Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Iomega Corporation fourth quarter analyst conference call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session. As a reminder, this conference is being recorded Thursday, January 22, 1998. I would now like to turn the conference over to Mr. Kim Edwards, President and Chief Executive Officer of Iomega Corporation. Please go ahead sir.
As we conduct the call, various remarks that we make about future expectations, plans, and prospects, constitute forward looking statements for the purposes of the Safe Harbor Provision under the Private Securities Litigation Reform Act. As you know, actual results may differ materially from those indicated by these forward looking statements as a result of various important factors including those identified in the 96 Annual Report, Form 10-K, and most recent 10-Q.
Okay, let me give you a couple highlights and then provide you with a brief overview of what happened in the quarter.
fourth quarter sales were a record $547 million, up 38% from a year ago. Although we are not totally pleased with the revenue, I am very encouraged with the Q4 97 total drive unit volume which was about double Q4 96. Of course the majority of this growth was in the OEM Zip drives, which carry a much lower selling price and lower tie rates than the after-market drives and therefore we will report proportionally lower revenue.
For the year, total drive unit volume was up 72%. Zip tie rates were down significantly this quarter compared to last, primarily as a result of the increase in OEM drives that we have experienced throughout 1997. As you will recall, OEM drives represented less than 10% of drives shipped in the fourth quarter of 96 and now are 34% during Q4 97. We believe that reducing prices to expand Zip sales to a broader customer base may have also contributed to lower tie rates because we are selling to a less computer savvy user. Educating these users and Zip built-in customer segment as to why they need more disks will be a major market focus in 1998.
Q4 net income grew 77% over Q4 96 to a record $36 million or 0.13 per share. Gross margin was 33% where it was 29% a year ago. The biggest contributor to margin strength was the increased percentage of the Zip disk sales as a percent of the total.
fourth quarter Zip drive sales remained strong, as evidenced by a 62% increase in the total units shipped versus the third quarter. Units shipped were up about 2 1/2 times fourth quarter 1996. For the year, Zip units shipped were twice 1996. OEM Zip drive shipments were up about 55% over the third quarter and represented 34% of total Zip drives. This percent of OEM shipments was down a couple of points as a result of strong after-market drive shipments in Q4. We were very pleased with the sale of Zip drives to OEM's and the after-market. We have now shipped over 12 million total Zip drives. The progress in the quarter represented another step forward in making Zip the new standard in the removable storage market.
Jaz volume was up just over 7%. For the year, it was up almost 50%. Jaz disk tie rates were flat compared to the first nine months of 1997. The delay of Jaz2 was a very big disappointment in terms of missed revenue, but the right decision in terms of maintaining our quality standards.
Ditto unit volume was down about 40% compared to fourth quarter 1996. Zip and Jaz have definitely eaten into the QIC tape market, causing overall market decline. You may recall that we have been redirecting tape development resources to Clik throughout the year and the anticipated market decline reinforces the earlier decision.
Overall in the fourth quarter, shipments of our total personal solutions averaged over 1 million per month, and in fact Zip alone averaged about 1 million per month.
Now I'm going to provide some commentary on the quarter. A few problem areas affected our fourth quarter revenue.
The first, the Asian currency crisis was encountered by the industry and I would have to say was out of our immediate control. The crisis had a major impact on our Asia Pacific sales and in our case we are fortunate that AP represented less than 10% of business going into Q4. Even so, our fourth quarter Asia Pacific sales of $49 million, which by the way was up 88% over a year ago, was about half what we had planned.
The second was within our control. The single biggest factor affecting our performance in the quarter was the delay in shipment of our new products. Jaz2, Buz, and Ditto Max Pro did not ship in the quarter as planned. Availability issues associated with some of the components constrained both Zip Plus and Zip notebook drive shipments and design issues slowed shipments of Ditto Max. Combined, our estimates is that these constraints and the delays of drives plus associated disks accounted for about $70 million in missed revenue for the quarter. As of now, Zip Plus, Ditto Max and Ditto Max Pro are shipping in volume. The notebook drive is ramping, although we are still component constrained. And Jaz2 and Buz are expected to ship this quarter.
Okay, that's a brief synopsis of what went well and what didn't in the fourth quarter. I already said in the next few minutes that commentary on our business as we enter 1998.
First, let's look at the forward technology platform, starting with Zip. Our current notebook drive that we are shipping is 15mm. Our second generation will be 12.7mm, allowing it to be in many of the newer, thinner notebooks. The 12.7mm development is proceeding well and we expect the production version of the drive to be available for OEM qualification in the second quarter. Although several of the major notebook manufacturers have expressed interest in qualifying the production drive, we don't anticipated OEM volume in the second quarter. However, what this does mean is that the Zip family will cover all market segments by the end of the second quarter. The product lineup will include Zip Plus, a premium product at $199; Zip Classic, for the price-sensitive segment at $149; the 3 1/2" internal ATAPI Zip for OEM's and after-market; the 3 1/2" internal SCSI Zip for OEM's and after-market; and the 15mm and 12.7mm Notebook Zip drive for OEM's and after-market. Of course, all but the 12.7mm Notebook drive are shipping now. Further Zip developments include [OEM?] line extensions and cost reductions. Although we don't have first quarter plans to further reduce pricing, our goal remains to by getting the drive to an everyday everywhere $99 street price. We will continue to analyze market demand to determine when we fire this bullet.
Next, let's take a minute to address Ditto. Entering the quarter, the family is in a very good state with the Ditto 2GB available for the entry-level customer for $159 external and $119 internal. The Ditto 2GB design can now also read/write the 3.7GB Travan cartridges and we are stickering retail boxes accordingly. The step-up model, Ditto Max can read/write 3, 5, and 7GB cartridges and is available for $199 for the internal or external drive. Finally, the Ditto Max Pro positioned for the power user or office use can read/write 3, 5, 7, and 10GB cartridges and is available for $299 for the internal or external model.
