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Quantum Corp. (NYSE:QTM)

F3Q11 (Qtr Ended 12/31/2010) Earnings Call

January 26, 2011 5:00 pm ET

Executives

Rick Belluzzo - CEO

Jon Gacek - President and COO

Linda Breard - CFO

Bill Britts - EVP for Sales, Marketing and Service

Shawn Hall - General Counsel

Analysts

Brian Marshall - Gleacher & Company

Shebly Seyrafi - Capstone Investments

Chad Bennett - Northland Securities

Eric Martinuzzi - Craig-Hallum Capital

Alex Kurtz - Merriman & Company

Brian Freed - Wunderlich Securities

Glenn Hanus - Needham & Co

Ryan Esposto - Sterne Agee

Brian Alger - Wedbush Equity Management

Operator

Ladies and gentlemen thank you for standing by and welcome to the Quantum Corporation Third Quarter 2011 Conference Call. During today's presentation, all parties will be placed in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This is call is being recorded today Wednesday, January 26, 2011.

I would now like to turn the conference over to Mr. Shawn Hall, General Counsel. Please go ahead, sir.

Shawn Hall

Thank you and welcome to our conference call. Here with me today are Rick Belluzzo, our CEO; Jon Gacek, our President and COO; Linda Breard, our CFO; and Bill Britts, our EVP for Sales, Marketing and Service.

The webcast of this call, our earnings release, and a quantitative reconciliation of any GAAP and non-GAAP financial measures discussed today can be accessed at the Investor Relations section of our website at www.quantum.com and will be archived for one year.

During the course of today's discussion, we will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements include statements regarding our business strategy, opportunities and priorities, anticipated product launches and plans, future financial performance, including expected revenue, gross margin and expense performance, and debt covenant compliance, and trends in our business and in the markets in which we compete.

We would like to caution you that our statements are based on current expectations, and involve risks and uncertainties that could cause actual results to differ materially. We refer you to the risk factors and cautionary language contained in today's press release announcing our fiscal Q3 2011 results, as well as to our reports filed with the Securities and Exchange Commission from time to time, including our most recent 10-K filed on June 11, 2010 and our most recent 10-Q filed on November 5. 2010. these risk factors are incorporated by reference in today’s discussion and we undertake no obligation to update them in the future.

With that, I will turn the call over to Rick Belluzzo.

Rick Belluzzo

Thanks Shawn. Good afternoon and thank you for joining us. Today, we are going to change the structure of our call given the organizational change that we announced two weeks ago. I will start with an overview of our strategy and results, Linda Breard, our recently promoted CFO will follow with the financial discussion and then Jon Gacek, in his new role as President and COO will provide more details regarding our operating results and expectations for Q4.

As we stated at the start of this fiscal year FY2011 has been defined as marking the beginning of a new period for Quantum highlighted by a focus on growing our business and taking advantage of the work we have completed over the last few years. This work has resulted in increased profitability in both margin and absolute levels, a greatly improved capital structure and most importantly set a strategic opportunities built around significant market changes and improved technology in products.

In FY2011 our goal has been to deliver our first year of overall revenue growth in more than four years, and although we are likely to be relatively flat for the year we still expect to deliver growth in a number of key areas including our overall branded business and branded disk systems and software. Therefore, we believe we are well positioned as we enter FY2011.

Let me expand a little bit on the opportunities that we had focused on. Our aim has been to transition Quantum to become a storage systems specialist and as a result, we are focused on four key opportunities. First, the tape market remains a significant element of the storage market and we are now well positioned in the strongest segments of this $3 billion market with a very solid product offering. This is a highly profitable business and we have near term incremental opportunity as a result of the disruptions caused by Oracle’s acquisition of Sun and a more general move towards consolidation.

Our Q3 results demonstrate the relative strength of our tape business although our branded automation revenue was down slightly year-over-year the decline was less than that of the overall market suggesting that we gained market share. In addition, our revenue grew again sequentially.

We have more work to be done here given the incremental opportunity but we feel that we can grow share and offset some of the near term market decline as we target our incremental investments to make tape more valuable including areas such as encryption, long term retention in the archive and the cloud.

The next opportunity is with DXi and the growth with deduplication and replication. This is a fast growing market that is still in the relatively early phases of adoption. Since the change in the EMC relationship we have been focused on building our VAR[ph] channel and establishing a run rate business in the mid range while selecting pursuing large enterprise opportunities.

Our results in the past year have been inconsistent as a result of the slower than expected build of the channel business and the lumpiness of the enterprise business. These dynamics changed this quarter as we made excellent progress mid range run rate business adding the most customers ever in a single and growing the VAR channel significantly. Yet we had a weak quarter for the enterprise business which we attribute to the timing of deals and a new product transition. Despite the enterprise weakness total DXi revenue grew year-over-year and was flat sequentially, and we expect future quarters to have more traditional pattern of large enterprise deals.

In addition today, we announced DXi 2.0 our most significant software release to date which we feel will strengthen our position as one of the leaders in the disk backup and duplication market. Jon will provide more detail on our DXi progress and plans in just a few minutes.

The third area of opportunity is the StorNext business where we had a record quarter this quarter. The market for our high performance file sharing and advanced archiving remain strong and again we feel we are well positioned to grow this business over the next year through a continued focus on vertical markets and delivering greater success through our expanded features and functionality.

Finally, over the next year we will be working to expand our available market for StorNext and other key technologies by delivery our integrated solutions of hardware and software and expand our addressable market and leveraging our go-to-market capability. Of course behind all of this is our ability and drive to position Quantum as the storage systems specialist by bringing all of these elements together providing a common management framework and ensuring that our service offerings provide unique expertise.

In short, we continue to feel we are well positioned to capitalize on the four area of opportunities we just discussed. We clearly have work to do to build our go-to-market position and further expand our product portfolio. We believe that our strategy will enable us to more than offset any segment that have revenue decline and therefore increase profitability. While building momentum has been a challenge we see distinct progress and look forward to continued improvement.

