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Xyratex Ltd. (NASDAQ:XRTX)

F1Q08 Earnings Call

March 27, 2008 5:00 pm ET

Executives

Steve Barber - Chief Executive Officer

Richard Pearce – Chief Financial Officer

Adam Wray - Executive Vice President

Todd Gresham - Executive Vice President

Brad Driver – Investor Relations

Analysts

Aaron C. Rakers - Wachovia

Paul Mansky - Citigroup

Keith Bachman – Bank of Montreal

Shebly Seyrafi - Caris & Company

Robert Semple - Credit Suisse First Boston

Daniel J. Renouard - Robert W. Baird & Co.

Clay Sumner - Friedman, Billings, Ramsey Group

Marko Vucenovic - FTN Midwest Securities Corp

Glenn Hanus - Needham & Company

Tom Curlin - RBC Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2008 Xyratex Earnings Conference Call. My name is Karen and I’ll be your coordinator for today.

At this time, all participants are in a listen only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. If at anytime during the call you require assistance, please press star followed by zero and a coordinator will be happy to assist you.

I would like to turn the presentation over to your host for today’s call, Mr. Brad Driver. Please proceed.

Brad Driver

Thank you, Karen, 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 fiscal first quarter 2008 results conference call.

On our call today are Steve Barber, CFO, and Richard Pearce, Chief Financial Officer. Today’s call is being recorded and will be available for replay on the Xyratex’s investor relations home page at www.xyratex.com. I’d like to remind everyone that today’s comments including the question-and-answer session will include forward-looking statements, including but not limited to a forecast of future revenue earnings and other financial business activities. These statements are subject to risk and uncertainties that may cause actual results in advance to differ materially. These risks and uncertainties are detailed as Xyratex’s filings with the Security and Exchange Commission, including the company’s affidavit February 20, 2008. Also please note that in addition to reporting financial results in accordance with general accepted accounting principles or GAAP, Xyratex routinely report certain non-GAAP financial results. These non-GAAP measures together with corresponding GAAP numbers in 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 P.R. newswire and our website. Xyratex delivered a solid quarter in line with our revenue expectations and at the top end of our EPS expectations. I was pleased with our execution on networked storage solutions and storage infrastructure divisions and as anticipated we are now seeing evidence of an increase in capital equipment investments.

I’d now like to provide you with some commentary about our results for the first quarter. Please note that all numbers are in accordance with GAAP unless stated otherwise. Total revenue was $217.1 million, down 8.2% as compared to the first quarter of last year and down 12.5% from our prior fiscal quarter and in line with expectations. This reflects year-on-year growth on our networked storage solutions business offset by reduction in our storage infrastructure revenues as we have previously outlooked. Our networked storage solution products were $187.8 million or 86.5% of total revenue. This is an increase of $24.2 million or 14.8% compared to the first quarter of last year and up .3% compared to the $187.2 million in our prior fiscal quarter. Year-on-year performance reflects the growth of the networked storage market that we serve, the success of our customers, and our market share.

We continue to experience strong revenue contribution from our major tier one customer, NetApp, reflecting their strong position in the storage market, as well as seeing positive growth across our broad range of customers.

I continued to be encouraged by the progress we are making in establishing ourselves as a significant technology provider and recognize industry standards to the data storage market. Sales of our storage infrastructure products were $29.3 million or 13.% of total revenue, down $43.5 million or 59.8% compared to the first quarter of last year and down 51.8% over our prior fiscal quarter. Both above expectations, this significant sequential reduction in revenue, reflects the current environment of CapEx spending constraints, we outlooked within the HDD industry.

Gross margin was 15.1% for the quarter compared to 19% in the same period a year ago and 18.5% in our prior fiscal quarter. This reduction is primarily due to the significantly reduced revenue from our storage infrastructure division in the quarter.

The gross margin for our networked storage solutions products was in line with our expectations, 14.7%. This compares with 13.6% last year and 15% last quarter. Gross margin for the storage infrastructure products was 18.9% compared to 31.6% last year and 27.9% last quarter, primarily is a result of the significant reduction in revenue in the quarter.

Non-GAAP operating expenses totaled $32.4 million compared to $32.2 million last year and $34 million last quarter and those are in our original forecast. This reflects our actions to manage discretionary expenses in the current business environment. On a non-GAAP basis, net income was $ .75 million and 93.7% reduction compared to $11.9 million a year ago and down from $13.1 million in the prior quarter.

Earnings per share for the quarter on a non-GAAP basis was .03 cents based on $29.8 million shares outstanding on a weighted average treasury method in Q1. During the quarter, we purchased 169,000 shares as part of our stock repurchase plan at a cost of $2.6 million in aggregate.