Now, Jaz. This quarter we expect to be shipping the Jaz 2GB at $649 for the external and $549 for the internal. And Buz at $199. In addition, we will continue to offer Jaz 1GB at $399 for the external and $299 for the internal. Due to the nature of the competition in the segment, I am not going to provide more detail other than to say that going forward we intend to pursue a value line and high performance line of Jaz products for power users. We will continue our unique strategy of making money in this business, and monitor demand closely to determine when to take further pricing action.
Our final and newest technology platform is Clik, which is still in development. You'll recall that Clik is a miniature drive with a 40MB removable disk for hand-held consumer electronics and computer devices. The disk is capable, for example, of holding 25 to 40 high quality photographs and is targeted to be sold at $9.95. We expect to provide OEM's prototype units for evaluation starting this quarter. The product is targeted for availability in the second half of 1998. While we have several interested OEM's and endorsements from major PC and digital photography players, none have committed to including Clik in their products at this time. We are continuing our development efforts on an external Clik drive to build consumer pull-through just as we did with Zip.
Now, on to the geographies. Europe had an excellent fourth quarter with revenues of $197 million, up 56% from $127 million a year ago. As you recall, we sent Kevin O'Hare over in mid-1996 to assess our strategy in Europe. Under his leadership, Europe grew 76% in 1997 to $520 million, representing 30% of our total revenue. This is up from 24% of total Iomega revenue in 1996. We are well-positioned in Europe and we remain bullish enough about 1998 that we are going to test some tele ads in the U.K. possibly yet this quarter as part of our global demand creation campaign. I'll talk more about the campaign in a moment.
I already mentioned that the currency crisis hit Asia Pacific hard in Q4 and we don't anticipate a big improvement in the short term. For the quarter, sales were $49 million, up 87% over fourth quarter 1996. The year totaled $159 million, up 45% over 1996. We'll continue to build the AP infrastructure, but we'll spend our money cautiously as we wait for the economies to stabilize and hopefully strengthen. We have already reallocated funds from AP to other geographies where we believe we can get a better return for our dollar.
Q4 growth in the Americas was a disappointing 23% over Q4 96 with revenues totaling $301 million. Lower-priced OEM sales were very strong, consistent with our stated strategy of getting inside the box and as planned we had--relatively speaking--much lower drive and disk revenues. The disappointment was that retail revenues were up less than 20%. As I mentioned earlier, we believe the delays in new product introductions cost us in the ballpark of $70 million worldwide. The Americas accounted for over 61% of our 1997 sales, it's safe to assume that the majority of these missed sales occurred here. For the year, the Americas exceeded $1 billion, actually $1 billion 61 million, up 31% over 1996. Although we are pleased with our progress with the OEM's, we are intent on creating new programs to increase pull-through of Zip built-in, and starting this quarter we're turning up the marketing heat in the retail and distribution segments as well.
Let me touch on a few aspects of our first quarter demand creation campaign. Starting this quarter, and specifically at the Super Bowl, we are going to--as we say in the business--turn up the volume. Real, real loud. And for those of you who saw Iomega at Comdex, you know that we know how to turn up the volume. Tune in to the Super Bowl pre-game to see the existing Zip build-in ad plus one of our new series of premiere television ads. You'll see it again when they repeat it in the fourth quarter of the Super Bowl and then we'll run a second new ad during the post-game. For the balance of the calendar quarter, we will continue running TV ads nationally and we'll be running complementary print ads in major computer and consumer magazines. Pardon me for mixing metaphors, but to give you a sense of the level of noise, we expect to increase our number of gross impressions in the quarter to about 1 billion. That's more than 15 times first quarter 1997. The overall demand creation campaign will target Zip and Jaz users and in a sense create broader awareness of the Iomega brand. I can't give you too much detail on the second quarter, as the specifics of the Q2 demand creation program are not yet finalized. Although we don't expect to have a good indication of the outcome of the demand creation until the April/May time frame, it is our intent to monitor demand very closely and adjust the demand creation spending accordingly.
For 1998, we intend to take demand up another level by channeling over $100 million into print and TV ads in the Americas and using price to expand the market for our products. In addition, our plans are to substantially increase awareness of Iomega through channels and OEM partner programs. We intend to leverage the strength of our global position and the Iomega brand. Our funding mechanisms for the demand creation programs are currently being evaluated and include increased SG&A, headcount delays, reallocation of resources, price decrease delays, and more aggressive cost reductions. We are committed to making a very big investment in demand creation because we believe in the market and we want to capitalize on the competitive advantage that rapidly growing our installed base can provide. We are intent on funding the investment in the manner than will have the least effect on net income. However, if volume does not materialize early enough or to a substantial degree, the increased funding will most likely have a negative effect on net income in the near term. If the demand creation program works as planned, we will accelerate Zip time to standard and build a very strong global Iomega umbrella brand for all of our products to flourish under. If it doesn't work, at least we will have a better understanding of the size and elasticity of the market early in the game.
Now I need to again touch on a distasteful subject: disk piracy. We continue to aggressively protect our intellectual property and battle unfair competition. On our last conference call, I told you that an independent laboratory tested our disk and the knock-off disk from Nomai in a controlled, double-blind test procedure. Ours worked as expected, however the independent laboratory found that theirs were not 100% compatible as claimed. The media used in the knock-off disk does not meet our quality specs and the disk has a potential to cause catastrophic damage to the Zip drive recording heads causing a serious risk of unrecoverable data loss for our users.
On the basis of these independent lab tests, following court hearings of which both sides were represented by lawyers, we obtained a preliminary injunction in London on October 31 barring Nomai from selling or marketing their XHD disks in the United Kingdom with any claim of Zip compatibility. And we obtained a temporary restraining order in November during Comdex from a federal judge in California barring Nomai from selling or marketing the knock-off disks in the United States with any claim of Zip compatibility. Both these orders remain in place, so Nomai has been prevented from selling in the U.K. since October 31 and in the U.S. since November 20.
