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Simon Biddiscombe - President & CEO

Analysts

Katy Huberty - Morgan Stanley

QLogic Corporation (QLGC) Morgan Stanley Technology, Media & Telecom Conference Call February 26, 2013 3:45 PM ET

Katy Huberty - Morgan Stanley

Okay, good afternoon. Let's go ahead and get started with the QLogic fireside chat. I am Katy Huberty, Morgan Stanley tech hardware analyst. To my left is Simon Biddiscombe, CEO of QLogic and we are just going to kick off with the discussion, but I'll leave a few minutes at the end for questions and if you have one just raise your hand and I'll stop.

So to kick off the discussion Simon, your stock is up this year, you talked about stabilization on the last call, but more importantly, you talked about having a number of factors that are in your control this year versus last year when you were more dependent on the Intel Romley product cycle which didn't live up to anybody’s expectations. So talk about the factors that are in your control that are going to drive growth regardless of flattish server storage maybe?

Simon Biddiscombe

So, yeah your observation is absolutely right Katy. If you look back a year, the expectations that we had were almost entirely predicated on the launch of a new processor and servers that would be based on those processors as well and it just did not play out the way anybody expected. As I look into 2013, and frankly, as you then begin to look into 2014 as well, the calendar years, I think despite really compelling product cycles that are ahead of QLogic and in every instance the solutions that we are going to need to be able to serve those product cycles are essentially in the market today or will be in the market here very shortly.

So the first one is clearly old things that are tied to our Mt. Rainier technology which is the bringing together of everything that QLogic has historically done in networking technology with the PCIe, SSD or the standard form factor SSD capabilities that are becoming more prevalent across the server market. And we saw with our solution a whole series of problems that haven't been solved by the technologies that are in the market at this point in time. So I am very excited about the Mt. Rainier technology and I'll come back to that.

The second is clearly the continued adoption and ramp of all things 10-gig and converged both on the host side and on the switch side. On the host side, our positions are well understood. FCoE has not adopted at the rates that people expected it to a number of years ago, but we do continue to be believers in the technology and we do have investments behind FCoE and the underlying Ethernet on the host side.

On the switch side, really for us its about bringing to market a whole series of capabilities that enable Ethernet switch vendors to match to our fiber channel capabilities and therefore have a converged offering and the biggest customer that people broadly understand we work with is HP and then there are others that are rolling into places as we sit here today.

And then clearly the target market, the target markets that the incumbent walked away from at 8-gig, opened up opportunity to ourselves and to our competition as well. But we did a fantastic job securing what we believe to be the vast majority of that market in terms of the designs that were available.

And finally 16-gig is here, 16-gig is real and we enjoy a price premium associated with 16-gig products that gives us a better revenue scenario than it would if we were selling 8-gig products. So as I look into 2013 and frankly as I then look into 2014 as well you've got an expectation for relatively stable fiber channel environment with five distinct product cycles that sit on top of it as we move forward.

Katy Huberty - Morgan Stanley

Okay. And one of the messages at this conference and with guidance was that enterprise servers and storage companies are talking about a tougher path to better second half. So seasonality that's a little different than last year. Is that consistent with how you would think about the year. Do these factors under your control change your seasonality versus maybe the end customers?

Simon Biddiscombe

I don't think so because you are going to see a continued ramp of each of those cycles, so I don't think there is going to be a step function at any point in time. Each of those will contribute meaningfully as you move forward throughout the year, but I don't think it changes the dynamics around seasonality.

Katy Huberty - Morgan Stanley

Okay. And when you think about the HBA business that was down double-digits last year, you talked about stability; does that mean a flat business ex-market share gains or is that business started to grow again?

Simon Biddiscombe

So, my expectation is that it's a flat to slightly growing business. There are others who serve exactly the same market who have higher expectations for what that market will deliver as we move into 2013 and beyond. What I do believe is that fiber channel is here to stay. I do not believe that the fiber channel market is something that is going to erode significantly over the course of the coming years. I think those who have chosen to deploy fiber channel technology for storage within the enterprise cost of customer are going to continue to deploy fiber channel over the years to come. From a market share perspective, really our market share sits between 53% and 54% and has been from it five years at this point in time. So market share really doesn’t change significantly from year-to-year. So I am expecting that to be a stable contributor to the QLogic story over the course of the coming years, not just quarters, years.

Katy Huberty - Morgan Stanley

Okay. Over the last year you talked about the correlation between total server shipment and QLogic’s HBA business breaking apart a little bit because a lot of the servers are going in the cloud environment and they are not leveraging fiber channel stand. Do you expect normalization in that this year or do you think that the two markets will continue?

