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Xyratex (NASDAQ:XRTX)

Q4 2011 Earnings Call

January 05, 2012 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 -

Analysts

Keith F. Bachman - BMO Capital Markets U.S.

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

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

Glenn Hanus - Needham & Company, LLC, Research Division

Nehal Sushil Chokshi

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter and Fiscal Year 2011 Xyratex Earnings Conference Call. My name is Keith and I will be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. And I would now like to turn the conference over to your host for today, Mr. Brad Driver, VP, Investor Relations. Please go ahead, sir.

Brad Driver

Thank you, Keith. And good afternoon, everyone. Thank you for taking the time to join us this afternoon. I'd like to welcome investors, research analysts and others listening today to Xyratex's Fourth Quarter, Fiscal Fourth Quarter, and full fiscal year 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's 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 and the full year.

Richard Pearce

Thank you, Brad and good afternoon, everyone. I'd like to thank you for joining us today. Our press release is available both on PR Newswire and our website. I'd now like to provide you with some commentary about our results for the full fiscal year and the fourth quarter of 2011. Please note that all numbers are in accordance with GAAP unless stated otherwise.

Revenue for the full year was $1.45 billion, down 9.6% compared to fiscal year 2010. Revenue for the fourth quarter was $388 million, down 2.3% as compared to the fourth quarter of last year and up 7.1% from our prior fiscal quarter. Sales of our Network Storage Solutions products in the fourth quarter were $353 million, representing an increase of $26 million or 7.9% compared to the fourth quarter of last year and up 4.7% compared with $337 million in our prior fiscal quarter. Revenue from our Network Storage Solutions products for the full year increased 5.2% to $1.32 billion in 2011 compared to $1.26 billion in 2010, accounting for 91% of total revenue and 95% of gross margin.

The change from the prior year reflects growth across the majority of our major customers, including Dell, EMC, HP and IBM, offset by a proportional product volume shift as per our contract with our largest customer, NetApp, which Steve will describe in further detail. Sales of our Storage Infrastructure products in the fourth quarter were $35 million, down 50% compared to the fourth quarter of last year and up 36% compared with our prior fiscal quarter. Revenue from our Storage Infrastructure products for the full year was $124 million, down 64% compared to $343 million in 2010, accounting for 9% of total revenue and 5% of gross margin. The fiscal year performance for our SI division reflects reduced demand for capital equipment from our 2 major customers, Seagate and Western Digital, as a result of their proposed acquisitions from Samsung and Hitachi, respectively. The impact of the 2 natural disasters in Japan and Thailand reduced demand for PC drives and increased competition from Teradyne.

For fiscal year 2011, gross margin was 15.4% as compared to 17.6% in fiscal 2010. The decrease from the prior year was primarily due to the decrease in SI revenue, partially offset by an increase in our NSS gross margin. Gross margin for 4Q 2011 was 17.7% compared to 16.1% in the same period a year ago and 16.7% in our prior fiscal quarter.

For the full year, gross margin in the NSS business was 16.1% as compared to 13.3% in fiscal 2010. The gross margin for Q4 2011 was 17.7%, up from 13.3% a year ago and up from 17.2% in the prior quarter. The increase, as compared to the last year was primarily due to favorable changes in customer and product mix.

For the full year, gross margin in the Storage Infrastructure business was 8.3% as compared to 33.4% in fiscal 2010. The gross margin for Q4 2011 was 18% compared to 29.7% in the fourth quarter of last year and 9.6% in the prior quarter. The decrease as compared to last year was primarily a result of decreased revenues relative to fixed costs.

For the full year, non-GAAP operating expenses increased by 21.4% to $179.1 million as compared to $144.6 million in 2010. The primary reason for the increase was increased R&D investments in the new SI product platform and the NSS ClusterStor beta program launch. Decisive actions were completed during 4Q to reduce expenses in our SI business to better align our cost structure with our business expectations.

Non-GAAP operating expenses in the quarter were $44.3 million compared to $42.5 million in 4Q of last year and $45 million last quarter. 4Q expenses includes $2.75 million of restructuring costs. The full benefit of this restructuring exercise will be experienced beginning in Q1 2012, partially offset by increased expenditure related to our ClusterStor business. We expect Q1 expenses to be in the range of $40 million to $43 million.

For fiscal year 2011, GAAP net income was $28.3 million or $0.93 per diluted share compared to GAAP net income of $139.4 million or $4.46 per diluted share for fiscal year 2010. On a non-GAAP basis, full year net income was $39 million or $1.28 per diluted share compared to $135.7 million or $4.34 per diluted share a year ago.

GAAP net income in the quarter was $18.5 million or $0.65 per diluted share compared to GAAP net income of $32.3 million or $1.02 per diluted share in the fourth quarter of 2010.

On a non-GAAP basis, net income for the fourth quarter was $20.8 million or $0.73 per diluted share compared to non-GAAP net income of $21.9 million or $0.69 per diluted share in the fourth quarter a year ago. The reconciliation between non-GAAP and GAAP net income is provided in our press release.

