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Sphere 3D’s (ANY) CEO Eric Kelly on Q2 2017 Results – Earnings Call Transcript

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Sphere 3D Corp. (NASDAQ:ANY)

Q2 2017 Earnings Conference Call

August 14, 2017 5:00 pm ET

Executives

Lauren Sloane – IR, The Blueshirt Group

Eric Kelly – Chairman and CEO

Peter Tassiopoulos – Vice Chairman and President

Kurt L. Kalbfleisch – CFO

Analysts

Hubert Mak – Cormark Securities

Operator

Good afternoon. My name is Mike and I will be your conference operator today. At this time, I would like to welcome everyone to the Sphere 3D Second Quarter Fiscal Year 2017 Earnings Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] Thank you.

I will now turn the call over to Lauren Sloane, Investor Relations for Sphere 3D. You may begin your conference.

Lauren Sloane

Thank you, operator, and good afternoon everyone and thank you for joining Sphere 3D’s earnings conference call for the second quarter of fiscal year 2017. 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 Q2 earnings release over the wire service and we have posted it on our Web-site at investors.sphere3d.com. This call is also being Webcast and a replay will be available on the Investor Relations section of our Web-site for 30 days.

Before we begin, I would like to remind you that during today’s call, we will be making forward-looking statements regarding future events and expectations. We caution you that such statements reflect our judgment as of today, August 14, based on factors that are currently known to us and that 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 which we will file later today, which contains our Q2 fiscal year 2017 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, the 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 Web-site.

With that, I will turn the call over to Eric. Please go ahead.

Eric Kelly

Thank you, Lauren, and thank you everyone for joining our second quarter 2017 earnings call. Today we will be discussing the significant progress we have made in the first five months after the HVE/UCX acquisition, and highlighting key updates made during the quarter, our strategic initiatives to unlock shareholder value, the equity capital raise we just announced, and provide a summary of our financial results. Kurt will be discussing financial details for the quarter and the first half of the year, and Peter will provide an overview of our progress in both our virtualization and storage businesses.

The HVE acquisition had [indiscernible] both in terms of revenue and pipeline growth, the integration of our core technologies into their product lines, and leveraging the Sphere 3D partner network and infrastructure. First, let me discuss the revenue growth. When we announced the acquisition in January of this year, we stated that the 2016 estimated non-GAAP revenue was over $7 million. Since the completion of the acquisition, the first five months GAAP revenue from the HVE/UCX acquisition was over $4.8 million, which puts us on a run rate to exceed $11 million in annualized revenue and represents more than a 50% growth over the previously disclosed non-GAAP revenue for 2016.

We have made significant progress in the integration of the collective core technologies, such as Glassware, DCO, also called Desktop Cloud Orchestrator, and our Guardian OS, our software defined storage operating system. These technologies will be included in our next-generation products and will be introduced throughout the remainder of this year, allowing us to continue to be a technology leader and enabling us to continue our focus on addressing many of the fastest growing sectors in our industry, such as converged infrastructure market which is growing over 45% per year, the enterprise flash storage market which is growing over 27% per year, and the hybrid cloud market which is growing over 22% per year.

I would also like to review some key highlights from our financial results. Net revenue for the six months ending June 30, 2017 was $41.2 million, compared to $39.2 million for the six months ending June 30, 2016. With the success of the acquisition in January, we expect this momentum to continue through the second half of the year. And despite the normal seasonality we typically see in Europe in the third quarter, our business for the month of July has been strong, showing a 28.4% higher revenue number compared to our revenue in April of Q2. This is one of many positive indicators which give us confidence for the second half of this year.

As I indicated earlier, the positive traction from our HVE acquisition, which is evident in what is trending to be more than 50% revenue growth from the acquisition when compared to what they achieved in 2016, we see HVE/UCX as one of our core assets and we plan to remain focused on building on recent growth success and the integration of our collective core technologies. As we look ahead, we have made tremendous progress already and have a strong pipeline of customers and new partners.

