Xyratex Ltd. F2Q10 (Qtr End 05/31/2010) Earnings Call Transcript

| About: Xyratex Ltd. (XRTX)

Xyratex Ltd. (NASDAQ:XRTX)

F2Q10 (Qtr End 05/31/2010) Earnings Call

June 30, 2010 4:30 p.m. ET


Brad Driver - VP, IR

Steve Barber - CEO

Richard Pearce - CFO


Amit Daryanani - RBC Capital Markets

Ananda Baruah - Brean Murray

Glenn Hanus - Needham & Company

Keith Bachman - Bank of Montreal


Good day ladies and gentlemen, and welcome to the second quarter 2010 Xyratex earnings conference call. (Operator Instructions)

I would now like to turn the conference over to your host for today, Mr. Brad Driver, VP of Investor Relations.

Brad Driver

Thank you and good afternoon everyone. Thank you for taking the time to join us this afternoon. I'd like to welcome investors, research analysts and others listening today to Xyratex's fiscal second quarter 2010 results conference call. On our call today are Steve Barber, Chief Executive Officer; and Richard Pearce, Chief Financial Officer. Today's call is being recorded and will be available for replay on Xyratex's investor relations homepage at www.xyratex.com.

I'd like to remind everyone that today's comments, including the question and answer session will include forward-looking statements, including but not limited to a forecast of future revenue and earnings and other financial and business activities. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. These risks and uncertainties are detailed in Xyratex's filings with the Securities & Exchange Commission, including the company's 20F dated February 23, 2010.

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

Richard Pearce

Thank you, Brad and good afternoon everyone. I'd like to thank you for joining us today. Our press release is available both on PR Newswire and our website. I'd now like to provide you with some commentary about our results for the second quarter. Please note that all numbers are in accordance with GAAP unless stated otherwise.

Total revenue was $455.9 million, up 134.1% as compared to the second quarter of last year, and up 42.9% from our prior fiscal quarter. Sales of our network storage solutions products were $343.9 million, or 75.4% of total revenue. This is an increase of $159.6 million or 86.6% compared to the second quarter of last year, and up 26.9% compared with $271 million in our prior fiscal quarter.

The increase in revenue reflects strong demand across our customer base. Sales of our storage infrastructure products were $112 million or 24.6% of total revenue, up $101.5 million compared to the second quarter of last year, and up 64 million or a 133.3% over our prior fiscal quarter.

The increase in revenue reflects increased demand and capacity by both of our largest customers. Gross margin was 18.1% for the quarter compared to 12.9% in the same period a year ago, and 18.1% in our prior fiscal quarter. This increase compared to last year is due to the high proportion of SI revenues.

The gross margin for our network storage solutions products was 12.8%. This compares with 12.7% last year and 15.2% last quarter, in line with our prior guidance. The decline in gross margin compared to the prior quarter reflects the expected transition to the next generation product by one of our major customers. This product contains high density and higher cost disk drives, which result in reduced gross margin percentage.

The gross margin for the storage infrastructure products was 34.6%, compared to 18% last year and 34.7% last quarter.

Turning to non-GAAP expenses, our operating expenses totaled $35.5 million compared to $27.9 million last quarter. This $7.7 million increase was in line with our expectations and consisted of approximately $6 million of investments within the two divisions, and $1.7 million of bonus accruals resulting from the quarterly performance.

Moving on to net income. On a non-GAAP basis, net income was $46.8 million or $1.49 per diluted share, compared to a net loss of $6.6 million a year ago and net income of $29.4 million in the prior quarter.

Turning our attention now to the balance sheet, cash and cash equivalents at the end of the quarter was $58.3 million compared with $53.7 million at the end of Q1. This was above our original expectations, despite certain quarter end customer payments of approximately $20 million being deferred over quarter-end as a consequence of global public holidays at the end of May.

Cash flow from operations was $8.1 million in the quarter. Inventories increased by $30.2 million to $189 million in the quarter. Inventory turns were 7.8, compared to 6.5 for the previous quarter. This reflects the increased revenue in the quarter.

Accounts receivable increased by $43.7 million in the quarter to $245.3 million. Day sales outstanding were 49 in the quarter, compared to 58 in the previous quarter. The prior quarter was particularly high due to the timing of shipments in the quarter.

Headcount at the end of May was 1,905 permanent employees, an increase of 12% or 204 employees. Over 65% of this increase has been in our global manufacturing and fulfillment operations to meet increasing customer demand, with the balance being in key technical skill areas needed to support the increased opportunities we are addressing.

