Quantum Corp. (NYSE:QTM)
F2Q10 Earnings Call
October 27, 2009; 5:00 pm ET
Richard Belluzzo - Chief Executive Officer
Jon Gacek - Chief Operating Officer and Chief Financial Officer
William Britts - Executive Vice President for Sales and Marketing
Jerry Lopatin - Executive Vice President of Engineering
Shawn Hall - General Counsel
Brian Freed - Morgan, Keegan
Jeff Crown - Goldentree
Joe Feshbach - JFP
Ladies and gentlemen thank you for standing by. Welcome to the second quarter 2010 teleconference. (Operator Instructions)
I would now like to turn the conference over to Shawn Hall, General Counsel. Please go ahead.
Thanks and good afternoon. Here with me today are Rick Belluzzo, our CEO, Jon Gacek, our COO and CFO, and Bill Britts, our Executive Vice President for Sales and Marketing. The webcast of this call, our earnings release and a quantitative reconciliation of any GAAP and non-GAAP financial measures discussed today can be accessed at the Investor Relations section of our website at www.quantum.com and will be archived for one year.
During the course of today’s discussion we will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements include statements regarding our business strategy, opportunities and priorities, anticipated product launches and plans, future financial performance, including expected revenue, gross margin, and expense and income performance, and debt covenant compliance and trends in our business and in the markets in which we compete.
We’d like to caution you that our statements are based on current expectations and involve risks and uncertainties that could cause actual results to differ materially.
We refer you to the risk factors and cautionary language contained in today’s press release announcing our fiscal Q2 FY 2010 results, as well as to our reports filed with Securities and Exchange Commission from time to time including our most recent 10Q filed on August 7, 2009.
Such reports contain and identify important factors that could cause actual results to differ materially from those contained in our forward-looking statements. All such risk factors identified in our press release and in our filings with the SEC are incorporated by reference into today’s discussion. We undertake no obligation to update these forward-looking statements in the future.
With that I’ll turn the call over to Jon Gacek.
Thanks Shawn. Good afternoon and thank you for joining us as we are report our second quarter results. We are very pleased with our Q2 results and the continued progress we have made in your overall operating performance. On a non-GAAP basis, these results include the highest non-GAAP gross margin in 10 years, the highest operating margin in 9 years and the most profitable September quarter also in 9 years. In addition, revenue increased sequentially by 9%. This is the first such increase in seven quarters, and we are quite proud of the progress that we made.
Here are a few highlights. First, disk systems and software revenue including related software maintenance and service revenue was $28.2 million compared to $20.8 million a year ago. This is a year-over-year increase of 36%. Second, our non-GAAP gross margin was 47% compared to 42% for the same quarter last year. As I said, this is the highest level we have achieved in 10 years.
Third, our non-GAAP operating expenses were $54.1 million, down $15.9 million or 23% from Q2 of fiscal ‘09. As a reminderQ2 of last year include a $11 million of royalty revenue from the settlement with Riverbed deduplication patents and approximately $1.8 million of associated legal costs that were included in G&A.
Fourth, our non-GAAP operating profit was 16% compared to 9% in the same quarter last year. This was the largest operating profit we generated in 9 years. This non-GAAP net income increased a 106% to $23.2 million or a $0.11 per share compared to an $11.2 million or $0.05 per share for the second quarter of last year. Again, this is the best performance in the September quarter since fiscal 2000.
Sixth, as we did last quarter we generated a GAAP net profit of $11.4 million in Q2 compared to a net loss of $3.3 million in Q2 of last year. And finally, we generated cash from operations of $31.4 million; we had EBITDA of $32.7 million during the quarter, paid down $20.5 million of our senior debt and ended the quarter with a cash balance of $85 million.
I would like to refer everyone to the financial statements and the supporting schedule included in the press release, it will be helpful to refer to those documents as I make my comments. With that I will move to revenue.
Revenue for our second quarter ended September 30th was a $174.9 million compared to $215.4 a year ago and $160.3 million in the prior quarter, which is a sequential increase of $14.6 million which is the first sequential revenue increase in seven quarters.
