Earnings Call Transcript - SMCI Q4 2020

Operator, Conference Operator

Thank you for joining us for the Supermicro Fourth Quarter Fiscal 2020 Financial Results. I will now turn the conference over to James Kisner, Vice President of Investor Relations. Please proceed.

James Kisner, Vice President, Investor Relations

Good afternoon, and thank you for attending Supermicro's call to discuss financial results for the fourth quarter of fiscal 2020, which ended June 30, 2020. By now you should have received a copy of the news release from the company that was distributed at the close of regular trading and is available on the company's website. As a reminder, during today's call, the company will refer to a presentation that is available to participants in the Investor Relations section of the company's website under the Events and Presentations tab. We have also published management scripted commentary on our website. Please note that some of the information you'll hear during our discussion today will consist of forward-looking statements including without limitation, those regarding revenue, gross margin, operating expenses, other income and expenses, taxes, capital allocation and future business outlook, including the potential impact of COVID-19 on the company's business and results of operations. There are a number of risk factors that could cause Supermicro's future results to differ materially from our expectations. You can learn more about these risks in the press release we issued earlier this afternoon, our most recent 10-K filing for 2019, our March 2020 10-Q and our other SEC filings. All of these documents are available on the Investor Relations page of Supermicro's website. We assume no obligation to update any forward-looking statements. Most of today's presentation will refer to non-GAAP financial results and business outlook. For an explanation of our non-GAAP financial measures, please refer to the accompanying presentation or to our press release published earlier today. In addition, a reconciliation of GAAP to non-GAAP results is contained in today's press release and in the supplemental information attached to today's presentation. At the end of today's prepared remarks, we'll have a Q&A session for sell-side analysts to ask questions. I'll now turn the call over to Charles Liang, Chairman and Chief Executive Officer.

Charles Liang, Chairman and CEO

Thank you, James, and good afternoon, everyone. Today, we have released our fiscal fourth quarter and full year fiscal 2020 financial results. Now let's take a look at some highlights from the quarter. Our fiscal fourth quarter net sales totaled $896 million, up 5% year-over-year and 16% sequentially. Our fiscal Q4 earnings per share was $0.68. We saw double-digit growth in Edge applications and some key data center and cloud customers. This was offset by softness from some customers who are seeing the worst effect of the COVID-19 threat. Before we dive into the financial details, I want to provide you an update on our business strategy. Last quarter, we talked about our four strategic high-growth market segments, and we are aligning our resources accordingly to speed up our growth for the coming quarter and years. These four strategic markets are: first, organic enterprise and channel business, including server, storage, IoT and AI, which are our historical growth areas; second, our new 5G, Edge and Telco business; third, our new large data center and public cloud; and fourth, software and global service. I'm pleased to share that we have made good progress in three of these four market categories this quarter. The strategy enables us to win more high-profile customers among enterprise, data center and 5G Telco infrastructure builders. In addition, we have continued our investment and growth trend in software and service by doubling this team's head count over the past year to prepare a series of higher-value product lines. Unfortunately, COVID-19 poses significant disruption on our organic enterprise and channel business and slowed their growth in the near term. But we are encouraged by our progress in our two new strategic drivers this quarter, the large data center and cloud as well as 5G and Telco. And they prove that our overall growth strategy is working well and will drive much stronger results in the future. Going forward, we also plan to accelerate our unique online business into an official phase to complement our strategy. We have been preparing and fine-tuning this business for a few years. And I am optimistic that it will speed up, bringing new revenue growth and profitability to us. How do we move this business into an official phase? Supermicro