Xyratex Ltd. Q2 2009 Earnings Call Transcript

| About: Xyratex Ltd. (XRTX)

Xyratex Ltd. (NASDAQ:XRTX)

Q2 2009 Earnings Call

June 24, 2009 5:00 pm ET


Brad Driver - Vice President, Investor Relations

Richard Pearce - Chief Financial Officer

Steve Barber - Chief Executive Officer


Aaron C. Rakers - Stifel Nicolaus & Co.

Glenn Hanus - Needham & Company

Jayson Noland - Robert W. Baird & Co.

Keith Bachman - BMO Capital Markets


Welcome to the second quarter Xyratex earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's conference, Mr. Brad Driver, Vice President of Investor Relations.

Brad Driver

Good afternoon everyone. Thank you for taking the time to join us this afternoon. I would like to welcome investors, research analysts, and others listening today to Xyratex’s fiscal second quarter 2009 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 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’s 20-F dated February 18, 2009.

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 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.

Richard Pearce

Good afternoon everyone. I would like to thank you for joining us today. Our press release is available, both on PR newswire and our Web site.

Overall, I was pleased with our results for the quarter given the ongoing challenges posed by the global economic conditions. We reduced our expenses slightly more aggressively than I projected and I feel we are better positioned to achieve our near- and long-term financial objectives.

We have begun to see some improvement in the capital expenditure forecasts by a number of our customers for the second half of our fiscal year.

I would now like to provide you with some commentary about our results for the second quarter. Please not that all numbers are in accordance with GAAP unless stated otherwise.

Total revenue was $194.7 million, down 26.9% as compared to the second quarter of last year, and up 5.9% from our prior fiscal quarter.

Sales of our Networked Storage Solutions were $184.3 million, or 94.6% of total revenue. This is a decrease of $48.3 million, or 20.8% compared to the second quarter of last year, and up 11.2% compared to $165.7 million in our prior fiscal quarter.

The decline in revenue as compared to the same quarter a year ago primarily reflects the implementation of our license agreement with NetApp, as I previously discussed, whereby a maximum of 25% of their volume can be undertaken through an authorized manufacturer.

As compared to the prior quarter, we experienced greater demand from a number of our tier-1 and tier-2 customers.

Sales of our Storage Infrastructure products were $10.5 million, or 5.4% of total revenue, down $23.4 million, or 66.0%, compared to the second quarter of last year, and down 42.3% over our prior fiscal quarter. This performance was less than expected, primarily due to the timing of shipments across the quarter end.

The overall scale of the revenue this quarter reflects the specific industry dynamics in the disk drive capital equipment market that we outlooked in previous earnings calls.

Gross margin was 12.9% for the quarter compared to 15.3% in the same period a year ago, and 11.4% in our prior fiscal quarter. This reduction in overall gross margin, compared to the prior year, primarily reflects the lower proportion of Storage Infrastructure revenue in the quarter and the change in the sales mix of our Networked Storage Solutions products.

The gross margin for our Networked Storage Solutions products was 12.7%. This compares to 14.0% this period last year and 11.2% last quarter. The decrease in gross margin is primarily a result of product mix.

The gross margin for the Storage Infrastructure products was 18.0%, compared to 24.9% last year, and 15.2% last quarter, in line with our expectations.

This reduction in gross margin, compared with the prior year, is due primarily to the relatively low SI revenue in the quarter.

Non-GAAP operating expenses totaled $31.4 million compared to $35.6 million in Q2 of last year and $31.7 million last quarter. Expenses in the quarter included an increase in bad debt provision of $1.2 million and therefore, on a normalized basis, we have seen a material decline in our quarterly run rate as a result of our expense controls and the restructuring we have undertaken. The total costs related to restructuring are $4.2 million year-to-date.

On a non-GAAP basis, net loss was $6.7 million. This compares to $4.6 million profit in Q2 2008 and a net loss of $10.8 million in the prior quarter.

