Netlist Inc

Good day, and welcome to the NetList fourth quarter and year-end 2021 earnings conference call and webcast. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing star, then zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on a touch-tone phone. To withdraw your question, please press star, then two. Please note, this event is being recorded. I would now like to turn the conference over to Mike Smargiasi, Investor Relations. Please go ahead.

Thank you, Tom, and good day, everyone. Welcome to Netlist's fourth quarter and full year 2021 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 investor section of the NETLIS website at netlis.com. Before we start the call, I would note that today's presentation of NETLIS 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 statements because of the number of risks and uncertainties that are expressed in the call annual and current SEC filings, and the cautionary statements contained in the press release today. NETLIS assumes no obligation to update forward-looking statements. I would now like to turn the call over to Chuck.

Thanks, Mike. And hello, everyone. On this call covering the annual results, I'd like to begin by highlighting the significant progress NETLIS made in 2021 across all areas of its business. Total revenues tripled compared to the prior year, which consisted of a doubling of product revenue to more than $100 million and the addition of $40 million in licensing revenue. Gross profit increased 6x and the company delivered $11 million in net income before taxes. We ended the year with a much stronger balance sheet as working capital tripled compared to the end of 2020. The strong performance is the result of NETLIS' ongoing execution of our product and licensing strategies. Some key results include, one, entering a strategic agreement with SK Hynix that recognize the strength of NETLIS' intellectual property while bolstering the company's products business. Two, stepping up intellectual property enforcement against significant infringing parties. Three, expanding near-term product offerings. And four, investing in R&D to drive strategic growth in the coming years. For a closer look into these areas, let's start with intellectual property. Many of you follow Netlist's legal activities. As you know, Netlist has invested a great deal of time and energy to develop and defend its IP over the past two decades. The goal has been to enter licensing agreements with companies that implement Netlist's technology and high performance memory. We've made excellent progress in this area during 2021 and have already seen returns on this effort, starting with SK Hynix. Entering into a multifaceted arrangement with SK Hynix was a major step forward for the company, opening up multiple avenues for growth through licensing and supply of Hynix's memory products. We have quickly ramped up operations with Hynix. and expanded the revenue stream. And moving on to Google. An important milestone in 2021 was resuming Netlist's patent infringement action against Google. We first took legal action against Google in 2009 for their infringement of Netlist's memory module patents. Early on, Google and two other entities enlisted for support. together attempted to invalidate Netlist's 912 patent. After a legal battle lasting over a decade, Netlist fought off the challenges and finally received vindication from the Federal Circuit Court of Appeals that the 912 patent was not invalid. After winning at the appeals court and the patent office, Netlist's action against Google restarted and is now before Chief Judge Seaborg in the Northern District of California. Chief Judge Seaborg supervises the administration of the entire district, along with handling a docket of cases that include patent matters. Given the tenor and outcome of our February 10th Case Management Conference, his involvement is a very welcome development. Accordingly, we've withdrawn the motion to transfer the case to what we assumed would be a quicker docket. The judge stated that Netlis' case against Google is the oldest on its docket, quote, by light years, unquote, and seemed inclined to meaningfully move the case forward. Indeed, the court will hear the party's various pending motions, including intervening rights, on March 3rd. Following a ruling, we expect Chief Judge Seaborg will set a schedule finally allowing us to bring our case against Google before a jury. It is encouraging to see this case moving forward again and to know that Netlist will have it stay in court to address Google's longstanding infringement. Moving on to Samsung. Netlist's breach of contract case against Samsung wrapped up on February 14th with a concise post-trial hearing at the federal court in the Central District of California. A definitive judgment issued the very next day against Samsung on all three of Netlis' claims and this final judgment confirms what we've known all along, that Samsung does not have a license to Netlis' intellectual property and must now again secure legal permission from us to continue selling its infringing products. In an attempt to escape the Central District of California, Samsung petitioned the Delaware Federal District Court to rule that it doesn't infringe certain NetList patents and that these patents are unenforceable. In NetList's recently filed motions to dismiss, we've shown why Samsung is wrong. Beyond highlighting that Samsung is improperly asking a Delaware court to reconsider the California case, we explain why Samsung has no standing to bring its complaint at all. Samsung is now asking the Delaware court for another opportunity to amend its accusation against Netlis. We move the court to ignore these unfounded pleas. We expect the Delaware court to rule on Netlis' motions in the coming months. Following an