Kim Edwards: Good afternoon. This is Kim Edwards. Welcome to our 3rd quarter '97 analyst phone conference. Today I'll start off with a summary of the highlights of the 3rd quarter and then turn it over to Len, our CFO, who is going to provide a little more detail.
[Ed. -- Usual disclaimer here regarding not breaking out disk tie ratios and Safe Harbor language on forward looking statements]
OK. Let me hit the highlights and then provide you with a brief overview of what happened this quarter. Third Quarter sales were a record 432 million, up 39% from a year ago. Net income was up 135% to a record 30 million or 22 cents a share. Gross margin increased to 32% versus 26% a year ago. Cash flow was 33 million dollars positive; backlog was 379 million up from 183 million last quarter; Zip drive unit volume was about 26% over the 2nd quarter and this was about the same percentage increase we experienced in the 2nd quarter over the 1st. Jaz drive unit volume was flat compared to the 2nd quarter, but disk sales were very strong, coming off the disk recall in the 2nd quarter. OEM Zip drives were up more than 60% (I said six zero percent) over the 2nd quarter and represented just over 35% of total Zip drives shipped. And this was quite an encore performance for our OEM team following Q2 when OEM units were up about 60% over Q1. Today we announce that we shipped 9 million Zip drives in just over 2 1/2 years since our first shipment in March of '95. So with that let me provide some commentary.
As we stated from the introduction of Zip, we are committed to achieving a retail price of $99 for the external Zip drive to expand the size of the available market and in fact starting at the end of September, some retailers began running the external Zip drive on special for 99 bucks. In fact, CompUSA and Best Buy offered it [at] $99 after $50 and $30 store rebate, respectively. This occurred a couple of weekends ago, and both accounts reported excellent sell through.
We are now shipping ZipPlus and expect to ship the 15mm notebook Zip drive in November. These key product extensions represent two more steps in our progress toward becoming the next standard in removable storage. And in addition, if you attend Comdex, you have a chance to see the working prototypes of the 12.7 or the half inch notebook drives in our booth.
As part of our PC OEM effort, tune in to our TV ad for the "Zip Built In" starting November 17th and running through Thanksgiving and then for another 2 weeks early in December. It will appear in the top 7 markets by PC use on some of the top rated shows including NYPD Blue, Mad About You, Seinfeld and Frasier.
In Q3 we introduced Jaz 2GB, the two gigabyte version of Jaz which can read and write 1 gigabyte disks from our Jaz 1 gigabyte product. This means that the Jaz 2GB is compatible with the installed base of over 1 million Jaz 1 gigabyte drives. And as was stated in the press release we expect to ship Jaz 2GB this quarter.
Issues found in our compatibility testing have resulted in postponing Buz until 1998. You may recall in last quarter's conference call, I mentioned I view this as a tactical product, but we did want to bring you up to speed on where we stand on it in this call.
In tape we expect to start shipping the internal DittoMax, our next generation 7 gigabyte tape drive later this month, and we expect to ship DittoMax Pro, our 10 gigabyte solution in November. Both of those capacities are compressed capacities.
We are continuing our R&D efforts on n-hand and as many of you know that we use an interactive development process that intimately involves the customers in our product development and design. And in the case of n-hand since first showing at Comdex 1996 we made significant changes to the drive based on feedback from both OEMs and our end users; and our new drive will be center stage at Comdex.
We are continuing our focus in building our world class management team as evidenced by our addition of Frank Forsythe as President of our Professional Products Division. There, Frank is responsible, of course, for our Jaz business. He joins us from Apple where he was Senior Vice President and General Manager of the Power Macintosh group and previously was responsible for worldwide operations.
We are also pleased to have added two new members to our Board of Directors: Dr. David A. Duke, former Vice Chairman of Corning and Jim Sierk Senior Vice President of Quality and Productivity for Allied Signal, bring very relevant experience. As examples, David has experienced rapid growth in the technology business when he was responsible for Corning's optical fiber business. And Jim spent most of his career in Operations at Xerox, a company very well known for quality, training and innovation, and is now responsible for Allied Signal's quality initiative, supply chain management and technical and customer excellence.
Now we need to touch on a very distasteful subject: its called disk piracy. We have continued to aggressively pursue the protection of our intellectual property and as part of this, we have had an independent laboratory test our disks and Nomai's knockoffs in a controlled blind fashion. Ours worked as expected. However, the findings were that Nomai disks were not 100% compatible as claimed; the knockoff disks performed poorly in our drop test and failed to adequately protect the recording media from contamination. Moreover, the independent lab concluded that the knockoffs had the potential to cause permanent damage to the recording heads. Our own tests show that the media used in the knockoff disks does not meet own quality specifications. In addition to the protection of our intellectual property rights, we are very concerned about our customers using these disks and losing data or permanently damaging their drive.
Our patent infringement case against SyQuest is progressing with a trial date of January 1999 already set by the judge.