Since then, Nomai has admitted that it's disks are rejected by our notebook drives. They never were subjected to the U.K. or U.S. injunctions. Nomai argues that it should be permitted to sell its disks for desktop drives only and claims to have a new disk that doesn't damage desktop drives. We don't think so! We ran a test on the new disk at room temperature and had independent testing conducted in both the U.S. and Germany. Nomai's so-called new disk are no less damaging to Zip desktop drives than the old disk, damaging heads at both room and elevated temperatures. These new tests have been submitted to the London and California courts. We are waiting for a decision from the California court on our motion for a preliminary injunction which would remain in effect until the trial. In the U.K., we anticipate a hearing date sometime in February after which the court will issue a decision on the continuation of our injunction there. We have a separate motion for preliminary judgment pending in the U.S. on copyright and patent infringement grounds. Things are progressing as we planned.
In Germany, we have preliminary injunctions in place against three distributors. We've been deposed and are scheduled for hearings in February. One distributor continued in persuading a German court to modify the injunction previously entered against it based on, absent at the time, test results on Nomai's so-called new disks. As I mentioned earlier, we have now tested the new disks. They don't work at all with notebook drives and the testing caused catastrophic head damage to a significant percentage of the desktop drives tested with the knock-off disk. The battle with that distributor isn't over.
In France, we had a setback in December when a preliminary injunction was lifted by an appellate court. That injunction covered Nomai's initial cartridge design, which it redesigned over the summer. Nomai never came to market with the design covered by the June injunction. The lawsuits in America and France asserting copyright infringement and other claims against Nomai's current cartridge was heard on November 20 and a ruling is expected later this month. Suffice it to say, we will continue to aggressively enforce our intellectual property rights and the rights of our customers to not be misled by product claims we believe to be false. Frankly, we think Nomai 's marketing action to date shows the contempt they have for customers and a lack of concern for the customer's data.
Nothing has changed on our patent infringement case against SyQuest, which is progressing with a trial date of January, 1999 set by the judge.
With respect to the consumer litigation described in our SEC filing, we have reached agreement with the plaintiff attorney in the two class action suits regarding rebates and technical support. We believe that these settlements are very positive for both our customers and our company, and are quite pleased that we were able to reach a agreement with the plaintiff at such an early stage.
On the personnel front, Scott Flaig joined us in December as Executive Vice President of Operations, responsible for all areas of operations including manufacturing, materials, supplier relations, corporate engineering, quality and customer satisfaction. Prior to joining us, Scott was an adjunct professor at Northwestern University, lectured at Harvard and other universities, and consulted in the area of supply chain management. That's not why we hired him. Before joining Northwestern, Scott was senior vice president of worldwide operations for Dell Computer. At Dell, Scott was instrumental in developing Dell's widely recognized operational excellence initiatives. We're looking for him to do the same at Iomega.
Additionally, Dave Henry has joined us as Vice President of Worldwide Marketing, responsible for all corporate marketing. Dave joins us from Lithonia Lighting, where he served in various senior marketing and product engineering roles. Most recently, he was responsible for corporate marketing activities including product development, technical marketing, channel marketing and marketing communications. Prior to this, he was responsible for product management with the General Electric Battery Group. Dave will be the acting Senior Vice President of Marketing and Sales while we continue the search for the right person to take on the 1998 marketing challenges.
With Scott's appointment, we are elevating a level of personnel throughout operations. A few examples of this are:
Bill Kennedy who was previously responsible for the distribution center, procurement, and customer satisfaction is now focused solely on the distribution centers, charged with globally creating world class DC's by 1999. We believe that Bill's and Scott's backgrounds are highly complementary in this area of the supply chain and will allow us to achieve this goal in a very compressed time frame.
Wayne Stewart, previously Senior Vice President of Operations, is chartered with creating a certified supplier base. One that has the quality standards, financial well-being, and capacity to meet our needs. This reassignment was made because its major implications on cost, availability, qualities, and inventory management.
This gives us some indication of the caliber of persons that Scott is enlisting to address these issues and opportunities in these two specific areas. Scott will be doing much the same throughout other areas of operations.
Okay, I believe that I have provided you with a fairly objective assessment of the fourth quarter, covering both good and bad. However, overall I must say that I am pleased with our 1997 performance. Net income doubled to $115 million on sales of $1.74 billion, reflecting 43% growth. For the year, we doubled the number of Zip drives shipped and shipped more Zip drives every month in Q4 than we shipped in all of 1995. Cumulatively, we have now shipped more than 15 million personal storage solutions. Zip demonstrated significant progress towards becoming the standard in removable storage with more than 12 million drives now shipped. Most importantly, and it's a part of our stated strategy, we grew our OEM unit Zip drive volume up about 11 times over 1996. I applaud all the Iomega people that made this happen. We made tremendous progress in 1997 [said 1998, meant 1997] in meeting the needs and expectations of our OEM customers. As we enter 1998, the big areas of focus are globally creating and filling a much higher level of after-market and OEM demand, protecting our intellectual property, and better understanding and meeting the needs of our customers. Continuing to focus on improving quality and customer satisfaction are integral to all of this.
With that, let me turn the call over to Len to provide the financial details and then we'll give you a chance to ask your questions. Len.
The gross margin dollars in fourth quarter 97 was $183 million, up 59% over fourth quarter 96 on revenue growth of 38% and are up 30% over third quarter 97 on revenue growth of 27%. As a percentage of revenue, fourth quarter gross margin increased to 33.4% versus 29% in fourth quarter 96 and versus 32.5% in third quarter 97. An increase in gross margin dollars is predominately due to Zip drives. The unit volume is up, Zip Plus at $199 retail had a favorable impact on the mix, and drive cost continues to go down as a result of our productivity and cost reduction program. On disks, while tie rates are down, unit disk volume was higher than third quarter 97 and contributed to the increase in gross margin dollars. Jaz gross margin dollars were down in fourth quarter 97 with the fulfillment of Jaz 2GB having an impact on the manufacturing costs and on Jaz 1GB device sales. Finally, our OEM Zip unit sales were 34% of Zip unit sales of in the fourth quarter of 97 and we're up 55% over the third quarter of 97. Overall our gross margin increased from 32.5% in third quarter 97 to 33.4% in fourth quarter 97. Zip gross margin percent was slightly up from third quarter 97 even though tie rates were down due to the favorable impact of Zip Plus and drive cost reduction. Jaz gross margin percent was down slightly from third quarter 97. Zip sales dollars were a greater percent of the total revenues than in third quarter 97 and this change in the overall mix had the effect of increasing the gross margin percent from 32.5% to 33.4%.
