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Xyratex Ltd. (NASDAQ:XRTX)

F3Q09 Earnings Call

September 30, 2009 5:00 pm ET

Executives

Brad Driver - Vice President, Investor Relations

Richard Pearce - Chief Financial Officer

Steve Barber - Chief Executive Officer

Analysts

Aaron C. Rakers - Stifel Nicolaus & Co.

Amit Daryanani - RBC Capital Markets

Jayson Noland - Robert W. Baird & Co.

Glenn Hanus - Needham & Company

Analyst for Keith Bachman - BMO Capital Markets

Operator

Welcome to the third quarter 2009 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 third 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 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, 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 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.

Now I would like to turn the call over to Richard to review the financials.

Richard Pearce

Good afternoon everyone. I would like to thank you for joining us today. Our press release is available, both on Business Wire and our Web site. I would now like to provide you with some commentary about our results for the third quarter. Please note that all numbers are in accordance with GAAP unless stated otherwise.

Total revenue was $246.3 million, down 12.3% as compared to the third quarter of last year, and up 26.5% from our prior fiscal quarter.

Sales of our Networked Storage Solutions products were $208.6 million, or 84.7% of total revenue. This is a decrease of $4.5 million, or 2.1%, compared to the third quarter of last year and up 13.2% compared with $184.3 million in our prior fiscal quarter.

We are beginning to see the positive effects of growth and demand as products ramp with a number of our new customers we have won over the past 18 months. I continue to be encouraged with the demand momentum we are seeing with new and existing customers and the progress we are making in regards to increasing the scale of this business.

Sales of our Storage Infrastructure products were $37.7 million, or 15.3% of total revenue, down $30.0 million, or 44.3%, compared to the third quarter of last year, and up 259% over our prior fiscal quarter. This performance included greater than anticipated revenues of test racks from one of our larger customers.

Gross margin was 16.7% in the quarter compared to 17.6% in the same period a year ago and 12.9% in our prior fiscal quarter. Whilst a positive increase over the prior quarter, the reduction in overall gross margin over the prior year primarily reflects the relative higher proportion of Networked Storage Solutions revenue in the quarter.

The gross margin for our Networked Storage Solutions products increased to 14% compared to 13.3% for this period last year and 12.7% last quarter. The increase, as compared to last quarter, is primarily due to product mix and operational efficiencies.

The gross margin for the Storage Infrastructure products was 32.4% compared to 31.6% last year and 18% last quarter. The increase, as compared to last quarter, is primarily a result of increased revenues relative to fixed costs.

Non-GAAP operating expenses were $30.3 million, a 20% reduction compared to $38.0 million in Q3 of last year and compares to $31.4 million last quarter. These expenses include $2.0 million of legal costs associated with our intellectual property litigation involving Teradyne.

I believe our decisive actions to significantly reduce costs early in the year were appropriate and positioned us well through the current economic situation. While we see growth going forward in the business, we will continue to carefully manage costs.

On a non-GAAP basis net income was ahead of expectations at $10.7 million, flat compared to a year ago, and compares to a $6.7 million loss in the prior quarter. Fully diluted earnings per share for the quarter, on a non-GAAP basis, was $0.36 based on there being 29.7 million shares outstanding on a weighted average treasury method in Q3.

GAAP net income in the quarter was $7.8 million and included an amortization of intangible assets expense, non-cash stock compensation, and restructuring costs. The reconciliation between non-GAAP and GAAP net income is provided in our press release.

These positive earnings reflect an increase in overall revenue, particularly in our NSS business, coupled with continued focus on cost management. Short-term visibility is improving and I expect this positive momentum to continue into the fourth quarter.

Turning our attention now to the balance sheet, cash and cash equivalents at the end of the quarter was $38.3 million, up from $27.2 million at the end of Q2 and we continue to focus on working capital in the face of increasing orders.

Cash flow generated from operations was $13.6 million in the quarter.

Inventory decreased by $2.1 million to $100.0 million in the quarter. Inventory turns were 8.1 compared to 6.6 for the previous quarter.