Year-over-year revenue declined $40.5 million; however, as I walk through the revenue detail remember that our non-GAAP gross margin is up over 500 basis points from the same period a year ago.
Royalty revenue was approximately $16.8 million for Q2 compared to $30.6 million in the same quarter a year ago. The decline was primarily due to the fact that last year we recognized an $11 million royalty related to Riverbed and our deduplication patents. In addition, we had a decline in year-over-year LTO and DLT royalties.
For the quarter, non-royalty revenue totaled $158.1 million, of which 73% was branded and 27% was OEM. That compares to non-royalty revenue of a $184.8 million a year ago, of which 66% was branded and 34% was OEM.
System merger with ADIC in 2006, we had focused on transitioning our revenue stream to higher margin products, which has been one of the primary reasons for our year-over-year revenue declines. However, during this time, our non-royalty branded share has an increased from 52% of product revenue to 73%, the highest percentage in the company’s history and a significant contributor to the increase in non-GAAP gross margins from 31% to 47%. We strongly believe this yield a more valuable business.
Looking further at revenue classifications, devices and media totaled $27.7 million compared to $38.8 million in Q2 a year ago, the decline is attributable to an anticipated declines in OEM devices of $5 million, branded device revenue of $2 million and branded and OEM media revenue of $4 million.
This is an example of how we’ve manage the business as we transform Quantum. This is a low margin product category and we are focused on generating gross profit dollars. As a result we have reduced sales of low margin products and pursued revenue growth when it’s profitable. Tape automation systems revenue was $65.5 million compared to $85.8 million in Q2 of fiscal ‘09. $11 million of this decline was related to branded automation products and the remainder was related to OEM products.
The decline in branded automation was primarily related to volume declines in North America across midrange enterprise and entry automation. However, as I previously mentioned, we had a sequential increase in automation with both branded and OEM growing for the first time in the 11 quarters.
Disk systems and software products and related service revenue was $28.2 million up from $20.8 million a year ago. On a year-over-year comparison, we had a significant increase in our Quantum branded DXI revenue, a modest increase in StorNext revenue and a slight decline in license revenue from EMC.
I mentioned on last quarter’s call that we expected to close several DXI deals in excess of $1 million during the quarter. It turned out that we actually closed three; we also had a number of very large following orders from existing customers and saw a very good demand in our larger DXi7500 systems. Customers like the scalability of the DXi7500, its VTL interface and tight integration with tape. In addition, during the quarter we had a major software release that significantly increased our replication capability and overall system performance.
Finally, last week we announced our new DXi6500 family that is focused on the midrange mass market. This product will begin shipping during the current quarter, we are very pleased with our progress in this category overall, particularly with our traction with our channel partners. We expect that our new DXi 6500 will contribute immediately to our disk systems and software revenues.
As for the future EMC license revenue, we expect that the amount Quantum we’ll recognize in Q3 will be down from Q2, however, we expect the amount recognized over the next three quarters in total will be similar to what we recognized in the first half of this fiscal year.
Moving to service revenue, it was $39.8 million this quarter compared to $41.6 million a year ago. This decline is a result of the decline in OEM out of warranty repair offset by an increase in service revenue related to contract uplifts of our branded product install base.
Turning to gross margins. Non-GAAP gross margin in Q2 was 47.1% compared to 41.9% in the prior period. This improvement was driven by an improvement in mix including an increase in disk system and software revenue, a decline in low margin OEM automation sales and a decline in low margin devices in media revenue.
In addition, we continue to achieve cost reductions in manufacturing and lower warranty costs. The 500 basis point improvement over Q2 of last year came even as royalty revenue declined $14 million including the $11 million last year from Riverbed settlement, and non-royalty revenue declined $27 million.
This quarter’s results show how much progress we have made improving our mix to higher margins branded products and how much leverage we get when revenue increases. We are very pleased with the quarter’s gross margin and believe it as a great indicator of the overall value of the business.
