Quantum Corp (QMCO) Q1 2022 Earnings Call Transcript

Good afternoon, everyone, and thank you for participating in today's conference call to discuss Quantum's Financial Results for the First Quarter Fiscal 2022. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Brian Cabrera from Quantum.

Good afternoon, and thank you for joining today’s conference call to discuss Quantum’s first quarter fiscal 2022 financial results. I’m Brian Cabrera, Quantum's Chief Legal and Compliance Officer. Joining me today are Jamie Lerner, Chairman and CEO; and Mike Dodson, CFO. This afternoon, we issued a press release, which you can access on Quantum's website at www.quantum.com under the Investor Relations section. There is also a slide presentation that we will be using in conjunction with today’s call that may be accessed through the webcast link on the IR website and is also posted as a PDF in the Investor Relations section. As a reminder, comments made during today’s conference call may include forward-looking statements. All statements other than statements of historical fact could be deemed as forward-looking. Quantum advises caution and reliance on forward-looking statements. These statements include, without limitation, any projections of revenue, margins, expenses, adjusted EBITDA, adjusted net income, cash flows or other financial items, any statements concerning the expected development, performance and market share or competitive performance relating to products or services. All forward-looking statements are based on information available to Quantum on the day hereof. These statements involve known and unknown risks, uncertainties and other factors that may cause Quantum’s actual results to differ materially from those implied by the forward-looking statements, including unexpected changes in the company’s business. More detailed information about these risk factors and additional risk factors are set forth in Quantum’s periodic filings with the Securities and Exchange Commission, including, but not limited to, those risks and uncertainties listed in the section entitled Risk Factors in Quantum’s quarterly report on Form 10-Q and annual report on Form 10-K as filed with the SEC. Quantum expressly disclaims any obligation to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise, except as required by applicable law. Additionally, the company’s press release and management statements during this conference call will include discussions of certain measures and financial information in GAAP and non-GAAP. Included in the company’s press release are definitions and reconciliations of GAAP to non-GAAP items, which provide additional details. For those of you unable to listen to the entire call at this time, a recording will be available for at least 90 days in the Investor Relations section of Quantum’s website. Now, I’d like to turn the call over to Chairman and CEO, Jamie Lerner.

