Electronics For Imaging, Inc. Q2 2010 Earnings Call Transcript

Electronics For Imaging, Inc. (EFII)

Q2 2010 Earnings Call Transcript

July 22, 2010 5:00 pm ET

Executives

JoAnn Horne – IR

Guy Gecht – CEO

Gordon Heneweer – Interim CFO

Analysts

Shannon Cross – Cross Research

Ananda Baruah – Brean Murray

Corey Meehan – BMO Capital

Morris Ajzenman – Griffin Securities

Richard Gardner – Citigroup

Operator

Good evening. My name is Tracy, and I will be your conference operator today. At this time, I would like to welcome everyone to the EFI second quarter 2010 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions) Thank you. I would now like to turn the call over to JoAnn Horne, Investor Relations for EFI.

JoAnn Horne

Thank you, operator, and good afternoon, everyone. I have here with me today Guy Gecht, EFI’s CEO; and, Gordon Heneweer, our interim CFO.

Before we begin the prepared remarks, let me review the Safe Harbor statement. During the call and during the question-and-answer session that follows, the company will be making many forward-looking statements, including, but not limited to, statements regarding expected continuation of certain positive trends, revenue recovery, gross margins, warranty costs, gross – collaboration with our OEM partners, APPS revenues and Radius integration, Q3 outlook, and statements and assumptions underlying any of the foregoing. Forward-looking statements are subject to risks and uncertainties that could cause our future results to differ materially or cause a material adverse effect on our results.

For more information, please refer to the risk factors discussed in EFI’s SEC filings, including, but not limited to, the annual form on 10-K, the quarterly reports on 10-Q, the Form 8-K filed with the SEC today, and the attached press release. The company recommends that you read these documents in conjunction with a review of our financial statements. We undertake no obligation for forward-looking statements or information discussed today.

In addition, reference will be made to non-GAAP financial measures. Non-GAAP financial measures have limitations in that they do not reflect certain items that may have material adverse impact on our financial results. Information regarding reconciliation of the non-GAAP and GAAP measures can be found in the press release that we issued this afternoon and on our Web site at the IR section at www.efi.com.

I’ll now turn the call over to Guy Gecht. Guy?

Guy Gecht

Thank you, JoAnn. Thank you all for joining us today. We are very pleased and encouraged by our Q2 results with both sequential and year-over-year growth in all three of our business segments, while in both Inkjet and Fiery, we saw greater than 30% year-over-year growth.

Despite the $0.03 hit on our bottom line caused by the sharp decline in the euro against the dollar during the quarter, we still exceeded our EPS expectations, delivering $0.09 per share, and generating from our business approximately $12.4 million in cash, adding $8.4 million net cash to the balance sheet. By maintaining our focus on our cost structure and maximizing resources, we reported our first successive quarter of positive operating margin. Mostly importantly, we look for the (inaudible) and the fast pace of revenue recovery from last year’s level to continue into the third quarter.

Our results were driven by increasing demand for our newest industry-leading products, customers globally are attracted to our latest products due to the substantial ROI and the features that have enabled them to win shares in their local markets.

Expanding on our Inkjet results, the Inkjet segment reported another strong quarter, with revenues increasing approximately 15% from Q1 2010. It is the second consecutive quarter of greater than 30% year-over-year growth for Inkjet, with revenues increasing 38% from Q2 last year. The results were driven by strong demand for both the GS and the newly released GS5000r product as companies are starting to select UV technologies to replace both analog and solvent ink-based printers.

This transition in our innovative UV product portfolio has positioned EFI for success. Globally, the growth in our UV ink volume is evident that many of our customers are winning business with our state-of-the-art products. And our main (inaudible) remains Europe as we continue to face challenges and demands, and available financing for our end users.

The GS product continues to see good demand despite the relatively high price point. And we are seeing a very high ink usage rate, approximately three times the level of our QS products. While this level of utilization help drive UV ink demand, it also drives a much higher warranty costs that are impacting on gross margins. I will expand on this point in a minute.

Also during the quarter, we started to commercially ship the GS5000r, our first 5-meter UV roll-to-roll product that helps complete our product portfolio. The unique features there – on this spot retail printer enables our customers to generate new offerings for applications that will positionally sell this a less productive equipment.

