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Xyratex Ltd. (NASDAQ:XRTX)

F3Q08 Earnings Call

September 30, 2008 5:00 pm ET

Executives

Brad Driver - Vice President of Investor Relations

Richard Pearce - Chief Financial Officer, Director

Steve Barber - Chief Executive Officer, Director

Analysts

Aaron C. Rakers - Wachovia Capital Markets

Paul Mansky - Citigroup

Thomas Curlin - RBC Capital Markets

Keith Bachman - BMO Capital Markets

Shebly Seyrafi - Caris & Company

Glenn Hanus - Needham & Company

Jayson Noland - Robert W. Baird & Co.

Clay Sumner - Friedman, Billings, Ramsey Group

[Brian Duncan - The Boston Group]

Operator

Welcome to the third quarter 2008 Xyratex earnings conference call. (Operator Instructions) I would now like to turn the call over to Brad Driver, VP of Investor Relations.

Brad Driver

I’d like to welcome investors, research analysts and other listening today to Xyratex’s third fiscal 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 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 20F 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 the corresponding GAAP numbers and reconciliation to GAAP are contained in our earnings press release. We encourage listeners to review these items.

I would now like to turn the call over to Richard to review the financial details of the quarter.

Richard Pearce

Our press release is available both on PR Newswire and our website. Xyratex delivered a satisfactory quarter. Overall I was pleased with our execution in our businesses especially given the uncertainty of economic climates and the caution demonstrated by our SI customers. 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 $280.8 million up 19.9% as compared to the third quarter of last year and up 5.5% from our prior fiscal quarter as expected. Sales of our networked storage solutions products were $213.1 million or 76% of total revenue. This is an increase of $39.1 million or 22.5% compared to the third quarter of last year and a decrease of 8.4% compared with $232.6 million in our prior fiscal quarter.

This strong performance follows approximately $20 million of pull forward in sales by customers into our fiscal second quarter ahead of our SAP ERP system installation in June. We saw strength in demand across a broad range of our customers in the quarter and were able to meet overall demand through the ERP transition. I continue to be encouraged by the demand momentum we are seeing in this business.

Sales of our storage infrastructure products were $67.7 million or 24% of total revenue up $7.5 million or 12.4% compared to the third quarter of last year and up 99.5% over our prior fiscal quarter. As anticipated we are now seeing the deployment of additional production capacity by our disk drive customers to meet the seasonally higher demand in the second half of the year.

Gross margin was 17.6% for the quarter compared to 17.9% in the same period a year ago and 15.3% in our prior fiscal quarter. The gross margin for our networked storage solutions products decreased to 13.3%. This compares with 14.9% for this period last year and 14% last quarter. The decline as compared to last quarter is primarily due to the one-time direct labor costs associated with the implementation of our SAP ERP system. The gross margin for the storage infrastructure products was 31.6% compared to 27.2% last year and 24.9% last quarter benefiting from increased revenue and product mix.

Non-GAAP operating expenses were $38 million compared to $34.6 million in 3Q of last year and $35.6 million last quarter. The increase was primarily as a result of incremental headcount.

On a non-GAAP basis net income was $10.6 million, a 43.2% increase compared to $7.4 million a year ago and up 133% from $4.6 million in the prior quarter. Fully diluted earnings per share for the quarter on a non-GAAP basis was $0.36 based on there being 29.9 million shares outstanding on a weighted average Treasury method in Q3.

GAAP net income in the quarter was $7.7 million and included amortization of intangible assets expense, non-cash stock compensation, and related tax totaling $2.9 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 $27.2 million down from $54.6 million at the end of Q2. This primarily reflects the increase of NSS inventory associated with the SAP transition and ensuring maximum production flexibility for our customers during this transition. In addition, we repurchased 190,000 shares during the quarter at a cost of $2.9 million. Net cash used was $19.3 million in the quarter. Inventories increased to $156.6 million in the quarter. Inventory turns were 5.9 compared to 5.1 for the previous quarter.

Accounts receivable increased by $9.9 million in the quarter to $155.2 million, up from $145.3 million last quarter. Day sales outstanding decreased to 50 compared to 62 in the previous quarter.

Headcount at the end of the August quarter was 1,861 employees, up 159 or 9% over the previous quarter end, 60% of whom were to support growth in our Malaysian operations with the balance being growth in R&D, after conscious deconstraining headcount growth through the first half of 08.

In summary, this was a satisfactory quarter for the company.

Now before I turn it over to Steve for his comments, I would like to provide you with our business outlook for our fiscal fourth quarter ending November 30. 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 20F filing.

