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Broadcom Corp. (NASDAQ:BRCM)

Q2 2009 Earnings Call

July 23, 2009 4:45 pm ET

Executives

Peter Andrew - VP of Corporate Communications

Scott McGregor - CEO

Eric Brandt - CFO

Analysts

James Schneider - Goldman Sachs

Randy Abrams - Credit Suisse

Uche Orji - UBS

Sumit Dhanda - Bank of America/Merrill Lynch

Adam Benjamin - Jefferies & Company

Mark Lipacis - Bank of America/Morgan Stanley

Tim Luke - Barclays Capital

Craig Ellis - Caris & Company

Ross Seymore - Deutsche Bank

Craig Berger - FBR Markets

Srini Pajjuri - CLSA

Dan Amir - Lazard Capital Markets

Ruben Roy - Pacific Crest Securities

Cody Acree - Stifel Nicolaus

Suji De Silva - Kaufman Brothers

David Wu - Global Crown Research

Mahesh Sanganeria - RBC Capital Markets

Shawn Webster - JPMorgan

Tristan Gerra - Robert Baird

Arnab Chanda - Roth Capital

Operator

Welcome to the Broadcom second quarter year 2009 Earnings Call. (Operator Instructions).

Your speakers for today are Scott McGregor, Broadcom's President and Chief Executive Officer. Eric Brandt, Broadcom's Chief Financial Officer, and Peter Andrew, Vice-President, Corporate Communications.

I would now like to turn the call over to Mr. Andrew. Please go ahead.

Peter Andrew

During this call we will discuss some factors that are likely to influence our business going forward. These forward-looking statements include guidance we will provide on future revenue, gross margin and operating expense targets for the third quarter of 2009 and any other future periods, as well as statements about the prospects for our various businesses, potential market share and the development status and planned availability of new product's.

You should note that the guidance we provide today is based upon forecast that require us to make certain estimates, judgments and assumptions using the information that is available to us at this time. It should be clearly understood that our actual performance and financial results may differ substantially from our forecasts and other forward-looking statements we make today.

Specific factors that may affect our business and future results, include among other thing general economic condition, are discussed in the risk factors section of our 2008 Annual Report on Form 10-K and subsequent SEC filings. A partial list of these important risk factors is set forth at the end of today's earnings release.

As always we undertake no obligation to revise or publicly update any forward-looking statement except as required by law. Please refer to the Investor Section of our website at www.broadcom.com for additional historical, financial and statistical information, including the information required by SEC Regulation-G.

In addition, we've placed a slide deck, which is available now in the Investor Relations section of our website, it is on the right hand side of the page under the "2009, Q2 Earning Information" section. In this deck we have incorporated additional tables and information regarding our historical performance and our future guidance.

With that, let me now turn the call over to Scott.

Scott McGregor

Good afternoon. Thank you for joining us today. We are pleased to report net revenue of $1.04 billion in the second quarter, which came in at the upper end of the guidance range we provided and represented an increase of 22% sequentially and a decline of 13% year-over-year. On a product revenue basis, excluding licensing revenue, second quarter revenue was up nearly 17% sequentially and down about 17% year-over-year. Eric will talk more about the numbers in a few minutes.

Growth in the quarter was driven by a return to more normal customer ordering patterns, following the dramatic decline in orders and adjustments in Q4 2008 and Q1 2009, due to the economic downturn. Our Mobile and Wireless target market led the growth in the quarter, where we experienced strength in a number of areas including wireless combo chips, cellular basebands, stand-alone Wireless LAN Solutions, Bluetooth and GPS.

Within our Broadband Communications target market we experienced broad base growth, as it appears our customers brought their inventory levels more in line with the new level of anticipated end demand.

Finally, our Enterprise Networking target market revenue declined overall as we anticipated. The PC and server related areas grew a bit more than we expected, while our switching business was down pretty much in line with expectations. We believe that we've seen a bottom in switching demand from our Enterprise Networking customers.

Based upon the customer activity we've experienced to-date, we expect the revenue momentum we experienced in the second quarter to continue into the third quarter. We anticipate this revenue growth will be broad based, with the greatest dollar growth contribution from our Mobile and Wireless target market driven by new product ramps and our customers preparing for the upcoming holiday season.

Since the economic situation remains uncertain we'll continue to be cautious about increasing operating expenses. However, we are taking this opportunity to accelerate both 65-nanometer and 40-nanometer tapeout to enhance our competitive and cost position and we'll add resources judiciously for opportunities that have strong ROIs.

Overall, we'll continue to focus our engineering investments on convergence and the positive end-user experience generated by incorporating feature-rich network connectivity into Broadcom's key platforms.

I'll now turn the call over to Eric, for details on the second quarter numbers, and third quarter guidance.

Eric Brandt

Thanks, Scott. As you probably noticed this quarter we modified the presentation of our income statement to break out our intellectual property licensing revenue. In order to provide the appropriate comparison, prior periods have been recast into this new format. As you will note, we've had a small amount of IP licensing revenue included in our financials beyond the revenue associated with the QUALCOMM or Verizon agreements.

Historically when we've provided revenue guidance, as we did in April, it has included these amounts for both gross margin and product revenue. As you look at the financials, the key change is that there was approximately $6 million in licensing revenue in Q1 and Q2 of this year, which has been reclassified from overall revenue to licensing revenue, which impacts product gross margin by approximately 40 basis points in both periods, due to the new presentation format.

Small amounts of chip based licensing revenue have been a part of product sales for sometime and as such have been part of the margin guidance. Please refer to the slide deck on the Investor Section of our website for quarterly data going back to Q1 2007 under this new mapping. We've also included slide showing what Q1 and Q2 results would have been under both the old and new methodologies so you are able to get a clear picture of our results in either scenario.

Moving to the financial overview. To summarize, total revenue of $1.04 billion including $966 million in product revenue and $74 million in licensing revenue. Total revenue was up 22% and product revenue was up 17% from Q1. Utilizing the new classifications on an apples-to-apples basis, product gross Marge in Q2 increased 20 basis points to 46.3% versus 46.1% in Q1. Please refer to the web financials for our full reconciliation of how the reclassification affects these numbers.

Q2 2009 GAAP R&D plus SG&A expense was $502 million. On a comparable basis these expenses increased just $4 million over Q1, which was well below the guidance in April. Earnings per share for Q2 were $0.03. This includes approximately $0.01 per share negative impact associated with the nonrecurring items in Q2 of settlements, our charitable contribution, asset impairment and the remnants of our previously disclosed restructuring that we undertook in Q1 2009.

Stock based compensation represented approximately $123 million or approximately $0.24 per diluted share. Cash flow from operations for Q2 was $328 million, which includes the $200 million payment from QUALCOMM. Our cash and marketable securities balance increased to a balance of $2.3 billion at the end of the quarter.

Moving to revenue and gross margin. In April, we said that we expected Q2 revenue in the range of $900 million to $975 million. What occurred in Q2 was Broadcom generated total net revenue of $1.04 billion, of which $67 million is attributable to the QUALCOMM agreement. Removing the QUALCOMM license revenue yields revenue, using the old methodology, of $973 million in revenue at the high end of our guidance range.

With respect to Broadband Communications we saw solid growth across all targeted end markets. In the Mobile and Wireless end market we experienced broad base growth across virtually all segments. As forecasted our Enterprise Networking targeted end market decline, driven by principally by Ethernet switching, offset somewhat by growth in the controller product lines.

Our Q2 GAAP product gross margin increased 20 basis points to 46.3%, up from 46.1% in Q1, which is slightly below the improvement estimate provided on our last earnings call due to somewhat higher E&O charges than anticipated.

Moving to operating expenses. As you will note from the income statement with respect to operating expenses, we've adopted the format used by other companies with significant licensing revenue, which now includes product costs, but no longer breaks out gross profit or gross margins as distinct lines in the financials. As such, I will refine my commentary on operating expenses through the R&D and SG&A expenses.

Once again, we had better than expected performance in controlling our R&D and SG&A expenses. Total R&D and SG&A expenses for Q2 were up only $4 million from Q1 levels, much less than the increase of $10 million to $20 million we expected in April. Much of this favorability came as a result of tight cost controls, particularly in the areas of employee costs and discretionary spending, as well as continued favorability in the mask and prototyping area.

During the quarter, we also booked $3 million of net expense associated with a number of one-time items. The most significant of which are; $58 million settlement gain principally related to the QUALCOMM agreement. $11million asset impairment related to a specific customer intangible associated with the AMD DTV acquisition, as revenue is currently forecasted below the initial projections. While disappointing, we've already begun to take action on the digital TV cost structure.

A $50 million pledge from the Broadcom Foundation to support mathematics and science education in the communities in which Broadcom operates. We increased total company headcount in Q2 by 15 to a worldwide total of 7,200.

Moving to the balance sheet, as I mentioned earlier, total cash and marketable securities were $2.3 billion, as we generated positive cash flow from operations of $328 million. We repurchased approximately 2 million shares of stock in the quarter at an average price of $25 per share as part of our ongoing goal to offset dilution associated with our annual equity grants.

