FOOL CONFERENCE
CALL SYNOPSIS*
By Debora Tidwell
(MF Debit)
Iomega
Corporation
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1821 W. Iomega Way
Roy, UT 84067
(801) 778-1000
http://www.iomega.com
UNION CITY, Ca., January 28, 1997/FOOLWIRE/ --- Iomega Corporation released their results for the fourth quarter and fiscal year 1996 after the market close today. For the quarter, the company reported revenues of $397 million, up 167% compared to $149 million reported in Q4 last year. Net income for the fourth quarter was $25.9 million or $0.19 per share, excluding a one-time pre-tax charge of $9.1 million ($5.6 million after tax) for previously announced organization changes in Europe and the U.S. This is a 137.5% increase over net income of $9.9 million or $0.08 per share reported in last year's fourth quarter. Net income in the fourth quarter, including the one-time charge, was $20.3 million or $0.15 per share.
SEQUENTIAL QUARTER COMPARISONS. Fourth quarter revenues of $397 million compared to $310 million in the third quarter, representing sequential growth of 28%. Earnings per share of $0.19 was up 111% sequentially over the $0.09 per share reported in the third quarter. Net income of $25.9 million was a 102% increase sequentially over third quarter net income of $12.8 million reported in the third quarter.
FY 1996 RESULTS. For the year, revenues were $1.2 billion, an increase of 272% over FY 1995 revenues of $326 million. FY 1996 net income was $62.9 million or $0.47 per share, before the one-time charge mentioned above. This is a 571.4% increase over earnings of $8.5 million or $0.07 per share in FY 1995.
IOMEGA CEO KIM EDWARDS' INTRODUCTORY REVIEW OF RESULTS
Iomega continues to believe that it is in the company's best interests not to break out disk tie ratios, drive volumes, and Zip versus Jaz sales at this time.
Before getting into the numbers, they thought it was of benefit to review the overall business environment as they entered the fourth quarter. In addition to reporting on running the business on a day-to-day basis, Edwards always ends his overview with a summary of how they did relative to their primary objective of building a strong corporate foundation. It is in this context that they wanted to preface the numbers with the following qualitative assessment of the fourth quarter.
INVESTED IN SPACE AT RETAIL. Given that the fourth quarter is normally the strongest selling season in retail, Iomega invested heavily in creating demand and acquiring significant shelf space at all of the major retailers. The investment resulted in a very strong presence at virtually every computer retailer in the United States and the major ones throughout Europe. To ensure that they were prepared to meet upside demand, they increased their finished goods inventory, particularly of Zip. Because of the excellent ramp of Penang, they expanded production capacity for Jaz, Ditto, and Zip in Penang to be prepared to meet upside demand.
CHANGES IN EUROPE. In the second quarter they announced that they changed the reporting structure of European marketing and sales to strengthen their European effort. They gave Tim Hill responsibility for global marketing and Ted Briscoe global sales. At the time, they said that these changes should allow them to be more responsive to market conditions, implement new programs faster, and provide clearer performance expectations by improving their speed and consistency of global communications and leadership. Edwards also said that the moves would have a positive impact on the fourth quarter. Plus, in the background, their cost reduction efforts were kicking in. Overall, they were much better positioned than any of their competitors, and the fourth quarter and total year results reflect it.
WEAK RETAIL SALES FOR COMPUTER INDUSTRY. What they didn't know was that US retail sales would be very soft, particularly for computer-related and consumer electronic products. In fact, now they know that most of the computer and electronic retailers had declines in fourth quarter comparable store year-over-year sales. The foot traffic just wasn't there. The American consumer was waiting for the next generation of lower-priced and/or higher-performance computers. Fortunately, Iomega addressed the European organizational issues early enough to have a very positive impact on Q4.
RESULTS. With that as the business environment, let's get into the results. They are very pleased to announce that they had record sales of $397 million, bringing the total year to $1.213 billion. As a reference, this places the new Iomega ahead of Microsoft, Apple, Dell, Compaq, and AOL for speed of growth from $150 million to $1.2 billion. What's the relevance of the $150 million in sales? That was the level of previous year sales when they created the new Iomega in January of 1994.
