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QLogic Corp. (NASDAQ:QLGC)

F2Q10 Earnings Call

October 21, 2009 at 5:00 pm ET

Executives

Simon Biddiscombe – Senior Vice-President and Chief Financial Officer

H.K. Desai - CEO

Analysts

Aaron Rakers - Stiffel Nicholas

Amit Daryanani - RBC Capital Markets

Kathryn Huberty - Morgan Stanley

Paul Mansky – Canaccord Adams

Min Park – Goldman Sachs & Co.

Rajesh Ghai - Think Equity LLC

Jason Nolan – Robert Baird

Mark Moskowitz - JP Morgan

Himon Tabar for Kaushik Roy - Wedbush Morgan Securities

Glenn Hanus - Needham & Company

John Shaw - Jefferies

Brent Braceland - Pacific Crest Securities

Douglas Ireland - JMP Securities

Unidentified Analyst for Keith Bachman - BMO Capital Markets

Operator

Good day and welcome to the quarter fiscal year 2010 QLogic earnings announcement conference call. (Operator Instructions) At this time, I would like to turn the conference over the Simon Biddiscombe, Senior Vice-President and Chief Financial Officer

Please go ahead, sir.

Simon Biddiscombe

Thank you, Gwen. Good afternoon and welcome to QLogic quarter fiscal year 2010 earnings conference call. Joining me on our call today are H. K. Desai, our Chief Executive Officer. I will begin the call with a review of the quarter financial results. H. K. will follow with a discussion of the current state of our business, on progress our strategic initiatives. Afterwards we will open the call for questions.

Certain of our comments today will include forward-looking statements regarding future events and/or projections of the financial performance of the Company based on our current expectations. These comments are subject to significant risks and uncertainties that could cause our actual results to differ materially from those expressed in these forward-looking statements.

We refer you to the documents QLogic files with the SEC, specifically our most recent forms 10K and 10Q. These documents identify important risk factors that could cause our actual results to differ materially from expectations. We do not intend to update the forward-looking statements that we make today.

In our quarter earnings press release issued earlier today, we reported both GAAP and non-GAAP results. The difference between the results in fiscal year 2010 is due to stock base compensation, acquisition related charges, special charges, gains on sales of previously impaired investment securities, and the related income tax effects. A reconciliation of GAAP net income to non-GAAP net income and a summary of the non-GAAP adjustments are included in our earnings press release. All of the references we will make on our call today relate to non-GAAP results unless otherwise stated.

Turning now to our financial results for the fiscal quarter ending September 27, 2009.

Our revenue in the quarter was $131.5 million, a decrease of 23% from the same quarter last year. This revenue represents a sequential increase of $8.7 million or 7.1% which exceeded our forecasted range of flat to up to 3%, provided during our second quarter earnings conference call.

Revenue exceeded our expectations primarily as a result of a 6.4% sequential increase in revenue from a host products. Our quarter revenue from host products, which are comprised primarily of Fibre Channel and iSCSI host bus adaptors, was $94 million and decreased 21% from $119.7 million recorded in the quarter of last year.

Host products also include FCoE converged network adaptors, InfiniBand host channel adaptors, and 10 gigabyte intelligent Ethernet adaptors.

Quarter revenue from network products, which are comprised primarily of Fibre Channel and InfiniBand switches, was $24.5 million and decreased 16% from $29.8 million recorded in the quarter of last year.

Our quarter revenue from silicon products comprised primarily of Fibre Channel and iSCSI protocol chips was $9.6 million and decreased 39% from $15.7 million recorded in the quarter of last year. Silicon products also include chips for embedded applications for converged networks.

Our revenue from royalty and service was $3.3 million.

Our quarter gross margin of 65.5% declined from 71.3% recorded in the quarter of last year, primarily due to lower volume to absorb manufacturing costs, unfavorable product mix, as well as the impact of a one time royalty last year.

Our gross margin was slightly above our forecast of approximately 65%, provided during our second quarter earnings conference call.

Next I would like to cover our quarter operating expenses. Total operating expenses were $52.8 million, down 10% from $58.4 million reported in the quarter last year.

Engineering expenses in the quarter of $29.7 million increased 2% from a year ago an increase as a percentage of revenue from 17% to 22.6%.

Sales and marketing expenses in the quarter of $17.2 million decreased 21% from a year ago and increased as a percentage of revenue from 12.7% to 13.1%.

G&A expenses in the quarter of $6 million decreased from $7.5 million a year ago and were 4.5% of revenue in the current quarter.

Operating profit in the quarter was $33.3 million which was 25.3% of revenue.

Interest and other income was $2.3 million in the quarter.

Our income tax rate for the second quarter was 29.5% which was consistent with our expectation.

Our second quarter net income of $25.1 million declined from $45.2 million in the prior year. This represented a net profit margin of 19.5% in the second quarter.

Our second quarter net income per diluted share of $0.21 exceeded the high end of our forecasted range of $0.16 to $0.18 provided during the first quarter earnings conference call. This represents the 57th consecutive quarter of profitability for QLogic.

Turning now to our balance sheet. The Company’s cash and investment securities were $340.4 million at the end of the second quarter. We continue to maintain our strong cash position and we have no debt.

During the second quarter, we generated $31.6 million of cash from operations. During the quarter, we purchased $48.6 million of the Company’s common stock at an average price of $14.85 pursuant to our stock repurchase program. Since 2003, we have used $1.35 billion to repurchase 87.3 million shares of the Company’s common stock.

