Item 2. Management’s Discussion and Analysis
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Note About Forward-Looking Statements
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) and other parts of this report include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements other than historical facts and often address future events or our future performance. Words such as "anticipate," "estimate," "expect," "project," "intend," "may," “will,” “might,” "plan," "predict," "believe," "should," “could” and similar words or expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words.
Forward-looking statements contained in this MD&A include statements about, among other things:
● specific and overall impacts of the COVID-19 pandemic on our financial condition and results of operations;
● our beliefs regarding the market and demand for our products or the component products we resell;
● our ability to develop and launch new products that are attractive to the market and stimulate customer demand for these products;
● our plans relating to our intellectual property, including our goals of monetizing, licensing, expanding and defending our patent portfolio;
● our expectations and strategies regarding outstanding legal proceedings and patent reexaminations relating to our intellectual property portfolio;
● our expectations with respect to any strategic partnerships or other similar relationships we may pursue;
● the competitive landscape of our industry;
● general market, economic and political conditions;
● our business strategies and objectives;
● our expectations regarding our future operations and financial position, including revenues, costs and prospects, and our liquidity and capital resources, including cash flows, sufficiency of cash resources, efforts to reduce expenses and the potential for future financings;
● our ability to remediate any material weakness and maintain effective internal control over financial reporting; and
● the impact of the above factors and other future events on the market price and trading volume of our common stock.
All forward-looking statements reflect management’s present assumptions, expectations and beliefs regarding future events and are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from those expressed in or implied by any forward-looking statements. These risks and uncertainties include those described under “Risk Factors” in Part II, Item 1A of this report. In light of these risks and uncertainties, our forward-looking statements should not be relied on as predictions of future events. Additionally, many of these risks and uncertainties are currently elevated by and may or will continue to be elevated by the COVID-19 pandemic. All forward-looking statements reflect our assumptions, expectations and beliefs only as of the date they are made, and except as required by law, we undertake no obligation to revise or update any forward-looking statements for any reason.
The following MD&A should be read in conjunction with our condensed consolidated financial statements and the related notes included in Part I, Item 1 of this report, as well as our Annual Report on Form 10-K for our fiscal year ended January 2, 2021 (the “2020 Annual Report”) filed with the Securities and Exchange Commission (the “SEC”). All information presented herein is based on our fiscal calendar, and references to particular years, quarters, months or periods refer to our fiscal years ended in January or December and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company,” “Netlist,” “we,” “us,” or “our” as used herein refers collectively to Netlist, Inc. and its consolidated subsidiaries, unless otherwise stated.
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Overview
We provide high-performance modular memory subsystems to customers in diverse industries that require enterprise and storage class memory solutions to empower critical business decisions. We have a history of introducing disruptive new products, such as one of the first load reduced dual in-line memory modules ("LRDIMM") based on our distributed buffer architecture, which has been adopted by the industry for DDR4 LRDIMM. We were also one of the first to bring NAND flash memory ("NAND flash") to the memory channel with our NVvault non-volatile dual in-line memory modules ("NVDIMM") using software-intensive controllers and merging dynamic random access memory integrated circuits (“DRAM ICs” or "DRAM") and NAND flash to solve data bottleneck and data retention challenges encountered in high-performance computing environments. We also offer storage class memory products called HybriDIMM to address the growing need for real-time analytics in Big Data applications, in-memory databases, high performance computing and advanced data storage solutions. We are continuously developing and improving upon the HybriDIMM product while exploring opportunities with strategic partners. Our NVMe SSD portfolio provides industry-leading performance offered in multiple capacities and form factors.