SALES RESULTS AND COMPARISONS. Sales of $397 million for the quarter was 28% ahead of the third quarter this year and 2.7 times Q4 1995. Total year sales of $1.2 billion are 3.7 times last year's $326 million. As they mentioned earlier, while US retail was soft for computer and consumer electronics, the actions Iomega took in Europe had a major impact on Q4. Europe's Q4 sales were $127 million or 2.5 times Q3 1996. A more interesting comparison is that Europe's Q4 sales were 1.5 times Europe's total 1995 sales. For the year, Europe totaled $296 million, just short of all of Iomega last year. They are also pleased to announce that their Far East sales broke the $100 million barrier, providing a good springboard to move into 1997.
NET INCOME AND COMPARISONS. Net income for the fourth quarter was $26 million or $0.19 per share, excluding a one-time charge associated with the upcoming relocation of their European headquarters to Geneva and the move of their high volume manufacturing from Roy to Penang. The $26 million was 2.6 times the $9.9 million in the fourth quarter of 1995. Net income including the one-time charge was also at an all time high, totalling $20 million or $0.15 per share. This brings total year 1996 income to $63 million or $0.47 per share, excluding the one-time charge, versus total year 1995 net income of $8.5 million or $0.07 per share. Including the charges, net income was $57 million or $0.43 per share.
GROSS MARGINS. The best part of the story is that, even with the $100 street-price reduction enacted on Jaz in Q3 and the $50 rebate on Zip, Iomega's cost reduction programs increased their gross margins to 29% this quarter, up from 26% in the third quarter. In fact, while they don't break it out in any more detail, compared to last quarter, the margins improved on Zip, Ditto, and the Jaz product lines. They have repeatedly stated that their strategy is to hit key consumer price points to expand the market for Zip drives and ultimately get them to $99. Their improvement in gross margin this quarter demonstrates that, while often very challenging, their plan to continue to hit attractive price points is viable and in fact worked as planned in the fourth quarter. Internally they knew that in the second half they had to reduce prices and yet improve margins through cost reductions to stay on track toward achieving their ultimate goal of getting the external Zip drives to $99 at retail.
SALES BY PRODUCT LINE. Sales for the new personal solutions which only include Ditto, Zip, and Jaz, totalled $389 million for the quarter, up 2.9 times from the $134 million they contributed in the same quarter a year ago. Ditto sales were $39 million, up 20% from Q4 1995 and from the last quarter. Zip and Jaz combined totalled $350 million, up 30% from $269 last quarter and 3.5 times the $102 million a year ago. For the year, Ditto totalled $128 million, up 48% from $86 million in 1995. Their disk-based products, Zip and Jaz combined, grew $1.05 billion, up 6 times from the $174 million last year. Although they do not break it out in any more detail, OEM Zip drives accounted for less than 10% of their total drives sold in the fourth quarter and were down in absolute units versus the third quarter. The two key factors affecting Q4 OEM shipments were that much of the OEM drive requirements were shipped in Q3 as they build their computers for Q4, and a major customer emphasized the non-Zip SKUs to reduce their inventory on lower-end units in response to their competitors' price reductions. Although they no longer consider it material information, as of December they have shipped over 4 million Zip drives.
MARGINS HIGHER ACROSS PRODUCT LINES. For the quarter, gross margins from Ditto, Zip, and Jaz was $113 million, up from $78 million last quarter and $40 million a year ago. For the year, gross margin from these products totalled $324 million, 5 times the $65 million last year.
REVIEW OF FINANCIALS BY LEN PURKIS, IOMEGA'S CFO
Firstly, revenues breaking through the $1.2 billion level is a major accomplishment, with just over $1 billion to Zip and Jaz, both products being in their first full 12 months of sales. Each of the three product groups of Zip, Jaz, and Ditto have recorded increased revenues in each quarter of 1996. International sales totalled $410 million for the year, or 34% of total revenues, which is up close to 4 times the 1995 total of $103 million or 32% of total revenues. The fourth quarter 1996 revenue growth of 28% over third quarter 1996 was driven by Europe which more than doubled its revenues to $127 million. The rest of world revenues, which is the Americas and Far East, grew over the third quarter 1996, but the softness in the US retail market for computer and consumer electronics did impact quarter over quarter growth.
REBATE ACCOUNTING. Purkis reviewed how rebates are accounted for. Their investor relations group has spent a lot of time since the last call explaining the accounting, even to the level of detaill of key accounts. The accounting is simple and straightforward as follows. Within a quarter, gross revenues are reduced by the expected take-up rate of cash rebates which after 6 months of actual experience supports the range of about 50% previously mentioned by them and consequently supports the accounting entries in the third and fourth quarter financial statements. The approximate 50% range has been supported by cash paid out for valid claims and by claims in process but not yet paid out the proper accruals have been made at the end of the third quarter and fourth quarter to ensure that firstly, revenue within a quarter is properly stated and reflects a reduction for cash rebates relative to units sold in that quarter, and secondly the balance sheet properly reflects the liability to customers for claims still to be paid out.