Receivables of $75.2 million at the end of the September quarter increased from $68.9 million at the end of the June quarter. DSO at the end of September quarter was 52 days compared to 51 days at the end of the June quarter. We expect DSO in the future will range from 45 to 55 days.

During the quarter, we continued to make significant progress with regard to inventory. Inventory at the end of the September quarter was $23.3 million and decreased sequentially from $29.9 million at the end of the June quarter.

Annualized inventory turns for the September quarter was 7.8 compared to 5.7 turns for the June quarter.

Turning now to our outlook for our third fiscal quarter. We expect total revenue for the December quarter to be in the range of $134 million to $140 million. . We expect gross margin to be approximately 66%.

Based on these outlook combined with the planned operating expenses of approximately $54 million and a projected annual tax rate of approximately 28%, we expect to achieve non-GAAP earnings per diluted share of approximately $0.22 to $0.24 in the December quarter.

Actual results for future periods may differ materially due to a number of factors, including those outlined during the course of this conference call, in the Company’s filings with the SEC, and in the disclaimer statement at the end of our earnings press release.

I will now turn the call over to H.K. H.K.?

H.K. Desai

Thanks, Simon. My remarks today will be focused on the current state of our business, and then our quarterly update on our strategic initiatives.

Our revenue in the second quarter was $131.5 million up 7% sequentially and exceeded our forecasted range of flat to up to 3% provided during our first quarter earnings conference call. On a sequential basis, revenue from host products grew 6.4% and revenue from netware products declined 2%.

Our revenue from silicon products increased sequentially by 30% primarily driven by growth in both our fiber channel and Ethernet solution products..

We are particularly pleased with our expense management during the second quarter and by the fact that our offering margin increased sequentially from 23% to 25.3%.

During the second quarter our net income for the diluted share was $0.21 and exceeded the high end of our forecasted range of $0.16 to $0.18 provided during our first quarter earnings conference call.

Despite the fact that we continue to experience the effects of the broad macroeconomic slowdown, we are cautiously optimistic given the signs of stability and all the indicators of recovery we are experiencing in our business.

We are encouraged by the improvements we have experienced in the order trends and shipments during the September quarter and by the forecast we are receiving from all our OEM customers for the December quarter. We are clearly benefitting from the server update cycle that is beginning. Based on research suggest this will continue to calendar 2010 driven by the transitions to the Intel Nehalem EX base servers increasing the adoption of BM ware and other high providers and the shift to Windows Server 2008 R2.

These factors are working together with an expected gradual enterprise IT replacement cycle. QLogic is strongly positioned with a broad product portfolio to be a significant beneficiary of these several grid cycle.

In FCoE yesterday we announced that IBM Power Systems has chosen our single chip 81/00 converged network adaptors or CNS for native FCoE connectivity in the IBM Power Systems portfolio of tower red mount and servers.

Previously we had announced that IBM had contributed our 80/100 Series CNS across its Intel based server portfolio blade system Systemax. With the addition of power systems for large scale Unix and Linux deployment we continue to expand our leadership positions in FCoE.

This is a significant milestone that presents an expanded market opportunity for QLogic. Until this achievement we have not had access to the IBM Power Systems and connectivity market.

In August we announced that our 80/100 Series CNS REM CELP qualified with EMC Symmetrix, V-Max Symmetrix DMX and CLARiiON CX4 as well as EMC Solara NetSystems. As enterprises implement our CNS through our server customers, they can use converged 10-gig Ethernet to connect new servers through their storage networks and create broader access to the capabilities of EMC Systems.

In August we also announced that NetApp selected our single chip converged network adaptor technology exclusively to provide native FCoE target connectivity for NetApps Storage Arrays.

In addition we announced that NetApp had selected our 80/100 series CNS as a primary CNS for FCoE host connectivity. All FCoE connectivity will be supported across a wide range of NetApp unified storage systems as well as any server qualified with these storage systems.

Lastly for FCoE, in August we completed qualifications and began worldwide shipment of the QLogic branded 80/100 Series CNS to our authorized distribution partners. These availability of the only single chip low profile CNS opens a significant opportunity for our worldwide resellers.

It is a compact and efficient second generation local adaptor, the 80/100 Series CNS can be used in the full range of rack and tower server products. The 80/100 Series CNS has been studied in extensive combination of configurations including with the Cisco Nexus 5000 Series FCoE switch product family and all leading operating systems environments.

The result is industry leading fabric solutions available today, available worldwide and fully supported. The biggest OEMs in the industry are choosing QLogic to deliver single chip native FCoE connectivity for the servers and high density storage systems by virtue of offering you superior technology. IBM, EMC and NetApp as well as our worldwide channel partners are now shipping our market leading second generation FCoE converged network products.

All at once network plus architecture for FCoE shares many common attributes with QLogic Fibre Channel adapters including common storage FPIs and common management tools. The large base of existing QLogic Fibre Channel HBA users can take full advantage of all our second generation FCoE CNa products using the same binary operating systems device drivers thereby gaining the benefit of that kind of testing, maturity, and stability while enjoying the full advantages of convergence.

This fully supports the value proportions of FCoE which is built around preservation of the Fibre Channel software stack and operates the model. We believe our market leadership and the largest install base of 2-gig, 4-gig and 8-gig Fibre Channel adapters are key adoption accelerators for our converged networking products.

We are continuing to successfully tone our Fibre Channel market share into a market leadership position in the converged network space. During the quarter our revenue from solution that solved the converged network market grew strongly from a relatively low base in the first quarter.