As we indicated in April, we expected inventory turns to improve. Based on the strong work of our operations team and increased demand we were able to improve turns to 7.4 times. Assuming no further shocks to the industry we anticipate turns will improve further next quarter.

Our accounts receivable day sales outstanding increased one day to 39 days. Also during the quarter the US Court of Appeals for the Ninth Circuit ruled on a case between Xilinx and the Commissioner of Internal Revenue, regarding the treatment of certain compensation expenses under R&D cost sharing agreements.

While the case may be appealed and reversed, it affects many companies with cost sharing agreements and we are one of those companies. The most significant affect for Broadcom is a one-time reduction of our federal and state net operating loss carry forwards of approximately $600 million and $300 million respectively.

Additionally, there is a minor P&L tax impact of approximately $3 million in the quarter. For more information regarding the tax impact of the decision and the Xilinx case to Broadcom refer to this quarter's 10-Q.

Moving to expectations, we currently expect total net revenue in Q3 to increase 7% to 14% from Q2. Included in that number is licensing revenue, which should be approximately $55 million. We anticipate the QUALCOMM agreement to provide $51.7 million per quarter in licensing revenue in Q3, through the first quarter of 2012, then step down to somewhat lower levels through the end of the agreement. Please refer to our 10-Q for more detail on the accounting.

In looking at what we expect to happen in our target product markets in Q3. In Broadband Communications, we expect revenue growth across virtually all targeted end markets. In Mobile and Wireless, we anticipate strong sequential revenue growth virtually across the board, driven by new product ramps and normal seasonality. Our Enterprise Networking business should also grow solidly in Q3, driven by improving customer order patterns, particularly in the Ethernet switching area. We expect product gross margins to improve solidly by around 125 basis points or more.

With respect to R&D and SG&A expenses in Q3, we expect the core businesses expenses to be up $15 million to $20 million, of which more than half will be driven by tapeouts and prototyping costs as we drive to not only second and third generation 65-nanometer products and new lower cost optimized products to improve gross margin, but also stepping up the pace of 40-nanometer tapeouts. In fact, in Q2 revenue from 65-nanometer products were close to 30% of our product revenue. Beyond that, with the options litigation cases picking up we expect additional legal expenses in the quarter associated with that.

Finally, we expect stock based compensation to be up $5 million to $6 million due in part to a Q2 reversal of $4 million associated with our employee stock purchase program and the full quarter effect of our annual equity grants made in Q2.

I will now, turn the call back over to Scott to talk more about the state of the business.

Scott McGregor

Thanks, Eric. I will start out with comments about our Enterprise Networking target market since this Group was in the news quite a bit in the last few months. First some brief comments on Emulex and FCoE or Fibre Channel over Ethernet. We tried unsuccessfully four times to enter into a negotiated transaction with Emulex with that opportunity now behind us, we've moved on to other value creating alternatives to capitalize on the converged enterprise networking opportunities.

This is a market that will take a number of years to materialize, so we have time to develop and deploy our strategy. With regard to our plans for incorporating the FCOE stack into our converged NIC product offering, unless there is a material event, we will pursue our normal way of disclosing our products, which is to wait until our customers' products enter the market.

Moving on to the performance of our Enterprise Networking target market, revenue in the quarter was down 4% as we had expected. As growth in controllers was more than offset by declines in switching in other areas. The strength in the controller space was driven by an improvement in the PC market.

On the switching side revenue was down, driven mainly by weakness in the enterprise segment. Our customer service provider business grew in the quarter and we believe we've seen some signs of customer activity returning in the enterprise market that will lead to growth in the third quarter.

From a product perspective, as we look into 2009 and beyond, our investments will focus on driving 10 gigabyte Ethernet deeper into server, switches and the metro space.

In our Broadband communications target market revenue grew almost 15% sequentially, driven by broad base growth across the product areas. As we anticipated, customers have resumed more normal ordering patterns. We are also seeing increased activity in digital TV and consumer electronics, as our customers prepare for the upcoming holiday season.

Broadcom is deploying new platforms for the home such as Internet-ready digital TVs and Blu-ray players, network set-top boxes and advanced high speed Broadband modems. By incorporating Ethernet wireless LAN, Bluetooth, MoCA and other communications technologies into our SoCs, our customers are able to differentiate and dramatically expand the capabilities of their product lines. One example of this is flat panel TVs, which have been around for a number of years competing mainly by making the panels bigger and increasing the picture quality. By adding internet connectivity digital TV manufacturers are now able to offer customers a user experience comparable to PCs and smartphones.

These advancements can be seen in LG's broadband HDTV family of products. By utilizing Broadcom's digital TV silicon with integrated Ethernet technology LG is able to offer Netflix instant streaming and Yahoo! Widgets directly through their HDTV, enabling the whole new entertainment experience in the home.

We see a number of long-term positive trends in our Broadband Communications target market. One is Internet-enabled platforms within the home continuing to grow. Also, demand for online video content will drive sales of next generation high speed modems utilizing DOCSIS 3.0 and EDSL and (inaudible) access technology.

And finally, demand for greater bandwidth throughout the home will drive the adoption of gigabyte Ethernet, 102.11n and MoCA high-speed home networking technologies.

In the second quarter, we took an $11 million impairment charge in our DTV business, reflecting reduced revenue expectations from a customer in the business we acquired from AMD last year. When we bought the business it was our intention that the people could be leveraged to other parts of our business given the commonality of the technology. However, current forecast of the DTV business, coupled with our desire to maintain tight cost control unfortunately requires us to take action. We do continue to see DTV as a long-term growth driver for Broadcom.

As we look into the third quarter, we anticipate that our Broadcom Communications target market will experience broad based revenue growth. In our Mobile and Wireless target market product revenue was up approximately 34% sequentially across a number of different areas including wireless combo chips, cellular basebands, stand-alone Wireless LAN Solutions, Bluetooth and GPS.

Starting out with our cellular products, we experienced solid revenue growth driven primarily by single chip EDGE baseband and power management chips going into volume production at one of our customers. We believe we are the only supplier that's in volume production with an EDGE analog and digital baseband in RF all on a single 65-nanometer die.

We are making good progress with our EDGE solutions with our lead customers and have increased volume production of our 3G basebands as our newer solutions start to roll out in phones this quarter. Our goal in the cellular area is to provide a complete platform including connectivity solutions with enough flexibility to enable our customers to select features and functions they want to utilize in either discreet or integrated bases.

Wireless combination chips continue to see strong customer demand and remain a major growth opportunity for Broadcom. In the second quarter revenue generated from our wireless combo chips represented over 10% of Broadcom's total product revenue. Our wireless combo products today are providing feature rich network connectivity for cell-phones and personal media devices.

We are in many of the best selling products for multiple manufacturers around in the world. Our steady cadence in bringing wireless combo products to market started with our Bluetooth plus FM product and was followed by next generation devices, incorporating 802.11g. Later this year we anticipate products on the store shelves including our new Bluetooth plus GPS product and our new triple-play solution, including Bluetooth, FM and 802.11n.

In total we have five combo chips sampling in the market today, of which three are now in volume production. On a cumulative basis, Broadcom has generated over half a billion dollars in revenue from our wireless combo devices.

In the PC space, wireless LAN and Bluetooth revenue grew over 50% sequentially. Broadcom has announced a series of wireless combo cards targeted at the PC, UMPC and netbook markets. These combo cards leverage our state-of-the-art wireless LAN and Bluetooth technologies and have better coexistence performance, smaller size, lower solution costs and provide many of the advantages of our single chip combos.

We also continue to focus on stand-alone wireless LAN, where we experienced solid double digit revenue growth in Q2 and expect continued momentum into Q3.

Lastly, I would like to highlight our establishment of the Broadcom Foundation, with initial pledged funding of $50 million. The Foundation will enable us to significantly expand our support of math and science education and community services. Broadcom is committed to support the communities where we work and to invest in the future through education.

So in closing, it was a good quarter for Broadcom and we look forward to strong revenue growth again in the third quarter.

This concludes our prepared comments. We were now ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions).

Our first comes from James Schneider of Goldman Sachs. Please go ahead.

James Schneider - Goldman Sachs

I guess first of all on the gross margins, what do you think it will take to get the product gross margins back within your target range? Is that just on mix or do we have to get all of the cost reductions on the optimized 65-nanometer and 40-nanometer part to get there? And in what timeframe do you expect that?

Eric Brandt

Jim, there is a lot of moving parts on that one. I think that we are excited that we are seeing solid improvement going into Q3. I think that we have a number of initiatives underway. Many of which we talked about with respect to the tapeouts and cost optimized products. I think there could be some benefits from mix as well, and obviously, tailwinds as we work through some of the E&O that we have taken in the event that we get to sell some of that product.

