PMC-Sierra Q1 2009 Earnings Call Transcript

| About: PMC - (PMCS)

PMC-Sierra, Inc. (NASDAQ:PMCS)

Q1 2009 Earnings Call

April 23, 2009 04:30 PM ET


David Climie - Vice President, Marketing Communications

Michael W. Zellner - Chief Financial Officer

Greg Lang - President and Chief Executive Officer


Sandy Harrison - Signal Hill

Kevin Cassidy - Thomas Weisel Partners

David Wu - Global Crown

James Schneider - Goldman Sachs

Daniel Morris - Oppenheimer

Romit Shah - Barclays Capital

Shawn Webster - JP Morgan

Ruben Roy - Pacific Crest Securities


Good day ladies and gentlemen, and welcome to the PMC-Sierra 2009 Q1 Earnings Release and Conference Call. Today's conference is being recorded. Today is Thursday, April 23, 2009.

And it is now my pleasure to introduce your host Mr. David Climie. Please go ahead sir.

David Climie

Thank you. Good afternoon everyone, and thank you for joining our investor conference call. With us on the call today is Greg Lang, President and CEO, and Mike Zellner, Vice President and CFO. Please note that our first quarter 2009 earnings release was disseminated today via Business Wire after market closed, and a copy of the release can be downloaded from our website.

Before we begin, I would like to point out that during the course of this conference call, we'll be marking forward-looking statements that involve a number of risks and uncertainties. These risks and uncertainties include, but are not limited, to product demands, inventory levels, pricing, exchange rates, taxation rates and other risk factors that are detailed in the company's Securities and Exchange Commission filings.

Actual results may differ materially from the company's projections. For further information about these risks and uncertainties, please read the company's SEC filings including our Forms 10-K and 10-Q.

If you are asking a question during the Q&A session of today's call, we request that you limit yourself to one question. And if you would like to ask a second question, please re-queue with the operator. Thank you.

And I'll now turn the call over to Mike Zellner.

Michael W. Zellner

Thanks Dave. I'll review our first quarter 2009 results and financial position and then turn it over to Greg to discuss our business activity in detail.

As discussed in our last earnings call, PMC-Sierra experienced lower sequential sales activity in the first quarter, primarily due to a weaker global economy. Revenue in Q1 was $102.6 million versus our guided range of $90 million to $100 million. Although most of our businesses were down sequentially, strengthened China enabled us to finish above the high end of our guidance for Q1.

As Greg will go into, our WAN infrastructure business benefited from telecommunication build-out in China. Our turns business, meaning those orders booked and shipped within the same quarter, was 34% of revenue in Q1, compared with 18% in Q4.

By region, Asia continued to generate the strongest results in the quarter. The following geographic breakdown on revenue is provided on a build to basis. The breakdown is as follows: China 46%, Japan 14%, other Asia 22%, North America 14%, Europe and other Geos 4%.

In Q1, we had three customers that represented greater than 10% quarterly revenues, namely Huawei, HP and ZTE.

Gross margins in the first quarter were 130 basis points higher than our Q1 guided, primarily... guidance, primarily due to the strength in our WAN infrastructure business in China, as previously noted.

On a non-GAAP basis, operating expenses were down $4 million from 57.3 in Q4 to 53.3 in Q1. Our operating expenses have declined 8.3% over the last two quarters with our continued focus on operating expense discipline.

In Q1, our non-GAAP operating income before other income and taxes was $12.7 million or 12% of sales.

Non-GAAP net other income was 400,000 in Q1. The non-GAAP tax provision was 600,000 for the quarter compared to $5.3 million in Q4 primarily due to changes in product and income mix across our subsidiaries. Non-GAAP net income for Q1 was $12.4 million or $0.06 per share on a diluted basis.

Q1 GAAP net loss per share was $0.02. The comparable GAAP measure of each of gross margin, operating expenses, operating income, provision for income taxes and net income are reconciled to the related non-GAAP amounts in our reconciliation of GAAP to non-GAAP measures included in our press release today.