Turning now to Fibre Channel, according to the recent data from Dell’Oro Group Q2 2009 standard report, QLogic continued its undisputed market leadership in SAN adapters. Overall QLogic achieved over 54% market share in Fibre Channel adapters, a full 16 point lead over our nearest competitor. We are clearly meeting the demanding requirements of all OEM and channel customers and providing superior value. This is an ideal position to occupy as we enter the age of convergence.

For the second quarter of 2009 QLogic widened the lead over the nearest competitor in the fast growing 8-gig Fibre Channel adapter market and gained nearly 3 share points on a sequential basis while our nearest competitor lost nearly two share points.

During the September quarter, our revenue from 8-gig Fibre Channel adapters more than doubled sequentially and for the first time contributed more than 20% of our revenue from host products. This is the second consecutive quarter that revenue from 8-gig Fibre Channel adapters has doubled and we believe was driven primarily by the high performance Intel Nehalem base server platforms and the increasing adoption of BMWare and other high providers.

In the expanding blitz of our market, we have more than 70% revenue market share for all Fibre Channel Mezzanine Cards according to the Dell‘Oro Group report.

Turning now to our network products during the quarter, we announced that we have been named the manufacturing and marketing partner for the new HP Virtual Connect 8-gig, 24 fibre channel modules. The new merchant connect module extend the HP Virtual Connect portfolio, now operates in 8-bit system and closer to provide wired ones, [Inaudible] is and SAN connectivity for the HP product line and into the blade system C-class blade servers.

Our InfiniBand initiatives continues to progress well. Continuing our track record of bringing industry leaders together to drive innovation in the HPC space, we announced the collaboration with AMD, MSYS, Dell and Microsoft to create oblique access for the first time to an HPC cluster. The cluster consists of Dell PowerEdge Servers and Qlogic QDR InfiniBand switches and adapters running on Microsoft’s Windows XP Server 2008 operating system.

In closing, we are cautiously optimistic given the signs of stability and all indicators of recovery that we are experiencing in our business. We are obviously encouraged by this fact and believe that when combined with our extremely careful operating expense management, the Company is well-positioned to experience continued improvement in financial results.

This concludes the opening remarks. Operator, now we are ready for the question.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Aaron Rakers with Stiffel Nicholas.

Aaron Rakers - Stiffel Nicholas

I guess the first is with regards to guidance. If we could take the midpoint of the guidance or basically the guidance ranks that you have given up 2% to 5%. If I strip out last year, it looks like their normal seasonal trend was somewhere in the high-single digit to 10% sequential range. So, first of all, can you help us connect the [Inaudible], given your positive commentary, relative to what looks to be a bit below seasonal type, sequential guidance for this December quarter.

Simon Biddiscombe

Sir Aaron, this is Simon and I will answer that one first, I think you said you had two questions, but the actual range is broader than you suggested that the range is 2% of the low end to the 6.5% of the high-end right? The 140 represents 6.5% growth over the number that we just posted.

There is no doubt that as we look at the trends within the business at this point in time, when we look back into the September quarter, when we look at the October quarter, the month of October activity to date and then when you look at the forecast that we receive in for the remainder of the December quarter, that things continue to improve, we remain cautious and frankly we remain conservative as it relates to the outlook, primarily because we have been through a tough year, like many other companies and we are going to be cautious and conservative as it relates to where we are today and the guidance we provide versus what you correctly pointed out as typically our strongest seasonal quarter than we suggested.

Aaron Rakers – Stifel Nicolaus & Company, Inc.

Okay. The second question relates to the 8-gig product cycle that you guys are seeing. If my memory serves me right, you have actually seen still benefit from an ASP perspective from 8-gig over 4-gig so maybe the update there on that, as well as, is there a gross margin benefit at all that you are seeing from the 8-gig cycle in your host product division?

Simon Biddiscombe

It does continue to be some premium associated with the 8-gig products over previous generations of the products today, that is somewhere around 10% to 15%. From the gross margin perspective on the percentage basis they are very consistent with the host products. So, 8-gig is very consistent with the other host products.

Operator

Your next question comes from Amit Daryanani with RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

So, going back to some the comments you had earlier. Is it fair to think that if things continue to improve to the extent that you are talking about it, could you have the same set of revenue upsides as you did this quarter again which is up a particular basis points from the high end of your guidance.

Simon Biddiscombe

I think that remains to be seen. It is the long way from here to the end of December, right? You want to comment H.K.?.

H.K. Desai

I think, let me talk about what Simon said before. What we have seen in the September quarter. Linearity was really good, we had a strong July, August too was even better than seasonality and in the second month so we have been very good standing and a strong September. So, we see really good…, October what we have seen so far were shipments over backlog or the forecast in the stability what we are seeing, using all the positive sign and we are a little bit more cautious than probably we should be but we are conservative and that is what we have normally done in the Company and I think that is what we give the guidance because we have to understand that still we went to last three or fourth quarters that like the old word is macro impacted and we want to be cautious about that.

Amit Daryanani - RBC Capital Markets

Fair enough and probably worthwhile for you to be more cautious than not. If I just, again, maybe just sticking to the guidance again, in the past you guys have talked about heading 30% margin on a $140 million turn revenue run rate.

I would suggest the high-end of your guidance where you are talking about $140 million on sales that the EPA should be like $0.26, $0.27 not $0.24. It there some sort of OpEx that is coming back in the model in the December quarter that we should be aware of, or why the Delta?

