Penguin Solutions, Inc. (PENG) Earnings Call Transcript & Summary

Great. Welcome back to the Barclays Global TMT Conference. I'm Tom O'Malley, I cover SMID cap semis for Barclays. We're happy to have SGH with us. We've got CEO, Mark Adams and CFO, Ken Rizvi. I think we're going to start off with some slides from Mark, and then we'll launch into a little bit of Q&A afterwards. But with that, I'll turn it over to Mark. Great to have you.

Thanks, Tom, and good afternoon, everybody. Really looking forward to today, and I appreciate you taking the time on your schedules. I think we have, on our first slide, the safe harbor language so if you want to plow through that. We've all seen this, and I don't dare try to read it, but we will do our best not to violate any of the terms and conditions on this slide. Next slide, please. So, many of you might know, we have repositioned the company under the SGH brand. And we repositioned it as a brand that powers growth and expands possibilities. What that means to us, is that we are in the middle of a transformation of this company, and we are just beginning, in fact. And the company has had a long history doing certain things well. Great manufacturing quality, good supply chain management capabilities, and we've taken the opportunity to use that platform to grow and scale SGH on a growth and diversification strategy that will allow us to expand both the markets we look at as far as competing in, as well as the opportunities to scale our capabilities as an organization. The company has been around since 1988, primarily, in the Memory business up and through 2017, a number of different variations. There was a public company, they took it back private. It went back public again in 2017. And again, all as a memory company, both in terms of memory module and, at one point, enterprise storage, which they sold off at one point, I think it was in 2013. Today, the company has 4,000 employees. We have $1.5 billion in revenue. We also have 1,800 or so patents, and we're coming off a really strong financial year, our fiscal year 2021, which ended at the end of August 21. Our fiscal year, again, revenue $1.5 billion, but an EPS non-GAAP of $5.22. We, from a company, are transforming SGH to be a value-add specialty solutions company. And we use our diverse family of businesses to tie together a core competency around design and manufacturing and service of our largest customers, and we continue to find niche applications with these customers that we are capable of adding value through some mechanism. The mechanism, more often than not, is our designing capabilities with a global engineering team. We also have an outstanding manufacturing quality base in the company. And then, from a service perspective, across our businesses looking to provide value-added services at SGH to grow and scale the company. Next slide. Of the 4,000 employees, we have a geographic footprint, both in the U.S., some small presence in Europe and in Asia. In the U.S., we have manufacturing of memory technology solutions in Newark, California. We manufacture our high-performance computers in Fremont, California. In our edge and IoT solutions in our Arizona facility. We also have research and development out of Raleigh, North Carolina -- actually, Durham. And that is based on the acquisition of Cree LED and the continued presence we have on the East Coast. We have manufacturing and back-end test and assembly in Malaysia. And for our LED products, we also have a back-end test and assembly facility in Weizhou, China. So, truly a global footprint, as we build out this platform at SGH. Next slide. Today, we operate in 3 lines of businesses: first, intelligent platform solutions, where we deliver high-performance compute and edge compute solutions to a variety of end markets, including hyperscale data center, financial, government, oil and gas and other vertical markets. From a Memory perspective, we build custom memory solutions, today, as a primary part of our business that is targeted to telecommunications, networking, government, hyperscale, data center, cloud and compute companies. And then LEDs, which is a slightly different channel with the acquisition of our Cree business, the LED business sells to a number of different specialty verticals, high-power LED products. And those products today go to verticals such as architectural lighting, stadium lighting, video screens, emergency vehicles, horticulture and the likes. And so, you can see a diverse set of large and different vertical end market schedules that we ship to on a global basis. One thing I'd like you to take away from the lines of business is that, in each of our businesses today, they're specific to being a designer, a manufacturer and a supplier of advanced semiconductor solutions across those verticals, whether it be compute, Memory or