GAAP loss in the quarter was $2.2 million and included amortization and intangible asset expense, non-cash stock compensation, and related tax totaling $3 million. 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 equivalence at the end of the quarter was $57.9 million compared with $70.7 million at the end of Q4. This reflects a significant increase in finished goods inventory as we prepare for the transition of our new ERP system now scheduled for June. Payments of $2.6 million related to the stock repurchase plan we commence January 14 and payments of 2007 bonuses.

Cash flow used in operations was $6.8 million in the quarter. Inventories increased by $21.5 million to $113.1 million in the quarter. Inventory terms was $6.3 compared to $7.7 for the previous quarter. This primarily reflects the lowest storage infrastructure revenues.

Accounts receivable reduced by $20.8 million in the quarter to $101.5 million. Base sales outstanding were $43 in the quarter compared to $52 in the previous quarter. Headcount at the end of February quarter was 1,613 permanent employees, essentially flat as compared to the last quarter.

In summary, this is once again a solid quarter for the company as we remain focused on executing to our strategic and operating plans.

Now, before I turn it over to Steve for his comments, I would like to provide you with our business outlook for the fiscal second quarter ending May 31st. Our business outlook is based on current business expectations. It should be noted that there are a series of forward-looking statements that involve risk and uncertainty. 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 form 20-F filing.

The second quarter of 2008, we are projecting total revenue to be in the range of $232-252 million, up 8.2% to 18.3%, as compared to last year, and up 6.9% to 16.1% compared to Q1. This is represented by revenue from networked storage solutions of $204-$216 million up from storage infrastructure of $28 to $36 million.

Q2 gross margin is expected to be 15.2% to 16.2%. We are estimating non-GAAP earnings per share to be between .03 and .15 cents. Non-GAAP earnings per share excludes non-cash compensation, amortization of intangible assets, and related taxation expense.

The number of shares outstanding at the end of Q2 on a weighted average treasury method is expected to be $29.9 million, excluding the effect of any further share repurchases.

Our cash position at the end of Q2 is expected to be approximately $50 million, which reflects the continued build-up of inventory related to our ERP transition and again excludes the effect of any further share repurchases.

I’d now like to hand it over to Steve for his comments.

Steve Barber

Thank you, Richard. Good afternoon, everyone. Thank you for joining us today. As Richard noted in his review of the financial, we did a good job of responding to the needs of our customers and a number of our networked storage solution customers, driving additional requirement and strong demand in the quarter.

Infrastructure and capital equipment was ahead of expectations for the quarter, albeit that historically level as the industry continues its focus on capital revisations and optimization through the first half of this year; however, as we anticipated, we are now seeing evidence of an increase in capital equipment of the investment for the second half of the year.

I remain optimistic in my view of the growth prospects in the data storage industry and our ability to benefit from that growth in the market we serve. We continue to see multiple and significant drivers on the growth in the digitization of data and the result in data storage needs.

With our established presence in both the disc drive and enterprise storage sectors and strong track record of delivering highly competitive and competing solutions. I believe we remain well positioned to benefit from this growth.

In reviewing our performance last quarter, I will cover out two business areas separately. Starting first with networked storage solutions. As Richard noted, we grew revenues in our NAS business by over 14% in the quarter on a year-over-year basis. Significantly ahead of the overall external storage market, which grew 7.6% year-over-year according to recently published data. We remain focused on gaining market share through supporting our existing customer’s growth and broadening our overall customer base.

Xyratex continues to be a major participant in the rapidly-growing data storage market. We shipped 217.5 [pedabytes] of external storage in our fiscal first quarter, representing almost 5% growth over the prior quarter and over 59% growth over a year ago. Based on recently published data on the total pedabytes shipped in calendar fourth quarter 07. We estimate that Xyratex once again maintains its position as a leading provider to the market, shipping almost 14.5% of the worldwide external storage system [pedabyte] to our customers. For the calendar year 2007, based on the same published data, Xyratex shipped almost 14% of the worldwide external storage system capacity from our factories.

For calendar fourth quarter 07 on a year-over-year shipped capacity basis, Xyratex grew its shipped capacity 63.2% compared to the market 56.3% growth. Our first quarter of p8 shipped capacity, we’ve made out the following in terms of disc drive interface. Private channel totaled 68.4 pedabytes, (inaudible) totaled 143.8 pedabytes, and (inaudible) totaled 4.99 pedabyte. Fourth quarter private owned systems remained the larger portion of our shipment, we continue to see increasing demand.

