Xyratex Ltd. (NASDAQ:XRTX)
Q4 2008 Preliminary Earnings Call
January 6, 2009 5:00 pm ET
Richard Pearce – Chief Financial Officer
Steve Barber – Chief Executive Officer
Amit Daryanani – RBC Capital
Keith Bachman – Bank of Montreal
Jayson Noland – Robert Baird
Shelby Seyrafi – Caylon Capital
Good day ladies and gentlemen and welcome to the Xyratex fourth quarter and fiscal year conference call. (Operator Instructions) I would now like to turn the call over to Mr. Brad Driver, Vice President of Investor Relations.
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 preliminary fourth quarter and fiscal year 2008 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 home page 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. 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 20-F dated February 20, 2008.
Also please note that in addition to reporting preliminary financial results in accordance with GAAP, generally accepted accounting principals or GAAP, Xyratex routinely reports certain non-GAAP financial results. These non-GAAP measures together with the corresponding GAAP numbers and reconciliation to GAAP are contained in our earnings press release. We encourage listeners to review these items. I would now like to turn the call over to Richard to review the financial details of the quarter and fiscal year.
Good afternoon everyone and thank you for joining us today. Our press release is available both on Business Wire and our website. As we noted in our press release earlier today, there's one area of our 4Q financial performance which represents a material uncertainty and has resulted in all financial results in today's earnings call being described based on preliminary, unaudited information.
As we indicated in our updated guidance in December, the fourth quarter presented a number of challenges for us as we experienced the initial impact of the global economic downturn. For the fourth quarter, our year over year revenue increased by 15.1% and for the full year, revenue was up by 12.7% versus 2007 broadly in line with our expectations and within the low end of the revenue range we guided to a year ago.
Despite the satisfactory revenue performance for the full year, we have incurred a number of significant charges in 4Q primarily as a result of the global economic downturn and I would like to address these matters before I move on to the more normal financial commentary for the fourth quarter and full year.
On the FAS142, the company is required annually to review goodwill for impairments. We have looked at what constitutes fair value in light of the new fair value standard, FAS157, and decided that in these circumstances, it is appropriate to use the market value of the company based on the share price as this represents level evidence of fair value rather than the traditional DCX model approach which represents level three evidence. This has resulted in a full impairment of Goodwill representing a $34.3 million non cash charge.
We have also performed an impairment assessment of long lived assets under FAS144 and concluded that no impairment is required here. For the purposes of assessing the carrying value of the company's deferred tax assets, the company has considered the guidance under FAS109. As a result of the analysis, a valuation allowance representing a non cash charge of $20.6 million has been taken.
This valuation allowance relates primarily to UK tax losses which are not expected to be utilized as a result of the current economic situation, Certain tax concessions in the UK and the tax structure of the overall Xyratex Ltd. group. This valuation allowance does not indicate in itself that the overall Xyratex Ltd. group will not be profitable in future fiscal periods.
In line with the updated financial guidance we provided in December, we have also undertaken a detailed assessment of our NSS inventory and identified additional provisions in two specific areas. Firstly, an incremental inventory provision of approximately $5 million primarily relating to our RAID products which have seen a material decline in demand.
And secondly, a specific provision of $9.5 million representing inventory and future vendor claims associated with a specific NSS customers product forecast which currently indicates a transition to an updated version sooner than originally planned, giving rise to an exposure on long lead time components.
The value of this exposure is dependent upon product demand and final timing of this proposed transition. The company is still assessing the extent of this specific provision and opportunities to mitigate the overall exposure.
The outcome of this exercise is not expected to be finalized until the end of January at the earliest, and hence the company has provided at this point what it believes will be its maximum probably exposure of $9.5 million. This is the one area where the company recognizes a material level of uncertainty and has resulted in all financial results being described a preliminary.
Adjustment to the charge may be required once the analysis is completed and any such adjustments will be reflected in a subsequent filing giving final 2008 fourth quarter and full year results.
