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NetLogic Microsystems, Inc. (NASDAQ:NETL)

Q3 2008 Earnings Call Transcript

October 28, 2008, 4:45 pm ET

Executives

Leslie Green – IR, Communications Consulting, LLC

Ron Jankov – President and CEO

Mike Tate – VP and CFO

Analysts

Adam Benjamin [ph]

Arnab Chanda – Deutsche Bank

Ruben Roy – Pacific Crest Equities

Nicholas Aberle – Caris & Co.

Sandy Harrison – Signal Hill

Matt Robison – Pacific Growth Equities

Kevin Cassidy – Thomas Weisel Partners

Gary Mobley – Piper Jaffray

Suji De Silva – Kaufman Bros.

Dan Moves [ph] – Oppenheimer

Cody Acree – Stifel Nicolaus

Romit Shah – Barclays Capital

Operator

Good afternoon, and welcome to NetLogic Microsystems' third quarter 2008 financial results conference call. Leading the call today are Ron Jankov, President and Chief Executive Officer; Mike Tate, Vice President and Chief Financial Officer. My name is Latrice [ph]. I will be your coordinator for today’s call. (Operator instructions)

I would like to now turn the call over to Leslie Green, Investor Relations for NetLogic Microsystems. Please proceed ma’am. Pardon the interruption. This is the operator. Ms. Leslie Green, you may proceed.

Leslie Green

Thank you, Latrice, and good afternoon, everyone. Please note that our third quarter 2008 results were disseminated by Business Wire after market close today and a copy of the release can be downloaded from our website at netlogicmicro.com.

Before we get started with our financial results for the third quarter, I would like to point out that during the course of this conference call, we will be making forward-looking statements that are based on certain assumptions and expectations of future events that are subject to a number of risks and uncertainties, and actual results may differ materially.

For a discussion of such risks and uncertainties, please see today's earnings release, the risk factors in our Form 10-K, filed on March 14, 2008, and Form 10-Q, filed on May 7 and August 6, 2008, as well as other reports that the Company files from time to time with the SEC.

All forward-looking statements are qualified in their entirety by this cautionary statement, and the Company undertakes no obligation to publicly update forward-looking statements for any reason, except as required by law, even as new information becomes available or other events occur in the future.

Also on the call we will be making reference to non-GAAP financial measures. A reconciliation of non-GAAP to GAAP financial information is in today's earnings release. The reconciling items between GAAP and non-GAAP are stock-based compensation, amortization of intangible assets, and a fair-value adjustment for the inventory acquired. These items have been removed from the cost of revenue and operating expenses for non-GAAP reporting.

I will now turn the call over to Mike Tate to discuss our third quarter results. Mike?

Mike Tate

Thank you, Leslie. Good afternoon, everyone. Today we reported that revenue for the third quarter of 2008 was $38.3 million, which was consistent with our previous guidance of $38.3 million. Q3 revenues grew 5% sequentially, from $36.5 million for the second quarter of 2008 and 39% from $27.5 million for Q3 of the prior year.

Revenue from Cisco Systems, our largest customer, was $13.9 million or 36% of our total revenue, compared with $16.3 million or 45% of our total revenue for Q2 2008. The $13.9 million was lower than our expected amount due primarily to a drop off in product polls [ph] late in the quarter.

Revenues from Alcatel-Lucent were 10% of revenue in Q3, which represented growth from the second quarter. We did not have any customers about 10% of our revenues in the third quarter.

Our Q3 non-Cisco revenues were down by about 21% in the third quarter, reflecting the continued strong adoption of our products and our continued revenue of diversification.

Our non-GAAP gross margins for the third quarter were 66.2%, which excludes stock-based compensation expense, the fair value adjustments related to the inventory acquired from Cypress Semiconductor in Valeros and the amortization of intangible assets. There is a complete reconciliation between GAAP and non-GAAP gross margins in today's earnings release.

Our Q3 non-GAAP gross margin was ahead of our guided gross margins of 66%, given our continued strong manufacturing execution and improved product mix. Q3 GAAP operating expenses were $20.8 million, which included $4.4 million of stock-based compensation and $300,000 for the amortization of intangible assets. This compares with GAAP operating expenses of $18.6 million for the second quarter of 2008, which includes approximately $3 million of stock-based compensation and $300,000 for the amortization of intangible assets.

Non-GAAP R&D expenses were $10.9 million for Q3, as compared with $10.6 million for Q2. Non-GAAP SG&A expenses, excluding stock-based compensation and the amortization of intangible assets were $5.2 million for Q3, as compared with $4.7 million for Q2.

Total non-GAAP operating expenses during Q3 were $16.1 million, compared with $15.3 million for Q2 2008. This compares favorably with the $16.2 million that we guided to last call.

Q3 interest and other income was approximately $400,000, compared with our guidance of $300,000. Our Q3 tax provision was a benefit of approximately $200,000 and reflects the current positive mix of our foreign and domestic book income and losses.

On a GAAP basis, our Q3 net income was $1.3 million or $0.06 per diluted shared, compared with net income of $2.3 million or $0.10 per diluted share for Q2 2008. Non-GAAP net income for Q3 was $9.8 million or $0.42 per share, compared with $9.2 million or $0.40 per share, for Q2 2008.

We had fully diluted shares of 22.8 million on a GAAP basis and 23.5 million on a non-GAAP basis. With respect to the balance sheet, cash and cash equivalents increased by $12.3 million in Q3, to end the quarter at $85.9 million, compared with the $73.7 million at the end of the prior quarter.

