Penguin Solutions Inc (PENG) 2019 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the SMART Global Holdings First Quarter Fiscal 2019 Earnings Call.

(Operator Instructions) As a reminder, today's conference is being recorded for replay purposes.

It is now my pleasure to turn the conference over to your host, Ms. Suzanne Schmidt with Investor Relations.

Please go ahead.

Thank you, operator.

Good afternoon, and thank you for joining us on today's earnings conference call to discuss SMART Global Holdings first quarter fiscal 2019 results.

Ajay Shah, Chairman and Chief Executive Officer, will begin the call with the discussion of the market and the business, followed by Jack Pacheco, Chief Operating and Financial Officer, who will review the financial results in more detail and provide the forward guidance, after which we will open the call to your questions.

As a reminder, our earnings press release and a replay of today's call can be accessed under the Investor Relations section of SMART's website at smartgh.com.

We encourage you to go to our website throughout the quarter for the most current information on the company, including information on the various financial conferences we will be attending.

Before we begin the call, I would like to note that today's remarks and the answers to questions may include forward-looking statements.

Any statement that refers to expectations, projections or other characterizations of future events, including financial projections and future market conditions, is a forward-looking statement.

Actual results may differ materially from those expressed from these forward-looking statements.

For more information, please refer to the risk factors discussed in the documents we file from time to time with the SEC, including our most recent Form 10-K.

We assume no obligation to update these forward-looking statements, which speak as of today.

Additionally, during this call, our non-GAAP financial measures will be discussed.

Reconciliations for those directly comparable GAAP financial measures are included in today's earnings press release.

I would also like to introduce Karl Motey, who has just joined SMART in a newly created position of Vice President of Strategic Marketing and Communications.

Many of you may know Karl from his most recent work at both Adesto and Spansion.

With that, I will now turn the call over to Chairman and CEO, Ajay Shah.

Thank you, Suzanne, and welcome to everyone on the call.

Good afternoon.

I'm pleased to report that we completed the first quarter of fiscal 2019 with record high net sales of $393.9 million, which was 48% higher than the year-ago quarter, and exceeded the high-end of our guidance.

Non-GAAP gross profit increased to $85.6 million, and operating expenses declined by 2% from the prior quarter, demonstrating our ongoing focus on expense control.

Non-GAAP earnings for the quarter totaled $1.75 per share.

I'll now review each of our 3 areas of business and then turn the call over to Jack for a more detailed review of the numbers as well as our guidance going forward.

Turning first to our Specialty Memory business.

Net sales grew by almost 14% to -- sequentially to reach $140 million for the quarter.

The continued proliferation of all-flash arrays within server and storage applications was a strong driver for this business.

Behind this growth are applications such as artificial intelligence that utilize all-flash arrays for data access.

Flash is also becoming more prominent in industrial applications, which are requiring more application-specific solutions compared to the normal data center applications.

We continue to make excellent progress in developing key new solutions for our OEM customers.

During the first fiscal quarter, we introduced 96-gigabyte Gen-Z Memory Module, or also known as ZMM, which enables OEMs to adopt the new Gen-Z interconnect protocol standard.

This protocol, which SMART helps standardize through the Gen-Z consortium, is designed to handle advanced workloads and to enable data-centric computing with scalable memory pools and resources for real-time analytics and in-memory applications, while delivering high-bandwidth low-latency software-efficient and power-optimized solutions.

As many of our investors know, we develop such memory modules and subsystems.

We actually are a buyer of memory semiconductor devices, which we then incorporate into products for our customers.

It bears repeating that we provide the specific product requirements of our customers in vertical application areas, such as networking, telecom, enterprise storage, industrial and defense, to name a few.

These markets are characterized by long design cycles and relatively long life cycles, and tend to be much more sticky in terms of their -- because they are tailor-made for those particular applications.

Given these long life cycles, products that we are actually shipping today tend to be based on memory technologies that are more mature and were often designed in some time ago.

Much of the volatility in the memory semiconductor market that is being talked about today is tied to leading-edge products such as DDR4 and not the more mature technologies.

