SMART Global Holdings, Inc.
Q3 2018 Earnings Call Transcript

Published: 22 Jun 2018

[Operator:]

Good day, ladies and gentlemen and welcome to the Third Quarter Fiscal 2018 SMART Global Holdings Incorporated Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Ms. Suzanne Schmidt. Ma’am, you may begin.

[Suzanne Schmidt:]

Thank you. Good afternoon everyone and thank you for joining us on today’s earnings conference call to discuss SMART Global Holdings’ third quarter fiscal 2018 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. Also in attendance and available for the Q&A portion of the call is Iain MacKenzie, our outgoing CEO. 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 www.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 that 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, non-GAAP financial measures will be discussed. Reconciliations for those directly comparable GAAP financial measures are included in today’s earnings press release. And now, I would like to turn the call over to Ajay Shah.

[Ajay Shah:]

Thank you, Suzanne, and welcome to everyone on the call. I'd like to begin by saying I'm very pleased to be here, my first full quarter as CEO at SMART, as we continue an exciting phase of growth and also continue to broaden our offerings and customer base. I'm very honored to take this position from Iain MacKenzie, who served as SMART CEO for the past 13 years. Under his leadership SMART has grown into a great leader and a valued partner to our OEM customers worldwide. With the company's tremendous success to date we now have the opportunity to continue building on this position and to pursue many exciting new opportunities. I'm looking forward to continuing to work closely with Iain as he remains on the Board of Directors at SMART. Turning to the business, the third fiscal quarter which we concluded late in May marked a turning point in terms of our longer-term strategic direction. Meanwhile, while we [audio gap] strategic moves, we continue to execute well by leveraging our business model and unique competitive positioning across all of our different business units. We reported another strong quarter with net sales of $335 million or about 62% higher than the year before. Non-GAAP operating income of $53.8 million was 117% higher than a year ago and non-GAAP diluted EPS came in at $1.84 per share or roughly 2x over year ago period. Our results continue to be driven by both our specialty memory business and our growing business in Brazil. I'll cover each of these areas and also comment on our recently announced acquisition of Penguin Computing which puts us in a new business before turning the call over to Jack for a more detailed review of the financials and our guidance for the fourth fiscal quarter. Moving to our specialty memory business, we had another very solid quarter with net sales in excess of $100 million for the third consecutive quarter. Our extensive knowledge of the memory markets and our deep customer relationships provide us the visibility to drive sustained and predictable growth in this area. Underpinning this outlook are several factors. We continue to be the key supplier to our major OEM customers that require application-specific DRAM and flash-based memory products and we are a trusted partner and supplier to these customers for a whole range of different specialized solutions. Additionally, as we have mentioned in past quarters, newer nonvolatile NVDIMM solutions utilizing all flash arrays within servers and storage equipment is driving increased demand for both our flash and DRAM solutions. In the backdrop of the health of the overall memory market, we continue to see a constructive supply-demand dynamic with multiple demand drivers along with orderly supply expansion. In particular, relevant to us, prices of DRAM devices such as DDR3 that are a major part of our DRAM product mix have been very steady. Also while many of the new designs we have utilized 3D NAND our shipping mix today for NAND flash continues to be based on the stable market for SLC and MLC technologies. Moving now to our recent acquisition of Penguin Computing, through this acquisition we are greatly increasing both the markets and the technologies that we participate in and serve and also the types of customers we reach via Penguin's leading position in specialty compute and storage solutions. These products and services target applications in artificial intelligence, machine learning and high performance computing using state-of-the-art open technologies and advanced architectures. We are very excited to have Penguin as the cornerstone of our new business unit which we call the SMART Specialty Compute and Storage Solutions or SCSS business, which will serve as a broad platform for us to further build on by leveraging our shared infrastructure and proven ability to integrate and scale businesses. Finally, referring to our business in Brazil, we had another extremely strong quarter which came on top of the exceptionally strong fiscal second quarter. In our third fiscal quarter that we concluded we had stronger than expected results, thanks in part to pull-ins as our customers prepare for the production slowdown during the World Cup event by building a little early. Building on our success in the memory markets in Brazil, we have recently partnered to create a new business unit in Brazil focused on batteries for smart phones. We've been investing in this in terms of the manufacturing lines and processes as well as the staffing that is required for the business and we expect first shipments to begin in our fiscal 2019. Longer term we continue to target other areas in Brazil including communications devices such as Wi-Fi Bluetooth modules and other products to support the Internet of Things or IoT markets. With that, I'll now hand you over to Jack to discuss the financials in more details.