The increase in cash was the result of the continued positive cash flows from operations during the quarter. Our accounts receivable was flat in dollars at $14.7 million and represented 35 days.

Third quarter net inventory decreased by $1.7 million and was at $14.4 million, compared with $16.1 million at the end of Q2.

This concludes my review of the quarterly results, and now I would like to turn the call over to Ron.

Ron Jankov

Thank you, Mike. We are very pleased with our record Q3 results. Q3 was another strong quarter of revenue growth with further customer and revenue diversification and a record level of design wins. The continued growth of IP traffic coupled with the increasing speed and complexity of converged networks are presenting us with tremendous opportunity to broaden the reach of our advanced product portfolio as well as expand our customer base. We continue to believe that our long-term growth prospects are stronger today than ever before.

In the near term, we are closely monitoring the repercussions of a weakened global economy and its impact on our existing run rate design. Clearly with the recent economic slowdown it is appropriate to be very cautious and monitor the demand environment closely. Although we are not immune to an industry slowdown, our strong business model and industry leading technology positions us well to expand our leadership and competitive leadership during these challenging times and emerge even stronger as the business markets normalize.

To highlight the strengths of our business model, it is important to note that most of our products are full custom products with significant competitive advantages and in some cases with no competitive equivalent part available. As a result, many of our design wins are sole sourced allowing us to command premium value for the unique capabilities we provide for our customers. Our design cycles are long which also result in a product life that is on average five to seven years.

In addition to these long development and production cycle there is stickiness [ph] to our designs based on the large amount of engineering resources, previously and currently being invested by our customers to take advantage of our unique hardware and software functionality. Because of this huge investment, we’re seeing our customers look to leverage this investment by replicating these designs across multiple system designs and porting them to your international design locations.

Our long-term gross margin target is 65%. Given our fabulous model, the value of our products, the longer design cycles and our operational execution, we believe our margins to sustain the current level even in the weakened economy. Also we’re generating very healthy cash flows. For Q3 our free cash flow of $11.6 million represented 30% of our revenue. For the first nine months of the year our operating cash flow of $32.8 million is up 94% year-over-year.

While we will not be slowing down our product development efforts including our development of 40 nanometer product designs we will be very prudent on all discretionary spending to further control operating expenses in this environment, which will allow us to continue to generate strong free cash flows.

Our superior product roadmap and engineering execution has positioned us strongly in our target market. Over the last 24 months we have greatly broadened our product portfolio including the NL 6000, NL7000, NL 8000 and NL 9000 families of advanced knowledge-based processors. The NETL7 family of deep packet inspection Layer 7 processors, our second generation NETLite processors and a complete suite of 10-gigabit PHY products.

We also have multiple chipsets of 55 nanometer process node something not offered by our competition. Much of his development is the result of our customers challenging us to further extend the capability of our products to meet rapidly increasing bandwidth and performance requirements of the network. A great example of this is our most recent announcement of the NFL 91024XT, the third member in our revolutionary NL 9000 hybrid knowledge-based processor family. This is our most advanced KBP introduced today and is able to achieve an industry best 1.5 billion decisions per second and even lower power given its hybrid architecture.

Our aggressive product development has allowed us to increase the competitive differentiation of our portfolio and to maintain higher ASPs while we offer our customers unique solutions to meet their aggressive roadmap. What is particularly exciting is that the R&D investment for all of these announced products is behind us but the revenue ramp associated with the significant number of design wins we have been awarded is still to come.

It is for these reasons that we believe that we are well positioned to weather the challenges that the current macroeconomic environment presents. However, in the near term the current financial conditions had impacted demand especially in the enterprise market. In October we had seen some softness from certain customers including two of our top three customers. In addition, due to some demand weakness we’re working with both of these customers on an inventory rebalancing in Q4.

As a result our Q4 revenues are expected to decline from Q3. However, we continue to see good momentum and strength from a broadening base of other customers which helps to partially offset this softness. Excluding the revenues of these two large customers the remaining revenues are expected to grow in Q4 by more than 10% sequentially following a quarter when the revenues from this group were up 22%. This continued strength is being driven by a combination of brand new customers, product ramping for the first time, and the relative health of the following key markets.

First, are very successful penetration of the designs in the advanced mobile wireless infrastructure market is beginning to show meaningful return several quarters ahead of our earlier expectation. Based on the strong demand for video and smart phones from Apple, RIM, Samsung, Nokia and others; carriers are upgrading their advanced 3G networks in order to ensure that the user experience for these devices meets expectations and is competitive with other carrier networks. As a result our existing customers that service this market such as Alcatel-Lucent are currently seeing strong demand to support these needs. In addition throughout 2009 we expect to see emerging NetLogic customers into this space such as Ericsson, Nokia, Tellabs, and ZTE become greater contributors to our revenue base. Further, our design wins in this space continue to grow as our customers accelerate their efforts to meet the increased complexity of the mobile wireless infrastructure market.

Second, we’re also very pleased to report that in the fourth quarter we expect to see good revenue growth in our NETL7 family of deep packet inspection Layer 7 processors. We’re seeing growing need for deeper packet inspection at many points across the network as networks try to handle ever increasing data and video traffic. Deep packet inspection is increasingly required to secure the network and enhance its efficiency by adding application level routing intelligence. We’re perfectly positioned to capture these emerging opportunities given our unique and expanding portfolio and market leadership in layer 7 processing.