In addition, we increased our global operations contractor headcount by over 350, or 30% in the quarter to support increased production activities.

In summary, this is a very strong quarter for the company in terms of revenue and EPS, and in our response to meeting increased customer requirements. The markets we serve remain highly competitive; however, I believe we remain well positioned to take advantage of the growth opportunities in the current markets we serve as well as potential incremental new markets we are looking to access in 2010 and beyond.

Now, before I turn over to Steve for his comments, I'd like to provide you with our business outlook for our fiscal third quarter 2010 ending August 31.

Our business outlook is based on current business expectations. It should be noted that there are a series of forward-looking statements in today's guidance that involve risk and uncertainty. Actual results may differ materially from our statements or projections. In order to clearly understand the risks involved, it is recommended that each investor review the risk factors outlined in our Form 20F filing.

For our third quarter 2010, we are projecting total revenue to be in the range of $385 million to $435 million, up 56% to 77% as compared to last year, and down 5% to 16% compared to 1Q. This is represented by revenue from network storage solutions of $305 million to $335 million, and from storage infrastructure of $80 million to $100 million.

For Q3, gross margin is expected to be 16% to 17%. We are estimating non-GAAP earnings per share to be between $0.87 and $1.16. Non-GAAP earnings per share excludes non-cash equity compensation and amortization of intangible assets. The number of shares outstanding at the end of Q3 on a weighted average treasury method is expected to be $31.5 million.

Our cash position at the end of Q3 is expected to be approximately $80 million, and trending in excess of $100 million at the end of our fiscal year depending on the timing of SI equipment shipments and any corporate activities.

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

Steve Barber

I'm very pleased with our record results, strong execution, and outstanding performance in the quarter. As we stated previously, and confirmed both by analysts and our customers in their March and April quarter earnings calls, the growth in integration and storage is showing no sign of slowing.

Data growth continues to be forecasted at over 50% compound annual growth rate, the recent industry reports increasing PC unit sale forecast to around 20% year-over-year growth this year. Our storage infrastructure customers continue to install incremental production capacity to match end-user demand and large substrate supply, which the outlook remained constrained beyond yearend.

In addition, we continue to make positive progress in broadening our customer base in both the disk drive and disk drive component sectors. We are very encouraged by the strong business environment and industry dynamics in both our businesses.

I'll now review our two businesses separately, starting with network storage solutions. Our fiscal second quarter revenues of $343.9 million once again exceeded our guidance range as we experienced strong demand across our breadth of customers through the quarter. The relative strength in enterprise data storage demand as we have experienced through the last three quarters is forecast by analysts to continue through the remainder of this year.

Based on recent research reports, sale of the external disk based storage systems grew 17% year-over-year in the first calendar quarter of this year to $5 billion. We shipped storage capacity, growing 59% year-over-year to 3,397 petabytes. Our largest customers, NetApp, IBM, Dell, and EMC all maintained or grew market share, with NetApp specifically increasing its position from 8.2% to 11.1% market share quarter-over-quarter.

In discussions with our customers, overall end user product demand was strong in the quarter, with notable strength in demand from NetApp with their fiscal year end in April. Despite macro concerns with regard to the European economic issues, enterprise storage demand appears to be unaffected to-date with many of our customers continuing to see strong demand in Europe.

Data growth results continue at current rates, driven by digital archiving, regulatory demand, business continuity and U.S. stimulus actions, including the rollout of electronic health records for all Americans by 2014. Consumer content creation enabled by solid-state memory and mobile devices and fueled by social networking site information exchange is further driving increased demand for data storage on disk drive-based systems.

Our customers are providing compelling storage solutions in unified storage offerings, NAS and iSCSI solutions aimed at the SMB sector, driving a product refresh cycle to enable real cost of ownership efficiencies in addition to fundamental incremental storage capacity required in a data center.

We shipped 822.42 petabytes of external storage in our fiscal second quarter, representing a 31.4% growth over the prior quarter and 120.3% of growth over a year ago. Based on recently published data on the total petabytes shipped in Canada in the first quarter this year, we estimate that Xyratex once again may take the position as a leading player in the market, supplying 20.6% of capacity on an annual basis. This sequential increase in market share is due to the strength in customer demand we have seen for 2 terabytes capacity disk drives, which are being deployed throughout our product line.

Our second quarter shipped capacity was made up of the following in disk drive interfaces; fiber channel: 72.06 petabytes; Serial ATA, 619.28 petabytes; SAS, 130.98 petabytes; and SSDs, 83 terabytes.