We also continued to make improvements in our operating efficiencies in both the second quarter and the first half of the year, evident by a greater than 40% improvement in our adjusted EBITDA for the second quarter and a 53% improvement for the first six months of this year, when compared to the adjusted EBITDA in the comparable periods in 2016. Kurt will provide the detailed results for the quarter and for the first six months during his overview, but I wanted to highlight these key results as a backdrop to emphasize the positive strategic progress we are making.

We are also excited about our engagement with Ernst & Young Capital Advisors to assist us in reviewing ways to increase shareholder value. As we announced in our recent press release, we have hired E&Y as our exclusive financial advisor to review strategic alternatives. They were the leading financial and business advisors in the United States, with a team of investment banking professionals that have advised on, structured and executed hundreds of M&A and financial transactions for private and public companies. They bring a deep industry-specific knowledge and an extensive network of relationships around the world.

Turning now to our capital structure, we announced this morning that we completed a $3 million equity private placement at a price of $5 per share. We believe the terms of this reflect investor sentiment regarding the value of the Company.

I will now turn over to Peter who will give you more details on the recent successes with our strategic partners, product launches, and customer wins. Peter?

Peter Tassiopoulos

Thanks, Eric. From a high level, we see our HVE virtualization team continue to be a momentum driver for the Company. As we had initially envisioned, the HVE brand is bringing increased attention to our broader Sphere 3D product portfolio as it gains traction in the market. Since the acquisition earlier this year, the entire organization has had a reenergized focus on our virtualization products and we have seen tremendous progress leveraging our technology and building key channel partners, both domestically and internationally.

Just recently, we received our first HVE order in Europe and have opportunities in a number of countries outside the United States. We are steadily expanding the HVE team’s reach by launching into the global Overland-Tandberg channel network while ensuring that we maintain the high levels of quality in customer service that the HVE brand is known for.

As we look to new vertical markets, we are also focused on our existing verticals, with continuing success especially within education. Our HVE team continues to grow our position in the education vertical, winning contracts with multiple institutions this past quarter. We recently announced that we have been awarded a contract valued at over $0.5 million to support technology initiatives for a school district in Oklahoma.

And additionally, we have been awarded a contract with the University of North Alabama to deploy next-gen desktop virtualization solutions. The University of North Alabama’s technology staff went through an eight-month process to evaluate multiple vendors and ultimately chose HVE as it provides one of the most robust, cost-effective and proven solutions to meet these requirements.

This is just a further example of how the HVE product offering excels when it finds itself in a competitive process. And this, along with others, is one of the many reasons why the introduction of the HVE product portfolio into the channel is being received very well.

We are actively integrating our other Sphere 3D technologies, like the Guardian operating system that runs our SnapServer product line, Glassware in a virtual appliance format, and a number of the V3 technologies including DCO, into the HVE platforms and expect to see a number of these integrated products coming to market throughout the second half of this year.

As an example, I’d like to highlight the recent HVE and Overland-Tandberg storage technology integrations that we have completed. Just last week we announced the availability of our SnapServer Hybrid and All Flash Array solutions as a continuation in the SnapServer brand’s tradition of providing rock-solid performance for thousands of organizations of all sizes. The SnapServer All Flash solution has shown a 300% increase in performance over spinning disk and additional updates on performance improvements are planned for later this quarter.

Earlier this summer, we announced the release of our new HVE appliances supporting non-volatile memory express or NVMe technology. These NVMe enabled appliances allow for 3x the drive read/write performance when compared to Flash-only platforms. These recent investments and subsequent launches of next-gen NVMe and SSD technologies gives us access to the storage and converged infrastructure market segments that are growing rapidly as IT performance, reliability, and security requirements continue to grow exponentially.

In addition to our successes in securing new customers in our target vertical markets like education and health care, I’m also pleased with our partnership progress. I’m excited to share with you today that we were named Partner of the Year by multi-billion dollar IT infrastructure vendor, Huawei, for a joint effort in building an HVE converged infrastructure platform. Our HVE team has now won this award two years in a row with the recent one being granted to us earlier this year at the Annual Huawei Americas Partner Summit.

