current debt to provide us with additional flexibility as we execute to our business plan. Over the next two quarters, we will pay interest only on our term loans, plus we have extended the term, which will decrease our quarterly debt service payments by 40% going forward as principal payments resume.

Nevertheless, we believe we may continue to be a net user of cash for the next couple of quarters, which is heavily dependent on our cash cycle as we adjust to slightly longer collection and inventory days noted earlier.

On the IP front this quarter, we continue to vigorously defend our patents in the U.S. PTO. As we noted during the first half of ’12, the U.S. PTO allowed 100% of the claims of two of our seminal patents, the 537 and 274, which is indicative of our leadership position in the high-performance logic-based memory solutions for this and future generations.

Increasing visibility of bid activity for HyperCloud and VLP, combined with the daily pulls of our products from worldwide major OEM hubs, gives us tangible evidence of growing revenue traction. As we have noted previously, the ramp up in our new products is taking longer than we originally expected. However, we remain confident in our ability to expand our revenue streams through product diversification as well as increased volumes given the superiority and proven performance of our new product lines over competitive products in this high-density space.

The reduction in manufacturing operating cost discussed earlier positions us to cross over into sustainable profitability once our new product revenues from 16 GB HyperCloud, 16 GB VLP, and our 32 GB product suite begin to accelerate.

I will now turn the call over to Chuck for a more detailed overview of our current business and go-forward strategy.

Chuck Hong

Thanks, Gail. HyperCloud is available for sale on HP’s top-selling, newly released Gen8 servers, and has also been designated as HP SmartMemory. This, coupled with the availability of HyperCloud on IBM System X servers, makes HyperCloud the first-ever proprietary memory technology to be widely adopted by the mainstream server market. HP and IBM account for a majority share of the server market, and they combine for even a larger share of the world’s high-density memory consumption.

We’re also in discussions with other major OEMs who are testing our products, and we hope to expand our qualifications on additional platforms in the second half of the year. Since our last call, we have continued to work directly with the OEMs to introduce our products to end-market users who will then run the products in their particular applications.

It remains early in the introduction process, but HyperCloud is currently being tested by an expanded list of potential end users and OEM customers, including the world’s top six server manufacturers, a major stock exchange and several large financial institutions on Wall Street, a major U.S. auto maker, a number of major firms in the oil and gas and semiconductor industries.

In addition, we continue to work on a number of benchmark studies and partner with vertical industries to provide the market with specifics around the increased productivity and cost savings offered by utilizing HyperCloud.

We recently announced a study performed by Deopli, one of the foremost thought leaders in the EDA infrastructure and cloud computing space. The study clearly demonstrated the superior performance capabilities of HyperCloud and we confirm its ability to address the memory challenges of today’s server memory bottleneck.

As we noted in our most recent white paper, OEM benchmark data confirms that throughput value, which is the truest measure of application performance, is an astounding 71% higher for 32 GB HyperCloud versus 32 GB LRDIMM in fully populated server platforms. Based on normalized throughput values, effective data rates for HCDIMMs are actually more than two speed grades faster than LRDIMMs and prove that LRDIMMs are not performing as specified. Only HyperCloud HCDIMMs provide maximum memory at maximum performance.

We’re also continuing to work directly with our OEM partners to qualify the next level of density, 32 GB HyperCloud DIMMs and Romley based servers. This will create a truly unique offering where we would have the only solution available in this segment of the market.

Beyond HyperCloud, we are moving forward with the introduction of other product lines that offer attractive growth potential. These include our next-generation of Vault products, NV3 and EV2, and our line of specialty memory subsystems including VLP and Planar-X RDIMMs. For instance, today we introduced our 32 GB 4Rank Planar-X register DIMM. This innovative circuit design of Planar-X module allows us to use twice the number of smaller density monolithic DRAM components within the standard DIMM dimensions.

In addition, our new Planar-X product reduces power consumption in power-sensitive applications across all Intel and AMD-based server platforms. We believe this is the most cost-effective 32 GB memory solution available today.

Our 16 GB VLP registry DIMMs, which leverage our Planar-X technology, are shipping in volume with IBM’s top-selling server blades. We are continuing to work with IBM to fill the supply pipeline and training the IBM sales force on the performance benefits of our product. We will follow this up with qualification of our high-performance 32 GB VLP, which we began testing during the second quarter.