Let me take a few more minutes now to provide some of the financial comments relative to our 3rd quarter performance. First, let me provide you with some insight into the backlog situation. Our backlog grew to 379 million at the end of Q3, which is substantially higher than the record 183 million reported at the end of Q2. As we mentioned in July, we have been constrained by a chip shortage and have given priority to the OEMs over retail. Accordingly, since much of the 26% increase in Zip drive shipments were lower priced OEM drives, our revenue did not go up proportionately and our retail backlog grew even larger. Additionally, sell through has remained very strong for Zip and Jaz. So once again, we started and ended the quarter with lower than desired retail inventories even though we shipped 26% more Zip drives.
As we mentioned last quarter, we believe that some of the 379 million in backlog is due to customers placing orders that are higher than their actual needs. We were very pleased with the 3rd quarter net income results; however, our backlog is evidence of continuing constraints on revenue. In Q3 we experienced constraints caused by parts availability due to the chip constraint that I mentioned in last conference call, and supplier quality problems. Additionally, transitioning OEMs from the IDE Zip drive to the ATAPI drive placed a significant strain on resources, balancing components and our production. Let me comment on these three issues that is, chip availability, parts quality and the ATAPI transition.
First I'll address the chip availability and the ATAPI transition issues since they are interrelated. During the third quarter we transitioned several of the major Zip PC OEMs to the higher yield, lower cost Zip OEM ATAPI drive and we are now shipping it in high volume. The drive contains a new higher level of integration and therefore does not rely on the chip that contributed to our Q2 constraints. Since the new chip is more readily available the transition has eased most of the chip availability issue and has improved our yields. We are also beyond the startup stage of production on the ATAPI drive. However, we will continue to ship the internal IDE drive to some OEMs into the first quarter of 1998 simply due to their qualifications cycles. To sum it up, transitioning some of our major PC OEMs to the ATAPI drive has freed up the IDE design chips, plus we have been successful in getting the IDE design chips earlier than previously committed by our chip supplier so the overall situation has improved considerably.
The second issue. During the third quarter we temporarily shut down Zip and Jaz production as a result of component quality problems, primarily related to plastic and metal parts. We addressed the issues inside the quarter and believe that we have fixed the known problems. In fact, we shipped a record number of Zip and Jaz drives in September and continue at the higher level of production as we entered into the 4th quarter. As an added measure we have our own employees at several vendors to ensure that the suppliers make and we receive good quality parts.
As you can tell from our results and the size of our backlog, demand remains very strong. We have taken multiple actions on multiple fronts to meet it. We will continue to give priority to our OEM customers. And although it is not an indicator of the quarter's performance, we have started the 4th quarter with continued strong sell-through and production at about the level of our internal plan. Looking back at the third quarter, I am very pleased with our financial results. The team managed to sell a record 432 million, earn a record 30 million or 22 cents a share, be cash flow positive by 33 million and take another big step toward our goal of becoming the removable storage standard by increasing OEM Zip shipments by more than 60% over the last quarter.
With that let me turn the call over to Len to provide you with financial details and then we will give you a chance to ask your questions.
Len Purkis: OK. Revenues are up 39% over third quarter '96 to 432 million dollars. All three geographic areas experienced year over year growth with Americas up 25% to 287 million, Europe up 114% to 108 million and Pacific up 25% to 37 million. Our global growth continues with international sales representing 34% of 3rd quarter '97 revenue, up from 26% in 3rd quarter '96. In fact the last 4 quarters international revenue now exceed half a billion dollars. The revenue growth over 2nd quarter '97 was 8% with Europe basically flat in its seasonal low period and the Pacific down 19% with growth over 2nd quarter '97 coming from the Americas which was up sixteen percent. By product group, Zip and Jaz are up 51% to 406 million dollars and Ditto is down 20% at 26 million dollars versus 3rd quarter '96. Ditto continues to be weak across all regions but the nine months of '97 is slightly ahead of 1996 same period. Our gross margin of 140 million dollars is up 72% over 3rd quarter '96 and represents 32.5 % of revenue versus 26.3% in 3rd quarter '96. The 2nd quarter '97 margin percent was 29.4%. Gross margin dollars are up 19% on revenue growth of 8% versus 2nd quarter '97. Comparing 3rd quarter '97 with 2nd quarter of '97 we saw Zip gross margin percent as relatively flat. Within the quarter we executed per our operating model. Zip gross margins were positively impacted due to higher disk volumes and lower drive costs which enabled pricing actions to be implemented and further penetration of our OEM unit sales to over 35% of total Zip drive sales, up from about 30% last quarter.
Jaz gross margins were higher with [?] pricing offset by lower drive costs and higher Jaz disk sales. The higher tie rate in Jaz is partially a catch-up from the impact of the 2nd quarter '97 Jaz disk recall. Therefore the catch-up on the Jaz disks in the 3rd quarter and the Jaz drive cost reductions were the primary drivers behind the increase in overall gross margins from 2nd quarter '97 to 3rd quarter '97.
Advancement in operating expenses continues. SG&A increased slightly from 16.2% last year to 16.8% and is up 12 million dollars over last quarter. This $12 million increase was driven by increased marketing spending and by headcount additions, predominately in the sales and marketing functions worldwide. R&D at 23 million dollars is up more than twice 3rd quarter '96 and represents 5.2% of revenue, up from 3.4% in 3rd quarter '96. Spending increased 6 million dollars from 2nd quarter '97 when it represented 4.3% of revenue. Overall operating expenses were 22.1% of revenue in 3rd quarter '97 versus 19.6% in 3rd quarter '96 with the increase driven by our R&D expense level growth.