Turning our attention now to the balance sheet. Cash and cash equivalents at the end of the quarter was $132.6 million, down from $136.2 million at the end of Q3. This includes expenditures for share purchases of $8.4 million in the quarter. Cash flow generated from operations was $7.5 million in the quarter. Inventory increased by $6.9 million to $164.2 million in the quarter, primarily due to our proactive steps in securing sufficient disk price supply related to the recent flooding in Thailand that Steve will discuss in more detail.

Inventory turns was 7.9 compared to 7.8 the previous quarter. Accounts receivable increased by $25.5 million in the quarter to $200.7 million and day sales outstanding was 47 compared to 44 in the previous quarter. Headcount at the end of the November quarter was 1,960 permanent employees, a reduction of 77 employees or 3.8% over the previous quarter. This reflects the actions taken to align our SI expense levels with our future business expectations.

Now before I turn the call over to Steve for his comments, I would like to provide you with our business outlook for our fiscal first quarter 2012 ending February 29.

Our outlook range is wider than normal due to the uncertainty surrounding disk drive availability. For our first quarter of 2012, we are projecting total revenue to be in the range of $275 million to $355 million, down 24% to 2% as compared to last year and down 29% to 8% as compared to 4Q '11. This reflects the anticipated product transitions that Steve will discuss in more detail in addition to normal seasonality.

We are experiencing increased demand for our SI products, in part related to the recent flooding in Thailand. We believe this may results in a onetime revenue benefit of approximately $50 million across Q2 and Q3. However, we expect margins to be lower as a result of costs associated with expediting this equipment to meet our customers’ urgent needs.

For Q1, gross margin is expected to be 15.5% to 16.5%. We are estimating non-GAAP earnings per share to be between $0.07 and $0.41. Non-GAAP earnings per share excludes noncash equity compensation, amortization of intangible assets, specified non-recurring items and related tax expense. The number of shares outstanding at the end of Q1 on a weighted average treasury method is expected to be 28.5 million. Our cash position at the end of Q1 is expected to be approximately $150 million.

In summary, we had a good quarter primarily as a result of better than expected gross margins in our NSS business. The full year was represented by a strong performance in our NSS business in contrast to our SI business where performance was significantly below our original expectations. The reason behind the poor performance in SI have been discussed over the last several quarters and we have acted to reduce our cost structure to reflect this.

I was particularly pleased with our cash generation. In fiscal 2011, our net cash increased by $42 million to $132 million whilst during the same period, we repurchased shares to the value of $32 million. I do believe our R&D investments in 2011 have put us in a good position to take advantage of many of the future opportunities we have identified.

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

Steve Barber

Thank you, Richard. I was pleased with the overall performance in the quarter. We executed well to the needs of our customers and addressed our cost base in certain areas of the business to match current market conditions and our business outlook. Some highlights from the quarter include, we took proactive steps to secure sufficient disk drive supply to meet the needs of our customers once the impact of the Thailand flood began apparent. Looking forward, we continue to work closely with our customers and the disk drive suppliers in order to meet as much of our customers’ needs as possible, recognizing the overall industry disk drive supply challenges expected through the first half of 2012.

With the support of our supply base, we have recovered supply lines for a range of other components impacted by the Thailand floods, with the replacement tooling, relocation of production, and qualification of alternative supply components. We established a dedicated task force to work with Western Digital, most severely impacted by the floods, to assist them into defining the opportune recovery plans for their Thailand facilities. And we successfully launched our first full solution product, the ClusterStor 3000, which we designed specifically to meet the needs of the high performance computing sector and expanded our OEM customer base with our alliance with Cray based on this platform.

For fiscal year 2011, our NSS business performed well, seeing strong demand across our market-leading customer base. We shipped over 4,000 petabytes or 4 exabytes in the year, a 33% growth in shipped capacity year-over-year, a clear indication of the growth in data storage demand and enabled by us integrating higher capacity disk drives within our storage platforms. For calendar 3Q, we once again maintained our position as one of the leading providers in the enterprise storage systems market, providing 19.6% of total petabytes shipped.

Our SI business was significantly impacted by constrained CapEx investment by the industry due to a number of factors, including the proposed acquisition by Western Digital of Hitachi's disk drive business and recently completed Seagate acquisition of Samsung's disk drive business. Additionally, there was some over spending in 2010 as some of the disk drive manufacturers sought to catch up after a period of constrained CapEx spending in 2008 and 2009, and we encountered increased competition. Finally, 2 natural disasters limited capital spending for periods of time through 2011. Recognizing this market environment, we focused on reducing cost and restructuring the business a better reflect anticipated revenue opportunities in the near to mid-term.

Looking forward into 2012, we are optimistic of the result of the opportunities that we see for the overall business. We have many new growth opportunities that we are currently engaged in that we believe will allow us to offset reductions in certain current enterprise storage programs and position us well for growth in this business in future periods.

