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Executives

Peter Andrew - VP of Corporate Communications

Scott McGregor - CEO

Eric Brandt - CFO

Analysts

Adam Benjamin - Jefferies & Co

Ross Seymore - Deutsche Bank

Craig Ellis - Caris & Company

Craig Berger - FBR Capital

Tristan Gerra - Robert Baird

James Schneider - Goldman Sachs

David Wu - GC Research

John Pitzer - Credit Suisse

Mahesh Sanganeria - RBC Capital

Srini Pajjuri - CLSA

Mark Lipacis - Morgan Stanley

Uche Orji - UBS

Sumit Dhanda - Banc of America

Stacy Rasgon - Sanford Bernstein

Quinn Bolton - Needham and Company

Broadcom Corp (BRCM) Q3 2009 Earnings Call October 22, 2009 4:45 PM ET

Operator

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

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

I will now turn the call over to Mr. Peter Andrew.

Peter Andrew

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

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

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

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

In addition, we've placed a slide deck, which is available now in the Investors Relation section of our website, it is on the right hand side of the page under the 'Q3-2009 Earning Information'. In this deck we have incorporated additional tables and information regarding our historical performance and our future guidance.

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

Scott McGregor

Good afternoon, and thank you for joining us today. Broadcom executed quite well in the third quarter, with substantially better results than we originally anticipated, driven by upside demand in our enterprise networking and mobile and wireless businesses. For the third quarter, we reported net revenue of $1.254 billion, which is up over $200 million and over 20% sequentially from our second quarter.

Broadcom's revenue is now up 47% from the trough quarter in Q1 2009 and down only 3% from our record revenue level reached in Q3 2008. Sequential revenue growth in the quarter was broad-based, as each of our businesses grew between 9% and 37%, driven by a return to more normal order patterns from our customers, a number of new product ramps, and our customers preparing for the upcoming holiday season. Broadcom was also successful in generating strong sequential gross and operating margin leverage.

So far this year, Broadcom has been able to achieve our 2009 financial goals of gaining market share, while at the same time generating strong cash flow from operations. In the last three quarters, Broadcom's revenue declined approximately 11% year-over-year, which is significantly better than the industry. We've generated over $650 million in cash flow from operations, far surpassing our $300 million goal for the entire year. At our upcoming Analyst Day on December 15, we'll discuss our goals for driving additional leverage in our financial model.

Based upon customer activity we've experienced to date, we expect revenue in the fourth quarter and in each of our target markets to be approximately flat with the third quarter of 2009. As I mentioned last quarter, and as we still believe today, the economic situation remains uncertain. Therefore, we'll remain cautious in the way we're running our business.

I'll now turn the call over to Eric for details on the third quarter results and the fourth quarter guidance.

Eric Brandt

As Peter mentioned, please refer to the data breakout in the investor section of our website for additional financial information that will supplement my financial commentary. We have included additional data to reconcile product gross margin and operating expense, as well as our modified presentation of our income statement to breakout our intellectual property licensing revenues that we introduced last quarter.

Moving to the financial overview; to summarize, total revenue of $1.25 billion, including $1.19 billion in product revenue, and $59 million in licensing revenue. Total revenue was up approximately 21% and product revenue was up approximately 24% from Q2 level. Product gross margin in Q3 increased 220 basis points to 48.5% versus 46.3% in Q2.

Q3 2009 GAAP R&D plus SG&A expense was $534 million. On a comparable basis, these expenses increased $31 million over Q2. This increase included $16 million related to our performance-based compensation plan, which I will discuss further in a few moments. Excluding this charge, our increase of $15 million was below the guidance we gave for Q3 in July.

Earnings per share for Q3 were $0.16. This includes approximately $0.02 per share negative impact associated with the asset impairment and the restructuring we undertook in the quarter related to our DTV business. Stock-based compensation represented approximately $129 million, or approximately $0.25 per diluted share.

Cash flow from operations for Q3 was $236 million. Our cash and marketable securities balance increased to $2.4 billion at the end of the quarter.

Moving to revenue, gross margin; in July we said that we expected Q3 total net revenue to increase 7% to 14% sequentially over Q2, of which licensing should be approximately $55 million. What occurred in Q3 was Broadcom generated stronger total sequential net revenue growth of approximately 21% to $1.25 billion, driven by sequential product growth of approximately 24%.

With respect to broadband communications, we saw growth in the broadband modems and digital set-top box end-markets. In mobile and wireless targeted end markets, we experienced revenue growth virtually across the board with strong new product ramps in cellular basebands and our combo solutions, as well as normal seasonality as our customers prepare for the upcoming holiday season. Our enterprise networking targeted end market came in stronger than we had anticipated, driven principally by improving customer order patterns, particularly in the Ethernet switching area.

Our Q3 GAAP product gross margin increased 220 basis points to 48.5%, up from 46.3% in Q2, which is significantly above the improvement estimate of 125 basis points we provided on our last earnings call. This was primarily due to changes in product mix, continued focus on cost improvement, and lower E&O charges in the quarter.

Moving to operating expenses; once again, we had better than expected performance controlling our R& D and SG&A expenses, excluding a formulaic increase to our corporate bonus pool. While R&D and SG&A expenses for Q3 were up $31 million from Q2 levels compared to an increase of 20 to $26 million, we expected in July, this increase included $16 million related to our performance-based compensation plan.

This additional charge is related to the stronger than anticipated relative revenue growth and cash flow generated in the quarter and expected for the full year and reflects a proportional increase as compared to the first half of the year. Excluding this unforecasted item, our increase of $15 million was below our guidance in July.

