Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Xyratex (NASDAQ:XRTX)

Q3 2011 Earnings Call

September 29, 2011 4:30 pm ET

Executives

Steve Barber - Chief Executive officer, Acting Networked Storage Solutions General Manager and Director

Richard Pearce - Chief Financial officer, Acting Storage Infrasructure General Manager and Director

Brad Driver - Investor Relations

Analysts

Ananda Baruah - Brean Murray, Carret & Co., LLC, Research Division

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Jung Pak - BMO Capital Markets

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Glenn Hanus - Needham & Company, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2011 Xyratex Ltd. Earnings Conference Call. My name is Georgina, and I will be your operator for today. [Operator Instructions] Today's event is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Brad Driver, Vice President of Investor Relations. Mr. Driver, please go ahead.

Brad Driver

Thank you, Georgina, 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 to today's Xyratex Fiscal Third Quarter 2011 Results Conference Call.

On our call today are Steve Barber, Chief Executive Officer; and Richard Pearce, Chief Financial Officer. Today's call is being recorded and will be available for replay on Xyratex's Investor Relations homepage at www.xyratex.com.

I'd like to remind everyone that today's comments, including the question-and-answer session, will include forward-looking statements, including, but not limited to, a forecast of future revenue and earnings and other financial and business activities. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. These risks and uncertainties are detailed in Xyratex filings with the Securities and Exchange Commission, including the company's 20-F, dated February 22, 2011. 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.

Richard Pearce

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

Total revenue was $361.8 million, down 16% as compared to the third quarter of last year and an increase of 7% compared to our prior fiscal quarter. Sales of our Networked Storage Solutions products were $336.6 million or 93% of total revenue. This is an increase of 6.1% as compared to $317.2 million in the same quarter a year ago and an increase of 11.8% compared with $301.2 million in our prior fiscal quarter. The increase reflects good demand from all of our customers. The increase from the prior year reflects the ramp of business with certain Tier 2 customers, which were acquired by Tier 1 storage providers, offset by a proportional product volume shipped as per our contract with NetApp.

Sales of our Storage Infrastructure products were $25.2 million or 7% of total revenue, down 77.7% as compared to $113 million in the same quarter a year ago and down 32.6% compared to our prior fiscal quarter. The decrease in revenue as compared to the third quarter of last year primarily reflects the significantly lower demand for disk drives, the uncertainty regarding the pending acquisitions by Seagate and Western Digital and increased competition.

Gross profit margin in the third quarter was 16.7% compared to 17.6% in the same period a year ago and 12.9% in our prior quarter. The decrease from last year resulted from the significantly lower SI revenues offset by a favorable customer and product mix in the NSS business. The increase compared to the prior fiscal quarter primarily reflects stronger than expected gross margin in our NSS business due to favorable customer and product mix. Gross margin for our NSS business were 17.2% as compared to 12% a year ago and 14.9% in our prior fiscal quarter.

The timing of the transition of a number of customer products has had a beneficial effect on gross margin. And at this time, we do not expect the same beneficial effects next year. As a result, we expect NSS margins in 2012 to vary between 14% and 16%.

Gross margin for the SI business was 9.6% as compared to 33.8% a year ago and negative 2.7% last quarter. The decrease in gross margin compared with the previous year was primarily the result of the impact of fixed operating costs on lower revenues. Additionally, as a result of the bankruptcy filing by Solyndra, we recorded a bad debt provision of approximately $1 million. Solyndra has been a customer for approximately 4 years.

Turning to non-GAAP expenses. Our operating expenses totaled $45 million compared to $46.3 million last quarter and $37.6 million last year. We commenced actions to reduced expenses in the SI business in September, including reducing the number of permanent and contract workers. We expect to spend $4 million on restructuring costs in 4Q 2011, and these are included in the non-GAAP EPS forecasts we included in our earnings release.

Therefore, the effect of these cost reductions will not begin until 1Q of 2012. We are planning to reduce quarterly operating expenses related to the SI business by approximately $6 million in 2012, although this will be offset to some extent by increased investment in the NSS business.

Moving on to net income. For the third quarter, non-GAAP net income was $12.7 million or $0.42 per diluted share compared to non-GAAP net income of $37.6 million or $1.20 per diluted share in the same quarter a year ago. GAAP net income was $9.7 million or $0.32 per diluted share compared to GAAP net income of $37.2 million or $1.19 per diluted share in the same period last year.

