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STEC, Inc. (NASDAQ:STEC)

Q3 2012 Earnings Call

November 6, 2012 4:30 PM ET

Executives

Mitch Gellman – VP, IR

Mark Moshayedi – President and Interim CEO

Raymond Cook – CFO

Analysts

Rich Kugele – Needham & Company

Aaron Rakers – Stifel, Nicolaus

James Schneider – Goldman Sachs

Gary Mobley – Benchmark

Sherri Scribner – Deutsche Bank

Manouch Moshayedi

Edward Parker – Lazard

Nehal Chokshi – Technology Insights

Richard Shannon – Craig-Hallum

Kaushik Roy – Hercules

Betsy Van Hees – Wedbush Securities

Operator

Good day, ladies and gentlemen, and thank you standing by. Welcome to the STEC Incorporated Third Quarter 2012 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) As a reminder, this conference is being recorded.

I would like to introduce our host for today, Mitch Gellman, Vice President of Investor Relations. Sir, please go ahead.

Mitch Gellman

Okay. Thank you, Karen. Welcome, everyone, and thanks for joining us for today’s earnings conference call. We hope that you’ve had the opportunity to read this afternoon’s earnings release containing our results for this third quarter of 2012.

Joining me for today’s discussion of our results, business outlook, and Q&A session are Mark Moshayedi, our President and Interim CEO; Manouch Moshayedi, Founder; and Raymond Cook, our Chief Financial Officer.

For those of you on the East Coast and in other parts of our country affected by Hurricane Sandy, we extend our wishes for a speedy recovery. In talking with many of you this week and last, we are glad to hear a common theme of resilience. As it turns out, we will be in New York on November 8 to present at Well Fargo’s Technology Conference, something that only days ago seemed unfeasible.

Before we begin today’s earnings call, I need remind everyone that our prepared remarks and answers to questions will include forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995 and are based on management’s current expectations.

These forward-looking statements include, but are not limited to, statements concerning growing acceptance, adoption, and qualification of SSDs within the enterprise storage and server markets; the qualification of STEC’s products and other developing technologies; the qualification of STEC’s products and solutions into emerging SSD system vendors, enterprises and non-traditional end-user customers; leveraging STEC’s sales and marketing and channel-support infrastructure to cater to enterprises directly and develop a new vertical market strategy.

STEC’s key product line initiatives and development; the transition from one product generation to the next; the length of qualification cycles; the capabilities, performance, cost advantages, and benefits of STEC’s products and solutions; the rapidly evolving enterprise storage and server markets; expected fourth quarter 2012 revenue and loss per share; and anticipated settlement of the previously disclosed federal and state class actions filed against STEC and several of its senior officers and directors entail various significant risks and uncertainties that could cause our actual results to differ materially from those expressed in such forward-looking statements.

These risks and uncertainties are detailed in periodic filings with the Securities and Exchange Commission. Special attention is directed to the portions of those documents entitled ‘Risk Factors’ and ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’. 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 the estimates change, and therefore, you should not rely on the forward-looking statements as representing our views as of any date subsequent to today.

Additionally, as we discuss our financial performance, we will be referring to certain non-GAAP financial measures. Please see the reconciliations of our GAAP to non-GAAP measures included in today’s earnings release.

Thanks again for joining us today, and now, I would like to introduce to you STEC’s President and Interim CEO, Mark Moshayedi. Even though this is his inaugural earnings call, Mark has a long and substantial history with our company, dating back to 1992. Mark has been an integral part of running STEC’s day-to-day operations since becoming the company’s President in 2007. As such, Mark provides STEC with continuity in its management. Additionally, he comes into this role with a good background and a strong commitment to help the company navigate through these difficult times.

I now would like to turn the call over to Mark. Mark?

Mark Moshayedi

Thank you, Mitch. Good afternoon and thank you for joining us today. We appreciate your patience as we continue to transition from a purely OEM-focused business model to one that also addresses enterprise and end-user customers. Although our latest generation of products, including PCIe accelerator cards, Gen 4 ZeusIOPS and MACH16 SSDs and enhanced audio software, are available at certain of our OEM, channel, and enterprise customers.