With the -- so as you look at our performance in Q1, we are demonstrating that the reductions in memory prices that you are seeing in the market for DDR4 or 3D NAND Flash products are not so relevant for our business.

With the reducing cost per bit for 3D NAND Flash products, we're actually seeing new opportunities for specialty SSD products in the various types of markets that I have talked about, and with both existing and new customers.

We continue to expand our sales force and our engineering capabilities in this particular line of business as we see our expanding market opportunity.

So we are seeing good opportunities and design wins in this business and remain optimistic about growth prospects in the coming periods.

Turning now to our Specialty Computing and Storage business, led by Penguin Computing, the acquisition we made about 6 months ago.

The increase in sales from this part of the business during the last quarter was primarily led by key new programs that are now ramping for high-performance computing, or HPC, and AI, or artificial intelligence, applications within the commercial and government sectors.

Additionally, during the quarter we released a new HPC cluster management software system, called the Scyld ClusterWare 11, which delivers state-of-the-art web-enabled cluster management software systems to customers in a broad array of industries from government and financial services to oil and gas.

This software system supports the growing worldwide HPC market with rapid provisioning, enhanced monitoring and increased security features, enabling customers to manage and secure their unique cluster environments with greater flexibility and customization than ever before.

We are seeing, as a result of such innovations, that our pipeline continues to improve and to expand into areas that we have not been involved with previously.

We are also actively engaged in initiatives to bring Penguin's margin structure closer to SMART Global's levels through a variety of activities, including a stronger focus on federal opportunities and an increase in our software and services business as well as internal improvements from supply chain and manufacturing integration.

We expect to see the full benefits of these initiatives over the next few periods.

Additionally, we are making good progress with our engineering teams to develop memory-focused solutions that we can integrate into penguin's platform such as SMART's NVDIMM products and our M4 SSD, which is a high-density Flash solution for such AI applications.

Finally, turning to our Brazil line of business.

We had a very good quarter.

Revenues for the Q1 period grew 26% from the same period last year to reach $199.3 million.

We also started shipping our new polymer cell-based batteries, which is a business that is just beginning to ramp.

However, looking forward, local content rules for the memory -- for the mobile memory sector, these are products for the smartphones, were recently reset for calendar 2019, at the 50% level, rather than the previously expected 60%.

Additionally, as we have indicated in the past, during the fiscal second quarter, which ends in February, we straddled a number of seasonal factors specific to Brazil.

This combination of year-end slowdown in manufacturing due to the holidays, year-end local content adjustments because local content requirements are an annual -- calendar year annual calculation, by our customers is leading us to expect lower revenues from Brazil in the near term and has reduced the visibility we normally have.

With this, I'll hand you over to Jack to provide more of our financials and commentary on some of our businesses.

Jack?

Great.

Thank you, Ajay.

Overall, gross revenue for the first fiscal quarter was $710 million, while net sales were $394 million.

As a reminder, the difference between gross revenue and net sales is related to our supply chain services business, which is accounted for on an agency basis.

Meaning that we only recognize the net sales the net profit on a supply chain services transactions.

Net sales increased by 5% over the previous quarter and by 48% over the year-ago quarter.

Our breakdown of net sales by end market for the first fiscal quarter was as follows: Mobile and PCs 46%; network and telecom 19%; servers and storage 13%; industrial, aerospace, defense and other 22%.

Now moving to the rest of the income statement.

Non-GAAP gross profit for the first quarter was $85.6 million, up 2% as compared with last quarter's $83.8 million, while non-GAAP operating expenses were $31.3 million, down 2% from the previous quarter, demonstrating our continuing focus in operational efficiencies.

Non-GAAP net income for the first fiscal quarter increased to $40.6 million or $1.75 per diluted share from $40 million or $1.72 per diluted share in the prior quarter and $26.3 million or $1.16 per diluted share in the year-ago quarter.

Adjusted EBITDA increased to $56.5 million in the first quarter, up $5.5 million from the prior quarter and up $19.6 million from the year-ago quarter.