Turning our attention now to the balance sheet. Cash and cash equivalents at the end of the quarter was $136.2 million compared with $126.9 million at the end of Q2. Cash flow from operations was $33.7 million in the quarter.

Inventories increased by $4.2 million to $157.3 million in the quarter. Inventory turns were 7.8, unchanged from the previous quarter. Accounts receivable decreased by $2 million in the quarter to $175.2 million. Days sales outstanding were 44 in the quarter compared to 47 in the previous quarter.

During the quarter, the company repurchased 2.1 million shares at an average price of $9 and a total cost of $18.6 million. At the end of the quarter, a total of 2.6 million shares have been purchased under the plan at a total cost of $23.9 million. As previously announced, the company paid its first dividend in the quarter of $0.05 a share and totaled $1.5 million.

Headcount at the end of the third quarter was 2,037 permanent employees, a reduction of 75 or 3.5% from across our SI division and related operations activity. We are in the process of implementing further headcount reductions in our SI business through the remainder of this year.

In summary, the results were good compared to our expectations driven primarily by better-than-expected gross margins in the NSS business. We believe the demand environment within the NSS business will remain relatively strong through the end of the fiscal year. We are not currently seeing an impact from uncertainty caused by recent financial market volatility. The SI business continues to be affected by a number of industry and macroeconomic aspects, which Steve will provide further commentary on shortly.

We are committed to improving our profitability, particularly in the SI business, through expense reductions and generating cash while continuing to invest in the business, including the many opportunities we see in the NSS business.

Now before I turn over to Steve for his comments, I would like to provide you with our business outlook for the fiscal fourth quarter. Our business outlook is based on current business expectations. It should be noted that there are a series of forward-looking statements in today's guidance that involve risks and uncertainties. Actual results may differ materially from our statements or projections. In order to clearly understand the risks involved, it is recommended that each investor review the risk factors outlined in our 20-F filing.

Although macroeconomic worries persist, the projections I'm about to provide reflect our current best estimates. These projections take into account forecasts from our customers, recent industry projections and our own modeling. For our fourth quarter 2011, we are projecting total revenue to be in the range of $343 million to $383 million, down 14% to 3% as compared to last year and down 5% to up 6% compared to 3Q. This is represented by revenue from the Networked Storage Solutions of $314 million to $344 million and from Storage Infrastructure of $29 million to $39 million.

For Q4, gross margin is expected to be 16% to 17%. We are estimating non-GAAP earnings per share to be between $0.27 and $0.45. Non-GAAP earnings per share excludes noncash equity compensation and amortization of intangible assets. The number of shares expected outstanding at the end of Q4 on a weighted average treasury method is 29 million, subject to any further buyback of shares in the quarter. Our cash position at the end of 4Q is expected to be approximately $120 million.

I will now hand over to Steve for his comments.

Steve Barber

Thank you, Richard. Firstly, I apologize for my voice on this call. I'm suffering from a sore throat. I was pleased with our overall performance in the quarter. We executed well for the needs of our NSS customers and gross margins improved as a result of near-term customer and product mix on annex [ph]. The market outlook remains positive. We expected strong customer demand through the remainder of the year.

Our SI business remains significantly challenged as a result of the disk drive industry's continued constrained capital expenditure and increased competition. As Richard indicated, in light of the market environment, we are aggressively reducing our cost structure in this business and reducing headcount accordingly. I believe these actions will allow us to improve the financial performance of the business even at lower revenue base while protecting our core assets and future product development activities, key to ensuring our readiness to support our customers' technology and capital requirements in the future.

I'll now review our 2 businesses separately starting with Networked Storage Solutions. Our fiscal third quarter revenues of $336.6 million were in line with our expectations for the quarter. Overall, the feedback from our customers remains positive as to the overall market demand for enterprise storage, and the demand continues to track to prior forecasts.

We've seen positive demand from Dell and HP as they integrate their recent acquisitions. IBM announced their product refresh of the XIV platform in July. [indiscernible] earlier this month. And our NetApp business remains very good.

With regard to our product portfolio, we continue to invest with our flexible OneStor architecture that enables our OEM customers to offer a range of scalable storage enclosures and disk drive capacities to meet the needs of their end-user customers. We are successfully executing on our strategy to complement our core storage businesses by providing OEMs with a portfolio of data storage solutions to address the needs of high-growth markets. The implementation of this strategy commenced nearly 4 years ago with introduction of our family of Integrated Application Platforms, combining storage and complete processor technology within an integrated optimized platform. This architecture enables our OEM customers to integrate software and storage into a single solution.

