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Executives

Mitch Gellman - Vice President of Investor Relations

Dan Moses - Chief Financial Officer

Manouch Moshayedi - Chief Executive Officer

Analysts

Kamal Das - Lehman Brothers

Richard Kugele - Needham & Company

Richard Shannon - Northland Securities

Daniel Morris - Oppenheimer & Co.

Gavin Duffy - Broadpoint Capital

Vijay Rakesh - Thinkpanmure

Aaron Rakers - Wachovia Capital Markets

Salomon Kamalodine - B. Riley & Company

Bob Gujavarty - Deutsche Bank Securities

STEC, Inc. (STEC) Q2 2008 Earnings Call August 4, 2008 8:30 AM ET

Operator

Welcome to the STEC Second Quarter 2008 Earnings Conference Call. (Operator Instructions) I will now turn the conference over to Mitch Gellman, Vice President of Investor Relations.

Mitch Gellman

First, let me update you on our upcoming conference presentation plans, particularly with three conference presentations this week and a non-deal road show. Again, all the week of August 4.

Tomorrow, August 5, Dan and I will be presenting at Pacific Crest Securities Technology & Leadership Forum in Vale, Colorado. And in addition, Pat Wilkerson, our Vice President of Marketing and Business Development will present at the PC Conference as part of a special keynote panel discussing solid state drive technologies and the markets they impact. The following day, Wednesday, August 6, we will present at RBC Capital Markets Technology Conference in San Francisco. And on Wednesday and Thursday, August 6 and 7, Manouch will be in New York City with Thinkpanmure for a non-deal road show. And the following Monday, August 11, Oppenheimer will bring their Southern California semiconductor bus tour to STEC.

And now today with me for this discussion and Q&A session are Chairman and CEO, Manouch Moshayedi, as I mentioned, and our Chief Financial Officer and Director, Dan Moses.

Various comments about the company’s future expectations, plans and prospects made during today’s earnings conference call, including the question and answer session, constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended, and Section 21E of the Securities Act of 1934 as amended, and are based on management’s current expectations. These forward-looking statements entail various significant risks and uncertainties that could cause our actual results to differ materially from those expressed in such forward-looking statements. The risks and uncertainties are detailed under Risk Factors in filings with the Securities and Exchange Commission made from time to time by us, including our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, and our current reports on Form 8-K, including the 8-K filed earlier today for this news release. The filings are available under the category SEC filings in the Investor Relation section at our website, which is www.stec-inc.com. Forward-looking statements in this teleconference are generally identified by words such as believes, anticipates, expects, intend, may, will, and other similar expressions. However, these words are not the only way we identify forward-looking statements. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances are forward-looking statements. Listeners are cautioned not to place undue reliance on these forward-looking statements, which represent our views only as of today. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change and; therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

I would like to thank you again for joining us, and now I would like to turn the call over to Dan Moses, our CFO.

Dan Moses

We are very pleased to once again report a better than expected quarter in the second quarter of 2008, with continued strong sales from our ZeusIOPS product line at $12.2 million in the second quarter of 2008, up from $7.0 million in the first quarter of 2008.

We received a second design win at a major Enterprise Storage customer and expect to ship qualification units for their end-user testing in the third quarter of 2008. ZeusIOPS product qualifications with other new customers are also progressing rapidly. In addition, we will ship production volume orders in the notebook and sub-notebook markets in the third quarter of 2008.

And finally, we are pleased to report that qualifications of our Mach8/IOPS for the Enterprise Server market are progressing very well in several potential high-volume opportunities that could commence in the first half of 2009.

Our new 210,000 square foot facility in Malaysia now accounts for about a third of our capacity output. Although we hope to accelerate capacity output in Malaysia at a more accelerated pace, we are very happy with the progress and are excited about the competitive advantages that the Malaysia facility will bring to us in the next few quarters.

For the second quarter of 2008, on a continuing operations basis, revenue by product lines were as follows: Flash memory was $32.2 million, or 57.3% of total revenue, an increase from $29.3 million in the first quarter of 2008. DRAM memory was $21.5 million, or 38.3% of total revenues, an increase from $19.8 million in the first quarter of 2008. And service revenue was $2.5 million, or 4.4% of total revenues. International sales comprised 16.4% of our total revenues in the second quarter of 2008.

