Xyratex CEO Discusses Q4 2010 Results - Earnings Call Transcript

| About: Xyratex Ltd. (XRTX)

Xyratex Ltd (NASDAQ:XRTX)

Q4 2010 Earnings Conference Call

January 6, 2011 4:30 pm ET


Brad Driver - VP, IR

Steve Barber - CEO

Richard Pearce - CFO


Shebly Seyrafi - CapStone investments

Gary Wey [ph] – Brean Murray

Glenn Hanus – Needham & Company

John Peck - BMO Capital Markets


Good day, ladies and gentlemen, and welcome to the fourth quarter Xyratex earnings conference call. My name is Jeremy and I'll be your operator for today. (Operator Instructions)

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

Brad Driver

Thank you Jeremy 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 fourth quarter and full fiscal year 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 page at www.xyratex.com.

I'd like to remind everyone that today's comments, including the question and answer session will include forward-looking statements, including but not limited to a forecast of future revenue and earnings and other financial and business activities. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. These risks and uncertainties are detailed in Xyratex's filings with the Securities & 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 would now like to turn the call over to Richard to review the financial details of the quarter and the full year.

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 Web site.

I'd now like to provide you with some commentary about our results for the full fiscal year and the fourth quarter of 2010. Please note that all numbers are in accordance with GAAP, unless stated otherwise.

Revenue for the full year was $1.6 billion, up 84.6% compared to fiscal year 2009. Revenue for the fourth quarter was $397 million, up 63.6% as compared to the fourth quarter of last year and down 7.8% from our prior fiscal quarter. Sales of our network storage solutions products were $327 million, representing an increase of $123 million or 60.6% compared to the fourth quarter of last year and up 3% compared with $317 million in our prior fiscal quarter.

The increase in revenue compared to the fourth quarter of last year reflects strong demand across our customer base.

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.

Revenue for the full year increased 65.2% to $1.26 billion in 2010 compared to $762 million in 2009. Accounting for 78.6% of total revenue and 59.3% of gross margin. The fiscal year performance for our NSS division reflects very strong growth across our major customers and some catch-up demand from 2009.

Sales of our storage infrastructure products were $70 million, up 77% compared to the fourth quarter of last year and down 38% compared with our prior fiscal quarter. Revenue for the full year increased 224% to $343 million compared to $106 million in 2009. Accounting for 21.4% of total revenue and 40.7% of gross margin.

Fiscal year performance for our SI division reflects stronger demand for our capital equipment by our two largest customers and a material amount of catch-up demand after a year of very little capital investment in 2009.

For the full year 2010, gross margin was 17.5% as compared to 14.4% in 2009. The increase from the prior year was primarily due to the increase in SI revenues.

Gross margin for 4Q 2010 was 16.1% compared to 15.6% in the same period a year ago and 17.6% in our prior fiscal quarter. The change from the prior quarter was primarily due to the decrease in the proportion of SI revenues.

For the full year, gross margin in the network storage solutions business was 13.3% as compared to 12.9% in fiscal 2009. The gross margin for Q4 2010 was 13.3% flat as compared to a year ago and up compared to 12% in the prior quarter. The increase as compared to the prior quarter is primarily due to product mix, specific to this quarter.

For the full year, gross margin in the storage infrastructure business was 33.4%, compared to 26.6% in fiscal 2009. The gross margin for Q4 2010 was 29.7% compared to 28.7% last year and 33.8% in the prior quarter. The increase as compared to last year is primarily a result of increased revenues relative to fixed costs.

For the full year, Non-GAAP operating expenses increased by 17.7% to $144.6 million as compared to $122.8 million in 2009. The primary reason for the increase is the growth in the overall business. In addition to certain acquisitions undertaken during the year.

Non-GAAP operating expenses in the quarter were $43.5 million compared to $29.6 million in 4Q of last year and $37.8 million last quarter. The increase in expenses is primarily related to additional R&D expenditure in both businesses, including two acquisitions in Q3.

We plan to maintain the current levels of expenditure through the first half of 2011 in support of the current level of business and in recognition of the industry dynamic in our competitive position. With in the storage industry technology continues to evolve rapidly. Our success is predicated on Xyratex being the forefront of new technologies and our ability to demonstrate a long-term technology product roadmap, in turn providing a leadership position for our existing and potential customer base.