On our broad product ranging from the needs of SMB firewalls with our low power low cost single chip solution to our recently announced industry best 20-gigabit solutions they are able to serve the entire breath of these new application. The NLS205, which was announced only six months ago to address high volume applications will begin to generate meaningful revenue in Q4 and is expected to continue to ramp over the coming quarters.

Also to extend our leadership in the high end, yesterday we announced the availability of our NLS2000 which provides up to 20 gigabit per second of deep packet inspection performance to expand advanced Layer 7 applications such as intrusion prevention, antivirus, anti spam and application identification.

Looking to 2009, these trends should continue to build momentum. In addition 2009 revenue should also benefit from the growth of 10 gigabit Ethernet. While the enterprise market as a whole appears to be experiencing some softness due to the macro environment there continues to be solid increases in the number of 10 gigabit ports as enterprises and data centers upgrade these systems in order to accommodate a multitude of video and virtualization applications representing in many cases new term for our both our knowledge-based processor families and our physical layer products.

For our physical layer products the transition from the legacy larger XENPAC modules to the low power, smaller form factor X2 module continues to be solidly underway. We hold a sizable market lead for these designs based on our industry leading power and footprint. Also our design win success continues strongly across all of our physical layer products including significant wins for the emerging SFP plus application.

2009 revenues should also benefit from the launch of a large number of NETLite designs that we have one over the past few quarters. These designs are expected to begin to contribute revenue in Q1. The success that we have seen for our NETLite processors is broad based as many entry level systems upgrade to the use of knowledge based processors for the first time expanding the term for our products.

During 2009 we’ll be shifting into a host of applications including enterprise desktop switches, aggregation boxes for GPON, cable and DSL and universal media gateways. Another promising area for 2009 is wire line telecommunications and cable. Even in poor economic conditions the growth of data, voice, and video traffic continues at a strong pace. Equipment needed to support this increased traffic and complexity requires an increased level of knowledge-based processors. We’re seeing the benefit of this trend as new equipment either incorporates knowledge-based processors for the first time or existing equipment upgrades to higher content per system.

This is a visible to us by the ramp of a growing number of new NL7000 and NL 9000 carrier boxes. They will be rolling out in 2009 from customer such as Alcatel-Lucent, ALAXALA, Cisco, Ericsson, Fujitsu, Huawei, Nokia, Tellabs and ZTE as well as the ramp of new cable boxes from Motorola and Cisco.

In closing, we will continue to execute on our aggressive roadmap to even further deepen our relationships with our existing customers. Our broadening product portfolio is taking us into new customers and new markets that are significantly expanding our term resulting in a record design win pipeline.

This continued adoption of our technology across a diversified customer and end-market base positions us well for many positive long-term trends. Also the proprietary and strategic nature of our products enables us to drive a premium value and maintain favorable margins providing us with a strong business model which allows us to make investments in to our technology but remain prudent on total spending and delivering strong cash flow. As a result our competitive positioning and breath of market opportunities will continue to expand thereby enhancing our growth profile when the economic backdrop improves.

At this point, I will turn the call over to Mike to discuss guidance for the fourth quarter. Then we will open up the call for your questions. Mike.

Mike Tate

Thanks Ron. As we look into Q4, given the current economic backdrop, we will continue to be conservative in terms of our revenue guidance. Additionally, although we will not slow down our development of advanced products we will work extra hard to control discretionary spending to minimize the total growth of operating expenses in this environment.

For Q4, as Ron mentioned based on October activity to date and current inventory levels we expect two of our top three customers to sequentially decline. This will be partially offset by an expected increase in revenues from newly ramping products and markets including the L7 and mobile wireless infrastructure.

Based on our backlog coverage, we expect revenues to decrease to $36.1 million, representing an approximate 6% sequential decline from Q3. Our Q4 revenue guidance reflects favorable sales linearity based on October shipments to date and full backlog coverage for the rest of the quarter.

We expect non-GAAP gross margins to increase to 67% from the 66.2% reported in Q3. The increase in gross margins is due to continued strong operational execution as well as favorable product mix. We expect non-GAAP operating expenses to decrease to approximately $16 million, non-GAAP R&D expenses to be approximately $11.3 million and non-GAAP SG&A to be approximately $4.7 million.

Also in Q4, we expect interest and other income to be approximately $300,000. The decrease reflects a decline in interest rates given our very conservative investment portfolio. We expect our tax provision to be a benefit for Q4 by approximately $200,000, which includes a benefit of the reinstated Federal R&D tax credit. We expect non-GAAP EPS for the fourth quarter to be $0.37 per share. We expect our GAAP EPS for the fourth quarter to be $0.02 per share. This includes an estimated $4.7 million in FAS-123R stock-based compensation, $3.3 million in the amortization of intangible assets, and $100,000 in the fair-value adjustment for acquired inventory.

Finally, we expect our GAAP share count to be approximately 22.7 million and the non-GAAP share count to be approximately 23.4 million in Q4. This concludes our prepared remarks for the call and now we would like to turn the call over to questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from the line of Adam Benjamin [ph]. Please proceed sir.

Adam Benjamin

Thanks guys. With regards to Cisco, can you talk a little bit about the Cypress or desktop switching business you acquired there as a percentage of the total there and how much of that had an impact on your weakness at the end of the September quarter?

