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Xyratex (NASDAQ:XRTX)

Q3 2012 Earnings Call

October 02, 2012 4:30 pm ET

Executives

Brad Driver - Vice President of Investor Relations

Richard Charles Pearce - Chief Financial Officer and Director

Stephen Barber - Chief Executive Officer and Director

Analysts

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

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

Glenn Hanus - Needham & Company, LLC, Research Division

Kenneth Miller

Jung Pak

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 Xyratex Earnings Conference Call. My name is Caris, and I will be your coordinator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. And I would now like to hand the call over to your host for today, Mr. Brad Driver, VP of Investor Relations. Please proceed, sir.

Brad Driver

Thank you, Caris, 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 Third Quarter 2012 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 and business activities. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. These risks and uncertainties are detailed in Xyratex's filings with the Securities and Exchange Commission, including the company's 20-F dated February 24, 2012.

Also, please note that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, Xyratex routinely reports certain non-GAAP financial results. These non-GAAP measures, together with the corresponding GAAP numbers 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 Charles Pearce

Thank you, Brad, and good afternoon, everybody. I'd like to thank you for joining us today. Our press release is available both on PR Newswire and our website.

I'd now like to provide you with some commentary about our results for the third quarter. Please note that all numbers are in accordance with GAAP, unless stated otherwise.

Total revenue was $275.7 million, down 23.8% as compared to the third quarter of last year and down 14.4% from our prior fiscal quarter. The decline in revenue reflects a softening in enterprise storage demand; delays in customer product acceptance which delayed revenue recognition; and the constraint on the supply of a specific component for our Capital Equipment order.

Sales of our Enterprise Data Storage Solutions products were $223.4 million or 81% of total revenue. This is a decrease of 33.6% compared to the third quarter of last year and a decrease of 19.8% compared to our prior fiscal quarter.

Sales of our Capital Equipment products were $52.3 million or 19% of total revenue, up 107.4% compared to the third quarter of last year and up 19.8% compared to our prior fiscal quarter.

Gross margin was 18.5% for the quarter compared to 16.7% in the same period a year ago and 16.5% in our prior fiscal quarter. The gross margin for our Enterprise Data Storage Solutions products was 15.4% compared to 17.2% last year and 16.3% last quarter. The decrease reflects changes in customer mix and lower overall revenues relative to operations costs.

The gross margin for our Capital Equipment products was 32.3% compared to 9.6% last year and 19% last quarter. The less-than-expected gross margin primarily reflects the deferral of customer acceptance on the initial shipments of our new Optimus 3500 system, representing approximately $21 million, which provides circa 0 gross margin in the initial product provision stage. It is anticipated that the effect of this revenue at circa 0 gross margin will now be experienced in the fourth quarter.

Non-GAAP operating expenses in the quarter were $41.5 million compared to $45 million in 3Q of last year and $42.4 million last quarter. The reduction from the prior year reflects reduced spending in R&D related to Capital Equipment products. As we previously stated, we are focused on ensuring that we are investing our R&D dollars on the right programs to provide the appropriate return.

On a non-GAAP basis, net income was $10.3 million or $0.37 per diluted share compared to a net income of $12.7 million a year ago and a net income of $9.3 million in the prior quarter. This includes a benefit of approximately $1.5 million from income tax changes.

Turning our attention now to the balance sheet, cash and cash equivalents at the end of the quarter was $103.2 million compared with $131.8 million at the end of Q2. This reduction was primarily related to the increase in inventories for both segments, including those related to the products where customer acceptance was delayed. Cash used in operations was $13 million in the quarter. Inventories increased by $28.9 million to $209.1 million in the quarter, as described above. Inventory turns were 4.4 compared to 6 for the previous quarter. Although this increase has impacted our cash position in the short term, this inventory is related to contracted customer demand. And therefore, I am confident that we will be able to significantly reduce our inventory over the next several quarters, including the inventory related to the revenue deferrals.

Accounts receivable decreased by $20.4 million in the quarter to $143.2 million. Days sales outstanding were at 47, not significantly changed from the previous quarter. During the quarter, the company repurchased 892,922 of its common shares at a total cost of $10 million, bringing the total repurchases for the first 9 months of the 2012 fiscal year to 1,199,275 common shares at a total cost of $13.6 million.

Headcount at the end of the August quarter was 2,032 permanent employees, an increase of 29 or 1.5% over the past quarter. This was specifically related to our recently established Mexico-based operations capability.

Now before I turn the call over to Steve for his comments, I would like to provide you with our business outlook for our fiscal fourth quarter 2012 ending November 30 and an early perspective on our outlook for fiscal year 2013. Our business outlook is based on current business expectations. It should be noted that there are a series of forward-looking statements in today's guidance that involve risks and uncertainty. Actual results may differ materially from our statements or projections. In order to clearly understand the risks involved, we recommend that each investor review the risk factors outlined in our Form 20-F filing.

For our fourth quarter of 2012, we are projecting total revenue to be in the range of $235 million to $285 million, down 39% to down 26% as compared to last year, and down 15% to up 3% compared to the prior quarter. For Q4, gross margin is expected to be in the range of 12% to 13.5%. We are estimating a non-GAAP loss per share of between $0.15 and $0.43. Non-GAAP earnings per share excludes noncash equity compensation, amortization of intangible assets and related tax effects, as well as certain nonrecurring items.

The number of shares outstanding at the end of Q4 on a weighted average treasury method is expected to be approximately 28 million. Our cash position at the end of Q4 is expected to be between $115 million and $135 million. The company announced its fourth quarter dividend of $0.075 a share, in line with the payment in the previous quarter payable on October 30. This dividend represents a yield of approximately 3% per annum based on the last 30-day average closing price. While I would typically wait to provide expectations for the next fiscal year until we report the results of the just-completed fiscal year, in light of the current market and business conditions, I would like to provide you with a brief commentary of our expectations for fiscal year 2013.