Accounts receivable increased by $42.3 million in the quarter, to $145.4 million, due primarily to higher revenues.

Days sales outstanding grew at 54 in the quarter compared to 49 for the previous quarter as a result of changes in customer mix.

Headcount at the end of the August quarter was 1,615 employees, a reduction of 65 employees, or 3.9% over the previous quarter end.

Fiscal year to date we have reduced headcount by 264 employees, or 14% overall, in response to the economic situation. We have no current plans for further significant restructuring actions at this time.

In summary, this was a very good quarter for the company.

And now, I'll hand it over to Steve for a few comments on our third quarter performance.

Steve Barber

Good afternoon everyone and thank you for joining us today.

I was pleased with our performance in the third quarter. We were able to support much of the strong demand across our range of Networked Storage Solutions customers and successfully met many of the demand challenges required by our Storage Infrastructure customers.

Our performance in Q3 was above our expectations. Despite these uncertain times in the broader economy and the seasonally slower summer period, we delivered good results in both our businesses.

As we look ahead we remain confident in the longer-term growth opportunities available to us in each of our businesses. With the creation of digital information and the associated demand for data storage continuing at a good pace, despite the current environment, the prospects for the wider data storage industry appear strong.

Inevitably this market will become increasingly competitive in the near term, however, I believe that with our industry-leading products and technology, ongoing technology innovation, and established competitive global fulfillment capability, we can continue to provide compelling solutions for our customers worldwide and benefit from the underlying growth in data storage needs.

In reviewing our performance this last quarter, I will cover our two business areas separately, starting first with Networked Storage Solutions. Once again, we grew both our revenue and overall chip storage in the quarter, maintaining our position as a leading provider to the external disc space storage market.

We saw strong demand upside from across our customer base coming into the quarter and a component health constrained by component material supply throughout the period. The industry-wide downsizing actions through the first half of the year have inevitably resulted in constrained supply of many components, including certain disk drive models with many components currently on 16-week lead time.

I believe overall we did a good job working with our key suppliers to secure material supply in order to maximize our ability to meet customer upside demand through our August quarter. We have continued to focus on driving material supply through September in striving to meet our customers' calendar quarter-end requirements.

Our NSS revenue was down 2.1% to $208.6 million compared to the third quarter of last year, but was up 13.2% over the prior fiscal quarter, reflecting the strength in demand we saw through the third quarter. We shipped 433.4 petabytes of external storage in our fiscal third quarter, representing a 16.1% growth over the prior quarter and 38.1% growth over a year ago.

Based on recently published industry data on the total petabytes shipped in Canada Q2 2009, we estimate that Xyratex not only maintained, but grew its market share, shipping over 16.9% of the worldwide external storage systems petabytes through our customers.

On a year-over-year basis Xyratex grew 58.58% compared to the market's 15.2% growth in shipped capacity in calendar Q2. Sequentially Xyratex posted a 48.4% increase, compared to the market's growth of 8.8%. And we shipped almost half the petabytes of capacity in solid-state devices, or SSDs, in the quarter as a number of our customers begin to integrate these devices into their products to provide enhance system performance, alongside core, conventional disk drive storage.

Our third quarter 2009 shipped capacity was made up of the following in terms of disk drive interfaces: fiber channel, 76.6 petabytes; SATA, 325.64 petabytes; SAS, 13.68 petabytes; and SSDs, 458 terabytes.

We continue to experience overall growth in demand across our global Networked Storage Solutions customer base and it continues to gain market share as a major OEM provider to this market. Based on our assessment, we believe that Xyratex is now in the leading two of the world's largest storage system OEM providers based on 2008 revenue.

Supporting our leadership position in the market, I'm delighted with the success we are making to further strengthen our relationships with a number of our major customers. We recently announced an expanded partnership and design win with Omneon, a long-standing customer of Xyratex who offers customers and professional media organizations an open platform optimized for the production, transformation, and distribution of digital media. Along with our current relationship for storage enclosures, Omneon will also introduce off storage server platform into their Omneon media grid storage solution.

