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Quantum Corporation (NYSE:QTM)

F4Q08 Earnings Call

May 15, 2008 5:00 pm ET

Executives

Richard Belluzzo – Chief Executive Officer

Jon Gacek – Chief Financial Officer

William Britts – Executive Vice President

Analysts

Brian Freed – Morgan, Keegan & Company, Inc.

Glenn Hanus - Needham & Company

Mark Moskowitz - J.P. Morgan

Robert Moses – RGN Capital

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Quantum Fourth Quarter Fiscal 2008 Conference Call. (Operator Instructions) I would now like to turn the conference over to Shawn Hall, General Counsel. Please go ahead sir.

Shawn Hall

Thanks and good afternoon and welcome. Here with me today are Rick Belluzzo, our CEO; Jon Gacek, our CFO; and Bill Britts, our Executive Vice President for Sales, Marketing, and Service. The webcast of this call, our earnings release, and a quantitative reconciliation of any GAAP to non-GAAP financial measures discussed today can be accessed at the Investor Relations section of our website at www.quantum.com and will be archived for one year. During the course of today’s discussion, we will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements include statements include statements regarding our business prospects, priorities, and opportunities; our financial forecast and anticipated future revenues, gross margins, operating expense, and income performance; trends in our business and in the markets in which we compete; and the expected timing, features, and benefits of new product releases. We would like to caution you that our statements are based on current expectations and involve risks and uncertainties that could cause actual results to differ materially. We refer you to the risk factors and cautionary language contained in today’s press release announcing our fiscal Q4 2008 results as well as to our reports filed with the Securities and Exchange Commission from time to time including our most recent 10-K filed on June 13, 2007, and our most recent 10-Q filed on February 8, 2008. Those reports contain and identify important factors that can cause actual results to differ materially from those contained in our forward-looking statements. All such risk factors identified in our press release and in our filings with the SEC are incorporated by reference to today’s discussion. We undertake no obligation to update these forward-looking statements in the future. With that, I’ll turn the call over to Jon Gacek.

Jon Gacek

Thanks Shawn. Good afternoon and thank you for joining us today. Today, we are reporting results for fourth quarter and fiscal 2008. This is the first full year since the acquisition of AIDC in August 2006. We are pleased with the progress that we have made this past year, but recognize that we did not achieve all the goals and objectives, particularly in terms of branded revenue performance and overall disk and software revenues. Having said that, our challenges this year were largely based on our own execution, and we believe that we have taken the right steps to address those issues and position the company to take advantage of our opportunities. Rick will talk more about our market position and opportunities after I discuss our Q4 and full year performance.

I would like to refer everyone to the financial statements and supporting schedule included in the press release. It will be helpful to refer to those documents as I make my comments.

Revenue for our fourth quarter and fiscal year ended March 31, 2008, was $228.9 million and $975.7 million respectively. Our quarterly performance was 5% below the low end of our guidance for the quarter. We experienced weakness in North America and Asia branded business. For the quarter, non-royalty revenue was $204.3 million, of which 66% was branded and 34% was OEM. This is the highest percentage of branded non-royalty revenue we have achieved since the Quantum-ADIC combination. We expect our branded revenue will continue to grow in absolute dollars and as a percentage of total revenue as we launch new disk and software products, leverage our channel, and improve our branded sales execution.

Looking further at various revenue classifications, devices and media totaled $58 million last quarter, compared to $81.6 in Q4 a year ago; $17.6 million of the decline was attributable to OEMs. We continue to be opportunistic in our media business, and we are just beginning to see the impact our LTO4 -drive on our branded business. Royalty revenue was $24.6 million for the quarter compared to $29.5 million in the same quarter a year ago. The decrease reflects decline in DLT royalty as well as the fact that last year’s royalty included $3.3 million from Data Domain that resulted from our cross license agreement with them. Looking further at product revenue, tape automation systems revenue was $93.9 million, compared to $119.2 million in Q4 of fiscal of 07. Most of this decline was related to OEM products, although we did see some small decline in branded entry and enterprise automation and a small increase in branded mid-range automation.

Disk systems and software revenue was $11.2 million, up from $8.6 million a year ago, and down $14.1 in Q3. In addition to the product revenue, we have $1.3 million of disk systems service revenue for a total of $12.5 million in revenue this quarter. During the year, we transitioned from our legacy disk products to the new DXi product line. For Q4, our legacy products made up less than 10% of this category. We really watch product line through and are really focused on DXi. On a sequential basis, we did see a decline in our DXi 3500 and 5500 revenue. In part, this reflected customers that would have purchased full capacity 5500 waiting for our new DXi 7500 which provides greater scalability, higher performance, and true edge-to-core target-based disk implementation.

Delay in shipping the 7500 did hurt us in Q4, but we decided it was necessary to ensure a solid product and to support our new OEM partner. Today, we announced general availability of the DXi 7500. In addition to the 200+ requests for quotes we’ve already received, we are encouraged by the feedback we have received from customers who are using the beta units. As of March 31, 2008, we had 1.5 million of DXi revenue that had been deferred. Today, we have 8 large pre-orders and approximately 80 million of sales opportunities in various stages of completion. Because 7500 is an enterprise product and allows for true edge-to-core disk implementation with integrated tape creation, we believe it will create continued demand for tape libraries over the long term which we expect will benefit us.