[Jack Pacheco:]

Thank you, Ajay. As Ajay mentioned, topline results were driven by both our specialty memory and our Brazil businesses supported by continued healthy dynamics in the global memory market. Overall gross revenue for the third fiscal quarter was $593.6 million while net sales were $335.5 million. As a reminder, the difference between gross revenue and net sales is related to our supply chain services business which has accounted for as an agency basis, meaning that we only recognize as net sales the net profit on the supply chain services transactions. Net sales increased by 7% over the previous quarter and by 62% over the year ago quarter. Our breakdown of net sales by end market for the third fiscal quarter was as follows. Mobile and PCs 61%, network and telecom 17%, servers and storage 14%, industrial aerospace, defense, and other 8%. As Ajay made it clear, we have launched a new business in Brazil to focus on battery assembly for smartphones. We expect to invest approximately $2 million to $3 million in startup costs along with R&D in the fourth fiscal quarter to support this new initiative and expect us to contribute to revenue in our Q1 of FY '19. With this investment we are leveraging our 15-year proven track record of establishing and growing businesses in Brazil. Similar to our mobile memory and DRAM initiatives, we have secured a partnership with the leader in this space, Samsung SCI. We are utilizing our in country manufacturing expertise along with the advantages for our customers of having local manufacturing. And now moving to the rest of the income statement. Non-GAAP gross profit for the third quarter was 78.5 million up 7% as compared with last quarter's $73.2 million while non-GAAP operating expenses of $24.7 million remain unchanged from last quarter. Non-GAAP net income for the third fiscal quarter was $43 million or $1.84 per diluted share compared to $37.7 million or $1.64 per diluted share in the prior quarter and $14.6 million or $0.92 per diluted share in the year ago quarter. Beginning this quarter and continuing forward we've excluded from a non-GAAP net income and non-GAAP earnings per share the effect of foreign exchange gains or losses. Adjusted EBITDA was $51.5 million in the third fiscal quarter compared to $56.2 million in the prior quarter and $29.9 million in the year ago quarter. Including in our third quarter GAAP fiscal 2018 results, our FX related losses that contributed approximately $6.9 million compared to the last quarter when we had FX related gains of $2.4 million and FX related losses of $1 million in the year ago quarter. Turning to working capital, our net accounts receivable increased to $262.1 million from $223.5 million last quarter as the day sales outstanding increased to 40.2 days for this quarter compared with 37.5 days last quarter. Inventory decreased slightly to $147.9 million from $148.6 million in the prior quarter while our inventory turn to 13.9 times compared with last quarter's 12.6 times. Consistent with past practice, accounts receivable days outstanding and inventory turnover are calculated on a gross sales and cost of goods sold basis, which are $593.6 million and $515.5 million respectively for the third fiscal quarter of 2018. Cash and cash equivalents totaled $64.5 million at the end of the third fiscal quarter. Third quarter cash flow from operations was $28.3 million compared with $34.7 million in the prior quarter. We had a very strong fiscal Q3 which was made even stronger as we saw some pull-ins from Q4 due to the World Cup. Our mobile customers are shutting down for a couple weeks in Q4 so they pulled-in some of their demand. Our second half revenues will grow over 14% from the first half with gross profit growing over 17% and our non-GAAP EPS over 23%. This will be a record year for SMART in terms of revenue and profitability. Now let me turn to our guidance. Our guidance includes our recent acquisition of Penguin computing which we closed on June 8 that Ajay discussed earlier. We currently estimate that our fourth quarter fiscal 2018 net sales will be in the range of $360 million to $380 million. Gross margin for the quarter is estimated to be approximately 22% to 23%. GAAP earnings per diluted share is expected to be between $1.41 to $1.50. On a non-GAAP basis excluding stock based compensation expense, acquisition expense, and intangible amortization expense, we expect non-GAAP earnings per diluted share will be in the range of $1.62 to $1.71. The guidance for the fourth fiscal quarter does not include any view on foreign gains or losses and includes an income tax provision expected to be in the range of 14% to 16%. We also have not reflected in a purchase price adjustments will be needed for the Penguin acquisition as we are in the initial stage of determining the appropriate adjustments. The number of shares used in computing earnings per diluted share in the fourth fiscal quarter was $23.4 million. Capital expenditures for the fourth fiscal quarter are expected to be in the range of $10 million to $14 million. Please refer to the non-GAAP financial information section and the reconciliation of non-GAAP financial measures to GAAP results and the reconciliation of GAAP net income loss to adjusted EBITDA tables our earnings press release for further details. That concludes my remarks. Operator, we are now ready to take questions.