LEDs. And so, we take a look at each of the type of businesses we're in, and we carve out a market opportunity that we think we can address with our design, manufacture and supply chain expertise to add value. On top of that, we're investing in further value for software and services across our lines of businesses to scale the company. There are 2 ways we're looking to grow and scale SGH. One is organically helping our portfolio companies operate at the highest level possible. These companies include Penguin Computing or IPS, Intelligent Platform Solutions, SMART Modular for our Memory Solutions and Cree LED, 3 outstanding brands. At the core of how we operate our portfolio companies is the SGH operating system, and it's based on lean principles. And lean, not just in the manufacturing or operational side, but everything we do at SGH, from cuing capital to implementation and quality across the company, best-in-class manufacturing, world-class supply chain management, focus on delivering outstanding customer service, both in terms of product and systems deployment. And doing so in a model that operates in a capital-efficient way. We run the company very well from a financial management perspective, but we're also looking to invest to scale the company and to add more capabilities that we can both serve our customers well, as well as drive the value in the markets of the company from where we started. Next slide, please. In addition to our operating focus, we continue to evaluate ways to scale up inorganically. We've got a very good playbook on how we look at acquisitions, and we will talk about what we've done so far to date. But the criteria we look at, in looking at future acquisition targets, is one, do the companies that we're looking at have the ability to compete in high-value specialty markets? We're not a high-value and commodity player, that's not our business. We look to use our capabilities as a company to differentiate our products in the niche markets we serve. The second thing that's probably most important to us, is the portfolio of customer relationships and partners that each of the businesses have. And as we look at other companies, we're looking to leverage this, because we've got such a strong set of customers on a global basis. Customers like IBM, Cisco, Amazon, Google, GE Lighting. A number of different customers, the U.S. government, Lockheed, Shell Oil, and you can go on the list. And the list of the customers demonstrates our capabilities to serve large Fortune 100 enterprises with the capabilities, both in all 3 lines of our business, be it compute, be it LED and be it Memory. The other criteria I want to touch on, is our compatibility with our operating system that I just reviewed. As we think about adding value, we're looking at targeting companies that give us the ability to leverage what we do well at SGH. And that list of developing great leadership, building quality, world-class manufacturing and supply chain, customer service and go-to-market, all those criteria that drive our operating system, we look at that as a key to whether we can add value to an existing company and help a company perform at their best. Honestly, a key criteria for us in acquisitions is the ability to create shareholder value. And as we look at finding companies that might not be in the right environment, might need additional capital, might be the benefit of our SGH operating system. We ensure that any acquisition that we look at, we'll be able to benefit and add value to our shareholder base, as far as the return and accretion native of the acquisition. And finally, probably most important to all of this is, the people that we're investing in, from an acquisition standpoint, that they align to our corporate culture and values at SGH. Again, a very defined recipe on how we look at acquisitions to complement our organic labor. Next slide, please. I want to give you a couple of examples of this in play because it's nice to talk about our playbook, but I want to show you what we've done. Let me pick 2, for example, one being, Penguin Computing. In the early years of Penguin, we were very focused on supply chain and operational excellence, and we drove gross margin up 500 basis points from the mid-teens to 20% in the first couple of years of working with Penguin. And this past year, we took a business that -- because of that, margin optimization was on a decline in the top line, we were able to shift that and actually grow Penguin over 30% year-over-year, '21 over '20. So again, margin enhancement and top line growth at Penguin. A more recent example is with our acquisition of Cree LED, formerly of Wolfspeed. Cree LED, at the time of our acquisition, was generating gross margins in the low 21%, 22% range. As reported on our Q4 call, our analyst call -- Investor Day -- investor call, we generated