In addition, we have signed a software licensing and distribution agreement with EMC Corporation. This is the agreement we disclosed in our January 2008 8-K. We will not be commenting on EMC’s product strategy or the expected financial details of our expanded partnership with EMC, but we do believe this is a significant achievement and an important validation of our technology. I will say that we do expect to recognize revenue related to this agreement in fiscal 2009.

Looking back, as we stated in our Q3 earnings call, we knew we would not achieve our original goal of $30 million of combined disk and software revenue in Q4, but over the year, we did establish ourselves as a significant player data de-duplication space. We improved our product offerings, and added a significant OEM partner for our software, we believe that our position in this market has improved over the last 12 months and is an important growth area for Quantum.

Turning to gross margins, non-GAAP gross margin in Q4 was 36.2%, compared to 33% in the prior period. This is the result of improving our mix through a higher percentage of branded product and service revenue, achieving greater efficiencies in our product and support cost structure, and generating higher and improved on our disk and software revenue. The increase in gross margin percentage has come over a period in which product declined 22% and our royalty was $4.9 million lower – difficult transition, yet our margins increased quite nicely. As we grow the branded tape, disk, and software business and our software OEM revenue grows, we expect gross margins will continue to improve.

Moving to expenses, non-GAAP operating expense totaled $74 million, compared to $75.4 million a year earlier and $70.2 million in Q3. For the quarter, R&D was $19.6 million, sales and marketing was $35.4 million, and general and administrative was $19 million. The sequential increase in R&D was the result of costs associated with the DXi 7500 launch and growth in our headcount to continue to support our disk and software roadmaps. The increase in sales and marketing was the result of hiring additional salespeople, marketing costs for the DXi 7500 launch, and seasonal compensation increases. Sequential increase in G&A was primarily the result of legal fees related to our patent infringement lawsuit against Riverbed. The suit is pending in California, and while we can’t comment on the details of the case, we can say that we expect the next milestone to be the claim construction hearing in July which will frame the key issues of contention. The case is scheduled to go to trial in February 2009, and we continue to feel good about the merits of our position.

Moving beyond expenses, non-GAAP operating profit for the quarter was $8.9 million, or 3.9% of revenue. This was clearly a step back from the prior quarter due to a combination of lower branded revenue and the additional spending in the areas described above. Net other expense of $200,000 was primarily the result of a $1.6-million loss for mark-to-market adjustment for our two interest rate callers. Our debt agreement requires us to have fixed interest rate on 50% of our total term debt. The derivatives do not qualify for hedge accounting, and therefore we will include gains and losses in interest and other income net, over the life of the caller contracts. These are noncash gains and losses. This loss offset our traditional interest income and some foreign currency gains.

Interest expense for the quarter was $9.8 million, compared to $14.8 million a year earlier. The interest rate for our acquisition debt, which is now at $340 million, at March 31, 2008, will be approximately 6.2% for the quarter ended June 30th – that’s 6.2% for Q1. For the fourth quarter, we recognized a tax benefit of $1.2 million related to foreign tax credits. We still believe it is reasonable to model tax expense of $1 million per quarter. This was really a year-end cleanup on some foreign items.

In summary, for Q4, we were breakeven with non-GAAP EPS of $0.00 compared to non-GAAP EPS of $0.01 in Q4 of fiscal ’07. For the full fiscal year, as I previously mentioned, we had revenue of $975.7 million, down from just over $1 billion in fiscal ’07. However, our non-GAAP gross margin rate was 36.1%, up from 32% the previous year. While non-GAAP operating expenses increased $17.3 million to $285.4 million. Non-GAAP operating income for fiscal ’08 was $67 million, or 6.9% of revenue. This compares to $56.6 million and 5.6% in fiscal ’07. Non-GAAP net income for the year was $27.5 million, or $0.14 per share, up from $19.7 million or $0.10 per share in 2007. Our full year non-GAAP gross margin dollars and percentage, operating income in absolute dollars and as a percentage of revenue, net income and EPS were the highest they’ve been in 5 years, further demonstrating the significant progress we’ve made in our operating model over fiscal ’08.

Focusing now on cash flow for the quarter and the balance sheet at March 31, 2008, I want to highlight several key points. Cash flow from operations for the quarter was $31.6 million. We paid down $20 million of our ADIC acquisition-related debt during the quarter, and as I just mentioned, the balance is now $340 million, down 32% from the $500 million at the time of acquisition. Deferred revenue increased $6.1 million to $104.7 million during the quarter. Sequentially, inventory increased $2.3 million, and accounts receivable decreased $26.8 million. CapEx was $3.8 million, and depreciation and amortization totaled $21 million for the quarter. EBITDA was $19.2 million for the quarter.