The primary reconciling items for Q1 are as follows: $9.8 million in amortization of purchased intangible assets, $5.5 million in stock based compensation expense, $3.6 million in net foreign exchange gains on the company's foreign tax liabilities, $1.9 million termination costs and $1 million of net tax effect on these and other items described in the press release.

Turning to the balance sheet, net of our $68.3 million face value of convertible notes, we ended the quarter with $249.6 million of cash, cash equivalents and short-term investments, an increase of $10.5 million from Q4. This included $70.5 million invested in the reserve funds which continue to be in the process of liquidation and are classified on our balance sheet as short-term investments.

The primary reason for the increase in the company's net cash position was as follows: positive cash flow from operations of $8.6 million, cash received from stock issuance of 4 million offset by 2.2 million associated with expenditures on capital and intellectual property.

Accounts receivables increased 200,000 to 40.4 million which reflects 36 days of sales outstanding based on quarterly sales volumes.

Our receivables profile remains healthy despite the challenging economic environment. Our net inventory at the end of Q1 was 30.9 million, a decrease of 3.1 million from the prior quarter. Net inventory turns on an annualized basis were 4.8, consistent with the prior quarter turns of 4.9.

It's also important to note that despite the decline in revenue, we have reduced our net inventory each of the past two quarters. We've maintained turns at 4.8 and in the channel, our deferred income, which represents channel inventory, has dropped 36% over the same period, an indication that we're getting back to more normal inventory levels. We believe our major customers will finish most of their excess inventory consumption in Q2.

I'll now turn the call to Greg for his briefings.

Greg Lang

Thanks Mike.

In the first quarter, we generated $102.6 million revenue, which is above the 90 to $100 million range that we provided during our January earnings call. We benefited from robust activity in China in Q1 associated with our wireless and wireline infrastructure products, while our other businesses experienced lower demand as we have projected earlier.

With better revenue, gross margin and tight cost controls, we generated close to $13 million in non-GAAP operating income. While this produced an operating margin that was below our target model of 20 to 25%, we're pleased with this quarterly performance, especially given the tough economic conditions in Q1.

And if we look at our peak revenue from Q3 2008 through the trough of Q1 of this year, our quarterly revenue declined by about 26%, which is a very reasonable decline among semiconductors. With improved bookings through Q1, we achieved an overall book-to-bill in excess of 1.1 and have a very solid backlog position going into Q2. We currently anticipate a resumption of growth in Q2 as well as for the balance of the year.

So, now let me get into the first quarter results by end market. In our Wide Area Network Infrastructure business, which includes both wireline and wireless products, we experienced rapid growth in China at about 20% quarter-to-quarter. But we had lower activity levels in North America and Europe as expected.

The sequential growth in business from our Chinese OEM customers was driven primarily by the carriers two year build-out program for 3G Wireless as well as demand for aggregation in Metro Optical Transport Equipment that's required to handle the increasing levels of data traffic in that market.

As you're all aware, earlier this year, the Chinese government awarded 3G Wireless licenses to each of the three domestic carriers. And the carriers have been moving quickly to get their wireless networks established as they're now competing directly against each other for customers.

On a combined basis, the three carriers are planning to deploy approximately 235,000 base stations throughout China in 2009. In addition, the carriers are also facing increasing requirements for wireless backhaul aggregation in Metro Optical Transport Equipment.

Our products play mostly in the backhaul portion of the network where the traffic is multiplexed and then taken from the base stations to the controllers and then backhaul to the central office. As well as partially in the Radio Access Network area of the wireless networks where we have baseband to radio switching devices.

In North America and Europe, our WAN infrastructure business slowed in the first quarter as expected. And we believe it starts to improve as we move into the second half of the year with inventories being worked down and end demand expected to be stable.