Ron Jankov

Hi Adam. I don’t think we’re going to break that out specifically I would highlight that the – we’re seeing a decline in the existing runway [ph] designs which includes both the business we acquired from Cypress as well as some of our NL 5000 programs and softness kind of played out towards the end of September and also continued in October. So with that we are taking a conservative view on Cisco going forward for the balance of Q4 and had them down. It also appears that there is a work down of inventories at board level going on as well that could be magnifying what we’re seeing here in Q4. And then finally just that where we sit right now in regards to new product designs we do have are lull of activity where we still have a pretty good portfolio of designs that are pending to ramp and that positions us well coming out into 2009.

Adam Benjamin

So at this point you feel pretty good about the 7600 starting in the March quarter?

Ron Jankov

Yes, just – it appears that the NL 7000 designs in particular should be good in the first half and then we still have I think it is about 19 designs pending. So it should get a pretty good amount in the first half going into the – building throughout the year.

Adam Benjamin

Okay and just on OpEx Mike, obviously you guys saw some weakness as others have had seen as well and you are guiding for pretty flat OpEx. As you look out into 2009 in terms of what you need to spend on take outs and new product initiatives, you know, how much control do you have over that line item in terms of keeping it a relatively flat going forward?

Mike Tate

Yes. We’re going to continue to be executing to our product roadmap which includes moving to 40 nanometers. You know the good thing for us is we have been phasing out 55 nanometer. That is on a big incremental step up to go to 40 nanometer. And so that will start in 2009 but we think there is good opportunity for other areas of discretionary spending where we keep OpEx growth pretty well contained. So it should be very nominal growth in Q1 and then a little incremental after that.

Ron Jankov

Also the engineering success of the 55 nanometer products that we have done this year also puts us in a good position because we don’t have to spend more money to re-spin those designs and most of the cost of the 55 nanometer development will be behind us in 2008. So that helps as well.

Adam Benjamin

Great and just one last question on gross margin. I know you guys have been hesitant to talk about gross margin you know much higher than the long term target of 65 but you have tracked above that all of ’08 and now your guidance is significantly above that. You know can you talk about where you think that could be going forward. I mean, is this realistic to stay in these levels or do you have kind of a one quarter benefit here that you are seeing in q4 that you expect to trend back down towards the 65 or should we think about it little bit higher going forward.

Mike Tate

Okay, right now we’re seeing the benefits good operation and execution, as well as you know kind of an increased contribution for the non Cisco revenues. You know, as we look into 2009 we’re excited by the fact that we’re going to see increased contribution of these 55 nanometer parts which also helped to contribute. You know at this time we’re not ready to change the long-term model but in the near term we feel good about kind of holding in the levels about the 65%.

Adam Benjamin

All right guys. That is all I have. Thanks.

Mike Tate

Thanks.

Operator

And our next question comes from the line of Arnab Chanda with Deutsche Bank. Please proceed sir.

Arnab Chanda – Deutsche Bank

Thank you. A couple of questions either for Ron or for Mike, you said that use weakness in two customers, the top customers but the other customers are growing. Are there some different dynamics there or is that’s just a question of your two top customers are little bit earlier making the adjustments. The others will do that. I don’t know if you can predict that somehow, but I will be curious, and I have a couple of follow ups?

Ron Jankov

Yes the dynamic is different is in the case of kind of everybody but those two customers. We had some new programs ramp that are ramping in Q4, for example, the mobile wireless infrastructure space, the NETL7 space, these are brand new designs that haven’t contributed at all. So they they’re coming off a serial base which is kind of easy to grow from. I wish it has the biggest dynamic. At those two big customers it just happens to be a quarter, Q4 is a quarter where we don’t have anything ramping so that is part of why the softness is a little bit more accented there. So really again our growth tends to hit that we have programs ramping.

Arnab Chanda – Deutsche Bank

Okay great. Second question, if you look at your products, product areas it seems like NETL7 is starting to create some benefit that. What are you seeing in that product line next year? I think you have talked about design wins for your node based processors Gen 4 et cetera as well as for desktop switchings. I will be curious on that area as well as the 10-gigabit areas what do you see in 2009?

Ron Jankov

Well I think these new products are going to be solid growth for us in 2009. Just to go kind of go through them, the NETL7 it is just getting started. So we should see steady growth from that product and we continue to bring out new products we brought out two about six months ago, the two single chips and we brought out another 20-gigabit solution and the strong interest in traction of all three of those products. So, I would expect steady growth in NETL7 next year. You didn’t mention NETLite but NETLite is getting ready to kick in. We’re starting to see some preproduction here in Q4. We’re already seeing some volume orders lineup for Q1. So that is good and the 55 nanometer parts as well either the Gen 4 stuff or the NL 7000 again across the board particularly in mobile wireless should grow nicely next year.

Arnab Chanda – Deutsche Bank

Okay great and then one other question I think Adam kind of talked about this a little bit but just from a different angle of the gross margins obviously you’re executions have been good, you have a good mix et cetera. Has there been any change in the competitive landscape whether within Cisco or outside that is changing kind of a competitiveness of this product line. How are you seeing competitions in where you do see it today?