Due to the ground-breaking product development of our engineering teams, we have built a robust portfolio of over 130 issued and pending U.S. and foreign patents, many seminal, in the areas of hybrid memory, storage class memory, rank multiplication and load reduction. Since our inception, we have dedicated substantial resources to the development, protection and enforcement of technology innovations we believe are essential to our business. Our early pioneering work in these areas has been broadly adopted in industry-standard registered dual in-line memory modules (“RDIMM”), LRDIMM and in NVDIMM. Our objective is to continue to innovate in our field and invest further in our intellectual property portfolio, with the goal of monetizing our intellectual property through a combination of product sales and licensing, royalty or other revenue-producing arrangements, which may result from joint development or similar partnerships or defense of our patents through enforcement actions against parties we believe are infringing them.
We also resell SSD, NAND flash, DRAM products and other component products to end-customers that are not reached in the distribution models of the component manufacturers, including storage customers, appliance customers, system builders and cloud and datacenter customers.
During the first quarter of 2021, we recorded net sales of $14.9 million, gross profit of $1.5 million and net loss of $4.0 million. We have historically financed our operations primarily with proceeds from issuances of equity and debt securities and cash receipts from revenues. We have also funded our operations with a revolving line of credit and term loans under a bank credit facility. See “Recent Developments” and “Liquidity and Capital Resources” below for more information.
Recent Developments
SK hynix License Agreement and Supply Agreement
On April 5, 2021, we entered into a Strategic Product Supply and License Agreement (the “License Agreement”) and Product Purchase and Supply Agreement with SK hynix, Inc., a South Korean memory semiconductor supplier (“SK hynix”). Both agreements have a term of 5 years. Under the License Agreement, (a) we have granted to SK hynix fully paid, worldwide, non-exclusive, non-assignable licenses to certain of our patents covering memory technologies and (b) SK hynix has granted to us fully paid, worldwide, non-exclusive, non-assignable licenses to its patent portfolio. In addition, the License Agreement provides for the settlement of all pending intellectual property proceedings between us and SK hynix with the settlement fee of $40 million payable to us by SK hynix, and the parties have agreed to collaborate on certain technology development activities.
Amendment to SVB Credit Agreement
On April 9, 2021, we entered into an amendment to a credit agreement dated October 31, 2009 with Silicon Valley Bank (“SVB”) (as the same may from time to time be amended, modified, supplemented or restated, the “SVB Credit Agreement”) to accrue interest on advances at a per annum rate equal to the greater of 2.25% above the Wall Street Journal prime rate (“Prime Rate”) or 5.50% and to extend the maturity date to December 30, 2021. The amount
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available for borrowing may be increased to $7.0 million and the maturity date will be extended to April 29, 2022 upon our request, if we meet certain conditions.
2019 Lincoln Park Purchase Agreement
On June 24, 2019, we entered into a purchase agreement (the “2019 Purchase Agreement”) with Lincoln Park Capital Fund, LLC (“Lincoln Park”), pursuant to which we have the right to sell to Lincoln Park up to an aggregate of $10 million in shares of our common stock over the 36-month term of the Purchase Agreement subject to the conditions and limitations set forth in the 2019 Purchase Agreement. During the first quarter of 2021, Lincoln Park purchased an aggregate of 1,669,429 shares of our common stock for a net purchase price of $1.6 million under the 2019 Purchase Agreement. In connection with the purchases, during the first quarter of 2021, we issued to Lincoln Park an aggregate of 129,468 shares of our common stock as commitment shares in noncash transactions.
2020 Lincoln Park Purchase Agreement
On March 5, 2020, we entered into another purchase agreement (the “2020 Purchase Agreement”) with Lincoln Park, pursuant to which we have the right to sell to Lincoln Park up to an aggregate of $20 million in shares of our common stock over the 36-month term of the 2020 Purchase Agreement subject to the conditions and limitations set forth in the 2020 Purchase Agreement. During the first quarter of 2021, Lincoln Park purchased an aggregate of 9,544,595 shares of our common stock for a net purchase price of $7.8 million under the 2020 Purchase Agreement. In connection with the purchases, during the first quarter of 2021, we issued to Lincoln Park an aggregate of 356,843 shares of our common stock as commitment shares in noncash transactions. In February 2021, we completed the sales under the 2020 Purchase Agreement.
