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PMC-Sierra, Inc. (NASDAQ:PMCS)

Q3 2009 Earnings Call Transcript

October 22, 2009 5:30 pm ET

Executives

David Climie - VP, Marketing Communications

Michael Zellner - CFO

Greg Lang - President and CEO

Analysts

Srini Pajjuri - CLSA

Dan Morris - Oppenheimer

David Wu – GC Research Ltd.

Ruben Roy - Pacific Crest Securities

Sandy Harrison - Signal Hill

Allan Mishan - Oppenheimer

Anthony Carbone – Orgia

James Schneider - Goldman Sachs

Eric Ghernati - Bank of America

Operator

Good day and welcome to PMC-Sierra 2009 Q3 earnings release and conference call. Today's conference is being recorded. Today is Thursday, October 22, 2009.

It is now my pleasure to introduce Mr. David Climie. Please go ahead, Mr. Climie.

David Climie

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

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

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

If you’re asking a question during the Q&A session of today's call, we request that you limit yourself to one question and if you would like to ask a second question, please re-queue with the operator. Thank you, and I'll turn the call over to Mike Zellner.

Michael Zellner

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

PMC-Sierra’s third quarter demonstrated a solid quarter of performance. Revenue in Q3 was $130.9 million. This was slightly above the mid-point of our guidance for the quarter, and an increase of $7.7 million or 6% over Q2.

Our turns business, meaning those orders booked and shipped within the same quarter, was 21% of revenue in Q3, compared with 23% in Q2.

By region, Asia continued to generate the strongest results in the quarter. The following geographic breakdown of revenues is provided on a build to basis. The breakdown is as follows. China 36%, Japan 15%, other Asian geographies 34%, North America 12%, Europe and other 3%.

During Q3, we saw China sales return to more normal levels. This sequential reduction was attributed to the initial Q2 rush of orders relating to the 3G build out, as well as the second quarter strength of Fiber-to-the-Home in Asia. The decline was more than offset by the rest of the business recovering generally and was in line with end market demand.

In Q3, we had two customers that represented greater than 10% of revenues, calculated on a rolling 12-month basis, namely HP most significantly and the Enterprise storage side of our business and Walway, mostly associated with our WAN infrastructure business.

Gross margin in the third quarter was 66.2% compared to 68.2% in Q2 primarily due to changes in product mix as well as having two customer funded aseck mass sets at 0 margin in Q3.

On a non-GAAP basis, operating expenses decreased from $53.2 in Q2 to $59 in Q3, as we benefited from favorable exchange rate in certain geographies, lower photo mass and wafer cost incurred during the quarter, and maintained our operating expense discipline throughout the organization.

As mentioned last quarter, we consider this level of operating expenses to be somewhat low from normal levels.

In Q3, we are pleased to have achieved the non-GAAP operating income before other income and taxes of $35.7 million or 27% non-GAAP operating margin, which is the second consecutive quarter in our new targeted operating margin range of 25% to 30%.

The non-GAAP tax provision was $1.3 million in the third quarter compared to $1 million in Q2, primarily due to changes in product and income mix across different tax jurisdictions.

Non-GAAP net income for Q3 was $34.5 million or $0.15 per share on a diluted basis, representing a $4.89 million or 16% increase over Q2 non-GAAP net income of $29.7 million.

Q3 GAAP net income per share was $0.12 versus $0.03 in Q2. The comparable GAAP measures for each of gross margin, operating expenses, operating income, provision for income taxes and net income are reconciled to the non-GAAP amounts in our reconciliation of GAAP to non-GAAP measures included in our press release issued today.

The primary reconciling items for Q3 are as follows: $9.8 million in amortization of purchased intangible assets, $5.1 million in stock based compensation expense, $1 million in net foreign exchange loss on the company's foreign tax liabilities, and $9.9 million of net income tax effect of these and other items, most of which relate to a net deferred tax recovery from foreign exchange translation of a foreign subsidiary described in the press release.

Turning to the balance sheet, net of the $68.3 million face value of our convertible notes, we ended the quarter with over $351 million of cash, cash equivalents, short-term investments, and investment securities, an increase of $65 million from Q2.

The primary reason for the increase in the company's net cash position is attributed to the positive cash flow from operations of $49.3 million, which includes $11.3 million from changes in working capital. This represents our strongest quarterly operation cash flow in nine years.

