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LSI Corporation (NASDAQ:LSI)

Q4 2008 Earnings Call

January 28, 2009 5:00 pm ET

Executives

Sujal Shah - VP, IR

Abhi Talwalkar - President and CEO

Bryon Look - EVP and CFO

Analysts

Kaushik Roy - Pacific Growth Equities

James Schneider - Goldman Sachs

Craig Berger - FBR Capital Markets

Shawn Webster - JPMorgan

Eric Ghernati - Banc of America-Merrill Lynch

Operator

Welcome to the LSI Corporation investor relations conference call.

(Operator Instructions).

I would now like to turn the conference over to your host, Sujal Shah, Vice President of Investor Relations at LSI. Mr. Shah. Please go ahead sir.

Sujal Shah

Good afternoon and thank you for joining us. With me today are: Abhi Talwalkar, President and Chief Executive Officer and Bryon Look, Executive Vice President and Chief Financial Officer. Abhi will begin the call with some opening remarks and highlights from our business, and then Bryon will provide fourth quarter and full-year 2008 financial results and guidance for the first quarter of 2009.

During this call, we'll be mentioning non-GAAP financial measures, which we may refer to as results excluding special items. Today's earnings release describes the differences between our non-GAAP and GAAP reporting. You can find reconsolidations of our non-GAAP financial measures to corresponding GAAP amounts on our website at www.lsi.com/webcast. At that site, you can also find a copy of the earnings release and a presentation, which highlights the key points from today's call, and provides an overview of our business. This may be particularly useful to new investors.

I also want to remind you that today's remarks will include forward-looking statements. Our actual results could differ materially from those suggested by the statements made today. Information about factors that could affect our future results is contained in our quarterly report on Form 10-Q for the quarter ended September 28, 2008 and our Annual Report on Form 10-K for the year ended December 31, 2007.

With that, it is now my pleasure to introduce Abhi Talwalkar.

Abhi Talwalkar

Thank you, Sujal. Good afternoon and welcome. I would like to start by recapping some of our accomplishments in 2008, and then address how we intend to emerge as a stronger company coming out of this economic downturn.

For 2008, LSI delivered many solid achievements, despite tough second half economic conditions; we demonstrated year-over-year revenue growth in storage systems, storage semis, our go-forward networking products and IP licensing. Our quarterly operating expense run-rate was significantly reduced. We grew non-GAAP earnings $0.44 per share representing nearly 70% growth over 2007.

We significantly increased our operating margins over 2007. We expanded non-GAAP gross margins by 320 basis points. We completed our shift to a 100% outsourced manufacturing model across all our product families. And lastly, we reduced our outstanding share count.

To compliment our financial performance, we also generated significant design win momentum at key customers in both storage and networking. Had it not been for the economic downturn, I am confident that LSI was on its way to achieving its target business model in the December quarter.

The progress we have made in such a short time reinforces that we have the right strategy and execution to drive long-term improvements in revenue, earnings and ultimately shareholder value. As we operate in this environment, our game plan is to play offense and emerge stronger through this downturn. We have just come off of two years of unprecedented design win activity and successful execution of those key programs will allow us to gain share and grow at above market rates as end market demand improves.

As we navigate through this environment, we have three main objectives; first, to extend our competitive lead in key product areas; second, to further elevate our design win momentum; and third, to carefully manage our solid cash position. Successful execution to these objectives should lead to significant increase in long-term shareholder value, which is the focus of this Management team.

Before I give you my perspective on extending our competitive lead and elevating our design win momentum, I would like to outline the changes we have made that have put us on solid financial ground. From prior to the merger through Q3 2008, we reduced our non-GAAP operating expense levels by approximately $60 million per quarter. We divested the lower margin and more volatile consumer and mobility businesses at the right time.

We changed our manufacturing strategy to an outsourced model making our costs mostly variable and lowering capital expenditure requirements. We are now taking the following additional steps to further reduce operating expenses and effectively manage our cash, including a 5% reduction of our global workforce. The suspension of company matching 401(k) contributions and freezing of our pension plan, the suspension of salary increases for all employees, reduction of all discretionary spending and a corporate level restructuring designed to increase synergies across our semiconductor investments, reduced overhead costs and eliminate corporate functions.

We expect the net impact of these and other cost cutting actions to be a $20 million reduction in non-GAAP operating expenses per quarter compared to our previous run-rate of approximately $245 million per quarter with no impact to the key programs that we expect to drive future growth.

Now let me talk about how we intend to emerge a stronger company through this downturn and drive long-term improvements to shareholder value. The key to extending our competitive position is delivering leading edge in differentiated technology and products that generate breakaway opportunities against the competition.

