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Emulex Corporation (NYSE:ELX)

F2Q09 (Qtr End 12/28/08) Earnings Call Transcript

January 27, 2009 5:00 pm ET

Executives

Jim McCluney – President and CEO

Jeff Benck – COO and EVP

Mike Rockenbach – CFO, EVP, Secretary and Treasurer

Analysts

Min Park – Goldman Sachs

Amit Daryanani – RBC Capital Markets

Glenn Hanus – Needham & Company

Kaushik Roy - Pacific Growth Equities

Shebly Seyrafi - Calyon

Jung Pak – BMO Capital Markets

Joel Inman – Baird

Douglas Ireland – JMP Securities

Operator

Good day and welcome to the Emulex Corporation second quarter conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the President and Chief Executive Officer, Mr. Jim McCluney. Please go ahead, sir.

Jim McCluney

Thank you, operator. Good afternoon and welcome to Emulex's second quarter fiscal year 2009 conference call. I'm Jim McCluney, CEO and President of the company, and with me today are Jeff Benck, our COO; Mike Rockenbach, our CFO; and Steve Berg, our Senior Vice President of Corporate Development.

Mike will start off our prepared remarks with the second quarter 2009 results and I will follow with my comments on the quarter and a discussion of our markets, and Jeff Benck will talk about our progress on the company's operating plan. After that, we'll provide some concluding remarks before we open the line for questions. Over to you, Mike.

Mike Rockenbach

Thanks, Jim. By now, you should all have Emulex's second quarter 2009 earnings release which was released earlier this afternoon. If you do not have a copy, the press release is available in the Investor Relations section of our web site at www.emulex.com. The press release and this presentation contains forward-looking statements including but without limitation statements regarding Emulex's business, operations and anticipated financial results for the third quarter of fiscal 2009 and beyond. These statements are subject to risks and uncertainties and our actual results may differ materially from those discussed in the forward-looking statements.

Those risks and uncertainties include economic conditions, market growth, IT spending patterns, changes in technology, evolving industry standard, competitive pressures, pricing pressures and fluctuations in OEM ordering pattern, the estimated total available market size, the ability to address these markets with available technology in a timely fashion, research and development activities, the inability to achieve the expected benefits from our globalization initiatives and the risks and uncertainties described in Emulex's SEC reports filed under the Securities Exchange Act of 1934, including forms 8-K and under the heading risk factors in Emulex's most recently annual report on Form 10-K and quarterly reports on Form 10-Q.

We undertake no obligation to update the forward-looking statements. Investors should also be aware that Emulex will not disclose in its Q&A or in conversations afterwards any material financial data that was not already disclosed in its conference call or its press release.

In addition, during this call, when we use any historical non-GAAP financial measure as defined by the SEC in Reg GAAP, you will find reconciliation to the most directly comparable GAAP financial measure in our press release available on our Investor Relations web site. All the references we will make today relate to our non-GAAP results unless stated otherwise. Today's conference call is being webcast and a recording will be available on the Emulex web site through January 2010. I would also like to remind participants that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording.

Sales for the second quarter ended December 28, 2008 totaled $108.7 million, a decrease of 17% from the prior year's quarter and a 3% sequential decline. Revenue is slightly higher than the preliminary results issued earlier this month but came in below the original second quarter guidance of $111 million to $116 million provided in October. Fully diluted earnings per share for Q2 totaled $0.23, a decrease of 32% from the $0.34 reported in the second quarter of the prior year, however EPS was up 5% from $0.22 reported in the prior quarter. Our fully diluted EPS for Q2 came at the high end of our October guidance of $0.20 to $0.23, and this includes an approximate $0.03 benefit from the retroactive restatement of the federal R&D tax credit.

Our host server products or HSP consists primarily of standard host bus adapters, converged network adapters or CNAs, custom form factor mezzanine cards for blade servers and ASICs used in server application. HSP revenues totaled $81.1 million, a decline of 14% from the second quarter of last year, but were sequentially flat with Q1.

Revenue from board-level products for the second quarter declined 16% year-over-year, representing an 8% decline in units; however, ports grew by 1%. Sequentially, ports for HSP board-level products increased by 4%, units increased 1% and revenues were essentially unchanged. The ASP for board-level products including standalone HBAs, CNAs and mezzanine cards declined by 1%. Year-over-year, ASPs declined by 8% which is below our expected annual decline rate of 12% to 15%.

Dual channel increased on a sequential basis and now represents approximately 50% of our fibre channel HBA revenue. We continue to experience good revenue growth on mezzanine cards for the blade server market. Mezz cards grew 13% sequentially and 65% year-over-year. With our blade server mezzanine cards continuing to show significantly faster growth in the overall blade server market, it is clear that we are gaining share.

Finally, HSP ASIC revenues were down 28% sequentially, but up over 40% year-over-year. Our second product line, embedded storage products or ESP encompasses SATA bridges and routers, fibre channel embedded SOCs and route switchers as well as single and multiprotocol embedded controller products for enterprise-class storage systems.

ESP revenues for the second quarter totaled $27.5 million, representing a decrease of 10% sequentially and 24% from the prior year's period. Because ESP is an OEM based business and our solutions are embedded inside the arrays, it can be difficult to determine exactly what the cause of weakness really is. However, we believe there are a couple of factors that could be having an impact: First, ESP is a component business selling primarily to contract manufacturers for the storage OEMs, those at the beginning of the supply chain. With the combined tightness in the credit market and expectations for flat to decline in demand in 2009, you are seeing an increased focus on minimizing inventories by the CMs.

