Gail Sasaki - VP, CFO & Secretary Chuck Hong - Co-Founder, President, CEO & Executive Chairman Michael Smargiassi - MD, Brainerd Communicators, Inc.

Sujeeva Desilva - Roth Capital Partners Richard Shannon - Craig-Hallum Capital Group LLC

Good day, and welcome to the Netlist Second Quarter 2018 Earnings Conference Call and Webcast. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Mike Smargiassi. Please go ahead.

Thank you, Brandon, and good afternoon, everyone. Welcome to Netlist's Second Quarter 2018 Conference Call. Leading today's call will be Chuck Hong, Chief Executive Officer of Netlist; and Gail Sasaki, Chief Financial Officer. As a reminder, the earnings release and a replay of today's call can be accessed on the Investors section of the Netlist website at netlist.com. Before we start the call, I would note that today's presentation of Netlist's results and the answers to questions may include forward-looking statements, which are based on current expectations. The actual results could differ materially from those projected in the forward-looking statement. Because of a number of risks and uncertainties that are expressed in the call, the annual and current SEC filings and the cautionary statements contained in the press release today, Netlist assumes no obligation to update forward-looking statements. During this call, non-GAAP financial measures will be discussed. Reconciliations for those directly comparable GAAP financial measures are included in the press release, which was filed on Form 8-K. I would now like to turn the call over to Chuck.

Thanks, Mike, and good afternoon, everyone. Second quarter results showed bottom line improvements on both a year-over-year and a sequential quarter basis. During the quarter, we also received a favorable remand order from the International Trade Commission, or the ITC, and the investigation of SK hynix resumed only with a one-month delay in the original trial date. In addition, we continue to advance the commercialization of HybriDIMM, Storage Class Memory technology, through engagement with key partners. During the quarter, we continue to see healthy activity around NVvault, with a new round of x86 platforms being introduced. There's not only renewed interest in DDR4 solutions, but also storage solutions using NVvault products. We have also seen significant interest in specialty DIMMs from many customers as the Tier 1 memory vendors are vacating the space amid a tight DRAM market. We have grown a number of qualifications in this space in both DDR3 and DDR4, which we expect will meaningfully add to revenues and gross margins by the end of this year. Our in-house manufacturing, testing and long-term support of the products we supply are resonating with customers as we have added over a dozen new customers and qualification in this space. Also, we just brought to market a line of enterprise-grade NVMe SSDs where we offer an attractive mix of high performance at lower cost compared to competitive solutions. This is a complementary product offering to our existing base of storage and server customers who already buy NV, EV and specialty DIMMs. We are currently sampling the Netlist line of SSDs and expect to see revenues from these products starting in Q4. HybriDIMM commercialization efforts are also accelerating via discussions with multiple OEMs, memory and ecosystem partners. This includes potential partners for the conversion of the HybriDIMM controller to an ASIC chipset and efforts to open up the technology through industry standardization. On the software side of development, we also entered into an agreement with ScaleMP, one of the premier software-defined computing companies. ScaleMP has pioneered the use of low-cost, high-capacity nonvolatile media as memory, and this collaboration will help us highlight and drive adoption of HybriDIMM's cost-effective fast storage and memory capabilities with end-users and various Big Data applications. At the Flash Memory Summit next week, we will be conducting private demonstrations of HybriDIMM for partners as well as introduce our new SSD line to customers. In addition, Rahul Advani, our VP of Marketing, will participate in the Developing Controllers for Emerging Memory Technologies panel, taking place on Wednesday. The panel will discuss a number of storage cost memory topics, including emerging technologies, special architectural features and the need for unique controllers. Moving to licensing. The actions against SK hynix in Germany and the ITC are proceeding as expected with both trials set for this December. In Germany, the parties are in the process of filing briefs with the court in preparation for the December 6 trial, which will address infringement and other related issues. The court's decision is expected in early 2019, and if decided in our favor, an injunction would go into immediate effect in joining the sale of hynix products in Germany. In the second ITC action against SK hynix, we petitioned the ITC commission in April to review the findings of the initial determination pointing to various errors in the decision to terminate the investigation and asked the commission to remand the further proceedings for claim constructions and infringement. On May 29, the ITC commissioners agreed with Netlist and issued a remand order, sending it back to the Administrative Law Judge, or ALJ, to resolve the party's claim construction disputes and continue the investigation. We expect to receive the Claim Construction Order by the tentative date of August 24. The investigation will then proceed through a fact discovery -- fact and expert discovery, culminating in the trial on December 17 through 21. Finally, the appeal of the first ITC action against SK hynix was filed last week with the U.S. Court of Appeals for the Federal Circuit. On this appeal, we are asking the appellate court to find that hynix products did, in fact, infringe on Netlist's patents and reverse the non-infringement findings -- non-infringement ruling of the ITC. We believe that we have strong arguments for the Federal Circuit to reach this conclusion and expect to receive the final ruling in this case by mid next year. In summary, the activity around specialty DIMM and the new family of SSD products is encouraging and bodes well for high-quality revenue growth in the second half of the year. The campaign to defend Netlist's IP continues on track, and we remain focused on securing licensing agreements that fairly compensate Netlist and its shareholders. I will now turn the call over to Gail for the financial review.