As revenues from our older generation products decrease, the revenues from our new products, particularly HyperCloud and VLP, will begin to ramp up commensurate with our success in securing interest and orders from end market users. This transitional process is tied to the natural server product cycle, and will continue in the near term until revenues from our new Romley-based products begin to supplant sales from existing servers.

We believe that HyperCloud, VLP, Planar-X RDIMMs, and NV3 will see meaningful increases in volume starting in the second half of the year, with average selling prices and gross margin dollars considerably higher than previous products, reflecting their high density and high performance attributes.

In addition, all of these new products are targeted at the entire server and storage space, giving us a larger and more diverse addressable market. These are also multi-generational products based on fundamental, groundbreaking IP. As a result, we expect the business to scale over many years once these products gain traction in the marketplace.

We’re clearly at an inflection point in our business as we bring multiple new IP products to the market and broaden our customer base. The ramp up and qualification has taken longer than expected, but this has been a major undertaking, in all facets of our business. We remain committed to taking full advantage of our emerging leadership position while laying out the groundwork to generate returns from our investments to the benefit of our shareholders.

Thank you all very much for listening today, and we’re now ready for questions.

Question-and-Answer Session

Operator

[Operator instructions.] Our final question comes from Rich Kugele from Needham & Company. Please go ahead with your question.

Rich Kugele – Needham & Co.

In terms of the quarter, can you give us a sense on how the quarter may have broken down between the various categories, and specifically how HyperCloud did?

Gail Sasaki

Our flagship products, HyperCloud and VLP, combining, made up about 20% of our revenue this quarter. HyperCloud was about half that. The two categories, which I know you’ve been tracking, battery-free was about 27%, and our battery-backed vault21%, and flash about 10%.

Rich Kugele – Needham & Co.

And then in terms of the breakeven levels, you’re going to go and reduce your opex by about 30%. How would that roll out over the balance of the year?

Gail Sasaki

I think between the next two quarters, including this one, we plan to average about $4.5 million or so in opex. We’ll do a lower number in Q4 than in Q3. And in terms of breakeven, dependent on the gross margin, but still probably in about the same range that we’ve discussed, about $18-20 million in revenue.

Rich Kugele – Needham & Co.

And then before I get into my technical questions, how much cash on the balance sheet do you actually need to run the business? I saw you increased your inventory. I assume that’s for third quarter ramps, but how much cash do you actually need to run an average quarter?

Gail Sasaki

Most of our needs are obviously working capital, and we have the $15 million credit line available to us, so we believe that we have sufficient cash to run each quarter.

Rich Kugele – Needham & Co.

Into next year?

Gail Sasaki

Into next year.

Rich Kugele – Needham & Co.

Now, in terms of the technical questions, and this ties into the ramp, what have the OEMs - without naming names - said about the ramp of the HCDIMMs and why, perhaps, it’s been slower? Have they been waiting for the higher capacity module? Any comments?

Chuck Hong

You know, I think we’ll have Chris go through the situation at the particular OEMs, but in general I think the Romley launched later for one of the OEMs, a few months later. Romley was slow to launch in Q2. That’s one. And then there has been a general softness in the server market. Perhaps Chris can address the specifics.

Chris Lopes

Is your question do we think the OEMs are waiting for the higher density, the 32 GB to come to market?

Rich Kugele – Needham & Co.

I was just speculating, is that part of why, perhaps, they’re not pulling as much. Or is it the other issues that Chuck mentioned in terms of just the timing and rollout of Romley. Any additional comments?

Chris Lopes

We’re seeing significant traction now on the 16 GB densities. There is really no other 16 GB solution on the market across these servers. We’ve covered about 1.1 million of the 3 million unit server market with the three qualifications in place today, on 16 GB. And we’ve got hubs filled for our customers. We are seeing weekly pulls on those hubs. So there’s traction definitely beginning.

Also, we’re seeing some pretty exciting benchmarks being done by some end users of our customers. Notably in automotive there’s a large crash simulation going on, where they’re seeing fantastic results. They’re doing, if I remember the numbers correctly, four times the number of simulations in the same amount of time from the previous purchase, and that is primarily due to the large memory footprint enabled with HyperCloud. So we’re expecting to be participating in some large RFQs very soon on that.

There’s also traction underway right now on 32 GB in the market, but not available for purchase. But I think you’ll see that pretty soon. I hope that answered your question.