There are several key development programs in 2009, which we believe will enable us to distance ourselves further from the competition yielding share gains and future growth. Our next-generation 40-nanometer read-channel technology will deliver best-in-class signal-to-noise ratio and allow us to leapfrog the competition. In systems, our next-generation external entry platform will incorporate LSI's leading-edge storage processor and deliver twice the performance and scalability at a far less cost.

We will work with HP and our other OEMs to aggressively ramp LSI's storage and virtualization technology to address today's growing end-user needs to reduce total cost of ownership. In SAS, we are accelerating our roadmap with our next generation SAS ROC chip which will deliver superior performance, and leadership data management capabilities. With new networking DSPs, we expect to maintain a sizeable lead versus our competition in delivering the highest channel density at the lowest power.

Finally, in the network processing, we will converge our leadership capabilities and traffic management, classification, and deep packet inspection technology with multi-core processing to deliver a next generation network processor for both the service provider and enterprise networking segments.

As we move through 2009, we plan to drive incremental design win momentum by specifically targeting industry-leading customers with these breakaway products. In storage systems, we expect to expand our customer base with both Tier-1 and emerging OEM accounts, while also furthering our lead in entry level platforms.

In HDD, we expect to secure key design wins at existing and new customers that will enable share growth in 2010 and beyond. In 6-gig SAS, we expect to supply to all top10 server OEMs and extend our leadership position. In SAN, we expect to gain share in fiber channel at Emulex, Brocade and QLogic. Finally, in networking, we expect to secure major new custom product wins at Cisco, as well as Intel.

Now, I want to review with you the business highlights for last quarter and for 2008, in our storage and net working businesses. I'd like to begin with the storage systems where we recorded our seventh consecutive year of revenue growth and continue to gain unit market share across IDC bands 136.

Our systems business showed strong momentum and resiliency as we grew 10% sequentially in the December quarter in a very challenging demand environment. The ramp of our flagship XBB2 mid-range platform continued during the quarter. This solution began shipping in the second quarter of 2008 into the high performance computing space through Silicon Graphics and Cray and was released by IBM in the general computing space under the DS5000 product line in September of 2008. In the next month, we expect to begin ramping the XBB2 platform at another major OEM customer further accelerating its growth.

In the very near future, we expect to release further enhancements to our mid-range system offering including negative 8-gig Fibre Channel and 10-gig iSCSI interfaces, innovative storage security solutions featuring Full Disk Encryption technology and a new high density enclosure that will have a 60 disk drives in a 4U rack optimized form factor providing customers with industry leading storage density.

In the fourth quarter of 2008, the HP began shipping LSI's storage virtualization manager software under their storage works SAN Virtualization Services Platform. This will enable delivery of SAN Virtualization and advanced data management functionality for their mid-range EVA product line. We also continue to experience significant growth in our entry level products with our revenues nearly doubling year-over-year in this category.

Given the economic environment and customers heightened interest in value price storage solutions, we expect demand to continue for these products which deliver superior performance and scalability at attractive price points.

I'll now turn to storage semiconductors which includes SAS, SAN and HDD. In SAS standard components, we grew 16% year-over-year in 2008, as LSI Storage controller ICs and software continue to be the solutions of choice among many of the industries leading server and external storage OEMs. Last quarter we announced that LSI had extended its 6-gig SAS leadership with Dell, Fujitsu Siemens, IBM, Intel, NEC, and Sun Microsystems, who will all bring LSI solutions to market in their 2009 server offerings.

We also recently announced, Supermicro, a volume leader in the white-box server market has chosen LSI's 6-gig SAS ROC and MegaRAID solutions for their next generation servers. With our performance and power advantage and roadmap acceleration, we expect to provide 6-gig SAS solutions to all top 10 server OEMs, firmly maintaining LSI's leadership in SAS.

In SAN, we grew over 28% year-over-year in 2008, as we continued to see healthy growth in Fibre Channel custom silicon shipments and expanded our position. All of our 8-gig Fibre Channel HBA and switch silicon components are now in production, and we expect to maintain our leadership position in this space.

Tuning to hard disk drive, in 2008 we delivered leading edge technology, expanded our relationship with Seagate, established a solid positions across all segments of Hitachi, and grew our preamps share. With Seagate, we secured two generation of SoC for enterprise drives, and were also solely awarded multiple mainstream desktop and notebook hard disk drive SoC design wins for platforms expected to ship in 2010 and 2011 timeframes.

In addition, we also secured our first SoC design for solid state drives. We believe that these awards are clear proofpoint of our strategic relationship with Seagate and reinforce our expectation of future success. With Hitachi we strengthened our position in SoCs and preamps. We secured next generation SoC wins in Hitachi's notebook and enterprise platforms to grow along with our existing win in their next generation desktop platform.