For our fourth quarter of 2008 we are projecting total revenue to be in the range of $287 million to $307 million, up 15% to 24% as compared to last year and up 2% to 9% compared to 3Q. This is represented by revenue from networked storage solutions of $232 million to $244 million and from storage infrastructure of $55 million to $63 million.

For Q4 gross margin is expected to be between 16.8% and 17.8%. We are estimating non-GAAP earnings per share to be between $0.32 and $0.44. 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 Q4 on a weighted average Treasury method is expected to be 29.9 million.

Our cash position at the end of Q4 is expected to be approximately $35 million as we do not anticipate the reversal of the increased inventory levels in NSS until 1Q 09.

Looking forward, as Steve has mentioned in previous earnings calls, we are working with NetApp our largest NSS customer to establish a second source for a proportion of our products in order to provide supply continuity protection. This is likely to be based on a licensing agreement which would result in a reduction in revenue associated with this program. In the medium term up to a maximum of 25% of total product demand may be outsourced to a third party contract manufacturer. This arrangement will provide ability for our customer to accommodate unforeseen outside demand.

I’d now like to hand over to Steve for his comments on our third quarter performance.

Steve Barber

Our performance in Q3 was within our expectations which I was relatively satisfied with when one considers the current uncertainties facing us all in these turbulent markets. Despite these challenging times in the broader economy and the seasonally slow summer period, we have once again delivered year-over-year growth in our NSS business and are now seeing investment albeit cautious in incremental production capacity by our SI customers.

As you look ahead we remain confident in the longer-term growth opportunities available to us in each of our businesses. In the nearer term however, given the stage of the macroeconomics, financial markets and as a result the caution expressed to us by our customers, there are some areas where we are incrementally more concerned about since the last time we spoke to you.

Our NSS business continues to be a strong year-over-year revenue growth business with growth year-to-date that has exceeded our initial expectations at the beginning of the year. However, due to the growth of the business with our [thickens] Tier 1 customer we are experiencing some additional pressure on our gross margin percentage. In addition, with the current uncertain market dynamics we will need to work closely with our customers in order to determine the right side of the business needed to support them over the next few quarters. With our customer breadth and diverse end use of market applications however, we believe we remain reasonably resilient to specific uncertainties in the financial IT market sector.

In our SI business since we last spoke much has changed in terms of the state of the economy, expectations on industry growth both with our enterprise sector, and certainly consumer demand. As a result our customers have expressed more caution in their growth plans. We do believe that had these conditions not worsened since June our outlook for Q4 would be near current consensus of the business due to the capacity needs of our customers. However, in an environment of uncertainty it is to be expected that our customers will be very cautious in their investment plans.

Given these dynamics we would expect the first half of 2009 to be very similar to the first half we experienced this year whilst the creation of information and associated demand for data storage is likely to continue to grow at a good pace despite the current environment. The market is likely to become increasingly competitive in the near term. I believe however that with our industry-leading products and technology, ongoing technology innovation and established competitive global fulfillment capability we can continue to provide compelling solutions for our customers worldwide and benefit from the underlying growth in data storage needs.

In addition to growing the business we successfully completed the transition of our business to a new SAP ERP system in the quarter. Whilst this did limit our ability to respond to upside demand placed on us by some NSS customers in June, we successfully recovered most customers’ backlogs enabling them to meet their second quarter demand. This was a significant achievement by all those involved within the company and acknowledged as such by our customers. Although I am pleased that this is now behind us, I recognize that there remains much work to do to fully optimize our business activities within the capabilities of this new platform.

In reviewing our performances last quarter, I will cover our two business areas separately starting first with networked storage solutions.

Despite the challenging economic climate and the seasonally slower summer period we once again grew both our revenue and overall shipped storage in the quarter maintaining our position as a leading provider to the external disk space data storage market. As Richard noted we grew revenues in our NSS business to $213.1 million up by 22.5% in the quarter on a year-over-year basis and down by 8.4% compared to the prior fiscal quarter. This year-over-year growth is meaningfully ahead of the overall external disk space storage market which grew 16.7% year-over-year according to recently published data. We continue to be encouraged by the rampant demand from both existing customers and our new Tier 1 customers which is providing us with a more diversified customer base.

We continue to be a major participant in the rapidly growing data storage market. We shipped 330.9 terabytes of external storage in our fiscal second quarter representing a 10.1% growth over the prior quarter and 83.1% growth over a year ago.

Based on recently published data, on the total terabytes shipped in calendar second quarter 08 we estimate that Xyratex once again maintained its position as a leading player in the market shipping 14.5% of the worldwide external storage system terabytes through our customers.