Design wins in our WAN infrastructure business kept pace with the prior quarter with many of those wins coming from our Metro Transport products and highly integrated switching devices for Tier 1 customers. We also captured a number of additional design wins in T1/E1 market this quarter which is used in wireless backhaul in Asia.

In Enterprise Storage, our business slowed in the first quarter given the general seasonality of this market as well as softness in the end markets. While first quarter seasonality in storage was typically CQ1 lower by approximately 10 to 15%, our enterprise business was down approximately twice that in the first quarter. This is not related to market share at all; it's simply the slowdown in end markets.

We've worked through inventory... we've been working through the inventory in this area. We believe that we should be mostly done by the end of Q2 as we're seeing signs of a modest recovery in our base storage business.

At the end of March, we were pleased to announce that our SRC RAID-on-Chip device started to ship into HP's next generation ProLiant G6 servers, along with our new 6 gigabit per second SAS expander switch device. We've been working in partnership with HP on the 6-gig SAS 2.0 project for over two years. And together we've developed a solution that delivers the best rate performance in the industry as well as the highest storage throughput ratings.

HP's G6 servers are shipping with our SRC RAID-on-Chip embedded on motherboards for racks, blades and towers, and we are off to a good start here in Q2. We expect that we should be able to generate approximately 30 to 35 million in revenue this year from this product, subject to market conditions and our customers' product ramp.

In addition, our joint development with IBM on the 6-gig RAID technology is progressing well. We've chosen important internal milestones as part of the overall development program with our partner. As I have mentioned previously, we strongly believe this partnership will provide the opportunity for further storage growth for PMC beginning in 2010.

During Q1, we continued to achieve robust design wins in Enterprise Storage with existing as well as new customers for our 6-gig SAS protocol controllers and expander switch chipsets. We believe that the industry transition to 6-gig SAS has started for enterprise servers in Q2 beginning with HP to be followed by 6-gig SAS storage systems later in the second half of this year.

We're also pleased that EMC recently announced its next generation Symmetrix DMX high-end storage platform in which PMC has slightly more content than in the predecessor DMX-4 platform.

In the Fiber-To-The-Home, our EPON business in Japan slowed as expected in Q1 as inventories were being worked down, while our China business stabilized.

We're encouraged that NTT in Japan is targeting 2.5 million new EPON FTTH subscribers this year and accelerating new video services for its customers. In addition, NTT East and West have committed to their next phase of next generation network build-out deployment this year, which bodes well for additional build-out of their network in our business for Q2 and Q3.

In China, we believe our OEM customers have worked down their EPON inventory levels. And given the China Telecom's recent bidding process has reached critical mass, demand will improve in Q2 as China Telecom moves to broader deployment of its EPON FTTH services.

Based on China Telecom's 2009 big quantity, we believe that the subscribers could be doubled that of 2008, which if achieved, would easily surpass North America's installed base.

In March, we announced the first... the industry's first Symmetric 10 gig EPON platform which delivers 10 gigabits per second upstream and downstream. Our systems integrate all the functionality required for OLTs and ONUs running at 10 gigabit per second rates and allows carriers to provide new services, such as HDTV broadcasting and other advanced business offerings.

These platforms are interoperable with more than 7 million EPON ONUs that have been deployed based on PMC-Sierra devices and enables smooth transition and a gradual upgrade from 1 gig EPON to 10 gig EPON. We're engaged with our leading Japanese and Chinese OEM customers on this 10 gig Symmetric solution. And the carriers in those markets are also interested, because it allows them to improve services while lowering their capital and operating expenses.

In our microprocessor business, we continued to experience lower activity in the first quarter as expected, due to lower demand and inventory levels in laser printers and enterprise networking. Given the soft demand in the corporate enterprise market right now for these products, we expect that inventories to be worked through in the first half of the year with potential for improvement in the second half.