prides itself in product innovation, which has been the key to our success in the past 27 years. Our server system building blocks, application optimization, and resource savings design vision separate us from our competitors, and we are very excited by our recent product introductions. Last quarter, we announced a new AI and machine learning system portfolio that supports the new NVIDIA A100 Tensor Core GPUs based on the latest AMD EPYC processors and Intel upcoming processors, armed with up to 5 PetaFLOPS of performance per 4U system with optimal thermal solution. These systems enable researchers to train the most sophisticated AI networks at an unprecedented speed. Next, we have introduced a new four-way enterprise platform based on the third-generation Intel Xeon Scalable processor, which is optimized to take on deep analytics and mission-critical applications. Most importantly, this quarter, our R&D is hard at work to expand our extensive AMD product lines, and working closely with our partners to seed our next-generation X12 Intel processor-based product line. These engagements will enhance the strong foundation for our growth in the coming quarters and years. At our recent virtual Storage Summit co-hosted with our partner, Nutanix and Intel, we discussed our completely refreshed storage portfolio. At the event, we introduced storage systems that offer the highest data density and optimized system performance for our customers, including our brand-new second-generation top-loading 60- and 90-bay storage, petascale EDSFF, high-performance storage, and software-defined solutions. Switching gears to 5G. We have also been recognized recently by VDC Research as the top 5G, Telco and Edge solution provider based on the highest customer satisfaction for its application-optimized products. As distributed compute becomes more critical for 5G infrastructure implementations, our Edge solutions are optimized to be deployed, managed, maintained, and secured on a mass scale. We see that most of the 5G, Telco, and Edge business opportunities are still in the early phase of deployments. This represents great market share opportunities for Supermicro. I want to get back and talk a bit more about our calendar quarter and business outlook. The logistical issues, rising shipping costs, and employees working from home, caused by the spread of COVID-19 in the U.S., disrupted our business in the short term. It lowered our business and revenue by some points and increased our business costs in the short term. As of this time, we have been aggressively shifting and growing certain operation and R&D works to Taiwan. By aggressively and efficiently growing our operation in Taiwan, I'm confident that this big step of change will yield bigger, long-term rewards, as our overall costs will be much lower when our operation and production volume in Taiwan ramps. However, we will also continue to optimize our operation in the U.S. by better business and production automation to address the ever-changing market dynamics. In summary, we are able to continue our growth moderately despite the continued disruption caused by COVID-19. We will provide a near-term outlook today that reflects some results from those threats of COVID-19. However, we are very encouraged as we look into the future, as the digital world continues to progress, evolve, and grow. Rest assured, we are using this period of disruption as an opportunity to improve our global business structure by shifting and growing certain portions of operation, production, and R&D to Taiwan, a much lower-cost country and less COVID-19-disrupted area. This change will result in our mid-term and long-term business revenue and profitability growth. Our enhanced mix of hardware, software, and service hybrid focus is the path forward for us to build higher product value, gross margin, and revenue growth over time. Our strategy will empower Supermicro to re-accelerate our revenue growth and resume our long history of strong market share gains. With that, we remain very bullish on our long-term opportunity to penetrate our roughly $100 billion total addressable market. Finally, we are pleased to announce today a $30 million stock repurchase program. Although the starting amount is modest, we would like to start utilizing our cash on hand to increase shareholders' value while maintaining sufficient cash resources to fund our operation and aggressive growth plan. The stock repurchase program reflects our ongoing commitment to improving the value of our common stock and will help us to offset dilution from our equity plan. I will now hand the call over to Kevin to review the results of the quarter in more detail.

