Xyratex CEO Discusses F3Q10 Results - Earnings Call Transcript

Sep.30.10 | About: Xyratex Ltd. (XRTX)

Xyratex Ltd (NASDAQ:XRTX)

F3Q10 (Qtr End 08/31/2010) Earnings Call

September 29, 2010 4:30 pm ET


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

I would now like to hand the call over to 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 third 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 third quarter. Please note that all numbers are in accordance with GAAP, unless stated otherwise.

Total revenue was $430.2 million, up 75% as compared to the third quarter of last year, and down 6% from our prior fiscal quarter. Sales of our network storage solutions products were $317.2 million, or 74% of total revenue. This is an increase of $109 million or 52% compared to the third quarter of last year, and down 8% compared to $343.9 million in our prior fiscal quarter.

The increase in revenue compared to the third quarter of last year reflects strong demand across our customer base. The decline in revenue compared to the prior quarter reflects normal seasonality and some catch up with customer demand in the prior quarter.

I continue to be very encouraged with the demand momentum we are seeing with new and existing customers, and the progress we are making in increasing the scale of this business.

Sales of our storage infrastructure products were $113 million or 26% of total revenue, up $75 million or 200% compared to the third quarter of last year, and flat compared with our prior fiscal quarter. This performance reflects product shipment execution improvements in excess of our original expectations, which enables some demand to be pulled forward from Q4, in line with customer requests.

Gross margin was 17.6% for the quarter compared to 16.7% in the same period a year ago, and 18.1% in our prior fiscal quarter. The increase over last year reflects a greater proportion of storage infrastructure business, while the slight decline compared to the prior quarter reflects a change in product mix.

The gross margin for our network storage solutions products decreased to 12% compared with 14% for this period last year and 12.8% last quarter. The decrease as compared to last year is primarily due to product mix.

The gross margin for the storage infrastructure products was 33.8%, compared to 32.4% last year and 34.6% last quarter. The increase as compared to last year is primarily a result of increased revenues relative to fixed costs.

Non-GAAP operating expenses were $37.8 million compared to $33 million in 3Q of last year as compared to $35.5 million last quarter. The increase in expenses primarily related to additional R&D expenditure in both businesses, including two small acquisitions in the quarter. The increased expenditure, including acquisitions is supported by the current level of business or future opportunities we have identified.

On a non-GAAP basis, net income was ahead of expectations at $37.6 million or $1.20 per diluted share, compared to $10.7 million or $0.36 per diluted share a year ago and compared to $46.8 million in the prior quarter.

GAAP net income in the quarter was $37.2 million and included an amortization of intangible assets expense and non-cash stock compensation as well as a $3.1 million tax benefit, of which $2.7 million relates to a correction of a prior period. The reconciliation between non-GAAP and GAAP net income is provided in our press release.

Turning our attention now to the balance sheet, cash and cash equivalents at the end of the quarter was $84.9 million, up from $58.3 million at the end of Q2, in line with our expectations. Cash flow generated from operations was $37 million in the quarter.

Inventories increased by $40.5 million to $229.5 million in the quarter, in support of the product demand and customer finished goods requirements. Inventory turns were 6.1, compared to 7.8 for the previous quarter.

Accounts receivable decreased by $17.8 million in the quarter to $227.5 million. Day sales outstanding were 49, unchanged for the previous quarter.

Headcount at the end of the August quarter was 2,008 permanent employees, an increase of 103 employees or 5% over previous quarter end. Of this increase, 60% was in the Product Development Group of the storage infrastructure business through both new hires and employees joining us from our recent acquisition of optical systems completed in June.

Now, before I turn over to Steve for his comments, I'd like to provide you with our business outlook for our fiscal fourth quarter 2010 ending November 30.

For the fourth quarter of 2010, we are projecting total revenue to be in the range of $395 million to $445 million, up 63% to 83% as compared to last year, and down 8% to up 3% compared to 3Q. The comparison with the prior quarter has been impacted by the pull forward of storage infrastructure revenue into 3Q.

Our 4Q projection is represented by revenue from the network storage solutions of $335 million to $365 million, and from storage infrastructure of $60 million to $80 million.

For Q4, gross margin is expected to be 14.5% to 15.5%. We are estimating non-GAAP earnings per share to be between $0.60 and $0.86. This represents full year non-GAAP earnings per share of between $4.27 and $4.53, which is well above our previous expectations. Non-GAAP earnings per share excludes non-cash equity compensation and amortization of intangible assets.

The number of shares outstanding at the end of Q4 on a weighted average treasury method is expected to be $31.5 million. Our cash position at the end of Q4 is expected to be approximately $105 million.