Operating income of 45 million dollars or 2 1/2% of revenue is more than double 3rd quarter '96 of 21 million dollars and represented 6.7% of revenues. Quarter 3 year over year net income is up by 135% on revenue growth of 39%. This quarter's net income of $30 million and EPS of $0.22 compared to $12.8 million and $0.09 per share same quarter last year.
We were cash flow positive in the 3rd quarter of '97 by 33 million dollars. For the year to date '97 we were 105 million dollars cash flow positive and this is the 4th quarter in a row that we are cash flow positive.
Strong collections performance -- inventory receipts and liabilities -- positively impacted our cash performance. We ended the quarter with 166 million dollars in cash and a $200 million revolver that is completely unutilized.
Nine-month results reflect continued operating leverage. Revenues for the 9 months of 1.2 billion are up 46% and close to total year 1996. Margin dollars are up 68% and net income of 79 million dollars or 58 cents EPS is up 114% over same period 1996 and is greater than total year net income for 1996. In fact the 9 month 1997 net income of 79 million is greater than the total of the last three fiscal years together.
Our balance sheet continues to be closely controlled. DSOs (days sales outstanding) of 55 days improved from 57 days in 3rd quarter '96, inventory turns of 6.2 turns improved from 5.1 turns in 3rd quarter '96. Debt to equity of 13% improved from 34% in 3rd quarter '96 and finally, we have cash resources totally more than 360 million dollars to fund future growth.
Kim Edwards: With that operator let's open it up for questions.
Todd Bakar (H & Q): Thank you. Congratulations Kim. A few questions. First of all, the backlog level up significantly. Can you give us some flavor on how much of the backlog is OEM versus retail?
Kim Edwards: OK Todd. I don't want to break it out on absolute terms, but as I mentioned, a large piece of this is....there is OEM content in there, however a large piece of it is retail and not only that the sell through is strong but we shipped OEM drives in Q3 at the expense of retail, even increasing it higher.
Todd Bakar: On the operating expenses were up a little more than I expected. Can you maybe give us some sort of flavor on what the trends are looking forward in terms of Op Ex [operating expenses] which I think were something like 22% combined.
Kim Edwards: Yeah, I think the biggest impact was really the sales and marketing and it's really in preparation for the advertising during late September and into Q4. I mentioned earlier on the call that we've got a TV ad running in November. A lot of that expense by the way... excuse me, I shouldn't say a "lot of it"... Some of that gets caught in the prior quarter, in other words 3rd quarter, even though the ad runs in 4th because of when we expense some of the items. So there is a mixture of 4th quarter advertising even back into 3rd quarter. Another issue is that with Comdex coming up we also incur some of the November Comdex expenses in Q3.
Todd Bakar: Is it safe to assume that the Q4 levels might remain up near Q3 levels and then come back down early next year?
Kim Edwards: Its definitely safe to assume that they will remain up in Q4. We've not finalized our '98 plans for advertising particularly as you see us put more and more effort on the Built In Zip ad campaign.
Todd Bakar: The shutdown that you alluded to, both for Zip and Jaz, can you tell us how long the shutdown was in place?
Kim Edwards: Let me first clarify. There were two separate shutdowns for two different parts: one relative to Jaz, one relative to Zip. Normally, I suspect that a lot of companies wouldn't even bring it up, but I think in the context of our backlog continuing to build, I thought it was relevant. The period of time in the case of Jaz was close to three weeks; in the case of Zip...I want to say in total it was probably a week...a week and a half kind of impact.
Todd Bakar: Do you feel comfortable that both issues have been overcome now?
Kim Edwards: Yeah. We believe we've got them behind us. As I mentioned we think we solved them inside the quarter which is what allowed us to have such a good production month, a shipping month, in September. So we had a strong September and we've entered the 4th quarter at similar rates to the strong September.
Todd Bakar: Just two more questions. Jaz flat unit-wise quarter-to-quarter, can you tell us why... Anything going on there that we should know about?
Kim Edwards: Well, I'd say the biggest thing was shutting the line down for 3 weeks. That's a heck a lot of the quarter right there.
Todd Bakar: Last question. On the OEM front, can you give us.. I think last quarter you talked who the top five OEMs were. Have those changed at all? And do you see.... As you make the OEM push particularly now with this advertising campaign as well...are you seeing the OEMs broadening their penetration of their own systems with the Zip drive?
Kim Edwards: No question about it, Todd. The other thing we're seeing is it going beyond even the big names into to these almost tertiary users at this point. You know there's a lot of Ma and Pa outfits out there building 10,000 PCs a year that are now incorporating Zip into it. Now I don't mean that's significant relative to the volume. I think it's significant in terms of the acceptance of the product in broad terms. Let me get back to the first part of your question or comment. Apple, Dell, Gateway, Micron and Compaq remain the top 5 PC OEMs in 3rd quarter.
Todd Bakar: OK, I won't take up any more. Thank you.
Kim Edwards: Thanks for your comments, Todd.