All in all, as I said before, it's hard to say how to draw conclusions in such a strange market, but I think the good news is, as we have with operating costs we have a plan on the table and we are executing against it and I think we are going to see some benefits in Q3 and we'll see how it plays out as we roll across into Q4 into next year.

James Schneider - Goldman Sachs

Okay. Fair enough. And then maybe just a follow-up on the OpEx side. How should we think of OpEx as we move into Q4 and specifically what you are expecting in terms of legal and tapeout expenses in the back-half part of the year? And then as part of that, at what point, either revenue or cash flow, would you expect that you might start to begin hiring back additional headcount?

Eric Brandt

Jim, we don't provide the guidance beyond the quarter. Certainly there are options litigation cases that are going to trial in October. And in February for our former officers and there will be some expense associated with that. In terms of projecting that expense, it's difficult to do so. I think having removed the QUALCOMM legal expenses, moving through virtually all of the Emulex expenses and we reported our results this quarter. Even in the face of those expenses on the legal and other service side we still have strong operating expense control.

As Scott mentioned, to the extent that we can continue to drive competitive advantage and cost reductions and tapeouts, we will not slow those down. With respect to people and fixed cost associated with our business, I think we remain cautious. We are watching the economy closely. I think there are a number of very high ROI opportunities and to the extent that we think that there are opportunities to really drive in very high ROI opportunities in front of us, we will add small amounts of people. A good example of that is in the combo chip area, where we are literally limited by the number of design engineers we have to service the customer request coming in.

Operator

Our next question comes from Randy Abrams of Credit Suisse. Please go ahead.

Randy Abrams - Credit Suisse

Want to follow-up on the gross margins. For the E&O charges I just want to get a sense on how much impact you have now, so if you were to look at it now versus where you were in 2008, before the downturn? In guiding up 125 basis points or more, maybe talk about what's factored into the base case and then what could get you the additional?

Eric Brandt

Sure. As I think I may have shown you the chart, we have plotted the data in terms of how E&O behaves as a percent of total inventory. And as we sort of looked at it, we expected it would go up this quarter. It went up a little more than we thought this quarter by amounts similar to prior quarter may be a little bit less. But typically these things tend to peak about one quarter pass to trough and then as you take a snapshot of that inventory, in the event that you sell that inventory and demand returns then you wind up selling basically 100% margin business. So to the extent that some demand returns for some of these older products we will benefit from that over time.

I think as we look at Q3, we will benefit certainly from the increased volume and the overhead absorption side of things. We've tried to be conservative as we look at E&O and not assume significant E&O movement one way or the other, even though the pattern would suggest it begins to move favorably as a tailwind after that quarter.

And then I think there is some product mix opportunities that are in front of us that could be beneficial into Q3 and into Q4. So we are watching all of those. We are trying to be cautious. And again, as I said many times, at least from my chair, I'm trying to play defense until we can really get comfort we've stabilized in the economy and in our gross margins before we start adding significant resources.

Randy Abrams - Credit Suisse

To follow-up, if you could look ahead, products ramping and wireless' had a big ramp for last couple of quarters. If you could look out a further quarter, we don't know the underlying macro, but across each of your businesses if you could talk, as enterprise is starting to rebound, you've had a big surge in wireless, maybe your expectations beyond this quarter for Broadcom specific events heading into the fourth quarter?

Scott McGregor

Yes. I'm sorry Randy we don't guide beyond the current quarter, so we will see in about three months and give you that information.

Operator

And our next question comes from of Uche Orji of UBS.

Uche Orji - UBS

Let me first of all ask you about if you can give us an insight as to the lead times across your various products. Are there any areas where you are experiencing tightness? Also, if you can talk about adjacent product that may or may not be creating problems for you, for example, we've heard reports about panel pricing, is that creating a concern for you within your product areas? So that's my first question and I have a follow-up.

Scott McGregor

Uche we have seen lead times move out a little bit on some our products. In some specific fabs we've seen some tightness in demand, but this is where Broadcom I think has an advantage where we do have our parts in general running in a variety of different foundries. So we've been able to mostly deal with those issues and they haven't materially affected our financials or our customers, although we probably could have shift a little more if we could have gotten some parts a little sooner than what we had. So a little bit but not much driving and I think we have been able to resolve that. Perhaps better than what we've heard from some of our competitors. In terms of have things like panel prices affected us, no, we don't particularly see that. We have potentially seen some cases where other parts are limiting our customers' ability to ship a little bit, but in general we haven't seen that as a major factor in our business.

Uche Orji - UBS

Then just to ask you about the (inaudible) business, I mean this is really one of the key drivers for revenue growth in the medium term. My question is are you able to give us any anecdotal data on the size of that business now and in terms of what you think, I know you're not going to guide out until your customers provide guidance of the product, but if we look out next year, what would you actually expect that business to be in terms of the size relative to your other businesses? And then also follow on from that, with that growth coming where is the gross margin of that business relative to your corporate average, what would normally take for that to be in line or even higher than your corporate average? Thanks.

Scott McGregor

We don't break out a lot of that, but I can give you a little bit of anecdotal information. We said on our last quarterly call that we expected we would ship millions of units and indeed we did ship millions of basebands in Q3. Also it did contribute overall. Our cellular business is now contributing meaningful revenue as a result of that. We've seen some pretty sharp ramp-ups in some of these products. That's all positive news.

On gross margin, we think of gross margin sort of overall in a cellular device, so we look at the combination of different ships we ship in there. We get a mix of different margins on the different chips and we think that the consolidation going on in the industry is already improving some of the fundamentals in that space and over time we expect that will help. Some of our products were designed for getting to market quickly and we are now doing more optimized products and other things. We do believe that over time we will improve the margins in that area overall. So I understand the reason for your question. You asked me to forecast a little beyond that. I have gotten out of the business of forecasting our cellular growth over the next couple years, so I am going to decline to do that. Needless to say, I'm pleased with the sharp ramp-up we've seen in our cellular demand and the products we shipped this quarter.

Uche Orji - UBS

Can I just ask you about multi-touch controller? How (inaudible) is this business and what are your plans for integrating that into other products given your track record with integration? Also what kind of competitive response do you have to some of these programmable IT and micro controller companies getting to the multi-touch controller space? That's my last question.

Scott McGregor

The touch controller space has been a relatively good opportunity for us. We don't ship that to a large number of customers today. And I'm going to decline to speculate on what we might do with that going forward, but I will tell you that you're right, Broadcom is good at integrating these things and we can certainly integrate that capability arbitrarily into the various devices we have targeted for the handheld portable space. We have that capability, but haven't discussed specific customer plans or specific growth in that market.

Uche Orji - UBS

Relative to macro controller solutions, what are the competitive advantages of yours as far as lot of macro controller guys are shipping, so are the Microchip, Cypress everybody has something in this space now.

Scott McGregor

I don't think that's a particular competitive advantage. I mean if you wanted to go after the space generically and provide touch screens for microwaves and all that stuff then integrating it with a micro controller makes sense, because you can provide a programmable solution. If your goal is to provide SoCs for media devices and cell-phones and stuff like that integrating with a micro controller doesn't particularly make sense, because you will be much better off integrating it with the rest of the device that may include many micro controllers and many other components you will be better off integrating it with that and not with a micro controller that doesn't fit with the rest of the system.

Operator

And our next question comes from Sumit Dhanda of Bank of America/Merrill Lynch.

Sumit Dhanda - Bank of America/Merrill Lynch

Eric, just to be clear here on the expected benefit into Q3 and gross margins, is it fair to assume that it's all primarily fixed cost absorption and that there is potentially more to come because your product revenues even in Q3 will be well below the peak levels that you recorded back in Q3 of '08?

Eric Brandt

I think you can assume that a good piece of it relates to tight cost control and overhead management. Yes, you are right that there is more there as we go back to our historic levels. Yes, there is an opportunity for mixed based upside in the quarter depending on how things play out. Again, we are trying to be conservative, which is why we said, up around 125 basis points or more.

Sumit Dhanda - Bank of America/Merrill Lynch

My second question related to your comments on 40-nanometer tapeouts, I think you have been on record saying that the extent of the expenses associated with those tapeouts won't be as lumpy or as significant or accelerated as 65, does that still hold true or are those plans changing given what you see in the competitive environment?

Scott McGregor

Sumit those plans remain the same. Some of our products get a real benefit from 40-nanometer, especially the very, very large products for those that need the speed or are particularly cost sensitive. Those are the ones that are the candidates to move the fastest. There are other products that frankly don't make sense to move there. And so we don't anticipate the grand migration. We have 65-nanometer in the 40-nanometer space and those tapeouts will be more moderated than the equivalent period in our development history when we did 65-nanometer.

Sumit Dhanda - Bank of America/Merrill Lynch

Then my last question here, on the DTV business I know you've addressed this specifically, but what in particular was a disappointment which is relating to these restructuring charges what part of the acquisition really disappointed?