Second, improvements in reliability and performance from low-cost SAS and SATA solutions combined with lower spending budgets could be driving end users to value price point solutions to meet their storage needs and our ASICs sold into thousand SATA have a lower ASP per port than the fibre channel ASIC. We began to see the effects on the ESP at the end of the second quarter and we expect these issues are going to continue to be a drag on the ESP revenues into the third quarter.

We have provided the geographical and customer breakdown for our revenues in the supplemental information in our press release. As we further discuss the income statement, I would like to remind you that we will be primarily discussing our non-GAAP results unless otherwise noted. You will find in our press release a reconciliation of the difference between our GAAP and non-GAAP earnings, as well as a discussion of why we believe non-GAAP financials are a relevant measure of our business for investors.

Second quarter gross margins were 65% compared to 67% in the September quarter. Second quarter gross margins were impacted by a reserve of approximately $1.7 million for excess and obsolete inventories of older generation products due to a reduction in forecasted demand. We are modeling for gross margins of approximately 66% for the March quarter.

Looking at operating expenses, during the second quarter OpEx decrease 3% sequentially to $48.3 million. Expenses decreased just a percent of revenue to 44% compared to 45% in the prior quarter. The decrease in absolute spending was a result of full-quarter benefit from the reductions we made in August, as well as our continuing focus on managing our controllable expenses. We exited the second quarter with a total of 806 employees compared to 853 at the end of the last fiscal year.

Q2 operating income of $22.8 million was down 10% sequentially coming into 21% of revenues compared to 23% in the first quarter. On a year-over-year basis, operating margin was down about 10 percentage points resulting from lower revenues, lower gross margins and higher operating expenses.

Other income decreased 50% sequentially coming in at $1.1 million, primarily due to lower interest income. With the goal of principal protection, we continued to invest in short-term government-backed instruments which while secure have an interest rate in the 1% to 2% range. We anticipate a similar level of interest income in Q3. Second quarter net income was $18.8 million, up about 2% sequentially, but down 34% from the prior year results.

Our tax rate for the quarter was approximately 21%. We saw some benefit on the tax front from the startup of our international operations combined with the retroactive reinstatement of the Federal R&D Credit. Based on our current modeling, we are expecting a 36% tax rate for the remainder of the fiscal year. Our net profit margin for the quarter was 17% which was up from 16% in the prior quarter, but down from the 22% reported in the second quarter of last year.

For the second quarter on a GAAP basis, we reported operating income of $10.2 million, net income of $10.5 million and diluted EPS of $0.13. The difference between GAAP and non-GAAP income in the second quarter is primarily attributable to amortization of intangibles, stock-based compensation and severance along with associated costs. FAS 123(NYSE:R) expense reduced GAAP earnings by approximately $0.05 per diluted share this quarter.

On a GAAP basis, Q2 R&D expenditures decreased 11% sequentially to $31.1 million compared to $34.8 million from the first quarter, primarily as a result of the headcount reduction made in the prior quarter. Quarterly R&D spending will vary depending on the timing of new product development expenses. Q2 R&D also included $2.6 million of stock-based compensation.

Second quarter GAAP sales and marketing expenses were at $13.3 million compared to $14.5 million, primarily as a result of the spending actions taken in Q1. Q2 sales and marketing expenses included $1 million of stock-based compensation. Sequentially, GAAP G&A expenses remained essentially flat at $9.5 million. This included $1.1 million of stock-based compensation.

Returning to the balance sheet, we exited the second quarter with total cash investments of $285 million. This represented a decrease of $9 million from the end of the first quarter. The decrease in cash reflects approximately $19 million in tax payments. Second quarter inventory levels decreased sequentially from $19.4 million to $14.9 million and our inventory turns of 11.5 exceeded our target range of 8 to 10 turns.

Our receivables were $64.6 million at the end of Q2 compared to $56.9 million at the end of Q1. Historically, we have seen payments from customers stretched out at the end of the calendar year as companies focus on strengthening their balance sheets for year-end reporting. Depreciation in the second quarter increased slightly to $5.6 million compared to $5.3 million in the first quarter. Capital expenditures during Q2 were essentially flat at $7.7 million.

Before I discuss our targets for the third quarter of fiscal 2009, I want to again remind everyone that there are numerous risks that can affect our future performance causing actual results to differ materially from forward-looking statements. These risks are noted in our public filings with the SEC and the Safe Harbor statement at the end of our earnings press release. As a result of these risks and uncertainties, we are unable to predict with accuracy what future quarter results might be and there is no guarantee that business will reach our expectations or goals.

Based upon current market conditions, our customers’ public comments and our most recent forecast, we believe that revenue for the third quarter ending March 29, 2009 could amount to approximately $78 million to $85 million which represents a sequential decrease of 22% to 28%. In the past few years, we have seen more seasonality in the third quarter. However, with current expectations for IT spending in 2009 being flat to down combined with tighter managing of inventories throughout the supply chain, we expect to see a greater decline in revenues for Q3 than we have seen in the past.

While we don't give specific guidance by product line, I want to also add that we are anticipating that spending pressure on IT budgets will favor low-cost SAS and SATA based storage systems at the expense of high performance but more expensive fibre channel systems causing the decline in expected ESP revenues to be greater than HSP during the March quarter. If we achieve revenues in this range, we anticipate non-GAAP earnings per diluted share of $0.02 to $0.05 assuming a 36% tax rate.

I will now turn the call over to Jim who will give you an overview of our progress, some color on the quarter and then update on the company's strategy.