Looking forward, as we begin fiscal 2009, while we have had challenges in growing our overall branded business and disk and software revenue, we believe we have a strong operating model and a solid foundation to grow our branded tape, disk, and software revenue. For fiscal 2009, we expect revenue of $950 million to $1.05 billion. In these numbers, we expect significant benefit from our DXi 7500, some benefit from our software OEM agreement, and a continued increase in our branded mix. We also are forecasting media royalties of $90 to $95 million for the year. We expect non-GAAP gross margins of 38% to 40% for fiscal ’09. This range reflects the growth of our overall branded business and our disk and software offerings as well as some contribution from our software OEM partnership. In 2009, we will continue to manage operating expenses very closely, but still invest in growth areas of R&D for disk and software and sales and marketing to grow our branded go-to-market reach. We expect non-GAAP OpEx of $300 to $310 million in ’09. All this results in forecasted non-GAAP operating margins of 7% to 9% for fiscal ’09. We expect our interest cost to be approximately $28 to $30 million for the year. We expect tax expense of $4 million, or $1 million per quarter for fiscal ’09. So if you take all those ranges together and do the math, this results in non-GAAP net income range of $35 to $55 million for fiscal ’09. As for the current quarter, or Q1 of ’09, we are not providing guidance beyond saying that we expect it to look a lot like Q4, reflecting the seasonal factors we typically experience in Q1.

Now, let me turn the call over to Rick to say a bit more about the past year and how we’re positioned to take advantage of the opportunities ahead. Rick?

Richard Belluzzo

Thanks, Jon, and thank you for joining us today. Fiscal 2008 was an important year for Quantum. We made significant progress in improving the core operating model of the company and further refining our strategic focus, but as we said last quarter, and as was reinforced by the challenges we had in Q4, we recognize that we must focus on growing branded revenue and our disk systems and software business to improve profitability and shareholder value. This continues to be our top priority, and I’ll talk about the actions we are taking in this area, but before doing so, however, I wanted to briefly reiterate that what we’ve been trying to accomplish since combining Quantum and ADIC just a little less than 2 years ago.

The Quantum-ADIC merger represented a very aggressive and ambitious effort to build a more valuable storage company. Our goal was to build $1 billion business with improved gross and operating margins and to establish a revenue stream that has fundamental growth potential. To achieve this, we embarked on a series of activities related to the combination. They’ve included taking a significant amount of cost out of the combined businesses, allowing low-margin OEM revenue to decline while growing higher margin branded business, shifting our investments do drive in greater growth potential – this has mostly been about reducing and optimizing tape R&D while growing disk systems and software R&D, aggressively driving integration activities to ensure that we can be cost-competitive while having a solid execution platform, and then finally building a growth business by combining technology from both companies in one of the most vibrant segments of the storage industry—disk space backup recovery and archive.

The last point I would like to make here is as we work to deliver on these goals, we also wanted to reduce the impact of the acquisition-related debt and thereby reducing interest cost for the company. It was our view that these actions were what would drive shareholder value - delivering a better operating model, creating more growth potential, and reducing much of the negative impact of debt, and we continue to believe that these are the right drivers for delivering such value.

The results that we have reported over the last year have demonstrated solid progress in the operating model of the company. As a result of all the actions we have taken, we have seen significant improvement in gross margins reflecting in better mix of products. Also, we have delivered improved operating income and cash generation capability. In addition to this, we have refinanced our debt, reduced our acquisition-related debt by 32%, and now have the opportunity to take advantage of lower rates. Finally over the course of fiscal ‘08, we made a significant transition in our investments in order to drive growth in our overall branded business, especially our disk systems and software business. While we feel very good about the progress of the company’s operating model, we are clearly behind in our goal of growing our branded business and disk systems and software revenue.

So, let me speak to the two primary reasons for the shortfall and what we are doing to address this. To begin with, our first generation DXi products introduced last year had taken longer than anticipated to the reach the maturity levels necessary to deliver on the market share and revenue goals. In part, this is also one of the reasons that we delayed the general availability release of our second generation DXi 7500. We wanted to make sure we incorporated the lessons learned both from our own experience and feedback from our customers. The other reason we have not executed as well as planned in growing our branded business and disk and software revenue involves some of the challenges that we’ve had in sales and marketing. While we see a significant opportunity in leveraging our installed customer base and channel partners, Q4 demonstrated that transitioning our sales force to align with our edge-to-core strategy had greater than expected impacts on our sales productivity, including extended sales cycles, deferring tape purchase, and reducing overall sale velocity. Despite these challenges, however, the market for disk space de-duplication and replication is still very young with tremendous opportunity. We believe that the actions that we have been taking to address our challenges and improve our execution will enable us to capitalize on this opportunity over the next year and drive improved results not only in disk software, but also in our overall branded business.

Let me begin with the product side. As Jon mentioned today, we announced general availability of our new DXi 7500 enterprise disk backup system with de-duplication and replication. With this announced, we can now provide customers with end-to-end de-duplication and replication through a single family of disk space solutions that also integrates closely with tape and together can all be deployed under a common management system. In addition, beyond providing the capacity, performance, scalability, and availability required in an enterprise environment, the DXi 7500 is the first solution in the industry that provides policy- based de-duplication. This means that customers can choose the de-duplication method that best meets their needs for specific backup jobs, taking into account disk capacity and backup window constraints.

As Jon mentioned, we have already received positive feedback on the DXi 7500 from customers, and we are excited about the long-term opportunity it provides us. Our strategy is to build on the foundation we have established. Moving forward, we’d like to leverage our disk, tape, and software assets including our de-duplication, replication, and data movement technology to deliver integrated data protection and management offerings across the distributed enterprise. Although we have just started down this path, we have already seen the benefits that a strong position in disk systems can bring to our tape and software sales efforts. Based on discussions with customers, it is clear that they are much more likely to engage with this on a broad basis when we have disk-based solution that can meet their needs.