Eric Brandt

Basically when we do the acquisition we do evaluation. As part of the valuation a component gets attached to intangibles which then get amortized. So, as you know, we completed this acquisition. We did the valuation analysis and attached things to goodwill and intangibles and a piece of it was attached to customer intangibles, and as you know, the market sort of fell right off, right after we closed the transaction. So those customer revenues actually came down over time. As those revenues come down over time compared to what you projected it triggers an impairment. That's sort of the dark side of the cloud. Silver lining in the cloud is actually those costs would have been amortized through our P&L anyway over a two-year period. So what we have done is accelerated that amortization due to the lower expectation of revenue, principally driven to economic conditions, but other things obviously as well can play into that. So, that's basically what it was.

Operator

Our next question comes from Adam Benjamin of Jefferies & Company. Please go ahead.

Adam Benjamin - Jefferies & Company

Obviously, there is a lot of talk out there about semiconductor companies either shipping below consumption or above consumption. I know it's difficult to fully know, but I was wondering, Scott or Eric, if you could take a crack at looking at the product lines that you guys have and giving us some color as to where you were in Q2 in terms of shipping into your customers, and then what your expectations are for Q3?

Scott McGregor

That's a difficult question to answer. You usually figure that out a quarter or two after the quarter you are in, and you find out, well, the customers have too much inventory or not enough. I mean, we are seeing very strong product demand driven by product ramps in things like combo and cellular and some products across our various families. We think those are pretty much totally in demand consumed, meaning they go out fairly quickly.

There are other areas we're less certain. It's a little harder to read the PC space and I know Microsoft reported just a little while ago and had some mixed message there. That's a little harder to read. In all cases across all our businesses, we work pretty hard to try and match our sales with what we see as underlying demand. I know it's surprising, but we often will ask customers are you sure, do you really need that? It looks like the market isn't as strong there and are you ordering enough? We also have that problem where we don't think they are ordering enough and we don't want to be in a situation where they are hoping for short lead time that we can't deliver on.

So, we work pretty hard and we think our guidance when we plan that and when we think about our customer revenue going forward, we try to do a good job at reflecting what we see as the actual demand. So, I can't really give you much more color than that. Again, we'll have a much better picture on your question in another quarter or two ourselves.

Adam Benjamin - Jefferies & Company

Just a follow-up to some commentary you gave about you could have shipped a little bit more in the quarter. You had some supply constraints with some customers. Can you indicate what specific segment that was associated with that you could have shifted a little bit more?

Scott McGregor

It was actually across a lot of different areas. It was wireless and there were some Broadband products we couldn't get enough supply. We could have shipped a little more. I don't want you think we could have shipped substantially more. It's a relatively small amount. We did see some tightness and customers had wanted product sooner than we could deliver it.

Adam Benjamin - Jefferies & Company

One last question for Eric just on gross margin. You guys have talked about the 65-nanometer really kicking in next year in terms of seeing some tailwind to gross margin. Can you talk a little bit about what you are see now that we're a quarter ahead with that and almost 30% of the mix 65, and then as you moved to 40-nanometer, do you get benefit of that in 2010 and kind of what percentage of the mix could that be in terms of timing?

Eric Brandt

Yes, certainly. We have been, as I mentioned earlier on the call, pretty focused on gross margin and understanding which products are below in gross margin and what the roadmap is to fix that. We are quite pleased to see our businesses taking that challenge and bringing forward second, third and fourth generation products that are 10, 20, 30, 40, and maybe between the first and fourth generation, 60% more smaller die sizes with increased functionality which drives higher margin.

So, I expect we'll continue to see more of that. As I mentioned, we were close to 30% of our revenue this quarter within 65-nanometer. As you can imagine, almost all of that would be in first generation products. So, as we roll through the second half of the year and into next year, I think you'll start to see the benefit of those second and third generation product, which will drive benefits hopefully in gross margin.

On the 40-nanometer side, in many of the cases where we've looked at our products and thought that at 65-nanometers we would have a problem, at 40 nanometers it changes the picture and looks like the crossover in 40 may be sooner than we thought. So that's one of the reasons why we are driving that forward aggressively.

Scott McGregor

I think if you go back a year or 18 months and look where the Broadcom engineering IQ points and passion was going, it was in creating new products, moving to a new process geometry and focusing on time to market. I think what you see now if you were to be able to measure, you would see the IQ points and the passion are shifting over to focus on gross margin a bit. So, that doesn't turn things around overnight. It takes a while for the products to come out and for those to start to ramp in the market and so forth.

I think just within our team there is a bigger focus on gross margins and improving gross margins than there has been in the past, and I believe that will bear fruit over time.

Adam Benjamin - Jefferies & Company

One follow up on the 40-nanometer, Eric. Should we assume that the 40-nanometer will go on the same track as the 65 and that the initial products will not be super-costed, I guess, for a lack of better term, and in 2010 you don't get the benefit and really by 2011, as you get your second and third generations of 40-nanometer, you see more of a significant benefit. Is that the right way to look at it?

Eric Brandt

I'm going to answer half and then hand it back to Scott. I can only tell you because I'm not a technology person. I think the nature of the conversation around 65 was very focused on integration of technology and there wasn't as much discussion around cost. I think now in 40 there is as much discussion around integration of technology as there is a cost benefit associated with 40.

Scott McGregor

I would say that's absolutely correct. One of the things when you put some challenges to smart people you get some interesting results. We found in our preliminary 40-nanometer designs that we can get scaling of analog components and radio components identical to the same kind of scaling we get in digital components, which is sort of surprising to many people. So, I think 40-nanometer will potentially have some different results than 65-nanometer in terms of products coming out the chute pretty cost optimized whereas we didn't do that as much in the 65-nanometer parts.

Operator

Mark Lipacis of Morgan Stanley has our next question. Please go ahead.

Mark Lipacis - Bank of America/Morgan Stanley

On the baseband side I understand you don't want to quantify the expected ramp, but can you give us a sense of the relative mix between EDGE and 3G you'd expect to see this year?

Scott McGregor

Mark, I don't think I even know the answer to that. We have a number of products ramping. One of the things that makes it challenging is if you get in high volume models, it doesn't matter how good the chip is. If you are in a high volume model that everybody wants to buy, it moves fast.

One of the things that has gone well for us is that we're in some very high volume models with our customers in the EDGE chips. The 3G chips are a little behind that in terms of the timing of rolling out. We think there are some interesting models. Those are coming out in as well. So I don't think I could guess the result by the end of the year. Certainly, at this point in time, we are shipping more EDGE than 3G.

Mark Lipacis - Bank of America/Morgan Stanley

That's fair enough. Second question, on the combo chip side, correct they I'm wrong, but my understanding is that you have a healthy share of Bluetooth chips that are shipping into hand sets. The combo chips, do you think that they enable you to gain share of the Bluetooth market, or given your healthy share already is it inevitable that you end up losing share in the handset side?

Scott McGregor

I think we're number one in the handset side today in Bluetooth by a pretty clear margin and I don't anticipate that that will change. To the extent that we can gain additional share points, there are a number of customers we haven't yet penetrated. There are some customers where we have 100% of their business and it's probably unrealistic to assume you can keep all of that. They will probably be a bit of a swirl in terms of that.

I would guess, though, that we would hold our gain share in the Bluetooth space. I think our combo chips make us more competitive in that space simply because they provide a really convenient experience for the customers whether they want to integrate Bluetooth with GPS or with FM or wireless LAN by providing that complete solution. I think we do get a lot of customers to favor that. We've seen some competitors talk about designs they have there. I think we feel like we are getting most of the high volume designs with these combo chips, and I think that's helping us hold share here.

Mark Lipacis - Bank of America/Morgan Stanley

Eric, I think you've said that you got a target for stock base comp to become 5% of sales. Again, correct me if I'm wrong, but can you help us understand your view of the timing of that bogey?

Scott McGregor

Just to give you some fact, this year's stock base comp grant was about $275 million in terms of value transfer. Last year it was about $425 million. So a very significant reduction in that number. As we remove those larger stock grants and dollars if you imagine the pig working its way through the python we begin to move down. Just in the face of that this quarter with some increased revenue and beginning to ramp down in costs, and you'll see after we get past Q3 as we normally do, things begin to drop down in terms of the quarterly run rate. We went from 14.5% to about 11.8% of revenue.

So we're moving in the right direction, both from the standpoint of the revenue benefit we get from growth, as well as from the actual cost reduction in the size and value of the grant. Depending on stock price as that rolls forward, we could see $50 million to $80 million just in stock base comp costs come out between 2009 and 2010. So, reduction of between $50 million and $80 million depending on the size of the grant and stock price at the time we make the grant next year.

We are moving quickly. I said in the Analyst Day there is a four-year amortization, so it takes time. While we'll reduce the grant over the next three years, it may lag a year or two. I think we are actually making progress maybe even a little faster than we hoped.

Operator

Our next question comes from Tim Luke of Barclays Capital. Please go ahead.

Tim Luke - Barclays Capital

Couple of quick clarifications on the targets of the gross margin. Can you just remind us what the target range is for the product gross margin going forward? With the licensing revenue, could you just remind us what the gross margin is for that? Is it like 90% to 100%?