Jim McCluney

Thanks, Mike. Before I review our second quarter results, I would like to discuss the broader economic environment and provide a framework for how we intend to manage the business during this calendar year.

Looking back at 2008, the year started off slowly with technology companies starting to feel the impact of weakness in the financial vertical. While early expectations were for a recovery of IT spend in the second half, the worsening of the credit crises and the disappearance of many bellwether financial institutions towards the end of the summer has further weakened this important sector and the economic malaise has now spread to all industry sectors in both developed and emerging markets.

Many industry analysts are now predicting that there will be no growth in technology spending in 2009 and some are modeling for spending to decline compared to 2008. The Goldman Sachs IT Spending Survey done in January expects a decline of 8% in developed markets and only modest growth of 3% in emerging markets, triangulating to a 4% global decline.

Within the next calendar year, we expect the historical seasonal revenue patterns will be exacerbated by the global recession resulting in weaker than usual results during the first half of calendar 2009. This view of the broader economy combined with the most recent customer forecast is reflected in our revenue guidance of $78 million to $85 million for the March quarter.

As we announced in October, we took action in the September quarter to realign our expense structure and while I expect our revenue results to remain choppy in the near term, as you can see from our second quarter results, we achieved our earnings target in spite of weaker than anticipated revenues.

Looking into 2009, we continue to roll out initiatives that emphasize product cost and operation expense reductions through efficiencies and improved productivity. However, we continue to execute strategic business initiatives to position the company not only to ride out the turbulence but to emerge as a better, stronger and even more relevant provider of converged connectivity solutions. I do want to make it clear that we are focused on executing for success and creating long-term shareholder value.

In addition to managing costs, we have enhanced our capabilities as an organization. I am pleased to report that we have recently added both breadth and depth of experience to our management team with the additions of a new Chief Marketing Officer and a new Senior Vice President of Worldwide Sales. We are also creating a leaner structure by reducing management layers and increasing our investments in faster growing geographies with new operations in both Asia and Europe to support our global customer base.

And finally, we are pioneering new technologies in convergence, security and virtualization and reaching into new OEM customers to provide incremental growth opportunities. Jeff will give you more insight into our strategies and goals, as well as some background on the new members of the executive team.

But first, let me discuss the second quarter results and some comments on our near-term expectations. As Mike mentioned, we reported revenue of $108.7 million for the second fiscal quarter. This slightly exceeded the high end of the $107 million to $108 million range of revenue we reported earlier this month. Nevertheless, the results did come in the lower guidance of $111 million to $116 million which we provided on our Q1 earnings call in October.

Looking at the two product lines, revenues for our host server products were essentially flat with the September quarter at $81.1 million, although our embedded storage products had a much weaker quarter than we had expected, showing a 10% sequential decline with total revenues of $27.5 million. Historically, our growth in the December quarter has been driven by the strength in our HSP revenues. It is also fair to note that our HBAs have typically had strong (inaudible) in the financial verticals with tax rate being the greatest negative impact during 2008.

We won't know formally until the (inaudible) reports come out in a few weeks but based on the fact that our host server revenue remained flat and our nearest competitor declined, I am convinced we gained market share in the December quarter. In ESP, we saw weakness in all of our protocols during the quarter but the greatest impact appeared in our fibre channel based solutions.

As Mike explained earlier, the economic situation has led to tighter inventory controls in supply chain which was a key contributor to the decline in ESP. That is what is behind this. Looking forward, I would like to provide a little color on some of the dynamics that we see in the market which we are factoring into our revenue guidance of $78 million to $85 million for the March quarter.

Over the past couple of years, the signs [ph] of becoming ubiquitous in the data centers, we have seen the HBA market followed more closely the characteristics of overall tax spending particularly during the March quarter. Taking into consideration the current spending environment and the latest forecast from our customers, we expect to see further softness in demand for HSP which has resulted in somewhat weaker guidance than we have historically seen in the first calendar quarter.

For ESP, as we mentioned, we are seeing the contract manufacturers for our OEM customers reducing their inventory levels in the face of uncertain demand. In addition to this, we anticipated over time an eventual migration away from the native fibre channels solutions-cum-IT budget constraints are driving customers towards lower end solutions and accelerating this migration. So the while the March quarter has historically been a very strong quarter for the embedded business, we have modeled for further contraction.

While it is clear that the environment is challenging, there are a number of reasons why I remain confident that Emulex is well positioned for success. First, we have tremendous assets and we remain in a solid position both from a financial and competitive perspective. Even in the face of lower IT spending levels, our products continue to be required for the data center and we are closely aligned with key OEMs jointly providing solutions for the enterprise customers. We have a growing customer base that spans all markets and we continue to expand the sales presence globally.

Second, while we continue to drive expense reduction opportunities, we have made and will continue to make investment in emerging technologies and innovative products that positions us for long-term growth. We see industry inflection points ahead that are creating significant new opportunities, particularly around converged networks, virtualization, intelligent services, and data security. These opportunities are further enhancing and deepening the relevance and relationship we have with our customers and partners.

And finally, I'm confident that with the new additions to the leadership team and with the new and exciting product and market opportunities ahead, we'll emerge stronger than ever.

With that, I will turn it over to Jeff who will give his perspective on our strategy and operational plans. Jeff?

Jeff Benck

Thanks, Jim. During the nine months since I joined Emulex, we have made a number of operational changes to improve our execution, strengthen our leadership team and drive new growth opportunities. I'd like to start my comments today with an update on these changes and how we are progressing.

