Imation Corp., Q3 2008 Earnings Call Transcript

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Imation Corp. (IMN) Q3 2008 Earnings Call October 21, 2008 10:00 AM ET


Bradley D. Allen - Vice President - Investor Relations

Paul Zeller - Chief Financial Officer, Vice President

Frank Russomanno - President and CEO


Chuck Murphy - Sidoti & Co.

Glenn Hanus - Needham & Company

Hamed Khorsand - BWS Financial

Lawrence Franco - Delaware Investments Inc


Good morning ladies and gentlemen, my and welcome everyone to your Imation Announces Third Quarter Conference Call. (Operator Instructions)

I would now like to turn the conference over to Mr. Bradley Allen. Please go ahead.

Bradley Allen

Thank you, good morning everybody and welcome to our third quarter conference call. Before I turn the call over to Frank Russomanno and Paul Zeller I want to remind all of you that certain statements that are made in the course of this conference call that relate to forward-looking statements are covered under the Private Securities Litigation Reform Act and factors that could cause our actual results to differ are outlined both in our press release and our SEC filings.

With that let me turn the call over to Frank Russomanno.

Frank Russomanno

Thank you and good morning. I want to make a few comments on the quarter and then turn the call over to Paul.

Q3 revenues and earnings were substantially below the company’s previous expectations as we noted in our press release of October 9. As a result, I expect that many of you have at least three questions about our performance. One, are the factors leading to Q3 results transitory or has there been a shift in the business? Two, what does this mean for Q4? Three, what about our long-term strategy; are we committed to transforming Imation to a brand and product marketing company and do we believe that strategy has value? Let me address each question in turn.

First, we believe some of the negative factors in Q3 are transitory, though we cannot predict when these factors will change. Demand slowed across several sectors n the US and Europe and more recently in Japan. We have been negatively impacted by a slow down in spending for consumer electronics and optical media.

For example, late in the quarter some retailers cancelled or deferred orders for CE products as they positioned themselves for a possible weaker holiday season. This situation contributed to the loss that we saw in Q3 in the electronics product segment. As data center customers in several large banks and financial services firms scaled back, deferred, or stopped purchase activity all together tape sales for some of our highest margin products were impacted which also pulled down our earnings. We saw this from several customers including Lehman Brothers, Merrill Lynch, Bear Sterns, and AIG.

I should add that a few verticals, such as Geophysical, oil and gas exploration continue to do well, but going into what appears to be a global slow down in economic activity we remain uncertain as to how quickly tape demand may improve.

The negative factors in Q3 are not totally transitory. Long-term the overall tape market will likely continue its slow decline. As we mentioned last quarter, we anticipate continued pressure as open architectures and newer tape formats replace Legacy formats as technologies such as virtual tape and deduplication become more widely adopted and as we continue to improve the cost per gigabyte through higher capacity tape cartridges. These factors have been known for some time and that is why we have been aggressive in optimizing our magnetic business as we reduce our manufacturing cost structure.

Also, assumptions for the optical disc market are changing. Although our acquisition of the TDK Recording Media business continues to deliver revenue and market share growth we anticipate a continued decline in the overall optical media market. Growth in Blu-Ray optical media is slower than originally thought and is not yet off setting declines in Legacy formats as alternative technologies such as MP3 players and hard drives continue to gain acceptance.

So, what does all of this mean for Q4? We expect the same factors that affected us in Q3 to continue to impact our business in the current quarter. As a result we will not meet our previous full year outlook and have adjusted it accordingly. Paul will have more to say about our outlook in a moment.

What about our long-term strategy? We remain firmly committed to our strategic direction for Imation and I believe it is more important than ever to remain on course. A year and a half ago, with some of you present, we laid out a clear, straightforward, and actionable strategy to transform Imation into a brand and product marketing company across both consumer and commercial markets by 2011. Over the past year and a half we have made significant progress in that journey.

We have accelerated the introduction of new products into the portfolio with a disciplined product evaluation, development, and launch process as evidenced last month at Pepcon [ph]. Within the past six months we have introduced more than 50 new products across multiple categories. We have hired people into Imation with diverse backgrounds and consumer marketing and branding, strengthening our skill sets in critical new areas. At the same time we have redeployed existing talent and focused our people and efforts in support of our future direction.

