Netlist, Inc. (NLST) CEO Chuck Hong on Q4 2020 Results - Earnings Call Transcript

Netlist, Inc. (OTCQB:NLST) Q4 2020 Earnings Conference Call March 1, 2021 5:00 PM ET

Company Participants

Michael Smargiassi - IR Officer

Chuck Hong - Co-Founder, President, CEO & Executive Chairman

Gail Sasaki - VP, CFO & Corporate Secretary

Conference Call Participants

Suji Desilva - ROTH Capital Partners

Richard Shannon - Craig-Hallum

Operator

Good day, and welcome to the Netlist, Inc. Fourth Quarter 2020 Earnings Conference Call and Webcast. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Michael Smargiassi. Please go ahead.

Michael Smargiassi

Thank you, Grant, and good day, everyone. Welcome to the Netlist Fourth Quarter and Full Year 2020 Conference Call. Leading today's call will be Chuck Hong, Chief Executive Officer of Netlist; and Gail Sasaki, Chief Financial Officer. As a reminder, the earnings release and a replay of today's call can be accessed on the Investors section of the Netlist website at netlist.com.

Before we start the call, I would note that today's presentation of Netlist 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 the 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. Netlist assumes no obligation to update forward-looking statements.

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

Chuck Hong

Thanks, Mike, and hello, everyone. We delivered solid financial performance for the year 2020 by increasing product revenue by 81%, tripling gross profit dollars and a 3.5% decrease and operating expenses, which resulted in a 42% improvement in bottom line results compared to the prior year.

We also made progress in key strategic areas. First, we were successful in expanding the customer base and creating new revenue streams and target markets through expansion of the enterprise SSD and embedded flash product lines. We also strengthened the sales and marketing teams with new leadership. Second, we made significant progress in the architecture and design of our CXL HybriDIMM product and hired key members for the R&D team to drive HybriDIMM's development in the coming quarters. And third, we made notable progress in protecting Netlist's intellectual property by advancing enforcement actions against SK hynix and Google.

We entered the new year with positive momentum in all areas of the business against the backdrop of an improving memory and storage markets. From the perspective of Netlist products, the market outlook has improved since the second half of 2020. Demand from data center, enterprise and mobile segments remains strong. As these sectors continue to make heavy investments to meet the expanding needs for high-performance computing and storage in the pandemic environment.

On the supply side, the global storage of semiconductors has been -- global shortage has been well documented and memory and SSDs are part of this general shortage. We expect components like DRAMs and NAND controllers, used to make our end products, to remain constrained through the first half. And we are working all avenues to secure these critical components.

On the other hand, if sufficient material can be sourced, the demand in ASP environment is quite favorable, with prices for most server memory having increased by around 20% since the beginning of the year. Analysts are projecting a continuation of this environment through the first half of 2021. As the market has tightened, we have seen opportunities to increase incrementally expand business with existing customers and start qualifications with new target customers.

During 2020, we expanded the Netlist NVMe SSD line with the addition of multiple products with the latest 96-layered NAND technology and leveraging out our world-class firmware optimized to handle the most demanding data center and enterprise workloads. We joined Celestica and Violin to showcase the capabilities of these products as supercomputing 2020. We will be introducing a new line of Gen 4 NVMe SSDs in the coming months. The Gen 4 products provide a faster interface to the system and superior overall performance. We have been pleased with the initial lab testing results and expect to commence sampling shortly.

We expect investments in sales and marketing leadership with new product lines to open new opportunities and help broaden the customer base and target markets, including the embedded military and the emerging edge computing segments. We are pleased to welcome back Todd Levy to Netlist as VP of Sales. Todd brings over 25 years of experience in the memory module industry and was a strategic account manager for Netlist years ago. He possesses expertise in the embedded, flash, ruggedized SSD and industrial memory segments. And brings with him a vast network of customer relationships and industry contacts.

Finally, we continue to advance the productization of HybriDIMM on the CXL bus and it starts to build out a broad-based design and verification team for the development of the ASIC controller. In January, we announced the appointment of Raj Gandhi, as Vice President of ASIC engineering to lead this team and the multiyear development effort. Raj held technical leadership positions at Marvell, Cavium and Qlogic and has a long track record of successfully developing and commercializing advanced ASIC products. He brings to Netlist unparalleled expertise in the ASIC development process.