We restructured our operations in fiscal Q1 across several functions, resulting in a 7% reduction in headcount. We rebalanced resources and shifted headcount to better align it with the growth opportunities internationally and in emerging markets. We improved some of our sales and development processes to speed execution and drive new innovation. We added new senior leadership in sales and marketing. We created an international fulfillment operation in Ireland and added some regional sales offices in EMEA and APAC to better serve our international customers. And we refined our product line strategies and had some new investments to growth opportunities that represent incremental business in the future.

While we fully expect that some of these changes would take time to have an impact, we were pleased to see that we gained share on our largest competitor in the December quarter. We're excited about this early indication of success and look to accelerate momentum as we continue to execute on our major initiative.

Moving on, let me share some further details on the additions that we recently made to marketing and sales leadership. In December, we announced that Steve Daheb joined Emulex as Chief Marketing Officer, coming to us from BlueArc where he led their marketing and business development efforts. While at BlueArc, he helped the company expand its position as the leading supplier of high-performance NAS system including a tripling of its revenues. Steve also brings relevant industry experience from time he spent at Tasman Networks and Brocade. He's a high-energy executive that has had a positive impact in the short time he's been on our staff.

Rounding up the management team, yesterday, we announced that Jeff Hoogenboom joined us as Head of Worldwide Sales. Jeff comes to us most recently from Cadence Design Systems and his background also includes senior roles at LSI and Intel. Jeff's a topnotch talent with over 21 years of broad industry experience in selling ASIC systems and software. He has expertise selling to OEMs and has also built channel programs from the ground up.

Both of these gentlemen have extensive knowledge of our specific customer base and are a great fit with the team.

Now, I'd like to update you on specific progress during the quarter in our two product lines. Starting with our host server product, the latest news on our 8-gig Fibre Channel HBAs is its certifications across all major OEMs are complete and production is continuing to ramp. Dell started shipping our 8-gig blade mezzanine cards this month and we expect to announce other 8-gig blade design wins during the quarter. 8-gig revenue is ramping but we expect the transition from 4 gig to take longer than our normal product transitions due to the economic environment combined with higher 8-gig optics pricing. In the meantime, we enjoy a strong and growing position in 4 gig which will continue to be the bulk of our HSP revenue for 2009.

We also put emphasis on our first-generation CNA which was qualified with EMC storage products during the December quarter. In addition, we were certified to work with NetApp Solutions and qualified as part of the server improvement process at IBM System x. And finally, our CNAs are enabling the Sun Microsystems' COMSTAR project.

We are gaining tremendous market insight on how customers will adopt and embrace network convergence and we are readying our single-chip solution for our second generation offering. Convergence is resonating with many of our customers because the ability to handle both data and storage networks on a single wire translates into significant power savings, less complexity, less infrastructure and lower management cost.

Now turning to our ESP business. Despite the business challenges in 2Q, we are nearing completion of development on several next-generation ASICs. These new ASICs preserve our customers' investment in fibre channel storage subsystems, but enable them to offer lower cost SAS and SATA drive. They are the foundation on which we will build complete embedded storage connectivity modules as part of our system and solutions initiative that we shared at our Analyst Day last May. We already have two design wins with key storage OEMs and we expect to deliver first qual [ph] units for certification before the end of the fiscal year.

Our customers have chosen to work with us because of our credibility in the enterprise and our trusted software extraction layer. We are engaged with several storage customers on additional opportunities that will leverage these new offerings. Our customers are also looking for ways to streamline their own operations and this is driving interest in the value proposition of our system and solutions business. We are continuing to identify target opportunities with mid-size storage OEMs where we can provide solutions that unseat competitive offering.

As we look to the back half of our fiscal 2009 and into 2010, we are driving a number of key initiatives for growth that I'd like to share with you. First, we are focusing our differentiation that will drive share gains to maintain a strong fibre channel HBA business. We will communicate a compelling vision and deliver a leadership roadmap for our converged networking products. We intend to deliver higher-value solutions to improve the growth of our embedded storage business. We expect to further diversify our product offerings to new protocols beyond fibre channel and by building software solutions.

We have the opportunity to be the leader in network consolidation delivering industry-changing virtual converged I/O solutions and as we expand from fibre channel to multiprotocol offering, we will leverage a common software, management and network services framework serving to migrate value and intelligence from the corporate network to the server connectivity network. Our expanded networking product portfolio will enable IT organizations of all sizes to deliver new business efficiencies and improve their return on investment in information technology whether they are focused on speeding discoveries, reducing risk, creating innovations, or simply servicing their customers.

Over the past 90 days, we have refined our plans to drive efficient execution, new growth, diversification, and market leadership. However, we still have a lot to do. Specifically, I want to reiterate our commitment to containing cost. We are scrutinizing every line item and questioning every purchase. All the employees in Emulex are empowered to find opportunities for saving. We have cut back on travel while maintaining close contact with our partners and customers. We are cancelling some of our own events and are holding attendance in industry events to a minimum. We transformed our partner conference into a series of regional events to save cost and spend more time with our customers around the world. It is our intention to continue to focus on minimizing cost while maximizing the quality of our investment. I look forward to updating you on our progress over the coming quarters on these key initiatives.

In closing, we will be celebrating our 30th anniversary next month. We will be marking this occasion by sharing with our customers as well as with the press and industry analysts our vision for the industry, our role in providing solutions to enable transformation of the data center.

Now let me turn it back to Jim.