GROSS MARGINS. Gross margins for the fourth quarter totalled $115 million, up 41% from the $82 million in the third quarter 1996 and up 2.5 times the $45 million in the fourth quarter 1995. In the fourth quarter 1996, the gross margin percent of revenue increased to 29% from 26% in the third quarter 1996. This increase was driven by volume increases and cost efficiencies that more than offset the flow-through of pricing actions taken in the third quarter 1996. All three product lines of Zip, Jaz, and Ditto improved their gross margin dollars and percent from the third quarter of 1996.
OPERATING EXPENSES. SG&A for the fourth quarter of 1996 is reported at $68 million. That includes $9.1 million for the one-time pre-tax charges for organizational changes in Europe and the US. Excluding this charge, SG&A for the fourth quarter of 1996 is $59 million or 14.8% of revenues versus $50.3 million or 16.2% of revenue in the third quarter of 1996 and $23.8 million or 16% of revenue in the fourth quarter of 1995. Total year 1996 SG&A, excluding one-time charges, is $181.6 million which represents 15% of revenue versus 1995 where SG&A represented 17.5% of revenue. They have leveraged SG&A. R&D at $13.1 million in the fourth quarter of 1996 represented 3.3% of revenue while up $2.6 million on Q3 1996. Total year R&D is $42.1 million or 3.5% of revenue, which is twice the level of 1995 and driven by the more than 80% increase in R&D headcount bringing it to around 260 people at the end of 1996.
OPERATING INCOME. The resulting operating income in the fourth quarter of 1996 before charges is $43 million, which is double the third quarter of 1996 and close to 3 times fourth quarter 1995. Total year operating income before charges broke the $100 million mark at $109 million, up close to 8 times the 1995 operating income of $14 million. The summary at this stage is that they grew revenues at close to 4 times 1996 over 1995 and they grew operating income before charges close to 8 times 1996 over 1995 -- good leverage.
BALANCE SHEET. They were $4 million cash flow positive in the fourth quarter, which is one quarter earlier than they had anticipated. And, they financed growth in the fourth quarter with internally generated funds. Cash at fourth quarter 1996 was $108 million, up from $103 million in the third quarter 1996. The total year 1996, their cash burn was $135 million. This was financed by convertible debt and equity totalling $235 million, leaving them with just over $100 million in cash at year end. Cash burn was approximately $100 million for capital expenditures and approximately $35 million was used for working capital growth.
NOTES PAYABLE AND CREDIT FACILITY. The notes payable at fourth quarter 1996 at $34 million compares to $30 million at third quarter 1996 and the increase represents increased use of the Heller line of credit in Europe which was used to finance the fourth quarter revenue growth in Europe. This facility has been extended through the end of the third quarter 1997 to coincide with the move of the European headquarters to Geneva and to accommodate finalization of a new credit facility. Iomega has selected JP Morgan and Citibank to co-arrange a new syndicated $200 million 3-year revolving credit facility. Both JP Morgan and Citibank have formally committed to the transaction and they expect to have this transaction closed in the next 60 days.
RECEIVABLES. Their DSOs at fourth quarter 1996 was 48 days versus 57 days at third quarter 1996, a 9 day reduction. Their net receivables grew 7% from $198 million in Q3 1996 to $211 million in Q4 1996 on revenue growth of 28% from $310 million to $397 million. The DSO improvement came primarily as a result of very strong collections this quarter. Additionally they have been working with their customers during 1996 to shorten the span where possible and in the fourth quarter they started seeing some of their efforts come to fruition. There is some seasonality to this DSO improvement as many of their distribution and retail customers closely managed inventory and timed deliveries earlier in the quarter than in other non-holiday quarters to make sure that product was available on the shelves for the holiday selling season. Early deliveries in the quarter mean that Iomega had a relatively better opportunity to collect more of the quarter's revenues within the quarter. Their bad debt reserve as of Q4 1996 amounts to $9 million, up from $7.7 million in Q3 1996 and represents 3.6% of gross receivables versus 3.4% in Q3 1996. In Q4 1995, the bad debt reserve was $1.9 million or 1.7% of gross receivables. Other receivable reserves amount to $31.9 million or 12.7% of gross receivables, up from $23.3 million or 10.1% of gross receivables in Q3 1996. Volume rebates in the form of co-op paying programs and channel and distributor incentives were the major drivers of the increase of the reserve over Q3 1996. Included in this reserve is the amount of Zip rebates accrued in the quarter, but not yet paid. Nearly all cash rebates relating to their third quarter Zip rebate program have been paid in fourth quarter 1996.