We have grown a solid portfolio of brands and products and built a platform for profitable growth with the acquisitions of Memorex, the TDK Recording Media business, Memcorp, and XtremeMac. We continue to invest in building our brands and extending brands selectively across product categories. For example, we recently launched a revitalized Memorex brand with new packaging and advertising aimed at a specific target demographic for that brand: female purchasers of technology products.

We have made substantial progress in another key area of our strategy, to optimize our core tape business without disruption to product supply or customer service. We are months ahead of our original plan as we consolidate all high-end tape coating activity into our Tera Ångstrom in Weatherford, Oklahoma by year end. A move we will believe will maintain the competitiveness and long-term health of our critical tape business.

As we enter the second phase of our transformation we continue to benchmark ourselves against companies with brand portfolios and those with significant distribution businesses across both commercial and consumer segments. As part of this process we have established a target business model in line with our strategic direction.

Given our year-to-date performance, as well as current market and industry conditions, we know we cannot simply grow our way into the business model. As a result we intend to reduce total operating expenses to drive profitable growth as a lean and fast acting company focused on delivering acceptable gross margins, improve operating profit and return on invested capital. We will focus our resources on key accounts and key products and stop activity that has marginal value. We also will continue to invest to rescale the company, strengthen our brands, and maintain out tape technology leadership critical to our future.

As we finalize our plans in the coming weeks we will have more information to share including restructuring charges, timing, and impacts.

We remain confident in the power of our solid brand portfolio and committed to transforming Imation into a brand and product marketing company across both commercial and consumer markets.

Finally, I recognize that our year-to-date performance is not what shareholders expect. It is not what I expect either, nor is it what I believe the company is capable of. As we have in the past, when faced with challenges this management team will make the necessary changes to improve results and regain our momentum.

Now let me turn the call over to Paul who will provide more details on the quarter.

Paul Zeller

Thanks Frank and good morning everyone. I have a couple of thoughts before I get into the details on the third quarter.

I believe that in times like this, when we are facing a difficult economy and a difficult industry condition, I think it is more important than ever to not only take the actions the near-term reality demands and we are doing that, but as importantly it is critical not to lose your focus on the long-term strategy which remains intact and appears as valid as ever.

Finally, these times demand transparency which we are committed to as we continue to transform the business. Now I will turn to the third quarter and our fourth quarter outlook.

Our revenues I the quarter grew slightly to $575.5 million in the third quarter. We saw 9% growth in optical products where we had one more months of TDK revenue in this year’s third quarter compared to last. At $255 million in revenues optical represents about 48% of total revenues for the company.

Magnetic product revenues declined 13% to $154 million driven by reductions in tape demand from our enterprise class of customers. Demand was soft through out the quarter, but particularly late in the quarter. Continued financial market turmoil disrupted IT spending for our tape products in this important customer sector. We also saw declines, as expected, in mature areas such as entry-level tape. Magnetic products represent about 29% of total revenues.

Revenues from electronic products and accessories totaled $95.4 million or 18% of our total revenue. This was up $21 million or 28% from last year driven by video products. Although we are pleased that we are seeing growth in this important category, we had expected even stronger revenues. Results were held back by soft demand from our major retail customers, especially late in the quarter.

Flash product revenues totaled $22.8 million and declined nearly 42% from last years third quarter. We had anticipated a decline in this category given our actions last year to rationalize our portfolio, especially in US retail, though we saw somewhat more of a decline than we had planned, driven by softness in the retail channel in the US and from Japan. Flash products represented only about 4% of revenues in the quarter.

On a regional basis our America’s segment revenue totaled $199 million in the quarter. That is down 19% from last year. Magnetic revenues were the most significant driver, but flash revenues were also down. Optical revenue was down somewhat year-over-year.

European revenues grew 10% totaling $167 million with growth driven by a global data media joint venture.

Asia Pacific revenues totaled $99 million up over 17% over last year driven by TDK revenues, especially in Japan. Our TDK acquisition had a $42 million impact on revenue comparability essentially from having an extra month of TDK results in the third quarter of 2008 versus 2007. If we exclude that impact total company revenues would have been down about 7.5% driven by magnetic tape, with CE growth about equaling declines in flash products.