Our investment in operating expenses continued. SG&A at 19% of revenues is up from 17.2% in the fourth quarter last year and 16.8% in third quarter 97. There are a number of key areas that have driven the increase of $29 million over third quarter 97. 30% of the marketing number increase is in advertising and that increased sales disproportionately in the fourth quarter. And we continue the investment in marketing costs in Europe, necessary to achieve the fourth quarter 97 revenue growth. Secondly, the costs of implementing our Oracle systems worldwide. Our first phase is now up and running. Additionally, there are two other areas that are up over third quarter, one being legal where the cost of litigation against Nomai in several countries increased our legal fees. And largely, our employee base increased by 370 people in the fourth quarter 97 increasing SG&A and our human resource function costs were increased to accomplish this.
R&D of $24 million is up 81% over the $13 million of fourth quarter 1996 and represents 4.3% of revenue versus the 3.3% in fourth quarter 96 and versus 5.2% in third quarter 97. For fiscal year 1997, we had R&D costs of $78 million, up from $42 million in 96 and we've increased our engineering group to 383 people from 260 people in 96. Our engineering centers of excellence are now in San Diego and Milpitas in California, in Utah, in Colorado and in Texas.
For 1998, we have looked at our operating model and we expect to follow it: Gross margins in the high 20's to low 30 percents, SG&A to range from 15 to 20%, and R&D to range from 3 to 5%. And for the 98 [said 99, meant 98] year we expect the tax rate to remain flat with 97 at about 35%.
Going into 1998 we have a backlog of $263 million, down from $379 million last quarter but up substantially from $76 million a year ago. Exiting the fourth quarter, the backlog had orders for new product shipments that are behind schedule. We believe that the backlog is still somewhat overstated. For example, we are still cleaning out the backlog following the increase caused by short supply throughout the year and we are working with the customers to get these rescheduled to a more realistic date. We expect some of the orders in the backlog to be canceled now that we can barely meet demand on many of our products
Better asset management. Our DSO has improved to 46 days from 48 days in fourth quarter 96 and from 55 days in third quarter 97, and is a major driver in our positive cash flow in fourth quarter 97. We were cash flow positive for the fifth consecutive quarter in the amount of $32 million, bringing total year cash flow to $137 million.
Our inventory of $246 million turned of 5.9 times and is up from $188 million in third quarter 97. The fact that Jaz2 drives and disks did not ship in fourth quarter and that Buz did not ship and that Ditto Max Pro was late shipping were factors in our raw materials and our work in progress inventory increasing by $18 million from the third quarter 97 to the fourth quarter. Finished goods inventory increased $40 million over third quarter with Jaz1 inventory of drives and disks being a major factor. The overall Jaz product was impacted by the announcement of Jaz2 not shipping. We also saw a build-up of Zip drives and disks inventory for the fourth quarter 1997.
Our capital expenditures in fourth quarter 97 totaled $34 million, bringing total year capital expenditures to $89 million. We entered 1998 with capacity for about 20 million Zip drives and about 3 million Jaz drives, and our 1998 capital expenditures could be double that of 1997, depending on the speed of growth in 1998. To assure financing of these improvements, we have commitments for a new three year $200 million line of credit underwritten by J.P. Morgan and Citibank, which we expect to have signed in the next week. This new line of credit is now unsecured and has a lower interest rate and fees.
In summary, the notable achievements in 1997: Revenue of $1.7 billion. Net income of $115 million is double that of 1996. OEM Zip unit sales for 1997 were above 30% up from 5% in 1996. Zip revenues broke through the $1 billion level. American revenues broke through the $1 billion level. Europe revenue broke through the $500 million level. And we generated $157 million in cash while growing the business 43%. Thank you.
Operator: We will now begin the question and answer session.
Kim Edwards: Okay, first of all Daniel, you might recall in last quarter's conference call we mentioned that we believe that some of the orders in our backlog are for customers increasing their orders to get better position on allocation. Throughout Q4, particularly in the December month, we saw that specifically happening where we able to meet demand on some of these products, we saw customers pushing orders out. Right away, let me clarify a point that I didn't state. Zip demand was actually up in Q4 over Q3 and up versus a year ago. What we saw was a slowing of the rate of growth, not a decline in growth. In terms of the question relative to the new products and AP, I don't believe we're going to see a benefit in AP in Q1 because we're still seeing the same issue over there in terms of the currency crisis. Nothing has significantly changed there, so we anticipate have to face this issue at least certainly through the first quarter, if not longer. In terms of the part relative to the product piece, while certainly we had backlogs for these new products spilling over from Q4 into Q1, the degree that that's going to result in increased sales in Q1 will not be known until the quarter's over. I simply don't know again how much of the orders are real. I again think we alluded to it. Of our backlog in Q1, I still think there are orders in there that are still residual as a result of our inability to fill our orders in Q3 of last year. We're in the process of working very closely with the customers to try to straighten out the order backlog make it as realistic or--I should say--reflect reality as best it can.
Daniel Kunstler: And on the competitors, where you able to identify any competitor that may have cost you revenues, particularly with Jaz?
Kim Edwards: Well, I have to say, any competitor that is out there selling a drive is theoretically replacing an Iomega drive. But in the grand scheme of things, Daniel, and again all relative, it was definitely Asia Pacific currency crisis and our own inability to get the product out the back door. Those were the two--by far--biggest factors in Q4.