The increasingly competitive environments over the past year and the slower-than-expected uptake of our new products with OEMs have made refocusing our go-to-market strategy a top priority. Our transition efforts are designed to enable us to ultimately capture an increasing share of a wider base of potential customers and deliver as much value to them as possible but this transition will not happen overnight. In fact, our pursuit of non-OEM accounts will continue well into next year and is expected to remain a core focus for us going forward.

Last quarter a non-OEM customer accounted for over 10% of our revenue, a testament that our new diversified strategy is starting to see traction and we hope to see more accounts like that in the coming quarters as our sales team targets various high-growth verticals. Our goal is to continue with this strategy and invest in infrastructure necessary to support and expand our end-user and enterprise customers. We anticipate that this transition will also result in shorter and more defined qualification cycles. Until then, we remain susceptible to risk – to the risk of serving mainly OEM customers. We believe this transformation of our business model is necessary for us to remain an important player in the evolution of the storage markets.

I will now turn the call over to Raymond to discuss our financial results.

Raymond Cook

Thank you, Mark, and welcome, everyone. Net revenue for our third quarter of 2012 was $42.1 million which was above the high end of our guidance range of $40 million to $42 million for the quarter. Net revenue by major product categories was as follows. Flash-related products accounted for $39.9 million or approximately 94.9% of total revenue. DRAM-related products accounted for $1.8 million or 4.3% of total revenue. And, service revenue was approximately $350,000. The flash-related revenue was comprised of ZeusIOPS of $33.1 million, MACH products of $3.6 million, and embedded SSDs and other flash products of $3.2 million. International sales comprised 31% of our total revenues in the third quarter of 2012.

For the third quarter of 2012, our GAAP gross profit margin was 37.0% as compared to 36.6% in the second quarter of 2012. Our non-GAAP gross profit margin was 37.5% as compared to 37.2% in the second quarter of 2012. The increase in gross profit margin was primarily attributable to an increase in the average selling price of certain SSD products, partially offset by an increase in flash component costs.

Our Q3 2012 GAAP sales and marketing expense was $7.3 million. GAAP general and administrative spending was $12.8 million, and GAAP research and development spending was $16.9 million. Total GAAP operating expense for the third quarter of 2012 was $37.0 million, and non-GAAP operating expense was $28.9 million. Our non-GAAP results for the third quarter of 2012 excluded stock option compensation expense of $4.1 million; securities, litigation-related costs of $2.8 million; SEC investigation and litigation costs of $639,000; class action settlement charge of $187,500; IP litigation costs of $616,000; and employee severance costs of $49,000, net of a combined tax impact of $70,000 for the third quarter 2012 non-GAAP items. The non-GAAP adjustments are detailed in our third quarter of 2012 earnings release that was issued earlier today.

Our benefit for income taxes was booked at an effective tax rate of approximately 3.2% for the quarter ended September 30th, 2012. The decrease in our GAAP effective tax rate to 3.2% for the three months ending September 30th, 2012, and from 33.6% for the three months ending June 30th, 2012, resulted primarily from the establishment of a full non-cash valuation allowance against all of our net U.S. deferred tax assets during the second quarter.

The establishment of a full non-cash valuation allowance does not have any impact on our cash, nor does such an allowance preclude us from using our tax losses, tax credits, or other deferred tax assets in future periods. To the extent that we are able to generate taxable income in the future to utilize our deferred tax benefits, we will be able to reduce our effective tax rate by reducing the full non-cash valuation allowance.

Our GAAP diluted loss per share was $0.42 for the third quarter of 2012. Our non-GAAP diluted loss per share was $0.24 for the third quarter of 2012. Our non-GAAP earnings per share guidance for the quarter was a loss per share of $0.27 to $0.31.

From a balance sheet perspective, the following are select accounts of interest for the third quarter of 2012. Cash and cash equivalents decreased $21 million from Q2 2012 to $186.2 million. Accounts receivable decreased $6.2 million from Q2 of 2012 to $13.2 million. Net inventory increased $9.9 million from Q2 2012 to $44.5 million. Capital expenditures were $2.5 million for the quarter, offset by $3.7 million of depreciation and amortization. Current liabilities decreased $2.9 million for the quarter to $64.6 million. We had no long-term debt outstanding as of September 30th, 2012. Net cash used in operating activities for the three months ended September 30th, 2012, was $18.1 million.