Before I turn the call over to Linda let me say a few words about the organizational change we announced two weeks ago. Earlier in this fiscal year we announced an expansion of Jon’s role and made him COO. The initial focus was our engineering and new product delivery. The progress here has been very solid and today’s announcement of DXi 2.0 is a very important milestone. Given this and the recent refinancing of our EMC debt it was time to take the next step making Jon President and promoting Linda to CFO. As part of this change we will move sales and marketing to Jon allowing him to fully integrate all elements of our operations and deliver improved overall market momentum. Jon has proven his ability to aggressively drive operational performance and we should benefit from his new focus.

Likewise, I am please to promote Linda to CFO. She has been a key contributor at Quantum for many years and has played an important role in our operational improvements and our financial progress.

I would like to summarize that all of the changes we have made have positioned the company well for a new period of growth. The consistent double digit operating margins and improved capital structure are very positive. While revenue momentum has not increased as quickly as we would like we remain positive and confident about the opportunity and we will continue to make any needed modifications to our approach as we drive for further success.

With that now, let me turn the call over to Linda. Linda?

Linda Breard

Thank you, Rick. Now, I will walk you through the detailed financial results for Q3. I would like to refer everyone to the financial statements and supporting schedules included in the press release and on our website. It will be helpful to refer to those documents as I comment.

Revenue was third quarter ended December 31 $176.2 million compared to $181.7 million a year ago, a year-over-year decline of %5.5 million. The primary driver of the decline was the reduction of the $5.1 million in OEM revenues that was anticipated and related to declines in devices, tape automation and service revenue in that order.

Non-GAAP gross margin was 44.6%, compared to 44.4% in the prior year period. Our non-royalty branded sales mix trended well this quarter which strengthened our overall gross margin position as did lower access and obsolete charges related to an inventory write down last year that did not reoccur in Q3 of 2011. Offsetting these increases to gross margin was a decline in royalty revenue of $2.5 million which carried a 100% gross margin.

In Q3, non-GAAP operating expense totaled $58.8 million compared to $57.9 million a year ago. Marketing and sales costs were higher due to increases in salaries and benefits related to growing our branded sales force and marketing team. Offsetting these increases was the reduction in general and administrative expenses driven primarily by a decrease in bad debt expense resulting from lower allowance requirements and provisions for bad audits that were recorded but were not repeated in the current year.

For the third quarter, we had a net tax benefit of $700,000 related to our successful closure of a foreign tax audit offset by recurring foreign and state taxes.

Summing it up for Q3, we had non-GAAP net income of $16.4 million with non-GAAP diluted EPS of $0.07 compared to non-GAAP net income of $16 million with non-GAAP diluted EPS of $0.07 in Q3 of last year.

Focusing on cash flow for the quarter and the balance sheet at December 31, I would like to highlight several key points. Cash provided by operations for the quarter was $18.4 million, we paid down $40 million of senior debt and refinanced our $122 million 12% debt that with $135 million of convertible debt at 3.5%. This will reduce interest expense by approximately $10 million per year. At quarter end the composition of our debt was $145 million of senior debt and $135 million in convertible notes. We ended the quarter with $93 million in cash

Interest expense was $4.8 million compared to $6.8 million a year ago. This included a cash interest expense of $4.3 million and amortization at issue cost of $500,000. The current coupon interest rate for our remaining senior $144.7 million at December 31 and average coupon rate for total debt will be approximately 3.8% for the quarter ending March 31

Non-GAAP EBITDA for quarter was $26.8 million and we are in compliance with all debt covenants at December 31, and we expect to be in compliance with our debt covenants during the next 12 months. For purposes of calculating our debt covenants, EBITDA for the last 12 months was $95.1 million.

On a sequential basis, manufactured inventory decreased $2.4 million. Accounts receivable decreased $17.9 million. We also had an accelerated payment of $10.7 million from one customer.

CapEx was $1.7 million primarily related to purchases of engineering equipments and other testing hardware in support of product development. Purchases of service parts inventory were approximately $700,000 and depreciation, amortization and service parts lower of cost or market expense totaled $13.2 million for the quarter.

In closing, we made great progress on the balance sheet in Q3 particular in improving our capital structure. We continue to generate strong cash from operations and are investing diligently in our business with focus on opportunity and growth. Today’s announcement of our new DXI 2.0 software release and refresh of our entire product portfolio over the past year are reflective of that focus.

From a external prospective our credit ratings with Moody’s was recently upgraded and was another acknowledgement of the progress we had made strengthening our balance sheet and the underlining business model.

Now, I will turn the call over to Jon.

Jon Gacek

Thanks Linda. For my part on today’s call I am going to talk about what went on in the business in Q3, briefly describe the new DXi 2.0 software platform we announced today and discuss what we are focused on and what we expect for fiscal Q4.

Starting with revenue performance, we recognize that total revenue amount of $176.2 million was below our guidance for the quarter however, we made significant progress in several areas that I would summarize.

First, branded revenue was $125.8 million, up $2.1 million year-over-year and $6.4 million sequentially. Year-over-year growth was the result of growth in our branded disk and software revenue which was up 26% to a new record level. In fact both StorNext and branded DXi revenue reached an all time high individually.

The sequential increase resulted from a slight increase in branded disk and software and growth in all tape automation segments with enterprise automation being the primary driver. Growth in enterprise tape was driven by both upgrades and new system sales to our installed base as well as the edition of new customers.

The addition of a significant number of new customers in all segments of tape automation is the second area of progress I want to highlight. In our enterprise and mid range automation segments we added 170 new customers in Q3. This is the third quarter in a row we have seen a significance sequential increase in a number of new tape customers. In addition in our entry level space we have also added many new customers and gained a significant amount of share, six points of share, since we began shipping the Scalar i40 and i80 just over a year ago. This is an important trend of strategy in tape is to grow our share and add new customers that we can sell future tape upgrades to as well as disk and software products in the future.

The third area progress was disk and software revenue. Including related service revenue was $30.7 million compared to $24.8 million a year ago and $30.6 million in the prior quarter. Although revenue was flat on a sequential basis there was a significant change in the composition of the revenue and how we achieved it.

Driven by sales that DXi 6500 and DXi 6700 our mid range DXi business grew a 115% sequentially and comprised 52% of the disk product revenue for the quarter compared to 24% of the disk product revenue in Q2. Helping to drive this growth was increased attraction with independent channel partners. In North America the number of channel partners selling our mid range DXi products rose by 33% sequentially. Mid range DXi revenue from our top partners in North America was up 50% over the prior quarter. 6500 and 6700 are the products that we had expected to be the primary drivers of our DXi grow and at this quarter we made substantial progress on this front.