Jim McCluney

Great. Good job. Thanks, Jeff. I'd like to conclude with some key summary points. Our December quarter results are typically our strongest of the year. Further from a revenue perspective, we fell just short of expectations. We did manage our cost structure to help deliver on guided EPS. The March quarter guidance of $78 million to $85 million in revenue and $0.02 to $0.05 in diluted EPS is reflective of a challenging market environment. Management is taking all necessary actions to realign our costs while at the same time remaining focused on our overall business strategy. We are diversifying our product portfolio and expanding our global reach into fast growing markets, all of which we spent in our gross prospects and reduce our business risk. Our balance sheet remains strong and we have an excellent customer base and loyal employees which positions us to come through this uncertainty in good shape.

With that, we'll try to take questions. So, operator, please go ahead and open the line.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We'll go first to Min Park with Goldman Sachs.

Min Park – Goldman Sachs

Great. Thank you. Just a few questions, please. First, I'm trying to get a better understanding of why your embedded segment met your sequentially up revenue target given the longer lead times for these products, was that a healthy percentage of the revenue already booked at the early part of that quarter and did orders just simply fall of the cliff after the first month or so?

Mike Rockenbach

Hi, this is Mike. You’re right. We do tend to have a lot of the business booked at the beginning of the quarter for the ASIC business because it is pretty early in the cycle and we did see less demands at the last – really at the tail end of the quarter and what we think is going on, it's a little hard to tell because we are a component within a system, but what we think is going is you are seeing tighter budgets in 2009 and relatively soft demand. At the same time, we’re seeing that contract manufacturers are living on pretty tight margins and they're increasing their focus on managing their own inventories. So the combination of those two things really ended up hitting us at the end of the quarter a little bit more than we expected and I think we did see maybe a little bit of some push outs by contract manufacturers at the very tail end to bring down their inventory levels and I think that was probably the primary impacts within the quarter.

Min Park – Goldman Sachs

Okay. And then just staying on the topic, we understand how mix can be hurting your revenue growth, but as it relates to the new design wins that you spoke about in the past, are you just seeing a slow ramp of the new products or just wholesale push out of launched it?

Jeff Benck

Hi, this is Jeff. We have seen some buying pattern shift from our end market fibre channel offerings to SAS and SATA. We have new products in the pipeline and some design wins to participate in that, but as we have stated before, some of those designs did move out. When we look at it now there is clearly a number of products that we have in development, some new ASICs in fact we referenced in the script that really gets after the SAS and SATA opportunities and help customers decide [ph] whether they still have fibre channel back end or if they want to bridge to the new technology, but those offerings won’t be out until later this year, so we didn’t see any benefit from that in the current quarter.

Jim McCluney

Yes. Just to amplify what Jeff is saying. I think, as we mentioned in the call that we think the tightening IT budget is out there. There is a bit of migration to some of the lower value blade systems out there. So we are anticipating for quite some time that we would see a natural migration away from the native fibre channel systems. That's going to be accelerated a little bit and the good news is we do have the products to address that, as Jeff said, coming out a little bit later in the year. So, we will catch that trend as it materializes.

Min Park – Goldman Sachs

Okay, and then just lastly, can you just talk about the priority for the cash in the near term? Are you in preservation mode? Do you plan to buy back more shares or are you still looking for acquisition opportunities at this point?

Mike Rockenbach

Well, I think certainly all of those are considerations, but cash preservation is certainly an important priority for us. Cash was down about $10 million roughly in Q2 because of two tax payments which accounted for about $19 million of expenses in the quarter and given where we are at in terms of our guidance going forward, we expect we'll be lower in terms of cash generation than we have historically, so cash preservation is certainly important for us. But having said that, we do have $100 million repurchase plan that the Board approved back in August and we continue to look for opportunities to diversify our business both internally and externally, but certainly I think cash preservation probably ranks right up there in terms of our top priorities in the near term.

Min Park – Goldman Sachs

Great. Thank you.

Operator

Thank you. We'll go next to Amit Daryanani with RBC Capital Markets

Amit Daryanani – RBC Capital Markets

Thanks. Just a question on the OpEx line I guess. Given the magnitude of the revenue drop, you are down about 25% I think in the March quarter and it looks like gross margin is actually holding up pretty well. Could you just talk about why is OpEx (inaudible) going to be flattish essentially or imagine the number would trend down given the drop in sales?

Mike Rockenbach

Yes, this is Mike. Our operating expenses -- we don’t have a lot of operating expenses that are variable directly with revenue. Our R&D investments make up pretty significant portion, about 60% of our OpEx and that tends to be for projects that are farther out. The other thing is, in the March quarter, we always have our payroll taxes start over again. That accounts for about $2 million. But having said that, we’re focusing on controlling the variable expenses that are within our control and our expectation is that we’re going to be able to offset most of that $2 million increase in payroll taxes from focusing on our expense management.

Amit Daryanani – RBC Capital Markets

Maybe in the different way, if the reality for us becomes -- it's an $80 million to $85 million quality [ph] business for the next few quarters, are you comfortable with the cost structure you have today or do you think there is room and need to do further cost containment?

Jim McCluney

I think, as Mike has said, we’re going to look at every line item in our expenses. We’re looking for every opportunity. I'll remind you that in the September quarter, we did some restructuring there and we continue to look at how we want to align our resources to our top line revenue and not just the ongoing work. We have a considerable number of initiatives underway and great responses from both the management team and the employees to do that. So more on that, we will report next quarter.