In calendar 2Q on a year-over-year growth in capacity Xyratex posted a 67.1% gain compared to the market’s 43.7% increase. On a sequentially quarterly basis Xyratex posted a 12.8% increase compared to the market’s 8.3% growth in shipped capacity.

Our 3Q shipped capacity was made up of the following in terms of disk drive interface: fibre channel totaled 86.12 terabytes or 27.4% of the total, SATA totaled $217.44 terabytes or 69.3% of the total. And [SAT] totaled 10.29 terabytes.

While [SATs] only comprised 3.3% of the total shipped capacity in the quarter, we are continuing to see strong growth and demand for this interface.

Other business highlights for the quarter include the following, following our success in securing a new design win with Dell QLogic earlier this year with our high density storage platform, the new product utilizing this Xyratex technology, the Dell QLogic model PS55E products were formally launched in early September. We commenced volume shipments to IBM following their formal launch in August of the IBM 2810 Model 814 trusted storage system, and a number of our publically listed NSS customers achieved increased success in the market with strong second quarter results from 3PAR, order desk compellents, data domain, Dell and NetApp. We continue to work hard to support the needs of these and all our customers.

In addition we continued to make good progress in securing new design win opportunities with both existing and new target customers with a number of products currently in evaluation for future programs. Complementing our industry-leading technology we continue to capitalize on our established flexible and global supply performance capability to support upside demand from customers worldwide maximizing their revenue potential in a volatile and highly competitive end user market.

As part of this full service offering our customers continue to highly value our system test processes to provide the highest possible shipped quality levels minimizing early life failures and in turn maximizing end user customer satisfaction. Recognizing the increasingly competitive end user market environment we continue to work proactively with our customers to reduce costs both through cost optimized product design as well as ongoing optimization of our global supply model. Pressure on commodity and freight costs are increasing our focus in this area to ensure that together with our global supply space we’re able to support the needs of our customers in the markets they serve.

In addition as Richard mentioned and we have previously discussed with you, we are working with NetApp to enable up to 25% of our product fulfillment to be undertaken by a third party contract manufacturer. This action will provide the required level of supply continuity and production capacity flexibility demand by our customers and is currently targeted to commence early in 2009. We maintain design control of all products supplied through this process.

Overall despite the continuing uncertainty of the market, data storage and particularly the enterprise data storage market appears to be proving itself resilient in the near term and we continue to see good underlying demand for our core data storage products with continued growth in this business through 2008. We remain focused on providing industry leading technology and cost optimized solutions, best-in-class product quality levels, and highly competitive global fulfillment service for our OEM customers.

Moving now to our storage infrastructure business. For the third quarter revenues in this business of $67.7 million were in line with our expectations taking into account around $2 million worth of additional equipment that shipped earlier than originally anticipated falling in our second quarter revenue.

As anticipated after a period of significant constraint in capital expenditure within the disk drive industry especially as it relates to Xyratex technology, we’re now beginning to see a return to incremental capacity growth by our disk drive customers. This investment continues as we’ve indicated previously to be somewhat cautious in the near term. Within this we believe that the excess internal test capacity resulting from the Seagate-Maxtor merger has now been fully utilized.

Whilst we are encouraged by the significant capital spending plans our customers have shared with the investment community, their near-term purchasing behavior has remained cautious. We do not however view this behavior as unusual based on the current worldwide economic climate and the resulting uncertainty of end market demands. We have been actively working on reducing lead times over the past few quarters to assist our customers in these uncertain times and our customers are taking full advantage of this added flexibility with us experiencing staged or incremental order activity through this last quarter. We have not historically experienced this degree of caution with regard to managing incremental capacity by SI customers.

Looking forward, based on our current market view we believe the disk drive industry will remain cautious with regard to incremental capacity growth. As a result we are planning our resources based on moderate growth and a similar investment phasing profile for SI business in 2009 as we experienced this year. We continue to believe however the long-term growth forecast for the disk drive industry will remain valid. However specific quarterly timing of capacity additions by our customers remains fluid.

It is evidenced by the recent increase in competitive activity that the disk drive process equipment sector is seen as an attractive growth market. From Xyratex’s standpoint we believe we remain well positioned to serve this market. Our SI business has been built from 30 years of disk drive manufacturing and process development within IBM and supported by a solid base of key patented intellectual property. Our strong track record of innovation and technology has enabled our customers to optimize their production processes to meet the needs of a highly volatile market demand environment. As illustrated previously we are and will continue to take the necessary steps to protect our intellectual property.