Also, Scott, perhaps you could just give some color on how you had seen linearity develop? Have things sort of strengthened as you move through into July, and also what percentage are you booked as you've entered the quarter?

Eric Brandt

So on the gross margin, we haven't changed from what the company has said historically. We've said repeatedly that it's really hard to draw conclusions in this cycle around where gross margin is going. When the company came out it originally said 50 to 52 non-GAAP and we said nothing different. Obviously, we are working our way through a difficult period of time and we've seen our gross margins drop 600 basis points in the last year, but beginning to see some pick up as we roll into Q3.

As you look at licensing, licensing has zero cost to goods attached to it. So all of the product costs are, in fact, attached into product revenue. So it's a % gross margin, if you will, or the way we're reporting it is we're showing product sales and product costs, which is how we are deriving gross margin.

To just touch on the point that you would ask about order trends, et cetera, we don't typically respond to that, I'll just make the following comments. Some people have commented that we sort of went into the downturn and didn't see as much of a dip as a lot of companies saw. That's probably true. I think as we come out product sales from the trough quarter of Q1 grew 17%. If you take out the $55 million licensing estimate for Q3, you are probably talking about product growth rate at 9.5% up to 17% in the guidance we've provided.

So, I think we are seeing good strength in our business in Q2. As Scott mentioned, we had small amounts of shortage at the end of Q2 and we probably could have shipped a little more. We are seeing good strength into Q3. It is way too early to call anything on Q4 at this point in time.

Tim Luke - Barclays Capital

To clarify on the licensing, on the payments from QUALCOMM, they go through to the second quarter of 2013 and do they go after the 51.7 down to a constant level or is it a gradual decline as we think about modeling that.

Eric Brandt

10-Q will come out tomorrow morning and you can read it all in detail. But just to give you the short answer, between now and the first quarter, it will be $51.7 million per quarter. As we from the first quarter of 2012 to the end of the contract, it will gradually step down to $43 million and I think to a sub-quarter which might be smaller than that, but it's in the Q. It's in that range and it should work your way to 2013.

Tim Luke - Barclays Capital

You had a very big PC, Bluetooth and wireless LAN quarter, up 50% quarter-over-quarter. How do you think about the outlook there going forward, given that big uptick? Just in terms of the broader context in the environment, how are you perceiving it? In the past we had discussions about different Ls and Ws and Vs, how are you framing the environment in terms of your expectations and how are you planning?

Scott McGregor

On the PC, Bluetooth and wireless LAN business, we're certainly seeing traction there from new products, and certainly the penetration of Bluetooth and the PCs continues to go up. We start seeing it more in peripheral devices and other things that are driving some growth there. So, that's a positive trend regardless of what happens in the PC space. I think in terms of the PC space, we'll have to wait and see whether the pickup we've seen is sustainable, whether it goes flat, whiter it continues to go up. We'll know more about that in another month.

In terms of the overall economy, I'm not an economist and we certainly talked about Vs and Ws and Us and Ls and that. I think what we do here, and Eric touched on this a bit, that our philosophy is that because it's hard to tell the difference between a V and first half of a W, we are planning on being fairly conservative. So, if it really is a V, we'll have even better results. If it's a W, we will have taken the financial prudence, I think, so that we don't find ourselves in a situation where our costs are too high. So, that's the conservative nature we're taking right now on the economy. Again, if it's a, V it will be even better.

Operator

Craig Ellis of Caris & Company has our next question. Please go ahead.

Craig Ellis - Caris & Company

Scott, you have mentioned in comments on Enterprise Networking that you are seeing some emerging signs of enterprise strength. Can you provide more color on where you are seeing that and how broad base it is?

Scott McGregor

We've definitely seen a pickup in activity from our customers and more orders. One of the things, as I mentioned before, we try to get a sense of where the underlying demand is from the end customers. What we see is that the carriers and infrastructure guys definitely are consuming more products. We see government driving that, someone suggested education is seeing a pickup that could be seasonal.

We try to get a sense where the corporate enterprise market is. That one is a little more puzzling to us. We definitely see some CIOs who are going to virtualization, so they're tending to buy rack mount servers and switches and things like that. That's probably contributing to some of the growth there, although our anecdotal survey of CIOs suggest that in general they are ordering a lot. So we're not seeing a pickup from that aspect of the market. Again, that's an informal anecdotal survey we do among CEOs we're familiar with and so forth.

So, I think that area I'm a little more skeptical of there, even though we've seen some order pickup from our customers there. Again, we probably wait on that one a little further. Overall, this is all built into our guidance and our thinking of the business, and just give you a sense of how we look at each sub segment of the market and trying to get our own view of where is that going.

Craig Ellis - Caris & Company

So is the present company included in that informal survey or not?

Scott McGregor

No comment.

Craig Ellis - Caris & Company

Switching gears a little bit to DTV. It seem like there's a bit of a reorientation in terms of expectations for that business going forward. How should we think about the breadth of your customer base and what can you do with Tier 1 customer penetration as we look out over the next 12 months?

Scott McGregor

The customer breadth is actually quite good. We've won a variety of customers. We are working closely with many more. I feel that's good. The impairment was really due to one particular customer in the acquired business. That's where that came from. I'd say there is probably some macroeconomic softness that's driving the number as well.

So, the disappointment again from one particular customer in their plans and some macro softness, but I'm very happy with the products that they are coming out with, the breadth of the product family. We've got some great customers. As I mentioned, we are really driving a differentiator in that market, which is Internet-connected TVs. I believe we have pretty much the best by far products that offer not only full analog, digital TV capabilities, integrating a lot of the different components there, more so than our competition, and now integrating a lot of the connectivity pieces, the networking pieces, there is an Ethernet capability right in the chip, as Ethernet 5 in our TV chips. It's different than you would see from the competitors who tend to be the entrenched single function TV guys that are going to struggle I think a little bit as TVs move away from just being TVs and more into the connected appliances that we see going forward. So, I'm still very bullish on that business going forward. It does remain as a real growth driver for Broadcom in long term, but again the impairments due to those two factors I mentioned.

Craig Ellis - Caris & Company

Okay. That's helpful and then the last one for me. You mentioned the engineering IQ that's focused on margin improvement now. Is that a byproduct of where you are in the 65-nanometer transition and the ability to focus on second and third generation products? Or is it more a function of where you are relative to your gross margin target or some combinations of those two or other factors?

Scott McGregor

It's both.

Operator

And our next question comes from Ross Seymore of Deutsche Bank. Please go ahead.

Ross Seymore - Deutsche Bank

Congrats on a strong quarter. Eric, when you mentioned about the mix dynamic for gross margin going forward, can you give us just a little more color on what that means? Can we interpret that to mean by the three main segments you talked about or are there intra-segment issues that we may or may not appreciate on a superficial level?

Eric Brandt

It’s actually both, Ross. It’s interesting, we will see a pick up I think in growth in some of the stronger margin businesses this quarter and depending on how much they pick up we may see upside to the number I provided. Again, trying to be cautious, but there is both embedded into that.

Ross Seymore - Deutsche Bank

So, is it more like Enterprise Networking bouncing back or some sub-segment of one of your other two segments, or again is that your definition of both?

Eric Brandt

It's really all of the above. As you know, sometimes we've said sort of, if you map the world into consumer and enterprise and highly competitive and low competitive, you can figure out where margin tends to migrate. And so while there is some enterprise benefit and the pick up in the enterprise business certainly helps there is some intra-segment or intra-biz target market dynamics which could benefit us in addition to the extent that we have reserved part based on the demand that we saw in Q1 and Q4 and then into Q2 this year that we are now beginning to see demand pick up. Remember that it's a snapshot and it sort of works its way to the pipe to the extent that any of that product gets consumed it is a 100% margin product and provides a benefit to us as well.

Ross Seymore - Deutsche Bank

If we switch over a little bit to the acquisition strategy, we are all aware of what happened or didn't happen with Emulex, how should we think of Broadcom's acquisition strategy after doing two relatively larger ones versus what Broadcom historically has done in the last 12 months?

Scott McGregor

Our acquisition strategy remains focused with our primary goal on finding the kinds of companies that give us new technologies or (inaudible) in white space or get us to market faster and in particular spaces. We continue to do that. We think we are really good at finding a smaller pre-revenue or early stage revenue companies and if you think of it like a switch with blades, we are looking for blades. We've got a great chassis and infrastructure and we'd like to slot some more blades in there to grow our business. Occasionally, we will look at other opportunities, whether they are divisions of public companies or even public companies. I don't see that as our normal style of acquisition, I see those as exceptions. If I look at our M&A radar chart, most of the things on there are, again the kind of historical acquisitions that we believe we've created a lot of share holder value with.

Ross Seymore - Deutsche Bank

Then two quick housekeeping ones. What do you think share count would be going forward and then especially given what you have said about NOL, if that impacts anything at all, how should we think about tax rate? Thank you.