As a result of our most recent review of customer forecasts, the transition in product and customer base, the impact of the macroeconomic environment and significant changes in the industry we serve, which has affected the demand behavior of some of our major customers, we expect revenue for the fiscal year 2013 to be down as compared to the fiscal year 2012 towards levels where we may incur losses. We have recently commenced the process of a thorough review of all aspects of our business and have concluded that due to the number of challenges that we expect to face in the next 9 to 12 months, we believe it is best to communicate with you our expectations at this time.

Steve will share with you some of the actions we have begun to implement in light of our revenue expectations, as well as share with you our strategy to position the company for growth coming out of 2013.

In summary, due to both business-specific and macroeconomic reasons, we expect the fourth quarter and at least the first half of the next year to be a challenging period for Xyratex. We are clearly focused on resolving those issues that are within our control, as well as ensuring that we understand how the current business environment is impacting our customer's end-user demand and adjusting our planning appropriately. I do believe that our focus on spending is appropriate and will not result in us limiting material revenue opportunities.

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

Stephen Barber

Thank you, Richard. Despite solid progress in many areas of the business through the quarter, our performance -- our expectations coming into the quarter was disappointing. Our revenues were impacted by a number of factors beyond the macroeconomic slowdown in end-user customer demand, as recently reported by a number of companies in the data storage sector, including a significant and unanticipated trend towards lower configuration systems that reduced disk drive content resulting in reduced revenue in specific programs.

Our component supply constraints and limited shipments of certain disk drive test systems, customer qualification and acceptance of a number of our disk drive test systems was delayed beyond the quarter end as we work to optimize these new platforms. And customer acceptance of a specific installation of a high-performance computing storage system was delayed due to technical issues.

More specifically, in our Enterprise Data Storage Solutions segment, there was a material decrease in the demand across our customer base through July and August. This is our planning forecast with many of our customers experiencing a decline in end-user demand. Secondly, we were impacted by specific component constraints for one of our disk drive test systems that prevented us from being able to recognize the associated revenue. This issue has now been resolved, and we expect to be able to recognize that revenue in our fourth quarter.

Thirdly, we saw a delay in customer acceptance and revenue recognition for a number of our recently installed Optimus 3500 disk drive test platforms in the quarter. While this is disappointing, in light of the efforts made to meet the required customer installation schedule for a new developed product, we are working very closely with our customer to meet the required acceptance specifications. And I'm confident that we will secure customer acceptance within the current quarter.

And finally, we saw a delay in securing customer acceptance and revenue recognition for one of our major high-performance computing installations in the quarter. While disappointing, we are encouraged with the user feedback received to date. In hindsight, given the highly complex nature of this technology and the specific installation, we were somewhat too optimistic in our assessment of the time needed to secure full customer acceptance for such projects. We are confident in this specific case that we, in conjunction with our compute partner, will secure customer qualifications, where there remains a question as to whether this revenue we recognized in our fiscal fourth quarter or in December, the start of our first quarter 2013.

While I'm disappointed that we experienced a number of issues that impacted our revenue results, I do feel we are taking the appropriate actions to resolve the issues within our control and recognize the associated revenue. Based on this experience, we are implementing a number of new processes that will assist in limiting many of this type of issues to reoccur going forward.

As I've discussed previously, the markets we serve are fundamentally changing. And as such, we have been adjusting our focus towards increasing our investments in areas of growth where we believe Xyratex is uniquely positioned to benefit. Specifically, big data and high-performance computing. We view this as an evolution of our business from one that we've been working towards for some time. Our ClusterStor high-performance storage solution provides evidence of our shift in direction towards being a solution provider as opposed to a purely an OEM component supplier. This platform solution provides a strong bait to address the high-growth, high-performance computing sector, as well as providing key building blocks for us to address the range of big data vertical sectors.

As part of the evolution of the business, we are actively reducing our investment in some areas of our material businesses. We initiated a number of decisive actions during the quarter across the business. We reduced our R&D and associated G&A spend in a number of areas to reflect changes in the markets we serve. Both the disk drive and OEM storage platform sectors have changed significantly causing us to revise our product portfolio and business models in these areas. These actions have resulted in staged reduction in our full-time employee headcount by approximately 10% taking place over this and the next quarter. Though difficult in the short term, I believe these actions are necessary in achieving our long-term strategic objectives and profitability.

Recognizing the changes in the markets we serve, we're in the process of evolving our business in multiple areas. We're focused on broadening our product base and accessible markets beyond disk drive capital equipment and OEM storage platforms into cloud-leading storage solutions for the big data and high-performance computing markets. We're investing in software development, solutions engineering and field application engineering as we scale this business and support -- and sell with business development with our major partners, as well as providing technical support for end-user customer installations.

This business sector represents a significant growth market opportunity and one where we have a performance and time-to-market advantage, which we plan to maintain through continued investment in both the platform solution and in extending our go-to-market relationship with major Tier 1 compute partners. We have developed a very clear and aggressive strategic plan in both our HPC and big data business areas, building our solid customer base in our disk drive capital equipment and OEM storage platform businesses.

Clearly, this represents a significant evolution of our market focus, but is one where we believe Xyratex is uniquely positioned to benefit. We are rapidly moving our product portfolio towards the provision of solutions as opposed to components. We significantly increased end-user market awareness and end-user linkage.

Through this broadening of our customer product portfolio, we remain encouraged with our market position and the business opportunities that we see in both the disk drive capital equipment and OEM storage platform sectors. Though these sectors are changing, they're a source of very significant opportunities that we believe provides meaningful building blocks to our new technology and partnerships with our existing customers.