Paycheck Protection Program Loan
On April 23, 2020, we entered into an unsecured promissory note with a principal amount of $0.6 million through Hanmi Bank under the Paycheck Protection Program (“PPP”) (“PPP Loan”) administered by the Small Business Administration (“SBA”) and established as part of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”). The PPP Loan bore interest at 1.0% per annum and would mature in April 2022 with the first six months of interest and principal payments deferred. The amount borrowed under the PPP Loan was eligible for forgiveness if we would meet certain conditions. In May 2021, the full amounts outstanding under the PPP Loan was forgiven.
Economic Conditions, Challenges and Risks
Our performance, financial condition and prospects are affected by a number of factors and are exposed to a number of risks and uncertainties. We operate in a competitive and rapidly evolving industry in which new risks emerge from time to time, and it is not possible for us to predict all of the risks we may face, nor can we assess the impact of all factors on our business or the extent to which any factor or combination of factors could cause actual results to differ from our expectations. See the discussion of certain risks that we face under “Risk Factors” in Part II, Item 1A of this report.
Impact of COVID-19 on our Business
The impact of the coronavirus disease (“COVID-19”) pandemic will have on our consolidated results of operations is uncertain. Although we initially observed demand increases in our products, we anticipate that the global health crisis caused by COVID-19 may negatively impact business activity across the globe. We will continue to actively monitor the situation and may take further actions altering our business operations that we determine are in the best interests of our employees, customers, suppliers, and stakeholders, or as required by federal, state, or local authorities. It is not clear what the potential effects of such alterations or modifications may have on our business, consolidated results of operations, financial condition, and liquidity.
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Results of Operations
Net Sales and Gross Profit
Net sales, cost of sales and gross profit for the three months ended April 3, 2021 and March 28, 2020 were as follows (dollars in thousands):
Three Months Ended
April 3,
March 28,
%
2021
2020
Change
Net sales
$
14,897
$
14,631
2%
Cost of sales
13,396
12,522
7%
Gross profit
$
1,501
$
2,109
(29)%
Gross margin
10%
14%
Net Sales
Net sales include resales of certain component products, including SSDs and DRAM products, and sales of our high-performance memory subsystems.
Net sales increased by $0.3 million during the first quarter of 2021 compared to the same quarter of 2020 primarily as a result of a $1.1 million increase in sales of other small outline dual in-line memory module (“SODIMM”) and RDIMM products, partially offset by a $0.6 million overall decrease in sales of NAND flash products (including a $0.7 million decrease in resales of NAND flash products and a $0.1 million increase in Netlist’s SSD products), a $0.2 million decrease in sales of our very low profile memory subsystem products and a $0.1 million increase in sales discount. Net sales in all periods presented were impacted by the change in the product mix and fluctuating customer concentrations.
Gross Profit and Gross Margin
Gross profit decreased during the first quarter of 2021 compared to the same quarter of 2020 due primarily to lower gross profits on the sales of SODIMM and RDIMM products and sales of enterprise SSD products. Gross margin (or gross profit as a percentage of net sales) fluctuates based on the change in our product mix over periods and the relative cost of the factory.
Operating Expenses
Operating expenses for the three months ended April 3, 2021 and March 28, 2020 were as follows (dollars in thousands):
Three Months Ended
April 3,
March 28,
%
2021
2020
Change
Research and development
$
1,124
$
654
72%
Percentage of net sales
8%
4%
Intellectual property legal fees
$
2,287
$
625
266%
Percentage of net sales
15%
4%
Selling, general and administrative
$
1,957
$
2,221
(12)%
Percentage of net sales
13%
15%
Research and Development
Research and development expenses increased during the first quarter of 2021 compared to the same quarter of 2020 due primarily to an increase in employee headcount and overhead.
