Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

LSI Corporation (NASDAQ:LSI)

Q2 2009 Earnings Call

July 29, 2009 5:00 pm ET

Executives

Sujal Shaw – Vice President of Investor Relations

Abhijit Y. Talwalkar – President, Chief Executive Officer & Director

Byron Look – Chief Financial Officer, Executive Vice President & Chief Administrative Officer

Analysts

Hans Mossesmann – Raymond James

Kaushik Roy – Wedbush Morgan Securities, Inc.

James Schneider – Goldman Sachs

Romit Shah – Barclays Capital

Daniel Amir – Lazard Capital Markets

Christian Schwab – Craig-Hallum Capital

Craig Berger – FBR Capital Markets

Sumit Dhanda – Bank of America Merrill Lynch

Shawn Webster – JP Morgan

Blayne Curtis – Jefferies & Co.

Suji De Silva – Kaufman Brothers

Operator

Welcome to the LSI Corporation investor relations conference call. At this time all participants are in a listen only mode. Later we will conduct a question and answer session. Instructions will be given at that time. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host Sujal Shaw, Vice President of Investor Relations at LSI.

Sujal Shaw

With me today are Abhijit Talwalkar, President and Chief Executive Officer and Bryon Look, Executive Vice President and Chief Financial Officer. Abhi will begin the call with some opening remarks and highlights from our business and then Bryon will provide second quarter 2009 financial results and guidance for the third quarter of 2009.

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

I also want to remind you that today’s remarks will include forward-looking statements. Our actual results could differ materially from those suggest by the statements made today. Information about factor that could affect our future results as contained in our quarterly report on Form 10Q for the quarter ended April 5, 2009 and our annual report on Form 10K for the year ended December 31, 2008.

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

Abhijit Y. Talwalkar

I continue to be pleased with our execution, the solid results we are delivering and the focus our employees are demonstrating in taking our business forward in a challenging environment. For Q2 our revenues exceeded the midpoint of our guidance range with strong sequential growth in storage systems and storage semis. We continue to maintain tight controls on our spending with non-GAAP operating expenses decreasing sequentially and coming in below the low end of our guidance.

We also continue to carefully manage our balance sheet and generated positive operating cash flow of $69 million in a difficult environment. In addition, we redeemed over $240 million of short term convertible debt during the quarter saving interest expense and benefitting our bottom line. While it is difficult to know if the economy is on a sustainable path to recovery, all of our businesses serving PCs, external storage systems, servers and networking showed sequential growth in Q2.

Before I talk about our businesses, here are the key takeaways that I would like you to get from this call: first, we delivered solid results in Q2 and are guiding to further growth in Q3; secondly, over the past several years we’ve made substantial changes in our structure and strategy and are at the front edge of seeing tangible results; and lastly, we are positioned to grow at above market rates across most of our product categories and are far from saturated in the markets we serve.

While financial results are visible to the investment community there have been significant company level changes and product line improvements that have been taking place below the surface transforming LSI in to a company that is positioned to grow faster than many of the markets that we serve. On prior calls we have discussed some changes that have been implemented including significant operating expense reductions, full restoration of the competitiveness of our HDD and networking businesses, divestitures of volatile businesses and the outsourcing of manufacturing operations.

We are now in the front edge of seeing tangible results from our transformation. Accumulation of design wins over the past two years which has led to stronger core businesses in storage and networking. Bottom line, over the past several years, LSI has become a stronger, better positioned and more competitive company. We have strengthened an already successful storage systems business expanding our product line and customer base and making acquisitions which have expanded our TAM. In storage semis we have established share leadership in SAS and SAN silicon and secured new design wins with the leaders in the industry.

In HDD we have technology leadership and are well positioned to gain share at existing and new customers. In networking, we have spent the last three years restructuring and refocusing that business and while strategy transformation can take time and be difficult to measure, we believe that we are at the edge of seeing the benefits of the changes we have driven. Our design win conversion rate which measures the amount of design wins that we expect to reach production and materialize in the revenue is currently running at 90% for networking design wins accumulated over the past two years.

This is considerably higher than the substandard levels several years ago. These significantly higher conversion rates are a direct result of our shift in product strategy and associated focus on industry leaders such as CISCO, Ericsson, Intel and [Waway] serving established multibillion dollar system segments. Even with the progress we have made in storage and networking, we are far from saturated in the markets we serve with approximately 20% aggregate share. This leaves significant room for growth and expansion.

Now, I want to review with you the business highlights for last quarter in storage and networking. I would like to begin with storage systems where we grew over 12% sequentially with growth in both mid range storage and entry level systems as datacenters added capacity following a weak first quarter. Even in a challenging environment IT managers cannot hold off capacity upgrades indefinitely because the demand for digital storage, data storage and management continues to grow.

Last week we announced an agreement to acquire ONStor a leading provider of network attached storage solutions including clustered NAS gateways. The acquisition closed this week and will expand our TAM and enable us to address the rapidly growing space of unstructured data such as email, web applications, archiving, video streaming, as well as numerous software as a service applications. NAS is a $3 billion plus market with attractive forecasted growth rates. With ONStor we will be in a position to enable our OEM customers to address this large and rapidly growing space currently served by companies like EMC and NetApp.

We have also successfully integrated 3ware in to our systems business and are benefitting from additional customer design wins as a result of the acquisition. In fact, we are seeing additional interest in 3ware products as a result of LSI’s commitment to the technology and road map. With 3ware, LSI is the number one host-bus RAID controller provider to the channel across both SAS and SATA technologies.