The disk drive sector has undergone a significant change and in the long term, will be comprised of only 3 disk drive suppliers, coupled with a projected decline in overall disk drive unit demand linked primarily to the decline in laptop sales and growth of flash-based tablets and smartphone devices and the resulting migration of data to cloud-based storage, we've prioritized our R&D investments on technology enablers to improve factory efficiency in a number of areas for our disk drive customers. Power consumption, process throughput rates and yields, factory footprint and overall equipment utilization are all areas where we are collaborating closely with our customers to develop innovative solutions to enhance the margin store base of Xyratex's process solutions.

We anticipate user demand increases for recording heads and media components within disk drives over the next few years as aero [ph] densities decline with the resulting need for incremental component process equipment capacity. Additionally, as demand increases for higher capacity devices to serve the rapidly growing power-based storage market, we anticipate incremental demand for additional 3.5-inch form factor disk drive production test solutions. Xyratex currently remains the only independent supplier of such systems.

In OEM storage and applications platform businesses, we continue to make solid progress in broadening our customer base as a number of our legacy customer programs decline. While we are experiencing some near-term demand reductions across our customer base with overall economic and competitive factors, we are working on a number of meaningful opportunities with both new and existing customers that I believe will be significant over the long term.

We expect some of these programs to launch in the fourth quarter or early part of first quarter next year. These new programs are driving us to implement new fulfillment models aligned with existing or preferred models for these customers as they work to optimize their supply lines. An example of this is our recent investment in establishing a Mexico-based operations facility and our scaling back of operations in our U.S. capability through the fourth quarter.

I remain very encouraged by the progress we're making in the HPC storage market and the growth opportunity this represents to Xyratex. Our early success with the launch of our ClusterStor 3000, and more recent 6000 platform, continues to gain momentum with the growing list of end-user customer engagements through our sell-with collaborative business development activities with our compute partners. Our ClusterStor HPC storage solution continues to receive very positive user and industry feedback. They seem to significantly raise the bar with regard to overall system performance.

Building our success in the HPC sector, we're leveraging our technology in developing solutions for the big data market. With no established leaders in the big data and public cloud sectors, coupled with a fundamental new supply chain structure for this market, we believe we are uniquely positioned to serve these high-growth sectors. Our portfolio of enterprise power storage platforms, HPC solutions, rack-scale expertise from our Capital Equipment business, close partnerships with the disk drive providers and our global footprint, all coupled with a highly competitive OEM business model, provide a compelling offering to this market sector.

We believe our rack-scale architectures are ideally matched with the needs of the sector enabling Xyratex to position itself as a leading provider of big data infrastructure solutions. We are already engaged in detailed discussions with a number of cloud service providers ranging from ISPs, Web-hosting providers, online gaming companies and major global telcos, all considering Xyratex as a compelling partner for their infrastructure architecture. We are focusing R&D investments in this area, as well as building user relationships in order to influence and define our R&D priorities.

In summary, the third quarter was a very difficult quarter resulting in disappointing financial results. Although we remain confident in our differentiated technology and market opportunities over the long term, the next 9 to 12 months will present a number of challenges as we work to backfill the reduction in revenue from some key legacy programs, overall demand concerns and more cautious capital allocations by our disk drive customers. As a result, we will be focused on our cost structure as we transition to the emerging opportunities that will take time to ramp to their full potential.

I believe the strategic plan that we have continues to develop and refine, is sound, leveraging our technology expertise and partnerships with some very significant customers and storage industry partners. We are prioritizing our investments in solutions to address high-growth sectors, and we are taking decisive actions to ensure our mature businesses -- business areas are optimized, efficient and profitable. We have a strong balance sheet of which to fund the investments needed to address our targeted new markets, both through internal organic investment, as well as potentially IP tuck-in acquisitions where we need to incrementally add technology to complement our current portfolio in addressing specific needs of the big data sector.

In closing, let me once again express my thanks to our employees worldwide for their efforts and commitments to our success. That concludes our formal comments. I would now like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And you have a question from the line of Aaron Rakers with Stifel, Nicolaus.

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

A couple of questions, if I can. First question, on the guidance that you've outlined, could you give us the expectations by segment? And then also, it looks like with that $21 million of revenue coming into the Capital Equipment side at a 0% gross margin, help us understand what you're applying on that segment's gross margin to get down to that 12% to 13.5% level.

Richard Charles Pearce

Yes, Aaron. As you know, we don't formally split out the segment or revenue guidance now in the formal comments, but happy to give you sort of some perspectives on that. My expectation for the HDD Capital Equipment revenues will be in the range of $60 million to $75 million in Q4. And therefore, using the range, which had been provided at a total level, the storage systems revenue should be in the $175 million to $210 million range. In terms of the gross margin, I think you pick up on a good point. The specific deferral, as you noted, was $21 million. In addition to that, there was a couple of additional machines, which were actually shipped in 4Q, which we didn't expect to have shipped into 3Q, which would've gone at 0 -- effectively 0 margin that you referred to. So approximately $25 million of that range that we just talked about will be, yes, those early-stage 0 margins. So that is having the effect that overall in that business, I would expect margins for the fourth quarter to be approximately 10%.

In terms of the Storage Solutions side of the business, again, as I previously guided, I think our longer term and what we've seen through this year, the margins will be somewhere between the 14% and 16% range. Actually in Q4, I kind of expect it to be just towards the lower end of that because of specific product mix. And obviously, if you've taken all that in and put it to your model, I think you'll then see how we get to our sort of 12% and 13.5% margin guidance.

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

Perfect. That was helpful. And final question for me, if you can, can you give us a breakdown of your largest customers in this most recent quarter? And I'd like to go back, and on top of that, if you can help us out, you talked about notable weakness in the month of July and August. Can you give us some color of what you necessarily saw in the month of September relative to that weak trend in July and August?