Our overall volume growth in the quarter was 4% driven by acquisition and revenue. Price erosion was a -7%, at the low end of our historic range. Currency translation, which was driven by a weaker dollar on a year-over-year basis, added about 3% to the worldwide year-over-year revenue growth. The dollar has strengthened recently however, and our outlook no longer anticipates receiving a currency benefit for the fourth quarter, assuming rates remain generally at current levels. It would, in fact, be a slight negative.

Gross margins were 15.5% to sales, down 8/10 of a point from last years third quarter. Gross margin included a $2 million inventory write off associated with our previously announced closure of our Camarillo manufacturing site. Excluding those charges margins were down about 5/10 in the quarter.

A penalty from product mix changes was the largest driver in that decline, although there were a number of moving parts in our gross margin result. The mix penalty was driven principally by softness in data center tape demand; these products carrying a higher than average gross margin.

We also experienced a decline in our CD product margins during the quarter which were impacted by economic factors in the US. We saw demand soften during the quarter and in some cases orders pulled back or deferred. We believe this impact was widespread and actually impacted others more than Imation. However, this lead to higher than expected levels of price erosion in the industry as supply exceeded demand, especially in video products, including flat panel TVs and really anything with an LCD screen. As a result our sell in prices were impacted and margins suffered during the quarter.

Margins in the rest of our business were solid in the third quarter. Our optical and flash margins were actually up compared to last year. In optical our margins have been benefiting over the last several quarters from a number of factors: First, we have seen a relatively stable pricing environment in both CD and DVD and second, we have been actively rationalizing our portfolio limiting low margin SKU’s and focusing on higher margin channels.

I have one final and important comment on optical margins. As we look forward we do see cost pressures coming from our suppliers based on raw material cost increases they have been experiencing. We are working to implement to our channel partners to protect our margins, but we do anticipate some risk of margin pressure in this area. This risk has been reflected in our outlook for the fourth quarter.

In the case of flash we saw significantly improved margins compared to last year. We continue to benefit from the change in strategy we began last fall when we started rationalizing our participation in the US retail market and began focusing our intention on higher margin and lower risk channels and regions. This strategy is working very well and while our revenues are down our margins are up.

Compared to last quarter our overall gross margins were down about 1 ½ points. We expected some level of decline based on a seasonal change in product mix with consumer revenues growing and representing a larger share of revenues in the second half of the year. On top of this we saw declines in our CE gross margins, as I just mentioned.

R&D costs were $5.6 million for the quarter. That is in line with recent quarters and in line with our expectations.

Selling, general, and administrative expenses totaled $70.4 million. That is down slightly from our run rate in the last couple of quarters despite increased spending on acquisition integration, brand investments, and legal costs. We continue to see cost reductions from acquisition synergies and in addition saw a benefit from reduced variable compensation in the quarter. These cost benefits were off set by currency exchange rates which increased the dollar equivalent of our SG&A internationally compared to prior periods.

As a percent of revenue SG&A was 13.3% which was in line with the ratios earlier in the year. We did not, however, see the improvements we expected in this ratio during the quarter due to softer than anticipated revenues. We do expect to see improvements in our SG&A ratio in the fourth quarter as we see seasonally higher revenues.

Our worldwide employee count ended the quarter at approximately 1,760. That is down about 10% or 190 employees in the quarter and down over 20% or 490 employees so far this year. This decline was driven by actions associated with our manufacturing restructuring as well as acquisition integration efforts.

Restructuring and related charges totaled $16.3 million in the quarter. The majority of those charges related to previously communicated plans principally associated with our Camarillo plant which will close by the end of this year. $14.3 million of the costs were recorded in the restructuring and other lined in the P&L and $2 million in cost of goods sold. We do not expect to incur any significant additional charges associated with these past programs. We do expect to record additional charges in the fourth quarter and into 2009 as we further examine our operating expense structure and I will say more about that in just a minute.

The operating loss for the quarter was then $8.7 million on a GAAP basis and $7.7 million of operating profit excluding restructuring and related charges.

Non-operating costs totaled $2.2 million I the third quarter which compared with $800,000 of expense in last years third quarter. That change was driven primarily by higher currency losses this year.

We recorded a $5 million income tax benefit in the quarter associated with the $10.9 million pre-tax loss we recorded, remembering that included $16.3 million in restructuring and related charges.