In addition, we have recently been selected by two of our major customers for their next generation of product. Due to the timing of their product announcements, we will not name these customers at this time.

For one customer, we've been selected to provide our latest storage sub-system for their next-generation flagship product, transitioning this customer product for our existing 16-drive array to our new one-store 24-drive based storage array. Xyratex successfully won this bid against significant competition based on our leading technology and products and proven execution performance to date in the supply of current products.

For the other customer, we have been selected to provide them with the design and supply of an incremental range of data storage products within their future storage portfolio. This is an important win for Xyratex, extending our relationship with this valued customer and was based on our proven product technology and the time-to-market advantage we're able to bring versus the alternative competitive offerings under consideration.

Overall, despite the continuing uncertainty in the market, data storage, and in particular, the enterprise data storage market, appears to be proving itself resolutely resilient in the near term and we continue to see good underlying demand for our core data storage products with continued growth in this business expected through 2009.

We remain focused on providing industry-leading technology and cost-optimized solutions, best-in-class product quality levels, and a highly competitive and flexible global fulfillment service for our OEM customers.

Moving now onto our Storage Infrastructure business, for the third quarter revenues in this business were $37.7 million, slightly above our expectations, with both of our two major customers contributing to the better-than-expected results.

As anticipated, after a period of significant constraint in capital expenditure within the disk drive industry, especially as it relates to Xyratex's technology, we are now beginning to see a return to incremental capital investments by our disk drive customers.

The third quarter revenue was fairly evenly split between customer technology investments to accelerate increases in aerial density, capacity investments, and investments to improve capital productivity of installed equipment.

Looking forward, based on our current market view, we believe that the disk drive industry will gradually resume capacity increases while continuing the investment profile we experienced in the third quarter.

Overall, PC shipments have continued to grow month over month, driving sustained disk drive demand. In addition, investments by the industry in increasing aerial density, is driving a solid road map of ever-higher capacity disk drives. As a result, we are planning our resources based on more disc growth in the near term and continue to believe the long-term growth will cause the disk drive industry, from a unit shipment and unit capacity standpoint, to remain very good.

It is evidenced by the recent increase in competitive activity in this market that the disk drive process equipment sector is seen as an attractive growth market. From a Xyratex standpoint, we believe that we remain well positioned in this market. Xyratex's business has been built on thirty years of disk drive manufacturing and processing development and is supported by a solid base of key, patented intellectual property.

Our strong track record of innovation and technology has enabled our customers to optimize their production processes to meet the needs of a highly volatile market demand environment. As we have stated previously we are, and will continue to take the necessary steps to protect our intellectual property.

This history of innovation continues through our current products development activities. We are well advanced in the commercialization of our next-generation automated disk drive test platform, or Optimus, which is specifically designed to comprehensively serve a 2.5 inch disk drive back-end test market.

The advanced capabilities of the Optimus platform enables customers to use this versatile system to address the broad requirements in the mobile and consumer segments, as well as the technically demanding requirement in the enterprise segment.

We have completed numerous key milestones for the Optimus program through close technical collaboration with our customer. We obtained engineering qualification in early June and subsequently received our first production orders. We began shipments of these units in the third quarter and have now obtained production qualification.

We recently completed installation and commission of systems that are being utilized by the customer for high volume production and we have recently received [inaudible] production orders which we will be shipping in the fourth quarter of this year and first quarter next year. I am very pleased with the progress of our development and operations teams to quickly effectively ramp this new 2.5-inch platform into a high-volume, disk drive manufacturing environment.

Recognizing the record industry transition toward 2.5-inch disk drives, this new test platform is dedicated for this form factor and is designed to meet the needs of future disk drive technology.

In addition to further advancing overall test kit ability, this platform provides significant overall cost of ownership savings for our customer. A key element of the significant improvement in factory space utilization of the space this system delivers, deferring the need for additional physical factory space.