On October 5th, 2012, the company entered into a Settlement Agreement to settle the previously disclosed federal class action lawsuit. The Settlement Agreement provides for the resolution of all depending claims in the federal class litigation without any admission or concession of wrongdoing by the company or other defendants. We have entered into the Settlement Agreement to eliminate the uncertainty, distraction, burden, and expense of further litigation. The Settlement Agreement provides for a fund of $35.8 million in exchange for a full and complete release of all claims that were or could have been asserted in the federal class action litigation.

As previously disclosed in the company’s second quarter 10-Q, we had recorded as of June 30th, 2012, an estimate settlement accrual of $35 million and an insurance claim receivable of $20 million, resulting in a net charge of $15 million. On October 18th, 2012, the company’s insurance carriers agreed to contribute $562,500 of the additional settlement costs of $750,000. As a result, the company has recorded an additional settlement accrual of $750,000 and an additional insurance claim receivable of $562,500, resulting in a net charge of $187,500 to other income expense during the third quarter of 2012.

The Settlement Agreement remains subject to preliminary and final court approval and certain other conditions including notice to class members and an opportunity for class members to object to or opt out of the settlement. At this time, there could be no assurance that the conditions to effect the settlement will be met that the settlement agreement will receive the required court and other approvals or that the settlement will become final.

Turning now to our guidance for the fourth quarter of 2012; we expect our revenues to be in the range of $36 million to $40 million, with non-GAAP diluted loss per share to range from $0.31 to $0.35.

I’d like to thank you for joining us today. This concludes our prepared remarks. I will now open up the call to your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from the line of Rich Kugele from Needham & Company.

Rich Kugele – Needham & Company

Good afternoon, gentlemen. A few questions if I could; first, you talk about diversifying your market presence. Now, is this a change where you want to start including, like, channel-based products? Can you just elaborate a little bit on what has to change either from a product line standpoint or what should we assume in terms of a margin profile? Are you going to need change from the 40% to more address the mid range? There is a whole host of questions, obviously, in that transition potentially. So, can you just elaborate a little bit on what you mean?

Mark Moshayedi

Yeah, thanks, Rich. When we were going after these enterprise end-user customers, the profile of the products doesn’t change. The same products as we’ve designed as our Gen 4 products, our PCIe-based products, MACH16-based products, our EnhanceIO products are the ones that are being taken out to these customers. And, then what we’re doing is we’re working with these customers to do any type of modification, if necessary, with a product from a software perspective to make it fit in their environment.

Our goal for the company from a margin base is still the same; we want to run an average of 40% margin base for the company so that doesn’t change. And, all we’re doing is we’re going to be expanding our sales and sales support infrastructure to be able to effectively go after a larger customer base which are the end-users of these products that are going to put it into storage and server subsystems.

Rich Kugele – Needham & Company

Okay. And, then secondly, can – has something changed at the enterprise level in your conversations with them to where you feel that even once you’ve gotten through all the qualifications and such that you just wouldn’t be able to replicate what you had done in the past?

Mark Moshayedi

Well, as we noticed last quarter, we had 10% customer that was basically an enterprise customer. So, the qualification cycles are shorter, the time to revenue generally works out to be a little shorter when we go after these type of accounts, and what they ask for is for us to help them with the qualification effort and making sure that the product fits in their environment and it plays in their environment.

This is completely different than how the OEMs do the qualifications where it takes a very long time for the qualification to complete. They have a process to go through and, at the same time, not only it takes time, but you also have the competitive nature that they bring in all the – any and all suppliers to compete for those slots. So, this give us more surety of success when we go after a larger number of customer and maybe each one doesn’t translate to be as big as an OEM would be. But, in aggregate, they actually work out to be much bigger.

Rich Kugele – Needham & Company

Okay. And, then just lastly, how long do you think it will take for this transition to be, call it, half your business?

Mark Moshayedi

We hope that by second half of next year it’s actually larger than half of our business.

Rich Kugele – Needham & Company

Okay. All right, thank you very much.

Operator

Thank you. And, our next question comes from the line of Aaron Rakers from Stifel, Nicolaus.

