Sphere 3D Corp. (ANY) Q3 2016 Earnings Report, Transcript and Summary

Good afternoon. My name is Kiersten. And I will be your conference operator today. At this time, I’d like to welcome everyone to the Sphere 3D Third Quarter 2016 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. [Operator Instructions] Thank you. Lauren Sloane, Investor Relations with Sphere 3D, you may begin your conference.

Thank you, operator, and good afternoon, everyone. And thank you for joining Sphere 3D’s earnings conference call for the third quarter of fiscal year 2016. With me on the call today are Eric Kelly, Chairman and Chief Executive Officer; Kurt Kalbfleisch, our Chief Financial Officer; and Peter Tassiopoulos, our Vice Chairman and President. Prior to the call we distributed our Q3 earnings release over the wire service and we had posted it on our website at investors.sphere3d.com. This call is also being webcast and a replay will be available on the Investor Relations section of our website for 30 days. Before we begin, I would like to remind you that during today’s call we will be make forward-looking statements regarding future events and expectations. We caution you that such statements reflect our judgment as of today, November 14, based on factors that are currently known to us, and that our actual future events and results could differ materially due to a number of factors, many of which are beyond our control. For a more detailed discussion of the risks and uncertainties affecting our future results, we refer you to our filings with the SEC including the Form 6-K we filed earlier today which contains our Q3 fiscal year 2016 financial results. Sphere 3D disclaims any obligation to update or revise these forward-looking statements to reflect future events or circumstances. During the call, we will also discuss non-GAAP financial measures. Unless we specifically state otherwise non-revenue financial measures we will discuss today are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the GAAP and non-GAAP results is provided in today’s press release and is posted on the Investor Relations section of our website. With that, I’ll turn the call over to Eric. Please go ahead.

Thank you, Lauren. Good afternoon, everyone, and thank you for joining us today. In addition to discussing our third quarter results, we plan to provide an overview of our customer engagements and partnerships, as well as an update on our four initiatives we discussed at our September annual shareholder’s meeting. Those four initiatives were: one, to continue operational efficiency improvement, that will result in a minimum $4 million additional annual savings; two, we discuss a non-binding expression of interest for the purchase of certain corporate assets; three, our discussions with a number of financial institutions to access additional capital; and four, the progress of large scale agreements and partnerships, which if it’s executed would significantly scale the business. First, we are delivering on our operational efficiency objective. As of last quarter, excluding the non-cash impairment charge, we have reduced operation expenses by more than $1 million compared to the previous quarter. We expect to see additional operational efficiency beginning in 2017. This gives us confidence that we are on-track to exceed to $4 million in annual savings discussed at this year’s annual shareholder’s meeting. Second, as we also noted in September, we have received a non-binding expression of interest for the purchase of certain assets. We are continuing to evaluate this and other options to maximize shareholder value and we will update you on this front as appropriate. Third, I would like to share with you an update on our financing activities. We have signed a term sheet with a large credit institution for a $25 million financing. We are able to structure this financing to support our corporate goals and future growth with a minimal dilutive impact to our shareholders. The term sheet contains a number of customary conditions including the entry of definitive documentation by the parties. And we will announce the additional details as this is appropriate. And fourth, we continue to see strong demand for both our hardware and software products. And we are in late-stage negotiations with several large scale agreements and partnerships, which if concluded would significantly increase the scale of our business, and allow us to increase the focus of the virtualization and storage businesses. Some recent positive indicators to the strong demand are: one, we have recently signed a term sheet that we expect will expand the virtualization portion of our business by more than $6 million annually starting early 2017; and two, for the nine-month period ending September 30, 2016, our disk systems business has grown by over 22% to $35.1 million from $28.7 million for the same nine-month period last year in 2015. Now moving on to our third quarter financial performance, third quarter revenue came in at $18.5 million. Our third quarter revenue is typically down from the previous quarter due to the historical seasonality we see in our European regions. So when I compare with the same quarter revenue of the previous year, European revenue increased by 2%. And our overall revenue was only slightly down by 1.6%. We believe the primary impact came from the merger activities from one of our OEM partners. In fact, we are already seeing positive traction from the same OEM partner this quarter as they have already exceeded 95% of their shipments in Q3. Kurt will provide you with more details on our third quarter numbers later in the call. However, now I would like to hand it over to Peter to provide more detail on some of the exciting new developments and progress we have continued to make in our virtualization business. Peter?