As a result we have increased our expenditure and R&D investments to both meet near term business demand and position us well for long-term opportunities, many of which we have already identified. We therefore feel the current levels of investments are appropriate.

For the fiscal year 2010, GAAP net income was $139.4 million or $4.46 per diluted share compared to GAAP net loss of $16.4 million for fiscal year 2009. On a non-GAAP basis, full year net income was better than our original expectations of $135.7 million or $4.34 per diluted share compared to $1.5 million or $0.05 per diluted share a year ago.

GAAP net income in the quarter was $32.3 million or $1.02 per diluted share. On a non-GAAP basis net income for the fourth quarter was $21.9 million or $0.69 per diluted share compared to non-GAAP net income of $7.9 million or $0.26 per diluted share a year ago.

GAAP net income in the quarter includes $13.8 million or $0.44 per diluted share relating to the reversal of evaluation allowance against deferred tax assets. As a consequence of this reversal, we are anticipating an effective tax rate in 2011 of approximately 15%. Although cash tax rate is likely to remain at approximately 5%.

The reconciliation between non-GAAP and GAAP net income is provided in our press release.

Cash and cash equivalents at the end of the quarter was $90.8 million, up from $84.9 million at the end of Q3, but below our previous expectations due to both the timing of and slightly lower levels of (inaudible) in the quarter. Cash flow generated from operations was $10 million in the quarter.

Inventories decreased by $33.8 million to $195.9 million in the quarter. Inventory turns were 6.7, compared to 6.1 for the previous quarter.

Accounts receivable decreased by $18.5 million in the quarter to $209 million. Day sales outstanding were 48, compared to 49 in the previous quarter.

Headcount at the end of the November quarter was 2,150 permanent employees, an increase of 142 employees or 7% over the previous quarter. Of this, approximately 20% was specific to R&D, with the balance in support of worldwide operations growth offset by a reduction of 263 manufacturing contractors in the same period.

Now, before I turn the call over to Steve for his comments, I would like to provide you with our business outlook for our fiscal first quarter of 2011 ending February 28 and our revenue projections for the full year ending November 30, 2011.

For our first quarter of 2011, we are projecting total revenue to be in the range of $355 to $405 million, up 11% to 27% as compared to last year, and down 11% to up 1% compared to 4Q '10.

This is represented by revenue from network storage solutions of $330 to $360 million, and from storage infrastructure of $25 to $45 million.

For our full fiscal year 2011, we are projecting total revenue to be in the range of $1.55 to $1.73 million. This is represented by revenue from our network storage solutions of $1.26 to $1.37 billion, and from storage infrastructure of $290 to $360 million.

NSS revenues are expected to be slightly lower in the second half of the year as we experience a transition in customer demand profile during the course of 2011. This includes the previously discussed dual sourcing of our major customer. The anticipated product in sourcing of a material customer of their next product refresh. The anticipated increase in demand following the recent acquisitions of two of our existing customers and the anticipated demand of the recent product launch of one of our major customers.

We anticipate approximately 75% of SI revenues being recognized in the second half of fiscal year 2011, reflecting more typical seasonality of the HDD industry, compounded by the introduction of new products and new customers during the year. While we do not yet have orders for the majority of these systems, we are confident in the forecast that we are seeing from existing and new customers.

For Q1 gross margin is expected to be 13.7% to 14.7%. We are estimating non-GAAP earnings per share to be between $0.12 and $0.48. Non-GAAP earnings per share exclude non-cash equity compensation and amortization of intangible assets.

The number of shares outstanding at the end of Q1 on a weighted average treasury method is expected to be $32 million. Our cash position at the end of Q1 is expected to be approximately $105 million.

In summary, we had a very good quarter and a remarkable year. I believe we have improved our competitive and strategic position to better serve our current customers and take advantage of many of the future opportunities we have identified in our review of the industry dynamics taking place in the markets we serve.