Simon Biddiscombe

There is OpEx that comes back in… I would actually like to say to say it is slightly different. What we said is that the OpEx in the December quarter will be approximately $54 million which is, if you recall, was our guide for the most recent quarter. We then delivered an OpEx number on the last quarter that was $52.8 million. Some of the cost associated with beyond the achievement on OpEx last quarter rolls into the current period is also some costs associated with new product roll-outs that will occur over the course of the next 90 days that will also impact us in the current period as well, so the OpEx sticks back up in the December quarter to approximately $54 million from where it was in the most recent quarter. We do see some margin improvement and we have characterized that within the context of the guidance that we have provided as well.

At the mid-point of the guidance we draw a line straight in the middle; you get to continued improvement in operating margins up to the 26.5% to 27% range.

Amit Daryanani - RBC Capital Markets

What takes us to 30% margins then, you need something higher than $140 million of sales, right?

Simon Biddiscombe

I think it is in the low 140s, and bear in mind I have never said 140. We have always said the low 140s and to the low 145 and you get back to your 30% operating margin.

Operator

Your next question comes from Kathryn Huberty with Morgan Stanley

Kathryn Huberty - Morgan Stanley

If we net the revenue growth sequentially in the quarter with just a sequential inventory decline. What manufactured units actually do and then what are you assuming inventories do in December to get to that sequentially gross margin guidance in December?

Simon Biddiscombe

If you look at 65.5% we just posted and as you correctly pointed out, cost of sales. Dollars which is how we think about the allocation of the manufacturer overhead within the organization actually went up by $3 million.

The decrease in the inventory was $6.7 million. We continue to operate in an environment where we work entire inventory. The assumption in the December quarter is that inventory continues to reduce. So there is a continued reduction in inventory in the December quarter that does continue to impact the gross margin from that perspective but we are still able to offer our 66% gross margin in the current period.

Kathryn Huberty – Morgan Stanley

Why is it that inventory continues to come down given that we are at a four-year low at this point and how many more quarters do you think it is safe to get it to a trough level?

Simon Biddiscombe

There is a couple of reasons. Number one is we are actually going through a fairly significant transition of activity where more of the inventory that would have historically been owned by QLogic will be owned by our manufacturing partners as we move forward. Max important transition that we have been working through over a course of essentially six to nine months at this point in time. So, we will continue to see inventories decrease as we move forward.

Now with that said, given the trajectory of the business and given the opportunity that would perceive exists when you are looking at our guidance range of 134 to 140. We have absolutely no desire to get fall short of product, right? So, we are balancing continued inventory reductions as a result of the change in the way supply change is managed against the need to continue to be able to deliver to our OEM partners.

Kathryn Huberty – Morgan Stanley

Got it and then lastly, H.K, a number of networking and semiconductor companies have high interest in FCoE. Is there any way that you can capitalize on your assets in Ethernet and in fibre channel in the form of either partnerships or new distribution partners?

H.K. Desai

So, what we said in our script is that I think we are in a great position as far as the FCoE technology is concerned. We have designed, I mean IBM will start shipping both X and blade and P Series in the blade. We OEMC qualified and start shipping the product NetApp is both for the target which is embedded solutions and also on the [O] side so there is a three tier when OEM starts shipping. There seems to be--we are in the channel and be partnering with other several switch guys and we have lot of tractions.

So, I think there a lot of momentum going on and we are looking at everything to make sure that we take advantage of our time to market and Fibre Channel installed base and we are working and I think we are very encouraged with what is happening in the last couple of months.

Operator

Your next question comes from Paul Mansky with Canaccord.

Paul Mansky – Canaccord Adams

Yes, great. Thanks for taking the question and congratulations on the solid quarter. As I look at your different segments, obviously, the one that stands out is the networking segments and it did not grow actually contrasted a bit sequentially. Maybe if you can give us a kind of a quick take relative to what you are saying in that business and then follow that up with how you view particularly the Fibre Channel side of that business as a strategic asset.

H.K. Desai

So if you look at the, we sequentially declined 2% on the networking business. Within that business there are two products, Fibre Channel and InfiniBand. Actually, Fibre Channel grew sequentially in the September quarter but InfiniBand is the one which has declined sequentially and that is the reason we declined 2%. We expect both Fibre Channel and IB Switch business to grow sequentially in the December quarter.

We said over the Fibre Channel, I think we have a lot of traction in the Fibre Channel, we will continue to do these things. Also in the FCoE converged network, there are a lot ethernet companies are looking for the Fibre Channel assets. So, we will work with them either supplying them with products, supplying them a module, patenting them, licensing all different things we worked on it but we did not announce anything until probably next year.

Paul Mansky – Canaccord Adams

And then, Simon I apologize if you covered this but I was hopping between a couple of calls. Did you mention head counts in the quarter as well as buyback metrics?

Simon Biddiscombe

I did not mention head count, you are the first person to ask so headcount at the end of the quarter was 1,044. It is very consistent with where we have been the end of June quarter as well. Buyback metrics, we said in the prepared remarks that during the quarter we repurchased just under $49 million worth of the Company’s common stock and that was out of an average purchase price of $14.85.

Paul Mansky – Canaccord Adams

Perfect. Thank you and then one last one for me. As your going through very clearly, cross cycles relative to next generation products, a lot is all about that, that was worth ultimately Brocade was going to be seen in the market. Can you update us relative to the competitive situation versus Brocade specifically?

H.K. Desai

You are talking about the FCoE, right?

Paul Mansky – Canaccord Adams

Yes, correct.