In summary, this was another excellent quarter for the company. Our execution allows us to meet some portfolio requests, and based on our fourth quarter projections, our full year revenue and profitability will exceed our prior expectations, primarily as a result of strong performance in our storage infrastructure business.

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

Steve Barber

Overall, I was very pleased with our execution and performance in the quarter. All the industry dynamics and our customer market position support my confidence in our growth opportunities today and going forward.

Each of our businesses we're aligned with the market and growth leaders. And we continue to make positive progress in increasing our breadth and depth with many of these customers, as well as developing relationships with new customers, such as Hitachi GST.

Although there was a slight slowing in data storage capacity that was required in the ships during the summer months, I attribute that to the fees on impact to (NYSE:PT) sales and not to a fundamental shift in demand for storage.

The new elevated growth rate projections remain in excess of 50% comp and annual growth rate as reported by IBC and Gardner. The growth dynamics that we've seen through 2010 remain. And our strong results and expectations for next quarter reflect these dynamics.

For our Storage Infrastructure business, the long term underlying fundamental dynamic of digital content creation is what drives our economic model. Our Network Storage is equally driven by the underlying growth in data creation.

I will now review our two businesses separately, starting with Network Storage Solutions. Our fiscal third quarter revenues of $317 million up 52% year-over-year was in line with our expectations as we experienced a return to more normal market demand and conditions.

After what we believe was some catch-up in demand during the first half of the year. We actually did very well, satisfying all the demand requirements of our customers in the quarter, including some late product configuration changes for some of our customers.

The areas of strength in integrated data storage demand as offered by recent analyst reports is reflected in the demand we're seeing across our range of NSS customers.

As reported by industry research, sales of external disk space storage systems for calendar 2Q10 increased 20% year-over-year with overall sales totaling approximately $5 million.

Total external storage capacity shipped grew 54.6% year-over-year to 3,645 petabytes with Xyratex shipping over 21% of this capacity in the quarter. This outstanding performance reflects the growth and market share performance of all our customers.

For example, NetApp grew it's market share of external disk storage systems market to 11.4% in the second quarter from 8.8% a year ago. We serve four of the seven tier one OEM customers who supply storage solutions to our respective markets, namely NetApp, Dell EqualLogic, IBM XIV and EMC Data Domain.

Our contract with NetApp provides us with at least 75% of their volume demand through fiscal year 2011, and a minimum of 50% in the following year, recognizing that NetApp currently represents only 49% of our NSS revenues last quarter.

In addition, we partner with strong tier two customers such as 3PAR and Compellent. And continue to see good growth from the segment of our market. We're optimistic that upon the completion of HP's acquisition of 3PAR we will serve five of the seven tier one storage providers.

Similarly, we would expect that HP positions 3PAR's product portfolio within it's storage strategy. We would see increased sales demands similar to that experienced with Dell, IBM, and EMC following their acquisitions of EqualLogic, XIV and Data Domain respectively.

Our strategy has been to develop and maintain strong partnerships with leaders in the industry and to support each in their growth and technical strategies. Aligning our efforts with only early stage companies to present PIP of experienced management and a well funded as well as target exciting growth markets will continue to benefit Xyratex as the companies get acquired or grow into successful companies in their own right.

In addition to the volume and market share growth we're seeing by many of our customers, we're also pleased with the quality recognitions received by one of our core customers, Compellent in the quarter.

Recognized by storage magazine, Compellent was ranked highest in all categories of quality for mid range arrays providing in quality products for our customer is a primary focus of ours as it provides a major differentiator in the marketplace for our customers.

With over 25 years of experience in the design of ongoing support of high performance, high-availability enterprise-class products, we have a strong track record of design innovation in terms of market leadership, which is a significant advantage for our customers. And I believe creates technology barriers to entry for our external competitors.

Our product and service offerings provide an increasingly compelling solution to data storage providers, allowing them to focus their resources and efforts on the software layers and applications needed to mange data as opposed to designing hardware.

Key to our solutions is the provision of an intelligent enclosure management firmware layer within our products, enabling our customers to rapidly transition between the ever faster technology inflection points enabling them to focus on the core value add.

We have strong designs in positions across our current customer base with a majority of these programs outlooking solid demand through the next 12 months. We have an extensive pipeline of opportunities, and with focus and execution provide us with very material business opportunities going forward with both existing and new customers.

We believe our compelling product technology and business model will enable us to secure new design wins and enable us to further broaden our customer base moving forward.

We continue to see strong demand for SBB compliant one-store range of SATA and 6-gig SAS solutions. This architecture is a key enabler for our customers to leverage common software applications across a wide range of products from high performance to low cost entry solutions, addressing multiple entities of market segment together with common field replacement units across the entire product range.

We're seeing significant customer interest in our range of application platform products integrating high-performance processor capability with high availability of storage.