Aaron Rakers – Stifel, Nicolaus

Yeah, thanks for taking the questions. First question on the Zeus Generation 4 product; I think last quarter you had mentioned that there were still three large OEMs that had yet to complete qualifications. Can you just give us an update where you stand on that and how we should think about those qualification cycles if they’re completed now in the context of your guidance in the current quarter? I think typically you’ve seen a little bit of a, call it, digestion phase after qualification into volume shipments.

Mark Moshayedi

So, all the qualifications of the existing Gen 4 products have been completed at all the accounts that were already working on the qualification. And, at this point, the revenue is only going to be a function of how much of those systems include our products and how much sell-through that they have from their end-customers. So, they’re – obviously, every quarter we come up with newer versions of products which we engage new customers on and that becomes a new activity.

So, this job of qualification actually is never-ending as you’re always going after new accounts for qualification and you get those qualifications completed and then you see the revenue. But, all the major accounts that we were engaged with, there – that’s already done and, at this point, we’re now going to just see how the sell-through of those products happen.

Aaron Rakers – Stifel, Nicolaus

Very good. And, then on – going back on the non-OEM customer, the 10%, can you just tell us – you just have one customer that’s a non-OEM customer. Or, is there a growing list of customers? And, if so, what is the total contribution of those non-OEM customers? I think you only referenced one that was at the 10% mark.

Mark Moshayedi

Yeah, I don’t have the breakout. Maybe Raymond does from an aggregate sales perspective but we were just highlighting the fact that there are large customers that are part of that non-OEM customer base, the enterprise end-users and channel customers. The – I can tell you that the activity is very high. The number of customers – it’s a very, very long list of customers. It’s not just one or two. But, as far as the aggregate, do you have the number...?

Raymond Cook

No. What we have is we have one non-OEM customer that was greater than 10% for the quarter.

Aaron Rakers – Stifel, Nicolaus

And, was your assumption that that customer would be at that mark going into this current quarter – into the September quarter?

Raymond Cook

Yes.

Aaron Rakers – Stifel, Nicolaus

You were, okay. And, then the final question for me, just an update; looking at that number, it would seem to imply that that fell into the Zeus bucket. Can you update us where we stand on the PCIe product? Are you generating revenue there at all? And, if so, is that within the embedded/other segment?

Mark Moshayedi

No, the PCIe product is released now and customers do have them in their hands and they are looking at them and they’re trying to qualify the products for their end-applications and we have of course – every quarter we release even higher density and faster products along with that line. But, the product is released, it’s in customers’ hands, they are being evaluated, and I’m not sure if we have a breakout of that product category at all in any of the sales.

Raymond Cook

No.

Mark Moshayedi

Okay.

Aaron Rakers – Stifel, Nicolaus

So, there’s no revenue that you’re calling out from that product?

Raymond Cook

Not that we’re breaking out specifically, no.

Aaron Rakers – Stifel, Nicolaus

Okay. Thank you.

Operator

Thank you. And, our next question comes from the line of James Schneider from Goldman Sachs.

James Schneider – Goldman Sachs

Good afternoon. Thanks for taking my question. Just a follow-up on the earlier discussion about the customer’s qualification of the Gen 4 products; clearly that’s not ramping that strongly at your traditional OEM customers. So, what are your customers telling you about that? Are they saying – why aren’t they ramping it faster? Is it that the cost point is too high or what are the main barriers to you ramping at the traditional OEMs faster than you have?

Mark Moshayedi

Well, again, there is a competitive nature to this market. Obviously, there are many suppliers now that are focusing on the same customer base. And, the competitive nature of it is that, obviously, they’re going to qualify multiple suppliers and whoever has the best cost and whoever they want to give the majority of their business to that’s their decision. We are engaged in that market space and we continue to be engaged in that market space and going after those OEMs and we hope that our future generations of products will be cost-competitive and competitive from a time-to-market perspective so we can recapture some of that market share.

James Schneider – Goldman Sachs

Thanks. And, then maybe as a follow-up can you talk about the competitive environment? Are there new competitors out there who are being price aggressive? Is it the same competitors who are – who have always been price aggressive and are continuing to do so? Maybe just any update on what you’re seeing out there among customers and competitors. Thanks.