We are actively engaged with our customers on future capability enhancements for this Optimus platform and we are pleased with the customer acceptance of the advance capability, high productivity, and roadmap extension offered in the Optimus platform.

We have begun to see customers migrate to 2.5-inch form factor disk drives from their incumbent disk drive test instrument. We have seen demand from our customers to convert existing installed test systems to 3.5-inch form factor as part of this migration towards dedicated 2.5-inch form factor test systems.

This conversion business will include a portion of the Xyratex worldwide install base of 2.5 million test box. Construction is in stark contrast to the multi-form factor capable systems previously adopted providing production flexibility for disk drive providers driven by variable demand.

In addition, we have build a patent media specifically discrete track media, and it is likely to be adopted for volume production in the near term on account of the increasingly clear significant economic challenges involved. The issue for discrete track media adoption is an expected aerial density improvement appears to be inadequate relative to the significant capital and material cost and finishes required for this technology. We anticipate therefore, that this will result in the aerial density growth rate slowing due to alternative technologies such as hammer and [inaudible] media being further out in time frame.

As a result, we expect that investments for component technology, as well as capacity, will be required. And we have for some time now been focusing our investments in the disk drive component space where we see growth opportunities looking forward.

We have an established presence in the desk drive test, media cleaning, and server track writing. A commitment to R&D is key to ensuring we are able to enhance our products' capabilities, provide additional feature and function and provide an upgraded path to extend the useable life of legacy installed systems.

We have, and will continue to invest strongly in R&D across all these areas to meet the needs of our customers, while making strategic investments in the areas of head media and capital equipment, to grow our footprint in the disk drive manufacturing and component factories.

There remains some caution in the industry in the near term with a range of approaches is being taken by drive providers in near to medium term. Despite the mixed signals, however, in the longer term we remain comforted in the underlying dynamics and growth potential available to us in this market.

In summary, I am pleased with our performance in delivering what was a very good quarter where we executed through a number of challenges. We remain focused in meeting the needs of our customers in this uncertain market, taking steps to provide upside capability should demand continue to grow ahead of expectations.

The outlook for 2010 remains somewhat uncertain with some analysts forecasting a possible slowdown in the first half of 2010, after this period of pent-up demand in the second half of 2009, and then a return to normal demand in the second half of 2010.

Overall, though, we continue to see good growth potential in our NSS business as overall market demand continues and our customers gain market share. Plus, we are now seeing some evidence of the long-anticipated return to capex spending in our SI business. And again, we see good growth potential here going forward.

I would like, as always, to take this opportunity to thank all our employees worldwide who have contributed towards our strong performance in the quarter.

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 Aaron C. Rakers - Stifel Nicolaus & Co.

Aaron C. Rakers - Stifel Nicolaus & Co.

First, a housekeeping question. Net App and Dell Contributions, I think actually surpasses 10% of revenue over the last few quarters, so it would be helpful to just get those two customers as a percent of your NSS segment.

Richard Pearce

For the first time, actually relatively pleasing in some ways, is Net App is actually slightly under the 50% of the revenue in the NSS business. In terms of Dell, you're right, that has been over a 10% customer now for the last couple of quarters and we prefer not to give specific revenues per customer as we go forward but between Dell and IBM, which are two of our newer customers our ramping referred to, they're approximately 30% of our revenues between those two customers.

Aaron C. Rakers - Stifel Nicolaus & Co.

And can you talk a little about the gross margin profile here as we move forward. Obviously solid job on both segments and I guess I'm just trying to understand, her as we move forward, are those sustainable levels for both segments, moving forward?

Richard Pearce

On the SI side of the business, and I think in keeping with our comments of the last quarter, it was our expectation that margins would be back to the 30%-type levels at this type of revenue level. And they would be expected margin profiles that we've given going forward and we still feel comfortable with those. Obviously, within quarters there will be certain product mixes which could take it slightly below or slightly above the 30% region, but we're happy with that from the SI perspective.