Thank you, Brian, and thank you all for joining us on today’s call. Earlier today we announced results for our fiscal first quarter, with revenues of $89.1 million, up 22% year-over-year, and both adjusted net income and earnings per share at the high end of our guidance. Our end demand remains robust, with strength at hyperscale customers driving a meaningful increase in sequential bookings. We remain restricted in our ability to fulfill all customer orders due to the ongoing supply constraints, which has caused our backlog to reach unprecedented levels. Historically, our backlog has been 5% or less of our reported quarterly revenue. As of the first fiscal quarter, our backlog has grown to $30 million compared to $14 million in the previous quarter and $2 million in the year-ago period. While not all backlog represents potential revenues in the following quarter, our end demand remains robust across our business, particularly with the hyperscaler customers, and we are seeing significantly higher levels of visibility. We are starting to see signs from one of our key suppliers that there will be more strength closing out this quarter and continuing to strengthen in the following quarter. Despite the near-term industry supply constraints, our long-term business transformation continues to move forward. During the quarter, our software and subscription customers grew more than 20% sequentially, with bookings up two times. While still off a small base, I'm pleased with the progress we continue to make toward our shift to a more recurring revenue model. Also, during the June quarter, we delivered an all-time quarterly revenue record for our recently formed cloud software and analytics group. This group, which represents the acquisitions of Square Box Systems and the CatDV media asset management business, benefited from the increased scale of the Quantum global sales force and generated a strong increase in six-figure contract wins during the quarter. We have already seen leverage in selling combined product solutions, such as our StorNext file system, CatDV software, and Quantum services, and created a significant increase in our ability to cross-sell to our current customer base. Recently, we successfully refinanced our remaining outstanding term debt, reducing the total annualized interest expense by $7 million and cash interest expense by $4 million. This transaction represents the final step in our debt restructuring and significantly enhances both our covenant and financial flexibility. We see this completed debt refinancing as a commitment to our shareholders to operate with strong financial discipline in order to drive improvements in our bottom line results while also maintaining a solid balance sheet. Mike will discuss more aspects of this transaction in greater detail during his prepared remarks. In addition to our successful refinancing, we received notice from the small business administration that our prior $10 million Paycheck Protection Program loan has been forgiven. This $10 million is currently represented in our short-term debt on our balance sheet as of June 30th, but it will be removed in the subsequent quarter, further strengthening our balance sheet. Another significant development since our last earnings call, in July, we acquired the video surveillance portfolio and assets from Pivot3. The acquisition adds an established customer base and product portfolio in the multi-billion-dollar surveillance market and provides a major advance in our share position in video surveillance. The transaction adds over 500 surveillance customers globally, including large airports, casinos, transit systems, and federal government programs. These customers currently use Pivot3 software running on server hardware to record and store surveillance footage in mission-critical workloads. Having served as the Chief Operating Officer at Pivot3 prior to joining Quantum, I am very familiar with these products and the customers, and I believe there is tremendous opportunity for Quantum to leverage their hyper-converged software platform with our BF series product portfolio. Our team has already had the opportunity to meet with a number of these customers, and the response both from customers and industry analysts has been very positive. As we stated, we expect this acquisition to be slightly accretive to EBITDA through the remainder of fiscal year 2022, and we believe there is significant upside potential based on the market opportunity and the scale of Quantum's global sales team and customer base. We see a meaningful opportunity to cross-sell and upsell surveillance solutions to our customers in sports, media and entertainment, higher education, retail, and government, and we are already seeing early traction in those trends. As the demand for video for entertainment and streaming services continues to grow, so does the use of video in the enterprise. Videos are used for communication and training in many enterprises and, in particular, the market for surveillance is expected to significantly expand, thereby increasing the need for efficient storage solutions that retain the data for long periods of time and also provide quick and easy access for managing, analyzing, and sorting the stored content. Surveillance video is being used for much more than just security, and the emerging use of AI and analytics represents a big opportunity to help customers enrich this video content to derive new insights. Our acquisition of Pivot3's surveillance portfolio is a key step toward establishing a more prominent position in this market. As I mentioned in my comments, we have continued to see strong demand and increasing orders from our hyperscale customers. We have established ourselves as the market share leader in the space, and we continue to gain share in this market based on the strength of our offerings. The orders are almost entirely for our tape storage products, which is the area that is being most affected by our current supply shortages. Our engineering teams remain engaged in the development of solutions and architectures, and we now have sold Quantum software into multiple hyperscale customers in addition to our tape storage systems. Industry analysts are projecting massive increases in the amount of cold data that must be stored and protected in the enterprise. We see this projected growth as an opportunity to transfer our knowledge of cold storage software and solutions gained from working alongside the world's leading hyperscale customers to help Fortune 500 companies address this massive data expansion. We look forward to sharing more information regarding our progress in cold storage data solutions in the coming months. In summary, the amount of unstructured data being generated globally continues to expand exponentially. We're seeing strong demand, broadening our footprint across software and solutions within multiple end markets. We're building on our market share leadership in hyperscale archives, and the acquisition of Pivot3 establishes a strong share position in video surveillance. The ability to cross-sell software from our recent Square Box Systems and CatDV acquisitions in December demonstrates our ability to integrate and accelerate adoption of new services across our customer base. Our unprecedented level of backlog and demand momentum demonstrates the significant progress that we've been seeing across our business and in the underlying business trends. With that, I'd like to turn the call over to Mike Dodson, our CFO, to discuss the financials.