Mark Moshayedi

The name of the competitors are the same old ones. I don’t think they really have changed in aggregate. Obviously, the pricing dynamics – the OEMs do an excellent job to reduce their cost basis quarter after quarter and you have to get competitive in that market space. So, as the technology moves forward and we get to smaller geometries, some of those allow us to be more competitive at some of these accounts. And, in some of the accounts where we are engaged with, it’s not a matter of the price; they need the support, they need the capabilities that we offer from a product perspective and we continue to enjoy that business. And, we continue going after these OEMs with those differentiated products.

James Schneider – Goldman Sachs

Thanks. And, then one last one for me; maybe you could comment on your cash management strategy at this point. Clearly, you’ve started to burn cash at this stage. And, I’m wondering if you can address what actions are you taking on the OpEx side or on the balance sheet inventory management side to bring that cash burn down. Or, do you think we’re going to see cash burn for a few more quarters to come until the back half of next year?

Mark Moshayedi

As we’re going through this transition, obviously, we’re going to re-look at our OpEx and how we have to reshape the company to better suit the new customers we’re going after and the new applications we’re trying to service. So, this is something that we’ll be looking at over the next couple of quarters and see how we have to change that OpEx number.

James Schneider – Goldman Sachs

Is there a minimum cash balance you’re looking to keep, below which you don’t want to go?

Raymond Cook

We look at our working capital requirements on a weekly basis. And, right now, we’re going through the transition of products. Inventory grew about $10 million this quarter, primarily raw materials, so we’ll continue to manage that. We do look at the cash needs and the requirements going forward for 12 months and have determined that we have adequate cash for at least the next 12 months of operations.

James Schneider – Goldman Sachs

Thank you very much.

Operator

Thank you. And, our next question comes from the line of Gary Mobley from Benchmark.

Gary Mobley – Benchmark

Hi, guys. Just a follow-up on the previous question; Raymond, correct me if I’m wrong, but is the quarterly revenue cash breakeven level or non-GAAP operating profit breakeven level about $80 million per quarter?

Raymond Cook

It’s around $70 million a quarter. Once we get back up to that higher run rate, the margins will go up because we don’t have that fixed overhead component. We can spread that over a larger revenue base. So, at about $70 million, 40% gross margin; yeah, you’re right about breakeven.

Gary Mobley – Benchmark

Okay. And, I understand that it’s difficult to try to replicate the same OEM business model you had a few years ago. It’s very bimodal I suppose. And, on the other hand, having to increase your sales force to touch each one of these individual enterprise customers case-by-case has got to be a difficult task. And, where do you think you’re at right now in building out your internal sales resources? And, can you build this into a scalable business model to where you actually make money on a case-by-case basis?

Mark Moshayedi

Well, obviously, we believe so and we’re adding the personnel necessary. It doesn’t take an army of people. Obviously, we’re targeting the Fortune 1000 type of accounts first and then we can expand from there. And, the type of revenue that we’re looking for, again, comes from a few customers and they come from the Web 2.0 categories, some financial sector, the government sector. So, we’re going after each and every one of these verticals with experts in those areas where they have the relationship and we’re going after the biggest opportunities that exist in each one of these verticals.

Gary Mobley – Benchmark

In your prepared remarks, you mentioned a non-OEM customer being more than 10% of revenue. Any other greater-than-10% customers?

Raymond Cook

We had three greater-than-10% customers for the quarter, Gary.

Gary Mobley – Benchmark

Okay. And, could you share with us the case for this non-OEM customer? What are they using the ZeusIOPS for and what exact – what problem are you solving for them exactly?

Mark Moshayedi

Yeah, it was – it’s being used for cloud computing.

Gary Mobley – Benchmark

All right. Thank you.

Operator

Thank you. And, our next question comes from the line of Sherri Scribner from Deutsche Bank.

Sherri Scribner – Deutsche Bank

Hi. Thank you. I wanted to ask about the new strategy to move somewhat away from the OEMs. Just trying to get a sense, historically, OEMs have seen that type of business – that direct business as competitive with them. What is your customers’ view about you changing your strategy and trying to go directly after their customers? What have you heard from them?

Mark Moshayedi

Thanks, Sherri, for your question. We are not going after our customers. These customers we’re going after actually are not really serviced by the storage OEMS. The applications are not generally applications that could buy from an EMC or an IBM or that type of equipment manufacturer. They are building their own systems and they are building their own infrastructure using components. So, this becomes a component sale as part of their infrastructure.