INVENTORY. Their inventories are down $6 million or 3% at $132 million for the fourth quarter 1996 versus third quarter and their inventory turns are up to 6.6 turns in the fourth quarter versus 5.1 turns in the third quarter. Raw materials are down 22% to $89 million, while finished goods are up 23% to $59 million fourth quarter over third quarter 1996. These moves predominantly relate to Zip.
CAPITAL EXPENSES. Their capital expenditures for the fourth quarter 1996 were $10.7 million. That brings total year capital expenses for 1996 to $101 million, including $28 million for the Penang facility.
OTHER METRICS AND SUMMARY. Overall their balance sheet is considerably stronger entering 1997 than as they entered 1996. Working capital of $270 million is up more than 20 times 1995. The current ratio is 1.94 versus 1.06 at the end of 1995. The debt-to-equity ratio is 31% or 17% excluding subordinated convertible notes, versus 81% at the end of 1995. Net worth is $334 million versus $63 million at the end of 1995. In summary, the fourth quarter was another period of setting new standards for Iomega with record revenues, record net income, record European revenues, record-low DSOs, record inventory turns, and turning cash-flow positive. It was a great way to finish 1996 -- the year Iomega broke through the $1 billion revenue mark, with growth of 3.7 times 1995.
KIM EDWARDS' REVIEW OF 1996 ACCOMPLISHMENTS AND PRIORITIES FOR 1997
REBATES - COMMERCIAL PERSPECTIVE. Although Len Purkis addressed the accounting side of the rebates, before they went on Edwards addressed the commercial side. Their initial response to the rebate program led to a high level of customer complaints. Iomega simply did not anticipate the success of the program in the third quarter and, therefore, fell behind and stayed behind in terms of the time it took for their customers to receive their rebate checks for merchandise throughout the second half. They better prepared themselves for the second period of the program and are now filling rebates in a timely fashion, well within the time stated on the rebate form.
BUILDING A STRONG CORPORATE FOUNDATION. As they have stated in all their previous conference calls, in addition to running the business on a day-to-day basis, they have continued to focus on their primary objective of building a strong corporate foundation. As they have stated many times, while many have been focused solely on the short term results or interim press releases, Iomega has been focused on building a solid corporate foundation. As they enter 1997, it is appropriate to summarize the 1996 accomplishments relative to building such foundation.
MANAGEMENT TEAM. It all starts with assembling what is now a seasoned, senior management team including Briscoe, Brown, Hill, Kelly, Kennedy, Krieger, Nagashwar, Purkis, Rodman, Sterling, and Stewart that has worked together to create one of the fastest-growing companies in the history of US business. Together they have already been to battle numerous times and learned how to win as a team. Recent executive hires including Doug Clifford as VP of R&D, L. Keating as VP and General Counsel, and Kevin O'Connor as VP Human Resources simply add to the management strength. At the beginning of 1997 in order to provide even more product line focus, they reorganized the company into a matrix product business structure. Ted Briscoe is moving from the VP of Global Sales to the Vice President and General Manager of Zip. He will retain responsibility for sales to OEMs since their number one priority is to get Zip into more boxes. Jim Kelly, previously VP of Ditto R&D now becomes the Vice President and General Manager of the Ditto product line. They are recruiting a General Manager for Jaz. Tim Hill, previously Vice President of Global Marketing has had his responsibility expanded to include Global Sales, excluding OEM.
