Q3 2023 Netlist Inc Earnings Call
Participants
Chun K. Hong; Co-Founder, President, CEO & Executive Chairman; Netlist, Inc.
Gail M. Sasaki; Executive VP, CFO & Corporate Secretary; Netlist, Inc.
Michael Smargiassi; IR Officer; Netlist, Inc.
Suji Desilva; MD & Senior Research Analyst; ROTH MKM Partners, LLC, Research Division
Presentation
Operator
Hello and welcome to the Netlist's Third Quarter 2023 earnings conference call and webcast. (Operator Instructions) Please note, this event is being recorded. I would like now to turn the conference over to Mike Smargiassi of Investor Relations. Please go ahead.
Michael Smargiassi
Thank you, Alan, and good day, everyone. Welcome to Netlist's Third Quarter 2023 Conference Call.
Leading today's call will be Chuck Hong, Chief Executive Officer of Netlist; and Gail Sasaki, Chief Financial Officer.
As a reminder, you can access the earnings release and a replay of today's call 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's 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 today's press release. Netlist assumes no obligation to update forward-looking statements.
I will now turn the call over to Chuck.
Chun K. Hong
Thanks, Mike, and hello, everyone. Third quarter product revenue improved 67% on a sequential basis, showing encouraging momentum. The memory market has begun to recover after a prolonged downturn. Current industry commentary indicates customer inventory is normalizing and the demand environment continues to improve. We have already seen increases in prices for DRAM and SSD products in the fourth quarter and leading-edge DRAM products may face supply shortages in 2024. We expect these positive trends to continue to boost our top line in the coming quarters.
AI computing is creating a need for a new breed of memory different from the standard computing memory that's been used in PCs and servers for the past many decades. Memory for GPU, which drives AI processing, must be high density, high performance and low power at the same time. Those features are what allows AI servers to create generative AI and process big data modeling. The new DDR5 DRAM products serves 1 part of the AI memory need and the other key product is high band with memory or HBM.
From a product revenue standpoint, Netlist's strategic supply agreement with SK Hynix puts us in a good position to capitalize on the new demand created by AI. Even more important is the leading-edge memory technology, which Netlist created over the past decade that are now being incorporated into memory products for AI. We hold dozens of seminal patents that read on AI memory and plan to leverage this unique position in order to maximize the value of our IP portfolio in the decade ahead.
On the legal front, I would like to start with the decision from the U.S. Court of Appeals from the Ninth Circuit that issued 2 weeks ago. This appeal stems from the Federal Court for the Central District of California's October 2021 order granting summary judgment in favor of Netlist and against Samsung for material breach of various obligations under the 2015 joint development and license agreement. Ultimately, the district court in that contract breach case held in summary judgment that Samsung materially breached the agreement, and Netlist properly terminated the agreement and entered a judgment in Netlist's favor in February 2021.
Samsung appealed the District Court's findings on the breach of contract action to the Ninth Circuit, which 2 weeks ago issued its split ruling on specific wording in the contract, asking the District Court to consider evidence supporting Samsung's obligations to supply Netlist with NAND and DRAM components. Netlist's interpretation is that the plain language of the contract requires -- alone requires Samsung to supply Netlist generally on DRAM and NAND products at Netlist's request. Samsung's view in the appeal was that the term should be very narrowly read as a limited supply obligation for the party's joint development.
Netlist's view is clearly shared by the Ninth Circuit Judge Desai, who wrote a very strong dissent pointing to Samsung's flawed and made-for-litigation theories and their appeal of this case. However, the 2 other judges that made up the majority on the ruling thought it prudent to ask the District Court to reconsider the decision, specifically to revisit the meaning of the supply provision in the agreement in light of extrinsic evidence that were not considered in the first instance. We look forward to the opportunity to present evidence on this issue and finally bring to light numerous harmful actions committed by Samsung, much of which were only viewed by the judge and not shown to the jury in the District Court trial. We believe that Judge Scarsi, our judge in the Central District of California, will resume the proceedings quickly.
Turning to Netlist's April 2023 win against Samsung in the Eastern District of Texas. The case is in post judgment briefing following the entry of a final judgment confirming Netlist was entitled to a total award of $303 million. Samsung filed motions for a judgment as a matter of law and a new trial on various issues, they lost at the April trial. Netlist filed a motion for Chief Judge Gilstrap to recognize and set a defined ongoing per unit royalty that Samsung would have to pay for their infringement going forward. The final submission date for briefing on all the post-judgment motions is December 1. The judge will then take all motions into consideration and issue an order.
Following the entry of an order from the judge, we expect Samsung to file a notice of appeal challenging the final judgment. If a notice of appeal is filed, the appeal process would take an estimated 12 to 18 months before the Federal Circuit Court of Appeals. I would note that Samsung continues to accrue significant liability for royalties and interest by selling their infringing DDR5 DIMMs and HBM components, products that will make up the bulk of its memory revenues through this decade.
