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Edited Transcript of NLST earnings conference call or presentation 27-Feb-19 10:00pm GMT

Q4 2018 Netlist Inc Earnings Call

Irvine Mar 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Netlist Inc earnings conference call or presentation Wednesday, February 27, 2019 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Chun K. Hong

Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman

* Gail M. Sasaki

Netlist, Inc. - VP, CFO & Secretary

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Conference Call Participants

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* Richard Cutts Shannon

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Sujeeva Desilva

Roth Capital Partners, LLC, Research Division - Senior Research Analyst

* Mike Smargiassi

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Presentation

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Operator [1]

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Good afternoon, and welcome to the Netlist Fourth Quarter and Full Year 2018 Earnings Conference Call and Webcast. (Operator Instructions) Please note, this event is being recorded. I would now like to turn the conference over to Mike Smargiassi. Please go ahead.

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Mike Smargiassi, [2]

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Thank you, Chad, and good afternoon, everyone. Welcome to Netlist Fourth Quarter and Full Year 2018 Conference Call. Leading today's call will be Chuck Hong, Chief Executive Officer of Netlist; and Gail Sasaki, Chief Financial Officer.

As a reminder, the earnings release and a replay of today's call can be accessed on the Investors section of the Netlist website at netlist.com.

Before we start the call, I would note that today's presentation of Netlist results and the answers to questions may include forward-looking statements, which are based on current expectations. The actual results could differ materially from those projected in the forward-looking statements because of the number of risks and uncertainties that are expressed in the call, annual and current SEC filings and the cautionary statements contained in the press release today. Netlist assumes no obligation to update forward-looking statements.

During this call, non-GAAP financial measures will be discussed. Reconciliations for those directly comparable GAAP financial measures are included in the press release, which was filed on Form 8-K.

I would now like to turn the call over to Chuck.

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [3]

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Thanks, Mike, and good afternoon, everyone.

In 2018, we moved forward on a number of initiatives, including the campaign to defend our IP, the expansion of the product offerings with the introduction of a new line of enterprise-grade SSDs, the strengthening of our balance sheet and the buildout of our patent portfolio. We ended the year with solid fourth quarter performance which included increased revenue and an expanded product margin compared to a year-ago period.

Moving to intellectual property initiatives. From March 11 to March 18, we will be in trial at the International Trade Commission, or the ITC, against SK hynix. We enter this hearing with positive momentum from 2 recent wins in the case.

First, in February, the ITC denied hynix's motion for summary determination of noninfringement of Netlist's '623 patent. hynix attempted to short-circuit the process without a trial, going straight to a final ruling on this patent and was denied based on the Chief Administrative Law Judge's view that a substantive merits of the '623 must be thoroughly considered in trial and a fast track to a decision is not appropriate. hynix tried to do this once before with the entire case, asking the ITC to forgo the trial and go straight to a ruling and failed as the commission remanded the case back to the Chief ALJ for a full trial. This most recent denial allows for due process and the facts to be considered for the '623 patent. The 2 patents asserted in this case are the '623 patent against hynix's RDIMMs, and the '907 patent against LRDIMMs. Both are children patents of the parent patents asserted in the first ITC action and importantly, contains specific claims that have been refined and honed in view of infringement shortcomings in the first case.

Second. Last year, we received a favorable claim construction for a Markman order, related to the claims from both the '623 and the '907 asserted patents from the ITC. In this comprehensive order, the Administrative Law Judge's ruling sided with us on the definitions of key patent claims at the heart of the investigation. This Markman order, as do most Markman orders, provides the framework from which the authorities will ultimately decide if the patents are valid and infringed by hynix.

We are encouraged by these favorable decisions, which acknowledged the improved infringement positions of the new Netlist patents asserted in the second ITC case. The initial determination of the investigation is scheduled to be issued by June 14, 2019, which will include a recommendation by the judge as to whether an exclusion order should be granted barring importation of SK hynix's RDIMM and LRDIMM products into the United States.

Turning to Germany. In December, a trial was held in the Munich District Court against LRDIMMs being marketed by hynix and Hewlett Packard Enterprises in Germany. This January, the court dismissed our action as the court followed a different claim construction than we advocated and did not find Netlist's utility model to be infringed. We plan to appeal the court's decision and have until March 5 to do so.

In the EU, we currently have a pending patent application from which the German utility model is derived. We expect to receive an initial ruling on the validity of this patent application in the coming months.