In contrast, our enterprise DXi 7500 and 8500 business was down 42% sequentially and comprised 41% of disk product revenue this quarter compared to 70% of the disk product revenue in Q2. So what happened?

With the launch of DXi 8500 we brought to market a product that had a slightly higher price but had significantly higher performance than the DXi 7500 and also higher performance than the Data Domain DD880.

However, we did not close significant number of large enterprise deals that we were working throughout the quarter. We believe that this rather was the result of the product transition and getting customers moved to the 8500 from the previous DXi 7500. To put some numbers behind this, our deals greater than $200,000for Q3 decline by $5 million compared to the prior quarter, and those deals in the prior quarter were primarily made of DXi 7500.

The deals we were working were pushed out of Q3 and will require more work to get closed this quarter, but we feel well positioned to win many of them. In fact in Q3 our win rate for enterprise DXi 7500 and 8500 deals was nearly 60% and our win rate for the mid range 6500 and 6700 was nearly 50%.

In summary on to this product 6500 and 6700 run rate business was very strong offset by weakness in big enterprise deals due to the product transition from the DXi 7500 to the 8500.

The last area of progress I want to mention is StorNext. This was the highest revenue quarter ever StorNext driven by growth in rich media archive, general achieve and file system licenses for work for management. A record 22% of StorNext sales for the quarter came from new customers.

As Rick mentioned, StorNext is becoming more and more strategic and you will see us not only enhance the software but also come out with software hardware bundles this year to increase the overall reach of StorNext.

Turning to the other product categories, royalty revenue was $15.6 million for Q3 compared to 18.1 in the same quarter year ago. The majority of the decline related to continue reductions in VLP royalties and we also experience the slight decline in LPO we have seen in this quarter.

Devices in media total $23.9 million compared to $27.3 in Q3 a year ago. The decline was attributable almost equally to reduction in branded device revenue and an expected decline in OEM device revenue. OEM and branded media revenue increased slightly over the same quarter a year ago.

Service revenue was $37.4 million in Q3 compared to $39 million a year ago. The $1.6 million declined was primarily the result of expected reductions of OEM out of warranty repair. Branded products service revenue remain fairly flat this quarter compared a quarter a year ago.

To summarize the revenue story, the absolute results don’t reflect the amount of progress we mad this quarter. We saw increased traction with the channel this quarter in both tape and disk the tape opportunity is real and significant and we are well positioned to capitalize on it. Our DXi products are strong and differentiated particularly with the DXi 2.0 software platform announce today, which I will discuss in a minute. In addition, the market for disk based backup and deduplication is growing. We have demonstrated that we can compete and win against the market share leader and we have distanced ourselves from the other competitors in terms of performance and value of our products. Finally, StorNext is growing becoming more strategic and has increasingly more applications to solve customer problems.

I will briefly describe our new DXi 2.0 software platform announced today and what it means to customers and Quantum. DXi products running DXi2.0 software beginning with our DXi 4500 and 6500 offering will deliver the highest deduplication speeds available for any open protocol inline appliances in their respective classes. Doubling performance over earlier generation DXi products and with no change in price. As a result, customers will be able to protect more data on smaller system, further solidifying our price performance leadership. In fact we will have as much as 5x advantage over the nearest competitive offering.

The DXi 2.0 software also provide enhance management features that significantly streamline deployment, monitoring and administration of the entire data protection process saving IT managers time even in complex multi-site backup and disaster recovery environment. The combination of this new software and refresh and expansion of our entire DXi hardware offerings over the last year provide significant differentiation that we can leverage in securing new customers, expanding our foot print with existing customers and increasing our momentum with the independent channel.

The technology advancement and performance benefits we see in DXi 2.0 are key elements of our strategy to grow our DXi business and continue to add new customers and channel partners.

As we entered fiscal Q4 and look forward to fiscal 2012, I want to make it clear what we see as the opportunities and what we are focused on and what we are going to do. Let us start with tape, this is the biggest piece of revenue stream today. Tape is a mature market but there is plenty of opportunities for Quantum.

We’re focused on growing our branded tape automation market share and adding new end user customers. We are doing this by leveraging our industrial leading tape automation product portfolio, capitalizing on the opportunity with channel partners creating by the Oracle acquisition of Sun and offering end user customers a better back up solution with our Scalar and DXi products.

We have very specific end user in channel marketing campaign to drive awareness around these points and we are aggressively working with channel partners to target end users. You can see in our results in this quarter that we having success adding new tape customers and we are going to continue to build on this opportunity.

For DXi, the market opportunity is large. We think EMC and Quantum are demonstrating that there is a lot of value for customers in improving their backup performance with target based deduplication appliances, and we believe we know have the product portfolio and product road map to be a leading provider in this market. We have had a big year in getting new product out to the market with the introduction of the DXi 4500, 6500, 6700 and 8500 all in the last 12 months. Our DXi 2.0 software further strengthens our product offering and market position by providing customers even more value at no additional cost. We will roll the 2.0 software out to the DXi 6700 and 8500 this summer.

On the channel side, we have also made measurable and notable progress. We will continue to focus on deepening our relationships with existing channel partners and adding new partners who can sell DXi. We are focused on adding more opportunities to our funnel and the channel is key to that strategy. Our win rates are good, our products are strong and the positioning with DXi 2.0 makes them even stronger.

We are working to ensure our partners understand DXi, how to compete with it and how to win. This market is still early in its lifecycle and we think we are well positioned to have significant growth here. We have to execute on the opportunity.

For StorNext we are coming off a record quarter, this was driven by market dynamics as a result in data growth such as HD and 3D content, proliferation of the used rich media on the web and companies having budget constraints but having more data to manage.

We are going to continue to enhance StorNext capabilities in our current core markets and start offering professional services to this customers. In addition in fiscal 2012 we will be offering targeted solution based on StorNext that are packaged with hardware to reach new customers and broaden our reach beyond where the product is sold today. These new solutions will be sold through our current StorNext partners but will also be made available through our existing tape and disk channel partners.