Thanks, Chuck. Revenues for the second quarter ended June 30, 2018, were $8.4 million, compared to revenues of $11.4 million for the 2017 period. Although revenues were down year-over-year and flattish between quarters, the mix and margins were improved due to growth in specialty and custom memory modules. Factory placements and their related revenue doubled year-over-year and increased by 20% consecutively. Although we don't guide, we do anticipate continued growth in specialty DIMMs in the third quarter as well as a modest increase to overall top line revenue. Second quarter 2018 gross profit was $482,000, and net loss was $3.4 million. We narrowed net loss by 10% year-over-year and 27% on a sequential quarterly basis. Operating expenses were $3.8 million in the second quarter, compared to $4.4 million in last year's second quarter, a 14% improvement year-over-year and a 22% improvement consecutively. Operating expenses without litigation costs decreased by 32% year-over-year and 13% from last quarter. As noted in our last earnings call, legal fees decreased on a consecutive basis, and given the current litigation calendar, we currently expect legal expense to be flattish in the third quarter and slightly higher for the fourth quarter in support of the second ITC action and German trials, which are scheduled for December. I would now like to provide an update on Netlist's NASDAQ status. Per the 8-K filing we made in early July, we're currently out of compliance with NASDAQ's minimum bid price and market capitalization requirements. During last quarter's call, we reported that we had attended a hearing of a NASDAQ panel in Washington, D.C. in May and we're waiting on the panel's decision. We did, in fact, receive an additional grace period from NASDAQ through September 25. And in early July, we provided an update of the plans we presented to return to compliance. We ended the second quarter with cash and cash equivalents and restricted cash of $8 million, compared to $8 million at the beginning of the quarter. The cash position was supported by a vote of confidence via direct personal investment of $800,000 from the company's CEO, Chuck Hong. In addition, the cash position at the end of the quarter included $2 million in net proceeds from the aftermarket ATM facility. As of January -- July 31, 2018, we have received total net proceeds of approximately $8 million on the ATM facility, with a balance of $1 million to utilize under the facility through November 2019. We continue to proactively manage the overall cash cycle, which includes access to a $5 million working capital line of credit with Silicon Valley Bank, providing borrowing of up to 80% of eligible accounts receivable to support our working capital and revenue growth. With product gross margins increasing and operating expenses lower than prior quarters, we anticipate minimal net cash burn in Q3 '18. Thank you for listening. Operator, we're now ready for questions.

[Operator Instructions]. Our first question comes from Suji Desilva with Roth Capital.

So on the products you're making with the DDR3, DDR4, where are you getting supply given the Tier 1 tightness? And what are some of the -- what's the characterism of the 12 customers you're qualifying with there?

Yes, Suji. The DRAM supply we buy at a component level from one of the major DRAM suppliers. We are also sourcing from a couple of the Taiwanese DRAM vendors. So we're able to secure DDR3 and DDR4 DRAMs in this tight market. In terms of the customer base, it's -- many of them are the existing storage appliance, server appliance, purpose-built server customers that we already have for our NV products and some of the other products, so it's mostly within the existing customer base.

Okay, helpful. And then with your newer SSD product, what's the addressable market there that you estimate? What's your ASP relative to the competition? And then what is the competition, how do you stack up versus the competition? Are you targeting a certain niche there? Or is it performance advantage? Any color there would be helpful.

Yes, these are NVMe SSDs. There's about 16 SKUs in the family of -- they're enterprise-grade, high-performance, high-endurance, and we will be slightly lower than the competition in terms of price. Performance-wise, it's comparable. So we think it will be very synergistic with our existing product line, and the products will be sold initially mostly to the existing base of storage and server appliance customers.

Okay. And then a question on the litigation side. If you look at these two opportunities, the ITC 2 and the German one, which one do you think you'll have some level of clarity? I know the final -- I know the actual dates are laid out, but some -- which one do you think you'll have clarity on in terms of the outcome sooner as these both progress?