Once again, we’ve made good progress in a number of areas across the business during the quarter. First, we continue to deliver a strong portfolio of products as evidenced by our recent RAID announcement. The F6412 the RAID controller. Featuring our advanced management software. The F6412E is a new standard for performance and efficiency, delivering up to twice the performance of our previous generation controller.

Recognizing the challenges facing data centers with regard to power and to energy consumption, Xyratex’s advanced (inaudible) in software can save up to 40% in power dissipation by utilizing our intelligence based software allowing the F6412 to automatically spin down to destroy when not needed. In conjunction with our established F5404E, high density RAID products, the software provides a new level of power efficiency for our customers. Many of our customers and prospects are focused on delivering green solutions and Xyratex is assisting them in achieving their goals.

I recently announced one store family of solutions continues to gain traction with many of our existing customers, as well as with new prospects. The opportunity to combine server, storage, and applications into one scaleable offering, allows our customers to drive fully integrated solutions. Many of these customers are interested in leveraging our operational capabilities and look to take advantage of the worldwide scale we provide.

Combination of product, solutions, and global operational capabilities continues to differentiate Xyratex from other providers.

In early February, we formally engaged with Dell in support of their integration of ecologic business and launch of the Dell ecologic PS5000 products. We’re working personally with Dell as they establish this business with a network. Dell was impressed with the overall value that Xyratex provided, including industry and closure technology, global operational efficiency, and the overall scale of the business. The Dell solution is specifically designed for (inaudible) scan applications, which is currently the fastest growing of all the nStore technology. According to recent industry reports, (inaudible) stands only a count for 5% of the market currently. Although sales of this technology have grown over 77% year-over-year.

During the quarter, we also began working with IBM in support of their devotion of the XIV technology in the data storage business. The resulting IBM product is designed specifically to capture and manage unstructured content, including medical images, music, videos, web pages, and other discreet files. In area of data storage, projected to see significant growth. Again, we’re working closely with IBM to support their business plan for this product.

Our focus on delivering to the expectations of these tier one opportunities is causing us to defer some opportunities that we have planned to pursue in smaller and potentially higher margin customer. I am, however, extremely excited about the opportunities to broaden our tier one program, reduce our customer concentration, materially increase our scales, and ultimately provide EPS accretion.

At this stage, we’re doing everything within our capability to ensure success of these programs; however, it is too early to predict the size or timing of the volume possibilities they may present.

Finally, we continue to our business development and extending our relationships with existing customers and broadening our customer base with new partners, which unfortunately we cannot name at this time.

Overall, despite the current economic climate, particularly impacting U.S. markets, we continue to see good in line demand for our core data storage products and continue to make growth in this business through 2008. We will remain focused on providing industry-leading technology solutions, best in (inaudible), and a highly competitive global fulfillment service for our OEM customer.

Moving now on to our storage infrastructure business. Firstly, before I comment on the business, as we announced earlier today in our earnings press release, I can confirm that Adam Ray has stepped down from his role at EDP of our storage infrastructure business for personal reasons and to pursue other interests. I’d like to thank Adam for his valued contribution in leading this business and wish him all the best for the future.

We have initiated an executive search for our successor and will make an announcement when this appointment is made. In the interim, I will be taking a more active role in an acting position and with the support of the management team will ensure the continued momentum in the business.

Moving onto to the business discussion. As expected, revenue for this business in first quarter was significantly lower than the previous quarters due to the phasing of capital equipment investments by our customers; however, we did achieve revenue of $29.3 million, which was above our expectations for the quarter. This represented a 59.8% reduction over first quarter 07 and a 51.8% reduction through our prior fiscal quarter.

As demonstrated in our recent earnings calls, we have been experiencing period of significant restraint in the capital expenditure with the disc drive industry, especially as it relates to Xyratex technology; however, as anticipated, we are now beginning to see the end of this major effect and the return to more traditional investment phasing within the industry with incremental production capacity being planned for the second half of the year.

As Richard indicated earlier, we are seeing evidence of this increasing level of capital equipment investments with over 60% of our second and third quarter revenue plans already covered by customer orders. This outlook supports the guidance we provided for this business in our last earnings call. Recent public statements made by our (inaudible) customers indicates that the support the increase in unit demand and individual disc drive unit capacity growth, it will need to commence investment in incremental production capacity in the second half of 2008. In addition, overall supply energy in the market remain at very low historical levels and the drive manufacturers operating their factories at or near maximum capacity levels.

