Netlist, Inc. (OTCQB:NLST) Q3 2021 Results Conference Call November 2, 2021 12:00 PM ET
Company Participants
Mike Smargiassi - IR
Chuck Hong - CEO
Gail Sasaki - CFO
Conference Call Participants
Suji Desilva - ROTH Capital
Operator
Good day, and welcome to the Netlist Third Quarter 2021 Earnings Conference Call and Webcast. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions]
I would now like to turn the conference over to Mike Smargiassi, Investor Relations. Please go ahead.
Mike Smargiassi
Thank you, Matt, and good day, everyone. Welcome to Netlist’s Third Quarter 2021 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’s results and the answers to questions may include forward-looking statements, which are based on current expectations. The actual results could differ materially from those projected in the forward-looking statements because of a number of risks and uncertainties that are expressed in the call, annual and current SEC filings and the cautionary statements contained in the press release today. 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.
On today’s call, I’m going to first provide a legal update, then we’ll cover the product side of the business in the context of the current market. We’ll start with Google. As you know from our previous calls, after a 10-year battle, Netlist secured a major victory against Google last year when the Federal Circuit Court of Appeals upheld the patent trial appeal Board’s decision that the claims of the 912 patent are valid. We are now working to establish the fact that Google infringed our patent and that their products have been infringing since we filed suit in 2009. As part of this process, Judge Armstrong, the judge presiding over this case in the northern District of California, will hold a hearing on November 10 to address the issue of intervening rights. When a company seeks intervening rights, it is arguing that for certain reasons, it shouldn’t be held responsible for infringing on a patent during a specific time period. Google alleges that it shouldn’t be responsible for any infringing act against the 912 patent that occurred before the conclusion of the reexamination just last year, a period of approximately 11 years. Google argues that because of clarifying amendments, Netlist made to some of the 912 patent claims during the U.S. PTO’s reexamination proceedings, it should have intervening rights between then and the federal Circuit’s 2020 ruling on the patent’s validity.
If the judge rules that Google can claim intervening rights, Netlist would be limited in the scope of its assertion of the 912 patent. If the judge rules that Google has no intervening rights, Google would be subjected to the Netlist’s patent infringement claims and subsequent damages for infringing acts over the course of those 11 years. Alternatively, the judge could grant Google intervening rights for some claims of the 912, but not others. We, of course, believe that Google does not have intervening rights for the period in question and have submitted convincing arguments to that effect. We are optimistic that the court will decide in Netlist’s favor on the issue of intervening rights, making way for us to pursue significant royalty payments and potentially damages for that entire period. In terms of the time line, we would expect the court to rule sometime before the end of the year.
Once the court rules on the issue of intervening rights, this case will proceed to the Markman process, also known as claim construction. Netlist will submit its opening Markman brief by January 21, Google will have until February 4 to respond, then we will have a week to respond to Google’s brief. Afterwards, Markman hearing is set to begin on March 9. Markman hearings are held for the court to define the key terms used in patent claims. These definitions are then used to determine the extent of infringement. So the Markman ruling is typically a pivotal moment in patent litigation because the definition of claims will, in turn, inform the likely course of the legal outcome. After the Markman hearing, the case will move to jury trial, where arguments from both sides will be presented to a jury regarding whether Google has used and continues to use our patented technology without a license. If Google is found to have infringed the 912 patent, it will be subject to damages for past infringement and have to purchase the license from us if it wants to keep using our technology or stop using our patented technology entirely. I should note that Judge Armstrong is the same judge who heard our original case in 2009 and is familiar with the history of our lawsuit.
Let’s now move on to Samsung. On October 14, the U.S. District Court for the Central District of California granted summary judgment in Netlist’s favor, finding that Samsung had committed material breaches of contract. This is a major victory for us as the order confirmed that Samsung no longer has a valid license to Netlist patents and therefore requires a licensing agreement. The judge reached this decision after finding that there was no dispute as to any material fact in the case, and therefore Netlist was entitled to judgment in its favor as a matter of law. The facts were clear and the summary judgment granted in Netlist’s favor is a strong validation of the positions that we took in the case. While the court denied our request for consequential damages, the jury will decide on direct damages during the trial in the Federal Court in a few weeks. Direct damages include the extra money we had to pay to secure components from other suppliers instead of purchasing directly from Samsung for a certain period of time. Consequential damages would have included our lost profits from the business, we could not conduct due to Samsung’s failure to supply us as required under the contract.
After the court issued the summary judgment, Samsung took a predictable step and file for declaratory judgment in the U.S. District Court for the district of Delaware, asking the court to rule that Samsung does not infringe on certain of Netlist patents and these patents are unenforceable. In the filing, Samsung alleges that Netlist did not offer reasonable and non-discriminating licensing terms and conditions progenic requirements. Netlist believes that Samsung’s declaratory judgment is entirely without merit, except for the fact that it is an admission that they do not have a valid license to Netlist patents. Indeed, Samsung cited as part of its justification for the filing that its customers, including Google, have sought indemnification to cover the potential liability created by Samsung’s lack of valid license to Netlist patents. Filing the declaratory judgment, which is limited in scope, Samsung is seeking relief in the event Netlist decided to bring a patent infringement suit against Samsung in the future with Netlist’s patents 523, 595, 218 and the 912. Samsung has also filed IPRs on the 523, 595, and 218 patents, the 912 is not included in the IPRs. IPRs stand for Inter Partes Reexams.