Our average sale price for non-service revenue was flat at $36 per unit in both the first and second quarters of 2008. Average shipment density of our memory products was increased slightly from 1.2Gb in the first quarter of 2008 to 1.5Gb in the second quarter of 2008, due to a shift in product mix towards higher capacity Flash products.

We shipped 1.5 million memory units in the second quarter of 2008, an increase from 1.4 million units in the first quarter of 2008.

Our GAAP results included several expense items that we do not expect to recur in our long-term operating model. These items are detailed in our second quarter of 2008 earnings release that was issued earlier this morning.

The following comparisons are based on non-GAAP operating expenses from continued operations for the first and second quarters of 2008. Non-GAAP sales and marketing spending increased from $4.3 million in the first quarter of 2008 to $4.5 million in the second quarter of 2008 due primarily to higher commission paid on increased sales and expenses related to the expansion of our international sales team.

Non-GAAP general and administrative spending increased from $4.1 million in the first quarter of 2008 to $4.4 million in the second quarter of 2008 due primarily to increases in property taxes and compensation expenses.

Our non-GAAP research and development expenses increased from $3.9 million in the first quarter of 2008 to $4.3 million in the second quarter of 2008 due primarily to an increase in payroll costs related to expanding global research and development efforts related to the continued development of our Flash SSD product lines.

Our capital expenditures were $8.6 million during the second quarter of 2008, as a significant amount of production equipment was put into service in our Malaysian facility.

Depreciation and amortization expenses were approximately $2.1 million during the second quarter of 2008.

I would like to thank you all very much for joining us today and this concludes our prepared remarks and now I’m going to turn over the call for questions for Manouch, Mitch, and myself. Thank you very much.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Kamal Das with Lehman Brothers.

Kamal Das - Lehman Brothers

Can you please update us again on how you see the $50.0 million SSD target for 2008?

Manouch Moshayedi

I think that by the end of the third quarter we will have done over $30.0 million of SSDs and we think that the fourth quarter should be a very good quarter for us.

Kamal Das - Lehman Brothers

In the SSD sub-segments, like Enterprise Storage, Enterprise Server, notebook, and sub-notebook, can you please explain to us how we should expect the growth trends to be and how we should expect the margin trends to be?

Manouch Moshayedi

I can’t really comment on all four, saying how the growth trends are going to be. But I think we have mentioned as least that ZeusIOPS is doing great, Mach8/IOPS is also doing great, and we are getting good qualifications done at server OEMs and on the Mach8/MLC, and automobile laptop SSDs are also progressing quite well. We are going to be shipping those types of parts in the third quarter already.

Kamal Das - Lehman Brothers

And how should we expect the margin trends in the four different segments?

Manouch Moshayedi

I can’t really comment on that. And I really would like to ask everyone to just ask one question at a time so we give everybody a chance to ask questions, also.

Kamal Das - Lehman Brothers

Sure. The last question from me, if I may. Can you also elaborate on the trends on your ramp in Malaysia and how that should impact your tax rate in 2009?

Manouch Moshayedi

Yes. We’ve [inaudible] on Malaysia we think that is going to be positively impacting our taxes in 2009 and we’ll be hoping to get it down below the 20% range.

Operator

Your next question comes from Rich Kugele with Needham & Company.

Richard Kugele - Needham & Company

When it comes to the inventory, can you just describe your procurement process? You know, when you get an order for an SSD, for example, and how that affects both your inventory and your working capital purchases? And the way you sign the contracts.

Manouch Moshayedi

The way that we like to work it is that once we have got a purchase order from a customer or a solid forecast along with a purchase order from a customer, we negotiate a price at that point, with the customer on an ongoing basis. So throughout the life of that purchase order, we lock in a price and delivery date. So we really don’t like to take any risks whatsoever on either availability or pricing of our components at that point. And we like to lock in all the boundaries of that purchase order at that point.

And that’s why you see our inventory go up to the extent that it has gone up. We received good purchase orders and forecasts from major OEMs that carry on up to first quarter of 2009 and as a result we locked in all the material that was needed for all of that purchase order.