The next phase of the strategy is to provide an integrated storage solution with both hardware and software content that addresses the needs of target high-growth markets. This led to the June announcement of our first such platform, the ClusterStor 3000, designed specifically to address the needs of a high-performance computing or HPC market.

The HPC data market -- data storage market represents a large and high-growth sector that provides us with an ideal opportunity [indiscernible] innovation in terms of performance, availability and ease of management, drawing on our proven enterprise path storage application platform technology. In conjunction with our investments in Lustre file management systems, we've been able to establish a truly world-class clustered file system developed in the support organization together with an industry-leading HPC data storage solution.

ClusterStor's architecture delivers 3 inter-related benefits to the HPC environment: linear performance scalability, ease in installation and management and enhanced storage system reliability at scale. We're currently shipping ClusterStor 3000's qualification systems to OEM partners. The feedback received to date has been very positive, and we intend to begin production shipments within the next few months. These target OEM customers currently participate successfully in each of these new markets, so we're excited by the opportunities this market represents.

Looking forward, we're actively engaged in a number of new opportunities to grow our business. Many of these opportunities are in adjacent, vertical markets where we're working through existing OEM customers and by engaging with a number of high growth or emerging OEMs, exhibiting integrated and compelling product technologies. The opportunities in the emerging cloud market are perfect examples of how Xyratex is participating in adjacent verticals. We have partnered with emerging [indiscernible] Structured providers that are leveraging our integrated application platforms as a basis of their solution. In addition, we feel our ClusterStor architecture is well suited for the cloud and big data application environments. And finally, Xyratex is investing in the development of next-generation architectures that provide the best-in-class performance, reliability and scalability for the cloud.

Overall, we've been encouraged by the strong customer bond [ph] We're seeing. We shipped over 1 exabyte of enterprise storage in the fiscal third quarter, representing a 13.2% increase over the prior quarter and 29.3% growth over a year ago. Based on recently published data on the total terabyte shipped in enterprise storage systems, for calendar Q2 2011 [indiscernible] Xyratex once again maintains its position as a leading player in the market, supplying over 17% of capacity.

Our strategy of expanding our product portfolio to address adjacent market demand through OEM customers is already providing a positive outlook for the business in regards of both revenue and associated improvement in gross margin. The enterprise storage markets continues to grow driven by the increasing investments in data centers both traditional and the cloud. Despite the continued growth in data content integration and replication, surveys of enterprise COOs continues to confirm strong demand for incremental storage and their resulting allocation of IT budgets for storage.

In addition, we are very pleased with the launch and volume ramp of our ClusterStor 3000 HPC platform. Our strategy is to continue to grow our business both in traditional markets and increasingly in the emerging cloud markets. I'm very pleased with our execution in the last quarter and year-to-date and remain confident in our ability to grow this business through enabling our OEM customers' businesses growth in their end-user markets.

Moving now to our Storage Infrastructure business. For the third quarter, revenues in this business were $25.2 million, in line with our expectations. The industry continues to be very cautious with respect to capital expenditures, and I see this continuing for the next few quarters. As we stated in our last call, in light of the current constrained investment environment by our disk drive customers, we're aggressively reducing cost in the business while maintaining our customer focus and investments in core technology. In light of need to restructure the business, last month we changed the management leadership in the business and appointed Richard Pearce as Interim General Manager of the SI business. Howard Leon [ph], along with a number of other senior managers, have left the company to pursue new opportunities. Richard has significant knowledge of the SI business and its customer base. He'll provide strict financial management of the business and will set the priorities for the business with the aim of meeting customer needs and optimizing returns.

In the longer term, we'll work to identify an experienced leader for the division either from internal candidates or from the results of an external executive search needed, although I'm not at this time defining a timeframe to fulfill this role. The disk drive industry remains in a position of uncertainty, awaiting the outcome of reviews by both the U.S. Department of Justice and the European Union Regulatory Authorities of the proposed industry consolidation actions by Seagate and Western Digital. The outcomes of these reviews are currently expected towards year end.