In summary, there is growth potential in all three product categories and we are very focused on growing Quantum branded revenue in tape products, DXi, as well as StorNext.

Let me close with our guidance for the current quarter. Q4 is typically seasonally down to Q3. We expect revenue of 165 to 175, but we believe it likely that the branded business will grow sequentially. We also expect non-GAAP gross margin of 44% to 45%, non-GAAP OpEx of $59 million to $61 million, interest expense of $3.2 million, taxes of $1 million in non-GAAP EPS of $0.04 to $0.05 on 270 million fully diluted shares.

As we look forward to fiscal 2012 and beyond there is plenty of opportunity in our core markets with Quantum to grow and deliver higher revenue and profits. In addition, our technology is extensible to a broader set of customers and the opportunity for growth is there. We started the transition to a growth company this year and we will continue that transition and work to accelerate it in 2012. We will give detailed guidance for fiscal 2012 on our Q4 earnings call, but at this time I can say we do expect growth involved total revenue and branded revenue in 2012.

Thank you and with that I will turn the call back over to the operator to take questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Brian Marshall with Gleacher & Company, please go ahead.

Brian Marshall - Gleacher & Company

I have a question with regard to the linearity of the quarter I mean, revenues obviously came in about $17 million in light of consensus expectations. You talked about expected weakness in OEM business and actually that mix went up so, I’m just trying to put it altogether and try to figure out how do we miss the low end by 5% and just figure out the linearity of what we are seeing there?

Jon Gacek

I will start with this and Linda we can jump in. Linda’s comment on OEM was when she is comparing it to year-over-year, so OEM that question of about her comments really when she compares with the last year. Our OEM business is actually was really close if not slightly above plan and the linearity of the branded business especially in this quarter is very backend loaded. As complete company we are usually 20 30 50, we talked about that for a long time, branded is more backend loaded than that and this particular quarter is even more backend loaded. So, we were running our deals all the way up until the ball dropped in New York would be the way to say that.

Brian Marshall - Gleacher & Company

That’s the case when we look at guidance being lowered for March. If these deals especially in the DXi 8500 front where simply pushed out into the March timeframe, can you sort of balance how that plays into consideration if these two deals are going to close in the March, can you talk about income at weakness that we are seeing in the other businesses that are non-DXi 8500?

Jon Gacek

Yes, as I said in there that we have a chance grow branded on a sequential basis. The OEM business we would forecast it down on sequentially Q3 to Q4 so that’s what going down, if you go up of our actual and we have to demonstrate that we can get the business closed. We have a lot of deals, we have new products, we had some very nice win and we have some nice win rates, but we have got to give more of a close. So, the sales guys have plenty of things to work. The number of slip deals was much higher than normal I would say and we got go get that business closed.

Brian Marshall - Gleacher & Company

Final question, f you look at the royalty business obviously down double digit both sequentially and year-over-year despite the fact your automation business. So, do you think that there is the trend in the industry perhaps to use less tape going foreword? Can you help me understand a little bit what the disconnect there?

Jon Gacek

Yes, so on the royalty business remember we get the royalty when the media[ph] manufacturers first sell in the channel and so those two things don’t always correlate to each other and this is Maxwell, Fuji, TDK, iNation so sometimes there’s no correlation between what’s going on in the market and was going on within the channel. In this next quarter there is actually a decline in the royalty rate. There’s some contention the media guys went late into the channel but we can’t really verify that at this time. We talked about it being a $15 million to $18 million quarter of business and we can see in that is that’s how we see it.

Bill Britts

I don’t think there is any indication that there is some fundamental shift in needy usage in the relationship to libraries at all. I don’t think that I think that the factors behind it are relative to the whole market as well as some other points Jon mention pricey changes then shifts in the channel inventory are there other factors.

Operator

Your next question comes from the line of Shebly Seyrafi with Capstone Investments. Please go ahead.

Shebly Seyrafi - Capstone Investments

You indicated earlier that your 8500 has strong performance and you have this DXi 2.0 software which is going to increase its performance further. The prior throughput of 8500 was 6.4 terabytes per hour. EMC just came out with the DD890 at 14.7 terabytes per hour. What with your new software will you eclipse EMC perhaps garner bragging rights again?

Jon Gacek

I am just going to comment generically and that 14 number is when they use their DD boost which is doing dedupe on the host as well as on the product. We don’t see that implemented very much. It’s a give marketing number but we don’t see it from a product perspective. Where people are deploying it would be VTL, OST and the configurations of (inaudible) and when we put 2.0 on 8500 which we be the summary we expect it to be right at or above them in all the measures at how customers actually deploy plus the DD boost number 14 is not a number we are capability of today

Shebly Seyrafi - Capstone Investments

On the disk system business you indicated that a lot of the weakness was due to the decline in the high end but the mid range grew very well so you said 115% sequentially. So now that the midranges over half of the disk business, do you expect meaningful growth in the disk business in the March quarter, and may be perhaps you can make me some comments about 2011, perhaps you want to make a doubling comment similar to what we made it a year ago so but any kind of projected expectation for the disk system and software business in fiscal 2012?

Jon Gacek

Without giving exact numbers if you take the mid point of the range we just gave which was 170 and we have a disk number embedded in that which is sequentially up to we just did. If we compare that number fund annual basis so we take to that actually done we add Q4 we will be up actually branded DXi in excess of 50% if we have that number. So, while we haven’t gotten as far along as we would like and I am not sure what the actual market growth is in the space right now. It’s probably somewhere between 40 and 70 we believe we’ll have grown 50% using those numbers in our branded DXi this year, which to us I hope people listening we understand we can do better than but it isn’t like we didn’t grow and we grew significantly.

So, when we look out 2012 and we look at the product offering in the market who we’re competing with, what the other choices are, we think we are very well positioned and we need to grow more because we think we have very, very good product. So while we didn’t get exactly want to be we’ve grown a lot this year, the products are a lot better, the 2.0 software further pushes them we go to a inline model now which also changes the cost model further for customers. So, we think shall we think very well positioned.