Daniel Kunstler: Okay, I'll take my follow-on right now. I was a little bit intrigued by the R&D numbers that Len mentioned of $24 million. That's considerably below my model. Of course the answer is obviously my model was flawed. Did you moderate your R&D expenses this quarter in anticipation of revenue results which were not quite to your satisfaction?
Len Purkis: No, not at all. In fact, if you look at the four quarters of 97, first quarter $15 million, second quarter $17, third quarter $23, fourth quarter $24, we haven't slowed our R&D spending. Given that it's $88 million for the year, which is coming up from $42 out of 96, no we did not slow our R&D spending.
Len Purkis: Finished goods inventory increased a total of $40 million over third quarter, with Jaz1 inventory of drives and disks being a major factor. The overall Jaz business was impacted by the announcement of Jaz2 not shipping. The other impact was that we built inventory in Zip drives and disks in the fourth quarter.
Cliff Josephy: Why would you get an inventory of Jaz1 finished goods due to Jaz2 not shipping? Wouldn't people want Jaz1 since they couldn't get Jaz2?
Kim Edwards: Cliff, first of all, while total Jaz inventory was up we do believe that not shipping Jaz2 had a negative effect on Jaz1 and even to the contrary, we believe that if we had Jaz2 out there side by side with Jaz1, despite what you might think, we would have sold more Jaz1 in the quarter because of the price differential people would have bought down, if you will.
Cliff Josephy: I gotcha. Kim, I have a question for you. How much did you spend on TV advertising in Q4 and these commercials that are going to be run in Q1, I guess they were produced in Q3 or Q4. When were they expensed? When was the production expensed if it was already, and when does the air time get expensed? Was that expensed in this quarter?
Kim Edwards: Okay, that's a lot of questions. First of all, we don't give out specifics on the advertising, but I will go back and make the point of, I don't have the data for Q4, but Q1 over Q1, 96 over 97, we're going to increase the number of gross impressions 15 times what we did one year ago. In terms of where the expense fell for the creation of these television ads, some of it occurred very, very late December, but majority of this occurred in the first quarter of this year.
Kim Edwards: Tom, [not?] saying they were really up, a couple of key pieces to this: I mentioned about our inability to get the Zip Plus and the notebook up to the level that we wanted--that was a contributor to increasing the inventory. More importantly, We had planned on even higher rate of Zip drive and disk sell-through in Q4. It didn't materialize to the degree that we expected. We did go ahead and bring inventory in and build finished goods with the intent of meeting that inventory that didn't materialize to that level.
Tom Cal: And the big push for advertising, what impact will that have on SG&A. Do you care to qualify that?
Kim Edwards: Let me say it this way: Essentially, the $100 million that we're talking about that will go directly to advertising only, that is print and TV and those kinds of things only, here in the Americas, essentially this will be an incremental to what we consider our normal operating expense for advertising and marketing funds. Now, as I also said, the challenge that we put to the organization is how will fund that and have the least amount of effect on the overall earnings of the company: we'll get a delay before additions, we're going to try to accelerate cost reductions; we're going to reallocate expenses. But as I also mentioned, we believe that accelerating the time to standard of Zip is the most important thing we can do. We'll spend at this level. We'll monitor the spending, but there is the possibility if the volume does not increase fast enough or to a significant degree, this could have a negative impact on earnings. I'd like to tell you more specifics, but the other thing I mentioned to you is that we don't have a specific role together on Q2 in detail. I will say this to you, Tom, as we see this incremental $100 million breaking out--that's sort of how we think about it, as incremental--the spending in that will probably be as a percentage about 15-20% first quarter, 15-20% second quarter, 20-25% third quarter, and 40% fourth quarter. So that gives you some semblance as to how it might break out throughout the year.
Len Purkis: [???], Stan, that they have capacity right now going into 98 for about 20 million Zip drives and about 3 million Jaz drives. As I said also, we spent about $89, $90 million on capital expenditures in 1997 and 1998 capital expenditures could be double that, depending on the speed of our growth in 1998, so I think from that you can see that we're anticipating putting into place capacity to fund future growth.
Stan Corker: Kim, could you comment on where you see the licensees in ramping up their production?
Kim Edwards: Yeah, they are just starting now and ramping at what I would consider low rates. They still expect to be somewhere by second quarter, in the area of a couple hundred thousand drives a month type of levels, and then they're still planning on--if the volume's there--to be somewhere around 500,000 drives a month level by year end. The only other thing I'd suggest, Stan, is at some point you may want to talk with them directly. I don't know if they're giving us any spin on that, because they are a licensee, but those are the kinds of numbers we're hearing from them.
Stan Corker: How concerned are you of Asia affecting the demand, especially on the notebook version?
Kim Edwards: Two points I want to make. If we look at our revenue, AP is less than 10%, and while I say that, the majority of that revenue is the revenue that stays in AP, the majority of it. As you know, most of the notebooks that are built over there really come back over here to the States or to Europe, so I'm concerned from the standpoint we don't see AP as being a large opportunity for growth this year, where a few months ago we felt it really was. On the other hand, because it's not the level of sales for us that it might be for other companies, we don't have the same degree of downside either. Quite frankly, I wish it was a lot bigger, but for the moment, it can't hurt us as bad because it's less than 10% of our sales and I still believe a lot of the product that we ship over there going forward in the notebooks is really for US or European consumption.