And, we are not moving away from OEMs, just to be clear; we are expanding our customer base to include enterprise and end-user customers. So, we are actively engaged with OEMs, and we are taking new generation of product quarter after quarter to these guys. So, there is no strategy of getting away from the OEM customers at this point.

Sherri Scribner – Deutsche Bank

Okay.

Manouch Moshayedi

Sherri, also – this is Manouch – one of the – some of the parts that we are actually selling to these end-user customers are going through some server OEMs. So, we’re partnering up with server OEMs that service these types of new customers.

Sherri Scribner – Deutsche Bank

Okay. And, then in terms of thinking about expanding that base of customers, traditionally to go after that type of cloud computing, to go directly to the end-customers that requires a relatively large sales force versus a sales force necessary to sell directly to OEMs. What type of investment do you need in your business to target that type of market? How much more does your selling cost need to go up?

Mark Moshayedi

Yeah. So, we increase that, of course, sales force as we go along and as we see more success in the enterprise side. So, there’s no end to it. Obviously, if you’re talking about $1-billion business, it doesn’t matter if you’re spending $100 million of that on your sales team. So, we’re trying to scale it as we grow.

Sherri Scribner – Deutsche Bank

Okay. And, then just thinking about the mix of business, are these cloud computing type of customers, these enterprise customers that you’re targeting, are they primarily interested in Zeus products? Or, are they more interested in the MACH product? Thank you.

Raymond Cook

They are generally interested in the ZeusIOPS SAS interface and our PCIe products.

Sherri Scribner – Deutsche Bank

Okay, great. Thank you.

Operator

Thank you. And, our next question comes from the line of Edward Parker from Lazard.

Edward Parker – Lazard

Great, thanks for taking the question. Just two questions for me; number one, are you going to file a Q here right after the call?

Raymond Cook

That’s correct.

Edward Parker – Lazard

Okay. And, then secondly, going back to the issue with the OEM qualification, I think last quarter you described a two-tier system where the first qual would be on a systems level and the second would be towards more of an end-customer qualification and that was slated, I think, to be done by the end of the year. Are you saying that both of those two different levels were indeed qualified? And, the issue now is just that the products haven’t been accepted by the customers?

Mark Moshayedi

Both qualifications have completed at all the OEMs that were qualifying the product.

Edward Parker – Lazard

Okay. Thanks.

Operator

Thank you. And, our next question comes from the line of Nehal Chokshi from Technology Insights.

Nehal Chokshi – Technology Insights

Thanks. So, just want to keep on going on this 10% customer; could you give us what that percentage was? And, also was this a direct attached storage model? Or, was it being used as a cache? And, a few follow-up questions with regard to that as well.

Mark Moshayedi

It was a direct attach storage, not used as a cache. And, as far as the number, I don’t know if you have it?

Raymond Cook

13%.

Nehal Chokshi – Technology Insights

Okay, great. And, then could you give a little bit more color as far as what vertical this was in? Was this a hyper scale implementation, i.e., web scale? Or, was this more like a financial services or a government type of customer?

Mark Moshayedi

All we can say at this point that it was a cloud-based computing environment.

Nehal Chokshi – Technology Insights

Okay. And, then for Kronos, is that being rolled into the embedded SSD and other revenue? Is that correct? Or, it’s just not even material that there’s nothing to be rolled into any of the product categories that you outlined?

Raymond Cook

Yeah, right now it’s not that material. And, we’re including it in with the SSD product line.

Nehal Chokshi – Technology Insights

Okay. And so, I noticed that the embedded SSD was up $1 million q-over-q. Is that truly embedded SSD? Or, is that the other part that’s driving that q-over-q increase?

Raymond Cook

That would be our embedded products.

Nehal Chokshi – Technology Insights

Okay. All right, thank you.

Operator

Thank you. And, our next question comes from the line of Richard Shannon from Craig-Hallum.

Richard Shannon – Craig-Hallum

Hi, guys. A couple questions for me. Maybe I’ll just ask in a direct fashion here. Regarding your OEM opportunity as you’ve looked at it over the past, say, six months or so, has your enthusiasm remained as high as it’s been in the past? What’s your view of the TAM? And, is your expectation of share that you’re going to get next year similar to what you were thinking of three and six months ago?