Turning now to intellectual property. During the past year, we took several significant steps to defend our patent portfolio against infringing entities. In January 2020, we commenced legal proceedings for patent infringement against SK hynix in the U.S. District Court for the Western District of Texas, asserting 2 new patents. The '218 and the '595, which are continuations of existing patent families that read on Hynix' RDIMM and LRDIMM, server memory products which combined for multibillion dollars in annual sales for Hynix. In June, we expanded the case with an additional action asserting the '523 a new self-test patent.

The court consolidated the 2 complaints into a single case and set a trial date for December 2021. On May 4, 2020, Hynix filed a motion with the Western District of Texas, requesting to transfer venue to the central District of California. In early February 2021, Judge Alan Albright denied Hynix's request and accelerated the dates for the Markman and jury trial. Hynix then filed a petition to the U.S. Court of Appeals for the Federal Circuit to appeal the judge's ruling. Netlist also filed its own brief with the federal circuit and opposition to Hynix' appeal.

Last week, the Federal Circuit denied Hynix's petition, rejecting all of their arguments for transfer and agreed with judge Albright and Netlist that the California case is moot and Texas is the proper venue for this case. This was a decisive ruling from the Federal Appellate court that ended hynix's legal tactics to delay new process and puts the case on track for Markman hearing on March 4, and a jury trial on July 6.

The Markman or claim construction is a critical milestone for a patent case. This is the process by which the court determines the definition of key terms of the asserted patents and thereby provides early indication of whether the patent claims in the case are valid and infringed. That in turn provides insight into the strength of the party's arguments and the potential outcome of the case. Given the fast track process of this court, we expect to receive a decision from the judge on the construction of key claims within days of the hearing. We are overall very pleased with the status of the Hynix patent infringement action. And look forward to the Markman hearing and commencement of the trial.

In the patent infringement case against Google, we believe we're finally on a path to getting due process after a decade of legal wrangling, whereby Google and its allies work together to tie up our patent in the IPR quagmire. And over that period, Google attempted to invalidate the '912 patent through a series of interparties, reexams and related appeals to the Federal Circuit. After 10 years of vigorously fighting Google's attempts to delay Netlist's day in court. The Federal Circuit affirm, the U.S. patent trial and Appeals Board's decision upholding the validity of the '912 patent. The June 2020 ruling by the Federal Circuit was a significant victory for Netlist as it was final and binding on future cases with respect to patent validity.

With respect to infringement, it is well-known that for many years, Google has manufactured and consumed billions of dollars of server memory. We believe that much of this infringed and continues to infringe on the '912 patent. After expiration of the appeal window to the Supreme Court in November 2021, the reexamination certificate for the '912 was able to publish this past February 8. After publication of the certificate, we were able to move forward with a long-awaited process of lifting the stay of the case in the northern District of California, and this has proceeded as expected. We recently filed a notice with this court updating the status of the '912, and this notice allow the court to lift the stay and start a new case management process. The judge has set the case management conference for March 11, after which we would expect to receive key dates of initial schedule for the Markman hearing and retrial.

On the IP generation front, we continue to organically add to our portfolio of patents for server and hybrid memory. In 2020, 5 new patents issued across U.S., China and the EU, covering inventions in hybrid memory, method and apparatus for presearching stored data and uniform memory access in a storage cluster. The Netlist patent portfolio now comprises of more than 130 issued and pending U.S. and foreign patents, many of them seminal in the areas they cover. In addition, the company has accumulated a vast portfolio of trade secrets associated with the inventions that have been patented. We believe in the fundamental value of our intellectual property and are committed to growing it and defending it. There is widespread implementation of Netlist's IP across various segments of the memory industry. And in addition to litigation, we remain engaged in discussions with potential licensees to pay for their unauthorized use.

I will now turn the call over to Gail for the financial review.

Gail Sasaki

Thanks, Chuck. During the 12 months ended January 2, 2021, product revenues grew from $26.1 to $47.2 million, an increase of 81%. Full year 2020 product gross profit dollars before manufacturing costs of $8 million increased by 95% compared to $4.1 million for 2019. After manufacturing costs, the net gross margins were 14.3% for the current year and 9.8% for the -- for last year. The significant increase in both revenue and gross margins was due to the overall growth of SSD revenue, including a significant contribution from new customers and the Netlist NVMe SSD product line.