We continue to work closely with our customers and industry partners to prioritize our product development roadmap, investing in the development of a compelling range of hardware platforms to enable our customers' success in the market. We're seeing strong demand for our SBB compliant one-store range of SATA and 6-gig SAS solutions with a common value proposition, common field spares, management and manufacturing.

These platforms enable our customers to utilize common software applications across a wide range of performance and cost platforms, addressing multiple end user market segments.

In addition, we're seeing increasing customer focus on our range of application platform products, integrating high-performance processor capability with high-availability storage. These platforms are of interest to both existing and a number of potential new customers evaluating these solutions with their software applications.

Recognizing the increasing scale of data storage deployments, we developed a compelling portfolio of high-density product solutions. After being first to market with a 4U height 48 drive enclosure, we're now developing a 5U height product with significantly higher density than the current competitor 4U 60 drive products in the market.

Beyond this, we're working to address the need of a big data platform, rack scale storage hardware where the minimum install is 1 petabyte. Big data applications are generally scientific data that carry a lot of value and where constant access with performance is required. Today we are serving those markets through our OEM customers with multiple enclosures. However, we can see a more efficient and more profitable way to address the same market with a targeted product.

To complement the big data hardware, we need a way to store the data efficiently with an expandable, reliable and manageable system, in order for the data to be easily presented to the OEM customer whose value lies in managing how this data is ingested, catalogued, achieved and processed. We're currently investing in the development of this software layer for availability in 2011.

Xyratex is a respected provider of industry-leading, high-capacity, high feature and performance data storage platforms supported by a pipeline of innovation and intellectual property. Recent innovations include integrated battery backup technology, eliminating the requirement for uninterruptible power supply to the rack; optical backplane technologies for high data rates and adaptive drive and energy conservation technologies. We remain committed to the long-term technology innovation and product development.

Complementing this technology and platform focus, we remain highly active in identifying further opportunities to grow our business, both with existing customers through working to access adjacent product ranges as well as engaging with a number of high growth or emerging storage companies, exhibiting innovative and compelling product technologies.

With the strength and breadth of our product portfolio, global fulfillment capabilities, competitive cost structure and strong customer relationships, we remain confident in our ability to retain and grow our leadership position in the OEM external storage market.

We recognize that we operate in a highly competitive market, which includes the potential risk to our business of customers choosing to in-source certain products when transitioning platforms or partnering with contract manufacturers to fulfill their volume demand. We will continue to focus on demonstrating our technology innovation and value-added service differentiation.

Overall, against the backdrop of strong customer demand, I'm very pleased with our execution in the last quarter and year-to-date. We have effectively supported our customers' upside demand and maintained our new product development commitments against extremely aggressive and challenging schedules.

Moving now on to our storage infrastructure business, for the second quarter, revenues in this business were $112 million, a 133% increase over our first quarter results and in line with our expectations. As anticipated, during the second quarter, we continued the shipment ramp to fulfill the increases of CapEx spending announced by Seagate and Western Digital during the fourth quarter of 2009.

As we stated previously, our first half revenue comprised approximately $50 million to $70 million of CapEx spending that we view as catch-up in investments from the historically low levels of CapEx spending by our customers during 2009.

As we entered our fiscal third quarter, we've seen some slowdown in capacity additions for the second half of the year by one of our customers. Despite this, we still anticipate that the second half revenue will be equivalent to the first half revenue as a result of the addition of two new significant customers we shall discuss shortly.

During the quarter, we have seen continued concrete evidence of the disk drive industry accelerating their investments, to increase their overall production capacity. In addition, we will benefit in the third quarter from the disk drive industry's aggressive investment in technology to achieve areal density innovations as well as expand capacity while improving capital productivity.

We are well positioned with our back end test product portfolio to benefit from this emerging market dynamic. Introduction of Optimus, our 2.5 inch disk drive dedicated platform has been very favorably viewed by the industry, and we continue to be pleased with the adoption rates we have achieved.

The investments we have made in technology innovation during 2009 are now being translated into the revenue as well as market share growth we're experiencing. During the quarter, we successfully completed a competitive technical benchmark by Hitachi Global Storage Technology, and we are delighted to be awarded HGSTs back-end test business. We have now received production orders for both Xcalibre and Optimus systems, with shipments to HGST commencing this quarter as part of their focus on improving disk drive production efficiency across their operations.