Kevin Bauer, CFO

Thank you, Charles. First, I'd like to thank our employees, customers, investors, and partners for their support as we navigate the ongoing challenges of the COVID-19 pandemic. Before jumping into the details of the quarter, we'd like to provide a brief update on the status of our operations. Recall, our largest production and employee presence is in San Jose, California. We continue to operate under increased safety measures for the health of our employees. While we have adapted well to current conditions, we continue to maintain a higher level of inventory and are adjusting our logistics to moderate costs. All that said, while we aren't satisfied with our operating profitability this quarter, we are proud of our results under these unprecedented times. While we don't have unique insight into the long-term trajectory of a global economic recovery from COVID-19, we believe that much of the effects we are seeing on our financials today and over the near term will likely prove transitory. Now let me turn to the details of the quarter. Our fiscal fourth quarter revenue totaled $896 million. This reflects a 16% quarter-on-quarter increase from the third quarter of fiscal 2020 and a 5% increase from the same quarter of last year. Systems comprised 83% of total revenue and volumes of systems and nodes shipped were up sequentially and year-over-year. System average selling prices increased quarter-on-quarter but declined year-over-year. Turning to geographic performance. On a year-on-year basis, the U.S. was up 4%, EMEA grew 13% and Asia was flat. On a sequential basis, U.S. sales grew 27% as we saw strength at a number of Internet data center and enterprise customers. EMEA grew 3% and Asia grew 2% sequentially. Before moving down the P&L, I'd like to point out a number of discrete items worth noting for investors. First, we recorded $17.4 million in expense related to incentive awards to our employees that impacted both cost of sales and operating expense. Remember, on our February call, we mentioned that we had expected to incur additional one-time charges of $35 million to $40 million. Second, we paid out approximately $26 million for those awards whose performance criteria was achieved in this quarter. Third, we recovered $4.8 million from customers related to previously reserved bad debt. Lastly, we released $3.3 million in tax reserves following the finalization of certain foreign tax returns for prior years, and our tax rate was reduced for export sales from the U.S. Turning back to our non-GAAP results. Q4 gross margin was 14%, down 150 basis points year-on-year and 370 basis points quarter-on-quarter. As you've likely heard from other market participants, commodity costs have been volatile. Gross margin was impacted by commodity costs, COVID-related costs, and customer mix in that order of magnitude. Turning to operating expenses. Q4 OpEx on a GAAP basis decreased 3% quarter-on-quarter to $114 million. On a non-GAAP basis, operating expenses increased 5% quarter-on-quarter and year-on-year to $91 million. The sequential increase in non-GAAP operating expenses was primarily due to the absence of $9.5 million in R&D credits the previous quarter. General and administrative also benefited from the aforementioned debt recovery. Other income and expense was a $0.7 million loss as compared to a $0.9 million gain last quarter related to the foreign exchange remeasurement of our Taiwan-dollar-denominated loans. This quarter, our taxes were a $7 million benefit on a GAAP basis and a $2 million benefit on a non-GAAP basis. In both cases, we benefited from our new tax structure and settlement on a tax audit, as highlighted in the discrete items mentioned earlier. Lastly, our joint venture contributed income of $3.5 million this quarter as compared to a $1.1 million loss in the previous quarter and income of $0.9 million in the same quarter a year ago. Q4 non-GAAP earnings per share totaled $0.68 per diluted share compared to $0.84 last quarter and $0.69 last year. Cash used from operations totaled $96 million as we paid out $26 million related to the one-time employee bonuses. And our accounts receivable was up $71 million sequentially on increased sales. Timing factors contributed to the large use of cash in Q4, and we currently expect cash flow from operations to improve in Q1. Capital expenditures totaled $9 million, resulting in free cash outflow of $105 million. Our closing balance sheet cash position, which excludes restricted cash, was $211 million. This quarter, our cash conversion cycle was 87 days, down from 92 days last quarter and within our target range of 85 to 90 days. Days sales outstanding was 37 days. Days payables outstanding totaled 52 days, and inventory days was 101. Now turning to the outlook for our business. The company expects net sales for the quarter ending September 30, 2020, in the range of $720 million to $800 million. In addition to typically somewhat weaker seasonal trends, we are cautious, given significant economic uncertainty. We expect gross margins to improve roughly 70 to 125 basis points sequentially as commodity cost pressures abate. With regard to operating expense, the $4.8 million debt recovery will not repeat, and we expect sequential increases in compensation, product development, and the completion of our year-end audit. We expect audit costs to revert to normal levels in the December quarter. We anticipate the GAAP and non-GAAP tax rate to be 18% for the year. We expect GAAP earnings per share of $0.03 to $0.27 and non-GAAP earnings per share of $0.10 to $0.35, both on a diluted basis. Our management team is focused on guiding our company through the continuing challenges presented by COVID-19. Although we're unable to predict the extent to which COVID-19 may further impact our business operations, financial performance, and results of operations, we believe we're well-positioned financially and strategically as we continue to serve our customers. Finally, as Charles mentioned earlier, we currently announced that our Board of Directors has authorized the company to repurchase up to $30 million of its common stock in a new share repurchase program. The program is effective until December 31, 2020, or until the authorized funds are exhausted under a 10b5-1 plan. With this small step, we are signaling to investors that we are committed to creating shareholder value with an efficient use of capital.

James Kisner, Vice President, Investor Relations

Thank you, Kevin. Operator, we're now ready to open the queue for questions.

Operator, Conference Operator

Your first question comes from Aaron Rakers from Wells Fargo.

Aaron Rakers, Analyst

Yes. Maybe the first question, if you can just talk a little bit about the demand environment. There's been a lot of discussion out there about kind of the cloud, the Internet data center, large data center customers going through some level of a digestion phase. So I'm curious what your insight is in terms of the demand profile there that you're seeing into the current quarter and whether or not you have any kind of indicators of a digestion phase materializing and any extent in terms of how material that might be or how long that could last?

Charles Liang, Chairman and CEO

Yes. Very good question. We did see a large data center, especially those social networking, those streaming even gaming large data centers have a strong demand during this COVID-19 period, especially. And we have most focus on the other side, enterprise channel. So that kind of increased demand, indeed, that did not help us a lot in June. But likewise, now we are extending our operation and business to Taiwan. Hopefully, our costs will decrease. So we will be able to participate more aggressively in those large data centers and cloud. And I believe this business may not be seen for another few quarters probably.