MANUFACTURING. On July 18th they announced their intention to purchase the manufacturing facility in Penang. The production ramp started the last week of August. Today, they are in a fully operational, world-class 376,000 square foot manufacturing facility in Penang. It is equipped with a team of individuals that, from a standing start in August, shipped more Jaz, Ditto, and Zip drives by December than the combination of Iomega's own Roy facility and Sequel had built in all but their combined best quarter. And, the team achieved quality standards that met or exceeded their other manufacturing locations. Although dependent on the mix of internal and external drives -- and they emphasized this is not an indication of 1997 demand or sales -- they have annual manufacturing capacity in place for about 8 million Zip drives, 1 million Jaz drives, and 1.5 million Ditto drives. Zip disk production is now in all 3 parts in the world with their own manufacturing in Roy Utah, Megamedia in the Far East, and Sentinel in Europe. Penang has begun pilot run of Jaz disks and will replace Seagate in the first quarter. Cost reduction efforts are starting to materialize as was evidenced by the 3-point gross margin improvement in Q4. While they regret the disruption they have created on the lives of their employees in Roy, the relocation of high volume manufacturing from Roy and Sequel to Penang is expected to reduce transportation costs and complexity since it puts them closer to their supplier base. Additionally, being there will reduce overall costs and further enhance quality levels.
PRICE REDUCTIONS AT RETAIL. The second-half 1996 price reductions were the first step on the path to getting the external Zip drive to $99. The product basket includes a proven full line of external and internal drives, media, and accessories for the Zip, Ditto, and Jaz technology platforms and working bench models of their recently announced n.Hand technology, the mini Zip-like drive. The 15mm notebook Zip drive is expected to ship in Q2 and is already supported by BST, CNF, and NEC. n.Hand, aimed at the consumer electronic applications is planned for production capability in late 1997. They expect to demonstrate the next generation of prototypes by June.
GET ZIP INSIDE BOXES. They have continually stated that their number one priority is to get Zip inside the boxes. For the last two quarters, they have had a two-prong effort focusing on increasing the number of SKUs offered by existing partners and on penetrating the remaining OEMs. They lost a couple that they had previously announced. Cayman has announced that they are exiting the PC business and Acer Basic has not done well resulting in them now offering it without Zip, although Iomega is continuing to work with them on other configurations. That being said, they are very pleased with their progress since they now have the top 6 of the top 10 non-Mac PC manufacturers offering internal Zip drives. Even more exciting is the association of Zip with the new MMX machines. In their recent MMX releases, Compaq, Packard Bell, NEC, IBM, Dell, Gateway 2000, Hewlett-Packard, and Micron all offered Zip in a SKU or as an option with an MMX machine. Zip is an enabling technology for multimedia computing in business and consumer applications requiring MMX performance. The list of the leading manufacturers offering Zip now includes Compaq, Packard Bell, NEC, IBM, Dell, Gateway, Hewlett-Packard, Micron, Unisys, Power Computing, and European integrators. Fuji, Maxell, and Sony are supporting the Zip standard by selling private-branded Zip disks. MCI or Matsushita Communications, their first licensee is now manufacturing Zip drives. Gateway and Micron are offering Ditto in their PCs and they private-brand for IBM and Sony. Jaz is being offered in Gateway, Power Computing, and Micron PCs and several vertical market applications. The installed base now consists of more than 4 million Zip drives and it is approaching 7 million personal solutions for Zip, Ditto, and Jaz combined.
GLOBAL EXPANSION. European and foreign headquarters in Geneva and Singapore should provide a strong foundation for further global expansion. Additionally, Geneva is expected to provide better access to senior management talent, easier travel, and a more flexible working environment. It is also a part of their overall international tax strategy. They expect to be fully operational in Geneva by March. The new European distribution center improved customer service and reduced transportation costs in the fourth quarter. On a lesser note, they are in the process of moving into their just-completed world headquarters in metropolitan Roy.
MOVE TO THE NYSE. They are now traded on the New York Stock Exchange which appears to have taken some of the intraday volatility out of their stock.
BACKLOG. At the end of the year, order backlog was $76 million, down from $93 million last quarter. They believe that this is mostly attributable to seasonality and their ability to respond quickly to retail order demand.
FINANCIAL HIGHLIGHTS. Looking at the foundation from a financial perspective, managing receivables to 48 days and holding inventory to third quarter levels resulted in their being cash-flow positive in the fourth quarter. This, coupled with their March debt and June equity offerings, allowed them to enter 1997 with $100 million in cash and they are negotiating an additional credit facility in the event they need funding for upside growth. For the year, they achieved $1.2 billion in sales and, excluding one-time charges, $63 million in net income. In doing so, they strengthened their international position with over $400 million or about 1/3 of their sales coming from international operations. They are proud to reiterate that their sales growth, that is that of the new Iomega from $150 million to $1.2 billion, was faster than Compaq, Apple, Dell, Microsoft, and AOL for the comparable sales period. From any vantage point, 1996 was an outstanding year. Iomega in the last 3 years has experienced what many companies experience in 10.