This history of innovation continues through our current product development activities. We are well advanced in the development of our next generation automated disk drive test platform. Recognizing the rapid industry transition toward 2.5 inch disk drives this new test platform is dedicated for this form factor and is designed to meet the needs of future disk drive technology. In addition, to further enhancing overall test capability this platform provides significant overall cost savings to our customers, a key element of these being the significant improvement in factory space utilization this system delivers deferring the need for additional physical factory space.

To put this in context, this platform increases test capacity from nine drives per square foot provided by our legacy systems to up to 43 drives per square foot. We’re on track to ship our first qualification modules to an existing customer in October in parallel with the commencement of customer defined system qualification testing in our facility.

We continue to invest in technology and product development across our wider range [inaudible] technologies enhancing our capabilities, adding additional feature function, upgrading and extending the usable life of legacy installed systems and expanding our accessible market within the disk drive production process.

Looking forward, we’re increasing our [inaudible] in the key enabling technology and purchase requirements needed for the deployment of patent media into high volume disk drive media production operations. The tradition from current recording technologies to initially discreet track recording, a later patent media, will be a key enabler for the industry to continue its growth in disk drive [arrow] densities beyond one terabyte per square inch.

The [inaudible] solutions needed for this are extremely challenging from a lithographic technology standpoint and volume throughput required to achieve the cost put needs of the industry. We believe we are well positioned to enable this technology transition based on our core expertise and high volume media process handling in conjunction with the lithography technology partners and our disk drive customers.

Whilst there is inevitable caution in the industry in the near term, we remain confident in the underlying dynamics and growth potential available to us in this market in the medium term.

In summary, this was a satisfactory quarter where we executed through a number of challenges. We remain focused in meeting the needs of our customers in this uncertain market. We continue to see good growth potential in our NSS business as overall market demand continues and our customers gain market share. We are seeing the long-anticipated return to cap ex spending in our SI business and again see good growth potential here going forward.

I would like as always to take this opportunity to thank all our employees worldwide who have contributed towards our performance in the quarter meeting the needs of our customers as well as assisting in the implementation of the new SAP ERP platform. We’re looking forward to another busy quarter and full year and remain excited about the opportunities available in serving the needs of our customers.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Aaron C. Rakers - Wachovia Capital Markets.

Aaron C. Rakers - Wachovia Capital Markets

One housekeeping item and then a few questions. With regard to the NSS segment, could you break down what was the NetApp customer relative to the non-NetApp customer base and split out if QLogic is now representing a 10% customer for you?

Richard Pearce

The NSS non-net proportion of the overall $213 million was approximately $133 million. In terms of the QLogic portion, I think during the quarter it’s still not quite got up to the 10% level yet.

Aaron C. Rakers - Wachovia Capital Markets

Can you take a step forward on what you’re assuming with regard to the NetApp business growth relative to the other customers in that segment for the November quarter?

Richard Pearce

Not too dissimilar in terms of the numbers that are out there. I would say I would probably expect the non-net element to grow somewhere in the region of 15% to 20% and then obviously the delta then in NetApp which will be obviously slightly below that when you work the numbers.

Aaron C. Rakers - Wachovia Capital Markets

Shifting gears to the other piece of the business and then I’ll cede the floor, it sounds like several things going on. Obviously I think everybody can understand the cautionary spending environment but one of the statements that you brought up was an increasing competitive landscape. Can you help us understand what you’re seeing there and to what extent that impacts your guidance going into the next quarter?

Steve Barber

As you’ve already written in some of your reports, we are seeing competitive entry into this market place. From our standpoint we don’t see that as a near-term impact. The reduction in our outlook is really all about total capacity planning or growth by our customers. However we are clearly the competitive hits very serious and are ensuring that our technology is designed to outpace the technology that is [inaudible] from any competitive thread.

Aaron C. Rakers - Wachovia Capital Markets

When you say guidance for the first half of fiscal 09 looking similar to what you saw in the first half of this year, are you telling us roughly like a $30 million number Q2 and Q3? Is that what we should infer?

Richard Pearce

We’re not giving forecast in terms of absolute numbers but I think when we look at the seasonality as we enter sort of more normalized phase now following the Maxtor-Seagate acquisition, I think in terms when you look at it proportionately throughout the quarters and obviously things can roll across between quarters but I think that we’re saying that one half is looking at a similar proportion of overall revenues as [inaudible] in 2009 as it did in 2008.

Operator

Our next question comes from Paul Mansky - Citigroup.

Paul Mansky - Citigroup

I just want to ask one question on each side of the business kind of building on the prior line of questions. A lot of different signals related to SI during the prepared comments, cautious spending but resumed spending, good growth going forward. As we wrap up all the considerations as you sit here today, do you anticipate the SI business to grow on the full year 2009?