H.K. Desai

We do not announce the design win because we do not believe in design win because design win sometimes half of them do not go to production. Other half, they will not make it anywhere so it is very, very difficult to run the business based on design wins. What we do is we always announce when the OEMs start shipping the products, so we have look at IBM, [X], Series and the blade. IBM produces blade, EMC AND NetApp also target in host. They are starting to shipping the products right now so we will look beyond that in a moment on that VR working with a lot of other remaining OEMs and we might be able to announce one or two either December or March quarters.

I think we are in a good place and we hope big time, time to market advantage for this converged network.

Paul Mansky – Cannacord Adams

Maybe if I ask it a slightly differently, are you seeing them stick around the qualification window broadly and over an extended period of time or are they being called from the herd?

H.K. Desai

When you said they means, what do you …?

Paul Mansky – Cannacord Adams

Brocade specifically,

H.K. Desai

I really do not know and I do not want to make any comment on or compare of.

Operator

Your next question comes from Min Park for Goldman Sachs & Co.

Min Park – Goldman Sachs & Co.

It is great, thank you. Just a couple of quick questions please. First, I just wonder if you can give us a little bit more bit detail on the year-over-year decline in gross margins, I know you noted that it had, was impacted by one time [Inaudible] you saw a year ago but if you kind of give us a sense of what was the decline driven volume versus mix?

Simon Biddiscombe

What we said in the prepared remarks was essentially three pieces, right? We said mix, we said volumes, and we said the one time royalty from the previous year, okay? One time royalty impact from the previous year was right around one gross margin point, okay? And then we have not broken out in percentage terms the impact associated with mix and the impact associated with the decreased volumes and nor do we intend to.

Min Park – Goldman Sachs & Co.

Okay and then second, actually just give us your thought on market share for the September quarter, if you have any feeling to it and particularly in the Mezz Card and the latest product platform?

H.K. Desai

So we do not have a, I mean nobody has announced the results yet in the September quarter, so we do not have a data from that perspective. But the way I look at from 40,000 feet, we are 54% market share overall in the Fibre Channel adapter including the Mezz Card and Mezz Card is only 40% market share and if you look a lot the growth has came from Intel-based server upgrade cycles and we have a lot more share than 54% on the Intel-based platforms. So we believe that, when everything is settled down people will regain market share in the September quarter. That is my personal belief.

Min Park – Goldman Sachs & Co.

Okay, great. I just lost, can you give us the run rate? I would like to know your idea on run rate revenue for FCoE this quarter?

Simon Biddiscombe

We have not broken it out, Min. What we said in the prepared remarks was that it grew very strongly from a small base. We are not going to break that out until it settles down a little. It grew strongly from a small base.

Min Park – Goldman Sachs & Co.

Do you have any sense that any of this is actually being put in production environments or just still going into test and labs?

H.K. Desai

Yes. If you look at this, if you look at our announcement, IBMX and IBM are shipping the products. It is the production. EMC is a shipping device and production NetApp is both for the target and also for the host. They are shipping so they are in the productions and the revenue we are getting is the production revenue. Not just not for testing.

Operator

Our next question comes from Rajesh Ghai with Think Equity.

Rajesh Ghai - Think Equity LLC

So talking of the solar upgrade cycle, you know, talking to your OEMs. What are the sense in terms of the length of the cycle? Is it going to be more prolonged than it was in the past? When do you really see this peaking? The second part of the question really is that with what innovation expected to be a major trend in this solar upgrade cycle and solar consolidation? How does that impact your business?

H.K. Desai

So let me take the first one. You know, if you look at there a lot of data about the cycles and the way we look at this like the Intel, the way we really figured out is look at the Intel processor roadmap. It is also going to depend on the way our OEMs are the platforms. So really, for us, I think it is going to continue in the 2010. I do not know beyond what is going to happen but we expect that cycle continue at least in 2010.

Because of this performance on the Nehalem processor, I think what we are seeing is - and it is what is going to drive. So, if it is for the higher performance, either 8-gig Fibre Channel or the FCoE 10-gig, I think, is going to be good for our business from that perspective.

Rajesh Ghai - Think Equity LLC

Following up on the last question about the FCoE and the increase over the last quarter, you mentioned that there were more deployments happening in production than in the past. Can you kind of break out the mix in terms of percentage? Do you know how much of it is now going into the deployment versus testing lab?

H.K. Desai

Well, the only thing I can say is that all these three OEMs side mentioned, they are in the production. So they are shipping the part and production over the 80/100 CNa. What we have seen with the end users, because we do not sell it to end users but some end users are going from moving from testing just a test site to a small SAN and some of them are also going to the real production. So, we start seeing the three types of drive on the FCoE.

Rajesh Ghai - Think Equity LLC

What part of your shipment is 8-gig now?

H.K. Desai

About 20% of the host products is 8-gig, right.

Simon Biddiscombe

Actually, more than 20% is 8 gig.

Rajesh Ghai - Think Equity LLC

My last question on the buyback as released free cash flow, for if you look at the last four quarters, your buyback has been significantly higher than your free cash flow and going forward, how should we think of the buyback funding? Will it be in synch with the free cash flow or they are going to be a little higher?

Simon Biddiscombe

So the answer Rajesh is the same one I have given for 18 months. We have all the flexibility that is necessary to participate in the market. Typically, we think about the buyback as the way to use the free cash that is generated in the business. But H.K. and I have tremendous amount of flexibilities that relates the actual levels of activity.

Rajesh Ghai -ThinkEquity

What do you think about the level going forward at this point?

Simon Biddiscombe

We do not ever communicate that in advance.

Operator

Your next question comes from to Jason Nolan with Robert Baird.