I would now like to provide you with a more general commentary about our results for our full year and fourth quarter. Please note that all numbers are in accordance with GAAP unless stated otherwise.
Revenue for the full year was $1,049.7 million, up 12.7% compared to fiscal year 2007. Revenue for the fourth quarter was $285.4 million, up 15.1% over the fourth quarter of last year and up 1.7% compared to our prior fiscal quarter.
Sales of our Networked Storage Solutions products in Q4 were $222.3 million, representing an increase of $35.1 million or 18.7% compared to the fourth quarter of last year and up 4.3% compared to $213.1 million in our prior fiscal quarter.
Revenue for the full year increased by 23.3% to $855.8 million in 2008 compared to $694 million in 2007, accounting for 81.5% of total revenue and 65.5% of gross margin. The fiscal year performance reflects the continued growth of the storage market and our OEM customers.
Sales of our Storage Infrastructure products in Q4 were in line with our expectation at $63.1 million, representing an increase of $2.4 million or 3.9% compared to a year ago, and down 6.8% versus our prior fiscal quarter.
For the full year 2008, revenue for this business was $193.9 million, down 18.4% compared to fiscal 2007, accounting for 18.5% of total revenue and 34.5% of gross margin. The fiscal year performance reflects the challenging HDD CapEx spending environment we anticipated and experienced in 2008.
For the full year 2008 gross margin was 14.4% compared to 18.1% in 2007. Gross margin for 4Q '08 was 9.8% compared to 18.5% for the same period a year ago and 17.6% last quarter. The reduction in gross margin primarily reflects the significant charges I previously mentioned and the event of the lower proportion of Storage Infrastructure revenue in the year.
For the full year gross margin in the Networked Storage Solutions business was 11.7% compared to 14.5% in fiscal 2007. The gross margin for the fourth quarter was at 5% and included provisions totaling $14.5 million as I mentioned previously. This compares with 15% in 4Q of last year and 13.3% last quarter.
For the full year gross margin in the Storage Infrastructure business was 27.1% versus 29.3% in 2007. In 4Q '08, the gross margin for the Storage Infrastructure products was 27.3% compared with 29.7% last year and 31.6% last quarter. Gross margin has remained under pressure throughout the year as a result of the significantly reduced revenue in this business, plus we have taken actions to reduce our fixed costs through this period.
We chose consciously not to take any actions that would fundamentally limit our ability to recover our capability when product demand returns. We believe that we will be able to continue to deliver gross margin in the 28% to 30% range in the medium term for this business.
For the full year, non GAAP operating expenses increased by 7.9% to $143.2 million as compared to $132.7 million in 2007. The increase in spending was primarily due to additional R&D head count in support of our business growth.
In addition, expenses increased by approximately $4 million as a consequence of adverse currency movements, and $1 million associated with the first full year affect of depreciation associated with the implementation of our new ERP system. These items were partially offset by reduced bonus payments of approximately $3 million.
For the fourth quarter non GAAP operating expenses totaled $37.2 million compared to $34 million in Q4 of last year and $38 million last quarter. For the fourth quarter 2008, GAAP net loss was $63.2 million or $2.17 per diluted share compared to a GAAP net income of $11.7 million in the same period last year.
For the fiscal year 2008 GAAP net loss was $55.4 million or $1.09 per diluted share compared to a GAAP net income of $28.1 million for the fiscal year 2007. On a non GAAP basis for the fourth quarter 2008 net loss was $6.3 million or $0.22 per diluted share compared to non GAAP income of $13.1 million in the same quarter a year ago.
For the fiscal year 2008 non GAAP net income was $9.5 million or diluted earnings per share of $0.32 compared to non GAAP income of $37.5 million or $1.26 per diluted share for fiscal year 2007.
Turning our attention now to the balance sheet, cash and cash equivalents at the end of the quarter was $28 million, up from $27.2 million at the end of Q3. Cash flow used in operations was $12.8 million in the year and cash flow generated from operations was $8.9 million in the quarter.