Separately, but related to our recent Samsung Eastern District of Texas final judgment, the PTAB entered its final written decision for two of Netlist's LRDIMM patents. A 3-member panel found that the challenge claims of both the 339 and 506 patents were unpatentable. The 339 patent was 1 of the 5 patents tried in the Samsung Eastern District of Texas case, comprising about 11% of the total award or the smallest segment of the overall $303 million award. The final written decisions on invalidity of the remaining 4 patents, which made up the bulk of the liability in this case, will be rendered by the PTAB in December and April. Let me correct that. The final written decision as to the invalidity of the remaining 4 patents, which made up the bulk of the liability in this case, will be rendered by the PTAB in December and April.
On to other actions, the case against Micron in the Eastern District of Texas, also before Chief Judge Gilstrap, is scheduled for a jury trial on January 22, 2024. Fact discovery has closed, and the final pretrial conference is currently set for May 20. The case addresses Micron's willful infringement of the same patents and same type of products that were part of the successful April EDTX trial against Samsung. On Wednesday last week, we received a highly favorable claim construction order with the court siding with Netlist on virtually all key claim terms at stake.
This order provides strong foundation for proving infringement and validity at trial. Given the PTAB's recent decision on 339 LRDIMMs patent, we will be simplifying this case and pursuing claims related to Micron's infringing DDR5 DIMMs and HBM components, which Micron has stated are strategic growth products related to AI and basis of their resurgence in the memory market. In Netlist's consolidated Micron-Samsung case in Eastern District of Texas, the claim construction hearing, which we thought went very well, took place on September 26 in front of Chief Judge Gilstrap. We look forward to the court's entry of a favorable claim construction order. This fact discovery in the case is scheduled for -- scheduled to close November 13. The pretrial conference is currently set for March 2024, with the jury trial start date on calendar for April 15, 2024.
These cases offer infringement of large volumes and significant dollars of DDR4 RDIMMs and LRDIMMs products. The Western District of Texas case against Micron, which has been stayed, we expect that the court will resume this case sometime in early 2024. This case involves 3 Netlist patents that cover Micron's DDR4 LRDIMMs and 1 patent which covers NVDIMM. Over the course of this year, the PTAB has found that the patent reading on NVDIMM to be invalid and the 3 patents reading on LRDIMM to be not invalid. The last of these decisions coming yesterday.
Having 3 patents validated by the PTAB, puts us in a very strong position, as we expect in the case to resume in the coming months. In our case against Google and Samsung, in Delaware, the court in Delaware held the claim construction hearing on October 20. We look forward to the court's entry of a favorable claim construction order in that action.
Finally, the Dusseldorf court in Germany held oral arguments on Netlist's case against Samsung on September 5. At the hearing, the Dusseldorf judge confirmed that if infringement were found that the court stayed -- if the infringement were found, the court would stay the action pending the German Federal Court's assessment of the validity of EP 735 and EP 660. EP stands for European Patent and these cover LRDIMMs. The court did enter a stay on September 25, thus implicitly confirming infringement by Samsung. The case has now stayed until the German Federal Patent Court, essentially the German version of the PTAB, holds an oral hearing on the validity of Netlist's asserted European patents. The hearing date is scheduled for March 2024 for EP 735 and July 2024 for EP 660.
Netlist only needs a favorable ruling on 1 of these patents to move forward with a request for injunctive relief, which is a default remedy in Germany, once there's a ruling of infringement on patents found valid.
In summary, Netlist remains committed to defending its IP rights and fairly licensing its technology and patents. As we have noted in the past, Netlist has a long history of innovation with more than 150 patents and 30-plus pending patents, which emanate from its product development efforts. Netlist's innovation are at the forefront of the industry's push into memory for AI. The rapid growth of AI applications and the requirement for HBM and DDR5 products, once again, spotlights the key role of Netlist's technology in the memory industry.
Now I will turn the call over to Gail for the financial review.
Gail M. Sasaki
Thanks, Chuck. Third quarter product revenue results reflect improvement in the demand environment, which analysts predict to accelerate through 2024. As discussed by Chuck, the strong growth suggested in AI servers for the enterprise data centers, which currently include large amounts of both HBM and DDR5 memory, marked the beginning of a new demand cycle. We believe we are well positioned to capitalize on these positive market trends due to our strategic SK Hynix supply agreement as well as our robust patent portfolio.
As a reminder, we do not formally guide, but given the market dynamics as noted earlier, we currently anticipate demand for products and ASPs to continue to improve as we move through the rest of the year and that Netlist's fourth quarter performance will show moderate sequential quarter improvement.