The key elements of our partnership allow us the opportunity to leverage while we serve our complete technologies and integrate with our storage, virtualization and network products to develop an unmatched complete data center experience, with a combination of software-defined data center, hyperconverged and converged architectures.

Another partnership milestone that we recently announced was that our HVE lines obtained Datrium Ready node classification. Led by founders and architects from VMware and Data Domain, Datrium is considered the leader in open convergence for private clouds. Datrium DVX and HVE’s Datrium Ready node bundles offers a single open converged infrastructure platform for high-performance primary application workloads and a cost-effective secondary storage workload, all at a fraction of the cost and effort of traditional infrastructure alternatives. We have already had several successful Datrium Ready HVE deployments and have a pipeline of opportunities that the joint Datrium and HVE sales team are pursuing.

Lastly, from a partnership perspective, we continue to work with VMware and Microsoft and leverage our multiple agreements with each of these technology giants. Look for more information on some of the new products we’ve been working on to be released at VMworld later this month.

On the Glassware front, we have a virtual appliance that encapsulates all the elements required to run Glassware inside a virtual machine ready to go. It has allowed us to quickly integrate into the HVE platform, have a Microsoft Azure stacked offering ready for release this year, and deliver Glassware from other public clouds. More importantly, it gives us the ability to provide a simple turnkey offering to existing customers that have deployed virtual infrastructure. All in all, this [indiscernible] reduce sales cycle and an easier path to deployment.

In addition, on the Glassware front, we recently announced that APPtechnology, headquartered in the U.K., launched a new offering to manage and migrate legacy applications utilizing Glassware 2.0 and its framework features. The offering is aptly named ‘Legacy’ and primarily focuses on migration of legacy applications, what are pretty much anything that is pre-Windows 10 by all accounts. This was an exciting step for us that came after prolonged validation with our partner. In fact, some of the applications they’ve used Glassware for can be seen on their Web-site and some of their product videos. The opportunity to work with them is exciting for us as we believe it can help expand brand awareness in Europe and can now introduce Glassware to a number of Tier 1 organizations that have already relied on APPtechnology to manage their application migrations in the past.

And finally, I think this has been an exciting first half of 2017. Our execution on productizing many of the technology innovations is moving very quickly. The addition of the HVE team coupled with the fantastic engineering talent we already possess has led to the commercialization of a number of our technologies at an even faster pace than we could have hoped for, and has given everyone a renewed sense of optimism for what we can do moving forward. I personally am very excited about the technology and commercialization roadmap, the new releases we have planned, and most importantly, the ability to architect, implement and support customers that wish to deploy them.

With that, I’ll turn it over to Kurt to review the financials. Kurt?

Kurt L. Kalbfleisch

Thank you, Peter. Good afternoon, everyone. Let me provide some detail on our financial results for the second quarter and first half of 2017. Please note the following financial highlights include results of the HVE/UCX acquisition on January 27, 2017.

Total revenue for the second quarter of 2017 was $19.4 million, compared to $21.7 million in the first quarter of 2017 and $19.6 million in the second quarter of 2016. OEM revenue was $3.4 million in each of the first and second quarters of 2017, compared to $3.6 million in the second quarter of 2016.

Branded product revenue was $13.7 million in the second quarter of 2017, compared to $16 million in the preceding quarter and $13.9 million in the second quarter of 2016. Regionally, the branded product revenue for the second quarter of 2017 was 16% in APAC, 34% in Americas and 50% in EMEA. Warranty and service revenue was $2.3 million in each of the first and second quarters of 2017, up from $2.1 million in the second quarter of 2016.