Now little bit our Q2 outlook. Based on our backlog and bookings to date, we currently expect PMC-Sierra's revenues in the second quarter of 2009 to be in the range of $114 million to $124 million, with double-digit growth in the range of approximately 11 to 20% quarter-to-quarter.

We expect our revenue to improve in each of the markets we serve with the exception of our microprocessor business. We had improved bookings throughout the first quarter and entered into the current quarter with strong backlog. That said, we're calling for only modest turns this quarter, which we believe is prudent given the strong opening backlog and very limited visibility into Q3 and Q4.

We believe that wireless build-out will continue through 2009 and 2010, but all patterns will not be linear. We continue to believe that PMC is uniquely positioned as a key supplier in growing internet infrastructure markets where we serve both the wide area, transport, the wired and wireless access networks as well as growing requirements for enterprise for network storage solutions.

Carriers around the world are seeing increasing requirements for bandwidth as more and more video and data are moved across their networks. We believe that while still in its infancy and we're still in the infancy of IPTV, video on demand, video streaming and teleconferencing as carriers in Asia, Europe and North America are just starting to roll out these services, such as providing full length movies and full length TV episodes across the fixed and wireless network.

In terms of storage and security requirements, the demand for enterprise and individuals to be able to encode, store, replicate and access digital information continues to increase as well and we believe this is a long term trend.

So when our Tier 1 OEM customers are looking to develop next generation equipment that's based on new architectures and protocols, PMC is there with the solutions they need to enable the next generation of performance, be it for Packet Optical Transport Equipment, 10-gig Fiber-to-the-Home or solid state storage solutions as a few examples.

I believe that PMC's product positioning in our target markets is excellent. Our Tier 1 customer relationships are strong. We have new product cycles that are starting for us this year.

Based on our current expectations, I believe that we'll be able to show growth in each quarter for the remainder of the year. And we'll be maintaining our focus on cost discipline throughout the year while ensuring we execute on all of our key product development efforts in storage and communications.

Our goal will be to keep up quarterly operating expenses essentially flat on a sequential basis through the remainder of this year. So any additional revenue we generate provides additional leverage to the bottom line.

So with that, I'll now hand the call back over to Mike for more details on our outlook for the second quarter.

Michael W. Zellner

Thanks Greg.

I'll now provide more information about our Q2 outlook. First, recapping on the top line, judged, shipped and shippable backlog at the beginning of Q2 was approximately 95 million.

Considering current levels of demand and our expectation of lower booking rates through the balance of the quarter, we estimate that potential revenue for PMC-Sierra for Q2 is in the range of 114 to 124 million.

Judged backlog today, including shipped plus shippable is approximately 113 million, indicating that we need 5% turns from this state to get to the midpoint of our revenue outlook for Q2. This level of expected turns is lower than normal since we believe most of our China business has already been booked for the quarter, and we may see some rescheduling into Q3.

Needless to say, our current backlog position is a healthy indicator. On a non-GAAP operating basis, we expect the overall gross margin percentages in Q2 to increase from 64.3% in Q1 to approximately 66% plus or minus 50 basis points due to the following: a 110 basis points improvement on product mix and higher volume to absorb our fixed costs, a 60 basis point improvement on not having a customer funded ASIC mask set at zero margin in Q2, as we did in Q1.

With our continued focus on efficiency, our non-GAAP operating expenses in Q2 are expected to be approximately flat with Q1 at $53 million. We will maintain our operating expense discipline into the second half of the year.

We expect non-GAAP net other income to be 200,000, which is primarily net interest income from our cash position offset by servicing our outstanding convertible notes.

We expect the non-GAAP tax provision in the second quarter to be between flat in Q1 and 2 million. As a reminder, the tax expense can be impacted by a number of variables associated with our FIN 48 liabilities, including but not limited to a change in foreign income and product mix.

Regarding share count, we ended Q1 with a diluted share count of 224.8 million. For the second quarter... in the second quarter, our diluted share account is expected to be between 227 and 228 million.