We also feel good about having EMC as our software OEM partner. The fact that we were chosen by EMC is a significant achievement and an important validation of our re-duplication technology. Beyond the DXi 7500 GA release, expanded EMC partnership and work we are doing on integrated solutions, we have also strengthened our executive leadership team with hiring of Jerry Lopatin as head of engineering. In the just the two months since he has joined Quantum, Jerry has already made significant contributions, drawing on his wealth of experience in the storage industry including stays at NetApp and ONStor.

Moving on to the actions we have taken to address the challenges that we’ve had in sales and marketing, we already discussed several of these in the last earnings call, such as the establishment of field marketing function to better assist sales, introduction of our disk tape solution, and the formation of a DXi specialist team in North America to support end-to-end solution sales and implementation. As we said, it will take several quarters to realize the full benefits of those actions as well as additional steps we took in the March quarter to grow our branded business and disk and software revenue. These latest steps include restructuring our North American sales organization to create stronger territories with higher win potential, segmenting out installed base according to different needs criteria, increasing our lead generation activities, and working more closely with ISBs and server vitalization providers.

In closing, the progress we made since the combination with ADIC has been very positive in terms of building an improved operating model and a foundation that allows us to pursue our edge-to-core data protection strategy. Our branded revenue shortfall and DXi performance represents disappointments that have limited the opportunity to deliver improved profits and shareholder value in recent quarters. However, we believe we are entering the next phase of that opportunity. This involves building on our second generation DXi product, the 7500, our expanded EMC relationship, and a significant series of changes in engineering, sales, and marketing. We expect all of this will start to impact branded revenue within a couple of quarters taking into account the seasonality we typically see in the first half of our fiscal year. As I said earlier, however, growing our overall branded revenue and our disk and software revenue remains our top priority. Thanks for joining us, and let me turn the call back over to the operator for Q&A. Thank you.

Question-And-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. (Instructions). Our first question is from Brian Freed with Morgan, Keegan & Company, Inc

Brian Freed – Morgan, Keegan & Company, Inc.

Hi, thanks for taking my call. A couple of question – first of all, looking at the balance sheet, accounts receivable continues to be an area of cash consumption, and I know you’ve gone through some Oracle transitions and the like, but can talk a little bit about your accounts receivable on your direction, where you expect that to go, and really also the confidence you have in your visibility?

Jon Gacek

Sure. I forget the number I just said. I was like $26 million. Receivables were done. I think if you look at the cash flow statement, it was one of the items where we definitely generated cash flow. We made lots of improvement in some of the operational things. I think there’s probably, I don’t know, 10, 15, maybe as much as $20 million that we can still go after, but our aging is like 95% current, and we collected about $13 to $15 million more this quarter than last quarter, so the trajectory is in the right direction. We have a little bit more work to go, but it’s not as far away from being where we want to be as it was the last couple of quarters.

Brian Freed – Morgan, Keegan & Company, Inc.

Okay. And as you look at accounts receivable going forward and given the mix between branded and OEM, should we expect that to be a little higher than the historical levels as branded revenue increases, say, versus a year or two ago?

Jon Gacek

Not necessarily. The branded business tends to be more back-end loaded, so that contributes to receivables going up. That would be true. Payment terms are different depending on the channel and the customer, but generally speaking, I would just say receivables is a place where we don’t have a lot of losses. We do have some collection challenges, but we really can’t turn the corner on that, so we’re much more into leveraging our balance sheet, trying to add new partners, and then collect the cash on time. So, I guess at some level, branded is a little more backend loaded and has a higher percentage that will make the aging go up, but we’ve really made a lot of progress there.

Brian Freed – Morgan, Keegan & Company, Inc.

Okay, and then secondly, with de-duplication down sequentially, and you talked a little about some customers who would have purchased 5500 who deferred for the 7500, I know you are not giving specific guidance, but as you look forward with the pipeline you see for the 7500, how fast do you think you’ll be able to actually book deals for the 7500? I mean enterprise class products tend to have a little bit longer test and eval cycle. Do you feel like you have a fair number in beta and proof of concept, or do you think it is a couple of quarter phenomenon before we really see those kick in.

Jon Gacek

How about if I start and then Bill can jump in. Because we’ve been talking about this product for a while, our guys have been out selling it for a while. I think Rick alluded to that as being one of the things that impacted our tape business. Customers are excited about talking about disk. They think we’ve got something unique. Our salespeople are excited about it, so there have been a lot of discussions with customers. How quickly it turns into revenue, I think, will remain to be seen. I think we will definitely have revenue this quarter that we’re in, and it is an enterprise product, so the sales cycle tends to be a little bit longer, but we have a lot of interest. I think in my comments I said we had approximately $80 million of deals in final and various stages. With that I’ll turn it over to Bill, and he can add more color.