Eric Brandt

So, let's start with the tax rate first. On the NOL basis, I mean one of the reasons why we don't have an ongoing tax effect from this Xilinx ruling, which other companies have is because of the ongoing losses we have in the US. So, interestingly these NOLs that we had were fully reserved based on our history. So, the impact is relatively low. Now our NOL amount has gone down even though these were fully reserved from about $3 billion to probably about $2 billion as a result of that. So, I don't think there is any meaningful impact to the tax line of the company associated with that.

On share count, we are running at about 500 million shares. We will continue to buy back stock to offset dilution. We were in the market a little bit this quarter. I anticipate we will be in the market next quarter as well to offset what we granted, which was about I think 10.5 million RSUs and about 2.5 million options. So, we are working to try to keep the share count relatively flat, subject to the Treasury method, based on the overhang that's out there as the stock price moves.

Operator

Our next question comes from Craig Berger of FBR Markets.

Craig Berger - FBR Markets

I just wanted to understand the competitive environment a little bit in the combo chip market. Where do you see competitors like TI, Marvell, it seems like you have a little bit of runway here as you have the market to yourself and I'm wondering how long will that last?

Scott McGregor

Well, it's hard to say. We certainly expected the competitors to come in sooner, but we also know it's really hard to do these combo chips. And we have seen our competitors struggle, really getting the performance, many of them will say they have the chips, but then when they get into customer labs the interoperability doesn't work. The radios have problems. I mean we've really seen a lot of that from competitors. We don't count on them screwing up forever. At some point we will see more competition, but our strategy is pretty straightforward. We are really raising the bar on that by creating additional categories of combos.

I mentioned we now have five different combos out in the market. And I believe there is an opportunity for us for quite a while to add additional capabilities and new functions in combos. We will keep a little close to the vest in terms of what we plan there. But we've got some interesting ideas in terms of how we can continue to increase the value of those combos to customers and keep that competitive advantage. So I think we're in pretty good shape on combos right now. Very few competitors are really able to field solutions there. I think by the time they do that we will be in additional generations down and additional capabilities.

Craig Berger - FBR Markets

Are you guys still on track to release new combo chips every 60 days? And can you also comment on the performance of your combo solutions versus the stand-alone discreet solutions? Thanks a lot.

Scott McGregor

We are certainly looking at introducing new combos. We don't have a specific timetable for when we do them. But we have quite a few in the shoot. We've created a very good portfolio of solutions ranging from combo chips, when people really care about the coexistences of the capabilities, small footprint, low power, et cetera. We have created some combo card solutions, which are really these mini modules that combine several of our discreet solutions and solve some of the problems and prewire some of the RFs, so it's easier to get it right for customers that provide very attractive price points and some of the advantages of a combo chip itself such as pre-integration.

Then we also offer a broad line of the discreet components as well for customers who just want one function or have other reasons they want a particular discreet chip. And I think we've shown that we can grow in all of those spaces which is really important. So it's not like we are favoring one versus the other. In fact, our highest growth rate was in some of the discreet pieces into the PC space. But we do expect we will continue to be competitive across all three of those categories. I think in all it's a very, very compelling product portfolio and that's what's driving the growth there.

Operator

Our next question comes from Srini Pajjuri of CLSA. Please go ahead.

Srini Pajjuri - CLSA

Eric, just a clarification on the balance sheet. The deferred income and also the long-term assets have jumped a bit. Is it all relates to QUALCOMM or is it something else?

Eric Brandt

The deferred revenue is about a $100 million jump relates to QUALCOMM. Maybe what we can do Srini is just take it offline when we do the call backs and just go through the individual lines and I can tell you what key items are.

Srini Pajjuri - CLSA

Then Scott on the fiber channel front, have you made the decision to develop this technology internally, and if so, what are the implications for R&D going forward?

Scott McGregor

Srini, we have not published our plans in that space. And probably will not do so. I think I said in my prepared remarks that unless there is a material event that necessitates it, we generally don't publish our detailed development plans on technologies. We'll share the details of that as the products start to ship with our customers.

Srini Pajjuri – CLSA

But I guess my question is more on the R&D expense front. I mean, do you think you have the resources to develop the technology internally as we stand right now or do we need to hire more people?

Scott McGregor

Well we forecast R&D in the guidance and that's comprehended in the numbers that Eric gave. We don't break out R&D for particular product areas.

Eric Brandt

The only thing I would just say is that we are in our summer planning process now where we go through our portfolio grade, do our risk adjusted planning and to the extent there are opportunities with higher ROI, which require significant resources. Now would be the time when we would reallocate resources across our portfolio of roughly 20 businesses back to where we can create the greatest return. And given that we spend $300 million a quarter on R&D before stock base comp. There is plenty of room to do (inaudible) if we need to.

Operator

Our next question comes from Dan Amir of Lazard Capital Markets. Please go ahead.

Dan Amir - Lazard Capital Markets

Couple of questions, first of all, can you comment a bit on your position right now in the IPTV and Blu-ray markets as it relates to your Broadband segments, kind of what you are seeing there and do you see it as one of your growth opportunities here in the near term?

Scott McGregor

Certainly. I'll start with Blu-ray. We definitely see Blu-ray as an opportunity in the business. We are offering a Blu-ray products and really featuring, again like in TVs we offer connectivity to the internet and connectivity across the other devices in the home. So those are things we drive into Blu-ray, we are one of the only suppliers that has an integrated front and back-end solution in Blu-ray so we can create a cost effective solution.

I believe that the retail price of Blu-ray is going to come down over the course of the next year and to the point where it starts to become a very attractive device to have as holiday gifts towards the end of this year and into next year. So we see the volume of those players picking up, and I have also seen some surveys recently that say they are becoming a much more common device that people acquire. So that's definitely a growth market for us there.

IPTV yes, absolutely. The challenge on IPTV has really been content, and getting quality content. But as we see that get into place and some of the carriers look at those technologies to deploy their content, I think that will improve. So, I do see IPTV as a growth market for Broadcom IPTV, IP set-top box as well. That's an area where we definitely have a lot of R&D focus, and attention, and we are working with a number of customers there. I think you will be pleased as you see some of that roll out.

Dan Amir - Lazard Capital Markets

Then a follow-up question on the cable and satellite markets. I mean, can you just give us a kind of snapshot what you are seeing right now in those end markets as related to your products?

Scott McGregor

They certainly continue to move forward there. The satellite space is highly competitive focused on the number of digital channels they offer. We see the promotion activity picking up towards the end of the year, and so we do see that segment along with set-top boxes in general growing and we forecast that. In terms of one of the segments we do see growth going forward into this quarter. So, absolutely opportunity is there for us.

Operator

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

Ruben Roy - Pacific Crest Securities

Scott, first of all, I wanted a clarification if I could on the combo chip commentary you had. When you said that the revenues contributed over 10% for Q2 that's just for the three volume products in the wireless area, right, it's not including potentially integrated or combo chips and other areas of your business?

Scott McGregor

That is correct. Actually I will give you a little more color on that. I think in our previous earnings call we had said that we expected those chips to make up as much as 10% of our business by the end of the year. We achieved that goal in the second quarter. So give you a sense that those products really have customer traction.

Ruben Roy - Pacific Crest Securities

Great. And all five should be shipping in production by the end of the year, is that correct?

Scott McGregor

If possible some of them might move into the first quarter of next year or early next year, but they are all sampling today and they are pretty solid products. One of them I think has good chance this year, the other one 50/50, maybe slip into or come out in the early part of next year. We will start sampling additional products as well. Think of it as a pipeline of products in that space, but we do intend to continue to build momentum in that area.

Ruben Roy - Pacific Crest Securities

Then just as an follow-up, from a longer term perspective is there any concerns you might have given the recent lawsuit won by Cablevision as it pertains to remote storage DVR, any impact potentially to your set-top business looking further out?

Scott McGregor

Well, actually it could even be a positive. It depends how the legal (inaudible) on that. But we're relatively indifferent to where the PVR capability is because if you have racks of PVRs in a central location versus you have one in every home. It doesn't really change the silicon opportunity for us in that sense. Actually, if you have it centrally it's going to drive things like a DOCSIS and higher speed connect to the home. It's going to drive infrastructure sales. There will be more switches sold. So, it’s probably a net positive for Broadcom if it moves towards centralized than if it's in the home. But it's not a huge swing for us either way. But I'd say on balance it would be positive.

Operator

(inaudible) of Sanford Bernstein has our next question.

Unidentified Analyst

I had a question on the royalties. First of all the other royalties if you take the QUALCOMM and Verizon numbers out, are those focused on a single business or just sort of spread across your entire business?

Eric Brandt

They exist in our business across a variety of different businesses. But they are IP related royalties we receive based on our chip business. As you can see they are about $6 million. They have been in our business for a while and we expect that they will. The reason why we typically haven't really discussed them is because they have been part of the business and the business units themselves actually create the opportunities as opposed to the Verizon and QUALCOMM opportunity which was more of a corporate opportunity.

