SMART Global Holdings, Inc. (SGH) CEO Mark Adams on Q3 2022 Results - Earnings Call Transcript

Jun. 29, 2022 10:21 PM ETSMART Global Holdings, Inc. (SGH)
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SMART Global Holdings, Inc. (NASDAQ:SGH) Q3 2022 Earnings Conference Call June 29, 2022 4:30 PM ET

Company Participants

Suzanne Schmidt - Head of IR

Mark Adams - CEO

Ken Rizvi - CFO

Conference Call Participants

Tom O'Malley - Barclays

Brian Chin - Stifel

Kevin Cassidy - Rosenblatt Securities

Sidney Ho - Deutsche Bank

Raji Gill - Needham & Company

Suzanne Schmidt

Thank you, operator. Good afternoon, and thank you for joining us on today's earnings conference call and webcast to discuss SGH's third quarter fiscal '22 results and the company's entered into a definitive agreement to acquire Stratus Technology.

Joining me today are Mark Adams, Chief Executive Officer; Jack Pacheco, Chief Operating Officer; and Ken Rizvi, Chief Financial Officer. You can find the accompanying slide presentation and press releases for this call on the Investor Relations section of our website. We encourage you to go to the site throughout the quarter for the most current information on the company, including information on the various financial conferences we will attend.

I would also like to remind everyone to read the use of forward-looking statements note that we have included in the earnings press release and the earnings call presentation. Please note that certain of the statements made today may constitute forward-looking statements and that these statements are our present expectations and that actual events or results may differ materially.

We will also discuss both GAAP and non-GAAP financial measures. Non-GAAP measures should not be considered in isolation from, as a substitute for or superior to our GAAP results. We encourage you to consider all measures when analyzing our performance. A reconciliation of the GAAP to non-GAAP measures is included in today's press release.

With that, let me turn the call over to Mark Adams, CEO. Mark?

Mark Adams

Thank you, Suzanne. And thank you to all who have joined us today. We are excited to share our third quarter results and to discuss SGH's planned acquisition of Stratus Technologies.

I will start today's call with a review of our operating results for the third quarter. Ken will cover our Q3 financials and our guidance for next quarter. We will then provide an overview of the planned acquisition of Stratus before opening the call for Q&A.

Q3 was another strong quarter as we delivered our ninth consecutive quarter of year-over-year top line growth with revenue of $463 million, above the midpoint of our guidance range. In addition, non-GAAP gross margins were at the high end of our guidance range at 25.7% and non-GAAP EPS came in above the high end of the guidance range at $0.87 per share.

Stepping back from our quarterly performance, I want to highlight what we have accomplished in the early stages of our transformation at SGH. In less than two years, we have grown top line revenue from $1.1 billion to over $1.8 billion over the last four quarters, expanded our gross margins from 19.8% to over 25%.

Diversified our revenue with the organic growth of IPS, and with the acquisition of Cree LED, strengthening our balance sheet, leveraging our strong cash flow generation and continue to invest in our long-term success as demonstrated by our announcement today of the planned acquisition of Stratus Technologies. More on that in a bit.

Now let me turn to a brief review of each of our businesses. Starting with IPS. Revenue came in at $95 million for the third quarter, up 16% sequentially and approximately flat for the third quarter of 2021. In addition, we expanded service revenue in the third quarter to $34 million, up 105% compared with Q3 of the prior fiscal year. Services revenue represented approximately 36% of IPS revenue in Q3 of 2022. A record for services as a percent of total revenue for IPS.

Heading into our fourth quarter, we are seeing strong sequential demand for IPS, driven primarily by growth in sales to our commercial customer base. Based on our backlog, our Q4 top line is anticipated to grow north of 30% sequentially quarter-over-quarter. While we benefited from a strong mix of services in Q3, our growth in Q4 is driven by new product rollouts that are more hardware intensive.

Looking out into the first half of fiscal 2023, we are seeing strong demand continue as we ramp new customers and expand projects at our existing customers. While we are not providing guidance IPS's current backlog is approximately $0.5 billion, an all-time buy.

Now turning to our LED solutions group. Cree LED had another strong quarter of operating performance. Revenue with $101 million in Q3, helped by strong performance in the Americas and EMEA, which partially offset demand softness in the Greater China, Southeast Asia region, which continues to be hampered by COVID-related policies affecting the supply chain networks.

Cree LED continues its focus on innovation by delivering differentiated solutions with a strong technology and value proposition to its customers. Just last week, at Lightfair 2022, Cree LED's XE/GLED family of products were recognized by the Edison Report as a top 10 must-see product, delivering significant performance advantage in color mixing applications. We remain confident in the long-term operating performance of the LED business.

In our Memory Solutions group operating under the Smart Modular brand name, revenue came in at $266 million, a year-over-year growth of 11%. Demand for our core specialty memory offerings such as DDR3, DDR4 and flash memory products from customers in the enterprise computing networking telecom and storage segments was key to our strong performance.

In Brazil, we experienced softness driven by a decline in consumer demand for smartphones and PCs, and we anticipate this will persist into the fourth quarter. We remain disciplined in managing our operating expense and capital expenditures as we continue to focus on generating cash from our Brazil operations.