Fully diluted loss per share for the quarter, on a non-GAAP basis, was $0.23, based on there being 29.5 million shares outstanding in Q2.

GAAP net loss in the quarter was $9.6 million and included an amortization of intangible asset expense: non-cash stock compensation, restricting costs, and related tax, totaling $2.9 million. 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 $27.2 million, down from $33.8 million at the end of Q1 but slightly above our projections.

Cash flow used in operations was $1.2 million in the quarter.

Inventories decreased by $9.5 million to $101.1 million in the quarter. Inventory turns were 6.6 compared to 5.9 in the previous quarter.

Accounts receivable increased by $16.6 million in the quarter to $103.1 million.

Days sales outstanding were at 49 in the quarter compared to 42 for the previous quarter, as a result of revenues in Q1 being weighted towards the start of the quarter.

As a result of our restructuring actions, headcount at the end of the May quarter was 1,680 employees, a reduction of 85, or 5% over the previous quarter.

In summary, as expected, this was another challenging quarter, given the global issues that continue to constrain overall demand. However, I am encouraged by the recent indications that market conditions have stabilized and that some of our customers have begun to expand their capital expenditure forecasts through the end of our fiscal year.

The company has significantly reduced expenditure, whilst also maintaining a high degree of flexibility to meet our customers' requirements in a demand environment that has limited visibility.

Given the limited visibility, the company believes that it is not appropriate to provide formal financial projections, however, the most recent customer forecasts do provide me with confidence that the company will return to profitability in the second half of 2009.

I would now like to hand over to Steve for his comments.

Steve Barber

As Richard has indicated, our fiscal second quarter performance was in line with our expectations, with our NSS business performing better and our IS business performing slightly below expectations due to the timing of shipments at quarter end.

Overall, while it still may be a little premature to talk of green shoots appearing in the market, from a data storage standpoint, we might conclude that the downturn in demand had bottomed and no longer appears to be worsening.

As we stated in our last earnings call, we focused our efforts this last quarter in narrowing the breadth of our business activities in order to focus on fewer programs and to execute on them well. We are focusing on strengthening our customer service, assisting our OEM customers' business success in these challenging markets, and providing wherever possible, flexibility against a backdrop of reduced forecast visibility.

In addition, we completed a second phase of business restructuring, including further headcount and benefits reductions through the quarter. We continue to focus on strict cash management.

I will now review our two businesses separately, starting with Networked Storage Solutions.

Our fiscal second quarter revenue was above our expectations, growing 11% sequentially to $184.3 million, as a result of relatively stronger demand from our larger customers, including Dell, IBM, and NetApp. Demand for the remainder of the year remains limited, however there are signs of our customers becoming more confident in their near-term planning assumptions.

In addition to the challenges of an environment of limited visibility, we've experienced constrained supply across some disk drive model through the quarter. However, with positive support from our major drive suppliers, we have to date, managed to minimize supply impacts to most of our customers' requirements.

As we stated earlier in the year, we took decisive actions for the first half of 2009 to reduce costs across all areas of the business in light of the economic downturn and reduced revenue outlooks. We reduced overall divisional costs by over 27% through the period whilst maintaining our investments in key, next-generation technology and programs.

We shipped 373.34 petabytes of external storage in our fiscal second quarter representing a 28.8% growth over the prior quarter and 31.0% growth over a year ago. Based on recently published data on the total petabytes shipped in calendar Q1 2009, we estimate that Xyratex once again maintains its position as a leading player in the market, supplying over 14% of capacity on an annual basis.

The SATA driver device continues to dominate shipments with most of our major customers adopting these drives because of their mainstream product lines. Fiber channel remains relatively flat while SAS continues to increase. Additionally, we have steadily increased shipments of solid-state drives within our enclosures to an increasing number of customers.