Revenues for the fourth quarter ended January 2, 2021, were $11.5 million compared to revenues of $9.4 million in the year ago quarter, an increase of 23% and relatively flat consecutively. Q4 '20 product gross profit percentage before manufacturing costs decreased to 15.2% compared to 20.7% for Q4 '19 and slightly down consecutively. After manufacturing costs, the net gross margins were 12.7% for the current quarter and 15.3% for last year's quarter. The difference in gross margin percentage variance between quarters reflects a more favorable DRAM and NAND market in Q4 '19 as compared to Q4 '20 across all product lines.

And although we don't formally guide, industry commentary indicates improvement in the demand and pricing environment for the first half of 2021. Although there remains uncertainty still due to -- in the demand due to COVID-19. However, given Netlist's current pace and mix of bookings, we are cautiously optimistic about the first quarter's performance and expect modest growth for the first half of '20.

We ended the year with cash and cash equivalents and restricted cash of $16.5 million compared to $17.5 million at the end of the third quarter. Cash burn in Q4 was approximately $2 million within our near-term target range of $1 million to $2.5 million. The current cash balance provides us with substantial runway for investments in HybriDIMM CXL as well as to execute on intellectual property portfolio activity during 2021. We have approximately $2 million remaining on the equity line if we choose to use it, which does not expire for another approximate 1.5 years.

As always, we continue to very carefully manage the operational cash cycle, which for Q4 20, included increased inventory turns as we decreased days in inventory by 48% to 27 days. We kept days sales outstanding that actually increased to 40 days and that was offset by a decrease in days payable to 52 days. We continue to maintain a $5 million working capital line of credit with Silicon Valley Bank to support working capital and revenue growth.

Finally, we will be participating in the Arete Tech Conference 2021, taking place March 3 and fourth. and we will also be participating in the Roth Annual Conference, which will take place March 15 to 17. Both conferences will take place virtually.

Operator, we are now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question will come from Suji Desilva with ROTH Capital.

Suji Desilva

Congratulations on the progress in 2020 here. I understand the outlook, COVID is still impacting your visibility. But have the supply constraints perhaps cause you to leave some revenue on the table in the fourth quarter or the first quarter relative to what you could be doing?

Chuck Hong

Suji, there are some shortages of critical components like NAND controller, that is going to keep us from maximizing on the opportunity. But I think in general, we're seeing a significant uptick in demand, and we're trying to fill much of that as possible. And we've been successful, by and large, in filling much of that increase in demand.

Suji Desilva

Okay. That's helpful. And then can you give us a sense of the SSD market, the NVMe SSD product line is ramping here? Can you give a sense of what kind of expectation you have in '21 for the contribution to revenue versus '20 to give a sense of how quickly it's kind of growing in? And maybe you can layer into that discussion, the embedded end market, what the timing of that coming online is for you versus data center?

Chuck Hong

Yes. I think the numbers increased quite a bit. Last year, I think we were $1 million or $2 million of SSD, enterprise SSD sales in 2019. And we got, to some place, a little over $10 million, I believe, in 2020. We expect that to grow further this year. No we don't have a specific number. But I think it could grow almost quite nicely this year, just the momentum right now of our existing customers and as we bring on new customers in this environment, we're seeing more opportunities because there is a just the general shortage of product across the industry.

Suji Desilva

And Chuck, the embedded opportunity versus the traditional enterprise data center opportunity, what's the timing of that coming on?

Chuck Hong

Yes, yes, sorry. I missed that part of the question. Yes, I was talking -- most -- I was talking about the enterprise SSD. On the embedded flash market, that's really a new product line that we started to create or build out more robustly, starting Q4 of last year. So we're active in the marketplace. I think the market for ruggedized, military, industrial applications for embedded flash, they're quite varied. And we're seeing a lot of opportunities. So I think this year will be the first full year that we will carry that product line. So we're very helpful given the market conditions to see new opportunities.

Suji Desilva

Okay. Switching over to HybriDIMM. I hear you talk about it more on this call. Can you give us a sense of what's going on with the controller development here? Is there still a partner involved? And when that controller samples becomes available for HybriDIMM?