In addition, as we announced in October, we recently renewed our bank facilities with HSBC representing a $55 million line of credit undrawn at year end, thus providing us with a strong liquidity position.
Inventories decreased by $32.8 million to a total of $103.8 million in the quarter. This reduction includes additional inventory provisions of approximately $10 million. Inventory terms are 7.5 compared to 5.9 to the prior quarter.
Accounts receivable decreased by $14.3 million to $140.9 million in the quarter. Day sales outstanding were 46 compared to 50 in the previous quarter.
Total shareholder equity reduced in the quarter by $73.2 million to $206.1 million primarily as a result of the Goodwill and deferred tax write offs in the quarter. The reduction also includes $12 million related to our foreign currency hedging instruments. This is however, ultimately positive for the company as it reflects the long term benefit from the stronger U.S. dollar relative to ongoing Sterling expenses for which significant benefit will be seen in 2010 and beyond assuming current exchange rates.
Head count at the end of the fourth quarter was 1,879 permanent employees, essentially unchanged over the prior quarter.
Given the reduced visibility caused by the recent changes in the macroeconomic environment, Xyratex Ltd. will not be providing formal financial guidance for the first quarter of 2009. We can however, confirm that the company does not expect to return to profitability on a non GAAP basis before the second half of 2009, primarily as a result of SR revenue which we expect to be between $15 million and $25 million in each of the next two quarters.
In light of this uncertainty, and as we announced in December, we have initiated a number of cost reduction actions through 4Q including a planned reduction in our total regular work force by approximately 10% or 185 employees through the first quarter of '09. We will provide further details of the savings and one time associated cost when we have finalized this process. We expect to benefit from the reduced costs of these actions in Q2 onwards.
The number of shares outstanding at the end of Q1 on a weighted average is expected to be $29.5 million. Our cash position at the end of Q1 is expected to be in the range of $35 million to $45 million.
I will now hand over to Steve for his comments.
Good afternoon everyone. Thank you for joining us today. Despite the slowdown in demand in our NSS business and the one time impact to our financial fourth quarter results, I believe we delivered a relatively good performance in 2008. We grew our overall revenue for the business by over 12% over the prior year to more than $1 billion.
We successfully diversified our NSS customer base with two additional major customers ramping product demand through the year in the form of Dell and IBM. We saw significant growth in several newly public and vertical OEM NSS customer accounts.
We successfully implemented a new scalable ERP system across the company with limited impact to our customers, albeit having to increase the IT level through the transition period. And, we continued development of a major next generation disc drive test platform available for customer delivery in second quarter.
Consistent with the message from many technology companies, we're entering a period of increased uncertainty with limited visibility of end user demand, particularly in the near term. In light of this, as we previously announced, we're taking a number of actions to reduce our cost base whilst ensuring we continue to invest in next generation technologies, products and processes needed for the future success of the business.
These actions include; implementing a reduction in our permanent full time work force of approximately 10% or 185 employees worldwide. More than half of these reductions have already been completed with the balance to complete by the end of the first quarter in compliance with UK regulatory processes, reducing our direct labor and contract work force at our NSS California and SI Malaysia operations by 19% compared to third quarter '08 levels, closing two NSS R&D sites in the U.S. and consolidating these activities into other facilities, for some of the NSS operations activities in the Asia region in order to close an office facility in Malaysia later this year current to the lease break, and further reducing discretionary expenses including contracted activities and deferred salary increases world wide.
Throughout the process of identifying areas to reduce costs, we've ensured that we protect our investments in core product and process development as well as customer support to ensure we remain well positioned when our customer demand recovers.
As part of this, we're taking the opportunity to accelerate a number of specific programs to improve operational efficiency, continue to reduce our break even position, improve cash management and improve our strong competitive position.
Our confidence in the underlying business however, remains despite the near term industry wide uncertainty. Analysts continue to forecast in excess of 50% annual growth in debt creation with no expectation of this slowing down any time soon despite the current economic conditions. All of this need to be stored on and driving demand for disc drive data based storage systems. As a result, we believe that spending on data storage capacity will need to continue throughout this period of IT budget constraints.