In addition, we received cash from employee related stock issuance of $17.3 million, partially offset by expenditures of $1.6 million associated with capital and intellectual property purchases.

Accounts receivable increased $2.8 million to $48.3, which reflects 33 days sales outstanding based on a quarterly sales volume. This was down one day compared to the prior quarter and remains a healthy collection profile.

Our net inventory at the end of Q3 was $23.6 million, a increase of $800,000 from the prior quarter. Net inventory turns on an annualized basis were 6.8 compared to 6.2 in Q2.

In dollar terms, we increased inventory slightly in support of product shipments in an upward projector and continue to manage inventory tightly with attention toward end demand.

I will now turn the call to Greg for his briefing.

Greg Lang

Thanks, Mike. As Mike noted, we generated approximately $131 million in revenue or 6% growth in Q3 and that was following a 20% growth quarter in Q2.

As we expected, we benefited from strong growth in both our enterprise storage and micro processor businesses, while our WAN infrastructure and Fiber-To-The-Home business were lower sequentially.

The combination of higher revenue, solid gross margins and continued cost control, allowed us to generated close to $36 million in non-GAAP operating income in Q3, up $5 million from the prior quarter.

The performance in Q3 equates to a 27% non-GAAP operating margin, which is the highest operating margin since the year 2000.

From an operating profit perspective, it’s $2 million better than the peak quarter of 2008 before the recession took hold.

In Q3, we experienced improved bookings throughout the quarter and achieved an overall book-to-bill greater than one with a solid backlog position going into Q4. We believe that we worked through some inventory issues over the last few quarters and the pipeline is now at reasonable levels.

So now let’s talk about the third quarter by end market. In the enterprise storage business, we saw activity improve again this quarter following sequential growth in Q2. The main drivers of growth in Q3 were a ramp in production of the 6 gig SAS 2 RAID-on-Chip device at HP, as well as a broader recovery in the enterprise storage segment.

Our 6 gig RAID-on-Chip device called the SRC started to ship to HP ProLiant G6 servers in Q2, but due to success of the HP servers, we experienced a stronger than expected increase in Q3. Previously we were estimated approximately $35 million in revenue in 2009 from this device, but we’ll exceed that this year. We’re still holding to the estimated $75 million per year run rate for this device at HP. So we think there could be an additional $30-$35 million revenue coming in 2010.

During Q3, we also had double digit growth in our fiber channel and 3 gig SAS products as inventory in the supply chain had worked down and end market started to improve.

In the storage systems segment of the market, the industry is starting to transition from 3 gig to 6 gig SAS and this will continue into the fourth quarter and into next year. PMC has a strong design win position in storage systems at 6 gig SAS where we have both controller and expander solutions, so we believe that we will be increasing our market share in this segment going forward.

Based on our tracking of design wins, we believe we won the majority of new tier one 6 gig platforms awarded to date in the external storage market and there are numbers still pending.

Today in 3 gig SAS, we have only expanders, but in 6 we’ll have an end-to-end ship solution with both protocol controllers as well as expanders.

We’re also pleased to announce this past quarter that Net Ap began shipping their mid-range and entry level product lines, including the fast 2,000, 4,000 and 6,000 enabled by our SAS controllers and expanding switching shift sets.

Also in Q3, HP began shipping its storage work D2000 disc enclosures with our 6 gig SAS 2 expanders. These enclosures simplify capacity expansion of HP proliance server environments to external storage.

Now in our Wide Area Network Infrastructure business, which includes both our wireline and wireline infrastructure products, we saw a pick-up in activity from North America and European customers, but it was not enough to offset the anticipated slowdown that we experienced in the China market.

As a reminder, we mentioned back in April, that the China market was going to slow in the second half and it’s played out basically as we had expected it to.

While the three carriers in China continue to build out their 3G networks, as well as improve the aggregation and metro transport in infrastructure, they did slow their ordering Q3 after a fast start in Q1 and Q2. Our view remains the same though that in Chain we are only at one year into a three-year network build out and with carriers now bringing on new Smartphones, including iPhones, Blackberry, and oPhone, more subscribers will be moving over to 3G networks and that more mobility bandwidth and back call capacity will be required to support all the additional data and video being moved over the edge of the network.

In terms of new product development in our WAN infrastructure business, this summer we announced a new device called HiFi that enables the convergence of TDM and packet based networks into the optical transport network, which is the industry’s new standard for simultaneous support of carrier Ethernet, video, storage area network, and SONET / SDH protocols.