Point to note regarding capital expenditure for the disc drive industry is a wide variety of investment by the disc drive companies, outside the production equipment we currently provide. A good example of this is significant investments being made in the current fiscal year of the disc drive companies. In new production facilities, buildings, and in support of future media and demand. This results in a lack of direct correlation between overall CapEx spend by the industry and the revenue projections of individual capital equipment providers such as ourselves. We anticipate in the next fiscal period of our major customers, the mix of capital expense will shift to a more traditional mix with a high percentage of the total capital budget directed towards production equipment rather than physical facilities.

Overall, we are anticipating continued growth in disc drive shipments throughout the year as well as continued growth in unit disc drive capacity. The underlying growth in digitally stored data is showing no signs of slowing. The disc drive remaining the only viable technology to this growth. This is evidenced with the continued growth and volume of products we’re supplying as well as the products we’re supplying, as well as the trend toward ever higher drives shipped within those systems. Year-over-year, we shipped almost 60% more pedabytes of capacity. This continues to drive market opportunities for our business, there remained a number of specific company dynamics affecting our business. We believe we are well positioned to serve this gray market, specifically as it relates to our product net and we see growth opportunity across the sector. Firstly, as we indicated in our full year guidance of 2008 at the beginning of the year, we anticipate the majority effect of utilization of the FFC…will have been completed in the second half of this year. This in turn we anticipate will result in new investment levels approaching more historical levels in the second half of the year. As with all our customers, Seagate will remained focused on the maximum utilization and efficiency of that capital and we will work closely to support them in these efforts.

Secondly, Western Digital is currently expanding their business on a number of fronts, including the integration of the ___ Media business and broadening their product range into the enterprise storage market. We continue to work closely with Western Digital to support them in their gross plan.

Thirdly, we believe we remain well positioned as a future potential provider of production test equipment to Hitachi. Although, as we have indicated previously, we do not anticipate any near to medium term demand and remain focused on optimizing their current production.

Finally, we are engaged in a number of potential target customers, both disc drive companies and media providers. We will continue to work hard positioning the benefits of our products and technologies to these prospective customers.

In summary, on the disc drive industries (inaudible) near term business challenges through the first half of the year, we remain confident of the growth potential available in the market in the medium term. We continue to work closely with our disc drive customers to ensure our market roadmap are aligned to their business needs.

Based on the market conditions we currently see, we anticipate a return to historical product demand through the second half of the year. (inaudible) may well prove to the be the patent of the industry going forward. This aligns with the overall disc drive demand phasing through the year.

Overall, I remain optimistic on the growth of the data storage market. We are well positioned to support investment phase in the disc drive sector in the second half of the year. We’re seeing continued growth in the business. We continue to work closely with our large data base customer, Net___, following the strengthening of our relationship with them in January when we entered a new agreement to develop next generation disc space storage technology. We’re working closely with Dell and IBM and have the opportunity to see additional growth with these new relationships and we are seeing a number of our other customers making positive traction in the markets they serve. As a result, I believe we are well positioned to benefit from the growth in the data storage market.

Once again, I’d like to take this opportunity to thank all our employees worldwide who have contributed to the good performance in the quarter, meeting the needs of their customers, as well as making good progress on a number of internal programs. I look forward to your continued commitment as we support the growth of the business through the remainder of the year.

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

Operator

Ladies and gentlemen, if you wish to ask a question, please press star following by one (instructions) Your first question comes from the line of Aaron C. Rakers with Wachovia Securities.

Question-and-Answer Session

Aaron C. Rakers - Wachovia

Thanks for taking the question. One clarification and a few questions. In terms of your networked storage systems business, can you just give us a breakdown of your largest customer relative to your non-NetApp customers as you’ve done in the past several quarters?

Richard Pearce

So in the quarter, NetApp represented approximately 72% of the revenue of the business.

Aaron C. Rakers - Wachovia

Right. So one of the questions I have on that is if we look at Network Appliance and what they reported in their January quarter, it looks like that business was down about 2% or 3% sequentially. So I guess the question is have you seen a change within the order patterns or the pull through from Network Appliance to cause a little bit of a disconnect here or what is exactly going on in terms of that business you’re seeing with them?

Richard Pearce

Fundamentally, we’re not actually seeing anything different or out of line than our original expectations. The phasing is the course between ourselves and NetApp are different and, therefore, in certain courses we see spikes in growth and also I guess if you look historically it is quite normal for us to see flatness (inaudible). If you look back from 3Q to 4Q, again, the business grew by about 10% in that period and as we look out into the next period, our forecast 13% increase overall in the NSS business and that’s a pretty linear mix between the NetApp and the non-NetApp business. Fundamentally, I’m not seeing anything different, but I just think the offset in the times of the year which sometimes this confusion.