1997 PRIORITIES
On a broader front they are elevating customer satisfaction to an executive level position under Bill Kennedy and making it a key priority for the organization and, specifically, the executive team. Bill will retain responsibility for logistics since the organization is key to managing their supply and fulfillment chains. While they have made significant progress in improving technical support and shortening the time to get rebates, delighting the customer will be placed in the forefront of all that they do. Getting Zip inside more of the boxes remains the number one priority. They will continue to work closely with those OEMs currently offering Zip drives in their PCs to broaden the range of consumer and commercial SKUs -- with the retailers to convince them to offer additional SKUs, and with the remaining PC OEMs to get them to include Zip. In parallel, they will enact their strategy of broadening consumer demand by offering attractive consumer price points, ultimately $99 for the external Zip drive. A cross-platform objective is creating broad demand for all of their products. They will employ all of their marketing skills and attractive consumer price points to do so in 1997. They need to bring n.Hand to market and penetrate beyond the traditional computer applications. They need to place more emphasis on cash management and particularly better management of their inventories through better supply-line management. What a difference a year makes, and even more so two. 1994 at $141 million in sales, 1995 at $326 million, and 1996 at $1.2 billion. From $150 million to $1.2 billion, the new Iomega just might be the fastest-growing company in US history and they enter 1997 with a fully staffed, experienced, battle-hardened management team ready to address the highlighted 1997 priorities.
In closing Kim Edwards extended his thanks to everyone who supported Iomega throughout an exciting and challenging year and all the Iomega employees and their customers who helped them to create history.
QUESTION AND ANSWER SESSION
MCI PRODUCING ZIP DRIVES. The first question asked the company to give more information as to when MCI started production, are there any royalty payments included in the fourth quarter, and does the company see any need for additional licensing arrangements during 1997. The company responded that they started in December, there are no royalty payments in Q4. The agreement with them will result in relatively insignificant royalties going forward, it's more to get another partner in creating a standard. And, yes, they see the need to get other manufacturers of the ilk of MCI involved in building Zip drives. The company was asked if they see MCI servicing any of the existing OEMs or will those be separate customers. The company said that it is hard to specifically answer because they are going to have to decide, but Iomega hopes MCI does service OEMs.
BUILDING OEM RELATIONSHIPS. The second question asked for a discussion of the timeline with regard to the OEMs. The company answered that with regard to some of the announcements, if you read when they are actually going to start shipping, some of the companies haven't even done so. Based on what Compaq announced, they don't think Compaq has yet to ship an MMX machine with Zip in it. Secondly, in most of those cases, if they have shipped it is very minimal. Those announcements were about 1.5 weeks ago, so they are just starting to build some CPUs with Zip drives in them. Iomega thinks there has been a major step forward for them relative to the MMX machines and the association of Zip within them. If someone purchases an MMX machine, whether it be business or consumer, the likelihood is that they intended to use it in some graphics environment. And, obviously Zip allows them the storage to serve that kind of need. The issue that customer is going to have with potentially competing technologies is that they may not be fast enough to do the kind of work that needs to be done if you buy an MMX machine. It's been interesting in 1996 to work with the OEMs to get them to stick Zip drives in there. It clearly has been the pull through at retail of the blue box that has got them considering and finally sticking them in, but they were not quick to adopt that. So, going forward, Iomega is looking to the platform like an MMX to help clearly solidify the real benefits of Zip to the end consumer inside of the box.
GROSS MARGINS. The company was asked if on the gross margin line in Q4 there was anything unusual, either positive or negative charges or gains in the quarter and did the tie ratio change at all affecting gross margins either up or down. The company responded that there was nothing unusual either way in terms of margin in Q4, it was a combination of cost reductions and obviously the additional volume has some benefit from carrying overhead in Q4. The tie ratios, speaking with regard to Zip and Jaz because they are the significant ones, were essentially similar to the third quarter 1996. The tie ratios did not change materially in Q4. The majority of this margin improvement was cost related.