Total product revenue for the second quarter of 2017 was $17.1 million, compared to $19.4 million in the preceding quarter and $17.5 million in the same quarter last year. Disk systems revenue was $11.5 million in the second quarter of 2017, compared to $15 million in the preceding quarter and $11.8 million in the same quarter last year. Tape automation, tape drive, and other related revenue was $5.6 million in the second quarter of 2017, up from $4.4 million in the first quarter of 2017 and compared to $5.7 million in the second quarter of 2016.

Our gross margin for the second quarter of 2017 was 27.7%, compared to 31.4% in the first quarter of 2017 and 29.6% in the second quarter of 2016. Gross margin includes the amortization of intangible assets and cost of goods sold in the amount of approximately $600,000 for each of the quarters. When excluding the amortization related to the intangible assets, the gross margin was 30.6% in the second quarter of 2017 compared to 34% in the first quarter and 32.6% in the second quarter of 2016. Please see today’s press release for a reconciliation of this non-GAAP gross margin to GAAP gross margin.

Total operating expenses for the second quarter of 2017 when excluding share-based compensation were $10.1 million, up slightly from $9.5 million in the first quarter of 2017 and down from $11.8 million in the second quarter of last year. When compared to the second quarter of 2016, operating expenses excluding share-based compensation have been reduced by 14%. Depreciation and amortization expense was $1.5 million in each of the first two quarters of 2017, compared to $1.6 million in the second quarter of 2016.

Net loss for the second quarter of 2017 was $7.5 million or a loss of $1.81 per share. This compares to a loss of $7.8 million or $2.50 per share for the first quarter of 2017 and a net loss in the second quarter of 2016 of $9.6 million or $4.86 per share. All per share information is reported with consideration for the 1-to-25 reverse split that occurred on July 11, 2017.

Adjusted EBITDA, which excludes share-based compensation expense, warrant revaluation gain, acquisition cost, and loss on revaluation of investment, in addition to interest, taxes, depreciation and amortization, was negative $2.6 million in the second quarter of 2017 compared to an adjusted EBITDA of negative $966,000 in the first quarter of 2017 and improved from a negative $4.6 million in the second quarter of 2016.

Turning to the results of the first half of the year, total revenue for the first half of 2017 was $41.2 million, up from $39.2 million compared to the first half of 2016. OEM revenue for the first half of 2017 was $6.7 million, down from $7.6 million for the first half of 2016. And branded product revenue was $29.8 million for the first half of 2017, up from $27.2 million in the first half of 2016. Warranty and service revenue was $4.6 million in the first half of 2017, compared to $4.4 million in the first half of 2016.

Total product revenue for the first half of 2017 was $36.5 million, up from $34.8 million in the first half of 2016. Disk systems revenue was $26.5 million for the first half of 2017, up from $24 million for the first half of 2016. Tape automation, tape drive and other related revenue was $10 million in the first half of 2017 compared to $10.8 million in the first half of 2016.

Our gross margin for the first half of 2017 was 29.7%, compared to 30% in the first half of 2016. When excluding the amortization related to the intangible assets, gross margin was 32.4% in the first half of 2017 compared to 33% in the first half of 2016.

Total operating expenses for the first half of 2017, excluding share-based compensation, were $19.6 million, reduced by 15% from $23.1 million for the first half of 2016.

The net loss for the first half of 2017 was $15.3 million, or a net loss of $4.22 per share, compared to a net loss of $17.7 million or $9.29 per share in the first half of 2016. Adjusted EBITDA for the first half of 2017 was a negative $3.6 million, an improvement of over 50% from a negative $7.6 million in the first half of 2016.

On the balance sheet, total cash and cash equivalents at June 30, 2017 was $3.3 million, compared to $5.1 million at December 31, 2016. Cash used in operations was $3.1 million during the second quarter of 2017, compared to $4 million in the first quarter of 2017 and $8.6 million in the second quarter of 2016. Cash used in operations was $7.1 million for the first half of 2017, reduced from $13.8 million for the first half of 2016.

At June 30, 2017, we had $18.2 million outstanding under our third-party debt, $24.5 million outstanding under our related-party convertible note, and $1.3 million outstanding under our related-party term loan.