Kim Edwards: Todd, I think anything I tell you is total speculation, because again, you know the biggest issue that we have is that we don't have the second quarter numbers for any of the major OEM's right now. For me to try to guess what the usage is going to be for the year, I'm literally throwing a dart at a very, very large dart board, and it would be a very, very big guess. I think, on the other hand, I will say that Len mentioned we have the capacity for 20 million total drives, that is probably [to Len] do you have the split on OEM versus [to us] it's somewhere around, I'm trying to remember the numbers, just give me a second. We have the capacity right now for probably 6, 8 million OEM drives and plan to add more capacity, but let me also comment back to this whole demand creation activity. It certainly isn't targeted just to sell those blue Zip drives. It is certainly targeted for creating more pull-through at the consumer and corporate buyer levels. The other thing I wanted to clarify is the $100 million I spoke about is here in North America, it's on the Iomega advertising side, I didn't include the spending that goes specifically at the OEM's and the channels. We have significantly increased that level of spending over 97 also, so we're really going to be coming at the OEM's in two manners. One, to all the customers with the $100 million spending, but secondly some direct effort working with them as a partner to pull through more Zip drives. And again, it would be pure speculation for me to try to tell you some level of what they might be considering I don't even have the second quarter forecasts.
Todd Bakar: How does the sub $1000 PC phenomenon, because very few of those are using a Zip drive, and that seems to be some of the better selling consumer models out there, how does that affect you? Are those people coming back and buying retail, or is the market working against you in the sense that they're not able to put as many "luxury" items in the box to get to their very low price points?
Kim Edwards: I think the last part is, definitely the can't put as many luxury items in a box under $1000, and I'm sure as you know you're going to see a few PC's out there this year, probably under $500 so that area is going to be difficult for us to get an OEM drive in. Now I didn't say we've given up on that, in fact, after a lot of dialogue that's going on internally, but on the other hand we believe that the person that spent the $500 or $1000 may very well be willing and capable of affording $99 or $149 for a Zip drive, so we're going to target them very heavily in the after-market. But at this moment, the PC people just, I don't know of any of them that are thinking of putting a Zip drive in one of these really, really low-end PC's.
Todd Bakar: Just a second question, that is, back on the advertising front, your advertising was up pretty dramatically it looks like in Q4, yet you didn't see quite the sell-through you were hoping to. What gives you the conviction that the sell-through will be there given this huge advertising push next year, and how flexible is that spending?
Kim Edwards: Let me speak to the flexible piece first. We believe that we will not have a good handle around the success of this program until somewhere in the April or May time frame, and let me explain why it takes so long. It isn't that we won't be doing advertising short term; you'll start seeing it this weekend on Super Bowl, but the old rule of thumb on advertising is to get a person to buy you've got to hit them seven times with the same ad, so that's a part of the cumulative effect on the individual and that's why I get out to the April or May time frame. Now, if it takes us until May and we say this isn't working and we do want to turn the faucet off, we will have already committed some spending that will go into the third quarter, but probably won't have committed much to fourth quarter. But there will be a continuing expense liability to us if it takes us until May to find out. I will say that if we go back to the June ad that we ran a couple years ago, the good news there is that we spiked up almost the same that we started the advertising. So somewhere between short term we'll feel the impact and the April May time frame. Did that answer your questions?
Todd Bakar: Yeah, I think so. In order to make this work, do Zip sales have to accelerate from what you've been at the last quarter or two?
Kim Edwards: The rate of growth of Zip sales would have to accelerate to really make this work. I probably ought to think a little harder about that. Particularly on the retail side, because we still make much better margins on the drive and disk sale over there in retail than on the OEM side. We're planning on accelerating the OEM drives even independent of this, but we also believe that this will accelerate the OEM drives too.
Todd Bakar: Thank you.
Kim Edwards: You're welcome.
Kim Edwards: I'm sorry, ask that one more time?
Joseph Besecker: What I'm really getting at, maybe you have a better way to answer this, Kim. You're spending all this money on advertising when you've really seen kind of this lag especially in domestic sales. You indicated however that you're not only going to advertising domestically, I think you're going to advertise in Europe as well.
Kim Edwards: [quick interjection] Yes
Joseph Besecker: [continuing] But, you've taken no pricing action since really to speak of since the second quarter of 97. We're seeing them out there drives sometimes under $100 because of the repeal of MAP, but for the most part they're still in the $130 range. One time I've heard you say that your estimates said that lowering this drive to the price point of $99 would increase demand, and we can argue on that number, but something X times. Wouldn't that money probably be better spent getting that price point down than Super Bowl type advertising?
Kim Edwards: Well, here's our answer to that question. If a person doesn't understand why they need a Zip drive, if we give them away for $25, they're not going buy it. And we're at a level now of user out there who really needs to understand why do they really need a Zip drive. We need to explain that. Therefore, I'd rather spend the money explaining that to them and then subsequently bring the price down, than to put the price down out there and have them simply walk by the shelf, never even thinking about the possibility of buying a drive.
Joseph Besecker: The question was asked to you, I guess by Daniel Kunstler about competitor landscape, and I guess you're also educating people to the total marketplace as opposed to your specific.
Kim Edwards: [quick interjection] No question.
Joseph Besecker: [continuing] decreasing that... let me skip that then, I've got your answer on that. Nomai, can you give me kind of an idea of legal expense for this quarter--I might have missed that--and possibly the legal expense going forward?
Kim Edwards: Joe, we consider that competitive. By that, we don't want Nomai to have the faintest idea what we have spent or what we intend to spend, but I will continue to say we will be very vigorous in protecting our intellectual property against any pirate out there.
Joseph Besecker: Last thing, on Clik!, have you been to the consumer electronics show, and I believe in February there's a digital camera show, I guess in New Orleans. Can you give me a kind of what the feedback you're hearing from the OEM's--this is a product that you kind of have to build in--what the general overall feeling is on lead time and designing a drive into a product such as a digital video camera? What kind of responses, in general not specific, because what kind of objections and that kind of thing on Clik!.
Kim Edwards: We're hearing more and more positive response to the product. The question as to how long it takes to build this product in, still remains roughly a year, however, we'll put a lot of effort into this after-market drive with the possibility of having products out there in the short term, at least we don't have Clik! built in, but have the compatibility with the after-market drive, so that's one of our short-term solutions to the built in issue, however, we're still as I mentioned earlier, we're going to start providing prototype units to OEM's this quarter, and they're not going to make a hard decision until they have a product in their hand that they can read and write to and know it really works and we're about to start getting over that hurdle.