Moving to the U.S. Patent and Trial and Appeal Board, or the PTAB. In January, we received a favorable decision that denied Google's rehearing request and upheld the validity of our '912 patent. Google first requested re-examination of the '912 patent in 2010, thereby staying our litigation against them for most of this decade. Other parties also participated in the effort to invalidate this patent but failed and gave up years ago, while Google continued the fight to invalidate. This comprehensive and final ruling by the PTAB rejected Google's 3 main arguments for invalidity and in the process, reinforced the seminal value of the '912, which covers server memory modules and the specific use of rank-selecting signals, teachings that can be found in the current DDR4 server memory modules as well as the new DDR5 standards now being established. Google has approximately 60 days to file notices of appeal to the Federal Circuit. If they do not appeal, the currently stayed litigation with Google regarding FBDIMMs and potentially other products would become unstayed.

Also in January, patent litigation initiated by SMART Modular against Netlist HyperCloud products was dismissed with prejudice by the U.S. District Court for the Eastern District of California. Netlist and SMART Modular jointly agreed to drop claims against one another, including counterclaims Netlist brought against SMART Modular, in their '295 patent, which was the subject of a final ruling of invalidity from the PTAB.

Overall, with the addition of Chuck Hausman in October as our Chief Licensing Officer, we're pleased to report that the activity level in the area of intellectual property, both in terms of licensing discussions as well as new patent continuations, has been at its highest. We expect this strength to continue over the course of this year as we engage in multiple litigations and negotiations as well as redoubling our efforts on submitting new patent applications.

Our portfolio today contains over 100 patents, many seminal, covering memory modules, solid-state drives, high-bandwidth memory and other related products and technologies. In the past 2 years, as we continue to update and expand our IP, keeping pace with the evolving memory industry, 13 new patents have been granted and dozens more applications have been placed in the pipeline. By pursuing patents on the innovations created by our engineers in the course of product development, we believe we will continue to strengthen the platform to launch new products as well as secure licensing agreements.

Turning now to product update. During the fourth quarter, Netlist participated in Supercomputing 2017 in Dallas, Texas, where we worked in cooperation with our partnership to highlight Netlist's NVMe SSDs, solid-state drives, as well as HybriDIMM storage class memory and NVvault offerings. This included comarketing and product demonstrations at the show. We were pleased with the level of activity and follow-up discussions with the system manufacturers and customers. The interest in our SSD products and DRAM products was strong and has led to dozens of qualifications being started.

As mentioned last quarter, central to the continuing effort to grow our product business are the new lines of enterprise NVMe SSDs that we introduced last year. NVMe SSDs are the fastest-growing part of the enterprise SSD market with a 40% compound annual growth rate. These recently introduced SSDs have been very well received in the market with more than 55 customer samplings, of which 15 qualifications are now complete and 12 more are in process. The remaining are in the prequalification evaluation stage. These SSDs are high performance, fully featured and have capacities ranging from 2 terabytes to 16 terabytes. This traction places us on a path for revenue ramp on production orders from SSDs in the first half of the year.

Our NVvault additional qualifications are in process with next-generation Intel and AMD platforms, and we are now working closely with an x86 processor vendor to design in our NVvault in their reference platforms.

Regarding the commercialization of HybriDIMM, we have made significant progress in this area in the last quarter as in-depth discussions continued with potential ASIC partners for the development of the media controller and continued progress with our software partners, ScaleMP, as well as memory and server ecosystem partners.

I'll now turn the call over to Gail for the financial review.

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Gail M. Sasaki, Netlist, Inc. - VP, CFO & Secretary [4]

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Thanks, Chuck. Revenues for the full year ended December 29, 2018, were $33.5 million compared to revenues of $38.3 million for the 2017 period. The year-over-year variance in revenue was due to a decrease in Samsung resale products mitigated by an increase in higher-margin Netlist specialty DIMM revenue. Revenues for the fourth quarter ended December 29, 2018, were $9 million compared to revenues of $8.5 million for the 2017 fourth quarter, an increase of 6% year-over-year. Revenues for the quarter were up by 25% consecutively.

Fourth quarter product gross margin, measured before manufacturing costs, was 14.3% in the fourth quarter, benefiting from the more optimal product mix, up 2% consecutively and up by 6% in comparison to last year's fourth quarter. Q4 net gross margin was 9.5%, up consecutively as well as year-over-year. And although we do not guide, given the current pace of bookings as of today, we do anticipate a flattish or slightly down first quarter revenue performance compared to last quarter due to the industry-wide decrease in demand and resulting lower ASPs from what we see as conservative purchasing behavior by our customer base.