Thanks, Eric. Welcome, everyone, to our third quarter call and thank you for joining. As you know, we’ve had a few bumps along the way this year, but we’re continuing to make progress on quite a few areas of the company. We continue to deepen our strategic partnership with companies like NVIDIA, VMWare and Microsoft, as our way to generate and build the pipeline of virtualization opportunities and sales. Quick examples includes our work with VMWare, we’ve hosted a global webinar targeting an elite and qualified group of 1,100 IT customers and partners and evangelists that VMWare calls vExperts. VMWare vExpert program is VMWare’s exclusive global evangelism and advocacy program. vExperts apply and then are appointed by VMWare each year based on their level of engagement and contribution to the VMWare knowledge and technical communities. Our webinar to vExperts featured an introduction and overview of our distributed desktop hyperconverged V3 solutions. Over 700 of the vExperts registered for the webinar with over a third of them attending live and the others reviewing the recordings online and afterwards. vExperts in attendance represented countries from all over the world. We’ve also been actively working with our partners in other targeted marketing and outreach campaigns. Last quarter, both NVIDIA and VMWare sponsored lead-generation campaigns, promoting our virtualization products. We also did some focused demand generation efforts of our own at both the VMworld tradeshow held this summer in Las Vegas, and in partnership with Tech Data at the Microsoft World Partner Conference in Toronto. As for Microsoft, I’ll give an update on progress in a moment. As we have expanded on during previous calls, our V3 virtual desktop infrastructure point strategy continues to include multiple phases that include proof-of-concepts or POCs. Last quarter, we had two of our V3 proof-of-concept trials turn into follow-on orders that are now in full production, and we continue to expand on existing POCs and bringing new opportunities. We’ve also kept our focus on recruiting and on-boarding additional lead program partners. The additional lead partners will allow us to increase our virtualization pipeline reach and provide additional support for our sales efforts. Lastly, we expect to see a decent increase in virtualization revenue on completion of the agreement that Eric mentioned earlier. Now a bit about Glassware and Microsoft, our most recent progress with Microsoft includes an elevated status to now be part of what they call Managed ISV Program, where we are one of a small handful of select accounts in the U.S., I believe less than 10 actually. As such, we now have a dedicated Microsoft account management team that is charged to help us grow our business in the Microsoft Azure cloud. With this expansion of our relationship, Microsoft is funding marketing and lead-generation campaigns that start later this month that will target outreach to millions of IT partners and end-users to promote our Glassware containerization solutions deployed in the Microsoft Azure cloud, as well as provide access to Microsoft sales team, sales engineers and solution architects to help us close the business. I would also like to give you an update on some recent Glassware 2.0 activities, as you may recall from our previous earnings call in August, we highlighted that co-hosted the Glassware 2.0 launch event at one of our premier UK-based channel partners. That event which focused primarily on the capability of Glassware to extend the life of 16-bit and 32-bit windows applications has already resulted in a completed and successful proof-of-concept with a UK-based corporation that has listed on the FTSE 100 Index. For those that are not familiar with the FTSE, it’s a share index of the 100 companies listed in the London Stock Exchange with the highest market capitalization. We’re now moving on to the next phase by providing them a production environment. We continue to work on a number of other opportunities in similar fashion including opportunities in retail, healthcare and MSP located in North American Europe and to see additional successful POCs turning to larger production-scale implementations. Taking a fair bit of time and we invested heavily in foundational work to create the right environment for success, we believe that these positive lead indicators in our virtualization business confirm that our strategy to deliver one unified and vertically integrated offering that converges our virtualization storage technology allowed us to deliver a differentiated value proposition to our partners and customers and that will translate into success. With that, I’d like to hand it up to Kurt to go through the financials. Kurt?