Our consolidated results for the third quarter demonstrate the benefits of our growth and diversification strategy. We believe we are in the right markets, benefiting from long-term secular growth drivers such as AI, machine learning, data analytics, cloud and high-performance computing.

I want to recognize our nearly 4,000 employees worldwide for a strong third quarter. We are in the beginning stages of a major transformation and I couldn't be more excited about the future of SGH.

And now I'll hand it over to Ken for a more detailed review of our Q3 financial performance and our guidance for next quarter. We will then provide an overview of our announced acquisition of Stratus before opening the line for Q&A. Ken?

Ken Rizvi

Thanks, Mark. I will focus my remarks on our non-GAAP results, which are reconciled to GAAP in our earnings release table. The third quarter of 2022 is the ninth consecutive quarter of year-over-year growth for SGH, demonstrating how our strategy continues to yield positive results and benefits from our diversified revenue streams. We see tremendous opportunities ahead for SGH to deliver advanced technology solutions for our customers across all three of our businesses.

Now let me turn to our detailed results for the third quarter of fiscal 2022. We reported another strong quarter. Net sales were $463 million, a 6% increase year-over-year from the third quarter of fiscal 2021. In addition, non-GAAP gross margin came in at 25.7% at the high end of our guidance range and non-GAAP diluted earnings per share was $0.87 for the third quarter, above the high end of our guidance range.

Our gross margin and earnings per share were higher in the third quarter, in part due to the timing of higher margin service revenue for IPS, which was originally expected in the fourth quarter. For the third quarter, IPS had revenue of $95 billion, up approximately 16% sequentially, driven by growth in commercial and federal sales. In addition, we had record services revenue in IPS in the third quarter which helped the overall margin profile for SGH.

We continue to see strong demand for IPS into the fourth quarter of 2022 and demand trends remain strong as we look into the first half of 2023, as Mark highlighted earlier. We expect fourth quarter IPS revenue to have a greater mix of hardware.

Our LED solutions group had revenue of $101 million in the third quarter, which was relatively flat with the same quarter a year ago. Sales were impacted from lower demand in the Greater China and Southeast Asia region, which represented over 35% of LED sales this quarter.

Our Memory Solutions Group had revenue of $266 million in the third quarter, which was 11% higher than the third quarter of the previous fiscal year, driven by growth in our Specialty Memory business. Non-GAAP gross margin for SGH in the third quarter of 2022 was 25.7%, up from 21.9% in the year-ago quarter. Non-GAAP operating expenses for the third quarter were $64.6 million, up from approximately $52 million in the third quarter of 2021.

Operating expenses were up primarily due to the continued investments across all three of our businesses as well as a reduction from financial credit in Brazil. Operating expenses benefited in the third quarter of 2022 from $3.3 million in financial credits in Brazil, which was down from $6 million in the second quarter. This credit is expected to provide approximately $2 million of benefit in our fourth quarter of 2022.

Non-GAAP diluted earnings per share for the third quarter of 2022 was $0.87 per share, up 24% from $0.70 per share in the year ago quarter. Adjusted EBITDA for the third quarter of 2022 was $64 million or 14% of sales compared to $51 million or 12% of sales in the year ago quarter.

Now turning to working capital. Our net accounts receivable totaled $357 million compared with $386 million last quarter, and days sales outstanding came in at 31 days, down 13 days from the last quarter. Inventory totaled $365 million at the end of the third quarter, up from $334 million at the end of the prior quarter. This growth was driven primarily by higher inventory for IPS as we prepare for build in the fourth quarter and into the first half of fiscal 2023.

Inventory turns was 10.1 times in the third quarter versus 8.1 times in the prior quarter. And consistent with past practice, accounts receivable, days outstanding and inventory turnover are calculated on a gross sales and cost of goods sold basis, which were $1.037 billion and $922 million, respectively, for the third quarter.

As a reminder, the difference between gross revenue and net sales is related to our logistics business, which is accounted for on an agent basis meaning that we only recognize the net profit on the logistics services as net sales.

Cash and equivalents totaled a record $387 million at the end of the third quarter, compared with $366 million at the end of the prior quarter. Third quarter cash flow from operations totaled $36.7 million compared with $32.2 million in the prior quarter.

With the continued global electronic supply chain constraints as well as the inventory required to support IPS demand, more of our capital has been tied up in working capital over the past year. For those of you tracking CapEx and depreciation, CapEx was $9.2 million in the third quarter, and depreciation was $10.6 million.

In the third quarter, we repurchased 448,000 shares, spending approximately $10.2 million during the quarter under our $75 million share repurchase authorization, and we continue to repurchase shares into the fourth quarter.

As a reminder, our capital allocation strategy is as follows: first and foremost, we will continue to invest in our businesses as we see significant opportunities for further organic growth in each of our three business segments; second, we will continue to review and seek acquisition opportunities such as Stratus for further scale and diversification in a disciplined manner; and finally, the share repurchases provide us flexibility to return capital to our shareholders in an opportunistic and price-sensitive manner.

With the opportunity ahead of us to acquire Stratus Technology, we have suspended our share repurchase authorization effective today to align our capital resources towards the strategic acquisitions.