I'll now look at our two business areas separately starting with Networked Storage Solutions. Despite the challenging economic conditions, we maintained fourth quarter revenues at Q3 levels. We delivered 18% year over year growth, once again well ahead of the overall disc space storage market which grew 8.8% year over year according to recently published data.
We shipped 352.1 pedabytes of external storage in our fiscal fourth quarter, representing a 12.2% growth over the prior quarter and 69.4% growth over a year ago. Based on recently published data on the total pedabytes shipped in calendar third quarter, we estimate that Xyratex once again maintained its position as a leading player in the market, shipping over 17% of the world wide external storage system pedabytes through our customers.
For calendar third quarter on a year over year basis, Xyratex grew 100.5% compared to the markets 41% growth in capacity. Sequentially, Xyratex posted a 48.2% increase in shipped capacity compared to the markets 6.8%.
On an annual basis, we continue to see phenomenal growth in shipped capacity in this business. For the full year, we shipped a total of 1,168.5 pedabytes, or more than an exobyte of storage to our customers, a growth of over 76% year over year. We've seen steady demand increases from several newly published customers and vertical market segment OEM's, albeit offset by some demand reduction from certain Legacy customers.
We believe a number of these customers will continue to drive demand even in an environment of constrained IT budgets as they serve specific vertical and specialized markets such as data duplication, video editing and data management. Other customers, including our largest customer Netta, provide compelling data center operating efficiencies which are likely to become an increased focus area by end user customers in the current environment.
In addition, as I mentioned earlier, we experienced good demand from our two major new customer Dell and IBM this year as they ramped their respective programs. Our success in supporting these companies' initial growth and program requirements represent a major achievement for the NSS division in the past year.
The success in diversifying the NSS customer base and providing products and delivery solutions that meet their needs comprised a significant part of our 2008 plan. While we did see increased revenue from these large customers, pricing is extremely aggressive and places pressure on our NSS gross margin percentage.
We've seen strong interest in our one store family of storage products across much of the OEM customer base. The reduced total cost of qualification and after sales support are proving to be compelling factors behind the one store product success. Customers are able to take advantage of the commonality provided at different density and capacity configurations while reducing support costs by leveraging a common spare capability.
We anticipate more customers migrating their products to the storage base in these tough economic times driven by the increased needs to focus on the lower cost of bringing products to market, and using the slower economy timing to refresh existing platforms. That has been evidence by recent transitions by a number of our customers to fix gigabyte and to SBB controller formats as another.
With our RAID solutions, as part of our review of the business ahead of the anticipated challenging business environment, we have taken the decision to narrow our focus. Our systems integrated markets remain attractive for our array of products we've decided to reduce the segments that we target.
The Florida markets demand for specific feature and function drove more R&D than we can currently support. In addition, in this credit constrained environment we believe a number of the target customers may represent a high degree of risk. As a result, we'll focus our investment to meeting the needs of established RAID customers. As a result, as Richard noted, in a decision taking inventory provision in this area of the business.
Overall however, we remain cautiously optimistic for the business outlook for this division in 2009. Ongoing data growth will drive ongoing demand for data storage systems. In addition, we believe our business model will become even more compelling for a number of our target customers as they consider areas to optimize their businesses, reducing fixed costs and partnering with Xyratex for their storage system needs.
Moving on now to our Storage Infrastructure business revenue of $63.1 million in the fourth quarter was in line with our expectations. Demand from both our primary customers for the full year was down versus our expectations at the beginning of the year as a result of the focus placed by the industry in minimizing CapEx investment through 2008.
Additional production capacity was highly weighted towards the second half of the calendar year in line with the fading of end user disc drive demand. Looking forward to 2009, we anticipate similar fading with the majority of end user customer demand fully in the calendar second half. We believe there are a number of dynamics underway which may reduce the perceived impact to our business in 2009.