We continue to show a high growth in UV volume as we posted a 15% growth for the second quarter, bringing the growth rate to 34% over the same period last year. We believe that our customers, especially our GS customers, are using our printers instead of printing via analog technologies, and winning market share from other digital printing devices. The demand for UV ink is also a leading indicator for future demand for new equipment as customers will need more capacity at some point. Yet, obviously, we are disappointed with the gross margin in our inkjet segment.

We knew coming into this quarter that we would not keep the historic level of 40%, even with the increase in volume due to the three factors that I mentioned on our Q1 earnings call, one, the feedback related to the latest QSR streaming to configuration we are implementing to increase utilization, which continue to drive growth in our ink volume; two, the introduction of the GS5000r this quarter as we arm our field technicians with spare parts and fine tune the initial installations in the field; three, the product lines of Rastek and Jetrion, where the volume are still too small to achieve more mature gross margin levels.

This three were certainly factors in the quarter. But as I mentioned earlier, gross margin were also significantly impacted by the increase in warranty costs on the GS series. We had expected the warranty costs to decrease as the product becomes more mature. However, with this level of high utilization, the actual warranty costs went up this quarter. We’re working to resolve the warranty cost issue and have already implemented the design and style changes that would significantly reduce the GS and GSR warranty costs. With the changes we are making in the products and the growing demand for ink, we continue to target long term margins at or above 40%. We expect those steps to result in an increased gross margin in Q3 for the Inkjet segment on revenue fairly even with Q2, which is what we’re currently anticipating.

Turning to the Fiery business, we saw another very strong quarter as we reported sequential revenue growth of 3% for the quarter, which exceeded our own expectations as we were coming off a solid first quarter. Year-over-year revenue growth for the business was 35%. Part of this revenue strength came from our higher-than-expected, especially with the Xerox Color 80 and 100 ppm machines. We continue to be very part of the work and collaboration that we have done with Xerox on the devices.

Konica Minolta announced their new 80 ppm production engine, an exciting new product that we expect to play a significant role with the high Fiery catch rate once this new engine starts shipping.

And lastly, on the new engine front, Canon announced an improved 70 ppm product engine that we’ll see later this – in the year. And as with other engines, we feel confident that most of the engines will be sold with our Fiery content. Looking at Q3, we expect Fiery revenue to be roughly flat with the Q2 results, before the approximately $2 million benefit from an organizational change that I will discuss with you.

Our application business has a strong booking quarter, in fact, our all-time high bookings in the June quarter, although many of the deals haven’t yet contributed to revenue. We continue to read the US market in business process automations, while making progress on expanding globally. On that front, we won the (inaudible) of Service Point Solutions, a leading digital reprographics and documents management service provider, to supply software to automate operations across the network of 116 locations in eight countries.

We recently closed the transaction of Radius Solutions, which we announced last quarter. And so far, the integration of the Radius business automation software designed for the packaging industry into the APPS product portfolio has been small. We expect Radius to contribute an additional $2 million to $3 million next quarter to the APPS revenue.

As I mentioned earlier, we made this quarter an organizational change so that the Proofing workflow that was part of the APPS business were now reporting to the Fiery business unit. We see ever increasing technology and distribution synergies between the Fiery and the Proofing teams. And we believe this change will drive further efficiencies. This will also allow the APPS to focus on the Radius integration and make others to have global leadership in business process automation for the printing industry, matching our position in the US market.

Going forward, the approximately $2 million in quarterly revenue from the Proofing business would be reported as part of the Fiery business. In Q3, we expect APPS revenue to increase slightly quarter-over-quarter as the $2 million reduction in our APPS revenue will be more than offset by the increased revenue from the Radius acquisition.

Gordon will provide more details on the financial performance. But in conclusion, we are very pleased with – that all the metrics are moving in the right direction, with the exception of the Inkjet gross margin. We are especially excited about the rebound in cash generation, which I have highlighted over the past few quarters as one of the key goals as we work to restore shareholder value. We continue to prioritize keeping strict control on expenses as evidenced by the reduction in OpEx last quarter despite the revenue growth of 7.5%. The $50 million in cost reduction we have implemented over the past year has positioned EFI for strong – for continued expansion in our operating margin.

Looking at the outlook for Q3, we are expecting roughly 20% year-over-year top line growth, with EPS in the range of $0.12 to $0.14. Once again, we’re not factoring into the EPS outlook any impact from potential dollars strengthening against the euro during the quarter.