[Operator:]

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

[Kevin Cassidy:]

Thank you and congratulations on the good results. But in your guidance can you break it down for us a little bit of what – at least what Penguin is in your guidance, and how much revenue is included in that?

[Ajay Shah:]

Right now we're not quite prepared to do that. We have been trying to figure out all the different adjustments that are related to the Penguin acquisition. So as Jack said earlier, we have made the best estimations we can, but it's hard to give to you a lot of detail there right now.

[Jack Pacheco:]

It's a very high level estimates right now Kevin, but nothing that we want to kind of firm up and detail yet.

[Kevin Cassidy:]

Okay and maybe if you can also the change in reporting of FX as a GAAP only and non-GAAP can you say what was in that decision?

[Jack Pacheco:]

Sure, I mean we can't guide FX gains or losses, it was never in our guidance. And so we had this, the non-GAAP EPS did not have guidance and we'd have in the results and it starting to cause a confusion with some investors and other people and we kind looked at our peers in this space and our peers do not include it in their non-GAAP calculations, so we just thought it made more sense for the investors to take it out or make it easier for them to look at the comparison on a quarter-by-quarter basis.

[Ajay Shah:]

Just to add to that, if you think about you’re looking for our operating results and this gives you a very clear view of our operating results. Now, every quarter the exchange rates move and you get a gain or a loss. Actually our analysis shows that over multiple years they more or less even out, but in each quarter they do provide volatility. So we’re trying to provide a look which will reduce that volatility and then of course there is some volatility from the currency movement.

[Kevin Cassidy:]

Okay, understood, yes. May be if I can even ask one more just on Brazil are you seeing any change in the economic atmosphere or any of these the inflation rate picking up is that going to affect your operating expenses in Brazil?

[Jack Pacheco:]

It can. When I look at the indicators down in Brazil I mean inflation still in May was only 2.86%, so I mean it picked up I mean a tad, really, really small. I mean, so they kept their bank rate at 6.5%, so we really aren’t seeing the indicators in Brazil slowing down or really changing right, I mean the Real has been kind of moving – weakening but the other indicators have stayed strong. I mean the inflows of the Bovespa are on pace to be the same as the last year, so there is nothing that tells us there was any real issues in the country.

[Kevin Cassidy:]

Okay, great. Thank you.

[Operator:]

Thank you. Our next question comes from Blayne Curtis with Barclays. Your line is now open.

[Blayne Curtis:]

Hey guys. Thanks for taking my question. I'm curious obviously it's hard to track seasonality given some of the ramps you've had particularly lately in Mobile. I'm just curious the comments about the pull-in if you could quantify that and maybe what August seasonality is if you minus all of these content gains you've had in Mobile over the last year?