In addition to our comment on the storage market we serve in our NSS business, the growth we believe will continue to fuel demand for disc drives across the consumer market. While growth in PC and laptop sales may be reduced compared to recent growth rates, we believe that growth in demand with back up external disc drives will increase as users add storage capacity to existing PC's.
PVR sales and add on external drives may well increase in the current environment and consumers are increasingly aware of the value of their personal stored data in the form of documents, photographs and audio files, creating further demand for external back up disc drives or remote data storage providers.
This entire industry is clearly facing some uncertainty in demand in the near term. Looking forward to 2009, our primary customers have both announced reductions in capital spending in their current fiscal years ending June of '09. Recognizing the expected fading of demand for our SI products, these reductions are unlikely to have much effect on our anticipated first half '09 revenue.
We'll get a better understanding of the second half of '09 demand through the second quarter as our hard drive customers update capacity planning. Discussions to date with our customers have indicated that disc drive industry is expecting overall demand growth to be around half that of historical rates and that the reduced capital spending will be focused in two areas.
Firstly, investments to improve capital productivity and capability of installed equipment. We expect this customer strategy to benefit our immediate business as customers upgrade a portion of 51 installed Xyratex systems, plus potentially upgrades to installed disc drive test systems to enable testing of alternative compact drives or enable functionality.
Secondly, investments accelerate increases in aerial density. We anticipate that our infrastructure customers will increase the pace that they use high aerial density technology in the new year enabling either higher capacity drives to slow average sales price declines; or enabling reduced material costs to improve margins.
We expect this to benefit our test business since it will result in a proportionately increased test times as well as our media writer group as a result of a proportional increase in media writer process times.
We've now completed a detailed review and management restructuring across the entire business in attempts to strengthen our business strategically and build upon our industry leading market position. The management team is focused on four key area; customers, growth, operational efficiency and talent development.
The effective scaling back of R&D investment in a number of technology areas will anticipate limited customer focus in the near term whilst focusing investments in those areas that will provide operational cost savings for our customers or enable increased aerial density designs.
As previously mentioned we have now completed development and testing of our next generation disc drive test platform designed specifically for two and a half inch four track drives as the industry rapidly transitions to this format. We're working with one of our customers to commence factory evaluation of this system over the next few months, ahead of anticipated volume demand in the second half of the year.
We believe this system provides extremely compelling technical process and factory cost advantages over potential competitive solutions. In designing this new test system, we've increased our accessible market by as much as 20% within some disc drive manufacture processes by enabling the server process to be undertaken in our test track as opposed to a stand alone piece of equipment. Providing this capability, we anticipate the current equipment provider has simplified the overall production process for our customer.
With regard to competition in this market, we believe our ability to protect the high value segments of the production rack market remains strong as evidenced by the patent litigation we initiated against Teradyne in the summer. This litigation process is proceeding and we intend to defend our intellectual property rights.
In early December we obtained new information supporting our claim that Teradyne disc drive test system infringes on Xyratex's IP. This new information has been provided to both Xyratex and Teradyne. However, we are unable to comment further on this topic due to confidentiality agreements.
It would appear that the competition have found that entering this market has proven much more technically challenging than they had originally planned. We clearly view all competition as potential threats, and as a result have worked to position our technology products differently to where we believe the competition are ailing. Incorporation of server capability is an example of this as well as disc drive interface test capability and we believe any competitor design will be unable to provide these features without infringing on Xyratex IP.
We are leveraging a broad deep domain experience gained over the last twenty years. With Xyratex's production equipment to be utilized to qualifying tests for over 1.3 billion disc drives to date, we will continue to accelerate innovation based upon our learning and feedback from over 160,000 drives today being qualified and tested on Xyratex's production equipment.
Looking forward towards next generation recording technologies and the equipment needed to enable volume production we've enhanced our technology team with the appointment of an industry veteran, [Peter Golia] as Chief Technology Officer. Peter joins us with 20 years experience in drive technology positions with HP, D8 and WD. We believe Peter will provide strong leadership in setting our growth strategy for the division as the industry adopts new technologies such as patent media.
