Quantum Corp /De/ Q3 FY2022 Earnings Call

Good afternoon, everyone, and thank you for participating in today's conference call to discuss Quantum's Financial Results for the Third Quarter of 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 third 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, a copy of 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 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, also 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 date 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. These risk factors include, but are not limited to, 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 the 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 would like to turn the call over to the Chairman and CEO, Jamie Lerner. Jamie?

Thank you, Brian, and thank you all for joining us today. Earlier this afternoon, we announced results for our third fiscal quarter. Revenue was $95.3 million with backlog increasing sequentially to $62 million, another quarterly record for the Company, with strong demand offset by ongoing supply chain headwinds. Our recurring revenue transition continued to accelerate with more than 255 customers utilizing Quantum's subscription solutions, up 30% sequentially and 98% year-over-year. With more products transitioning to a subscription contract, our year-over-year subscription revenues increased more than 190%. Our flat third quarter revenue results are not indicative of the true underlying demand trends in our business, which have been at historically high levels, but impacted by the unprecedented supply chain headwinds. The third fiscal quarter represents our fifth sequential quarter of bookings exceeding revenue. As Mike will discuss, we estimate that roughly $26 million of customer orders in the quarter could not be fulfilled, which had a major impact on revenue, gross margins, earnings and adjusted EBITDA. I'll discuss the supply chain situation and the actions we are taking in more detail shortly. Our hyperscale business grew meaningfully both sequentially and year-over-year despite the supply challenges and has become less lumpy over the last four quarters. Our media and entertainment vertical has begun to stabilize, while not above pre-COVID levels. Our progress within StorNext, the first point product we transitioned to a subscription model has begun to take hold. Revenues for StorNext in the third fiscal quarter were flat year-over-year, but the prior year was primarily a product sale. While this quarter, we are deferring a portion of the initial upfront revenue due to our shift towards subscriptions. The chart on the left provides a picture of how significant the increase in backlog has been over the last five quarters, while revenue has remained essentially flat. The disconnect between our reported quarterly revenue and acceleration in levels of backlog is due to the unprecedented headwinds we have faced within our supply chain. Also during the quarter, we had multiple shipping partners decide not to accept deliveries on New Year's Eve, a change from years past, which further limited our ability to ship and recognize revenue. We also saw significant cost increases for raw materials needed to fulfill customer orders, coupled with much higher levels of freight and shipping costs that were materially higher than we previously anticipated. Now let me turn to a more detailed discussion of the supply situation, which remains very dynamic with new challenges being introduced that weren't present even a few months ago. While supply of tape drives has improved for LTO-7 and LTO-8, the biggest impact to our business remains the quantity of supply, which has not yet returned to normalized levels. During the third quarter, LTO-9 tape drives started shipping, but overall supply of LTO-9 drive has been constrained due to initial manufacturing challenges, which is typical during a transition to a new version of LTO technology. This was especially notable with one of our largest hyperscale customers who converted a large order for LTO-8 drives to LTO-9 drives during the quarter and increased their order by $10 million. Due to limited availability of LTO-9 drives, this switch impacted our ability to fulfill the order and our reported revenue as our prior guidance included shipments for LTO-8-based drives to this customer. In addition to the headwinds we are facing in supply of tape drives, we are experiencing broad-based shortages of components for servers, network cards and circuit boards, very consistent with what peers in the storage industry are citing. We continue to work closely with our suppliers, as well as our contract manufacturers to mitigate current supply shortages, which as of today, we lack the visibility to state when a more normalized supply chain will return. Under these circumstances, we are immediately implementing a series of cost reduction measures. We are instituting pricing increases across our product categories, and we are focusing on supply chain and operational excellence. Some other highlights from the quarter include continued share gains in the hyperscale tape market. As of today, four of our hyperscale customers now utilize more than an exabyte of storage capacity, and we continue to view this business as a growth driver in future years. During the third fiscal quarter, we closed a multimillion-dollar video surveillance deal at a government agency, which is currently in backlog. This deal highlights our recent success at the cross-selling and up-selling occurring between Pivot3 and Quantum-based solutions. Another example of our product cross-selling success we've had to date, we sold StorNext as the subscription combined with tape to create an effective customer-friendly solution for long-term retention of surveillance data. This was a conversion win utilized by a large distributor in Southern California previously using a competitive solution. The newly deployed solution now captures surveillance data on Quantum software and uses Quantum tape for long-term retention and archiving. We believe this type of win is very repeatable and only Quantum offers this end-to-end portfolio. Also during the quarter, we closed a multimillion-dollar object storage deal with a genomics research institution and closed our first six-figure software-only object storage win at a large semiconductor manufacturer with a third-party providing the hardware component. Both customers are managing large unstructured data sets and Quantum solution offers unique value in terms of scale, durability and ease of use. It was also a solid quarter for the H-Series and F-Series within primary storage, mostly within the media and entertainment vertical. We continue to get recognized for our innovation during the quarter as our Ransom Block solution garnered two industry awards, and our solutions for ransomware protection and cyber resilience continue to resonate and gain traction in the market. Now I'd like to turn the call over to Mike to provide more detail on the results, then we can take questions.