William Britts

I think you’re absolutely right. We should anticipate that in the enterprise, especially I think when you look the way that we’ve positioned this product and the capabilities of this product, it is not as simple as just plugging in a midrange appliance and immediately having disk space with de-duplication running. This is really a fundamental shift in the way that this de-duplication market will unfold because we’re offering the scalability through our policy-based de-duplication the ability to really choose different de-duplication methods that match up with the customer requirements whether it’s trying to increase data retention on disk, show disk backup window, being able to keep up replication for disaster recovery – there are a number of parameters that customers quite frankly haven’t really had any kind of solutions unique in that regard. So, we actually have kicked off a consulting service that helps customers work through this redesign of their backup and being able to take advantage of the economics of disk space backup with de-duplication, but also to b able to solve some of these problems that up to this point really weren’t possible disk space backup. So impact on this quarter – we have a number of customers that have already pre-ordered. We’ll be implementing those after late June/early July. That we anticipate getting reference customers, and some of the betas that have been running up and referenceable, and I think the proof of concept and the evaluation and all the things that go along with enterprise product, that will build over the next several quarters.

Brian Freed – Morgan, Keegan & Company, Inc.

Okay, and then my final question Jon. One of the criticisms of you guys is you’ve shot pretty high on your guidance historically. While you have made a lot of progress, you haven’t always quite delivered as you were intending to. As you look at ’09, do you feel like you’ve set the bar as far as high as you did in ’08, or do you think you are slightly more conservative? I’m trying to get your thoughts about how do you opted to set the bar and your level of confidence in getting there.

Richard Belluzzo

Well, I would say that we’re smarter now, and what I mean by that is we had a full year of operating as a combined company. I think on the cost side in particular, we have a good handle over how to manage that. We have a couple of unique items like the lawsuit that we can’t exactly forecast what we’re going to spend, so on the expense side I think we just have more experience. On the revenue piece, we’ve done actually a fairly good job of forecasting where we’d be on the OEM business and some of these changes that we made in the portfolio of those products, and a place where we’ve candidly just not done as well is on the branded growth opportunity in both adding both new headcount the disk and software products. We talked about this a lot that we have a lot of infrastructure in place, we see signs of it with our customers, so I don’t know if I want to characterize it as conservative or aggressive. We think it is a reasonable plan that’s consistent with where we are in the marketplace, and candidly you pointed out probably the most important fact – we’ve got to deliver results, and if we deliver results, the numbers will be better, the stock price hopefully would improve, and that’s really what we’re focusing on – it’s delivering results.

Brian Freed – Morgan, Keegan & Company, Inc.

Alright, thanks Rick.

Operator

Thank you. Our next question is from Mark Moskowitz of J.P. Morgan. Please go ahead.

Mark Moskowitz - J.P. Morgan

Thank you, good afternoon! Two questions – EMC World is next week, and obviously you talked a little about your software relationship forthcoming, but you just kind of contextualize your overall relationship with EMC in terms of data de-duplication? How that’s going to make a splash next week? Should we expect it to have a little more stage presence than usual?

Jon Gacek

I’m going to let EMC comment on EMC. How they’re going to position it and what they are going to do, that’s really their challenge. You’ve followed us over the years. We’re not going to talk about our OEM partner’s products on these calls or others, so we’re going to leave that to them.

Richard Belluzzo

I would just add that the EMC relationship definitely enriches what we do with them. We’ve certainly partnered with them on the tape side. Now with this opportunity, we think we can get more traction and be more active with them across the board.

Mark Moskowitz - J.P. Morgan

And then, just as a followup to the EMC commentary and I’m not trying to get any sort of quantitative metrics if you will, but just want to understand the economics of the relationship – the expanded relationship or enriched relationship, are there upfront sweeteners in terms of where you had to give up a little more to keep EMC excited about data de-duplication or was it pretty similar to some of your prior arrangements with the OEMs?

Jon Gacek

This is a different deal for us. Most of our OEM arrangements have been hardware product-based relationships of tape drives or tape automation, and this is a software-based relationship, so the margins are obviously software-like or better, and they are the largest independent storage company. They have access to lots of customers, and we think, as Rick pointed out, it just helps us across the board as we engage with them in the field.

Mark Moskowitz - J.P. Morgan

And as you get prepared to be engaged with them in the field, are you guys having to realign your head count in terms maybe giving them some folks that are going to be able to be positioned to help out there with that rollout in terms of either on the support side, customer education, customer training… Can you walk us through what may happen in terms of your outlook?

Richard Belluzzo

I think the key part of that is that this is an OEM relationship, so it’ll be their product using our software, so they’ll be responsible for everything in terms of the go-to-market, in terms of support – it’s their product, their brand, they are taking it through their go-to-market machinery. As we said earlier, we learned a lot during the last year, and we developed this technology – this end-to-end solution – and we’re basically transferring that knowledge to them, so that they can be successful. If you look at the release of the 7500 and you look at the enterprise capabilities of that product and you understand where EMC has been successful, you can see why it’s very good fit for them.

Jon Gacek

I’d always say there certainly has been OpEx impact, because we’ve been doing work to support these product, and that’s an adjustment we’ve already made.

Mark Moskowitz - J.P. Morgan

Okay, and then shifting gears, can you talk a little more about the disk and software revenue velocity. Obviously, you’ve been pretty candid about the disappointment on Quantum’s part, but can you maybe just talk a little bit about how much of this is being driven by competitive forces?