On the NSS side of the business, I think at the last call we were forecasting margins in that business on a sort of medium-term basis to be between 12% and 13%. I think that was slightly increased from where we previously looked on the longer term, 11% to 12% a couple of quarters back. I still think, again in the sort of medium term, a 12% to 13% profile is appropriate.

We have made some good advances this quarter in terms of operational efficiencies and that's come both with the benefits that we are starting to get now from the SAP system, which went into full utilization about a year ago and some initial issues, which we did expect, which took those expenses up a little bit.

In addition to that, obviously we got increased volume, which helps in terms of spreading fixed costs. And the other benefit that we're seeing at the moment is a number of the products that we've got today are heading towards what I'll call the end-of-life phase with some of our customers with the new products coming on, as we speak. We're in that kind of transition phase. And often you get a sort of short-term benefit as those products come to their end. We're getting the benefit of lower component costs within that.

But actually, as we look forward into the models, I am expecting the margins to come down slightly from where they are today. I think possibly we may be able to retain the 13% to 14% for the next quarter or so as that transitions happens but I would look more and in my modeling I've really got between 12% and 13%.

Aaron C. Rakers - Stifel Nicolaus & Co.

Over the last couple of years I think a normalized SI revenue in the second half of the fiscal year would be somewhere in that $60.0 million to mid-$60.0 million range. Are you reluctant of saying that we're getting back there in the November quarter at this point, or any thoughts on what the November quarter SI business could look like?

Richard Pearce

I would be reluctant in saying that. Obviously, we're not giving specific guidance and I think that's still appropriate given the visibility that's out there. But again, given the lead times in that business, you would know by this time where we have relative certainty on what those Q4 shipments are going to be.

There are consensus numbers out there and I wouldn't violently disagree with those current numbers. We're still in—slightly coming out of the very difficult economic situation that we've had and we're not expecting a sudden increase in those numbers, so I wouldn't want you to be led in that direction.

Operator

Your next question comes from Amit Daryanani - RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Just to follow-up on the SI question there, I guess the flip of what we've seen is in the first half of the side of the fiscal year that business typically tends to get cut in half. Given the fact we aren't seeing the big ramp up to $60.0 million at all in the back half of this year, would you expect this business to kind of hold up a lot better in the first half of fiscal 2010, or would you still expect a big degradation over there?

Richard Pearce

Visibility is not great and we have just been starting to see the signs of some recovery, as you and Aaron had talked about typical revenues and unfortunately in that business, based on the lumpy nature of it, there isn't necessarily a typical revenue profile.

But I think it is safe to say that revenues in the first half of the year, based on the absolute production of disk drive units, is likely to be less than the back half of the year, on an ongoing basis. And therefore I would expect the first half of next year to see some reductions, albeit from the lower-than-typical levels that we've seen in the second half of this year.

I think overall, as you would expect, we would expect to see some increases in the SI business overall year-on-year. But back to a similar profile and having some reduction in Q1 and Q2 next year.

Amit Daryanani - RBC Capital Markets

On the Networked Storage side of things, typically November quarter tends to be the one where you see some decent sequential growth in the business. Given the fact that things seem to be getting a little bit better over here, would you expect that in line with the historical seasonality growth in the November quarter in that segment?

Richard Pearce

I would expect to see some growth there, yes, coming into the November quarter. Again, typically and our customer profile has changed slightly and I think historically we've often seen the third quarter be relatively flat, flattish to down, in that quarter, primarily led by the extent of the Net App revenue and the fact that their year end falls in our second quarter, we tend to see a flattening our third quarter, which obviously we've not seen this year, and we've actually had a 13% increase.

I wouldn't necessarily expect to see a similar level of increases as we go into the fourth quarter because we have been seeing some quite good ramps in our other customers in Q3. That said, I do think that there is an opportunity for those revenues to grow somewhere within a 5% to 10% range in the fourth quarter.

Amit Daryanani - RBC Capital Markets

You have done, obviously, a really good job in controlling the costs down through the downturn. As sales start to improve for us, hopefully in November, year-over-year if not fiscal 2010, could you talk about how much opex dollars would you have to uptick in terms of increased expenses?