We are well positioned to benefit from Intel storage-optimized Xeon processors, C5500 and C3500 formally codenamed Jasper Forest which enables the significant performance advantages to our customers' products. We are well advanced with a number of new customer programs utilizing this technology, and need to launch new products over the next six months.

We are very advanced in the development of our next generation high density storage platform, with initial (BTU) that's now being provided to a limited set of customers for early evaluation. We see this platform providing the basis for both standalone high-density archiving solutions for our customers and the key component within the next generation, the big data platform we are developing.

We continue to see strong growth in applications demanding 1 petabyte as a minimum install. I see a clear opportunity to better enable our OEM customers to serve this market with a new and innovative architecture. Linked to this is our continued investment in the OEM-centric software layer needed to provide a scalable, reliable and customizable maintenance system necessary to enable our customers' time to market.

We recently acquired a small team with key software development skills as part of our continued investment in strengthening our capabilities in this area. We are committed to the total quality of our platforms, from initial architecture to the quality of each unit that leaves our factories, and continue to invest and expand our unique capabilities combining our hardware test process and other services to enable our customers to experience significant improvements in the field quality performance of our products, reducing field service costs and enhancing customer satisfaction.

With respect to competition, we continue to compete with in-house development teams within our larger customers. Although we believe at an executive level with our new customers, there's an overall direction towards outsourcing of the platform design. We believe we are well positioned to benefit from this trend, based on our business model, capability and execution performance.

This trend to outsource the platform, it enables these companies to redirect internal resources to value add software application development where they can differentiate their product offerings, providing a full service offering to our customers from innovative product design to international product safety approvals with a compelling offering, awarding our customers needing to assign dedicated internal resources to manage the technical aspects related to the contract manufacturer build to print before a model. Our extensive market-leading customer base reflects our success in selling our value adds to the marketplace.

Compared to the last quarter, we shipped 785.22 petabytes of external storage in our fiscal third quarter, representing a 4.5% decline over the prior quarter and 81.2% growth over a year ago. For calendar Q2 on year-over-year basis, Xyratex shipments grew 98% compared to the market's 54.6% growth in capacity. And sequentially, Xyratex experienced a 12.2% increase compared to the market growth of 7.2%.

Our third quarter '10 shipped capacity was made up of the following in terms of disk drive interface; fiber channel, 65.82 petabytes; SATA 591.4 petabytes; SAS 127.85 petabytes; and SSDs 140 terabytes.

To summarize, our business model and growth strategies continue to be supported by significant growth in petabyte storage capacity demand, relationships with the leading global storage providers, including four Tier 1 providers to date, additional opportunities to expand the depth and breadth of our partnerships with existing and new customers, and strong execution in the areas of new product development and operational efficiencies.

Moving now on to our storage infrastructure business. With third quarter revenues in the business of $130 million, we saw a seasonally strong demand, including some pull forward in shipments as required by one of our customers. On balance however, conditions reflected more normal demand in the quarter compared to the first half of the year, where business levels introduced catch-up investments for approximately $70 million, following the unusually reduced CapEx spending in 2009.

Revenue was higher than we expected as a result of production qualification with our newest customer, Hitachi GST being completed ahead of schedule. This early configuration resulted from close collaboration between the highly capable engineering and manufacturing teams within Hitachi GST and Xyratex's storage infrastructure.

Revenue in the quarter from back end test products was slightly above 70% of total revenue and was fairly evenly split between 2.5 inch and 3.5 inch disk drive form factors. We think back end test plus the added addition's increasing in the 3.5 inch segment, although 3.5 inch segment is slowing primarily as a result of the reduced near term demand in the (modular) segment.

The 3.5 inch segment is strengthening, primarily as a result of the enterprise storage demand, as well as a technology inflection with the introduction of new (storage) products with increased capacity for catch-up.

The remainder of the revenue for the quarter was in the disk drive substrate and media manufacturing segment. We estimate our market share in back end test segment continued to grow through the quarter as a result of three factors: increased adoption rate of our Optimus 2500 products, our dedicated 2.5-inch disk drive processing platform, a pick-up in demand for our incumbent dual 2.5 inch and 3.5 inch disk drive processing platform, and the addition of a third customer to have adopted both platforms.

Our strategy is to advance digital storage innovation as the leading capital equipments technology supplier to the disk drive industry with focused, collaborative innovation in three segments of disk drive assembly and integration, disk drive substrate and media manufacturing, and disk drive head fabrication.

Our industry-leading position in the disk drive assembly and integration segment is the heritage of its SI business. Our 15 years of technology innovation in back-end test server have been and will continue to be the foundation of the technology and support of this segment. Our broad product line, technology depth and collaborative approach have enabled SI to earn business with the top three disk drive manufacturers.