In our SI business, we ended the year with a lower cost base and a tightly focused investment portfolio. We expect a onetime benefit of the result of the Thailand floods as the disk drive and disk drive supply chain providers work to recover their damaged production facilities. The pace and scale of this equipment refurbishment or replacement activity will however be determined by the pace of recovery of key component supply, particularly recording heads.

In addition, we anticipate some rebound in CapEx spending in the second half of the year once hopefully the Western Digital HGST acquisition is completed. And there is clarity within the disk drive industry as to this consolidation, and our disk drive customers can resume capital spending.

We recognize the desire by the disk drive providers for dual sourcing. And as a result, we've seen increased competition within some product areas. Hence, we continue to focus our R&D investments in new product innovation and working in close collaboration with our customers to enhance the install base, improve factory efficiency and lower the operating costs.

We believe this will allow us to continue to provide innovative and competitive products and achieve a significant market share within each customer. In addition, we are continuing our investments in component process equipment in anticipation of higher growth in component volumes compared to disk drive units. As the rate of growth of areal density has declined, we expect the number of heads and disks within disk drives to increase over the next few years, ahead of the commercial availability of the next generation recording technologies, including HAMR being introduced into volume production.

In the Enterprise Storage business, in the near-term, we are monitoring and working through some potentially challenging disk drive supply issues as a result of the floods in Thailand that may impact our ability to meet demand for – from our system enclosure customers. We believe, based on discussions with our disk drive suppliers and our customers that we are well positioned in the medium term and beyond with regards to securing disk drive supply and meeting the needs of our customers. Our procurement team is working very hard to reduce the near-term risks associated with some of the supply constraints and minimize the impact to our planned shipments and revenue. The challenge we believe, may well not be a macro shortage of enterprise class disk drives but more the challenge of accurate forecasting with limited flexibility to change forecast in an environment of no buffer inventories that have historically enabled moderate changes in disk drive model mix of the point of finish system shipments.

With regard to recent this drive the price fluctuations, whilst our contractual terms generally treat these costs as a pass through, we will continue to work to minimize the increases to our OEM customers. As we have commented previously, we are managing a number of transitions within our storage platform customers through 2012. With our NetApp business reducing from 75% to 50% of NetApp's midrange product volume in accordance with the agreement signed in 2008 and a planning assumption that our proportion of this business decreases by an equivalent percentage over the following 2 years. In addition, we are anticipating a reduction in our EMC business as they did a main business transitions to an in-house EMC platform solution.

Offsetting these revenue stream reductions, we are expecting continued growth from both IBM and HP together with initial revenue from ClusterStor products and other customer opportunities. With our increasing focus on providing higher value add solutions together with our cost actions to realign the business, we see the opportunity to increase earnings in fiscal year 2012 compared to fiscal year 2011. We are currently engaged in a number of new development programs and in early discussions with customers for potential programs, including but not limited to, development and supply of complete OEM products, products with disk drives are integrated at the last moment by our customer for increased end user sales flexibility and designed services royalty-based models where we develop and customize products for the OEM customer and enable our customer to maximize their relationship with contract manufacturing partners for volume production and fulfillment.

We currently provide such a service as part of our agreement with NetApp with a portion of total demand being fulfilled by their CM partner. Our business development focus remains dual path, serving both global data storage leaders together with selected emerging customers with innovative disruptive technologies, proven management teams and solid funding structures. Xyratex has a strong record of supporting emerging storage customers through leveraging our product platform, development expertise, global manufacturing and fulfillment capability and in some cases, our balance sheet to enable early working capital needs. We are currently partnered with a number of such innovative emerging customers, some of whom we announced previously and we will continue to seek to engage with such companies with our technology, enterprise, data storage platforms and system integration expertise can assist these companies in scaling their businesses.

In November, we announced an OEM agreement with Cray, a recognized leading supplier in supercomputing. Cray's Sonexion storage solutions leverages our high-performance computing, or HPC architecture, as the basis of its design. We're delighted with this partnership extending to both product and Lustre support and are very excited about their recent win at NCSA at the University of Illinois.

As I've mentioned previously, we identified an opportunity in HPC data storage 2 years ago to leverage our technology expertise and secure a leadership position in this growing market. We determined that we could assist existing and targeted OEM customers in addressing the needs of HPC data storage through the provision of our optimized solution. By integrating our class in the enterprise storage platform with the Lustre file system and the comprehensive management framework, we can deliver 3 interrelated benefits to the HPC environment with a near performance scalability, easy installation and management and enhanced storage system reliability at scale.

Based on the customer and end user response we've received at the recent SC11 event in Seattle, we believe we have a compelling solution in the ClusterStor 3000 platform.

Over the last few years, we've been executing on our strategy to diversify our customer base and to expand on our core storage enclosure technology by increasing our value add that we provide our customers through a range of solutions capabilities to address the needs of hybrid markets such as HPC and cloud. We introduced compute capability into our OneStor product family, delivering a range of Integrated Application Platforms, which incorporate Intel's server functionality in single and dual motherboard configurations. These platforms enable our OEM customers to integrate software and storage into a single enterprise quality solution. And more recently, we've started to provide increased software and solutions content to our OEM partners through our significant investments in those clustered file systems and software development capabilities enabling our OEM partners to capitalize on the fast growing HPC data storage market, as well as the emerging cloud market.