Finally, before I turn the call over to Steve I would like to briefly comment on our recently approved board dividend program. Our board has approved a dividend program that will commence in fiscal Q3 2011 providing an annual yield of approximately 2% in line with the industry average. Given our past years performance our cash position and confidence in the long-term strategy we felt it appropriate to return some value to our shareholders.

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

Steve Barber

Thank you, Richard. Good afternoon, everyone and thank you for joining us today. Overall, I was extremely pleased with our execution and performance in the quarter and the full year. Our fiscal 2010 performance represents a record revenues earnings by the company.

We made significant progress across our business and further strengthening the company's position. The benefit from the significant growth in digital data creation of storage including we broadened our storage infrastructure product portfolio and disk drive recording head and media market with the acquisitions of OSC and NSS. And secured the design with (inaudible) in technology.

We added Hitachi GST to our SI customer base. We expanded our relationship with one of our larger (inaudible) customers with their launch of a new major midrange product in the quarter. And we strategically positioned the business to address the needs of the emerging high growth high performance computing sector so our investment in (inaudible).

We continue to project growth of IT spending. Double-digit disk drive unit growth and more than 50% compound growth of data creation in 2011, long-range demand forecasts of our major customers.

With each of our businesses, we're aligned with the market and growth leaders. We continue to make positive progress in increasing our breadth and depth within many of these customers, as well as expanding our market in our Si business, in fiscal 2010.

I will now review our two businesses separately, starting with Network Storage Solutions. Our fiscal fourth quarter revenues of $327 million, up 60.6% year-over-year was in the low end of revenue guidance as we experienced some softening in the November quarter demand compared to initial customer forecast and expectations.

Based on our discussions with our customers and current forecasts we believe this relates to the timing of end user sales, as opposed to any slowdowns in overall demand across our customer base.

Our full year revenue of $1.26 billion, which is up 65.2% year-over-year, is a record fiscal year performance and reflects the strength and the growth of our diverse customer base on executing growing the business.

To date we have benefited from the massive consolidation with the storage market. As a result, we now serve five of the seven major data storage providers, namely NetApp, IBM, Dell, EMC, and HP. In each case, Xyratex provides key hardware technology supporting these customers’ major storage product platforms.

Our strategy has been to develop and maintain a strong partnership with the leaders in the industry and to support each in their growth of technical strategies. We've been successful in aligning our efforts with early stage companies with key IP, have experienced management teams and are well funded.

Our deep understanding of disk drives falls for both the NSS storage systems business and our SI disk drive business provides a key strength in our overall customer offering.

Our intelligent enclosure management firmware app within our products enables our customers to rapidly transition between the ever-faster technology inflection points enabling them to focus on the core value add of their data storage management application.

This know how translates into comprehensive system tests that allows us to identify and remove disk drives and other components indicating signs of early life defects prior to us shipping product. This in turn results in enhanced field quality performance for our customers; reduced field service calls and enhances end user customer satisfaction.

We continue to invest in next generation product technology, an innovation across our range of platforms providing compelling products to enable our customers to address multiple end-user markets.

Our full platforms include our SBB compliant one-store range of SATA and 6-gig SAS solutions enabling our customers to leverage common software applications across a wide range of high performance to low cost entry solutions, as well as 2.5 inch and 3.5 inch disk drive form platforms. Common field replacement units minimize field service calls. Product development costs are reduced and time to market schedule is minimized.

Our high-density storage platform extends the one storage family to provide key enabling technology to address the rapid growth in high storage capacity applications. (inaudible) level units of our next generation high-density platform are currently under evaluation with a number of our customers. Our range of application platform integrating high performance capability with high availability storage in both ATX and SBB full factor based high availability solutions.

These products address the increasingly clear market trend towards the serverization of storage, enabling customers to run their applications closer to the storage in a single integrated appliance model with the ability to add expansion storage as needed.

In support of the extension of the strategy of providing foundational enabling technology for OEM customers, we recently announced we have reunited with the core founding architectural and development team. Through the acquisition of (inaudible) and bringing Dr. Peter Graham and Peter Javanic back together within the Xyratex organization. Together they are leading our investment in Lustre based storage solutions and ensuring that Lustre continues to be a nation of high performance computing data storage.