Finally, we continue to grow share in preamps and introduce new notebook, and desktop, and enterprise preamp products to deliver high performance and low power solutions for next generation drives.

Now, I would like to review the networking business where our investments are aimed at delivering products and software to enable intelligence, security and control for voice, video and data traffic. Industry leader Cisco estimates that global IP traffic will increase by a factor of six from 2007 to 2012. Real time video, video-on-demand. IPTV and Internet TV will account for nearly 90% of all consumer IP traffic in 2012, when there are expected to be 500 million fixed broadband users and 3.5 billion mobile users.

LSI is uniquely positioned to deliver solutions that will meet these real time needs. LSI is the most complete offering of networking solutions, including advanced communication processors, voice and video media processors, content security processors, as well as multi-service processors. This go-forward family of products delivered growth from 2007 to 2008 of more than 35%, reinforcing our strategy.

Our design win and revenue growth at Huawei continued, with shipments of StarCore media processors, link layer multi-service processors, as well as custom silicon. At Ericsson, we are shipping our communications processors in VDSL broadband access equipment are now in production with three of the top four OEMs.

In addition, a major working networking customers selected StarPro Media processor for their next-generation voice-over-IP enterprise solutions, which we expect to go into production in the second half of this year.

In summary, the significant progress we have made in each of our businesses reinforce that our strategies is the right one. The composition of our global customer base, our design to win momentum, and strong cash balance positions us well to weather this environment and emerge as a stronger company.

Now, I will turn the call over to Bryon, who will take you through our results and provide guidance.

Bryon Look

Thank you, Abhi. Before getting into specifics on the quarter, I'd like to make a few comments on our overall financial performance and strategy. We are focused on aligning our investment with our key markets of storage and networking, successfully executing a number of initiatives, which have enabled significant progress in reducing operating expenses and fixed manufacturing costs.

Despite the challenging macroeconomic environment, we have been able to deliver 2008 non-GAAP net profit of $283 million, up 68% compared with 2007. Visibility in our end markets, however, continues to be limited. With this is in mind, we expect to continue having tight controls on spending, as we seek to maintain a strong balance sheet.

Our net cash position, or cash and short-term investments in excess of convertible debt, increased during the quarter to $524 million. The vast majority of our cash and short-term investments were held in US, where we continue to maintain excellent liquidity in high quality instruments. We are confident our financial position today will allow us to continue investing for the future.

The highlights for the December quarter and all of 2008 include the following. Revenues were $610 million for the quarter and $2.68 billion for the year.

Consolidated gross margins excluding special items were 45.2% for Q4, and 46.9% for the full year 2008. Operating expenses excluding special items were $232 million for the quarter and $958 million for the year.

Net income excluding special items was $41.3 million, versus 6.8% of revenue for the December quarter, and $283 million or 10.6% of revenue for 2008.

Earnings per share excluding special items was $0.06 for Q4 and $0.44 for the year. Operating cash flow for Q4 was $98 million and $278 million for the year. We ended the year with cash and short-term investments exceeding $1.1 billion.

Now, turning to a more detailed discussion on revenues. Revenues for Q4 were $610 million, which is sequentially down 14.6%. Revenues for 2008 were $2.68 billion.

Semiconductor revenues for Q4 were sequentially down 25% to $374 million, primarily due to the macro economic environment, and substantial declines in end-user demand for PCs and servers.

Semiconductor revenues for the year were $1.8 billion. Our storage semiconductor revenues, which includes hard disk drive silicon as standard components. The storage area network ICs were, $239 million representing a 39% of total revenues in the fourth quarter and $1.2 billion or 45% of total revenues for 2008.

Revenues were down $96 million or 29% sequentially. Q4 revenues in our networking business, $114 million representing 19% of total revenues for the quarter and down 20% sequentially. Networking revenues for 2008 were $518 million or 19% of total revenues. Revenue for the IP business in the fourth quarter was $21 million.

Turning now to our storage systems business. Systems revenues were $236 million in Q4 or 39% of total, up sequentially $22 million or 10% as the external storage market faired better than other IT product categories. Revenues for 2008 were $882 million or 33% of total revenues.

Combined revenues from storage systems and storage semiconductors amounts to $475 million or 78% of LSI's total in Q4 and $2.1 billion or 78% of total revenues for the full year 2008.

Moving next to gross margins. LSI's consolidated Q4 gross margin including special items was 45.2%, which was sequentially down 310 basis points from Q3. This sequential decline in gross margin was driven primarily by a higher percentage of storage systems revenues, along with mix. Consolidated gross margin excluding special items for 2008 was 46.9%, which represented a 320 basis point improvement from 2007.