Lastly, let me give you a quick update on the CFO search. The search is going well, and we see significant interest in the position as we continue to interview the most qualified of the large pool of candidates. This is obviously a very important hiring decision for the company and me personally. And we are determined to take the appropriate time to make the best possible decision.

In the meantime, we have dipped the bench of highly experienced people in our financial organization under Gordon’s leadership. And I’m pleased with the work they have done bridging the gap to the next CFO.

Now, I will turn the call over to Gordon to provide better details on our Q2 2010 financial performance.

Gordon Heneweer

Thanks, Guy. Before I go through the detailed financial review, I want to remind everybody that on the IR page of our Web site, we have posted our GAAP results, the reconciliation between our GAAP and non-GAAP results in a geographical breakdown of our revenues.

Now, moving on to the quarter, revenues came in at $119.1 million, up 7.5% sequentially and 32% on a year-over-year basis driven by a 38% increase in Inkjet and a 35% increase in Fiery Q2 2010 versus Q2 2009.

Non-GAAP net income for the quarter was $0.09 per share, a significant improvement over the breakeven results reported in Q1 2010, and up from the $0.12 per share loss in Q2 2009. Our Q2 2010 EPS results reflect strong improvement in operating income, partially offset by a $0.03 foreign exchange loss in other income.

Before I go through the quarter in detail, I wanted to highlight some key milestones we achieved during the quarter. The Inkjet business achieved its first $50 million revenue quarter since Q3 ‘08, approximately 15% sequential growth driven by very strong demand for our UV products, including our newly released GS5000r roll-to-roll 5-meter printer.

UV ink established record quarterly revenue and volume driven by our GS series printers. Non-GAAP operating margin improved to 6%, the highest level since Q4 2008. We generated $8.4 million in net cash, exceeding our goal to generate cash equal to or better than pretax net income. Adjusted for special items, total cash generated was $12.4 million.

We continue to make good progress on our commitment to improve our balance sheet as DSOs dropped to 57.9 days, our lowest level since Q2 2008. Our recurring revenues were 26% of total revenues, representing a new record in absolute dollar terms.

Now, moving on to the product line results, for the second quarter, our Inkjet products contributed 42% of revenue or $50.2 million, up approximately 15% and 38% from Q2 2009. Q2 revenue was driven by very strong demand for our UV products, including our newly introduced GS5000r five-meter roll-to-roll UV printer.

As I will discuss in a moment, the transition from solvent-based printers to UV technology is occurring at a faster pace than expected. In fact, during the quarter, our UV ink volumes increased 34% on a year-over-year basis, establishing a new quarterly record for UV ink volumes. As we have mentioned in the past, we believe ink volumes are a key indicator of the end demand our customers are seeing.

Fiery revenues outperformed our own expectations. That's coming off an exceptionally strong Q1 2010. We anticipated a sequential decline in Fiery sales. However, revenues came in at $54.5 million, up 3% from Q1 2010 and up 35% on a year-over-year basis. Q2 Fiery revenues were driven by continued strong demand for our most advanced digital controllers in the high-end production market.

Our tax rates on recently launched OEM engines such as the Xerox 80 ppm and 100 ppm engines continue to be very strong. Fiery revenues represented 46% of total revenues for the quarter, down from 48% in the prior quarter. During the second quarter, our APPS business contributed 12% of our total revenues or $14.5 million, up 3% sequentially and 8% on a year-over-year basis.

As noted in our Q1 2010 conference call, we announced our intention to acquire privately-held Radius Solutions, a leading provider of software solutions exclusively focused on the packaging market. The acquisition of Radius Solutions complements our MIS portfolio and provides excellent synergy for our Jetrion printers. On July 2nd, 2010, we closed the acquisition of Radius Solutions for a total purchase price of approximately $18.6 million, including earn out. Beginning in Q3 2010, Radius Solutions will be fully integrated into our APPS business and will be slightly accretive to Q3 earnings contributing revenues of approximately $2 million to $3 million.