Our deep understanding of disk drive technologies together with the innovation needed to integrate the thermal and dynamic performance or the dynamic requirements of disk drive into test platforms and enterprise systems is core to Xyratex's technology and expertise. Building on over 25 years of product development, we're seeing increasing advantages from the technology, skills synergies and requirements across our product and solutions portfolio. All of our products require the integration of many types of disk drive technologies into a range of high-density, high-availability, scalable solutions. As demand for enterprise data storage high-density and rack-scale solutions increased, our disk drive process equipment experience is increasingly benefiting our wider product portfolio.

We are actively taking advantage of this expertise across our global operations and individual product development groups to provide compelling and innovative solutions our customers in all sectors of our business. Complementing this core expertise and underpinning our strategy to provide increase to value add is now a significant investment of recent years in software development, building a meaningful firmware, software and file management systems development organization. This investment in software resources has provided significant differentiation in our ClusterStor solution enabling increased margin opportunities as we scale the business. The modular ClusterStor architecture allows us to incorporate new hardware and software capabilities quickly and cost-effectively. Building on this base, we see future opportunities to leverage key elements of the ClusterStor solutions architecture to deliver optimized rack-scale storage solutions to address the needs of the rapidly growing public cloud market. We're currently engaged with a number of public cloud providers to gain insight into the specific requirements of this sector as we develop our cloud strategy.

By leveraging our existing IP and infrastructure, together with our OEM margin profile business model, we believe we are very well positioned to address the rack-scale storage infrastructure needs of the public cloud market. We address the private cloud market opportunity today with our integrated application platform and data storage enclosures through our OEM customers with a number of our emerging customers providing portals to private and public cloud storage through their solution offerings.

In summary, while we expect 2012 to be a year of transition, with certain legacy programs declining and new programs ramming -- with new programs ramping, we believe our current initiatives will provide earnings growth potential over forthcoming years. As the leading OEM providers in the industry, we believe we are well positioned to benefit from the continual growth in data creation and storage. We serve all segments of the data storage market, including traditional private data centers, consolidated data centers or private clouds and the emerging public cloud, which is expected to dominate future data storage capacity growth. Our range of technology supports key elements of the data storage food chain from disk drive production, the key building block of all data storage, to modular storage enclosures and server storage appliances and to rack-scale HPC and cloud infrastructure solutions. We are optimistic as to our future business prospects. I'd once again like to take this opportunity to thank all our employees worldwide for your ongoing opportunities in meeting our customer commitments, executing to our customers’ requirements, resolving the technical challenges that arise in the technology business and delivering on our product development margins. We can all be proud of our achievements in 2011 and look forward positively to a challenging and rewarding new year ahead. Thank you for your continued support, commitment and innovation as we strive to enable our customers’ success in the expanding data storage market. That concludes our formal comments. I would now like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Aaron Rakers from Stifel, Nicolaus.

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

A couple of questions if I can real quick. Number one, with regard to the hard disk drive situation right now, I know you guys are wearing on some conservatism around ability to meet demand. What's your availability look like today? Have you been meeting all the demand requirements of your customers? And what are you factoring in your assumptions for the February quarter between the split of businesses and kind of on that, are you expecting that you're able to meet all that demand through the quarter?

Steve Barber

Aaron, Steve here. The answer is yes, we have been able to meet demand to date. As I said in my comments, we are reasonably well positioned with regard to supply commitments that we have from the suppliers. It will ultimately come down to very careful forecasting and alignment of disk drive demand planning with end user sales demand and that's clearly where we're working closely with our customers to ensure we have got that correlation. As you saw in Richard's outlook for the quarter, we have provided a wider range than normal really to take into account the uncertainties that do exist. Right now, we are reasonably positive but there is clearly risks associated with the rest of the quarter because disk drive supply will ultimately be tight.

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

And are you breaking down what that revenue range looks like by the segments?

Richard Pearce

What, into SI and NSS?

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

Yes. Or pick one.

Richard Pearce

Yes and no. You can work that out. And then I think we've discussed this historically. The SI revenue in Q1, we still anticipate that to be relatively low. So around about $25 million to $35 million. Once we've seen a pickup in orders as I mentioned earlier, those orders following the Thailand situation have come through really too late in terms of one, the lead times required for us to actually get hold of the parts and manufacture the equipment and in fact some of our customers’ factories obviously, they're coming up but not ready to receive some of that equipment in Q1. So I will not expecting a significant benefit in Q1 as I mentioned in my comments. The real benefit there for us is in Q2 and Q3. So obviously, with that, you can then take a wider range and work out the NSS number from that.

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

Okay, fair. And final question for me. Can you give us some color on your key customer trends this last quarter with regard to contribution to the NSS segment?