Jason Nolan – Robert Baird

Yes, thank you, a couple of questions on InfiniBand. I guess it was not as resilient maybe during this downturn as some would have thought. Is there any sense that it is InfiniBand projects will reaccelerate once strategic dollars come back into the budgets?

H.K. Desai

I think, you are probably right about this thing and I do not know, if you do not have a data to really say that but a lot of full benefits came on the server upgrade cycles on the host side and InfiniBand did not see that, but we also have some products releases, we came out this quarter, so we expect that in the December quarter we will have sequential growth in the IT business both for us, which is in the HCA that is we think..

Jason Nolan – Robert Baird

Then, just to follow up there, H.K., when do you have to decide on investment plans beyond the 40-gig level here?

H.K. Desai

For IB?

Jason Nolan – Robert Baird

Yes.

H.K. Desai

We will be investing in the future technologies.

Operator

Your next question comes from Mark Moskowitz with JP Morgan.

Mark Moskowitz - JP Morgan

Thank you, good afternoon. I have a couple of questions, maybe if we could come back to the FCoE, I am just curious in terms of when do you really expect the standards to be probably accepted and what have been the hurdle so far from the partners out there?

H.K. Desai

There is no hurdle in the standard I mean. To finalize the standard, it is going to take probably two or three years, but I think if everybody is building the product to work the standards are agreed upon. There is no hurdle. There is no question about these things and there is always going to be some kind of upgrade in the standard and that normally requires some form of software changes but I think they are all set for these things and the market is happy.

Mark Moskowitz - JP Morgan

Okay, now a follow up to that, as far as the areas where you do feel FCoE could be in production and not just in the labs, can you give us a sense as the Greenfield deployments start to become reality, what type of workloads will be supported by this type of technology? Also, at the same time concurrently evaluated maybe the kind of an idea as an alternative.

H.K. Desai

What we have seen, we do not really talk about it as much but what we have seen and heard from partners, there are some--some of the end users start deploying as a separate stand, as a Greenfield and I think that is what we are seeing and we are seeing more and more traction into this technology because it is so easy, because people who has fiber channel, they can run our same binary 8-gig driver or 4-gig driver onto this FCoE technology.

So this is so easy for them to convert to this technology and they are allowed to look at this and see we can converge from that.

Mark Moskowitz - JP Morgan

Okay and then coming back to the host business, H.K. can you give us some of the idea in terms of the complexion of the OEMs in the September quarter? Were there any major fluctuations or surprises? Were they pretty even trough in major OEM accounts in terms of the poles and the hubs and how has it been so far at the month of October?

Simon Biddiscombe

So if you look at the--Mark it is Simon, if you look at the top five OEMs, four of them actually grew in the quarter and one of them declined in the most recent quarter, the September quarter. The one that declined was actually Sun, that will come as no surprise. Sun is now approximately 8% of our revenues and we do actually expect that next quarter, being the December quarter, will be an even smaller percentage of total revenues.

So as we built the guidance model for the December quarter, we have been very conservative as it relates to Sun, very specifically, but when you look at the other principal OEMs last quarter, there were strength across the other four main ones.

Mark Moskowitz - JP Morgan

Okay, if I could squeeze one more question at least?

Simon Biddiscombe

Yes, go ahead.

Mark Moskowitz - JP Morgan

This dawn off of Jason’s question regarding InfiniBands, I am curious. Are you seeing any sort of shift where maybe InfiniBand has also been impacted by the lack of discretionary dollars out there but also maybe 10-gig or just ethernet as they come offset solution. I still working at it again versus InfiniBand?

H.K. Desai

What we are driving and what we believe Mark is that InfiniBand is really HPC technology and that is what where our focus is and I do not think any of our technology is not good enough to drive the market, more latency than what InfiniBand has. So I think we believe that HPC or the high end of the niche market will always continue as InfiniBand and that is what we driving and that is our focus.

I do not think 10-gig or anybody is really impacting, I think this is really more one quarter issue for us and I think we believe that as macro level turn around and our products are mature enough which is a QDR, we will start seeing the growth, starting the December quarter.

Operator

For our next Kaushik Roy with Wedbush Morgan Securities.

Himon Tabar for Kaushik Roy with Wedbush Morgan Securities

Thank you, this is Himon Tabar for Kaushik Roy. I have two questions; one quick one was the recent announcement regarding IBM Power Systems. What is that exclusive agreements for QLogic or will IBM using multiple vendors on that?

H.K. Desai

I think we cannot answer that question, we have to talk to IBM but historically, if you look at the V-series and the power, they normally go with one supplier. I am telling you historically, I do not know what they are going to do on the F series something but you should talk to them, but historically they normally stick with one supplier.

Himon Tabar - Wedbush Morgan Securities

In terms of the recent increase in the R&D expense going forward like a few quarters down the line. Can we assume that will go down to historical level, once the technology transition is complete?

Simon Biddiscombe

I think it is a very recent increase in R&D expenses primarily associated with the acquisition of NetXen. So when we bought NetXen at the end of April, it came along with the approximately 90 incremental engineers, that was very little other expenses associated with net and given that it was a start-up. So, as we work through product roadmaps over the course of the next few quarters, I think what you will see is that we get back to target range as it relates to expense to revenue. We will get back to the 18% to 21% of revenues associated with R&D, and in fact we are about far off it in the most recent quarter R&D as a percent of revenue was 22.6%. So, I think what you will see as we move forward is revenue is continuing to grow is that we get closer to that expense to revenue rate show that the Company’s has historically enjoyed.