We continue to make progress in both mid range and entry level storage systems. We announced enhancements to our flagship XBB2 mid range product and are now in volume shipments to our OEMs. LSI is the first major storage supplier to ship systems with 8 gig fiber channel interfaces which provide up to twice the bandwidth per channel between server and storage applications. In entry level storage systems which are focused on the small and medium business segment IDC’s latest data confirms that LSI is the storage system volume share leader in this space based upon the aggregate shipments of our OEM customers. Over the past two years we have gone from having a minimal presence in this space to being the number one volume leader which is a testament of our innovation and time to market execution.

I’ll now turn to storage semiconductors which includes SAS, SAN and HDD. IDC estimates that server shipments grew approximately 8% sequentially in the second quarter following a sharp decline in server purchases in Q1. In SAS we are now in production on the industry’s highest performance 6 gig solutions, in fact we just launched a new generation of high performance mega RAID SATA and SAS RAID controller cards based on LSI’s 6 gig technology. In addition to leadership performance, the mega RAID 9200 family is optimized to support solid state drives.

Going forward we expect to ship to all 10 server OEMs, also expect to capitalize as SAS sees greater adoption in external storage systems which we believe is an emerging multi hundred million dollar market over the next several years. During the quarter Dot Hill, NEC, Sun Microsystems and Xyratex all selected LSI’s 6 gig SAS solutions to enable their next generation external storage platforms. Last quarter we also mentioned that we secured a key 6 gig SAS storage processor design win at the largest unit volume external storage OEM for a next generation platform.

In SAN, customers continue to see the value of our IP offering as well as the time to market benefits we enable. During the quarter we recorded design wins based upon our 40 nanometer technology for fiber channel and fiber channel over Ethernet protocols in top of the rack modular switches as well as server HBA applications.

Now, turning to hard disk drives, our business saw an upturn in demand in the second quarter and HDD revenues exceeded our expectations. We continue to make progress and are engaging new customers and are confident that we will increase our share in SoCs as we move forward. In order for LSI to expand our customer base two things need to happen: first, customers need to be willing to move beyond a captive single supplier model in to a dual supplier model; and second, LSI must have compelling technology with time to market advantages. We firmly believe that both of these conditions are materializing in front of us.

Last quarter we delivered the industry’s first 40 nanometer full low-density parity check or LDPC rechannel and have sampled this to our HDD customers. The feedback has been extremely positive. LDPC is a new type of coding scheme that is critical to reach the next level of aerial density and LSI is the only company that has this today. With time to market and cost per area being key factors for an HDD OEM’s competitive position, we expect to gain more ground by being first in this critical technology transition.

In preamps we are sampling the true store PA2900 which is the industry’s first preamp capable of covering the notebook, desktop and enterprise hard disk drive markets. This enables customers to deploy a single part across all major HDD segments. We expect this new offering to help us continue gaining share in preamps. In solid state drives we continue to make progress and are on track to deliver custom flash controllers for two leading enterprise HDD customers and one leading SSD flash manufacturer. We expect these solutions to go in to production in 2010. In Q2 we added to this momentum by displacing a competitor in a volume SATA SSD controller application at the same top tier SSD flash manufacturer.

Now, I’d like to review the networking business where we continue to secure new wins in our three focused segments which are: wireless; wireline; and enterprise infrastructure. In wireless infrastructure we shipped both network processors and DSPs. We expect to continue to benefit from deployments of wireless networks in emerging geographies. The success of our DSP family in this space is a result of its market leading multi core architecture which enables greater channel densities and faster voice and video processing at a fraction of the cost and power consumption.

As we mentioned last quarter [Waway] is already in mass production with our newest generation DSP in their wireless base station products. Last quarter [Waway] selected our DSP for another high volume application which we expect to begin ramping in the second half of 2010. In addition, we are in the final stages with the number one and number two providers in the wireless market with our network and multiservice processors. We expect to begin production by the end of 2009 with these two.

In enterprise networking we continue to expand our footprint and success in high volume platforms. In April we talked about winning DSP business at the world’s volume leader in enterprise networking and several high volume gigabyte Ethernet designs with the leading provider of PC and server chipsets. In addition, we now have secured two significant custom design wins at a major networking OEM for Ethernet and fiber channel switch applications. Also in the enterprise space we announced video processing software for multi core media processors that enables cost effective any-to-any video collaboration for enterprise networks. We have secured a strategic design win for our DSPs based upon this offering with the volume leader in enterprise networking.

In May, we announced that LSI [inaudible] deep packet inspection technology has been integrated in to the new HP XML Accelerator to significantly increase the performance of servers hosting SAP and other enterprise applications. The HP XML Accelerator with LSI technology speeds SAP communications by up to 400% to help customers respond quickly to business demand. We expect to begin ramping with HP early next year.

All-in-all, a very good quarter in regards to business performance, new product execution and continue design win momentum. Now, I’ll turn the call over to Bryon who will take you through our results and provide guidance.

Byron Look

First of all I’d like to start by saying that we continue our focus on driving solid financial results despite this very difficult business environment. We have made significant progress on many fronts during the quarter. Achieving sequential top line growth while consistently meeting product development milestones and further adding to growth via strategic acquisitions, all while making excellent progress on our cost structure. The resulting improvement in net income together with solid working capital management drove positive operating cash flows and an expansion of net cash in the quarter.

