Xyratex Ltd. F2Q08 (Qtr End 05/31/08) Earnings Call Transcript

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 |  About: Xyratex Ltd. (XRTX)
by: SA Transcripts

Xyratex Ltd. (NASDAQ:XRTX)

F2Q08 Earnings Call

June 25, 2008 5:00 pm ET

Executives

Brad Driver – Vice President of Investor Relations

Richard Pearce - Chief Financial Officer

Steve Barber - Chief Executive Officer

Analysts

Aaron Rakers – Wachovia Capital Markets

Keith Bachmann – BMO Capital Markets

Jayson Noland – Robert W. Baird & Co.

Mark Combs - Pipeland Data

Clay Sumner – Friedman, Billings, Ramsey Group

John Flagg– Citigroup

Patrick O’Brien – Needham & Company

Operator

Welcome to the Second Quarter 2008 Earnings Conference Call. (Operator Instructions) I would now like to turn the call over to your host for today’s call, Vice President of Investor Relations, Mr. Brad Driver.

Brad Driver

Thank you and good afternoon everyone. Thank you for taking the time to join us this afternoon. I’d like to welcome investors, research analysts, and others listening today to Xyratex’s Fiscal Second Quarter 2008 Results Conference Call.

On our call today are Steve Barber, Chief Executive Officer, and Richard Pearce, Chief Financial Officer. Today’s call is being recorded and will be available for replay on Xyratex’s Investor Relations 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 and earnings and other financial business activities. These statements are subject to risk and uncertainties that may cause actual results and events to differ materially. These risks and uncertainties are detailed in Xyratex’s filings with the Security and Exchange Commission, including the company’s 20-F dated February 20, 2008.

Also please note that in addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, Xyratex routinely reports certain non-GAAP financial results. These non-GAAP measures, together with 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 would like to thank you for joining us today. Our press release is available both on P.R. Newswire and our website.

Xyratex delivered a strong quarter with revenue above expectations and EPS at the top end of our outlook. I was pleased with our execution across both our Networked Storage Solutions and Storage Infrastructure divisions and as we mentioned during our last call we are seeing our customers increase investment in capital equipment.

I would now like to provide you with some commentary about our results for the second quarter. Please note that all numbers are in accordance with GAAP unless stated otherwise. Total revenue was $266.5 million, up 25.1% as compared to the second quarter of last year and up 22.8% from our prior fiscal quarter. This reflects a combination of continued year-on-year growth in our Networked Storage Solutions business and a gradual improvement in the industry dynamics currently impacting our Storage Infrastructure business.

Sales of our Networked Storage Solution products were $232.6 million, or 87.3% of total revenue. This is an increase of $63.4 million, or 37.5%, compared to the second quarter of last year and up 23.9% compared with the $187.8 million in our prior fiscal quarter. The quarter revenue exceeded our revenue projections, primarily as a result of customers pulling forward shipments from Q3 to minimize any impacts from the introduction of our new ERP system, which was successfully implemented over the first two weeks of June.

Notwithstanding this, the growth, excluding this pull-forward reflects the growth of our networked storage market that we serve, the success of our customers, and our growing market share. I continue to be encouraged with the demand momentum we are seeing with new and existing customers and the progress we are making in regards to increasing production and volumes.

Sales of our storage infrastructure products were $33.9 million, or 12.7% of total revenue, down $10.0 million, or 22.8%, compared to the second quarter of last year and up 15.6% over our prior fiscal quarter. This performance was slightly ahead of our expectations, reflecting approximately $2.0 million of demand we were able to deliver ahead of original customer commitment. The overall scale of the business revenue this quarter reflects the specific industry dynamics in the disk drive capital equipment market that we indicated in previous earnings calls.

Gross margin was 15.3% for the quarter compared to 17.0% in the same period a year ago and 15.1% in our prior fiscal quarter. This reduction in overall gross margin, compared to the prior year, primarily reflects the lower proportion of storage infrastructure revenue in the quarter.

The gross margin for our Networked Storage Solutions products was 14.0%. This compares with 14.4% this period last year and 14.7% last quarter. The decrease in gross margin is primarily a result of product mix. The gross margin for the storage infrastructure products was 24.9% compared to 28.0% last year and 18.9% last quarter, in line with our expectations. This reduction in gross margin compared to the prior year is due primarily to the [inaudible] revenue in the quarter.

Non-GAAP operating expenses totaled $35.6 million compared to $32.0 million in Q2 of last year and $32.4 million last quarter. Our total expenses in the quarter were essentially in line with our expectations. We continue to invest in the growth of our NSS products and the customer base and the future opportunities we see in the SI business.

In addition, the dollar weakness continues to have a negative impact due primarily to our UK and Malaysian expense bases.

On a non-GAAP basis, net income was at the top end of our expectations at $4.6 million, a 10.6% decrease compared to $5.1 million a year ago and up from $0.75 million in the prior quarter.