Lustre is broadly recognized as the leading open high performance cluster with over 60% share of the top 100 HP systems globally. We are committed to working with all of stakeholders in the Lustre open community in order to continue the ongoing development in support of Lustre.

Recognizing the growth in high performance Lustre file systems we are focused on enabling our OEM partners to leverage Lustre in their next generation HP technologies.

At fiscal fourth quarter we shipped 804.17 petabytes of enterprise storage representing a 2.4% growth over the prior quarter and 84% growth over a year ago. The data storage market that we and our OEM customers serve continues to exhibit strong growth as reported by industry research sales of external disk space storage systems for calendar 3Q 2010, increased 19% year-over-year basis to nearly 5.2 billion. The calendar Q3 on a year-over-year basis, Xyratex grew 81% compared to the market's 65.2% growth in shipped enterprise storage capacity. Overall in calendar Q3, we estimate that Xyratex once again maintained it position as a leading player in the market shipping over 18% of this capacity in the quarter.

On an annual basis we shipped over three (inaudible) of enterprise storage almost doubling our 2009 shipments. Our fiscal 4Q shipped capacity was made up of the following in terms of disk drive interface; fiber channel, 75.39 petabytes; SATA 577.06 petabytes; SAS 151.44 petabytes; and SSDs 270 terabytes.

We believe we are well positioned to benefit from the continued growth of data storage based on our relationship with leading global storage companies and our compelling technology portfolio. We are investing in R&D and remain focused on delivering innovative solutions to benefit our customer’s products, driving operational efficiencies and working to secure new design wins with both existing and new customers.

Moving on now to our storage infrastructure business as Richard mentioned revenue for the fiscal full year was $342 million well above our original expectations. This included catch up investments in the first half of the year of approximately 70 million holding an unusually reduced Industry CapEx spending of 2009.

As Richard has stated we anticipated revenue patterns for 2011 we felt more typical with disk drive seasonality with up to 75% of global revenue being recognized in the second half of the year. Our fiscal year 2011 revenue outlook reflects anticipated contribution in the latter half of the fiscal year from the broadening of our product portfolio into the (inaudible) and medium manufacturing and head fabrication segments, as well as the addition of Hitachi GST as a new customer.

Our focused collaborative innovation with customers along with organic investments links the acquisition strategy of targeted to approximately offset the catch-up investment spending we benefited from in 2010 fiscal year. In our fourth quarter revenue from drive system products were slightly above 60% of total SI revenue with more than 60% of it being in support of 3.5-inch form factor systems.

We find capacity additions increasing in the 3.5-inch segment while the 2.5-inch segment remains soft primarily as a result of reduced new term demand in our mobile segment. The 3.5 segment is strengthening primarily as a result of the enterprise storage demand as well as the technology inflection with introduction of new disk drive products with increased capacity for data.

The remainder of the revenue the quarter was the disk Drive Substrates and Media Manufacturing segment. We estimate our market share to be approximately 70%. During the quarter we believe we grew share as a result of three factors. The steadying increasing adoption rate of Optimus 2500 product, 2.5 inch platform, the continued strength and demand of our incumbent dual 3.5 inch and 2.5 inch disk drive platform and our expanding customer base.

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 25 years of technology innovation in back-end test server has 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, which accounts for approximately 80% of the marketplace.

Disk Drive Substrates and Media Manufacturing is our targeted near-term high-growth segment. As perpendicular magnetic recording technology approaches its practical technology limit in areal density.

Our recent acquisitions of Solutions Link which includes (inaudible) and certified product portfolio and Media Test IP know how combined with our incumbent position in work flow information, media cleaning and recent entry into substrate inflection of our expanding IP position in the segment.

Disk drive head fabrication is our targeted longer-term segment high growth segment. As next generation Optic Technology transitions such as HAMR introduced into volume production. The acquisition of MRS along with our previously announced OSC works (inaudible) and product portfolio complimented by our organic development program focused on next generation dynamic electrical head test all formed the foundation of our ever expanding IP foundation and head fabrication segment.