Moving to expenses, non-GAAP operating expenses totaled $54.1 million compared to $70 million a year earlier that is a $15.9 million reduction or 23%. The cost decrease was primarily related to decreased cost and sales and marketing and G&A of $9 million and $5 million respectively. The sales and marketing decline was primarily related to lower headcount and better sales utilization. The decrease in G&A was primarily related to declines in legal and professional services cost.
As I previously mentioned, non-GAAP operating profit for the quarter was $28.3 million or 16.2% of revenue compared to 20.2% or 9.4% of revenue in the same quarter a year ago. We generate improved results from both pay products and disk systems and software products. Interest expense for the quarter was $6.9 million compared to $7.5 million a year earlier, this includes cash interest expense of $6.5 million and amortization of debt issue cost of $400,000.
The coupon interest rate for our remaining senior debt of $187 million at September 30th will be approximately 3.8% for the quarter ending December 31 and our average coupon rate for our total debt will be 7.8% for that same quarter ending. We expect interest expense will be approximately $7 million per quarter for the remainder of fiscal 2010.
For the second quarter we recognize a net tax benefit of $500,000 primarily related to foreign taxes, we still believe it’s reasonable to model a million per quarter in tax expense. So summing up for Q2, we had non-GAAP net income of $23.2 million with non-GAAP EPS of $0.11, compared to a non-GAAP net income of $11,000,000.05 in the same quarter last year.
Focusing on cash flow for the quarter and the balance sheet at September 30th, I would like to highlight several key points. Cash flow from operations for the quarter were $31.4 million, $12.4 million resulting from the net EMC prepaid license fee, we paid down $20.5 million of our senior debt in Q2, and that quarter end the composition of our debt was $187 million of senior debt, a $122 million outstanding with EMC and $22 million of convertible debt. We ended the quarter with cash of $85 million.
Non-GAAP EBITDA for the quarter was $32.7 million. We continued to be in compliance with all debt covenants at September 30, and we expect to be in compliance with our debt covenants during the next 12 months. For purposes of calculating our debt covenants, our EBITDA for the last 12 months was $111.6 million. Sequentially, manufacturing inventory decreased $4.7 million; accounts receivable increased $17.5 million. We had an accelerated payment of $11.7 million from one customer.
CapEx was $1.2 million, purchases of service parts inventories were approximately $1.5 million and depreciation, amortization and service parts lower of cost to market expense totaled $14 million for the quarter.
Looking forward to Q3, we are forecasting revenue of $175 to a $185 million, a slightly lower gross margin percentage due to mix changes, and slightly higher non-GAAP operating expenses and as a result we expect non-GAAP operating income to be essentially flat or similar to what we just did in Q2.
Now, let me turn the call over to Rick.
Thank you Jon. Today, I would like to discuss two topics. First, I would like to talk about how our Q2 performance aligns with the work that we’ve been doing to transform the company, and then I would like to make some comments on our go forward plan.
Q2 is a very critical quarter for Quantum given the ongoing impact of the economic downturn and changes in the deduplication landscape. Despite these factors we were able to capitalize on a number of the initiatives that we have been implementing over the last year, which allowed us to deliver very strong results.
In addition, during the quarter we also made an aggressive shift in our go to market focus as the EMC relationship went through a dramatic change. All of these demonstrated that we remain very clear about what we have to do to complete the transformation of Quantum into a higher value storage systems company.
As we’ve discussed in the previous earning calls, we’ve been driving this transformation for the last few years as illustrated by our focus on two primary objectives. First, improving our operating model, and then secondly, growing our disk systems and software revenue.
First, with regard to our operating model. We have been focused on improving both our gross margin and operating margin, our goal has been to deliver a non-GAAP gross margin in the mid 40% range and non-GAAP operating margins in excess of 10%. To achieve this we have worked to shift our revenue stream to higher margin higher value segments while allowing lower gross margin businesses to decline.