Rick Belluzzo

I would just add your comment about the mid range channel growth is very fundamental to what we have been saying for a year in that we believe that we not just have a big deal business and a project oriented business but we have to get smart more smaller velocity business working for us. I would say this is the first quarter where we would say that happened and we believe that is the momentum creator and that you have more customers who would be buying more units and would do be doing more upgrades etc and the channel is getting more confident. So, that’s the bit of the theme here of a feeling that was more done this quarter than it looks was because we did add a lot more customers and we had a lot more channel partners in the space and that we would get the more normal performance out of the enterprise business because its the stack up to be a much better story going forward.

Shebly Seyrafi - Capstone Investments

My gross margin model is still getting higher gross margin than you are guiding and I am just wondering whether you have to give faster and additional incentives that creating a segment by segment declines in your gross margin to obtain the disc (inaudible) for example going forward?

Jon Gacek

No, when you add a new customer we are going to be aggressive on price. Our material margin are the way we think about that particular margin was a little lower this quarter but since for us is really met and my experience is when you all these new analysts are doing to model just the way that makes work and what the actual margins or the products can drive it will be a little bit different. You will see it thus grow you will see the margin go up we do have a very leverageable model.

Operator

Thank you and your next question comes from the line of Chad Bennett with Northland Securities. Please go ahead

Chad Bennett - Northland Securities

Yes, just couple of things so I’m trying to not to beat a dead horse here but at the high end of the DXi business trend reconcile the comments we made on the September quarter when the 8500 I think wasn’t out yet but was soon to be out post call. You talked about orders that’s already been won or driven at that point and a pretty big pipeline and you know that what you just were getting business quicker than you even thought because the product was (inaudible) yet. What happened from when to the end of quarter that basically fell apart?

Jon Gacek

We just didn’t get the deals closed, we have a lot of deals we pushed up more deals at that size and then we have as we are we had a lot of proof of concepts out and I mentioned that our win rate was higher actually. So, wasn’t that we lost we did have more deals we did have the line of sight more opportunity than we seen in long time although everything you said exactly what we saw at the time the difference is we got to the end we didn’t get the deals closed and they pushed.

Rick Belluzzo

It speaks a little bit to the fact that were still building critical map I mean we can’t have five deals to effect our result at the enterprise level and that’s because we don’t have we haven’t know building up critical mass there. We look back in any quarter and look at a handful the deal they were very large and so we are susceptible to that and I think that was probably as much of the issue is anything but we were (inaudible) to lined up to be to actually end the quarter

Bill Britts

To couple with what Rick said was we just had more then handful, I mean our enthusiasm was built around we have more then 5 we have still more than five, we got a lot of large deals we are working that we haven’t closed yet.

Chad Bennett - Northland Securities

Do you think at all and they seem to be separate but your VARs that sell the high-end product DXi product and your mid range product, do you think there was any cases of them being more focused on the mid range than the high end just because yields are more easier to get done, did you see any of that?

Jon Gacek

No, I would say this though the high end deals we do and not all of those are built through partners, most of them do but we have had some of our larger deals we’ve taken direct them make sure billed recently. So, I actually think the shift to the mid range is a really healthy thing for both the mid ranged products and the enterprise products because as partners get comfortable and capable of selling the mid range product they will be willing to take around more high end products which is was what I was referring to about in my comments about them having the more capability to be able to go further on our product line.

Chad Bennett - Northland Securities

I know you gave what the high end products did sequentially. What’s the comparison year-over-year as a percentage of disk off of revenue?

Jon Gacek

I don’t know. Maybe a year ago virtually all of our business was high end (inaudible).

Bill Britts

Yes, a third maybe.

Jon Gacek

But in scale we had a lot of deals. We had a lot of deals just move out and we are doing more proof of concepts, performances I mentioned quite a bit higher than what they have seen from us in the past and it’s just (inaudible).

Chad Bennett - Northland Securities

What did StorNext did year-over-year?

Jon Gacek

No, we didn’t break this up. StorNext was up, I am trying not to give on product revenue.

Chad Bennett - Northland Securities

You gave it on the last release.

Jon Gacek

Percentage increase?

Chad Bennett - Northland Securities

Yes, percentage increase year-over-year?

Jon Gacek

Probably 10%.

Chad Bennett - Northland Securities

I know you don’t segment the business anymore like this but can you just talk about how sequentially the tape business did September to December this year versus last year on a product basis?

Jon Gacek

I don’t know from year ago.

Rick Belluzzo

It’s in our website on tape system. This quarter we were up $6 million sequentially and we were up couple of percentage points actually year-over-year. We had five quarters of branded growth so that tape automation overall is on our website. I just have it off the top of my head.

Operator

Our next question comes from the Eric Martinuzzi from Craig-Hallum Capital. Please go ahead.

Eric Martinuzzi - Craig-Hallum Capital

As far as your people investments in the business, I know you are just buttoning up your fiscal year ended ’11 from March 31, but curious to know where are you focused on investments in people, sales, marketing, R&D? Does that head count need to rise to capture next year’s growth?

Rick Belluzzo

We’ve been pretty consistent in that in sales and marketing we are today investing ahead of revenue. We feel like we have largely adequate resources to deliver on our program. There are a few places here and there where we might invest incrementally more around things like inside sales and some other aspects. We think we are invested for the revenue strategy and growth that we have.

The second place we have invested is engineering because we believe that we want to increase the pace of our product and gain more depth there. So, I think this we have had some increase there. But overall, our headcount has not grown a lot. We really don’t expect it to grow a lot. We would love to grow more in sales and marketing but that’s going to first follow as we get more results from the investments that we have already made.

Eric Martinuzzi - Craig-Hallum Capital

How does that juxtapose with pipeline? You talked about the number of deals you guys have. You had a pipeline entering the December quarter, you have pipeline entering the March quarter, how does the pipeline compare quarter over quarter?

Jon Gacek

Pipeline slightly up from where we started in the December quarter which when you think about the seasonality that’s actually is a good sign and in particular with the (inaudible).

Rick Belluzzo

To your earlier question, we have invested in the last year more in defining opportunities and lead generation and that has been an area that we have made incremental investments because we do think we in a number of places need more opportunity and especially with our channel we want to be able to speed the channel. More opportunity because we think we will get something in return for that when we do that. So that is another area that we focus on.

Operator

Our next question comes from the line of Alex Kurtz with Merriman & Company. Please go ahead.