Richard Charles Pearce

Okay. Yes, again, taking those 2 parts separately, and I think this is obviously information that we give out in these calls. So in terms of the third quarter, as a percentage of our Storage Systems revenues, NetApp represented 42%, Dell represented approximately 24%, IBM represented 19% and HP represented 7%. So going on to the second part of your question, in terms of July and August when we started to see the slowdown, I think and as you said, it was kind of across the customer base. Based on the expectations that we had as we went into the quarter in June, and I guess when you look at the guidance that we've given for the fourth quarter, then it's relatively clear that those same difficult economic circumstances and pressure on the demand has continued into September and hence, that's reflected in our guidance for the whole of the fourth quarter.

Operator

And your next question comes from the line of Ananda Baruah with Brean Capital.

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

I guess sort of in light of what Seagate and Western Digital talked about doing kind of longer-term CapEx, you had your Analyst Day recently, can you just give us some sense of -- given numerically, I guess what your assumptions are, sort of, from a -- looking around your business perspective as to how we should think about SI or the old SI, Capital Equipment, going forward? Are you sort of assuming that, that was leaning toward your assumption that there's going to be sort of maintenance CapEx from this point forward with maybe the optionality for some potential at some point? Any help around that thought should be useful.

Richard Charles Pearce

In that side of the business where Xyratex slows, I think, we've covered this on a number of occasions. We obviously provide into the overall data rather than the number of drives we've shipped. So we are really looking at numbers of fracs and overall petabyte shipments, let's put it in those terms. So I think as we see the cloud continuing to grow, and I'd use that term, in summary, that there will still be a requirement for new Capital Equipment, and particularly, in the 3.5-inch sector. So we are seeing some requirements for that going forward. So I wouldn't categorize it as being a maintenance business going forward. That said, you make an excellent point in terms of the current situation of the disk drive market. And whilst we have shipped in that marketplace record unit shipments for the year, and I think Seagate came out with announcement about that yesterday, it is significantly below where the original expectations were. So there has been a slowing in the market and hence, where you've seen the revenues in both 3Q and 4Q from our original expectations moving out now into 2013. If I look at that business holistically and in terms of the guidance or at least the expectations we've given for next year of where we see the business going, I think we've kind of seen a similar trend between the Storage Solutions sector and the SI in terms of the expectation that revenues would be down by a little in both of those sides, and as I've said in my comments, towards levels where we were getting towards those that we could incur losses and, hence, while we are undertaking a thorough review of all those businesses and making sure that we kind of balance the investments against where we see the opportunities in those areas.

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

That's helpful. And I guess if I could ask some follow-up along those lines. It's kind of like in your commentary, you were sort of simulating, I guess, softness in revenue for the next 3 quarters, the first -- through the first half of 2013. And I think your remark was to the point when you may actually experience ongoing operating losses through that period. What -- I guess, what gives you the kind of confidence, which is kind of a tough word so I guess what -- sort of what was for sort of the suggestion that it might sort of -- you might swing from a loss in the first half to making sort of to a profit in the second half of the year. I guess, what are the dynamics area are you thinking about there?

Richard Charles Pearce

I think traditionally, the first half of the year is slower for us. And as Steve has commented in this call and in previous calls, we have a number of -- a couple of customer opportunities, specific customer opportunities within the platform side of our business, which we expect to be coming on board and ramping as we go through next year, as well as in the High Performance Computing and the Big Data market area that we have talked about this year. And so in terms of where that technology has come, and again, referring back to Steve's comments, we are encouraged with that and the recent installation, whilst we've had difficulties in terms of performance acceptance. I think we are getting there, and the technology is definitely getting a positive feedback from the customer base. So based on that, we do expect that side of the business to have significantly higher revenues next year than this year. But again, those revenues would tend to be in the back half of the year. The Capital Equipment business, which we talked about, again, that tends to be Q2, Q3, more towards Q3, and we have got some positive indications from the disk drive customers in terms of their requirements for our equipment in that area. So I guess that's what gives me the greater confidence as we move out the back half of the year. I would sort of step back and say I've not said it at this time that we are going to make losses in the front half of the year. But I think there should be caution in terms of how we look at that the first 6 months. And obviously, you take the comments in terms of the full year, saying that we're heading towards revenue in levels where we make our loss and that we expect to pick up in the back half of the year. I can understand why one may therefore summarize it in the first half of the year, losses are more likely than in the back half of the year.

Operator

And your next question comes from line of Glenn Hanus with Xyratex.

Glenn Hanus - Needham & Company, LLC, Research Division

It's Glenn at Needham. So maybe a little more color around OpEx for the fourth quarter and going into next year. You mentioned a 10% headcount reduction. So maybe you could talk quantitatively, then also qualitatively give us more color on how you're reallocating resources. And I think you mentioned something about some change in supply arrangements, and there's some ongoing changes in your go-to-market model, so could you address all that?

Richard Charles Pearce

Okay. In terms of the fourth quarter, Glenn, I expect a small increase in our OpEx in the fourth quarter, 2 reasons primary for that. One being the reorganization for redundancy cost, which we will reorganize as part of the reorganization and reducing the permanent workforce, which we referred to in today's comments, as well as a specific product -- project expense related to High Performance Computing, which is deferred over actually from the last couple of quarters. I think we recognize the -- and into the last few quarters, we've actually been under our OpEx expectations. So I would expect a small pickup in the fourth quarter versus the third quarter to maybe a couple of million before then seeing the reductions in the early part of next year. At this stage, I really won't want to commit to an overall expense number while we are going through this thorough review. And I'm sure Steve will comment further later in this call. But obviously, we are looking to make additional significant investments in the areas of specifically HPC and Big Data where we see the opportunities. So yes, we need to balance those new investments against, what I would call, the more mature areas. We have taken a significant amount of cost out of, for example, the Capital Equipment business this year. So whilst I don't see us actually meet that cost that we come out at this stage, we won't be taking significant additional cost out of that business without really a core base. So hopefully, that answers your question. But again, I wouldn't, at this stage, want to be tied to 2013.