MARGIN IMPROVEMENTS FROM PENANG. The company was asked if they expect to continue to see more benefits out of the Penang facility on the gross margin and how significant could that contribution be. The company responded that they have already stated that moving to Penang will affect transportation costs, it will shorten the delivery cycles from their vendors for their capital usage, but also manufacturing costs and overhead structure are lower in Penang, so certainly one of the prime motivations for moving over there is lower costs across the board and better management of the supply line. So, they certainly expect to have a benefit going forward. They don't provide future projections, so they can't give specifics on their expectations on the absolute number of cost reduction going forward, but they do expect it to have a positive impact. While they talk very positively about Penang, they took over the EAI facility from Seiko-Epson in Q3 and it has been doing an excellent job for them, so they may continue on with that facility for longer than they had anticipated a quarter ago. So they are still balancing EAI and Penang facilities.
MARKETING STRATEGY FOR Q1 & Q2. The company was asked what their marketing strategy will be for the first half of the year. They responded that they will still continue to maintain a high profile at retail even recognizing the seasonality in the retail channel particularly in computer and consumer electronics. They think it is a key part of their strategy going forward to continue to create retail demand both at the consumer and business to continue to generate increased interest inside the boxes, so we will continue to see Iomega's presence at retail. Another thing they mentioned is that, as the numbers probably indicate, they had a very strong presence in Europe at the major retailers too. They know there has been a lot of dialogue asking if they reduced advertising in Q4 and the answer is, absolutely not, but they spent the money differently. For those, again, who don't realize it, when you get your floor space at a retailer, it costs advertising dollars. To Iomega it is just another means of advertising.
BONUSES AND OTHER Q4 ONE-TIME CHARGES. The company was asked if there were any one-time charges in the fourth quarter such as management bonuses. They responded that they have accrued throughout the year to cover things like the management bonuses so there aren't any one-time hits in the fourth quarter in SG&A for such things. They were asked what their reserves are for customers who have more than 45 days of inventory. They answered that they have a revenue recognition policy which recognizes that there are returns from the field that they reserve for and they reserve for customers where they have right of returns. They accrue for that in deferrred revenue and the sales reserve at the end of the fourth quarter is about $15.6 million, which is up from about $11 million in the third quarter and the driver of that is really the volume increases they have had in the US, Europe, and the Pacific for normal returns and those numbers are the deferred margins on those sales.
PLANS FOR ZIP GOING FORWARD. The company was asked to discuss the plans for the Zip drive -- do they plan to do a 200-megabyte or higher capacity version, is their goal just to drive sales growth through pricing, will there be lower gross margins as the mix changes to include more OEM sales and how will they maintain profitability. The company responded that they have repeatedly stated that it is their objective to drive the retail Zip drive down to $99 to broaden the consumer demand. They know that people buy things at $99 a lot more than they buy at $199. The first step toward that was the $50 rebate that allowed them to advertise at $149.95. They have also repeatedly stated that they have 200-megabyte Zip drives working in the laboratories and would decide if and when to introduce them based on a combination of consumer demand as well as competitive products that are available. The company disagreed with the analyst's statement that demand for the external Zip drives or the retail Zip drives is waning or flattening, they think it is a matter of coninuing to build awareness for the product as well as continue to be aggressive on any consumer price points. In terms of OEM drives, certainly OEM drives would tend to be lower margins than the retail drives. So, they do have somewhat of a balancing act that they have been entertaining all along. The other side is the disks, which is where they make the majority of the margin anyhow.
N.HAND PRODUCT DEVELOPMENT. The company was asked about how they will create demand for n.Hand, given the assumption that the future of it will depend on successful OEM sales programs to a group of customers they haven't sold to in the past. The company responded that they don't deal with those class of customers today because they are more consumer-electronics. Secondarily is the fact that they don't have a hole in whatever their device is where Iomega can stick an n.Hand drive in it. They will have to custom design a piece of equipment, whether it be a camera or cell phone or whatever around n.Hand. The implication of that is, typically with an OEM for a total design cycle, you're probably looking at around 12 months. Iomega is talking about the possibility of having n.Hand in production in late 1997. But, in the meantime, in parallel, they are going to be working with the OEMs to try to develop a co-development program to keep those time frames reasonable. In terms of the overall style, in many cases they are going to take advantage of a lot of what they learned with Zip relative to staying focused on the customer's perception of the technology. They don't talk about what makes Zip or Jaz work, they talk about what Zip and Jaz will do in terms of work for the consumer. They will take the same approach to n.Hand. They will position it as a consumer solution as opposed to some piece of hardware. That again will probably entail them looking at software different than they ever have before relative to the computing because the person using the camera may have no interest whatsoever in having any relationship to a computer. So they have to take all of that into account. It does present some new interesting challenges that they haven't faced before although, on the other hand, they have been in consumer electronics sales and marketing both in this life as well as their prior lives.