Alex Kurtz - Merriman & Company

Bill, having heard a lot from you today can you just give us a sense what you saw from an execution perspective on these larger deals and on the flip side, what would the positives would be with 55s and the 6700? Second I would like to hear from you, Bill, is do you think you have the personnel right now to win those bigger deals? You are obviously becoming a company focused on growth areas and you need better execution type guys out in the field. Do you feel you have those in the stable right now? I’d like to hear your color on that.

Bill Britts

Let’s go back to the 8500 to start with your question. We were building off to some of the earlier question we were very bullish on the 8500 really from the standpoint of the ability to really have industry leading performance and we were very aggressive in the way that we conditioned the product relative to EMC data domain. That EMC continues to be our number one competitor in that space.

So, as Jon mentioned, we had a lot of very, very large complex deals where we did a lot of proof of concepts. There was a lot of detailed planning with customers and questions around how to integrate in their environment. In several cases very large deals that pushed in part because the customer was trying to consider their complete architecture.

So, from that standpoint the product transition we probably are a little bit overly optimistic about how quickly we are going to be able to work through the evaluation process in some of these opportunities. We have absolutely the right people to be able to compete against anybody in this space, and that’s part of the reason why we are encouraged by the win rates.

We’d like to close rates in terms of the pipeline we ended the quarter with. We like those close to be better and that’s getting closer to the customer being a little bit more I would say complete in the way that we launch this campaign.

We have a very different sales model than an EMC or an IBM where it’s all about account control. So, our positioning is really about making sure the customer understands our differentiation and how we deliver value in these backup redesign.

One thing I would to Rick’s comments about where we are investing for next year, we have already started this and we are investing ahead of the curve in terms of pre-sale solution architect people that can really start outside of our box and really started to help the customer understand how to integrate our solutions into their environment. That’s critical and I think that’s part of the reason why these deals pushed over into the quarter.

In terms of 6700, it maybe sound a little overly bullish to say it was a breakthrough quarter but it was really about the fact that we had much broader participation from the channel in terms of selling DXi. That was the encouraging part. We had more (inaudible) that actually were successful winning very important head to head competitions against EMC Data Domain. The market continues to have new competitors, new entrants, that’s confusing the end user customers in a lot of cases and where we’ve actually gone in and force either a PLC, an evaluation or had (inaudible) comparisons with our product. We’ve been very successful.

As I say that, we are picking up velocity on that but we are still not in a leverage position in terms of the mid range. So, when I think about capacity not just our capacity but these channel partners that are looking for a competitive solution to EMC, we are the logical choice and the 2.0 introduce just makes that whole comparison that much more clear cut. You think about how this market is evolving they are going to be the low end solution where it is just base appliances but they don’t really have the capability that we do with our family of appliances. At low end you’ve got IHBs[ph] that are basically tapping on dedupe to their application and customers are interested to buy it but they already see some of the difficulties in being able to scale that. At the very high end you’ve got the Data Domain release of their new products are really up in the stratosphere in terms of price, in terms of part of the market they address

So, I feel very, very good about our portfolio. The feedback from our partners is extremely positive. As Jon said, we need to close more business across the portfolio and build off of that momentum.

Alex Kurtz - Merriman & Company

Bill, just one follow up on the comments around 8500 that’s obviously much more direct model business. You’ve in the past said that Quantum had a different model than EMC but the 8500 is going to get a lot of attention from EMC. In those deals they are going to bring all of their guns to fight in those specific. As a follow up from my earlier question, do you think you have a resources in place to consistently compete in that high end?

Bill Britts

Let me answer it from this perspective. We need to be very, very clear on the qualifications of this opportunity. We try to fight a multi-front war with those guys, we will be stretched then. So that absolutely is part of the consideration that we have. We have proven over the last several years that we can compete head to head against them even in their large installed base accounts. The reason is that we have a more complete solution when you think about not just the disk part of it but the integration would take and the ability to manage this environment.

The 2.0 announcement really takes one of these, I’ll call it, burn factor but I also look at it as we’ve implemented it very, very effectively into our set of products trade offs, if you will, in terms of all the things that go into making the single scalable software architecture, being able to handle multi protocol, being able to do things with Edge-to-Core deployments, this is really where we can compete very effectively. We can’t fight a multi-front war but we’ve been very effective in this last quarter we had a number of wins where the customer was previously running EMC Data Domain products. We displaced them in part because of our more complete solution.

Alex Kurtz - Merriman & Company

Jon, just a quick question here. Is it safe to assume the 30.7 is disk systems software and services is the same number for branded or is that slightly a lower number?

Jon Gacek

Yes, it’s basically the same. We had a little bit of OEM but nothing big enough to write about it yet.

Operator

Our next question comes from the line of Brian Freed with Wunderlich Securities. Please go ahead.

Brian Freed - Wunderlich Securities

If you look at the tape market can you talk a little bit about what you are seeing transitionally there, particularly if you look at the opportunity to take share from what used to be the Sun Storage Tek base post the Oracle acquisition? Do you see the majority of those opportunities at the high end or do you think it’s fairly evenly distributed from low end to high end?

Jon Gacek

I’d say most of what we are seeing is in mid range up in the enterprise. A lot of the big opportunities are where customers have got legacy Storage Tek Oracle equipment. They are looking at some kind of large maintenance renewal. We had a lot of traction with partners that basically had nice symbiotic relationship with Sun Storage Tek and that they took a lot of the responsibility for supporting those installed base accounts. That’s really where we have a very good value proposition we can start the conversation really around we can get you into technology refresh and its some pretty simple pay back, less than a year payback and then when we are able to actually get in and do more detail about the product differentiation it just allows us to close those deals. So, that that as Jon mentioned new customer acquisition really picked momentum in this last quarter in a lot of that in was mid range and low end of the enterprise towards technical base.

Brian Freed - Wunderlich Securities

So if you look at the target opportunity what is say is more of the SL 500 and again below installed base versus displacement of the SO 8500 class product?

Jon Gacek

No, I’d say more L700 kind of in that SL 500 3500 range.

Bill Britts

Also we often times customers are looking at large Storage Tek library and they are doing up a backup redesign and they may end up buying smaller tapes and disk as that solution which is something we try to play and so it will look like a smaller library but in fact it replace large library and put in tape it, now disk in front of it is part of that solution is what makes it all work.