Tom Cowen (Soundview Financial): Hi guys, nice quarter. I was wondering if you would discuss your strategy or what you allege in your patent infringement lawsuit against Nomai, and could you take us to where the status of the courts are. I know the French court put something out in June and has that court spoken since then? Have you heard back from the German court on their reasons for lifting the injunction? And what should we expect there going forward? And if you could take a worse case scenario and if Nomai is successful in defending itself what type of impact would you think they would have on your... I imagine most of it would be... on your gross margin line.
Kim Edwards: OK. First of all, thank you for your congratulations but let me get to your questions in sort of in reverse order. I don't see it important speculating on any scenario with Nomai because we fully intend to vigorously enforce our intellectual property rights. Believe me we are not intending to give up here. On the subject of the strategy I think that many of you might imagine on the call here...you know... we're embroiled with litigation against with what we consider a major competitor and it would be very inappropriate for me to comment on our specific plans, 'cause we have no intention of tipping our hand to them. Now let me give you some specifics in terms of the status on this litigation and let me first start in France and then comment in Germany. On September 26th we were granted permission by the District Court in Paris to file what is called an "early fixed date hearing summons". In our summons, which was filed and announced in our press release on September 30th, we are seeking permanent injunctive relief and damages based on Nomai XHD disk introduced by Nomai in France during September. Our claims will be heard on an expedited basis on November 28th in Paris. In a separate complaint, also filed on September 30th, we claim Nomai has infringed our pending European patents and that proceeding will be relatively inactive until our patents issue in Europe. That's where we are with Nomai in France and we will continue to vigorously enforce our intellectual properties on that front. But now let me comment on Germany... Give me a second please...
Tom Cowen: Could you comment on when the court decides... I know the court did something in June....did the court do anything since June?
Kim Edwards: Let me comment on the German thing here. The Hanover court ruled that Nomai's copying of the Iomega Zip cartridge did not amount to unfair competition under Germany's unfair competition statute with respect to Nomai's alleged exploitation of Iomega confidential information. The court ruled that since Nomai offered an oral undertaking in Court to not distribute any disk based on an exploitation of a confidentiality breach, Iomega could simply enforce that undertaking. The court said that any violation of the undertaking by Nomai would be subject to fine. We believe that these rulings and a number of other findings by the court were in error and should be reversed by an appellate court and we have filed our notice of appeal, in fact, on October 15th. So that's sort of the sum and substance of the French situation and the German court situation.
Tom Cowen: OK, thank you.
Kim Edwards: You're welcome.
Patrick Manning (Bentley Capital Management): Good quarter guys, congratulations.
Kim Edwards: Thank you, Patrick.
Patrick Manning: What's the situation here with the gross margins; its very impressive sequential uptick and I assume a lot of it is driven by the tie ratios on the Jaz. So, should we expect a downtick and of what magnitude in the 4th quarter. Also maybe you could talk about how the chip integration of the ATAPI drive is likely to play into that... and if there is going to be any pricing action there in the 4th quarter?
Kim Edwards: OK. Let me sort of answer it in reverse starting with chip integration in the ATAPI drive. The ATAPI drive is definitely lower cost for us. You know that was the reason we went to that level of integration as well as the compatibility. But, again also it is lower cost. It also gives you higher yields which, of course, also effect costs too. As I mentioned on the OEM side, we have been ramping that drive throughout Q3, which had a positive impact on OEM drive cost overall and the better that mix ... the more we ship of the ATAPI drive the better the cost will be. Now in addition to that, if you look at the Zip product line margin in total... in other words, OEM, retail, disks and drives... it was relatively flat Q3 over Q2, that is gross margin percent. The biggest impact on gross margin in Q3 and accounted for virtually all of the increase was that from the Jaz product offering, in other words drives and disks combined. Jaz drive costs went down and we had a very rich mix of disks. Now, let's qualify... when we look... you know we had a recall in Q2 of Jaz disks and that effected our ability to get Jaz disks out in Q2. We think effectively what happened in Q3 is that we caught up. And in fact over that 6-month period our disk tie ratios were about running what they've been in the past.
Glenn Hannick (Needham & Co.): Hi. Great quarter, guys.
Kim Edwards: Thanks, Glenn.
Glenn Hannick: Could you talk a little bit about the MAP restrictions with retailers and how you get to the $99 price... just sort of walk us through what the changes have been with your arrangements with the retailers so that now we can get to this $99 price, and what implications that has for the retailers in managing their own business.
Kim Edwards: Yeah...hey, you know, first of all let me... for those of you on the call that don't recognize the term "MAP". What "MAP" stands for is "minimum advertised price". And what this allows us to do is effect the advertised price of any product that we sell. I say the "advertised". Inside a store a customer can sell it for anything they please. But what occurs here is, if they agree to advertise at a particular price level, we provide them funds, market development funds, for doing so. If they don't advertise the minimum advertised price, they won't get those funds. So, the retailer is strongly encouraged through getting additional profits to stay on MAP. We took Zip, the original aftermarket Zip drive, off of MAP in the 4th quarter. And, in fact, what that allowed the retailers to do was to sell it for anything they pleased, but probably even more importantly for them, advertise it at anything they pleased. ZipPlus, however, has been held on MAP, and the Zip disks are on MAP. Now the impact of all that to us is, when we take something off of MAP there is no price change to us, but the retailer now can advertise, as CompUSA and Best Buy have done, $99 Zip drives, or if they want, you know, whatever price they please, because they no longer get the what we call "behind the line" dollars, the market development funds, if you will. So what MAP is really intended to do is ensure that the retailers make profits and, in fact, we believe that at this point the original Zip is mature enough that it was time to take it off MAP. And as we had expected it doing so, we have seen $99 Zip drive prices and we suspect that you'll see them again during the Christmas quarter. Glenn, did that answer your question?
