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Executives

Dr. Paramesh Gopi – President & CEO

Bob Gargus – SVP & CFO

Analysts

Ambrish Srivastava – BMO Capital Markets

Patrick Wang – Evercore Partners

Brian Peterson – Raymond James

Krishna Shankar – ROTH Capital

Brian Thonn – Kingdom Ridge Capital

Applied Micro Circuits Corporation. (AMCC) F4Q 2013 Earnings Conference Call April 25, 2013 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Quarter Four 2013 Applied Micro Circuits Corporation Earnings Conference Call. My name is Shawn and I’ll be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session toward the end of this conference. (Operator instructions) As a reminder, this call is being recorded for replay purposes.

I would now like to turn the call over to your host, Mr. Bob Gargus, Senior Vice President and Chief Financial Officer. Please proceed, sir.

Bob Gargus

Good afternoon, everyone, and thank you for joining today’s conference call. On the call with me is Dr. Paramesh Gopi, our President and CEO.

Before turning the call over to Paramesh, I want to remind you that the forward-looking statements discussed on this call, including guidance we will provide on revenue, non-GAAP gross margins, non-GAAP operating expenses and certain other financial targets are based on the limited information available to us today. That information is likely to change.

There are numerous risks and uncertainties that affect our business and may affect these forward-looking statements. These risks include items such as the completion and performance levels of our ARM-64 bit X-Gene Server on a Chip products; the TAM and market acceptance of such products; the amount and timing of payments under the Veloce merger agreement; product development and introductions, design wins, manufacturing and supply availability, product demand and mix, the impact of personnel reductions and departures, employee relations, the integration of new or moved operations; risks resulting from macroeconomic conditions and market and other risks as set forth in our SEC filings, including our Form 10-K for the year ended March 31, 2012.

Our actual results may differ materially from these forward-looking statements. Applied Micro assumes no obligation to update forward-looking statements made on this call. I want to point out that Applied Micro has several analysts that cover our stock and this creates a range of variability relative to the Street financial models. When we say Street estimates, we mean the consensus of the major analyst models, and not necessarily the guidance that was given by the company.

With that I’m going to turn the call over to Paramesh. Paramesh?

Paramesh Gopi

Thanks, Bob. First I’d like to point out that we achieved breakeven on a non-GAAP basis while fully preserving all of our strategic product initiatives focusing on X-Gene and expanding connectivity into the data center while sustaining our Telco product leadership.

This achievement is a direct result of our solid base business. Our data center connectivity products and embedded processor products continue to drive meaningful margin contribution as they reside in high volume routing and switching platforms from the worlds leading networking and data center OEMs.

Our profit breakeven puts us in a strong financial position to continue to execute on our X-Gene strategy. This also positions us to build on X-Gene time-to-market lead to gain market share and translate that revenue growth and expanded profit margins.

Let me now comment on our significant progress with respect to X-Gene this past quarter. First, APM shipped X-Gene, the world’s first and only ARM-64 bit Server on a Chip silicon platform. X-Gene samples and development platforms were shipped to multiple Tier-1 customers ahead of schedule.

Market interest and demand for X-Gene platforms has far exceeded our expectations and further cemented our first mover advantage, paving the way for accelerated market adoption of ARM-64 bit servers.

Second, HP announced the availability of an X-Gene cartridge for their Moonshot production server platforms. Customers will be able to order an HP project Moonshot system with APM’s X-Gene server later in 2013. Commercial availability is a major step for the industry as a whole and clearly validates the following.

Number one, software ecosystem readiness, our seeding of the ecosystem with hardware development platforms last year paved the way for commercial deployment such that software should not becoming a gaining factor in X-Gene adoption. Number two, X-Gene provides true enterprise class ARM 64-bit high performance processor cores coupled with fabric and networking and offers substantial TCO savings.

Based on our test in the lab so far, we believe that X-Gene performance and TCO savings are consistent with our expectations. Number three, our ARM server revenues are expected to occur in calendar year 2014. We believe X-Gene is positioned to be the clear leader in this space. Third, I’d like to offer another proof-point that X-Gene is being recognized as the world’s first and highest performance ARM 64-bit core. Earlier this month, Altera Corporation announced a strategic cooperation initiative with APM to partner on FPGA plus X-Gene platforms for Next Generation data center and Service Provider solutions.

Fourth, we are pleased to announce the world’s first enterprise class ARM 64-bit server system developed in platform based on X-Gene. This platform consists of both X-Gene hardware and software components including compilers, operating systems, virtualization, and application software for multiple Tier 1 ecosystem partners.

We expect to be shipping these development platforms during the June quarter. Finally let me share with you what I believe is the most compelling and most exciting proof-point for us. Our APM website, www.apm.com is now fully running on an X-Gene server on a chip platform. We invite you to experience this at your earliest convenience.