Finally, I’d like to give you a brief update on Micron. The Federal Court in the Western District of Texas has consolidated our two patent infringement cases against Micron. The judge is scheduled both the court hearing and a Markman hearing for March 31, 2022. Based on the local rules of this venue, discovery will begin once the Markman hearing concludes. The fact that Judge Allbright heard our patent infringement case and conducted our Markman’s hearing against Hynix, provides the court with a certain level of technical familiarity with these patents.
Moving the three cases through the legal process last quarter required an all-hands on deck approach as we address mediations, hearings and discovery. For example, in the Samsung breach of contract case, we managed 25 depositions and processed more than 800,000 pages of discovery documents, much of it dropped on us in the 11th hour. We believe we have a strong position in all of the cases and that our ongoing investments and the litigation will pay off in a major way. Whether through the judicial enforcement or good faith negotiations, we look forward to entering into licensing agreements with these companies, which fairly compensates Netlist and its shareholders for the value of our intellectual property. That concludes the legal update.
Now I’d like to turn your attention to the product business. As you know, the market is experiencing a period of turbulence. Memory chip stocks have retreated from a peak earlier in the year. Goldman Sachs expects PC demand to fall 12% year-over-year in 2022. Meanwhile, slow economic growth in China, along with the clamp down on the country’s big tech have depressed demand for memory and storage in Asia. We are seeing weak spot prices for DRAM since the end of the third quarter as supply started to exceed demand. Customers have aggressively stocked up in the first half of the year and are sitting on a good amount of inventory. As a result, DRAM ASPs remain under pressure in Q4. That said, outside of DRAMs, the global chip shortage is by no means over. In fact, the Wall Street Journal last week noted that it is worsening. Hoarding is commonplace and wait times for chip deliveries continue to lengthen. Disruption in the supply chain and marketplace are substantial and some analysts now expect shortages to last until 2023. Our Q3 top line results reflect some of these disruptions. The revenues came in lower than anticipated due to both shortages of some components required to fill book the orders, while at the same time we saw a drop-off in demand for memory modules. Bottom line loss was larger than expected, largely as a result of increased investments in R&D for CXL and increased legal expenses from the three concurrent litigation. Some of these costs were offset by the increased revenue from our Hynix supply agreement and by continued healthy demand for Netlist SSDS.
While Netlist is not immune to current market turbulence, we see a number of positives that keep us in a bullish frame of mind. One of the positive trends is the change in the profile of the memory and SSD buyers. Whether they are HR and accounting firms or global service behemoths, many of the high-volume customers today are cloud service providers. Companies like ServiceNow, Netflix, eBay, Twitter, Uber, LinkedIn, Instagram or Facebook, are directly configuring servers that run their applications. In the past, they used to just accept whatever server configurations that the box makers were selling. But these days, they are dictating exactly what components they want in their servers.
Performance matters a great deal to most of these cloud service providers. They understand things like how quickly data gets pulled out of an SSD drive and the impact of that speed on the performance of their applications. So rather than accept what comes prepackaged, they are now telling the box builders to buy a specific memory, a certain SSD, this controller or that CPU. It is in this context at a high-end SSD product like our N1962 NVMe SSD really shine. Qualification progress process is rigorous and time consuming. We can take six months and longer to qualify a single product. That said, we think that once the cloud service provider and software as a service customers, CSP and SaaS customers, learn more about our high-performance products they will start to request more of them. These companies represent the top quartile of the enterprise customer pool in terms of stickiness and the length of product life cycles, some that can extend three to four years.
For the past 40 years, companies like ours have sold almost exclusively to OEMs and box builders. Today, our end customers are the companies that provide cloud services and social media platforms that businesses and consumers depend on. This is how the customer base is changing, and we believe we are well positioned to take advantage of this evolution in the market.
In closing, despite the market volatility that impacted us in Q3, we believe that Netlist is on the right track. We are bullish about the future, and we are backing it up by investing in our company’s core areas, CXL controller R&D and patent licensing. We are expanding our sales and marketing organization with experienced sales and marketing talents with access to the cloud customer base. We have also begun working closely with Hynix on the supply side to explore potential cooperation on hard-to-source components for the industrial market. Over the coming quarters, we plan to refresh and expand our product line, grow the patent portfolio and diversify the licensing revenue stream. The end goal is to extract the most out of our intellectual property and achieve strong and sustained growth.
I’ll now turn the call over to Gail for the financial review.