Ron Jankov

Well I think the change in our gross margins is not a direct impact of competition you know the sockets that we win continue to be one to date 12 to 24 months to win a design and then there in production for many years. So I don’t really see the competitive dynamics as what is driving our gross margins up. I would say really two things that Mike mentioned. We’re doing a really good job on manufacturing execution and probably this includes the fact that we have gone down the process node so quickly we really have a cost advantage terms of die size. But the bigger impact is the kind of boxes we are going into. Just again not to overplay this mobile wireless but it is a perfect example of all these trends in that these mobile wireless boxes have an extreme need for knowledge based processing. So they are willing to buy the most valuable part we have for these applications. Basically they want the want the best thing they can get from us which means this gives us the best gross margins. So I think it more (inaudible) opening up and our ability to grab it with our most valuable parts. That is the single biggest dynamic that is driving gross margin.

Arnab Chanda – Deutsche Bank

And then last question for Mike what are you going to do with your cash. You have obviously shown in the past some desire to doing acquisitions. Are there some considerations for buybacks? I don’t know if you have any thoughts on uses of cash?

Mike Tate

Sure. Yes – but management and the board at least at this stage where the company stands in its growth profile the best use is to continue to hold the cash for potential strategic opportunities. You know there is nothing specific that we are out there looking for but we’re keeping our eyes open for anything that might make sense to kind of further enhance our growth profile you know that seems to be the best position for us right now.

Arnab Chanda – Deutsche Bank

Thanks Mike. Thanks Ron.

Mike Tate

Thanks.

Operator

And our next question comes from the line of Ruben Roy with Pacific Crest Equities. Please proceed sir.

Ruben Roy – Pacific Crest Equities

Thank you. Mike I think I think you use the term lull of design activity was that specific to Cisco and if so is that something that is having to do with the macro recently over the past quarter or two or is that a function of kind of having 21 new platforms at Cisco ramping and kind of just a lull while those platforms are ramping?

Mike Tate

Yes, it was specific to a Cisco and the other customer that is sequentially declining in Q4. You know so far this year with Cisco we have had successful launch of some – about five designs but right now in Q4 that is a pause of any contribution of new program designs. But yet Q3 was another quarter that we closed three more designs with Cisco. So the design pipeline continues to look very promising and we’re entering 2009 with 19 pending designs to ramp. So that is also very positive. I don’t think that we have seen any slowdown in design activity or the timing of ramps because of the macro environment, just the normal types of product ramps hits and misses that you see as boxes get ready and launches is what we’re seeing right now. And as we look into 2009, you know, across our whole customer base you know we believe all the design we have won are pretty much on track now.

Ruben Roy – Pacific Crest Equities

Okay, thanks. And just one for Ron. In terms of the term you said that the term continues to expand. What is your feeling on 2009, may be 2010 in terms of what the term should grow at outside of kind of looking at what is the macro is doing near term?

Ron Jankov

Well I think that is a caveat, the last part of the sentence (inaudible). Well some of these new ones I mean specifically the wireless NETL7 and NETLite are brand new markets for us. So I’m not being vague but it is hard to know exactly how quickly they are going to grow. I think we’re encouraged that they started to grow it here in Q4 which is kind of a quarter ahead of schedule for two of them. So they’re going to grow nicely for us next quarter. To put our term number on it I think it is just too early for us to nail down a number there especially in the macroeconomic environment, which slow it down a little bit.

Ruben Roy – Pacific Crest Equities

Sure, and then just finally Ron, the mobile wireless infrastructure customer that is ramping in Q4 is that an existing customer or is that a new customer that is actually ramping in Q4?

Ron Jankov

Q4 it is mainly an existing customer but it is a combination of higher content in new boxes. That is what is moving our numbers at that existing customer as I have talked before in the past about the F3 generations of products where they go from a very low content in the generation one to kind of medium content in generation two to very high generation content in generation 3 box. So in Q4 we’re seeing a bigger mix of Gen 2 boxes versus Gen 1 and the first kind of preproduction of Gen 3. So that is moving the number. Not so much that they’re selling more boxes but we’re selling more dollars per box.

Ruben Roy – Pacific Crest Equities

Great. Thanks a lot Ron.

Operator

And our next question comes from the line of Nicholas Aberle with Caris & Co. Please proceed sir.

Nicholas Aberle – Caris & Co.

How is it going guys? Thanks. The first question on inventories adjustment at this point from where you guys stand where do you guys expect the inventory adjustment to be finished exiting Q4?

Ron Jankov

Well you know, for the one customer it is a typical pattern that we have seen over the last couple of years where they are very focused on their year-end inventory balances and the indications are that they will be through at the end of the year. And we expect growth with them in Q1. You know on the other side because it is the customer because they are in the hub situation and pretty lean we don’t think it’ll take long for them to normalize their inventory to reflect the current demand levels.

Nicholas Aberle – Caris & Co.

Got you and then in terms of visibility I mean you guys continue to have better visibility than most of the group. Did you guys have to use turns, some of your extra turns in Q3 given Cisco’s downtick at the end of the quarter?

Ron Jankov

Q3 was lower than we expected but you know we always have given ourselves protection by the type of guidance we’re giving with no turns. So, you know effectively there were some turns that were allowed in the quarter for Q3. As we go into Q4 once again we’re guiding the same philosophy where we have full backlog covers and you know expectations to have any turns to hit (inaudible).

Nicholas Aberle – Caris & Co.

Got you. And have you guys seen any adjustments in lead times in your customer base?

Mike Tate

We haven’t adjusted our lead times for the customers because you know we have sole-sourced products. So we have to have a good lead time to be able to manage our pipeline. In terms of the supply chain certainly it is less tight than it was early in the year but we are trying to maintain our lead times with the customers despite that.