This device reduces our customer’s line card variance by about 75% and achieves approximately 50% power savings over previous approaches and we now have more than six leading OEMs that are working with us on their new OTN platforms using the HiFi product.

This week, we announced a new member of that product line called the Meta 20G, which now enables carrier Ethernet switch and router equipment to seamlessly connect to new metro OTN transport equipment that’s being introduced.

The Meta 20G integrates carrier Ethernet mapping and framing of the 10 gig Ethernet LAN and WAN as well as OTN mapping of IP serves such as SAN and video protocols and we also have customers signed up and working with us on this device as well.

Now in the broadband access market, we experienced a slowdown in Q3 after a very strong pickup in activity in the second quarter.

Our EPON business in Japan remains strong as they continue their next gen network build out of NTT East and NTT West. Japan remains a global leader in Fiber-To-The-Home subscriptions and we’re encouraged that NTT is increasing the level of additional video services for its customers as it targets to add another 2.5 million EPON Fiber-to-the-Home subscribers this year.

In China, our Fiber-To-The-Home business was robust in the second quarter as expected, but slowed in Q3 as China Unicom’s rollout is much slower than expected.

China Unicom centralized bid indication for deployment in 2009 was in the range of about 5 million subscribers, but now appears that China Unicom will likely only deploy connections for approximately one million this year.

So while it’s encouraging to see a second large Chinese carrier deploying EPON networks, it looks like the China Unicom growth plan for Fiber-to-the-Home will be pushed in to the first half of next year.

The other major carrier, China Telecom, remains on track to add approximately 8 to 10 million new EPON Fiber-to-the-Home subscribers in 2009.

Now in the Korea market, we’re encouraged to see Korea Telecom starting to increase deployment of its EPON network and as well SK broadband starting to deploy GPON in the second half of this year.

In both Japan and China, we continue to work with carriers and key customers on the next gen symmetric 10 gig EPON, which delivers 10 gigabits per second upstream and downstream speeds. We currently are working with 8 major tier one OEMs with regard to our new 10 gig EPON technology solution.

In our microprocessor business, we had a solid recovery in our end markets in Q3 as inventory levels were depleted over the past three quarters.

Growth in our laser printer business was the primary driver in the third quarter, but we also experienced increased activity in the enterprise networking market as well.

During Q3, we experienced improved bookings each month and entered into the current quarter with a solid backlog. We’re once again calling for only modest turns this quarter equal to those in Q2 and Q3 this year and approximately 21% of revenues.

It’s also interesting to note that we’re within about $3 million dollars of our peak revenues last year at the midpoint of our Q4 guidance of let’s say $136 million and we’re already surpassed the peak earnings. So in addition, at the midpoint of our Q4 guidance, our 2009 non-GAAP EPS will grow by approximately 11% over 2008. Our best results since 2001 despite the challenging economy.

With rapid growth and video and digital media, as well as exploding data traffic on mobile networks, there’s no question these wireless and wired networks need to migrate from their voice-based TDM heritage to packet-based networks and we believe PMC is uniquely positioned as a critical supplier to the infrastructure that will store and serve these bits as well as packetize the access and metro markets to support the traffic growth profile.

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

Michael Zellner

Thanks, Greg. I'll now provide more information about our Q4 outlook. Judge, ship and shippable backlog at the beginning of Q4 was approximately $107 million.

Considering current levels of demand and our expectation of booking rates through the balance of the quarter, we estimate that a potential revenue for PMC for Q4 is in the range of $132 to $140 million as Greg mentioned.

Judge backlog today, including shipped plus shippables is approximately $122 million, indicating that we’d be at approximately 21% turns from the beginning of the quarter and 10% turns from this day to get to the midpoint of our revenue outlook for Q4.

On a non-GAAP operating basis, we expect our overall gross margin percentage in Q4 to be in the range of 66% to 69%.

Non-GAAP operating expenses in Q4 are expected to be in the range of $53 million to $54 million, increasing from the $50.9 million in Q3 primarily due to higher takeout activity.

On the general note, depending on the number and timing of tape-outs, which do vary from period to period, our expenses could be affected by a couple of million dollars in any given quarter.

We expect non-GAAP net other income to be $300,000, which is primarily net interest income from our cash positions offset by servicing our outstanding convertible notes.