Before turning to the product lines, let me briefly comment on the macro environment. Q4 fiscal 2013 financial results – excuse me – I’m going to reset our Q4 fiscal 2013 financial results will include the following. March quarter revenues were $56.3 million up 9% sequentially and up 15.5% compared to a year ago in the March quarter. This revenue achievement was in the mid point of the guidance given during the last earnings call. Our backlog as of the end of the quarter was 57%. We ended the quarter with 85.5 million of cash on the balance sheet with no debt.

Let me now turn to our connectivity business. Our connective revenues were $25.7 million and increased 21% sequentially over the December quarter. We are very encouraged by the continuing strong design win traction. Last quarter, we garnered more than $64 million in expected lifetime value compared to $60 million achieved in the December quarter. We would like to begin by discussing our Altera partnership.

As part of our strategic cooperation initiative with Altera, we sold our TPACK product line but the terms of the sale allow us to retain full access to all current TPACK IP for our current and future 100-gig products. Moreover, our strategic cooperation initiative with Altera enables the APM to bundle our data center and OTN files and framers along with Altera FPGA insuring our participation in the high margin service provider 100-gig and 400-gig marketplace.

It will also enable APM and Altera to cooperate on joint platform bundles for networking, wireless, and data center applications for X-Gene and Altera FPGAs. This is absolutely key as we expand X-Gene’s reach into the broader service provider market through Altera’s sales force and channel partners.

Service provider market conditions remain murky, as the carrier and telecom infrastructure got off to a slow start in 2013. If an increase in carrier spending does occur in the second half this calendar year, we are well positioned to take advantage of service provider CapEx increases due to our design wins and our new partnership with Altera.

Let me now return to our mainstream data center connectivity business outlook. According to the Cisco cloud index, global data center traffic will grow from 1.8 zetabites per year in 2011 to 6.6 zetabites per year in 2016. This represents a cumulative aggregate growth rate of 31% through 2016. Edge routers continue to be the fastest growing part of data centers of all sizes.

APM’s strong design position on OTN and Ethernet converged line cards continues to drive growth and the resulting data center revenue was $12.8 million for the March quarter and relatively flat compared to the December quarter of $13.1 million. Our product mix continues to shift to our data center business as our newer product lines begin to mature in this sector.

Our five design wins for both service provider, telecom and data center vectored nicely particularly with our high speed 100 gigabit per second QPS gear marks and gearbox product. Design wins for our 100 gig QPS gear marks product used in 100 gig coherent applications, now include eight of the world’s largest optical module manufactures and vertically integrated 100 gig system companies.

Each customer is actively designing one or more solutions based on our chips. Two of the largest customers are now entering production ramp mode which is expected to result in meaningful revenues later this calendar year.

Let me now turn to our computing business. Computing revenues were $29.2 million for the fourth quarter and were down slightly from the December quarter’s $29.5 million. This was anticipated as the December quarter was up sequentially 24% over the September quarter and was not surprising given the Q3 book-to-bill of 1.39.

The book-to-bill for the second half of Fiscal Year ‘13, Q3 and Q4 combined, was 0.96. We continue to garner design wins for our TSMC-based power PC products in the 11 AC enterprise AP NAS and DAS Markets. It is important to note that our revenue this past quarter was slightly muted by the faster than expected 11n to 11ac transition in the enterprise wireless infrastructure. We continue to see strong demand for our products in this space and an increasing shift towards X-Gene based ARM derivatives for the embedded market.

Leading networking OEMs have taken a close look at our on capabilities and have identified specific platforms that would benefit from X-Gene. Developing the software ecosystem for this diverse and complex networking application requires a cooperative effort to address common challenges. APM is proud to be a founding member of the Lonaro Networking Group or LNG. LNG offers a forum for members to implement standards thereby accelerating the broader ARM networking and Linux software ecosystem initiatives.

In the embedded networking space, 2013 should be a pivotal year in the transition from single instruction set architectures, or ISAs, to dual instruction set architectures. That is PowerPC going to PowerPC plus ARM.

These ARM cores will run application software on control plains. Our unique differentiation of offering both ARM and PowerPC processors on the same dye today puts APM in a good position to lead the transition towards an all ARM-based infrastructure for the embedded space.

With that, let me turn the call over to Bob. Bob?

Bob Gargus

Thanks, Paramesh. Fourth quarter revenues were $56.3 million, up $4.6 million or 9%, compared to the prior quarter and increased 15.5% compared to the same quarter a year ago. I would remind you that the consensus was $56.0 million. Sales to North America accounted for approximately 42% of total revenues, sales to Europe contributed 16%, and sales to Asia contributed 42%.

Wintec, a global logistic support vendor, accounted for approximately 18% of March quarter revenues versus 21% in the December revenue – December quarter. There was one distributor that was more than 10% and that was Worldwide Avnet, which accounted for 25% compared again to 27% in the December quarter.

