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Executives

Brad Driver - Vice President of Investor Relations

Richard Charles Pearce - Chief Financial Officer and Director

Stephen Barber - Chief Executive Officer and Director

Analysts

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Glenn Hanus - Needham & Company, LLC, Research Division

Kenneth Miller

David Ryzhik

Xyratex (XRTX) Q4 2012 Earnings Call January 10, 2013 4:30 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 Xyratex Ltd. Earnings Conference Call. My name is Darcel, and I will be your operator for today. [Operator Instructions] I would now like to turn the conference over to your host for today, Mr. Brad Driver, VP of Investor Relations. Please proceed.

Brad Driver

Thank you, Darcel, and good afternoon, everyone. Thank you for taking the time to join us this afternoon. I'd like to welcome investors, research analysts and others listening today to Xyratex's Fiscal Fourth Quarter and Full Fiscal Year 2012 Results Conference Call.

On our call today are Steve Barber, Chief Executive Officer; and Richard Pearce, Chief Financial Officer. Today's call is being recorded and will be available for replay on Xyratex's Investor Relations homepage at www.xyratex.com.

I'd like to remind everyone that today's comments, including the question-and-answer session, will include forward-looking statements including, but not limited to, a forecast of future revenue and earnings and other financial and business activities. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. These risks and uncertainties are detailed in Xyratex's filings with the Securities and Exchange Commission, including the company's 20-F dated February 24, 2012.

Also, please note that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, Xyratex routinely reports certain non-GAAP financial results. These non-GAAP measures, together with the corresponding GAAP numbers and the reconciliation to GAAP, are contained in our earnings press release. We encourage listeners to review these items.

I'd now like to turn the call over to Richard to review the financial details of the quarter and the full year.

Richard Charles Pearce

Thank you, Brad, and good afternoon, everyone. I'd like to thank you for joining us today. Our press release is available both on PR Newswire and our website.

I'd now like to provide you with some commentary about our results for the full fiscal year and the fourth quarter of 2012. Please note that all numbers are in accordance with GAAP unless stated otherwise.

Revenue for the full year was $1.16 billion, down 20% compared to fiscal year 2011. Revenue for the fourth quarter was $265 million, down 32% as compared to the fourth quarter of last year and down 4% from our prior fiscal quarter.

Sales of our Enterprise Data Storage Solutions products in the fourth quarter were $200 million, representing a decrease of $152 million or 43% compared to the fourth quarter of last year and down 10% compared with $223 million in our prior fiscal quarter. Revenue from our Enterprise Data Storage Solutions products for the full year decreased 26% to $974 million in 2012 compared to $1.32 billion in 2011. These products accounted for 84% of total revenue and 79% of gross margin in 2012. The reduction from the prior year primarily reflects the impact of the weaker demand during the second half of 2012 across the majority of our major customers, and as we have discussed previously, the proportional product volume shift under our contract with our largest customer, NetApp, as well as certain other customers moving to in-house solutions for next-generation products.

Sales of our Capital Equipment products in the fourth quarter was $65 million, up 87% compared to the fourth quarter of last year and up 25% compared to our prior fiscal quarter. Revenue from our Capital Equipment products for the full year was $185 million, up 49% compared to $124 million in 2011. These products accounted for 16% of total revenue and 21% of gross margin. The fiscal year performance for our Capital Equipment products reflects the onetime impact on demand of floods in Thailand in 2011, partially offset by more cautionary capital spending by our 2 major customers, Seagate and Western Digital, recognizing their acquisitions of Samsung's and Hitachi's disk drive businesses, respectively, and overall reduced demand for PC drives.

For fiscal year 2012, gross margin was 16.9% as compared to 15.3% in fiscal 2011. The increase from the prior year was primarily due to higher margins for our Capital Equipment products. Gross margin for Q4 2012 was 14.5% compared to 17.7% in the same period a year ago and 18.6% in our prior fiscal quarter. The decline in the quarter was primarily due to the impact of fixed costs relative to the lower Storage Solutions revenues.

For the full year, gross margin for the Enterprise Data Storage Solutions products was 15.9% as compared to 16.1% in fiscal 2011. The gross margin for Q4 2012 was 14.2%, down from 17.7% a year ago and 15.4% in the prior quarter. The decrease as compared to last year was primarily due to the lower revenues relative to fixed costs. We have commenced a program to reduce these costs in line with reduced revenue leverage, including a shift in production to lower-cost locations.