Richard Kugele - Needham & Company

Can you just give us the ZeusIOPS percentage of total SSD, or however you want to present it.

Manouch Moshayedi

Dan mentioned in his remarks, also, there was over $12.0 million, I think it was $12.2 million, of total ZeusIOPS in Q2. So about a $5.0 million increase over Q1, mostly for qualification, for production with a current OEM customer that we have.

Just in the past few weeks we have received qualification notes from another major enterprise server and storage OEM that has qualified us on our ZeusIOPS across multiple platforms. So, we think that around the end of this quarter we will be shipping good quantities of ZeusIOPS to that customer to be built into their customers’ car units and hopefully in Q4 of this year we will see more production units. And we are pretty confident that by the end of this year we will have received more qualifications from the rest of the storage and server markets on ZeusIOPS.

Operator

Your next question comes from Richard Shannon with Northland Securities.

Richard Shannon - Northland Securities

Maybe a quick question on the large enterprise storage and server customer you talked about. You talked about getting designed in across a wide range of products here. Across that whole range, does this mean you have kind of effectively shut out the competition there? Is that a sole-sourced opportunity across the range there or can you help us understand that a little bit better?

Manouch Moshayedi

As far as SSDs go, we have no competition in some of these markets. As I have mentioned in many of our calls in previous quarters, we see the ZeusIOPS type of product line not to have any competition, at least for the next, I had mentioned two years about a year ago so I would say that there’s at least another year left of anyone coming into that market.

And we, frankly, not seeing yet anyone showing up with performances that we can offer our customers for those types of SSDs. So at this point, there is no competition to shut out. We are the single source at this point.

Richard Shannon - Northland Securities

It seems like the company might be making a statement that you’re being designed in across the wide range of products and therefore might be making a more of a strategic conclusion there. So I guess I just wanted to make sure that’s what you were saying.

Manouch Moshayedi

Well, the thing is across a wide range of enterprise server, enterprise storage types of groups of products, you’ve got the very high-end enterprise type products and you’ve got low-end and mid-range, and we’ve been given qualifications on across-the-board with all of those, from low-end to mid-range and high-end, using our ZeusIOPS and Mach8/IOPS for everything.

Richard Shannon - Northland Securities

I think you mentioned last quarter expecting to get to roughly 50% of production from laser by the end of the year. I didn’t hear you make that specific of a statement this time. I’m wondering what your goals are. Do they continue to be at that level?

Manouch Moshayedi

I think we’ll be a bit higher than 50% of our production by the end of this year out of Malaysia.

Operator

Your next question comes from Dan Morris with Oppenheimer.

Daniel Morris - Oppenheimer & Co.

Just wanted to dive in a little bit more on the Mach8/IOPS announcement. So, when you look at this market, and you’re saying you’re going to ship it in the first half of 2009, how exactly do you see the market evolving? Do you see it favoring MLC-based or SLC-based type of solutions?

Manouch Moshayedi

Well, two different markets. On the SLC-based we are talking about market IOPS, which goes into enterprise servicer markets. On MLC-based ones, you are talking about laptop type of product lines and that’s with laptops and automobile laptops.

So on the automobile and on the laptop Mach8 we are already shipping that product line out and we are in production with that product with customers already.

On the Mach8/IOPS for server applications, that’s what we’re talking about in the first half of 2009 picking up. So that one is in the last stages of qualifications and basically getting everything ready for production in Q1 and Q2 of 2009.

Daniel Morris - Oppenheimer & Co.

Have you had any feedback from any of the field deployments that you’ve had on Zeus?

Manouch Moshayedi

End-user feedback?

Daniel Morris - Oppenheimer & Co.

Yes.

Manouch Moshayedi

It’s been great. I think if you go into some of our customers’ websites and see the comments that they have made, also, you’ll see that their customers are extremely happy with the SSD-based storage system and we definitely not only are saving them money but it gives them a lot more efficiency in their system. So as far as we know, everything has been quite positive about SSD-based storage products.

Operator

Your next question comes from Gavin Duffy from Broadpoint Capital.