Richard Pearce

Yes. I mean, obviously sales have increased actually in this quarter and we have done a reasonably good job of containing any expense increases, and in fact, reducing our expenses from the second quarter to the third quarter.

I'll admit that from my recent findings we do have some specific gaps in some R&D areas that we will be looking to add some staff, particularly as we look at growth opportunities there. So I do see overall our expenses increasing.

That said, and something that we've talked about in previous quarters, is that we do have the benefit of the exchange rate changes that we've seen over the year and the strength in the pound. And in fact, there was a report came out from RBC recently which alluded to those benefits that Xyratex would get on the basis that we have a relatively significant cost base in terms of our opex here in the U.K. and the exchange rate having moved from approximately 1.9 now to 1.6 does give us some benefit.

So as we look into next year, whilst our current expenses this year are around $30.0 million on a non-GAAP basis, in spite of the increases that I see that we will probably need, based on the increased business, the benefit of the exchange rate will probably counteract that and we will probably maintain a similar expense going through into 2010.

Operator

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

Jayson Noland - Robert W. Baird & Co.

A couple of housekeeping first. Any feel for tax rate in fiscal 2010?

Richard Pearce

Yes, obviously our tax rate, as far as it's reported, has changed slightly as well, based on the fact that we previously had the deferred tax sitting on the balance sheet as an asset, but obviously with the downturn we actually wrote all of that off.

So what we're really seeing in terms of our tax rate at the moment is just a cash tax rate and not necessarily seeing the tax rate as a benefit of our deferred tax assets, which sit in the U.K.

So this quarter I think we see an effective tax rate of around 3.6% and in Q4 I don't expect there to be a significantly different rate, from about 5%.

But the way that the tax works currently, and we have relatively significant losses which should last us at least into 2010 and 2010, is that in reality we're only paying tax on the profits that we make in the U.S. because of the tax losses that we've got in the U.K. and those taxes tend to be somewhere between $0.5 million and $1.0 million a quarter. And that's really the tax that you're going to see in 2010.

So on the basis that profitability increases, it could be quite a low rate, but in terms of reported next year, between $2.0 million and $4.0 million and that will be the cash tax rate and the effective tax rate. And I will tell you in the short term there is no likelihood of us actually reversing the asset and rewriting it back on the books at this stage. So that shouldn't change for at least a year.

Jayson Noland - Robert W. Baird & Co.

Steve, maybe if you could give us an update on the manufacturing transition with Net App.

Steve Barber

There's really no change where we continue to support Net App under the current agreement where their CM has the ability to build up to a maximum of 25% of total demand. That approach has now been operational for some quarters and is a pretty stable platform.

We don't really see any significant changes there going forward. So pretty much stabilized, working [inaudible] is in place and it's reflected in our revenue projections.

Jayson Noland - Robert W. Baird & Co.

You had mentioned the 24-drive array, how much traction will that have over time here and is there a gross margin impact within NSS?

Steve Barber

[Inaudible] transition from 16-bay legacy systems to the higher capacity platform. We have a number of customers who have now confirmed design wins to transition over. We've also secured some additional new wins, as I alluded to in the commentary, with that platform. From a margin standpoint, ultimately the margins varies because of drive pricing is really the dominant factor, not the core in array in terms of design we bring to the table.

So we're looking to see, we will always have a dependency, I guess, on where drive pricing is at any one time. And it's been interesting in the last couple of quarters that drive pricing on enterprise drives has not decreased as per historical levels. In fact, drive pricing has remained pretty stable through that time, and that has an effect on the overall gross margin as a percentage, that we report, based on the drive pricing at any one time.

Richard Pearce

[inaudible] slightly when I've talked about the 12% to 13% that we expect, and then there is some factoring in there of moving toward the 24-bay and the fact that there are more drives than per unit and that slightly affects the margin percentage, but not necessarily absolute margin.