[Jack Pacheco:]

Yes, we wouldn't say that typically we have a seasonality in this quarter, but what we have seen is that our customers who produce mobile phones are shutting down for couple of weeks a piece in the month of July right, so when they shut down we're going to lose a couple weeks of revenue in this quarter and we - our sales we think picked up last quarter because people were building ahead and it's just pacing of the shutdown.

[Blayne Curtis:]

Got it, okay. And then I do want to ask you on the battery investment and to the extent that there would be potential that would be included in some of the content framework and then just with that also just the step up in CapEx so I was just curious what that investment is?

[Jack Pacheco:]

Yes, so I mean, the battery business and costs, in Q4 they're just pure costs, so we're going to have about $2 million or $3 million extra cost in the P&L from the battery business. We will have more on revenues until next year on that business. I mean the $10 million to $14 million is in line with our CapEx plan for the year. It just happens to be a little bit backend loaded. We're still waiting under our 2%, 4% of revenue as far as our CapEx guidance. It is just when the CapEx comes in when we have to pay for it kind of a little bit but more backend loaded. And we did have some CapEx for the batteries business that we are going to spend in Q4 as well.

[Blayne Curtis:]

Okay, thanks guys.

[Operator:]

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

[Sidney Ho:]

Yes, thanks for taking my question. Just a little following up with the previous question on Penguin, you guys disclosed the Q1 numbers, can you at least talk about what you believe it will be up or down versus the calendar Q1 just totally based on seasonality and can you also talk about whether on the non-GAAP basis are you expecting that to be margin and/or EPS accretive in the next quarter?

[Ajay Shah:]

Let me try a part of that. From a revenue standpoint we do expect the revenues. So the comparisons are difficult. Let me explain first that Penguin is operated on the calendar fiscal quarter and we have operated as you know on a fiscal quarter which would end our year in August. So you're now comparing their previous quarter with having now been restated into our fiscal quarter. So, when we report it, we report it their fiscal quarters as opposed to our fiscal quarter. So, I know this is a little more difficult to model exactly right now, but this is just that we are literally one week and a few days away from that acquisition having closed. And so we're trying to restate everything into our fiscal quarters because that's what you would all expect us to do. So really at this stage providing you with a lot of guidance as to exactly what Penguin is expected to be would be a little premature as we get those numbers a little more firmed up we will be happy to get it for you. We have tried to be careful in terms of how we looked at the overall revenue numbers or results.

[Sidney Ho:]

Okay, that's fair. Maybe switching subject to the battery business again, can you give us an idea how to think about the size of that market going forward and are there any local content requirements similar to the memory side of things that you expect that will kind of help you guys?

[Jack Pacheco:]

Yes, I mean that market of course has local content regulations around 60% today and we peg that market - I mean ASPs are lower than - we peg the market as probably a couple of $100 million market in total today and so hopefully…

[Ajay Shah:]

I mean just in the Smartphone category there are 55 million smartphones and the average selling prices are what in the $10 range? 8 to 10?

[Jack Pacheco:]

Yes, so lower ASPs that we've seen today, so….

[Ajay Shah:]

So that gives you around the overall market being by $500 million, $600 million and we hope to get our own fair share.

[Sidney Ho:]

Okay, I’d like to squeeze in one more on the Brazil mobile side. The ASP is certainly trending in the right direction and you talk about $30 ASP is possible by the end of this year. One is that [indiscernible] and two, are you seeing any signs that the memory modules are getting too expensive as a percentage of bill of materials and content are not moving as quickly or any color will be great?

[Ajay Shah:]

Well, I have never had a conversation with a customer who didn't complain about the price. So I'll start with that. We are not - we continue to see applications driving the memory requirement rather than prices. Because people are using applications that require the memory, but of course there are different price points for different customers and they continue to be some segments where they're going to look for less memory and other segments but overall we're not seeing those segments change, so far I mean with the only thing we kind of worry about and keep an eye on is the exchange rate. The exchange rate so far has moved within the range, not enough to really change the big picture, but if the exchange rate was to change in a dramatic way, would that affect the affordability, that's probably the bigger question than memory content.