Now let me turn to our fourth quarter guidance. We expect that our net sales for the fourth quarter of 2022 will range from approximately $420 million to $460 million, or approximately $440 million at the midpoint. Our guidance incorporates the strong demand in our IPS business, but an offset primarily by slower demand in memory.

Our GAAP gross margin for the fourth quarter is expected to be between 22.5% and 24.5%. Non-GAAP gross margin for the fourth quarter is expected to be approximately 23.5% to 25.5%, in part due to the greater mix of hardware in our IPS business in the fourth quarter, as mentioned earlier. Our non-GAAP operating expenses for the fourth quarter are expected to be approximately $62 million to $66 million.

GAAP diluted earnings per share for the fourth quarter is expected to be approximately $0.22 plus or minus $0.10. On a non-GAAP basis, excluding share-based compensation expense, intangible amortization expense, debt discount and other adjustments, we expect non-GAAP diluted earnings per share will be approximately $0.65, plus or minus $0.10. Cash capital expenditures for the fourth quarter are expected to be in the range of $9 million to $12 million and approximately $38 million to $41 million for fiscal 2022.

Our GAAP diluted share count for the fourth quarter is expected to be approximately 55 million shares based on our current stock price. And our non-GAAP diluted share count is expected to be approximately 53 million shares as it includes the benefit of our convertible note cap call.

Our forecast for the fourth quarter of fiscal '22 is based on the current environment, which contemplates the global economic environment and ongoing supply chain constraints. Please refer to our non-GAAP financial information section and the reconciliation of GAAP to non-GAAP measure tables in our earnings release for the further details.

Now let's turn to the exciting news regarding the announced acquisition of Stratus.

Mark Adams

Thanks, Ken. Now I'd like to discuss today's announcement that we have entered into a definitive agreement to acquire Stratus Technologies, a global leader in simplified, protected and autonomous computing solutions in the data center and at the edge.

Today's presentation is on our IR website. For those following the presentation, please turn to Slide 3. We believe that the acquisition of Stratus will be a significant milestone in SGH's transformation into a growth-oriented, diversified company. The business, its products, customers, financials and leadership very much aligned with our acquisition framework. Specifically, we expect Stratus to expand our presence in high-value specialty markets with differentiated solutions in the data center and at the edge.

Lead the industry and high availability, fault-tolerant platforms, software and services, bolster our existing IPS technology offerings, allowing us to more comprehensively address our customer needs, increase our services capabilities and infrastructure, resulting in an additional $80 million of higher margin recurring revenue for IPS. Strengthen SGH's large-scale customer base as Stratus serves a global set of customers, including more than 50% of the Fortune 100 at an estimated $150 million in annual revenue and to be immediately accretive to non-GAAP gross margin, non-GAAP EPS and free cash flow.

Let me turn you to Slide 4. Over the last four years, SGH has had a successful track record of M&A, allowing us to diversify our revenue streams and scale our overall business. Leveraging our SGH operating system, we have effectively integrated three acquisitions, which make up our Intelligent Platform Solutions group.

By strengthening our IPS leadership team focusing on development of more differentiated technology and products and investing in the scaling of our services organization. The IPS business has grown top line revenues more than 30% in fiscal 2021 as compared with fiscal 2020 and has made similar gains in the first half of '22 compared to the first half of '21.

The acquisition of Cree LED has been a great success as well. Our team has managed a complex manufacturing transformation, leading to gross margin expansion of close to 1,000 basis points in less than 18 months. We believe the acquisition of Stratus presents another exciting opportunity to create value for our shareholders as we continue to transform SGH.

Now on to Slide 5. Through our growth and diversification strategy, SGH has transformed from a specialty memory products manufacturer to a developer of differentiated value-add solutions for computing, memory and LED specialty end markets. Our revenue has nearly tripled, and the mix has changed dramatically as well. Memory Solutions was 57% of our overall sales in Q3 2022, down from 100% in fiscal 2016. And Brazil was less than 25% of overall sales this past Q3, down from 46% in 2016.

Our adjusted EBITDA and free cash flow are significantly higher, and our leverage on the balance sheet is significantly less. And in fiscal 2021, Silver Lake sold its remaining stake in SGH and we have since evolved in a fully independent public company with a board comprised of exclusively independent directors, except for myself, given my role as SGH's CEO.

Next slide, please. Stratus based in Maine, Massachusetts was found in 1980. The company is a longtime leader in developing high availability, fault-tolerant platform software and services serving Fortune 500 enterprise customers. Stratus has nearly 500 employees in 17 locations around the globe and brings approximately $150 million in high-margin revenue as part of the acquisition. It's also a recognized innovator with over 70 patents and applications that will add to the SGH IP portfolio.

Please turn to Slide 7. Stratus developed in markets high-availability fault-tolerant computing solutions for large-scale enterprises in the data center and FDAs. The company has offering specifically to address the information technology or IT edge and the operational technology or OT edge. Stratus is truly global, with nearly 60% of its revenue outside of the U.S. Their customers, which include more than 50% of the Fortune 100, operate in a diverse set of vertical markets such as financial systems, retail, oil and gas, telecommunications, transportation and government.