We expect a non-GAAP tax provision for the fourth quarter to be in the $1 to $2 million dollar range. As a reminder, the tax expense could be impacted by a number of variables associated with our FIN 48 liabilities, included but not limited to a change in foreign income tax and product mix.

Regarding share count, we ended Q3 with a diluted share count of $231.9 million. In the fourth quarter, our diluted share account is expected to be between $235 and $237 million.

For the following quarter, we do plan on the following significant GAAP to non-GAAP reconciling items. One, amortization of purchased accounting costs associated with past business acquisitions. Two, stock option expense as required under FAS 123. Three, FX gains or loss on our net foreign tax liabilities, and four, income tax effects of the above adjustments and other tax items as specified in our reconciliation of GAAP to non-GAAP measures included in our press release issued today.

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

With that, we'd like to open up the call up to questions. Operator, if you would please open the lines.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from Srini Pajjuri – CLSA.

Srini Pajjuri - CLSA

Greg, you mentioned that you have a lot of design wins in the 6 gig SAS on the system side and obviously been giving the number on the server side as to how much revenue that would contribute. I’m just wondering, do you have a number in mind as to how much incremental revenues the 6 gig SAS in systems could contribute next year?

Greg Lang

The general thing that I’ll comment on first is the transition on the systems side tends to be slower. It’s not as fast as the server transition that HP just went through. So we expect this transition will probably take a couple of years.

Next year, we think the net positive gain for us as a company is probably on the order of $25-$30 million dollars. That captures essentially the share gain that will pick up over the course of the next several quarters.

Srini Pajjuri - CLSA

You’ve been talking about a new customer on the server side, IBM. Any updates on when we might see that design win or initial ramp up from the customers?

Greg Lang

I think the work that we’re doing right now first off with the joint venture that we have going on with them with the rate stack, etc. and getting product ready is going very well. So the general working relationship is very good and the milestones are being met.

In terms of when the business would start, it’s timed around the time the Westmere ramp, which is end of Q1, beginning of Q2 timeframe of next year. There has not been a design win awarded or announced at this point. So we’ll probably hear something later in the quarter, maybe the beginning of Q1 as we get closer to the Westmere timeline.

Srini Pajjuri - CLSA

My last question on the OpEx front. Mike, you said it’s increasing. Down as we enter into Q1 or any other item that could offset that decline?

Michael Zellner

Again, I think Q3 was actually an anomaly low quarter where we virtually had no tape out. So it’s more typical that we do have various tapes out on a quarter-to-quarter. So I would say that’s more typical.

In addition, there’s a few things that occur early in the year associated with payroll taxes and things like that can actually cause expenses all things the same to drift up a little bit. So I would say Q4 is more sort of typical in what you should think about in terms of a go forward scenario.

Operator

Thank you. The next question comes from Dan Morris from Oppenheimer. Please go ahead.

Dan Morris - Oppenheimer

Just want more color on the Fiber-to-the-Home business, specifically I think you mentioned that China Unicom was a little bit slower than expected in deployment. Is that something demand driven, is it if they’re going to go EPON or GPON route or anything like that?

Greg Lang

No, it’s really I think just kind of start-up challenges. It’s a new technology, new deployment, new capabilities. They decided on EPON, so they’ll be going with EPON. So it’s really not in that cycle.

The other thing to keep in mind is they’re still doing a ton of work on the 3G wireless front. They see a huge opportunity to grab some share from the China mobile folks. So I think that’s also a bit of a distraction factor.

The good news is they continue to push ahead and I think we’ll see the benefits of that beginning of next year.

Dan Morris - Oppenheimer

Just an update on GPON efforts and any distraction you’re getting there?

Greg Lang

GPON is still relatively modest relative to EPON, but we do see it starting to pick up. For example, Korea, the HANORO or I guess it’s SK Telecom. They’ve decided to go with GPON and to give you an example, we won eight of the ten design win opportunities that we saw support that ramp. So we’ll see some GPON business coming out of Korea in the short-term.

We’re also targeting a number of folks who are providing into some of the bigger providers, the ODM level, and we think that’ll help us break into some of the other markets probably in Europe first and later in N.A.

In terms of giving you any kind of estimate of scale. One of the first thresholds, we just break through the million dollar mark on a quarterly basis on revenue. I think we’ll probably break through that this quarter on GPON. So that’s a good step, but we’re just getting started there, but the signs are good from a design win standpoint. When we get into new design opportunities, we’re winning far more than we’re losing. So that’s also a positive, but it’ll be a bit before the revenue.