Simon Biddiscombe

No, the two markets will diverge. And I think what you have to do is become a little bit more sophisticated in how we think about the corollary between the fiber channel market and the underlying server market; I think the way look at it today, you really have to look at the enterprise cost of servers suppose to just be in entire X86 market and then you have to look at the OEMs who serve that part of the market. So as you correctly pointed out, on a calendar year basis our fibre channel business was then by -- our host business was then about 10% okay. We have actually looked at the combination of HP and IBM X86 units staying 10%, so those two significant contributors to our revenues and bear in mind those two companies are almost half of our revenues on a quarterly basis.

Katy Huberty - Morgan Stanley

Right.

Simon Biddiscombe

Any impact that they feel is significant either benefits or detriment to our performance on a quarter to quarter basis, so that’s a corollary; you’ve got a look at what’s going on HP and IBM and you have got to look what’s going on in enterprise class servers as opposed to that broad X86 market.

Katy Huberty - Morgan Stanley

Now Emulex claims that they are gaining share in fibre channel and that they are leading in 16-gig technology and I guess, you don’t agree with that, so we would love to hear your thoughts on how QLogic is positioned to lead in 16-gig?

Simon Biddiscombe

Sure. So 16-gig’s been shipping in since September. Last year our market share was 54%, as I said it’s been 53% to 54% for five years at this point in time on a quarter-to-quarter basis; it can be up a little bit, it can a down a little. Our expectations for the current period is much stronger than our nearest competitor’s expectations for the current period; I think just by the comments that we both made we would expect to gain significant share in the March quarter. And then we will see how the remainder of the year plays out. I think what we do have is a very solid track record of delivering technology the results in over generation-after-generation continued gains in market share and I see no reason to believe that 16-gig will be any different than 8-gig was as it relates where we end the year relative to market share, so I don’t see that it will change.

Katy Huberty - Morgan Stanley

And is your difference in guidance for the first quarter relative to Emulex, that is related to customer exposure and the seasonality in those businesses?

Simon Biddiscombe

Absolutely, a part of it, right and that there is an element of they have business that always struggles in the first quarter of the calendar year having been very strong in the fourth quarter of the calendar year. So my business to believe they perform their business, but I will say, I am pleasantly surprised by how much better my business is expected to perform, it amazes.

Katy Huberty - Morgan Stanley

Shifting over to Ethernet market, there is an expectation that normally would drive adoption of Ethernet and drive your business; why does that not play out in your mind that the IP bridge change equation?

Simon Biddiscombe

I think there was unrealistic expectation that there would be a step function in server demand as a result of the Romley launch and I think we are one of those who always thought that perhaps it wasn't quite the significant step in features and functionality that you had seen in the previous in Nehalem launches……

Katy Huberty - Morgan Stanley

More like an evolution?

Simon Biddiscombe

It’s not more like an evolution to us, and then it hits and a terrible time for the enterprise market, okay, so it hit a tough time where people would necessarily spend their money but anyway in the other rates the people expected to spend. So first of all you didn't see significant step function revenue for the 10-gig markets because there wasn’t a significant step function in revenues associated with the overall server market that we are so attached to when it comes to Ethernet based technology.

Its undoubtedly a more competitive market as well, right; its not the market that we serve in the fiber channels space with other participants and each of us bring different value propositions to different parts of that Ethernet market; I think long ago, although we continue to believe that its roughly $1 billion in total started segmented into individual markets where we believe we can be very successful and dominant the way we believe others could be more successful based on value propositions that they bring to the market as well.

So we are going to continue to make sure we focus on it. We are going to continue to make sure that specifically as it relates to things like storage protocols that we are the leader and we are going to continue to invest in Ethernet based technologies but often as a delivery mechanism for much higher value add solutions and that would include things like FCoE, that would include things like the Mt. Rainier technology that just here is responsible for so. It’s a delivery mechanism upon which we have to continue to differentiate and upon which we have to continue to drive higher value.

Katy Huberty - Morgan Stanley

I want to shift to Mt. Rainier in a second but just to wrap up the discussion around Ethernet, we talked in the HBA phase that technology doesn't get pulled into the cloud, when we think about Ethernet and cloud datacenters, its been a 1-gig world, its transitioning to a 10-gig world, is that an opportunity that you would expect to change?

Simon Biddiscombe

It is and we do chase it. We are far more sophisticated than at any point in the past in how we engage with that specific side of mega data set of customers okay, there are five or six of them that we actively engage with. We are not necessarily trying to fight the low cost war. What we are trying to do is make sure that we can deliver it to them a differentiated capability that they perceive is a value as it relates to solving one problem than trying to solve.