Amit Daryanani

Alright. And just a final question from me at least. You are talking about 25% of sequential drop in sales. There's been no market share issue in the December quarter, but do you think either pricing or market share is playing a part in the severe drop in sales in March?

Jim McCluney

We look at -- as you mentioned, we believe we gained share in our host business in December quarter. Frankly, a lot of initiatives we have put in place we didn’t expect to see as quite as much pickup so quickly from a share perspective because we have put some of the stuff in place and we look to gain momentum as we go forward. So we certainly don’t look to give back share in the March quarter. When we look at the ESP business, those designs you get designed in and they tend to be sole sourced because of the nature of the design. So that business can shift depending on what our storage OEMs do and how their products are selling, but it's again not really a share shift kind of dynamic that we see going on there.

Mike Rockenbach

Yes, this is Mike. Let me just add a little bit onto that. We didn’t see any forward projections in terms of guidance from a competitive standpoint on what their expectations are for the different products, so it's kind of hard to speculate on whether we’re going to gain or hold market share in the March quarter, but we do have a lot of initiatives that we think are moving us in the right direction. And then we kind of talked about a little bit in our comments, in the March quarter, we are expecting to see some of the things going on and ESP are going to impact that with the larger decline than on the HSP side. So I think we're doing the right things in terms of executing the initiatives we’ve been working on for the last three or four months or so, to do the right thing on the market share side from HSP. So I think those are really the two things that are coming into plan in the March quarter.

Amit Daryanani – RBC Capital Markets

Fair enough. That’s it from me.

Operator

Thank you. We’ll go next to Glen Hanus with Needham & Company.

Glenn Hanus – Needham & Company

Good afternoon. As you get into the June quarter then, and I know you’re not giving any specific guidance. On the ESP side, do you feel like the supply chain issues were pretty well played out and will you to start to see some initial revenues from the new design, so that we could speculate there would be some sequential pick up then in June and September?

Mike Rockenbach

It's a little bit too early to tell about the June quarter, Glen. I do think that certainly with the focus on managing inventories by the CMs that a lot, if not all of the impact of that, could be done in the March quarter. The ramp of the new designs, we start shipping products quals to the OEMs in June, but I wouldn't anticipate a lot of revenue from that. I think the wildcard is really what’s going on in overall spending and what’s going to be the implications on the fibre channel portion of the ESP business versus SAS and SATA. We playing both, but on a per port basis, the ASPs are lower for us in SAS and SATA. So we'll have to get closer to June to see how that plays out.

Jim McCluney

The macro environment is the hardest thing to call.

Glenn Hanus – Needham & Company

Okay, thank you.

Operator

And we’ll go next to Kaushik Roy with Pacific Growth Equities.

Kaushik Roy – Pacific Growth Equities

Thank you. I'm trying to understand the gross margins. I believe $1.7 million charge you took in December for absolute inventory, right?

Mike Rockenbach

Right.

Kaushik Roy – Pacific Growth Equities

So if HBA pricing are holding okay and if ESPs are likely to go down more than HSPs in March, shouldn't gross margins be slightly better than 66, maybe closer to 67?

Mike Rockenbach

Well, the E&O of about 1.7 million in Q2, that’s about 2 percentage points. We don’t anticipate an E&O charge in Q3, so we should see better gross margins from that. Having said that, when we get down to that $78 million to $85 million of revenue, we've got some inefficiencies in terms of operations that's going to flow to the P&Ls. So I think that’s going to have a bit of drag so that’s why we won’t quite get back to that 67% range in Q3. But from a pricing standpoint, we certainly see that ASPs are trending well. They’re actually below what we’ve been targeting at that 12% to 15% rate and yes, we continue to do things on our side to improve our cost of our own supply as well.

Kaushik Roy – Pacific Growth Equities

And within ESP, can you comment which gross margins are better, is it the fibre channel portion or the SAS/SATA?

Mike Rockenbach

I think gross margins are pretty comparable between the products at the ASIC level. When we start getting into the systems and solutions business, that has a lower gross margin percent but higher absolute dollars; it's really the price per port which I think becomes more meaningful on the consumer side as the SAS and SATA's value proposition and the entire budgets, you still have storage requirements, digital data continues to grow. You got to address that, but you got tighter budget constraints. So you start to look at more applications where SATA or SAS is good enough to handle that versus something that's got a higher per port cost.

Kaushik Roy – Pacific Growth Equities

Mike, on taxes, why are you expecting 36% because if the international thing is playing out, you should at least be 35% or lower? And then secondly on taxes, is the tax credit something like a one-time thing or does it flow through into the next couple of quarters or so?

Mike Rockenbach

The R&D tax credit was reinstated, so that does provide a benefit going forward. However, it was more meaningful in Q2 because there is a catch up, because there is a gap of about a year, so we had to catch up for -- it was reinstated retroactively back to the end of the calendar year, so it was more meaningful of an impact in Q2. On a go forward basis, the tax rate in Q3 and Q4 is driven by where revenue will come from. ESP being a component level part has a more significant amount of international revenue overall. So given a decline in ESP, our expectation is that that's going to have an implication on the tax rate for those two quarters. So 36% for the back half of the year, I think for the full year, that still gives us a tax rate that's down pretty close to 30% and that compares to 34% in the prior year. So we are getting the benefit from the international tax things that we’ve got underway, but it is going to be to having an impact based on what the different products lines do or how much revenue is outside the US.

Kaushik Roy – Pacific Growth Equities

Last question, I think Jeff you mentioned that because of the slow down in the macro economy, you’re seeing a slower ramp of 8 gig. So does that also mean that you might see that adoption of FCoE getting pushed out further or not really?