For the full year, gross margin for the Capital Equipment products was 22.4% as compared to 8.3% in fiscal 2011. The 2011 gross margin was impacted by volumes being significantly lower than expected and additional provisions related to the reduction in demand. The gross margin for Q4 2012 was 15.8% compared to 18% in the fourth quarter of last year and 32.3% in the prior quarter. The gross margin in the fourth quarter was negatively impacted by shipments of our new Optimus 3500 system at a very low gross margin in the initial product provision stage, as discussed in our previous earnings call.

The full year non-GAAP operating expenses decreased by 4.7% to $170.6 million as compared to $179.1 million in 2011. The primary reason for the decrease was a reduction in expenses in our Capital Equipment business to better align our cost structure with our business model, partially offset by increased investment in our emerging High Performance Computing data storage solutions.

Non-GAAP operating expenses in the quarter were $46.8 million compared to $44.3 million in 4Q of last year and $41.5 million last quarter. 4Q 2012 expenses include $4.1 million of restructuring costs and also includes some other nonrecurring items. We expect expenses to reduce to approximately $40 million in Q1 2013.

We are planning operating expenses in our 2013 fiscal year to be at a similar level as 2012. This reflects expense reductions, which we have undertaken in relation to our Capital Equipment and OEM storage lines and reallocation of resources and some further increases to enable growth of the Solutions products, particularly in sales and support. We commenced investment in developing our ClusterStor product line to serve the HPC data storage and Big Data market in mid-2010 initially with R&D and through 2012 in sales and support as we successfully brought the product to market. We expect over 30% of our operating expenses in 2013 to be supporting products targeted at the HPC data storage and Big Data markets.

Moving on to net income. For fiscal year 2012, GAAP net income was $17.7 million or $0.63 per diluted share compared to GAAP net income of $28.3 million or $0.92 per diluted share for fiscal year 2011. On a non-GAAP basis, full year net income was $24.6 million or $0.87 per diluted share compared to $39 million or $1.27 per diluted share a year ago. GAAP net loss in the quarter was $7.9 million or $0.29 per diluted share compared to GAAP net income of $18.5 million or $0.65 per diluted share in the fourth quarter of 2011. On a non-GAAP basis, net loss for the fourth quarter was $6.4 million or $0.24 per diluted share compared to non-GAAP net income of $20.8 million or $0.73 per diluted share in the fourth quarter a year ago. The reconciliation between non-GAAP and GAAP net income is provided in our press release.

Turning our attention now to the balance sheet. Cash and cash equivalents at the end of the quarter was $117.2 million, up from $103.2 million at the end of Q3. The strong cash position of the company at the end of Q4 represented an opportunity to return capital to shareholders in advance of potential taxation increases or onetime special cash dividend and an accelerated quarterly cash dividend of approximately $56 million in aggregate, which we paid in the current quarter. Cash flow generated from operations was $19.7 million in the quarter.

Inventories decreased by $37.5 million to $171.6 million in the quarter. Inventory turns were 5.4 compared to 4.4 for the previous quarter. Although we've made good progress, relatively higher inventory levels have continued to impact our cash position. This inventory is related to contracted customer demand. And therefore, I am confident that we will be able to continue to reduce our inventory over the next several quarters.

Accounts receivable decreased by $10.3 million in the quarter to $132.9 million. Days sales outstanding were 45 compared to 47 in the previous quarter.

Headcount at the end of fourth quarter was 1,931 permanent employees, a reduction of 101 employees or 5% over the previous quarter end, predominately from our operations activities as we scale down our capability in line with current demand.

Now before I turn the call over to Steve for his comments, I'd like to provide you with our business outlook for our fiscal first quarter of 2013 ending February 28.

For first quarter of 2013, we are projecting total revenue to be in the range of $159 million to $189 million, down 46% to 36% as compared to last year and down 40% to 28% compared to 4Q '12. For Q1, gross margin is expected to be 19.5% to 20.5%, which includes expected benefits related to approximately $12 million in revenue from our higher margin HPC data storage products, which have been deferred from 2012 and for which we have subsequently received acceptance confirmation. We are projecting non-GAAP net loss per share to be between $0.01 and $0.21. Non-GAAP net loss per share excludes noncash equity compensation, amortization of intangible assets, specified nonrecurring items and related taxation expense.