Fully diluted earnings per share for the quarter, on a non-GAAP basis, were $0.15, including approximately $0.06 related to Q3 pull-forward based on there being 30 million shares outstanding on a weighted average treasury method in Q2.

GAAP net income in the quarter was $2.2 million and included amortization of intangible asset expense, non-cash stock compensation, and related tax totaling $2.4 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 equivalents at the end of the quarter was $54.6 million, down from $57.6 million at the end of Q1.

Cash flow from operations was $4.4 million in the quarter. Inventories increased by $48.7 million to $140.4 million in the quarter, in order for us to hold sufficient finished goods inventory at quarter end in order to be able to support the shut down of our NSS operations during the transition to SAP while not impacting supply to our NSS customers. Inventory turns were consequently 5.1x compared to 6.3x for the previous quarter.

Accounts receivable increased by $22.9 million in the quarter to $145.3 million. Days sales outstanding were 62 in the quarter reflecting the timing of shipments in the quarter being back-end weighted.

Headcount at the end of the May quarter was 1,702 employees, an increase of 89 over the previous quarter end, with 92% of this increase related to growth in our Asia and U.S.-based operations in support of NSS business growth in the quarter.

In summary, this is once again a very good quarter for the company. We remain focused on executing to our strategic and operating plans, but at the same time remain flexible to adjust the changing requirements from our customers, particularly with our Storage Infrastructure customers.

Now, before I turn it over to Steve for his comments, I would like to provide you with our business outlook for our fiscal third quarter ending August 31. Our business outlook is based on current business expectations. It should be noted that there are a series of forward-looking statements in today’s outlook 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.

For our third quarter of 2008, we are projecting total revenue to be in the range of $236 million to $296 million, up 18.0%-26%, as compared to last year, and up 4.0% to 11.0% compared to Q2. This is represented by revenue from Networked Storage Solutions of $214 million to $226 million and from Storage Infrastructure of $62.0 million to $70.0 million, representing a significant increase from the previous two quarters as outlooked.

For Q3 gross margin is expected to be 17.82% to 18.8%. We are estimating non-GAAP earnings per share to be between $0.35 to $0.47. Non-GAAP earnings per share excludes non-cash equity compensation, amortization of intangible assets, and related taxation expense.

The number of shares outstanding at the end of Q3, on a weighted average treasury method, is expected to be 30.1 million.

Our cash position at the end of Q3 is expected to be approximately $35.0 million, reflecting payment to the increase in NSS inventories in Q2 driven primarily by the SAP implementation. This exceptional usage of cash should reverse itself in the fourth quarter as inventories return to a more normalized level.

I would now like to hand it over to Steve.

Steve Barber

Thank you, Richard. Good afternoon, everyone. Thank you for joining us today.

I am pleased with our performances last quarter. We supported the upsize demands from our customers in both divisions, as well as prepared ourselves for the transition to SAP-based RP system immediately following the quarter end.

This transition was successfully completed as planned on June 9. As you might expect, recognizing the scale of such a transition, we are experiencing some initial issues impacting the business. We are focused on resolving these issues and anticipate closure of these by the end of this month. This is a key milestone in the company’s development and a key enabler to support our future growth.

Demand for our Storage Infrastructure capital equipment was at the higher end of our expectations for the quarter, as we were successful in being able to provide for additional equipment ahead of our initial outlook. Looking forward, as Richard has indicated, we remain cautiously optimistic with regard to the incremental capital equipment investment needed by our disk drive customers. The underlying demand for disk drive continues to be in line with growth expectations for the year, according to recent industry reports.

However, our caution reflects the fact that disk drive industry continues to review the extent of their capacity growth plans the second half of this year. And as a result, there remains uncertainty with regards to the timing of their investment in capital equipment.

In our Networked Storage Solutions division we responded well to the needs of our diverse and broadening customer base and continue to expand our business with new customer design wins and new program wins within our existing customer base.

Looking forward, we see continued growth in demand across our customer base and are focusing on both current programs as well as ramping new programs for a number of our customers. We continue to outlook significant growth in demand for their storage, supported by both industry reports and forecasts by our customers. With our established presence in both the disk drive and enterprise storage specters, we believe we remain well positioned to benefit from this growth.

In reviewing our performance this last quarter, I will cover our two division areas separately, starting first with Networked Storage Solutions.

Once again, we grew both our revenue and overall shipped storage in the quarter, maintaining our position as a leading provider for the external disk-based storage markets. As Richard noted, we grew our revenue in our NSS business by 37.5% in the quarter on a year-over-year basis, and by 23.9% over our prior fiscal quarter, both significantly ahead of the overall external disk-based storage market, which grew 10.8% year-over-year according to recently published data, not withstanding elements generated since that pull-forward. We continue to be encouraged by the ramp in demand for both existing customers and our new tier-one customers, which is providing us with a more diversified customer base.