Some highlights from the recent quarter include: revenues at $521 million for Q2 exceeding the midpoint of our guidance by $21 million; consolidated gross margins excluding special items were 42.1% at the midpoint of guidance; operating expenses excluding special items continuing showing significant progress closing the quarter at approximately $207 million demonstrating 3% sequential and 15% year-over-year improvement; and non-GAAP earnings were $0.01 per share at the high end of our guidance range. I’d like to add that the significant progress the team has made across the company of managing our expenses was a key contributor in helping achieve positive non-GAAP earnings in the quarter.

In addition, we delivered positive operating cash flows in Q2 primarily due to significant net income improvements along with diligently managing our working capital. DSOs or days sales outstanding remain on track while inventory dropped sequentially by $43 million. Inventory levels have improved by approximately $100 million or 39% over the last 15 months demonstrating both the value inherent in our manufacturing strategies and our efforts to efficiently manage our working capital.

Our net cash position or cash and short term investments net of debt increased by $44 million to $524 million in Q2. Keep in mind these results include the $20 million in cash we paid for the 3ware acquisition in the quarter. Finally, after redeeming approximately $243 million of convertible subordinated notes within the quarter, our cash position remains very strong at approximately $874 million.

In terms of our continued efforts to capitalize on strategic M&A opportunities, we announced and closed in April the acquisition of the 3ware business from AMCC. We completed our integration activities and we’re already seeing encouraging results from that business. As noted previously the acquisition is expected to be neutral to non-GAAP EPS in 2009 and the full quarter financial impact of the transaction is included in our guidance going forward. This week, we closed the recently announced acquisition of ONStor for $25 million of cash inclusive of net liabilities. We expect the acquisition to be roughly neutral to our non-GAAP EPS in 2009 and we included the financial impact of this transaction in our Q3 guidance.

Now, turning to a more detailed discussion on the quarter; revenues for Q2 were $521 million which is up $38 million or 8% sequentially. Semiconductor revenues for Q2 were up $19 million or 6% sequentially to $344 million. Our storage semiconductor revenues which include hard disk drive silicon, SAS standard components and storage area network ICs were sequentially up $24 million or 12% to $231 million and represented 44% of total revenues in the second quarter. The sequential increase in revenue was primarily due to inventory replenishment along with a modest increase in end market demand.

Q2 revenues in our networking business were $99 million representing 19% of total revenues for the quarter and up $3 million or 4% sequentially. Revenues for the IP business in the second quarter were $14 million. As we have previously mentioned, IP revenues from the closure of contracts can vary quarter-to-quarter but we do expect IP revenues to increase in Q3 and grow for the full year in 2009 over 2008 levels.

Turning now to our stored systems business, system revenues were $177 million in Q2, sequentially up $20 million or 12% from a seasonally low Q1 2009. We experienced increased demand for products in both our entry level and mid range product solutions along with growth in our internal direct attached storage business. The storage systems segment represented 34% of LSI’s total revenues in the second quarter.

Moving next to gross margins, LSI’s consolidated Q2 gross margin excluding special items was 42.1% which was sequentially down 60 basis points from Q1 ’09 and at the midpoint of the guidance we provided in April. The sequential decline in gross margin was driven by a margin decline in our semiconductor business offset partially by a margin improvement in our systems business. Semiconductor gross margins excluding special items decreased from the first quarter to 45.4%.

This level is lower than one might expect given the higher sequential revenues, however we experienced higher than normal costs primarily associated with a couple of items: first, there was the carryover effect of fixed cost absorption of semiconductor products manufactured in Q1 and sold in Q2; second, we experienced higher than normal intellectual property litigation costs. Both of these items are substantially behind us and we expect to see our semiconductor gross margins expand going forward. With respect to Q3 we are guiding our semiconductor gross margins excluding special items to recover and expand approximately 360 basis points to 49%.

Storage systems gross margins for the second quarter excluding special items sequentially improved significantly by 580 basis points to 35.8%. This increase was primarily driven by a return to a more normalized mix of higher end, higher margin products along with increased overall absorption on fixed costs. Moving now to operating expenses, R&D together with SG&A expenses excluding special items totaled to $207 million in Q2 beating the midpoint of our guidance by approximately $11 million.

Operating expenses excluding special items declined $7 million or 3% sequentially. Our lower Q2 op ex levels reflect the timing of some tape outs combined with our continued commitment and focus on reducing our cost structure where possible while continuing to drive revenue growth opportunities. Interest income and other net of interest expense excluding special items was a loss of $.5 million for Q2.

Now, let me turn to the special items that we recorded in the second quarter which netted to $69 million. Special items, primarily non-cash included $43 million in amortization of acquisition related items, $17 million of stock-based compensation expense and $8.6 million of net restructuring costs and other items. The tax provision for the second quarter on a GAAP and non-GAAP basis was $5.2 million. On a GAAP basis, second quarter net loss was $61 million or $0.09 per share. Net profit excluding special items was $7 million or $0.01 per share.

Turning now to the balance sheet and cash flows, second quarter operating cash flows were quite strong coming in at $69 million. The sequential improvement in operating cash flow was driven primarily by material reductions in our inventory balance along with a significant improvement in net income. We continue driving efficiencies in working capital items. We have significantly reduced our inventory balances, dropping $62 million or 28% over the last two quarters and have stabilized our DSOs to approximately 46 days.

Going forward we do expect some level of variability driven primarily by period-to-period working capital variances along with timing of payments. We’re on track to deliver positive operating cash flows for the full year 2009. During the quarter we used our strong cash position to redeem the outstanding balance on our 6.5% convertible notes six months early which significantly reduces our interest expense going forward. Our cash and short term investment balance remains very solid ending the June quarter at approximately $874 million even after redeeming $243 million of debt.