Jeff Benck

I think that’s true, that some customers have said that they’re going to stick with their technology they are deploying today. Obviously, we've fully vested in fibre channel, so we’re comfortable supporting them with those solutions and that's where a lot of our share gained activities are at. We kind of always knew with new technology particularly FCoE that it wasn’t going to be overnight switch. We think there is a lot of value in convergence. I think if customers do, particularly in some the emerging geos, roll out new data centers, they will look for the benefits and value that that can bring. But we've said before that when we look at calendar year 2009 that this is a year where a lot of trials are going on, a lot of test is going on, but we don’t really see that there will be significant revenue for us on our CNA products in 2009. It will be more of a calendar year 2010 event.

Kaushik Roy – Pacific Growth Equities

Okay, great. Thank you.

Operator

We’ll go next to Shebly Seyrafi with Calyon.

Shebly Seyrafi – Calyon

Yes. I'm trying to figure out what the long-term expected growth of your ESP and HSP segment is after the economy stabilizes and then after these inventory reductions are over. I mean, right now, you're experiencing this shift from fibre channel to SAS and SATA. Perhaps you can maybe tell us where we are in that shift and if you do have a long-term growth idea for that segment?

Mike Rockenbach

Hi, Shebly. This is Mike. Well, we don’t really get into the specific details at the product level with any SP, but I think the transition towards SAS and SATA has been under way for the last year or so, and I think that's going to continue on for the next couple of years probably, but you didn’t see a refresh of the hard drives themselves going to 8 gigs, so there is a finite life on how long that’s going to last. Having said that, all the infrastructure inside the arrays is still fibre channel. So, there is a very vibrant market and opportunities for the solutions that we're developing and launching over the next few months. To be honest with you, right now, given the current environment, I don’t think we are in the position to talk about long-term growth. I think the focus that we have is continuing to execute our business, making longer term investments because we have the wherewithal to do that, but at the same time being fiscally responsible and controlling what our expenses are. But I think we’re going have to wait and see kind of where things settle out in 2009 before we get to a position where we're going to be able to talk about a longer-term model.

Jeff Benck

But when we at it from a product pipeline, we talked about before that we are developing systems and solutions business which is a bigger revenue opportunity because we take on more of our storage OEMs' responsibility for the system. It will provide growth for us as we bring those products to market. We also have a number of bridging solutions that leverage not only fibre channel but SAS and SATA technology and bridging between those. So we're at the kind of sweet spot of the market is going to be. We've got technology that's positioned over the long term to address it.

Shebly Seyrafi – Calyon

Okay. Yesterday you’re chief competitor stated that it's noticing that its OEM customers are reducing their forecasts. Even in January, I was getting the feeling, we have done almost on a weekly basis and that the situation was very fluid. Are you seeing this as well?

Jim McCluney

Yes. It's very fluid out there. As we mentioned on the call, we are getting a wider range in our top line to accommodate some of the uncertainty and we’re running with what we see out there and “it ain’t done until it’s done,” but I think we are giving you the best guidance we got at this point in the market and in the quarter.

Shebly Seyrafi – Calyon

Yes, but to be clear, are you seeing for example in the last few weeks of January is not simply [ph] worse than say a month ago which was worse than a few months ago that kind of thing?

Jim McCluney

Well, I think it is fair to say that everybody is re-assessing their business real time and there is real dynamics that are coming to play, and that is reflected in the top line, that is reflected in how we look at expenses. I think you can say that it is continuing to evolve and you certainly look at the guidance that we are giving for the March quarter. That is quite a bit different than what we would have seen historically in terms of the March quarter. But it is fair to say it is a fluid environment, no doubt about it.

Shebly Seyrafi – Calyon

Okay, final question from me, I believe you take the midpoint of QLogic’s guidance, it would be like 18% decline. I think you were calling for the HSP segment to do better than your ESP segment. Is it possible that you can beat the midpoint, say that is 18% decline? Is it possible for this quarter?

Jim McCluney

I think we will wait and see where we end up on the quarter until we get to the end of it, but we have given our guidance and I think that is our best reflection of what the quarter looks like right now.

Shebly Seyrafi – Calyon

Thank you.

Operator

We will go next to Keith Bachman with BMO Capital Market.

Jung Pak – BMO Capital Markets

Thanks, it is Jung Pak for Keith Bachman. Can you tell us how much cash you generated from operations? And secondly, how much cash are you comfortable or targeting, minimum amount of cash you are targeting going forward?

Mike Rockenbach

Cash was down about $10 million; we had about $19 million in tax payments; so round numbers we had about $10 million from operations in the quarter excluding the tax payments. We have not sat down and said, “Gee, this is the exact minimum of cash.” I mean, I think it is a combination of a number of different factors, certainly cash generation going forward comes into play and when we look at March, we don't see that that model is going to throw up a lot of cash in the March quarters. So, I would suspect that is going to have us be inclined to hold a little bit more cash.

On the other hand, we are focused on our expenses and doing things to continue to preserve cash that we can without impacting our business to the negative over the long haul. And certainly you have seen valuations come down across the board and diversification is very important to us, so we are going to invest for the future, but we are going to do it in meaningful ways that are cognizant of the environment we are in. But we have not sat down and said that this is our minimum of what we can live with in terms of the minimum cash balance.

Jung Pak – BMO Capital Markets

Okay, how much of your cash is accessible?