Xyratex continues to be a major participant in the rapidly growing data storage market. We shipped 285.1 pedabytes of external storage in our fiscal second quarter, representing a 31.1% growth over the prior quarter and 95.4% growth over a year ago. Based on recently published data on the total pedabytes shipped in calendar first quarter of 2008, we estimate that Xyratex once again maintains its position as a leading provider to the market, shipping almost 14.0% of the worldwide external storage system pedabytes to our customers.

Our second quarter of 2008 shipped capacity was made up of the following, in terms of disk drive interfaces. Fibre channel totaled 88.91 pedabytes, ATA boxes, or SATA, totaled 189.27 pedabytes, and Fast totaled 6.92 pedabytes. While Fast composed only 2.4% of total shipped capacity during in quarter, we are continuing to see strong growth in demand for this interface.

Other business highlights in the quarter include the following:

We announced the next component of our OneStor Extensible Storage Platform, a new member in the platform family. The SP1224s is 2U storage system based on 2.5 inch Form Factor drives and provides 85% flat efficient power efficiency. Compared to the standard 3.5-inch drives, the small Form Factor drives consume less power with double the performance density, making the OneStor SP1224s ideal for transaction-intensive applications. This product is in evaluation by a number of current and targeted customers.

We continue to build our disk array RAID controller business adding new features and functions to meet the needs of our customers. Our F6412E RAID controller launched last quarter is receiving strong interest from current customers looking to increase the performance of their rates.

Xyratex continues to see strong customer demand for our family of application-label platforms as the convergence of storage and server continues to gain momentum.

Following our announcement of Dell as a new customer last quarter, we have successfully executed the Dell volume ramp requirement through the second quarter and continue to work closely with them in their sales deployment of the Dell PS5000 products worldwide.

In addition, we continue to work closely with IBM through their integration of their XIV business.

We have seen strong product demand from a wide range of our customers through the quarter, with some particularly strong demand late in the period, which we were able to meet with our flexible and responsive total fulfillment capabilities.

Also we continue to make good progress with steering design wins with new and existing customers. We are unable to name of these at this time for competitive reasons.

We continue to monitor developments in the external disk-based storage markets, both from a technology standpoint as well as potential competitive threats to this business. We are very aware that our customers have a choice with whom to partner with or to in-source their storage solution requirements. We remain committed to providing a highly competing package of industry-leading product designs and technology, highly flexible and competitive global fulfillment capability, and industry-leading systems capability and integration services, an area receiving creeping interest in the marketplace. We are never complacent and will continue to invest in development of our product programs in order to provide our customers with a time-to-market advantage in industry-edge platforms and system performance.

Overall, despite the ongoing uncertainty in the market reflecting the current economic climate, we continue to see good underlying demand for our core of data storage products and continue to anticipate growth in this business through 2008. We remain focused on providing industry-leading technology solutions, best in class product quality levels, and a highly competitive global fulfillment service for our OEM customers. We are excited by the growth prospects for this business.

Moving now on to our Storage Infrastructure business: Before I comment on our performance within this division, as we announced on June 9, I am pleased to welcome Harold Lehon as the new EVP and General Manager for this division. Harold brings significant relevant experience to the SI division. I look forward to working with Harold in delivering the innovation and technology knowledge needed to enable the success of our capital equipment customers.

For the second quarter revenues in this business of $32.9 million were marginally ahead of our expectations, as a result of our being able to deliver around $2.0 million worth of additional equipment earlier than originally anticipated. As we have stated in our recent earnings calls, we have been experiencing a period of significant constraints in capital expenditures within the disk drive industry, especially as it relates to Xyratex’s technology, primarily related to the consolidation of HDV providers.

However, as anticipated, we are now beginning to see a return to a more traditional investment phasing within this industry with incremental production capacity being planned for the second half of the year, in line with seasonal disk drive demand. While these indications are encouraging, the scale of incremental production capacity invested in the second half of the year by the disk drive industry remains uncertain at this stage.

The disk drive industry has historically only added production capacity when demand for drive arises, hence delaying planning of capital equipment until demand for this drive in the market becomes certain. At this point in the year, the disk drive industry is effecting the likely demand for the second half of the year and it is normal for us to have a more cautious view of capital equipment demand. As a result, we will continue to work closely with our disk drive customers to ensure that we remain best positioned to meet their needs and that will affect capacity planning for the rest of this year and into the first part of 2009.

With recent industry reports saying no slow down in the forecasted 55%+ growth in the United States are being stored annually, any usual disk drive capacities growing at 30%-35% per annum, we are anticipating continued growth in both disk drive unit volume shipment and unit capacity through the year.

With disk drives the only remaining viable technology enabler to this growth, we believe we remain well positioned to benefit from this growth in the medium term. A number of factors support this view.