When our results are normalized to exclude restructuring our year-to-date tax rate was about 31% which is somewhat lower than our typical tax rate and reflects the benefits of various tax planning strategies, mostly associated with our acquisitions as well as lower overall income.

Our loss per share on a GAAP basis in the third quarter was $0.16 per share. Excluding restructuring and related charges we had earnings per share of $0.11.

The company’s financial position remains strong despite a difficult environment and financial results that were less than anticipated. The company continues to believe the fundamental cash engine remains intact.

Cash from operations totaled $8.6 million this quarter including $5 million we spent associated with restructuring. This compares to a modestly negative cash from operations in last years third quarter.

So far this year we have generated $87 million in operating cash and over $160 million in the last four quarters. Cash outflows during the quarter included capital spending of $3.2 million and dividends of $5.9 million.

We did not repurchase any shares during the quarter and our share authorization remains at about $2.3 million shares.

As a result of all of this activity that I just described cash and equivalents ended the quarter at $112.8 million down $4.9 million from last quarter.

In our press release issued this morning we made some statements regarding the potential for a goodwill write off before year-end. I would like to provide some further background and color on this issue.

As many of you may remember, last year-end we were required to take a sizable non-cash charge for goodwill impairment; that totaled $94 million. The applicable accounting standards require us to reconcile our current market capitalization to book value when we complete our annual goodwill impairment assessment. Last years charge was driven by the market value of the stock in relation to underlying book value at that time.

Given current stock price volatility there is risk that an additional charge will be required this year as well. Depending on the results of our analysis, which is underway, this could apply to either our quarter three results or to quarter four. As such I would like to caution you that there is some chance that our Q3 numbers would need to be adjusted to reflect this. We have approximately $60 million of total goodwill remaining on our books as of September 30.

As Frank just mentioned we are in the process of reevaluating our operating expense structure. The economic and industry realities we’re facing have created near-term pressure on our profitability that wasn’t anticipated. As we have before this team stands ready to do what it takes to improve the health of our business model and provide a reasonable return to our shareholders. As a result, we anticipate in the next several weeks announcing the details of a restructuring program. I know that you probably have a number of questions about the program, however, we are still in the process of finalizing our plans and while the details are not firm our resolve to take action is. We will have more to say about this in the near future.

In providing our 2008 outlook last quarter we had stated that we would be closely monitoring the external environment and its impact on our business. I think it’s fair to say that while we had some concerns about the economic environment then, we had not anticipated the level of disruption we have experienced this quarter. Based on the weakness we saw in our business in Q3 and significant uncertainty in the global economy as well, we expect continued weakness in the markets we serve into the fourth quarter.

Actual results will also likely be impacted by additional restructuring charges associated with the company’s cost reduction efforts I just discussed. In addition, the recent decline and increased volatility in our stock price and the downturn in economic conditions that impact our business outlook increase the possibility of a goodwill impairment in 2008 as I also just mentioned. Neither of those costs are reflected in our current outlook at this point.

With those caveats we are targeting revenue of between $560 and $580 million for the fourth quarter which would bring full year revenues to between $2.165 and $2.185 billion. We are targeting fourth quarter operating income in the range of $7 million to $14 million. Again, these targets exclude any potential charges for restructuring and goodwill impairment. That would bring full year operating income to the range of $30 to $37 million. That full year includes restructuring and related charges of $21 million which have been incurred in the first three quarters of the year. Excluding those charges, represents a range of $51 to $58 million in full year operating income.

We are targeting quarter four diluted earnings per share of $0.11 to $0.23. For the full year this is between $0.44 and $0.56 and includes the negative impact of approximately $0.39 from restructuring and related charges.

Capital spending is targeted to be approximately $15 million for the year. The full year tax rate is anticipated to be in the range of 33% to 35% absent any 1-x items that may occur in the future.

Depreciation and amortization expense is targeted to be approximately $50 million.

In summary we were obviously not pleased with our near term results, nor with the need to take down our targets for the year. We believe the primary factors affecting our performance include the macro economic issues affecting many companies as well as some of the specific issues impacting the financial sector which clearly hurt our enterprise tape numbers.

Having said this, we continue to believe that the strategy we have established is sound and the steps we are taking in our transformation are the right ones. To that end we believe we need to make some adjustments in our operating expenses to improve our business model. As I said, we will have more to say about that in the coming weeks.