Aaron C. Rakers - Wachovia

You talked a lot about now starting to see some of the CapEx come back into the hard disc drive market and shift more favorably for you guys. It sounds like the first half of the year is getting a little bit of better impact from that. Would you characterize it as a pull-through or a pull-forward from your initial expectations for the year relative to the second half or is this incremental demand that you hadn’t previously forecasted for the full year?

Richard Pearce

It’s difficult to tell at this stage, but I’d say when we provided the full cost back in January, there were some questions out there in terms of our competence levels the volumes would come in Q3 and Q4. We have seen slightly better volumes in one Q than the original forecast and again in terms of 2Q. We’re now starting to see again the demand coming through at slightly higher levels than the numbers out there in the marketplace. So I think overall I’d say possibly slightly higher, but at this stage it’s a little early to tell. So we’re really seeing some pulls we’re expecting to see in 3Q coming into 2Q, but equally equivalent we were expecting in 4Q coming into 3Q. So it’s too early for us to say now what will happen in 4Q, but I think overall it’s just a very encouraging sign.

Aaron C. Rakers - Wachovia

If we think about a normal CapEx spending environment, how do you guys characterize normal, you know, be it as a percentage of what Seagate or Western Digital typically spends. I’m just trying to understand the phrase around normal, what that might mean?

Steve Barber

Aaron, Steve here. The CapEx expenditure of the disc drive companies come in a wide variety of areas, some of which can be aligned with product variable. Some of it ends up in digital facility. I think if we look back over history, it’s difficult for us to see a direct correlation…(inaudible)

Aaron C. Rakers - Wachovia

Final question for me. Share repurchases, $2.6 million. Surprised you weren’t a little bit more active given where the shares were at. What’s your thinking around share repurchases here going forward?

Richard Pearce

Our intention is to continue to be active in the market. It was the first time that we ever got into such a program and I guess in terms of the timing, Aaron, obviously we didn’t start the program because of the blackout of the year end, really the earliest that we could start was around January 14th and then because it’s really our shortest quarter that we’re out of blackout, we can only run and ran from Jan. 14 up until Feb. 14 and then we were in a position where obviously we had to put a (inaudible) if we want to continue to participate. We took the opportunity as well as we could based on decisions we made, pretty much a broad level of pricing levels and where we would enter the market and I guess it was always our intention to tread carefully in the early stages just to see what the market reaction was, but depending on where the stock price goes in the near term, I still intend to be active with after the first million that has been put aside for that program.

Aaron C. Rakers - Wachovia

Thank you very much.

Operator

Your next question comes from the line of Paul Mansky with Citigroup.

Paul Mansky - Citigroup

Just want to talk to you a little bit about gross margins on the systems side. I mean your 30 basis point decline sequentially isn’t that big of deal in the grand scheme of things, but when you look at it in the context of a 2 point mix shift relative to your tier one customer, it is a little bit contrary to the way at least I’ve historically thought about the model. Is there any way you can provide some context as it relates to what’s going on in the margin side?

Richard Pearce

Again, Paul, there’s fundamental I can’t put my finger on and say this is the reason for it. Ultimately, that’s the 2 point decline that we see in there is primarily related product mix within NetApp and non-NetApp side of the business and product mix and customer mix of those on the NetApp side that take more technology and those that take slightly less technology. As I look out going forward, Steve in his comments talked about our relationships that we now have with Dell and IBM and the opportunity that we see there and I think again if I look back at previous calls, I’ve always referenced the point that opportunities could come forward with NetApp-type margins and sort of non-NetApp-type margins to the extent that they’ve got potential to being relatively large. Equally we’re encouraged with that, obviously because it does allow us to look up customer concentration issues, which are a big focus of ours as well as just…scale. So I think going forward, to the extent that that side of the business continues to grow, then my expectation with the margins would continue in the sort of range that we see today.

Paul Mansky - Citigroup

I noticed that there is no reference to Solar in your prepared remarks. Can you provide us an update on your latest thinking there?

Steve Barber

We continue to make good progress in a limited way in that area. We continue to be progressing our activities with customer we’re working with for some time. We are approaching this market cautiously. We’ve made the point that we have technology which is attractive to enable us to move the customers into production. It is a rapid (inaudible) and we are being quite cautious and not over-committing ourselves to the customers. It is a different application of technology that we have and, therefore, we’re taking it one step at a time.

Paul Mansky - Citigroup

Are you forecasting internally any revenue contribution at all in the current year?