While this is currently anticipated to be a challenging period we are entering in our industry, we believe that our core expertise, significant install base of production systems and the confidence our customers place in our ability to deliver positions us well to support these customers through this period. We remain therefore, cautiously optimistic for our prospect for the business in 2009.
In closing, I believe the results of 2008 were relatively good, especially given the industry and macroeconomic environment. Our fourth quarter GAAP results were clearly disappointing dominated by one of our accounting actions as well as what we consider to be prudent actions to reduce certain cost levels in light of the current market environment.
I believe the actions we are taking to reduce these costs will enable us to weather the current economic storm and result in us being a more efficient and focused business ahead of the market recovery.
I'd like to take this opportunity to thank all our employees' world wide who have contributed towards our performance in the quarter and through 2008. It is regrettable that we are faced with the need to close the year with head count reductions as a result of the economic downturn we are now experiencing.
Whilst recognizing the contribution of our valued employees now leaving the business, our focus now is on looking forward, investing the next generation technologies, products and processes needed for the future success of the business, Xyratex's compelling portfolio of products and processes, great employees and an enviable customer reputation. We intend to build on these strengths and the future success of the company.
That concludes our formal comments. I would now like to open up the call to questions.
(Operator Instructions) Your first question comes from Amit Daryanani – RBC Capital.
Amit Daryanani – RBC Capital
Just a quick question on the NSS side, can you split out what the net App and non app revenue stream looked like?
In the quarter approximately 60% of the revenue related to net app and that compares to a four year number of around 66% and that the percentage of the NSS revenue.
Amit Daryanani – RBC Capital
Could you talk about, the last quarter you talked about transferring some of the business to EMS ODM for wire net app, could you just update us on the process and sort of the impact on the revenue and gross profit line from there?
Reiterating what we said at the last call and we actually said some of the information we give with regard to our relationship there, but effectively as we said the last time, the agreement we have with Network Appliance is that at least in the medium term, we will retain at least 75% of the overall business with the capability to move up to 25% to a second source. We will receive compensation for any proportion that does move to that second source by way of a royalty stream.
We haven't seen any impact of a new second source within the results to date but there has been some movement to that source as we start to ramp that up in the first quarter. Obviously, we're only a few weeks into that. We're not giving forecasts at this stage and I'm not able to tell you what the figure will be in terms of the impact, but obviously it's in the early stage of ramp. My expectation is that it will be somewhere in the 10% to 20% region in that first quarter.
Amit Daryanani – RBC Capital
On the SI segment, you talked about sales being around $15 million to $25 million for the next two quarters. If you kind of look back in Feb '08 time frame when the sales were around $30 million, they're running around 19% gross margins. Is that the kind of margin level we should think about the next quarter or two as the sales are at a kind of lower base over here?
As we said in the script the lower margin is often reflected by the lower level of business and whilst there is a significant amount of variable cost in there which we will be able to mitigate over the early quarters, if I look back to Q1 of last year to where we had around $30 million of revenue, gross margin was around 18%. To the extent that we're in the kind of $15 million to $25 million range, my expectations are that margins would drop to around the 15% level approximately.
Amit Daryanani – RBC Capital
You talked about in the medium term margins getting back to 28% to 30% range. Can you quantify what medium means to you?
I think medium term means to me in the foreseeable term, but obviously as always in that business those margin projections are over a longer period so of course as I look out for the full year of next year, I see us returning to those type margins over the full course of that year as we have been in each of the previous years with the exception of last year, but obviously last year we're coming in at 27.1 so slightly under that reflecting the lower revenues.
But over the period of the year and going forward, I would expect to get back to the 28% to 20% level.
Your next question comes from Keith Bachman – Bank of Montreal.
Keith Bachman – Bank of Montreal
Just two questions. First a clarification from the previous caller. Your comments on aggregate gross margins just ranges – I didn't fully appreciate that. You thinking in the upcoming quarter it will be around the 15% level given the volume variance that you have?