Firstly, as we enter the second half of the year we are seeing the real evidence, albeit cautious at this stage, in the anticipated investment stage of the industry in additional production capacity ahead of the seasonal increase in disk drive demand in the third and fourth quarters of the year. We are encouraged by recent new product announcements by both of our current major customers, Western Digital and Seagate, reaffirming their commitments to maintaining their market leadership positions.

Specific announcements includes WD’s 1 char byte Caviar GB drive, launched this month, and Seagate’s preannounced 400 GB notebook drive anticipated to launch later this year. We are encouraged by recent public statements by Hitachi reconfirming their corporate commitments to the HGST disk drive division. Based on our interaction with HGST to date and a thorough evaluation of our technology, we believe we remain well positioned to benefit from future production of Hitachi investments. As we have indicated in previous calls, however, we believe that such potential for us remains a second half of 2009 opportunity.

With regards to potential competition in the IV division, we remain continually paranoid with regard to competitive threat. We have [inaudible] market with limited success to date and we continue to be aware of potential new competitors as well as the on-going risk of the disk drive companies choosing to in-source certain process rated activities. To this end, we remain focused on providing industry-leading technology through design innovation and to broaden our already strong patent portfolio in this area, which we would intend to use aggressively in order to protect both our intellectual property and market leadership position.

In addition, we remain highly focused on cost and our business model to ensure that we compliment our compelling technology with highly competitive solutions. Our pricing, our target gross margin reflects this strategy, clearly differentiating ourselves significantly from many other capital equipment providers who may consider targeting this market.

Within the technology area we continue to monitor closely the development of Fast memory devise market recognizing the compelling features of this technology for certain data storage applications. We continue to believe that Fast memory will compliment the disk drive technology in the market but we will remain [inaudible] applications. If our Fast platform project continues to decline, on a relative gigabyte basis and in terms of the data storage market, we believe that disk drives will remain a significant dominant technology in terms of total capacity, certainly in the medium term.

In terms of additional opportunities, as well as securing new customers we believe we are well positioned to expand our interaction with customers in the provision of our process information and technology. Our investment in establishing highly capable application engineering development teams in terms of our disk drive customers’ production facilities in Southeast Asia, coupled with our established production capability within the region enables us to provide a highly responsive service to meet the local customer needs. We are focusing our heads to grow this service supporting our hard drive customers in their efforts to optimize their factory businesses.

Finally, although the majority of our focus remains on broadening our presence in the disk drive markets, we remain fully committed to supporting our limited but important activity within the thin film photocell sector. We continue to work closely with our established customer in this market as they work to optimize their production processes and plan for future expansion.

In addition, we have initiated discussions with other photocell providers where expertise may assist these customers move from photoshop line to high volume production. We believe our expertise in the area of petition process information with high volume processes positions us well to serve both the thin film photocell market and the disk drive media and media photocell markets.

Based on our early-stage position in the market as it relates to the photocell market, we anticipate this remaining a small but important element of our overall division in the Photo division.

In summary, while there remains some uncertainty as to the scale of incremental production capacity the disk drive industry will make through the remainder of this year, we remain confident of the growth potential available to us in this market.

Once again, we performed very well this last quarter across the businesses. We are making good progress while supporting and enabling the growth of our existing customers. We continue to identify new outside opportunities to enable us to grow ahead of the underlying market and are working to secure these.

Given the industry fundamentals and opposition with the leading market share providers, we are in a very good position to grow our businesses in the long term. I remain very excited about the growth opportunities we see ahead. Our strong position in both the external disk drive, disk storage, and disk drive markets provides us opportunities to grow our business on a wide front.

I would like as always to take the opportunity to thank all our employees worldwide who have contributed towards the strong performance in the quarter, meeting the needs of our customers as well as assisting us in achieving the transition to SAP earlier this month. I am very conscious of the huge amount of effort and planning in the preparation and thank each and every one of you.

We are looking forward to another busy quarter and a full year and remain excited about opportunities available in serving the needs of our customers.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Aaron Rakers with Wachovia Capital Markets.

Aaron Rakers – Wachovia Capital Markets

First question for me, given according to my model it’s kind of a bit more of a tempered storage infrastructure outlook going into the August quarter, can you just, and are you reaffirming your prior full year guidance?

Richard Pearce

I think the only guidance we have provided was back in January. We gave revenue guidance for the whole company and I think we’re still comfortable with that and the third quarter outlook that we provided, while recognizing that they are slightly down from where the consensus numbers are. I don’t think that they’re necessarily surprising or elsewhere from where we actually expected to be. So, I guess the answer is, yes, we are comfortable with the guidance that we gave at the beginning of the year.

Aaron Rakers – Wachovia Capital Markets

And just to maybe clarify that a little bit, so I think I’m thinking about things right. When you originally gave that guidance you were basically assuming a flattish-type SI number for the full year. That is still your assumption, and given that, that would imply a pretty hefty pick up going into the fiscal fourth quarter.