We have a strong balance sheet and a committed leadership team with good opportunities in front of us. This management team remains dedicated to long-term shareholder value creation and we remain committed to the strategy we have established.

Frank and I will be pleased to take your questions at this time. Thank you.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Chuck Murphy from Sidoti & Co.

Chuck Murphy – Sidoti & Co.

You mentioned the pressures that you’re seeing in tape from the open architecture in the deduplication. Can you talk about when that sort of pressure might kind of plateau and what kind of impact are you seeing on your margins these days for tape?

Frank Russomanno

When we talked about the factors impacting tape, the ones that we outlined they are virtual tape and deduplication, both of which have been around for a while, have impacted us over the past couple of years. When exactly is that going to reach its peak, that’s very difficult for us to say because that is a facility-by-facility decision as to what their plans are for their data.

What we are confident of is that archival storage is the best and most cost effective way to store your data long-term. We see very little impact in that area, however when we talk about back-up that is an area where we have lost the volume.

Now, let’s dig a little bit deeper into the enterprise and separate it into data center environment and mid-range environment. In the data center environment there are several new growth formats, by they the IBM system of 3592 and the Sun StorageTek T10000 systems. Both of those systems are gaining momentum around the world and we see positive growth opportunities for both of those. We continue to grow quarter-on-quarter with T100000 especially and we do have both the Sun and IBM distribution business; so we don’t believe we’re losing share in that segment.

When it comes to the open formats with the LTO there five suppliers like you know and there are currently four major LTO formats out there, LTO 1 to LTO 4. LTO four is gaining momentum and growing fast, LTO 3 has peaked and we are able to participate once again with both the IBM brand, Imation brand, TDK brand, as well as the Sun brand to sell those products.

The issue for us there is we see some former data centers moving to open architecture and its hard to tell via changes in technology like virtual tape and deduplication versus open architectures like using more LTO which is of greater impact. Well obviously we would prefer open architecture if someone is going to make a change because then we have a chance to participate with all of our brands. But, it is very difficult for us to put a precise time on when this all might change, especially in today’s economic conditions.

Paul Zeller

The one thing I would add is that these trends from alternate technologies are not new trends. These are little things that have been impacting us all along and the primary factors affecting us this year are more economically driven, especially, as we have said, in earlier quarters and again this quarter in that financial sector which obviously is going through some difficult times.

I would like to mention one other thing. I am told I transposed a number in my remarks and I jut wanted to clarify that. Our revenues for the quarter were $527.5 million, I think maybe I quoted $575; I just wanted to correct that.

Frank Russomanno

Chuck let me go back to one last point. Like Paul said, again, these are not new trends. We have known about these. What we actually did was pull forward our decision on our Camarillo facility to get that into this year rather than waiting into next year, because we do see this trend as being one that is coming up and it looks like it’s moving even faster than we would have thought a year ago, as far as the technology switch the softness in the market. We have got the capacity and the ability to handle everything in our Weatherford, Oklahoma facility; so we think we’re positioned well and safe for next year especially.

Chuck Murphy – Sidoti & Co.

Do you think there reaches a certain point though where the data centers that would be considering moving to mid range tape, that it kind of reaches equilibrium, so to speak, or is it kind of going to be a trend for awhile now?

Paul Zeller

I think that would be really difficult for us to say, because that is a facility by facility decision and today’s decisions are so clouded by what is happening with the economic realities of, as you would expect our major data center uses our financial institutions and it’s really difficult for us to say. It would probably take a very large piece of primary research done on an international scope to answer that question.

I can tell you that certain markets like Japan have moved quickly to open architecture, but that is just one country and one region. The US is so varied and so broad I would be real hesitant to answer that with any real basis of factual knowledge.

Chuck Murphy – Sidoti & Co.

Do you have any sense on what the financial institutions are as a percentage of your tape revenue?

Paul Zeller

I don’t know that we have any specific number on that. Maybe we will try to take a look at that and give you some idea here before the call is over.

I can tell you though in the US they are a fairly significant portion. If you look at verticals in the US you would start with financial institutions as being the largest vertical we have; telecommunications being a second vertical; geo physical is a third vertical, but that is a number we would really have to look at carefully. Remember we sell through distribution we don’t sell direct to these facilities. We have end-user contact with them, but we have never quite listed them in our like top 25 customers, because their sales are found in our distributors.