Richard Pearce

Yes. Within those lines, as we normally provide, NetApp was around 43%. So slightly up on 3Q, which is kind of expected in line with the normal pattern there, that was around 23%, IBM was around 17% and EMC was around 10%.

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

And HP?

Richard Pearce

Not too dissimilar from the previous quarter, but around about 6%.

Operator

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

Keith F. Bachman - BMO Capital Markets U.S.

I wanted to follow from Aaron's comment or question, rather. On the disk drive orders you mentioned $25 million to $35 million because orders are getting -- are not getting captured. But what does the pipeline look like if we look out further into the order book?

Richard Pearce

Obviously, with the orders that we've been getting in and the onetime, as I described it, benefit of $50 million, approximately in -- across Q2 and Q3. Those orders are coming in and I guess at this stage, it's very much the recovery post the flood and not looking out past the first half of the year. So -- and we wouldn't be expecting that -- any orders at this stage for that period. The indications from customers in terms of their forecasting look relatively strong for the back half of the year as well, but we don't have orders and we wouldn’t expect them at this time.

Keith F. Bachman - BMO Capital Markets U.S.

Okay. You mentioned competition or Teradyne. Is -- I think the press release said competitions increased or something along those lines. But could you give a little more color on where that competition is currently showing or where -- more importantly, where you think it's going to change or manifest itself over the next couple of quarters?

Richard Pearce

Yes. I mean, I think in terms of the SI business, we do mention Teradyne specifically and in our major products stream there which is in the disk processing systems, Teradyne is really the primary competition in that area. And absolutely that they have shown a much stronger position and strength in 2010 versus ourselves, so that is the major competition, obviously. And I think we’ve discussed it historically. At the moment they only have a competitive product, which plays into the 2.5-inch market, that is an area where we have been improving our equipment, as well as and again, mentioned in my comments, the 3.5 product inch platform has been sort of a new platform, which we have been introducing and developing through 2010 as yet. And yes, there's no expectation at this stage that we will see competition in that 3.5-inch market from Teradyne. When speaking to our customers, we are not seeing competition in that area. But in 2010, Teradyne had a very successful year. I think if you listen to their course particularly, obviously in the 2.5-inch market that is an area that we are addressing and seeing some success in re-establishing ourselves really within that 2.5-inch market with those customers.

Keith F. Bachman - BMO Capital Markets U.S.

Okay. All right. One last one for me. On NetApp, am I reading situation right? So they were at, in terms of that mid-market category, during their most recent quarter that just closed, they were at the 50% threshold. So they will be -- that threshold will remain constant through the year. So your business mix with NetApp should remain consistent with the underlying growth of network appliance. And then next year, you think, or the next 2 years that it will be reduced from, say, 50% down by 25% over the next 2 years, is that kind of a fair way to think about it?

Richard Pearce

Well, actually, I mean, we had 75% of the NetApp business in that product stream within the majority of the fourth quarter. So the change in the 50% really comes in through the fourth quarter and so we're not expecting to see that until 1Q. And hence, really, one of the main reasons is, as I touched on, while we're expecting to see, as well as the disk drive supply situation and as well as a seasonality, that is the primary factor in the revenue reduction between Q4 and Q1.

Keith F. Bachman - BMO Capital Markets U.S.

Okay. But the NetApp business, you think will be run rate with -- for you, whatever the growth rate in NetApp is over the next 4 quarters?

Richard Pearce

From whatever they have in Q1?

Keith F. Bachman - BMO Capital Markets U.S.

Yes.

Richard Pearce

Yes.

Operator

The next question is from the line of Glenn Hanus with Needham.

Glenn Hanus - Needham & Company, LLC, Research Division

Maybe we could follow up on gross margins for each side of the business and how we should be thinking about sort of puts and takes in each segment on the gross margins.

Richard Pearce

Yes. Obviously, we covered the gross margins for the quarter in the NSS side, 17.7%, which was above our expectations and slightly above Q3. Again, there's some favorable product mix in there and custom mix as well. I think in the last call, kind of we'd adapt my expectations for 2012 on the NSS side of the business to around 14% to 16% for fiscal 2012. As I look at it now, having considered Q4, my expectations would be that we are likely to be towards the top end of that in through 2012. We still have some product and customer favorable positions on what I would call was our legacy type businesses as we go into the year. And then as we enter the back half of the year, the expectation of revenue coming in from our ClusterStor products, at some reasonable level, should also help the margins in those periods. So overall, yes, my expectation is we will be toward the top end of that.

Glenn Hanus - Needham & Company, LLC, Research Division

And so it sounds like the disk drive price increases you mostly be able to pass-through, is that how you would characterize that?