Distributor revenues for the fourth quarter were approximately $39.8 million compared to $33 million for the prior quarter. Inventory in the channel based on sell-through numbers increased to 78 days compared to 61 days for the December quarter.

Turning to the P&L, as previously mentioned, we delivered on our commitment of breakeven on a non-GAAP basis, and we delivered a small profit versus a street consensus of a loss of $0.01. Our non-GAAP net income for the quarter was $0.01 million, or $0.00 per share, compared to the non-GAAP net loss of $6.9 million, or $0.10 per share, for the prior quarter.

Our non-GAAP operating margin was a negative 1% of revenue and improved 14.1 points from the negative 15.1% achieved in the last quarter. Our non-GAAP EBITDA for the quarter was a positive $2.9 million, or 5.1% of revenues, compared to a negative $3.9 million, or negative 7.6% of revenues, for the prior quarter.

The fourth quarter non-GAAP gross margins, including licensing, were 63.8%, which was much higher than the 57.2% for the December quarter. This was higher than our guidance of 59.5%, plus or minus 0.5 point. So let me explain the delta as well as specify which parts are not recurring items.

First, the gross margin excluding TPack for the fourth quarter was 62.9% versus 56.5 for an improvement of 6.4 points. Of this, 3 points was anticipated as favorable product mix and included in the guidance.

An additional 2.3 points came from the sale and recovery of previously reserved inventory, meaning it was on 100% gross margins. This is not a reoccurring item, meaning it was a one-time favorable impact. The remaining 1.1 points was caused by favorable absorption and yields, which tend to vary quarter to quarter, and this quarter it was favorable.

Looking forward to the June quarter, we expect no licensing revenues. And we expect gross margins to be approximately 56.5%, plus or minus 0.5 point. If you take the 62.9% achieved in March, the delta to the June guidance of 56.5%, plus or minus 0.5 point is a decline of 6.4 points. The decline is comprised of 3 points due to unfavorable product mix and 3.4 points due to the non-recurring favorable impact in the March quarter from the sale of previously reserved inventory, variances and absorption. Basically, this means that we are guiding to gross margin levels similar to those achieved in the December quarter, i.e., 56.5%.

Non-GAAP operating expenses were 36.4 million and came in higher than the guidance of 34 million to 34.5 million. These operating expenses were higher than our guidance mainly due to legal costs that were incurred related to, one, the disposition of our TPack operations and two, a litigation where we were the plaintiff. Both of these matters have concluded successfully and we do not expect these costs to reoccur going forward.

For the June quarter we expect our non-GAAP operating expenses to be in the range of 30 million to 31 million. This reduction will relate primarily from the restructuring plans that were implemented during the December quarter.

Our non-GAAP interest and other income was 0.5 million. Interest and other income expected to be approximately 0.4 million for the June quarter. We expect to incur approximately 0.3 million in taxes, primarily relating to our international operations for the next several quarters. This relates primarily to our operations in India where the tax holiday that we had previously enjoyed has expired and is no longer available.

The share count for diluted EPS purposes was 68.5 million shares. Looking forward to the June quarter, we expect the share count to be approximately 70 to 72 million shares, the increase is primarily due to additional equity grants related to the Veloce post closing earn out milestones and additional shares related to our corporate equity incentive program likely to be issued in May.

Turning to the balance sheet. Our cash and investments totaled 85.5 million or approximately $1.30 per share at the end of the fourth quarter, an increase of approximately 1.2 million from the December quarter. Our DSO at the end of March was 39 days. We expect this measure to be in the range of 30 to 42 days going forward. Our inventory turns for the March quarter were 6.3 similar to the turns for the December quarter.

Let me take a couple minutes to bring you up to speed on the Veloce payments. Aggregate Veloce payments are expected to be in the range of approximately 139 million up to a maximum of 178.5 million. Let us assume the payout to be the maximum amount of 178.5 million.

Of this we have already paid 33.2 million comprised of approximately 3 million shares and 16.6 million of cash, leaving a balance of 145.3 million. During the June quarter, we are expected to make payments estimated to total at least 47 million comprised of approximately 32 million of cash and approximately 15 million in stock or 2.3 million shares.

Another milestone payment of approximately 27 million could be paid either in the June or the September quarter. The cash versus stock split of the 27 million is not known at this time. This would bring the total to be paid by September 2013 to 74 million.

Our decision as to what mix of cash and stock to use in making these payments have been based and will continue to depend on several factors including our stock price and cash requirements at the time the payments become due. Although we are mindful that this creates some uncertainty as to our future cash balance, we expect that our resources will continue to be sufficient to make such payments while maintaining adequate cash to run our operations.