We are running one app that the China run, okay. And its interesting how the QLogic technology is including things like offload and including things like an Ethernet based Rainier are of extraordinary interest across a whole series of those customers because they solve one specific problem that each may have, okay and it’s a different problem for everyone of them, its not a marginalized world in that regard. But in every instance, we are able to engage because we bring higher value add to the table and we are not trying to fight the cost of lowest cost Ethernet capability. Very interesting market.

Katy Huberty - Morgan Stanley

So let's shift the discussion to Mt. Rainier, incredibly interesting investment over the last couple of years that turns into revenue over the next couple of years, maybe just as an introduction talk about what that product does? We've heard a lot about flash, it’s mostly been adopted by hyper scale companies, enterprises have been handicapped by the availability and the scalability and everything they need enterprise class wise, hyper scale companies don't need, what does Mt. Rainier bring to the market?

Simon Biddiscombe

See you answered it beautifully for us right. So I'll answer it and (inaudible) you can add. The problem with any PCIe SSD that is deployed today is its DAS, its direct attached storage and anything that's on that individual drive as it sits in a server is not replicated elsewhere across the datacenter. Its not part of us and if that server goes down you lose the data. That does not meet any enterprise class compliance policies associated with security and back up and replication of data and sonic. So that's problem number one.

Problem number two is in fact its hostage in an individual server, it means that you can't share it, so if you got applications that need to share data, if you got clustered environments that are requiring access to data, one individual drive that is DAS is not available to a broad set of applications that require access to it, okay. So that's the problem that's prevented enterprise class customers being able to deploy PCIe SSD, okay.

What we do as you correctly point out, solve all of those problems and we do it with a pro, an HBA type technology that also has a separate processor complex on it that results you have been able to use that PCIe SSD as part of the stand.

So it’s of part of the stories exist in the stand and because you can network them, you can access to them and therefore be able to run VM type environments, Oracle RAC, DB2, SQL and so on and so on that require sharing and clustering and virtualization and so on and so on. We solve all the problems that have prohibited rolling adoption of the PCIe SSD in the enterprise.

Katy Huberty - Morgan Stanley

And just to be clear, you're not getting into Flash business?

Simon Biddiscombe

No, I think our channel product may have an SSD option associated with it but in most cases, our principle right to market is through our OEMs and each of our OEMs has a chosen provider of Flash technology or they will have a chosen provider of the Flash technology and we will be agnostic and there will be an ecosystem that we can attach to.

Katy Huberty - Morgan Stanley

Okay, and talk about, is the product that customer, how many customers what's the timing of qualifications and moving the needle on revenue?

Simon Biddiscombe

So the first customer had the product almost a year ago at this point in time. March of last year we first delivered the product to an OEM. Every major OEM, server and storage, has the product. They’ve got it at various stages of development; they’ve got it at various stages of qualification.

We've undertaken extensive field trials. We had multiple data that we've undertaken over the course of the last year. The end user interest is extraordinarily high. The OEM interest is extraordinary high at this point in time. As I said, we will launch a channel product here coming up at the end of the quarter and then the OEMs will fall in place subsequent to that.

Katy Huberty - Morgan Stanley

Okay, and is this technology that the OEMs can evangelize for you or is this something that you need to invest?

Simon Biddiscombe

It's a bit of both, right. So we as part of our advanced solutions sales process have been engaged with that extend that enterprise class of customer who has rolling deployments of fibre channel as you think about the major financial institutions, you think about the major telecom companies and so on, they are the huge consumers of fibre channels. So we engage with them directly not to sell the product but to evangelize the technology and result seem to be solution being pulled back into the major OEMs who are the providers of the technology to those major end users, that's the top stay and attack and there is always the bottom is up attack which is between QLogic and the OEMs as it relates to the value of the technology in the qualification process and so on.

Katy Huberty - Morgan Stanley

Shifting to the financial model, the company has enjoyed a stable growth margins within a relatively tight range. As you think about growth coming from the five factors that you can control, is there anything different about the margin profile for instance, Mt. Rainier or the Ethernet business that would change the growth margin profile?

Simon Biddiscombe

So the Ethernet business does have a lot of gross margin associated with it. Obviously, I mean the company is running a healthy 67%-68% margin for a number of years. The long-term model calls for roughly a point that of gross margin erosion per year associated with a greater mix of Ethernet within total QLogic, okay. Rainier for example has pretty consistent gross margins with everything else that we do at this point in time. I will also Katy I think we are doing a really good job managing the gross margin, right. We work extraordinarily hard to make sure that any ASP reductions we are seeing unmatched by cost reductions such that we can protect the value that we think exists in our products and the value that exists to shareholders in the business model as well.