We can try to get an answer to that when we get back in though.

Chuck Murphy – Sidoti & Co.

I am just trying to get a sense, is it ½, is it 1/3 is it more like 10% kind of thing?

Glenn Hanus - Needham & Company

Well I can tell you it’s not 10%, that I’m sure.


Your next question comes from Glenn Hanus from Needham & Company.

Glenn Hanus - Needham & Company

Can you give us a little more financial color on plans for operating expenses and gross margin in the fourth quarter?

Paul Zeller

Sure. As we think about moving into fourth quarter and in any quarter you have variability and it can move because of product mix, early seasonality comes into play, especially in fourth quarter. As you look at that seasonality I would anticipate fourth quarter gross margins will be lower than third quarters, but so will operating expense ratios be lower than third quarters.

I would say versus the 15.8% our 15.5% reported result in gross margin, we could see something closer to 15% in fourth quarter whereas operating expenses we could see lower than quarter three levels, maybe down to 13% in total with SG&A around 12% and R&A at 1%. Those are just some rough numbers to give you an idea, but that’s the kind of progression that I think would be logical as we look at our numbers.

Glenn Hanus - Needham & Company

Okay and stock options this quarter were $2 million or so?

Paul Zeller

I think they were generally in line with previous quarters. I tell you what, when I get them I will get them back to you.

Glenn Hanus - Needham & Company

On the electronics business you said that lost money, but that is sort of where you are really growing or planning for more growth going forward. Could you talk about the trajectory in that business and plans to restore profitability?

Frank Russomanno

The electronics business in the third quarter lost about $4 million. That is a really important piece of business for us and I would like to back up and tell you why we believe that.

First of all electronics is a large and growing piece of business globally. Secondly it allows us to develop a deeper relationship with channel partners and gain more shelf space. Third we see expansion opportunities outside of the US which are very positive as part of our business model. Then last but not least, as we surveyed that market there are tier 1 and tier 2 players in CE. We believe there is a position available for a strong tier 2 company in CE that could go across the entire electronics department and we believe the Memorex brand is the brand that can do it.

As far as what happened in the quarter Paul can give you some more details around what happened with the products and those categories but fundamentally there was softness in the business. We had orders cancelled and deferred at the end of the quarter which didn’t allow us to get the right mix into those accounts and the volume and quite honestly there were significant price changes in flat panel, anything with a flat panel like Paul said in his earlier comments.

Having said all that, this is a business that is important to us because it does provide growth opportunities that are rather significant. Secondly it is a business that we can manage. It is a business that is heavily dependent on inventory and SKU management and we will do that. We will get that as the integration, I would have to admit the integration is pretty much done, but it is going to take a stronger hand to manage the inventory levels and also SKU management for that product line; but, fundamentally the approach is right.

In the recent quarter we have opened up accounts in Mexico, in Canada and we are getting business outside of the US which is typically another positive for us.

Paul, why don’t you talk a little bit about the inventory situation.

Paul Zeller

One of the realities of this quarter and this sounds too convenient but this was a unique and difficult quarter in terms of how fast the demand turned. Obviously we are not the only one experiencing that. Actually, I think the fact that we have a global reach, we have multiple channels including commercial channels, really helped us mitigate some of the risk in this business. Though we are not proud of losing money in a quarter where we clearly should have made some money, it was a unique quarter and I think we see the fundamentals of the business still intact. We see the opportunities clearly there and the interest from our retail partners is definitely there.

We did have inventory of flat panel TVs that caused us some issues relative to how quickly in certain SKUs prices turned, especially 32” and some of the digital picture frame inventory and that hurt us in the quarter. But, overall I think it is not making us feel concerned about the long-term business model. It is more in a unique issue relative to the quarter and I think one of those transitory issues we talked about.

Frank Russomanno

Glen just let me close with something because I want to be really specific to your question because it is really important. I think there are really three things we need to do in order to improve our results in IEP or electronics products. Number one is the inventory management. Number two is the sourcing and the model we use for sourcing, currently we have a facility in Hong Kong that came with the acquisition. I think that needs to be strengthened and it needs to move to a higher level to participate in the scale that we want this business to be at. Then last but not least is the actual channel expansion.