For the second quarter of 2009, we plan for the following significant GAAP to non-GAAP reconciling items. First, amortization of purchased accounting costs associated with the past business acquisitions, stock option expense as required under FAS 123R, FX gains or losses on our net foreign tax liabilities and the income tax effect of the above adjustments and other tax items as specified in our reconciliation of GAAP to non-GAAP measures included in our press release today.

Additional non-recurring items associated with restructuring of other costs positive or negative are always possible.

With that, we'd like to open the call up for questions.

Question-and-Answer Session


Thank you. (Operator Instructions) Our first question today comes from Sandy Harrison of Signal Hill. Please go ahead.

Sandy Harrison - Signal Hill

Yeah, thanks. Good afternoon everyone.

Michael Zellner

Hi, Sandy.

Greg Lang

Hey, Sandy.

Sandy Harrison - Signal Hill

I guess, with such strong results from China and a couple of different areas both wireless and wireline, it would be helpful if you guys could perhaps sort of break out, what came from wireless, what came from wireline, and what sort of your expectations are from each one of those sub-segments going forward?

Greg Lang

Yes. That's... I think it's easier said and done, Sandy. Because if you go back and look at the products that we actually sell into the space, they are heavily in a mix. That's basically we are selling into the backhaul portion of this. But technically most of them are wireline products. But some of them are used for backhaul, some of them are used to enhance the capacity in the equipment that's already installed. So I don't think there is a crystal clear way to actually separate them.

Sandy Harrison - Signal Hill

Okay and then just a quick follow up if I could. There has been a fair amount of activity in some of the storage systems vendors and just the whole ecosystem over there. How has that generally impacted you guys with the competitive environment changing and potential pairings and so forth of now your customers, with some of your customers' customers?

Greg Lang

Some of our customers' customers. So I'm not sure what you mean by pairing of our customers' customers. Just in general, a comment just in general on the storage market that, I think you saw in our numbers and I think you saw from some of the... some of our customers who announced that business was down more than, I think people expected this quarter. And we were down a bit little more than that because we have (ph) such inventory to burn off. So we do think that the... for us the bottom of that has been reached, and we expect that we'll see some growth, modest growth in Q2 and then healthier growth in Q3 as we see some of that inventory drink it behind us. I'm not sure if that was your question Sandy, if there's something else.


Thank you. Our next question comes from Kevin Cassidy of Thomas Weisel Partners. Please go ahead.

Kevin Cassidy - Thomas Weisel Partners

Thanks for taking my question. May be to follow up with Sandy's question about storage. Can you say... you say that's going to be growing as you go through the year, do you expect that?

Greg Lang

The storage business?

Kevin Cassidy - Thomas Weisel Partners


Greg Lang

Yeah, we do expect growth in Q2, and I would expect growth in Q3 and Q4 as well.

Kevin Cassidy - Thomas Weisel Partners

Okay. And turning to the Fiber-To-The-Home in North America. Can you talk about some design activity happening there?

Greg Lang

Design activity? In North America, North America, obviously the two big guys in North America are Verizon and AT&T. I think Verizon's numbers are up to around 2.5 million subscribers in North America. I think I'm not sure exactly what the AT&T number is, but they are definitely trailing with Verizon. But it seems to be relatively slow but steady burn in both cases. Both of them are using GPON or moving I should say, to GPON technology from BPON.

For us, in terms of our own revenue stream, we don't participate or have not participated in 2.5 million subscribers that are out there today from Verizon or from AT&T. And we're working hard to win some of that business going forward. So as it opens up from a market standpoint, we can participate in that as well.

Just to give you a -- just a reference point, data point on the North American numbers I just quoted, Japan has installed about 11 million subscribers relative to the 2.5, 3 million that North America has. And China, we think, is going to be probably in the $8 million plus... million subscriber range by the end of 2009 as well. So, we're getting further and further behind in the North American market I think. But, eventually I would like to see that this market catch up as well. And timing is probably good for us since we're just working on getting our customer penetration in this geography.