Katy Huberty - Morgan Stanley

Okay, and at the Analyst Day in September you offered about operating margin target of 20% to 25%, you are tracking in the high teens, so little bit below that range, does the improved revenue growth in calendar ‘13 get you got above 20%?

Simon Biddiscombe

Its expectation right, so you get to 20% that's roughly $130 million of revenues and that is the right number. So my expectation is with some of that level of revenue growth we will get back to the 20% to 25% margin, but now looking to the other side of the equation which would be cost reductions in this point in time. As long as we continue to see the stability and as long as we can continue to have a belief right the growth that exists in the five product cycles that were ahead of us will continue to make sure, we do the right things from an investment perspective.

Katy Huberty - Morgan Stanley

Okay, and then lastly on cash given the confidence in the business over the course of the next couple of years. What would you willing with that $0.5 million of cash that sitting on the downstream?

Simon Biddiscombe

So $400 million is offshore which makes it a little difficult to consider doing anything other than M&A associated with [IP] that's [owned] offshore, so that is really the only available solution as to how we can deploy that cash and then about $100 million of it is on shore and the $100 million will be there to continue to allow us to run the business and to continue to buyback and we have been very consistent with how we thought about the buyback we typically return cash to shareholders in excess of free cash flow on an annual basis, that is been the way for many, many years at this point in time and the buyback will continue to be the way we return the excess cash in the existing business.

Katy Huberty - Morgan Stanley

Other technology companies have raised that against international cash is that something that makes sense in your mind?

Simon Biddiscombe

I think so I mean we don't feel like, we are in a position where we have to do that, but its certainly the case that as the offshore cash continues to grow and the offshore cash continues to go the other way at some point if we are going to continue the buyback and our expectation is that we will continue the buyback than access the cheap capital which it is, absolutely feels like the right thing to do. So at some point putting some leverage in place in order to continue the buyback whilst cash builds offshore or be something that we give consideration to as you pointed out as many technologies companies have over the years.

Katy Huberty - Morgan Stanley

Let me stop there quickly to see if there are any questions in the audience. Question here.

Question-and-Answer Session

Katy Huberty - Morgan Stanley

So maybe you could talk a little bit about the leverage you address to match the ASP declines to your cost reductions and that’s pretty much predominantly through pretty ordained kind of contract arrangement or could you talk a little bit more about it.

Simon Biddiscombe

You got it. Most of our major arrangements with our customers have built in cost reductions on our quarterly basis and we try and apply the same logic to our suppliers and sometimes it works, sometimes it doesn't, but that's exactly what we are trying to manage.

Katy Huberty - Morgan Stanley

And then the other question I had is transition at 32-gigabit, is this really a 2014, 2015 or how should we think about it?

Simon Biddiscombe

Not ’14, ’15. So I think ’15 will be the beginning of the 32-gig cycle, certainly from a host perspective. I have no idea whether the switch vendors will have switched products in the market prior to that which is typical of course by the way. But no I think ’15 at the earliest is probably the 32-gig cycle at this point in time. It may even roll into ’16. We will see.

Katy Huberty - Morgan Stanley

Simon you put a word for the 10-gig Mt. Rainier Flash Hyper Scale all at the same time, is it feasible to say Mt. Rainier at this time not limited.

Unidentified Company Representative

So Mt. Rainier is a technology that we build and there are a lot of different ways to deploy the technology in the market. The first point product that we are going to deploy in the fiber channel base, what it does the technology is not limited to any specific wire. So fiber channel, Ethernet, iSCSI, FCoE is transparent.

Katy Huberty - Morgan Stanley

So as with any technology there's a roadmap is just as you said today, it’s an 8-gig product because that solution that was available when we started the product that's still 99% of the market that we shipped today is 8-gig. With time you will see other wires.

Simon Biddiscombe

Yes.

Katy Huberty - Morgan Stanley

And with time you will see significant increases in the functionality and feature set associated with the solution as well that make it even more compelling than it is today, and I'm very excited about roadmap associated with the [migrania] technology family.

Katy Huberty - Morgan Stanley

What are some of the used cases? Where are the end customers most excited? What vertical? What application?

Unidentified Company Representative

I think when you look at clustered apps like Oracle RAC, DB2, SQL, Exchange, some of these business apps that you see which requires the uses [san] and which requires cluster and high availability is really where the biggest differentiation. So we do provide a single server just like everybody else does at multi-place, but the unique differentiation this product brings is the multi-server capability with that.