Disk Drive Substrates and Media Manufacturing is our targeted near-term high-growth segment. As perpendicular magnetic recording technology approaches its practical technology limit, we believe demand for media will increase at a higher rate than disk drive volumes in order for the industry to meet overall demand, the growth of demand for data storage capacity.

Our position in the workcell automation, media cleaning and recent entry into substrate optical inspection forms the foundation of our IP position in this segment.

Disk Drive Head Fabrication is our targeted longer-term high-growth segment. Next-generation energy-assisted magnetic recording technologies such as heat-assisted magnetic recording or HAMR are introduced in the inter-volume production.

Our recent acquisitions of Optical Systems Corporation with its workcell, metrology and test IP and product portfolio in the head fabrication segment along with our organic development program in next-generation dynamic electrical head tests forms the foundation of our IP position in this segment.

Though we have mentioned it in the past, I'd like to take this opportunity to remind investors of the key market factors underlining the SI business model. There are three elements that influence the revenue and growth in the SI business with each element impacting the revenue in a different timeframe.

Firstly, disk drive unit shipments, this metric is very closely monitored and reported due to the direct influence it has on our SI customers. Quarterly disk drive unit shipments have a limited impact on the SI business. In reality, the only influence is the timing of capacity additions in the period of a few quarters.

Secondly, total disk demand and capacity per platter, these metrics are indirectly monitored and analyzed on an annual basis for industry market analysts such as TrendFocus. This metric commonly referred to as areal density is a leading indicator of the rate of technology innovation by the disk drive industry, however, of more relevance to the SI business by track density and bit density metrics of disk drive products ramping into volume production.

Total disk demand and capacity per platter have a much more dramatic effect on the SI business. They are leading indicators of technology innovations that we will be ramping into high-volume production. Such new technologies generally result initially in lower yielding disk drives to the drive test process. In addition, the drives contain an increased number of data bit, but in turn require material increase in inspection, metrology and formatting capacity within the manufacturing process.

Technology transitions such as the introduction of HAMR and bit-patterned media into volume production as well as incumbent technologies reaching practical areal density limits are key top level metrics that will impact SI's model in the time horizon of four to eight quarters.

And finally, digital content creation, measured by total bit storage demand, this metric is indirectly determined and monitored quarterly by calculating the total bytes shipped by the disk drive industry. The digital content creation metrics commonly measured as the growth in total bytes shipped by the disk drive industry has been growing at over 50% combined annual growth rate throughout the period of late 2008 to today.

Areal densities are of the incumbent perpendicular memory recording or PMR technology has recently slowed to less than 30%. Digital content creation is a leading indicator of the fundamental health of the future SI model in the time horizon beyond two years, and it is this macroeconomic which forms the basis of our strategic planning in this business.

While the disk drive industry is currently experiencing a lag in unit sales growth, total bit demand and digital content creation continue to grow. The rapid pace of market shift requires SI customers to continually increase capacity as well as production capability.

Cost of ownership, capital productivity and operational flexibility are key requirements to support all our manufacturers across the disk drive supply chain and is where our focus and innovation and product roadmap is.

Collaborative technical engagements with our three customers along with our industry-exclusive position in the 3.5-inch disk drive segment has enabled us to grow share as demand has shifted for 2.5-inch disk drive segment.

We presently have an active technical collaboration with a full disk drive manufacturer who serves the enterprise segment. We're encouraged by the progress of this technology and focus engagement, although do not enter the break for potential for material volume production reductions until our 2012 fiscal year.

With regard to technology portfolio, I am pleased to report that a key patent in back-end test related to asynchronous test architecture has been validated by the U.S. Patent Office after a challenge and reexamination. This fundamental technology patent was essential to our litigation with Teradyne throughout last year. This happened at counterfeit filings that have been granted or are pending in many other countries.

Xyratex is committed to securing and protecting our individual IP right worldwide, and we are very encouraged with this confirmation of the patentability of the claims in this patent, as well as the patentability of newly presented claims that were incorporated into the reexamination process.

Clearly, our performance in the quarter across both our businesses was excellent. The growth through latter half of 2009 through 2010 to date was executed very well and has exceeded our expectations.

Our fiscal year is expected to be significantly better than originally forecasted as a result of continued strong industry dynamics in business execution, expansion of our SI customer base with Hitachi GST, expansion of our product portfolio with key technology barriers-to-entry and time-to-market launches and our product portfolio as opposed to the technology trends taking place within the disk drive industry.

In conclusion, I would like to take this opportunity to thank all our employees for their contribution to the excellent quarter and look forward to a successful Q4.

I continue to believe that with our continued strong execution, we will capitalize on many of the opportunities available to us and create a greater value for our shareholders.