Included in the first quarter GAAP fiscal 2019 results are FX-related losses of approximately $3 million compared with FX-related losses of $6 million last quarter and FX-related losses of $3 million in the year-ago quarter.

Turning to working capital.

Our net accounts receivables increased to $330 million from $237 million last quarter, and our day sales outstanding increased to 42 days for this quarter, compared with 32 days last quarter.

Inventory decreased to $188 million from $221 million in the prior quarter.

Inventory turns were 13x compared with last quarter's 11x as we begin our efforts to improve Penguin's inventory levels.

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 $710 million, $625 million, respectively for the first fiscal quarter of 2019.

Cash and cash equivalents increased to $63 million at the end of the first quarter compared with $31 million at the end of the prior quarter as we reduced inventory and our prepayments for accounts payable in Brazil.

First quarter cash flow from operations was a positive $35 million, compared with a negative $9 million in the prior quarter.

As we indicated last quarter, we have recently implemented a program to help reduce our exposure to fluctuations in foreign exchange rates versus our prior practice of utilizing our cash to pay our accounts payable early in Brazil to minimize our FX exposure.

We also began to recognize our revenue in accordance with the revenue recognition ASC 606 in the first quarter.

The new standard had a positive impact of $7 million on revenue in our Specialty Memory business and $1 million on net income overall, which was in line with our expectations headed into Q1.

As we discussed on the last call, our fiscal Q2, ending on March 1, tends to be a weaker quarter as our business in Brazil typically experienced a seasonality in the quarter due to holidays as well as customer shutdowns in December and January.

Additionally, as Ajay mentioned earlier, local content rules for the mobile memory sector were set at 50% for calendar year '19 versus the previously announced 60%.

As you will recall, last year, there were many shortages but now availability is much better and memory prices for mobile are falling.

We are therefore, also seeing some delayed purchases and reduced lead times as customers are trying to move out orders as late as possible in anticipation of falling memory pricing.

Now let me turn to our guidance.

We currently estimate that our second quarter fiscal '19 net sales will be in the range of $310 million to $325 million.

Gross margin for the quarter is estimated to be approximately 18% to 20%.

GAAP earnings per diluted share is expected to be between $0.53 to $0.57.

On a non-GAAP basis, excluding stock-based compensation expense, acquisition-related expense and intangible asset amortization expense, we expect non-GAAP earnings per diluted share will be in the range of $0.73 to $0.77.

The guidance for the second fiscal quarter does not include any view on the foreign exchange gains our losses and includes an income tax provision expected to be in the range of 16% to 20% due to lower contribution from our mobile memory business in Brazil, which has a 9% tax rate due to our PADIS benefit.

The number of shares used in computing earnings per diluted share for the fiscal -- second fiscal quarter was 23.4 million.

Capital expenditures for the second fiscal quarter are expected to be in the range of $4 million to $8 million.

In terms of the tariffs put in place on imports from China, we have not seen, and we do not expect any material impact to our business as we have worked through our suppliers and customers to minimize any impact of these on our business.

Please refer to the non-GAAP financial information section and the reconciliation of non-GAAP financial measures to GAAP results and reconciliation of GAAP net income to adjusted EBITDA tables in earnings press release for further details.

That concludes my remarks.

Operator, we are now ready to take questions.

(Operator Instructions) Our first question comes from Kevin Cassidy of Stifel.

I guess the first obvious question is the Brazil.

What was the reason why they didn't move to the 60% local content rule and stayed with 50%?

Yes, Kevin, looks like when the government agencies were looking at that rule, we had a lot of shortages in 2018, and so they were doing it back when the shortage were there and people were not able to meet at 50% -- 60% number, so they reduced it to 50%, based on what the companies could do based on the calendar '18 numbers.

This happens that it all works in every years.

Right.

And now since they did that, of course, and put that then, of course, it looks like there is ample supply of memory, but the rules are what they are.

Okay.

And is this the main reason why gross margin is declining so much?

Is it less exposure to Brazil and higher to your new specialty computing and storage?