Thank you, Peter. Good afternoon, everyone. Let me provide some detail on our financial results for the third quarter. Please note the following financial highlights reflect the addition of the RDX products acquired in August 2015. Total revenue for the third quarter of 2016 was $18.5 million compared to $19.6 million in the second quarter 2016 and $18.8 million in the third quarter of 2015. OEM revenue for the third quarter of 2016 was $3.2 million compared to $3.6 million in the preceding quarter and up from $3 million in the third quarter of 2015. We believe our OEM revenue which was abnormally impacted due to merger activity of one of our major OEM partners. We have already seen recovery in the fourth quarter, and as of today shipments of this customer in Q4 have already exceeded 95% of the entire Q3 shipments. Branded product revenue was $13.3 million for the third quarter of 2016 compared to $13.9 million in the second quarter of 2016, and up from $13.1 million in the same quarter last year. The reduction is related to lower sales in the EMEA region due to expected seasonality. Regionally, the branded product revenue for the third quarter of 2016 was 16% in APAC, 26% in the Americas, and 58% in EMEA. Warranty and service revenue was $2 million for the third quarter of 2016 compared to $2.1 million in the second quarter of 2016, and down from $2.7 million in the third quarter of 2015. Total product revenue for the third quarter was $16.5 million compared to $17.5 million in the preceding quarter and up from $16.1 million in the same quarter last year. Disk systems revenue was $11.1 million in the third quarter of 2016 compared to $11.8 million in the second quarter of 2016, and up from $10.1 million in the same quarter last year. Tape automation, tape drive and other related revenue was $5.4 million in the third quarter of 2016, down from to $5.7 million in the second quarter of 2016, and down from $6 million in the third quarter of 2015. Our gross margin in the third quarter of 2016 was 28% compared to 29.6% in the second quarter of 2016, and 29.2% in the third quarter of 2015. The gross margin includes the amortization of intangible assets and cost of goods sold and the amount of approximately $600,000 for each of the comparable quarters in 2016 and approximately $700,000 for the third quarter of 2015. When excluding the amortization relating to the intangible assets, the gross margin was 31.1% in the third quarter of 2016 compared to 32.6% in the second quarter of 2016, and 33% in the third quarter of 2015. Total operating expenses for the third quarter of 2016 when excluding share-based compensation, and impairment of goodwill and acquired intangible assets were $10.7 million compared to $11.8 million for the second quarter of 2016 and $11.9 million for the same quarter last year. When compared to the third quarter of 2015, operating expenses excluding share-based compensation and impairment of goodwill and acquired intangible assets were down $1.2 million or 10.1%. We expect to hold expenses steady in Q4 of 2016 and see additional reductions in the beginning of 2017. An impairment charge of $34.4 million was recorded in third quarter of 2016. We tested carrying value of goodwill and intangible assets for impairment on annual basis and during the interim period if an event occurs that we warrant impairment testing. During the third quarter, as a result of declining market capitalization driven by our lower share price, it was determined that carrying value exceeded its estimated fair value. This is a non-cash charge to the income statement. Depreciation and amortization expense in third quarter of 2016 was $1.5 million compared to $1.6 million in the second quarter of 2016, and $1.8 million in the third quarter of 2015. The net loss for the third quarter of 2016, including $34.4 million for impairment of goodwill and acquired intangible assets was $43.3 million or a loss of $0.84 per share, compared to a loss of $9.6 million or $0.19 per share for second quarter of 2016 and net loss in the third quarter of 2015 of $10.2 million or $0.26 per share. Adjusted EBITDA, which excludes share-based compensation expense, impairment, warrant revaluation gain and acquisition costs, in addition to interest taxes and depreciation and amortization, was negative $4 million for the third quarter compared to an adjusted EBITDA of negative $4.6 million in the second quarter of 2016 and the third quarter of 2015. The decrease in the loss during the third quarter of 2016 was largely due to the decrease in operating expenses. On the balance sheet, total cash and cash equivalents at September 30 was $5 million compared to $8.7 million at December 2015. Cash used in operations was reduced $1.8 million during the third quarter, down from $8.6 million in the second quarter of 2016, and down from $3.7 million in the third quarter of 2015. At September 30, we had $18.2 million outstanding under our third-party debt, $24.5 million outstanding under our related third-party convertible note and $2.5 million outstanding under our related party term loan. With that, I will turn the call back over to the operator.

[Operator Instructions] Your first question comes from the line of Hubert Mak from Cormark Securities. Your line is open.

Hey, guys.

Hey, Hubert, how are you doing?

Good. I guess, the first question really how is the - looks like you guys are - have some early evidence of our conversion on some of these deals here. Can you give us a little bit more color in terms of how do we see that throughout Q4 and to next year like is this sort of starting of some of these deals coming through or - and specifically what type of solution? Is this like integrated solutions or this is a specifically like virtualization products?

Yes, Hubert, this is Eric. If you look at some of the kind of the deals that we highlighted as across the board, some of them are virtualization which includes our Glassware and V3, and a number of them are complete suite of products. And so, it’s really exciting to see the proof points come to fruition where you actually have your virtualization platforms and your storage platforms integrated together. But we’ve seen it from our storage platforms as some of the larger opportunities, the combination, and then also virtualization, so it’s across the board. And it’s really interesting when you talk to the customers, because they may start at one product line today, but knowing that they’re going to expand to the next product line down the road. For example, someone may be looking for a virtualization platform, but knowing that integrated storage is going to be part of their solution months down the road, so it’s across the board. And I think as Peter highlighted, we’ve gotten some exciting opportunities just from the launch that we did in Europe this summer in July. So we’ve started expanding not just throughout North America, but we now started launching the business in Europe as well. And as we’ve mentioned, we’ve already gone from a proof-of-concept with a very large organization all the way now we’re into production. So pretty excited that the customers are seeing the full suite of products as one of the big benefits to working with us.

Okay, and a follow-up here on the $25 million, I guess, financing here.

Yes.

I guess, I didn’t hear in your preamble. But what is the thought behind this debt financing? Is this to repay existing debt or is this an additional on top of like another facility that you’re looking to utilize for working capital purposes?

It will be both, Hubert. It will be some additional capital to fund some of our growth initiatives, but also to pay down some of the debt that we have as well. And I don’t know, Kurt, if you want to add to that or…?

No, we haven’t specifically given out the breakout, Hubert. But Eric is 100% correct in his description. It will work in both, but there will be additional working capital that is coming out of the facility.

Okay, great. I’ll pass the line.

At this time, I would like to turn the call back over to Eric Kelly for closing remarks.

Well, thank you operator and thank you everyone for joining us today to discuss our strategic business initiatives, as well as our third quarter results. I must say that we’re very excited about the expansion of the partnerships that we have developed and how they’re now developing, the new customer engagements that we have now had, not just here in North America but now starting throughout Europe, and the $25 million financing that we have just signed the term sheet for. So when you look at all of that, we’re pretty excited about this is going to be - has its poise for a very fast start in 2017. So we look forward to updating each of you on these initiatives as they unfold. And again, thank you for joining us today.

This concludes today’s conference call. You may now disconnect.