Joseph Besecker: Okay, thank you.
Kim Edwards: I don't know, Joel, the benefit for you or for myself as to what I would like to see because the only thing that matters to our P&L is what's happening here. The thing that we have said repeatedly is that the OEM tie ratios we had expected to be lower than the retail and that has definitely panned out. We definitely saw that in Q4, and would anticipate that being the case going forward, but I will back the advertising that we will be doing on television. The ad itself is really aimed at two things. One is selling more disks, but also selling more drives. But, in addition to that, it's also aimed at getting the installed base of drive people out there to use more disks. We get much lower tie ratios on a Zip drive that goes into a PC, so we want to talk to that person that owns a PC about why they need to use disks and instead of sitting here and continuing to tell you rates are significantly different, we want to try to fix that. But that's going to take, that's where you need the big level of advertising, is the second we going into a education campaign, it's a much more expensive than a pure awareness campaign. The majority of dollars in 98 are going to be spent more in the vein of educating that just making people aware of the product.
Joel Pitts: A second question in terms of the tie ratios. Do you see any falloff in the tie ratios on Jaz this quarter?
Kim Edwards: No, in fact what I mentioned in the earlier discussion is that our fourth quarter Jaz tie ratios were approximately the same as the first nine months of 97, and the reason I put it in those terms is, if you were around you will recall second quarter we had a Jaz disk recall as a result of a bad batch of media so our tie rates went down. In the third quarter, we made up for all that, so the tie rates went way up. But if I look through the first nine months of the year and take an average versus the fourth quarter, the fourth quarter was very similar to that first nine month rate.
Joel Pitts: Gotcha. One last question. You got the deal with Micro where they're doing the Zip built-in as the drive A. Are there any potential additional deals of that sort in the offing?
Kim Edwards: We don't have anybody lined up to do that immediately. We're hopeful that when Micron starts to bring this to market it will put both pressure on the other competitors as well as just make them aware the benefits of doing so. But at the moment there's no one planning to do that in the short term.
Kim Edwards: Well, first of all, Patrick, let me make it clear, we want to get to $99 hopefully yet this year. Let's make that point very, very clear. We need to make an effort, in our opinion, to fund this program in the near term, one of which is delaying price reductions. Now, back to the other question, what gives us this opinion that we ought to do it this way? We've done enough research out there to, in our minds, to convince us that there are just too many customers out there that don't understand what they need removable storage for at all. At any price. So there I get back to, we better address the fundamental need issue, or otherwise you're just going to get price-oriented short-term and still not get the volume to the level that you want. So in the short term, we want to build hopefully the education side and then follow in the not to distant future with price thereafter. Don't believe we're not intent on getting the price down, but as I suggested, we've got enough information that says there are just too many of the mass market users out there that really don't understand the need for removable storage. Let me just add one other piece. I'm certainly not going to argue with the component shortage issue, however, I will say we did not have component shortage issues on the basic Zip drive. We were able to in our opinion meet the demand out there and get the channel inventory even higher than we had anticipated. The component issues apply solely to three of the new drives, not to the core drives themselves. The volume drives were not limited by component issues.
Kim Edwards: Okay, in terms of the confidence, we wouldn't be stating on the call that we expected to ship in this quarter if our confidence wasn't fairly high, and in terms of the revenue, I'm not exactly how you worded this Joe, but coming back this quarter given that we didn't generate any revenue with Jaz2 in Q4, we would expect to certainly have some piece of that revenue shipped this quarter, however, it's now January 22, recognizing that we haven't shipped the product and that part of the quarter is behind us, so I think that's another factor that we need to...
Joseph Besecker: [interrupting] Am I wrong in the number of $70 million that was thrown out as the lost revenue from Jaz2 not shipping? Am I right in that?
Kim Edwards: Well, no, that was actually a combination of...
Joseph Besecker: [interrupting] a combination of Asia and Jaz2?
Kim Edwards: [continuing] no, no, a combination of several new products there were either delayed or, for example, Buz did...
Joseph Besecker: [interrupting] Buz... Okay, Buz and Jaz2.
Kim Edwards: [continuing] ...not ship at all, Ditto Max Pro did not ship at all, but Zip Plus, the notebook, and Ditto Max itself were delayed in the quarter.
Joseph Besecker: [interrupting] Okay.
Kim Edwards: [continuing] So the sum of all those. I will tell you, the majority of the, or a big piece of the miss was in the Jaz2 area.
Joseph Besecker: Right. And if you're able to ship that in the first quarter we could see some of that, I would think, coming in this quarter. Let me ask you if you could address the question of the pricing of the Jaz2? When you finally ship that, it will be at those prices that you quoted earlier?
Kim Edwards: Yes.
Joseph Besecker: And do you think the pricing is in line with the other storage, the other competitive landscapes?
Kim Edwards: Hey, Joe, the only thing I can say is as I said earlier in the call, we've got this unique strategy with our power user products of making money, so beyond that I'm not sure what else to say.
Joseph Besecker: Okay.
Kim Edwards: Howard, on the contrary. I mentioned earlier how demand was actually up in Q4 over Q3 and certainly up a year ago. What we saw was the rate of growth of demand declined, not demand itself.
Howard Rosencrans: You had said, though, there was a shortfall from your expectations in Q4, in terms of the overall revenues, right?
Kim Edwards: Yes, I think we accounted for roughly order of magnitude $70 million of new products..
Howard Rosencrans: Okay, but in terms of the actual, in terms of what did ship, maybe I'm confused, in terms of what did ship, was there any erosion from your expectations? From the products that did ship.
Kim Edwards: Actually, within our own operating plan, we shipped more Zip drives in Q4 than we had anticipated.
Howard Rosencrans: And as it progressed throughout the quarter, was there like in October did you ship more and November did you ship more and December you ship less, or basically there was a continuous stream where you shipped more than planned each month?
Kim Edwards: Howard, we don't break out the months. We only report the quarters.