That's just for the SI business.
Keith Bachman – Bank of Montreal
I'm looking for the aggregate. I wondered if you just wanted to make some comments on the aggregate level that you're expecting if you add both divisions together.
I'll talk individually. Obviously we talked about the SI business so then on the NSS side of the business, obviously in 4Q we had a 5% gross margin reflecting the charges. If you back those charges, you would get to approximately 12% for that business.
And I think as we move forward into next year given the reduction that we're seeing in our RAID business at this stage which is obviously the higher margin providing piece of that business, I would say approximately 12% is a good level to use for the first half of next year.
Keith Bachman – Bank of Montreal
Going back to the drive business, I know you said you're looking to enforce your IP against Teradyne but do you have any comments on where Teradyne is versus acceptance at WD? Any kind of evidence that you're hearing back from the client?
I would prefer not to comment regarding that under the confidentially agreement that we have between the parties.
Your next question comes from Jayson Noland – Robert Baird.
Jayson Noland – Robert Baird
In the NSS side of the business that gross margin of 12%, would that include the royalty stream that you would receive?
It would, yes.
Jayson Noland – Robert Baird
On the royalty stream, is that something that would be paid to perpetuity or is it being paid for intellectual property?
Without getting into specifics the royalty is linked with the product that we provide today and our IP is linked to. To the extent that those products continue then there will be a royalty stream and that's as I stand today as far out as I can see in the medium term but obviously if the customer went towards a product which didn't need our IP then I wouldn't get a royalty stream for that.
So I couldn't say today. It's going to in perpetuity yes, related to those products but I'm assuming that in years to come there will be product changes. It will depend on whether my IP continues to be within those products.
Your next question comes from Shelby Seyrafi – Caylon Capital.
Shelby Seyrafi – Caylon Capital
You talked about achieving profitability in the second half of the year. I've been trying to figure out how that happens with various scenarios. It looks like if you take a 10% reduction in your OpEx for example to reflect the head count reduction, that gets you to OpEx percentage around 14% to 15% but your gross margin, it doesn't look like it's headed much higher than say 14% any time soon. I'm just trying to see what kind of gross margins do you think you can achieve in the back half of fiscal '09 to achieve profitability?
I guess obviously given the gross margins for the two divisions and the return to profitability across the whole business obviously relies a lot upon where you see the SI revenues ramping in Q3 and Q4. So if I look at the NSS business on its own then yes, throughout the period it remains profitably in its own right but the business that provides the greater leverage is obviously the SI business.
We've given some indication of range in the first half of the year but obviously depending on where you set your expectations in 3Q and 4Q that will ultimately define the profitability and obviously our expectations there is there is a considerable ramp is 3Q and 4Q as there has been in 2008.
Shelby Seyrafi – Caylon Capital
I'm trying to figure out how much flexibility you have in terms of your OpEx for this 10% head count reduction while still running the business. Do you think that you can lower the OpEx one more 10% in the back half and still achieve, basically run the business?
I think at the moment in terms of the OpEx decisions that we've taken in the short term to reduce the overall costs, as I said head counts go down 10%. I think across the board with the other actions we're taking, we would expect to see our OpEx from around Q2 reduced by 10% overall if you look at Q3 and Q4 run rates.
At this time, we think that that in itself is sufficient and it takes us down to the level that at this stage given our projections for Q3 and Q4 and going forward, we wouldn't want to take it down any further at this stage and don't have the need to do so. Obviously as we go through into Q2 if we felt toward the back end of that quarter that our estimations for Q3 and Q4 were overstated, we may need to have a relook at that, but at this stage we haven't got plans to further reduce those costs.
At this time we have no additional questions. I'll have the call back to the speakers for closing remarks.
We'd like to thank everyone for joining us this afternoon. We'll report our Q1 earnings in late March and do look for a final fourth quarter and fiscal year end results in our 20 Feb or sooner in February. Thank you and we'll talk to you soon.
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