The breakdown of shipping capacity by interface type for Q2 was: fiber channel, 80.02 petabytes; SATA, 279 petabytes; SAS, 14.31 petabytes; and FSBs with software interface, 13.6 terabytes.

Whilst we consciously narrowed our business focus primarily on OEM customers this last quarter, we have continued our business development activities around both current and selected target new accounts, building on existing relationships and seeking to diversity our customer base.

We were delighted to announce a new OEM partnership with LaCie designed to deliver premium storage systems which target video professionals. This new partnership will leverage the proven Xyratex sources of technology with LaCie's respected brand product portfolio and customer support in the market.

This is our first significant win in the Apple/Mac environment, a sector which is driving much of the entertainment multimedia market with high definition video design development and production.

As we indicated on our last earnings call, we took the decision to limit our product development and business growth activities in the general application market resulting in choosing to disengage with some previous customers. We chose to increase our focus on the vertical market applications where we have been most successful as well as continue to support our key OEM customers with our array of technology.

In the current environment we believe we must seek to protect and build on our existing OEM customer relationships by focusing our available resources on developing the robust needs of those accounts.

In addition to the new business announcement this quarter, we continue to work closely with a number of target OEM customers where we have products and technologies in evaluation. We are optimistic that we will be awarded further incremental opportunities with some or all of these current and new customers through 2009.

The data storage market we serve remains robust despite the current market conditions the industry is facing. A recent industry research report stated that the amount of data stored digitally is expected to double every 18 months due to the pace of digital information created and transmitted over the Internet, phone networks, and airwaves, actually increasing through this downturn.

The same report also noted that more than 30% of the information created today is security-intensive, requiring high standards of protection, and this will grow to around 45% by the end of 2012.

The report specifically outlooks that the financial collapse will lead to more regulation and government oversight, driving more mandated record keeping compliance and add increased levels of digital information stored.

Whilst this trend is encouraging for our business, end share remains highly competitive and is a key OEM partner to major brand names in the sector, we remain highly focused on driving business operation efficiencies and key product and technology development.

Moving now onto our Storage Infrastructure business.

Revenue of $10.5 million in our Q2 was slightly below our expected range for the quarter, however, the shortfall was entirely due to the timing of the shipments at the back-end of the quarter. Overall revenue for the first half of the year, of $29.0 million, was within our anticipated revenue range for the period.

In our last two earnings calls our comments on the business were made against the backdrop of rapidly reduced visibility and aggressive consumption of inventory in the channel as opposed to reflecting our comprehensive analysis of the end market demand data. As we stated in those calls, management took decisive action in the SI business, starting in December, to make prudent business model adjustments based upon unprecedented actions taken by our disk drive customers to curtail manufacturing output and eliminate capital purchases in order to protect cash.

We took significant actions for the first half of 2009 to restructure the SI business, reduce the overall cost base, and focus our activities on key technologies that are required by our customers as they enter the anticipated period of resumed growth.

We reduced permanent headcount by over 25%, contractor headcount by over 85%, and overall costs by more than 17% from the peak in fourth quarter 2008.

These actions lowered the fixed costs and break-even point for the business, which will have a positive effect on the performance of the business in the second half of 2009 as demand begins to recover.

Digital content creation, replication, distribution, and archiving continue to drive the growth of data storage at 40% to 60% compound annual growth, according to industry reports. In the measure of true end user market demand and our detailed analysis confirms our view that the unprecedented action taken by the disk drive companies to curtail manufacturing output earlier this year, primarily reduced inventory levels through the entire supply chain and has resulted in component shortages acting as a constraining influence on an overall market recovery.

In addition, PC sales have proved far more resilient than had been anticipated at the start of the year, with recent industry reports indicating the total of U.S. PC unit shipments grew 10% year-over-year in May, 6% year-over-year in April, and 12% year-over-year in March.

Disk drive unit growth is just one driver for our SI business. As we said in the previous call, the disk drive companies must continue to invest in improving aerial density in order for them to simply maintain market share and product margins due to the continuous reduction in disk drive ASPs.