Richard Pearce

Yes. Our legacy contracts that we have today in the OEM type business we have, disk drives are essentially a pass through item. We really charge for the services and the testing capability that we put into those drives rather the cost of the drives themselves. So in the majority, yes. Potentially, on our -- the ClusterStor business, it could be slightly different than that. The drives are not necessarily a pass through there. So we have got some sensitivity to the pricing on that. Obviously, we've not given formal pricing going out a long way on those products. And I guess the market expectation is at the moment that the disk drive pricing will sort of hold, and obviously, we've seen that the recent pre-announcement from Seagate. So the indications there that the prices are holding at the moment. But as the disk drive world gets back online to more fuller production in the back of the year, that we'll then start to see those prices come down again.

Glenn Hanus - Needham & Company, LLC, Research Division

And then you've made some comments on the SI side of the business on gross margins. Could you go through that?

Richard Pearce

Yes. I mean, obviously, this year has been a very difficult year in the SI business overall and from a gross margin perspective. As we go into 2012, my expectations are that in the first half of the year, we should be getting gross margins somewhere in the sort of 15% to 20% region and I did talk a little earlier about -- we are seeing some benefits in the Thailand situation, but my expectation is lower margin on that because we are having to expedite materials to get them in the time for when our customers need them. I guess that made both the question why you can't pass those costs on. Yet, to give some clarity around that, the new product platform which we have been developing over the last year or so, which the customers have been desiring earlier than was originally expected because of this situation in Thailand. But I'd say in the development side of there, we were late and therefore we've not been able to undertake the cost-reduction work that we would normally want to in a normal product cycle there. But we've given pricing indications to our customers and based on the Thailand situation and obviously, as I discussed a little earlier again, re-establishing ourselves as the primary provider in there. It wouldn't be appropriate at this stage to be increasing those prices to those customers. That said, as we work through the year, I do expect us to be able to take some cost out of those products and to get back to slightly better margins on the SI business and I'd expect as we go into the back half of the year, that margins would be more towards 25% to 30%.

Glenn Hanus - Needham & Company, LLC, Research Division

So is it fair to say you still feel that sort of the steady state gross margins in that business, you can sustain the 25% to 30% long-term or no?

Richard Pearce

I do absolutely. Whilst I'm not giving guidance here for the year, now 2012. My expectations are when we get our expense base in order and we've restructured and we've got it on top of these new products that we bring through; I would be looking to get back to the 30% level that we've seen, sort of priced 2010.

Glenn Hanus - Needham & Company, LLC, Research Division

And then switching to operating expenses. You look like SG&A came in pretty light for the quarter, maybe you could talk about that? And then as we go through next year, you mentioned $40 million to $43 million in the first quarter, which I think implies some incremental expense in the first quarter on a run rate basis and so what's going on there? And how should we kind of model through next year on OpEx?

Richard Pearce

On a run rate -- obviously, in Q4 we had expenses of $44.3 million, just over $2.5 million of that was restructuring costs. So I guess you could normalize that down to $42 million. And then in the ranges which I provided earlier within my comments, I provided the range of $40 million to $43 million in Q1 so...

Glenn Hanus - Needham & Company, LLC, Research Division

So flat?

Richard Pearce

Flat, yes. On the SI side of things, we will get the benefit of those expenses. But again as I mentioned, particularly on the ClusterStor program where we're looking to ramp those products and at this stage it means quite a lot of evaluation units going out, which get expensed depending on the stage of the product evaluation. So, yes, that is driving slightly additional expenditure on one side whilst we're reducing on the other side. But overall, I do expect a slight reduction on Q4 and then those rates to stay relatively consistent as we go through the year. Again maybe a couple of months back, I would've looked to take the expenses down further but with some of the orders that we're seeing come through on the SI side, as well as some of the opportunities that we're seeing on the ClusterStor business, I think it's appropriate that we keep it at those sort of levels and maybe even increment a little, particularly on the ClusterStor side.

Glenn Hanus - Needham & Company, LLC, Research Division

Maybe lastly, on the -- to follow up on ClusterStor, do you have some -- in addition to Cray, do you have some unannounced design-ins now or do you have just a number of -- is it in the category of a number of bake-offs you're currently engaged in and maybe you'd just kind of give us some more color around the opportunities there?

Steve Barber

Steve here. I think we have approached this in a typical valid [ph] fashion of making sure we don't overextend ourselves. Clearly, we are delighted with the relationship we've established with Cray. And we're working very closely with them as they deploy that into end-user applications. In parallel, as you might expect, and as you alluded, we are in active discussions with regard to qualification, evaluation with a number of other partners, both a mixture of OEM and in some cases, a reseller type model. Some customers’ reengagements right now seem to prefer reseller approach because it allows them to introduce the product faster than a full OEM qualification. So they can watch their space. We are pretty excited by the opportunity we see there and certainly do anticipate the ability to share publicly a wider customer engagements through the course of the first half of this year.

Operator

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

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

Just real quickly. I guess, following up on the drive supply topic, I guess, of the potential constraints -- and I guess maybe, just let me put it that way, which drives are more plentiful right now, and I guess, might be less of an issue going forward? Is it the fiber channel drives or are they the non-fiber channel drives?