That concludes our prepared comments. I'd now like to open up the call to any questions at this time.

Question-and-Answer Session


(Operator Instructions) Your first question comes from the line of Aaron Rakers with Stifel Nicolaus.

Aaron Rakers - Stifel Nicolaus

First of all, Steve, I want a point of clarification. Did you say that NetApp was 49% of NSS revenue or total revenue?

Steve Barber

NSS revenue.

Aaron Rakers - Stifel Nicolaus

So if I look at that, that would imply as much as a 20% type sequential decline. Can you help me understand that a little bit, because I think that that looks obviously much stronger than seasonality? I'm just curious what you're seeing demand-wise there?

Steve Barber

I think in the last quarter, it represented approximately 56% of our NSS revenue. So we have seen it coming. But to a degree that that's expected, it's relatively normal seasonality. And then obviously within our second quarter, we see what is then the fiscal yearend of NetApp. So we often do see that seasonal decline into 3Q and then I think into 4Q, which is currently what we're outlooking.

So in reality, no real changes in there and nothing unnatural.

Aaron Rakers - Stifel Nicolaus

And then on the other side of the business, when you look at your guidance in the pull-forward, first of all, did you see any contributions from Hitachi and are you expecting Hitachi contributions in your current quarter?

Steve Barber

Yes, we did see some contributions from Hitachi in the quarter, and that was slightly unexpected in terms of the timing. The timing was toward the end of the quarter, which I felt that was going to go forward in our 4Q. Yes, they are meaningful. They are not material in that they are not over 10%, but they are meaningful revenues and obviously a good indicator of the acceptance of our products in there. And again, we expect to see some level of real revenue in 4Q and then obviously in 2011.

Aaron Rakers - Stifel Nicolaus

Given your commentary around the overall SI space, the areal density dynamics and what we're seeing in the market right now, and if we adjust for the $70 million pull-forward in business that we saw in fiscal 2010, once we adjust that, is your guidance longer-term thinking that it's fair to assume 10% growth more or less in line with unit growth in the hard drive space or something less than that, just kind of a framework of how we should think about the trajectory of that business looking out beyond just this next quarter?

Richard Pearce

I actually don't want to particularly get caught at this stage by giving projections out either next year or going into following years. Obviously we've talked about the approximate $70 million pull-forward. We're not really definitely about that number, but we think that's a reasonable number for this year's pull-forward.

There are obviously numbers already out there in terms of the market consensus for the next year, which I guess would imply if you normalized for that pull-forward kind of 10%-ish based on the previous projections for the year around $320 million I think were the consensus for SI for this year. I guess given the best of the results that we've seen here in 3Q, that number was more like $340 million for this year.

So if you normalize that down, you're looking at $260 million to $270 million numbers. The number in the marketplace for next year are around $280 million. I'd say at this juncture we're not uncomfortable with that number.

Obviously there are a lot of unknowns in there. But I think if I look historically to the extent we do get normalized here, we would expect, all other things being equal, because of the fact that Steve has mentioned, that the growth opportunity definitely would be in excess of 10% and 13%.

But as for next year, all I can say at this time is we're relatively comfortable with the numbers that are there and that we intend to provide in the normal course of business in sort of full-year revenue guidance when we can get our 4Q numbers.


Your next question comes from the line of Shelby Seyrafi.

Shelby Seyrafi - Calyon Securities

So your largest customer revenue was down 30%-plus or so sequentially. It's historically a lower-margin segment for you. I'm curious how with a larger non-NetApp business, your NSS gross margin declined sequentially. You talked about year-to-year on the call due to mix. But what about sequentially?

Richard Pearce

I guess in the old days when we spoke maybe a couple of years ago, non-NetApp revenue as we used to call it primarily reflected tier-2 type revenue whereas if you look at our revenue profile today, and yes NetApp in the quarter 50%, Dell would have increased quarter-on-quarter to just under 20%, IBM would have increased in the quarter just over 17%.

So actually if you look at the groups of what I would call our tier-1 customers, then approximately 85% of our revenues are coming from those three customers. And the revenue profiles between the three are not significantly different.

So to the extent that NetApp is down. I guess from discussions we have recently and also previous conference call, we are seeing the slight decline actually in the NetApp margins as we migrate from the old product set into the new product sets.

So the combination of those factors then comes together with seeing the slight decline in margins almost as we predicted.

Shelby Seyrafi - Calyon Securities

I think a big part of the gross margin decline in NSS was due to volume. There was a big decline in your NetApp business, for example. But I'm curious do you go back you think to 13% plus even with the new NetApp business and your existing IBM business. Do you think we can come back to 13%-plus in the NSS gross margin?