This has been, and continues to remain, a fundamental requirement of the industry. In order for disk drive companies to introduce new high-unit capacity drives, which enable higher unit prices, and/or enable material cost reductions through reduced material content. We have continued to see such investments, albeit with a high focus on cash, through Q1 and into mid-second quarter.

These technology investments began to increase last in the first half of 2009 and we are anticipating some acceleration through the second half of the year.

As I mentioned in my business comments, we have seen supply constraints on certain disk drive models needed to support our enterprise storage systems products through May and June. We do not believe this is due specifically to increased market demand of enterprise-class products, but more likely to be a result of overall constrained production capacity to serve all disk drive markets. This situation, together with aerial density investments, is now driving demand for incremental equipment, particularly in the next-generation technology platforms.

As we indicated in our previous earnings calls this year, based on our critical analysis and deep understanding of the fundamentals in this business, we anticipated a catch up in demand for disk drive production capital equipment in the second half would be needed to recover from the unprecedented actions to reduce production and curtail investments by the drive companies earlier this year.

We are now seeing this expedition unfold. Through the second quarter we have begun to see improved visibility in this business, with our disk drive customers requesting us in some cases to accelerate deliveries of key equipment containing advanced technology that is required by our customers in Q3.

As indications of this, we entered this current quarter with over 75% of the quarter projections booked with confirmed orders, compared to almost no orders in place going into Q2 and we have received orders for five of our next-generation test systems.

Discussion with our disk drive customers has indicated that while the industry is expecting overall disk drive unit demand growth to be below historical rates, they will focus their reduced capital spending in two areas.

Firstly, investments to accelerate increases in aerial density. We believe that our disk drive customers will increase the pace that they introduce higher aerial density technology the second half of the year, enabling either higher capacity drives to slower ESP designs or enable reduced material costs to improve margins.

We have seen this strategy begin to benefit our production test system business since aerial density increases, resulting in a proportional increase in test times, as well as our media writer equipment business, since it results in a proportional increase in media writer process times.

Secondly, investments to improve capital productivity and capability of installed equipment. We expect this customer strategy to benefit our media cleaning business as the market upgrades a portion of the installed base of 51 Xyratex cleaning systems, although this is not expected to begin before late 2009.

Plus, we have begun to see demands for upgrades for installed disk drive test systems to enable testing alternative form factor drives and enable server field functionality.

In this second area, we are working closely with our disk drive customers in assessing the yield and productivity benefits of upgrading the installed production test systems with our 3DP test cell technology. At least you may see some roll out of this upgrade program in the second half.

On our next-generation optimized production test platform we are well advance in qualifying the system with the one customer. They supply the subset of this platform to two additional customers for evaluation, including a Japanese customer as we outlooked during last quarter's comments. This platform is receiving a great deal of interest from our customers as a result of the significant improvements in dynamic and field performance. In addition to the factory productivity benefits, this platform provides over legacy systems and competitive offerings in consideration.

We are committed and will continue to leverage our broad and deep domain expertise gained over the last twenty years. Xyratex's production rack equipment has been utilized to qualify and test over 1.3 billion disk drives to date. We will continue to accelerate innovations based upon our learning with our customers and feedback from over 760,000 drives a day being qualified and tested on Xyratex's production and rack equipment.

We have invested a great deal in our technology and as an innovative company, we are committed to protecting our valuable intellectual property. Overall, we are gaining confidence in our second half of 2009 outlook for the SI business, with a solid order load in place for Q3 and encouraging early discussions with regard to Q4 demand.

Compared with prior years, our 2009 revenue projections remain materially lower but we remain confident in the underlying long-term growth limits for this business, moving forward into 2010.

The integration is showing no signs of slowing. Disk drives remain the only competitive data storage solution and we remain well positioned as a leading provider of production process and test equipments to the disk drive industry.