We expect our full year revenues will continue to be impacted by the proportional product volume reductions from our largest customer NetApp and the movement of certain other customers to in-house solutions for next-generation products. We expect this will be partially offset by the ramp of our new OEM customer opportunities together with the anticipated increase in our HPC data storage solutions. The success in these areas is largely aligned with the success of our OEM partners. In consideration of these factors, we expect revenues in 2013 to be in the range of $825 million to $975 million, and at the lower end of the range, we would expect to incur losses.

As our business evolves towards a more solution-orientated model, we expect to have lower revenues offset by higher gross margins overall, which we would expect to generate positive net margins in 2014. The number of shares outstanding in Q1 at the weighted average treasury method is expected to be 27.1 million. Our cash position at the end of Q1 is expected to be approximately $90 million, which includes the payment of dividends of approximately $56 million in December 2012, which I discussed earlier, and therefore, represents a real increase in cash excluding dividends of approximately $30 million.

I'll now like to hand over to Steve for his comments.

Stephen Barber

Thank you, Richard. The second half of the year was clearly challenging for us. We experienced a material softening in Enterprise Storage Demand across our OEM customer base, coupled with continued demand softness in the disk drive market and the resulting cautionary capital spending by our 2 major customers. In response, we took decisive steps to reduce cost, reducing headcount by 5% as well as driving process efficiencies in many areas of the business. We are very focused on producing greater profits more consistently.

In parallel with these expense actions, we continue to invest in our solutions business where we see material growth potential. We are making good progress towards our goal of positioning ourselves for growth in the areas of High Performance data storage, Big Data and Public Cloud markets. During the quarter, we successfully completed the qualification process of Blue Waters with our partner, Cray Computing. Blue Waters is one of the most powerful supercomputers in the world with 25 petabytes of storage, delivering over 1 terabyte per second of sustained file system performance. Our experience in delivering a system of this leading edge complexity has significantly enhanced both our technical capability and the industry respect in this sector.

To support ourselves with the business model and our compute partners in this market, we expanded our outside installation and support capabilities. In addition, we have recently entered into partnerships with both Dell and HP to serve the High Performance data storage and Big Data markets. We've had early success working with HP to install our ClusterStor data storage solution at a U.S. federal government site. This market is demonstrating good growth, and we believe we are well positioned with our compute partners to serve a broad spectrum of the market from high-end research laboratories to mid-range and low-end industry and enterprise applications.

As we enter 2013, our strategy includes continued focus in our 2 established businesses, ensuring that we can directly align our capability with the business levels we see looking forward. These remain attractive markets for us to serve supported by the continued growth of data stored ultimately on disk drive base platforms, increasingly in cloud data center applications. While disk drive unit shipments declined through 2012 as PCs and laptops see the effects of the growth in flash-based memory devices, including smartphones and tablets, data storage is still growing at a compounded annual growth rate in excess of 40% and is being serviced increasingly by higher-capacity 3.5-inch disk drives. More terabyte devices are now shipping in volume to cloud storage applications. The manufacturing process time for these devices are significant, with the need for incremental production test capacity resulting in demand for our products.

We have a strong order book for 2013 already secured with a number of new opportunities emerging through our collaborative customer engagements. We remain focused on 3 primary areas: core technology development to meet emerging customer process and productivity needs; collaborative partnerships with our disk drive and component customers; and effective outsourcing of selected noncore development requirements.

Our OEM storage business remains compelling as Tier 1 and emerging OEM storage companies increasingly focus on software and applications, relying on third-party partners to provide hardware platforms and combined storage and service solutions. As our internal development budgets continue to be challenged, more opportunities are emerging for us as a valued hardware platform provider. In this business, we continue to focus on platform architecture, system integration and operational delivery, enabling us to continue our success in broadening our OEM customer base.

Our hardware technology platforms now support HP's recently announced 3PAR Storeserv 7000 series storage solutions. As we announced earlier today Avid has combined our OneStor hardware foundation with industry-leading Avid ISIS software to deliver it's high-density data storage solution for media enterprises. We've been working throughout 2012 to support a new major Tier 1 storage OEM on a new storage product release scheduled for this month. We're delighted to have been selected by these companies as an enabler to key products in their storage system portfolio, and we look forward to positive market reception for these products and ramping volumes through 2013.