I think the more products we can get in to more channels that can allow us to manage this mix better, there are some products with higher margins than others, in other words there is less competition on some than others, the better we will be at managing this business overall.

Last but not least I don’t want to omit XtremeMac. We also put XtremeMac into our results and XtremeMac is not yet in business and we won’t see any positive opportunity from those people and so all we have is the cost in there without many sales until the end of this quarter. That is another factor that impacted it. Far from panicking on that business, we think it is critical to our future growth.

Paul Zeller

Glen, I have got those numbers for you on stock compensation expense. Just short of $3 million, about $2.8 million in the quarter; about $2 ½ in SG&A; a couple hundred thousand in cost of goods sold; and about $100,000 in R&D. For the full year you can anticipate around $10 million in total.

Glenn Hanus - Needham & Company

Just back on the outlook for a second, as you go into next year gross margins do you think they should sort of stabilize and be flattish next year or continue to sort of trend down slightly as we go through next year? Then operating expenses excluding stock options is around $74 million right now. Can you give any range of on the quarterlies or of quarterly run rate basis where you think you might be able to take operating expenses too?

Paul Zeller

In terms of specifics we are going to provide much more detail when we come out of this year end as we always do and give our ’09 guidance. I can make some higher-level comments.

We have seen some of our higher margin tape business move towards open formats; we have talked about that. That’s happening and accelerated to a degree, but that is also why we are taking costs out is accelerated rate and why we have not only consolidated converting in Mexico, but we have consolidated all of our tape coding in Weatherford.

On OpEx we are taking actions from the synergy side of things and we are nearing the end of that, but there is some important work left to go here in the fourth quarter. As we mentioned we are going to take a hard look and are taking a hard look at our operating expenses going forward and plan to make some further reductions. All of those go into the mix and we will have more to say as we get towards the end of this quarter and into January and give our final 2009 outlook.

Glenn Hanus - Needham & Company

Do you think you can grow in 2009?

Paul Zeller

We are going to provide that input when we finish the fourth quarter and provide our outlook for 2009.


Your next question comes from Hamed Khorsand from BWS Financial.

Hamed Khorsand - BWS Financial

According to the guidance you provided you guys are indicating a sequential increase but you were making comments during the general statements about how revenues were starting to shrink or decline towards the end of the quarter. So what has happened between September and this one month of the Q4 where you are now expecting a sequential increase in Q4 revenues?

Paul Zeller

I think the key element on that is just that we would normally expect a really strong finish in September, that is typical of our business and we didn’t really see that. That is what we were talking about. It wasn’t so much that revenues were going away as we didn’t see the strong finish we expected.

The second comment I would make is that fourth quarter just seasonally is always a stronger quarter for us. It has been traditionally in tape and on the consumer side of things really September, October, November are the three peak months in the consumer electronics business, so we get a couple of those months in our fourth quarter. So, that is really the reason why we believe sequentially we should be improved moving from third quarter to fourth quarter.

Hamed Khorsand - BWS Financial

Is there any operating expense level you want to achieve?

Paul Zeller

As we finish our work on this restructuring plan we talked about, we are going to provide some more input here in the next several weeks. I think you can plan on us giving some more specifics in that regard.


Your next question comes from Chuck Murphy from Sidoti & Co.

Chuck Murphy - Sidoti & Co.

I was just wondering, not to harp on the cost savings thing, but if we assumed you weren’t doing any further restructuring or that sort of thing why has there not been the drop in SG&A, for example, yet?

Frank Russomanno

Well I think for a couple of reasons. One is our synergy savings were relatively back end loaded to start with, A; B, we have been experiencing a relatively sizable currency penalty just in dollar terms with a substantial change in rates year-over-year. Third is we have had some extra legal expenses associated with several pieces of litigation, the Phillips matter and the Sandis [ph] matter and so there have been some things that have been impacting us in the interim here. We have been seeing some cost benefits, they have just been offset by some of these other factors in the interim.

Paul Zeller

Chuck on a ratio basis our top line hasn’t grown at the level we would like to have seen, there for the ratio looks higher than it should be at the current levels.

Frank Russomanno

That points to the reason why this team is saying we need to deal with our operating expenses.

Chuck Murphy - Sidoti & Co.

Can you remind me what the other net line is on your P&L? What is included in that?