Our incumbent back-end test platforms such as Xcalibre are the only commercially available systems capable of handling both 2.5 inch and 3.5 inch disk drive form factors, and we anticipate these systems representing a significant portion of our business opportunity with HGST.

In addition, we initiated a major development program to expand the Optimus portfolio into a system capable of handling both 2.5 inch and 3.5 inch disk drive form factors. This system will be backwards compatible with our existing commercially available systems, which should provide significant cost of ownership as well as capital productivity benefits to our customers.

During the quarter, we advanced the production qualification of Titan, our substrate optical inspection platform and we have now received multi-system volume production orders that will be shipped during the second half to a leading glass substrate provider. In light of the current constrained supply of glass media through 2010, and announcements by the large substrate industry to invest an additional production capacity onstream from early 2011, we see a potentially significant opportunity for this high volume substrate inspection system for deployment within these new factory expansions. Also during the quarter, we shipped the Phoenix system, our next generation media cleaning platform, and entered production evaluation and qualification.

Depending on the outcome of this evaluation, this initially represents an opportunity, first to roll out an upgrade cycle across the installed base of legacy Xyratex media cleaning systems in customers’ factories. And finally, we recently completed the acquisition of the assets of Optical Systems Corporation, a respected provider in the disk drive industry of automated production technology. We are delighted to have the OSC team join the business, enabling us to expand our automation IP and portfolio into disk drive head fabrication and assembly. We anticipate the total cost of this acquisition not to exceed $5 million, including potential earnout of the next three years.

As I highlighted at investor conferences earlier this month, we are anticipating some slowdown in the rate of areal density growth over the next three to four years as a result of the technical and economic challenges of implementing next generation recording technologies. In our view, we believe such a trend will result in either additional disk drive unit demand or additional component content within individual disk drives or both ahead of next generation recording technologies being implemented in volume production. As a result, we are executing our growth and investment strategy within the storage infrastructure business with a focused bias towards broadening our customer base in our traditional product segments as well as to penetrate into the areas of disk drive heads, media, and substrate, expanding our product portfolio in the disk drive manufacturing and component factories. Our acquisitions of OSC is one element of this strategy.

In summary, I am pleased with our strategic position in the disk drive market and the execution of our technology investment strategy. We are a valued partner now with the three leading disk drive manufacturers, a leading 2.5 inch large substrate manufacturer, and we continue to make early but encouraging progress with additional leading companies in the disk drive and disk drive component space.

I believe our technology and our comprehensive product portfolio will enable us to maintain a leadership position in the areas where we currently provide capital equipment. Our expanded investments in technology, innovation and product development position us well to expand our footprint within the capital equipment processes of our current customers, as well as allowing us to access new customers.

I am confident that our focus, extensive domain experience and execution will allow us to meet the requirements of our customers over the coming years. Against this positive market demand environment, we continue to be challenged by isolated component supply constraints, as well as extended lead times that have challenged us and the wider industry since the fourth quarter of last year, and we continue to take corrective steps to protect material supply. Our actions year-to-date have enabled us to satisfy up-side demand across a majority of our customers.

From our standpoint, we believe that component supply issues and lead times will continue to challenge us throughout the rest of this year, despite our actions to mitigate this risk due to the overall capacity constraints affecting supply of certain semiconductor and capacitor components.

I once again would like to take this opportunity to thank all our employees worldwide for their contribution towards the company’s outstanding performance in the quarter. I very much appreciate the efforts of all our employees in executing to our customer commitments, driving product shipments and quality and delivering on our product development milestones. We remain well positioned in both the market sectors we serve to benefit from a continued growth of data storage demand through the remainder of the year and beyond.

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 the line of Amit Daryanani of RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Thanks and congratulations on the nice quarter guys. Yes, I just got a quick question start out with. How much was NetApp as a percent of revenues for you guys this quarter?

Richard Pearce

NetApp actually increased slightly in the quarter to approximately 55% of our revenues from around 51% in the previous quarter. And not unexpected being the NetApp yearend falls within our second quarter. So it's pretty much in line with our expectations.

Amit Daryanani - RBC Capital Markets

Got it. And then you said the midpoint of the guidance if I look at the NSS segment, it looks like it will be down about 7% sequentially. Historically it's been volatile, but it tends to be, kind of, flattish over the last eight, nine, 10 years. Can you just talk about what's driving that segment down 7% on your guidance for August quarter?