In addition, the macro environment remains challenging for the industry, with depressed consumer spending and specifically notebook sales significantly below original expectations. Recent industry reports have further reduced their forecast of PC unit sales growth for 2011 in some cases to now as low as 1%. Effective tablet sales of laptops and PCs in the longer term remains unclear, although it certainly represent an impact in the near term. In contrast, the growth in data centers in terms of supporting the growth of cloud storage and online application services remained strong with the disk drive industry continued to see strong demand for high-capacity 3.5 inch devices used in these applications.

I believe the connection between tablets and the cloud is increasingly clear with the growth of tablets driving demand and growth for replicated content across multiple data centers across the globe needed to provide responsive access to consumers. While it remains unclear at this stage what effect the shift by users from PCs to tablets will have on the total terabytes of data storage needed, it is possible that the growth from new and replicated content integration and in turn the storage of this data will continue at historical levels with more than 50% compound growth. The emergence of tablet devices, together with the growth and ease of access to cloud-based storage, is likely to result in an increased content integration and storage by consumers.

We're witnessing a clear shift by consumers from storing data locally on their PC or laptop to instead storing their data remotely in the cloud data center with a third-party provider. The future of disk drive industry remains very positive as a key enabler to the growth of cloud storage.

Until some of the uncertainty around industry consolidation and future data storage demand is resolved, I believe, based on our interactions with our customers, that they will remain cautious in their capital equipment investment plans. For this reason, we are not yet anticipating a recovery in the disk drive CapEx markets before mid-2012.

Through this period, we will scale back our activities in this business in order to reduce our expense base. We're actively refocusing our R&D activities around specific products and technologies needed to support our customers' roadmap and process efficiency requirements. We are updating [ph] Our R&D focus on developing solutions needed to enable future recording technologies for our customers. While these are not near-term revenue opportunities, they represent key technologies for the future. In addition, we are analyzing all aspects of our organizational structure, execution processes and operations with a view to optimizing, streamlining and reducing costs prior to our fiscal year end.

Whether the industry consolidation acquisitions are approved or not, we see good opportunities with both existing and new customers. Our new disk drive test platform qualifications for both 2.5 inch and 3.5 inch form factor drives continues to progress well with our current customers, positioning us well when demand for incremental production capacity resumes. Qualification of our test platforms is progressing well with Toshiba, and we are working closely on potential revenue opportunities related to production capacity growth in digitized components.

Despite the technology challenges facing the industry in increasing areal recording densities, higher capacity disk drives continue to be developed with 3 terabyte disk drives now shipping in volume and 4 terabyte drives recently announced by 2 providers. These higher capacity drives demand ever higher manufacturing test times, driving ongoing demand for capital equipment investment. We fully recognize competitive risks in the business. Teradyne has developed competitive 2.5 inch disk drive test platform and we see competition from Hitachi High-Tech in media optical inspection technology.

We clearly recognize that in many cases, our customers wish to source through 2 suppliers to provide them with specific technology features or to provide competitive benefits. Our objective has always been and remains to develop a leading product technology, execute our commitments and to exceed our customers' expectations. This objective is at the forefront of our minds as we determine our investment priorities through this challenging period for the business. We are focused on staying ahead in our technology solutions, providing our customers with solutions that deliver operational and cost benefits to their business.

In summary, we're experiencing a unique set of circumstances that are affecting the global economy and the wider disk drive industry itself. We are focused on executing and developing the right products and technology to meet the requirement for disk drive market as it navigates through this very challenging period and to be ready to responds to unforecasted demand, should it arise.

In the near term, we are focused on reducing divisional operating costs and investing appropriately for the future and I remain optimistic as the future of the disk drive industry and Xyratex's ability to benefit from the continued growth in data content and storage.

I would once again like to take this opportunity to thank all our employees worldwide for your efforts in meeting our customer commitments, executing on our customers' requirements, resolving technical challenges that arise in this technology business and delivering on our product development milestones. We are clearly facing near-term challenges in our SI business that inevitably affects the wider company and many of our employees. And I look for your support and commitment as we work through these.

That concludes our formal comments. I would now like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And gentlemen, your first question today comes from the line of Aaron Rakers with Stifel, Nicolaus.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

A couple questions, if I can. First of all, in looking at what you'd announced, just to be clear, the $1 million charge, bad debt charge, that -- if I back that out, is it fair to say that your gross margin on the SI business is roughly, what, 13.5%, 14%? Is that the way to think about it? And how are we thinking about gross margin in this next quarter and when maybe we can get back into, let's just say mid-20% plus gross margin in that business?