Semiconductor gross margins excluding special items decreased approximately 260 basis points from the third quarter to approximately 49.9% in the fourth quarter, primarily due to mix.

Semiconductor gross margins for 2008, excluding special items were 51.1%, which represented a 450 basis point improvement from 2007. Storage systems gross margins excluding special items were 37.7% in Q4, a sequential decline of 100 basis points, primarily due to year-end pricing pressure and promotional activities. Systems gross margins excluding special items for 2008 were 38.4%, which represented a 100 basis point increase from 2007.

Moving to operating expenses. R&D together with SG&A expenses, excluding special items totaled $232 million in Q4, representing an $11.6 million sequential improvement. Operating expenses excluding special items improved $12 million or 5% compared to Q4 of 2007.

In 2008, operating expenses excluding special items totaled $958 million or 35.8% of revenues. Interest income and other, net of interest expense, excluding special items was $4.8 million for Q4.

Now let me turn to the special items we reported in the fourth quarter, which netted to $648 million, and include an impairment to goodwill and other intangibles for our semiconductor business.

As a result of the economic downturn in 2008, our stock price declined to a level significantly below the value of the assets on our books, and lead to a requirement that we measure and reassessed the fair-value of those assets, including goodwill.

The result of this assessment was an impairment to goodwill and other intangibles for our semiconductor business. This accounting charge is a non-recurring, non-cash charge.

Special items primarily non-cash included a $542 million impairment charge for goodwill and amortizing intangibles, $61.1 million in amortization of acquisition related items, $18 million of stock-based compensation expense, $16.2 million in net restructuring costs and other items, and $10.8 million in write-downs of investments.

The full year 2008, the tax provision on a GAAP basis was $27.7 million and the non-GAAP tax rate was 9%. On a GAAP basis, fourth quarter net loss was $606 million or $0.94 per share. Net income, excluding special items, was $41 million or $0.06 per share for Q4 and $283 million or $0.44 per share for 2008.

Turning now to the balance sheet and cash flow, we continue to experience strong positive operating cash flows, with the fourth quarter at $98 million. Operating cash flows for the year were $278 million. We ended the year with our cash and short-term investments at approximately $1.12 billion after repurchasing approximately $119 million of convertible notes during Q4. In addition to repurchasing the convertible notes at a discount, we are avoiding the negative carry we would otherwise have on the notes. As I mentioned earlier, our net cash position at the end of the year remained strong at approximately $524 million.

Continuing with the quarter, inventories increased by approximately 5% or $11 million compared to Q3. But we are down $20 million or 8% year-over-year. Depreciation and software amortization was $23 million in Q4 and $88 million for the full-year 2008. And capital expenditures were $17 million in Q4 and $67 million for 2008.

Given the macroeconomic environment, our visibility is more limited than it has been in the past. With this in mind the following is our guidance for the first quarter of 2009, revenue is in the range of $440 million to $500 million. We expect our businesses to be sequentially down primarily due to the continued softness in our end markets.

We expect IP revenues to be flat compared to the December quarter. Consolidated gross margin, excluding special items, is expected to be in the range of 41% to 43%. Semiconductor gross margin is expected to be approximately 46%, and systems gross margin is expected to be about 36%, each excluding special items.

Operating expenses are expected to be in the range of $220 million to $230 million, excluding special items. In addition, we expect the following; interest income and other and interest expense to net to an expense of $2 million, special items net to approximately $75 million to $95 million, the GAAP tax provision to be a benefit of approximately $14 million, and a non-GAAP tax rate of approximately 15%.

We expect our GAAP provision and non-GAAP tax rate to continue to vary quarter-to-quarter based on profitability in different geographic tax jurisdictions and certain discrete items. However, we expect a non-GAAP tax rate of approximately 15% for 2009. We expect Q1 2009 GAAP net loss per share in the range of $0.10 to $0.20, non-GAAP earnings per share in the range of breakeven to a $0.07, and a share of approximately 649 million shares for GAAP and non-GAAP purposes.…

For the full year 2009, our goal is to drive positive operating cash flow. We expect to have certain payments that are potentially more heavily loaded towards the first half of the year, negatively impacting operating cash. This may cause some differences in operating cash flow levels between the first and the second half of the year. As I noted however, our goal is to drive for positive operating cash flows for the full year, while recognizing we will be subject to some level of variability throughout the year.

In addition, we expect to depreciation and software amortization of approximately $20 million and capital expenditures of approximately $13 million in Q1. For 2009, we expect capital expenditures of approximately $50 million and depreciation and software amortization of approximately $85 million.