Mark Moshayedi

It’s a competitive market obviously and, with many players in the market right now and trying to service these customers, we’re still very enthusiastic about the product line and our roadmap of products that are being taken out to these customers. And, it’s going to be a battle from one part number to another part number. So, there’s no new challenge that’s being put up here. It’s just you have to take it one page at a time and go through this thing and just see how it plays out.

Richard Shannon – Craig-Hallum

Okay. As you’re talking to your enterprise and just starting with the channel type of customers here, what’s the message you’re giving them? What kind of feedback are you getting in terms of how you’re differentiating and what – where the customers see your value relative to the competition?

Mark Moshayedi

Obviously, they see – these customers see the value that we provide by our CellCare technology, by developing the core products and being able to give them the supports that they need for the endurance of the products that we sell. So, the feedback has been great so far, and we provide a lot of other support and services along with the sale of the products from an integration perspective. So, so far, the feedback has been great.

Manouch Moshayedi

Greg, also having had the OEM pedigree has definitely helped us out in terms of understanding what does the customer need and how critical their data is and how much they want to keep it and make sure that it works 24/7 for the next five years. So, a lot of the customers that are coming our way these days, they tell us about their horrific stories of using some SATA drive, consumer-type of drive that they’ve bought in the past and, as a result, now they’re turning in to the other SSD vendors.

Richard Shannon – Craig-Hallum

Okay. I appreciate those thoughts, Manouch. Just two quick ones for me; you mentioned this 10% non-OEM customer in the quarter. How do you characterize the sales pipeline for similar size opportunities out there, any idea? Can you, say, quantify – give us a sense of how many other types of customers have that potential?

Mark Moshayedi

At this point, we’re trying to build the sales channel around this. There are a few other ones that are probably similar sized and we’re just engaging with those customers and we’re trying to bring them in as quickly as possible.

Richard Shannon – Craig-Hallum

Okay, fair enough. And, the last one for me; as everyone is probably asking, when do we see the sales inflection point here? Clearly, your guidance doesn’t show that for the fourth quarter. Would you expect to see that in the first quarter, i.e., can we see sales start to grow sequentially?

Mark Moshayedi

That’s all we could hope for. We only forecast one quarter at a time so that’s all we just hope for.

Richard Shannon – Craig-Hallum

Okay, fair enough. Thanks a lot, guys.

Operator

Thank you. And, our next question comes from the line of Kaushik Roy from Hercules.

Kaushik Roy – Hercules

Thank you. So, in March of 2011, revenues were about $95 million, OpEx was $22 million. Now, revenues are about $42 million, and OpEx is $29 million. So, the question is does it make sense to cut OpEx and right-size the company before you change the distribution strategy?

Mark Moshayedi

As I mentioned earlier, we’re looking at all of the options as we go through this new strategy and rebalancing the organization. So that is something that will be happening over the next few quarters.

Kaushik Roy – Hercules

And, then on the gross margin side, as you change the distribution strategy, what is your expectation? Do you think gross margin goes up or it could trend down a little bit? Thank you.

Mark Moshayedi

We think it will stay flattish and as I – as we mentioned earlier, our target is to keep it at the 40% level. And, as our sales grows, it should actually increase from where we’re at today to the 40% level.

Kaushik Roy – Hercules

Okay. Thank you.

Operator

Thank you. And, our next question comes from the line of Betsy Van Hees from Wedbush Securities.

Betsy Van Hees – Wedbush Securities

Thanks for taking my questions. Just a couple of housekeeping; I was wondering on OpEx, as we’re looking at Q4, is it going to be basically flat to Q3 or up or down?

Raymond Cook

I think that what we’ll see is we’ll continue to build out our sales and marketing team. So that is certainly a focus of ours to continue build that out. So, we’ll see some incremental growth there. But, I think from an R&D and G&A perspective, it should be fairly flat.

Betsy Van Hees – Wedbush Securities

Okay. And, then we can expect gross margin to come down then just a smidge? Is that fair?

Raymond Cook

We would anticipate with the lower revenue guidance that we’ve given and our fixed overhead costs that we would see a slight decrease in the gross margin percentage.