John Dean (Salomon Brothers): [Dean didn't respond so they moved on]
Mike Rappoport (Race Bolker?): Good afternoon and thanks for the continued execution and for hosting us over in Penang. The question is, can you give us some detail as to the attach rate, particularly at the direct PC OEMs and how that might have changed over the last couple of quarters?
Kim Edwards: Mike, as I said at the beginning, we don't provide the tie ratios. However, we have told everyone from the very beginning that we expect the attach rates for OEM drives to be less than the attach rates for an aftermarket product and, in fact, we have stated it's a total 2-to-1 kind of difference at the offset. I think it's really simple. When someone goes out to buy a blue external Zip drive, they bought it for the specific intent of using an external Zip drive. In the case of a PC, they might have just bought a PC that had a Zip drive in it or they may have bought one intentionally to get a Zip drive. But it could be either case.
Mike Rappoport: Right. What I actually wanted to know is, let's say the PC OEM -- how many of their boxes have your drive attached rather than the disk attachment rate?
Kim Edwards: Quite honestly, we don't track it and I want to tell you why. The reason we don't track how many is because the only thing that really matters to us is to get into high-volume SKUs. In other words, in one case you could be in 10 SKUs and have no volume with them versus another case -- one that is very high volume. We learned that early on incidentally, so we haven't paid a whole lot of attention. There are people around here that know some of these numbers but quite frankly I'd be reluctant to give them out because I don't think they are indicative of the number of Zip drives sold. You could have a very high number and yet it wouldn't necessarily mean it is a lot of Zip drives.
Mike Rappoport: Right. What I am trying to get at is how are we moving along the road to becoming a standard with new PCs we have.
Kim Edwards: Ok, well, the thing you missed earlier on it is that our OEM Zip shipments were up 60% this quarter over last quarter and last quarter they were up about 60% over first quarter. And, in fact, this quarter -- third quarter -- they represented just over 35% of our total Zip shipments.
Mike Rappoport: Do you think that the percentage of new PCs in total being shipped now to customers with Zip drives is increasing as a percentage of all PCs?
Kim Edwards: Absolutely.
Mike Rappoport: Do you have a level where you think it is now? Is it 2%, 3%?
Kim Edwards: We just don't provide that information.
Mike Rappoport: Ok, well thanks for the execution and thanks for the trip to Penang.
Kim Edwards: Thanks for coming over there, by the way.
Mike Rappoport: I appreciate it.
Rick Barry (Robertson Stephens): Thanks and great job this quarter, Kim. I have a question about R&D. This past quarter your R&D spending was really at an unprecedented level. You spent 5.25% roughly of sales. If I sort of trend line that with the last few quarters you would have had operating margins, obviously, a lot higher. What should we look forward to the next few quarters? Is it going to stay about that level or is just boosted for some special projects?
Kim Edwards: A big piece of it is... the way we account for R&D is that we expense a lot of the non-cap equipment. We have a bunch of new products coming out that hit the R&D line. So, it's not just the personnel expense if you will. That number will bounce around a bit as a percent of sales depending on what stage we are in terms of new product introduction.
Rick Barry: Alright, let me ask the question a different way. Do you still feel comfortable in the next quarter or the next few quarters with North of 10% operating margins?
Kim Edwards: We don't comment forward on operating margins Rick.
Rick Barry: Okay.
Paul Weinstein (Paine Webber): I was just wondering if you could give a doubtful accounts number this quarter? The reserves you've taken for doubtful accounts this quarter?
Kim Edwards: Just a second. Len is looking up the answer. If you have another question, go ahead and ask it.
Len Purkis: Our bad debt reserve was around $12 million at the end of the quarter two and around $11 million at the end of quarter three, still about $1 million. If you recall the way we figure our bad debt reserve, it's based on a formula based on the aging of our receivables and reflects the quality of our assets. It's that part of our bad debt reserve that is down quarter over quarter. We still have generally enough in our bad debt reserve to take into account the rates specific in the markets we are serving. Those reserves are the same quarter over quarter. So it reflects the quality of our portfolio getting better.
Cliff Josephy (HD Brous) (Note: it was really Howard Rosencrans): My question concerns your capacity constraints. My sense is that you have cleaned up to some degree the problem you cited in Q3 both with the Jaz and with the Zip with obviously you had some of both in Q2 as well. Obviously we are all looking for a very substantive increase in Q4 given the favorable seasonality and your monster backlog. Is there some sort of constraint in the fourth quarter and what is the magnitude of it? Last quarter you quantified what you felt was lost as a function of Zip chip and as a function of Jaz disk. Could you quantify that for us as well?