Furthermore, we’ve aggressively managed our cost structure to ensure that our investments were focused on our strategic priorities. Our Q2 results were very much in line with this focus on gross margin, operating margin improvement. As Jon said, our non-GAAP gross margin of 47% was the best in 10 years and a non-GAAP operating margin of 16% was the best in nine years.
Many of the initiatives that we’ve implemented over the last couple of years have taken hold and resulted in significant enhancements to our fundamental business model and it is important to note that while our overall revenue performance of Q2 improved from recent levels, these gross margin and operating margin results were mostly driven by a combination of shift in our revenue priority and aggressive cost management.
Our second main objective has been to build a growth platform in disk systems and software. We’ve endeavored to position the company in two growth segments of the storage industry.
First, disk systems backup with a focus on deduplication, and second, high performance file sharing with intergraded archiving. These two segments have ample opportunity for growth and today more than 60% of our R&D investment is focused here.
Last quarter we said that our goal from Q2 was to begin sequential revenue growth in disk systems and software, and we increased revenue by nearly 50% over Q1. We did this even in the phase of the EMC data domain transaction, aggressively adapting our go-to-market priorities and delivering very solid results. Our focus here is very clear and we will strive for continued sequential growth.
In short, we know that becoming a more valuable storage systems company ultimately requires the establishment of both a solidly improving operating model growth platform. In Q2 we were very successful in delivering on both of these goals.
Let me provide some additional background on our Q2 results. There was a mentionable improvement in the storage purchase environment during the quarter with a significant recovery in EMEA.
In recent quarters it has been difficult to get deals through the approval process resulting in widespread delays. This quarter, there continued to be deals that pushed out, but clearly not as many. It also appears that channel inventory started to improve in order to replenish at sustainable levels.
The enterprise segment of the market demonstrated the greatest while the mid range continues to suffer from a constrained economic environment. In short, the IT purchasing environment demonstrated clear recovery which was a factor in our improved performance. Our revenue growth was most notable in higher margin segments.
Non-royalty branded revenue was up 13% sequentially well OEM sales were up only slightly. Additionally, our strongest sequential growth was in disk systems and software followed by tape automation and service revenue. This was the biggest contributor to our gross margin improvement and reflects our established revenue priorities.
To growth in disk systems and software was most significant growing from $19 million in Q1 to $28 million in Q2, with related software maintenance and service revenue included. The growth was most notable in our branded DXI sales and driven by enterprise wins including several million dollars plus deals.
Our goal in the enterprise market is to focus our sales efforts on consumer environments but we have proven success. One thing is clear the market for de duplication replication is very strong.
Our sales vitals are growing and it’s important for shareholders to understand that we have been primarily operating in a relatively narrow segment of the disc backup and deduplication market. That is VTL enterprise systems and we have been very closely tied to EMC. In other words, we haven’t really begun to capitalize on the opportunity outside of the enterprise and as we now have the opportunity to do so with other new DXi6500 family which I will discuss shortly.
Looking more specifically at our branded DXI results for Q2 I just wanted to mention some of the highlights. Revenue grew significantly with the DXi7500 revenue at record level. We also set new records for the number of repeat DXi7500 customers and the number of replication licenses sold.
Our million-dollar plus deals included new DXI customer wins was where the tight utility companies in the world and another national utility provider Europe. Other notable wins included a large deal with one of the biggest US insurance companies, a new DXI customer and we repeat business with a US Federal Reserve Bank, and one of the largest wireless providers in America and Paris Airport System. While the EMC portion of our disk revenue was slightly down, EMC continue to sell EMC disk libraries with Quantum deduplication technology throughout the quarter.
Our software revenue predominantly StorNext was up in Q2 with modest growth both year-over-year and sequentially. In addition to a strong contribution from federal government sales, we closed several major StorNext deals included a new win with one of the leading US cable TV networks and repeat purchases by a large multimedia retailer and one of the largest system integrators in China.