Yes, that's one reason why the margin is down a little bit, and also mobile being down as much as it is too, you've got some fixed cost in Brazil that we won't -- we can't cover all the fixed cost in Brazil as much to the lower number so it will knock the Brazil margin down a little bit as well.

It's just the positive leverage versus the negative leverage, in this case, volume leverage is negative in Q2 as opposed to in previous quarters where it was positive.

Our next question comes from Sidney Ho of Deutsche Bank.

I just wanted to follow up with Kevin's question.

I think the local content rule going down from 60% to 50%, you guys had alluded to that last quarter in earnings call and at that time you guys said the expectation is that it's not going to impact too much.

I just want to know how -- what has changed from then to now that seems to have a bigger impact?

Sidney, first of all, let me -- just a bit of clarification.

We don't think Q2 is particularly impacted by the 60% to 50% move, just to be clear.

The impact of that reduction is a calendar year reduction for 2019, and as you know, our Q2 is really a February quarter.

So as a point of clarification, the 60% to 50% move is not very relevant for our Q2 results or Q2 expectations, to be clear.

It does have more of an impact in the calendar year 2019.

If you look at how customers are -- if customers we're expecting a ramp-up to 60%, and you now had a reduction to 50%, they effectively have less pressure to buy sooner.

All right.

That makes sense.

Maybe just a question on the guidance, on the revenue guidance.

When you think -- when you talk about increasing seasonality in the press release, I just want to understand the magnitude.

Are you expecting the Brazil side of things to be down 30% and the other 2 businesses to be up?

How much of that down, call it 20%, 30%, is driven by units versus pricing?

So I think that in Brazil, we are indeed, in that range, 25% to 30% reduction in top line for Q2.

And the other 2 businesses together are roughly flat quarter-over-quarter.

The other 2 businesses essentially combined.

So the point I'm saying is that we get some seasonality in all the businesses, right?

As you have holiday periods and people are manufacturing less.

But the more significant effect is in Brazil where we literally, even we shut down for literally 2, 2.5 weeks, most of our customers shut down from, I believe, it's about the 14th of December till like 5th of January, something like that.

So that long shutdown has an impact.

Got it.

Maybe just one last question and I'll go away.

On the gross margin side, Jack, you mentioned the change in local content rule on the mobile side of thing have some impact.

Is there anything that you will point out what are the drivers for gross margin to be down 200 to 400 basis points in Q2?

And beyond that, how do you think that will come back in the following few quarters?

Well, first of all, you have Brazil being a packaging operation as the high fixed cost in the facility, right?

And so when we've been growing the business, we get the benefit, as Ajay mentioned earlier, but when it goes -- when you're losing revenue like we're losing in Q2 in Brazil, that cost doesn't go away, so it has a big negative impact on gross margins.

And then Penguin -- the Penguin margin is lower than we had originally anticipated, so it put a little negative impact and majority of it is just losing -- Brazil's down 30%, 40% of revenue, and that loss puts a big impact on the margin percentage.

How about the following few quarters?

How do you think that -- when do you think you will get back to this 20% to 23% range that you guys talked about?

We need Brazil to get back closer to where -- Brazil has to kind of come back and get to closer to where it is today and then we improve the Penguin gross margins and so we will get back there, but it's really the biggest thing is going to be, Brazil when it bounces back will help the margins go back up.

And the same with operating improvements, too.

Yes.

Our next question comes from Suji Desilva of Roth Capital.

So on Brazil, can you update us on what the smartphone content trend for smartphone is, dollar content?

And if that's being impacted by the pricing?

So at the end of quarter, Q1 ASPs were still pretty good like $30.05.

I think we're down about $0.70 from Q4, so we're not -- not that big of a reduction in Q1 on the ASPs.

Okay.

Right, that's pretty steady.

And then on Brazil, the growth opportunity in the battery.

Can you talk about the timing of when that revenue could layer in there?

How many quarters away that is?

A little -- I think we had $700k of revenue in Q1.

So a little bit of contribution in Q1.

I mean, It'll start -- we will start seeing more of a contribution out into the Q3 and Q4 from that business.

Okay, great.