Richard Pearce

That's what we are projecting and not what we've been projecting for a year or so. I think I've been relatively consistent during this year, saying my expectation of near mid-term margins were between 12% and 13%, which we've seen this year. And as our tier-1 business increases on aggregate, then my expectations in the longer term are 11.5% to 12.5%. And that's been a relatively consistent message over the last quarters.


Your next question comes from the line of Amit Daryanani.

Amit Daryanani - RBC Capital Markets

Could you just quantify how much of an impact the pull-in have on the SI segment in terms of revenues this quarter?

Richard Pearce

I guess we didn't put a definitive number on it. Overall, our SI revenues are up from the midpoint of our previous guidance by approximately $20 million. A good proportion of that was pull-forward.

Amit Daryanani - RBC Capital Markets

Just going back to the NetApp downtick this quarter, if I look at it historically, the only time it's been down this much really was August of '08 when you entered into the recession. So I'm wondering are you seeing incremental outsourcing that never happened this quarter away from you guys to closer to that 25% threshold maybe?

Richard Pearce

No, I guess I have come back to my previous response. We're not seeing yet anything unusual in there. And again I think we talked about this in previous quarters. Just a daze towards the back end of the quarter and the start can have sort of a $10 million or $20 million difference just in one day and sort of offsetting one another.

So there really is nothing unusual in there. We did see some stronger pools into what was our Q2. That obviously had a doubling effect. You see when in one quarter it goes up again and in the next quarter, which obviously magnifies the situation in terms of decline. But obviously in 4Q we're projecting on a whole that revenues are going up and as part of those projections we're seeing a relatively strong forecast increase in the NetApp demand within that.

So I would repeat that there is nothing unusual within that. And I wouldn't sort of point anyone to really anything into that in terms of that NetApp business overall from their perspective and already changes within their proportion at this time.

Steve Barber

And finally on inventory, up 20% or so sequentially seems high given the fact that the sales guidance even in the NSS segment is up 10% I think so. Could you just talk a little bit more on why you're building so much more inventory ahead of sales where you will see some growth but not that dramatic?

Richard Pearce

And I'll be honest with you and as candid as I can. But the inventory numbers are slightly higher than I would have actually liked at the back end of the quarter. As you can see in the 3Q results, obviously we have seen a slight revenue decline.

And I guess we come from the backdrop throughout the year of trying to catch up and trying to make sure that we can execute to our customers requirements in the face of difficult situations and getting hold of parts. Parts and strength in particular areas.

And I think we talked about this in previous call. We've made extreme efforts to make sure that we have the parts pipeline there and the parts coming in. And then do meet our customers commitments.

During the quarter, I think we just announced on top of that and we no longer feel that we are in constraint in that many areas. We built up buffers over than period. And yet, the slight decline in revenue or that sort of stabilization in that business has mean that we are in a better position as far as our customers would see it from our inventory.

And working with them, we did actually build some buffers in because obviously they've seen extreme increases in their demand in the previous two quarters. So we're probably in a little better position in terms of inventory from their perspective.

I guess from a company perspective, yes, it does have a cash impact. We have insured I'd say in all the significant areas that where we have all this inventory ahead that we do have full coverage in terms of risk from those customers.

So to a degree of aptitude I guess overall the cash is in line with our projections. So I'm happy with that. So yes I do note your point and it is something that we'll be looking at as we go forward.

Amit Daryanani - RBC Capital Markets

So finally, if I flip that around, components are getting easier to come by going forward. We would expect you to kind of work that inventory down and that should actually help you generate better cash generation going forward? Is that fair?

Richard Pearce

Yes, I think that is fair.

Steve Barber

Equally, our customers require us to hold levels of finished goods to provide them the flexibility to meet a somewhat unpredictable demand of particular configurations. So as Richard said, we have really struggled to reach those levels through the course of year because of material supply challenges.

We're finally getting a vision now where we are in compliance with all our customers FGI requirement level.


Your next question comes from the line of Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

First off, could you provide some color on the segment level revenues and then I'll add a few follow up please?

Steve Barber

In terms of next quarter?

Keith Bachman - Bank of Montreal


Richard Pearce

Yes, which we did. So we provided SI at $60 million to $80 million and NSS from 335 to 365.

Keith Bachman - Bank of Montreal

Okay. Could you just jump into a little bit on mix please in the impact to gross margins as we look out not only this quarter as well as how should we be thinking about it over the next couple of quarters?

Richard Pearce

Between the two business?

Keith Bachman - Bank of Montreal

Yes, within each of the two businesses. How will mix impact gross margin? And just to make sure, can gross margins on the storage side, can they move lower because of NetApp or anybody else. So it's gross margin context within each of the divisions?