Thank you, Jamie. Welcome, everyone, to our call today. Our third fiscal quarter of 2022 represented another quarter of strong customer demand, albeit with continued significant supply chain headwinds, as Jamie summarized earlier on this call. Revenue for the quarter was $95.3 million, up 2% sequentially. Adding to the ongoing supply chain constraints during the quarter was rising cost pressures that impacted our gross margins to a greater extent than expected. As a result of the continued strong customer demand, coupled with the supply chain constraints, the customer order backlog grew over $10 million during the quarter to $62 million from $50 million last quarter and $30 million as of June 30, 2021. Approximately $26 million of orders in the ending backlog could have been shipped to customers in the third fiscal quarter, if we would have had the support from the supply chain. This $26 million in unfulfilled orders compares to just over $15 million in unfulfilled orders in the prior quarter. Just over $50 million of the ending backlog represented tape products for which the majority was for orders from our hyperscale customers. As of today, we anticipate that the supply chain constraints will remain challenging, eliminating the Company's ability to ship against all customer demand and recognize a meaningful portion of the current backlog. During the third fiscal quarter, secondary storage revenues were up 17% sequentially, primarily driven by the increase in hyperscaler revenues as well as the improving supply of LTO-7 and LTO-8 drives that help support sequential revenue growth. Primary storage systems saw a sequential decline in revenue, down 17%, partially due to a delay in the recovery within our federal vertical combined with deferring a portion of revenue as we grow our subscription business with revenues from StorNext. The increase in devices and media during the third quarter, up 20% sequentially benefited from improved supply of certain tape drives following multiple quarters of headwinds. GAAP and non-GAAP gross margin in the third fiscal quarter was 37%, down over 4 percentage points from the prior quarter. During our call last quarter, we noted our expectations were for cost pressure that at the time, we anticipated could impact our gross margin by as much as 2 percentage points. However, during the third fiscal quarter, we experienced much higher manufacturing costs, combined with higher freight, warehouse and other logistics costs that, in total, had a more severe impact than expected on our gross margin in the quarter. Given the increasing costs in virtually all aspects of our supply chain, we are implementing another price increase this quarter. As we mentioned on the call last quarter, we implemented a 5% price increase for our products, but now feel a more substantial additional increases required to offset the rising cost environment. We expect to benefit from these price increases to take one to two quarters to gain full traction. GAAP operating expenses in the third quarter were $42.4 million compared to $39.3 million in the prior quarter. Non-GAAP operating expenses in the third fiscal quarter were $36.4 million, an increase of approximately $1 million sequentially. The increase was primarily due to inclusion of expenses related to a full quarter of Pivot3 and EnCloudEn, increased sales and marketing spend and increased investment for the development of next-generation LTO technology. These increases were partially offset by a nonrecurring benefit from reduced ERP support costs related to legacy installation that is being replaced. Given the continued pressure on revenues due to the supply chain constraints, combined with the increasing supply chain cost environment, in addition to increasing our prices, we are also implementing certain operating expense reduction programs in the fourth fiscal quarter. We expect to reduce our operating expense run rate between $1 million and $2 million during the fourth fiscal quarter. GAAP net loss in the third fiscal quarter was $11.1 million or a loss of $0.19 per share. This compares to a net loss of $9.3 million or a loss of $0.16 per share in the prior fiscal quarter, which included a debt extinguishment charge of $15 million, partially offset by a gain of $10 million for the forgiveness of the PPP loan. Excluding stock compensation, restructuring charges and nonrecurring charges, non-GAAP adjusted net loss in the third fiscal quarter was $4.6 million or a per diluted share loss of $0.07 compared to adjusted net income of $114,000 or breakeven in the prior quarter. Adjusted EBITDA in the third fiscal quarter was $0.8 million, reflecting lower-than-expected revenues and gross margins due to the unprecedented headwinds we have faced related to the supply chain constraints and related increased costs. 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 released today. Now turning to the balance sheet, liquidity and cash flows. Cash and cash equivalents and restricted cash were $4.3 million as of December 31, 2021 compared to $23.2 million on September 30, 2021. Adjusted working capital, excluding cash and deferred revenue balances increased by $6.5 million during the third fiscal quarter to $62.3 million from $55.8 million at the end of the prior fiscal quarter. This increase was primarily the result of an increase in accounts receivable, inventories and other current assets, partially offset by an increase in accounts payable. Outstanding debt as of December 31, 2021, was $101.7 million after netting $4.6 million in unamortized debt issuance costs compared to $104.5 million of outstanding debt as of September 30, 2021, after netting $4.9 million in unamortized debt issuance costs. To summarize the $18.9 million decrease of cash of net cash used during the quarter, over half of the net use of cash was the net increase in working capital and net paydown of debt. With the remaining use primarily related to the EnCloudEn acquisition of $2.8 million, net cash used by operating activities of $2 million, excluding changes in assets and liabilities and $1.6 million of CapEx for the quarter. As of the end of the third fiscal quarter, we remained in compliance with all debt covenants. But given our current expectations that the supply chain disruptions we have experienced in the last four quarters will continue in the foreseeable future. We have begun to work with our lenders to address any potential future covenant compliance issues, as well as any potential need for additional liquidity. We believe this is simply the prudent course to take at this time to get in front of any potential issues as we attempt to work through and address headwinds from the supply chain. Finally, turning to our financial outlook. We do expect continued pressure on revenues due to supply chain constraints, combined with the increasing supply chain cost environment. To a lesser extent, we also have lower seasonal demand in the fourth fiscal quarter. Taking these factors into consideration for the fourth fiscal quarter of 2022, we are guiding revenues of $92 million, plus or minus $5 million; non-GAAP adjusted net loss of $4 million, plus or minus $1 million. Non-GAAP adjusted net loss per share of $0.07, plus or minus $0.02 and adjusted EBITDA of breakeven plus or minus $1 million. With that, I'll turn the call back to Jamie for closing comments.