[Jack Pacheco:]

And last quarter Sidney, we had the highest, we shipped the highest percentage of the high memory content eMCPs in Brazil ever, so they are buying more than, not less last quarter.

[Sidney Ho:]

Okay, very helpful. Thanks a lot.

[Operator:]

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

[Rajvindra Gill:]

Thank you. The question also on the local content rules you mentioned that you're targeting WiFi Bluetooth modules and IoT products in Brazil, did those specific products also have local content rule similar to memory in mobile phones, and PCs, and you mentioned 60% for batteries I believe and you can may be expand on that?

[Ajay Shah:]

So the little WiFi Bluetooth thing that we built today which is a little board based solution does have some local content rules for PC's and but it's not a lot, but as we talk about getting more the IoT we wouldn't anticipate that as we ramped up our capabilities and production in the country grew that they would probably enact some type of rules around that.

[Jack Pacheco:]

There's been a lot of interest from particularly government related agencies in promoting IoT for a variety of verticals. So they have actually put out a white paper related to IoT for aquaculture, Smart city’s, energy management couple of different areas, so there's actually a lot of interest in that area and they want to make sure that they have domestic providers for these.

[Rajvindra Gill:]

And then just going back to Penguin and I understand the dilemma that you're in but we're trying to get a sense of what the core business is doing and forecasting in the future and not just a quarter. So it does look like the OpEx, kind of it moved up. The implied OpEx is up about, call it $10 million increase. And I'm looking at the revenue in fiscal year ’17 for Penguin what you said is $166.5 million. I don't know what the growth rate will be next year. But any kind of color as we look at it, I mean how do we model OpEx in November, February, May, August how we model revenue for the future quarters.

[Ajay Shah:]

That was going to be the guess.

[Rajvindra Gill:]

We're going to take $166 million that you did in fiscal ’17 grow by 20%, otherwise you're going to have a model that, so I was wondering if you can provide any more detail on that?

[Jack Pacheco:]

Yes, I mean like the numbers you saw probably in the first quarter aren’t the most worst numbers to use you know on a quarterly basis at Penguin. But they have a little more variability in the quarter, so that's what we're trying to get – really get our hands on. I mean our business tends to be a little more stable on a quarterly basis. They have a little more peaks and valleys and we're trying to get our handles around that and once we get our hands around that, then we definitely will come out with more information as to what's going on with that business. But if you need something today, I'd say their first quarter numbers probably aren't the worst thing to use you could.

[Rajvindra Gill:]

Okay. Got it. That's helpful. And in terms of the currency, so the real depreciated against the dollar making the phones more expensive, PC is more expensive in Brazil. It doesn't appear to be there that has had an effect on the unit demand of people buying phones and PCs. I mean obviously from a P&L perspective you're putting in a GAAP as a loss, so I'm just wondering, did you see any impact from demand - from a demand prospective were you able to offset that by the pull in or the higher density phones, just wondering if you can talk about that?

[Ajay Shah:]

I mean we had good demand in the quarter and it was higher than we had anticipated from the pull-in so we did not see any perceived weakness in demand in the quarter due to the real and we talked about the fact that the real weakened enough, demand could slow down. In this quarter now we've got the shutdown for the World Cup, so it's kind of an anomaly in this quarter. I think it's going to take a little while to see what happens with the demand based on the Real.

[Ajay Shah:]

Yes, I mean so far we're not - anecdotally we're not hearing any, I mean push for some perspective the Brazilian Real is off by about 12% year-to-date and when we look at that in the grand scheme of things, that's not going to completely change the demand picture. If the Real were to significantly weaken from here, it would force manufacturers to change the prices on the shelf and that then might have an impact both in terms of which kind of phone the customer chooses as well as the total unit count, it's possible, but it's a purely speculative at this point we're not seeing a specific impact from what has happened so far.