Our growth model is based upon a clear understanding that is driving this industry innovation roadmap for areal density. Our growth model parameter for planning and managing our businesses are as follows: digital content creation and storage is modeled at a conservative 55%, areal density is modeled at approximately 25% compound ground Emetics along with other parameters results in a calculated disk drive growth rate of approximately 12% compound growth.

Market shift in the (inaudible) segment, particularly in the consumer segment requires customers to continuously increase capacity.

Cost of ownership, capital productivity and operational flexibility are key requirements to support all manufacturers across the disk drive supply chain and is where we focus our innovation and product roadmap. As a result we plan to maintain our R&D spend rate in the first and second quarters at the run rate we executed in the fourth quarter.

In 2011 there are several very significant new products that we believe our customers will adopt in the latter half of the fiscal year. We anticipate approximately 54% of our fiscal year revenues will come from new products that are presently in engineering development and customer complication. As a result we anticipate that greater than 85% of revenues in fiscal year 2012 will come from products that were developed in 2010 and 2011.

Beside the market and undergoing dramatic changes driven by three primary factors. Companies are assigning an increased proportion of internally funded R&D into Areal density innovation as a way of development. Technology challenges in the equipment development are requiring significant increases in R&D spending on equipment and innovations. And independent specialized equipment companies lack the business scale and global support structure (inaudible).

Our strategic plan is focused on executing our defined product roadmaps, securing the technology of the leadership position within the industry and providing a continued stream of equipment innovation supporting the areal density roadmap of the disk drive industry.

The critical factors in our collaborative engagements to our customers include cost of ownership, capital productivity and operational flexibility. Xyratex business scale and global infrastructure will provide the operational efficiency leverage in the industry to enable the business level to maintain high levels of R&D investments in capital innovations.

In summary, fiscal year 2010 represents an important year in the company's development and one that we will reflect on as strategically and financially significant for the following reasons. We delivered record revenues and earnings of $1.6 billion and non-GAAP earnings per share of $4.34. We invested in core and new technologies, both organically and through acquisitions, expanding our markets and positioning us for growth in core market segments. And we added some significant new customers and product lines.

As Richard mentioned in his comments I'm also pleased that our board has approved a shareholder dividend program and that as a result of our 2010 performance and confidence in our long-term strategy for the business I believe this is a significant milestone for our company and reflects our focus on returning value to our shareholders.

In conclusion I would like to take this opportunity to once again express my sincere thanks and appreciation to all our employees for their contributions to an excellent quarter and full year. We should all be very proud of the company's performance in 2010.

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

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

Question-and-Answer Session


(Operator Instructions) And our first question comes from Shebly Seyrafi from CapStone investments. Please proceed.

Shebly Seyrafi - CapStone investments

Yes. Thank you very much. Can you elaborate a little bit more about this softening of demand that you saw in the month of November. How much of that was from your largest customer versus your other customers in NSS and also maybe you can talk on when you saw this slowdown, was it in late October or what part of November you saw this slowdown? Thank you.

Richard Pearce

Yes, sorry I think just on the slowdown. It was more throughout the November quarter and in fact it was more towards actually the beginning of the quarter, hence my comment in terms of the cash and the timings within the quarter. So we actually saw revenues start to pick up again in October and November. In terms of whether we had specific customers in there, not really, it was kind of across the board softening and only minor I would say. So I think a question we often get on this call is what the proportions of revenue across the customers so maybe to address that now.

Netapp represented around 50% of our revenues in the quarter, which was pretty consistent actually with the previous two quarters. DOW was around 17%, again relatively consistent with the previous quarters and IBM around 14%. So there was no particular customer in there that we were seeing a softening from.

Shebly Seyrafi - CapStone investments

Great. Can you elaborate a little bit more on this transition that is taking place and why you think that in fiscal H2 of this year you expect your NSS business to decline?

Richard Pearce

Yes. I think the four points mentioned in the call, the first one obviously from our major customer. I think we've talked in quite a lot of detail over the last quarters around the transition from the older product that we provide to the newer product levels and that we're moving from having 100% of that new product that we had in 2010 to having 75% of that product in 2011. That transition between sort of 100% and 75% will happen over the year. So it's likely that we'll have a greater proportion than 75% for the first quarter and the second quarter before we go down to potentially the 75% level at the backend.