As I mentioned earlier, our net cash position at the end of the quarter improved sequentially by approximately $44 million to $524 million. Our large cash balance puts us in a solid position to continue supporting our businesses, investing in our future while continuing to optimize our capital structure. Finally, with respect to Q2 results, depreciation and software amortization was $23 million and capital expenditures were $8 million.

The following is our guidance for Q3, revenues in the range of $520 to $570 million. Sequentially we expect our networking semiconductor business to be down. Relative to Q2 after holding flat from Q1 to Q2, we do expect legacy networking revenues to decline in the third quarter. We expect our storage semiconductor business to be up in Q3 and we expect storage systems to be up sequentially primarily due to expected seasonality as the second half of the year tends to be stronger than the first.

In addition, we’ve included in the guidance for storage systems the revenues we expect to record from the recently acquired ONStor business. We expect IP revenues to be sequentially up compared to the second quarter. Consolidated gross margin excluding special items is expected to improve to a range of 43% to 45%. Semiconductor gross margin is expected to sequentially expand 360 basis points to be approximately 49% and systems gross margin is expected to sequentially expand 20 basis points to be approximately 36%, each excluding special items.

The sequential improvement in semiconductor margins is primarily driven by the items I noted early in the call which are substantially behind us going in to Q3. Operating expenses excluding special items are expected to be in the range of $211 to $221 million which is up from Q2 primarily due to the timing of tape outs to support new design wins as well as operating expenses associated with the ONStor acquisition and a full quarter of 3ware expenses.

In addition, we expect interest income and other and interest expense to net to zero, special items netting to approximately $55 to $75 million, GAAP and non-GAAP tax provision to be approximately $6 million for Q3 and as a reminder our tax provisions can vary quarter-to-quarter based on our profitability in different geographic tax jurisdictions and certain discreet items. We expect Q3 GAAP net loss per share in the range of $0.12 to $0.02, EPS excluding special items in the range of breakeven to $0.06 per diluted share and share count of approximately 650 million shares for GAAP and 655 million shares for non-GAAP purposes.

In addition, we expect depreciation and software amortization of approximately $23 million and capital expenditures of approximately $15 million. In summary, our continued focus on executing to our key objectives has resulted in significant progress in our design win activities and product investments further strengthened by new and immediate opportunities from two recent strategic acquisitions. Substantial improvements in our cost structure while consistently meeting or exceeding our key internal and customer milestones and a solid foundation in our cash position and overall balance sheet.

Now, let me turn the call back to Abhi.

Abhijit Y. Talwalkar

Before we go to your questions, let me offer some quick closing comments. As we continue to navigate the challenges of a difficult economic environment, I am pleased with the revenue growth we are generating and the diligence we are showing on expense control to drive earnings growth. While we are prudently managing our business in the short term we are focused on driving the business forward. We are at the leading edge of seeing the benefits of the design wins we have secured and been in development on for the past two years.

I’m confident that LSI will emerge as a stronger company out of the downturn and outgrow our end markets in storage and networking as we move forward. Let me hand the call back to Sujal.

Sujal Shaw

At this point we’ll begin the Q&A portion of the call. Operator, will you please give the instructions for the Q&A sessions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Hans Mossesmann – Raymond James.

Hans Mossesmann – Raymond James

Just some clarification or explanation on the hard disk drive side of the semiconductor business, you say that you’re confident that you’re going to have some penetration in to some customers that traditionally have done kind of single sourcing of components. To the degree that you’re successful what particular areas or products do you believe are going to be first and allow you to have that success? Would that be with the preamps, would that be SoCs, would it be a combination of things? Just general commentary there would be helpful.

Abhijit Y. Talwalkar

We’re already shipping preamps across the ACD companies so really our focus here is SoCs which is clearly a larger part of the semiconductor opportunity that we have. We are focused across all segments enterprise, notebook as well as desktops in particularly are clearly the three that we were working to try and penetrate given our leadership position and I think a growing desire of wanting a dual supplier sort of approach is around desktop and notebook segments.

Hans Mossesmann – Raymond James

Then in terms of the timing, when do you think you can talk about this or when does it become material enough to talk about? Are we talking six months, a couple of years?

Abhijit Y. Talwalkar

These companies are all right now in the midst of driving decisions, evaluating new sort of rechannels and making their decisions over the course of the next three to six months. That will drive development cycles that would produce HDDs in the 2011 time frame. So, we expect the revenues to be achieved in sort of the mid 2011 if we’re successful in securing one or more of these companies.

Operator

Your next question comes from Kaushik Roy – Wedbush Morgan Securities, Inc.

Kaushik Roy – Wedbush Morgan Securities, Inc.

Can you comment how much of the upside was due to inventory replacement and how much was due to real improvement in demand? As a follow up, if you could comment on the linearity for the June quarter and what you’re seeing in July so far in terms of channel and OEM inventory that would be great.

Abhijit Y. Talwalkar

I’ll certainly offer and then Bryon can jump in and add some additional color. Let’s take linearity for one, linearity was actually reasonable relative to the June quarter. We certainly saw more than typical increase in strength in the latter part of the quarter relative to how much of the growth in Q2 and in particular the HDD space was driven by inventory restocking versus natural demand. That’s probably a question everyone is trying to get their arms around as to how much of this is driven by demand, real demand, incremental demand versus how much is inventory restocking. I’d say there were certainly quite a bit of inventory restocking. With that said, I still believe that inventories are generally on the lean side versus having any concerns on an inventory buildup.