Non-GAAP gross margin for the second quarter was 53.3%, even with the prior quarter, and up 110 basis points on a year-over-year basis. Second quarter gross margin was driven by better-than-expected revenues in our Fiery business and was offset by a mix of lower margin Inkjet products in addition to the Inkjet cost challenges that Guy outlined earlier. Not included in our non-GAAP gross margin is a $2.3 million non-cash charge related to excess solvent inventory. Looking ahead to Q3 2010, we expect a slight improvement in overall gross margins.

As I discussed earlier, the industry migration to UV technology is occurring at a more rapid pace than anticipated, thus, reducing the demand for inventory related to certain solvent products. As a result of the reduced demand, we took a $2.3 million non-cash charge, representing inventory in excess of our current requirement related to these solvent products. Going forward, we expect a continuing trend of increased demand for our leading edge UV printers and inks, while demand continues to tail-off for solvent related products.

Now turning to expenses, non-GAAP expenses – our non-GAAP expenses, which include the impact of amortization of acquisition-related intangibles, stock-based compensation, non-recurring charges and gains, and the related tax effect to these adjustments were $56.4 million and down $0.5 million or 1%, compared to the prior quarter, and down $0.3 million on a year-over-year basis. Our ongoing cost containment efforts have allowed us to maintain relatively flat OpEx despite increased revenue.

Moving on to the individual line items of the P&L, R&D operating expenses were $24.1 million, down $0.9 million or 3.7% from Q1 2010. On a year-over-year basis, R&D expense is down 8% driven by lower headcount and reduced compensation expense. In the second quarter, R&D expenses represented 20.2% of revenue, compared to 22.6% in the first quarter of 2010.

Sales and marketing expenses are $25.2 million, up $1 million or 4.3% from $24.2 million in Q1 2010. As anticipated, the increase was primarily driven by higher tradeshow expense and T&E expense, partially offset by lower headcount and related compensation expenses. On a year-over-year basis, sales and marketing expense was up 4.1% driven by increased tradeshow expense. For the second quarter, sales and marketing expenses represented 21.1% of revenue, compared to 21.8% in the first quarter 2010.

G&A expenses were $7.1 million, down $0.6 million or 7.5% from the first quarter of 2010 and up $0.8 million or 12.2% year-over-year. The sequential decrease in G&A spending was primarily attributable to lower compensation and consulting expenses. For the second quarter, G&A expenses represented 6% of revenue, compared to 7% in the first quarter of 2010.

For Q3 2010, we expect non-GAAP operating expenses to increase approximately $1.5 million from Q2 2010, primarily due to the integration of Radius Solutions into our APPS business.

Now moving onto operating margin, non-GAAP operating margins were 6% in Q2 2010, a significant improvement over the 10.7% operating margin loss in Q2 2009 and 410 basis points better than the prior quarter’s operating margin of 1.9%. We expect to see continued improvement in our operating margin performance as revenue continues to scale upward. Over the past year, we have made significant and permanent changes to our operating cost structure, which in turn gives us excellent operating leverage – excellent operating margin leverage.

Foreign exchange losses in the euro and British pound currencies negatively impacted EPS by approximately $0.03 per share and drove a $1.8 million loss in other income, compared to a $2.3 million loss in Q1 2010. The primary driver for the loss was foreign exchange volatility created by an approximately 8.5% decline in the euro, primarily during the month of May. During the quarter, we took steps to reduce our overall euro-based exposure such as managing our euro denominated cash account to minimum daily balances, thereby mitigating a portion of the euro-based exposure. As mentioned in the past, the company has not had any material hedging programs in place. And we do not anticipate changing our current practice.

Rounding up the P&L, our tax rate for Q2 remained at 25%. As we have mentioned over the past several quarters, changes in either the geographic mix or product mix on worldwide sales may have a significant impact on the tax rate in future quarters. In addition, our non-GAAP tax rate anticipates the renewal of the R&D tax credit in 2010.

Turning to the balance sheet, in Q2 2010, we exceeded our goal of generating cash equal to or greater than pretax net income. Total cash generated was $12.4 million when adjusting out special items such as $2.4 million in payments for acquisition-related expenses and $1.6 million in payments related to prior period restructuring, resulting in $8.4 million in net cash generation for the quarter. We ended the second quarter with $213.2 million in cash, cash equivalents, and short term investments.