To summarize, through September we expect to have paid a total of approximately 107 million in Veloce consideration. Let me also cover here the impact of the sale of TPack to the financial models. Basically the impact of the fiscal year ‘14 income statement will be to lower revenues by 7 million to 10 million and to lower expenses by 7 million to 10 million, i.e. the disposition is profit neutral although it impacts revenue, gross margin as a percent of revenue and operating expenses.

Turning to GAAP, our non-GAAP financials include certain items required by GAAP. Our net loss on a GAAP basis was 30.2 million versus a net loss of 71.6 million last quarter. The difference on our fourth quarter GAAP net loss of 30.2 million in our fourth quarter non-GAAP net income of 0.1 million is a delta of 30.3 million.

The 30.3 million is primarily comprised of 22.2 million for the acquisition of Veloce, 2.7 million of stock-based compensation, 0.2 million of restructuring charges, 1 million of amortization of purchase intangibles, 5.2 million from the impairment of certain equity investments assets and marketable securities, offset by a favorable 1 million of other income tax adjustments, a complete reconciliation between GAAP and non-GAAP financials is set forth in our earnings release which can be found in the Investor Relations section of our website. Please note that there is no reconciliation for forward-looking non-GAAP measures.

That concludes my remarks. Let me turn the call over to Parmesh. Parmesh?

Paramesh Gopi

Thanks, Bob. In summary we had a very good quarter where we delivered our guidance, achieved profit breakeven, even on a non-GAAP basis and are executing extremely well on our ARM X-Gene Server on a Chip strategy.

Our March quarter revenues excluding TPack were $55 million. Against this we are guiding our June quarter revenues to be in the range of 52 million to 56 million with a midpoint of 54 million. We expect gross margins to be in the 56.5% range plus or minus 0.5 a point. With the expense reductions we implemented in the December and March quarters, we expect to be breakeven in the June quarter.

With that let me turn the call over to Bob. Bob?

Bob Gargus

Thank you, Parmesh. Just before going to Q&A, let me specifically recap our guidance for the June quarter. Total revenues excluding TPack are expected to be in the range of 52 million to 56 million with a mid point of approximately 54 million. While we exited the quarter we have a backlog coverage of 57%, our backlog coverage jumped to 74% as of the first week of April due to a large customer that was moved into the June quarter.

Total gross margins were expecting to be 56.5% plus or minus 0.5 a point, OpEx roughly 30 million to 31 million, interest income of 0.4 million, and taxes of about 0.3 million. I also want to mention that we are committed to breaking even at a minimum for each of the quarters of FY ‘14.

That concludes our formal remarks. Operator, please provide instructions to our listeners for the queuing process.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Ambrish Srivastava from BMO Capital Markets. Please proceed.

Ambrish Srivastava – BMO Capital Markets

Hi, thank you. Bob, just a clarification on the gross margin for the remainder of the fiscal year. Given that TPack is not in the P&L anymore, how should we be thinking about GM for the remainder of the year?

Bob Gargus

So if you look at the gross margins for let’s say like the June, September, December quarters, I think they were right in that 56.5% 57% range. We don’t really see a major change in those, at least until X-Gene starts creating revenue, so for now, we guided to the 56.5 for this quarter and out in time, again it will be a function of product mix unless we happen to get favorable variances like we had in the March quarter. So 56.5 to 57 is probably a good range for now.

Ambrish Srivastava – BMO Capital Markets

Okay, and so good segway into X-Gene Paramesh. Good progress so far. It seems to be ahead of schedule. A couple of questions. Just please remind us between now and end of the year what are the key milestones we should be looking for. And then, just going back to the project moon shot announcement from HP, if I remember correctly, the statement from APM indicated that you would be ready to ship for revenue by the end of this year so that seems that will be ahead of the schedule that you had laid out, thank you?

Paramesh Gopi

Let me take it back and recap. It’s a major quarter for us because now we’ve brought a significant amount of reality in this category and being actually the first and only legitimate solution in this space also has a very unique pole position and view into adoption cycles for such technology, so coming back to the adoption cycle itself, we’ve always maintained that it would occur in the following fashion. We would have customers sample our platforms and sample our silicon this quarter.

Next quarter would be the quarter where we put our silicon on their boards, bring up the boards along with us while they are simultaneously starting to develop a new software from FPGA platforms that were there last year this time to our silicon platforms and then between June, between the – and in the fall of this year.

They would be what I call pilot infrastructure testing where they would actually start to run key applications for their respective application benchmarking for their data center deployment and they would have a feedback cycle to us in terms of optimizing things like tool change and so forth between the fall and the winter and that we would be ready to ship GA product first half of next year, I mean first quarter of next year.

Now having said that, we’ve been very pleased with the progress we’ve made so far in terms of the rate at which things have come to fruition in terms of our development. Just to come back and answer your specific question about HP, I think it was the first time HP acknowledged that they will be scheduled availability of release of a moon shot cartridge with an X-Gene 64 bit server on it end of the year, so that is in concordance with the HP server platform release.