QUALITY AND RETURNS. The company was asked to talk about the quality of Jaz in its ramp process versus the quality of Zip during the similar process including returns in Q4 versus Q3, charges in Q4 versus Q3, and the Seagate relationship. The company said that they don't provide specifics relative to any of the product breakouts but they would say that they have addressed this issue in previous analyst calls and want to make it very clear -- they are not experiencing any unusual return rates for Zip, Jaz, or Ditto. Returns are accounted for in their warranty reserves based on their rate of return experience. There is nothing unusual going on. Beyond that there is not much more to say. Relative to the Seagate question, as they continue to state, Penang has come up much faster than they have ever anticipated. That had a major impact on their changing some of their thinking relative to production on all of their products. Part of what happened is that, at one point they thought they had to have Seagate just to build the disks that they saw, given the ramp of Penang, there just wasn't the level of volume that would require both Seagate and Penang in the near term. They also added that they will continue, which they were doing all along, to try to get Seagate's platters qualified so they have them as another potential vendor for Jaz disks.
COMPETITION. The company was asked about competition for Jaz and Zip. The company started with Jaz. Through all of 1996, for all intents and purposes, they saw no direct competition to Jaz. It's the only product that is out there in the marketplace at 1 gigabyte with the speed it has and is just significantly different than anything else out there. From an LS-120 or Mitsumi point of view, again in 1996 there was really no presence there. They have yet to see any Mitsumi drives in the marketplace at all and very limited LS-120 drives. They think they have the latest version of that drive. It has been cost reduced, however, from what they have seen it still has performance limitations relative to its ability to play PC-quality video and they think these things are going to hamper its success with the end user. Iomega did a lot of testing way back when in terms of what is acceptable and what isn't in terms of performance and, in terms of Zip, they recognized that it had to "feel like a hard drive" and they think there is a certain technical limit that they think you have to be at before it feels like a hard drive and, at least from what they've seen so far, that product does not feel like a hard drive.
BACKWARD COMPATIBILITY. The company was asked if backward compatibility is still an objection at times with OEMs. They responded that, in reality, they are more talking to the end user who doesn't appear to have any concerns about backward compatibility whatsoever. Another thing they said we all know and the industry continues to want to ignore is that there was no backward compatibility when we went from 5.25" to 3.5" floppies. This industry has already overcome this once before. They said they certainly, when talking to the customers, do not see backward compatibility as being an issue. The fact that they now have 10 different PC manufacturers including Zip suggests that, at least to some degree, somebody at those PC manufacturers also does not think backward compatibility is a big issue.
ZIP MARKET PENETRATION RATE. The company was asked to compare penetration of Zip drives in the market to CD-ROM drives or modems when they first came out. The company responded that, unfortunately, they didn't have those numbers at hand and that all they know is that, in the period of time they have been in the market, they are way ahead of either the CD-ROM drive or modem in their volume ramp to standard.
BACKWARD COMPATIBILITY. An analyst said that a quarter or two ago in a conference call, Kim Edwards mentioned that Iomega had engineers working on backward compatibility and asked if any progress has been made on it. Kim Edwards asked to interrupt the questioner and stated that he absolutely never stated that. Iomega has stated from the very beginning that they felt it was important to provide a low-cost drive as well as the performance and that backward compatibility was just too expensive relative to accomplishing that.
TAXES. The company was asked what they thought the effective tax rate would be in 1997. They responded that in 1996 they have grown in Europe from $85 million to $296 million and in the Far East from $18 million to $114 million and they started manufacturing in Malaysia. Growing their business so rapidly on a global basis has necessitated them to stay very close to the business in terms of tax structure, cash management, and currency exposure. So, to the extent that they get tax rulings and holidays that are available to them in Europe, Malaysia, and the Far East, they have worked with the business to include a tax efficient structure in their decision making process. So, taxes are now an integral part of their business strategy. The tax structure and negotiations on holidays, if they are successful, should lower the overall tax rate of Iomega in 1997. Part of the problem is that they still have a lot of this under negotiation and depending on the outcome of those negotiations, it has a very big swing on their actual results. They aren't prepared right now to answer the question, but should have a decent handle around it by the second quarter. Until they finish the negotiations with the tax authorities it would be pure speculation. They asked to get those behind them and then they will share it with everyone.
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