With that, I will turn the call back over to Eric.

Eric Kelly

Thank you, Kurt. I am pleased with the milestones we have achieved over the first half of the year and this quarter, and I am excited by the traction we have begun to see with the revenue contribution from HVE/UCX over the first half of this year as well as the HVE virtualization and Overland-Tandberg storage technology integrated roadmap advancement. We will continue to execute on our strategy for growth while maintaining our focus on improving operating efficiencies to ensure long-term stability for our Company.

With that, I would like to turn the call over to the operator.

Question-and-Answer Session

Operator

[Operator Instructions] We have a question from the line of Hubert Mak from Cormark Securities. Your line is open.

Hubert Mak

I guess the question I have is really on the pipeline. Obviously you are calling out a number of initiatives here for growth. So, will you sort of be able to circle in on maybe to one or two top growth drivers that you see over the near-term? And how that will reaccelerate revenue growth here heading in the back half, because I’m trying to understand sort of in the context of the revenue growth like your expense ticked up as well it looks like in the quarter, or at least adjusted EBITDA came in negative here, so I’m just trying to think of how you think about the profitability here going forward as well?

Eric Kelly

I think we tried to highlight that. Let me kind of just – I mean there is a couple of growth drivers. One is, as we highlighted, the HVE/UCX acquisition, and the traction that we are getting with them as we integrate them into our current network of partners. So, you look at the combination of those two, between the size of the deals they are able to put together, they are in a very fast growing market, anywhere from 29%-plus to 45%-plus growth market, and then being able to introduce them to our channel partner that we have had traditionally. I think Peter highlighted a couple of those, both here in the U.S. as well as those throughout Europe.

So, we are continuing to accelerate their introduction into our current partners. And one of the things we didn’t highlight was we also have a pretty large installed base that we are able to go back into, to be able to accelerate some of the growth on the back end of the quarter, or the back end of the year.

Hubert Mak

And are you able to sort of give us an idea of what kind of growth we’re going to see here in the back half on these growth drivers?

Eric Kelly

I mean kind of what we highlighted for HVE is over 50% growth this year compared to what they did in 2016. So, we have some pretty significant momentum that’s taken off since the acquisition in January and we see that continuing. But if you just kind of look at the $4.8 million that we did in the first five months and you just kind of just extrapolate that over a 12 month period, that’s over 50% growth rate. And we still see some momentum coming from other initiatives that we have in place. So, we are pretty excited about that and it also helps us broaden our portfolio as we talk to our customers. So, it brings on both of our HVE technology as well as our storage product line as well. And Peter, I don’t know if you want to add to that.

Peter Tassiopoulos

I’ll comment a bit, Hubert, to the second half of your question. So, this was the first full quarter with the entire HVE team, which had a slight bump-up in the OpEx, but that was slightly offset by some of the other reductions that we did. But I wouldn’t take that as a trend moving forward. That was just taking into the fact that the guys were on – and the entire HVE acquisition was there for a full quarter versus a partial quarter. So that attributes to some of the bump that you saw in the OpEx. Does that make any sense?

Hubert Mak

Yes. Okay, and just lastly, just to clarify on that point then, in terms of the expense, sort of your operating cash expense, do we expect that sort of at least stay at this level here for sort of at least over the next year, or do you think that [indiscernible]?

Eric Kelly

That one is for Kurt. Kurt?

Kurt L. Kalbfleisch

We expect to be able to maintain and improve on the cash expense. You can see the significant reduction in the cash used in operations we were able to achieve first half of this year versus first half of last, and we expect to be able to maintain and continue to reduce that over the last part of this year and then moving strongly into next calendar year.

Operator

Okay, thank you.

Operator

That was our last question. At this time, I will turn the call back over to Eric Kelly for closing remarks.

Eric Kelly

Thank you, operator, and I want to thank everyone for joining our second quarter 2017 earnings call. We look forward to give everyone an update on our Q3 results in November. With that, operator, that should end the call.

Operator

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

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