Turning to Slide 8. The planned acquisition will both complement and strengthen IPS' current offerings and operations. IPS is focused on developing differentiated solutions for the edge, core and cloud. Stratus offers application-specific products at the edge with their FT server and DTC edge products. Stratus' V-Series and serve DC product lines complement our IPS high-performance computing platforms, software and service portfolio.

As we have noted on prior calls, growing our services offerings has been a high priority for IPS. We set a record for services as a percentage of IPS revenue in our third quarter. Stratus will bolster our services scale adding roughly $80 million in maturing revenue. In addition, we see potential for significant revenue synergies and the cross-selling of IPS and Stratus products and services to the future combined customer set.

We believe the acquisition of Stratus will drive further growth and profitability as part of our IPS business. The addition of new technologies and services, the expanded reach to a global set of new enterprise customers, the higher gross margin model and a leadership with a proven track record gives us the confidence that this can be another winning acquisition for the company and our shareholders.

Now let me turn the call back to Ken for a transaction overview.

Ken Rizvi

Thanks, Mark. Let's turn to Slide 9, the transaction overview slide. We expect to purchase Stratus for $225 million in cash at closing. There is the potential for an earn-out of up to $50 million, which can be paid in cash or stock or any combination thereof at our option. The earn-out is also subject to Stratus achieving certain gross profit targets 12-months post-closing.

We remain focused on maintaining a prudent balance sheet as we continue to scale and diversify SGH. We exited the third quarter with cash and equivalents of a record $387 million, and we intend to finance this transaction with cash on hand and up to $125 million from our revolving credit facility.

Pro forma leverage is expected to be 2.5 times on a gross basis and up less than a quarter turn compared to our gross leverage prior to this transaction. And we expect to close this transaction by the second half of calendar year 2022, subject to regulatory approvals and other customary closing conditions.

Now turning to Slide 10. As Mark highlighted earlier, this transaction expands our capability in high-value specialty markets in the data center and at the edge and aligns to our growth and diversification strategy. From a financial standpoint, Stratus fits well within our acquisition framework. It adds more than $150 million of annual revenue, including more than $80 million of higher margin recurring revenue. It improved SGH's overall non-GAAP gross margin by more than 150 basis points and is expected to be immediately accretive to our non-GAAP EPS.

The Stratus acquisition is a significant milestone for SGH and its business, products, customers and leadership further transform SGH into a growth oriented diversified company. On a pro forma basis, the addition of Stratus further strengthens IPS. Our IPS segment becomes a larger part of the SGH story with revenues becoming 27% of our LTM sales, up from 21% prior to the acquisition.

With that, let me open the call to questions. Operator?

Question-and-Answer Session


[Operator Instructions] The first question is from the line of Tom O'Malley with Barclays.

Tom O'Malley

Good afternoon guys and thanks for taking my question. My first one is just into the August outlook. You guys have talked about a sustained amount of time here of year-over-year growth in August. It looks like from a year-over-year perspective with the guidance you're going ex-growth. You mentioned really strong IPS of greater than 30%. But could you just walk us through -- you called out memory as a weaker segment. Can you talk about what's driving that? Is it just the consumer business in Brazil? And then you also didn't mention anything on the LED business. Could you give a little color on what that business is doing into August?

Mark Adams

Sure. Tom, thanks. This is Mark, and thanks for the question. Before I answer it, I just want to make a clarification. I think Ken might have misstated, we did not suspend our share repurchase program, and we are continuing to repurchase shares in the fourth quarter. I caught that, but didn't want to interrupt the presentation. But again, we did not suspend share repurchase, and we are continuing to repurchase.

Now back to Tom's question, the way I look at our fourth quarter guide is that the biggest headwind we're facing at SGH is through the impact of the consumer demand environment in Brazil tied pretty much exclusively to mobile phones and notebooks. And that impact is, again, a headwind when considered against the IPS positive forecast.

And the LED side, Tom, so lot less severe but still a little bit of headwind given that about 30%, 35% of the business is in our Asia Pacific region, and we've got some supply chain issues as well as demand side issues primarily due to the COVID lockdown feeding into the quarter. And so I think I look at the LED business may be flat to down single digits. And the Brazil business is down relative to the broader trends I discussed, again, offset by some of the strength in IPS.

Ken Rizvi

And Tom, just to highlight there, if you look at IPS, we've been talking about it, and there is some variability quarter-to-quarter, but we saw a great growth Q3 to Q2, in record services which we printed, which is fantastic to the margin profile. We're going to see strong growth here into Q4. And as we look at the demand trends for that business into the first half of next year, they look fantastic. So those are specific to IPS and specific to SGH in terms of what we're seeing. And so a lot of good opportunity for us in that segment.

Tom O'Malley

Just another follow-up, I guess, on the memory and LED businesses. I mean, just generally, you're seeing weaker data points on consumer-facing applications, can you just comment -- I mean, I don't see -- is there any reason why that would improve for both the LED and the Memory Solutions business into the first half of the next fiscal year? Or do you have any commentary would that deteriorate further?

Mark Adams

Well, obviously, the environment is a little bit tougher to predict given the volatility in the markets. We think LED is relatively stable, plus or minus from where we are sit today. I think that, again, depending on how things play out in China because I guess, actually, Tom, just as a data point or 2, the U.S. and European markets were actually growth segments China was down, which offset that growth. So some positives on the LED demand. It's just the China thing was bigger as we entered the quarter and again, appropriately setting expectations.