over 30% gross margin, up over 800 basis points in just 1 year. In addition, revenue growth in the mid- to high-single-digit growth quarter-over-quarter in the first 6 months we've owned the asset. We do this, again, by using our operating system at SGH, and really working with each of the companies to see where we can leverage our capabilities as an organization and scale and grow and drive efficiencies to deliver great top line growth, as well as margin expansion in each of the businesses we have. Next slide, please. I mentioned at the outright of this presentation, our strategy is about growth and diversification. Many of you who have been in or are following SGH over the years know that it came out of the memory industry for many years. As recently as 2017, 100% of our business was in Memory. In addition to that, obviously, all of our earnings power was in Memory. On our Q4 call, in the past year, Q4 '21, we had close to 50% of our revenue being outside of Memory in compute and LED. In addition, over 60% of our operating income in Q4 '21 was LED and compute, with Memory being less than 40%. We're clearly on a path to differentiate SGH into a portfolio of specialty solutions beyond Memory. Next slide, please. As we think, going forward, of our capital allocation priorities, they really break down into 3 areas: First, we want to invest for growth organically as we see tremendous opportunities across all 3 lines of business. When you think about high-performance computing, AI and machine learning, we couldn't be more excited about the continued growth coming off a over 30% growth year in Penguin. In Memory, as you think about the applications driving memory, in Memory compute, hyperscale and data center storage. It's just a great opportunity for us to continue to scale that business in Specialty Memory, as well in LED, in a business that was harvested as part of the transition from Cree and Wolfspeed. We picked up a business that has tremendous technology, leadership in the industry and is also a prime to grow. So we are going to test and continue to invest in the infrastructure and capabilities of all 3 businesses to drive growth. 2021 was up over 30% total growth for the company and 2030 -- '22 is a growth year as well as we've articulated on our prior calls. Beyond our organic investments, we will continue to look at strategic and accretive acquisitions. We spent over $300 million since 2015 on acquisitions and really changed the trajectory of the business. We will continue to look in a rational and controlled way to find complementary assets will help SGH scale. I mentioned the discipline of the company. Under Ken's leadership, we continue to strengthen our balance sheet, and we will continue to be very conservative as we position ourselves long term. We have an appropriate level of debt for this business, we're keeping a strong balance sheet on the cash level, and we will look to utilize this, only again, in high-return, high-value areas to grow our company. So again, organic growth, investment capabilities, looking at M&A as a useful tool for accretive acquisitions and maintaining a strong balance sheet. Next slide, please. 2021 was just an incredible year for the company, perhaps the best ever. As I mentioned, total sales were up from $1.5 billion coming from $1.1 billion in 2020, up 34%. Our gross margins, which were 19.4% in 2020, were up over 240 basis points to 22.2% in fiscal year '21. And our non-GAAP EPS, as I mentioned at the outset, was $5.22, up 102% over 2020. Now, if you dig a little deeper about the trending, the second half of our '21 was even more impressive. Q4 fiscal year '21 revenue was $468 million, up 50% when compared to the same quarter of 2020. Our gross margins were 26.4% when compared to a gross margin below 20%, we're up 690 basis points Q4 2020 when compared to last year prior Q4. And additionally, just in the quarter, we posted $2.16 non-GAAP EPS in the quarter, up 163% compared to Q4 fiscal year '20. Just an incredible year at SGH and the team fundamentally believes we are just beginning. Next slide, please. So, you can see that we're very focused on the levers that drive outstanding value for our investors. Revenue growth over 34% gross margin expansion, I just articulated. 22% for the year, up a few hundred basis points, gross margin expansion in the quarter for Q4, up to 26.4%. Operating margin expansion comes with that and significant cash flow generation. The levers that we're using to make SGH a different company, and we are very optimistic about the future of SGH and our ability to generate attractive returns. Next slide, please. So, with that, as I mentioned, on a mission to power growth, expand possibilities, we are excited about our future and look forward to working with all of you. I'll now take questions and ask you open the line for Ken as well.