Operator

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

Glenn Hanus - Needham & Company

Could you comment on the components issue? Did that hold back any revenues for this quarter? If so, can you give us a rough idea?

Richard Pearce

It hasn't actually been that material in terms of our third quarter. I mean, I guess we've had more issues as we've been heading into September and we've—September being the actual quarter end of a number of our significant customers. That has created some challenges.

I will tell you, at this stage we have not missed significant revenue and we haven't significantly let down our customers and we've done everything that we can to not do that. There are some specific areas which are causing us issues. Materially versus the overall revenue, then we haven't seen that many misses.

We do see there continuing to be challenges as we go into October, November, and December. It's a little bit early for us to comment on whether that will significantly impact our overall revenue. I do believe that there is potential upside opportunities but unfortunately based on the components, we might not be able to meet those.

Steve Barber

We have frustrated and disappoint some customers at the September quarter that we just closed due to material. And getting material late in the month and the ability to process that in time to meet all the upside demand we saw from all of our customers. I think we have done as good a job as we possibly could in securing the allocation of available material, but we have frustrated some customers because of—we've left revenue on the table, end-user revenue. Because of supply constraints.

I will probably highlight disk drives as having been a factor through [inaudible]. We saw evidence of that in our August month. It's become more of a factor in September and we don't see that issue resolving itself as we go into October. So supply constraints across the range of enterprise drive providers.

Glenn Hanus - Needham & Company

Could you comment on, following up on Jayson's question there about going to the license model, beyond Net App, as we look to next year's revenues, how do you feel about assessing the risk that there could be another shoe to drop there. Is that further out or is there some risk there?

Richard Pearce

There's been really no additional expectation other than our relationship with Net App at this stage, that we will be moving to that type of model with any of our other customers.

Glenn Hanus - Needham & Company

Could you comment on Hitachi, on the SI side, as a potential customer, what might be going on there and revenues and opportunity?

Steve Barber

We continue to engage with both Hitachi and Fujitsu, Toshiba. On a number of fronts. I think we can see potential there. There is certainly interest in our current bionics[?] generational platform that we are currently launching. There are certainly compelling reasons for them to be evaluating those products.

When we might see traction, we've got volume orders, is still uncertain. As it stands here today, it's difficult to really assess what their potential buying intentions might be. But there is certainly specific potential there, against in-house teams or in-house solutions that are currently in use.

Operator

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

Analyst for Keith Bachman - BMO Capital Markets

I wanted to go back on the gross margin question. For the SI business, with high revenues and the spread in fixed costs, shouldn't you be able to at least maintain your gross margins?

Steve Barber

In the SI business, yes, I think we said we would—we are anticipating that we maintain our gross margins at approximately the 30% level. Obviously, we have recovered to slightly about that this quarter. We do benefit sometimes from product mix. But yes, we are looking to maintain those margins.

I guess it was the NSS side of the business that we said that there was some caution in terms of the current level, the 14%, that we were looking more in the medium term for a 12% to 13%-type model.

Analyst for Keith Bachman - BMO Capital Markets

What was the impact on the NSS gross margins with the ramp of new customers and a lower Net App mix?

Steve Barber

I guess there are many factors in that.

Analyst for Keith Bachman - BMO Capital Markets

[Inaudible] a factor?

Steve Barber

Not necessarily a big factor. No. It was more in terms of the production efficiencies that we are seeing and in addition to that, as I said, some of the products that we have for a number of our customers heading towards this transition end-of-life where we get the benefit. So the gross margins between all of our major customers are not significantly different.

Analyst for Keith Bachman - BMO Capital Markets

On the higher DSOs, was that due to a change in the customer mix for the NSS business or just a mix in your business with higher SI business?

Steve Barber

That was primarily a change in the NSS business itself.

Operator

This concludes our Q&A session.

Brad Driver

Thank you for joining us this afternoon everyone. We will report our Q4 results in early January. The specific date we will post most likely around mid-December. In the meantime, have a very good rest of the week.

Operator

This concludes today’s conference call.

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