In summary, we have demonstrated solid financial performance in 2008 and drove positive operating cash flows, our higher revenue levels, improved gross margin profile, and lower operating expense base, resulted in substantial improvements in net income.

In addition, we successfully balanced investments in additional growth engines, and continue to focus on the future. Macroeconomic environment continues to be a concern however, impacting end-user demand for our products, while limiting our visibility. Hence our balance sheet and cash position remained strong, we expect to maintain course on our longer term investment strategies, their networking and storage businesses, while tightly managing those expenses and other expenses.

Now let me turn the call back to Abhi.

Abhi Talwalkar

Thank you, Bryon. Before we go to your questions, I want to provide some perspective on our business and what we can expect going forward.

The economic climate remains uncertain with limited visibility and this is reflected in our guidance for Q1. The greater than typical seasonality, we are anticipating this tight economic factors that are impacting demand in our markets and for our customers. Over the past year, this management team has established a strong track record for execution and earnings growth and we have acted quickly to adjust expenses based on current conditions. Our cash position is strong enabling us to continue to invest at the levels needed to capitalize on the opportunities we have before us.

I would like to reiterate that our goals are to extend our competitive lead in key product areas, maintain and elevate our design win momentum and effectively manage our cash. By playing off hands, we expect to emerge a stronger company as economic conditions improve. Clearly, we are in a very difficult environment, our management philosophy during this time is to be aggressive and to continue to invest in winning new designs and building on the momentum that we have.

However, if the environment should continue to deteriorate or persists for an extended period time then in conjunction with our customers, we will reevaluate our priorities. Now let me turn it back to Sujal.

Sujal Shah

Thank you, Abhi. At this point, we will begin the Q&A portion of the call. Operator, will you please give the instructions for the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions). And for our first question, we'll go to Kaushik Roy with Pacific Growth Equities.

Kaushik Roy - Pacific Growth Equities

Thank you. Can you Comment on the December quarter? I mean, when did you start seeing the weakness? Was it November, end of November, or is it like towards the end of December that things basically fell of the cliff?

Abhi Talwalkar

Well, are you referring to the overall business Kaushik?

Kaushik Roy - Pacific Growth Equities

Yes, overall business. And I understand the weakness is mostly coming from semiconductor side, the hard disk drive, but that's probably what I am getting to because

Abhi Talwalkar

Well, I mean, I would say that we started seeing a softening in our end markets in the September month. We saw a deceleration in October and November, and certainly majority of the deceleration was in the October-November months. And that was certainly lead by the PC categories itself, where we do have about a 15% exposure. Servers have been hit pretty hard as well where we have really close to a 25% exposure.

We did not see softening in networking until sometime in the middle of the quarter, and as we said earlier, the external storage business had held up relatively well, but certainly, its Q3 to Q4 growth was suppressed from sort of historical seasonality that we see, which can be as high as 20% to 25%, and that only grew 10%.

Kaushik Roy - Pacific Growth Equities

And in terms of the demand, what are you seeing in January now? Can you comment on the channel or OEM inventories? I mean, the number. I mean, how much confidence do you have in the revenue guidance? I mean, are your customers still changing their forecast or are you seeing some kind of, let's say, warming?

Abhi Talwalkar

We look at lot of different data points and try to triangulate and use the best information, the best insight we have to establish our guidance. Clearly, we are in a far better position today in terms of visibility than three months ago. At the same time, we are in a very difficult environment. I would say that a lot of the inventory correction that has been going in as all our customers are reacting to end product demand dropping across these categories.

A lot of that inventory correction has been going on in the last two three months. So inventories are starting to get to, if not already very lean sort of levels, right. So we are starting to see a tightening, certainly the consensus hope is we start to see some level of stability and bottom in the Q2 timeframe, but it is very difficult to predict as you know.

Kaushik Roy - Pacific Growth Equities

One more question on margins, on operating margins. It seems like for Q4 your operating margins came in at below the low end of OpEx guide which is great, but can you tell us like why the midpoint of OpEx for March is only 225. I guess, what I am trying to get to is I know I am going to get this question from investors like why are you not cutting more?

That's the first part of the question. The second part of the question is that Abhi I think you mentioned $20 million per quarter savings in OpEx going forward. So can you give us a timeframe or in what areas. That will be helpful, thanks.

Abhi Talwalkar

Well, relative to margins I think overall gross margins came in where they did because of a number of factors. One of them certainly our overall semiconductor versus systems mix was different. We had a much bigger drop in semiconductors led by the PC and server softness and sort of a stronger systems mix.