Thank you, Jamie. Welcome to everyone who has joined our call today. Our first fiscal quarter 2022 represented another strong quarter of customer demand, demonstrating continued acceleration in our underlying business. As Jamie mentioned, first quarter revenue was $89.1 million, up 22% from the same period last year. Near-term supply shortages continue to present headwinds for our secondary storage systems business during the first fiscal quarter. Revenues from secondary storage were up more than 7% sequentially, but remained restricted by our ability to obtain key components. As Jamie mentioned in his opening remarks, we do expect the supply chain to begin to firm up by the end of this quarter and continue to show improvements into next quarter. Although it is still too early to understand the rate of improvement, we do believe we will see a demonstrative improvement starting in our fiscal third quarter. Primary storage systems declined sequentially, primarily as a result of the lumpiness of the M&E business during the COVID recovery period, and to a lesser extent, the impact of differing software revenue sold separately on a subscription basis. The slight sequential decrease in devices and media was impacted by supply constraints related to certain products. In line with Jamie's comments, our business has had very limited backlog historically, equaling less than 5% of our reported quarterly revenue. Our backlog grew to $30 million at the end of the June quarter, with a significant order contribution from our hyperscale customers. In comparison, we reported fourth quarter revenues of $92.4 million, with a backlog of $14 million, and in the year-ago period reported revenues of $73.3 million, with a backlog of $2 million. While not all backlog represents potential revenue in the following quarter, when looked at in total, we believe the underlying business trends remain robust, and our visibility has improved significantly versus the year-ago period. On a GAAP and non-GAAP basis, gross margin in the first fiscal quarter was 42%, flat with the prior quarter. GAAP operating expenses in the first quarter were $37.3 million compared to $36.6 million in the prior quarter. Non-GAAP operating expenses in the first quarter were $33.3 million, an increase of $1.3 million sequentially. The sequential increase in non-GAAP operating expenses was primarily due to higher general and administrative expenses, partially offset by lower sales and marketing expenses and R&D expenses. The higher G&A expenses were primarily driven by seasonal increases in audit-related services, as well as increased legal and other expenses related to debt refinancing and business acquisition costs. GAAP net loss in the first fiscal quarter was $4.2 million or a loss of $0.07 per share compared to a net loss of $17.5 million or a loss of $0.35 per share in the prior fiscal quarter, which included a debt extinguishment charge of $14.8 million related to the retirement of 50% of our senior secured term loan last quarter. Excluding stock compensation, restructuring charges, and non-recurring charges, non-GAAP adjusted net income in the first fiscal quarter was $125,000 or breakeven compared to adjusted net income of $2.1 million or $0.03 per share in the prior quarter. Adjusted EBITDA during the first fiscal quarter was $5.4 million, which reflects an increase of $4 million on a year-over-year basis and a $3 million decrease sequentially, primarily due to lower revenue and higher operating expenses. There is a full reconciliation of our non-GAAP results to the most directly comparable GAAP measure in both the press release and the Form 10-Q release today. Now turning to the balance sheet liquidity and cash flows. Cash and cash equivalents were $24.6 million as of June 30th, 2021, compared to $33.1 million on March 31st, 2021. Adjusted working capital, excluding deferred revenue balances, increased by $2.8 million during the first fiscal quarter to $58.1 million from $55.3 million at the end of the prior fiscal quarter. This increase was primarily the result of a decrease in accounts payable and other accrued liabilities. Outstanding long-term debt as of June 30th, 2021, was $81.3 million after netting $8.8 million in unamortized debt issuance costs and $11.9 million in the current portion of long-term debt. Current long-term debt includes the $10 million PPP loan, which was forgiven in July. This compares to $90.9 million of outstanding debt as of March 31st, 2021, after netting $9.7 million in unamortized debt issuance costs and $1.9 million in the current portion of long-term debt. During the first fiscal quarter, before the effect of changes in assets and liabilities, cash generated from operations was $3 million, offset by $10 million in net cash used by changes in working capital accounts. Other notable uses of cash in the first quarter of fiscal 2022 were $1 million in capital expenditures and the paydown of long-term debt of $500,000. Last week, we announced the successful refinancing of the remaining portion of our outstanding senior secured term loan. Following a competitive proposal process, the company remained with the existing lenders and replaced the existing term loan facility with a new $100 million senior secured term loan that matures in 2026. The new facility bears an interest rate of LIBOR plus 600 basis points. This refinancing significantly improves our covenant and operating flexibility, while significantly reducing the related interest expense. To put this into perspective, when we began the calendar year 2021, we were incurring an annual run rate of interest expense of approximately $30 million, of which $22 million represented cash payments. When we raised equity in February of this year, we paid down half of the term debt, which reduced our annual run rate of interest expense to $15 million, of which $11 million represented cash payments. Then, following the completion of our recent refinancing, our annualized interest expense was further reduced to just under $8 million, of which $7 million represents cash payments. Collectively, these transactions have reduced our annual interest expense by $22 million with an EPS benefit of $0.32 per share and a reduction of annual cash payments for interest of $15 million. At the end of the first fiscal quarter, there were no funds drawn on the company's credit line. Finally, turning to our financial outlook. Given the ongoing supply chain shortages for the second fiscal quarter of 2022, we are guiding revenues of $88 million plus or minus $4 million, which includes a $2 million contribution from the Pivot3 acquisition, non-GAAP adjusted net loss of $2 million plus or minus $1 million, non-GAAP adjusted net loss per share $0.04 plus or minus $0.02, and adjusted EBITDA of $2 million plus or minus $1 million. At this time, we are maintaining our full year revenue guidance range of between $380 million to $420 million, with the range reflecting the potential timing and magnitude of the supply chain improvements. Our fiscal year 2022 guidance excludes any projected revenue contribution from Pivot3. With that, I'll turn the call back to Jamie for closing comments.