Kevin Bauer, CFO

Yes. Aaron, I can augment that by describing a little bit of what we're seeing in the current quarter. So I think evidence that would align with what you're hearing from other parties is that as we entered into July, we definitely saw that our customers were taking a pause after having a strong June. And so I think as opposed to last quarter's comments, where I said we started off strong, and let's see where we go; this quarter, we're seeing a pause in July, yet currently now, we're starting to see an order flow pickup. So we hope that, that is a good turn to our July results. So a little bit different topology as compared to last quarter.

Aaron Rakers, Analyst

Okay. That's helpful. And then you talked a little bit, I think in your prepared remarks, about kind of significant component cost headwinds, but it sounds like those might be abating here as we move into this current quarter. Can you help us understand or appreciate how you're kind of seeing component cost trends into this current quarter and kind of how much of that 70 to 100 basis point improvement in gross margin might be assumed from component cost dynamics?

Kevin Bauer, CFO

Sure. I think what we're seeing is that you got a little bit heated with component costs, and things are moderating a little bit. For us, Aaron, it takes time for us to digest inventories that we have on hand. And we believe that towards the end of the quarter, we'll be able to see some moderation in component costs. I think that's a fair portion of what we described in terms of our expectations for Xeon improvement. Other things that we continue to battle are the momentary high costs of logistics and freight. As we kind of mentioned earlier, it was tough in the last quarter. It kind of loosened up in June. It was looser in July and seems to be tightening up a little bit. But beyond that, what we've done is we've looked at some of our components that we bring from Asia to look at what are those that we can start shipping by sea. It might take a little bit more in terms of inventory holding, but it's definitely worth it when it comes to some components like motherboards and those kind of things, we can afford to do by sea. So we're kind of managing that. And hopefully, we'll have some improvement in that arena as well.

Aaron Rakers, Analyst

Okay. Very helpful. And then a final quick question. There's a lot of discussion out there about Intel timing, and I know it might be longer term in nature around the cadence of their product cycles. But any thoughts that you guys might offer in terms of how the cadence of Intel's moves product-cycle-wise, 10-nanometer, 7-nanometer affects your kind of outlook and appreciating that's probably a longer-term question.

Charles Liang, Chairman and CEO

Yes. I mean, Intel, as you know, they postponed their 10-nanometer and also the coming 7-nanometer technology. So that did impact some to us. However, we also grow AMD product line very aggressively. So overall, there are some impacts for our maybe September quarter. But long term, we should be able to adjust efficiently.

Kevin Bauer, CFO

Yes. Aaron, that's one of the considerations as we look forward when I said that product development costs may increase a little bit is that now we have to think about multiple platforms, given the dynamics of Intel's timing and pushing the pedal to the metal a little bit more on alternate processors.

Operator, Conference Operator

Your next question comes from the line of Ananda Baruah from Loop Capital.

Ananda Baruah, Analyst

A few, if I could, Charles and Kevin. Kevin, to start, just a point of clarification. When you were talking about sort of seeing a pause in July after June and now seeing order flow pick up, was that your enterprise and channel business? Or was that the hyperscale public cloud business?

Kevin Bauer, CFO

I believe we are observing this across several areas, not just in hyperscale, but likely in more traditional sectors.

Ananda Baruah, Analyst

Great to hear that there has been a pickup. I was curious about the linearity of the slowing and it seems that was primarily a July issue. Could you provide any insights on how we should consider seasonality leading into December? I realize it may be unclear right now, but any information for our modeling would be appreciated.

Kevin Bauer, CFO

Yes. That's a little bit hard to call right now. I believe that we all are hoping that things return to normal a little bit and that we have some seasonality certainly in December and maybe a little bit better than normal. I don't know, Charles, do you have anything to augment that?

Charles Liang, Chairman and CEO

Yes. I mean September traditionally is our soft quarter. And December, we had 20% higher than September in history. So this year, I believe we will have some impact like that, although coronavirus is impacting us, but we are doing what's possible to adjust our workload. We will feel December will be a much stronger quarter, yes. That will be still the case.

Ananda Baruah, Analyst

Really helpful. Regarding cost optimization, you mentioned the shift of production to Taiwan and the acceleration of your online business. Could you explain the various initiatives that will assist in optimizing the cost base? Additionally, can you provide some insight into the timing of when you may start to see benefits from these optimization efforts?