In addition, we are now partnered with Microsoft through their recent acquisition of StorSimple and to support the supplier of their future cloud gateway. Our class-leading high-density enclosure has been selected by 3 major Tier 1 storage customers to expand their product portfolios to provide high-capacity Big Data solutions, again, with volumes ramping through 2013.

Looking forward, we were recently selected as a single solution provider to deliver the next-generation platform for one of our existing Tier 1 customer programs, driving a major codevelopment project through 2013. And specific to emerging OEM customers, our strategy of targeting compelling and well-positioned storage solutions companies continues to show success with 2 new additions during the quarter. We believe we are applying appropriate levels of investment in these established businesses to meet the requirements of our existing customers, as well as deliver innovation for next-generation platforms, which we anticipate will create opportunities to win new customers. Equally, we're reducing operational costs, rightsizing our global manufacturing capability and optimizing internal processes. We believe these are sound businesses within our portfolio that will deliver positive financial contribution to the overall company.

In mid-2011, we identified strong growth opportunities for storage solutions in the high-performance data storage sector. The data explosion is demanding more storage performance. The storage IO's scalability now is the primary reason behind most enterprise system architectures running with less than optimum utilization. This problem equally affects all data-intensive applications across High Performance Computing, Big Data analytics and cloud applications.

Our ClusterStor engineered system architecture is integrated to compute, storage, networking and software to offer an optimized and high-performance platform with proven scalability. ClusterStor now leads the market in storage IO performance, enabling higher efficiency and reduced overall compute system costs with regard to CPUs, memory and interconnect.

In 2012, we invested significantly in our partnership with Cray, developing and launching our second-generation platform, the ClusterStor 6000, which has recently been deployed in the SSA [ph] Blue Waters supercomputer facility, together with Cray's XE6 and XK6 compute platforms. In conjunction with other compute partners, including Bull, Dell and HP, we have deployed the ClusterStor data storage solutions in leading oil and gas installations, U.S. and European government sites and major academic institutions. These partnerships should enable us to expand our addressable markets for these solutions. We've invested and continue to invest in talent across all aspects of the business with a specific focus on software development, professional services and technical support skills interfacing with end-user customer installations. We are highly focused on accelerating the growth of this business through 2013 and into 2014. We expect higher margins in the solutions market when compared to our OEM storage business as Xyratex provides increased value together with sales and support capabilities.

Additionally, we're expanding the ClusterStor business footprint to address the adjacent and growing market of Big Data infrastructure. The cost-effective and innovative solutions are required to enable the analysis and processing of high-volume, high-velocity and high-variety information assets. In applications such as oil and gas, the need to migrate vast demands of data in and out of High Performance Computing environment for data analysis processed seamlessly in a shared environment is a large and growing sector. To address this need, we're developing a ClusterStor [indiscernible] plant expected to launch later this year followed by a number of targeted application-focused solutions. This strategy should enable us to expand the addressable market for our ClusterStor business, leveraging our relationships, technology and existing and future customer needs.

In parallel with our focus on High Performance Computing and Big Data sectors, we're investing in the development of solutions for the growing Public Cloud market. This is clearly an attractive market with cloud-related spend forecast by industry analysts to more than double from $91 billion in 2011 to over $200 billion in 2016.

Emergence of new service providers outside the existing Big 4 seeking to provide storage as a service and related offerings is creating demand for configured ready-to-use solutions. We believe Xyratex is well positioned to address this sector, drawing from our core OEM storage technology and now our ClusterStor engineered system expertise with HPC and Big Data market. In addition, our OEM business model with its low gross margin structure provides a compelling capability for these Public Cloud data storage providers who are competing against the established Big 4. Our initial plan includes enabling customers to capture the data and monetize data through technology and products that we can bring to market.

We can -- drawing on our technology and business model, we're in a position to address the data storage part of the cloud, enabling our customers and service providers to provide additional services to end users, generating repeatable revenue streams and leveraging additional value from the installed infrastructure.

In summary, a year ago, we discussed how Xyratex had a clear intent to enter the high-performance data storage market in a controlled but disruptive way. We exited the year with an enviable position in the market space, having delivered the fastest HPC storage system and over 1 terabyte per second sustained performance with reliability metrics that are the envy of the industry. What we have learned and gained from this experience is that the core Xyratex values and DNA of being partner orientated, customer-centric, together with a deep technology expertise, packaged as a quality solution with a low-cost business model, are all essential attributes to our success.