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Intellectual Property Legal Fees
Intellectual property legal fees consist of legal fees incurred for patent filings, protection and enforcement. Although we expect intellectual property legal fees to generally increase over time as we continue to protect, defend and enforce and seek to expand our patent portfolio, these increases may not be linear but may occur in lump sums depending on the due dates of patent filings and their associated fees and the arrangements we may make with our legal advisors in connection with enforcement proceedings, which may include fee arrangements or contingent fee arrangements in which we would pay these legal advisors on a scaled percentage of any negotiated fees, settlements or judgments awarded to us based on if, how and when the fees, settlements or judgments are obtained. See Note 7 to the condensed consolidated financial statements included in Part I, Item 1 of this report for further discussion.
Pursuant to the terms of the TRGP Agreement, the legal expenses we incurred for our first action against SK hynix at the ITC and our U.S. district court proceedings that were paid directly by TRGP were excluded in their entirety from our financial statements. As of January 2, 2021, accumulated deficit excluded $1.7 million and $10.2 million of such legal expenses incurred in 2018 and 2017, respectively. No further legal expenses will be paid by TRGP under this agreement. TPGP did not fund the legal expenses incurred for our second ITC action and our proceedings in international courts as well as other District Court proceedings. We believe that the SK hynix License Agreement falls outside the scope of the TRGP Agreement.
Intellectual property legal fees increased during the first quarter of 2021 compared to the same quarter of 2020 due primarily to higher legal expenses incurred to defend our patent portfolio internationally.
Selling, General and Administrative
Selling, general and administrative expenses slightly decreased during the first quarter of 2021 compared to the same quarter of 2020 due primarily to a decrease in outside services.
Other Expense, Net
Other expense, net for the three months ended April 3, 2021 and March 28, 2020 was as follows (dollars in thousands):
Three Months Ended
April 3,
March 28,
%
2021
2020
Change
Interest expense, net
$
(147)
$
(148)
Other expense, net
(2)
(3)
Total other expense, net
$
(149)
$
(151)
(1)%
Interest expense, net, consists primarily of interest expense on the $15 million secured convertible note issued to Samsung Venture Investment Co. (“SVIC”) (“SVIC Note”) in November 2015 and a revolving line of credit under the SVB Credit Agreement, along with the accretion of debt discounts and amortization of debt issuance costs on the SVIC Note. During the first quarter of 2021, other expense was consistent compared with the same quarter of 2020.
Liquidity and Capital Resources
Our primary sources of cash are historically proceeds from issuances of equity and debt securities and receipts from revenues. In addition, as a result of our entry into the SK hynix License Agreement, we plan to use the settlement fee received to support our operations. We have also funded our operations with a revolving line of credit under a bank credit facility, a funding arrangement for costs associated with certain of our legal proceedings against SK hynix and, to a lesser extent, equipment leasing arrangements.
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The following tables present selected financial information as of April 3, 2021 and January 2, 2021 and for the first three months of 2021 and 2020 (in thousands):
April 3,
January 2,
2021
2021
Cash and cash equivalents
$
21,616
$
13,326
Convertible promissory note and accrued interest, net
16,438
16,310
Total PPP Loan and accrued interest
643
641
Working capital
6,925
(2,726)
Three Months Ended
April 3,
March 28,
2021
2020
Net cash used in operating activities
$
(4,291)
$
(4,380)
Net cash used in investing activities
(41)
(12)
Net cash provided by financing activities
14,322
1,289
During the three months ended April 3, 2021, net cash used in operating activities was primarily a result of net loss of $4.0 million and non-cash adjustments to net loss of $0.6 million, offset by net cash outflows from changes in operating assets and liabilities of $0.9 million driven predominantly by an increase in inventories due to higher purchases to support increased sales, partially offset by an increase in accounts payable. Net cash provided by financing activities during the three months ended April 3, 2021 primarily consisted of $9.4 million in net proceeds from issuance of common stock under the 2020 and 2019 Lincoln Park Purchase Agreements, $4.0 million in proceeds from exercise of warrants, $0.4 million in proceeds from exercise of stock options and a $1.0 million in net borrowings under the SVB Credit Agreement, partially offset by $0.3 million in payments of taxes related to net share settlement of equity awards.