Brian Freed - Wunderlich Securities

The second question related to the StorNext and what I’m saying is some other the rearchitecure of back up and archive, definitely see a lot more focus on the archive layer within the industry and a lot of those archives tend to be your front ended by a file system. Do you continue to see that as a trend, number one? Two, do you feel like that you are somewhat unique in your ability to front in tape with a file system architecture versus other competitors out there? As you think about opportunities for that do you think ultimately some of cloud type opportunities which today are primarily disk will ultimately begin to operate at a lower cost, storage solution based on tape?

Jon Gacek

Yes, we were seen traction archives basis a lot of that is rich media and in rich media they put two things, there is the size of the archives so that its very large and HD content and 3D content in that space are driving that, but also its performance and StorNext is super high performer and in fact tape is very high performance when you need to stream a large amount of data, its actually faster than disk. So, we find ourselves now been architected much broadly with StorNext over the top and as being the data mover and an opportunity to sell our tape and then have other peoples disk be almost the cash or the working part of the archive.

We’ve been to some customers where some of the sort of high flying recently acquired name brand solutions that you talked about, they can just compete with StorNext solution and tape, when there is a lot of data we need it quickly. So that’s driving our business we think that’s more extensible into a similar type of structure may be not as big, and then candidly people just have a lot more data they are trying to manage it and StorNext plays very well there.

Brian Freed - Wunderlich Securities

My final question this is may be pointed more towards Bill, if you look at the sales cycle for DXi 8500 how do you think the roll out of 2.0 software influence that, I think you said on the call that you have it out fairly rapidly, but you think a long it the valuation cycle on those products and may be pushes the ramp beyond the fourth quarter into the first, what do you think evaluation is well underway?

Bill Britts

The most significant part of that is it’s a 2.0 software release, so anybody buying appliances now that upgrade is very clear cut in terms of what you have to do in, it provides more head room. If you to think about disk back up with deduplication a lot of the real value comes from the fact that people retain data longer and as you start to grow you need to think about that scalability. So, essentially what 2.0 from a practical stand point for these customers just gives head room to grow as they deploy these appliances in their environment.

So the short answer is it will help the decision making process because you have more complete understanding of a road map we previewed these with number of customers in the last quarter. Customers and enterprise space they want know what your road map is they want to understand how your architecture works it’s a very, very strategic decision for them is as we start to think about what are the architecture they are investing in.

Jon Gacek

This point is, nobody has asked question, this made me think about this particular competitive environment as we came we refreshed our entire our hardware portfolio. EMC just announced the upgrade to their hardware couple of weeks ago and our road map this was planned to work out this way and we are going to get be right to them or pass them in the case of mid range space already. So, we close the gap technically and Bill points out we have some unique features of how we win we are specialist in backup and that’s going to continue, it doesn’t mean our products are all better than theirs because they are the good products too but we closed the gap dramatically and in fact if we pass them in the mid range again and we’re be our cycle.

So there is lot of spring in our step around the product in the sales guys like it in the number deals we have is very strong. We just have to get it booked. When you go and supply transitions we got off to a great start we got some nice deals still what we got in closed.

Operator

(operator instructions) Our next question comes from the line of Glenn Hanus with Needham & Co. Please go ahead

Glenn Hanus - Needham & Co

The EMC refresh have any impact on the sales cycles and your ability to close the 8500 deals or do you feel it was more around this complete architectural evaluation that you mentioned?

Jon Gacek

Without knowing everything could I would have soon a lot of that was under NDA it could have entered into I mean we had a number of customers were they had closed Quantum and EMC installed base and they were evaluating what they do next and those that would be a subset of the deals that pushed where there was no discussion. They didn’t decide by either of us. So that applies to some of that but I get back to as I said making sure that the customer understand how they get values from different implementation that we do.

The characteristics for us are in fiber channel environment we do extremely well we improved our NAS and OSP protocols implementation greatly over the last year. We have a very strong story in terms of being able to actually integrate with tape and be able to have as part of the kind of core offering in the data centre. The number of customers that start out saying that they won’t eliminate tape completely and then eventually they move to some kind of next approach that’s pretty high and we gain credibility to that processes. There is certain type of customers that may be lean in on buying the whole empty stock but we compete very, very favorably and it’s not just a matter of who has got the (inaudible).

Glenn Hanus - Needham & Co

Any update on budding Fujitsu NetApp relationship and status?

Bill Britts

No, we didn’t have anything number wise for this close is the same as we got the NetApp still forcing 20 some countries in Europe. The Fujitsu product seems to be, we are starting to see more in Europe I think that tracks close to that. So there are signs that they are making progress when you hits up financially we are going to make sure we will bring it up.

Glenn Hanus - Needham & Co

Jon, would you anticipate some gross margin expansion through next year as the next returns more favorably to disk?

Jon Gacek

Are we talking about margin?

Glenn Hanus - Needham & Co

Gross margin.

Jon Gacek

Yes, as we grow branded generally in the products that we have as those grow margin will grow up. As Linda pointed out this quarter year-over-year royalty was down a little over 2 million that’s a 100% margin that falls out. So within the branded piece of the mix any of the three products are good all those will help our margin. We also had some things that have been decline like the tape (inaudible). So growth will definitely push it up. The point is that its branded not brand (inaudible) tape automation and branded tape and disc have similar structures they both did margins they are both above the average buy and large with royalty exception.

Operator

Our next question comes from the line of Ryan Esposto with Sterne Agee. Please go ahead.

Ryan Esposto - Sterne Agee

You guys are delevering significantly you did a lot on the balance sheet. One, should we continue to see same level of CapEx and do you have any targets for debt in the next years as you start to plan next fiscal year? Two, do you see that any advantage in the field that just a fact goes by people a type of thing?

Linda Breard

Let me take on CapEx perspective, we typically ran out $10 million to $12 million. Last quarter it was a little bit higher, we get a lot of investment related DXi 8500, so I would probably say $12 million to $15 million of probably reasonable for CapEx.

On the cash perspective, we are generating about $20 million a quarter cash from operations and we have been aggressively paying down the term debt and will continue to do so. We have some excess cash flow requirements that happen every fiscal year end begin March 31 and we have paying down and not fear that they don’t have they will be repay to more, that we will continue to deal over the balance sheet and use our cash to pay down. So there is no real target set on when we would pay that down other than that where managing our cash balances along with actively trying to reduce that balance over on $145 million term.