Richard Pearce

Yes, I think that's the correct way to look at it. And I guess that was pretty much in line actually with our expectations that margin would continue to be depressed in the quarter given the low volumes and the product mix that we saw. As we move then into the fourth quarter, we expect we won't have obviously the effect of another Solyndra situation, but I still see margins sort of at the higher end of 10% to 15% but still sort of tracking in that range. And then as we move into next year, once we take some cost out of the business in operations as well as in the OpEx areas, then I would expect to see the margins pick up to sort of the low end of the 20% in the first half of the year when our expectation, I think, that which is -- I'm not giving guidance for next year as we speak now, but our expectations are, and I think Steve covered it in his comments, that it's going to be a relatively slow start for the year as is common in the SI business anyway. And we really need to get back to revenue levels of kind of $50 million or $60 million a quarter before we get into the sort of 25% to up to 30% range where we've historically been. And again, we're now guiding for next year. We see that coming potentially at the back end of next year.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Okay. Good. And can you walk through, as you have in the past, your customer concentration within your Systems business?

Richard Pearce

Sure, yes. As a percentage of the Systems business, NetApp in the quarter actually reduced to just under 40%. That's not uncommon in terms of the spread. Obviously, our quarter is not aligned, and within our second quarter, the year end happens. [indiscernible] So if you actually go back over the last 3 years, you will see that type of a trend. So you shouldn't read anything in terms of either NetApp performance or the proportion of business, which we understand does change at the end of our fiscal year of which NetApp can outsource. So that's kind of normal-ish for us. Dell actually increased to around about 27%. IBM was around 12%, pretty consistent with the previous quarter. EMC was 8%, again which is consistent with the previous quarter. And HP actually increased to 8%, which kind of is almost doubling the volumes that they have from the previous quarter as they now integrate the 3PAR acquisition. We also have slightly better revenues with some of our, if I can term, smaller Tier 2 customers; people such as Harris, Harmonic and Daystrom [ph]. So yes, hopefully, that gives you the spread you're after.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

And then a final question on that same topic. When we think about the current macro backdrop, I guess I'm a little bit perplexed at your comfort level in the current trends and the current dynamics. You have not seen any changes as far as your customer order patterns or visibility as far as that's concerned at this point?

Richard Pearce

Yes, I guess -- I mean, I guess a simple answer to that is no, that we've not seen any changes in those patterns. So as per our comments that we made, we are not seeing any impact on that side of the business.

Operator

Your next question comes from the line of Amit Daryanani with RBC Capital Markets.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Just want to follow up on the SI side. Could you maybe one help us understand if you think there's some pent up demand on the SI side that could come unleashed, I guess, once these deals are done with the HD [ph] vendors? Or do you think that may take a while? And then just secondly, I want to understand, for you guys to get to this low 20% gross margins in the first half, does that imply revenues in the $30 million, $35 million range? Or what's the revenue run rate you're assuming at that point?

Richard Pearce

I guess I'll take your second question first, if I may. Again, we're not providing guidance for next year, but in terms of revenue levels, then in the first half of the year, I guess my expectations, as we stand today, are levels of somewhere between $20 million and $35 million in each of the quarters in the first half of the year. It's my best estimate today. And at those levels, given the reductions that we are going to be seeing out of the operations costs, then my expectation is that we would get to the 20% type level, low 20s, on that side of the business. In terms of the pent-up demand, and I'll let Steve jump in if he wants as I answer this. And I think there is the uncertainty as we've discussed around the acquisitions. But also, as we've seen from the many reports, then it's a challenging time in terms of numbers of disk drive -- unit shipments of disk drives being shipped at the moment. And therefore, again, relating back to our comments, we believe that our customers are heading up towards the higher levels of the total capacity that they've got. That said, the normal demand is that it starts to reduce in terms of the growth in the first half of the year. So whilst there be demand now, my expectation is still the drive companies will not look to add incremental capacity until it is necessary. And therefore, the expectation -- I think there's also an expectation that the PC sales in a number of reports, which are at the moment actually do start to increase again next year, up from maybe the 1% levels we're seeing this year to maybe 4% or 5% next year and that should help. And therefore, we really see better demand coming towards mid to the back end of next year.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Got it. That's helpful. And then secondly, I guess could you just remind us how does the NetApp deal sourcing work at the end of this fiscal year for you? Did the number jump to about 50% that they can source away from Xyratex? And...