Richard Pearce

Yes, I think it won’t be far away from flattish, that’s correct. I think the range I see for SI business in Q4 is still relatively wide and I think we’ve been pretty consistent in saying we are uncertain at this time when the actual ramp for our SI customers will begin. I think there are some timing issues within that but I think that overall flattish is still relatively good guidance from that perspective, but probably without giving any guidance here for Q4, getting to the levels of last year, or even above those levels, would imply a relatively large ramping for Q4 and that would be toward the top end of the range as I would look at it today.

Aaron Rakers – Wachovia Capital Markets

Can you just quantify, like you have in the past, the net contribution within the Networked Storage systems business and then you also mentioned a pick up in demand in the final couple weeks of the quarter. Is that broad-based or is that more specific to certain customers that you’re seeing? Any color on that would be very helpful.

Steve Barber

It’s very broad-based. And I guess it’s a little bit difficult for us to tell which of our customers were depending on sales more or less for our SAP introduction. Obviously our larger customers were extremely well briefed and some did decide to take more because historically they may had some experience with SAP either themselves or other vendors of themselves. So it’s across the board. As I look at Network Appliance, they represented 70% of the revenue in the NSS business, which again continues the downward trend, again as we previously outlooked, as we sought to bring on some of the newer customers, particularly some of the bigger newer customers that we brought around the last couple of quarters.

Operator

Your next question comes from Keith Bachmann with Bank of Montreal.

Keith Bachmann – BMO Capital Markets

Steve, I want to go back to that question that was just asked because your opening comment was that you weren’t surprised by the revenues for the August quarter, yet it was below Street estimates. So let’s go back to November for a second. If you look at November, is it going to be flat, up or down, from where you’re currently guiding August to? Total revenues.

Steve Barber

I think the challenge we’re facing right now is that the underlying dynamics appear to not reflect the forecast levels we’re seeing from our customers on their incremental capacity. And I think we’re in the normal June phase where there’s always a degree of uncertainty. I think the industry is looking to see how the rest of the providers have fared in the second quarter before they firm up their plans for incremental capacity. So the guidance we have given for the third quarter really reflects what we can see today in definitive forecasts and demand from our customers.

In reality I think we do see uncertainty and a significant range for the remainder of this year. And I think, as I said in the prepared comments, our challenge is to ensure that we are as best prepared as we can be for our customers once they start to finalize their plans. And I think we will find ourselves in a similar situation where lead times and respond to short lead time demand. I think we have been here before, pretty much for the last three or four years. This is a period of some uncertainty towards the level of investment that we make in the second half of the year.

Keith Bachmann – BMO Capital Markets

But if I took it one level further and I’m sorry, it just leaves some uncertainty which I don’t think you actually want, is the Networked Systems business, I would assume would be up sequentially, and yet the Storage Infrastructure historically has been flattish from August to November, so wouldn’t that be a reasonable place to start?

Steve Barber

It’s a reasonable position. I think the route here, as Richard commented, we are anticipating a wider range at this time. But I keep making a point, it is purely based on the definitive forecasts that we have today, at this point in the year. My view is that they will vary to a wide degree as our customers start to put up their expansion plans in the second half.

As Richard said, in response to the question, we fell comfortable with the guidance we gave back in January for the full year. On the SI side of it, there’s clearly a wider range than we’ve been able to guide to previously.

Keith Bachmann – BMO Capital Markets

I just think at this juncture, with that uncertainty, prudence should be a little more conservative is the appropriate area. But we’ll move on from there.

The gross margin on Systems was a little bit low at 14%. If I try to do some of the math going through to August, it seems like you’re imputing a step up there in terms of the margins on that side of the business. (a) Is that assumption correct, and (b) what are you seeing that would cause you to come to that conclusion?

Richard Pearce

I think the answer is, yes, if you do your numbers, then we are anticipating a slight up tick in that, and that, Keith, as in my statements, previously is really just down because of the product mix we see coming through from the customers. So, without getting into the total details about that, there is slight differences in the margin profile, depending on fibre channel, ATA flat boxes and we were slightly surprised by the mix in Q2 toward some of the slightly lower margin boxes, but the orders and the forecasts that we’re seeing for Q3 would take it up a little. It doesn’t take a lot in terms of a change to actually have an impact there. So a slight increase is probably what you’re seeing in your model, is in line with my model as well.

Keith Bachmann – BMO Capital Markets

Okay, last one for me and then I’ll cede the floor. As you spent a lot of time talking about the competitive landscape in your opening remarks on the drive business, have you actually seen a change in the competitive landscape? Particularly from Teradyne or I would like to hear a little bit of comments there. And particularly what area, if any.

Steve Barber

I think we have seen competitive threats pretty much on an annual basis across the range of technologies we provide to the disk drive sector. I can certainly name companies where they have provided limited quantities of product into our customers. If you go into their factories you can see products provided by competitors, from time to time. In [inaudible] we have a good track record of continually outpacing the competition with regard to our technology innovation and that continues to be our theme. There is inevitably going to be an increasing attractive market for people to look at and as a result we should expect continual interest or investments by new competitors looking at this market.