As far as in the fields in EMC the ops was good something that can’t be used against sales force, and I think Bill would agree with that sell us something that was pulled out against that set that we have been financed by EMC and so I think that’s a good think to have to top the table.

Ryan Esposto - Sterne Agee

As it relates 2.0 software release can that be layered all your existing base like we see a cycle some of your existing customers go for this software upgrade to you will get a bump from that?

Jon Gacek

So the existing customers can upgrade as part of maintenance for the current product portfolio and then what we believe it will drive in additional upgrade cycle within that installed base because the performances a lot better.

Rick Belluzzo

The other key point to notice that all of our appliances are replication compatible so you have got 7500 that is going to be replication comparable with 6500 with (inaudible) the new software.

Ryan Esposto - Sterne Agee

On you StorNext have you guys ever give a number who lots of business is now?

Jon Gacek

We haven’t. Basically, with this part of the technology grouping because the products are based on this thing same technology. We talked about that every quarter and we believe this overall packet is going to grow prior pieces is much relevant.

Ryan Esposto - Sterne Agee

So may be down the features have comes more significant yield?

Jon Gacek

Actually may be opposite, turning to merge, StorNext is all software but as we talk about it we will become a clients based and use them the appliances that potentially that we use for DXi, so we think overall if anything that emerging not diverging.

Ryan Esposto - Sterne Agee

Finally, are you guys seeing any you know as roll out new products, you announced the Fujitsu deal and obviously in tap with the big partner with Data Domain in the past and these cycle take a long time for sales guys in the field to ship mode, are you seeing any momentum there or you getting more reverse enquiry into you know doing certain types of configuration using your guys’ this product at least help with you know that selling to the enterprise?

Bill Britts

That’s just deal by deal and relationship by relationship so I wouldn’t generalize from it, but yes there are examples that’s good.

Operator

(Operator Instructions) The next question comes from the line of Brian Alger at Wedbush Equity Management. Please go ahead.

Brian Alger - Wedbush Equity Management

This question is probably directed may be at Rick. I’m trying to reconcile a couple a things here, now coming to the quarter obviously business look to pretty good, we talked about the growth year-over-year for the systems business. On that strength you picked a lot of coverage on the Street half of dozen of or so analyst and here we come in with report today that its no where near what any of the analysts were expecting, no one was talking about a shortfall of this magnitude and it boils down to you internally understanding your ability to close sales and that sales funnel and then communicating with the Street, because I have been around the stock over a year now and unfortunately more often than not, there seems to be something each and every quarter that we aren’t expecting and with the stocks in here $2.70 and people expecting completing different outcome, I’m wondering what have guys down in internally to scrub the numbers better and to may be give you ability to communicate better the Street going forward?

Rick Belluzzo

I would start by saying need I’m not to make excuses but throughout this transition we always have had a lot of moving pieces relative to revenue declines of some segments and revenue increases etc. That is why we have always tended to focus on ultimately what we are trying to deliver is improved operating performance that would be largely impacted by revenue. So, that has been our focus that we think is changing to where the overall number now does start to make a lot more of a difference because we have seen some of the revenue changes to the point that we are increasingly in our systems companies were increasingly a branded company and we are driving overall revenue performance and growth.

So that that transition is a occurring but if you go back historically they are just always been a lot of moving pieces which is been challenging for us around what we say but you will find us be a lot more close to aligning with our operating income performance than our EPS guidance, because of the way we manage things. So that point number one.

Point number two is that if you look at the numbers, as we said, we feel like we were largely on track that we grew our disk and software business 26% year-on-year, we should have grown it more than that you know approaching 50% or so percent and we can point to this deal slippage around the enterprise has been the biggest challenges behind that, but a lot of the rest of the business performed as we had planed and as we had driven the overall performance.

It really gets down to this choppiness that we have in the enterprise relative to the end of the quarter that ultimately its what it was and as Jon has said repeatedly we have to close business, so we have to focus on that, it’s really not about predicting its about been able to close business as we think. We have shown you know some difficult in doing that its in the quarter.

Brian Alger - Wedbush Equity Management

I appreciate the answer, but I mean you guys presented at Needham and you are in front of the Street and I understand you are in a quiet period and all but you guys missed by miles, it was even close and I mean the communication with the Street is what I’m disappointed with. Look I’m happy with the cash flow the $0.07 quarter free cash flow in my math and the guidance that you have for the next quarter is great on free cash flow basis but what’s lacking here and what I’m fearing the stock is going to struggle with for some time is confidence in terms of the communication with the Street.

Rick Belluzzo

The communication with what, our timeframe or guidance?

Brian Alger - Wedbush Equity Management

Look you finish the quarter, the deals obviously slipped but you had to have had some slipping before the quarter ended and to miss the quarter by this much and to not have your guidance and not preannounce, as a shareholder I’m blown away that the number is what it is today.

Rick Belluzzo

Again, I would say that we have through this transition, we have focused primarily, we spent lot of time talking about this on our earnings number as being the most important aspect of the guidance that we provide and we performed very close to that and therefore chose not to preannounce. There was nothing said at the Needham conference that reaffirmed our guidance. We talked about the opportunity. We talked about the strategy that we are pursuing, we’ve even acknowledged that the DXi business had in previous quarters had some of these challenges but that we are focused on building a run rate business and driving enterprise opportunity on top of that. We felt short largely in one segment of that which is around the enterprise opportunities and we chose to focus on the messaging that we have given consistently overall as time period not changing.

Operator

(Operator Instructions)

At this time, I’m showing no further questions in my queue. I would like to turn the conference back over to management. Please continue.

Rick Belluzzo

Thanks for joining us for the Q3 call. As a reminder Q4s a lot of period are called will be generally in the late mid-May timeframe. We will look forward to get back to you then and will also talk about fiscal year ‘12 at that time. Thanks very much.

Operator

Ladies and gentlemen, this concludes our conference for today. If you'd like to listen to a replay of today's conference, please dial 303-590-3030 or 1-800-406-7325, with an access code 4401361#. We thank you for your participation and at this time, you may now disconnect.

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