Richard Pearce

Okay. Yes, I'll start with the SI business. And I think again, consistently through the year we forecast margins to be between 30 and 35 actually in the first three quarters, we've been at the upper end of that.

And I think consistently we have forecast 4Q to be down. And that is specific to certain product families that we're supplying in the 4Q that we've been aware of for some time now.

So I think the guidance and also the consensus is at the low end of that range, so the low 30s, but that's not an indication of where we see those margins going forward.

So as we move into next year, on a normalized basis and I'd say on an annualized basis because obviously there are volumes use which do affect the SI business just on the fewer volume of it. But I would expect to be seeing those margins get back into the sort of upper end of the 30% to 35% on a sort of annualized basis.

From an NSS perspective, I think we've seen that quite a lot of the effects of the transition of the Netapp new product range and the lower margins, again, which we consistently have discussed in the area.

So I'm expecting the product mix within the Tier I group and within the end margin profiles to remain pretty consistent into Q4 and also the early part of 2011, not that I'm expecting the latter part to change much but I'm not necessarily providing guidance on the average (time).

Keith Bachman - Bank of Montreal

So as I understand, just to follow up, you usually have pretty good visibility into the disk drive equipment orders even as you look one quarter out. So I would imagine your visibility into the November quarter are already pretty much done or close to it. But can you give some context on how that visibility looks into the following quarter, and is Hitachi and/or Hoya part of that potential group of orders?

Richard Pearce

So as we look out into the next quarter, taking your specific points on that we do have approximately 90% to 95% of order coverage on that. As you say, we normally would have at this point of time only two months to go of that quarter, and based on the nature of that business, Showa and Hoya don't make up a material part of that revenue expectation in 4Q.

As we look out to 2011, and again, without trying to give specific guidance on that, at this time my expectation is a more normalized profile in 2011. So if I look to 2010, the pull forward that Steve and we consistently talk about and we'd estimate that around $70 million, we really saw that as pull forward into Q2 primarily.

So if I look out the next year and the consensus numbers which are out there, I would expect next year to be a similar profile to this year with the exception of that pull forward into Q2. So the $50 million to $60 million in Q1 and Q2, and then the higher numbers in Q3 and Q4.

I have to say that's the best estimates that we are proposing to give for the guidance on that next quarter.


Your next question comes from the line of Ananda Baruah with Brean Murray.

Ananda Baruah - Brean Murray

Just a couple of questions. I guess just going back to SI revenues, is there any way you guys can help us think about what is sort of the maintenance component of SI is now that we are sort of past the make-up spending and kind of trailing out from the growth component that you guys talked about, how are your expectations for next year?

I guess the consensus number you said you feel it's okay. I guess that's kind of based more on the 10%-ish unit growth estimates you guys have. Any help there would be nice.

Richard Pearce

Sorry, can you just repeat? I honestly missed the start of that question there.

Ananda Baruah - Brean Murray

Certainly. Assume there's no growth and drive the next year, what would the maintenance spend be in SI?

Steve Barber

As I said in my comments, the growth is driven by unit volumes as well as capacity of the drives. Unit volumes actually is the lesser element in terms of our business volume. So it really depends on the rate of growth of individual drive capacity.

I think you got to look at the demand. Is capacity demand going to continue at 2% compound growth? If so, then you either (finish it up) with more disk drives or fewer, larger drives. So maintenance is a difficult term. I think you really got to stop at the macro (per day). You know, what is the demand for data capacity next year and is it going to continue at the 2% of growth that we've seen over the last few years? If so, you can then extrapolate backwards as to how you are going (solution that) either with more units of drives or bigger capacity drives.

And either of those would drive demand for incremental production capacity.

Ananda Baruah - Brean Murray

I guess of the 270, 280 number that you said you guys feel relatively comfortable with right now for our fiscal year '11, is there any way given the view right now that you guys have that you could give us a sense for how much of that is maintenance related growth related?

Steve Barber

We definitely interpret it as maintenance-related. So within those numbers that we are providing and where we get our comfort from, we are anticipating added (IVT) and added Gardner that the rate of digital creation will remain at somewhere between 50% and 55%, and extrapolating that is how we sort of come to our numbers.

Yes, as we've seen in 2009, if they have a slight downturn all the providers turn down their CapEx and defer capital expenditure, that can happen for a relatively short period of time as they use that for any sort of excesses they may have.

But fundamentally, potentially it catches up as we've seen this year. So we are facing I guess our feeling of being relatively okay next year, based on our expectation that digital content will continue at 55% and the economy in the state of disk drive providers are not going to sort of put them in any position that they would do something unusual, i.e. stopping either capital expenditure or ramping it up extremely quickly.