To make a point, we have invested significantly in our products over the years in this area, we have established a very strong patent portfolio and we will certainly take whatever steps are necessary to protect our intellectual properties and our marketing positions in those areas.

Operator

Your next question comes from Jayson Noland with Robert W. Baird.

Jayson Noland – Robert W. Baird & Co.

First, just a housekeeping question on the SI business. You’ve given a percentage of purchase order commitments in the past, do you have a feel for that looking into the back half of the fiscal year?

Richard Pearce

I think probably what we gave the last time, just looking at the whole year. So we’ve really given out the one taste, so at this stage we’re not giving a percentage for the second half of the year.

Jayson Noland – Robert W. Baird & Co.

And on NSS, it seems that you have become the easy choice, really, for a lot of new and upcoming storage OEMs. Could you talk a little bit about long-term competitive threats there, how sticky these relationships would be?

Steve Barber

There will always be competition in the space. The data storage market is particularly competitive. We’re an extension, I guess, of the competitor pressure that’s the disk drive industry. Again, our approach has been to continually execute on product innovation, bringing products to market in a very timely fashion, giving our customers a time-to-market advantage as we transition each of these technology transitions.

There will always be competition and I think the combination that we are seeking to provide of a leading edge technology as well as a highly competitive and flexible global service, as you say, it is a very attractive and compelling model to many storage companies out there who see Xyratex as a way of accelerating their interest in the market. So we will never be complacent. We have to continue our focus in R&D and design innovations in order to outpace the competition.

Jayson Noland – Robert W. Baird & Co.

Then the last question on R&D allocation, could you talk broadly about historical R&D dollars spent by head count across the two segments and then going forward would there be much of a change to that and how much, if any, is allocated to solar?

Steve Barber

We don’t actually break out the R&D by division. I can confirm that our R&D expenditure is increasing. We saw an increase of approximately $2.5 million between Q1 and Q2 and I expect that to continue to increase slightly as we move into Q3. That R&D expenditure is obviously looking at both sides of the business, on the NSS side particularly as we bring on new customers and some of the bigger tier-one customers that we brought around recently and there is a significant amount of R&D looking at future products for those customers.

On the SI side of the business, again, as we innovate our products there and as we see with respect to our previously strong opportunities as we move both into the back end of 2008 and then into 2009. So, I think you can expect to see a trend of increasing R&D spend there.

From a solar perspective, again, I won’t want to break out the actual amount that we’re spending on the solar industry, but what I can say is that we’re maintaining our levels of spend and actually seeing those increase slightly.

Operator

Your next question comes from Mark Combs with Pipeland Data.

Mark Combs - Pipeland Data

Earlier you mentioned that you have a certain amount of definitive orders in place for the Storage Infrastructure business. Given what the estimates are out there for HDV demand, how do those definitive orders map to that? The orders in hand suggest a lower HDV environment, a higher HDV environment, and does that imply that you probably have more orders coming, or less?

Steve Barber

I think at the moment we are anticipating a need for additional capacity across the industry to deliver the total drive demand that is forecasted, based on industry reports. From our view, we believe there is going to be a shortfall and therefore our strategy is to be as far ahead as we can be with material and ability to respond to demand in response to short lead time orders.

We are providing to two customers to date. As market share shifts among the industry that is a factor that is out of our control. So it’s difficult to be definitive as to rates of our particular market opportunity with the customers we serve today.

Mark Combs - Pipeland Data

I’m sorry, did you say that you expect HDV demand for the full year to come in lower than what?

Steve Barber

No, no, I think what we’re seeing is a wee confirmation of the forecast through the course of this year. Pretty much every update we’re seeing from public research is consistent. We’re not seeing any slowing down or reduction of demand. We’re seeing, if anything, demand increasing. The underlying demand appears to be consistent with the expectations we had at the beginning of the year. What we’re seeing from a [inaudible] standpoint, we’re seeing just a continued uncertainty or debate within the drive industry as to the extent they want to increase capacity the second half. And I think it’s our standpoint to stay as close as we can to the customers to show them we are able to meet their requirements once they define their plan.

But I think a lot will depend on the outcome of these drive companies’ performance in the second quarter before they really firm up their plans for the second half.

Mark Combs - Pipeland Data

So you’re saying that every indication is that HDV demand will come in at least at the expectations of the industry so the follow up question would be, if that ends up being the case, would it be safe to assume that your initial expectations for the Storage Infrastructure at the beginning of the year would also come in line?

Steve Barber

That will depend on market share. It depends on what allocation of market share the customers we serve are able to maintain.

Mark Combs - Pipeland Data

Right. So assuming that the HDV market comes in line and WD and Seagate maintain their market share, then the assumption is that the number of orders that they would have to place for Q4 would have to increase to match the current expectations in the market place?