Nicholas Aberle – Caris & Co.

Perfect. Any granularity that you guys can provide regarding just the difference in demand trends across generations between 2, 3, and 4?

Mike Tate

Obviously, we don’t have – we haven’t split that out specifically. In general I think it is more enterprise based. It seems to be place where the impact is the greatest but in general it is relatively broad based not a point product.

Nicholas Aberle – Caris & Co.

Got you. Last question, you talked about 19 pending design wins at Cisco, did you guys say that you expect all 19 of those to ramp in ‘09 or those are going to take a couple of years to ramp up? Thanks.

Mike Tate

The bulk should ramp in ’09. I think that is a few of the very, very high-end routers where the design time is the longest. Those could ramp late into 2010 but certainly the majority of those will start to launch in 2009.

Nicholas Aberle – Caris & Co.

Thanks guys.

Mike Tate

Thanks.

Operator

And our next question comes from the line of Sandy Harrison with Signal Hill. Please proceed.

Sandy Harrison – Signal Hill

Thanks. Thanks for taking my question guys. As far as the (inaudible) product and what you guys are seeing there, the enterprise markets Ron, you have had a couple of comments in the Q&A and also in your prepared remarks about some of the things you guys are seeing there. How is the data center environment? We’re heard relatively decent messages from them. What are you guys seeing there and what is sort of catalyst should we be looking for to watch and ‘09 for the data centers specifically?

Ron Jankov

Well certainly the market drivers for it are video and a virtualization applications. That is what is going to drive the changes in the data center. You know, we’re relatively conservative about in general the total business in data center across the board, but the exception of that is the 10-gig area. You know that certainly a higher percentage of the boxes that go into the data center are going to have 10 gig versus 1 gig both 5 and also when they go to 10 gig per port they tend to use a lot more knowledge-based processors. So what we are bullish about is, I guess, the conversion of the data center from a 1 gig base to a 10 gig base and in the first case we really don’t participate in the second case we participate with multiple products.

Sandy Harrison – Signal Hill

Got you and then as you look at some of the other drivers outside of the data center and the Telco, are you guys seeing any with your relationships and your new designs and the setup boxes are you seeing some of the infrastructure behind it coming in from a Telco perspective on 10 gig or is that something that is follow a little further down the line?

Ron Jankov

We’re definitely seeing that are wire line business looks pretty good for 2009 and again that is driven a lot by new product launches and especially new customers. When you look at our customer base for wire line by the end of 2009 versus right now it is more than double in terms of not only the number of customers but also the revenue potential of those customers, (inaudible) some really big guys like Ericsson, and Nokia, Tellabs and ZTE. These are going to be major additions to our customer base. So we’re quite bullish about wire line for 2009 because obviously our customers. Also again going back to our existing customers the fact that we’re going to ship a lot more boxes with the higher content version bodes well for those designs in addition to the new customers.

Sandy Harrison – Signal Hill

Got you, and then on the gross margins and sort of (inaudible) the question I had earlier is that some of the product mix you’re seeing is hurting a little on the revenue line, it is helping on the gross margin line and that over time that should turn back to more towards your long-term model?

Ron Jankov

In the near term we will probably execute the long-term model at 65% but you know, you should think over time a slight trend down. Nothing too dramatic in ’09 though.

Mike Tate

And to counter that trend this increasing amount of both wire line and wireless infrastructure where they use our valuable products that a stabilizing trend on gross margins. Even looking out not just in 09 but beyond that. So we do have some positive trends on that both in the near term and in the medium term.

Sandy Harrison – Signal Hill

Just and then my last question just from a qualitative view as you guys look at the customers and as you sort of look at the end markets and you had some cancellations from two of your customers more from an inventory perspective, you know, you when you guys look at sort of where you’re seeing the weakness causing you to go towards the sequential decline, how much of that is you think truly driven by demand declines versus attempts just lower just inventory in anticipation of potential demand declines?

Ron Jankov

That is always hard to tell. It’s a combination for sure. The one thing I would like to make clear is we haven’t gotten any cancellations. We have worked with the customer to reschedule some stuff because we would rather have it when they want it versus shipping it before they need it. So we have not had to take any cancellations. So it is just reschedules at this point. The mix between them bringing down inventory in preparation for a demand decline versus demand decline that is a hard call.

Sandy Harrison – Signal Hill

Got you. Thanks for that clarification guys.

Operator

Our next question comes from the line of Matt Robison with Pacific Growth Equities. Please proceed sir.

Matt Robison – Pacific Growth Equities

Just could you tell me a little bit about the pace of completion of your customers products if there has been much change in the schedule from what you might have anticipated three months ago and just you can attribute those changes to just more typical pitfalls or do you think there has been some impact of steady programs with your customers. Also if you could, I don’t know if you said you’re not, if you could comment on the headcount in the quarter. And thirdly the number of customers who have for those 9000 series products at this point?

Ron Jankov

Okay, certainly the little bit of a lull we’re seeing here in Q4 at two of our biggest customers I don’t think that is related to the economy at all. It is just the normal you know, steps that it takes to get a product into volume production. It is usually some last minute software changes or something like that which I really don’t think have anything to do with the economy. And in general although there is clearly going to be caution on the part of our customers and how much they spend on OpEx, the same that we’re going to do I think these major new programs will go forward as quickly as possible. I think it is a very competitive environment out there and our customers need to get these boxes into the space. I think this is particularly true in the wire line and wireless Telco areas where the specs are changing so quickly and really they need the new boxes to be competitive. So I don’t see that changing. I will let Mike talk about the headcount.