As was stated in the prepared remarks, the ITC 2 case -- so basically, there are three cases that are open. You have ITC 1 case, which came out of the ITC, which -- where the appeal process started last week with the filing of the appeal. And so that will get to a final ruling probably about 12 months from now. The ITC 2, we will see a -- likely a Claim Construction Order from the Administrative Law Judge handling the case by tentative date of 24th of August. So that will be a good indication of where we stand as it -- in terms of infringement. And then, finally, the German case, which is going very well for us, we'll go to trial on December 6. We've already started multiple brief filings of that, in that case, both parties. And they expect to render a decision within a month or two of the trial in Germany. That's how the process works there.

Okay. And then last question, perhaps for Gail. You said the cash burn outlook was minimal in 3Q. What was the cash burn in this quarter?

It was actually a net cash burn of zero.

Okay, yes, because cash was flat, right?

Yes.

Our next question comes from Richard Shannon with Craig-Hallum.

Maybe I'll follow up on Suji's first question regarding the DDR3 and DDR4 products. Chuck, you mentioned supply from a major OEM and a couple of maybe the smaller Taiwanese guys. Are you getting enough supply for the demand that you're seeing there? Or what's kind of the balance between that right now? And do you expect it to be able to get enough supply for the foreseeable future?

I think that for the DDR3 products, we are getting sufficient supply. The demand on ECC, SODIMMs, ECC VLP, RDIMMs, these are -- they're niche products, difficult to source. We're able to get the DRAMs and build them in our factory and ship it to customers. We're doing that very well. So that business is growing. DDR4, most of that is coming from one of the major suppliers, and there, we are constrained on the DRAM supply. But over the next few months, we expect DDR4 DRAMs to be available for the server market from the Taiwanese DRAM suppliers.

Okay. Fair enough. Second question on NVvault. I think last quarter, you talked about having 15 qualifications. I think the prior call you talked about having 12. Can you talk about the number of qualifications you have and give us a sense of what kind of a ramp we might be able to expect over the next 1 to 3 quarters or so?

The qualification, the numbers are about the same as the last quarter. It's just further into the process of qualification -- being qualified. And we expect those revenues to start coming in, in the second half. We can't say exactly what the number will be, but it'll be -- we think it'll be over $1 million a quarter type of a run rate.

Okay. Does this have the possibility of getting to, I don't know, say, a $5 million to $10 million run rate sometime next year? Can you see far enough into the future to get a sense of whether that's possible?

I don't know about double digits, but certainly, it can get to $3 million to $4 million. It really depends on the attach rate, the adoption rate of NVDIMMs. Certainly, there's a large number of quals and the systems are out there. It's a matter of the end customer asking for NVDIMMs in these servers.

Okay. Fair enough. Maybe a financial question for Gail. As you get more contribution from Netlist products, I think you kind of alluded to higher gross margins coming here in the third quarter. Do you have any visibility in getting to above the 10% gross margin mark? I don't think you've been there for a few quarters and it seems like a mix would suggest we can get to -- get -- approach that or even get past that fairly soon. Can you comment on the path we should expect for gross margins here in the second half of the year and going into next?

Yes, I mean, it's maybe easier to think about it in two steps. So our product margins between the two quarters increased by about 20%. And the product margins themselves are probably getting into the 12% range for Q3. So we have a fixed cost at the factory, so the larger the revenue, the larger the margins, the less that affects that number. So getting to 10% by the end of the year, certainly, going -- exiting the year, we definitely see that in our plans, and then we think it's quite viable.

Okay. Maybe two last questions for Chuck. Chuck, regarding HybriDIMM, you talked about and I think you've mentioned in the last call as well, but your efforts to drive standardization of that. Can you give us an update on what things you've done? Where the process sits? How long this could take, probability of success, et cetera?

Yes, Richard. We are in the process of preparing a proposal for JEDEC, and that will be put in front of the various committees over the next couple months. And then there is a quarterly meeting scheduled early September where we will be making what effectively would be a second showing of that proposal and taking questions, and that will kick off the process of standardization. So we believe -- I don't know what the odds are, JEDEC is a -- the process is complex with a lot of parties. It's a committee decision-making, but we believe we've got good support from a large group within the industry in support of this technology.

Okay. Good to hear. I look forward to updates on that. So the last question, Chuck. Talk about making progress on a partner for the HybriDIMM ASIC. Any expectations you'd like to set in terms of when that could be done?

We're still in discussions with multiple parties. We believe the standardization effort will be helpful. We have support of a couple of large users, and they will -- large server manufacturers, and that will become apparent through the JEDEC standardization process and I think, with an open standardization, will attract parties to come forward on funding and designing the ASIC.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.