Operator

Your next question comes from David Wu - GC Research Ltd.

David Wu - GC Research Ltd.

Greg, I just got off the phone with…and I was wondering are there any signs of customer hesitation or somewhat not very good outlook to you that would lead you to believe there’s risk in your guidance and I also want to see where the China ramp down…hitting at least a plateau or valley somewhere in Q4 or still going down?

Greg Lang

On the first question on the customer front. I would say there’s no signs that we have that the people are starting to get skittish about this quarter and I’m not sure what segment that are friends down South are referring to.

David Wu - GC Research Ltd.

Your friends down South across everything. They think that we could repeat fourth quarter last year. I guess that must be the nightmare scenario and too close to Ronald Reagan country.

Greg Lang

I don’t know if we’re necessarily seeing the same thing. As you heard, we’ve got it relatively conservatively with only 10% turns left to go to hit the quarter and so the bookings and the backlog that we have now definitely supports the business level. Now there is always a risk that could get pushed out, but we haven’t seen signs of that. In fact, if you look across some of our segment in the storage segment, that segment seems to be very strong. I think EMC announced good growth last quarter and expecting more growth this next quarter. So we’re certainly seeing that reflected in our numbers. I’m not sure where that sensitivity is coming from.

The second part of your question was on the second half, the turndown on the wireless side in China. I think we’ve seen that drop. We don’t expect it to take another step down in Q4.

David Wu - GC Research Ltd.

If you look at next year, the big revenue driver is still coming from the storage side based on what you said so far.

Greg Lang

There’s no question the biggest driver for us overall for the company are in the storage business. It’s over a billion dollar TAM and we’re not as penetrated as we can be and we think there’s a couple years worth of growth still in this business just on the things we’re doing today. So that’s clearly going to be the lead, but I also think there’s growth potential in the Fiber-to-the-Home business as that technology matures and markets pick up more and deploy more of the new technology there.

Even in our metro business. As you know, there’s a big transition going to packet networks there and I think we’ll start to see some benefit from that later in the year. So we really do have growth potential in all three of our major business segments for next year, storage leading the way.

Operator

Your next question comes from Ruben Roy of Pacific Crest. Please go ahead.

Ruben Roy - Pacific Crest Securities

Greg, can you maybe give a little bit of detail into end markets and your expectations just a little more granular for Q4 in terms of what the dynamics might be to reach the high end versus the low end of guidance?

Greg Lang

Sure. To start with storage, Q4 generally what we’ve seen in the last couple years is the strongest quarter of the year in the storage business. So we’re expecting that business to grow again for us this year.

The communication in Fiber-to-the-Home business, both of those segments we expect some I would call it quite modest upward growth, but still positive this year. I guess it’s kind of a similar story what I talked about in 2010, which is growth in each segment with storage leading the way. To hit the high end, we’d need to see probably on the communication side and to see some stronger growth out of Fiber-to-the-Home and core wireline business, which right now we’re assuming fairly modest numbers.

Ruben Roy - Pacific Crest Securities

Just a follow-up on the storage side, in terms of storage systems, it sounds like a little bit of a recovery there from customers like EMC etc. What’s your visibility into kind of how that business works out over the course of 2010 and perhaps talk a little bit more about your expectations for market share gains in storage systems themselves.

Greg Lang

We think about this in kind of two different pieces in the storage market. One is on the server side and the other is on the target or kind of the system enclosure side, if you will.

On the server side, we saw a very nice year of growth this year with our first customer first big win with HP. They’re obviously the leader in the server space and we were able to capture a very large percentage of their business and have enjoyed that ramp up.

Year-to-year, that will contribute probably on the order of $30 to $35 million more in growth by itself next year.

Outside of HP, the other growth that we have on the server side of the business, the most substantial piece would be IBM. IBM will represent for us in time I believe tens of millions of dollars of revenue growth on an annual basis; however, it will be starting up next year. So it’ll probably ramp to that level over some period of time.

So we do see a substantial business growth opportunity if we’re able to earn that business and then if you go down the list there’s other guys, Dell and some of vendors as well, they’re all opportunities.

So we see quite a bit of growth over the next couple years. There’s potential there, because we’re the new guy.