early summary judgment when in California confirming Netlis' proper termination of the JDLA, NETLIS filed a patent infringement action against Samsung in December in the Eastern District of Texas. NETLIS is asserting three of its patents, the 506 and 339 patents, which claim aspects of NETLIS's innovations for LRDIMM technology, and the 918 patent, which claims NETLIS's innovative power management technologies found in virtually all new DDR5 memory products. Judge Gilstrap will preside over the case. This venue has historically had a quicker time to trial, typically in the range of 12 to 14 months. Samsung's response to the suit is due in April, and we expect a case management conference to take place shortly thereafter. Now on to Micron. As you may recall, Netlist launched this action against Micron in April 2021. NETLIS filed two distinct actions simultaneously in the same court, one for patents covering our LRDEM innovations and one for a patent covering NVDEM inventions. The cases proceeded together in parallel and passed through much of the initial work underpinning claim construction. Most recently, we requested a transfer of the case from the district's Waco court to its Austin court. Due to our significant efforts to date, moving under a rapid case schedule, Micron already filed its opening claim construction brief. A Markman hearing was set for the end of March in Waco, but that date may get pushed back due to the intra-district transfer. The case management conference is set for March 3rd, where we expect Judge Akel to determine the timing on remaining claim construction deadlines. As expected, Micron filed Interparty's re-exam on Netlist patents. Those IPR proceedings will follow their own independent course. Finally, Netlist was very active on the patent issuance front. In 2021, we received 10 new patents, seven in the US, two in Europe, and one in China. Some of these new patents protect the power management portion of the DDR5 memory module. DDR5 memory, we believe, will become dominant within the next few years, making these patents very valuable. Now, let's move on to product side of the business. As we noted earlier, product sales more than doubled in 2021 and grew 36% on a consecutive quarter basis. Analysts are forecasting nearly 30% compounded annual growth in NVMe SSD demand through 2025. Netlist continues to invest a significant amount of resources into this market, including development of its NVMe SSD product line. During 2021, we introduced the Gen 4 NVMe SSDs, which have exceptional read-write performance. With better supply chain agility on high-end SSDs, Netlist can provide shorter lead times compared to the major SSD suppliers during a tight market environment. In 2021, Netlist ramped qualification activity for the Gen 4 products, resulting in doubling of SSD revenue during Q4 compared to Q3. And we expect to grow these revenues through 2022. Netlist's relationship with SK Hynix is providing positive returns for overall product revenue. As Netlist's access to Hynix product line continues to grow, we are seeing increased number of opportunities and the work together with Hynix strengthens Netlist's resale infrastructure and seeding the market of these products is starting to pay off. Combined with Hynix's DRAM modules and components, We are strategically diversifying the product portfolio from server memory and enterprise SSDs to IoT and embedded solutions. This is enhancing Netlist's competitive position and our ability to meet the broader needs of our customers. After a strong Q4 performance, we see continued momentum into 2022. We expect to see DRAM and NAND prices stabilize in the spring of 2022 as inventory levels adjust, resulting in reduced volatility. In addition, recent fab contamination at Keoxia is likely to result in NAND flash supply constraints that further supports price stabilization. As we move through 2022, we anticipate a market where supply continues to tighten and demand increase. Together, these trends will create what we believe will be a favorable environment to grow product sales. We will be watching this market very closely. Finally, across the industry, we're seeing a significant investment into CXL. This is the first new bus in computing since the advent of PCIe decades ago, and it will open up huge market opportunity. Netlist's goal is to capitalize on its years of investment in storage class memory and marry our technology with the CXL bus. This groundbreaking technology called hybrid memory expansion uses the lowest cost for memory raw material, NAND flash, to create the performance of the highest cost memory raw material, DRAM, at a fraction of the cost of traditional memory. In 2021, we invested heavily in the ASIC engineering team headed up by Raj Gandhi as VP of ASIC, tripling the size of this group. With the core design and verification resources in place, we are accelerating the development of the ASIC controller for HMX. By the time Intel and AMD launch CXL-enabled server systems in 2024, we will be well positioned to offer this technology to the market. By replacing DRAMs and NAND at a fraction of the cost, HMX has the potential to fundamentally upend the economics of memory. In closing, 2021 was a record year across the business. We delivered strong financial results, entered into a strategic relationship with the world's second largest memory maker, and laid the groundwork for a diverse and growing products business. We entered 2022 with strong momentum. As a result of the success of the past year, we've become a significantly larger entity with clear growth opportunities. This is due in no small part to Netlist's shareholders who have believed in and remain dedicated to the company. We thank you for your support. I'll turn the call over to Gail for the financial review.