Steve Barber

If I take your previous statement, if I go back to 2008, which I guess is a more -- last year was a very strange year, let's put it that way. But 2008 in the NSS section, we were probably down around 10% actually. So it's not an uncommon trend, and again, relating to our previous comment, a lot of that is driven by Network Appliance in terms of where the yearend falls and obviously being such a substantial customer, yes, that does have an effect on us.

So that is primarily the reasoning in there, obviously our customers had some ups and some downs, but at the moment that's the best forecasting we've got and as I say it’s pretty much inline actually with what we would expect to see in 3Q before them picking up again in the fourth quarter.

Amit Daryanani - RBC Capital Markets

Got it. So your reflection of, kind of, what your normal seasonality would look like given how big NetApp has gotten for you guys. And then just a final one for me, how much did you guys benefit if at all on the OpEx line from a weaker pound, a stronger dollar, and could you just remind how much of your OpEx is really U.K. centric today?

Richard Pearce

Yes. We've really been seeing those OpEx benefits coming through this year. Throughout the whole of the last year, we hedged almost two-thirds or so, a large proportion of what I would call our U.K. exposure. And that really is the only exposure that we have in all of our other expenses. Comps, et cetera, tend to be U.S. dollar based.

So, this year we've seen benefits in overall expense by approximately $12 million over the year. If you look at 2010 over 2009 and that really is relating to a roundabout £14# million worth of expenses that we have here in the U.K.


Your next question comes from the line of Aaron Rakers of Stifel Nicolaus.

Aaron Rakers - Stifel Nicolaus

Yes. Follow up I guess on Amit's question first of all. Can you quantify how big Dell is because I think within that business you historically had other plus 10% customers? And I have some follow ups.

Richard Pearce

Yes. Dell is approximately 15%, based on the increase in overall revenue. That has their revenue, kind of, flattish over the quarters. IBM actually increased to around, again, they are approximately 15% in the quarter.

Aaron Rakers - Stifel Nicolaus

Okay. Perfect, and then only SI side of the business, you know, last quarter you guys had given some color about your visibility there saying I think it was a 100% visibility into the guide and then even going out two quarters and talking 70% visibility into the August quarter at that point in time. It looks like the guidance would imply that you are assuming to get to kind of a level second half versus first half, somewhere let’s call it $70 million at the midpoint for 4Q. Can you tell me first of all what your visibility is now currently into that fiscal fourth quarter?

Richard Pearce

Yes. I mean that's the visibility going out, it's not too much different when we talked about it last quarter, so we have pretty much -- yes 100% coverage for 3Q and in excess of 70% out into 4Q. So, a pretty similar trend to that which we saw when we reported last quarter. And yes, I think, the comments that you make we have sort of guided towards first half or second half revenues in that side of the business being relatively consistent, albeit the first half revenues did have some benefit of what we will call sort of hangover from 2009. But I think your comments there are pretty much on in terms our expectations for the second-half of the year.

Aaron Rakers - Stifel Nicolaus

Right. And in the context of fiscal fourth quarter then, obviously some more constructive commentary than what we have ever heard from you on Hitachi before. Can you help us quantify how big Hitachi looks like, coming into fiscal fourth quarter, any color? How we should think about that new opportunity as we look into next year from a size perspective and maybe that in the context of the comment about either Seagate or Western Digital slowing a bit in terms of their CapEx spend?

Richard Pearce

Okay. We might share some of these between Steve and I. If I take the first part of your question in terms of this year, obviously they are a new customer, and therefore there will be certain qualification requirements on the equipment that we ship in there at the early stages, which will be in the second half of the year.

But based on my expectation in terms of actual revenue that we will see in the books is that this year it's likely to be less than $10 million of actual recognized revenue in our fiscal year. As we move out into 2011, I think it is still very early stages in terms of this customer, and we're optimistic about the opportunities in there. I wouldn't necessarily be wanting to put a hard and fast number on that at this stage.

I think that 2011 in total, both from Hitachi and from our other customers, we have a much better view on '11 in kind of September/October timeframe. I'll probably pass over to Steve.

Steve Barber

Aaron, Steve here. Clearly we are delighted to have been selected, but actually the scale really much depends on how aggressive Hitachi are, and how successful they are in gaining market share. I think our business is really driven by incremental production growth, capacity growth, and therefore I think we need to look forward as to what their incremental growth might be in a normal scenario.

Clearly, if they take actions to increase market share or focus on factory optimization, which could potentially mean displacing legacy product with Xyratex's technology, clearly that could increase opportunities significantly. At this stage we're assuming it will be incremental, and based on their current market share versus where WDSC data, if we can make some judgment of what the potential is. But as Richard said, we have a good feel for that until later in the third quarter this year.