Steve Barber

I think we do predominantly due to the comment I made regarding the now consumption or full utilization of the Maxtor assets. We do envision that when you look at the growth requirements across our two customers, we are looking at growth for 2009. As Richard said we’re not going to give specific guidance in this call but our guess on our current assessment, yes we would certainly see some degree of growth over 2008.

Paul Mansky - Citigroup

But just to kind of drill down a little bit more finely because I want to make sure we calibrate the model correctly here, your comment earlier regarding to very similar to first half of 08, that was on an absolute basis, that wasn’t on a relative basis meaning the first half of 08 SI was down almost 50% year-on-year?

Steve Barber

Yes. We’re not expecting a year-on-year decrease. In terms of part of the previous question, a proportion of the overall annual business to be similar in 09 and 08 which I guess due to the low levels in terms of the percentage relative will mean at an absolute level. Our expectation is that it will be at similar levels.

Paul Mansky - Citigroup

The second question pertaining obviously to the NSS side, clearly your positioning us for some changes there as we model that given you elaborating a bit more on the NetApp relationship. How should we be thinking about that relative to obviously the license revenue contribution and whether it’s accretive or dilutive versus gross profit dollars as we start modeling that through in the first part of the year next year?

Steve Barber

It’s relatively difficult for us to give firm guidance on that at this stage because I think when we originally spoke about it, it was back at the January time when we were reporting on last year’s 4Q. And I guess to be honest it’s probably moved a little bit slower than we originally anticipated and we’ve still yet to define when and absolutely how this model is going to work. I think you’re correct that to a degree it will have an impact obviously negatively on the absolute revenue growth that one could have seen to the extent that you allow a licensing agreement on the outsourcing. I guess on the flip side of that you get royalty income associated with it without the additional revenue which to a degree helps on the gross margin percentage.

I think if you look at, and again we’re not giving guidance in terms of 09, but if you look at obviously the current customer that we’re trying to take this process with is Network Appliance, NetApp, we’re also seeing as we’ve also referred to in previous questions a growth in terms of the QLogic business now with Dell and also some other Tier 1, Tier 2’s growing in that area. So I’m still anticipating that even with this movement on the Network Appliance business that we would still see growth into 2009. And I think whilst it’s positioning, it’s also something that we’ve supported; we understand that there is a limitation from a Xyratex perspective in terms of factory capabilities.

We have now two plus Tier 1 customers asking us in terms of our flexibility and our capability to meet potential upsides. So I think it’s actually within our interest to work with this model both for NetApp and even though nothing has actually been discussed or documented at this stage, it could be a model that we then look to roll out for some of our bigger customers in ongoing years.

Paul Mansky - Citigroup

Are there any rough metrics you can provide us relative to per X amount of legacy, NetApp revenues, assuming you move to this outsource relationship, the gross profit contribution would be Y?

Steve Barber

I don’t think we’re in a position to do that at this stage until we’ve finalized the agreements with NetApp.

Operator

Our next question comes from Thomas Curlin - RBC Capital Markets.

Thomas Curlin - RBC Capital Markets

Can we talk through the timing for this transition I think you said intermediate term or medium term? I assume that means sometime in fiscal 09 we’d start to see that. How does that look?

Steve Barber

I think my comment on the medium term, when I talk medium term I guess I was referring within that comment to the overall model and the up to 25% and I look at the medium term as being the next two to three years. But I would anticipate that we started to utilize this model at some point in time in the first half of 09.

Operator

Our next question comes from Keith Bachman - BMO Capital Markets.

Keith Bachman - BMO Capital Markets

If you said this I apologize, but what would you anticipate the storage and network systems gross margins to be in the November quarter given I assume the ERP people count is all behind us? What would you anticipate those margins to run back to?

Richard Pearce

I’m expecting key margins to get back up to the 14% to 14.5% type levels in Q4. Just to add a little to that, whilst the SAP one-time incremental cost of labor we’ve seen in 3Q, there are a number of challenges that we’re still addressing in the SAP system in terms of how long processes are taking. So we’re still having to provide additional resources to be able to meet the customer’s demands in the short term. So there are small incremental labor and overhead costs associated in 4Q but not near to the level of $2 million that we saw in 3Q. I’m talking more up to $0.5 million or so.

Keith Bachman - BMO Capital Markets

That helps because you’ll still have it sounds like pretty healthy margins in storage infrastructure in the November quarter then.

Richard Pearce

Yes. As always when we’ve got relative revenues in there, we would guide around about 30% level.

Keith Bachman - BMO Capital Markets

On the cash, obviously your cash balance was down significantly. I know it was because of some of the balance sheet requirements. How does that transition over the next couple of quarters?