Byron Look

On the linearity I think Abhi’s got it summarized there. We tend every quarter to be more back end loaded, we turn a lot of the revenues inside the quarter. In Q2, probably something closer to the high 30%s to 40% of the revenue came in-in the last month and rolling in to the current quarter it’s still pretty early for us to be able to call that given the nature of that profile.

Operator

Your next question comes from James Schneider – Goldman Sachs.

James Schneider – Goldman Sachs

I guess if we could start off first of all on the non hard drive storage components HPA, SAS, etc., could you give us some color about what trends you’ve been seeing over the first couple of quarters of the year? Then, given what you’re hearing from customers how do you expect these to grow heading in to the back half? Then, as a follow up, on the op ex you had a pretty nice under run there, you talked about reductions due to lesser tape outs, are there more opportunities for kind of structural reductions there? And, can you talk about any more color around the other reductions that were made?

Abhijit Y. Talwalkar

Let me take the first question, the non ACD sort of semiconductor business in storage is largely influenced by server sales. I think what we saw in the second quarter was a level of stability in the server sort of end demand and purchasing that was going on because in Q1 we got hit with both a seasonal drop which is pretty significant, this is something that’s gone on for years in servers, on top of it an economic sort of back drop that was sort of challenging and in the midst of a pretty significant transition in terms of Intel processors. All those things contributed to a pretty tough Q1 I think for everyone as well as a slow start to Q2.

We started to see some life in the enterprise server space in sort of the middle and the latter part of Q2 and I think that bodes well relative to the second half. Kind of consistent also with what you may be hearing from Intel, the new Intel based servers that everyone is shipping are being received very positively in terms of immediate ROI and tremendous price performance. We’re fairly optimistic that we have a shot at returning to sort of typical or modest to typical seasonality in the second half for that end market.

Relative to our overall op ex, yes we did do fairly well in Q2. Keep in mind some of that was due to some movement of some tape outs that we’ll have to carry in to this quarter itself but overall we’re very pleased with where the third quarter op ex guidance is despite some of that movement in tape outs while also absorbing incremental costs associated with two acquisitions in four quarters. We’re still within sort of the guidance range that we had been forecasting over the past two quarters.

In terms of more improvements as you know we’ve been driving significant improvements over the past two years. We’re constantly looking for opportunities to drive greater level of efficiency and that’s just a way of life in tech and certainly from an LSI standpoint.

Operator

Your next question comes from Romit Shah – Barclays Capital.

Romit Shah – Barclays Capital

Just on the drive business, I’m sorry if I missed it but could you give us what your expectation is for that business to grow in Q3?

Abhijit Y. Talwalkar

We’re not going to provide any specifics but the expectation of that business is to be up Q2 to Q3.

Romit Shah – Barclays Capital

Then Abhi I would think at this point you guys would have a little bit better visibility relative to maybe the last couple of quarters but you still have provided a fairly wide range for guidance for Q3. Can you give us some of the puts and takes that get you either to the high end versus the low end?

Abhijit Y. Talwalkar

I don’t think our range is too wide. We’re ranging anywhere up to 9% in terms of total growth at the top end, around 4.5% to 5% at sort of midpoint kind of consistent with what we are seeing across companies or product categories consistent with our end markets. Keep in mind that 80% of our products are influenced by end product categories that are in sort of enterprise business oriented IT and so that’s very consistent with what we see. We’re seeing growth across our storage systems business, we’re seeing semi to be sort of flattish, that is largely driven by a declining legacy business in networking.

Some of the puts and takes or some of the variables that would drive that to be higher certainly continued strength in the hard disk drive business, do we have a sustainable recovery, is there end market incremental demand in growth especially coming out of Asia around desktops and PCs that would bode well. I think on the server side given the tremendous sort of reception that the industry has had on these new Intel based servers that also bodes well. Those are some potential incremental catalysts in terms of the growth. We’ve got some product cycles that are coming in our storage systems business. Depending on how aggressively we can get those ramps, that also bodes well for the second half.

Byron Look

It has been a little more challenging to forecast the declines in the networking side and that’s really, the legacy business is what’s driving some of that in Q3. I did want to point out that we did narrow the range of that guidance even though you might feel that it’s wide, from the prior quarter.

Romit Shah – Barclays Capital

Have you guys quantified in the past or are you able to quantify today how much legacy networking business you have? I remember last year you guys, I think that business fell off less than you expected and what are your thoughts around legacy networking for the remainder of 2009?

Abhijit Y. Talwalkar

The rough context and the rough numbers that we used, we had about a $500 million overall networking business last year, half and half of legacy and non legacy. Coming in to this year we said we would see the legacy business decline about $100 million. It held up relatively better than we anticipated in the first half but we continue to hold to our view that we will expect a $100 million in total decline on that legacy business this year.

Operator

Your next question comes from Daniel Amir – Lazard Capital Markets.

Daniel Amir – Lazard Capital Markets

In your prepared remarks you talk about the flash controller business, can you expand a bit about that opportunity and it seems like you’ve mentioned that you’ve gained a design win or designed someone out. On the SATA side can you expand a bit more.

Abhijit Y. Talwalkar

We’ve been focused on building a position in overall flash based storage on many different dimensions from making sure our storage systems and our RAID adapters are optimized to take full advantage of the IO performance that flash technology provides to thinking about optimize host rate solutions in the near future, leveraging flash to making sure that we’re working with industry leaders and enabling them with custom sort of flash controllers leveraging some of our IP in both enterprise, SSDs as well as notebook oriented SSDs.

So, what we talked about in the prepared remarks were really good progress relative to working with companies who we believe will be major players in enterprise oriented SSDs as well as what we announced in this past quarter we were able to secure what we believe is a very meaningful flash controller design win at a top tier flash and SSD provider today that provides both enterprise and notebook SSDs. Yes, that was displacing one of our competitors.