Steve Barber

That reads back to the original comments that our view is that the SI business will be similar to last year is we feel remains our position that we gave back in January.

Mark Combs - Pipeland Data

During the last round of investor conferences you were expressing a great deal of bullishness, with actually 2009 prospects. Can you comment on that?

Steve Barber

Really just to reconfirm the points I’ve made earlier. We can see a return to what I call normal conditions. The transition, following the acquisition of Maxell by Seagate is now pretty much behind us as we go into 2009 and therefore assuming that we can maintain our position with Seagate and they maintain their market share, then we would anticipate an increase in demand coming through from Seagate in 2009.

And as I said in my notes, I think the positive comments we’ve seen with regards to Hitachi’s commitment to the drive industry positions us with a real opportunity and we will work extremely hard with Hitachi to position ourselves as a supplier of choice for them, once they start investing additionally back into this year.

Mark Combs - Pipeland Data

So those of us who have made 2009 estimates based on comments that you have made to this point, we have no reason to change that estimate then?

Steve Barber

Yes.

Operator

Your next question is a follow-up from Aaron Rakers with Wachovia.

Aaron Rakers – Wachovia Capital Markets

I want to go back on a prior comment that you had made on the systems mix having an impact within the Networked Storage systems business. If I look at what you’ve disclosed, we actually saw a pretty significant increase in the fibre channel shipments in the quarter. Help me understand the disconnect there because I figured with that dynamic that would actually help out the margin structure a bit.

Steve Barber

The comments that Richard had made referred to fact that we saw quite a significant shift toward the 1-terra byte starter drives in the quarter. The data drives currently are at a price premium from the previous generation drives and therefore they [inaudible] material content we saw that rise in the box level, that they have a gross margin effect.

Aaron Rakers – Wachovia Capital Markets

And I guess the other element to the gross margin is clearly as you ramp with Dell and then down the road with IBM and XIV, can you tell us what type of margin structures, do those carry even a below net app gross margin structure for those businesses?

Steve Barber

We can’t really comment on that at this stage.

Aaron Rakers – Wachovia Capital Markets

And then final question, on the share repurchase front, it looks like you are a little bit lighter than what I would have expected on the share repurchase. What are your thoughts around use of cash on share repurchase going forward?

Steve Barber

As you say, share repurchase is relatively low in the quarter. We only repurchased around $0.5 million worth of shares. We had set parameters at the beginning of the quarter in terms of where we acquire during that quarter and I think obviously we saw quite a significant appreciation of the stock during the period which meant large chunks of that period it was outside the parameters that we had set.

We will obviously review that now as we move into the third quarter and out of our blackout and then look at where we will set those parameters for the third quarter. From a cash perspective, we are looking to see cash reduced in Q3, related primarily to the SAP introduction. That really should have no impact on our thoughts going forward in terms of share repurchases. As I said, I expect that to reverse itself as we move into Q4. I have no concerns in terms of our cash position overall and we will continue to look to repurchase shares as the price becomes attractive in our eyes.

Aaron Rakers – Wachovia Capital Markets

On the Networked Storage Systems guidance that you provided, do you expect any further mix shift down with regard to your net app business? I guess what I’m asking is if you broke that down into net app versus non-net app customers relative to your guidance how would that look?

Steve Barber

Again I say that we would remain consistent with what we said all along from the net app position, we are continuing to see that business increase but we’re actually seeing greater increases in the other side of the business, particularly as we bring in the other tier-ones and that in itself should obviously have the affect that as a proportion of the business, network appliance reduces and we get a better diversification of the customer base as we move forward. So I would expect it to head more towards a run rate of 60% as we exit the year.

Operator

Your next question comes from Clay Sumner with FBR.

Clay Sumner – Friedman, Billings, Ramsey Group

Just wanted to return to the SI business a little bit. Steve, just wondering if you’re seeing anything at this point to suggest that your SI customers are finding ways to free up capacity?

Steve Barber

What do you mean free up?

Clay Sumner – Friedman, Billings, Ramsey Group

Are they finding ways to use the equipment for efficiently?

Steve Barber

No more than normal. The industry is very focused on maximizing utilization of their processes. We steady are working hard with our customers to extend the life of their assets, optimize the positions of those assets. They, in turn, are working on improving efficiency, yield, and process time. That’s the nature of that industry. We don’t expect change one way or the other, it’s just an ongoing focus across the board on maximizing process efficiency within the factory.

Clay Sumner – Friedman, Billings, Ramsey Group

It doesn’t sound as if you had much extra capacity yourselves to deliver more SI business in the quarter you just reported. You’re now guiding a little lower than people expected for Q3. If demand does happen to come in better than you expect, can you talk about your ability to build to that upside in demand?

