Analyst Conference Call Summary

conference date: February 7, 2012 @ 2:00 PM Pacific Time
for quarter ending: December 30, 2011 (second quarter, Q2, fiscal 2012)

Forward-looking statements

Overview: Lower profit on increased revenues as costs got out of control.

Basic data (GAAP) :

Revenues were $195.2 million, up 9% sequentially from $178.9 million and up 10% from $177.5 million in the year-earlier quarter.

Net income was negative $2.3 million, improving sequentially from negative $2.7 million, but down about $6 million from $3.7 million year-earlier.

EPS (earnings per share) were negative $0.07, improving sequentially from negative $0.08, but far below the positive $0.12 from year-earlier.

Guidance:

Full fiscal 2012 updated to: revenue between $770 and $800 million, with gross margin between 26% and 28%, leading to GAAP EPS of negative $0.15 to negative $0.30, but non-GAAP EPS of $0.15 to $0.30.

Above excludes any restructuring charges.

That is an increase in revenues but a decrease in margins and EPS.

Conference Highlights:

Sales were strong, demand was strong, resulting in market share gain and record revenue for a December quarter. However, expenses increased due to the high fixed cost of doing business in Europe and foreign exchange effects. Service margins were lower and product mix resulted in lower margins, but believes those are temporary issues. Restructuring of European operations to align costs is planned. But grew revenue in Europe despite the weak economy there.

Sees a clear path to $1 billion in annual revenue. Realigning business for sustainable, profitable growth.

Non-GAAP numbers: net income $1.3 million, EPS $0.04.

Gross margins down 275 basis points y/y.

Added 100 new customers in the quarter. Demand was strong for new ICE X HPC platform; $90 million in orders, with delivery beginning this quarter. Made progress with Hadoop program and Red Hat relationship. Shipped a large number of Hadoop clusters in the quarter. New storage server products introduced. Had minimal impact from hard disk drive (HDD) shortage issue.

Channel sales accounted for 17% of revenue, direct sales for 83%. U.S. business was 52%, international 48%. Product revenue accounted for 73%, services for 27%.

Public sector accounted for 63% of total revenue. Cloud 15%, manufacturing 10%. Compute was 84% of revenue, storage 16%.

Doing well in life sciences. Initiating a sales campaign for genomics.

When new products replace older ones, the service contracts are replaced, resulting in lower margins (because the newer products are more reliable).

Rackable products sold well, but this reduced average margins. However, 2012 new Rackable introductions will have better margins.

Cash burn was about $20 million, leaving $95.1 million cash and equivalents at the end of the quarter. Cash use was mainly for working capital for contracts awarded. Inventories ended at $117.6 million, up almost $7 million in the quarter and $18 million in the last 2 quarters. Accounts receivable increased to $120.7 million. In January borrowed $15 million.

Two >10% customers, Amazon and the U.S. Government.

Cost of revenue was $143.0 million. Gross profit was $52.2 million. Operating expenses were $54.1 million consisting of: $16.3 million for R&D, $23.1 million for sales and marketing, $14.8 million for general and administrative. Other expense $0.2 million. Income tax provision $0.1 million. Includes $2.2 million stock based-compensation expense.

R&D expense was up almost $3 million y/y, sales and marketing up over $5 million, and general and administrative up $3 million. Cost of revenue was up $18 million.

Long term margin goal is 30 to 32%. Margin problems are temporary. Confident will be back on track by end of fiscal year.

Permanent CEO announcement should be within the next few months.

Q&A:

Has all the bad news been revealed? The basic margin issues are mostly temporary in nature. Any CEO would have addressed these issues at this time. Of course there is always the possibility of unanticipated problems.

Why did you not act earlier on European margins? We see tremendous opportunity in EMEA. We have been losing money there for several quarters. We thought we could scale the business to cover the costs. The macroeconomics of Europe make that plan unworkable. Hence the restructuring.

Visibility, given guidance was reaffirmed in December? We get visibility through bookings and pipeline. Our revenue is back end loaded in each quarter. So we don't know where we are until we close the books. But we are getting better visibility as we book the larger contracts.

Europe % of revenue? $28.6 million in the quarter, about 15% of total revenue.

Any margin impact from HDDs? Customers were understanding about alternative suppliers for drives. Customers absorbed pricing changes.

Service attach rate to products is growing, and product sold is growing. The margin issue comes from older service contracts expiring. New products contain new warrantees and service contracts with lower margins. This transition will last several quarters.

We have confidence that 2012 products are going to sell at higher margins.

Rackable business is not all in cloud segment. Includes Hadoop and HPC. Amazon business is Rackable, which fluctuates according to their infrastructure needs.

March quarter, down 19% sequentially last year, this year? We raised our revenue guidance for the year, showing the strength we see for second half of fiscal year. We are winning more deals over $10 million. They are strategic; they drive market acceptance; we might accept lower margins for certain deals in certain verticals we want to enter.

Europe has been unprofitable for 6 quarters. The plan is to be profitable in 6 to 9 months, but must execute on the plan. Cost structure and revenue were nearly flat from Q1 to Q2, the main difference was in mix. This was largely because it is hard to predict what specific revenues would fall into Q2 and which ones went into Q3. FX rates can hurt because we do large projects that take a long time to convert to revenues.

Shouldn't you be hedging FX to prevent that? Hedging is not free, but we will look at hedging discrete large deals.

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