In summary, we are very pleased with our Q2 performance as we responded to the recent market events and executed solid revenue results in the areas that provided the best margins, and we did this while continuing to manage our expense structure carefully. In Q2, we were able to demonstrate the value of our strategy. Now of course our priority will be to continue the momentum we established into Q3 and beyond.
Before I address this topic, let me say a few words about the impact of the EMC Data Domain transaction. Pervious to this event, we had built our deduplication go-to-market focus and R&D around optimizing with EMC.
EMC’s acquisition of Data Domain requires to reevaluate our program and make aggressive moves. On a positive note it clearly demonstrates the importance of deduplication, which is resulted in more customer visibility and higher sense of urgency for storage companies to define their plans.
As one of the few leaders in this breakthrough technology, we believe that there are many opportunities to capitalize on this increased attention. As for EMC they remain an important partner overall, we will continue to deliver on our commitment to meeting their requirements for our deduplication software and will also continue to partner with them closely as their exclusive tape automation provider.
Of course we know that EMC sales incorporating our deduplication software will diminish even though it declined only slightly in Q2. As a result we are pursuing a new agenda based on the reality of the changed dynamics with EMC and the expectation that there will be minimal ongoing opportunity with them related to deduplication in fiscal 2011.
So, now, let me say a few things about our priorities for the coming quarters. Well, let me start with tape. We continue to execute our tape business in the way that recognizes the mature nature of the technology. We have a very clear roadmap that will deliver several incremental opportunities in the near term.
Those will include the introduction of a new entry-level library which will shift in the current quarter and the recent release of LTO5 early next year. The entry-level library will greatly improve our competitiveness in this segment.
We also must remember that while a tape market is mature it was still a $3.6 billion market in 2008 and it’s forecasted to remain around $3 billion in 2012. And as the worldwide leader in open systems tape automation we see opportunities to take share from weaker suppliers.
In summary, we have a very focused strategy and a new product plan that will allow us to continue to contribute to this market and make it a very attractive business. Additionally, we will have some near-term opportunity with products like our new entry-level library as well as solutions like our recently introduced tape encryption product.
Turning to disk. The VTL mass disk based backup market is expected to double from 2008 to 2012. Within this category the deduplication segment has even greater growth opportunity. Our plans in this area include the following.
First, today, nearly all of our disk systems revenue in the VTL is in the VTL enterprise segment of the market, and the DXi7500 is well positioned in this segment. The combination of Quantum and EMC have enabled us to establish a leadership position with over 800 petabytes of data up protected using our de duplication technology.
In the near term we will focus our enterprise sales efforts to gain accounts and revenue with the Quantum brand recognized that EMC will likely try to shift its customers to data demand technology. We will also focus our sales resources where we have the best opportunities to win and we will continue to enhance our product offering as we did with the recent 1.2 software release, which greatly improved performance in a number of key areas.
We will use an aggressive account focus, our VTL position and our integration with tape to deliver greater revenue momentum. We started to establish this with our Q2 results and expect that we will be able to continue to deliver strong momentum going forward.
Second, last week we introduced a new platform focused on the midrange NAS segment of the disk backup market. The DXi6500 family consists of five pre-configured appliance model for protecting environments from 3 to 30 terabytes of primary data.
Market research shows that 75% to 80% of mid-range customers have not yet adopted deduplication, in large part, because of the concern over complexity and cost. Therefore, the DXi6500 family was designed to provide an unparalleled combination of simplicity and value, while delivering all the benefits of advanced deduplication technology.
We have bundled all license software features in the price of the appliances and made it easy to order, deploy, operate and manage. All of this mix in DXi6500 an ideal offering for the independent channel. We also see this is an incremental opportunity in a segment of the market where data domain has been strongest to where the timing is quite good.
As the EMC data domain transaction has created a lot of disruption to the channel and with ISVs. We had to capitalize on this and build a revenue stream to complement the traction that we have obtained in the enterprise VTL segment of the market.