And then one last quick question on Specialty Memory.

Is this new level of revenue sustainable and growth from here?

Or was there some sort of lumpiness in ordering that might have driven it?

I know you talked about flat sequentially but any color there would be helpful.

Yes.

We talked about this about $7 million impact in that revenue from the -- our new revenue recognition standards that's roughly a onetime in the quarter.

And we have some good demand, especially in the networking and the storage, in the Flash, all-flash array guys.

And so I would think that Specialty might come down a little bit from those numbers.

These are pretty -- these are high numbers for Specialty but year-over-year that business will continue to grow.

But I think the numbers could come down a little bit in the next quarter or so for that business.

It might get some quarter-over-quarter type of variations, right?

Depends on when a customer is stocking more or less.

But as I was trying to explain in the prepared remarks, the price declines have not really been a factor in our business so far.

And furthermore, as Jack said, I mean, we are still looking at a pretty nice double-digit growth rate with some level of price declines built into our business model.

We've seen -- DDR4 has gone down about 25% over the last 6 months and we've grown that business.

So we really aren't -- we've been saying that business is not dependent on memory pricing, so it's been very nice in this environment.

Our next question comes from Raji Gill of Needham & Company.

A few follow-ups on the local content rules.

I'm still kind of struggling to understand why the drop to 50%, and also the commentary around, kind of, lack of visibility.

Has this happened in the past where there's been situations where you expected the content rules to be X and that ends up being Y?

I'm just struggling with the lack of visibility commentary in terms of understanding those content rules.

Sure.

I'm still -- I mean, the local content lack of visibility really are -- I mean, they're kind of tied together but yes, we just -- in the past it's been a rare occurrence where they have taken a local content rule and changed them down based on the view they get.

Remember, the way these are said, as you've got this agency that works with this industry association has SMART, it has our competitors in it, it has our customers in it.

And this is a long process and they get together and try and determine what people can do.

And so when they were working on these numbers, we are in a shortage environment and people are struggling to meet the demand of 50%, not necessarily 60%, so I think they took that at that time into account and it takes Brazil a long time to publish the data, but they finally published it.

Of course, by the time they published it, we are in a market where availability is a little more available, but it is what it is.

So I think that'll -- now how that is playing a little bit on visibility is, if you are in a falling memory environment and you only have to purchase 50% of your memory from within country, you can delay a little bit of what you want to buy within Brazil, and so you can push demand out a little bit into future quarters if you want to.

So just -- gives us just a weaker -- so the customer have just given us not as good visibility right now as to what they want, based on the local content rules change and just the market in Brazil.

And, of course, it has been the holidays and everything.

So it's been a little more muted from Brazil, let's just say, in the last few weeks.

And just a few specifics there, Raji.

The publish date for this 60% to 50% was December 7, and literally 5 days later the country went on holiday, right?

So we have a difficult time getting very specific information from our customers as to exactly what they plan to do.

In fact, they are barely coming back to work right now.

So that's one issue with respect to visibility.

The other is -- and this is to state a little bit of what might be obvious, which is when memory prices are falling, customers tend to want to buy with shorter lead times, and they want to buy at a lower price because they expect the price to be lower, if you buy later.

So that's a typical customer behavior, and that's not unusual, that's was true in 2017, early part of 2017 anyway.

It's not unusual for customers and for us, as a buyer of memory devices to buy later, simply because we can.

So if the 50% is going to continue in the calendar '19, and you're going to have start seeing reduction in your pricing in terms of what you're getting ASP per phone and then maybe you're talking about unit softness as well, I think it's fair to assume that, I guess, the previous commentary maybe of 15%, 20% growth in Brazil over the next year or so is not remotely going to happen.

Because you don't have any of those factors, those positive factors that you had maybe in the last couple of years, they're all going to be negative factors now.

And there is no visibility to calendar '20.

Is that correct, so we don't -- I mean if -- we had no idea...

Sorry to interrupt, please finish.

No, I am just saying we don't know -- I don't -- it doesn't seem to me that it just automatically steps up as I originally anticipated that there are other factors in terms of...