Mike Tate

You know we grew our heads by 12 people by 252 at the end of the quarter.

Ron Jankov

And quite a number of 9000 wins. The 9000s we had quite a few number –- a large number of 9000 design wins in Q3, I don’t have the total aggregate number in front of me I will have to get back to you on that.

Matt Robison – Pacific Growth Equities

Fair enough. Thanks a lot.

Ron Jankov

Thanks.

Operator

And our next question comes from the line of Kevin Cassidy with Thomas Weisel Partners. Please proceed sir.

Kevin Cassidy – Thomas Weisel Partners

Thank you. Related to the 3G upgrades, can you say geographically if there is more demand in one area than another?

Ron Jankov

It seems to be pretty broad based. Certainly the U.S. was surprisingly strong, I guess is surprisingly strong in the current quarter. It seems like the success of the iPhone and the new phones from RIM, for example, are forcing the carriers to upgrade the 3G infrastructure even in the current macroeconomic environment. So that is pretty positive and in general worldwide we see it, these 3G upgrades are very early in their life cycle basically for the upgrades. I think the first wave of the 3G already went out but this is essentially upgrading them to handle video. We’re very, very early in that prospect. So the compares are very easy.

Kevin Cassidy – Thomas Weisel Partners

Okay. Also with the new product announced NLF2000, do you have design wins announced there or when do you expect revenue to start?

Ron Jankov

We don’t have any design wins announced for that yet. It is a brand new product we just started to give to customers. So no announced design wins but the interest in design activity on that are very high.

Kevin Cassidy – Thomas Weisel Partners

Okay no time frame announcement here?

Ron Jankov

No. Usually from announcement of a product to when we announce customers or design wins as offset by six months or so they need that long to do their designs.

Kevin Cassidy – Thomas Weisel Partners

Right. Okay, thank you.

Operator

And our next question comes from the line of Gary Mobley with Piper Jaffray. Please proceed sir.

Gary Mobley – Piper Jaffray

Hi guys. I had a couple of questions. First for Ron, I wanted to drill down on the – I’m sorry for Mike I want to drill down on the previous topic and that is OpEx. Just curious how much you could actually ratchet down OpEx if you were to eliminate consultants, fees as well if things got really bad cut bonus accruals. And for Ron I had a question regarding NGN builds, I’m curious if you can give us an update what is going on in Japan and Korea and how your revenue momentum with the ALAXALA is being impacted as a result?

Ron Jankov

Okay I guess first on the operating expenses you know, a decent amount of our spending is on new product development and we’re committed to the roadmap that we have shared with our customers and really believe that 2009 is an exciting year of new product introductions. So we have no plans on slowing down that investment at all. You know there is always areas of discretionary spending that we could look to tighten our belt on or see if there ways to save money on that. So that is going to help this kind of continue operating expense growth moderated but it could be challenging to see it significantly decline in any meaningful way next year.

Mike Tate

Regarding Japan and Korea, the ALAXALA business remains stable and actually we have good visibility into Q1 with that business.

Gary Mobley – Piper Jaffray

Okay, thanks guys.

Ron Jankov

Thanks.

Operator

And our next question comes from the line of Suji De Silva with Kaufman Bros. Please proceed.

Suji De Silva – Kaufman Bros.

Hi guys. I think you said lead times hadn’t come in here. So that could mean you had some visibility perhaps maybe small but it is in 1Q. Can you give us an early look and the context of the question is how order patterns are trended as we have gotten end of September into early October?

Ron Jankov

Yes so – our lead times are still 12 to 16 weeks so we are filling in January and February as we speak. You know, I think it is too early to make real [ph] based on that activity on the quarter as a whole. So you know, at this time customers are still placing orders through the longer lead times for us.

Suji De Silva – Kaufman Bros.

Okay, I guess Mike the question was, are orders kind of coming down week by week as you have seen late September early October. Is that the trend you are seeing?

Ron Jankov

No, no. Outside of the two top customers we spoke to we continue to see pretty stable ordering trends.

Suji De Silva – Kaufman Bros.

Okay great. And do you guys have a total number of design wins. You have given that in the past, I don’t know if I had missed that?

Ron Jankov

Q3 was another record for us. So it is just over 20 again, which is up from Q2.

Suji De Silva – Kaufman Bros.

Okay great. And then last question –

Mike Tate

The design win pipeline is significantly bigger now than it was at this point last year. It is a good 30% to 50% more design wins that are queued up then at this time last year.

Suji De Silva – Kaufman Bros.

Okay, it is a good sign. And lastly Ron you have been pretty bullish on the wireless infrastructure market. I think you have drawn out potentially being 10% of revenue in ‘09, now that it seems you are ramping up early can you talk about your comfort level with that goal perhaps if that was conservative?

Ron Jankov

We’re pretty good about that the goal at this point.

Suji De Silva – Kaufman Bros.

Okay. Great thanks guys.

Ron Jankov

Thanks.

Operator

And our next question comes from the line of Dan Moves [ph] with Oppenheimer. Please proceed sir.

Dan Moves – Oppenheimer

Hi guys. I was just wondering if you could give us kind of an idea how – what percentage of your revenues are coming now from 55 nanometer.