Looking forward, we believe we remain well positioned from the inevitable growth in the data storage sectors we target. We are partnered with market-leading customer brands that are well positioned in the market with best-in-class, differentiated solutions.

Corporate users and small-to-medium businesses will need to catch up in their hardware regimens after extended periods of budget constraints and we have a compelling road map of products to address our customers' target markets.

I would once again like to take this opportunity to thank all our employees worldwide for their contribution towards the company's performance, but more importantly, their dedication to our customers' success. We have completed a very challenging period for the company through the first half of 2009 and now need to focus on rebuilding as we work to support the anticipated market recovery through the second half of the year.

Thank you for your support and commitment to the growth and success of the company.

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

Question-and-Answer Session


(Operator Instructions) Your first question comes from Aaron C. Rakers – Stifel Nicolaus & Co.

Aaron C. Rakers – Stifel Nicolaus & Co.

A housekeeping question, can you give the breakdown of NetApp, how big that was a percentage of your Systems business.

Richard Pearce

Not December, actually, from the last quarter, so approximately 60% of our NSS revenue was NetApp.

Aaron C. Rakers – Stifel Nicolaus & Co.

And you had mentioned that you're seeing some improved order patterns from some of those customers. Maybe it would help us understand, as far as this next quarter, are you forecasting that business to being up sequentially? Just any help there in terms of patterns from that business here looking forward.

Richard Pearce

As I said, we're not giving formal guidance at this stage, but to give some flavor around that, and referring back to the comments I made in the call, and as we have said in previous calls, we are focusing more on our larger customers, and as passed on in Steve's comments, we have seen some of our smaller customers, particularly in the array side of the business, we've actually decided not to focus on those guys.

So going back to those comments, whereas NetApp has continued at a relatively similar level in terms of percentages, previous quarters, we have actually seen increases in Dow that we have announced previously. And IBM, actually the revenue in Q2 kind of doubled from the revenue levels that we have in Q1.

As we look then, into Q3, I think obviously in Q2 we would have seen the benefit in that quarter of network appliances, year end, which always has an effect of making our Q2 normally actually better than our Q3.

As I look out, again, I wouldn't be expecting a significant uptick into Q3, but equally, I wouldn't be expecting at this stage for it to be reducing in that quarter. So I think there's a good likelihood that it will be stable to having some small increases.

Aaron C. Rakers – Stifel Nicolaus & Co.

And then final question on the Storage Infrastructure side of the business, I guess two things. Can you talk about the competitive landscape, i.e. what you have seen from Teradyne at this point.

And then also I would love to get your thoughts on looking out longer term, the impact of pattern media, if you have started to see any deployments relating to that or what we should think about in your business model.

Steve Barber

On the pattern media side we continue to work closely with our disk drive customers. It's clearly very much still in the laboratory stage and there clearly are some challenges on bringing that technology into production mode. Our view right now is that it will be a fairly lengthy process to bring that to the market. And because of the production equipment costs associated with bringing it to volume production, I think the drive guys will find ways to delay having to make that transition for as long as they possibly can. But we are certainly working towards to a system where we can getting early into the development process.

With regard to Teradyne, I can't comment as to their activity in the market. With regard to our lawsuit against Teradyne, we feel strongly that our patented technology should and will be protected but clearly due to the nature of the litigation still pending, we are unable to provide further details.


Your next question comes from Glenn Hanus - Needham & Company.

Glenn Hanus - Needham & Company

Maybe to follow-up on Aaron's question on the Networked Storage Solutions side, could you talk about the gross margin performance. You had good uptick in gross margin on that side of the business. Could you discuss how you achieved that uptick and the sustainability of 12.7% or what we should think about going forward there.

