SGH (2019 - Q1)

Good day, ladies and gentlemen and welcome to the SMART Global Holdings First Quarter Fiscal 2019 Earnings Call. At this time, all participants are in a listen-only mode. Following management’s prepared remarks, we will have a question-and-answer session and instructions will be given at that time. [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. Suzanne

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 a 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 the 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 am 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 will now review each of our three 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% 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, our applications such as artificial intelligence that utilize all-flash arrays for data access. Flash is also becoming more prominent industrial applications, which are requiring more application-specific solutions compared to the normal datacenter applications. We continue to make excellent progress in developing key new solutions for our OEM customers. During the first fiscal quarter, we introduced the 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 developed 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 lifecycles and tend to be much more sticky in terms of their – because they are tailor made for those particular applications. Given these long lifecycles, products that we are actually shipping today tend to be based on memory technologies that are more mature and were often designed in sometime 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. So as you look at our performance in Q1, we were 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 are 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 platforms 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 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 straddle a number of seasonal factors specific to Brazil. This combination of a 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 will 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 an agency basis, meaning that we only recognize the net sales, the net profit on the 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 on 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 days 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 13 times compared with last quarter’s 11 times 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 and $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 new 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 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 are 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 or losses and includes an income tax provision expected to be in the range of 16% to 20% due to the 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 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 with 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 our earnings press release for further details. That concludes my remarks. Operator, we are now ready to take questions.

Thank you. [Operator Instructions] Our first question comes from Kevin Cassidy of Stifel. Your line is now open.

Thanks for taking my question. I guess the first obvious question is Brazil, what was the reason why they didn’t move to the 60% local content rules and stayed with 50%?

Yes, Kevin. It 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 shortages were there and people were not able to meet at the 60% number. So they reduced it to 50% based on what the companies could do based on the calendar year ‘18 numbers.

Just happens that it all works in arrears.

Right. And now since they did that of course and put that then of course, it looks like there was 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 know, you have got some fixed cost in Brazil that we won’t – we can’t cover all the fixed cost in Brazil as much with the lower number. So it will knock the Brazil margin down a little bit as well.

And just the positive leverage versus the negative leverage in this case, volume leverage is negative in Q2 as positive in previous quarters where it was positive.

Okay. Yes, I will just get back into the queue and let others to ask questions. Thank you.

Thank you. Our next question comes from Sidney Ho of Deutsche Bank. Your line is now open.

Great. Thank you. I just want to follow-up with Kevin’s question. I think the local content really going down from 60% to 50%, you guys have alluded to that last quarter in the earnings call and that at that time you guys said the expectation is that it’s not going to impact too much. I just wonder 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 the February quarter. So, as a point of clarification, the 60% to 50% move is not very relevant for our Q2 results or due to expectations to be clear. It does have more of impact in the calendar year 2019. If you look at how customers are – if customers were expecting a ramp up to 60% and you now had a reduction to 50%, they effectively have less pressure to buy sooner.

Alright. That makes sense. Maybe just a question on the guidance – on the revenue guidance, when you say – 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 two 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 two businesses together are roughly flat quarter-over-quarter, the other two businesses essentially combined. So the point I am saying is that, we get some seasonality in all the businesses, right, as you have a holiday periods and people are manufacturing less, but the more significant effect is in Brazil where we literally – even we shutdown for literally 2, 2.5 weeks. Most of our customers shutdown from I believe it’s about December 14 till like the January 5 something like that, so that long shutdown has an impact.

Got it. Maybe just one last question, I will go away. On the gross margin side, Jack you mentioned the change at local content or the mobile side of things have some impact. Is there anything it 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 a – Brazil being a packaging operation is the highest fixed cost in the facility right. And so when we have been growing the business we get the benefit, as Ajay mentioned earlier, but when it goes – when you are losing revenue – like we are losing Q2 in Brazil that cost doesn’t go away. So it has a big negative impact in gross margins. And then Penguin – the Penguin margin is lower than we had originally had anticipated. It put a little negative impact – and a majority of it is just losing, Brazil is down 30%, 40% of revenue and that loss puts a big impact on the margin percentage.

And how about the following few quarters, how do you think that will – 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 closer to where it is today and then we improved the Penguin gross margins and so we will get back there. But it’s really the bigger – the biggest thing is going to be Brazil when it bounces back will help the margins go back up.

Okay. Thank you very much.

And the operating improvements we have too.

Yes.

Alright. Thank you.

Thanks, Sidney.

Thank you. Our next question comes from Suji Desilva of Roth Capital. Your line is now open.

Hi, Ajay. Hi, Jack. 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? Thanks.

So, I mean in the quarter Q1 ASPs were still pretty good like $30.05. I think we are down about $0.70 from Q4, so not that big of a reduction in Q1 on the ASP.

Okay, right. Now, it’s pretty steady.

Yes.

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?