Betsy Van Hees – Wedbush Securities

Okay, great. And, then to my second question is – congratulations on the 10% customer. You talked about the transition cycle will be shorter and defined qualification cycles. So, I was wondering if you could give us a little bit more granularity on what are those new cycles compared to the current qualification cycles that you have.

Mark Moshayedi

Generally, OEMs take six to nine months to qualify the products. What we’ve seen in these customers, depending on the size of the opportunity and how advanced they are in their thought process in rolling out the new application, it could take three to six months, maximum. Generally these type of customers don’t look at beyond that type of a window. And, if they’ve got something for two years from now, they’re not engaging with vendors today. So that’s the type of – the window of opportunity that we see for the first engagements. And, then once the systems are in place and they’re going through the general rollouts, we could see a ramp, of course, in that – in those applications and a take-up of the products that could continue for about a year.

Betsy Van Hees – Wedbush Securities

Thanks. That was really helpful. And, my last question; in 2011, you guys exited in Q4 with about 157 days, and you did a great job of bringing the inventory level down to 107 days. And, every quarter we’ve had this uptick and now we’re at about 155 days. So, how should we be looking at inventory in Q4 and into next year?

Raymond Cook

Well, I think the inventory will be a factor of our transition of the product line, and we’re taking in different geometries of NAND right now. The raw materials makes up the majority of our inventory today. So, we’ll continue to see the inventory stay in the levels that they’re at. We may see an uptick or a decline in any given quarter depending upon the revenue profile.

Betsy Van Hees – Wedbush Securities

Thanks. And, my last question; is there any risk potentially to inventory write-downs? Or, are you going to be able to sell through, do you think, all this inventory at the current prices that you bought it at?

Raymond Cook

Yeah, we review our inventory on a quarterly basis in conformity with GAAP and ensure that it’s at a lower cost of market standpoint and we’ll continue to do that. We don’t see any need to have a write-off of any of the inventory that we have.

Betsy Van Hees – Wedbush Securities

Great. Thanks so much for taking my questions.

Operator

Thank you. And, our next question comes from the line of Rich Kugele from Needham & Company.

Rich Kugele – Needham & Company

Just had a couple of follow-up questions. First is what are the predominant – is Gen 4 the predominant product line generation you’ve got out there today? Or, is Gen 3 still shipping in any way? And, then I have a follow-up.

Mark Moshayedi

Gen 3 is trailing off and Gen 4 is the main product line, with the PCIe of course that’s been introduced getting the uptick over the next couple of quarters.

Rich Kugele – Needham & Company

Is there any mix percent you might be able to provide?

Raymond Cook

We don’t break it out between the generations.

Rich Kugele – Needham & Company

Okay. And then lastly, Mark, you still have that “Interim” title in front of your position. Is that – is there – are there any updates there?

Mark Moshayedi

No. We hope that we can clarify this case with the SEC and get past that and Manouch could hopefully resume his role as the CEO.

Rich Kugele – Needham & Company

Okay, great. Thank you very much.

Operator

Thank you. And, we also have a follow-up from the line of Nehal Chokshi from Technology Insights.

Nehal Chokshi – Technology Insights

Yeah, thanks. I want to drill a little bit more into where you are with migrating to the new business model. Could you discuss how many sales teams you guys have now or at least give a range? I would be guessing it’s in the 10 to 15 range at this point in time. Would that be about accurate? Or, if you could give more color that’d be great.

Mark Moshayedi

We can just tell you that we are maybe 30% of the way there from our hiring forecast.

Nehal Chokshi – Technology Insights

When you say 30% of the way there, you mean from your long-term objectives or for fiscal year 2012?

Mark Moshayedi

For the next quarter or so.

Nehal Chokshi – Technology Insights

Okay. And, then you guys have provided a little bit larger range in your revenue guidance, $4 million. Over the past four, five quarters, you’ve typically given only a $2 million range. Could you run us through the logic for why you’re providing a little bit larger range in your revenue guidance this quarter?

Mark Moshayedi

We don’t have all of your forecasts from our OEM customers in yet, so we want to be as prudent and conservative as possible with numbers.

Nehal Chokshi – Technology Insights

Okay. Thank you.

Operator

Thank you. And, this concludes our question-and-answer session for today. We thank you for your participation, and you may now disconnect. Everyone, have a good day.

Raymond Cook

Thank you.

Mark Moshayedi

Thank you.

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