Daniel Amir – Lazard Capital Markets

I guess the follow up question, a bit on the gross margin side, you mentioned that semi gross margins is suppose to increase nicely, can you just expand on the system gross margin, I may have missed, it, kind of what your visibility is there and when do you expect kind of gross margins to look like in the second half there?

Byron Look

Recovering from soft revenue levels as well as soft gross margins, in the first quarter we had really solid improvements in gross margin in systems in Q2 and that was driven by not only the revenue growth of course in that business at 12% sequential growth on the top line but also back to a more normalized mix of mid range systems as well as growth in the entry systems. So, that on a relative basis in terms of the contribution of gross margin, that improvement or that growth in terms of our mid range revenues took our margins up by over 500 basis points in Q2.

We would expect going in to the second half of the year to typically see seasonally revenue growth and we’d expect continued normalized mix of our mid range and entry systems. That should enable us to continue to keep those gross margins in the mid to high 30s for our systems business.

Operator

Your next question comes from Christian Schwab – Craig-Hallum Capital.

Christian Schwab – Craig-Hallum Capital

Could gross margins expand back to recent levels in 2008 in the back half of the year should the economy continue to improve? Meaning, semiconductor revenues back in to the low 50s and storage systems back up in the high 30s?

Byron Look

Yes, I think we’re certainly moving in that direction, that’s our expectations. We continue to drive improvements in gross margins with top line growth.

Abhijit Y. Talwalkar

We’re guiding 49% in terms of semis in the third quarter so that’s getting back pretty close to last year and that’s in the third quarter. Fourth quarter with revenue growth hopefully if the market is stable and behaves seasonally that’s only going to improve. In terms of systems, you saw a pretty sizeable swing from Q1 to Q2, it will be incrementally harder to keep moving at that rate but we’re certainly fairly confident that if the revenue growth is there and the product cycles kick in that we should be able to get back in the high 30s.

Christian Schwab – Craig-Hallum Capital

So just elaborating on your just recent comments, should the economy stabilize and not roll over or just continue to slightly improve and given the significant design wins that you spent a lot of time talking about, we would expect nice sequential revenue growth and gross margin expansion again in December?

Abhijit Y. Talwalkar

We’re not guiding that quarter, we’re guiding Q3 and we feel pretty comfortable about guiding Q3 and we’ll talk about Q4 as we close Q3.

Operator

Your next question comes from Craig Berger – FBR Capital Markets.

Craig Berger – FBR Capital Markets

On servers do you think we’re back towards consumption levels on servers with the third quarter outlook here? I ask just because it looks like server revenues were still down 23% in June and IT demand is down like 6% or 7%.

Abhijit Y. Talwalkar

Craig if you’re asking about consumption levels to a year ago or whatever base line you’re using, no. That’s going to take some time because if I remember my data correctly server units overall year-to-year in terms of what the consensus is across industry analysts, units are dropping 12%, 13%, 14%. Some of that forecast has improved from what was closer to 18% to 20% at the start of the year so we’ve seen some improvements but we’re not back to the consumption levels of last year.

Craig Berger – FBR Capital Markets

Separately on hard disk drive chips, it seems like the market is consolidating and some competitors are getting out. What gives you confidence that the market is consolidating around you and Marvel and when do you expect to see some of those second tier chip suppliers bow out of the market?

Abhijit Y. Talwalkar

All I can point to is the market has been consolidating if you look at the last two or three years. We’ve been a consolidator both in terms of the merger between LSI and Agere, the acquisition of Infineon’s hard disk drive business. So, we’ve been a consolidator and I think it is a game of both scale and a game of time to market transitions on rechannel technology which also requires sufficient scale and the right expertise. The field is narrowing as a result of that high bar. We’re very confident that we’re one of the key players going forward.

Craig Berger – FBR Capital Markets

Next, on inventory do you guys have enough in case the quarter comes in stronger? Then the last question is uses of cash and any thoughts around share buyback?

Abhijit Y. Talwalkar

Relative to inventory, despite my inventory comment being that we’re probably on the lean side, I’m very comfortable with our supply chain. Our responsiveness has been stellar over the past three, or four years and we’ve rarely left money on the table. I don’t have concerns on that, we’re watching that very closely. I’ll let Bryon comment on your other question.

Byron Look

We’ve got a strong cash position with the outstanding balance we have, certainly with the redemption of the outstanding debt we have and so forth. We’ll continue to look at what the best uses for that cash are going forward. I mean, must look at some of the things we have done over the past number of quarters whether it’s acquisitions or redemption of convertible notes or we did buybacks a while back. We’ll continue to look just broadly at the best uses for our shareholders of the cash that we have.

Operator

Your next question comes from Sumit Dhanda – Bank of America Merrill Lynch.

Sumit Dhanda – Bank of America Merrill Lynch

A couple of questions, Abhi or Byron, any thoughts on your target of high teens operating margin as you’ve gotten a better handle on expenses here and obviously have done a reasonable good job on that front. What revenue level we can think about as where you might achieve those operating margin targets?

Byron Look

First of all, I think we’re still very focused on driving to that target operating model, that 47% consolidated gross margins and on being able to drive 17% operating income. Clearly, we get there faster with the sort of actions that we’ve taken in terms of optimizing our cost structure. Also of course, getting there at a certain revenue level depends on a certain mix of product as we go forward here. But, I think we’re comfortable doing that. I think we have said that holding things as they are we should be able to get to those levels somewhere in the $650 to $700 million revenue level. But, it depends a lot on those other factors.