Thanks, Mike. We believe the underlying demand trends in our business, strong order flow and record levels of backlog reflect the positive momentum of our business transformation. Bookings outgrew revenue for the fifth consecutive quarter, and we continue to drive growth across our hyperscale business, demonstrating the value we're delivering for these leading-edge customers. We are also closing a higher number of deals, both in number and dollar value across a larger customer base. And we are continuing to convert more customers to a software subscription-based model. Our business is being limited by this unprecedented supply chain environment, and we are working diligently with our suppliers to manage the situation as effectively as possible. The Quantum team remains committed to delivering continued order momentum, and we are well prepared to exit these constraints at a much higher velocity than just a few quarters ago. With that, we will now take any questions you may have.

Thank you. At this time, we will be conducting a question-and-answer session. Our first question is from Craig Ellis of B. Riley. Please proceed with your question.

I wanted to make sure I understood the variance on revenues to start. So I think I heard that there was a $10 million LTO-8 to LTO-9 customer order change issue that impacted sales. Are you saying that, that was the reason that revenues were so materially below the guidance midpoint or is that plus other issues? Can you Mike, just give us a buildup of what the specifics were between, where the guidance midpoint was and where revenue shook up?

Sure, when you look at the guidance of $104 million going to $95 million, really it was supply chain issues, which we knew going in. But really what was different within the quarter was the transition from LTO-8 to LTO-9 was one big issue, where we had forecasted more LTO-8 revenue, but we had customers that were changing their orders from LTO-8 to LTO-9, and we were constrained in LTO-9. So that was one significant difference or issue that drove the decline. And the other really is a more broad-based shortage of components, servers, network cards, circuit boards to a greater extent than we had experienced in the prior quarter. And really what's the other significant contributor to the revenue shortfall from the midpoint.

As a follow-up to that and before my second question then, can you just comment on how confident you are in the businesses' ability to forecast demand levels and forecast component needs and really align forecast to customer desires. They're absolutely component constraints out there, and everybody is facing them, but it seems to be impacting Quantum, particularly abruptly in the most recent quarter?