Richard Pearce

Put it in non-fiber channel. Near line is probably the area that's the tightest, which I guess correlates to the fact that, that's the highest demand in terms of quantities right now. So near line, SAS and Iseler [ph] is where we're seeing constraint supplies.

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

Got it. I guess if you sort of take a look at the way when you net out what you think the order book will look like for near line drives versus what you've been taking in so far, I guess what availability has been so far in more of a normalized basis. Do you need to see -- does the industry need to see meaningful, I guess, a return to supply in near line drives, to be able to hit what you think is a reasonable order book or is the current rate right now, will that get you where you need to be?

Steve Barber

I think at a total level, the current capacity outlooks we’re seeing across the customer supply base appears to meet overall demand. As I indicated, the challenge we're going to have is ordering the right models of drives, the right capacity of the drives and features that align with the end user sales demand. And historically, we provide on hubs and buffers of material around us to be able to switch from say, a 1 terabyte drive to 2 terabyte drive or vice versa very late in the day at the last minute depending on the end user customer’ particular configuration requirements. That flexibility is no longer there or extremely limited and therefore, we are expecting pinch points through the quarter or this quarter or possibly going into the second quarter where on a week-by-week basis, we simply don't have the right combination of drives coming towards us that is required or being demanded by end user sales. So hence the extreme work we're doing right now with customers in conjunction with the suppliers to ensure that we've got the very best ordering demand precisely by model type that we need. And I think the guidance we are getting right now from the drive suppliers is provided we do give them accurate demand outlook, then I think we, overall as an industry, we're going to be reasonably well supported with the current supply that exists. I think it's probably the say, the number of reports on this that it appears to be the retail sector and in some cases, PC drives that are seeing the most constraints with overall supply. Enterprise drives appears to be reasonably well protected. And the drive suppliers are I think, doing their utmost to ensure that, that supply is met. That caveat as I said earlier is all about accurate planning. And inevitably in this marketplace, there will be times where we get it wrong to a small extent where the end users’ sales demand is slightly different to what was forecasted and we'll get a mismatch, which we'll recover within a week or so, but you will see those pinch points on a week-by-week basis is our view going into this quarter.

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

Got it. That's helpful. And I guess on SI, with everything you guys are doing to I guess, to regain your positioning within WD relative to Teradyne, willing to eat the cost and everything else that goes with it. Do you have any sense for -- of the new orders that are coming in from WD? Do you have a sense for where you stand from a share position relative to Teradyne? And where do you hope to be when this whole cycle is over from a share position perspective?

Richard Pearce

It's a difficult question to answer, that one. I mean, obviously, if you look historically, our store base is significantly greater than Teradyne so that should always be to our advantage. As we are working today, I think, our main priority and WD's main priority is the recovery from the flooding and therefore, a lot of that depends on which equipment has been affected by the flood in terms of where orders might go to. So I'd have to say I'm not aware of what they're ordering from Teradyne at the moment I have to almost wait to listen to their earnings call to see what they come up with in terms of orders. Yet my understanding and my belief is that we are in a good position with that customer in terms of our relationship now and going forward. I wouldn't want to make a prediction in terms of what market share we might get and arrogantly think that we should get a greater percentage. I believe that we have been investing significantly in R&D and are creating compelling products, which add value to those customers and ultimately that will put us in a good position to get, as I said, a significant market share. Yet my desire would obviously to take a majority share within those customers, but I wouldn't want to say at this stage that, that's what my expectation is.

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

Okay, great. I guess just last one for me and I can do the rest on the callback. What's the buyback philosophy now with stock at $14 and earnings improving and sort of all that, and you have the dividend going?

Richard Pearce

Yes. We are continuing to monitor that. Obviously, our cash position is very strong at the end of the year. My expectations are that we will continue to be cash-generative through 2012 and all things being equal, my expectations are towards the back end of the year that, that cash position could increase to somewhere of approximately $200 million. So with that in mind, we are still looking at the stock price versus the value of our assets and cash. Notwithstanding yet the size of the business, we will still consider what we should be doing on the buyback. As we noted at the end of Q4, obviously, we've bought back a large proportion of what the board had previously approved in terms a share repurchase. So as we go into 2012, we will, as a board, be sitting down and looking at that. Obviously, we’re starting -- we started to pay our dividend in Q3 of last year in our intention to pay a quarterly dividend. But that said it isn't a significant value relative to our cash position. So I guess the short answer is we will continue to consider share repurchases and we will be looking at that as we go into the new year. Obviously, we are still looking at acquisition opportunities. I've got nothing at the moment, which I would say was close to being executed but we’re not obviously, in a good position should such opportunities available themselves.

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

Do you guys sort of have a stated desire to increase the dividends on an annual basis?

Richard Pearce

We haven't yet stated dividend policy, no. I mean, we did increase the dividend in Q4 over Q3 by $0.005, which was approximately 10%. That said, our share count had come down by that 10% relative to the share repurchases. So as an overall cost of the company, it was pretty similar. So I wouldn't want the markets to take that guidance but that was our expectation going forward. But, yes, again in conjunction with discussing the repurchases, it is the board's intention to sit down and look at the cash situation and create a dividend policy and potentially then advise the market what that is.