Kim Edwards: Howard, let me answer your first question and I'll come back to the second one and let me answer it in a couple of perspectives. Just to give you some idea, we have right now approximately 80 lines -- capacity for Zip drives of about 14 million. Jaz, by the way, I think it is close to a couple million and Dittos is a half million or thereabouts. So from a pure production capacity point of view, that is not a point of issue. The issue, if we are going to face any issue in Q4, it will be component availability. At the moment, as I suggested earlier, because of getting through this jockeying on the transition from IDE to ATAPI... that, by the way, has had a major positive benefit to us. Getting a major OEM switched over to the ATAPI drive, ramping the ATAPI drive up in production, actually freeing up some of the IDE chips for some of the remaining OEMs that haven't switched over, all of these benefit together to provide additional chip availability. But, unfortunately, we could have another surprise. We don't expect any in the quarter, but at the moment chips don't seem to be a big issue. The only other thing I have here Howard is it is hard to determine what we could have shipped in Q3 that we didn't because as I suggested I think some of the backlog is overstated, but I think it was somewhere in the minimum of $50 million and could have been $100 million that was available to quench demand in Q3 that we were unable to fill.
Howard Rosencrans: So you really at this juncture obviously you can't tell what the component situation is but you feel you have no capacity constraints in Q4?
Kim Edwards: Yeah, but that's pretty unfair. We are in much much better shape in chips, which was the biggest issue that we faced in Q2 and Q3. But, effectively we have two chip suppliers, the second of which is the new one who has, for whatever reason, much more people and is more desirous of shipping us the chips we need both for OEM and aftermarket drives.
Howard Rosencrans: That's phenomenal. That's great. One quick comment, just one quick clarification on the SG&A in the fourth quarter. You had said it would be the same amount, is that in absolute dollars or as a relative percentage of sales?
Kim Edwards: No, what I actually said was that, as a percent of sales, our biggest quarter in margins spread is Q4. We catch some of that in Q3, which was sort of what I answered before, but Q4 is generally the big hit in terms of the big marketing hit because it is a combination of Christmas advertising and Comdex which is very expensive.
Howard Rosencrans: But SG&A you expect in Q4 as a percentage of sales to be higher.
Kim Edwards: As a percentage of sales.
Stan Corker (Emerald Research): Congratulations, guys, on the quarter. To follow up on a little bit from Howard's question regarding capacity, I think it was about 9 or 12 months ago you made a statement during one of the conference calls that you had capacity of about 8 million drives reserved for this fiscal year I believe. It looks like you are well on target to ship over 7 million units in a year which is ahead of the industry analysts forecasts of about 12 months ago. Now, moving beyond Q4 to next year, what do you have in the pipeline to be able to increase capacity to meet significant demand increases in the next year, both internally as well as with OEM licensees?
Kim Edwards: First of all, for all intents and purposes, at least for the last 18 months, I don't know that production capacity has ever been our issue. It has always been component availability, even into Q3 this year. However, the new platforms, we believe, are a major step beyond the availability issues because of the level of suppliers today. Secondarily, we are at about 14 million in production capacity ourselves, but NEC and MCI are planning to begin their ramp in early 1998. Early in the year, MCI is committed to come out of the blocks some time in Q1 in the 100,000 per month area and I believe NEC is about 50,000 a month and while I don't know that MCI has specific firm plans, they talk in terms of ramping that into the 500,000 to 700,000 per month level sometime in the third or early fourth quarter next year. So, I think we will have all the production capacity and then some and, again, it is going to get down to chip availability. But, as is evidenced by even the month of September and switching over the vendors, chips are much more available than they have been in the past -- a much different scenario.
Stan Corker: So you don't see any problem on the drive, what about the media? Right now you single source on the media from Fuji. With this new announcement of Fuji and Sony collaborating on a competitive product, do you see that posing any issues regarding capacity of the media and can you say anything about your plans for a second source?
Kim Edwards: Let me start by saying, first of all, Fuji has been an outstanding partner from Day 1. When I think about the capacity they put in place early on, it was just astounding considering where we were to begin with. Secondarily, they have gone out of their way per this announcement with Sony which we have been aware of for quite some time that they would continue to support us at least equal to the past if not even more so. They have also been a very active partner on n.Hand so, to them, Iomega is a fairly large customer and, as I say, they have just been an excellent partner from Day 1. We have also been fortunate, by the way, that [?] really started out in charge of the media division when we first started speaking to them. He has since been promoted to he is now in charge of all of [?] so we have been able to maintain that relationship which we think brings large benefits going forward.
Stan Corker: So the bottom line is you don't see that relationship being an issue?
Kim Edwards: We do not, Stan.
Stan Corker: Okay, thanks a lot.
Kim Edwards: You're welcome.
Patrick Manning (Bentley Capital Management): If I could just get a clarification on the SG&A again. Did I judge correctly that you said it was going to be up as a percentage in Q4? Because that pattern would be at odds with the percentage pattern that your SG&A has exhibited historically in the fourth quarter. It has gone up in absolute dollars historically but down as a percentage.
Kim Edwards: As you know the way you calculate this is divide by the top line. But, we are going to do TV advertising plus a big deal at Comdex again plus an awful lot of in-store and print advertising, so that is why it could be up slightly Q4 over Q3 as a percent of sales but the other thing you gotta think of in the same dialogue is what is the revenue. That's the biggest unknown quite frankly.