[Jack Pacheco:]

Yes, I mean what do you think might happen as you might see the lower cost cell phone that Ajay mentioned sell more than the higher ones. The last quarter we sold more higher in memory than we have. And if you look at our – the results we expect. If you look at the second half results versus first, I mean we expect that overall we'll grow the business as we talked about in the call, all right. So overall I mean business will be up in the second half of the year versus the first half even though the second half the real will have weakened.

[Rajvindra Gill:]

Great, thank you very much. I appreciate it.

[Operator:]

Thank you. Our next question comes from Mark Lipacis with Jefferies. You line is now open.

[Mark Lipacis:]

Hi, thank you for taking my question. Jack, maybe could you just review for us the exposure you have on the topline, the COGS and the OpEx to the Real what percentage of your cost structures is exposed to the Real and just spell out perhaps the just the mechanics of how the Forex losses is manifest on that line item? Thank you.

[Jack Pacheco:]

I mean, that’s right. So in the FX loss start I mean where we are exposed really to the Real from an FX perspective is that we purchase all of our wafers in dollars and if you take those invoices convert them into Real when we get them and then when we go to pay them we have to convert them back into USD. And so if the Real has moved in that time period where are you going to get an FX loss like we did in Q1 and it goes right we have an FX seen in Q2 could do it the other way this quarter it dramatically weak and we've shown a much bigger FX loss we had before. So that's really our biggest exposure from a pure FX last stand point. Now on the C&L we priced our customers in dollars. So our exposure there is we do have to convert across from dollars to Real, you know, the Real weakens or strengthens I mean it will have some impact on revenue, but not a dramatic amount. And then if you look at our cost structure our local costs are better in real when at weekends and fairly we would get a little bit of a benefit in the rest of the P&L with a weaker Real?

[Mark Lipacis:]

Okay, thank you. And so is the COGS, is the COGS mostly dollar based and is it OpEx that is more heavily weighted to the Real?

[Ajay Shah:]

Our 85% of our COGS are material base right and our materials are going to be most that is the Samsung wafers coming in based on USD.

[Mark Lipacis:]

Got you. That's helpful. Thank you.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from Suji Desilva with Roth Capital. Your line is now open.

[Suji Desilva:]

Hi, Ajay, Jack and congratulations on the results here. A couple questions on Penguin did you have any inventory of the mark up with the acquisition that needs to flow through that might dampen gross margin the next few quarters or was that not material?

[Ajay Shah:]

We will have to do that, that's some of the stuff we haven't determined yet Suji, but we know we have – inventory will have to get marked up we're just not sure of it and where it has to go.

[Suji Desilva:]

But your gross margin does not encompass that effect at this point?

[Ajay Shah:]

Correct.

[Suji Desilva:]

Okay good. Got it. And then also I think this question may be premature as well, but I'll ask anyway. The segment reporting the way it is now will it stay this way? Will you have a separate SCSS line? Will it be combined in especially memory? Any thoughts there on how you will report segments will be helpful. Thanks.

[Ajay Shah:]

Yes, that's premature as you said, Suji. We've thought about it. We haven't come to a definite conclusion yet we're still - Brazil we have there's a lot of analysis, you have to do to determine from a segment perspective what you have to do and so we're starting that analysis now.

[Suji Desilva:]

Okay, great and last quick question on specialty memory, what percentage DDR4 versus DDR3 today is that shifting dramatically or staying stable?

[Ajay Shah:]

It's probably about 30% DDR4 today.

[Suji Desilva:]

Okay, great. Thanks guys.

[Ajay Shah:]

Thank you.

[Operator:]

Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Ajay Shah for any further remarks.

[Ajay Shah:]

Well, again thank you operator. Thank you all of you for joining us on this call this afternoon. We look forward to seeing you out on the road in the coming months and to reporting on our progress next quarter. Once again, we thank you for your interest and goodbye.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a great day.