Richard Pearce

Yes. Again, yes, is the short answer. I think we've covered it in previous calls, so I've got no issues with addressing it in this call and at the end of our fiscal year. Then the minimum amount of products -- of the latest product that NetApp takes from us goes from 75% as it currently is in this year down to 50%. So we do have another, I'd say, legacy products still with NetApp, which remains at the 75% level, but today, that represents less than 20% of the overall business. So potentially, we reduced by 1/3 to 30% of the overall NetApp business. Equally, NetApp still does continue to grow at the same time. So in balancing those effects, maybe a 20% reduction overall would be a reasonable estimate in that NetApp business.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Yes. And I guess the part I was really trying maybe to understand was, is your sense talking to NetApp at least at this point that it's all going to happen, let's say, in the Q1 for you guys? Or do you think that kind of degradation will be more spread throughout fiscal '12 and give you an opportunity to maybe offset it with some other growth drivers?

Richard Pearce

Yes, I think. And again, something that we talked about this year, obviously last year, which was the first period when any amount of the product could move across, we didn't see it all move across from day 1. But that said, it was the first year that they were actually bringing up a second source. So you wouldn't have expected it to transition immediately. Again, my expectation is that on day 1 it won't necessarily all transition, but I think the capability is there in their second source. So we should expect to see a large proportion of that effect actually happening in our Q1.

Operator

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

Ananda Baruah - Brean Murray, Carret & Co., LLC, Research Division

I guess just following up on that one. I mean, if you took a look at sort of like what your -- I guess what your base case was for NetApp, you actually maybe even say like a little bit softer than base case, the NetApp next year and then your base case for all the other ramping relationships. How would you expect growth sort of fall out next year relative to this? Without giving specific guidance. Can you give us some sort of body language around it?

Richard Pearce

Yes, I think in previous calls, we discussed that we see the business being kind of flattish next year, and I guess the expectation -- flattish to maybe even slightly up. The expectation there would be the SI revenues would increase from this year. I think we're still thinking that, that will be the case. And the NSS would be sort of flattish to potentially slightly down next year, a couple points. What we have seen, and I think that's been reflected obviously in some of the gross margins that we've seen in Q3 and the gross margins that we're looking at in Q4, in some of the legacy products that I guess we weren't anticipating would continue through this year in the NSS business have actually continued in this year. It's still our expectation that as we move through 2012, some of those will start to drop off. So I do think that as it stands today -- again, we're not going to give you any guidance, but overall, as we stand today, I would expect sort of flattish across the business, slightly up on the SI business, maybe slightly down on the NSS business.

Ananda Baruah - Brean Murray, Carret & Co., LLC, Research Division

I got you. Now this has to be down because some of the legacy stuff has sort of had a longer tail to it this year than your stuff.

Richard Pearce

Yes. And also, at the NetApp side of things, I think we're not just talking about maybe on balance and again it's not a science as we stand today but expecting that the NetApp business with the move there will represent about a 20% reduction. I think we've been relatively clear with our NetApp business. And obviously, you can get that from the MD&A data anyway. So you would expect the NetApp business this year to be somewhere sort of 560, sort of 585, 590 region. So you if you look at the 20% coming off that, then, yes, it's a relative slug actually coming off the revenue. That said, going back to the sort of comments that we've had on the margin, we do expect to sort of maintain relatively strong margins into next year. So that should be helpful.

Ananda Baruah - Brean Murray, Carret & Co., LLC, Research Division

Got it. And I guess on SI, sort of given, I guess, the shifting of R&D dollars relative to some of the initiatives, could you give us a sense of -- if any of the -- I guess what's going on with some of the newer stuff that you're working on, the timing and the magnitude of what we should expect now and to what extent the competitive positioning shifts in the marketplace with what other folks are doing, as best you can see?