Gavin Duffy - Broadpoint Capital

Is there any timing on the receivables from the notebooks, that notebook market that actually negatively impacted Q3? I just didn’t know if there were any of these that kind of had a bit of a long payment kind of feature.

Manouch Moshayedi

Are you talking about payment terms?

Gavin Duffy - Broadpoint Capital

Yes. I’m just saying that because of some of these being newer projects, was there anything that it would be the payment was kind of something that you would figure might come in Q4.

Manouch Moshayedi

No. The payment terms with our customers are pretty simple and they are standard terms that we offer most of our large customers. So we don’t see any sort of a glitch in terms of payment terms.

Dan Moses

And we feel like we have very good liquidity. We’ve still got over $60.0 million of cash on our balance sheet. We announced last week that we just closed on the Wachovia loan deal so that gives us additional availability in the event that sales ramp up very, very quickly. So we’re able to tap into that line, as well, for working capital. So we feel from the liquidity standpoint we’re in very, very good shape.

Gavin Duffy - Broadpoint Capital

And can you maybe talk a little bit about some of the drivers that people are looking at in enterprise storage to go across multiple platforms, from the very high-end now down to maybe some of the small-medium business applications?

Manouch Moshayedi

What is the exact question?

Gavin Duffy - Broadpoint Capital

Basically some of the market drivers for enterprise storage now where your customers are looking at deploying it over multiple platforms. First it seemed like it was only at the very high end and now it seems like there is maybe some small-medium business opportunities.

Manouch Moshayedi

That’s right. So the very high-end storage systems that are very expensive are basically targeted towards the very large corporations, but I think you will see that even in the low-end and the mid-range type of storage systems that are for smaller companies, the SSDs are very much deployable and useful.

So we expect all of those markets to grow quite fast once qualifications at customer bases is done. As we’ve mentioned, we are still evangelizing this whole market on the very high-end SSDs. So the results will come a little bit slower than usual, however, we have shown quarter after quarter that the growth is an absolute possibility and it’s happening and people are embracing this technology. So going into 2009 we are extremely positive about the whole SSD market, especially in the enterprise group of products, from low end to the very high end.

Dan Moses

And, Gavin, I think one of the things I would add is in the past quarter we continued to move along with our ZeusIOPS product and that’s going very, very well and we’re starting to add additional customers, but we’ve been now qualifying for several months our server product line and we’re getting very, very good feedback and these are very high-volume potential opportunities with all the major server customers.

So that’s probably been the biggest news in the quarter for us, is that not only are the ZeusIOPS qualifications going and we’re adding customers, but we’re getting extremely good feedback on our Mach8 product line.

There are other enterprise server-type of SSDs out in the market but where we feel like we distinguish ourselves is we have the most applications where there’s a mix of a need for both high-read and high-write speeds. Our product, we believe, is by far the best-in-class and so we’re getting great feedback and we think there are some good opportunities for us in the next couple of quarters there.

Operator

Your next question comes from Vijay Rakesh with Thinkpanmure.

Vijay Rakesh - Thinkpanmure

It looks like your new enterprise OEM with the ZeusIOPS, is the ramp kind of similar to your first win? How should we look at that?

Manouch Moshayedi

It should be about the same. So we think that in Q3 we will already ship some products to build at the sample quantities for their customer base and then go into Q4 and Q1 next year, hopefully based on customer orders. So, same type of ramp as before.

Vijay Rakesh - Thinkpanmure

It looks like you now have a second enterprise customer. How do you see the competition on the enterprise side?

Manouch Moshayedi

How do we see enterprise SSDs coming and competing with us?

Vijay Rakesh - Thinkpanmure

Yes.

Manouch Moshayedi

Well, as I’ve mentioned over and over again, we still don’t see anyone competing in this market or having a viable product. So, same thing as before. We are the only company out there, we have no competition in this market and we don’t really foresee one for the next at least four quarters or so.

Vijay Rakesh - Thinkpanmure

The [inaudible], when you start to see that start to come down, is that Q1 2009 when you start to see that start to come down?

Dan Moses

Yes, we’re working on putting in the systems to transition a lot of the sales over to Malaysia. Hopefully that begins to ramp up in Q4 but I would say if not Q4 for sure by Q1 we should start to see that start to come down.