On the consumer business in Brazil, that's a hard one to call. However, I think what we're seeing is a little bit of inventory work through that reduce some of the customer demand, there's global demand issues on mobile notebook. And I think some of our customers are working through inventory that minimize their forecast for us in the quarter, which is impacting our forecast. I think -- I don't think they are working through a ton of inventory, but significant enough to impact Q4 we'll watch it and try to be kind of as transparent as we can. I don't have much more than that because it's just -- it's kind of uncertain to be able to predict.


The next question is from the line of Brian Chin with Stifel. Please proceed.

Brian Chin

Good afternoon and thanks for letting us ask a few questions. Congratulations on the acquisition. Maybe the first question again, kind of a little bit more near term, but kind of building off that commentary, Mark. Yes, I think there was a lot of reports in recent weeks about one of the big handset companies cutting back on some of their production to realign with weaker demand. It seems like that would the expectation was that would largely be over kind of towards the latter part of July. And so that would seem to fall well within the fiscal 4Q. And so is there any optimism there that off kind of the shoe tops that business in Brazil, maybe you could rebound a little bit. Rebound maybe not the right word, but maybe kind of would be at a low this quarter and sort of would trend more towards a normalization in early next year?

Mark Adams

Yes, I think it's obviously, again, I want to be careful. But I would say the argument there that makes sense to me is that it's not like they're sitting -- our customers are sitting on months of inventory. I think what there has been has been a little bit of concern on the demand side that has built up some shorter-term supply inventory within their own system or balance sheet, so to speak.

So I think my sense is that it could get better from here from Q4 into Q1, Q2, but we're just -- we're trying to be careful given that we don't know where we go from here and the broader demand of the consumer products. But I do believe that the inventory isn't as severe as I've experienced in other times in the memory business. I think it's real, but it's not as significant as some other cycles I've been through. So I think the argument is it could be shorter, and we just don't know enough to predict Q1 yet.

Brian Chin

No, that's fair enough. And just also to clarify, you fan it out to specialty memory to IPS, which sounds pretty stronger than LED with the exception of supply chain in China. Sounds like you have seen good demand there. Any other sort of telltale indications of maybe downward changes in demand in those other markets? It doesn't sound like it, but I wanted to clarify.

Mark Adams

Yes, Brian. Thanks for the question. No, I mean that's the -- I mean we're kind of it's interesting because as we're sitting here telling you a little bit about the LED in China and Brazil and the consumer business, we've got a record backlog in IPS, $0.5 billion backlog and quarter-over-quarter growth of 30-plus percent.

So it is mixed demand signals, I think. By the way, I think that's kind of what's going on in the broader market. I think consumer has been hit primarily and even if you look at some of the major retailers and their more recent announcements and then down into the technology sector, I think consumer tech has been hit a little bit, but the enterprise space. And especially, I think some of these long-term markets, these broader secular investments that the large-scale enterprises are making in terms of AI and machine learning and what have you. I think people are going to invest through the cycle with a strong balance sheet. And we feel -- our line of sight there is pretty good. So that's how we look at our business today.

Brian Chin

Great. Maybe if I can ask 1 question about sort of the Stratus acquisition. Can you provide any more details about, I think $150 million? It sounds like you bifurcated sort of what the hardware versus the software and services looks like. So can you give an indication like what the recent annual growth rates have been for Stratus, sort of what the delta is in the margin profile for its software services versus the hardware? And anything else you want to comment on in terms of how it really measures or synergize as well with the Penguin Solutions business.

Mark Adams

Maybe I'll take the second part first, and then I'll hand it over to Ken for some of the financial metrics that you asked about. As many of you know, we've been investors in IPS since I joined the company. And after a few years of some declining business at IPS, the business has had 30% growth, '21 over '20. And 30%, roughly, a little bit more than that in '22 first half versus '21 first half. And we are very bullish about the business.

Stratus, an innovator, strong patent portfolio and a specialty provider of fault-tolerant high availability, platforms, software and services, has a very similar strategy in terms of the data center all the way out to the edge and building custom solutions for their end customers. And again, as I mentioned, the customer base at Stratus, 50% of the Fortune 100 and the customers and their loyalty to Stratus have been fantastic.

As we think about building out our capabilities and our scale at IPS, the service infrastructure that Stratus brings to our ability to serve our customers and to scale into high-performance compute and edge applications in their customer base is significant. If you take a look at the combined service businesses of the two companies, you're well over $150 million, $160 million, and Ken can talk to that in a little bit.

So the overall solutions mindset, service orientation differentiation, serving enterprise customers is going to scale IPS and also allow us to expand our gross margins in the process to make this a winning transaction. Ken, maybe you can take it from here.

Ken Rizvi

Yes. Brian, just on the financial side, this is a fantastic transaction for SGH. We talked about the revenue is $150 million plus of revenues. We think we're going to do better than that.