We ended Q3 2023 with cash and cash equivalents and restricted cash of approximately $51 million compared to $31 million at the end of Q2 2023. We raised approximately $29 million in net cash from the registered direct offering during the third quarter. In addition, we proactively raised approximately $2 million under the $75 million equity line of credit during Q3, with close to $36 million remaining on that line.
In addition, with a $10 million working capital line of credit with Silicon Valley Bank, we continue to maintain significant financial flexibility and liquidity going forward. As always, we manage the operational cash cycle very carefully, which improved by 85 days in Q3 '23 compared to last year's Q3, which is why we expect cash burn to remain relative stable even as we go through this period of increased legal activity.
Operator, we are now ready for questions.
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from Suji Desilva of Roth MKM.
Suji Desilva
So just to understand, first question, the finding in the Central District Court case for Samsung. What is, if any, the relationship of that to the Eastern District of Texas Samsung finding of the $303 million?
Chun K. Hong
Suji, yes, the Central District of California case, which was appealed to the Ninth Circuit, is a case about a license, whether Samsung had a license and when they breached the license, we terminated that license. And the District Court in California found that it was a material breach and the judge -- the material breach was significant and quite obvious, so that the judge did not put this in front of the jury and decided himself. He thought that it did not need to go to a jury. That the evidence was plain and overwhelming. So he made the decision himself.
Now that has been appealed. And the case has been remanded back to Judge Scarsi. And he will be determining whether to put the issue in front of jury or once again decide himself that upon further review of the extrinsic evidence in the case, whether the supply obligation that Samsung had was general or was specifically tied to the joint development, so that will be a key decision which will obviously impact the Eastern District of Texas award, because if the decision is that the supply obligation was narrow, per Samsung's interpretation, that would mean that Samsung did not breach.
If the interpretation was that the supply obligation was broad, which is our interpretation, and was the interpretation of the -- of Judge Scarsi, if that interpretation remains in the remand, that would mean that Samsung did not have a license and breached the agreement. Therefore, that -- all of the award, the infringement -- that came out of the infringement case will stand. So I hope that was clear. There's a lot of information there.
Suji Desilva
No, that absolutely helped, Chuck. And then the timing of going back to -- in California to the judge and the procedure thereafter. What's the time frame for that process?
Chun K. Hong
He will officially take possession of this remanded case on November 8 and from that point on, it is up to him, depending on his docket when he will schedule either a retrial or he may decide in another summary judgment and reach the same conclusion himself. That is left to the judge for him to decide whether there is extrinsic evidence that changes his original interpretation of the clause of the supply provision in the agreement.
Suji Desilva
That's helpful. And this question may be oversimplifying, but I'm wondering, you seem to have a similar arrangement with Hynix where it is being worked as broad availability of product. And I'm just wondering if the language is different or comparable such that 1 is working the way you had intended and the other 1 is being questioned as to whether it was intended that way. Is that too technical to discuss here? Or is that a fair question?
Chun K. Hong
Yes. I think in terms of broad strokes, that is clearly the intent. That was the intent in the Samsung case. And Hynix is -- there is obviously, as we've seen through the pandemic and at other times, the value of supply of memory products and memory components is enormously -- it's invaluable to be able to secure, have a contracted supply. That is a very rare arrangement with any customer. And it is because -- only because of our IP and patent portfolio, the strength of that, that they've signed up to that supply agreement, both companies. Samsung did not perform. They initially provided significant support.
There was no support before the agreement, and then there was a lot of supply after the agreement. And then after a couple of years, they unilaterally cut us down to virtually no supply. So it is in stark contrast to Hynix, which is performing to its agreement, per the agreement and the intent of the agreement between parties.
Suji Desilva
Okay. Okay. Chuck that's very helpful. Maybe on the financial scale, the litigation expense went up here. Is that something we should expect to stay elevated the next few quarters? Or is that because of all the activity in the quarter that it spiked up here?
Gail M. Sasaki
Yes, I think that over the next couple of quarters that will be elevated and then it will track down from there.
Suji Desilva
Okay. Great. And then last question, as the revenues recover here, just what elements are needed for the gross margin to recover to prior levels? I know it's relatively lower here, just to understand what needs to happen for that expansion happening in?
Gail M. Sasaki
Well, we have seen a shift in pricing as we enter Q4. So I think ASPs going up will help the flexibility in our pricing. And we -- as demand has increased, it's going to help on the customer side in terms of better prices. And then as we continue to purchase more and more, it should help our buying power from Hynix. So that is a significant part of our revenue is the resale piece. But we'll start to see some of our custom projects kick in to the revenue over the next several quarters and those obviously are -- tend to be much higher margins, and that will be part of the increase as we go through 2024.
Operator
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