Richard Pearce

We are actually. We have a relatively strong (inaudible) the one customer that we have been shipping to in that market space. I think relative to that customer, again that we’re not able to name at this stage, but that particular program we probably come to the end of the first phase of it and therefore I’m not anticipating any significant revenues from that customer and to the extent I can’t see at the moment any customers being active outside of that one customer in the short-term. In overall revenues, I still think our revenue will be very similar to last year in terms of Solar based on our not getting any more customers. So it’s not a case of us having no revenue in this year from Solar.

Paul Mansky - Citigroup

Perfect, and I’ll take a third as well if I may and a quick one, but as it relates to R&D efforts on the system side, can you talk a little about your plans relative to support for solid state store technologies. Are you looking at it? Are you already in development or are you going to pass at this point?

Steve Barber

We are already active in this area for certain customers that we can’t observe. We are integrating drive technology for very specific application activities, very significant cost differential between (inaudible) So we’re currently active with customers. We’re seeing discussion with other customers who are looking at potential benefit that Solar can bring to them, but it’s all around their particular application and for the benefit of an extremely high IOP capability….to enhance their application, then it really becomes a potential opportunity, but the price is going to be a factor for some time.

Operator

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

Keith Bachman - BMO Capital Markets

First on the infrastructure side with gross margins. Obviously pressure this quarter because of the revenues. As you look out, as you mention, in the August quarter with better volumes, do you see that coming back into the 29-30% range, given the mix that you currently see?

Richard Pearce

Yeah, the primary reason, Keith, the margins are where they are is a fixed cost element. Therefore, in 2Q, the projections are higher but not that much higher. So do I see the margins coming back a little? More towards toward 24-25% type ranges. As I look out for the full year, I think the consensus is somewhere between 29-30% for the year and I wouldn’t change expectations for the year. So overall, I still feel comfortable with where the margins sit, but it’s just a matter of phasing of the volumes and the fixed cost.

Keith Bachman - BMO Capital Markets

To be fair, I was asking about the August quarter. The second question I have is do you see any changes in the competitive landscape on the infrastructure side of the business?

Richard Pearce

We’ve always seen time to time competitors looking at this space. If I look back historically where the areas that we operate within, we have seen opportunities, proposals to the drive companies and I think our approach has always been to simply make sure that we are aligning our road maps with the needs of those drive companies and to provide compelling technology. (inaudible)

Keith Bachman - BMO Capital Markets

Okay, so no real change in the competitor dynamics?

Richard Pearce

We always going to see and expect potential new entrants looking at this market.

Keith Bachman - BMO Capital Markets

Okay, last one for me. I think you mentioned you saw perhaps a different dynamic on first half and second half in the infrastructure business as you think about the longer term potential. If we start thinking about in 09, is there any way that you could just characterize is the first half 80% of the second half or 60%? Any way that you can think about that or characterize it based on what you’re seeing now?

Richard Pearce

I made the comment in the prepared script. It’s going to become the pattern going forward. If you look back in our history, we haven’t actually seen that pattern or be it when you look at the relative volumes of drives shipping out of the drive companies, there is certainly a biased second half of the year and, therefore, as I look at it objectively I might expect those drive companies to phase their investment or capacity towards the third and early part of the fourth quarter… (inaudible) My initial view is that this could be an underlying patent that we see going forward.

Keith Bachman - BMO Capital Markets

I think, Steve, you said that you thought the systems business in May was going to be about 13% annual growth. Did I hear that correctly?

Richard Pearce

I think I said that. Yeah.

Operator

Your next question comes from the line of Clay Sumner with FBR.

Clay Sumner - Friedman, Billings, Ramsey Group

Richard, you talked about the inventory build-up, explained it around the BRP transition you guys will be undergoing. I was just wondering the if the come-back of the SI business is also a factor and if you could just maybe weight which factor is more important. I realize some of the SI business has a fairly long lead time.

Richard Pearce

It does. That is a factor, Clay, but I’d say that’s less of a factor. I didn’t go into it in too much detail in the call, but obviously at the last call I spoke about our plans to introduce the new ERP system actually in March of this year and we were on track in terms of preparations for transition cost and hence we were already building up our inventory of finished goods in preparation for that, because it will take our system down potentially for a couple of weeks and we want to make sure we don’t let any of our customers down in terms of their expectations. What happened in terms of the March go-live date as we call it, we had obviously the Dell takeover of Equalogic and with that came a number of what we would see as (inaudible) but they needed to be undertaken in a short period of time and making those changes as well as changing a new system and that risk was something that we were not willing to do and, therefore, we moved out the go-live date and unfortunately we had to move it out three months, because I won’t let it be done at quarter end in case it gives me trouble in terms of reporting. We wouldn’t do it at April, because it’s Network Appliance’s yearend. So we wouldn’t want to have problems encountered with regard to that. So it’s moved out until June. So hence, we did do a build up, but now it will start to dissipate some of that with the next month, but then we’ll start to build it up again.