Kevin Cassidy - Thomas Weisel Partners

Thank you.


Our next question comes from David Wu of Global Crown. Please go ahead.

David Wu - Global Crown

Yes. well, I guess congratulations in order. And I was wondering two things, can you clarify the growth of the server business? Is that a function of -- in the second quarter cleaning up of the channel inventory plus the initial volume from the build of the ProLiant rate project? And Q3, Q4 I assume that it's a hockey stick kind of a build in these OEM rollouts, right?

Michael Zellner

Yes. So, to clarify... hello David and thanks for the congratulations. But to clarify, it's really driven by... the server business is driven by the beginning of the early ramp of HP's ProLiant G6 platforms. So, we... as you I think are aware we had won this business with them a while back and had been working hard to help get everything ironed out and deliver best-in-class industry leading performance, and we've done that. Their Tylersburg platform just started to roll out at the end of last month and so we're seeing some of the early ramp of that business. That is a big driver for our storage business thought the next three quarters.

So, the question earlier, why I should expect growth the next three quarters? It's certainly that server business with HP will be driving that. And as there are more and more of these new Tylersburg based platforms that go out from HP, we will benefit from that directly.


Thank you. Our next question comes from James Schneider of Goldman Sachs. Please go ahead.

James Schneider - Goldman Sachs

Hi, good afternoon. I guess first off Greg, could you give us a sense of how you... you talked about the China Fiber-To-The-Home business being relatively weak in Q1 as they burned off inventory. Can you give us some kind of sense of the profile of that Fiber-To-The-Home business in China as we move throughout the year, please?

Greg Lang

Profile in what sense?

James Schneider - Goldman Sachs

How do revenues go as we move throughout the year in that business?

Greg Lang

Well, so there has really been two factors. You guys have heard us talk for the last two quarters about burning off inventory and kind of a bit of low in the -- for us Q bidding purchasing process going on. So there's two things that have happened: one is we've consumed the excess inventory in that space. But also we've now reached critical mass in this next round of bids. And the way it works basically is the China carrier will put out a bid for certain number of units but it's the 37 provinces that actually place the orders and actually pursue it.

So we're now in kind of order placement mode and actually collecting some of that demand in terms of our business. So both things kind of happened as once, so I expect actually the Fiber-To-The-Home business will probably be our largest growing business quarter-to-quarter this quarter. And I expect it could be running at a healthy cliff into Q3 as well. So it's taking a good step forward given both of those factors that have been eliminated and should stay healthy throughout the year. We also could see China Unicom who has not done any deployment thus far rule out their own offering which could add on top of that as well.

So it's a very positive signs right now we're on China with Fiber-To-The-Home front in addition to the 3G space.

James Schneider - Goldman Sachs

Thank you.


And our next question comes from Dan Morris of Oppenheimer. Please go ahead.

Daniel Morris - Oppenheimer

Hi guys, nice execution in this environment. Just looking at your comments about most of China 3G already being booked and you could see some push-out there. Could you just elaborate a little bit on that what you're seeing? Have you already started to see some push-outs or what was the reason for that comment?

Greg Lang

The reason for that comment is because we're fully broke (ph) at the beginning of the quarter. We do expect this to be a two year, a two year type of build-out in China. But as we know those orders don't come in on a linear basis. So there could be some rescheduling late in the quarter, but at the same time we could give additional upside. So it's a basically limited visibility as what I would call it. It's great that we have the backlog today, but we don't want to.. be overly optimistic based on strong early backlog.


Thank you. And our next question comes from Romit Shah of Barclays Capital. Please go ahead.

Romit Shah - Barclays Capital

Hey guys, you know Xilinx made the comment yesterday that the 3G build-out could slow in Q3. Curious what your take is on that. It sounds like you're expecting some sort of slowdown perhaps in the second half of the year. Just additional color on, are you implying that the growth gets decelerated, but still be positive? And then also I think in the last conference call, you indicated that you thought storage would be the largest market for PMC in 2009, and just wondering if that's still your expectation. Thank you.