So that was a large part of it along with some other mix related issues, our legacy networking business did decline as expected. So that's how to answer you overall margin question. Relative to the operating expense reduction, we started taking action obviously in the fourth quarter. We expect to realize that full $20 million per quarter savings this quarter as we exit Q1 and that's certainly baked in to our guidance.

Kaushik Roy - Pacific Growth Equities

If I take out $20 million from the December quarter, I'll probably only get to $12 million?

Abhi Talwalkar

I guess my theme was relative to Q3. Given some of these actions were also taken in this quarter as well that full run-rate won't achieve entirely in this quarter.

Kaushik Roy - Pacific Growth Equities

Okay. Great. Thanks.

Sujal Shah

Okay. Thank you, Kaushik. Could we have the next question please?

Operator

And for our next question we go to James Schneider with Goldman Sachs.

James Schneider - Goldman Sachs

Good afternoon. Maybe starting off from a networking business for a second, can you give us a sense of what you are seeing in that business and whether you expect to see it fall off at a faster rate even than it did in Q4? And where you see the breakpoints going out throughout the year and what impact that's going to have on gross margins?

Abhi Talwalkar

I mean relative to our networking business, we close the year in our networking business. I don't have the exact total, but somewhere around $518 million to $520 million or so. About 50% of that being legacy, the other 50% being the go forward business. Legacy in 2008 did not decline as rapidly as we thought. And frankly, it's very hard to call right now as to how legacy will behave throughout this year.

We could see declines in upwards, around $100 million or so, but still way too difficult to call it. We are seeing some situations where some of the product categories have exist out there where we had legacy business are continuing to chug along just fine, because people may not be in new platforms as they are differing some of that expenditure and some of those call cycles given the overall economic environment. So some of that is going to be favorable, some of that may not be favorable.

So, I guess that's all I can offer at this point in time. Clearly the business is down quarter-to-quarter like all of our segments, because of end demand.

James Schneider - Goldman Sachs

Understood. And then maybe just to follow-up on the OpEx, maybe just ask the question in a different way. What would you have to see in terms of cash flow or other metrics for you to institute a more broad-based restructuring or headcount reduction?

Abhi Talwalkar

Let me try to answer your question and then Bryon can add to it. If you look at what we have done as a management team, we have reduced the overall OpEx by about $75 million on a quarterly run rate since right at the beginning or prior to the merger. So we've taken significant actions to get our cost structure down.

We started taking action relative to reducing our expenses further in the fourth quarter and it will be down $20 million off of that Q3 sort of run rate. We think at this point in time, we've taken the right action. We were trying to find the right balance of short-term versus long-term, we've got tremendous design-win momentum. I want to make sure this company is positioned to grow faster than its peers as the marketplace returns from a technology purchasing standpoint.

With that said, like everyone else, we're watching this environment very closely. Should the duration of this downturn persist or extend or deepen, we absolutely have to reevaluate and take the necessary steps. I think we've demonstrated our ability to do that as a management team.

Bryon Look

The only thing I'd add to that is that I think maintaining positive cash flow is going to remain a very high priority item for us. And so we're going to continue to watch that very carefully. If this downturn gets worse, it's get prolonged, and has an impact in terms of ability to maintain positive cash flows, then we'll have to look at whether some other actions that we need to take.

Sujal Shah

Hey, thank you Jim. Could we have the next question please?

Operator

And for our next question, we go Craig Berger with FBR Capital Markets.

Craig Berger - FBR Capital Markets

Hey guys, can you update us on what you're seeing in the hard disk chip space from a competitive situation what are you seeing out of ST and Marvell competitively and how do you see your position relative to those guys?

Abhi Talwalkar

Well, we don't specifically about our competitors, but there are a number of changes in the overall competitive landscape, Craig, in 2008 relative to some strategic decisions some of our customers made. We believe all those decisions are very favorable to LSI's competitive position. So we feel very good in terms of where we were at relative to our SoC design win activity, as well as where we were at in our read channel cadence around our 40-nanometer next generation read channel technology, which obviously, we've had lots of in depth reviews and discussions and so forth with our big customers. And then in the preamp space, we continue to feel like we can keep growing our preamp share throughout this year as we have the last two years.

Craig Berger - FBR Capital Markets

Is it fair to say the hard drive SoC space is consolidating from three chip suppliers to two or is it too premature to say that?

Abhi Talwalkar

I would just support the fact that that industry has been consolidating and we have been an aggressive consolidator.

Craig Berger - FBR Capital Markets

And then on your semi segment gross margins, what did you say was that the reason that they're going to be down? TSM is giving price cuts right now and you guys are fabless.

