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DOT HILL SYSTEMS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement for Forward-Looking Information Certain statements contained in this quarterly report on Form 10-Q, including statements regarding the development, growth and expansion of our business, our intent, belief or current expectations, primarily with respect to our future operating performance and the products we expect to offer, and other statements regarding matters that are not historical facts, are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and are subject to the "safe harbor" created by these sections. Because such forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, actual results may differ materially from those expressed or implied by such forward-looking statements. Some of the factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements can be found in Part II, Item 1A, "Risk Factors" and in our reports filed with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the year ended December 31, 2013. Readers are cautioned not to place undue reliance on forward-looking statements. The forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update such statements to reflect events that occur or circumstances that exist after the date on which they are made. The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included in the preceding pages in this quarterly report on Form 10-Q and our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013. Overview We design, manufacture and market a range of software and hardware storage systems for the entry and mid-range storage markets. We focus on selling through Server-based original equipment manufacturers (OEMs), such as HP, Dell Inc. or Dell, Lenovo Group Limited, or Lenovo, Advanced Micro Devices, Inc., or AMD, and Stratus Technologies, or Stratus; as well as into Vertical Markets through embedded solution OEMs, such as Teradata Corporation or Teradata, CGG Veritas or CGG, Motorola, Inc. or Motorola, Tektronix Inc. or Tektronix, Samsung Electronics or Samsung, Concurrent Computer Corporation or Concurrent, Autodesk Inc. or Autodesk, Imagine Communications and Nokia Siemens Network or Nokia Siemens, which primarily include media and entertainment, telecommunications, high performance computing, digital image archive, big data and oil and gas. Our Vertical Market customers are OEMs, who embed our products into their solutions, as well as resellers. Typical customers for our storage systems products, which include our AssuredSAN line of storage array products, include organizations requiring high reliability, high performance networked or direct attached storage and data management solutions in an open systems architecture. Most of our sales through our Server OEMs go into the IT infrastructure of companies and organizations to support a wide variety of internal applications, including email, Enterprise Resource and Planning, retail transactions and voicemail. On the other hand, much of our product sales into Vertical Markets support the revenue streams of embedded solution partners' end-user customers, such as the central office infrastructure of telco providers, video editing and streaming appliances, and big data analytics solutions. Our storage solutions consist of integrated hardware, firmware and software products employing a modular system that allows end-users to add various protocol, performance, capacity or data protection schemes as needed. Our broad range of products, from small capacity direct attached to complete multi-hundred terabyte, or TB, storage area networks, or SANs, provide end-users with a cost-effective means of addressing increasing storage demands at compelling price-performance points. Our current product family based on our AssuredSAN architecture provides high performance and large disk array capacities for a broad variety of environments, employing Fibre Channel, Internet Small Computer Systems Interface, or iSCSI or Serial Attached SCSI, or SAS, interconnects to switches and/or hosts. In addition, our Assured family of data protection software products provides additional layers of data protection options to complement our line of storage disk arrays. Our current mainstream AssuredSAN(TM) family of entry-level and mid-range storage products and Just a Bunch of Disks, or JBOD, arrays are targeted primarily at mainstream enterprise and small-to-medium business, or SMB, applications. Some of our AssuredSAN products have been distinguished by certification as Network Equipment Building System, or NEBS, Level 3 (a telecommunications standard for equipment used in central offices) and are MIL-STD-810F (a military standard created by the U.S. government) compliant based on their ruggedness and reliability. Our products span Price Bands 2 through 5 as defined by International Data Corporation. Our AssuredSAN 3000 Series product addresses the entry-level market (bands 2 and 3) and AssuredSAN 4000 and Pro 5000 Series products address the mid-range market (bands 4 and 5). AssuredSAN Pro 5000 Series products include RealStorTM software that incorporates autonomic real-time data tiering via a virtualized back-end. With RealStor, businesses gain the advantage of using very high 16-------------------------------------------------------------------------------- Table of Contents performance Solid State Drives (SSDs) to their maximum benefit, while storing less frequently accessed data on larger and much less expensive hard disk drives (HDDs). Our AssuredSAN 3000 Series product is typically, but not exclusively, sold through our Server OEM partners and AssuredSAN 4000 and Pro 5000 Series are typically, but not exclusively, sold through our Vertical Market partners. Our agreements with our customers do not contain any minimum purchase commitments and may be terminated at any time upon notice from the applicable customer. Our ability to achieve and maintain profitability will depend on, among other things, the level and mix of orders we actually receive from such customers, the actual amounts we spend on marketing support, the actual amounts we spend for inventory support and incremental internal investment to develop or enhance our products, our ability to reduce product cost, our product lead time, our ability to meet delivery schedules required by our customers and the economic environment. Our products and services are sold worldwide to facilitate server and SAN storage implementations, primarily through Server OEMs, Vertical Markets partners that include embedded solution OEMs that integrate our products into their solutions, and value-added resellers, or VARs. Our storage system products' Server OEM partners currently include, among others, HP, Lenovo and Stratus, who purchase our AssuredSAN products, and Dell and AMD, who purchase our AssuredVRA products. Our Vertical Markets partners include Teradata, CGG, Motorola, Tektronix, Samsung, Concurrent, Autodesk, Imagine Communications and Nokia Siemens. Although our products and services are sold worldwide, the majority of our net revenue is derived from