Awesome. Well, thank you, Mark, for walking us through the slides. I appreciate the overview. It's really been a remarkable transformation from the SGH of old. So, I just want to start out. So, you have such a history in memory. What made you want to come back to industry? You've had a great career already. What about this company really drew you back in and was exciting for you to kind of take over from here?

Well, I think when I met the folks at Silver Lake who were, at that time, still involved in the company, the way they articulated the strategy of what they were trying to achieve, I fundamentally believed in the strategy. Second, the market opportunities, not necessarily just in Memory, but really, untapped at the company in terms of Intelligent Platform Solutions, the compute side of this business. And then, of course, I knew about the Cree asset from a former life when I was CEO at Lumileds. And so, I had a pretty good understanding of the markets and the serviceable addressable markets of these businesses. I really like the idea of creating custom semiconductor solutions because there are so few companies in the industry that do it well. And when you think about each of these businesses, what it does start as, we're developing and designing unique solutions for customer environments. It's not a trading business of sorts. It's not a commodity business to the PC and mobile space. These are individual markets we're serving that have unique requirements and it taps into what we do, and I knew the markets well enough to say there was an opportunity. I mentioned some of the customers earlier. It's amazing for a business that's 1 5 last year and on a run rate last 2 quarters that would suggest closer to 1 8. It's amazing the type of customers and the Fortune 100 we're dealing with, the Googles, the Facebooks, the Amazons, the IBMs, the Dells, HPs, the U.S. government, Shell Oil. I mean, the list is unbelievable, because we have a place in the industry ecosystem that what we do is very unique and valued. And I think, the customer engagement was a great platform for us to invest and scale this business beyond where we are today. And finally, the people and the culture. As you mentioned, I've been in the industry, I was President of Micron. And one of the hidden advantages of Micron that I see in SGH is the people and culture. The company comes first, and people want to win as a team, and I think that's such an incredible asset to leverage going forward. And the collection of all that is just -- it's been an exciting path for me to get back in the workforce as a CEO here, and excited about our future.

Great. And I think that during the slides, you talked about, in one of the slides, the minimum cash position that you want to maintain, but you also talked about your goal as a company to continue to acquire. I mean, as a portfolio company, you're going to want to scale. Can you talk about when you guys feel as though you're ready to make the next move? And when you're going to acquire a company, you laid out some tenants about what you look for. Is it more helpful to have something that overlaps exactly with what you're looking at today? Or do you think that you'd branch out, to perhaps a fourth fork and look to do what you've done in a new area?

Yes, I think there's really 2 questions there. One is timing with a question mark, and then I think the other would be, if we do something or when we do something, what would that look like, relative to our existing businesses? So, let me take the first one. On the timing perspective, needless to say, we're coming out of a good year. But I'll tell you, if we do nothing, we're excited about our business today organically. The compute business is growing, as we said, 35%, 34% year-over-year. The top line of business is growing year-over-year, '21 to '20, and we see continued growth. So, in our fiscal year '22, if nothing happens, we have enough opportunity. We believe, in tremendous scale from where we sit today. So, I say that because the capital markets are a bit frothy and the assets and M&A valuations are a bit on the high side. And that's just not our DNA. We're not going to go overspend dramatically just to get an acquisition done. We continue to look. We continue to be approached. Obviously, the balance sheet is much stronger. our presence in the market is better known, I believe. And so, we have the capabilities to do a transaction, but I'm not sure that we need to do something right away, because I just think that we've got so much momentum that I want to be selective, and Ken and I spend a lot of time on what that looks like for us. So, timing-wise, we could do something today. It's -- the balance sheet and the cash flow has been great. But that's not where our head is at relative to valuations. Now, that can always change. But I would just say, that we will continue to look. As it relates to -- more likely to strengthen one of the existing portfolio companies versus a fourth leg of the stool. I'm not going to give you the answer, that's just on the both sides of the fence. I'm going to pick a path. I would say, it's more likely -- not guaranteed, but more likely, we're going to strengthen one of the existing businesses. And I would say, more likely, compute and LED than Memory. For those of you who are new to the company, memory has got 2 components. We've got a Brazilian business, which is an in-country manufacturing operations. Generally, think about this as a low margin 17%, 18% gross margin with low OpEx and [indiscernible] in the double digits. We are the largest memory manufacturer in Brazil, by far, by a factor of 4. It's a good cash flow business. We have a Specialty Memory business, and then roughly think about these in the category, $450 million plus or minus. We have an existing Memory business that I think is a great cash flow platform for us to grow more strategically and add higher value in other businesses such as compute and LED. Compute consists of 2 areas: High-performance computing, which is a high-growth business for us; as well as edge IoT. And if you take a look at that, that today is roughly in the area, $450 million, plus or minus. And then of course, Cree LED, slightly below that, slightly in -- running about $100 million, $110 million on a quarterly basis, just more or less from our first 2 quarters. And so, if you think about the businesses, the one with the highest growth due to the spend in AI and machine learning is our IPS business. And then the one with the most attractive industry structure is, of course, the LED business, which Cree is a market leader, technology leader and really a balance sheet leader, relative to the other companies. And so, I would say, likely something in the compute and/or LED space, nothing imminent, but I'm just trying to answer your question.