Richard Pearce

I was in hopes you’d address something in some of the prepared comments. Cash is down as you say at the end of the quarter just over $27 million. We had forecast it to be approximately $35 million so it wasn’t within the realms of our expectations but as you say, inventory is the main cause of it in the NSS business where you must link again to my previous comments on us ensuring that we have enough inventory available around us to allow for the upsides which are projected to a degree from our customers also considering at the same time that we have this SAP implementation which as well as causing issues potentially on building products at the early stage, there’s also concerns when you undertake those types of implementations in terms of ordering. So we had quite a lot of product headed towards us.

I’d say that the 3Q/4Q was more in line with our expectations and not the high side before costs so we do have more inventory as it stands today. Again 4Q is looking in line pretty much with my expectations rather than the upside forecast. I’m not actually expecting this inventory to reduce to normalized levels as I would put it until the first quarter of 09. So as we run through 4Q as I said again in the comments, I’m not expecting the cash to increase significantly from today’s levels into the back end of 4Q but I would anticipate it increasing in 1Q.

And if you had asked me today where I thought that number was in terms of how much additional inventory have you got today that you wouldn’t have had had you not been implementing SAP, I would say somewhere between $25 million and $40 million. It’s difficult to be absolute at this stage but I would expect to see that number then roll through into the cash benefit within 1Q.

Keith Bachman - BMO Capital Markets

Moving on to the next subject, the NetApp transition to an ODM, I assume that’s an existing program? If you could just clarify that they would in fact move that to an existing ODM, is that a fair way to think about it rather than NetApp’s next program?

Steve Barber

Yes, that’s correct.

Keith Bachman - BMO Capital Markets

How do you think NetApp’s ongoing next program which you guys are working on, will that go into the new model as well underneath that 25% umbrella?

Steve Barber

I think that there is a likelihood given the flexibility that they are requiring following initial stages of us getting the product up to a certain level that we would look towards that model.

Keith Bachman - BMO Capital Markets

Does this make you think any different about your longer term relationship with NetApp on their willingness or interest in looking at Taiwanese ODMs?

Steve Barber

There’s always going to be that risk with any customer who is going to continue to look at alternatives but it’s really down to us to continue to execute with best-in-class products. I don’t see this as more risk than any other relationship with any of our customers. We have got to continue being best-in-class to be able to maintain our relationship with any of our customers.

Operator

Our next question comes from Shebly Seyrafi - Caris & Company.

Shebly Seyrafi - Caris & Company

I just want clarity on this storage infrastructure segment again. Is it fair to say with the final conclusion here that it’s going to be around 13% to 14% of revenue in the first half of 2009? That’s what you had the first half of 2008.

Richard Pearce

Yes. It won’t be dissimilar levels to that to the extent that both sides of the businesses grow approximately the same level next year, yes.

Shebly Seyrafi - Caris & Company

So my model gets me to around say $40 million from $60 million-ish in the November quarter, so that’s a decline of about a third. How much of that do you think is Teradyne and how much of that do you think is the cautiousness you’re noting from your customers?

Steve Barber

Are you talking about 4Q now or going into 09?

Shebly Seyrafi - Caris & Company

09. You’re dropping from $60 million with my model in Q4 to $40 million in Q1. How much of that drop of about a third is Teradyne versus the cautiousness?

Steve Barber

It’s really all based on our assumptions of all our quarters. It’s really difficult for us to predict and I think the driver is we’re all having difficulty estimating overall demand not only in 4Q but certainly as we go into the first half. And as a result I think at this point it’s just [inaudible] down to yourselves and investors is that we think the first half will be a light first half. The degree of it and how relative it is to 08 is actually quite difficult for us to be specific just yet.

Richard Pearce

I guess I’d add in there, it’s seasonality instead of caution. We do expect to see the seasonality in a normalized disk drive industry whereby the actual unit volumes of disk drive shift is often relatively flat if not down in 1Q/2Q calendar albeit the terabytes may increase slightly as the capacities increase but you really do start to see the ramps up in 3Q and 4Q and hence. As I guess I’d said, now that we don’t have the Maxtor issues or risk benefits on issues we’ve had over the last few years, we do expect to see that type of seasonality on a normalized basis rather than I think the Teradyne threat predominantly within that.

Shebly Seyrafi - Caris & Company

And separately, you’re talking about say 25% of your NetApp business going away over the next two to three years. If I use two years, that’s 12.5% or so per year and NetApp itself is growing around 15% so should I think about your NetApp business growing like low single digits in 2009?