Operating expenses for the full year 2018 were $18.7 million compared to $15.3 million in 2017. Full year operating expenses without litigation costs were down by 2.9%, or 23%. Total operating expenses including litigation were $5 million during the fourth quarter, flattish consecutively and up compared to last year's fourth quarter. Again, the year-over-year increase reflects increased legal activity in support of patent portfolio prosecution, defense and the trials at the ITC and in Germany.

Operating expenses without litigation costs in the fourth quarter decreased by 15% from the fourth quarter of last year and were also down by 22% consecutively.

We ended 2018 with cash and cash equivalents and restricted cash of $16.7 million compared to $19.4 million at the end of the third quarter, a net cash burn of $2.7 million, of which $2.3 million was used to pay down legal expenses. Q4 '18 cash cycle improved by 5 days for the quarter and by 53 days for the full year. We continue to proactively manage the cash balance, which includes access to a $5 million working capital line of credit with Silicon Valley Bank, providing borrowing of up to 85% of eligible accounts receivable to support working capital and revenue growth. In the next -- in a few weeks, we will be participating in one-on-one meetings at the 31st Annual ROTH Conference, taking place March 17 to 19. Institutional investors should contact their ROTH representative for additional details. We look forward to talking with you at that time.

Operator, we are now ready for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question will come from Suji Desilva with ROTH Capital.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [2]

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So looking ahead, the ITC trial that we're watching closely, the March trial date and then the June determination, are there any other events or kind of dates to watch other than those key milestones that would provide indication as to how the -- how it's going for you guys along the way? Or is it really just those 2 catalyst dates?

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [3]

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For the ITC 2 case that -- those are the 2 periods that we should be looking out. There are -- in between the trial and the initial determination by the Chief ALJ, there will be briefings from both parties as well as the ITC staff attorney that takes place. In the end, it is the judge's ruling which we will all be looking for.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [4]

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Okay. That's helpful. And then with the outcome of the Google track, can you talk about what are some of the next dates or steps are in that process?

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [5]

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Yes. This -- as I mentioned, this almost a 10-year fight on the -- with Google started out with us suing them for infringement of FBDIMMs on a patent called the '386. The '912 patent is a child of that '386 patent, and Google and others have been trying to invalidate it because it is what we call a seminal patent that reads on the architecture of the memory modules, server memory modules. So Google has fought that pretty much to the end. They have an option to appeal this to the Federal Circuit Court of Appeals. They have the next, I believe, 60 days to do so. If they do not, then the original litigation, which is currently stayed, will and can and will become unstayed. And it will become an open litigation at that time on the FBDIMM product, which had -- which they consumed back earlier in the decade as well as potentially other products that -- server memory products that they're consuming today on which we believe the '912 patent reads.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [6]

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And that would happen automatically, Chuck, the unstaying of that case?

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [7]

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No, we would have to take actions, but the only thing that kept this case stayed for this long was the continued fight by multiple parties to invalidate -- try to invalidate our patents. Now the law -- I think, the rules in the PTAB are changing with the new director of the patent office so that they don't have these unlimited challenges. In the past, the same party or multiple parties can bring unlimited number of invalidity challenges and just continue this to drive things on. But at this point, we believe that the ruling that the PTAB provided, the content of that ruling, was -- is very compelling and thoroughly addressed and essentially repudiated the arguments that Google made, the 3 specific arguments. So it is unlikely that they would be able to prevail or reverse this ruling at the Federal Circuit. That is the opinion of our attorneys. And if that is the case, we will see if they do appeal or not, but -- so yes, we think there is a lot at stake there.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [8]

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It seems the regulatory regime is moving toward your side in some ways. That's helpful.

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [9]

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Yes, I think, in general, some of the legislation as well as certainly the rules within the USPTO are starting to shift a little bit, the pendulum swinging back to protect the rights of the patent owners.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [10]

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Yes, that's very timely. And then a couple of questions on the business. The enterprise NVMe SSD, what do you consider as the '19 -- 2019 revenue opportunity? Or maybe you can talk about the portion of the market you're addressing just to give us a sense of across the 20, 20 customers you talked about, how big that business could potentially get for you.