Unidentified Analyst

How should I think about that growth going forward, because I mean again if I pull the Verizon and QUALCOMM numbers out it actually looks like that other royalty has actually been growing at a fairly good clip over the last two years?

Eric Brandt

All we do is put it about one quarter out. I mean to some extent it sort of depends on the sale of other people's products. But we will provide whatever color we can. I got to be honest with you this is the first quarter we pulled it out and we are still trying to get our hands around how to forecast it more broadly. So what I would suggest, you just stay tuned and we'll give you more information as we go through and hope we'd be able to give you a better way to line it out.

Unidentified Analyst

I have one more question for you. I know you've been talking for sometime about increasing transparency to the investor community. On the whole, I think you've been making good on that. You talked about share base coming down and I know you report your result in GAAP. However, investors typically really still do look at you on a non-GAAP basis. I was just wondering what your point of view is on at what point you feel investors really should begin thinking about on how to model and how to actually do your valuation on a GAAP basis versus non-GAAP?

Eric Brandt

I would answer that the way I have been answering all along. Our job is to put up the numbers and people have various methods they use to value companies. Some people use GAAP numbers. Some people use cash flow numbers. From our perspective that's really your call and all we really want to do is give you the ability to see all of them. At the end of the day though one of the real reasons to sort of move to GAAP is, because we had made a commitment to reduce stock based compensation and without really measuring it and reporting it on a regular basis, people are having a hard time believing we were going to do it. And I think we were doing it and I think you are getting leverage in the EPS line both from the leverage of our core business, excluding stock based comp and other pieces, plus the benefit of stock based comp coming down. So once we get aligned with the rest of the industry and stock based comp is in the 4% to 5% range of revenue, it doesn't matter one way or the other. But the issue really is, how do you think about the delta? What I'd rather be telling you, what I think it is, as it's reported, and then let you decide how you want to value and whether you want to move to non-GAAP. But at the end of the day all of that data is available for you on our web financials and you can model it however you choose to.

Unidentified Analyst

So should I anticipate that cash compensation is coming up as stock comp is coming down, do those things exactly match or is there a delta between those as well?

Eric Brandt

Well, first of all, we target our cash comp at the 50th percentile, and so to the extent that we are below, we will deal with it, we are pretty darn close to that number. I think that what you will probably see more from us is, historically we haven't had a very large bonus tied to current year performance, which we don't believe is the right thing to do. So, we are increasing the current year performance component of people's compensation, that is a cash component, but do not expect that we are offsetting anywhere near the reduction in stock based comp for cash.

Operator

And our next question comes from Cody Acree of Stifel Nicolaus. Please go ahead.

Cody Acree - Stifel Nicolaus

You mentioned earlier a bit of shortages, but the lead times were extending, I assume those were a tandem comments. Was the lead time extension meaningful, would you characterize it as something that you are starting to get concerned with or was it just on the margin?

Scott McGregor

I wouldn't say, if I had to think of the top things I worry about, it's not on that list. So it's a factor. I mean whenever there is shortages with customers, the customers are never happy about that and we work really hard to try and solve those problems. We've got a great operations team that jumps right on those things and we can often figure out ways to accelerate product for customers who really need it. So, I think we are really good at that. I would say it's a fairly small issue at this point. I don't see it as a major issue like we have seen at the other points in the semiconductor cycles where you have massive allocations or shortages, certainly not all.

Cody Acree - Stifel Nicolaus

Lastly, I hate to bring up combo chips again, but we just heard from QUALCOMM we were hearing continual emerging market growth, cheaper cell phones, ASPs coming down in the phones. Where do you think that there is a fit or a price band where combo chips make sense, and then there is a point where you have to go to a discreet solution where you're just not paying for all of the functionality that a combo chip provides?

Scott McGregor

I don't buy your distinction because if you need the components of a combo chip, the combo chip absolutely makes sense. If you don't need the components of a combo chip, then you can buy the discreet. For example, if you only want Bluetooth in a phone and you don't care about FM and you don't care about wireless LAN, you just buy Bluetooth. That's fine and we have great products in that space.

FM, some people will put in because the relative increment is fairly small, but you wouldn't just sort of throw in wireless LAN just because there was a combo chip available unless you needed it because that's a significant price component.

So, we believe we've created the combo chips that make sense in the market. For example, we see a large segment of phones that need Bluetooth plus GPS. That's why we introduced the combo chip and that space, Bluetooth, wireless LAN, FM radio makes a lot of sense for smartphones.

We see wireless LAN adoption in phones as a major driver. I think we expect that pretty much all smartphones will have wireless LAN and it will start to penetrate down into the feature phones as well just because both the costs has come down and it offers incredible amount of capability.

So I think those are the more meaningful factors driving the dynamics in the combo space, and not so much that you wouldn't buy the combo product unless you needed the features and we have the discreet components as well.

Cody Acree - Stifel Nicolaus

Is there a price point that you think on the handset itself where it's $70 phone or $100 phone where that probably does not warrant a combo chip?

Scott McGregor

There are phones that aren't going to have connectivity in them. The ultra low cost phones don't have Bluetooth in them. There are some phones that might have FM in them, in some of the regions FM radio is popular, as is a flashlight capability in the phone. Those are popular in many parts of Asia and other developing countries.

So, that would be a case where we don't particularly focus on those markets and you could go buy a FM chip from somebody. As soon as you start introducing Bluetooth in a phone, we don't believe that there is a phone that you wouldn't find a Broadcom solution for in that space. I don't believe all phones will have Bluetooth or all phones will have wireless LAN. I think the ultra low cost ones, again, won't have connectivity in them. So, that's not a market for us.

Operator

Our next question comes from Suji De Silva of Kaufman Brothers. Please go ahead.

Suji De Silva - Kaufman Brothers

On the broadband side, are there some upgrade trends that you think continue to be strong through this holiday season that can drive growth, perhaps even if the economy stays soft, things like DOCSIS, HD and so forth?

Scott McGregor

Absolutely, I do believe we were seeing continued move over to DOCSIS. That's more next year phenomena, but HD continues to be a phenomenon. People will buy a new TV set and they really want to get the better picture quality. Again, in a down economy, people tend to cancel vacation. They tend to cancel other expenses. Since they are going to spend more time at home, they put their money instead in the home. So we see some benefit from that.

I think the other factor that is not quite an upgrade per se but it's important which is the cable guys moving from analog to digital and reclaiming the analog bandwidth and doing that with DTAs and basically rolling out a more complete digital line-up, which isn't something the subscriber would necessarily apply for ,but that would be something that they would provide set back boxes for the subscriber TVs and they would upgrade their set-top box for the benefit of the carrier to offer more capabilities and reclaim the analog bandwidth.

So that's another opportunity in that space as well that I think will be a wave over the next couple of years.

Suji De Silva - Kaufman Brothers

On the combo chips, is that one of the areas of focus for the second or third generation 65-nanometer products and 40-nanometer products? I'm trying to understand where the gross margin of this business might trend as you go from three to five products I know the ASPs might move blended up or down depending on what you are introducing, but is this one of the areas where you think you can get gross margin up because of cost?

Scott McGregor

Our engineering team in the combo area has done a great job in terms of looking at ways to really drive cost down and really create far more cost effective products in that space. So as those products rollout over the next year or so, yes, think I there is margin opportunity in that space.

Suji De Silva - Kaufman Brothers

Can you help draw a line as to what carrier spending has been like from your perspective in terms of last few quarters? Has it rebounded and is it continuing or has it held up and been stable and that's expected to continue?

Scott McGregor

I would say it's held up and it's become more broad based in terms of the regions. I think we called out China in previous calls and I think that's migrated to some other regions as well, and not specifically China. I don't think I could forecast it going forward and how long it continues, but I think there has certainly been benefit from some of the stimulus packages that have gone on around the world.

Operator

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

David Wu - Global Crown Research

Yes. Thanks for getting me in. Can you maybe help me with one thing? The $200 million worth of QUALCOMM payment, where does it all fit into the income statement for the June quarter?

Eric Brandt

It fits into a couple places. If you look at the revenue component, which represents QUALCOMM, which is about $57 million, that actually splits into two pieces, a piece which relates to the current payment, which was done in the middle of the quarter. So, that $36 million of that $67 million actually is in the current quarter's payment from the $200 million.

Then there is $31 million which was on the balance sheet due to the sunset royalties based on the Santa Ana trials. So, that's what makes up to $67 million. Then, in addition, there is a $65 million settlement, which is based on the valuation work in terms of what the damage component of the payment would be attributable to. So that's how you use roughly $100 million of the $200 million that comes in. Then there is another $100 million which is sitting in deferred revenue.

David Wu - Global Crown Research

So it's in deferred revenue, okay. The other thing I was wondering is the tightness that you mentioned in some of the foundries and certain processes. Is that a phenomenon that with all the foundries are ramping production it's a non-repeat item for Q3?