Richard Pearce

As you say, we did have see a performance of 12.7% in the quarter. That compared to just over 11% in the previous quarter. A couple of main reasons for that. One is we are making progress in terms of reducing the operational costs. We talked about that probably in Q3 and Q4 that we had seen an uptick in our overall operational costs, related in some way to the implementation of our SAP system and we started to see some benefits from better understanding of the SAP system and coming to terms with that, as well as just the focus that we're putting on overall operational costs.

The other element that we've seen during the quarter is that disk drive prices actually have come down relatively significantly and therefore they are representing a lower proportion of the overall cost of the products and hence, based on the pricing that we have, that gives us a better percentage margin, albeit the absolute margin would stay the same, relatively, but obviously we have actually seen revenues go up. So therefore, we have actually seen a strong increase in the actual number of units that we shipped.

In terms of the sustainability of that margin, again, when we talked about this last quarter I think I gave some indication that my expectation was that margins would be in that 11% to 12% region, given our focus on the tier-1 customers. I think given where we've seen the disk drive pricing and also the benefits that we're seeing in operational costs, and as I said earlier, we have actually taken operational overall costs down slightly more aggressively than I projected, which I am happy with, and I do see us being able to maintain those margins in the sort of 12% to 13% range now as we move through to the end of the year, rather than that 11% to 12% range that I gave an estimate of last quarter.

Glenn Hanus - Needham & Company

Any thoughts on the outlook, and this is back on the NSS side again, the outlook for any other business going through a contract manufacturer? Do you think you will hold just to the 25% going through NetApp or might there be other sort of shoes to drop from that standpoint, with other customers that might curtail the revenue stream as we start to look out for a year?

Richard Pearce

I think there's been no developments on that side to date. I know we talked about the possibility of that when we talked about the NetApp experience, but I would say that nothing more has materialized on that. We still consider that as a possibility but I think talking about year out or so, given where we are today, it's unlikely that we will see anything happening in the near term with regard to other customers.

Glenn Hanus - Needham & Company

On the system infrastructure side, you are anticipating good pickup here in the second half of this year. How do you feel, I mean, typically as you've gone into the first half of the calendar year, that side of the business is a slower period. Do you think you can kind of maintain the sort of fourth quarter levels that you achieved this year going into the first half of next year as perhaps Seagate starts to come back on?

Richard Pearce

It's pretty early for us to say that. I think, back to Steve's comments on visibility, we still have relatively limited visibility into the fourth quarter, albeit we have a lot better visibility now in Q3 and actual orders sitting there, than we obviously did at the start of the year.

But my expectation is that the start of the year, as it has been in recent history, will continue to be the lower portion of the year, particularly when compared to 2010. So I would expect one half of 2010 to be lower than the back half of 2010.

Given the very low revenues in 2009, relative to history in that business, I think I would be expecting better revenues in the first half of 2010 than 2009. I wouldn't like to say at this time whether or not they will be at the same levels as Q3 and Q4 and part of that is because as I said today, I'm not too sure what Q4 is likely to be and I think it could be quite a wide range, depending on what we're seeing out of the HDV marketplace.

I think there is some encouraging news out there and I guess there is a press release come out earlier today from Seagate in terms of pre-announcing with regard to their Q4 and also their Q1 outlook, which kind of does confirm to a degree the statements that we made earlier today and I think we just need to see how that comes through before I would like to make any predictions on that.


Your next question comes from Jayson Noland - Robert W. Baird & Co.

Jayson Noland - Robert W. Baird & Co.

Continuing on the SI side, the bookings that were mentioned that's from the single customer.

Richard Pearce

I think it's relatively common knowledge at the moment that our major customers are still WD and Seagate and also a little bit in terms of the SATA customer that we have, so that's your mixture of all of those customers in Q3 rather than just one specific customer.

Jayson Noland - Robert W. Baird & Co.

And on the gross margin side in SI, would we expect to see some of the same ranges there as that business comes back, assuming the scales there. Your gross margin in the current quarter was okay relative to the run rate.