Bryon Look

No, Craig. I think the real reason for that is really we're operating at a lower revenue level. We still do have, despite all of our actions, to really go fabless. We still do have to fix some fixed costs and so there is a lower amount of absorption there that'll hurt the gross margin for semiconductor. And then the other factor is mix, which is always consideration in any particular quarter. This last quarter, I just had an example between semi and storage we had a greater percentage of storage systems revenues and that really had a more than negative effect in terms of our overall consolidated gross margins.

Craig Berger - FBR Capital Markets

And then just housekeeping, can you confirm, you said interest expense of $2 million a quarter, and if so why? And then finally, how deeply has SAS penetrated into the systems business? Thank you.

Abhi Talwalkar

Let me take the SAS question and then Bryon can answer the other question. SAS today from a SAS drive and to silicon in external storage, SAS silicon external storage, I would say it's still in its early goings, because most of that is primarily in entry systems, which is still a category that's developing and growing.

We believe that SAS will become much more prominent in external storage in 2010 and beyond as more of the midrange systems start looking at SAS as a more favorable alternative than fibre channel, and that is clearly a big growth opportunity for LSI.

Bryon Look

To your question Craig regarding the interest, the guidance on that was going to be a negative $2 million for Q1, just to clarify.

Craig Berger - FBR Capital Markets

Why do you have expense, if you've got so much more cash?

Bryon Look

Well, if you look at the net between the interest rates that we are paying on the outstanding convertible notes, its 6.5% on the 2009s, even though we did take out some of the convertible notes in the fourth quarter, specifically about a $119 million worth.

We still have the remainder of that which is now in the current liability section, and we are paying again 6.5% on that, 4% on the 2010 notes that we have outstanding.

Craig Berger - FBR Capital Markets

Okay, but you've booked $5 million as income in the fourth quarter, is there something in there?

Bryon Look

Yes, there were some other items in the fourth quarter that affected that. Again, that's interest income expense and other items. So we did have some favorable in the fourth quarter, some gains on some short-term investments for example.

Abhi Talwalkar

Okay. Thank you, Craig. Could we have the next question please?

Operator

And we go next to Shawn Webster with JPMorgan.

Shawn Webster - JPMorgan

Yeah thank you. Circling back up to the inventory question for LSI's inventories, what are you expectations for Q1 and did you have an write-downs in the last quarter.

Abhi Talwalkar

So relative to write-downs, there were probably just not really material consistent with past quarters. I would say relative to our expectations for the first quarter, we are expecting the inventory levels to be lower than they were in the fourth quarter. Clearly with the lower than expected revenue levels in the fourth quarter, they did have some impact on that increase, but again we could see that reversing in 2009.

Shawn Webster - JPMorgan

Okay. And then on the gross margins, for the sequential declines you experienced in Q4, how much of that would you attribute to just revenue scale versus mix or pricing pressure?

Bryon Look

It's, I would say, it's the combination of all of those. I would say on the semiconductor side, it's a combination of levels as well as mix. On the system side, more factor since revenues were up in the quarter, more factor in terms of end of year pricing pressures and promotions that we ran to drive future derive demand and revenue.

Abhi Talwalkar

Yes I would just add pricing pressure I don't think was a factor relative to our semiconductor gross margins. That was more of mix and absorption driven by a lower revenue base. In the system space, certainly as Bryon said, there was certainly more competitive intensity and promotional activity in the fourth quarter.

Shawn Webster - JPMorgan

I see, and as you go into Q1, the down again is that again revenue scale and mix or what are your expectations to drive that down.

Bryon Look

Yes, I would say generally that's still going to be the case. Lower revenues overall and then the mix of our businesses with sequential downs and plus all of our semiconductor businesses as well as our system's business.

Shawn Webster - JPMorgan

Okay. And then, did you have 10% customers in the quarter?

Bryon Look

Yes we did and they remained IBM and Seagate.

Shawn Webster - JPMorgan

Okay. And then for your tax rate for 2009, you mentioned you had a $14 million benefit for Q1. How should we think of your GAAP taxes for the full year?

Bryon Look

Well, on the GAAP basis, we are not really providing guidance there, but I know that, for a lot of you, you have been modeling that. You would probably use numbers that were consistent with what you have been modeling, which I believe is around most of the models that I've seen have been sort of the $9 million to $11 million per quarter range.

Shawn Webster - JPMorgan

$9 to $11 a quarter?

Bryon Look

Right.

Shawn Webster - JPMorgan

Okay. All right. Thank you very much.

Abhi Talwalkar

Hey, thank you Shawn. Could we have the next question please?