Katy Huberty - Morgan Stanley

Another questions here?

Unidentified Analyst

Can you talk about a little bit about what happens if ARM servers become a little bit more prevalent, is there a problem for your fiber channel business or is it, how do you…

Simon Biddiscombe

I think ARM servers will become more prevalent okay, but I think it becomes a used case in the (inaudible) scale environment primarily. So I don't think it necessarily becomes a use case within the enterprise at any point soon and therefore I don't think it has significant impact on the Fiber Channel business that is very enterprise centric at this point. I think when I think about ARM based solutions or even (inaudible) solutions and so on, I think we look at those as being very hyper scale type environments and not enterprise participants class product at this point. And maybe I am going to change when time stops, but not at any point within our planning horizon around Fiber Channel.

Unidentified Company Representative

Okay, and one more thing I would like to add is whether the ARM processor comes in enterprise or not, we came in enterprise. The difference in this server, enterprise versus the hyperscale server is, enterprise servers requires lot of (inaudible). So whether you have an ARM processor IA64, X-64, s park processor, any of these enterprise, anything that goes in enterprise is going to IO. So if those processors were to move into an enterprise plan, the technology will continue to be there because they will require an IO. That is not a processor dependent. It's an IO that you need on enterprise.

Unidentified Analyst

You mentioned that’s non-linear unlocks, the incremental $500 million target opportunity. Can you talk about cannibalization? You said that that number bakes in some cannibalization but can you maybe quantify that?

Simon Biddiscombe

Yeah, so we have laid a precise model for people because we don’t want people to be able to back in to our ASP assumptions. So we're very careful not to give you all the pieces to be able to answer the question. The way we characterize it as we look at the number of applications that exist within the enterprise that will benefit from Rainier type functionality and then we look at that as a percentage of the overall HBA market that we're shipping in to on an annual basis and we get to the kinds of numbers that you are talking about.

Undoubtedly (inaudible) will be cannibalistic as it relates to today I sell a fibre channel HBA tomorrow I sell a Rainier. What is extraordinarily interesting, is the fact that this is the first time that market share could shift because major end user say I probably wouldn’t of trade it for just your HBA versus the competition HBA, but for Rainier I will trade, because the Rainier capabilities are so compelling relative to anything that exist in the market people will consider taken out competitions products and replacing it with Rainier within the enterprise cost customer. So I don’t know if it’s cannibalistic to my traditional HBA business, but there is an element of opportunistic, I get to win the other guy business as well. And that’s really interesting to us.

Unidentified Analyst

When you think about these new markets, not Rainier the target storage market, how significant could those new market opportunities be may be three years out?

Simon Biddiscombe

Huge. I think the target market is sized I told you that’s roughly $150 million opportunity and we think we have secured substantial majority of that market. So I think that can be a significant contributor when you get 2015 is current rate we have talked about. The target markets interesting it takes forever to get anything to ship in the target market, okay I joke about the fact that two years ago we secured one design its going to production June of 2014, right some 3.5 years from winter production and that’s the way storage market works the good news is it will then ship for years subsequent to that.

So I am confident that the positions we have been able to establish in the target market are going to be very compelling in 2015 okay. I am also confident that what she has done with the Rainier technology we will do with it as it relates to the road map, opens up enormous opportunities to us relative to anything that we are going to do in other adjacent markets moving forward.

Katy Huberty - Morgan Stanley

Okay, so the traditional HBA business has been the vast majority of revenues overtime maybe if it is a 50-50 split between the Ethernet plus these new businesses versus HBA?

Simon Biddiscombe

I think only time will tell, what I need is that HBA business to be stable; everything else will be growth that sits on top of it, and that is an extraordinarily compelling story.

Katy Huberty - Morgan Stanley

Okay.

Unidentified Company Representative

I think we are going to be could be the next generation of HBAs in general, so you go to look at it the components that you build out and the next generation and I am not saying 2014, ‘15 I am got the years out. The next generation HBAs would required this to be phenomenal technology that is going to require because SSDs bring in very important performance benefit to the market place. If you harm the way (inaudible) is that performance benefit for the application and server there is no reason to believe that given our (inaudible) that being a de facto in the market place as IO.

Katy Huberty - Morgan Stanley

Okay, so the market may joint together overtime.

Unidentified Company Representative

Right.

Katy Huberty - Morgan Stanley

Okay, great. We are out of time. So I am going to wrap it there. Thank you gentlemen for your time.

Simon Biddiscombe

Okay, thanks very much. I appreciate for the time. I appreciate it.

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