Operator

Move on next to Glenn Hanus with Needham & Company

Glenn Hanus - Needham & Company

Can we go back to the host business, in the September quarter, could you talk a little bit more about the outperformance there from a product perspective. Where did they come from? Was the fiber channel ethernet stronger than you expected or maybe give some color where the outperformance came from there?

H.K. Desai

I think, the outperformance came because of the soared up cycle on the 4-gig and 8-gig and it is also based on standard kind of the Mezz Card..

Glenn Hanus - Needham & Company

Okay, so more on the fiber channel side than you expected.

Simon Biddiscombe

Yes, yes, absolutely. Now what would I say Glenn that the converged network products did do battle and we have expected them to and in fact we look just at the NetXen related business, the products that came from NetXen acquisition. That is actually performing a little better than $5 million run-rate that we have expected for the full year, so both on the fiber channel business and within the converged products, things were a little better than we expected them to be.

Glenn Hanus - Needham & Company

Could you comment on your Silicon bucket and other bucket you saw strong sequential growth there, little more color on where that came from. Where is NetXen from where you break that out and that more on Silicon bucket and how should we think about that is we do our models for December?

Simon Biddiscombe

As you do your models, let me answer how you should do your models first. As you do your models for the December quarter, you should assume that the Silicon bucket is roughly flat from where it is today. You should hold it in a roughly at that level so model for you is after the December quarter. And then, with regard to the service and royalty bucket, you should have roughly $2 million in that bucket as we move forward.

Glenn Hanus - Needham & Company

And in the December quarter?

Simon Biddiscombe

In the December quarter, you can keep it in as you move forward from there. That is just expense around based on royalty payments, service contracts will enter into any period, so put $2 million on that line as you move forward and for Silicon hold it roughly flat, that is where it is today.

Now, going back to your first question which is where are the NetXen products? They are actually split. There are NetXen products that we sell in embedded applications on the part of Silicon revenue line and there are NetXen products that we sell as cards and a part of the host product line.

Glenn Hanus - Needham & Company

Okay.

Simon Biddiscombe

They are all converged products by the way. Other converged products.

Glenn Hanus - Needham & Company

Right, okay. As we worked on our long-term models here, I think you have indicated good sighting that the lower numbers that the 10 expansion for calendar 2010 opportunity is something in the area of $50 million.

Could you maybe give us your view of the incremental market opportunity in calendar 2010 and calendar 2011. How we might, some range or something, think about?

Simon Biddiscombe

We have not ever said how the incremental opportunity is in 2010 based on the Dell’Oro information. What we have always pointed to is the opportunity that exists in 2013 versus the opportunity that we served today and that is where you get the last incremental 10 that we are able to participate as both the converged network and the 10-gig Ethernet network continue to grow, markets continue to grow over the course of the next four years.

H.K. Desai

So Simon, if you look this thing and when we said, according to the Dell ‘Oro in 2013, the converged network adapters would be about $370 million and 10-gig will be about $400 million and there was a so called converged network alarm, [CNOM] as we call it, it is worth $60 million. If you look at this thing worth 800 plus market, I think the key question is going to be, you are not breaking this out right now, there is a lot of confusion in the market right now and the people do not think about the converged network adapters that separately then, some people are thinking Ethernet is also a converged network adapter anyway.

We have all this businesses we have our alarm, we have our ethernet and we have the converged network adapters. So I think there is a confusion going on. So we are going to wait till things settle down and then we will start reporting this number, but what we are seeing is that we are playing in all these three markets and using momentum in our business, including the 10-gig Ethernet product. Like Simon said, it is performing better than what we have projected. We thought it was going to be worth $5 million in FY2010, which is about three quarters.

I think it is going to be slightly better than that. So the reason we do not want to breakout right now is let us let things settle down in the next one are two quarters then we start to decide whether it is going to be a separate revenue or is it going to be all Ethernet and CNa together or not. I think it will wait until probably next fiscal year that we start breaking it up.

Operator

Your next question come from John Shaw with Jefferies

John Shaw - Jefferies

A couple of things, could you talk a little bit about pricing and the supply chain, in the sense, any tightness there or did you incur any cost? Because you have to get products faster in terms of air freight or anything, anything along those lines?

Simon Biddiscombe

So when we talk about pricing typically, we are thinking about ASP erosion that we have endured and the ASP erosion that we saw last quarter was very consistent with the ASP erosion of the business as normally experienced, right. So no surprises from and ASP erosion perspective. There actually were some incremental costs that we experienced last quarter associated with expedites of product and so on, in order to continue to meet the demands of the OEMs.

So yes, we did have some incremental impact, the gross margin last quarter but it was not significant.

John Shaw - Jefferies

Okay, were you able to pass that or it was an impact on gross margins?

Simon Biddiscombe

It varies by OEM, and I do not think I could tell you the answer in its entirety.

John Shaw - Jefferies

Okay, and the question that probably for H.K. in terms of product strategy now, that you have in that sense, it seems like it is an independent product line today. Could you update on the integration as to what is the roadmap, where do you plan to take it? Or do you plan to keep it independent?

H.K. Desai

So NetXen is completely integrated in our host business. So it is a part of host business. Management wise, every way it is completely integrated. We are really surprised with the speed of integration happened, compared to what the experience I had in the past with other companies I had acquired and one of the reason is that culturally, they probably matched us better than any other companies I acquired. They are a great engineering team. They work extremely well with our team, either as engineering or in the marketing.

It was the easiest integration in have ever done in the last 15 years running this Company. So it worked out real well. Product plan, we already have a product plan, but I am not going to talk about those strategies really, right now here.