Steve Barber

Again when I say 25% going away, as you say a lot depends on the ramp of how quickly we’re able to get a third party up and running with this model. As you say, if you look at the NetApp growth this year over last year from a Xyratex perspective, then there’s somewhere between 10% and 15%. If we’re able to put this model in place sooner rather than later in 09, then I think we are looking at somewhere between flat to low single-digit growth.

Shebly Seyrafi - Caris & Company

Finally for me, if you do the price per megabyte, it declined 17% sequentially. That’s what my model spits out. That’s the worst decline in years. It was down 4% and down 6% sequentially the prior two quarters for example. I’m trying to figure out how much of this NSS gross margin decline is related to increased pricing versus simply this ERP system?

Steve Barber

There’s always going to be a factual actually, as you introduce new drives where you always see affect on the margin to a small extent because those leading edge drives do attract a higher price. So certainly we will see some affect of that with a rapid transition towards the terabyte drives early in the quarter. That pricing has declined through the quarter and therefore will become less of an impact.

But I guess if you look back over our history in that business, you always see those minor variations within quarters as we introduce or move more towards a higher proportion of higher capacity and therefore higher price drives. It’s very difficult for us to accurately forecast the timing of those transitions and the shift of our customers as when they move from one generation of drive to the next. So there is always going to be some variability in our gross margin in that business relating to drive price but I think the bigger factor is the ramp of our second and soon-to-be third Tier 1’s where those businesses will by nature drive a low gross margin.

Operator

Our next question comes from Glenn Hanus - Needham & Company.

Glenn Hanus - Needham & Company

On the NS side, could you talk a little bit about at a kind of higher macro level in looking at all your customers if you photograph the demand trends and forecasts you’re seeing now versus three or four weeks ago before all the most severe aspects of the financial issues started to really hit? How much more cautious are they in their forecasts or not? Can you give us some color around that?

Steve Barber

Obviously when you look out to 4Q with the numbers that we’ve provided, we’re still outlooking a relatively significant increase from 3Q. Now there is the issue in there that we have, which is difficult for us to define absolutely in terms of the poor forward we had into Q2 because of the SAP system, but I would say that we’re seeing some relatively strong demand from some of our bigger customers in NSS excepting in there obviously if you look at the QLogic product, obviously it’s still relatively new and it’s ramping relatively quickly. So we’re getting the benefit of that. We don’t have that many customers that are solely exposed let’s say to the financial sector so the majority of our customers across our customer base. We address a number of the sectors, some of which are being less impacted by the economies today than others. I would say that there is a slight decline in some of our customers but overall from a revenue basis, we’re not really seeing in the short to medium term outlook which is the next quarter to two quarters ahead, which is as far as we really get data in that business.

Glenn Hanus - Needham & Company

I think you came in in the NSS about at the low end of the guidance range if my numbers are right here?

Steve Barber

We did, yes.

Glenn Hanus - Needham & Company

Any color around being at the low end rather than the high end or why that happened?

Steve Barber

Slightly, back to my previous statement in terms of I think it was relatively difficult for us at that time to predict how many and to what extent our customers had listened to us in terms of our desire for them to order early into 2Q because of the SAP transition. And therefore at the time we estimated around $20 million had been pulled forward. We weren’t absolutely certain at that stage, but I think that did come to fruition that it was those sort of levels and people had listened and therefore Q3 was at the low end of the range and the range was really posted there with that in mind. So it wasn’t a total surprise to us.

Glenn Hanus - Needham & Company

Just with the existing credit crunch going on, are you seeing any evidence among suppliers or customers in all the points you touch out there in issues with working capital issues, financing issues?

Steve Barber

I think across the board everyone is focusing very heavily on cash, as are we here and definitely getting directed by our Board to do so. And I guess that’s been compounded by the fact that with the SAP implementation, it does mean we’ve ourselves had extra working capital demands. I would definitely say that in some of our smaller customers are probably those that get impacted the most significantly in these times. We are seeing some level of debt sort of taking a few weeks longer to pay down in the overall picture of things to the extent that we have quite a concentrated customer base and actually quite a concentrated supplier base when you look at the disk drive providers and a couple of the major CMs we use.

So I think the extent the majority of the people we deal with are large players, we’re not seeing an overall issue let’s say but definitely within some of our smaller customers and suppliers, I’m definitely noticing that there is a greater focus on working capital. But we wouldn’t necessarily see that in our numbers just because they don’t represent a large proportion.

Operator

Our next question comes from Jayson Noland - Robert W. Baird & Co.

Jayson Noland - Robert W. Baird & Co.

On the SI side if you look out into fiscal 09 with the potential introduction of a competitor there, would you expect any sort of a negative impact to gross margin?