our U.S. operations. We began shipping products to HP in the fourth quarter of 2007. Our products are primarily sold as HP's MSA 2000/P2000 product family. The agreement with HP does not contain any minimum purchase commitments. In October 2011, we extended our supply agreement with HP by five years to expire in October 2016 and also extended the expiration of 1.6 million warrants granted to HP in March 2008 to expire concurrently with the supply agreement in October 2016. Net revenue from HP approximated 55% and 52% of our total net revenue for the three and nine months ended September 30, 2014 compared to net revenue from HP of approximately 58% and 56% of our total net revenue for the three and nine months ended September 30, 2013. We expect sales to HP to continue to decline as a percentage of total revenue, but we still anticipate it to represent a substantial percentage of our total net revenue in 2014. The demand for our products has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following: • our ability to maintain and enhance relationships with our Server OEM and Vertical Markets customers, as well as our ability to win new business; • our ability to source critical components such as integrated circuits, hard disk drives, memory and other components on a timely basis; • the amount of field failures resulting in product replacements or recalls; • our ability to launch new products in accordance with OEM specifications, schedules and milestones; • our ability to sell Dot Hill branded products through resellers; • our ability to win new Server OEM and Vertical Markets customers who embed our products into their solutions; • general economic and political conditions and specific conditions in the markets we address, including the continuing volatility in the technology sector, current general economic volatility and trends in the data storage markets in various geographic regions; • the timing, rescheduling or cancellation of significant customer orders and our ability, as well as the ability of our customers, to manage inventory; • our customer's product launch timelines and sales cycle; and • the inability of certain of our customers who depend on credit to have access to their traditional sources of credit to finance the purchase of products from us, particularly in the current global economic environment, which may lead them to reduce their level of purchases or to seek credit or other accommodations from us. For these and other reasons, our net revenue and results of operations for the three and nine months ended September 30, 2014 and prior periods may not necessarily be indicative of future net revenue and results of operations. Our manufacturing strategy includes outsourcing substantially all of our manufacturing to third-party manufacturers in order to reduce sales cycle times and manufacturing infrastructure, enhance working capital and improve margins by taking advantage of the third parties' manufacturing and procurement economies of scale. In September 2008, we entered into a manufacturing agreement with Foxconn Technology Group, or Foxconn. Under the terms of the agreement, Foxconn supplies us with manufacturing, assembly and test services from its facilities in China and final integration services including final assembly, testing and configure-to-order services through its worldwide facilities. In November 2011, we amended our 17-------------------------------------------------------------------------------- Table of Contents agreement with Foxconn to extend the manufacturing agreement for a period of three years and are currently in negotiations to extend our contract. In addition, Foxconn agreed to waive the requirement for a letter of credit and improved our payment terms. The majority of our products sold in 2013 and to date in 2014 were manufactured by Foxconn. We expect Foxconn to manufacture substantially all of our products throughout 2014. Critical Accounting Policies and Estimates An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the unaudited condensed consolidated financial statements. Management believes that there have been no significant changes during the three and nine months ended September 30, 2014 to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, except for the addition of the contingent liabilities and research and development and capitalized software development costs policies. Refer to Note 1, Summary of Significant Accounting Policies, of the Notes to Unaudited Condensed Consolidated Financial Statements. Results of Operations The following table sets forth certain items from our statements of operations as a percentage of net revenue for the periods indicated (percentages may not recalculate due to rounding): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 NET REVENUE 100.0 % 100.0 % 100.0 % 100.0 % COST OF GOODS SOLD 67.9 67.5 67.3 67.5 GROSS PROFIT 32.1 32.5 32.7 32.5 OPERATING EXPENSES: Research and development 17.1 18.3 18.0 19.1 Sales and marketing 6.7 6.8 6.6 7.2 General and administrative 4.8 7.4 5.7 6.5 Total operating expenses 28.6 32.5 30.3 32.8 OPERATING INCOME (LOSS) 3.5 0.0 2.4 (0.3 ) Other income (expense), net (0.0 ) (0.0 ) (0.0 ) (0.0 ) INCOME (LOSS) BEFORE INCOME TAXES AND DISCONTINUED OPERATIONS 3.5 0.0 2.4 (0.3 ) INCOME TAX EXPENSE 0.2 0.1 0.1 0.1 INCOME (LOSS) FROM CONTINUING OPERATIONS 3.3 (0.1 ) 2.3 (0.4 ) LOSS FROM DISCONTINUED OPERATIONS (0.0 ) - (0.3 ) - NET INCOME (LOSS) 3.3 % (0.1 )% 2.0 % (0.4 )% 18-------------------------------------------------------------------------------- Table of Contents Three and Nine Months Ended September 30, 2013 Compared to the Three and Nine Months Ended September 30, 2014 Net Revenue Three Months Ended September 30, 2013 2014 Increase/(Decrease) % Change (in thousands, except percentages) Net revenue: Server OEM $ 35,126 $ 31,643 $ (3,483 ) (9.9 )% Vertical Markets 17,477 20,478 3,001 17.2 % Consolidated net revenue $ 52,603 $ 52,121 $ (482 ) (0.9 )% The decrease in Server OEM net revenue was due to a $1.7 million decrease in revenue from HP from $30.5 million for the three months ended September 30, 2013 to $28.8 million for the three months ended September 30, 2014, along with a decrease of $1.8 million in sales to various other Server OEM customers. Sales to HP approximated 58% of our net revenue for the three months ended September 30, 2013 compared to 55% of our net revenue for the three months ended September 30, 2014. The increase in Vertical Markets net revenue was due to an increase of $7.0 million that was primarily due to a ramp in sales to existing Vertical Markets OEM customers. This increase was partially offset by a $4.0 million decrease in revenue from Tektronix from $6.6 million for the three months ended September 30, 2013 to $2.6 million for the three months ended September 30, 2014. Sales to Tektronix approximated 13% of our net revenue for the three months ended September 30, 2013 compared to 5% of our net revenue for the three months ended September 30, 2014. Revenues to Tektronix can fluctuate quarter to quarter based on the nature of its business model. |