Richard Pearce

Okay relative to the run rate. Yes, but obviously there is a certain amount of fixed costs within that which need to get spread over at very low volumes. But going back to Steve comments, we have reduced our expenditure quite considerably in SI, brought down our break-even levels.

So going back to some statements I previously made, when we get up to what I would say a more acceptable type revenue in that area, which we are expecting in Q3, then my expectation is that the gross margins will return to levels of approximately 30% at reasonable revenue run rates and I'm comfortable that we can provide that in Q3.

Jayson Noland - Robert W. Baird & Co.

You had mentioned solid state drives. I guess could you just describe a little bit how you're participating in the integration of the SSD into the chassis work that you're doing?

Steve Barber

We've worked with a number of customers so far. Worked with them to qualify a range of SSDs. Some of those customers are purchasing independently, once they've done the qualification. Others, as we are starting to see now, are looking to us to purchase and integrate those as a bundled solution. So we're seeing different customers approach them in different ways. It's fair to say they are used very selectively. Typically one of the slots in the array will comprise the SSD with STAT drives, high-capacity drives filling the rest of the slots.

Jayson Noland - Robert W. Baird & Co.

On the NSS business, I assume with one of your customers here, there is going to be some consolidation. Data Domain. Are they less than 10% of revenue in NSS? Either direction the company goes would potentially have a negative impact for Xyratex?

Richard Pearce

I can confirm that they are less than a 10% customer. In terms of which way they might go and whether that's positive or negative for Xyratex, Steve.

Steve Barber

That's a difficult question. I think if NetApp is ultimately the acquirer then I would anticipate that they would seek, over time, to look at converging the array technology that we provide. Today we provide different platforms to those two different customers for their systems. I think there is certainly opportunity with NetApps in control that they would seek to consolidate and from the Xyratex standpoint look towards maximizing volumes over fewer product types.

If it is a different acquirer, it's more difficult to predict because we don't have relationships with all of the potential acquirers out there.


Your next question comes from Keith Bachman - BMO Capital Markets.

Keith Bachman - BMO Capital Markets

I wanted to ask more broadly, as you look out over your drive business or the storage side, are there product expansion opportunities, either organically or inorganically. I assume that the solar stuff is still kind of on the back burner but are there targets out there where you can expand beyond what the inherent growth rates are with our existing customers? Particularly interested on have asset prices come down on any expansion opportunities on the drive side, you could get a greater part of the production line.

Steve Barber

I guess that's an ongoing focus within the company. We have a history of expanding our footprint within the drive companies by both organic and acquisitive additions of IP to the product portfolio. That will continue. And certainly as you might expect in the current environment, we have increased our focus there to see if there are particular areas that are worthy of consideration, both from our perspective and that of feedback from the drive customers themselves.

So we will continue to look at areas where it makes sense to broaden our portfolio. But ultimately it has to be a case where it's one plus one equals three or five, not simply just pure additive when you take into account the management challenges integrating any acquisitions into the organization.

And the debate is continually underway as to whether we try and access some of those additional parts of the manufacturing process organically or whether it's better to try and get access faster through potential acquisitions.

And there are some interesting IP opportunities out there that have been around for some time and we will continue to look at them and decide whether the current environment makes it any different or more attractive to go after those.

Keith Bachman - BMO Capital Markets

You mentioned the gross margin range that you're thinking about over the next couple of quarters, but within the storage side of the business, how do you think mix might impact the gross margins on that side of the business in particular?

Steve Barber

I think as Richard indicated, a lot of the gross margin durations we see today with a high proportion of our revenues coming from tier-1 type customers, is really driven by the selection of the drive, specific the drive types, and the pricing of those drives in any one quarter. I think it's fair to say we've seen relative stability on most of the high volume drive types through this quarter, which has had an effect on our margins.