Thanks, Mike. Demand is strong, evidenced by our growing backlog and continued customer order momentum during the quarter. We're seeing increasing opportunities to penetrate further into Fortune 500 enterprise accounts, with both our software and product solutions. The acquisition of Pivot3's surveillance business offers immediate access to over 500 new customers, with whom we expect to see cross-selling opportunities across our portfolio of software and data storage solutions. With a significant milestone of our debt restructuring behind us, our new financial flexibility will allow us to responsibly grow our business. I would like to welcome the new members of the Quantum team from Pivot3, led by Ross Fujii, General Manager of the Strategic Markets Business Unit, who most recently served as Vice President of Engineering and Alliances at SolarWinds, and Curt Wittich, who will be heading up Sales. In conclusion, I'm pleased with the execution our team has delivered in a difficult operating environment. The opportunities for long-term growth and transformation towards a more software-centric model remain intact. Quantum's focus remains on establishing and enhancing our position as a global leader in archive storage solutions. With that, we will now take any questions you may have.

Ladies and gentlemen, we will now have our question-and-answer session. Our first question comes from Craig Ellis with B. Riley Securities. Please proceed with your question.

Yeah. Thanks for taking the question, and congratulations on the growth in the backlog. I just wanted to start with a clarification on the dynamics within product revenue in the first quarter and what you're seeing in the second quarter. So, for the first quarter, can you just provide a little bit more color on some of the things that were happening in primary storage since that was down more than what I'd expected? What did you see in government and some of the new customer segments? And then, with the second quarter, as we look ahead, what are some of the gives and takes at the primary and secondary level, then below that within guidance?

Hey, Craig. It’s Jamie. We’re observing two key trends. Our cloud customers, especially the ten largest hyperscalers, are performing very well and are increasing their orders with us. We are currently working with six hyperscalers, either in production or testing phases. This has generated significant momentum, but our main sales remain focused on tape products, which are currently limited in supply. In addition, our traditional market in high-end post-production within media and entertainment is recovering; our sales have risen 22% year-over-year, but they have not yet returned to historical levels. There's a noticeable absence of summer blockbusters in theaters, and major movie productions continue to be affected by COVID and the Delta variant. While the media and entertainment sector shows promise, it still lags behind past performance, particularly in Europe and Asia compared to the U.S. These dynamics balance out our backlog, which reflects strong sales, although they heavily lean towards hyperscalers, which face the most constraints. However, we have received updates that issues with our tape components should improve this quarter. We are taking a cautious stance on estimates, not expecting immediate improvements, but indications from our suppliers for October, November, and December suggest we will be in a better position. We aim to translate this into supply commitments, which we don’t have yet, but strong data from suppliers indicates substantial improvements as we head into the fall and winter. Consequently, we anticipate shipping at significantly higher levels during that period.

Got it. That's really helpful, Jamie, thank you. And then the follow-up is to Mike. Mike, I think I got most of the guidance elements, but if you could provide any color on your expectations around gross margin? And then with respect to the near-term guidance and the full year guidance, you included Pivot3 in the near-term guidance, but didn't include it in the full year guidance. Why was that? And is it reasonable to think that just adjusting for the timing of the deal that the current quarter's revenue would be a reasonable proxy for what you could do going forward, or can some of the synergies that Jamie talked about in his prepared remarks start to hit as we get into fiscal third quarter or fiscal fourth quarter of the year there?