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [11]

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We believe the NVMe SSD markets are -- it exceeds now 10 billion annually. Now the bulk of that market is addressed, served by the major suppliers like Samsung, Intel, SanDisk, Western Digital, Micron, Toshiba. We are addressing the -- a niche portion of this market with -- we have some higher performance as well as specialized form factor, and we are going after the system integrators and the smaller data centers in that market. So it is a big market. We believe that our plan calls for us to exceed the 10 million in sales of SSDs this year. I think we will see some evidence of that traction in -- starting next quarter. We -- as I mentioned, we have some 50 customers in the pipeline, a dozen or more qualifications completed and another dozen in process. So qualifications are always a precursor to purchase orders. So, so far, I think we're optimistic about the SSD product line.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [12]

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So Chuck, first revenue could be 2Q -- as early as 2Q '19. Is that right? Did I hear you right?

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [13]

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Yes. Yes.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [14]

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Okay. Great. And then last question for Gail on the OpEx side. The litigation is relatively high in your OpEx now. Is there sort of a guidance for how that plays out the rest of the year? Is there some front-end load to that? Or should it be sort of a steady spend given your activity?

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Gail M. Sasaki, Netlist, Inc. - VP, CFO & Secretary [15]

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We do expect it to go down in Q1 and then further decreased after the ITC trial.

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Operator [16]

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The next question will be from Richard Shannon with Craig-Hallum.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [17]

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I'm going to follow-up on a couple of these topics here. Maybe let's touch first on the first quarter and then give us some brief thoughts on revenues. I would assume that gross margins would generally reflect the curve of revenues during the quarter, so being flat to down.

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Gail M. Sasaki, Netlist, Inc. - VP, CFO & Secretary [18]

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Gross margins, I expect it to be, yes, flat.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [19]

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Flat. Okay. And while I could probably calculate this off the top of my head, I'll just ask you directly. What do you think about cash burn in the quarter?

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Gail M. Sasaki, Netlist, Inc. - VP, CFO & Secretary [20]

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Well, I think I could talk about cash burn for Q4 being $2.7 million, of which $2.3 million was for litigation. Q1, we will continue to manage the outlay for legal. But a way to think about the rest of the business is we had about $2.3 million in Q4 of total OpEx without legal, of which $2 million is cash based. We brought in $1.3 million from product margins. So you're looking at less than $1 million cash burn. As long as we continue positive work on cash cycle, I think we can anticipate less than $1 million on the rest of the business and then however we can negotiate legal payments going forward. I think that maybe will help you put some numbers together.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [21]

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Okay. Yes, that will help a lot. Let's see here, Chuck, following up on a couple of other topics. Just want to get your sense overall of your Samsung-branded revenues going forward. Is this something you expect to be at least a flat if not growing business? Or is this not going to sustain? Just a high-level thought there would be great, please.

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [22]

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Given the massive decline in the DRAM and NAND pricing quarter-to-quarter, I think we're expecting about a 50% price decline year-on-year. But from last quarter alone, I think we're already seeing anywhere from 20% to 30% price decline. So if the volumes were the same, I think you just have a natural decline. As Gail mentioned, I think we're looking at a slight -- flat to a slightly down quarter, which means we have -- we are generating more volume, but I don't think enough to make up for the decline in the ASPs of memory and SSD products.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [23]

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Okay. That's helpful. Chuck, my last question is, in your prepared remarks, you talked about Chuck Hausman, your new licensing person VP. You talked about greater activity there. Wondering if you could help characterize this. And curious to the extent to which this is contingent upon having success with -- either with the ITC court or Germany or whether it's outside of that. And any viewpoints on when some of that may be -- may get to a successful conclusion.

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Chun K. Hong, Netlist, Inc. - Co-Founder, President, CEO & Executive Chairman [24]

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Yes, Richard. Chuck Hausman comes from a nonpracticing patent entity. So his background and orientation is really working with potential licensees, whether they are makers or users of infringing products. So he has a lot of contacts and network of in-house attorneys in this industry. So that's enabled us to reach out probably in a more friendly manner to engage in discussions proactively, not necessarily tied to litigation outcome, but in view of the strength of the patent assets that we have today and juxtaposing that with what is going on in future, in upcoming memory standards such as DDR5. So you don't need to, in some cases, clearly prove through a litigation process or on a virtue of a positive ruling for people to see that, "Okay, it's inevitable. The train is coming down the tracks, and I don't need to get hit by it before I do something." So I think it's a different approach than what we've had here in the past, which is kind of okay litigation, outcome and then look for a licensing deal. This is more of a proactive outreach and broad discussions, and I think it's been helpful.

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Operator [25]

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Ladies and gentlemen, this concludes today's question-and-answer session and thus concludes Netlist's Fourth Quarter and Full Year 2018 Earnings Conference Call. We thank you so much for joining today's presentation. You may now disconnect your lines. Take care.