Chuck Hong

Yes. We are finish -- we finished out the architecture and specifications last year and starting with the hiring of Raj, we've -- we are now embarking on the process to code the RTL. And then towards the end of the year, we'll start to work with the back end vendor that create the actual ASIC. We have hired on quite a bit of engineers in the last couple of months, and we'll continue to add to that. I mean it's a significant effort.

As to the partners, we would define partners as any major strategic customer for this product that would come in as a potential investor and a partner for this technology. We are talking to a number of people. And we'll continue those discussions until we get to an agreement. We're still early in the design process. So we still have work to do, but we're very hopeful that this will be a major kind of transformative technology in the industry with the emergence of the CXL bus.

Suji Desilva

Okay. The last question for me. On the litigation front, you're very clear on Hynix, what's going on in Western District Texas. Can you talk about the Google litigation and just outline for us what the next steps would be from here, just so we have that clearly?

Chuck Hong

Yes. As I stated, we have a case management conference coming up next week, and that really kicks off the case. That is where the parties and the judge together, mainly the judge sets out the rules and the time line for various submissions of briefs. There is probably a joint statement between the 2 parties being submitted to the court a couple of days ahead of that. And once you have this case management conference, a lot will become clear as to how to the dates and the events that will take place over the course of this case. So we will know more -- quite a bit more next week.

Operator

Our next question will come from Richard Shannon with Craig-Hallam Capital Group.

Richard Shannon

Can you hear me?

Gail Sasaki

Yes, Richard.

Chuck Hong

Yes.

Richard Shannon

Sure okay. Good. I had an echo there to start with. Let's see here. Maybe a numbers question, Gail, did I catch your wording right that you're expecting growth in the first half of this year? And is that compared to the first half of last year?

Gail Sasaki

Good question. No -- yes, we are expecting growth in the first half of the year, and it's compared to Q4 of 2020.

Richard Shannon

So the run rate of Q4, do you expect to be higher than that then?

Gail Sasaki

Yes.

Richard Shannon

Okay. All right. Got that. And then how should we think about gross margins? And I think maybe endemic in that question is kind of thinking about the mix and then also the kind of the commodity costs there. How should we think about SSDs relative to the Samsung revenues and other revenue streams here? And then are we expecting any sort of headwind in the cost that will allow you to keep gross margins at least at the levels that you ended last year?

Gail Sasaki

Yes. I think the level of gross margin in totality will be about the same. We will benefit. We've already started to see some benefit in both sides of the business. But I think at the end of the day, it will be about the same as Q4. For the first half of the year anyway, until we get some better visibility going forward.

Richard Shannon

Okay. All right. That is fair. Let's see here. Chuck, in response to the last question regarding SSDs. You talked about having some growth on a $10 million base from last year, but you didn't want to give a number yet, which I guess I get at this point. Maybe if you can characterize it another way, which is to help us understand what size of the market do you think you're addressing, you're not only with the kind of the enterprise SSDs but also in the embedded flash area? What kind of a TAM are you looking at? And over what time can you grow into a certain amount of share there?

Chuck Hong

Yes, Richard, I mean we know that the overall NVMe SSD market is in the high $40 billion and $50 billion. We participate in 4 different form factors of this. We tend to be on the smaller form factors with higher capacities and higher speeds. So it's a smaller niche of that broader market. But certainly, our opportunities are -- we're addressing a TAM of multibillion dollars. It's just a matter of us securing the call slots and executing that. So there's a lot of headroom to grow. There's no doubt about that. It's just -- I think what we've done last year is just a start. It's a matter of -- I think the current couple of big customers, they continue to grow their business, and we're seeing bigger shares. But the challenge is securing multiples, many more of those types of high-growth customers.

Richard Shannon

Okay. My last question on the topic of litigation here. I'd love to ask about across both of your major situations here with Hynix and Google, but any thoughts on kind of the tenor of discussions outside of the legal realm here in terms of settlement -- potential settlements? Are there are any of those going on to a more fruitful or precise degree than what you've had in the past?

And I guess I'm particularly interested about Google, which is obviously, as you described in your prepared remarks, in state of limbo for 10 years here. Can you give us any sense of what's been going on there in terms of discussions as well? That would be great, please.

Chuck Hong

Well, I can't speak to the specifics legally. But I think we've stated in the past, and on this prepared remarks for this call that we remain engaged with both of those parties as well as other parties.

Operator

This concludes our Q&A session, and the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.