Yes. Absolutely. It's really helpful. Why don't we turn to that business just because of the excitement on the growth? And I mean, the IPS side. So you mentioned, when you were going through the slides, how you interact with some very large customers across these businesses. In particular, when you're looking at the IPS business, why do these larger customers turn to you? And how are you winning versus competition in that space?

Well, I think there's a couple of things. First of all, when you look at Penguin as a stand-alone platform, they're really one of the only pure plays left in high-performance computing. Secondly, that know-how really adds a lot of value to commercial customers who are looking to get into AI and machine learning. I say this because, traditionally, large companies, normally, would staff large IT departments to support their businesses. But the new wave of customers in data centers, and hyperscale, and financial institutions, and oil and gas and U.S. government, they're looking to invest where their commercial needs are, at the application layer. Now, the idea that they would be experts in integrating thousands of nodes of GPUs and CPUs, advanced memory technology, enterprise storage technology, networking and cooling systems, and managing those data centers, that's just not what those companies want to invest in, they need a partner. And quite frankly, we are probably the best in class at that kind of service for our customers in managing the design upfront, all the way into deployment and through post-sale maintenance, uptime and break fix kind of solutions. And so, from our perspective, we are an ideal candidate. We're flexible. We're nimble. We're investing. And we don't really dictate the conversation where we're more of a partner. And when you compare us to some of the larger companies that are -- this is part of the whole, at Penguin, this is all we do. And I would tell you that the capabilities, the know-how of 20 years in the business, the design capabilities, the innovation around working with the likes of NVIDIA and AMD and Intel on the processor side, memory technology, the storage people. We integrate that into world-class solutions, and I think we're looked at as someone who's really kind of well versed and well known in this segment of high-performance compute.

Great. That's really helpful. And then, I just wanted to ask one on the LED business as well. You went through a manufacturing transition, you highlighted the growth, as well as the gross margin performance, which I think we've seen over the first couple of quarters here. Can you just talk about the health of the LED market in general? The industry has been known to have some pricing pressures, as well as competition on the low end, but you've managed to kind of carve out an area in that business, where you guys may not be facing that or at least can find areas of high value-add solutions. Can you talk to that dynamic and why you think you think you can success there longer term?

Yes, for sure. The LED business has been through some substantial headwinds over the last 3 years. Most of those headwinds were in a market called mid-power and low-power LEDs. That part of the market, which is substantial, in terms of the capacity, was subsidized by the Chinese and Taiwan government. And so, you've got a number of companies who had excess capacity driving down price in the mid-power and low power part of the market. Over 95% of our business today at Cree LED is in the high-power part of the business, where there's really only 3 competitors. OSRAM, which was recently acquired by ams. NICHIA, which is a small LED high-power mid-power company out of Japan. And then Lumileds, which is a portfolio company of Apollo Global Holdings. That market is much more dependable. And in each case, I think we're pretty well positioned from a go-to-market. Having said that, even in the high power space, the demands that drive high power in some of these vertical markets faced a headwind. And so, we think, not only did we buy with an opportunity to drive manufacturing efficiency like we have. We think we kind of bought the business at a relative trough. For example, when we bought Cree LED, it was running about $95 million to $100 million in quarterly revenue. And this was once a business that, just 3 or 4 years ago, was at about $600 million of revenue in the same markets. Our suspicion is that, as the LED industry is shaking out, we think there's, again, relatively good growth, and we're being cautious in our prior guidance of mid-single digits, but we think there's good growth in this industry in addition to the operating and gross margin expansion we've achieved.

Very nice. With that, I think we've run out of time. Yes, I just want to say thank you again to Mark and Ken for joining us. It's been a great year and looking forward to what's next for you guys. So, thank you again for joining.

Thanks for having us.

Thanks, Tom.