Ambrish Srivastava – BMO Capital Markets

Okay, thank you. One real last follow-up before I recede the floor. What is the mix of the customers that are showing the interest? Is it mostly kind of the newer data center outside of the traditional players? Where is the majority of the interest coming from? Thank you.

Bob Gargus

Let me take you back to the way X-Gene was conceived. X-Gene was conceived after a lot of feedback from what we call vertically integrated mega data center operators and the category would exemplify people like Amazons of the world, Google of the world, et cetera. That’s one thing, right?

The other category of customer would be essentially the traditional server OEM, right. And those would be the Dell’s and HP’s of the world which we’ve already announced are fully in sink with us and participant in rolling out platforms based on our silicon and the third would be the networking/converge networking OEMs, the class of those would be exemplified by people like Huawei and Cisco, right? I would say that the interest is coming and the traction is across the Board and there are things we can disclose and there are things we can’t, but one should assume that it’s a very wide set of traction that we’re getting with this product.

Ambrish Srivastava – BMO Capital Markets

Thank you very much. Good luck.

Bob Gargus

Thanks.

Operator

Thank you. Your next question comes from the line of Patrick Wang of Evercore Partners. Please proceed.

Patrick Wang – Evercore Partners

Yeah, hi guys. Good job hitting breakeven on the quarter. You know my first question, I wanted to ask you about this core business you guys have got going on. It sounds like you’re on an apples-to-apples basis taking it down a little bit sequentially. I think you said your backlog coverage is about 57%. Can you talk about just what you guys expect over the next couple months here and how we should think about carrier CapEx spending and how those trends play out?

Bob Gargus

So Patrick, this is Bob. I’d say first, the base business has been and continues to get good design win traction and while we started on April 1 with 57% backlog, that backlog increased to a more normal 74% by April 7 and there was a big large order which you guys do the math will be like $9 million to $10 million that moved into the June quarter which is what caused that to rebound that way.

Now the reason that we guided to be down slightly in the June quarter, and by the way, most of the street models I had guided to before was flat with the June or with the March quarter, okay? So from that perspective, this is not a big change and that was anticipating basically what I think everybody is learning now which is the Service Provider CapEx was slow or very muted at least in the first quarter.

Now there are signs or rhetoric out there that that will increase during the remaining part of the year and to the extent it does, we should see the benefit from it but I’m not going to build that into the guidance until I start to see it in the order patterns.

Patrick Wang – Evercore Partners

Got you. Okay, that’s helpful. So if we do see an uptick in spending there, it would show up in the September quarter or perhaps even later on this quarter in the June quarter?

Bob Gargus

Yeah, so Patrick, maybe some color there, right? I think if you look at the net number of hundred gig links that are going to be lit up this next year by any Analyst estimate, between the last six months, those estimates have been revised dramatically to show somewhere between 12% and 20% increase in terms of large scale adoption of hundred gig, right? While we haven’t seen that trickle down to more WDM or more inter data center type actual awards at the equipment level. I can tell you that we are in a fantastic position because of our design win momentum in that space and our existing socket positions to really benefit once that space starts to get funded.

Patrick Wang – Evercore Partners

Okay. Got you. That’s helpful. My next question is, you know, Bob thanks for kind of laying out the Veloce components of payments here. So, if we kind of fast forward to the September timeframe, you said that you’ll have about 74 million left to be paid, 107 kind of in your back pocket already. Assuming kind of breakeven for the next couple quarters until we get there, let’s just assume worst case scenario, what happens to your cash?

Bob Gargus

So first, the cash ended the quarter at 85 million. That’s pre the TPack, so the cash will go up by the 30 million of TPack and then it will go, you’ll have cash going out based on the 47 million that we just talked about which I think was about 31 million in cash, so that’s going to bring these back down to about the 84, $85 million level and then I don’t know how much of the 27 million second milestone that we talked about is going to be paid in cash versus stock.

Even if half of it was cash, that would still only take me down to about the $70 million level which is very easy for us to handle. Now from that point going forward against the remaining Veloce payments, questions going to be, what our cash positions like at that point in time, what other possible assets could be monetized, what kind of business we’re doing, and how much we might want to issue in shares and what the stock price is and just too many variables to really speculate on.

Patrick Wang – Evercore Partners

Okay. Got you. But it seems like from now until September, you guys are assuming even flattish trends without an uptick that cash should be fine?

Bob Gargus

Yeah, we should still be in the, I’ll give myself a little wiggle room for working capital quarter-to-quarter which you never know about. But we should be in the $65 million plus or minus 5 million kind of range.

Patrick Wang – Evercore Partners

Okay. Got you. That’s good to hear. And then last question on X-Gene. There seems to be...