Again, as we've talked about previously, there's been an amount of consolidation and we've seen in some of the larger company's that Steve's talked about acquiring some of our Q2 customers over the last couple of years. And is our expectation that on a product line with one of those customers that they will be in sourcing that product line towards the backend of the year so hence we'll see the benefit of the revenues and bigger end. The first half of the year and those start to fade out in the backend of the year. That is balanced with, on the same point in terms of consolidation.

Actually, we've seen two significant Tier One company's, one who is a current customer and one who is a new customer acquiring two of our, what we would call the Tier Two customers over the current period and in a similar way we've seen with other acquisitions, our expectation is that the products that would actually ramp during the year and if so, the new product that was introduced by one of our major customers this last quarter. We do expect to see that ramping during the year so there is some slight counterbalancing of revenues we expect to see shifting but that's really the transition that I'm alluding to.

Shebly Seyrafi - CapStone investments

And finally for me I think you are guaranteed what 50% of your largest customers business after this fiscal year? Do you expect another step down in fiscal 2012?

Richard Pearce

In fiscal 2011 actually we've got 75%. In fiscal 2012, it will be 50% as a minimum, which I think we've previously talked about. At this stage we've not gone out of 2012 into 2013 to have those discussions yet.

Shebly Seyrafi - CapStone investments

So that's a distinct possibility considering what they just did, right?

Richard Pearce

I guess I can't really.

Shebly Seyrafi - CapStone investments

Thank you. I appreciate it.

Richard Pearce



Our next question comes from Ananda Baruah of Brean Murray. Please proceed.

Gary Wey [ph] - Brean Murray

Okay. This is Gary Wey [ph] for Ananda Baruah. Thanks for taking the question. My first question is do you guys think there will be an incremental to your storage infrastructure revenue guidance if the drive vendors what you ask them incremental capacity at some point this year? And I have a follow-up.

Steve Barber

We based our outlook on the forecast and our view of what the demand will be in 2011. Based on our modeling of capacity growth and unit’s volume growth, we're confident in our forecast. There's always the potential beyond our current outlooks and those you've seen by our customers. I think the industry is currently erecting around 11% to 12% unit growth over the course of the year. The debate will be about areal density because of the technology challenges that are facing the industry on the current recording.

So there is some uncertainty as to when areal density will be through the course of the year. We've taken a view of what we're think it will be in our modeling and that is what we are seeing with our customers. So I think we're confident with the guidance that we've given on the call today but there's always the potential for us to be on the conservative side.

Gary Wey [ph] - Brean Murray

Okay. Thanks, that was helpful. My second question is just try to guess from yourselves, whether you think the part could become as large as ecologic? Thanks.

Steve Barber

Difficult to say. It's a different market space. It's much more high end currently. We don't have any insight yet as to regard HP's intention. Whether they intend to lead the part in that space or potentially broaden it into an affordable marketplace. I think the comments I could say right now would be that the HP sales force behind that product potentially, is that we could potentially see upside demand with what we saw historically with 3Par alone.

Gary Wey [ph] - Brean Murray

Thanks, that's all for me.

Steve Barber

Okay. Thank you.


Our next question comes from Glenn Hanus with Needham & Company. Please proceed.

Good afternoon. Could you comment maybe on the system infrastructure business? Could you comment a little bit on the ramp you're seeing at Hitachi and your outlook for next year?

Steve Barber

I'm not comfortable giving any guidance customer by customer. We continue to be encouraged by our relationship with Hitachi. And we've included in our forecast they've provided us but I don't feel it would be appropriate to provide specific details to their investment plans.

Glenn Hanus - Needham & Company

Okay. Maybe talk about gross margin trends in each side of the business for modeling next year?

Richard Pearce

I think as I said earlier on the NSS side of the business we did see some mix benefit in the quarter, which I see as being one off, and hence the margins in the quarter of 13.3%. We, as I've done over the last year continue to forecast on the longer term of product margins there between 11.5% and 12.5% with my expectation that in the first half of the year, we will be towards the higher end of that guidance. In the first half of the year we will be towards the higher end of that guidance range.