Greg Lang

Yeah. Thanks for the question. Reality is in the second half, I don't think we -- I don't think any of us know how strong the business will be in China. We've certainly seen a very strong uptick as I mentioned earlier, at 20% quarter-to-quarter for us in the first part of the year. But we do expect it to last for some period of time. Exactly how the orders are going to come out in the second half is pretty hard for anybody to predict right now. Well, there is one analysis done by Goldman Sachs that I saw that suggested that there's going to be -- the orders in the second half would be on the order of 10% below the orders in the first half. But other than that I really haven't seen a quantifiable analysis.

So, I think it's hard for us to really gauge at this point. We know there's aggressive build plans. We really didn't get started until probably the March timeframe of this year, but we also know that it's not going to be a linear ramp. So, I think we're in kind of -- let's take it a quarter at a time and see what comes through. But on the whole, it's going to be I think a good couple of year run.


Thank you. And our next question comes from Shawn Webster of JP Morgan. Please go ahead.

Shawn Webster - JP Morgan

Yeah, thanks for taking my question. Last quarter your lead times were in like eight to 10 weeks. So, I was wondering if you could give us an update there on that. And also I was hoping to get maybe your thoughts on Broadcom's acquisition of Emulex, fiber channel is a smaller piece of your storage product line. But I was just wondering if you had some thoughts on the ecosystem there and how that may or may not change the competitive dynamics?

Greg Lang

Yeah, so, actually I feel that I answered your question a little earlier. I'll just add one as well on the storage front. I do believe by the time we exit 2009 storage, that will very likely be our largest business segment in the company. So that was one of the other earlier questions I still think that's very possible and if not probable.

The question that you asked, the first question was on lead times, I don't know that there is any material change in lead times for us right now. So, I don't know that it's worth trying to dissect that for us right now, because I think it's in line with what we had seen in the last call.

Now, on the second question that you asked on Emulex and Broadcom, this Emulex, business is in base there... the bulk of their business is in fiber channel HBAs. And I believe their largest competitor is QLogic in that arena. We don't participate there at all today on the server HBA side. So there is little overlap between our business models today. I think out in time our guess is probably 2012 timeframe fiber channel over Ethernet might become more relevant. And then we could see some overlap in the enclosure side of our business where we have fiber channel ports and those could be we could get into a competitive situation we're competing from a fiber channel and fiber channel over Ethernet space. But in the near term there is near zero impact on that type of a transaction.


Thank you. And our next question comes from Ruben Roy of Pacific Crest Securities. Please go ahead.

Ruben Roy - Pacific Crest Securities

Thanks. I would like to sneak two questions in if I could, first for Mike. On a gross margin increase, as you look out to the second half and assuming that storage does recover and becomes the largest percentage of your business, how should I think about gross margins looking at towards the end of the year?

And then just for Greg, on the HPQ number that you gave us, 30 to $35 million for this year, when you look out to 2010, I remember back at the Tech Day a couple of years ago when you announced this win, looking at the market share that HPQ had in the server market et cetera. And we are talking about potentially double that number on an annualized run rate for PMCS when the program really got going. Is that still a valid number to think about, something in the 70 to $75 million range as an opportunity for PMCS as you look out longer term? Thank you.

Michael Zellner

So let me answer the margin question first. As I think we've said in the past, our target for margins in the mid 60 is still our target, and we think very doable. We don't see anything that would suggest that certainly at this time, it would suggest that that doesn't continue to be a reasonable target for us.

In terms of -- you may have a question around the SRC device itself, because as Greg mentioned it's going to be become a much more significant piece of the overall revenue pie for us. And the way I'll answer that is it really won't have a negative impact on our gross margins from the company's standpoint. If you look at that device as a discrete item it may be slightly lower than the storage margins in general. But there are other devices sort of the C6 and the QEA et cetera that actually are above it. So again we have no reason to believe that kind of generally our target for the mid 60s isn't intact and very doable for us for the rest of the year.