Sumit Dhanda – Bank of America Merrill Lynch

The second question I had was on the IP stream, the number was down $8 million in the second quarter, is the expectation that it will rebound to Q1 levels by Q3? I guess as a follow on to that, that’s about 150 basis points or so to gross margin, is that part of the reason why your semiconductor gross margins are seeing a significant bounce in Q3?

Byron Look

First of all, relative to the expectations for rebound or growth in the IP revenues for Q3, yes we guided that that would be up and yes, our expectations would be that we would be able to get back in to the range of the levels that they were at in the first quarter. Yes, the level of IP revenues does have an effect on our gross margin performance. That typically carries better than our corporate average gross margins. That had an effect in Q2 and it will have a positive effect as we don’t expect to see any of those same costs hitting us in the third quarter.

Sumit Dhanda – Bank of America Merrill Lynch

Abhi, your comments on seasonality in your systems business in Q3 despite what seems to be a relatively tough environment for the enterprise segment, is that more predicated on the tailwind you anticipate from the ramp of Nehalem versus just an improvement from a depressed level in the business? Is that what you’re primarily banking on here?

Abhijit Y. Talwalkar

Well, if you’re referring to our storage systems business, it’s really [inaudible] or independent to my comments on Nehalem. The systems business and sort of the strength that we expect and the growth that we expect quarter-to-quarter is driven by a number of factors, back to my comment that digital content continues to grow, IT shops have to continue to add more capacity. We’re in the midst of a pretty strong product cycle with our high end midrange platform that we released in the latter part of 2008 and now have multiple OEMs shipping. We’re seeing strength out of companies such as IBM and Teradata and so forth. There’s a number of factors that are contributing to that as well as another product cycle that we’ll see in the later part of this year.

Sumit Dhanda – Bank of America Merrill Lynch

I meant your SAN and SAS business.

Abhijit Y. Talwalkar

I think the growth there or the anticipated let’s just say optimistic view is that some of the unique sort of environment that was created in Q1 of seasonality, a major transition, economic back drop, I think a lot of those things certainly feel like they are at least behind us and we’ve got stability now in terms of server purchases in end markets and the receptivity and the technology has been very positive and there’s an opportunity here to return to let’s just say modest seasonality relative to this end market.

Sumit Dhanda – Bank of America Merrill Lynch

My last question Bryon, is there a dollar amount you could give in terms of the anticipated contributions from ONStor in Q3? I don’t know if you highlighted that earlier or not.

Byron Look

No, again we said that relative to the full year 2009 overall financial impact would be roughly neutral to our non-GAAP EPS. We did bake all that in too because we were able to close that transaction this week. We did bake that in to the guidance that we provided for the third quarter.

Sumit Dhanda – Bank of America Merrill Lynch

Is it fair to assume that it’s a small amount, less than $5 or $10 million?

Byron Look

Yes, that’s a fair thing to say, it’s in the single digit revenue level.

Operator

Your next question comes from Shawn Webster – JP Morgan.

Shawn Webster – JP Morgan

It looks like your inventories fell pretty good and Seagate are fairly low as well. Can you give us any commentary on your lead times for some of your chip components, not just in the hard drives but maybe in your other chip areas and are you experiencing any tightness currently?

Abhijit Y. Talwalkar

No, we’re not experiencing any tightness that would bring about any kind of concern. Across most of our product lines in the chip space and customers we’ve got established sort of inventory, or hubs, or replenishment pull base so we’ve got good visibility there Shawn. So, based on those hub and replenishment sort of models, lead times generally have not been a problem for us back to our question earlier on our ability to respond to significant upsides.

Shawn Webster – JP Morgan

Do you expect your inventory dollars to go up in Q3?

Byron Look

Perhaps slightly but, I think we’re pretty comfortable with the levels we’re at now. We’ve taken them down by quite a bit over the last several quarters.

Shawn Webster – JP Morgan

Then on you Ethernet business, your new PHY can you give us an update there on when that should start ramping and starting contributing meaningfully to your revenue stream?

Abhijit Y. Talwalkar

We’re progressing very well. As we said, the lead design there that we’ve been in development for 18 months is starting to hit production and we’ve got three or four other designs right behind it across different segments and across two generations. We believe in 2010 we’ll start to see meaningful revenue across this collection of wins.

Shawn Webster – JP Morgan

Then maybe just squeeze in one last one for me, op ex up a little bit in Q3, how are you trying to manage your op ex as we go through Q4 and in to next year? Is your intent to keep it flattish or do you have programs that you intend to ramp on?

Byron Look

Well, I think we’ve driven a lot of the spending out of our cost structure. We’re not going to stop looking for opportunities to do so and we’ve been able to successfully absorb actually some incremental costs as we’ve gone through. We’ve spoken in past calls about the level of design win activity that we’ve had, we need to support that with in some cases some initial spending and so those things are where we try to offset some of that and you’ve seen in the results over the last several quarters now.

Abhijit Y. Talwalkar

We’ve been able to consistently hold a tight grip on op ex while taking on significantly more designs and design win opportunities. That recipe worked for us throughout 2008, something that we’ve been attempting to do in this sort of environment and that’s what we’ll continue to work on doing. We’d like to see as much leverage as possible as revenue starts to come back with economic recovery as well as, as these design wins kick in.

Operator

Your next question comes from Blayne Curtis – Jefferies & Co.

Blayne Curtis – Jefferies & Co.