Stephen Barber

And Glenn, just to add a couple of comments there. I think the point of our reducing headcount really is allowing us to transition the skill sets towards the areas where we see opportunities for growth, particularly in the High Performance Computing side and Big Data, which as you might expect is much more software-centric than some of our mature businesses. So whilst we are scaling some of our activities back in the mature businesses, we are recruiting and adding skills in the software side, both development and solutions engineering to support installations for those systems. And then just to complete the point you made with regard to operations model, again, we're transforming -- transitioning our historical fulfillment structure really to reflect the needs of the growth customers that we're now engaged with. With adapting our model to fit and optimize alongside their supply chains, that's causing us to, as I mentioned in the notes, set up a facility in Mexico alongside key customers, fulfillment hubs and in turn, scale back some of our historical capacity that we have operated in the U.S. So there's a number of moving parts, which right now, as Richard said, I don't think we're in a position to really quantify the OpEx trend for next year. I think we'll certainly see it as some reduction as we move into the first part of next year but potentially increasing as we make the investments I've outlined in -- towards the new business areas.

Glenn Hanus - Needham & Company, LLC, Research Division

And the last part of my question there about changes in your go-to-market model. Could you talk about that a little bit more?

Stephen Barber

Certainly. With the High Performance Computing sector market that we're addressing right now, it's very clear that we've had to adapt our, I guess, our historical OEM model to be much more collaborative in working with the compute partners in taking our technology to end users. That's caused us to expand our customer-facing organization, both commercially and technically, probably more on the technical side actually with regard to Optimizing Solutions and Storage Solutions, bringing these visions online for end user customers. So pretty much a collaborative go-to-market approach, a lot more end user contact visibility, awareness than we've historically had visibility in our end relationships. Still selling -- we're still selling through our computer partners but much more closer involvement with regard to the end customers’ requirements.

Glenn Hanus - Needham & Company, LLC, Research Division

And you seem to hint a more possibility of tuck-in acquisitions in related to technology requirements in some of these new areas?

Stephen Barber

Yes. I -- we've had a long history, as you're aware, of relatively small acquisitions, very much IP-based. So technology and associated resources that have allowed us to fill gaps in our portfolio. Our investments in Lustre file management business was a good example of that to provide us a key enabler for the High Performance Sector. As we broaden that portfolio solutions into the Big Data market, it's clear that in a number of the vertical sectors using Big Data, there are specific applications that are required by those sectors, and we're doing some fairly detailed work now looking at the range of vertical sectors in that market to identify the ones that we are best suited to address initially and those where we need additional technology capabilities that we currently don't have in our portfolio. So yes, we are actively looking at a number of areas where we would either organically create that technology or potentially look at tuck-in acquisitions that bring that IP and the associated skills with it into the Xyratex organization.

Glenn Hanus - Needham & Company, LLC, Research Division

And just lastly, any thoughts about the dividend and share buybacks going forward, given the new strategic emphasis?

Stephen Barber

I think our board continues to recognize the investor value placed in such programs. If I was to gauge current view, I think it's certainly more supportive toward dividend than share buybacks. But I think that the board will continue to review and consider its position as we move forward as we indicated when we first started these bunch of programs. But certainly, the dividend and also we've made this month is -- I think there's ongoing support and confirmation by the board that this is appropriate for the company.

Operator

And your next question comes from the line of Bob Sales [ph] from K [ph] Capital Management.

Unknown Analyst

I'm fairly new to the company so I have basic questions and a number of them. So you can cut me off if you need to, and I can circle back, no problem. On the HDD side, can you just walk through one more time the mechanics of the gross margin between Q3 and Q4?

Richard Charles Pearce

Sure. And given you're newish to the story, I think historically, if you look at that segment, we have looked at gross margins of approximately 30%. Now this year has been slightly challenged where there are number of cost issues that we had going through last year, which we've addressed at the back end of last year through this year. So -- but coming forward a little bit, if you take that sort of 30% margin as being a normal position and one which we made while expect to provide next year, then if we look at the fourth quarter and the guidance that I've given, our revenue is between $60 million and $75 million. Of that revenue, approximately $25 million relates to products where we are really making 0 margin as there are a brand new platform, which in its initial stages has relatively high product costs relative to the pricing. And therefore, and we have communicated this over the last several quarters, we will not be making any margin on that. So that portion of that at 0 margin versus the other side of the business that's more normal margins of, let's say, 25% to 30%, that's how we're now coming out with approximately a 10% margin guide for Q4 in that business.

Unknown Analyst

Got it. And then with respect to the hard drive business, again, would that unrecognized revenue then be recognized early next year? And is it folded into the guidance that you've offered for 2013?

Richard Charles Pearce

Sorry, the unrecognized revenue from Q3 will actually -- will be recognized in Q4. So that is the Q4, which is that recognized revenue is of this new product, and that is what is putting the margin down in Q4. So it's not going into 2013.

Unknown Analyst

Okay. Got you. And then, again, for the HPC market, you mentioned, I think, there were some deferrals that sounds like one or more deferrals of...

Richard Charles Pearce

There was one specific in Q3, which amounted to approximately $10 million. The assumptions that I have at the moment within the guidance I've given is that, that revenue won't be recognized until the first quarter 2013.