Richard Pearce

Yes. I think we've spoken on this call and a number of conferences about the investments that we've been making in the component side of the business and some initiatives, actually a number of year out that we're looking at. I think we haven't seen the ramp in the component side of the business that we originally anticipated. I think for a couple of reasons: one, obviously, just generally the number of units being shipped and the pressures on the growth of the disk drive industry being one; and two, I think some of the areal densities may have just been squeezed a little more than we expected. And therefore, the reduction in areal densities has not caused the increase in components to happen potentially as quickly as we had forecast and maybe others had forecast. That said, from everything that I see and obviously, I've become a little more involved in the SI business, particularly over the last few weeks. The expectation out there from analysts and within our customers is that areal densities will be challenged as we go out 1 year, 2 years. So we do expect that -- the number of components per drives to increase and the number of components in total, and therefore, test equipment related to those to increase. So the investments that we've made in the areas, both acquisitively and through our internal investments, I think still represent reasonable value. But to the extent that we don't necessarily see that ramp coming from maybe even a couple of year in that side of the business, they are the areas where we will be reducing some of our R&D expenditure in the near term. We definitely will not be reducing our expenditure in our core areas of DPS and certain media areas. We may be reallocating some of that expense and very much working with our customers in understanding their products and technology requirements in the near term and ensuring particularly in the light of the increased competition that's coming over the last couple of years from Teradyne that we are focusing on those areas of our customers. So my expectation in our core businesses of the back end test, which I think again we've been pretty clear throughout represents, say, 70% of our business with the year. We will not be reducing our expenditure in those areas, and we are expecting those core businesses to actually see some rebound coming through next year. But in some of those other newer areas, I would say we're a little bit on hold on those at the moment, but we still do see opportunities for those a couple of years out. And we're still at slightly lower levels continuing to invest in that technology, one we believe it's the right place for us to be. And two, we believe our customers holistically across that business do need our capabilities in there as technology moves forward.

Ananda Baruah - Brean Murray, Carret & Co., LLC, Research Division

That's really helpful. And I guess just last one for me. I guess if you think about the potential outcomes for the proposed acquisitions from Seagate and Western Digital, what's the optimal outcome for Xyratex from a potential pan perspective as you go into '12?

Richard Pearce

I think the optimal position is that the uncertainty is concluded sooner rather than later. It's the uncertainty, which I think gives our customers and ourselves an issue -- I don't think we've got particularly any preference to whether it happens or not. That said, I do believe we obviously -- our success is dependent on the success of the disk drive, and I actually think that the acquisitions are correct thing to happen, such that the disk drive can remain very competitive against flash technology. So I think it's the right thing for the industry. And the disk drive industry obviously is important to us. So my desire is that the uncertainty is cleared as soon as possible, and that it is positive in terms of supporting and seeing those acquisitions go through.

Steve Barber

I'd add that the -- with Samsung being acquired, the potential of increased [indiscernible] for us because Samsung has historically been in-house solutions. So basically, the time [ph] increases marginally 10% or so by Samsung coming into the fold of Seagate.

Operator

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

Glenn Hanus - Needham & Company, LLC, Research Division

Just back on NetApp for a second. Would you expect to see that percentage rebound as it normally does, I assume, this coming quarter?

Richard Pearce

I guess my expectation is yes. Again, back to my previous comments that a normal trend does continue. And therefore, overall, on a normalized basis, I would expect to see the NetApp number go back up obviously given that the reduction in our proportion, which actually happens in line, again to be clear, with NetApp, quarter. And so it will be at the start of November rather than the end of November, could have a minor impact on our revenue in the quarter. But overall, yes, I wasn't sort of making any predictions on what NetApp may or may not be, and my expectation is it's a normal pattern.

Glenn Hanus - Needham & Company, LLC, Research Division

And any update there on where it stands as you exit 2012 and start to look towards 2013 in your discussions about your potential relationship going forward?

Richard Pearce

No further discussions on that, that I can report on at this stage. It is my expectation that we will have a continuing relationship with NetApp as we go through into 2013, but it's relatively early stages on discussions on that. And when I'm in the position to give further details on that, I will.

Glenn Hanus - Needham & Company, LLC, Research Division

And back on the investments on the NSS business, could you talk a little bit more first on ClusterStor, your go-to market process there, how that's going? And then from an overall investment standpoint, the increase you mentioned, is that pretty much all R&D? Or is there some sales activities and how to think about that?

Richard Pearce

Well, I'll let Steve cover the ClusterStor strategy, and then I'll talk a little bit about the increase in expense we expect on the NSS side of the business and where they will be.