Yes, Craig, I can address that. We have made a notable shift from our previous forecasting approach. This shift occurs on several fronts. Initially, we used to predict demand based on anticipated parts arrivals. Now, we are basing forecasts on deals we have already secured and on inventory that we currently possess, which includes parts that are either on hand or en route. We have encountered numerous de-commitments and missed delivery schedules from our suppliers, as well as pricing discrepancies. Consequently, our forecasts now rely significantly on existing orders and available inventory, which enhances our accuracy. In addition, we are fundamentally redesigning our products and the components used within them. Many vendors, such as Cisco and Ford, are experiencing supply chain challenges. Unlike them, we do not have the same purchasing power, so we are adapting our designs to incorporate more widely available components at lower prices. This strategy allows us to circumvent competing for supply chain attention against larger companies. By implementing a more cautious forecasting method and adjusting our product designs for better component availability, we aim to improve our outcomes. Overall, we are adopting a more conservative approach than we used to.

And then the second question, Mike, I want to couple to speak items on the income statement. So gross margins, you were clear that you've got cost pressures, a range of them that have caused gross margin to be down 400 basis points in the quarter. The question is this, when do you expect a material improvement in gross margins? And when would you expect that we could see adjusted EBITDA move materially back into the black?

We have increased our prices by 5% across all our products, and with the additional increases this quarter, we plan to implement further hikes that will likely exceed 10 points. The challenge lies in the timing since we have outstanding quotes and purchase orders. If the quotes aren't accepted, we can revise them to reflect the higher prices. For some of our larger contracts, we have the flexibility to renegotiate prices in response to significant cost increases. This gives us some immediate leverage, but I estimate it will take one to two quarters to fully realize the effects due to existing quotes and ongoing business before we can effectively implement the new prices and see the advantages.

So are you saying that you can proceed?

And then, the second part of your question was EBITDA.

Yes.

When we examine the EBITDA roll forward, we had an expectation of $5 million this quarter. However, due to lower revenue, we experienced a loss of $3.3 million in EBITDA, and with the EBITDA margin decreasing from 39% to 37%, we faced an additional loss of 1.9%. This led to a total decline of 5.2% based on the quarter's results, although we recorded $0.8 million. If we had reached that expected level, we would have come in at $6 million. Our priority is to navigate through the supply chain constraints, although forecasting when this will end is challenging. In the meantime, we are adjusting our pricing to improve gross margins irrespective of revenue levels and implementing cost reduction measures that will amount to $1 million to $2 million in Q4. We believe these actions will help mitigate the EBITDA shortfall.

Our next question is from Nehal Chokshi of Northland Capital Markets. Please proceed with your question.

So given the supply chain limitations, it feels almost useful us to talk about revenue. The much more important thing here is bookings, and thank you for being transparent about the bookings for the December quarter, but what do you expect for the March quarter as far as bookings go?

We expect another quarter where bookings will exceed revenue. We do not anticipate a significant decrease in the backlog, which indicates strong booking performance. We aimed for a growth rate of 15% to 20% in our hyperscaler business, which we initially thought was ambitious, but we've more than doubled that rate at this time. We had set a minimum target of $8 million in annual recurring revenue by March 31, and we will either meet or surpass that goal. Additionally, we set a target of $160 million in recurring revenue, which we will also exceed by the end of this year. We are experiencing strong bookings, which is an unusual feeling because we are achieving some of the best sales results the company has seen in many years across various sectors such as video surveillance and object storage. However, we are struggling to fulfill those orders. We will continue to focus on driving bookings, increasing our backlog, and expanding our subscription customer base, which is performing well. The transition is going smoothly, and our new products are gaining traction, particularly the Ransom Block, which was recognized as this year's coolest storage product. We feel optimistic about that aspect of the business. However, we need to reduce costs, gain better control over pricing, and manage our supply of materials to navigate this challenging period. Once we get through this, there is no doubt that we will emerge as a larger revenue-generating company than we were before. The strength of our bookings is evident when you consider the $95 million we achieved and add the $26 million we couldn't ship, or even when you look at the increased backlog. Regardless of how you analyze the quarter, it's clear that we are selling significantly above historical levels. I'm concerned about the need to gain better control over our materials and pricing, and until that is resolved, we need to manage our costs internally to adapt to a better supply environment.

Right understood. By the way, what is the EBITDA covenant that you guys are going to proactively work towards making sure there's no issue with?

I'm sorry, I'm not sure we got your question.

So I believe there are typically some debt covenants related to EBITDA; what is the actual debt covenant on EBITDA?

The covenants, we don't have an EBITDA covenant strict EBITDA covenant. We've got leverage covenants, fixed charges ratio covenant. We were okay at the end of the quarter. We'll work with our lenders and to the extent that we need any kind of a waiver or need to work with them. We're highly confident that we'll be able to negotiate and work with some lenders on that.