Bob Gargus

Patrick? One other thing, right. I mean, I wanted to also make one point. I think Bob made it but I want to emphasize it. We’ve so far been very judicious in the way we’ve actually used our equity in the company to incentivize Veloce folks and we’ve got the right mix in our mind to make sure that the Veloce folks who are truly, I’ll call it part of the transformation of our company are here for the long term, right.

So I think the ability for us to continue to give them the right long-term incentives, as well as short-term incentives by blending the cash, as well as the equity is really helping us both from a team acceptance and team retention and integration kind of scope, all the way to actually really becoming stakeholders in building a real solid server business.

Patrick Wang – Evercore Partners

Got you. Okay. That’s – it sounds like your team is pretty pumped over there. So just last question for me. When we take a look at X Gene over the course of this year you’ll have a 40-nanometer part out, production kind of in the back half of the year. Intel will have their first well, I guess, their second generation Avaton and Sosion in the fourth quarter. And you guys would really on be the 64 bit solutions out there. But when we get to the point when you kind of look at the compare and contrast the two, look Intel has got a lot of marketing muscle and they’ve got a lot of experience in server. What’s the best way to think about how X-Gene stacks up even with the 40-nanometer part?

Bob Gargus

So I think, let me take you back to a larger market trend here, right? I think the market has spoken largely that there is a need for alternative architecture to x86 for cloud and web scale data center workloads, right. That market is now fully serviced by the higher end of the Intel Xeon architecture, right.

So the way we view it is that the market has spoken relative to the actual TCO requirements that are going to be required for specific cloud workloads. And those TCO requirements involve the ability to fuse very high performance networking and mixed signal along with correctly sized processor cores that give you the requisite level of performance to have what I call a clean and seamless work load port from the current infrastructure to an ARM based infrastructure.

Having invested in both 40 and 28, remember our view and I think we’ve talked about this earlier on the last call, that our 28-nanometer test chips are already on their way. And we’ve talked about this publicly before that when we do a server, and the server market expects what I call a volume generation and the technology generation. And we’ve also publicly disclosed that while on this generation of product, our entire focus has been how do you provide maximum 10-gig and maximum memory bandwidth and maximum integrated I/O with the requisite performance.

And by the way, I’ll say that I don’t think anybody in the processor space has broken 2.35 gigahertz or 2.4 gigahertz in 40-nanometers. So from a performance perspective, we’ve done something that nobody else has done. From an integration perspective, we’ve done something that nobody else has done. So if you look at traditionally the Atom class of parts versus the Xeon class of parts, the way to think about our offering is closer to a Xeon class offering than an Atom class offering, number one fused with the maximum amount of I/O.

I mean we have 40-gigabits per second of Ethernet on this generation. Our next generation as we’ve talked about will embody the notion of 100-gig Ethernet type I/O connectivity, right? So I think if you compare this you almost want to say that we cannot reinvent the cloud software. We have to be able to work within the software environment that exists today.

We have to give folks the requisite performance levels that they require today. So I will say that we have embodied all of what people need to run current and future workloads and really change the I/O, the storage bandwidth as well as the net TCO because of the unprecedented level of integration that had been brought to the space.

Patrick Wang – Evercore Partners

Okay. Got you. Good job and good luck guys. Thanks.

Bob Gargus

Thank you.

Operator

Okay. Thank you.(Operator Instructions) Your next question comes from the line of Hans Mosesmann of Raymond James. Please proceed.

Brian Peterson – Raymond James

Hi, this is Brian Peterson in for Hans. Bob just a quick question. The channel inventory spiked up pretty significantly sequentially. What’s your comfort level there?

Bob Gargus

Pretty good because we think that that’s in anticipation of deliveries that will be going out in the June quarter from channel. So remember when we look at sell-through we’re looking at a backward basis. But we’re always sensitive to it, that’s why we also reported to you guys and I would expect this thing to come back down probably in the June quarter.

Brian Peterson – Raymond James

Okay. And is that build more connectivity your computing related and did you guys disclose the turns coverage implied in the guidance?

Paramesh Gopi

So the guidance turns business if you did it as of April 1 would be 47% and would be high. If you do it as of April 7 because of the large order that moved into the June quarter, it would be 26% and that’s fairly consistent because in the last few quarters we’ve been around the 75, 76% coverage or 24, 25% kind of turns. So this is kind of right in there with more normal kinds of turns. And now you asked another question I don’t think I answered it the first.

Brian Peterson – Raymond James

The mix of the inventory build with connectivity versus computing?

Paramesh Gopi

Yeah, so it was more connectivity related because if you notice the mix went up by three points and that was caused because more of our shipments were connectivity related.

Brian Peterson – Raymond James

Okay, got it. That’s it for me. Thanks guys.

Bob Gargus

Thank you.

Operator

Thank you. And the next question comes from the line of Krishna Shankar of ROTH Capital. Please proceed.