Howard Rosencrans: It seems that maybe I'm reading it wrong, or maybe I'm just being too downbeat about it, but it seems as if you have this very exotic plan to re-ramp demand in 1998, or to get demand to some new level in 1998. Again, maybe it's just my downbeat read on it, but is there something here that changed in your mind, in terms of Zip progression and how it was going? Again, maybe it's just my read.
Kim Edwards: Well, again the rate of growth is not at the level we want it to be, and we know there are several ways to affect that rate of growth. And we're certainly going to try one of them. In fact, throughout the year, we'll be trying two of them: price and education.
Howard Rosencrans: I guess it's just confusing to me. You said in terms of products that did ship, specifically the Zip, which is obviously the critical, critical product, Zip in fact was ahead of plan for the quarter, so the rate of growth exceeded your expectations. Again, this is my understanding of it. But the rate of growth did in fact exceed your expectations.
Kim Edwards: The units shipped in Q4 for Zip were more than our original plans. The rate of growth for Zip did not go up at the rate that we had hoped, and we're going to fund demand creation activities to try to increase the rate of growth beyond what it's currently growing.
Howard Rosencrans: Thank you.
Kim Edwards: Wait a second now. Remember, what we said earlier we shipped a lot more OEM drives with lower revenue and disk tie rates than after-market drives. What I said about the quarter was that I was disappointed about the revenues, but quite honestly pleased with the unit volume growth of Zip drive.
Joel Pitts: Gotcha. Okay. Good. So the real issues are revenue versus units.
Kim Edwards: That's correct. Every time you ship an OEM drive, it has two effects versus after-market. First of all, the price is much lower on the drive, and it carries a lower tie ratio, which results in lower revenue also.
Joel Pitts: Right. Okay. A couple of other questions. In terms of your licensees, are they free to pursue OEM deals of their own?
Kim Edwards: Yes. In fact, we're trying to support them to support us.
Joel Pitts: Good. Second question: I know that you've been looking for an alternate source for media for the Jaz drive. How's that going?
Kim Edwards: At the moment, we do not have anyone near qualification.
Kim Edwards: Again, we don't break out the monthly rates at all, just the quarters.
Tom Cal: Okay, thank you. Any read on the short level of inventory in your channel, where that is relative to where you want it to be, I know with the backlog situation earlier [???] it had been lower than you wanted?
Kim Edwards: In terms of the quarter, the December quarter, our inventory is up in the 8, 9 week area. Our target has always been in the 6 to 8 week area. I would say at this point we have more inventory in the channel than we prefer to have, but the good news is that with the advertising that we're going to put in place, the product's there to be bought off the shelf. We're not in the position that we were going into Q4.
Tom Cal: Am I correct that any of the inventories over four weeks, I guess you would put that into reserves?
Kim Edwards: That is accurate. That is correct.
Len Purkis: Yeah, as you know with the revenue recognition we defer margin on basically the excess of over four weeks of inventory in the channel. If you remember at the end of the third quarter, we had very low inventory in the channel and the reserves of margin was about $25 million then. At the end of the fourth quarter, it's up to $42 million. And that's the deferred margin on revenues, deferred out of fourth quarter.
Todd Bakar: Okay, and then what's the, you used to have another reserve as well?
Len Purkis: The only other reserves I'm going to [???] is the bad debt reserve and the receivables reserve. Is that the one you're talking about?
Todd Bakar: Exactly.
Len Purkis: Okay, bad debt reserve was $11.3 million, back up about $700,000 from $10.6 at the end of the third quarter. The biggest increase there was reserves we took against the Asia Pacific receivables. In fact, part of it was offset by the increased portfolio in Europe and the U.S. and we still have a general bad debt reserve included in there because of the nature of the business we're in. The accounts receivable reserve was $28 million, coming up from $25 in the third quarter, and that's really due to increased price protection and a rebate. And the $2 to $3 million increase there was an increase in rebates, and that's purely volume driven in the fourth quarter.
Todd Bakar: Kim, how much as you see the ramp up in Zip product, what kind of cost reductions have you seen, let's say in the fourth quarter, from a component standpoint and is the rate of cost reduction going forward, do you see that accelerating, or kind of the same pace as you look out to 1998?
Kim Edwards: We did see further cost reduction is the drives themselves. Going forward, now, while we'll still see some incremental cost reductions along the way, the biggest cost reductions are going to require further level of integration. I would expect to see another level of integration, somewhere in the second, third quarter time-frame. And that Todd, by the way, is going to be partially driven or limited by the OEM's qualifying it. We're going to go through every tiny turn of the board with a significant integration, they're going to have to totally requalify the drive. So that's what's going to be more the pace of the item than anything else.
Todd Bakar: Is it safe to assume that until you do lower prices on the Zip drive, your gross margin will continue to expand on the drive itself, excluding the mix between OEM and retail? The price are basically staying flat and your costs are going to continually come down, correct?
Kim Edwards: When you say excluding the difference between those, OEM and retail, then I would have to say yes.
Todd Bakar: The only thing to offset margins going up faster or not going up as fast, would be the mix of OEM versus retail?
Kim Edwards: Yes.
Kim Edwards: [??? hard to make out as people laugh and Cliff says "I didn't mean that to be funny" ???] Director of Advertising.
Cliff Josephy: One other question, if I can, bringing out your notebook drive with VST and CNF, and they're preparing it to be used in some of these machines, when are we going to see OEM drives going directly to the OEM's?
Kim Edwards: I think that's going to be contingent on qualifying the 12.7mm. As best I know right now, and as I mentioned we'll be getting those samples out here shortly to the major OEM's although as I also mentioned, I don't anticipate any volume from them, at least in the second quarter.
Cliff Josephy: We won't see any OEM's getting 15mm drives, then, I guess?
Kim Edwards: There's no one that I know of today that's going to design a 15mm into an OEM notebook, at least not that I know of today.
Kim Edwards: Okay, thank you very much. Operator, thanks.
Operator: Ladies and gentlemen, that does conclude our conference for today. You may all disconnect.