Rich Kugele – Needham & Co.

So would you expect HyperCloud to see greater revenues in the third quarter, or will it be more in the fourth quarter?

Chris Lopes

I think it will start to ramp. The fourth quarter is where I think you’ll see a lot more. There’s several large financial institutions that have some year-end dollars marked to make some large server purchases, so we’re keeping a pretty good pipeline on that end user market, working with our sales team and Wall Street. And the bulk of a lot of those actions should happen in the fourth quarter. So the third quarter should continue to ramp.

Rich Kugele – Needham & Co.

Thank you. And Gail, would you see the second quarter, then, as the trough for revenues? Or do you think we have another quarter down before it stabilizes?

Gail Sasaki

You know, since we’re not guiding revenue, and we’re only halfway into the quarter, it’s really difficult to say at this point.

Operator

Our next question comes from Mark Kelleher from Dougherty & Company. Please go ahead with your question.

Mark Kelleher – Dougherty & Co.

Rich asked most of my questions, but I did have a couple more. You said you believe you’re at an inflection point. Maybe this goes to Rich’s last question. Was that specifically just sort of the general inflection point, or do you think that the increase in HyperCloud can offset the decline in your older products now in this quarter? I guess that’s another way to ask that same question. What did you mean by you’re at an inflection point?

Chuck Hong

I think the term inflection point is we’re talking about the overall business, not, let’s say, quarter to quarter. HyperCloud, we’ve worked on it over the last few years, but it’s really come to market in Q2 and with some of the delays in the Romley launch, just in maybe the last month of Q2. So you’re starting to see traction, pulls and shipments, that are starting to take place right now. And to the extent a lot of these deals are done in the last month of any given quarter, and historically it’s been this way, we’re going to see how much it accelerates, the ramp that’s going on today. But shipments are increasing.

Mark Kelleher – Dougherty & Co.

So we should see more HyperCloud revenue in this quarter, and then more the next quarter. The HyperCloud should be on a nice ramp up, even if it doesn’t offset the decline on the other side?

Chuck Hong

Absolutely. We’ll see a definite increase from last quarter, and then we should see a bigger increase next quarter as well.

Mark Kelleher – Dougherty & Co.

And those are carrying higher margins, right?

Chuck Hong

No, relatively it’s carrying good margins. I think the goal initially is to win a lot of sockets, so we’re going to be fairly aggressive in the pricing of the product.

Mark Kelleher – Dougherty & Co.

And just in terms of the legacy products, and the decline, is that on a declining path that you expected? Or has that decline been faster than you initially thought it would be?

Gail Sasaki

I think it’s about what we expected. Maybe a little bit faster. The demand has actually been what we expected, but due to the end of life situation, the customer has been a little bit more conservative, I think, in terms of the weeks that they’re carrying inventory. So that’s partially what we saw during the second quarter, and will continue to see.

Chris Lopes

Yeah, let me add a bit to that. On the decline of the Westmere based products, notably the PERC and the NV2, we are seeing less inventory, or buffering, in the contract manufacturers that purchase on our OEM’s behalf. So we were hurt a little bit by that this last quarter in that they really weaned out a lot of their inventory and reduced their order rate. We are very confident that we’ll keep building that product through the rest of this year, at a lower rate, but it will continue into the first quarter, we think, of next year.

Operator

[Operator instructions.] Our next question comes from George Santana from Ascendiant. Please go ahead with your question.

George Santana - Ascendiant

Gail, I just wanted to clarify a couple of numbers. The gross margin you said should be trending back up to the low 20s, 20-25% in the third quarter, and then achieving greater than 30%? I’m not sure if that’s the fourth quarter or into New York.

Gail Sasaki

Our target model is 30% and above, which we’ve been able to pretty consistently achieve. I did mention that Q3 will be in the range of 20-25%, and then trending up in later quarters.

George Santana - Ascendiant

You mentioned a figure of 19-20, and I thought initially it was Q3 revenues, but perhaps not. I’m not sure what the 19-20 was.

Gail Sasaki

Oh, I think Rich Kugele asked me about a breakeven revenue maybe? It wasn’t a percentage, it was in terms of dollars. Is that what you’re talking about?

George Santana - Ascendiant

Yeah, you put some $19-20 million figure, and I thought it must be the third quarter revenues, but you’re not guiding revenues, right?