Gail Sasaki
Thanks, Chuck. The third quarter results reflect record sales growth of 162% compared to the prior year’s third quarter. Pricing was mixed with growth consecutively and better margin performance in Netlist SSD and Netlist branded product lines, while resale SSD and DRAM pricing softened towards the end of the quarter. Gross profit dollars nearly doubled compared to the prior year’s quarter, although gross margin percentage decreased quarter-over-quarter, mainly due to increased resale revenue as a portion of the product mix and a softening pricing environment of that resale revenue. The increase in operating expense quarter-over-quarter was due to increased legal fees as a result of significant activity and IT enforcement actions as well as increased investment in the sales, marketing and engineering teams to support the sales and R&D acceleration.
Although we don’t formally guide, given Netlist’s current pace on mix of bookings this quarter, we expect to see a moderate increase in product revenue in Q4 over Q3. We remain very focused on growing the Netlist SSD revenue alongside the resale revenue and continue to make investments in sales and marketing resources to leverage our product performance and availability of supply advantages with current and new customers. I would note that the market environment remains fluid, industry commentary points to demand normalization and resulting softness in the pricing environment as large customers work through their inventory as we close out 2021 and enter 2022.
We ended the quarter with cash and cash equivalents and restricted cash of $73.2 million compared to $53.4 million at the end of the second quarter. This strengthening of our cash position was due to an increase in cash from a combination of the equity line of credit and exercise of warrants. Also helpful to cash during the quarter was the $10 million 60-day term line of credit we established with SK Hynix as part of the recent transaction. During the quarter, net cash cycle improved by 12 days, which included improvement in days sales outstanding and days payable outstanding as noted, offset by a decrease in inventory turns, resulting in an improvement that we noted earlier by 12 days. In the third quarter, we also entered into a new $75 million 3-year equity line of credit and updated our shelf registration to provide ongoing financial flexibility.
In closing, we look forward to speaking with you at the Roth 10th Annual Technology Virtual conference taking place November 16 through 18. Investors interested in meeting should contact their Roth representative.
Operator, we are now ready for questions.
Question-and-Answer Session
Operator
We will now begin the question-and-answer session. [Operator Instructions] Our first question will come from Suji Desilva with ROTH Capital.
Suji Desilva
Congratulations on the litigation progress here. Update was very clear here, so I don’t have many questions there. So just a question on the product side. On the Hynix resale, has that ramped up to the potential $30 million per quarter run rate yet? Or I’m curious how close it is to that? And how much of the margin there? Because I’m trying to kind of pull out the margin that’s for the core products?
Chuck Hong
No, the answer is, no, it’s just really beginning. We saw some increase in Q3 over Q2. The agreement was signed in April and I think we got set up in that quarter, and then in Q3, we started to execute on that agreement and provide a forecast and they started to ship. The market turned significantly in Q3 from Q2, especially on the DRAM and memory side. So there was some amount of hesitation to bring on very much inventory. But I think things have stabilized a bit, although it’s still soft, but it’s stable. And I think we’ll see some improvement in the Hynix revenues starting this quarter more so than last quarter. So I’ll let Gail address the margins.
Gail Sasaki
Hi Suji. I’m not going to break out that in particular, but I’ll just note that the resale margins overall did go down consecutively, and I think that was mainly due to the softness, which we experienced at the end of the quarter. We expect that to stabilize in this current quarter. So, I think that the overall margins for the resale business will grow during Q4.
Suji Desilva
Okay. Helpful. And then on the product side, the SSDs, Chuck, is the right way to think about this that you get qualified at hyperscale and cloud and SaaS customers, and then you can ramp into them? And if that is the way to think about it, how is that qualification breadth today versus two to four quarters ago?
Chuck Hong
It is improving. We brought on a handful of very experienced sales and marketing personnel that have reach into the end customer space, and we’re seeing some very good activity with some brand name customers in that space. The design and the qualification work is done sometimes directly with that named cloud service provider or sometimes it’s done with the ODM or the CM, the box builder builds under the direction of that end customer. But we’re seeing some decent activity now, much more so than a couple of quarters ago with these end customers.
Suji Desilva
Okay. That sounds promising. Good. And then lastly, CXL on the Intel transition to servers. Can you talk about what the time frame for that impacting your revenue opportunity is? And how it shows up as CXL starts ramping as a interface technology for Intel?
Chuck Hong
CXL is going on to per Intel’s plan on their Granite Rapids, starting with their Granite Rapids, and that has been delayed by Intel couple of quarters. So we’re looking at 2023 or beginning of 2024. So, there is still ways to go. There’s a lot of investments going into this area by the market. We’re making significant investments ourselves on the AC controller and the software that goes on to our product. But we expect it to be a enormous market. It is really the first new bus that the computers have seen since the PCIe, and it will open up huge markets for a lot of different suppliers. But we aim to go in with a groundbreaking product in HybriDIMM using NAND as the basis so that we can create DRAM like product in a fraction of the cost, and that is the value proposition that we have on the CXL product.
Operator
This concludes our question-and-answer session, which also concludes our conference for today. Thank you for attending today’s presentation. You may now disconnect.
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