Through this business evolution, we've learned how to be at the heart of the open-source technology community, driving important roadmaps, technology directions and innovation that can benefit the wider community, and supported by our unique IT, to deliver greater value to our customers and partners alike.

Community leadership, coupled with important innovation, is another factor to our business model that we believe will service well in addressing the nascent Big Data infrastructure and Public Cloud data storage market segments. These segments rely on the fundamental technology that Xyratex can deliver, without creating a walled garden of vendor lock-in, choosing instead to compete in a multivendor environment based on the merits of our technology and ability to deliver business value to our customer.

In closing, let me once again express my thanks to our employees worldwide for their efforts and commitment to our success. Thank you for all your continued support and innovation as we strive to enable our customer success in the expanding data storage market.

That concludes our formal comments. I would now like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Aaron Rakers with Stifel, Nicolaus.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

A couple of questions. When we look at your guidance, can you help us, I guess, first of all, from a segment perspective, think about the breakdown of your 2 segments, how we should think about that first?

Richard Charles Pearce

Yes. Aaron, for the HDD Capital Equipment business, the seasonality that we often see, we're seeing again this year, so some of the orders, which we're anticipating to come in the first quarter, will actually move down to second quarter. But we do have a strong order book, as Steve mentioned in his comments. So within the first quarter, Capital Equipment revenue is going to be somewhere between $10 million and $20 million, which then lead the storage systems revenues between $149 million and $169 million.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Okay, perfect. And when you talk about the $12 million from the HPC business going into the February '13 quarter, can you give us the reference point? What was that revenue contribution in the November quarter? And then I'd also be interested if you have that revenue number for the August '12 quarter.

Richard Charles Pearce

Related specifically to the HPC business, Aaron?

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Right.

Richard Charles Pearce

Yes, I mean, we're not breaking it up. But I think we did cover it when we spoke about it in the last earnings call. So overall for the year, for 2012, in terms of revenue, it was slower than we had originally anticipated. However, I think as Steve covered in his comments, we were delighted actually that we did get the experience of the Blue Waters installation, which is the installation where the revenue was deferred into the first quarter. So last year, we had revenues of approximately about $20 million in that, excluding the Blue Waters, which is now moved over into Q1. Overall for the first half of the year, this is still a ramping business. So we would expect for the first half of the year, revenues to be somewhere around about $30 million. And that includes that $12 million, which is rolled over from 2012. As we look out to the full year, and again, I think in line with the comments that I provided on the last earnings call, we projected revenues for that business of somewhere between $60 million and $100 million in 2013, and we're still confident in that level for this year.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then if I take all of that and I think about the breakdown of your customers, can you walk through that? And in particular, I know that you've been dinged by a transition. You referenced that transition at NetApp in particular. Can you help me understand exactly the timing of when that happened? So 2 questions there: first of all, the breakdown of customers there; and secondly, when exactly the transition started between yourself and Jabil in that NetApp relationship?

Richard Charles Pearce

Let's start with the breakdown of customers. So for the fourth quarter, NetApp represented approximately 45% of revenues.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

That's just of that segment, correct? Or total?

Richard Charles Pearce

Yes, of that segment, of the Enterprise Data Storage segment. That represented approximately 15%, and IBM represented approximately 22%. I think moving on to your other question, obviously, the transition of the NetApp products happened some 3 years ago. And we talk about this regularly in our calls. In terms of the latest transition, effectively that happened in November of 2012. So we moved from being 50% of the particular product range that we were in with NetApp to being a 25% provider in November. So effectively, almost totally, yes, the first quarter of 2013 is showing the effect of that versus the fourth quarter of '12.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

And so you were fully at 25% through the month November?

Richard Charles Pearce

No, no, no, we were at 50% through the month of November. And now we're moving to 25% from November.

Operator

And your next question comes from the line of Paul Mansky with Cantor Fitzgerald.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Yes, just kind of building upon the former discussion, obviously, it looks like a pretty good ramp you're expecting in the HPC in the back half of the year. Given all the puts and takes on the storage side of the business, the new platforms ramping, HPC ramp, NetApp essentially winding down, obviously that changes your traditional seasonal pattern quite a bit. Can you frame up for us a little bit more how we should be thinking about linearity across the storage business throughout the course of the year?