On the recurring margin profile, that just adds great visibility to us as we look out over a 12, 24-month window in terms of both the revenue and the margins. If you back into the gross margin percent here, this business is 45%, 50% plus type of gross margin, and we think it can do better than that. And at the end of the day, it's going to produce a lot of great cash flow from a financial perspective. My guess is we will do north of a 10% cash-on-cash return for this investment.

If you look at what we've done in the past, if you look at Cree as an example, that has high teens, low 20% cash-on-cash returns. And so our recent acquisition history has been good. We are focused on generating positive and strong cash flows, and this should be similar results in terms of great cash-on-cash returns.

In terms of the growth profile, just to answer your first question, when we look at this business, you have two segments. And one of the areas that we've talked to and spoken at even at your conference was a focus on the edge, and that's where we can differentiate as we look out over the next 1, 3, 5 years. And in that specific space, if you look at the Stratus business. That part of the business has been growing in that high single-digit range. We think that can get up to that low double-digit range over time, which will be fantastic. But overall, revenues relatively flat with that bifurcation of strong growth in the edge market.

Brian Chin

Great. Thanks for the color.


The next question is from the line of Kevin Cassidy with Rosenblatt. Please proceed.

Kevin Cassidy

Thanks for taking my questions. Congratulations on the acquisition. Just one thing. You didn't mention much about the supply issues that you talked a lot about last quarter with IPS growing 30% quarter-over-quarter. Are all the issues resolved? Or is that still limited?

Mark Adams

Kevin, thanks for the question. I think it's best to say that some of the demand that pushed out from Q3 pushed into Q4. Similarly, Q2 to Q3, and we've had this dynamic, I would say there's been some mild improvement, but we're not out of the woods yet.

I think as you can tell from the broader backlog, remember, this is a business that was doing roughly around $240-ish million less than two years ago. And we've got a backlog of $0.5 billion. So we're still working through that. We're confident in our Q4 guidance that considers and contemplates that. But I think the business is still constrained.

Kevin Cassidy

Okay. Great. And just on Stratus. What's their engagements with their customers? You mentioned 50% of the top Fortune 100 companies, how long is their engagement in those services? Are they scheduled out for five years or three years at a time?

Mark Adams

Yes. It's interesting. And we had a chance to talk with a number of their customers in the process. This is a company I've known for a long time since my time at NCR, and their customer relationships are really just best-in-class. They are in these large customers because they serve a very specific and need relative to mission-critical applications that require this fall tolerant high availability type of architecture and software platforms.

And so these agreements do go out. I think the average customer life span is somewhere around 8 to 10 years, somewhere in that neighborhood. And so these applications like credit card processing is a good example of one retail operation, financial institutions. The end markets we talked about are very sticky and really allowing us to think about how to engage further.

And you might imagine that with these type of customers, the type of names and logos that they have in their user base, you might imagine that there's a lot of investment in terms of AI and machine learning that will open the doors for us to go market our high-performance compute and portfolio of products and services, which is, I think, is really the revenue synergies I'm referring to, we haven't even contemplated when we talk about the transaction. So we think this is a great transaction that light of a company like Stratus has just got such a long history of customer service in mission-critical applications at large enterprises, and we're really anxious to take the next step and try to expand those relationships.

Kevin Cassidy

Okay, sounds great. Thanks.


The next question is from the line of Sidney Ho with Deutsche Bank. Please proceed.

Sidney Ho

Thanks for taking my question and congrats on the deal. It's great to see it immediately accretive. Just a couple of quick follow-up here. It sounds like gross margin expansion is a key consideration here. You talked about their gross margin in the 45%, 50% range and you think you can do better. What's driving the expected gross margin improvement?

And secondly, can you walk us through how you think about this cross-selling between organic SGH at Stratus? I assume there's not much product or service overlap, but is there much customer overlap? And do you have to significantly expand your sales force to address that?

Mark Adams

Okay. Thanks for the questions, and I'll try to address them in that order. As far as the gross margin expansion from the 45% to 50% range that Ken gave in terms of his discussion of the overview of the transaction. I'd like to walk you through kind of where we came from. The Cree transaction we did back in March of '21, where we closed that, that was a carve-out in nature. Stratus will be a major part of intelligent platform solutions.

And so this is less of a carve-out and more of a combination. And in light of that, we have some opportunities to take advantage of the strengths of each organization, and there's certainly strength on both sides of the table. So this is more a combination and less of a carve-out. So there's opportunities in there to be more efficient as we think about the new combined entity of IPS.

Secondly, when you think about the combined operating expense of the two businesses today, IPS doesn't exist in Stratus. You've got an OpEx somewhere in the neighborhood of $140 million, $150 million. And conservatively, we think there's probably over 12 to 18 months, it's probably 10% is how we're looking at it and modeling above and beyond day one accretion. And that would come in the area of shared services in finance, HR, IT, legal, corporate marketing, those types of things.

And then as we think about the overlap in terms of some of the customer engagements as well as our go to supply chain management and PLM, there's opportunities there. And so when we look at our overall model going forward, we think with scale it will continue to grow. Remember, this is a growth business. We see pretty good opportunities to leverage that scale as this business continues to grow over the long term.