Thanks, Chuck. During the 12 months that ended January 1, 2022, total revenue increased 201%, and product revenues grew from $47.2 million to $102.4 million, an increase of 117%. We also recognized significant licensing revenue from NETLESS's strategic agreement with SK Hynix. 2021 marked the second highest revenue year in NetList history. Gross margin dollars were $49 million, a 6x increase for the current year compared to 6.7 million for 2020. Excluding IP licensing revenue, gross margin percentage was 8.7% in 2021 compared to 14.2% in 2020. This reflects increased resale revenue, which represented a larger portion of the product mix, as we leveraged the product supply agreement with SK Hynix. Fourth quarter revenues were $36.3 million compared to $11.5 million in Q4 2020, an increase of 216% and also up 36% on a consecutive quarter basis. Gross margins were 5.6% for Q4 2021 and 12.7% for last year's quarter. The gross margin percentage variance between quarters is primarily due to product sales mix, but was also due in part to a temporary downturn in the market price of DRAM during the second half of 2021. The increase in operating expense for both 2021 and the fourth quarter was due to increased legal fees related to IP enforcement actions and to expansion in the sales, marketing, and engineering teams necessary to support sales and R&D acceleration. As a reminder, we do not formally guide, but given NETLIS booking and shipments to date, we can expect to see a sizable increase in product revenue dollars for Q122 as compared to Q421. While the market environment remains fluid with pockets of price softness, specifically in the DRAM market, we believe the long-term memory and storage industry trends remain favorable, and we remain well-positioned to drive 2022 financial performance. We will continue to invest in growth across all areas of the business, both at R&D, the product business, as well as to support IP enforcement activities. As for our balance sheet, we significantly strengthened the balance sheet during the year into 2021 with cash equivalents and restricted cash of $58.6 million compared to $16.5 million at the end of 2020. In the fourth quarter, we utilized $16.8 million of cash to retire the Samsung Note and currently have no significant short or long-term debt. We also opportunistically raised approximately $13 million during the quarter at an average price of $6.77 and maintained significant financial flexibility and liquidity with $63 million remaining on the equity line. As always, we continue to very carefully manage the operational cash cycle, which for Q4 21 included improvement in day sales outstanding, an increase in days payable, offset by an increase in inventory days, resulting in a cash cycle of just under seven days, an improvement of 12 days compared to last year's Q4. In addition, we increased availability on our working capital line of credit with Silicon Valley Bank from $5 million to $7 million to support revenue growth, and we continue to expand our lines of credit with key vendors. Finally, we will be participating in the 34th Annual Roth Conference, taking place March 14th and 15th, and we look forward to seeing you there. Operator, we are now ready for questions.

We'll now begin the question and answer session. To join the question queue, press star, then 1. If you're using a speakerphone, please pick up your handset before pressing any keys. To remove yourself from the question queue, press star, then two. And the first question comes from Suji De Silva with Roth Capital. Please go ahead.

Hi, Chuck. Hi, Dale. Congratulations on a strong end to the calendar year. So I just wanted to clarify there, Dale, that the gross margin weakness primarily is at the DRAM price softness. Is that describing that? Just to understand.

Both the – product mix with a higher percentage of resale, as well as the DRAM softness at the end of 2021.

And you expect that to persist into 22 near term, which you can tell?

No, actually, we expect, we're planning on improvement in the product margins, although we will continue to have a higher percentage of resale business. We did have some learning curve in regards to product regarding Hynex, but we've added expertise, as we mentioned, to better capitalize on the opportunity. So we're definitely focused on increasing growth in the margin dollars as well as maximizing the percentage.

Okay, great. That's encouraging here. And then maybe, Gail or Chuck, the Hynex agreement, the resale, when do you reach a full run rate there? I know you were building out the distribution infrastructure. I'm curious if you're at that full run rate yet or when you would reach it.

Hey, Suji. Yeah, I don't I think there's still quite a bit of headroom left to continue to grow that business. There is a total dollar limit to the amount of annual purchase. We've not hit that number, but I think there will be some flexibility to even go beyond that number, you know, as we build out the partnership.

Okay, great. And then on the SSD area, what is, Chuck, a rough estimation of the expected growth, the revenue level for 22 versus 21? I know it did pretty well in 21. I'm curious how quick you expect that SSD business to ramp.

I think that we did very well in Q4 compared to Q3. And we do have quite a bit of new customers now qualified in the pipeline. And the Gen 4 business, I think it will continue to grow nicely. You know, I can't put a number on it right now. But, you know, I think it will be substantial growth compared to last year.

Okay, great. And lastly, on the litigation front, I didn't know if I missed this in the preparatory remarks. Is there a Markman hearing coming up, and what's the schedule for that?

Okay. Well, there are three cases that all have Markman hearing, the clean construction hearing and a ruling that's involved because all patent cases have that. The Micron, as mentioned in the prepared remarks, was supposed to happen on the 31st of March, but... Now with the move from Waco to Austin, that will likely be delayed. We will know more at the case management conference on Thursday. For Google, the same thing. There will be a case management conference on Thursday, and I think that will shed light on when a markman would take place in that case. Samsung, now a case at the Eastern District of Texas under Judge Gilstrap. They will set out a mark mandate when we have the hearing sometime in April. But that will, again, because of the local rules in that venue, will likely happen relatively early, you know, maybe mid-year or sometime in Q3. Okay.

Thanks for clarifying that, Chuck. Thanks, everybody.

Thanks, Suji. Thank you, Suji.

This concludes our question and answer session, which also concludes today's conference call. Thank you very much for attending, and you may now disconnect.