We will be integrating Pivot3 into Quantum as we move forward. In the near term, we have enough visibility to indicate its expected contribution to the current quarter's revenues. However, for the full year, we are maintaining our guidance. The revenue range of 380 to 420 will depend on how quickly we can address supply constraints and ship against our existing backlog. This reflects our approach to Pivot3 in relation to our current quarter guidance and our annual forecast.

Got it. And then just stay detailed related to the acquisition. I know it was some cash, some shares. Can you help us with the share elements so that we can get the share count correctly in the bottom of our models?

The total deal amounted to $5 million in cash and $3 million in shares, along with some licensing fees that contributed to the total purchase price of $8.9 million. The shares were valued based on the average price five days prior to closing. Considering the overall share count, we had a weighted average of 57.1 million for the quarter ending June 30, and on a diluted basis, it was 68.6 million.

Got it. And I'll hop back in the queue. Thanks for the help, guys.

Okay. Thanks, Craig.

Thank you. Our next question comes from Nehal Chokshi with Northland Capital Markets. Please proceed with your question.

Yeah. Sorry. I was on mute there. Nice booking strength, and thank you for that clarity and transparency on the backlog and therefore clear booking strength here. So, looking at the guide, it certainly implies that you remain supply constrained. The key question is then, given commentary around ongoing strong demand, can you comment on what you expect the bookings in Q4 to look like and thus backlog at the end of the September quarter, given, let's say, the midpoint of the current guidance?

Yeah. We would expect at this guidance level of $88 million, that we would continue to build the backlog, but at a much lesser rate than what we built this quarter.

Okay. And so that then would imply that your bookings would not be as strong in the September quarter as it was in the June quarter. Is that seasonality, or is that something else going on?

I mean, part of the strength that we saw this quarter was really the hyperscalers were placing big orders that go beyond the quarter. So, part of that is just getting in the queue that they're already in the queue. So, it's not necessarily indicative of lower demand per se.

Understood. The software and subscription customers that grew by over 20% sequentially led to bookings increasing twofold. This indicates that you're gaining not only more gross profit dollars but also more revenue dollars per customer transitioning from CapEx to subscription. Is that correct?

On average, bigger deals. Yeah.

Okay. All right. And presumably, most of the software and subscription is going to be hitting primary storage, or is it evenly distributed between primary and secondary storage?

Yeah. Definitely today it's weighted very heavily towards primary because that's the StorNext product that is selling as a subscription. As we move forward, and we move forward with a cold storage software as a service, we'll see more on the secondary side, but that is yet to be released.

Okay. All right. And seeing other software and subscription transition stories where it does actually impact the product revenue negatively. And it certainly seems like that could be the case with respect to primary storage. Yet, on the other hand here, you are saying that look, it's actually growing, not only in gross profit dollars, but revenue dollars. So, can you just really say what's the bridge between the primary storage security decline versus you seeing the increase and naturally revenue dollars as these customers transitioned to software and subscription?

I believe we're in the early stages of this transition. As mentioned in our prepared remarks, our revenue was slightly affected by the deferred subscription revenue. Therefore, we experienced a minor impact, and I would anticipate that as we gain more scale, this impact will become more pronounced.

Got it. Thank you very much.

Okay. Thanks, Nehal.

Thank you. Our next question comes from George Iwanyc with Oppenheimer. Please proceed with your question.

Thank you for taking my questions. So, maybe digging into the near-term guidance just a little bit more. So, if you normalize for the $2 million you expect for the three-year, is still kind of pulling back. How much of that is the software transition? And then, is it still primarily primary storage, and you’re better than near-term headwinds that you're projecting for?

Yeah. It’s Jamie. Hey, George. Almost all of the pullback is just not being able to get tape material. So, we could sell at historic or beyond historic levels. I mean, we are closing the contracts. It's just we have a higher mix of tape than primary, but it still meets all our sales objectives. I mean, our sales team is meeting or beating their plans. We're just very restricted on how much tape libraries we can ship because we are missing a key component. So, we guided based on little or no improvement and actually some pullback in our ability to get supplied this quarter. And then again, anticipating improvements in our fiscal Q3 but anticipating no improvements in this quarter. And if there are significant improvements, we'll probably get back on the phone and give some visibility there. But right now, we're modeling no improvements and even some more deterioration.