Your next question comes from Ananda Baruah from Brean Murray.

Ananda Baruah - Brean Murray

Steve, can you, I mean I guess give us some sense, I guess now that you have visibility into what I'm going to assume is likely the bulk of the capacity adds from Seagate and Western Digital. Give us some sense if you could of what you think I guess normalized ongoing CapEx capacity -- not capacity spend in SI, but I guess revenue in SI would be from your perspective, excluding kind of what the Hitachi stuff might be as we go into next year?

Steve Barber

There's a number of variables to take into account there, and as we indicated previously, we're not providing formal guidance for 2011 at this stage. We think we'll have a lot more visibility of that come the third quarter. But I think as we've indicated previously, we had around 50 or so million dollars of, as you said, catch up in our revenues this year which was really a rollover from historical low levels of spend last year.

So netting that off is pretty much where the consensus has ended up. In reality, depending where our two existing customers and how quickly SSD ramps, whether that would offset that catch up this year is difficult to project. This year is also strange in that the industry is constrained on 2.5" large substrates.

And therefore, that will create potentially a pent-up demand for certain disk drive types, which may result in I guess a normal pattern going into the first half of next year, as supply starts to improve, and demand can then be fulfilled in certain mobile applications where those components are required.

So with those moving parts, I guess I'm going to hold off giving you a definitive number for where we see 2011. I think we really have to analyze these moving elements and draw those conclusions, come the third quarter timeframe.

Ananda Baruah - Brean Murray

And more of a clarification, you mentioned around the Hitachi opportunity that durability to gain share going forward was kind of significant driver of what the opportunity might ultimately be. You may have answered this, but just to make sure I have this, is that the primary driver in the near term or the intermediate term of what the opportunity might be as opposed to they just replacing legacy equipment?

Steve Barber

As I said in a previous question, I mean our business there is driven by incremental production capacity. So every year capacities of drives increase, and therefore you need additional production capacity to manufacture those drives, even if the total units doesn’t increase. So assuming that the market shares of those three customers remain static, all three would require incremental production capacity in order to maintain that market share.

And my answer to the previous question was more about the size of that opportunity. And in reality, there is an additional factor there as to whether Hitachi is focused on market share growth or maintaining of market share. And we don't have visibility on that at this stage. Therefore, our assumptions have to be focused on sizing the opportunity really driven by where they are today and maintaining that market share and going into 2011 as individual drive capacities increase.

Ananda Baruah - Brean Murray

If I could just ask for any kind of framework around the media cleaning refresh opportunity that you guys talked about? And then any newer consensual product areas in SI that you are looking at expanding into as we think about second half of this year going into next year, even if you can give us kind of order of magnitude? I mean anything that we could use to sort of kind of frame it for ourselves, the significance of those types of things?

Richard Pearce

Again, I'm going to not get drawn into giving you some definitive numbers. Certainly there is, as you said, we are executing against our strategy, which is to expand our footprint beyond the disk drive presence into disk drive components, because we believe in the next three to four years that component count will increase to compensate for slowing areal density growth.

The acquisition that we mentioned in the call will allow us to access the disk drive head technology marketplace, a new sector for us. Again, we are setting realistic expectations of our penetration into that space, but recognize once we have proven that technology we would be wanting to look to expand it broader than where we are currently thinking.

Similarly with the last substrate technology where we're currently in volume shipments to a provider in that space; assuming that program is successful, really we would look to expand our market presence both with substrate providers, but also media providers, which is a pretty significant marketplace for us to assess as we exit this year.

So, expanding our footprint into the component space does provide us with growth opportunities above and beyond the legacy business that we've seen in that area, which has been predominantly disk drive focused.


Your next question comes from the line of Glenn Hanus of Needham & Company.

Glenn Hanus - Needham & Company

Maybe you could talk about gross margin on each segment of the business. On System Infrastructure, you really came in at a good level there, maybe talk about sustainability or changes there going forward and some commentary on the NSS side going forward?

Richard Pearce

On the SI side of the business I think we have given relatively consistent ranges in there of between 30% and 35% gross margin. And this quarter and the previous quarter we've been at the high end of that range. I think in this quarter obviously we were helped by the significantly high volumes over which to bear our fixed costs.