Now, the second market underneath the storage business is this target side and there’s we’ve been entrenched a little bit longer, but our share will improve generation to generation from the SAS 1 gen to the SAS 2 gen, we have a chip set in gen 2 versus 1 switching device in gen 1 and the design wins as we track them will favor us from a share position standpoint. We think our share can approximately double between those two generations. That transition will take a couple of years as well to happen and that’s the comment that I made earlier where I thought we could see $25 to $30 million dollars of growth year-to-year on that segment.

Operator

Thank you. The next question comes from Sandy Harrison from Signal Hill. Please go ahead.

Sandy Harrison - Signal Hill

Greg, you talked about some of the markets, specifically storage and I guess for almost two or three years now you’ve been talking about storage being the growth engine and then you highlighted that so far on the call today as sort of the big driver. Kind of looking back when you started talking about storage and the growth engine and sort of looking on the path you are now, would you consider yourself on track, ahead of plan. What would you say if you would have asked yourself a couple of years ago where you’d be today, where is that?

Greg Lang

I’ll comment maybe a little bit more independently, because as you know, I’ve been with PMC for about a year and a half, but if I take a look outside and look at what PMC management team was thinking three or four years ago when they started to really make these heavy investments. I think it’s a fantastic success story to go from essentially zero to a couple hundred million dollars of business with hundreds millions more left to be earned or gained. I think is a very hard to duplicate type of success story.

So it’s been a big success. There are pieces of it that we thought would happen sooner. There are pieces we thought would happen slower, but overall I think it’s been a very positive success story with still quite a bit of room left in the growth engine.

Sandy Harrison - Signal Hill

Then a quick point on some of the stuff you’re doing in the OTM space. You had your first product announcement last quarter and you talked a little bit about what you thought the market size was and now you’ve introduced two other devices. When you were talking about the market size, was that TAM or SAM and now that you’ve had a quarter under your belt and the device out there, what’s your opinion on the OTM market, its opportunity, and when do you really think that’ll start to contribute in ways like some of your other growth engines have?

Greg Lang

We think the market here is on the order, the total market, is probably on the order of about $400 million dollars. The piece that we participate in, so if you want to think about the serviceable part of that market, it’s probably in the order of $200ish and we think we’re in a position to participate very strongly in that $200. I won’t try to guess that share position at this point, but I think we have an opportunity to gain majority share of that piece that we participate in.

In terms of when it will move the needle, I mentioned earlier, we’ll start to see some revenue in the late second half of this next year in 2010, but it’ll be 2011 that we’ll start to see it move the needle and I’m expecting it’ll grow for a few years after that as well as more and more carrier move their networks to these more efficient packet networks. We’ve announced, for example, Verizon has been one of the most aggressive at driving kind of the requirements and setting the bar very high on this and they’ve made their RFQ’s very public. We’ve won the two major guys that are going to be supplying for Verizon, both Fujitzu and Tellabs. So that’s a good indication of kind of I think the power of the solution that we’ve bought to the market. Now we’re out to basically make sure we get our fair share of the rest of the business.

Sandy Harrison - Signal Hill

Just a last question on North America and Europe, you mentioned seeing them come back in Q3, but not enough to offset the declines as you had forecasted in China. What sort of your best view of what you think North America and Europe are going to do for the rest of the year and sort of your crystal ball for next year?

Greg Lang

I think the gains that we saw were somewhat just excess inventory being consumed. I don’t expect an aggressive pickup in deployments in N.A. for us and from a revenue perspective until we get to the OTM products. I expect along the same lines of what we’re seeing now.

I do think that the carrier CapEx should improve in 2010. I think we’re seeing some modest improvement in the second half. I think it’ll improve again in 2010 as people get serious about their packet network transition.

Operator

The next question comes from Allan Mishan from B. Advisors. Please go ahead.

Allan Mishan – B. Advisors

Mike, what’s your thinking on the tax rate for next year?

Michael Zellner

Obviously we don’t guide out beyond the quarter. Thinking of it in terms of a dollar as opposed to a percent is the right way to think of it. Kind of similar guidance as I gave for Q4 is the right way to think of it. I think your thinking is kind of correct that way.

Allan Mishan – B. Advisors

Greg, you mentioned the OLP business in Japan, was Japan in total for EPON actually up quarter-to-quarter and then it was just China that was down and that dragged the whole unit down. Is that the way to think about it?

