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Too Much Demand

As an investor these are the kind of problems we can handle. Granted, we would like to not have any problems but too much demand can be fixed.

OCZ (NASDAQ:OCZ) CEO Ryan Peterson stated in the September 5th conference call:

"We have more, more than sufficient demand for our product. We really do not have any demand issues. We have an issue with too much demand, but not too little."

"New Bookings in the quarter were well in excess of the prior quarter which leaves us with an insurmountable backlog -- which is both good and bad." (Note: The 27 million backlog from last quarter has been filled.)

Supply, Demand, and Gross Margins

The problem that OCZ is encountering is a perfect storm of supply and demand. Manufacturers of NAND flash cut production back (Toshiba 30%, Micron 15%, Samsung 10%) according to Mr. Peterson via the conference call. Micron has publicly confirmed that the industry is experiencing a shortage.

Just to show how supply - constrained the company is, Mr. Peterson said:

"We may be getting between 30-50% of the 25 nanometer flash we require. If we switch to a new node (via Barefoot 3) it won't be a problem anymore." Later on he stated,

"Sept, Oct, Nov, we will be getting less than 50% of the flash we ordered. This may ease over time. This for us comes down to how quickly can we move to new flash (19/20 nanometer)."

...

"We essentially ran our inventory, the flash, for our big volume products, this is agility and vertex, completely dry."

Last quarter, the company caught some flack for buying 14 million of 25 nanometer NAND on top of the already massive build up they acquired. Stockpiling did pay off as they have used all of the consumer side NAND. This will improve the companies' cash position and reduce its inventory liability.

On the demand side, Apple is sucking up huge amounts of NAND flash for its iPhone 5 and iPad Mini. Apple did reduce orders for NAND flash from Samsung recently, but whether it will have any effect on easing the supply problem is unknown.

Mr. Peterson did go into some details on how this was affecting OCZ.

"In order to deliver products to consumers, we have used enterprise grade NAND in consumer products. That had a significant negative impact on our gross margins."

...

"Gross margins, if you do not neg out the use of enterprise flash usage in building Vertex 4 then margins would be down. Accounting treatment is the accounting treatment, we will treat it appropriately. We will cull out those numbers. Net of that, I think the margins are generally non affected by the issue. The only effect of the shortage would be us using enterprise grade flash for Vertex 4 series. Any other effect of a shortage would really be positive to gross margins."

...

"At least on a GAP basis the gross margins will be down sequentially."

Gross Margins, without a doubt, are going to be down a lot. It appears to just be a temporary problem that should be reasonably fixed once the supply situation eases up and/or they move to the 20 nanometer NAND via Barefoot 3.

Barefoot 3 SSD Controller and Market Opportunities

A solid state drive controller chip is the heart and soul of any solid state drive. It defines what NAND flash you can use, how stable your SSD will be, and the speeds in which it can operate. It is the brains which drive the SSD. That being said...

OCZ's Controller, called Barefoot 3, has already sampled and it is 19/20 nanometer NAND compatible. The current generation of controllers use 25 nanometer NAND. Let's assume that OCZ does in fact get this to the market in a reasonable amount of time to compete. What will it mean for OCZ?

If they can get Barefoot 3, out they stand to accomplish two things:

(1). If they license it to 3rd parties for use in SSD's, they will make considerable high gross margins. If a NAND shortage is occurring industry wide, (something Micron has confirmed) then most SSD producers that cannot manufacture NAND will be looking to exit the supply-challenged 25 nanometer NAND ASAP and move to the 19/20 nanometer NAND. This will ease pressure and open the supply of the ever-so-precious NAND. This is not to say that Ocz is alone in the rush to get new controller chip designs out, but if OCZ even takes a small chunk of the market the gross margins of the company will get a significant boost. OCZ has a history of licensing out SSD controller chips through its acquisition of Indilinix.

(2). OCZ will reduce costs of their SSD products. Currently, they use an OCZ/Marvell chip for the Vertex 4 and Agility 4 line. Marvell provides the controller chip and OCZ provides the firmware. Once Barefoot 3 is out, OCZ will be able to put this in its upcoming SSD products and thus it will improve gross margins.

NAND Supply Agreement

"Working on a NAND flash supply agreement is the most important thing we can do as a company" - Mr. Peterson, CEO of Ocz

The CEO Mr. Peterson talked for a bit during the conference call about how they have had to build the business and build revenue to even get the attention of the NAND manufacturers to "even get in the room with those people".

This might account for OCZ pushing for increased revenues and market share at the expense of profits, in order to secure a NAND deal.

Once they secure a deal, it would make shortages less likely.

Buyout Rumor Question and Microsoft Win

Of course we all hope and pray that one analyst would be brave enough to ask the question about the buyout rumor (burning all bridges he has with the company simultaneously). Joel from American Capital queried the buyout rumors from Seagate (NASDAQ:STX) and Western Digital (NASDAQ:WDC) at 25:56 into the call. The response from the CFO was:

"I'm...I'm not entirely sure that I can comment or know how to comment on that, but..."

The voice inflection right after he says "I'm"... is worth listening to.

The company also confirmed a Microsoft (NASDAQ:MSFT) contract win.

"We have a fairly large win from Microsoft that is starting in Q3."

Rising Prices of SSDs

An interesting point is that SSD prices may increase soon much like hard drive prices increased last year due to the flooding. If the NAND supply issue is affecting all SSD producers, then we may see an increase in prices. SSD companies may be able to charge more as consumers will not have any choice if they want SSD technology.

"We have the ability to modulate our prices higher to recoup costs in using enterprise NAND in consumer products." -Mr. Peterson

Of course companies like Micron (NASDAQ:MU) or SanDisk (NASDAQ:SNDK) that produce NAND flash may not be affected as harshly and may decide not to raise prices.

Conclusion

OCZ has booking in excess of 140 million and while they reduced guidance for the quarter, they are not pulling guidance of 650-700 million for the year. However, the future supply of 25 nanometer is very murky. The company has some challenges in store for it and it will be a nasty quarter or two.

Hopefully, they can get Barefoot 3 out as soon as possible to make the jump to 19/20 nanometer and end the supply problems.

A summary of the entire conference call is located at my instablog.

Source: OCZ - A Problem Of Too Much Demand