John Shaw - Jefferies

Sure, no. I appreciate that. Just one thing, I think, Simon. You mentioned and talked about the Silicon and the royalty, could you just give us more color on how hosts versus networks could do in the December quarter.

Simon Biddiscombe

Now, we are just saying that they can both grow. They will both grow, actually not”can both grow”, will both grow, it is the right way to say it.

H.K. Desai

Both will grow, I think it is always to difficult to predict really.

Operator

Your next question comes from Brent Braceland with Pacific Crest Securities.

Brent Braceland - Pacific Crest Securities

Thank you, Simon, a follow up question here on the operating leverage, as you think about going into 2010, the OPEX level of $54 million a quarter, is that enough to get you back to a 5% to 10% growth rate assuming server storage refresh next year or do you plan on having to invest additional dollars in the R&D or what it may that gets back to growth.

Simob Biddiscombe

So Brent, we have not really have the perspective on 2011 at this point in time, fiscal 2011, which would begin in April. When you look at the full year of fiscal 2010, what we have said for an extended period is we expect the OPEX to be around $215 million, if you put the $54 million in the current period, you end up putting just over $55 million in the March quarter and that makes sense given that we have to endure all of the incremental payroll taxes and the resets of all the benefits and so on in that period.

So you end up looking at something just north of $55 million number in the March quarter. Once you get beyond that, I think we are going to work really hard to make sure that we are able to deliver and sustain the business model and I think there is a company, we have done a very good job about an extended period of time. So without wishing to tell you what we think 2011 looks like at this point in time, suffice to say we are going to continue to drive towards the model.

Brent Braceland - Pacific Crest Securities

Perfect, I guess, we have to wait for that. H.K. last question, for you, obviously in the Nehalem upgrade has certainly helped try to rebound the server side, the Nehalem EX is coming out beginning next year. It sounds like there is a dozen design--core larger systems. How shall we think about the Nehalem EX launch in the first part of next year impacting the seasonality, do you think this larger core systems could actually increase the attach rate on either the fibre channel or the CNas.

H.K. Desai

I think that the key point really because of the upgrade of this high-performance processor and particularly high performance process on particularly on the [57.03] side. I think it is really be a boost to the 8-gig Fibre Channel and the 10-gig FCoE so we believe that we will continue the growth and we ride the cycle at least for sometime next couple of quarters.

Operator

(Operator instructions). Your next comes from Douglas Ireland with JMP Securities

Douglas Ireland - JMP Securities

I have two questions. One, do you have any color around the surge in growth and impact, was there anything specific that happened there?

Simon Biddiscombe

No, Douglas, we have looked at that in detail. This is Simon. There was not anything specific. If you think about our go to market models as it relates to fulfillment. We put in products into the OEM’s manufacturing location. So it is indicative of fundamental trends that they maybe seeing but it does not mean anything to us other than we are all manufacturing sites for the principal OEMS.

Douglas Ireland - JMP Securities

I was wondering if you think there are any technology that you need early changes of approach that are necessary to capitalize on the solid state drive opportunity with its IO intensiveness?

H. K. Desai

We always look at all these supports really and we decide whether it matches or go to market models or would it match our business model and we then decide based on that. So right now we are not doing anything on that side.

Douglas Ireland - JMP Securities

Finally, Simon you said that we should look at silicon being flat in December and ongoing and services royalty revenue flat at $2 million going forward. When I looked at that, I infer that there are no deals on the horizons to put fibre channel over Ethernet into other switch vendors’ products. Is that reasonable?

Simon Biddiscombe

Not necessarily. No. Because as we think about the way we engage with those customers in some circumstances it may be achieved and some circumstances it may be a module that will be selling to them that could be captured within the network product line. So you may be applying a degree more intelligence to it does than it deserves.

Operator

Next is Keith Bachman with BMO Capital Markets.

Unidentified Analyst for Keith Bachman - BMO Capital Markets

[Inaudible] for Keith. You guys talked about server upgrade cycle benefitting through 2010, I was wondering if you can talk about for a seasonality for March, shall we expect revenues to be roughly flat with December?

Simon Biddiscombe

So we are only providing color and commentary on the December [John], we are not offering anything as it relates to the March quarter at this point in time. We will give the 90 days between here and May before we say anything.

Unidentified Analyst for Keith Bachman - BMO Capital Markets

Okay, fair enough. On the tax rates, should we be modeling 28%?

Simon Biddiscombe

Twenty-eight for the full year. It is 28 for the full year which means you need 29 this quarter, next quarter.

Unidentified Analyst for Keith Bachman - BMO Capital Markets

Okay, great and last, on your inventories, is there an absolute level that we should be looking at? Roughly $20 million for December or lower?

Simon Biddiscombe

No, we deliberately say how much inventory was expected to decrease in the current period, we continue to work hard to reduce it and as I said, we are going through some significant changes in the way the supply chain is managed and the ownership of the inventory between ourselves and our contract manufacturing partners and so on, but no. We are not offering you an absolute dollar number you should be looking for.

Operator

There are no further questions at this time. I would like to turn the conference back to Mr. Biddiscombe for the closing remarks.

Simon Biddiscombe

Thank you very much, that concludes our call for today. We look forward to updating you on our progress next quarter. Thanks again for your time and good bye.

Operator

Thank you everyone. That concludes our today’s conference we thank you for your participation.

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Source: QLogic Corp. F2Q10 (Qtr End 9/30/09) Earnings Call Transcript

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