As I look out from at least the rest of this year, I would expect it to continue to be in those ranges. There is some variability based on the products mix within there but I think 3Q would definitely be up towards the higher end of that. As I look out, I do have some visibility of the product ranges that we will be shipping out towards the back end of the year and actually possibly in 4Q we might be at the lower end of that range, but nothing significant to read into that between customers or whatever. It really is just down to product mix within that.

On the NSS side of the business, obviously this quarter coming in at 12.8%, which was actually almost spot on what we had in the fourth quarter of 2009. We did have some real benefits going into 1Q, which I think we talked about last time and particularly the slower transition of some of our old legacy products particularly on the NetApp business which provided in the very short term a high margin level.

I think in that business for a number of quarters now we've consistently projected margins at the sort of 12% to 13% range or 12.8% and also with a caveat in there that says that if Q1 [ph] business grows considerably based on the margin profiles we could be seeing that sort of margin range going to be 11.5% to the 12.5% range.

So, I think we've hit the range where we kind of set the expectations in the second quarter. As we moving out into the back half of the year, maintaining very strong performance from our tier one customers, then I think we will be potentially heading towards the lower end of the 12% to 13% range but within the sort of 11.5% to 12.5% again that we talked about previously.

Glenn Hanus - Needham & Company

Okay. How about on OpEx, can you give us some color there? You were up this quarter in line with expectations, was that rolled out as planned and what are your thoughts going forward?

Richard Pearce

We've obviously increased our expenditure actually quite considerably in the second quarter. I mentioned whilst obviously a portion of that is related to the bonus accrual behind the performance that we had year-to-date, the majority of the increases that we've seen is actually investments in the business. We've really cut back on expenses in 2009, when this time last year or at least a month beforehand, our priorities at that time were very much focused on cash and almost survival of the business as with many businesses.

Things have changed significantly over the last 12 months. And now we're really looking at investment opportunities such that we can look to expand and grow in 2011 and beyond. So we put investment into those areas. I think we are going to continue with the level of investment, albeit the $7.7 million in increased expenditure that we've seen between 1Q and 2Q, I would expect that to be going up in the next quarter by between $1 million and $2 million and then remaining flat into the fourth quarter.

Some of the expense that we're adding is variable rather than the fixed, which is obviously a choice we've made. And as we look then into 2011, we will look at those opportunities and understand whether that's a reasonable level to maintain those into 2011 or whether or not on some of those variable elements we would choose to cut back on those.

Glenn Hanus - Needham & Company

In the NSS side, could you comment a little bit on what you're seeing in terms of expansion opportunities within your customers, particularly IBM, perhaps any of the other large OEMs where you have relatively small but growing footprint?

Steve Barber

We have been very active in exploring other opportunities with our existing customers, as I said in the script to look at enabling them access broader marketplaces, leveraging actually common building blocks. And we're certainly exploring a number of opportunities with existing customers, but equally looking to engage with current non-Xyratex customers that are out there in the marketplace today.

So we see a number of areas where we can see potential to deploy our technology broader than where it's today. And clearly, because of the confidentiality of those programs, we're not in a position to share with you at this time anywhere they are, heading towards product announcements or anything of that sort.

We're encouraged. We recognize it's an extremely competitive market in which we operate, but we do see real opportunities to expand our presence, both with current and potentially new customers.

Glenn Hanus - Needham & Company

And then maybe lastly, as we look at modeling into 2011, should we anticipate the NetApp transitioning some business back to Jabil, I guess, in the first or second quarter of 2011?

Richard Pearce

Yes, I think we've been relatively clear on the contractual status between ourselves and NetApp in terms of if I can term them sort of legacy products and new products. I think everyone is relatively aware that on the legacy products, we have an agreement that a third-party, which in this case I think everyone knows has been Jabil on that product, but NetApp can source up to 25% of that volume.

And on the new products, we're sort of moving into that model as of the next fiscal year. To the extent that a large portion of the products in this year has been the old legacy products, we've already had the effect of up to 25% going to Jabil. And then as we migrate across to the business, which we are now in the process of doing, on the new business we will almost be in the same situation.

So that in itself shouldn't have a less significant effect into next year. As we move into the back half of the year, obviously we're getting the benefit of 100% of the revenue on what is becoming the largest shipping product. So I guess we will see a slight takedown to balance that against NetApp's overall growth themselves.

So I think when you look at the model today, which shows flattish to marginally up in the NSS part of the business in 2011, we're relatively comfortable with those projections which are out there.

Steve Barber

Glenn, I'd just add that 75% will go through the end of the fiscal '011.


(Operator Instructions) Your next question comes from the line of Keith Bachman of Bank of Montreal.