Clay Sumner - Friedman, Billings, Ramsey Group

Okay. Then, Steve, you talked about moving back toward the traditional mix of your hard drive customers CapEx and I know it bounces around significantly quarter-to-quarter, but you guys had reached kind of roughly 25% of Seagates’s CapEx for several quarters. Are you talking about getting back to that kind of level?

Steve Barber

It could be if they cease with the plans on facilities. As you’re aware, Seagate is investing in two major facilities as we speak. Our understanding is that there are no near to medium term similar plans and, therefore, we might expect a shift of the CapEx expenditure towards production capacity as it relates to hard drive. That also links in with the fact that we believe that they will be completing the utilization of the (?) effort through the second half of the year. So those two factors I think would potentially return us back to historical spend within the total CapEx.

Clay Sumner - Friedman, Billings, Ramsey Group

Etoxy was a pretty warm prospect at some point last year and then they went cold at the end of 07 and early 08. Can you just talk about that. Are they likely to become a customer any time in 08?

Richard Pearce

We haven’t stopped engaging with them, Clay, but it is clear within the organization that the focus has turned on optimizing and maximizing the capability of their current assets and facilities and certainly the sketch we’ve had the previous year in demonstrating the benefits of our technology over their existing facilities has positioned us in a good place. I think certainly in the near to medium term in fiscal 08, they would succeed in securing additional production capacity simply by optimizing what they have today and with the financial challenges that the division is under, I think that the direction they’ve been given. So we will continue to work very closely with them. In reality, where it is today, I think they will probably be a likely customer for us in the second half of 09. Conservative, but I think they certainly would focus on getting a lot out of their production capacity in 08 and, therefore, not need incremental…

Operator

Your next question comes from the line of David Kayhill of RBC Capital Markets.

David Kayhill - RBC Capital Markets

Hey guys, just two quick questions. What level of risk do you guys decide at this point to be Seagate’s in the second half of the year given what feels like slowing hard disc drive industry trends?

Richard Pearce

I’ve seen a number of research recently speculating what drive demands will be in second half against the macro economic trends that are going on right now. Our view is that there will be a relatively significant phase of additional capacity investments across the industry second half. In Seagate’s’ case that is we believe will necessitate incremental production capacity and certainly discussions and outlooks and guidance we’re receiving from those customers append our expectation for the second half. I think the overall volume projections that are being planned. The incremental capacity growth of individual drives as they introduce new products in the roadmaps. Those factors certainly today are supporting our projections for the need for equipment and overall capacity. Whether that ends up in surplus capacity at the end of the year, I think it’s really too early to tell. It’s not an indication we see today.

David Kayhill - RBC Capital Markets

Also, you talked about the current Equalogic business at Dell. What’s your confidence level in participating in next generation design with these guys and the new product, the 5000 I think, is that part of the next generation or how do you guys feel like you’re positioned not only today but as they roll out new platforms?

Richard Pearce

I think we are as well positioned as we can. We have been protuitive to some extent of the opportunities we engage with these customers, acquiring customers that we were previously engaged with. I think in both cases those customers are impressed to see what a compelling solution we can provide and we are already in dialogue of potential extend of product ranges to utilize other parts of our technology sect. It’s very early, Dave, in relationship, but overall to date I think they’re very, very positive and I would say, to answer your question, they are extending beyond the current immediate boxes that we’re supplying to those companies.

David Kayhill - RBC Capital Markets

In addition to that, if you look at what capacity levels are you guys at in the storage systems business today with your own infrastructure. Obviously Dell and IBM volumes can be pretty substantial if Equalogic and XIV ramp as most companies plan. I mean where do you think or is there more CapEx needed from your standpoint to support those volumes today or where do you typically run relative to full capacity?

Richard Pearce

I think as we said in the press release, we have made a fair amount of effort and proprietary action through the first half of this year in the U.S. and Europe and Indonesia. In anticipation of (inaudible) and that included some CapEx. In reality, the prices are not significant CapEx drivers. We do drive some production test equipment, but historically the bulk of our CapEx in our business has actually been more toward mold tooling for specific front moldings that we customize for our customers. We are investing. We don’t envision that it will be a significant sect change in the level of CapEx or investment we need to make to support the business, but we will continue as we have done through the first quarter both optimizing our term production facilities to make sure we have test capacity to support the volumes that we outlook for the rest of the year.,

David Kayhill - RBC Capital Markets

Great. One little question. Sequentially deferred revenue, it looked like it was down. Can you add some color on what exactly is going on there?