During the three months ended March 28, 2020, net cash used in operating activities was primarily a result of a net loss of $1.5 million, adjusted for non-cash charges of $0.5 million, offset by net cash outflows from changes in operating assets and liabilities of $3.3 million driven predominantly by increases in accounts receivable due to higher sales and in inventories due to higher purchases to support increased sales, partially offset by an increase in accounts payable. Net cash provided by financing activities during the three months ended March 28, 2020 primarily consisted of $1.5 million in net borrowings under the SVB Credit Agreement, partially offset by $0.1 million in payments of note payable to finance insurance policies.
Capital Resources
2019 Lincoln Park Purchase Agreement
On June 24, 2019, we entered into the 2019 Purchase Agreement with Lincoln Park, pursuant to which we have the right to sell to Lincoln Park up to an aggregate of $10 million in shares of our common stock over the 36-month term of the 2019 Purchase Agreement subject to the conditions and limitations set forth in the 2019 Purchase Agreement. As of April 3, 2021, an aggregate of $2.0 million in shares of our common stock was available for purchases over the remaining term under the 2019 Purchase Agreement.
2020 Lincoln Park Purchase Agreement
On March 5, 2020, we entered into the 2020 Purchase Agreement with Lincoln Park, pursuant to which we had the right to sell to Lincoln Park up to an aggregate of $20 million in shares of our common stock over the 36-month term of the 2020 Purchase Agreement subject to the conditions and limitations set forth in the 2020 Purchase Agreement. In February 2021, we completed the sales under the 2020 Purchase Agreement.
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SVB Credit Agreement
On October 31, 2009, we entered into the SVB Credit Agreement, which provides for a revolving line of credit of up to $5.0 million. The borrowing base is limited to 85% of eligible accounts receivable, subject to certain adjustments as set forth in the SVB Credit Agreement. As of April 3, 2021, the borrowings under the SVB Credit Agreement bear interest at the Prime Rate plus 2.75% per annum and mature on April 30, 2021.
As of April 3, 2021, the outstanding borrowings under the SVB Credit Agreement were $4.6 million with additional borrowing availability of $0.4 million. During the three months ended April 3, 2021, we made net borrowings of $1.0 million under the SVB Credit Agreement.
Paycheck Protection Program Loan
On April 23, 2020, we entered into the PPP Loan with a principal amount of $0.6 million through Hanmi Bank under the PPP administered by the SBA and established as part of the CARES Act. The PPP Loan bore interest at 1.0% per annum and would mature in April 2022 with the first six months of interest and principal payments deferred. The amount borrowed under the PPP Loan was eligible for forgiveness if we would meet certain conditions. In May 2021, the full amounts outstanding under the PPP Loan was forgiven.
Sufficiency of Cash Balances and Potential Sources of Additional Capital
We believe our existing balance of cash and cash equivalents together with cash receipts from revenues, the settlement fee received under the SK hynix License Agreement, borrowing availability under the SVB Credit Agreement, the equity financing available under the 2019 Lincoln Park Purchase Agreement, funds raised through other future debt and equity offerings and taking into account cash expected to be used in our operations, will be sufficient to meet our anticipated cash needs for at least the next 12 months.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditure or capital resources that is material to investors.
Critical Accounting Policies and Use of Estimates
The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of net sales and expenses during the reporting period. By their nature, these estimates and assumptions are subject to an inherent degree of uncertainty. We base our estimates and assumptions on our historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. We review our estimates and assumptions on an ongoing basis. Actual results may differ from our estimates, which may result in material adverse effects on our consolidated operating results and financial position.
Our critical accounting policies and estimates are discussed in Note 2 to the condensed consolidated financial statements in this report and in the notes to consolidated financial statements in Part II, Item 8 of our 2020 Annual Report and in the MD&A in our 2020 Annual Report. There have been no significant changes to our critical accounting policies since our 2020 Annual Report.
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Not applicable.
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