In the SI business as we look out, again we've consistently guided around 30% and those levels actually increasing over the last year, primarily related to the volume of that business. This year we were around 33.4% and I see a relatively similar percentage next year based on not a dissimilar revenue. I think the midpoint of our range of around $325 million in revenue, just slightly under the revenues that we've had this year but anticipating a pretty similar range to this year.

Glenn Hanus - Needham & Company

Could you comment a little bit more about the OpEx investment in the first half next year? Is that mostly R&D in the system infrastructure business and maybe you could elaborate a little?

Richard Pearce

It's actually a mixture. Our increased R&D expenditures have been relatively evenly split between both sides of the business within the SI side of the business as Steve talked about within his comments. We've been introducing the new Optimus system into both 2.5 and 3.5 and have significant expenditure related to that, which will continue in the first half of the year, looking to introduce those products, particularly the new ones in the back half of the year.

As well as that we've invested quite significantly to the optical inspection equipment and the new customer as well as obviously the acquisitions that we've made in Q3 that we talked about on the SI side of the business in OSC and more recently on December 1, MRS.

On the NSS side of the business, as again as Steve mentioned, we're making some significant investments in terms of the Lustre technology that we're bringing those skills back together. As well as looking at the application platform side of the business and as we've discussed the serverization of that business, which is a relatively new area for us, requiring relatively significant investments.

And of course the new product we introduced or one of our customers introduced at the backend of last year. That has taken significant expenditure to get that product to it's level and those expenditures will continue as we bed down that product and ramp it into the back half of next year so hopefully that is a relatively comprehensive list there across the two businesses.

Glenn Hanus - Needham & Company

Thank you very much.


Our next question comes from John Peck with BMO Capital Markets. Please proceed.

John Peck - BMO Capital Markets

Thanks for taking the question. Let me ask again about Glenns question on the SI business. Of your guidance for the fiscal year, how much to you guys expect from new customers versus (inaudible)?

Steve Barber

I'm not totally comfortable providing that information because it would give some indication to the intentions of the new customers. I'd reiterate the comment saying we continue to be encouraged by our engagement with new customers. We see more changes with both new and existing customers as we broaden our capability into the component side of the marketplace. The acquisitions we've made together with the internal technology we have, allows us now to provide equipment in the media side of the business as well as the recording head technology side of the business. Both the combination of new customers and new product technology revenue stream factored into the outlooks we've given on SI.

John Peck - BMO Capital Markets

Can you say whether the contribution for the new customers, is it going to be more on the traditional driver company's or is it more of the media and head guys?

Steve Barber

I think the drive side of the business will continue to dominate. It'll be our largest simply because of the scale of those pieces of equipment.

John Peck - BMO Capital Markets

I'm asking within the newer customers?

Steve Barber

I'd rather not get into specifics about individual customers demand.

John Peck - BMO Capital Markets

Okay, that's fair enough.

Steve Barber

I think the component side; we'll start to see more growth as we go into 2012. We'll start to see good indications this year of demand. I think really the anticipation is we'll start to see more demand of component technology expansion as typically recording becomes more challenged and then we'll start to see growth.

John Peck - BMO Capital Markets

Okay. I'd like to ask just because it is a growing concern as how much does your guidance factor in share loss potential from Teradyne?

Steve Barber

I think we factored in, recognize we do recognize our customers are wishing to deal forth. We know that today with one of our current customers based on our outlooks of a degree of products being supplied by competition.

John Peck - BMO Capital Markets

Okay. Thank you.


We do have a follow-up question from Shebly Seyrafi with CapStone investments. Please proceed.

Shebly Seyrafi - CapStone investments

Yes, thank you. So how much visibility do you have to your SI business this year and in particular in fiscal Q2? You're talking about pretty sizable ramp to hit your full year target? How much visibility do you have say for at least fiscal Q2? I mean do you expect meaningful ramp in Q2 or do we think about fiscal Q3 or when it spikes?