Richard Belluzzo

Let me give you give us a little bit of background, and I’ll have my partners here jump in because I think that is an important discussion to have. When we merged companies, this de-duplication opportunity was just in its very early phases, and we saw the opportunity to quickly come together and put a product together and a strategy together that would allow us to finally get beyond some of the negative dynamics of tape and have a growth platform that would take us into the future. At the time, Data Domain was really the only company in the market; they had been out there for some time ahead of us, and we chose to move quickly to put a product together, and we made some tradeoffs to get the product to market, with a very limited product line, and we felt that was important to get established and maybe even more importantly to learn. And so we went through a very significant learning about how these products fit into the environment and what range of capability should take place, and through that we developed what we believed was a very unique strategy that we called edge-to-core which means putting systems in the edge of the network at remote sites, being able to replicate that to a data center with a single scalable architecture, and being able to integrate with team for longer term archives, and that we decided was our competitive advantage.

Frankly, our first generation of products really did not embody that, but we believe that what we learned and what our technology can do is really about that. We then immediately embarked on the development of a second generation product, the 7500, which took us 2 years versus six months for the first product, and now the strength of that has allowed us to leverage the opportunity with EMC. So through the process, we feel the market is wide open. We feel that Data Domain is the real competition who has been out there for a while. The reality is that not many other players have really been able to come forward with effective solutions. They are complex challenging products.

We believe that today now with the 7500, we have this unique edge-to-core integration with tape strategy and product line that we think will give us substantial advantage moving forward, and so the last couple quarters have really been about living in that learning, deciding how hard to push our current 5500 because there was a tendency since that was the high end of our product line, those products tended to get pulled up into larger environments, we had to pull back on that until we could get the 7500 out – so we’ve made a lot of adjustments and a lot of transitions to bring us to the point we’re at today where we have a low-end product, a data center product, a mid-sized product that are all able to operate and scale and integrate with tape.

So, we think that in some ways the market is just like it was a year ago – we’re much more experienced and we have a much better product line that we think gives us the opportunity now to move with more velocity, with more momentum, and that’s what we intend to do.

Mark Moskowitz - J.P. Morgan

I appreciate the expanded response there. One question I do have for either Bill or Jon is, with the 7500, can you give us a sense in terms of the conversion rate in terms of when you book the order until you actually can shift it? Are we talking weeks or months? It kind of goes back to Brian’s earlier question in terms of understanding the funnel here. Is this going to be more of a back-end fiscal ’09 type of event in terms of how you get to your guidance or is it going to be…

Jon Gacek

So, you’re asking two questions there. On the get-an-order-and-ship-it, I think we’ll have during the year 1 week lead time that will probably get shorter as we get towards the end of the quarter and build some inventory, so that’s a not a big deal. We do have a funnel that we talked about that I think is unique because of the way we announced the product as early as a year ago and then have been talking to customers about it, so we do have a funnel, but I do think there is the enterprise sales cycle which Bill can address.

William Britts

I think there are two aspects to this; one is the work that we’ve already been doing with customers to help them lay out this integrated disk tape solution and the ability to replicate from small branch office sites back to a centralized site which really accomplishes the DR function and centralizes management of the backup for distributed sites. Those are much larger scale types of backup we are protecting that is going on right now, and generally what we see is people want to start with some type of proof of concept where they start with an initial purchase of several systems and then they expand out from that. So, I do anticipate that over the next several quarters, we’ll continue to see increased uptake in the number of customers that want to basically deploy this type of approach. They are in a lot of cases deferring or trying to squeeze as much as they can out of their current infrastructure, and then they’re looking at being able to make big investments as they completely redesign the backup solution to be able to take advantage of the fact that we can, through one common replication process, link those distributed sites to core data center and then be able to do offsite disaster recovery without really having to use different products for that entire solution. So, I think there will be customers that will buy 7500. We know that we’ll have 7500 sales in this quarter. We already have a backlog. We anticipate that a number of those customers will continue to add to their environment as they actually roll out their internal projects for being able to deploy this.

Mark Moskowitz - J.P. Morgan

Thank you.

Operator

Thank you. Our next question is from Glenn Hanus with Needham & Company. Please go ahead.

Glenn Hanus – Needham & Company

Good afternoon. On the revenue outlook for next year, Jon, are you willing to maybe kind of give us some sense as you go through the categories – for instance, sort of the tape library area – should we think about that as sort of flattish year over year, and the royalties down a little and the drives and media - maybe just kind of go through at least qualitatively how we should think about modeling the pieces.

Jon Gacek

Yeah, so I have a few pieces of that. The royalties, we gave have a specific range on – that was $90 to $95. I said in there that 7500 was significant, so I would say that by far and away the largest area of growth will be in the disk and software area. I think you could also add to the comment since you asked the question – we will have a higher branded mix and that range that we gave of $950 to $1.05 billion – that will give us an opportunity for some growth. So if the brand is going to grow, that means OEM is going to come down some, and that’s helping with the margin getting to the 38% to 40% range, and I think in the tape automation area branded, we think we can do better there than we’ve done this last year. I’m looking at Bill, and he’s nodding yes. We think our sales team is going to benefit from having this product that is an enterprise class product, it fits with our calling patterns and our customers that buy tape want to talk to us about both. I think I said it in my comments and you guys might have missed it - we think we will sell tape as we sell more disk, and in that order – so, that’s kind of pieces I’m unprepared to talk about from a forecasting perspective. I do think the margin of 38% to 40%, that’s real, and that’s really being based upon some of these mix issues.