Unknown Analyst

Okay. And so does that -- the challenges you're having with the acceptance of the technology trouble you in terms of being accepted in growing in that opportunistic marketplace?

Stephen Barber

No, it doesn't. It simply represents the particular scale -- excuse me, the large scale of a particular installation that's going on. In a slightly strange way, whilst this has proved an extremely challenging installation because of the sheer scale of the overall compute facility. What it has presented is, I think, has built -- has gained us confidence in the platform and I think positions us extremely well as we move back towards what I'll classify as more normal installations that we are projecting through the course of 2013. So while it's challenging, I think it has really accelerated our progress in the platform and our ability to really launch that product or ramp that product faster into 2013 than maybe we had originally anticipated.

Unknown Analyst

So the new customers that you hope to come on board in 2013, HPC customers?

Stephen Barber

Yes, they are, but a broader base not -- as I indicated earlier, we're broadening our go-to-market capability through partnerships with additional Tier 1 compute partners. Those partners will expand our accessible marketplace beyond, daresay, supercomputer, the bulgy [ph]type installations into more wider-ranging commercial applications where we're seeing significant adoption of HPC solutions into commercial and business-related sectors.

Unknown Analyst

Okay. And then I think one of the big struggles with the new investors coming into -- looking at your stock at the current prices would be that NetApp is still 42% of Storage revenue, which adds up to still a big chunk of overall revenue. And I think that the new investors like myself wonder if that's got to go to 0 during this transition. And so I guess -- I know it's difficult for you to talk about specific customers, but help walk us through what the composition of the revenue profile looks like 12 months, 18 months down the road? And again, I know those are long time frames but really kind of focusing on how this big customer transition happens.

Richard Charles Pearce

Yes, I think and maybe it's probably best if we loop back with this and have a separate call maybe [indiscernible] even with the Brad Driver, our VP of Investor Relations. Just on your NetApp point, and again, recognizing you're a new investor, I think we've been very open with the investors on our call, as well as individually where we see that NetApp business going. Today, we fulfill 50% of the volume of a specific product line for NetApp. And that proportion of our business will be reducing as we go into 2013 to 25% of that. So within the projections and the early expectations for 2013, which we have provided -- which I provided earlier, the expectation that, that NetApp number effectively comes down by 50% as we go into 2013. And then, as we look into 2014, I'd say at this stage, our expectations are that there is not significance for NetApp going into that period for Xyratex. So hopefully that addresses the first major questions, but I think rather than going through each of the customers and the profiles, we should probably do that and very happy to set up a call.

Brad Driver

I would just interject, my contact information is on the bottom of the press release, so feel free to give me a call.

Unknown Analyst

Yes, I'm so sorry. I didn't mean to...

Stephen Barber

Actually, just in closing, our comments, the transition of our NetApp business has been something we've known about for a long time, and we are taking actions to broaden our customer base and product portfolio quite significantly since the intentions of that customer were clear. And our breadth of customer base that we have today and the additional new programs with both new -- and new customers -- I'm sorry, current and new customers, as I alluded to in my comments, is evidence that we are continuing to focus on broadening our customer base and recognize this, as an OEM provider, there will always be ongoing cycles where we are designed into some specific platforms or not. That's the nature of an OEM marketplace. So greatly, I would just simply encourage you to follow up with Brad to get more insight into the strategy and our views going forward.

Unknown Analyst

Okay, will do. So one more nuts and bolts question. The inventory of $209 million in the quarter, I think, can you describe what that inventory might look like over the next several quarters, whether it continues to go -- or whether it goes up, down or stays flat?

Richard Charles Pearce

My expectation at this time is that it would start to go down. I did expect the inventory actually to go down between Q2 and Q3 and then again into Q4. But obviously with, I guess, the somewhat surprising demand that we talked about earlier, that has come on to us relatively late, we do -- a number of the components are on long lead times that we buy in. Based on the OEM end market that we serve that we are holding quite an amount of inventory at the moment for our Tier 1 OEM customers, which now we are planning more prudently and conservatively in terms of the amount of inventory required, we're turning off that flow. But it does take some weeks and months to actually turn that inventory off and then to burn what you have in stock. Also, we've obviously been impacted by some of the revenue recognition deferrals, which are still sitting with inventory. So I would expect to see that inventory number coming down as we go through the next 2 or 3 quarters and actually creating positive cash, which is what you would have seen in the cash outlook that I gave earlier.

Operator

And your next question comes from the line of Kenneth Miller with Nokomis Capital.

Kenneth Miller

I wanted to start by asking you if you can give us some more granularity on what's going on in the Enterprise Storage Solutions business. If I'm doing the math right, your guidance implies that's going to be down 40%, 50% year-over-year next quarter. Obviously that's even worse than the presumable 33% or so decline from your NetApp business declining. So am I correct that your business outside of NetApp is actually declining faster than NetApp? And if so, why and what -- have you lost any major programs? Have you lost any major customers? Help me understand why -- I always thought you were trying to make up for your well telegraphed loss of NetApp revenue with new revenue, but it seems like that category is actually getting worse than NetApp?

Richard Charles Pearce

I guess, just on the math, if I look at the 4Q of 2011, we have revenues in that sector of around $350 million. Now the midpoint of the forecast, which I've given there are roundabout $190 million to $195 million. So I accept that is a relatively significant reduction, but not greater than the reduction, I would say, that we've seen in the NetApp business. And so, just as a point of math in there, in terms of the other areas then, yes, I think we talked about some other major customers that we've seen transition during the year. EMC was one of our major customers, which we did state was coming to an end during 2012 and that has happened. So that's kind of almost now down to 0. So that's gone from a relatively significant customer in 2012, around about $111 million -- sorry, in 2011, to now we're going at a run rate of close to 0 as we end Q4. So yes, there are some customers, which have obviously declined at a greater rate than NetApp, yes.