Our third focus areas will be partnerships that range form alliances with ISVs, such as Symantec to do OEM customer development opportunities. We’ve already had several announcements regarding tighter integration between our DXi products and Symantec OST, included will be the first and still only deduplication provider whose products are certified for direct tape creation through net backup OST.
Additionally, we are in the process of working through various OEM opportunities. The EMC data domain combination has raised the status of deduplication and it has become a strategic issue for a number of large storage companies. We expect to play a role in providing solutions to some of these companies, but it is too early to provide any indication of timing.
In short, these three initiatives extended our enterprise VTL leadership, establishing the strong position in the mid-range NAS market and developing new OEM and/or alliance partnership will allow us to continue to build momentum and a boarder revenue base in the very fast growing disk backup and deduplication market.
Now, let me turn to the other component of our disk systems and software focus StorNext. StorNext is a well established high performance clustered file system that also offers quality based tier storage in archiving as well as deduplication. This gives us a powerful asset we could leverage in a market with significant opportunity.
In the media and entertainment space where we have established a leadership position, the continuing growth of high-definition content and more recently the move to 3D has created tremendous demand for storage. At the same time we are seeing new opportunities in areas such as healthcare, life sciences and energy where the need to share manage or protect hundreds of terabytes and even petabytes of data is critical, and finally, the high-performance scalability and resiliency of StorNext provides new opportunities in developing segments like cloud computing.
In summary, the traction and growth prospects we are seeing with DXi and StorNext along with the opportunities for new partnerships should enable us to continue building quarterly momentum with our disk systems and software products providing an increasingly significant revenue stream and profit contribution.
Let me close by saying we are very excited about our Q2 results and the momentum that we established. While the market is still very competitive and still marked by uncertainty we intend to extend this momentum into Q3 and beyond. We are in the midst of a broad-based new product introduction cycle and we have a leadership position and exciting growth statements.
With that I’ll turn call back over to operator for questions. Operator.
(Operator Instructions) Your first question comes from Brian Freed - Morgan Keegan.
Brian Freed - Morgan Keegan
First question, on your new product can you talk a little bit about how it differentiates from both your prior products as well as the competing data domain products and specifically how you make use of SSD and those products?
Well, I’ll start and I’ll have my partners here jump in as necessary. So, we had a mid range product offering that was first launched with the original DXi. We learned an awful lot in that process.
When we reentered the market with this 6500 line we were really focused on this notion of simplicity, and we wanted to take our latest software and we wanted to take a new hardware family, we wanted to put those together, we wanted to package them in a way that allows people to implement these solutions, to sell support, et cetera, very easily, and really worked to align all the software hardware features to make that happen.
Additionally, we recognized that this is a new platform. So we made a number of decisions around hardware that make this platform very extensible over time. Those include the latest Intel processors and SSDs, which frankly as we advance our software will give us more performance capability over time.
So we really focused on the immediate opportunity in the mid-range with the NAS segment of the market and we also introduced a product that over time are our software will further take advantage of some of the advanced hardware features to be able to tell customers that not only you are buying a simplified good value solution, but there is also a growth path that a software improves you will be able to have this to be an enduring platform in terms of performance.
Brian Freed - Morgan Keegan
Secondly, as you look at, I know you mentioned that you expected immediate contribution. As you kind of look at product cycles in terms of the valuation adoption, typically the enterprise where you have had the bulk of your tractions seems to be fairly long product email cycles. What are you seeing in terms of the new 6500, do you think it will have a little bit shorter go-to-market cycle than say the historic DXi7500 products?
Brian, this is Bill. The whole process of how we sell it and really focusing on the channel and being able to bring some of these characteristics as we’ve kind of looked at the product portfolio, are really important in the mid-range, ease of use, simply to deploy, easy for the channels to be able to quote to be able to have the user install these systems.
We think it should be shorter in sales cycles. We think that demonstrating the value of the product is going to be more straight forward, because it’s really optimized around different used cases and the models kind of our tailored specific used cases. As far as what we’ve seen so far, we just announced the product last week; we anticipated we would be shipping in November.