Operator

And we go next to Sumit Dhanda with Banc of America - Merrill Lynch

Eric Ghernati - Banc of America-Merrill Lynch

Hi, this is Eric Ghernati for Sumit. Thanks for taking my question. Just looking back to the OpEx savings, you're expecting $20 million, not all of it. A reduction of $20 million from the $245 million, not all of it will be achieved in Q1, but just looking at the trajectory of OpEx going to Q3 and Q4, I know it's a bit early, but how do you think about OpEx, including those savings given your comments that you basically want to build the company to be able to compete. That's my first question.

Abhi Talwalkar

Well, first of all, we are not going to guide OpEx beyond Q1. Relative to build the company, as I talk about extending our competitive lead seeking to elevate our design win momentum, that fall within the existing investment envelope that we are talking about in Q1. And as a management team, we are going to continue to be very diligent about managing cost and looking to continue to squeeze cost, clearly one of the objectives of realigning the company's structure around a single semiconductor group was to go pursue additional synergies opportunities.

So, I think we are not done from constantly pursuing and managing expense efficiency, right? But I am surely not going to guide beyond Q1.

Eric Ghernati - Banc of America-Merrill Lynch

Okay. And then, Abhi thanks for giving a lot of details of with the spec toward different sub-segments within your storage semiconductor. So if you could just give us an idea of how your HDD performed year-over-year for the full year 2008? Thank you.

Abhi Talwalkar

I don't think we breakout HDD specifically from a year-over-year standpoint.

Eric Ghernati - Banc of America-Merrill Lynch

Okay. Thanks.

Sujal Shah

Okay. Thank you. Could we have the last question please?

Operator

And we go next to Ashley Hart with Raymond James.

Eric Ghernati - Banc of America-Merrill Lynch

Hi, thanks. It's Ashley calling in for Hans. Couple of quick questions for you. In terms of your long-term gross margin goals up 47%, I understand that those maybe pushed out of that, but is there a certain revenue level that you need to hit for these goal, based on your mix available and fixed cost now or certain mix that you are assuming to get there? Just help us understand looking into 2010 where your gross margins may be.

Bryon Look

Well, if you look at our performance for full-year 2008, I think there are some good proof points there related to our ability to achieve the business model targets, whether it's gross margin or overall. We certainly felt that we are in track to do that until the economic downturn hit us beginning at the end of September.

Relative to long-term, overall business model I'd say, probably that model remains the same, we should be able to achieve business model at perhaps slightly lower revenue levels based on taking down our operating expense base a little bit from what it was before. And as you've recall, in the past we said that we think we can get to business model in the range of about $750 million or $800 million of revenue levels.

Eric Ghernati - Banc of America-Merrill Lynch

Okay. That's helpful. Thanks. And then, your licensing business, you expect it to be flat in the first quarter. Did I hear that correctly?

Bryon Look

Yeah, that's correct. Quarter-to-quarter. But, yes, that was the guidance we provided.

Eric Ghernati - Banc of America-Merrill Lynch

Okay. And so for run rates going forward into 2009 do you see that not being impacted as much based on the macro environment and do you sort of expect to grow that business over 2008?

Bryon Look

I think it's still our intention to continue to invest in that thing and grow. We probably haven't felt the same effects that we have in that business relative to our product business. And we still have ahead of us the opportunity to get further benefit from tapping the entire patent portfolio of the combined company.

Eric Ghernati - Banc of America-Merrill Lynch

Okay. Thanks. And then just one last question, your product with IBM in the DS5000 line. You said that you expect to announce another customer for that in the first quarter?

Abhi Talwalkar

We expect to start ramping another customer, that's correct.

Eric Ghernati - Banc of America-Merrill Lynch

Okay. And can you share who that is?

Abhi Talwalkar

No, but you can probably deduce exactly who it is given it's the customer base that we've been shipping to. Historically, it's the Sun, Teradata, IBM. It's within one of our existing customers.

Eric Ghernati - Banc of America-Merrill Lynch

Okay, great. Thank you.

Sujal Shah

Thank you, Ashley. I'd like to thank all of you for joining us this afternoon. If you have any additional questions please call investor relations at LSI. Thank you and have a nice day.

Operator

And ladies and gentlemen, a telephonic replay of this conference will be available beginning today at approximately 6:00 PM Pacific Standard Time, and will run through 10:00 PM Pacific Standard Time on February 4. The replay access numbers are 888-203-1112. Again that is 888-203-1112 within the United States and 719-457-0820. Again that is 719-457-0820 for all other locations. The replay access code is 1632453, again that's 1632453. The webcast will be archived at www.lsi.com/webcast.

This does conclude today's conference. We do appreciate your participation and you may disconnect at this time.

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