Greg Lang

Japan was not up for the quarter. We saw some down side on the ONU side, but it was a healthy level, it wasn’t a big drop.

Allan Mishan – B. Advisors

What kind of seasonality do you expect to see in the storage business in Q1 now that you do have a large piece of revenue from servers in addition to what you have in systems?

Greg Lang

That’s a good question. I think we’re going to go back and look. Since we’re relatively new here, we don’t have a lot of history, but we’re thinking that it’s probably in the 8 to 10% range in Q1, but that’s something we’re kind of modeling right now.

Allan Mishan – B. Advisors

Down 8 to 10%?

Greg Lang

Correct.

Operator

Your next question comes from Anthony Carbone of Orgia.

Anthony Carbone – Orgia

Greg, I was wondering if you could give us some perspective of your growth opportunity with respect to your software development with IBM on the raid stack. In particular, can you speak to how and when you might be able to monetize this?

Greg Lang

The growth opportunity really comes from being able to provide a full solution to server OEMs who don’t have their own rate solution and right now HP is really the only guy out there that has the run raid software stack. So our ability to sell into the other server OEMs was limited by that fact. So that’s really what it does is it opens up the door for us to go participate in another several hundred million dollar chunk of the market beyond the HP business.

Anthony Carbone – Orgia

So would you be able to recognize any revenue with IBM or do they get a license free or software license free?

Greg Lang

We haven’t announced the terms of that arrangement, but basically they would buy a product from us that would include both hardware and software.

Anthony Carbone – Orgia

To that point, as I look over the analyst materials, it’s obviously very clear from a TAM perspective, this is the biggest growth in TAM for 2010. In fact, it’s probably the most meaningful expansion that you’ve seen on an annual basis. I was wondering how should we look at that? Is that just software revenue or is there some implicit assumption that this is going to be a card?

Greg Lang

Basically the way that we approach the customers is that we’ll work with them at whatever level of integration they’d like. If they’d like to buy the component and do their own software, we can support that model. If they’d like to buy a full board with the software included, we’re working to be able to support that model. So that’s really where that opportunity opens up and when you start talking about the ASP for a piece of silicon relative to the same ASP for a silicon on a board with other devices and a raid stack on top of it, the ASPs are quite a bit higher.

So the rest of the market, the ASPs will be higher than kind of a raid down type of solution. So I think I’m just confirming what you said.

Anthony Carbone – Orgia

Just lastly, as far as when the solution will be available. Can you give us some perspective there, because obviously there’s a lot of moving parts where to your point that you just made, the software could be available or be finished by midyear, but because it’s part of a card or integrated solution, you might not see revenue until 2010. Can you give us some perspective of puts and takes as far as how we should think about potential linearity as we go into 2010 or 2011?

Greg Lang

You should think of this as our first target for this full offering as IBM. So when I talked about that earlier and said we’re looking at timing that with Westmere, that is the first existence of that whole solution from us. I mean that’s probably the March-April timeframe.

Just one other comment on the market size. I think you’ve seen the addressable market slide from us previously and basically we’re estimating that the server market is roughly 50-50. Half of it is controller based, which means a lot more units, and the other half more of a raid adaptor and software, which is the higher value ASP solution, but that’s roughly how we see it breaking out from a total market standpoint.

Operator

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

James Schneider - Goldman Sachs

The question was already asked about Q1 seasonality for storage. How should we think about the Q1 seasonality for the traditional wireline business, the telecom business, given what the movements are with the China customers and do you anticipate any kind of yearend inventory reductions from those guys like they have done in the past.

Greg Lang

Historically, the communication business shows some strength in the first quarter, but we have a couple of interesting issues or interesting things to handle in our business, one of which is Japan. We have a high percentage of our business in Japan with the Fiber-to-the-Home part of our business in particular. They have a fiscal yearend at the end of March, so there’s times, there’s years where they’re working hard to work inventory down, but we also had a situation I think it was last year 2008 where they got more aggressive with their FTT deployment. We actually saw very strong Q1. So it’s a little bit hard to predict, given that what they decide to do kind on their overall government agenda, overwhelmed the normal seasonality to work down inventory. But I would say communications in general tends to be, Q1 tends to be a good quarter. I don’t know if I’d say it’s the strongest, but it’s a good quarter from a cyclical standpoint. China I would expect on Telecom and FTTH and then Japan could be offsetting some of that with a yearend working down of inventory.