Steve Barber

Deferred revenue primarily relates to the automation business. Again, there’s no real fundamental changes. It’s really just the timing of when we receive orders. We had quite a few of those received at the back end of 4Q when we took in quite a lot of deferred revenue and actually shipped that product in 1Q and not so much of those orders coming in 1Q, but that doesn’t mean I’m expecting that side of the business to fall away in any shape or form.

Operator

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

Glenn Hanus - Needham & Company

So overall, you’re basically reiterating your fiscal 08 guidance that you gave last time and are you also saying that the system infrastructure business year-over-year revenues still about flat as part of that?

Richard Pearce

Yeah, I think at this stage, Glen, that it’s not appropriate to revisit those projections that we gave at that time. I think it was the confidence that has increased to the extent that we seen the orders coming through and probably the markets confidence in that happening has come through from the statements made and the expectations in the hard drive industry, but yeah, I think before we readdress those matters, then I’d want to see some more data coming through in the next few months.

Glenn Hanus - Needham & Company

Then on the NSS side, you commented a little bit about NetApp, but just what changes if any have you seen in the forecast you’ve been getting from NetApp and non-NetApp customer versus what you had say one or two months ago. Any precaution out there?

Richard Pearce

Not really at all, Glen, no. I mean I’d say it was pretty much in line with where they were with NetApp. In terms of non-NetApp business, obviously we did have some expectations that that business was going to ramp quite significantly in 3Q and 4Q. Those expectations still fit out there, possibly now that we’ve focused ourselves more in line of Dell and IBM just to make sure that we don’t do anything to let those guys down, but there would be a little less focus on some of the sort of smaller opportunities, but I’d say we were more deferring those rather than completely turning those off. What that could mean is obviously the IBM and Dell things could be slightly higher than the other expectations. So revenue in that side of the business may chalk up a little bit but equally if I then refer back to my comments to Keith earlier, that would have slightly lower margin association with it and, therefore, I think at a net basis for the full year I wouldn’t be in a different position, but maybe slightly higher revenues in that business.

Glenn Hanus - Needham & Company

You mentioned that you were managing discretionary expenses a little more closely. Can you maybe just sort of comment about how you’re thinking about the target model or operating income and whatever timeframe you want to give sorted out in fiscal 09 or into fiscal 10. How you’re sort of managing the revenue opportunities that you’re seeing versus spending and what sort of model you’re thinking about these days.

Richard Pearce

Yeah, the model hasn’t significantly changed from where my thinking was and what’s out there in the market space. I think obviously we were anticipating a very low first quarter in the SI business. I was very keen, you know, a non-GAAP basis, that we didn’t post a loss which we had essentially managed to avoid doing that and that was from a mixture of slightly up on revenue would also keep a large degree of focus on expenses. Now, we haven’t, from my perspective anyway, taken expense actions which put us in terms of risk in terms of meeting the customer expectations, but we’ve looked at things in terms of salary increases, both in terms of the size of those and the phasing of those particularly in 1Q. We’ve taken a look at travel expenses. We’ve taken a look at new hires and essentially could some of them wait maybe until 2Q, which I think we’ve done. As we see now the business, as part of the expectations in this call, starting to look as though they’re going to ramp in the second half of the year as per our original expectation. I do think that I will start to see some hiring and we will start to incur R&D expenses on consumable type materials that are not inventory items going into 2Q and 3Q. So I would expect operating expense now to step back up again. Maybe not quite to the levels that were out there in the models, but pretty close to those as we go through 2Q. So no real fundamental changes, but encouraged by all the actions the business took and the employees took in 1Q and I’m very much encouraged that culture continue into the second quarter and into the back half, but equally we do see some good growth opportunities and we shouldn’t be missing investment opportunities to grow those in 09 and 10.

Operator

Operator

There are no additional questions at this time.

Brad Driver

All right, thanks again for joining us this afternoon. Just some logistical items we will be presenting at the Baird conference on May 15th in Chicago and we’ll be presenting at the FBR conference in New York on May 28th. Our Q2 earnings call will take place in June and the specific date for that call will be posted with the press release around the second week of June. Until then, have a nice rest of the week and we’ll talk to you soon.

Operator

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

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