Okay. So, maybe with the positives you're seeing from the sales team, can you give us a sense of how you feel about the solution selling strategy at this point? How much activity do you have with like the larger 500K plus deals? How much multi-product selling are you seeing right now?

We started with one hyperscaler with the goal of attracting more, and now we have six of the seven largest hyperscalers as customers, all at varying levels of production purchasing. We clearly lead the market share among the top 10 hyperscalers, particularly in the cold storage sector where we are significantly ahead of the competition. Our next goal after securing most of the hyperscaler business is to tap into the webscaler market, which includes major companies like Instagram and TikTok. Recently, we were awarded our first webscaler contract valued at just over $5 million, confirming our strategy in this area, with additional opportunities on the horizon. We have a new product launching this month aimed specifically at webscalers and Fortune 2000 companies, which will enhance our sales approach. Additionally, five of our six large hyperscaler clients have adopted our various software offerings, indicating strong progress. We remain the market leader in high-end post-production media, although that segment is currently impacted by the COVID pandemic. On the other hand, we have made strides in video surveillance through an acquisition of a company that generates over $2 million in quarterly revenue. Thus, we continue to lead in high-end hyperscale, gain traction in webscale, and maintain strong positions in media and entertainment despite COVID challenges, alongside significant gains from the Pivot3 acquisition. Our strategies are unfolding well, and we're optimistic that supply issues will be resolved within the next two to three months, allowing us to operate within our projected revenue range of 380 to 420 million. We plan to host an investor conference in late October to provide updates and refine our guidance by that time, clarifying our position regarding supply constraints.

All right. Just maybe one last question of looking at new opportunities. In your software subscription transition, you talked about potentially getting to a thousand customers in FY 2023. Do you feel you're on pace for that? And it’s like ransomware was another area that I felt like there was an opportunity. I imagine the supply constraints are probably still none of being your ability to full-fledged go after that opportunity.

Let's break the two out. I still think there's a strong ransomware opportunity for us. We actually have a very specific physical product that we're building for that. We have it in limited productions with a few hyperscalers who really need it. But we're going to make that more widely available towards the end of the year, but we're actually building some extremely unique intellectual property around ransomware – really physical ransomware protection. So, I feel really good about that piece, and I think that's going to be really strong for us. You had another part of your question.

Yeah. You feel like you're on pace adding software and subscription customers.

I believe our baseline goal was to acquire 500 customers, with an aspirational target of 1,000. We are currently on track to reach the 500 mark, though hitting 1,000 seems challenging. We need to transition more of our products to a subscription model. Currently, our CatDV and DXi products are not available on subscription. To get closer to that 1,000 goal, we need to accelerate this transformation. It’s a matter of assessing customer willingness to adopt the new model. So far, the shifts with StorNext and active scale have gone smoothly. I’m urging our general managers to expedite the move to subscription models for more products.

Thank you.

Yeah.

Thank you. Our next question comes from Bruce Goldfarb with Lake Street Capital Markets. Please proceed with your question.

Hi. Thank you for taking my questions. Congratulations on your results. First one, in regard to a component shortage issues, do you anticipate any contract changes in terms of price or terms with your suppliers to try to alleviate some of the shortages?

No. This supplier had some price changes earlier in the year, and their products are pretty structured in how they approach it. So, I don't expect any price changes. We've proposed options like, if we offered more money, could we move further up in the queue or purchase more supply? Naturally, you ask all those questions. If you provided the best pricing, would you ensure the best supply continuity? We explored all those options, but they are on allocation, and it's not really about price. It's simply a matter of them being able to produce these chips in the necessary volumes. Spending more money won't speed up production if there is a COVID outbreak in a factory. You can write all the checks you want, and it won't lead to a different outcome.

Thank you. Do you have any difficulty integrating Pivot3?