And finally, I just want to repeat what I just said. You mentioned Stratus has account teams serving existing customers. And obviously, on the IPS side, we have our own sales organization supporting our customers. But we haven't modeled in as far as the accretion that Ken discussed, we haven't noted any revenue synergies, of which we think there's relatively strong opportunities to convert and really market into Stratus' customer base on high-performance compute and some of our edge portfolio. And likewise, we think there's opportunities to do the same with Stratus' Technologies into IPS's customer base.

So all in all, this deal with the scale opportunities there, I mentioned and the efficiencies relative to a growing business as well as the revenue synergies, which we haven't really quantified because we're trying to be hard dollar in terms of our analysis. We think this is going to get better from here substantially.

Ken Rizvi

And Brian [ph], just -- I mean, just to reiterate in terms of some of the customer opportunities about 50% of the Fortune 100, which Mark mentioned, three of the four largest credit card companies, five of the largest 10 retailers in the world, over 11,000 systems deployed, over 4,000 and customer support customers. So it's really a fantastic opportunity to cross-sell across IPS and between Penguin Solutions and Stratus. And there is very limited overlap today, especially if you look at the product portfolio, this is really complementary to what we have today. And so there's some great opportunities then hopefully, we'll be able to share with you over the next 12, 24 months.

Sidney Ho

Great. That's super helpful. Maybe switching gears a little bit. Bigger picture question. Investors are generally worried about recession in the upcoming quarters. If there is a slowdown in global demand, which of your businesses do you expect to see the impact first? And which business do you think has the most staying power? It sounds like you're quite confident with IPS business. But what are some of the key metrics that you're watching and how quickly can you adjust your cost structure to protect your overall profit pool? Thanks.

Ken Rizvi

I think that's a good question and something that we look at on a weekly and daily basis. I mean we see the markets we know where they're at. I would say the area that we're seeing at the most is what we discussed earlier today is really more in that consumer-oriented market. That primarily for us, is Brazil because what we sell into that market is PCs and handsets or into the PC and handset supply chain. The rest of our business, if you look at where that is today, it's primarily to enterprise or enterprise spending. And there are some specific growth trends that we do have.

Now I can't call something 12 or 24 months out. But if we look at IPS as an example and we look out not only into the fourth quarter but into the first half of next year, we do see great demand trends for IPS, and these are specific to large-scale, high-performance compute systems. And so that will have some nice tailwinds for us and specific to that business line.

In terms of spending, I've been in semis for a long time, Mark has been at Micron and other semiconductors a long time as well. And so if there is a cycle, obviously, there are a lot of knobs that can be turned and there's variable expenses that come down. There's travel expenses that come down. There are other actions that we can take, and we would take and will take if we see a more challenging environment to ensure that we generate good EBITDA and good cash flow.

And I would say the 1 benefit, if you will, if things do get soft over the next 12 months would be in terms of working capital. That's been an area that we've talked about where we've invested quite heavily here over the last 12 months. And typically, if things get a little bit more soft, we will get a positive benefit to our working capital, which adds cash and cash flow to the balance sheet. So those are all things that we're going to be cognizant of and we monitor, and we'll take the correct actions as needed, Brian.

Sidney Ho

Okay, great. Thank you very much.


The next question is from the line of Raji Gill with Needham & Co. Please proceed.

Raji Gill

Yes, thank you for taking my questions. And congrats as well on the acquisition. Just a couple of questions on the near term and then maybe one question or so on Stratus. If we're looking at kind of the near-term outlook in August with the sequential growth in IPS and LED being down kind of low single digits, it implies overall memory being down roughly 19% to 20% sequentially. And I just wanted to kind of break that out a little bit further between Brazil and Specialty Memory. Given the fact that to your previous commentary, you're trying to focus more on enterprise spending. So I wanted to get a sense of are you seeing also a sequential decline in the specialty memory, which is tied to storage and is tied to server and tied to data center and networking? Or is the majority of the decline sequentially within memory, primarily related to Brazil?

Mark Adams

Yes. Good question. From a magnitude perspective, it's certainly more on the consumer-facing business in Brazil. I would say that -- the other thing I would say is that as we ran the business in Q3, we had some customer shipments in Q3 and in the quarter we just announced that we pulled into the quarter because our customers needed it, and we're more serviced that way in terms of our mindset of just doing the right thing. And so there might be a little bit of that on timing on specialty.

But in general, as you know, specialty has been a huge over performer for us this year, and it's really more of an emphasis on the consumer space. There might be some timing issues that Q3, Q4 revenue that was sold in because, again, had an outstanding quarter in Q3, and some of that did come in relative to customer requirements.

And so I would say that very heavily on the consumer-facing business in Brazil, puts and takes, especially could be flat to maybe down but like Ken talk to that. But I would just say we haven't seen the demand signals shifting in the enterprise specialty space for us has been, again, primarily Brazil.

Ken Rizvi

Yes. So Raji, on that one, it is, as Mark highlighted, if we see where that demand is softening. It is primarily that consumer-oriented spend, which is Brazil. It's essentially PC and mobile handsets in that market where we're seeing softness into Q4.

Raji Gill

Okay. Great. Thanks for that. And just on the inventory, the absolute dollar inventory increase. So if you look at it on a year-over-year basis for the May quarter, it looks like absolute dollar inventory increased 26% year-over-year in May and the revenue grew, overall revenue grew 6%. So inventory growth is far outpacing the revenue growth.