Richard Pearce

I think we should be thinking that Q3 is where it spikes. We will see an increase in Q2 but obviously based on the mid quarter of our guidance, full year and first quarter and our expectations that approximately 75% of the business will be in the second half of the year. That does not lead to too great a ramp in Q2. It will be approximately 30% type ramp in Q2 but, and we've got relatively reasonable visibility obviously into Q1 and Q2. As you move into the back half of the year again we have reasonable forecasts from our customers and estimations at this stage and based on that we have a good degree of confidence in those numbers in the back half of the year.

Shebly Seyrafi - CapStone investments

And I guess that's because new customers are expected to really go into revenue in fiscal H2? Is that the way you think about it?

Richard Pearce

That would certainly be in the second half of the year rather than the new customers. Yes.

Steven Barber

This is not unusual. I mean the private industry will leave installation of equipment until the last minute when they need it and what we're seeing this year is a more typical phasing of capital equipment installations inline with the second half peak demand volume.

Shebly Seyrafi - CapStone investments

And for your largest customer you have a lower segmented gross margin and so as that business with the customer becomes a smaller percentage of NSS in the second half shouldn't your NSS gross margin improve on a basis?

Richard Pearce

I don't think we've ever said it's the lowest of all of customers but obviously a major customer in NSS with a very competitive margin profile. The other customers we have in that side of the business are also major customers but also with very competitive margin profiles. The kind of non Tier One's as I would put them that we've previously had in there that commanded higher margins but significantly lower revenues have really converted now into Tier One customers and therefore they're all with those competitive margin levels in that side of the business.

Shebly Seyrafi - CapStone investments

Okay and the softening that we talked about earlier. That ended, it was started throughout fiscal Q4 and it ended. Are you seeing strength now, early January? Are you starting to see actually flipping all the way around to strength among the customers in that business?

Richard Pearce

Yes we saw, obviously a good November as I talked about in 2010 we provided guidance for the first quarter which shows a reasonable increase, sort of 7%, 8% in that side of the business as a mid point in Q1. And that's obviously based on what we've already seen today being a month into that quarter. So I guess the short answer is yes we are seeing strength in that side of the business in this quarter.

Shebly Seyrafi - CapStone investments

Okay and also in the SI business you're going to spend more, you're going to start to emphasize more the head side? Maybe I missed this? What portion of your SI business is head related now and where do you see that going over the next year or two?

Steve Barber

It's very limited today. As I said our business really comprises the core. The nearer term growth side of it is going to be in media substrate where we're already positioned with the acquisition. So we expect those to be more of a 2011 growth area. In the longer term we see head manufacturing as our third phase of growth. We already see some traction from our OSC acquisition. And as you are aware some of drive company's are expanding in the head and media capacity.

At the moment with new facilities coming online we think we are well positioned to deploy that OSC equipment into those installations, but I think it's in that order driving tests (inaudible) coming through next as the next growth and then head later really driven by slow down in areal density and ultimately the introductions of next generation recording technologies.

Shebly Seyrafi - CapStone investments

Okay. Last one for me. Your OpEx, I guess you're going to go to 11% or 12% of revenue or something like that in Q1 and you were 9% last year, when do you think you will have OpEX leverage in the future, if at all?

Richard Pearce

Well we're expecting obviously, particularly on the SI side of the business and I guess overall from the revenues to ramp on the second half of the year, but at the same time we would be expecting expenses to be flat. If anything we're down in the second half of the year so we start to see the leverage in the back half of the year.

Shebly Seyrafi - CapStone investments

I guess I was asking do you think you can go back to like a9% OpEx percentage or long-term model do you think around 10 to 11 is where we're at?

Richard Pearce

I think in the longer term as we go out then we can get back to sort of 9%, 10% levels in future years.

Shebly Seyrafi - CapStone investments

Okay. Great. Thank you.

Richard Pearce

Thank you.


At this time there are no more questions.

Brad Driver

All right. Once again, thank you for joining us this afternoon. With regard to upcoming investor conferences, we'll be presenting at the Needham Growth [ph] conference in New York on January 13. (Inaudible) conference and technology communication and Internet conference in San Francisco, February 9 through the 11th, and both will be webcast.

We'll report our fiscal first quarter 2011 results towards the end of March. In the meantime, if you have any additional questions please feel free to call me or email me with your questions. In the meantime, enjoy the rest of the week and we look forward to speaking with you in March.


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

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