Keith Bachman - Bank of Montreal

Could you go back and revisit on the cash flow a little bit? On a dollar basis, your working capital was up, sales were up as well. But could you just give us some visibility on how that unfolds for the next couple of quarters?

Steve Barber

I think we touched on it in the script. And as I've said in the script, we did anticipate working capital going up in the quarter and it did, albeit we were affected actually. And I have to admit I didn't know (inaudible) at the end of May, and therefore from a couple of customers, we had some significant payments that were held out by a day or so. So the cash at the end of the quarter would have actually been up to $20 million higher on the back of that.

In terms of forecast, as I said, I would expect the end of Q3 we are giving a cash outlook of $80 million. So ignoring the factor, the main payments I guess, yes we are looking to convert the majority of profit which is delivered in 3Q into cash and then again in 4Q we are projecting in excess of a $100 million in cash so again we will be looking at almost all of that profit heading into cash.

So we are already not looking as we move through the year now to increase our working capital any further as you move into the next two quarters. So actually expecting to see almost all of the net earning dropping through into the cash line.

Keith Bachman - Bank of Montreal

Okay, perfect. And then on the glass media opportunity, can you just give any color without sizing it but just timing of impact, just sounds like that's 2011 opportunity. Should we be even more thinking about the second half of 2011, just any kind of color on timing on when that may show up?

Steve Barber

It's very difficult to answer that question. We are currently shipping units to the customer that are being put into production use, we're certainly aware that the investment being made across that whole sector, increasing capacity to unlock the constraints for this year.

That capacity number of reports are indicating that additional capacity comes on stream around 2Q next year, that would indicate that we would see potential demand for this product late this year and early next year.

The size of it is actually difficult for us to really quantify at this stage because it’s unclear whether the product ends up being in full scale production use or for sampling or where in the process?

A lot for us to really learn about this sector as we move through that half of this year. We do see a great opportunity, our product is maybe demonstrating real differentiation over the legacy products that it’s replacing. Customer feels very excited about it, but the scale of the opportunity is not yet – we are not able to really quantify that is what it would mean for 2011 opportunity.

Keith Bachman - Bank of Montreal

Okay. And the final one for me is you mention you had some cuts on the drive infrastructure side of the business. Is there any color you can give us on material and timing. If you're keeping the forecast second half equivalent to first half and you said Hitachi is about $10 million, then does that thereby suggest that cuts were about the same amount as $10 million in potential cuts?

Richard Pearce

I am not going to go into any detail; I wouldn’t also say that our cuts would indicate that they are shipped out until the timing for installation of additional capacity. I should also caveat by saying, it is June. And this industry does tend to go through a number of oscillation in the June time frame as to really trying to size what capacity they want for the second half ramp. Our view is that push out or delay of installations will oscillate for the next few months before it settles down. And therefore while I did engage, we have seen some push out of demand from the customer. It's certainly more than offset by what we're anticipating from Hitachi and also on the substrate equivalent.

But it's June, and you've been in this market a long time. You recognize that there is the June gloom around the drive sector is an annual event, and it’s creating some uncertainty as to what degree of that capacity will actually be pulled forward and put back on the original schedule, or how much it will continue to be delayed.


You have a follow up question from Ananda Baruah from Brean Murray.

Ananda Baruah - Brean Murray

I believe you recognize overseas some kind of fee income from Jabil for your process that they used to manufacture whatever it is they manufacture for NetApp. I just confirmed that and that just remind us what overall net growth dollar impact is to you guys once you recognize the income versus if you had just done it yourself.

Steve Pearce

I guess to be clear, we don't actually get an income from Jabil. We do provide a license to NetApp, and therefore there is some form of royalty license that comes from NetApp. I don't think we've every actually given what the amount of that is.

I mean it’s to a degree in compensation for enabling a third party manufacturer. So that is in a level on the sort of legacy products and as you said historically, it's not necessarily a significant level, and we are not really in a position to provide the absolute amounts on that, but it is not hugely material in our overall numbers.


As there are no further questions, I would like to turn the call back over to Brad Driver.

Brad Driver

Thank you. Once again, thank you for joining us this afternoon. We look forward to speaking with you again on our Q3 earnings call, which will be scheduled for late September. Also, in August, we will be presenting at Oppenheimer technology conference in Boston, at which point we will provide further updates to the business environment. So please look for the exact date of this presentation on our calendar page of our website.

As always, you are welcome to call me if you have any additional questions over the course of the quarter.


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

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