Glenn Hanus – Needham & Company

Okay, that’s helpful. And how do we think about the DX in a disk system go-to-market model between you and EMC? How are you going to manage, and how much of resource are you going to put on this sort of go-to- market effort as opposed to look for EMC to generate license revenue? How should we think about that?

Jon Gacek

We work with EMC today selling tape libraries. They are our largest channel for our Quantum branded tape libraries, and so our guys work with their guys in the field today on backup opportunities that include tape, and we think this is an extension of that. Again, I’m not going to talk about their products, but in the field, we do partner with them already, and our goals are aligned in that we want to grow our business branded and become more profitable and they’re going to promote their products and they’re going to have a goal for theirs, and we’re there to assist them, which is what we do today on tape deals.

Bill Britts

I guess what I would add is we have OEM business right now with all the major OEM players. We know how to work in an environment where there is an OEM brand, there is a Quantum brand, and there are end-user customers that basically represent a lot of volume with EMC. They’re logically going to buy from EMC. We have our own branded channel. This market is going to evolve very, very quickly in terms of the adoption of disk-based backup with de-duplication and replication. We see that the market is going to grow very rapidly, specifically in this mid range and enterprise space, and we think that there’s plenty of opportunity for both of us to be able to achieve our goals in that space.

Glenn Hanus – Needham & Company

And Jon, maybe lastly – you went into the quarter with $3.5 million of DXi I think from last quarter that had been shifted but not booked, and then you said something in your script about the backlog now. Can you go through what happened?

Jon Gacek

So the difference between those, I was speaking specifically about 7500 this quarter which was $1.5 million. Last quarter, we’re talking about total deals that had been deferred.

Glenn Hanus – Needham & Company

How should we think about the mix within the DX family, the 7500 versus the 3500 and the 5500? Will most of the sales be 7500, an increasing percentage of the business be that way as you progress through the year, is that how to think about it?

Jon Gacek

We’ll have to see. I’ll give you a couple of thoughts and Bill can too. We think that ASPs on 7500 will be quite a bit higher because the product scales from – I think it’s 18 terabytes to 180. That’s a pretty broad range, and so those bigger systems are going to be high ASP systems, but we also think with the edge-to-core solution, we’ll drive what you’ve heard me refer to spokes or these smaller units as well. So, I don’t know that we know enough yet on how this is going to unfold. It is a higher ASP product. We think it’ll allow us to have a true hub-and-spoke model or edge-to-core, and think in dollars, it is likely to be skewed 7500 for a while, but we’ll just have to see how that plays out.

Bill Britts

Yeah, I think the other way to think about this is because we haven’t had a 7500 for the last year and basically there really hasn’t been an equivalent product in the market, that will grow much faster in terms of the number of customer that have been basically waiting for this scalability before they move forward with this type of solution. So, I think you’re clearly going to see a very rapid growth in what’s traditionally been the VTL space, where its more centralized, larger-scale types of deployment with higher ASPs, but as Jon pointed out, we’re really talking about selling a complete solution, and the fact that you now have this very scalable central core to be able to handle both disk and tape as part of that backup operation, that can be the target for the remote sites with the smaller types – 3500, 5500 - that would replicate back to the core. One other key part of this is the fact that because of the flexibility of the product both in terms of the methods of de-duplication but also the interface, you can have mixed environments where you would have NAS interface out at the edge that would replicate back to a partition on the 7500, that can also hold the VTL which has traditionally has been the core data center type of backups on the VTL. So, this is a very different solution than what’s been in the market today.

Jon Gacek

For us, it’s a huge difference. When you think about it, our largest product 5500 was 10.8 terabytes, now we’re at 18 to 180. We have licensable software features, you can partition it. It’s just a much different solution than what we’ve had this past year.

Glenn Hanus – Needham & Company

Thank you.

Operator

Our next question is from Robert Moses with RGN Capital. Please go ahead.

Robert Moses – RGN Capital

Hey Jon. I had a question for you. I am just trying to bridge some of the numbers that you gave for a good idea of cash generation in fiscal ’09. If we take maybe the midpoint of your guidance of $85 million of the EBITDA if you will - you told us it was $29 million of interest and $4 million in tax. Could you give us a sense of the depreciation number that you think above and beyond amortization, CapEx if you had to guess, and then lastly just on working capital, you mentioned $10 to $20 million you hope you can get AR down, and I guess with software and services growing, that could influence the deferred revenue line, but also just those three buckets - if not exact, just directionally so I can try to figure out free cash flow for ’09.

Jon Gacek

Well, I think on a CapEx basis, we’ve been I think we did $3.8 million this last quarter. We’ll spend a little bit more than that, probably on average. So, take a $20 to $25 million type of number. That’ll give you something to shoot at. Depreciation I believe was $21 for the quarter, so that’s $80. On the working capital side, I think there’s a little bit more in the receivables. Inventory – we had a little bit of a build, but we had some opportunities that we wanted to take advantage of, so maybe there’s $5 or $10 million on the working capital side. The deferred revenue is the one that’s going to be interesting because 7500 in fact has some software components to it. We’re going to sell separate software licenses which we are going to defer but collect cash for. So, that one’s a little harder to forecast.

Robert Moses – RGN Capital

That should generally be a contributor, as opposed to detractor?