So we’ll have just a month and half of actual shipments in the quarter, but we do anticipate this will be a much more easily quoted and deployed product than the 7500 VTL, which typically would require proof of concepts, bigger evaluation cycles and leads to a longer sales cycles.
Brian Freed - Morgan Keegan
One last kind of technology question, then I want to jump to the operating model. But, if you look at your bundle one of the products you deliver on [SDM] Express, can you talk a little bit about the adoption you’re seeing there. It looks like it gives customers kind of an end to end opportunity for backup and maybe eliminate the need for a third party provider of those backups of virtual machine.
Can you talk a little bit about it, and how many customers you have if you are getting good traction of that?
You are mixing a few things together. The midrange product that we currently have, the DXi7500 express, it will be the VTL product that continues on in that kind of space for customers that need 10, 20, 30 terabytes of data to protect. We also bundle in a software module called ES Express, which is just a tool for being able to do better data protection, easier data protection with deduplication just like backup plan; it’s like 7500 for VMware or virtualization types of environment.
So, in terms of the uptake of, it’s still early, we had that product in market a couple of quarters. I would say that it’s a better fit overall with the 6500 in terms of kind of ease of use, ease of deploy, the ability to quickly integrate into customer’s environment. And so, I would anticipate that the focus on the midrange, the simplicity of the new product will all help the up tick of ES Express.
Brian Freed - Morgan Keegan
Then turning to the operating model, Jon you’ve done a phenomenal job on the margins, so congrats there. If you look forward particularly as you try and pursue more branded opportunities in light of EMC’s moves, do you feel like you are going to be able to move operating margins further upwards or do you think they will trend flat to down going forward if you invest in your channels?
Man, you are greedy.
That was 15%. I think the main message here is we think we’ve done a good job on the cost model. We’ve definitely improved our mix; we tried to give all the shareholders a view of how much that’s moved. This quarter really demonstrated something that we haven’t been able to see in a couple of years, which is how much leverage we get when revenue increases and that’s really the next step in our model, is that as we grow revenue here especially branded, we get a lot of leverage, and we get at the gross margin line and we get it at the operating model lines.
We didn’t guide to higher operating margin or higher gross margin, we actually guided slightly down on the gross margin and flat on operating. But it does show as the business grows how much leverage we get and how much flows to the bottom line. So, as revenue grows overtime in the branded business, I think we will see an expansion. But in the short term we’re forecasting, this is a really good spot we’ve got now we have to replicate it a few quarters.
Brian Freed - Morgan Keegan
Okay. Yes, I’m not trying to be greedy Jon, you do need to invest going forward, I just wanted to make sure this wasn’t a one time anomaly and something we could see again in the future.
Yes. So I think on the investment side, we get this question from time to time. I think we feel like for the next two quarters in the sales and marketing side, we will do a few things. But we have capacity to sell more. And on the R&D side, we’ve got a lot of great opportunities ahead of us. We will spend a little bit more money in both those areas, but I will emphasize sort of a little bit money, we’re not going to spending a lot more.
(Operator Instructions) Your next question comes from [Jeff Crown] - Goldentree.
Jeff Crown - Goldentree
Just a quick question on the capital structures; you mentioned that you had about the term loan 122 of the EMC loan and $22 million that converts. The EMC loan how does that breakdown again. I think that is like 75 that’s due in September 14 and another 25 and then another 25, what’s the breakdown of that again.
This is 100 that’s due in September of 2014 and 22 that’s due in December of 2011.
Jeff Crown - Goldentree
And the term loan matures in July 14, correct?
Jeff Crown - Goldentree
And is this EMC loan subordinate to the term loan or para to the term loan.
Jeff Crown - Goldentree
Subordinated term loan. And both of the coupons are like 12%, correct?
(Operator Instructions) Your next question comes from Joe Feshbach - JFP.
Joe Feshbach - JFP
Couple of things; can you just provide maybe a little bit more color on the price performance advantages of the 6500 versus obviously a key competitor. Data domain, just sort of box to box, just to the extend that you can?