And I know that's in part for the preparation of the IPS build. But wanted to get a sense about your kind of -- you talked to Ken about your working capital management. But any risk there in terms of an overbuild? Are there -- is it almost all related to IPS? Is there some build -- an excess build that you had for Brazil or for maybe the portion of the specialty memory that you could see some sort of correction there?

Ken Rizvi

Yes. I'll give you a little bit of color there. It's a great question. If you look even Q2 to our Q3, more that 100% of our inventory build was specific to IPS. So if you looked at the other two segments, their inventory went down quarter-on-quarter. But that IPS segment, we're building these large systems. We've talked about that. We're going to see 30% plus growth quarter-on-quarter and you can't order it in one week and ship it out in the next week. That's just not the business profile.

And so we are building for not only for Q4, but that demand is there, and these are specific systems, either custom systems for large enterprises as we look out into Q1 and Q2. And so we have to prepare and have a little bit of inventory in order to satisfy that demand. But it's something we always look at. We have to -- We have weekly meetings looking at the inventory, making sure we have the supply to meet our customer needs and also making sure we're not over ordering. So there's line of sight into that spend.

Mark Adams

Yes. The only thing I would add there is that given the supply environment we're in and the backlog that we referenced, both Ken and I referenced, when you're able to get parts to take them right now, as you know, from the broader semiconductor supply chain issues. And so that only further has impacted our positioning on inventory and again, largely IPS, which is exciting for us as that business continues to grow.

Raji Gill

And a quick question on IPS. The services revenue, as you mentioned, was $35 million of the $95 million in the May quarter, which is almost 37% of the IPS revenue. Even though IPS is growing at on this 30%, you mentioned it will be more hardware, new hardware installations versus services. Do we expect then that the services related to those kind of new hardware installations and new contracts will come into play in the February, May, August quarter? I mean what was the lag in terms of the services revenue kind of being overlaid on those kind of new contracts?

Mark Adams

Yes, it's a good question. As we've talked about, I think you're pointing out to the nature of the business, especially as we're growing. Because it's quite possible that as we've talked about the growth in top line revenue, the mix as a percentage will change. But I think to answer your question more specifically around when the service base increases from these new installations, it's normally like a 1- to 2-quarter lag in terms of the service contracts and agreements because a lot of what we do upfront is on design engineering what have you in manufacturing the system testing the systems and then the service element is then kind of kicks into a higher portion of the transaction mix, if you will.

Raji Gill

Got it. And just a 1 question on...

Mark Adams

I want to emphasize -- sorry, just right because you brought another thought as I thought about the question you asked is, we are in a business where there are some of our competitors and some of our customers who are kind of more hardware mindset. And I've said all along, and Thierry's teams executed really well in this way. We’re not looking for hardware-only transactions. That's not how we're going to grow. And we're outgrowing the industry today and focused on delivering high-value services. And that's kind of what sets us apart, I think, from our competitors in the business. And so as we scale and as we grow our capabilities and services, I think you can only see that become more important as a profile of this business.

Raji Gill

Yes. That's super helpful to understand that. And just a quick question on Stratus. Based on your commentary, so it appears like the main differentiation and value add for this -- what this company brings is, I guess, deploying mission-critical applications for a lot of these customers you talked about. Just wondering how long has this company been around and what's kind of the competitive landscape in that market for mission -- deployment of mission-critical applications for the data center for the edge.

Mark Adams

So Stratus has been around since 1980. And at the risk of dating myself, I used to compete against Stratus when I was at NCR because it was a tandem status, Unisys and NCR to the stent had fall tolerant architectures in the data center mainframe part of the market, and this is reward again, these Fortune enterprise applications for mission-critical needs and 100% targeted uptime, 99.9999%. And so they have a 40-year history of serving the world's largest companies and mission-critical applications.

And when you think about the next generation of mission-critical applications, we're on the cutting to that with Penguin Solutions. And so the combination of customer relationships, existing service relationships, hardware, installations, platforms, it is just a fantastic combination of companies that have been doing this for nearly four decades with the innovation at a company like Penguin Solution offers. And I think that is just a great marriage of what we can go do at large-scale customers as we grow and expand the business from here.

Raji Gill

That’s great. Appreciated. Thank you.


There are no additional questions waiting at this time, so I will turn the call back over to Mark Adams, the CEO, for closing remarks.

Mark Adams

Thank you, operator. At SGH, we are focused on building long-term value for our shareholders. We are well positioned in attractive end markets such as artificial intelligence, machine learning, data analytics, high-performance computing and cloud solutions, each with compelling long-term growth potential. I am confident that we can continue to invest in our business while operating the company to maximize shareholder value. We operate with a capital-light model and are able to generate positive cash flows more effectively throughout market cycles when compared to more capital-intensive businesses. We will be disciplined in our approach to ensure strong continued strong financial performance and cash flow generation while investing for our long-term success.

In short, I continue to be very excited about our future at SGH. We appreciate all of you for joining today's call.


That concludes the SGH third quarter fiscal 2022 earnings call. Thank you for your participation. You may now disconnect your lines.

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