Our net inventory balance was $41 million at Q2 2010, a decrease of $2.3 million or 5%, compared to the ending Q1 ‘10 balance of $43.4 million. The decrease in inventory levels was primarily driven by the previously discussed write-down of excess inventory related to certain solvent products. Our goal is to actively manage inventory levels lower in the future, but we may increase inventory levels of key components if market conditions warrant such action.

Accounts receivable increased to $75.8 million, compared to $71.7 million at the end of Q1 2010. Despite the higher AR balance driven by a strong revenue quarter, DSO declined by 0.3 days from 58.2 days to 57.9 days. The DSO improvement was driven by continued focus on cash collection efforts in our direct sales businesses with excellent progress – excellent DSO progress made in our Inkjet segment.

As we move forward, we continue to focus on effective balance sheet management as a way to enhance cash generation from business operations. Looking forward to Q3 2010, we expect our cash balance to decrease from Q2 2010 as we closed the acquisition of Radius Solutions on July 2nd, 2010, for a total cash outflow or $14.4 million. As Guy mentioned, looking forward to Q3 2010, we expect year-over-year revenue growth of approximately 20%; and assuming relatively stable FX rates, non-GAAP EPS in the range of $0.12 to $0.14 per share.

Now, we’ll be happy to answer any questions.

Question-and-Answer Session

Operator

(Operator instructions) We'll pause for just a moment to compile the Q&A roster. Your first question comes from Shannon Cross from Cross Research. Your line is open.

Shannon Cross – Cross Research

Thank you very much. Good afternoon.

Gordon Heneweer

Hi, Shannon.

Shannon Cross – Cross Research

Hi. Can you talk a bit about – just what you’re hearing, both from your end customers for Inkjet as well as from your partners on the Fiery side, in terms of demand where what verticals are working? Did it benefit us that we’re in an election year? Just anything you think – any color you can give us would be appreciated, thanks.

Guy Gecht

So overall, I think that people feel more confident that the business is gradually picking up. I think our Inkjet customers are probably the most upbeat at this point. Obviously, when we sell them 35% more than last year in ink – UV ink, they turn it to a lot of money. And I think they're winning shares because they imported from us – we – they let them get the best quality, best speed, best media, et cetera.

But overall, I think that we’re hearing that things are pretty good. I would say that the European customers may be suffering a little bit more. They're still much better off than they were last year, but not as much recovery that the US-based customers are seeing. And then lastly, in Asia, the customers are very upbeat. And it seems like businesses is very strong there.

And as far as the OEMs, the OEMs also feel like things are much more stable and gradually improving. The people that have new engines are definitely seeing customers in the corporate production centers replacing their engines, the graphic market is – maybe a little slower. Financing, as we said, is more difficult.

So you saw the results from the (inaudible), they definitely do really well on the 80 ppm and 100 ppm. I think probably they really, really well with corporate and service fields, and the graphic art is not as formed, but still was very pleased the work that – the results there with the 80 ppm and 100 ppm. And everybody else that have little ppm machines and get customers to upgrade.

So overall, I would say that things – we feel pretty good about the pipeline and the opportunities. The customers seem to be, in general – on average, vary a bit; inkjet probably more than others because I think that’s the technology that's taking over from analog. But overall, the customers’ feedback is I think what’s reflecting in our results.

Shannon Cross – Cross Research

Okay. Great. And can you talk a little bit about your cash balance and what you’re thinking on cash? Clearly, you've spent some on the acquisition, but how you’re thinking about this as we go through the year.

Guy Gecht

So we’re very pleased with the cash flow this quarter. And we continue to make sure we work hard to generate more and more cash. We’ll continue to evaluate the balance. The acquisition opportunities, as I've said many times before, we’re not really looking at the big acquisition at this point. We don’t have targets like that. When we look – we normally look at more – something that fits where we are because there're plenty of opportunities in where we are right now. And we’re possibly considering to buyback given what the stock is. That will be a continuing topic for us to consider. And we need to see. We use the balance, (inaudible) that’s the difference – to go up. That's certainly something we'll consider.

Shannon Cross – Cross Research

Okay. And then, just one final question on gross margins, you talked a bit about the warranty. But can you talk about gross margins on Fiery, and I guess, also on Inkjet, just anyways that we’ll see a rebound on that component pricing and things like that? Anything that you see coming that they can help you there – really their – first the gross margins coming up or help it?