Jon Gacek

Absolutely. I think the balance sheet generally is a contributor, and I think the new products also will be a contributor, and that we will also generate some revenue from our OEM arrangement and also have software attributes to it, and I think the cash component of it will be higher than the revenue component. In other words, we’ll defer some of that as well. So, we have more upsides to cash flow with this new product and where we are in having the operating model like this.

Robert Moses – RGN Capital

So I guess the priority for cash then if I kind of run those numbers through will be $70 to $80 million and that would equate to what you did in debt pay-down of $20 million in the fourth fiscal quarter, and that’s kind of the use of cash I assume as we go forward.

Jon Gacek

Yeah, I think we’re going to continue to pay down debt aggressively. I think I didn’t mention it on this call, but you can see that we actually even after paying down the debt, we had higher cash balance this quarter than last. I don’t know that we need to carry $90 million in cash throughout the year. We will tow with that as we need to, but we’re pretty active, as you can tell from Rick’s comments – we want to continue to pay down the debt. Even thought the interest down, that value increases to the equity holders as we pay it down. I think we’re unusual – I think in our stock price you can see the signs of it. Today, we have more than half of our enterprise value is made up of debt, so as our overall enterprise value really hasn’t moved as much as some of the others in the space. It all comes out of an equity base, so we want to move that as much to the equity holders – that value – and we are going to continue to pay down debt aggressively.

Robert Moses – RGN Capital

Okay. Second, can you just maybe put the $80 million in sales opportunities in context? Is that proposals, are they firm orders, and does that relate specifically to the 7500 or is that across the DX family?

Jon Gacek

That’s across the DX family. It’s what’s currently showing up in our sale force numbers, and it tends to be conservative because the sales guys don’t get it all up front, if you will, so we feel good about that. That’s pretty high for us. Again, we can talk about the future. Our biggest focus for ’09 is executive, and it’s execution on the R&D side to get the products out, continue to develop, and it’s on the sales and marketing sides to continue to turn those products into branded revenue growth.

Robert Moses – RGN Capital

So you’d hope that that $80 million would translate into revenue at some point in fiscal ’09.

Jon Gacek

Yes, now we won’t win all those deals. Our win rate is not 100%, but we put it there contextually to say because we have gotten some comments, ‘gee, you guys have been talking about this for a while, that’s too bad.’ The fact is because we’ve been talking about it for a while, we’ve a got a bunch of opportunities, and now we actually have a product that is ready and we’re going to out and turn those opportunities into revenue.

Robert Moses – RGN Capital

Okay, just lastly then on the OpEx line, I think you’ve been running $70 to $75 million. I guess it was up a bit more because of some of the things you talked about – legal and R&D,etc. – if I take the $300 to $310 in OpEx or so - $75 million plus a quarter – how much of that would you say ramp up is due to discretionary spending in terms of hiring of sales force, hiring of R&D folks, and incremental legal (I assume those are the buckets) that we should think about in ’09?

Jon Gacek

Yes, those are probably the big three buckets. If your question is really about if things don’t go well, will we not spend the money – I think it’s where you’re probably headed when you used the word discretionary – we feel good about our opportunity right now. If we needed to pull back on something, we can do that, but I think the point that Rick was making in his section, we changed the whole operating model of the company, and we’re still spending money. I think we’re all agree we’re spending money to be a growth company, and if for some reason the economy got worse or we needed to slow down, we could do that. I think we’ve shown that we do a good job of managing expenses, and we have things that we could defer if we needed to, but our attention right now is we think we are well positioned, we think we have a unique market capability, and we have some new technology, and so we’re going to run with that opportunity in the next quarter or two, and in particular Q3 is such a seasonally strong quarter that we’re going to set ourselves up to really take advantage of that. On the legal front, obviously we spent more money on G&A. You can get a sense for what we’re spending a quarter there, and we’re not doing that because we have to; we’re doing that because we think we should.

Robert Moses – RGN Capital

Okay, fair enough. Thanks very much for the comments.

Operator

Thank you. (Instructions). And there are no further questions in the queue. I’ll turn it back to management for any closing remarks.

Richard Belluzzo

Again, thank you for taking the time to join us. I hope you got a sense for what we had to share today is that we feel like the core progress we made as a company has been good. We really are, in some ways, have a different opportunity before us, and that is that we have an opportunity to execute well in a very significant growth segment of the industry that is new for us, as we’ve largely been driven by the tape opportunity in the market. We clearly now find ourselves in a different place, but that place requires pretty aggressive and consistent execution both on the product and the sales and marketing side, and that’s what we’re really focused around, because ultimately we believe that shareholder value and making the company more valuable will be about having an asset – a business – that is in the right area with the right growth opportunity with the right business model and margin structure around it, and we see that as a pretty significant opportunity, and with our new announcements today with EMC the new 7500, we’re really going to run at this pretty hard. So, we’ll see what the next quarters will tell, but that’s our plan, to build off the foundation that we have developed with our operating model improvements, but really start to deliver high-margin revenue growth, and we think what’s going to pay off for the company, so we look forward to talking to you at the next call. Thanks.

Operator

Ladies and gentlemen, this concludes the Quantum Fourth Quarter Fiscal 2008 Conference Call. Thank you for your participation. You may now disconnect.

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Source: Quantum Corporation F4Q08 (Qtr End 3/31/08) Earnings Call Transcript

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