Ananda Baruah - Brean Murray

And then just quickly on I guess the 3PAR potential, I know that you guys have been pretty vocal about how EqualLogic has ramped for you as has XIV, kind of post their acquisitions. Do you have any visibility, can you give us what you guys are thinking in terms of the potential relative to those two that you see in 3PAR given where you guys stand?

Harold Lehon

Simple answer is no. Clearly we're still (inactive), the customers with the 3PAR team, but what are the implications of the details of the position behind that product we have really no visibility of at this time.

Ananda Baruah - Brean Murray

I guess that last one for me. So you guys said your inventory is a little bit higher than you'd like it to be. I mean should we just take from that that you'll let it work itself down, after the lower sales levels than you thought you had going into next quarter? And everything will be back to where you want it to be as we exit the year?

I know guys had mentioned, because I think gave me some comments about you're building ahead for some of your vendors so that you could opportunistically provide products to them as they wanted it. So is that something that's strategic it'll continue will the inventory just kind of come down as you exit the year?

Richard Pearce

We will continue to hold finished goods inventories at the levels as we've agreed with our customers and the levels that they feel comfortable with. We've potentially got slightly more than that and also slightly more than competitors as we stand today. The end of 4Q inventory will depend a little bit on how 1Q is looking and particularly in the SI business.

I talked about it a little while back and there our current expectations for those few things could change in that. But as I stand today if I were to expect, inventory is to be reducing somewhat toward the end of 4Q. But the great thing about the technology business is it cannot be changed quite quickly.

So I don't want to be hounded too much, except to say inventories are going to come down. It hasn't happened, but that is my expectation at the moment. And obviously converting some of that into cash as per the cap projections I just provided.


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

Glenn Hanus - Needham & Company

I think you said last quarter that Hitachi could be about a $10 million business here in the fourth quarter this year. Is that still roughly your expectation there?

Steve Barber

Yes, I think that's reasonable to say, yes.

Glenn Hanus - Needham & Company

OpEx, how should we think about that in the fourth quarter and going into the first two quarters of next year?

Richard Pearce

I would expect R&D to increase slightly into the fourth quarter, and that's primarily a function of opportunities, maybe these two small acquisitions in 3Q, which we had part of the incremental expense coming into 3Q. But we acquired in sort of mid-quarter. So we'll see the full impact of that which will probably add another $0.5 million into the R&D in total. We are still adding R&D resources in terms of the future opportunities that we see.

I wouldn't expect a significant increase in SG&A into 4Q. As we go into next year, I guess in the early half, I wouldn't be looking to see those expense levels change much. There's a number of variable in there. Exchange rate is starting to go slightly against us in dollar terms from where it was at the beginning of the year. With that said, the majority of next year is hedged at pretty similar rates to this year. So it shouldn't have a significant impact on us.

I guess the one thing I would say about the expenses is, yes, we know that they have increased during this year. 2009 was definitely a year where because of the economic uncertainty, we took down expenses as much as we could, because I guess 18 months ago there was real concern in the market at Xyratex's quality. That concern is working its way out, and we're having to reinvest in certain areas.

Competition has decided to scale their business, as well as the opportunities that we face it is the right thing to do in our opinion. So we have seen an increase in expense this year and we are keeping a close eye on that. And as I said, I would expect that to stay relatively stable in the early part of next year.

Glenn Hanus - Needham & Company

And then back on the network storage solutions business as we look into next year, I think given that you are going back to there will be some Jabil component again, models are sort of flattish year on year, is that roughly where you are still at?

Richard Pearce

Yes, I think we are for this stage, yes.


Your next question is a follow up from the line of Aaron Rakers with Stifel Nicolaus.

Aaron Rakers - Stifel Nicolaus

I guess my question was just asked, but I will slip one in here anyway. I guess for this November quarter, is your contributions from your three top customers expected to remain relatively unchanged by customer?

Richard Pearce

Relatively yes. I'd say the relatively equal increases across that make it slightly higher for NetApp obviously because of the slight offset we've seen in 3Q, but not that material.


There are no further questions in queue at this time. I would now like to hand the call back over to management for any closing remarks.

Brad Driver

Once again, thank you for joining us this afternoon. With regard to upcoming investor conferences, we will be presenting at the Needham HDD Conference to be held in Boston on November 4 and the Barclays Investor conference to held in San Francisco on December 8 and 9, as well as participating in the Stifel Nicolaus one-on-one conference on November 11.

The Needham and Barclays presentation will be webcast and you can access them on our investor page. So please check our investor calendar webpage for the exact time.

We will report our fiscal fourth quarter and fiscal year results around the second week of January. In the meantime, if you have any additional questions, please feel free to call or email me with your questions.

Have a good rest of the week, and we look forward to speaking with you in January.


Thank you for you participation in today's conference. This concludes the presentation. You may now disconnect your lines. Good day.

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