Richard Charles Pearce

Yes. Obviously, we touched on with Aaron the question in terms of the revenues in Q1. So I provided the sort of $149 million to $169 million as being split there. I would expect that revenue to stay relatively consistent as we go into the second quarter, maybe going up slightly. And then as we move into the back half of the year, that's when we would expect to see the ramp in the solutions products coming through. So I'd expect that to then be going up 10% or so -- 10% to 15% in Q3 and then a further 10% to 15% in Q4.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

So you -- so just basically to paraphrase, with respect to all the major new platforms that you've been working on, you expect to be in the market and fully ramped roughly around the calendar Q3 time frame?

Stephen Barber

Well, I wouldn't say fully ramped though. These products are coming online this quarter, next quarter. So I really wouldn't be expecting to see those ramping until 2014 in many cases. And obviously, we've seen the reduction to 25% levels at NetApp, and we will be seeing that in the first quarter, and that will remain throughout the year. So notwithstanding and not wanting to preannounce what NetApp's results are going to be, but assuming that they are relatively consistent throughout the year, we should continue to see a relatively consistent revenue stream from NetApp. That will then reduce almost to 0, but we're not sure yet what other products might be there, what spend as we go into 2014. And that's when we would expect to see some of the other areas starting to get to fully ramped. They will be ramping through the year. I'm not providing guidance yet for 2014. But again, I'd expect to see a drop off at the start of 2014 and NetApp start to move away. And as these others are ramping, as well as the HPC Solutions business ramping, that's what -- we would expect that to be picking up. And as I said in my comments, overall, and again, not giving any guidance here on 2014, but overall, we expect to see slight reductions in revenues overall in that business but offset by the higher margins that we're getting from the solutions and also providing greater profitability to the bottom line.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

And if I understand the transition vis-à-vis yourselves and Jabil and I guess with respect to the NetApp business, there is a license fee associated with that. Does that continue after your actual product revenue winds down to 0? Or does that terminate as well?

Richard Charles Pearce

That terminates as well.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Okay. And then lastly, for me, and I'll exit the floor. On the Capital Equipment side, specifically the 3.5-inch disk drives, have you seen or do you anticipate any changed competitive dynamic there?

Richard Charles Pearce

We have not seen a change at this time, no. We are still the sole provider of 3.5-inch disk drives. I think it's relatively well known that obviously, Teradyne is competing with us in the 2.5-inch market. And my expectation, particularly why that market is moving, is that they may well bring a product in the future. But I have no visibility of that at this stage. But obviously, as Steve said in his comments, what we're seeing in the market is a big shift between in terms of capacity requirements from 2.5 to 3.5 serving the cloud. And therefore, the majority of our revenue in the HDD Capital Equipment will come from 3.5-inch systems going forward. That said, we also do provide products into other areas of HDD Capital Equipment including the media areas. And what we're seeing on that side of the business is aerial densities continue to get more difficult. Disk speeds are actually slowing down in some of the applications that you're seeing going into the cloud market. So I think you've seen the announcements from Seagate and WD recently about some of the new drives, the helium-filled drives slowing down to 5,400. All of that helps us in terms of the density play that we have across our product portfolio there. So we're relatively optimistic about the opportunity for us in that business now that the transitions have happened, the overcapacity that the customers took on in the 2010 period starting to work themselves out. So I guess we are quite confident in that area.

Operator

And your next question comes from the line of Glenn Hanus with Needham.

Glenn Hanus - Needham & Company, LLC, Research Division

Just picking up on those previous questions, could you branch into gross margins? You talked about some pretty strong gross margin in the first quarter. Can you give us the breakout there for the quarter and the year and how you're thinking about each business and the gross margins?

Richard Charles Pearce

Yes. So obviously, the gross margins overall are better in Q1 within the storage systems side of the business, obviously benefiting from the HPC Blue Waters revenues that we got that we talked about. Margins in that part of the business are going to be somewhere between 18% and 20% in the quarter. Again, not wanting to give guidance for the full year, but previously, I think we've talked in that business about gross margins of being somewhere between 14% and 16%. As we now look at the transition in terms of our product portfolio, my expectations would be that margins would be more in the 15% to 18% range for 2013. Looking at the Capital Equipment products, again, obviously, we had a number of challenges in 2011, which we talked about on products and the significantly lower volumes. Margins have gotten better in 2012. But again, we have the challenge of the new product that we brought in that we talked about in the last couple of quarters at a significantly lower gross margin. As we move into 2013, and that's my previous comments on the mix of products that we're actually providing in the area of -- in terms of media and heads. Overall, I'd expect our gross margins to be getting back to the kind of 30% levels in that business for the year.