Scott McGregor

We'll never say non-repeat. I don't see it as something that persists over the next couple quarters. I think between our ability to move products around and ease shortages, I think we're dealing with it pretty well. Of course, if sales were to go up 50% then obviously we'd find some challenges. Based on where we see the revenue coming in and where we see customers, we think we can manage that.

Operator

Our next question comes from Mahesh Sanganeria from RBC Capital Markets. Please go ahead.

Mahesh Sanganeria - RBC Capital Markets

I have a question on DSL modem site. Looks like none of your larger competitors want to stay in the business and most of the business competition is consolidating amongst smaller players. I'm just wondering if you can comment on how that positively impact your market share? The second thing is, as DSL moves from being pure DSL to a gateway and you are able to integrate more functionality, should we think that ASP should trend up from here?

Scott McGregor

I think there are a number of trends that you've highlighted, certainly there has been some consolidation among some of our competitors. Broadcom has an incredibly powerful product line up in the DSL space. We've done a great job with integrating things like wireless LAN, tying the whole solutions together in the modems. I think we'll continue to do that and create great products there for customers.

We also see some migration possibly to GPON. So there is an opportunity in that space to increase the bandwidth for those kind of customers and we'll continue to look for new opportunities the ADSL2+, GPON, other things allow us to drive new technology and new innovation in that space. So, we do believe that we will maintain or increase our competitiveness in that area.

Mahesh Sanganeria - RBC Capital Markets

On the cable modem sides, you said that the DOCSIS 3.0 is a next year thing. Do you have a sense of how they head end deployment is in from that, can you get an idea of the exact precise timing of DOCSIS 3.0 deployment?

Scott McGregor

We certainly can get a sense of it. I mean, obviously, you need both the head end and the customer equipment in order to get the capability. Some people will deploy head ends and not populate them and some people will, while they are upgrading their modems or the set-top boxes anyway, they will put the higher end ones in, even though they haven't put the head end in yet.

So, I think each carrier will move. We work closely. We have great relationships with all the carriers and we work really closely with them to help them. We provide most of the head end solutions to them. So, we work closely to tie those together for them.

Operator

Our next question comes from Shawn Webster of JPMorgan. Please go ahead.

Shawn Webster - JPMorgan

On the tax rate really quick, Eric, are we supposed to be using what we have done before and in terms of modeling the tax rate going forward something in the 0 to 5%.

Eric Brandt

Yes, basically what it's been on a GAAP basis. If you are a GAAP guy, you're a non-GAAP guy, non-GAAP people are going to run 10. But I would say 2%, 3% is been roughly what it's been over time.

Shawn Webster - JPMorgan

Did you have any 10% customers in the quarter?

Eric Brandt

We only disclose that on an annual basis. So, we'll just wait until we do that on an annual basis

Shawn Webster - JPMorgan

On the products the Wi-Fi combo chips grew to over 10% in the quarter, how many of your product lines are in excess of 10% of your sales at this point?

Scott McGregor

Just to clarify, the combo chips in aggregate grew to over 10% of our business. So that would be Bluetooth plus FM and the wireless LAN combo chips that we have. So we don't breakout our particular products over 10%. We'll give you a little more color maybe at Analysts Day.

Shawn Webster - JPMorgan

On the lead times, at what point do things start getting tight. Was that just recently or was that earlier in the quarter?

Scott McGregor

I don't recall. I think it was over the course of the quarter we started to see some demand surge, certainly as you saw in our revenue growth and revenue growth forecast in this quarter. So I don't recall a particular time it was. There wasn't one instant or one particular time where there was a problem.

Shawn Webster - JPMorgan

What's your assessment of inventories out there from what you can tell out in the channel and your ODM and OEM customers?

Scott McGregor

In general, I feel it's pretty lean. I don't feel like there are large inventory pockets out there. There's is always going to be some, and generally you find those out in a couple months when the customer doesn't order a product. In general, I don't feel like we're in a high inventory situation right now.

Operator

Our next question comes from Tristan Gerra of Robert Baird. Please go ahead.

Tristan Gerra - Robert Baird

Given the ramping utilization rates, do you expect any changes with the pricing in the second half or in the first half of 2010?

Scott McGregor

We generally see our suppliers work with us to try and drive a continuous cost reduction in wafers. Each process geometry has its own sort of cycle and that it comes down fairly quickly in the early phases, and then moves to a more flattening of the curve as it gets more mature in the cycle. That's one of the advantages of moving to smaller geometries. It allows you to move over on to a more rapidly decelerating cost curve for wafer prices. So, I don't see anything particularly unusual in the market right now.

Operator

Our next question comes from Arnab Chanda of Roth Capital. Please go ahead.

Arnab Chanda - Roth Capital

Thank you. Question for either Eric or Scott or Peter. It seems like on a macro basis, you are getting your highest gross margin business grow the slowest and the lowest gross margin segment grow the fastest. Do you think that you can offset this sort of mix headwind with your cost reductions, and if so, when do we think we can do that?

Scott McGregor

Arnab, it's not exactly true. Again, if you look it at macro level and you are focusing on the growth rate of the enterprise space, certainly that would apply. I think as Ross asked earlier, as you look inside the businesses, that's not true. So, what had happened over the last year has been a little bit of that, but as much the effect of overhead being absorbed over a smaller base, which hit us 100, 130 basis points sort of peak to trough, and then an ongoing hit from this E&O effect.

Going forward, I think having as much attention on cost optimization, et cetera, and improving margin within our business units, I think that we'll see some benefit from that. It's early to call what it will be and to stick your hands up and say touchdown, but I have to say the intensity, the focus, the understanding of what that all means is part of what's driving some of these tapeouts and product changes and we are cautiously optimistic as to where it goes.

Arnab Chanda - Roth Capital

A question about the combo products. You've talked about that being a very strong driver for you, obviously has been. I assume its Bluetooth and FM combo today. If that's not correct please clarify that, and when do you think sort of a Wi-Fi, Bluetooth, et cetera, will start to be significant?

Scott McGregor

Well, the Wi-Fi, Bluetooth combo already is significant. 4325 product is one of our fastest growing products and is at significant volume today and we expect that will continue to grow. So that's a very hot product for us and we see considerable growth there. It's our second largest combo product in that space.

So, I feel, overall, we're going to see great traction across our whole range on combo products.

Arnab Chanda - Roth Capital

I know you don't want to talk too much of your baseband, but you probably know what's going to happen in Q3. What timeframe do you think you will ship 3G, is it already happened, or do you think that starts second half of this year?

Scott McGregor

We have been shipping 3G for awhile. So, absolutely.

Arnab Chanda - Roth Capital

It seems like there is a movement. In the smartphone market, one of biggest trends is the application processor. You haven't talked too much of broadband. I don't know if you have a product in that market yet. So, maybe if you could clarify if that's an incorrect misunderstanding and what you plan to do there?

Scott McGregor

I'd say it's a misunderstanding. Our basebands integrate an application processor in them. So generally, we'll offer a dual arm core baseband product. There will be for example on ARM11 dedicated to the baseband, and then in [ARM11 4] applications and that's all integrated in the SOC.

So to the extent that the customer wants a very high powered or a celebrity application processor, they are certainly welcome to add one. Our goal is to look at integration strategy for where we provide those just as part of the SOC.

We do have a family of graphic coprocessors, multimedia coprocessors, the 2727 being the first in that family. That offer very outstanding video and 3G graphics performance and still pictures and other things for when you really want something that is very specific in terms of the capabilities there.

So, we believe that the majority of the market can be captured with integrated application processors. We could certainly look to introducing an outboard application processor as well. We've certainly thought about that and that's a possibility for us as well.

Arnab Chanda - Roth Capital

The final transition to the digital broadcasting, has that helped your cable or satellite business or has that been affected at all?

Scott McGregor

Absolutely. I mean the $40 converter box turned into the buy a new digital TV, upgrade to cable, move to satellite. There are lots of different ways people solve that problem. We found that that was beneficial to our market.

In the cable space, though, I think the real driver now going forward is, as I mentioned earlier, reclamation of the analog bandwidth to reclaim that for digital use. I think that will be a longer term driver without a specific time period like we saw for the analog conversion on the airwaves.

Operator

This concludes the question-and-answer session. I will now turn the call back over to Scott McGregor for closing comments.

Scott McGregor

Thanks, everyone, for joining us on the call this morning. We are really pleased with our second quarter results and we do expect broad based revenue momentum to continue into the third quarter, so should be a good quarter.

Since the economic situation remains uncertain, our team is going to be cautious about increasing operating expenses. We will certainly take the opportunity to accelerate tapeouts or hire judiciously if we see a strong ROI for that.

Overall, we're going to focus our business really on trends like conversions and the positive end user experience that all of these feature-rich network connectivity opportunities offer, we'll add that to our key platforms.

So with that, thank you very much and have a good day.

Operator

Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.

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Source: Broadcom Corp. Q2 2009 Earnings Call Transcript
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