Patrick Manning: Well, I assume it is going to be up nicely.
Kim Edwards: (laughs) We're hoping that you're right Patrick.
Peter Monvay (Buckingham Research Management): I'm missing two areas. One if you had commented anything about the reception of the channel to ZipPlus and is there an update on the notebook situation. You may have covered this but I didn't hear it.
Kim Edwards: The reception of Zip Plus has been very favorable for a couple of reasons. With the broad awareness of Zip there is definitely an opportunity for up-sale to the Zip Plus from Zip. Secondarily, we have taken the original Zip off of MAP which means they don't get the behind-the-line dollars any more for holding the minimum advertised price though we maintained MAP for the Zip Plus so they can make more margin on Zip Plus than they would on the original Zip even though we believe they can bring in huge traffic through the pricing on the original Zip. We expect to ship the 15mm notebook Zip drive in November and in fact, when you come to Comdex you will be able to see working prototypes of the half-inch notebook version of the 15mm.
Joe Garner (Emerald Research) (Note: Actually it was Joe Besecker): You stated that you are giving priority to the OEMs. Going into the fourth quarter, now that you have a better handle on some of these production issues, give me the strategy, especially with the advertising, how are you going to balance that act between the retail channel and the OEM, especially going into this big fourth quarter retail. Can you give me a little color on that?
Kim Edwards: Well, even in Q4, if we have to make a decision between shipping an OEM drive or a retail drive, we will ship the OEM drive. We did that in Q3 and Q2, we'd do it again in Q4. I hope we don't have to make that decision because as I mentioned, chips are far more available now. Another thing is that the TV ad this year is aimed specifically at "Zip Built In". In other words, it is an ad aimed at pulling through the PC with a Zip drive as opposed to an ad aimed at the aftermarket Zip drive. However we will continue print advertising on the aftermarket Zip drive, and also point of sale advertising. So what we are doing is making a little bit of a balancing and starting now to do the true hard OEM PC-centered advertising and you are going to see more of that going forward.
Joe Besecker: The drive, at least from our research indicated that it was on allocation at the retail level for much of this quarter. We haven't seen much change of that. Do you see that changing in the fourth quarter?
Kim Edwards: You can go through some of the math. Our Zip drives were up about 26% in terms of units and OEM was up about 60%. That's 60% on top of 60% a quarter ago. So, clearly it was at the expense of the retail drives. That is one of several factors that drove the backlog up so large. However, going into Q4 we think we are in much better shape in availability of chips. As I mentioned, we had a record shipment month on Zip drives in September. You may also remember, Joe, because of our accounting practices, actually revenue recognition practices, if we ship a lot of product at the end of the quarter it doesn't go to revenue. We only recognize the sell through, not the sell in. When I tell you we shipped a lot of drives in September, a lot of those drives have not yet gone to revenue but the good news is that they have flowed into the channel, they are on the shelves.
Joe Besecker: One other question if I can. Several quarters ago we used that all-important word "challenging" when it came to Europe. Can you address how you see things in Europe? I guess you said they were flat this quarter from last. And how you see things shaping up in Europe?
Kim Edwards: Europe is up 114% from a year ago. To say the least, I'm very happy with our progress in Europe. Anytime I talk about advertising... well the TV ad is here in the United States... but when I talk about print or in-store, you don't see the activities going on over there. We are doing heavy duty advertising in store an in print in Europe also and it is very different. 114% from a year ago -- I'm very pleased with that. We took actions a year ago and they have paid huge dividends.
Joe Besecker: One more. The Sony question. We've had the LS-120, we've had PD, we've had all the different competitors, how is the new entry of Sony? Any plans you might have for the migration to the 200-meg Zip? I know that's something that could have been done some time ago. How does that affect your thinking going forward?
Kim Edwards: Quite frankly it doesn't affect it at all. As you know they announced a technology announcement in contrast to a product announcement. We are not going to sit here and try to overanalyze a technology announcement until they are really capable of shipping product. Then we can analyze as long as they have the channel and OEMs. Just hearing the technical specifications they are talking about, we suspect they are going to have cost problems and quite frankly with our knowledge of much of the media, we think they have some problems they haven't even encountered yet, but that we know about. And we are certainly not going to share them with them to make life easier for them.
Daniel Kuntzler (JP Morgan): On Europe, I'm just sort of intrigued somewhat from a management perspective to get these excellent results and this excellent growth at the same time domestically you are fairly severely backordered. What was the decision making process in allocating across geographies?