Krishna Shankar – ROTH Capital

Yes, congratulations on the progress with X-Gene. Can you help us understand the size of the market that the current version of the X-Gene is addressing and then when you bring the 28-nanometer product on what enhanced features and capabilities will that have?

Paramesh Gopi

Well, I think I’ll refer you to – I think I’ll make two statements here and the rest of it is pretty much we can – you can have an offline conversation. But this is for the cloud server market which today by multiple Analyst estimates is between 25 and 28% of all servers shipped. This is not a niche ARM core. This is a server class, enterprise class ARM core. So the addressable market for whatever generation that we bring, whether its 40 or 28 is the entire market type for the cloud, right. And the cloud market also has the largest growth CAGR in the entire server space.

So I think the point – the two points is that we are not a niche market player. This is for every variety of cloud work load because it is an enterprise class custom ARM core in both generations and it’s not a mobile or a sub par ARM core. I think that’s the number one point of clarification.

Number two point of clarification is that the iO mix that we’re targeting is squarely aimed at this market where higher performance networking and higher performance Ethernet, as well as the ability to scale out from a fabric perspective exists by definition in both generations.

Krishna Shankar – ROTH Capital

Great. And then on the connectivity side of the business, can you talk about what products will drive the connectivity part of the business over the next few quarters?

Paramesh Gopi

Yeah. I think we have said this. Once again, our entire business is moving towards data centers. And we – today, we pretty much have the core position in terms of the OTN and 10-gig Ethernet market.

As to give you some notion of the rate at which that market is accelerating, if you look at the company and its shipment of 10-gig OTN ports, essentially, we quadrupled the shipments in time rate between 2011 and 2005. Right. So, over six years, we shipped 1 million ports. Over the last two years, we shipped 1.5 million ports.

So we’re pretty much essentially driving the adoption of 10-gig converged OTN and Ethernet in the data center. And the biggest evidence of that is – look at the mega data centers and what types of edge router platforms as well as edge switch platforms on the telecom side that they’re using. If you look at a survey of that, we’re probably in over 60% of all those platforms.

Krishna Shankar – ROTH Capital

Great. Thank you.

Operator

Thank you. And your next question comes from the line of Brian Thonn, Kingdom Ridge Capital. Please proceed.

Brian Thonn – Kingdom Ridge Capital

Hi, guys. Thanks for taking my call. Two questions for you. First off, Bob, I think, you mentioned to an earlier question around gross margin expectation going forward without X-Gene of being – we’ll call it 56.5 to 57. What happens after X-Gene starts to ramp? What does that start doing to your gross margin?

Bob Gargus

We said before that we expect X-Gene to be in the 60 to 70% gross margin category. So the impact that it would have on our gross margins would be a function of what percent of the total revenue it is.

Brian Thonn – Kingdom Ridge Capital

So that’s going to be the same no matter whether it’s 40-nanometer or a smaller geometry?

Bob Gargus

We believe so. For now for planning purposes, it’s a good number to use.

Brian Thonn – Kingdom Ridge Capital

Okay, got it. And second, are there any, I mean I think Paramesh, you mentioned in your prepared remarks that you had seen pretty good demand for the platforms from potential customers out there with software providers. Is there any kind of color you can provide maybe on kind of the breadth or depth of client demand for X-Gene right now and realize it’s the sample product? I’m just kind of curious what’s the uptake like? Are there any either quantitative or qualitative measures you can give us to help us kind of track what’s going on with X-Gene right now?

Paramesh Gopi

I think the best; I think there are a couple measures we can talk about, right? One is that if you look at the range of customers that we’re sampling to, it’s absolutely single digit. They’re all extremely large OEMs or mega data center operators. They have been – involved with the initiative of putting on in the data center at a performance level that they’ve required because nobody wants to rewrite their software environment so number one.

Number two, I think the I can tell you that I think if I were to conglomerate or aggregate the amount, the number of boards that we’re going to be seeing leave our premises over the next month to two months, we’re talking about many, many hundreds of boards. Okay, these are boards. These are platforms, not chips.

Chips are a separate track, so at this point in time, we are way ahead of where we thought we would be relative to getting a fully functional software-ready ecosystem capable platform into the hands of these customers to start doing their development, application development, right.

So I think from where I stand and by all takes, we’ve brought an unprecedented level of reality to this category today. And truth be told, we are an allocation, relative to being able to support the intense amount of work that is going to be, that is there to ship this many number of full platforms to these top guys. So we’re pretty fired up relative to being able to drive the adoption of something like this into the marketplace because of our first mover advantage.

Bob Gargus

This is Bob. So when you start thinking about the number of Boards, the reason is it’s probably maybe higher than you might have thought about is because nobody wants a single board and want to fill up a rack or a cabinet or a couple cabinets fill up, so you know they are not going small. They are going kind of big real quick on this in some ways.