Steve Barber

I think we are showing that we are not constraining totally from our production and assembly and inflation capability. The issue really comes down to lead time being a critical component and that’s where we’re doing the details work, to really understand are there any areas there that we should think about building up some degree of inventory, whether it be silicon or wafer level, to give us a bit more flexibility to build those products in the quarter.

Clay Sumner – Friedman, Billings, Ramsey Group

You’ve talked about a couple of time on this call a kind of an upper end of the potential for the year at around the $238 million for the SI business. So you’re not expecting constraints for being able to hit that should upside develop any way you could go, significantly above that or is $238 million about as much as you could do?

Steve Barber

I don’t see anything today to keep us from meeting those numbers but it really comes down to our customers to ensure that we’re getting enough lead time to be able to find the materials to deliver. I don’t see us constrained, it really depends when the drive industry firms up its plans for the second half of the year.

Clay Sumner – Friedman, Billings, Ramsey Group

Are there any constraints on the other side of the business in the NSS business with regard to disk drives, etc.?

Steve Barber

Not affecting ourselves. Again, it just comes down to making sure we are forecasting and planning capacity with each of our customers. But we’re not being impacted with any constraints in that area.

Operator

Your next question comes from Paul Manksy with Citigroup.

John Flagg – Citigroup

This is actually John Flagg for Paul. First question, I’m trying to get a little more color on this NSS margin profile. How can we think about the margin profile evolving over the life of a customer relationship, for a new customer as the customer matures, how does that evolve?

Steve Barber

There’s generally, I guess you could say, where early programs evolve high cost edifice debriefing on the level of customized content with the deployment, which we can optimize really quickly and move toward volume production. Thereafter it’s really a case of working with our supply base, optimizing across the board to see where we are able to reduce costs. But I wouldn’t say that there’s a general pattern when it comes to gross margin profile over the life of a program or a customers.

John Flagg – Citigroup

And then on the SI side, how would you say from a visibility perspective, how do things progress throughout the quarter? Are you seeing less visibility now than you were a month or two ago?

Steve Barber

There is always a wide variation and wider range demand in the middle of the year. Right now we anticipate our customers becoming clearer on their requirements for the second half of this year, literally over the next few weeks. It’s just always at this time of the year there’s that uncertainty.

We are not seeing any indications of a slow down in the demand for disk drive units and therefore [inaudible] capacity needed by the industry and depending where the market share shifts then the object is to that we are able to afford our customers to maintain their market share.

Operator

Your next question is a follow up from Keith Bachmann with Bank of Montreal.

Keith Bachmann – BMO Capital Markets

Steve, I think you said if the net app business goes down as a percent of total, your gross margins in that business should go up, did I hear that correctly?

Steve Barber

I don’t think we actually commented that on this call. And a lot depends on what the mix of the other business is. Obviously as we bring on new tier-one customers, again, depending on the scale of those business, those business have stood up. So I wouldn’t like to give a definitive answer either way. Obviously it stands today and we’ve always said, that the bigger customers tend to be the lower margin customers so as net app reduces its percentage that to a degree should help the overall profile. But there’s a number of dynamics in that profile that won’t necessarily mean that it’s going to go up.

Keith Bachmann – BMO Capital Markets

The tax rate going forward, what’s the tax rate going forward?

Steve Barber

I think on a normalized basis we are comfortable still with the 15%-17% tax rate that we’ve given historically. A little higher this quarter, primarily related to the lower proportion of SI revenues. So the SI revenue gets the benefit of the 0% tax rate, and a number of NSS products are moving to Malaysia and we’re on force to secure similar tax rates for that side of the business, which should help us maintain that tax rate.

Keith Bachmann – BMO Capital Markets

And you also guided the share rate up a little bit. Your stock is going to be down pretty hard tomorrow, I would think. Why would the share count go up sequentially?

Steve Barber

That is just a feature really of incentives which during the quarter, the share price would have an impact on that and that does exclude anything we do in terms of share buy-backs. So in reality it’s toward flat.

Keith Bachmann – BMO Capital Markets

I think Clay talked being flat at $238 million in terms of the SI business, but as I recall on the opening part of this conference call you said that would be towards the upper end of the range.

Steve Barber

Obviously we’re not given formal guidance but that is towards the top end of the range that I’m seeing now for that period.

Operator

Your last question comes from Patrick O’Brien with Needham & Company.

Patrick O’Brien – Needham & Company

Just a little color on your solar opportunity. Anything changed during the quarter?

Steve Barber

Not particularly. We are comfortable with our positions there. We are pursuing opportunities based on the extensive gain in the relationship with the existing customer but I would make a point, this is not going to be a huge part of our business. It’s an important one, but it will be a relatively small part of the overall.

Brad Driver

This concludes our conference call for today and we would like to thank you once again for joining us. We will report our third quarter results in September. I would also like to let you know that we will be presenting at the RBC Conference on August 5 at the Citi Conference in New York on September 3, and at the Needham Hard Drive Conference on September 4. We look forward to speaking with you then.

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