Operator

Your next question comes from Aaron Rakers with Wachovia.

Aaron Rakers - Wachovia Capital Markets

I want to clarify one comment that you made earlier on the ZeusIOPS business. You mentioned that most of that was qualifications over production. Can you comment on how that looks in terms of specifically the production units now that EMC has really been out for roughly a quarter, in terms of shipping your Symetrics option of SSDs.

Manouch Moshayedi

Actually it looks pretty good. The comments that we’re getting back are very good and basically if you go and look at the logs inside of EMC’s website you will see that their customers are quite positive about it, also. I think everyone sees the potential of these enterprise-class SSDs into those storage systems. So as far as the customers are concerned, quite positive outlook on all of those systems that use enterprise-level SSDs at this point.

Aaron Rakers - Wachovia Capital Markets

And just to clarify the earlier comment, the customer win that you’re announcing here today, that is a new customer rather than an expansion within or across different product lines with an existing customer, correct?

Manouch Moshayedi

That is correct.

Aaron Rakers - Wachovia Capital Markets

And then with the ASP trend commenting on an overall basis being flattish, and while at the same time you’re seeing your ZeusIOPS revenue ramp quite a bit, I’m just trying to understand what are we seeing in terms of ASP trends within the SSD piece of the business?

Manouch Moshayedi

On the SSD side prices are quite stable, actually. They are not going down as fast as you would thing in terms of, because of flash pricing. The SLT flash that we buy is a very special flash line and is not readily available and as a result prices stay quite stable on that product.

Aaron Rakers - Wachovia Capital Markets

If I take what you said on the SSD side and what you’ve said on the total flash business in the quarter, it looks like the revenue outside of the SSDs was down a bit. Can you help me understand that and how maybe that trend looks going forward.

Manouch Moshayedi

I think that has to do with seasonal type of thing. But I think going forward we are doing quite well still with all existing customers and all the existing designs, if it’s a DRAM or compact flash type of product line for the networking sector. We see that business also growing, at a slower pace, but still growing a little bit. On the DRAM side we are definitely trying to keep it at that level that we mentioned, that we want to be in the $80.0 million range for the year for DRAM and we are trying to stay that way.

Dan Moses

And one of the trends we’re seeing, kind of looking out a couple of quarters, is that now we’re in front of a lot of new customers in the enterprise storage, server, and notebook arena that we really hadn’t sold to in the past. And as we’re going out and pitching our SSDs we’re also seeing some opportunities for some of the smaller-capacity flash items as well. So there are definitely opportunities for us there and so potentially there is room for growth in those small-capacity flash products as well, as we are kind of out in front of a lot more customers than we were in the past.

Operator

Your next question comes from Sal Kamalodine with B. Riley & Company.

Salomon Kamalodine - B. Riley & Company

I wanted to see if you could give a little more clarity on the revenue guidance for next quarter, maybe by breaking that out between your expectations for flash and VUM and maybe within flash give some sense for what your expectations are for SSD versus flash products from some of the other product lines.

Manouch Moshayedi

We can’t break the revenue down. We haven’t done it in the past. We can’t break revenue down with margins and specific product lines. But I think the guidance that we’ve give speaks for itself. It’s a very good quarter and I think also going into Q4 we are seeing quite a good amount of ramp from Q3.

Salomon Kamalodine - B. Riley & Company

So on that same topic of your expectations and the guidance, Dan, what should we model into the start up expenses for Malaysia for the second half of the year?

Dan Moses

The Malaysia, the ramp up has gone a little bit slower, which is I guess kind of comes with the territory of bringing up new facilities for us. I think we were hoping to be a little further along. So we’re at least expecting the non-GAAP again, Malaysia for Q3, until we at least get up to some more meaningful capacity output from Malaysia, so we’ll probably non-GAAP it again. So it should be a little higher than what you see in the tables in the back of the earnings release for Q2 for Q3.

The main management is in place, we’re adding additional head count in manufacturing and testing, which doesn’t have a lot of costs. So I would expect a small ramp into Q3 and then hopefully, as Manouch said, by the end of the year hopefully we’ll have some meaningful production out of Malaysia going forward.