I don't. I think the sales synergy has been pretty great. What I mean by that is, if you look at our current customers, they're large government customers, large sports franchises, large entertainment companies, large banks, and retail companies, all of whom use surveillance, right? There's surveillance in every stadium that we do, media and entertainment work with, the auto racing, sports teams. And so, we are seeing really good synergy where we go to a sports team and say, look, we've been helping you with your production video for 20 years. Would you also trust us with your video surveillance? And that synergy is playing out really well. Whether it's theme parks, critical facilities, also our university work, as well as our work with national laboratories. I mean, they're all places that are heavy users of surveillance. So, I think the selling synergy is playing out in real-time. There is some integration work with IT systems. We're in the middle of an ERP upgrade. So, we want to get our new ERP in place before we integrate some of these older ERP systems that we've acquired. And I think it will take some work, but I wouldn't characterize it as difficulty. I think it's going to be pretty straightforward. It also helps having been the Chief Operating Officer responsible for supply chain support. I ran sales and sales engineering. And so, I just happened to have that unique insight that makes us one somewhat easier. Curt Wittich, who runs sales for that organization, had been with Pivot3 for nine years. So, we just had a lot of insight into how that company runs, and it certainly made the diligence quite a bit easier having worked there.

Great. Thank you. That’s all I had and congrats on all the progress.

Thank you.

Thank you. Our next question comes from David Duley with Steelhead Securities. Please proceed with your questions.

Yeah. Thanks for taking my questions. A couple of them. Could you just perhaps try to take a guess at what you thought the impact was of the supply constraints either in your June quarter or your September quarter?

I think the best way to explain this, Dave, is to look at our backlog. We carried $30 million out of the quarter, and about a third of that could have been shipped within the quarter since we had the parts. The remaining two-thirds is for next quarter and beyond. That's likely the simplest way to describe it.

So then, roughly 10 million bucks.

Yeah. Yeah.

Okay. When the supply becomes available to shift all of your systems, do you expect this backlog to decrease, or are you transitioning to a new model that will enhance this facility and this business?

Go ahead, Mike.

No, go ahead, Jamie. You can.

Look, I think we expect the backlog in our traditional hardware-based products to go back to the sub-$5 million level, where it's insignificant. We don't talk about it. What we want to talk about is backlog in the form of RPO, TCV, and ARR. That's the backlog we want to talk about. We don't want to talk about, hey, I just can't ship tape libraries because I'm missing a component. So, I think the way we talk about just physical hardware backlog, which is essentially what we've got here, that will go back down to $2 million to $3 million level. And the backlog we want to grow is, again, our software subscription, which isn't really backlog. It's more RPO, ARR and a ratable revenue, deferred revenue. That's really what we want to build, not a hardware backlog.

Okay. And then, could you perhaps give us your kind of goals in the surveillance business now that you've got a platform and 500 customers, and you're doing $2 million a quarter, let's say, as your run rate. What kind of expectations can we have for this business over the next two to three years? Is it going to double in size, or how should we think about the growth trajectory of the surveillance business for you guys?

We see the surveillance sector as a growth opportunity, expanding at over 20% annually. We're increasing the deployment of more advanced cameras, including those with analytics, facial recognition, and license plate recognition for billing and drive-through applications. This growth leads to higher demands for storage and computing power, and our hyper-converged platform excels at handling both storage and analytics. We have a well-established product with a solid 15-year history and a customer base that includes leading casinos, major gas pipelines, large police departments, prison systems, and significant smart city initiatives. Our aim is to expand this customer base globally. We can offer Pivot3 software independently, allowing us to compete in markets such as India and China by using localized hardware which is advantageous for both geopolitical and pricing considerations. Our partnership with Lenovo enhances our capacity to operate in these regions, with them managing the hardware while we focus on software. Following our acquisition, we added ten successful sales representatives, giving us nearly 15 surveillance specialists globally, who will collaborate with our existing sales team of over 200. This positions us well for growth, and we anticipate significant new customer opportunities through partnerships and security integrators. Overall, the surveillance business has always shown growth potential, and acquiring a mature platform has accelerated our development process. We believe that within two to three years, we can more than double this business.

And just a final question on gross margins for the second half of the year. It seems like the guidance for the September quarter is conservative. However, for the December quarter, I would expect to see a significant amount of backlog transition into the sales funnel. What are the implications for gross margins when that occurs?