Greg Lang

And part two of your question on the HP part, your recollection is correct. We did say something in the order double that 70 to 75 million, I believe the number was. And we still think that's achievable in 2010, keep in mind 2009 is really a ramping up year, where we are transitioning from an old platform to a new platform. So that's why it's a partial for that number.

I'd also mention that's just one customer that we are targeting here. We also have this program going on with IBM, which will start generating some revenue in 2010. And we're also looking at, of course, pursuing other business in the service segment. So there is a lot of legs behind the growth potential in this part of our product mix.


Thank you. (Operator Instructions) So we do have a follow-up from David Wu of Global Crown Research. Please go ahead.

David Wu - Global Crown

Greg, as far as WAN, if you could tell -- is there another step function upward in the China rollout of that infrastructure that we're talking about, i.e. this is the first of year of the deployment in 3G infrastructure. Is 2010 another kind of a step function upwards, even though we can't forecast the quarter's -- with a precision at this point?

Greg Lang

I don't believe it we're going to see another step function. I mean the general, the high level estimates have been, basically a $40 billion CapEx spend and 20 in '09, 20 in '10, that's a little crude when you're talking about selling components into individual boxes. But I don't have any reason to believe there'll be step function to oppose that. I think that the levels that we've kind of ramped up to now, and where we kind of go back and try to calculate what kind of number of base stations we're supporting with that, it feels like we've kind of hit that level that is sustainable for the next couple of years.

So, I guess the answer is no, David. We don't expect a big step function up. Now, there is another peace of the business by the way for us to keep in mind is for more traffic that gets run over this network, the wireless network, this is worldwide not just China. The more people are going to realize, they have to upgrade their Metro infrastructure to transport the data on that. That's happening in North America, I think the iPod was a wake up call for... excuse me not the iPod, the iPhone is a wake up call for a lot of folks. The amount of data traffic you could actually generate off of the wireless network. So, we think there is a wave of infrastructure upgrades that will come from that. It will come from video on demand, video IPTVs network services.

But that's not necessarily same arena that you were talking about with China and specifically the wireless upgrade. But we think we'll get some residual benefit from it with all the traffic growth that's coming.


Thank you. Now we do have a follow up from James Schneider of Goldman Sachs. Please go ahead.

James Schneider - Goldman Sachs

Thanks. Just to follow up on the storage business. Greg, you talked about the 30 to $35 million business from HP this year. Could you give us a sense or a little more granularity of how much of that is in the second half of the year versus the first half? And then if you could address your storage customer inventory levels at this point that would be great. Thank you.

Greg Lang

Yeah, I mean, I won't try to guess the exact numbers but we're just getting ramped up this quarter and we'll do several million dollars of revenue this quarter and the rest is in the second half. So it's obviously pretty heavily weighted in the second half.

In terms of the inventory, we believe that we're going to be through the most, the bulk of the inventory on the storage side by the end of Q2. Clearly we've been working through that in Q1 and clearly that will also move into Q2. If you remember we had a very strong quarter in Q4 as well, there is lot of equipment guys. But it felt pretty... our business throughout where rates felt pretty hard in Q1. So, it trailed a little bit some of the fall-offs in the other businesses. And I think it'll take us into Q2 to actually work the rest of that off.


Thank you. And now gentlemen there are no further questions. Please continue.

Greg Lang

Thank you, Joshua. Thank you for attending our conference call today. And we'll be scheduling our second quarter 2009 earnings release for the third week in July. At that time we'll be reviewing our quarterly results and providing an outlook for the third quarter of 2009. Thank you and that ends today's call.


Thank you. Ladies and gentlemen this does conclude your conference for today. We thank you for your participation. You may now disconnect and have a great rest of your day.

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