Salomon Kamalodine - B. Riley & Company

So Q3’s start up expenses a bit higher than Q2?

Dan Moses

Yes. We’ll continue to hire but the higher dollar management is in place so we don’t expect a significant ramp.

Manouch Moshayedi

Just to clarify that, when we talk about hiring, we’re not talking about significant numbers higher. We’ve already got the equipment in there, people-wise it’s going to be a little bit higher. On that note, our R&D will constantly, for the near future, until we get all of our projects under control, is going to climb still and we re actually very happy about that, to be able to find resources that we need to service the customers.

Salomon Kamalodine - B. Riley & Company

With respect to the EMT business, just wondering what your expectations are for shipments to that customer in the second half of the year, and maybe just based on what you’re hearing in terms of the adoption rate of the SSD configuration of the Symetrics or at the end-customers.

Manouch Moshayedi

Again, I can’t comment on what we’re going to sell to a specific customer. So you’ve got to have a little bit more general question for me to answer.

Operator

Your next question comes from Bob Gujavarty with Deutsche Bank.

Bob Gujavarty - Deutsche Bank Securities

Just a few housekeeping-type questions. Traditionally you gave out just your top customers in the quarter as a percentage. Could you go through those? Maybe the top two?

Dan Moses

We have our top telecom customer with by far the largest customer again, coming in around 40%. We’ll have the Q out in the next couple of days which will detail that. And one of our top enterprise storage customers also over 10%. Probably high teens or 20%.

I think as we go forward, we are pretty concentrated with those two but we have a lot of opportunities, a lot of large potential customers so I think as we go forward we’ll add a lot of other additional large customers and some of those concentrations will shrink.

Bob Gujavarty - Deutsche Bank Securities

And there was a comment about the tax rate perhaps falling below 20%. Was that a quarterly number or is that a full-year number for next year?

Dan Moses

It’s a little bit difficult to say. There’re a lot of variables. I think that’s kind of a long-term model, is how I would say it, but I wouldn’t commit to what quarter it switches over or if it’s for the full year. It’s going to depend on a lot of different variables, including product mix and how quickly we can convert U.S. customers to be international customers by dealing with their international sub. So, definitely long term we think that that is very feasible but the timing of it is still a little bit still fuzzy.

Bob Gujavarty - Deutsche Bank Securities

CAPEX is up a little bit q-on-q. What’s your current plan for second half 2008?

Dan Moses

That was basically us putting equipment in service over in Malaysia. So we’re bringing all the lines up. So we went from not having equipment up and running and now it’s up and running and the next step is to basically go from one shift over there to multiple shifts. And so I don’t expect a lot more equipment to come on, I think all the equipment’s up and running now. I think we said our plan is probably kind of maintenance-level of $5.0 million or so a year going forward.

But we’ve done the up-front capital expenditures needed for the building and land and equipment in Malaysia so some of it depends on revenues and the need for capacity. But I think we’re in pretty good shape, but it should pretty much be maintenance-level for the next couple of years.

Bob Gujavarty - Deutsche Bank Securities

Just curious about what was the puts and takes in the quarter in terms of great SSD growth, I mean it looks like all the incremental growth was in the businesses you’re focusing on. Just curious about the margin profile there, given that all the good stuff that grew, just curious if there’s some puts and takes in the margin side that I should think about. Was there some other stuff that didn’t do so well?

Manouch Moshayedi

I think our margins during the quarter went up from last quarter.

Dan Moses

Yes, margins went up slightly. And DRAM actually also grew, too, so I think we had growth across the board. One of the new things moving into the second half is we’ve got new markets and we’ll be selling into the notebook and ultra-mobile notebook market so we’re adding a new product line and then towards the end of the year or early next year we expect significant growth also from the server platform. So, we’re kind of just layering in new buckets of revenue. So I think Q2 was good, we had growth kind of across the board. And we see the next two quarters additional growth in notebooks and then next year we expect significant growth in the server market as well.

Operator

At this time there are no further questions.

Manouch Moshayedi

Thank you very much everyone. Thanks for joining us on our call and I hope that we’re going to have a good day today. Talk to you all later on and we’ll see you in New York and on various non-deal shows that we come and visit.

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