Yeah. I think we've got two factors, right? As the secondary business grows, and it's driven by the hyperscaler business, that's going to be a gross margin headwind. And as we grow the primary business and grow the subscription revenue, recurring revenue, that will improve the margins. So, maybe they'll offset, as we go forward in the near-term. So, I'd expect plus or minus to be at the current level, maybe a little bit better, but only marginally.

Thank you.

Thank you.

Thanks, Dave.

Our next question comes from Steve Busch with Everglades Resources. Please proceed with your questions.

Hello, Jamie and Mike. And thank you for taking my call. Just want to say, hey, thanks for all your hard work. The last couple of years has been good to see Quantum's improvements. And so, my first kind of question on the component supplier, are they going to be able to keep up with any future growth that we have in that business, if they even just get back to the historical levels?

They will need to reach historical levels and exceed them. Historically, they have always managed to do that. Our collaboration with this supplier involves a depot, and we have never depleted it completely. We can draw as much as we need from it, and we provide them with visibility and forecasts. In the last 20 years of using this depot, we have rarely come close to emptying it, but now it is consistently empty. This indicates that if they can return to normal operations, they usually maintain enough buffer and excess inventory to accommodate large orders or growth. I believe they should be able to get back to that state, although I am not sure how quickly it will happen. It may take a few more quarters before the depot is overstocked again. However, we are receiving optimistic feedback from them about significant improvements expected in the fall. We are also waiting for the numerical commitments they will make, but they have indicated they can deliver much higher levels than we are currently receiving.

Okay. So, we don't need a second source, and there's the one anyway.

Yeah. There's no second source for this one.

Right. And so, is there a problem? You kind of mentioned, is it COVID-related?

It's a single source supplier, and many of these components are produced in Asia. When there is a COVID outbreak, they send everyone home due to government mandates. Unlike Amazon, they don't have the flexibility to continue operations during an outbreak. Some governments require that if there's a COVID outbreak, everyone must stay home for two weeks, leaving the factory inactive. This has been a significant issue. It’s a single supplier in one country, leading to a very rigid model.

Thank you for that. I'm looking at your slide today, specifically slide five of our presentation, which closely resembles the May Investor slide on page 14 that lists several customers, correct? In the May presentation, it's labeled hyperscale and webscale for data archives, including AWS, Microsoft, Google, Apple, Facebook, and others.

I believe that refers to the category of customers but is not intended to indicate that those are Quantum customers. While many in that category are our customers as well.

Correct. So, are we able to pursue any kind of ransom products that were discussed earlier? Are we seeing growth with them? Are we partnering with any companies, like AWS, to reach out to their customers for ransomware solutions?

Yeah. The solution that we're going to be bringing to market, think of it towards the end of the year, was co-designed with one of the hyperscalers.

Okay. That's good to know. And what would you say the overall market, two, three years out for that kind of product is sizable?

The short answer is we don't know. As I mentioned, it's a product that we haven't launched yet and is unique in the market. The security and anti-ransomware market is significant, but we are unsure of the percentage our products will capture. We need some time in the market to evaluate its positioning. This is a different approach than anyone has ever taken. It is completely inaccessible to hackers because the data is physically turned off and disconnected from any network. There’s no way to access it unless someone breaches the building. We believe this strategy will be interesting to observe. We've received a lot of positive feedback from analysts regarding both the anti-ransomware and cold storage services, and we plan to integrate them. When customers purchase our cold storage solution, they will also have the option for an anti-ransomware package, which ensures that their data is stored offline in a way that no technology can access it. We believe this combined offering will be very appealing, but currently, there is nothing like this on the market. We’re excited about it, but we think we’ll need a few quarters of sales data to truly understand its impact.

Right. Okay. Sounds good to me. All right. Thank you very much for your efforts.

Thank you. There are no further questions at this time. I'd like to turn the floor back over to management for any closing remarks.

Thanks everyone for joining us on today's call. I hope within the next several quarters, we won't need to discuss supply constraints anymore. I feel good. We're getting pretty positive data. That should be behind us pretty soon here. With that, thanks everyone. Mike will be sending out details about the investor conference in the October timeframe, and we'll provide a lot of updates at that time.

Ladies and gentlemen, this concludes today's webcast. You may now disconnect your lines at this time. Thank you for your participation and have a great day.