Guy Gecht

From the Fiery, we’re pleased with the gross margins. We managed to work around component increase, like (inaudible) meters, power supply, increase in price, well on the mix, and something – add-ons. So we’ll continue to work on that, but we’re pleased with what we are. We don’t feel like we're supposed to be a lot higher than what the gross margin is.

On the Inkjet, as I mentioned, we’re disappointed. We thought that we can get better Inkjet. Well, the volume recovered to the level of $50 million. This is our highest priority in the company today to improve that. The issue is not that we’re facing. As I said, the main issue is the warranty costs around the GS we shipped so far because of the high utilization level as a main factor. We already implemented some parts change and some design change that we feel that will reduce the warranty costs down. But we have, of course, install basis. We wouldn't have those power changes (inaudible).

So we continue to work on that. We think that in the – definitely, we will get to the 40% or better in the long term. We got to go – we got to solve issues we have, so that’s a priority, as I said, highest priority. But the opportunity in the segment is there. And its full potential should be 40% or better.

Shannon Cross – Cross Research

All right. Just a one follow-up, what’s your definition of long term?

Guy Gecht

It's not this quarter. It’s not very long. Volume will continue to go up. That will help. The UV ink will continue to go help. This will help. As I said, we have things that are driving it in the other direction. The Rastek and Jetrion are relatively new startup types of business that’s putting pressure downwards. But I think in the next few quarters, we should be done with the issues that I outlined. And we'll get back to more historic level of margins.

Shannon Cross – Cross Research

Okay. Great. Thank you very much.

Guy Gecht

Thanks, Shannon.

Operator

Your next question comes from Ananda Baruah from Brean Murray. Your line is open.

Ananda Baruah – Brean Murray

Hey, guys. Thanks for taking the question. Hey Guy, just on the demand commentary, I was just wondering if you could give us a little more detail around Inkjet and controllers in both the European and North America. Europe looks like it actually was the fastest growing region sequentially. Xerox, this morning talked about seeing strengthening in Europe. I think maybe that benefited you. I’m not sure. But it seems like it could have. So could you just talk around that a little bit? Thanks.

Guy Gecht

Yes. And overall, what we feel about the business is probably the best we felt in a very long time. Things really are looking good as far as customer reactions to – customer reactions to new innovation and the products we have, and how they feel about their businesses.

As far as specifically geographically, Europe, we had an exceptionally good quarter on the Fiery side. Xerox was a big factor. As they mentioned on their conference call, that on the Inkjet side, it was the toughest quarter. We still grew from last year, but far less than we grew this quarter. Well, we think that's following a very successful – that’s for sure, the last week of the quarter, the last week of June. We actually have good opportunities next week for us to close more business there. Keep in mind that for Europe, normally Q3 is fairly slow. There're a lot of vacations lined up.

So overall demand, we feel pretty good. Given the Q3 summer months, we feel the pipeline is very strong. We relatively have new products in every category. And we continue to work on new products in every category. So that’s not the last time we're going to launch new products. And we are constantly optimistic. We continue to improve the business, both from top line and bottom line.

Ananda Baruah – Brean Murray

And on the – do you use a FedEx update? Have things started there? And should we expect them to be – show up at the – show up at all the next couple of quarters at the top line.

Guy Gecht

Yes. The project that FedEx is doing to be very efficient and very competitive is something that benefits EFI. And we’re very pleased with the partnership and strong relationship we have with FedEx, and the fact that they like our technology in critical areas. The agreement about refreshing their engine is between them and Canon. So we don’t know exactly when and how many they’re going to upgrade. They don’t buy directly from us. They buy from Canon. Canon buys from us the normal quotas, so it’s difficult for us to know when it’s going to FedEx. So the best – having said all of that, to the best of my knowledge, we did not have any revenue – operating revenue for FedEx from the FedEx project this quarter.

Ananda Baruah – Brean Murray

Do you think they wait for the new Canon project – I mean, product in the second half of the year? Is that an important product?

Guy Gecht

Obviously, they are aware of the Canon lineups. So I’m sure they're making the right decision for them what to buy and for what location.

Ananda Baruah – Brean Murray

Yes. And I guess the last one from me for now, can you just talk just on the warranty cost issue, just specifically, what costs are more expensive than you think in the spot – in the dynamics around why that’s happening?