But whilst we can outlook with reasonable confidence towards the rest of this year, based on the outlook of type of drives and the type of products we are looking to ship, beyond that it really depends on decisions taken by our customers as to how quickly they want to introduce next-generation drives, which by that nature, demand a premium at the onset of their introduction.

So if those introduce in significant volumes then it technically has a negative effect on our gross margin percentage, simply because of the fact that we pass through all of that content through our revenue.


Your next question is a follow-up question from Aaron C. Rakers – Stifel Nicolaus & Co.

Aaron C. Rakers – Stifel Nicolaus & Co.

Earlier you had made the comment that your plan was to get back into acceptable ranges for the Storage Infrastructure business in the second half of the year. If I'm to assume that acceptable means a range that we can get back to, like a 30% gross margin, the last time you really did that was the second half of 2008, which was running about $60.0 million. Have you changed the structure in there to where we should think about that "acceptable" range differently, to get back to that gross margin level?

Richard Pearce

I think acceptable range is obviously relative and where we come from in the first half of the year and where we've reduced our costs from then, again, we're not giving projections but we are looking at significantly lower levels of revenue, which would be able to provide us with gross margins at the 30% level.

Again, we're not giving projections but there are numbers out there from the five [inaudible] which are covering us and we are not uncomfortable with the numbers that are out there, but we certainly don't need to get to the sort of $60.0 million levels to be able to provide that type of gross margin. And I guess I will reiterate, it's relatively acceptable given where we've come from and the climate that we're in.

Aaron C. Rakers – Stifel Nicolaus & Co.

And then two other questions. You had mentioned that you had five systems of your newer systems basically being tested or even deployed at this point. Obviously given this last quarter's revenue it doesn't look like really any of those hit, so do those flow into all of Q3 or do they flow over time into the revenue stream.

Steve Barber

In my script I said we had received orders for five of the new-generation systems. The timing of those, we're in discussion with the customers as to when they would like those specifically deployed. But we have five confirmed orders now for systems.

Aaron C. Rakers – Stifel Nicolaus & Co.

Any update finally on Hitachi and the opportunity there. Is that still further out for you as you see it?

Steve Barber

I think so, yes. Again, they've consolidated activity significantly in the current environment. But again, all continue to be interested in the technology we're able to bring, particularly this next-generation test platform, which I think has indicated bring a number of very specific features that help them and all the disk drive companies in a number of areas.


Your next question is a follow-up from Glenn Hanus - Needham & Company.

Glenn Hanus - Needham & Company

Could you talk a little about opex here. You had a bad debt provision of $1.2 million. Should I assume that was one-time event and remove that for going forward modeling? And so opex, should we look for that to come down still another about sort of $2.0 million over the next couple of quarters?

Richard Pearce

Yes, hopefully, I directed toward that in my comments, that we do see that as a one-off event and therefore the $31.4 million or so of opex that we saw in the quarter, if you normalize that, you are heading towards the $30.0 million levels.

Glenn Hanus - Needham & Company

So of the $30.0 million then, is there still another $2.0 million a quarter to go, or about $1.5 million to go, on opex reduction?

Richard Pearce

I think we've seen the majority of what we're planning at the moment. Back to the restructuring expenses, I'm not expecting that we're going to have significantly additional restructuring expenses as we move through the year. That said, we have seen some restructuring during this quarter that we will start to see the benefit of in the back half of the year.

The only caveat to that which I would put at this time is with regard to this litigation case that we have with Teradyne at this stage, which, as Steve talked about earlier, the expenses related to that for the year are now forecast to be quite significant and will probably counter any significant benefits that we see in the back half of the year.

So on that basis, I would expect our opex to be approximately flat, at that normalized level of around $30.0 million, as we go through to the end of the year.


There are no further questions in the queue.

Brad Driver

Thank you for joining us this afternoon. Our next earnings call will be in the middle to late September time frame, and as usual, we will put out a press release announcing the date and all the contact information for that.

In the meantime, thanks again.


This concludes today’s conference call.

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