Understood. Do you happen to know what are those levers and fixed charge ratios that must be met?

Yes, I mean it's roughly three times. I don't have it right in front of me, right. But we met them at the end of the quarter, and we'll work closely with the bank to see how our forecast look and stay ahead of it.

Okay. And then, yes, it's great to see continued traction with the subscription customers. I think you said in the press release, it was subscription customers were up 30% Q-o-Q. Your deferred revenue, though, was up only $0.4 million Q-o-Q and a de minimis amount in terms of percentage. How does that reconcile between the big increase in subscription customers on Q-o-Q basis, but we're not seeing that in the 4Q in terms of deferred revenue?

Yes, there's a certain seasonality in the contracts and signing up the contracts. So in the December quarter, it's a little bit slower, and you'll see that peak in the March quarter since everyone kind of coming over the calendar year and then signing up their new contracts. So it's just a bit of a seasonality because it's based on cash, right, cash receipts.

Our next question is from George Iwanyc of Oppenheimer. Please proceed with your question.

Jamie, maybe you can dig into the primary storage trends a little bit deeper. Can you give us a sense of how much the pressure you're seeing there is from supply chain? How much was the federal vertical dynamics as well as what you're seeing with that subscription transition?

Yes, as I mentioned in my comments, the media and entertainment business, I think, is strengthened. It's not at pre-COVID levels, but it is, I would say, within 10% or 15% of pre-COVID levels. So I think that has recovered relatively well. I think we've gotten stronger at selling StorNext into other verticals, healthcare, surveillance, life sciences. And so, I also think we have a series of new products. We launched StorNext 7 running on Amazon Cloud and AWS. We also did major upgrades to the H2000, H4000 and now we've launched the H4000 Essentials, which is StorNext combined with CatDV in a single appliance. So I'm seeing the sales momentum pick up in those products. We do have supply constraint. We didn't use to. But now we're just getting much longer lead times sometimes as much as five months for just a server, waiting on network cards, power supplies, things of that kind. One of the issues is when you ship to the U.S. government, you need to ship a server that has its whole chain of custody understood. And to get those systems quoted, ordered and shipped, that cycle time has now gone in the five- and six-month level. So what's happening in the government is even though we're getting strong orders, chain of custody based systems where they're entirely ensured that they were either entirely made in the United States or no one never touched them while they are outside the United States, the supply chain turnaround on that is much longer. So we are seeing supply chain headwinds there, but very strong order strength in the business.

And with the Pivot3 assets and what you're doing on the video surveillance side, can you give us an update there? How is the customer engagement going? What are you seeing from a cross-sell perspective?

Yes, I'm really encouraged. As I mentioned in my comments, we closed a $4 million surveillance deal with a government entity. Previously, we didn't have the technology to pursue opportunities like that. The Pivot3 business is performing better than anticipated. We created a three-year forecast before acquiring the business and are surpassing it in terms of bookings, although we're struggling to fulfill all those orders. In the past, we would receive servers we ordered within two to three weeks, but that's no longer the case. However, from a bookings perspective, Pivot3 is ahead of our plans, and I feel very positive about that business. Like our other operations, we're just facing challenges with materials and need to ship products.

Yes, I mean some of the cost savings we're doing unless you repeat them, such as a shutdown, right you need to do other measures. And we've got other measures in place as well. But yes, I mean you're thinking of it correctly.

Our next question is from Eric Martinuzzi of Lake Street Capital Markets. Please proceed with your question.

I wanted to delve deeper into the cost cuts. In the press release, you mentioned cost reduction measures across different product categories. Does this mean you are eliminating certain products that haven't been very productive due to low demand, or are the reductions primarily focused on personnel with widespread cuts to capital and operating expenses? What is the main focus of these reductions?

We are planning price increases across all product lines. Last quarter, we announced a 5% increase, and now we're implementing a more comprehensive program that should average around 10 additional percentage points. This aims to improve our gross margins in light of rising costs. Our cost reduction initiatives include shutting down certain operations and examining all discretionary spending, temporary employees, and contractors. We review all contracts for opportunities to renegotiate or postpone commitments. We consistently look for ways to optimize our expenses. For example, we recently moved out of our largest and most expensive facility, which will lead to benefits moving forward, particularly since we plan to sign a much smaller lease in that area. We continuously analyze various facets of our spending to reduce costs, and we also focus on leveraging lower-cost geographies. We have successfully transitioned some back-office functions to offshore locations, which remains a continuous effort on our part.