Glenn Hanus - Needham & Company, LLC, Research Division

Great. Could you -- on OpEx then, you said $40 million for the first quarter. And then it sounds like you're going to be ramping a little bit OpEx through the year. Can you talk about -- and then your headcount came down, I guess, 5%. I think we're looking for, what, a 10% headcount reduction. So could you talk about headcount? And then am I right about expenses ramping some through the year and where they would be ramping?

Richard Charles Pearce

Yes, I mean, the headcount we referred to in the call was obviously our regular headcount. And we're taking the opportunity as well as taking regular headcount. We're also taking out contract headcount to a higher proportion of levels. So getting near the 10% level that we were looking for. As we go -- and obviously, that means that the expenses actually come down in Q1 from the levels that we've seen in Q2 through Q4 the previous year. As we start to ramp our -- as I said in my comments, the solutions business, there is a great emphasis on sales and support within that region. So we would expect to see in line with the increases in that business, the expenses increasing yet slightly in Q2 because, yes, as I said, we're not expecting the ramp to happen until we get into 3Q. That said, obviously, we do need to have certain sales on the ground relatively soon to be able to facilitate those sales into the third and fourth quarters. So yes, not a big increase as we go into Q2. So I would expect relatively small increases of maybe $1 million or so a quarter. And I think then we would just have to take stock of how successful that business is looking at that time of whether we decide to ramp out a bit more or we decide to pull it back a bit more.

Operator

Your next question comes from the line of Kenneth Miller with Nokomis Capital.

Kenneth Miller

A couple of my questions have been answered. I do want to ask about the outlook for your storage infrastructure, your disk drive Capital Equipment business the entire year. Obviously, the companies are making a lot of disk drives than they probably thought when they completed the mergers beginning of 2012. Is there a potential for this year to be similar to the kind of 2009 or 2011 years in terms of extremely low capital expenditure given their overcapacity? Or do you have higher hopes for that given your position in 3.5-inch drives and the disk drive makers' investment plans?

Richard Charles Pearce

Yes, no, I really wouldn't expect us to go to the levels that we saw in those 2 years, Kenny. Whilst -- yes, hopefully we touched on it in the call. But whilst we are seeing units declining, we are not seeing a reduction in the actual level of data stored or the amount of tracks required, the amount of petabytes. And we really play more in the products that we provide into the overall density, the overall amount of petabytes or overall amount of tracks. So I think that coupled with the fact we are seeing in the 3.5-inch area where we have a much better footprint than we do in the 2.5-inch area, I would have to say that we have a good order book as we look into Q2 and Q3 in that side of the business. And if anything, I would be slightly more optimistic on that side of the business than pessimistic despite the data that you provided in terms of, yes, units are slowing down.

Kenneth Miller

Okay. And to make sure I understood correctly what you said about operating expenses, did you say $40 million GAAP next quarter? Or is that a non-GAAP number?

Richard Charles Pearce

That's a non-GAAP number. But it shouldn't really be affected by anything significant apart from equity expenditure.

Kenneth Miller

So no major restructuring charges next quarter?

Richard Charles Pearce

I'm not anticipating any, Kenny, no.

Kenneth Miller

And you plan on having GAAP expenses or non-GAAP expenses approximately level in 2013 versus 2012?

Richard Charles Pearce

It would be non-GAAP, but it would probably -- it should pretty much hold true for GAAP as well.

Kenneth Miller

Once again, excluding any major restructuring?

Richard Charles Pearce

Yes. At this stage, I'm not expecting any major restructuring expenses to go in there during the year.

Kenneth Miller

Okay. Can you do anything to help us better understand segment profitability in 2012? Obviously, the gross margin improved quite a bit in storage infrastructure. But can you help us understand whether that's kind of profitable on a stand-alone basis or not?

Richard Charles Pearce

Yes. I mean, we don't report down by segment, and I wouldn't want to give you specific details. But I am comfortable saying that at the revenue levels which have been predicted and which are pretty aligned with where the consensus revenues are at the moment, then that is a positive contributor in the HDD Capital Equipment and also the Storage Systems side of the business, which is the non-HPC data storage solutions area where obviously, we're investing quite significantly in the ramp. And that will be the area which we'll all get a negative contribution. So I guess to answer your first question on the HDD Capital side, yes is the short answer.