Paramesh Gopi

And I think to Bob’s point, there is one point I’d like to make and I think Krishna had asked the question. X-Gene is not in niche market. Many ARMs makeup – many small ARMs make up one big x86 architecture processor. X-Gene fundamentally has that enterprise level performance today and a typical cloud server populates multiple X-Genes on essentially blade and or multiple X-Gene in a rack, right?

So that’s the density that we’re talking about and then if you were to take that and extrapolate it, today’s market essentially if you look at the server market, 28% of all servers are exactly the target market for all of X-Gene, so if you look at today’s server market estimates they are estimating a server market anywhere close to between $12 billion and $15 billion for silicon. 28% of that market is the exact TAM for X-Gene class products. So 28% of that is roughly about $3.5 billion.

Bob Gargus

And Brian, just for what it’s worth, when I try to explain this to people, I say well you can have a lot of smaller RM cores and for certain work loads, they will do fine, but it’s a little bit like if you had a big rock that weighed 500 pounds and you had two big guys that could each lift 250, they can lift it but if you had 10 guys that could only lift 50 pounds, they all can’t get around the rock to put their hands on it so they can’t lift it no matter what, so there’s workloads. And the best proof I could say is if you could do little bunch with little cores, then atom and stuff like that would erode Intel’s Xeon class processor business.

Paramesh Gopi

That’s true. Yes.

Brian Thonn – Kingdom Ridge Capital

And so maybe to drill down the TAM a little bit when we think about when we do our own kind of bottoms up calculations, how should we think about I guess maybe the trajectory of units you think you can get into over time, maybe in ‘14 or ‘15, you’ve kind of given us the aggregate side.

I’m wondering if you can maybe help us a little bit with trajectory? And then also on the other side of that kind of ASP, I know you’re not just selling a CPU. You’re selling an SoC, which encompasses what we would traditionally normally think of as a CPU plus a chipset and you’ve got other IO aspects as well. So maybe can you help us with both of those legs there a little bit in terms of how an analyst like myself would size up the TAM?

Bob Gargus

So we’ve cautioned people that since we’re talking about revenue roughly a year from now, may be a little less, but in that kind of timeframe, it gets highly speculative as you go out in that kind of arena and when you’re talking about big guys that could be lumpy like the Facebooks or the Googles or the Amazons, let alone Dells, HPs, etcetera. Any one of those guys could throw off, for our size company, a meaningful amount of revenue quickly.

And the hardest thing to predict about new technology is adoption curve. So I can say it’s a big opportunity and I could tell you that it probably be more comfortable trying to make a guess for calendar year ‘15 revenue than I could for ‘14 until we get another quarter or two out and we see what kind of design wins and what the total benchmarks and other things that will be coming out in the near future here, what they exactly look like, then we can have a better feel for how fast the adoption rate might be.

Paramesh Gopi

Yeah. So to comment – to take Bob’s comments and give you further technology color on them, and answer your question in a little bit more pointed fashion, Brian, today, if you look at the cloud, the cloud is comprised primarily of E3 and E5 processors. This is from Intel today. Those processors were the ARM class processors and essentially if you take, if you assume that it’s a $2.5 billion market on an average people are paying just for rough calculations sake $1000 for a two piece system or for two processor chips, right?

Essentially that gives you the number that drives anywhere between 250 between hundreds of thousands of such units going into the cloud right for this particular market, so if I were to now translate that to market penetration for ARM, because we represent the first tranche of the ARM camp going there and couple them with Intel’s comments about other ISOs getting between 5% and 10% over the next two to four years.

One can easily look at the profitability of the ARM camp as being the leaders in that camp enjoying even if we get 100,000 units sold at those types of ASPs because we’re integrating so much of the networking IO, just to give you context, a 10 gig LAN on motherboard today costs in excess of $100.

The entire solution including the optics and so forth so because we’re integrating so much of that on to X-Gene, we are offering unprecedented value at similar price points. Therefore a conversion of 1% or 5% of that market, of that $2.5 billion TAM to us could represent $50 million to $150 million of revenue in the very near future in which case it becomes almost half our current revenue, right. So it’s a very, very small change in that market towards us represents very large earnings power for our business.

Brian Thonn – Kingdom Ridge Capital

That’s helpful. Thank you very much.

Operator

Okay. Thank you. No further questions at this time. I’d now like to turn the call over to Bob Gargus for closing remarks.

Bob Gargus

Well, thank you, everyone. We’d like to thank you all for your participation today. There will be an audio replay of this call available on the Investor Relations section of our website. You can also access the audio replay of this conference call by calling 888-286-8010 and entering the reservation number 65095963. We will also file a copy of the transcript of this call and an 8-K with the SEC in the next few days. Please feel free to call me if you have any additional questions. Again, thank you for your participation on the call today and have a nice evening.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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