Guy Gecht

Yes. So it’s a negative impact. It's something actually that is very good. Our customers are using GS quite a bit. Their ink consumption is about three times, sometimes better, on average, compared to the prior model of the QS. This is a very advanced, complex machine that prints over mainly 200 square feet an hour, very high quality. And we found out – and every machine comes with at least one year of warranty from EFI. That’s the standard, one year, but customers can buy higher or longer warranty. And we find out that warranty costs weren’t as much above what we expected because of the very high utilization.

Now, we believe that we know how to get it back to a much more reasonable number. And it's about replacing some parts and doing some design change that we started to do at the end of the quarter. But most of the install base, obviously, in the market is based on that the architecture that costs more to support and maintain. So we will – we'll see more and more install base of the new design. We thought that will – the design to survive much high utilization. And things will get out of warranty at some point. And so, I think that definitely, we have a plan to improve on that and get the gross margin that we can get in the Inkjet with the improved volume.

Ananda Baruah – Brean Murray

Okay. Great. That’s good for me thanks.

Guy Gecht

Thanks, Ananda.

Operator

Your next question comes from Corey Meehan with BMO Capital. Your line is open.

Corey Meehan – BMO Capital

Hi, guys. How are you doing?

Guy Gecht

Very good. How about you?

Corey Meehan – BMO Capital

Doing well. Thank you. It sounds like Fiery benefited from some positive mix through the higher-end units. Can you just go over just a little more detail on some of the drivers and, if you would, the impact with on a sequential basis?

Guy Gecht

The drivers are the usual things, the replacement cycles, so there's no engine. Customers that get to the end of their lease will buy into new engines. There's also switch from black and white to color. And there is – in the commercial market, there is also, pages moving from analog to digital.

We talked about – quite a bit on the Xerox 80 ppm and 100 ppm. It’s an excellent device that is – we worked multiple years very deeply with Xerox to optimize the Fiery business. I think both sides are very pleased with the outcome. We’re very pleased with the attach rate of the Fiery. Of course, Fiery is not the only solution that Xerox is offering. They have three options for this. And Fiery is one of them. But we’re very pleased with the collaboration and the work we’re doing together, and the actual results. And this engine's doing really well.

We’re doing really well with Konica Minolta. We’re doing really with Ricoh. And we’re doing really with Canon, so all of that contributes. Konica announced a new engine of 80 pages per minute. We really didn’t get to see revenue from this because it will ship later this year. As I mentioned, Xerox – Canon announced an improved 70 ppm that improved a little bit.

Those types of engines tend to go with a higher-end server as well as for the Xerox 1800. So that definitely helped the mix of revenue and gross margins. So that’s a good thing for us. And Ricoh will, of course, continue to refresh their lineup. So all our four major OEMs are in the process of refreshing and continuing to innovate results for us, which is very good for us.

Corey Meehan – BMO Capital

Okay. And then, just turning to the application side, if I look at the first half compared to first half of ‘09, revs are about flat. So I just want to go through – touch upon the longer term growth potential there. Do you expect more than a low single-digit or after normalizing for the acquisition as we move from the revenues to the Fiery division is higher than that attainable?

Guy Gecht

And so, we recorded 8% a year ago, I think, in the APPS in the Q2. But we had a really strong booking quarter, the best June quarter ever as far as bookings. And we did the last more subscription deals in the quarter. So we tried to push customers. In many cases, just to push the subscription. It's good. It's giving you a feeling – obviously, it's good. And those subscription revenue will come – will contribute the fourth – every quarter over the long time. So we think that that will help to get to the growth rate of maybe double digits.

We feel very good about the Radius acquisition. They are selling business process automation to the packaging segment processing industry. That’s probably the most robust, stable segment because packaging is – in that time, the good times, all these people consume packaging. And there's always a desire to optimize the packaging process. So that’s definitely something that we think we can go nicely.

So we're definitely aiming at better than low single digits or single digits. We need to prove that we can get there. But the booking in Q2 is definitely a first indication that the market is there, and people in the printing industry are looking to automate their process – the business processes and become more efficient. So I feel pretty good about where we are as far as the APPS business.

Corey Meehan – BMO Capital

Okay. Great. And then, just one follow-up, I believe you guys made a comment about G&A on a sequential basis. Do you happen to say what the – if OpEx would trend down on a sequential basis?

Gordon Heneweer

Yes, for Q3?