Gail Sasaki

No, we’re not guiding. He was just asking what potentially could be breakeven, and I didn’t say 19-20, I said 18-20, I believe.

George Santana - Ascendiant

And should we be expecting any special or extraordinary charges as you reduce opex this year?

Gail Sasaki

No.

George Santana - Ascendiant

For layoffs or anything else like that?

Gail Sasaki

No. We’ve had some replacement hiring where we’ve been transitioning a lot of our engineering and administrative functions, that we can, over to China, but that’s been going on for a while. And the other reduction is just because we accelerated R&D during the first half and completed a lot of our product roadmap earlier than we expected. So nothing that we would need to take a charge on.

Operator

And our next question comes from Richard Shannon from Craig Hallum Capital Group. Please go ahead with your question.

Richard Shannon – Craig-Hallum Capital Group

I apologize, I had to jump off for a little bit of the call. I’m not sure if you mentioned your expectations for qualification for the 32 GB HyperCloud. Was that something you expect this quarter, second half? And I think you mentioned IBM specifically. Maybe timing of other potential OEMs qualifying as well?

Chuck Hong

Some of those will happen this quarter, and others will happen in Q4. So we have both 32 GB HyperCloud, 32 GB VLP, 32 GB Planar-X. All of these products we expect to achieve qualification in the remaining four or five months of this year.

Richard Shannon – Craig-Hallum Capital Group

Kind of curious the extent to which you are directly involved with your tier one OEMs, like an IBM or HP, as you work with them as you’re marketing HyperCloud to their direct customers, the extent to which you’re directly involved with that and can actually see that. Any thoughts on how they’re marketing, especially relative to LRDIMM, which results seem to suggest they’re ramping up here from a small level as well? Any comparisons and contrasts that you can see as you’re active with those OEMs would be appreciated?

Chris Lopes

Sure. We have been very involved in a handful of selected, targeted end users, where in some cases we’ve had more to play in the performance benefits of HyperCloud than the OEM sales force. And then as the end customer has gotten excited about that, we’ve then brought in and worked together with both HP and IBM sales teams at the customer regarding that. In those cases, LRDIMM isn’t even on the table, not even a consideration. It just doesn’t provide the benefit for the price, and all the parameters that the end user wants.

In other cases, we’ve been working with the sales force in a more general sense, where we do customer training we would call it, but it’s really our partner training. We’ve done that with IBM’s Latin America and South America sales force just recently. And that’s led to some activity in Brazil that looks like it has some potential for us. We haven’t gone down to Brazil. I’ll be happy to hop on plane. But we’re not directly involved in the customer base that way. So working through the sales force there.

And then there’s still end customers, some of the oil and gas area, that have not used some of the servers that we’re qualified on. They use other families. So we’re doing a lot of education in that market so they can know what to look for, what to ask for, and can choose for themselves the kind of performance and may decide to take one of these three platforms in the market today that’s qualified.

Chuck Hong

One thing I’d like to add is, as I mentioned in the comments, that companies like HP have posted white papers that show the test results - benchmark test results - running memory-intensive applications, the side by side testing of HyperCloud versus LRDIMM and some other memory like the register DIMM has also been tested. And they showed the results. They posted those results in a fairly detailed white paper. And that’s available publicly to go online and see, and you’ll find that there is an enormous gap in performance between HyperCloud and LRDIMM.

So these types of data are now getting posted. It’s very recent. I think this was put up today maybe. And that will start to educate end users as well as the OEMs own sales and marketing people to go out and pitch the higher performance memory, higher performance of HyperCloud, to try to win deals with their end customers.

Operator

And ladies and gentlemen, at this time I would like to turn the conference call back over to management for any closing remarks.

Chuck Hong

I would like to clarify the quality of the revenues. We’ve seen a rapid decline in the PERC and NV2 revenues, and that was expected, and that is creating a transition in our business. But I think we should be reminded that those revenues are really for a specific product going to one customer versus HyperCloud, VLP, NV3. The new products that are emerging to replace the prior generation products are for the entire market. It is not just one customer specific. It is going out to pretty much all of the major server manufacturers.

So we believe we will go through this transition period, but will end up with a revenue mix and a gross profit mix which is far more diverse and with tremendous growth potential moving forward.

So with those comments, thank you again for listening in, and your interest in Netlist. Thank you.

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