Paul Zeller

It is interest income, interest expense in currency gains and losses generally. We have a modest amount of interest expense associated with our credit facility, basically charges for the facility. We have more interest income in that usually, just associated with our cash balances, but then the overall factor is transaction gains and losses on currency. We also have bank fees and a number of miscellaneous items that go into that line.

Chuck Murphy - Sidoti & Co.

I have a couple of questions regarding the balance sheet. It looked like the other current assets jumped pretty sharply sequentially in the PP&E fell pretty sharply sequentially. Is there any reason for that?

Paul Zeller

We had a distribution center in California that we had exited earlier in the year that moved from being a productive fixed asset to being an asset held for sale that means we reclassified it from fixed assets into other current assets. That wasn’t all of that change, but that was a reasonably key part of it.

Chuck Murphy - Sidoti & Co.

Do you have any sense of when you might be able to get that sold?

Paul Zeller

Obviously it is a difficult real estate market and it is a good piece of real estate, so we are not going to hurry to liquidate it into cash at the wrong price either. We will deal with that in a prudent manner and make sure that we’re getting a fair amount for the shareholder.

Frank Russomanno

I think Paul’s comments are especially critical since this is a California piece of real estate. In typical times California real estate has a really high value, so we are not in a hurry to try to sell an asset like that. We will look at other alternatives as to how to monetize that asset though, including lease.

Chuck Murphy - Sidoti & Co.

You mentioned that the optical margins were going to be under pressure due to raw materials. What raw materials exactly was that and…

Frank Russomanno

One of the main raw materials for our manufacturers, primarily in Taiwan and India and China, is polycarbonate and polycarbonate has been experiencing some relatively dramatic price increases and that is forcing cost increases on our side. We are, of course, trying our best to pass that on through the channel and the ultimate success of that will lead us to the question of whether we have some margin pressure or not.

Paul Zeller

We just felt it was prudent to kind of signal the risk.


Your next question comes from Lawrence Franco from Delaware Investments.

Lawrence Franco - Delaware Investments Inc

I was wondering if you could elaborate a bit on what specifically happened in Europe. Magnetic products and flash media products seem to have dropped off. The growth seems to have been lower than in Asia Pacific and electronic products by a large order of magnitude.

Then in the segment break down Europe seems to be the location of a fairly dramatic drop in operating income. Could you please elaborate on that?

Frank Russomanno

This is Frank and I will start. For years Europe has been our most consistent performer over the past three to five years I would say. They have been around within 3% to 5% range of all of their forecasts and all of our plans. This year is a very different situation and I attribute it to two factors:

First of all we do have a consumer and B-to-B business. The B-to-B business is being impacted in Europe by some of the same seasonality’s that have impacted the US especially in our data center markets where the financial institutions in Europe are suffering from some of the same problems, and we have not seen the level of orders that we had in the past. Not to mention the typical issues of changes in technology like virtual tape and deduplication, but Europe has finally caught up with the US and we saw that start to change in Q2.

Secondly, our retail business in Europe is somewhat soft and I think that also has to do with the economy, especially of late. Not to mention that our European team has been working very diligently on a very difficult integration of the TDK business. So, I would say that there is probably another challenge in front of those people in addition to the economic reasons I have already mentioned. That integration with the TDK brand, which is significant, in Europe TDK was one of their largest single markets. We have benefited from the sales, but we have also had some distraction of our team trying to integrate that. So I will let Paul go on a little bit more.

Paul Zeller

The only other factor I would add is just that we have had, in dollar terms, cost pressures in our SG&A from a stronger dollar which we didn’t see as much benefiting our gross margin. I mean usually in a strong dollar scenario you should see an overall benefit in your P&L; we are really not seeing that, we are seeing the cost pressures and not so much the benefits in gross margin.


I am not showing any further questions at this time.

Frank Russomanno

Okay then I would like to close the call with just a few comments. Obviously Q3 was a very difficult quarter, but on in which I believe that we learned a great deal about how to better manage our new business model. As we go forward we will remain bimodal. By this I mean you will see us improve our results while at the same time accelerate the transformation of the company with the actions we described today.

We look forward to talking to you again at the end of this quarter and if there is anything else that we need to do you will be reading about it, from us, in the next couple of weeks.

Thank you.


Ladies and gentlemen this does conclude today’s conference. Have a wonderful day.

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