Stephen Barber

And as we've said in the comments, we have seen reduction in demand pretty much across the board from our customers, pretty much from July, August timeframe we saw forecasting reduced quite significantly in the second half. So there's really a macro effect going on here, which is impacting the broad range of customers that we serve.

Kenneth Miller

So how much of this decline, where it seems like the rest of your storage business is declining just as fast or faster than NetApp. Obviously, EMC going away is declining really fast. But how much of the decline is due to macro factors and how much is due to program transitions that don't use an OEM?

Richard Charles Pearce

I guess we haven't broken it down into that specifics. But obviously from where we gave our previous guidance, that's more the macroeconomic factors rather than some of the programs moving away. So we're probably down by around $50 million in Q3 from where we expected to be on that demand from macro factors and not a dissimilar amount in Q4 from where we expected to be. So if you take that relative to last year's revenue, then you'd probably say 1/3 or 40% was due to macroeconomic factors and 60% to 2/3 was related to the distransition in programs that we're seeing from the likes of EMC and NetApp.

Kenneth Miller

And do you think it takes a macro turnaround to get the storage business growing again? Or do you have visibility on new programs that you've won that will make up for the ones you've lost, or are causing the decline this fiscal year?

Stephen Barber

As I said in the comments, we have been working with -- on 2 new programs, through the course of this year, which we anticipate will launch with those customers either in our 4Q or early in our first quarter. Those will ramp. So we'll see, as we commented earlier, we'll see the bulk of the effect of those in the second half of next year, depending on how successful those customers are in those programs. And that's part of this overall work that we've undertaken to broaden the customer base and expand the number of products and programs we're involved in. But they are long cycled as you might expect. These programs were awarded some 12, 18 months ago and it takes that period to codevelop and joint bringing products to market. So there are a number of similar examples that we continue to work on. And that, as I said earlier, we expect, [indiscernible], the size of that overall business will ebb and flow depending on which programs are that we're engaged in and the success of those programs as seen by our customers in the marketplace.

Kenneth Miller

Okay. And moving on to -- moving on to Storage Infrastructure business, what's your break-even level in the Storage Infrastructure business?

Richard Charles Pearce

Yes. I don't think we want to comment on specific sectors and specific break even positions. What I would say is that we've taken a significant amount of cost out of that business through 2012. And at the type of revenue projections that our expectations of 2013 and some of those have been in my comments earlier that we would expect it still to be a viable and slightly profitable business at those levels.

Kenneth Miller

At which levels, the $160 million to $180 million level?

Richard Charles Pearce

At -- I think, yes, in my previous comments I guided that across the businesses. We expect, yes, at this stage, and we're not giving guidance to 2013 but we would expect, yes, similar declines across those businesses. So at slightly lower revenue levels than we're seeing in this year that business can still be a profitable business.

Kenneth Miller

How many years out of the last 5 can -- if you include this fiscal year, have you made money in disk drive Capital Equipment? [indiscernible] 2010. I'm curious about the other years.

Richard Charles Pearce

Yes, yes probably, yes. Yes, well I know that 2 out of those years, we would have actually made money and I think if you go back and look over those years, the revenue profiles are significantly different and lumpy year-on-year and it wouldn't take too much intelligence to work out to what years they were that we did make money and those that we didn't.

Kenneth Miller

Help me understand why this business only carries mid-20s to low-20s gross margin. If it's a lumpy business, a limited number of customers, and it is cyclical, it seems like it should -- and you're the only supplier of some of the systems. Do you think it should carry enough gross margin to have cross cycle profitability? Otherwise, it's not really obvious why you're in the business at all.

Stephen Barber

I think it's historical reasons. Engaging with an extremely cost-focused industry, this being the hard drive industry. The expectations of that sector and the collaboration that goes on between ourselves and developing solutions for our customers to meet their particular specific requirements has led to that level, which is viewed by that industry as acceptable. And I think it's -- we should recognize that we're in the business of enabling disk drive companies to be successful. But in terms of scale, as well as cost. And therefore, focusing our solutions not only on the technology needed to achieve high yields and high throughput for its customers. Overall CapEx cost is a key factor and we've taken the approach that we are in this for the long-term, that we are a partner to those, today, very limited number of customers. And it is truly seen as a collaborative relationship as opposed to, I guess, maximizing an opportunity in 1 year, for example, and potentially causing those partners to look at alternative solutions, develop in-house solutions, et cetera.

Kenneth Miller

Can you tell me if you've made money on aggregate in the last 5 years in that business? I guess you probably have because 2010 has been a -- was a huge year. But it seems like strange to be in a business to help them maximize yield and profitability kind of at a -- with little regard to your own kind of profitability?

Richard Charles Pearce

Yes, I'm not going to answer that question whether in aggregate we have made money over the last 5 years and I guess you can run that through your models. What I would say is that we believe that, that business can get back to the levels of gross margin of 25% to 30% across the portfolio of products that we provide, at those type of levels based on focusing on a specific product set and having a more collaborative model with the 3 HDD customers that remain. But that can be a viable and profitable business and that we won't just be here to reduce the capital expense of those providers. I'd say historically, we probably saw a greater opportunity in that business than has actually been realized and we invested significant amounts of expense in that area or on that basis, which have affected the results over the last couple of years. Now, with the new cost structure that we put in place, as I said, it should be able to provide positive results at what we believe is a conservative revenue projection.

Kenneth Miller

Okay. And last question, with your comments about the buyback and dividend. I'm curious, you said you were more focused on the dividends than the buybacks. Given that you're stock, I think -- and as I was trading, sort of very low multiple, you have over $13 a share of tangible book value and almost $11 a share in actual working capital. Why wouldn't it make more sense to be buying back shares than in paying dividends when you're buying your shares at a big discount than just the working capital you have invested in the business?