James Schneider - Goldman Sachs

Maybe on the gross margin side, could you help us understand from a mid to long-term perspective, the 67% you guided to seems to have pretty much the high mix of storage products you’ve ever had in the company’s history. So should we think about that as kind of like a new baseline, if you will, gross margin level going forward or some puts and takes we expect next year to change that?

Greg Lang

We’ve answered questions in the past about how storage might impact gross margin. We said, you know, we’ve been able to work that such that we thought it would be hang in there relative to our overall company gross margin levels and that certainly played out to be the case.

So I think the kind of gross margins that we’re seeing now, we’re not guiding into next year yet, but the kind of gross margins that we’re seeing now, we have every intention to try to maintain those on a go-forward basis.

Operator

Thank you. The next question comes from Romit Shah from Barclays Capital. Please go ahead.

Romit Shah - Barclays Capital

There’s a lot of questions about seasonality in Q1, but I’m still trying to get my arms around Q4. If I remember correctly your Q3 term requirement was pretty conservative and you guys came in right around the midpoint. So if I take your Q4 outlook at face value, I’m trying to understand why your revenue growth is decelerating given that the WAN infrastructure stepped down behind us and you’ve got positive seasonality in the storage business for Q4.

Greg Lang

I think the short version of that is, first of all, Q2 we grew 20% over Q1. That was just a burn off inventory type of hold that I think everybody is familiar with . Then the growth we saw this last quarter was somewhat muted, because we have the downside on the wireless and strength on the storage side. The real reason behind that, the reason we were able to offset all of that decline was because this HP business was ramping up on the server side. Now it has ramped to more full strength, if you will. Closer to the end run rate that we’ll see from that design win and so that’s why you’re seeing the slower percentage growth is because we saw a lot of that big ramp in the last two quarters.

The other big question mark is just what does happen on the infrastructure build out in China and both on the wireless as well as the FTTH side, but we’re assuming very modest flattish type of numbers for Q4. So most of the growth is really still coming out of the storage business in the fourth quarter.

Romit Shah - Barclays Capital

Greg, what’s your expectation for (?) in Q4.

Greg Lang

It’ll be up slightly as well. We’re just kind of getting back into the end market levels this quarter.

Operator

Your next question comes from Eric Ghernati - Bank of America/Merrill Lynch. Please go ahead.

Eric Ghernati - Bank of America

With respect to the wireless segment, as we go into next year, shall we think about Q4 as the more normal run rates for the business going forward?

Greg Lang

Yes, I think it’s probably a fair baseline. I think there’s a question about whether or not it picks up a little bit next year, but I don’t expect it to jump up like it did this year in 2009.

Eric Ghernati - Bank of America

With respect to the IBM business, Greg, how fast should we think about it coming to the full run rate. Was it as fast as what you’ve done with HP or a little bit slower, next year I should say.

Greg Lang

I have to restate that we really haven’t won the business yet, so that’s the first job we have to do is go win the business, and then I expect it would probably be a slower ramp, because these are not glued down on mother boards. These will be a card-based solution. So we’ll have to work our way into that revenue flow.

Eric Ghernati - Bank of America

A question on fiber channel. How should we think about the business in 2010?

Greg Lang

When you say fiber channel, I assume you’re talking about kind of the target side of the business between fiber channel and SAS, etc. Fiber channel as a whole just as a data point is a fairly flattish business as SAS takes over, but I think the comment I made earlier, the most interesting part of that business other than just kind of getting back into end market run rates, which I think we’re doing this quarter and in Q3, the most interesting new growth coming in that business as the transition of SAS 2 and the share gains that we talked about and the roughly $30ish million of new market that we think we can pick up next year.

Eric Ghernati - Bank of America

Was there any NRE benefit in Q3 gross margins and if so can we get an idea of how much?

Michael Zellner

We had a couple of takeouts that in gross margin at zero margin and that happens time to time. We typically have one or so. That’s really what caused our margin movement from Q2 to Q3 from like 68% to 66% profile.

Operator

Gentlemen, there are no further questions at this time.

Michael Zellner

Thank you, operator. Thank you for attending today’s cal and we will be having our Q4 2009 call later in January and look forward to providing an update and guidance into Q1 for next year at that time. So that would end the call today. Thank you, operator.

Operator

Your welcome. Ladies and gentlemen, this does conclude the conference call for today. You may now disconnect your line and have a great day.

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