We had a little – I think we had 700k of revenue in Q1, so a little bit of contribution in Q1. I mean, it will start – we will start seeing it kind of – more of a contribution out into 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 had. We talked about this, about $7 million impact in that revenue from our new revenue recognition standard, that’s roughly a one-time in the quarter and some – 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 easier 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.

Yes, 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’re still looking at a pretty nice double-digit growth rate with some level of price declines built-in to our business model.

I mean, we’ve seen – DDR4 has gone down by about 25% over the last 6 months and we’ve grown that business. So we really aren’t – as we’ve been saying that business is not – it’s not dependent on memory pricing, so it’s very nice in this environment.

Yes, so impressive results there. Thanks guys.

Thank you. Our next question comes from Raji Gill of Needham & Company. Your line is now open.

Yes, thanks for taking my questions. 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 it happened in the past where there have been situations where you expected the content rules to be X and that ends up being why? I’m just struggling with the lack of visibility commentary in terms of understanding those content rules.

Sure. Yes, certainly, I mean, local, i mean, the local content and lack of visibility really are, I mean, they are kind of tied together. But I mean, users in the past, it’s been a rare occurrence where they have taken a local content rule and changed them down or based on the view they get. Remember the way these are set is you’ve got this agency that works with this industry association that has SMART, it has our competitors in it, it has our customers in it. And this is a long process and they get together in trying to determine what people can do, and so when they were working on these numbers, we were in a shortage environment and people were struggling to meet the demand. 50%, not necessarily 60%, so I think they took that at the time into account, and it takes Brazil long time to publish the data, but they finally published it. Of course, by the time they published it, we were in a market where availability is a little more available, but it is what it is. So I think that will – now how that is playing a little bit on visibility is, if you’re in the 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 it just – it gives us just a week – so the customers had just given us not as good visibility right now, so what they want based on the local content rules change and just the market in Brazil, of course, it’s been the holidays and everything. So it’s been a little more muted from Brazil, let’s just say, in the last few weeks.

Just a few specifics there, Raji, the published date for the 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 is to exactly what they plan to do. In fact, they’re barely coming back to work right now. So that’s one issue with respect to visibility. The other is, and this is the – to state a little bit of what might be obvious, which is, when memory prices are falling, customers tend to want to buy with shoulder lead times and they want to buy at a lower price because they expect the price to be lowered if you buy later. So that’s a typical customer behavior and that’s not unusual. That 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 the – if the 50% is going to continue into 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 you’re – maybe talking about unit softness as well, I think it’s fair to assume that, I guess the previous commentary maybe a 15% to 20% growth in Brazil over the next year, so it’s not remotely going to happen. Because you don’t have any of those factors, those positive factors that you had in 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 by the way.

Sorry to interrupt, please finish.

No, I was just saying we don’t know – I don’t think – it doesn’t seem to me that it just automatically steps up as I originally anticipated that there are other factors in terms of your local content rules...

Yes, there are other 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 a forecasting conundrum, because our fiscal year as you know is in 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 I’m – it’s a bit logistical mechanical, 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’re 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’m 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 as Penguin ramp up.

Yes, Raji, we’ve talked about – we’re working to improve the margins of Penguin to get them closer with SMART. So I think our view would be as we get into – our Q3 and Q4, we will work to get those margins improved and so hopefully we’ll have them going in the right direction, and so there won’t be a big negative impact to the overall margin as the business goes forward. So I think this quarter we hit about 20% margin versus, I mean, the forecast, next quarter we are 18% to 20%, I probably think you’re kind of be in that range over the next few quarters, and that is if Brazil comes back, hopefully, it will start seeing those margins go up a little bit as we start covering some of that fixed costs 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%, 23% [ph] range where they’ve been.

Okay, got it. I appreciate it. Thank you.

Thank you. [Operator Instructions] And we do have a follow-up question from Kevin Cassidy. Your line is now open.

Thanks for taking my follow-up. Some of the memory device manufacturers have pointed to data center customers as weaker, and just says they, may be as you described as lead times come in, they are holding less inventory. Are you seeing any effect of that in your specialty memory group?

I mean, one, we don’t directly sell data center guys, but our customers who sold to the data center guys in the networking space and the all-flash array space had a great quarter. So we wouldn’t – we don’t see those guys seeing the big impact.

Okay.

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

Yes.

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, I mean, at Cisco or NetApp or Rockwell, they do go into data centers but not the hyperscale [ph] data centers as much from what I know, right. The hyperscale guys tend to be – in a different supply chain.

Yes, and I’m sure those guys are – if you can push memory out and buy the last minute, they’re going buy the last minute. Kevin, there’s 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 and just in time delivery compared to a Specialty product wouldn’t…

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

Except in supply chain management, where we don’t really take – we’re 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 any 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.

DOE.

DOE, Department of Energy related labs. So if it extends into that, then it would have an impact, but so far, no.

Okay, great. Thank you.

Thank you. 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. 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.