Richard Charles Pearce

Yes, I think, obviously, as we have done over the last year or so, we would need to look at where the share price is at any one particular time and then make decisions based on that. In terms of a share repurchase program, we did have a program, which we put in place 2.5 years ago. We have recently purchased up to the maximum on that. So before we go back into purchasing shares, we would need to go back to the process of actually, formally get -- opening up a new buyback. So in the short term, we won't be seeing any buybacks because we don't have the actual program open. But as I say, we do need to look at it and I guess to a degree, be opportunistic if we believe that, that is the right thing to do.

Operator

And your next question comes from the line of Jung Pak with the BMO Capital.

Jung Pak

Question on -- related to the prior question on storage demand. You indicated that the month of September was slow across -- the month of September was slow in storage. Can you say whether this slowdown was across all your customers? In other words, have you seen any pick up in demand from any of your storage customers relative to the July, August timeframe?

Richard Charles Pearce

Yes. I mean, I have to say I'm not going to give specific guidance on specific customers, otherwise my customers won't be very happy with those who I say are not doing and those who are doing better. I would say in the majority of the cases, we continue to see a difficult demand environment. And I think if you look at our big customers NetApp, Dell, HP, they've all gone out their publicly themselves and said that. I know that we're not yet into their third quarter earnings season, but yes what's came out in their second quarter. So I wouldn't say there's any particular shining light within our customer base and say well these ones are doing particularly well versus all the others. There's differences in the levels versus our expectation. But, I'm sorry, I won't comment on specific customers.

Jung Pak

Okay. And the comments related to the lower config systems. Can you provide more color on what's driving the lower config systems? Is it the product segments that you provide, or is this a long term trend that you guys see going forward?

Stephen Barber

Difficult to tell. I guess we get used to certain portion, or certain quantity of disk drives per platform that customers look as their base entry level model. And we saw a shift downwards with regard to the average drive content per array in certain programs. That can only indicate as the customers are targeting, affecting to the marketplace or looking to provide lower-priced entry-level products initially. So it's difficult for us to judge. I know we have relationships, we don't always have end user visibility or view as their particular sales focus areas. Bear in mind that majority of these platforms are sold with a variety of different proportions that disrupt contents and then are added, as I've characterized as end user customers utilize the capacity, they then top off with additional disk drives that plug into the arrays. But as we indicated, that the shift towards a lower configuration, i.e. fewer disk drives, did come as somewhat of a surprise to us. And we don't have clear visibility as to whether that's getting a longer-term trend with that particular program, or a particular seasonal trend trying to encourage sales in this current macroeconomic environment.

Jung Pak

Okay. Last one. Related to that and your comments on FY '13 revenues being down year-over-year, how should we think about gross margins, both for the Storage business and the Capital Equipment side?

Richard Charles Pearce

I think my expectations would be similar to what we've said over the whole of this year in that on the storage solution side, we would expect it to be in the range of 14% to 16%, potentially ticking up more towards the back end of the year as we look to increase our sales of HPC products. And in the HDD Capital Equipment business, then we would be looking at margins around the 30% level based on lower overall revenues and the mix of products in there then I think is feasible that we would get to those levels.

Operator

And your next question comes from the line of Bob Sells [ph] with Lmk Capital Management [ph].

Unknown Analyst

Of the new engagements that you expect next year, can you break them down between your traditional engagements versus HPC?

Stephen Barber

We're expecting engagements in both areas. The ones I specifically commented on were traditional OEM storage system relationships where we are providing a component within a [indiscernible] customer's system. So those are new programs that we're working on for the last 12, 18 months that will launch when those customers announce their products and then we'll see a ramp as they gain tractions through the quarter next year. In parallel with that, what I didn't comment specifically, we are engaging on a number of fronts with regard to High Performance Computing platforms, leveraging our current relationship with our existing OEM and broadening that to additional computer OEMs to allow us to broaden that marketplace. Just FYI, the 2 I referred to specifically are OEM traditional storage system partnerships.

Unknown Analyst

And HPC revenue today represents what portion of the total revenue?

Richard Charles Pearce

Quite a small proportion this year. This year, my expectations are that we will only get between $20 million and $30 million in total revenue and that will be dependent on this $10 million recognition, which as I said earlier, I expect to roll over in 2013. As we look into 2013, my initial expectations would be that we would take that business up to somewhere between $60 million and $100 million. But I think, yes, that will be part of the overall review that we will be undertaking and maybe deciding to increase the investment into the area where we see greater opportunity.

Unknown Analyst

And big data today is still a virgin area in terms of revenue, right?

Richard Charles Pearce

Correct.

Unknown Analyst

And are you -- do you have expectations that will start to generate any revenue next year?

Stephen Barber

I think we want to set ourselves, relatively conservative views for that market. But in reality, what we're seeing is a number of our HPC discussions are blurring into big data. The question about big data is, which vertical sectors we go after, range of public clouds to oil and gas or whatever it is. So there are a number of particulars, large subsectors within big data that we are looking right now as to which one we particularly focus on, where we think we are best positioned to serve those marketplaces. Our objective will be to secure a foothold, start to gain presence in that space, leveraging our HPC platform next year with a view that that becomes a growth business in 2014 onwards.

Operator

And at this time, there are no further questions in queue.

Brad Driver

Thank you, Caris. Once again, I would like to thank you for joining us this afternoon. We look forward to speaking with you again on our Q4 earnings call, which will be scheduled for early January 2013. As always, you are welcome to call me if you have any additional questions over the course of the quarter. At this point, we just wish you a good week ahead. Thank you.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.

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