Kim Edwards: First of all, Daniel, the primary decision was pretty easy. We decided we were going to make OEM a priority and the majority we have based here in the states and most of the shipments go to the states. That made that decision very simple. Go where the OEMs are which for the most part is right here. We do some international shipments to some of the big brands. But the majority of that product goes through the states here. That part was easy. Quite honestly, at retail, the US is number one and it has to do with penetration and awareness. We can definitely get easier sell through here than in any other part of the world. Europe is number two and the Asia/Pacific area is number three. Any time we are prioritizing where we ship an external Zip drive, that would be how we prioritize it. Going into Q4, we think we are in pretty good shape in all 3 areas because as I mentioned we shipped a lot of Zip drives at the end of September and the selling is starting early this quarter. We think we will be far better balanced in Q4 than we have been in a long time geographically and, for that matter, OEM versus retail. Since you brought it up, let me give you a slightly different perspective. I'll tell you the one concern we have really is the interplay of that high backlog. The issue from a margin point of view that you run into with these empty shelves and high backlog... first of all you know that some of the backlog is probably overstated, but you get into a state that you really don't know what the flow through in Zip drives is. Therefore, even as we speak internally about what do we really think the demand is for Q4, in one state you can say with the huge backlog it must be bottomless. But you know that the backlog isn't totally real, so you can't conclude that. So we think that we are going to have an interesting quarter in terms of balancing the geographies that you brought up as we get back into kilter relative to the desired inventories in the channel. I can quite honestly, you sort of brought it up for another reason, but I think balancing the geographies is going to be maybe the biggest challenge in the quarter although we've learned that well in the past. You don't know that but we do. We've done that pretty well in the past. But that, we think, will be an interesting challenge, but one we think we're up to. I just wanted to make this point and I don't think it's ever been announced, a week from now we will have another distribution center in the United States in North Carolina and it is up and running this week and is shipping retail drives out of there starting this week. The primary reason for that is... don't hold me to these exact numbers... approximately 60% of all our sales are within 500 miles of that distribution center versus the one located here in Utah.
Daniel Kuntzler: There was another issue in this balancing between the OEMs and retail... when do you expect substantially all of the OEMs to have qualified the TI product.
Kim Edwards: Q1. By the way, the only issue that we have there is that they have qualification cycles. Once they are in a particular model and you are in there with a drive and you're not creating problems for them, they are not inclined to put the effort into it that is required to go through a whole qualification process.
Daniel Kuntzler: But they have got to be aware of your difficulty you have been experiencing getting enough of the chips.
Kim Edwards: They are, but some of them haven't felt it that badly because we have been robbing chips from the retail drives. Believe me, we have done everything possible to insulate the OEMs from this and I'm not going to say they were totally insulated, but some of them were not affected that badly this quarter.
Daniel Kuntzler: Finally, on the Ditto I am more intrigued than anything else given that is a small part of your revenue base, but it is down. Are there transition issues, mix things that are going on in that segment? Have you taken one step backward to take two steps forwards? Is anything like that going on?
Kim Edwards: Well, I think the biggest thing that is going on is... we have this confirmed by IDC... is the quarter-inch tape market which is what Ditto participates in has shrunk over the last 12 months and quite honestly we believe it shrunk more than IDC believes it has. But both of us believe it is for the same reason, which is Zip and Jaz. You've got users out there who before were using a tape drive to back up files. Very few people, by the way, back up their hard drive. They back up files. And Zip and Jaz are excellent at being able to back up files, they are very cost-effective, and of course they are random access. So, we know we have really eaten into our own quick tape market. And probably the only surprise to us is that it has really affected the overall market pretty dramatically over the last 6 months. I think if you go to retail any more the only drive you see out there any longer... you may see another SKU or two from someone else, but it is all Ditto drives. We've got the retail space.
Daniel Kuntzler: Is it worth you continuing to invest in the tape areas?
Kim Edwards: Well, we have already re-employed a lot of the Ditto technical resources or diverted them over to n.Hand and we have been doing that over the last 6 months.
Daniel Kuntzler: Okay, thanks very much.
Rick Barry (Robertson Stephens): In terms of the OEM business in Q4, would you expect OEM Zip to increase above the 35% level in Q4?
Kim Edwards: We are going to do our darnedest to get all the retail backlog behind us and that's the one thing that could drift down. It's not under us how big the real honest to goodness retail backlog is because of the situation we have been in for 6 months. We are going to do our darnedest to fill it. If it is big and we are able to fill it, that could hold... by shipping a lot of retail drives Q4 over Q3, that could hold the percentage growth of OEM down. The answer to your question is quite honestly that simple because we have been looking at that question ourselves and I wish I had a firm answer but we don't know how big that retail demand really is.
Rick Barry: I wanted to make sure I heard you right about Buz, you said it is first quarter of next year?
Kim Edwards: Yes. And I mentioned it in the last conference call. But this is a tactical product. The only reason we are doing it at all is we think it can generate some disk tie ratios. We are certainly not interested in getting into the video editing business. We are a razor and blade game, so what we found here was mainly that there are a whole lot of PCs out there that have installed a rule, if you will, so we ran into some incompatibility issues. Unforeseen ones because if they followed the rules we wouldn't have this problem. But it is our product. We can't release it if we are going to have compatibility issues. So we are re-evaluating how to get it compatible with a much broader range of SKUs and expect to have it out in Q1.
Rick Barry: In terms of n.Hand, when do you expect to begin shipments?
Kim Edwards: It's going to be some time in 1998 and probably the second quarter timeframe. I'm not going to get into specifics on the call, but at Comdex the drive we are going to show is going to be significantly different than the drive we showed a year ago. Throughout this product design process we have made so many changes although we think they are all great directions, it has delayed the introduction of the product. However, what we have today we believe is much more valuable than what we thought we had a year ago.
We appreciate everyone participating and look forward to talking with you next quarter.
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