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

Okay, great. And I will just leave one more in. Are you guys give annual guidance at any point this year; I guess maybe next quarter will be the time to do it when you get more visibility?

Richard Pearce

Yes. One, on the visibility and obviously, with the uncertainty surrounding disk drives at the moment, it definitely would not be appropriate to give guidance at this time. I think we will consider it. We normally -- we have historically, on occasion given full year guidance but only at this time of the year. As I say, it would not be appropriate at this time. But noting your point, we will consider whether it would be appropriate next quarter.

Operator

And your next question from the line of Nehal Chokshi with Technology Insights Research.

Nehal Sushil Chokshi

I just wanted to make sure I understand the source of the NSS upside relative to your prior guidance, which is about $25 million there. So was that with the large customers or is it with the up and new coming customers relative to your prior guidance that was provided?

Richard Pearce

Can I speak beyond on the question? I think from a $25 million -- I gave a range of $25 million to $35 million for the SI business in Q1.

Nehal Sushil Chokshi

I'm sorry. Maybe you didn't hear me correctly. For the November quarter, the guidance was $314 million to $344 million on the NSS and you had about $353 million. So from the midpoint, that was about $25 million upside. So I just want to get an understanding of the sources of that upside. Was that from the large customers or is it from the up-and-coming customers?

Richard Pearce

Yes. Again, apologies for not hearing your question correctly in the first place. So I guess I commented in the script there that it really came across the majority of our major customers rather than from the up-and-coming. And just to be clear again, we've had no revenue to date in the books from ClusterStor. So our expectations are that they come in 2012 and actually primarily at the back end of 2012 just in case that was part of your question.

Nehal Sushil Chokshi

Okay. And I still think of your major customers as Dell, IBM and NetApp and the up and coming guys really, HP and still within Dell, you have the Compellent and EqualLogic there. So just wanted to make sure we're on the same page as far as what we're talking about up-and-coming customers.

Richard Pearce

Yes. That's right. I mean, we look at Dell obviously, as an overall customer rather than by a particular product stream. But yes, in terms of the IBM, Dell, NetApp and EMC to a degree. Yes, they were the ones that showed the increase in Q4.

Nehal Sushil Chokshi

Okay, and then I have 2 more questions. So you guys did a great job of finding the Compellents and pars that were the up-and-coming customers, 3, 4, 5 years ago. It looks like the new crop of up-and-coming storage array customers tend to be focused on some combination of flash or all flash storage arrays. So given your competency and mechanical vibration, as well as there's something you've been doing in software, can you talk about how you expect to be able to continue to move where the industry appears to be moving towards, and have you guys started talking and supplying some of the pure flash storage array vendors yet?

Steve Barber

It's Steve here. I think the customers who we engage within that sector really look to Xyratex to provide a enterprise class solution for them. And as you rightly point out, a number of those customers, a number of the new emerging players in the sector are utilizing flash, either partially in their array or in some cases, a complete flash array. And we're engaged with a number of parties in both of those sectors today. We've previously announced, I guess, a couple of companies that we're engaged with. And through the course of next year as new products or customers that launch products, we'll have the opportunity to disclose other partners that we're engaged with today. I think your point about vibration and thermal expertise which is core to Xyratex's DNA is valid. However, the challenges of integrating flash into a high-density enclosure together with extremely hot Intel precipice is a strength that we have demonstrated to many of these customers. And therefore, that whole integrated solution of server or computer-based storage appliances is very applicable to a full flash-based array as it is to a drive array. I think drive clearly present more challenges when it comes the vibration aspects. But the integration and the interfaces of flash are equally not trivial. And I think we have proven ourselves as able to provide a very effective enterprise class solution for that sector of customers and hence do see ourselves well positioned to continue to engage with emerging players in this space whether they be disk drive based or flash or a combination of both.

Nehal Sushil Chokshi

Okay, that's great. Fantastic. And so your guidance, you have a $70 million range and you gave the storage infrastructure a range of only $10 million. So is it correct to assume that the uncertainty is actually on the NSS side or did you actually mean to give a bigger range on the SI side?

Richard Pearce

No, that's absolutely -- because obviously, they are the area which relies on the supply and availability of disk drives, so that is the area of uncertainty.

Operator

And there's no other questions at this time.

Brad Driver

All right. Keith, thank you. Once again thank you for joining us this afternoon. We look forward to speaking with you again on our Q1 earnings call, which will be scheduled for late March 2012. Also on January 12, next week, we'll be presenting at the Needham Annual Growth Conference in New York. And on February 8, we'll be at the Stifel, Nicolaus Technology and Telecom Conference in Southern California where we will provide further updates on our business at that time.

As always, you're welcome to call me if you have any additional questions over the course of the quarter. Until then, thanks and have a good rest of the week. Bye.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for joining us. You may now all disconnect. Everyone, have a great day.

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