Steve Barber

I think the simple answer is no, we don’t. I think it would be based on the future function our products can provide. We don’t see gross margin being under more pressure than normal and therefore I think at this stage our assumptions for 09 would be consistent with what we’ve seen in 08 to the overall margins in that business.

Jayson Noland - Robert W. Baird & Co.

A question on the NSS side, with the agreement with NetApp how much of that is supply continuity versus cost down? And I ask about cost down given the scale of an EMS provider in combination with Xyratex’s IP? Could you see a situation in the distant future where the manufacturing component is completely outsourced?

Steve Barber

I wouldn’t say I could necessarily foresee that but I think what the, at least in the short to medium term as we approach this model, it will enable people to examine that and look at all the services which the likes of Xyratex provides and gives versus that of an EMS ODM provider and whether or not it can be done more cheaply. My true feeling is at least in the short to medium term NetApp and ourselves have been discussing for a long time their desire from a risk perspective to have a second supplier, so I think it’s driven by that but I think the fallout of it will be to see whether things can be done more cheaply in that way. And I guess to a degree Xyratex should invite that because to the extent that we can get product to our customers more cheaply while not increasing our own production capabilities but by looking to CMs to do more for us, then it should actually be positive for us as well if that is the case.

Jayson Noland - Robert W. Baird & Co.

Any update on the solar opportunity?

Steve Barber

Just on the things we said previously, it’s a relatively small part of our SI business. I think we’ve been able to adapt our particular technology to our current customer predominantly because he has a unique form factor for the cell. I don’t see our technology being uniquely compelling for what I’ll call the majority of solar cell, thin film cell producers where just a single pane of glass. So the opportunities there I don’t think are huge for us, however we are working hard and can see an ongoing relationship with our current customer. But it won’t be a significant part of the SI business I don’t see going forward.

Operator

Our next question comes from Clay Sumner - Friedman, Billings, Ramsey Group.

Clay Sumner - Friedman, Billings, Ramsey Group

Steve you mentioned that the new hard disk drive test product was intended to ship this month and I think you said that your customers are testing it in parallel in your facilities. I’m just curious how soon the drive customers might be able to deploy that product in volume?

Steve Barber

Clay I think the qualification process is fairly lengthy and therefore it really would depend on what the demand is in the first half. Certainly it won’t be deployed for fourth quarter. I think our customers pretty much have planned the capacity around legacy systems for their need in Q4 really driven by our lead times and all are planning to place within the guidance we’ve given. So it really will be driven by overall underlying demand for capacity growth through the first half and our comments about the phasing in 2009. I’m not predicting anything out of the ordinary with regard to seasonal demand for drives in 09; therefore it’s likely only to be deployed in a production environment I would guess late 2Q once the customers start to ramp up for 3Q and 4Q 09. But we have to remain flexible. I think we will certainly not delay the qualification process. On that basis we want to make sure that’s completed and the customers are able to deploy it when they need it at whatever timing in the first half.

Clay Sumner - Friedman, Billings, Ramsey Group

Several weeks ago at a conference you suggested that Teradyne’s test product might actually be sandwiched between your products in a test process. I’m just curious if you’ve got any update there? Have you learned if it’s a similar design or something different?

Steve Barber

No, we don’t. While I would simply question on our views of how a product may be used and we’re speculating different techniques, we certainly saw that in use or that technique used in [inaudible] case as they utilize the Maxtor assets. We don’t have any definitive information as to how a Teradyne system might be used or its current technology capability.

Clay Sumner - Friedman, Billings, Ramsey Group

Is there any of the inventory surge being driven by this hard disk drive product or I think you said Richard it was mostly NSS related?

Steve Barber

It is mostly NSS. Obviously as volumes ramp in the SI business towards the second half of the year, we’ve seen some increases in the SI business but those are pretty much in line with my expectations and I guess the NSS ones which I focused on are those which are over and above what I would call a normalized inventory level.

Operator

Our next question comes from Brian Duncan - The Boston Company.

Brian Duncan - The Boston Company

I was wondering if I could get the percentage of inventory, the dollars of inventory, attributed to NSS and SI?

Steve Barber

We don’t specifically give that number but just to give it approximately 75% to 80% of the overall inventory is in NSS inventory.

Operator

There are no additional questions at this time.

Brad Driver

Thank you everyone for joining us this afternoon. Again, just for logistics we will be presenting at the Credit Suisse conference in early November. We’ll put that press release out with the date and time and the webcast access nearer to the conference time. Until then we will speak to you in January on our next earnings call. Thanks a lot.

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Source: Xyratex Ltd. F3Q08 (Qtr End 08/31/08) Earnings Call Transcript
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