I would simplify it by just saying that what we’ve done is bundled all of these kind of key features that are important to this particular disk based backup product that are bundling in the duplication license, the OST license replication, all of that, and then it’s focused on data to protect.
So, what we are trying to do is simplify the whole process of this is what a customer environment looks like, this is how much data that they want to protect with this particular model, and then be very aggressive in being able to bring all that together with a very simple to present solution with these different models, can they line up against those particular customer, data to protect in used cases.
So, when you look at the value that we are providing and having all of this bundled together it’s really kind of a different approach than what other people are taking in this space.
Joe Feshbach - JFP
Then, Jon do you just happen to have off the top of your head the service gross margin?
Yes, I can get that.
Joe Feshbach - JFP
I mean I can get it offline.
I will answer it along with the next question, it takes second to calculate.
Joe Feshbach - JFP
No problem, and then in terms of tape, I assume that the quarter got stronger not only because it’s a bit back end loaded because the economy got a bit better. Assuming my first statement is correct, have you seen momentum continuing in the December quarter in terms of customers loosening that, do you see some budget plus possibilities?
I’ll start and then I’ll Bill answer it. I think we do a lot of business at the end; the branded business does a lot in the third month and towards end of the year. Having said that, our funnels are really full and Bill is agreeing with that, and people are spending money. It comes down, as it does always, we have to go close the business and get the order and ship the product. So I think we feel good about kind of the environmental role on tape and on disk, both. I think our funnels are really strong on both of those.
Then, those are going to get augmented by what we would think about as two fairly incremental products both DXi6500, but we are quite excited about the new low end library too. We think it’s going to be disruptive. We will be the only one selling it, in other words we don’t have any OEMs for it, it’s just a branded product. And we will be competing with a product that was a very good product, has been around for quite a while. And we think we are going to grab some share there too.
So we are feeling good about kind of where we sit today, but we have a lot of work to do to close the quarter.
Joe Feshbach - JFP
The only thing I would add is that we are really pleased to see Europe come back to EMEA business and Q2 was quite strong relative to Q1 and it does look like the environment there has firmed up.
Joe Feshbach - JFP
Then, it wasn’t a huge number, but still service you had originally indicated that service revenues would probably be down sequentially and it looked to me like what they were either up or flat to up versus Q1 and I’m just curious whether demand for service is starting to reemerge as well?
In my prepared comments I talked a little bit about the fact that actually our branded installed base service contract was actually up. We also have it up repair component from our OEM business which has been trending down as our business has gone smaller there.
So we actually have seen an increase in our branded side similar to our product situation lower margin less profitable OEM repair business and the margin was 36% on service.
Joe Feshbach - JFP
Wow! Is that a thousand basis points better than it was a year ago or is my memory failing me?
It’s about quite a bit better. On $2 million less revenue it was $5 million more in margins.
But as Jon said, the service mix is a little bit like the product stuff. We had a higher content of OEM like repair device, repair OEM which is very price sensitive, very competitive, coupled with contracts where you have opportunity to differentiate with better service and the like. So, it’s the same kind of translation.
That’s why we have been so insisting over the last few years as we get beat up on revenue declines we were so insistent about the point that we are building a higher value business, and we will find some revenue base level that makes sense, given all the changes that we are making and we will grow from there.
But what we will end up with is a business that is higher gross margin, higher operating margin, more sustainable over time than the big lumpy lower margin OEM oriented kind of low end part of the business, which really dominated the Quantum business model several years ago.
(Operator Instructions) And I show no further questions, please continue.
Okay. Well, thank you for joining us. Of course you can sense our excitement, but I’ll also be really clear that we know we have a lot of work still to do; one quarter doesn’t make a successful company.
We are pleased to see with the progress that we have made in a lot of our initiatives. So we have a lot of work still to do, and we are not losing sight of that at all. We are very focused on product execution and market success and managing our cost, all the things that has brought us to this point. And so, we look forward to reporting on that during our next call. Thank you for joining us.
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