Steve Barber

Richard, so far, I guess, the market has been twofolds. We have been engaged with end users of HPC equipments through the development process of this platform, really to gain a deep understanding of the needs, specific needs around storage in that space. And that's been extremely helpful in us developing the architecture that we've actually brought to market. So we've been engaged with alpha systems in end user locations, but the [indiscernible] Now is predominantly OEM focused to HPC computer partners who sell into that marketplace. We're looking to integrate storage along with their computer applications. So we do see our route to market being through our OEM partners, both current and new partners, who access that space or specialize in that space. And whilst we continue dialogue with end users, it's really from a data-gathering standpoint to assess the performance requirements of that marketplace and equally important the road map where they see the performance requirements going that we can then make sure we have that embedded into our roadmap.

Richard Pearce

And, Glenn, just to chip in there, from an expense perspective where we mentioned that we expect to see some increases in the NSS side of the business, I expect to see slightly across both elements R&D and SG&A, more so on the R&D perspective, particularly related to ClusterStor and other areas that we look to address, particularly in the cloud that we talked about in the call. It's always to give approximate proportions. I would expect maybe R&D to increase twice as much as the SG&A, but there are increased sales and sales related costs related to the ClusterStor and the higher, I guess, Xyratex and even software content involved in that. So sales cost will also increase in that area.

Steve Barber

Yes. And specifically, Glenn, field application engineers associated with ClusterStor will be critical to provide storage support to the computer OEMs that we're dealing with. They will look for us to provide, I guess, increased levels of end-user support, technical support, than we currently see within our traditional OEM business.

Operator

Your next question comes from the line of Jung Pak with BMO Capital Markets.

Jung Pak - BMO Capital Markets

In your NSS business, are you guys expecting gross margins to be roughly flat sequentially in the fourth quarter?

Richard Pearce

Yes, I think flat set, yes, somewhere between the 16% and 18%. I think we feel pretty comfortable in that region.

Jung Pak - BMO Capital Markets

Okay. And then for FY '12, what's driving the increase in the NSS gross margins? Your previous assumptions were in the 11.5% to 12.5%. What's driving the increase? Just the -- I believe you said 14% to 16%?

Richard Pearce

Yes. A couple of reasons there. The first reason and I guess the primary reason and I guess as I touched on in terms of we continue to see and we see good margin in 3Q and 4Q related to some of the legacy products that we expected that we weren't going to have significant revenues for. I don't want to get into specific customers or products here, but there are a number of products that we expected to transition out, which have relatively good margins, and they're continuing on through at least the front half of next year. And the other item is, I guess, some of our confidence level was in the opportunities of having revenue of some of our new products, and particularly those in ClusterStor, as we go into the back end of the year have got greater. And as we've discussed previously, the margins related to those products, where we do provide more technology and more software within there, are greater. So it's really a mixture of those 2, but primarily the former being the legacy product lasting longer as, I guess, is often the case. Newer products take longer to come on than you think and older products last a bit longer than maybe you would have thought.

Jung Pak - BMO Capital Markets

Okay. That's very helpful. And then last quarter, for the SI business, you said you are comfortable with the consensus revenue estimates. So were the orders pushed out or canceled for this quarter?

Richard Pearce

They definitely weren't canceled, and you're correct in your statement there. There are some orders, which have been pushed out into -- my expectations will be the front half of next year.

Jung Pak - BMO Capital Markets

Okay. And lastly, any updates on the competitive landscape for the 3.5-inch test market? Are you guys still the only supplier there?

Richard Pearce

Yes, we are not aware of any other third-party competitors in that market space.

Operator

[Operator Instructions] And gentlemen, it doesn't appear that we have any more questions in queue at this time. So we'll go ahead and conclude the question-and-answer portion of today's event, and I'll turn the call back over to Mr. Driver for some closing remarks.

Brad Driver

Thank you, Georgina. And once again, thank you for joining us this afternoon. We look forward to speaking with you again on our Q4 and fiscal 2011 earnings call, which we scheduled for early January 2012. Also, in November, we'll be presenting both at the Needham ACD Conference in Boston and at the Stifel, Nicolaus Midwest Conference in Chicago, where we'll provide further updates to the business environment at that time. Additionally, we'll be presenting at the Barclays Conference in San Francisco early December.

Please look for the exact date of these presentations on our calendar page of our Investor Relations website. As always, you are welcome to call me if you have any additional questions over the course of the quarter. Have a nice rest of the afternoon.

Operator

Ladies and gentlemen, this does conclude the presentation today. Thank you so much for your participation, and have a great evening.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Xyratex Management Discusses Q3 2011 Results - Earnings Call Transcript
This Transcript
All Transcripts