Mike Rockenbach

It is all on short-term government securities, so it is all pretty accessible.

Jung Pak – BMO Capital Markets

Okay, thank you.

Operator

We will go next to Joel Inman with Baird.

Joel Inman – Baird

Hi, thanks. Can you talk a little bit more about where you are comfortable with operating margins going in the near to intermediate term and at what point you would feel the need to make more significant cuts?

Mike Rockenbach

Well, I think we are comfortable with where we are at for the March quarter. We are certainly being very focused in terms of what we are spending money on. But having said that, we are going to continue to look at what we are doing, make sure we are doing the right things to be efficient, increasing productivity and focused on providing value. But like I said, it is kind of hard to look at it and say, “Well, if there is an anomaly in one quarter to have a knee-jerk reaction and do something that is going to hurt our business and our prospects for the long term.” So again, I do not think we have really sat down and said, “This a line in the sand; we cannot go below this under any circumstances” because I think you got to take in to consideration of what is going on and what our opportunities are and that is why we have got a balance sheet that lets us make the right longer-term decisions.

Jim McCluney

We will more certainly be focused on every line item in expense, that is for sure. What we are not going to do is mortgage our future. Now we will get some excellent products coming down the line here, our customers’ feedback has been superb, there is some inflection points coming down there, and we are going to stay focused, and the history of (inaudible) through these troubled times are the ones that come out healthy (inaudible) and that is what Emulex is going to do.

Joel Inman – Baird

So is it fair to say that you do view this as a kind of an anomaly, next quarter, where in the next several quarters over the next year, you could return to 20% plus operating margins?

Jim McCluney

I do not think we are looking far enough out to that point to see that we are going to return to 20% operating margins in the next couple of quarters and that is really what are focus has been – is what does the front half of the year look like. Because quite honestly I do not think anybody has good visibility much past the March quarter. So, our focus is on the longer term certainly, but I think we are certainly not at 20% margins in the March quarter and we are going to drive our business for success and if that results in 20% operating margins, that is great, but it is really going to be focused on revenue growth and profitable revenue growth, and I think a successful business model would come out of it.

Mike Rockenbach

But it is fair to say, we will be continuing to work on expenses and bringing our burn rate down. We are looking at every line and then we are going through – we recognize that expense is very important but as Jim said we are balancing that out against customer (inaudible) and some great new products that we have in place that we do not want to jeopardize but we have a lot of emphasis and focus on it.

Joel Inman – Baird

Okay and then did you give a breakdown in your HSP business between fibre channel revenue and other that I missed?

Mike Rockenbach

We did not give that breakdown. We did have some CNA revenues this quarter, but it was predominantly native fibre channel HBAs and mezzanine cards and ASICs.

Joel Inman – Baird

Okay and then last one from me, just interest and other expense income going forward?

Mike Rockenbach

I expect it is going to be about the same level as we saw in Q2, around $1.1 million. That is really contingent upon what happens in interest rates and you continue to see interest rates come down and we are focused on principal protection, so they are invested in government securities which tend to have lower interest rates.

Joel Inman – Baird

Okay, thanks very much.

Mike Rockenbach

I think we have got time for one more question.

Operator

We will take our last question from Samuel Wilson with JMP Securities.

Douglas Ireland – JMP Securities

Thank you, this is Douglas for Sam Wilson, Douglas Ireland. You mentioned that you expected a longer adoption ramp for 8-gig products than you had seen for previous product transitions. I was wondering if you could give a little more color around that, maybe a little bit of timing – how that might affect ASPs and if that also extends to the adoption of fibre channel over Ethernet and your previous projections or how that changes your thinking around what happens with CNAs?

Jeff Benck

Yes, it does not change – we know that 8-gig will pick up and we certainly see virtualization can be a driver for 8-gigs as customers converge more workload on a single pipe. It is just that we also know because of the 8-gig optics being a bit more expensive than 4-gig it is not a price parity discussion which – in the past, it has helped us there also with 4-gig, there were some technology changes on the PCI interface that kind of helped things go along with RoHS.

So, there were a number of drivers that made 4-gig move very quickly and frankly the economic environment people – their qualifications may take a little longer and they may put off some of those transitions. So, we are just trying to signal the fact that we expect the 8-gig to be longer what we thought was a 4-gig transition and when we look at going forward, I mentioned already that with FCoE that we see some customers deciding to do evaluations but not moving the full deployment in 2009. And as far as ESPs, we do not see a significant shift here, I do not know if you want to comment more specifically.

Mike Rockenbach

We kind of talked about it in the past, ESPs are a little bit higher with 8-gig because of the cost of optics but overall, I think that is going to impact the transition a little bit but it is probably more driven by economics right now.

Douglas Ireland – JMP Securities

Okay, thank you.

Operator

And that concludes our question-and-answer session. I would like to turn things back to our speakers for their closing remarks.

Mike Rockenbach

Hi, this is Mike. I would like to thank everyone for participating in Emulex’s second quarter 2009 conference call. I would also like to note that we will be attending a couple of conferences over the next couple of months. February 9, we will be at the Thomas Weisel Partners Conference in San Francisco. February 26, we will be at the Golden Technology Conference in Las Vegas. And then March 3rd, we will be at the Morgan Stanley Conference in San Francisco. We look forward to speaking with you at one of these events. Thanks for joining us on the call and I hope you all have a good evening.

Operator

Thanks for everyone. That concludes today’s conference. You may now disconnect.

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Source: Emulex Corporation F2Q09 (Qtr End 12/28/08) Earnings Call Transcript
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