Ron Jankov

It is very small right now. It is really preproduction and early production. So it is just a few percent. What is important about it is one, it gives us the products of 55 are faster, lower power, and more functionality. So we can get a higher ASP for it, but it is also a smaller die size, so the manufacturing efficiencies are going to be excellent. We’re already getting good yields on that product. So what that means is as we ramp the production in ’09 and ’10 and bigger – mix becomes 55 that is going to continue to help us on the gross margin side. So that hasn’t actually hasn’t yet but it’ll help next year and into 2010.

Dan Moves – Oppenheimer

Okay great. And then your taxes, you get a tax benefit next quarter. If you look into 2009 that you mentioned 5% as a number before but with the taxes credit solved is that number is still good?

Mike Tate

Yes. Given that the tax credit is in place our current view for 2009 is the tax rate should be about 3% of our pro forma net income.

Dan Moves – Oppenheimer

All right. Thank you very much.

Mike Tate

Thanks.

Operator

And the next question comes from the line of Cody Acree with Stifel Nicolaus. Please proceed.

Cody Acree – Stifel Nicolaus

Thanks guys. Ron did I heard you correctly earlier you said that you did not believe that the fourth quarter order revenue fall off shouldn’t fall off from your two largest customers. Was it economic related, do you now believe that some of the hesitation may have been just around what is going on, on the macro?

Ron Jankov

No that is not what I meant to say. I apologize if I got that message across. My point was the fact that there were some boxes that we were – that had a possibility of ramping in Q4, brand new boxes and those boxes are looking like they’re going to ramp in Q1 rather than in Q4 and so that is not part of the overall demand trend thing. I think that was just related to the engineering – completing the engineering issues of that box and not related to general economy. I wasn’t commenting on how their general – the general softness of the market of course is related to the economy.

Cody Acree – Stifel Nicolaus

I see. I see and – but you do expect that some of those new programs that we had this lull in ramp in Q4 that to both those large customers start to ramp up back into some level of product or new design wins in Q1.

Ron Jankov

Yes.

Cody Acree – Stifel Nicolaus

And then lastly. If you just kind of just go through stratify some of your end applications as far as economic maybe resiliency or lack of impact on whatever kind of recession or worse that we are in, how would you quantify or qualify these?

Mike Tate

I mean clearly the ones that are coming from zero revenue in 2008 are have the easiest compares. So regardless of the economic environment, if it is a brand new program it is going to be positive for us and in that category would be the NetL7 and NETLite. They are mobile wireless. So, in all these new customers like Nokia and Ericsson, et cetera. So, with essentially no compares coming off of a zero number those will all be the biggest growth contributors. In a more general sense, it appears that high-end wire line and wireless basically going to support the new functionality of the Internet through the Telco infrastructure is going to be the strongest segment. Also I think 10-gigabit Ethernet will be strong again because the price point for 10-gig in terms of the optics and other things that are involved has come to the point where it makes a lot of sense to put 10 gig in many applications such as data centers but also even into switches and routers and though the number of ports for 10 gig is almost certain to increase next year regardless of the economy.

Cody Acree – Stifel Nicolaus

Thanks and then lastly, obviously, a bit of inventory jiggering [ph] here at the largest customers. Outside of that even though some of your customers are growing here, ramping in some new products there were some puts and takes I am sure within – underneath the numbers on some of your older products as well. How do you feel about the inventory balances at your customers outside of the new product ramps?

Ron Jankov

It is always hard to tell exactly. I mean, we felt we exited Q3 with pretty lean inventory out of our customer’s bases like we typically do. And we are seeing a decent amount of demand for the first month of October, but you know it is tough for us to get precise details on those.

Mike Tate

I mean, one thing that we do watch and has been stable is the continued pools of product in terms of you know expediting deliveries and making sure we are going to deliver when we said we were going to deliver et cetera. That has been pretty consistent at these other customers, which bodes well for their current demand.

Cody Acree – Stifel Nicolaus

Great. Thanks again.

Mike Tate

Thanks.

Operator

And our final question comes from the line of Romit Shah with Barclays Capital. Please proceed.

Romit Shah – Barclays Capital

Hi, guys. You have been assuming zero terms requirement for a few quarters now. Can you just tell in a normal environment what a typical turns requiring it would be? Thank you.

Ron Jankov

Yes, in a normal environment you know we still see about 5% to 10% turns in the given quarter. We do have 12 to 16 weekly times with our customers. So, at this point in quarter, to the extent any new turns come into the quarter given our lead times, we (inaudible) to schedule into Q1. And that is how we have been running the business all year long.

Romit Shah – Barclays Capital

Is there any effort being made to try to bring down those lead times?

Ron Jankov

Well, just given the nature of products and the significance of our designs to these programs, you know, the customers like to give us that level of visibility and we use it for our supply chain. So, you know, we don’t expect any changes to the lead times.

Romit Shah – Barclays Capital

Okay, thank you.

Ron Jankov

Thanks.

Operator

And there are no further questions in queue at this time and I would like to turn the call back over to Mr. Ron Jankov for closing remarks. Please proceed sir.

Ron Jankov

Yes, thank you. And thanks for everyone for joining us today. During the fourth quarter we will be presenting at several conferences around the country and we thank you for your continued interest in NetLogic Microsystems and we look forward to speaking with you in the near future. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. Have a great day.

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Source: NetLogic Microsystems, Inc. Q3 2008 Earnings Call Transcript
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