And this $1 million to $2 million savings in Q4. If I'm starting from a Q3 OpEx of $36.4 million and that includes EnCloudEn, and that includes Pivot3. Is that then to say that this $36.4 million maybe gets reduced by $1.5 million and so $35 million is the new run rate and that we get that kind of $4 million to $8 million of annualized savings. Is that the right way to think of that?

Yes, I mean some of the cost savings we're doing unless you repeat them, such as a shutdown, right you need to do other measures. And we've got other measures in place as well. But yes, I mean you're thinking of it correctly.

Okay. And then my last question on the supply chain issues. I know we don't have a real large sample set here. But from my experience, the de-commits can be driven by a couple of things. One can be your supplier is shopping that supply to get a better price, and you weren't able to meet the better price or it can be, they just didn't have it even though they had committed to you. So I'm just wondering if behavior on de-commits has changed in 2022 versus calendar 2021?

Yes, I believe it has changed. We have been receiving some products consistently for over 20 years, but our suppliers have now informed us that they will no longer produce certain items because they are shifting to more profitable products. Some parts we ordered over a year ago are no longer available, and we are seeing suppliers significantly increase prices, with one partner providing only six weeks' notice of a 25% price hike. This trend is becoming more frequent and happening more rapidly, prompting us to act quickly on price adjustments. We are also removing problematic components from our products instead of negotiating for them, as we lack the bargaining power of larger companies. Instead, we are redesigning our products to include components that are easier to source.

Okay. And I said that was my last one, but I do have one more a risk of substitution for Quantum product, specifically in the hyperscalers. I'm thinking they kind of designed for Quantum. So this is very low risk, but any behavior there that would indicate otherwise?

Yes, I mean it is a theoretical possibility. I want to recognize that. I have not seen any order switching, order cancellation because most of the components that are in short supply are made by a single supplier. So no other supplier is advantaged. So I have not seen people flip flopping orders to other suppliers so far.

Our next question is from Craig Ellis of B. Riley. Please proceed with your question.

Thanks for taking the follow-up. Mike, I wanted to just touch on the trends in the service revenue line. So we had a nice gradual climb as we were going from late fiscal '21 through the fiscal second quarter of '22. And in December, we pulled back a little bit. Can you just talk about some of the puts and takes that we saw in services in the quarter? And do you expect that we'll get back on that growth slide plant or where do we go from here in services?

Yes, similar to signing new contracts, there is some seasonality involved; if contracts aren't signed, we can't recognize the revenue. Historically, there's been a bit of seasonality in this area. We also have consistent efforts to improve our performance. Moreover, we are onboarding new services and expanding in other areas. So, it creates a balance along with a slight seasonal effect.

And is there any impact from supply chain there is any parts or components, spares, et cetera, in that line is that all true services?

Yes, it doesn't have a material impact. It did affect our costs, where we saw some of our costs increase due to decreased margins, but it didn't really affect our top line.

And so just on that margin point, I think 57% in the quarter, a year ago we were at 60%. What's your expectation for the margin trajectory in services from here?

We have programs in place to reduce costs on the gross margin side, but these initiatives are more challenging and take longer to implement. Therefore, we will primarily focus on pricing. We are looking at raising our service prices, which essentially means we will be discounting less. We will do our best to improve margins and aim to get back to 60%.

And how would you break out the drivers to the decrease from 60% to 57%?

We have a repair organization, and we saw an increase in repair costs, warehousing costs, and overall logistics for our spares organization. These were some of the main areas where costs rose.

Got it. And it's just better execution on those variables to drive it back to 50?

Yes.

We have reached the end of the question-and-answer session. I will now turn the call back over to Jamie Lerner for closing remarks.

Thank you. While our bookings were at the highest level they've been at in years, we have to recognize that the global supply situation put us in a position where the results have fallen beneath all of our expectations. But I'm confident in the underlying strength of this business. Our bookings levels, our hyperscaler wins, the strides we're making in video surveillance, tell me that we have a growing business. Now I'm also realistic. We've got to make some very, very quick cost cutting and sizable cost cutting. We've got to get our pricing in line with what our suppliers are doing with many of our components going up as much as 25%. And we've got to work very hard with our suppliers to make sure we get our fair share of componentry. But I think we can take those measures. We can do them quickly and see this to the other side of the supply chain. And when we do, I think Quantum is going to be a larger company, a better company and a bigger company, but we've got a few tough quarters to get through, and we're taking the measures to see that the Company can do that in a healthy way. With that, thanks everyone, for attending today.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.