Charles Liang, Chairman and CEO

Yes. I mean, since about 9 months ago or even 12 months ago, we started to grow in Taiwan aggressively, including engineering, the operation, and even sales, even customer service. So that transition will be up now, especially for coronavirus. As you may know, the coronavirus impact in Taiwan is much less than the United States. So we are moving to Taiwan for cost reasons and for COVID-19 impact reasons as well. And the result is gradually helping us. I would like to say that December quarter, it will have more next year, for sure, will be much more efficient. And it's kind of mid-term and long-term investment, but December quarter we will see some help. As to our online business, it's basically a complementary business to help our customers to get support, especially spare parts or when they need a mobile system, they can order from online. That system we have been preparing for many years. And now it is getting very mature. So we start to small-scale business the last few quarters. And then we will have a formal official release very soon.

Ananda Baruah, Analyst

That's very helpful, Charles. I really appreciate it. Let me ask one more question about your 5G initiatives. You've mentioned a couple of times during the call that you're observing progress in the public cloud area. Could you provide some context regarding what you're currently seeing and experiencing in both your 5G and public cloud initiatives? I understand, Kevin, that it's been a bit of a stop-and-start situation. However, I would like to get a clearer picture of the progress you've made. Do you believe these initiatives could have an impact in the December quarter if things align for you?

Charles Liang, Chairman and CEO

Good. Thank you for the question. Yes, we start to focus on 5G, Telco about 12 months ago. And now we already engaged a handful of good-sized customers. And they are very happy and very convinced with our product. So we see some production, some volume moving since last quarter. And those volumes will ramp up in this quarter and December quarter and especially for next year. With our operation, growing in Taiwan aggressively now, we soon will be able to ship really high-volume products from Taiwan operations. And that's why it's mature for us to start servicing large-sized cloud and data center. We already are working with a couple of those potential customers. And the response, again, so far, has been very commendable. So we will continue to push those opportunities.

Operator, Conference Operator

Your next question comes from Nehal Chokshi from Northland Capital Markets.

Nehal Chokshi, Analyst

All right. Really nice June Q results, by the way. To me, significant narrative of the investment theme here is what you guys have been talking about returning to our heritage of gaining market share. So within that investment theme, can you characterize how you think you did in the June quarter? And what is embedded in your September quarter in terms of market share trajectory?

Charles Liang, Chairman and CEO

Yes. Last quarter, I began to share that we engaged in another three-year business initiative focused on a large 5G telecommunications company, a significant data center and cloud sector, as well as software, AI, and service. We have seen healthy growth across all three new drivers. For 5G telecommunications, we have already engaged several customers. In the large cloud segment, we have also made customer connections. Additionally, in software AI and service, we continue to achieve high customer satisfaction, which encourages us to further promote services to our existing global customers. We anticipate that the feedback will positively impact our business plan.

Nehal Chokshi, Analyst

Okay. And then for September quarter, do you expect that outperformance to continue, and that's what's embedded in your guidance, and therefore, you're actually expecting the overall market to be down as much as 15% year-over-year?

Charles Liang, Chairman and CEO

To be very direct, I mean, we just moved a lot of business to Taiwan, especially operations. And September, the impacts, the advantages from that should be limited. December, I would like to say, will be much more significant. And then next year, we're sure we will see a lot of benefit from that. It will take some time to warm up.

Nehal Chokshi, Analyst

Yes, understood. Kevin, you mentioned some additional detail about order trends being relatively weak in July. Would it be accurate to say that it was actually down more than 10% year-over-year during that month?

Kevin Bauer, CFO

Well, I'm not going to give a specific number like that, but July was one where it was certainly a weak month. And so we're glad that we've seen the trajectory turn here. So all of that is embedded in terms of the revenue range that we've given.

Nehal Chokshi, Analyst

Okay. And why was there a lack of the $9.5 million R&D credit? Can you give more detail on that? And how should we think about going forward?

Kevin Bauer, CFO

Yes. So last quarter, if you recall, we had a significant one-time event where we received $9.5 million from a partner for the cancellation of a program. That's all we're just saying. It was a discrete of significant magnitude last quarter.

Operator, Conference Operator

And there are no further questions at this time. I'll turn the call back over to our presenters for some closing remarks.

Charles Liang, Chairman and CEO

Thank you. I would like to thank you, our employees, customers, and investors for their continued support. And thank you for joining us today and see you next quarter. Thank you.

Operator, Conference Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.