Yes, there are the factors.

Calendar '20 we don't know yet.

It hasn't been published.

Calendar '19 was published and it was modified.

We do believe, however, that these things being calendar year versus our fiscal year, creates a little bit of forecasting conundrum because our fiscal year, as you know, is an August year-end, and the calendar year, if customers were to somewhat back-end load the calendar year would then take us into Q1 and Q2 of our fiscal year 2020.

So it's a bit logistical, mechanical, and I know maybe even a little boring, but the fact is that from a forecasting standpoint, it brings in a little bit of a challenge in terms of how you look at which period is going to come into.

Sure, okay.

And I appreciate that.

And on the gross margins, they are down about 400 basis -- over 400 basis points on a year-over-year basis.

And so if Brazil mobile is going to continue to be underwhelming and soft for the next several quarters, how do we think about the gross margins going forward, because Penguin is going to drop off significantly in February, if I am correct, but yet, the market is still coming down?

But then we'll start to come back up pretty significantly in May and August.

So shouldn't that be -- you should have an adverse impact to margins in May and August.

Am I thinking about this correctly?

Or should they actually come down further in May or August?

Raji, we talked about we're working to improve the margins of Penguin to get them closer to what SMART does.

I think our view would be as we get into our Q3 and Q4, we'll work to get those margins improved and so hopefully, we'll have them going in the right direction so they won't be a big negative impact to the overall margin as the business goes forward.

So I think this quarter we had about 20% margin versus the forecast next quarter we have 18% to 20%.

So I think you'll, kind of, be in that range over the next few quarters and then as Brazil comes back, hopefully, we will start seeing those margins go up a little bit as we start covering some of that fixed cost in Brazil.

And then we'll grow -- we'll get Penguin better too and that will hopefully contribute to getting the gross margins into the 20%, 22% range where they have been.

(Operator Instructions) And we do have a follow-up question from Kevin Cassidy.

Some of the memory device manufacturers have pointed to data center customers as weaker just as they -- maybe as you described as lead times come in, they're holding less inventory.

Are you seeing any effect of that in your Specialty Memory group?

Well, you know, one, we don't directly sell data center guys but our customers still sell to the data center guys and the networking space and the all-flash array space had a great quarter, so we would -- we don't see those guys seeing the big impact.

Maybe -- the visibility we have from them, the forecast we get from them seem to suggest that they are okay.

But we -- as Jack said, I just wanted to repeat, we don't actually sell directly to any data center.

And even if we look at our big customers, a Cisco or NetApp or Rockwell, they do go into data centers, but not the hyperscale data centers as much from what I know, right?

Hyperscaler guys tend to be in a different supply chain.

I'm sure those guys are -- if you can push memory out and buy it the last minute, they're going to buy at the last minute, Kevin.

There is no reason for anybody to hold inventory.

Right.

And I guess those would be more considered commodity products that you would have to either hold inventory or just get it on just-in-time delivery compared to a specialty product wouldn't.

Those are standard DDR4 modules that they just buy from Samsung, Micron, Hionix, we don't play in that market.

Except in supply chain management, where we don't really take -- we are really simply a logistics provider.

Okay.

And one other question about U.S. government partial shutdown.

Is that slowing down any contracts from the specialty compute group?

Not yet.

So I read somewhere we're in day 17, and so far, we are not seeing issues with either orders or collections or anything like that.

If this continues and somehow it extends into -- I mean, today our main customers are the Department of Defense and the labs, the DOE, Department of Energy-related labs.

So if it extends into that, then it would have an impact, but so far, no.

Ladies and gentlemen, this concludes today's question-and-answer session.

I would like to turn the call back to Ajay Shah for any closing remarks.

Thank you very much for your interest and questions related to the company.

I will now ask Suzanne to wrap up the call today.

Okay.

Thank you, everyone, for participating.

We'll be at CES tomorrow and at the Needham conference the week after.

Thank you.

Ladies and gentlemen, thank you for participating in today's conference.

This concludes today's program, you may all disconnect.

Have a great day.