On your networking business Abhi you’ve talked a lot about some significant wins there, you elaborate a little on the PHY business? Is there any other major wins there and kind of if you could wrap some timing and size around that?

Abhijit Y. Talwalkar

Relative to PHY in particular?

Blayne Curtis – Jefferies & Co.

Any of the major pieces of business and you’ve talked about DSP wins and such, is there anything else to keep an eye on for 2010?

Abhijit Y. Talwalkar

Well I think the DSP wins that we’ve been talking about, these are wins that we started talking about 18 months ago because those are the development cycles and we’ve been able to proliferate our DSPs across multiple sockets, multiple product lines within the particular customer that we’re talking about both in terms of audio as well as now video oriented applications. We will start to see sort of the qualification cycle end on those and start shipping in terms of the first win towards the end of this year and more throughout next year. We believe that will only continue to grow as more and more voice and video traffic hits corporate networks and video in particular which is going to be a pretty significant driver in our view.

We have also won some sizeable sort of custom silicon opportunities in networking both in terms of Ethernet oriented switches but also additional fiber channel switch business as well that carry decent revenue levels as well as very nice margins to help to continue to drive our overall corporate gross margins up. Those are very significant design wins for us that we are well and deep in to execution and we are also participating in the overall converge network adapter space. This converge datacenter connectivity which is fiber channel, fiber channel over Ethernet as well as 10 gig through a number of relationships. So, as 10 gig is adopted in a more aggressive fashion which we believe is starting to happen in the server space, we will benefit from that.

Blayne Curtis – Jefferies & Co.

Then [inaudible] the networking business about call it $250 million this year, what kind of growth rates are we talking about for the business netting all those wins together for 2010?

Abhijit Y. Talwalkar

I’m not going to provide guidance relative to 2010 but we had said coming in to this year, we expect the go forward business to cross over and be greater than the legacy business. That occurred in Q1, it occurred earlier than we anticipated, continues to be the case, it will be the case for 2009, absolutely the case in 2010 whereas the vast majority of our networking business. As we said earlier because many of the wins that we’ve had in networking are through winning share and growing share we expect our networking business to be in a position to grow greater than the markets that we anticipate in in 2010, ’11 and ’12.

Blayne Curtis – Jefferies & Co.

Then I just want to follow up on the comments you made on the hard drive SoC, you’ve talked in prior calls about design wins at Seagate and Hitachi ramping end of 2010/2011, it seems like you’re qualifying it this call that they’re looking at rechannel options and if successful – did I miss something there or is there a change of tone or did you just word it differently this time?

Abhijit Y. Talwalkar

No, I think you missed something. Relative to the Hitachi and Seagate discussion we’ve had in the past, we’ve talked about those are new SoCs that we won back in the middle and second half of 2007 that are starting to approach sort of their production release as we speak and in to the first half of 2010. Relative to the new opportunities it’s not a secret that LSI is not participating in the SoC space with the other three hard disk drive players WD, Toshiba Fujitsu has a combination and Samsung.

As I said on the call and earlier in prior conferences, I believe the environment is right now for us to penetrate one or more of those companies because of our leadership rechannel technology and the 40 nanometer node that we have been sampling now for quite some time as well as a growing desire by these companies to have multiple sources for technology assurance and that bodes well for LSI. That’s why we’ve been fairly confident that we’ll have an opportunity to penetrate one or more of these three companies.

Operator

Your final question comes from Suji De Silva – Kaufman Brothers.

Suji De Silva – Kaufman Brothers

Real quick on the turns expectation, typically you guide to about 65% turns, is it similar this quarter or are you being more conservative?

Byron Look

It’s probably going to be about those sort of normal levels.

Suji De Silva – Kaufman Brothers

Then Abhi you’re providing more color on the other hard drive guys maybe dual sourcing, do you have a sense of what, in your discussions, they would think about, how they would think about splitting up the share? Just order of magnitude kind of thinking is it 80/20, 60/40, just some sense of what sort of their path is in terms of dual sourcing?

Abhijit Y. Talwalkar

I don’t have any views and even if I had views it’s not clear they’d be accurate representation. I think they’re the best ones to ask.

Suji De Silva – Kaufman Brothers

Lastly on the second half seasonality, correct me if I’m wrong, that was typically something of a budget flush from the enterprises. In your conversations with CIOs and all, what is the thinking around that this year given the particular circumstances versus typical years about that seasonality being driven by that?

Abhijit Y. Talwalkar

That’s typically what drives that seasonality. There’s probably a budget flush but the budget certainly is less than it has been historically so there’s still a big question as to what kind of kick do we see in the fourth quarter. I think there’s still a tremendous amount of caution out there, CIOs and IT managers still have a very tight grip on their overall budgets. You’re starting to see some loosening in certain areas where the business is starting to get impacted because they’re not buying more storage or more server compute capacity and so forth. I think enterprise is going to take a little bit longer but in the end we’re going to see some solid growth there as we exit ’09 but certainly in 2010.

Sujal Shaw

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

Operator

Ladies and gentlemen a telephonic replay of this conference will be available beginning today at approximately 6 pm Pacific Time and will run through 10 pm Pacific Time on August the 5th. The replay access numbers are 1-888-203-1112. Again, that’s 888-203-1112 within the United States and 1-719-457-0820. Again, that’s 719-457-0820 for all other locations. The replay pass code is 9748083. Again, that’s 9748083. Webcasts will be archived at www.LSI.com/webcasts. This does conclude your conference call for today. Thank you for your participation. You may disconnect at this time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: LSI Corporation Q2 2009 Earnings Call Transcript
This Transcript
All Transcripts