Corey Meehan – BMO Capital

Yes.

Gordon Heneweer

Yes. We’re going to see OpEx go up by about a $1.5 million. That’s directly related to the integration of Radius Solutions into the APPS business structure.

Corey Meehan – BMO Capital

Okay. That was total OpEx. Thanks for that clarification. Okay. That’s all my questions, very nice quarter. Thanks.

Guy Gecht

Thank you.

Operator

(Operator instructions) Your next question comes from Morris Ajzenman with Griffin Securities. Your line is open.

Morris Ajzenman – Griffin Securities

Hi, guys. Just a follow-up again, initially I guess before the call, the gross margin is a little disconcerting. But you've taken some clear explanations on it. And the item referring to higher warranty, again, I guess – actually, it sounds like it’s a problem that might be something – disguising the stuff that it could be good because of the high utilization, which is a reflection that the customers, obviously, are using the equipment. I’m just trying to get a feel for those, though, the impact – assuming – I mean, it takes a couple of quarters you’re working on better control of these plots and placements so they don’t break down as often and utilization keeps high. I mean, what increment or what hit to gross margin was that in this quarter? Is there any way you can give me some feel for the actual drag, which should turnaround based on what you articulated in capital mix in quarters?

Guy Gecht

We talked in the past about – when we get back to historic level of revenue in the Inkjet segment, we should be back at historic level of gross margin. Well, I talked about three elements that will slow us down, specifically in this quarter. Maybe the biggest one was the introduction of a new product, of the 5-meter when introduced in the quarter if (inaudible) technicians we've spoken about. Always, the first installations need a little bit more care in replacement. And the first parts cost more the next set of parts, and so on.

So what was really different this quarter that we did not factor into the outlook on the gross margin was that we expected the warranty costs on the GS to come down as it always comes down on new products as the products get mature. And it did it. And that’s actually went up a little bit. And as you mentioned, it's the best side of a good problem. The customers are winning deals. The GS is very busy. People work with the – many hours making a lot of money. And we’re working hard to keep them productive and to keep them in high production. It's costing us in time and material.

Now, we believe that we know how to overcome that. We implement changes in starts and design. But that was the most significant impact on gross margin. So if you look at the gross margins for the quarter, we said we’re not going to get 40%, but we were expecting to be somewhere above where we are and below 40%. And the biggest factor was what I talked about, the implication of utilization on the GS, the warranty costs, and things we had to do around that.

But this is not a long term problem. We have an excellent group that works on that. We came with solutions. As I mentioned, it's the highest priority in the company. And we are optimistic that we know how to solve it and make the gross margin grow to the good potential of this thing.

Morris Ajzenman – Griffin Securities

Let me ask this from you then, assuming all things being equal, the same thing now – same results on this quarter revenues. At two, three quarters out, how much high would gross margins be, 100 basis points, 200 basis points? Is this parts issue warranty under control?

Guy Gecht

Well as I said, we still believe and target the historic gross margin of 40% or better for the second.

Morris Ajzenman – Griffin Securities

Okay. So 40% could be there within a couple of quarters then?

Guy Gecht

I don’t want to say 40% in a couple of quarters, but you will see improvement in gross margin every quarter from us.

Morris Ajzenman – Griffin Securities

Okay. All right. Fair enough. Last quick question then, really, a lot of questions have been exhausted already. The R&D, going forward, as December sales are coming in here, and you – the company always prides itself on R&D spending. Well, what do you see that going on an actual dollar level over the next couple of quarters, next couple of years?

Guy Gecht

We worked on the – we made R&D more efficient. We moved some jobs overseas. And we believe that we got to a point where it needs to be. Obviously, if revenue is going to go way higher, we may go up to more opportunities and style innovations. So I would say from a dollar perspective, I will not anticipate too big of a change there. I think as a percentage of revenue, if you look at the difference in Fiery, it's higher because it's an OEM business. That’s what we contribute the products. And they are taking to upgrade and support that. On the Inkjet, it’s lower as a percentage of revenue. But overall for your side, we believe that the dollar amount is going to up, but not by a lot until the revenue is going to be significantly high.

Morris Ajzenman – Griffin Securities

Thank you.

Guy Gecht

Thank you.

Operator

Your next question comes from Richard Gardner with Citigroup. Your line is open.