Kenneth Miller

Okay. And going further, you think that the Enterprise Storage Solutions outside of your investments in HPC and Big Data is also profitable at your current expense structure?

Richard Charles Pearce

That's correct, yes.

Kenneth Miller

And are you speaking of 2012, 2013 or both?

Richard Charles Pearce

I'm speaking of 2013. But in terms of 2012, yes, most definitely on the Storage System side, we would have been profitable. Obviously, through 2012, we've taken quite significant expense actions on the HDD Capital Equipment business, and we've also been impacted by the lower margins on the new products that we pulled forward. So again, without wanting to break it down segment by segment, in 2012, at those levels, the HDD Capital Equipment business would not have been profitable.

Kenneth Miller

Okay. So HDD Capital Equipment was not profitable in 2012. Would you expect it to be in 2013 given the actions you've taken?

Richard Charles Pearce

That is correct.

Kenneth Miller

And in your Enterprise Storage Solutions, the core kind of OEM business is profitable in both 2012 and 2013, and that's being somewhat offset by the investments in High Performance Computing, Big Data and Cloud?

Richard Charles Pearce

That's correct.

Operator

Your next question comes from the line of David Ryzhik with Green Capital (sic) [Brean Capital].

David Ryzhik

David Ryzhik here for Ananda Baruah. Just wanted to -- how should we think about free cash flow for 2013?

Richard Charles Pearce

Again, referring back to my comments, and we provided some guidance, obviously, in terms of cash at the end of the first quarter, so my expectations for cash at the end of the first quarter is around $90 million, which given the special dividend that we paid in December, represents around about a $30 million increase in cash, net of those dividend payments that we made. As we go through the year, I mean, obviously, we're not expecting large profits. We've talked about that in the script and said that at the lower end of our range, we would expect to make losses. That said, we do expect the working capital requirements to go down somewhat, specifically in inventory again, which we referred to. So yes, my expectation, including the quarterly dividend, which we still anticipate paying and historically been at the $2 million level, so not that significant. So I'm relatively confident that cash will be north of $100 million at the end of the year. But I wouldn't want to give more granularity on the breakdown as we go through the year at this stage.

David Ryzhik

Great. And just a follow-up about the cost savings. It just seems it's -- I just wanted to confirm any reductions you achieved in the HDD segment. You're just going to reallocate to the higher-growth solution segment or none of that will be [indiscernible].

Richard Charles Pearce

Well, I guess to be clear, the expenses where we reduced expenditure in the HDD Capital Equipment business, I believe that we've concluded those reductions now for the business that we see. And in fact, the opportunities that we see going forward, we may, if they do avail themselves, actually increase that. So they aren't the expenses which we would be looking to reallocate. The business of the storage solutions is far more aligned with the new HPC data storage solutions. So it's those expenses which we're already expecting to reallocate between OEM storage solutions into HPC and Big Data storage solutions.

Operator

And your next question comes from the line of Aaron Rakers with Stifel, Nicolaus.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

My questions have been answered. I'll just ask one last one. You referenced the one customer that you had won a design win and that will be launched this month. Is that a new customer for you guys? Or is that an existing customer, just a new platform?

Stephen Barber

New customer, Aaron. We've been working on that product though the whole course of 2012 in parallel with the platform that we were developing for HP. HP launched that product just prior to the holidays. This new Tier 1 we anticipated is going to launch in January. And depending on their willingness to disclose that relationship, clearly, we'll share it with you.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

And that's in traditional? Or is that in the HPC cloud segment?

Stephen Barber

No, that's traditional OEM storage.

Operator

And there are no further questions at this time.

Stephen Barber

Thank you, Darcel. Once again, thank you for joining us this afternoon. We look forward to speaking with you again on our Q1 earnings call, which will be scheduled for late March 2013. Also in January 15, we'll be presenting at the Needham Annual Growth Conference in New York, and we'll be at the Stifel, Nicholas Technology and Telecom Conference in early February in San Francisco where we'll provide you further updates on our business. As always, you are welcome to call me if you have any additional questions over the course of the quarter. Thank you, and best wishes for a new year ahead.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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