During the quarter, the company also recorded GAAP-related impairment and restructuring charges for the digital TV business totaling $12 million. In addition, the company experienced an E&O charge related to cost of goods of approximately $10 million associated with digital TV, which was mostly offset by other E&O releases in the quarter.

Moving to the balance sheet; as I mentioned earlier, total cash and marketable securities were $2.4 billion as we generated positive cash flow from operations of $236 million. We repurchased approximately 6 million shares of stock in the quarter at an average price of roughly $28 per share as part of our ongoing goal to offset dilution associated with our annual equity grant.

As we indicated in July, we expected inventory turns to improve. Based on the strong work of our operations team and increased demand, we were able to improve turns to 8 times. Assuming no further shocks to the industry, we anticipate turns will remain in our targeted range of 7 to 8 times. Our accounts receivable day sales outstanding remain flat at 39 days.

Moving to expectations; we currently expect revenue in Q4 to be roughly flat to Q3 overall, as well as across each of our targeted end markets, which would be up roughly 11% versus last year. Bear in mind we have generally experienced stronger revenue growth in the industry in Q3 and Q2 on a product basis, partially due to the excellent work of our supply chain team and their partners.

In addition, we are waiting to see consumer sell-through for the holiday season and we will provide an update to our guidance at our Analyst Day in December.

We expect product gross margin to improve around 20 to 50 basis points, principally driven by improvements in cost and mix. With respect to R&D and SG&A expense in Q4, we expect the expenses to increase approximately $20 million, of which nearly half will be driven by legal costs associated with the options litigation case that begins this quarter.

Of the remainder, roughly half relates to tapeouts/prototyping costs as we drive to second and third generation 65-nanometer products and new lower cost optimized products to improve gross margin, and the rest is mostly related to increases in employee costs. This increase, however, does not include recognition of the benefit of roughly $60 million of additional D&O recovery, preliminarily improved by the court.

Now, I'd like to turn the call back over to Scott to talk more about the state of the business.

Scott McGregor

Our revenue from broadband communications grew almost 9% sequentially, driven by growth within the set top box and broadband modem product lines. The one head wind we faced in the quarter was in the digital TV market, where our results were negatively impacted by one large customer losing share in North America, and some share loss with other customers.

In light of these Broadcom-specific issues and the impact of the economic downturn on the digital TV market as a whole, we're taking actions to appropriately size this business. We remain committed to the DTV market. We will continue to invest, and we still see DTV as a significant revenue growth driver for the company in 2010. We are right-sizing our digital TV organization as part of our ongoing portfolio management, consistent with our revenue forecast and as a final step in the integration of the AMD DTV business into Broadcom.

So what is it that keeps us excited about our prospects in digital TV? First of all, as connected TVs starts to take off, we believe we're very well positioned to benefit from this trend. Our recent wins at LG and others exemplify why we are winning in this new and emerging segment. It's our ability to provide a complete solution, which leverages strengths in both video processing, as well as wired and wireless network connectivity.

Second, we've already begun to ramp some new North American digital TV customers. We believe that our position in North America will be more diversified, resulting in higher market share in 2010 than in 2009.

And third, we've recently won a number of new digital TV designs in Europe and Asia, expanding our market position outside of North America in 2010.

In Q3, we had five key broadband product announcements, including, number one, a new line of cable set top box solutions, incorporating a DOCSIS and Euro-DOCSIS modem and MoCA technologies, which enable advanced services, such as interactivity, 3D user interfaces and multiroom DVR capabilities. Two, a new line of satellite set top boxes incorporating MoCA.

Third, a single chip ADSL2+ modem incorporating 802.11m gigabit Ethernet switch and DECT cordless phone capabilities. Four, expansion into the GPON modem market, with a highly integrated solution also incorporating MoCA. And fifth, Microsoft Mediaroom client integration, enabling Broadcom to provide Microsoft certified, second generation set top box solutions to operators. We believe that the connected home provides a number of large and long-term opportunities, which we're in a very strong position to capitalize on, given our broad video processing and connectivity portfolio.

Broadcom's enterprise networking business delivered the highest sequential growth rate in the third quarter at approximately 37%. Growth in the quarter was broad based, as our customers in the enterprise and service provider markets began to roll out new platforms. Based on feedback from our customers, it appears this target market reached a trough in the second quarter.

Enterprise networking experienced solid growth in switch platforms for service provider deployment in China for 3G wireless infrastructure, PON build out and broadband. In addition, 10G switches in data centers, and (inaudible) in server controllers contributed to the Q3 performance. Enterprise customers increased their worldwide demand for gigabit server controllers, switches and (inaudible) used in stackables and core switches. We continue to see opportunities to expand Ethernet deeper into the service provider market and to increase adoption of 10G within enterprise, data center and service provider end customers.

Within our mobile and wireless business, Broadcom experienced solid sequential product revenue growth of over 30%, driven by growth within both our cellular and connectivity markets. Within the cellular market, we experienced strong sequential growth in the quarter, driven by one of our customers ramping new products, incorporating our baseband and power management solutions.

We've been benefiting from the emergence of what we're calling smart feature phones. These are high end EDGE or low end 3G handsets, which incorporate capabilities such as touch screens, downloadable widgets and push email. In addition to the ramp of our baseband and power management solutions, the third quarter also marked the first quarter of shipments for our multimedia coprocessor solution into a cellular handset.

Finally, in anticipation to a likely question from you, Nokia has begun volume production of their first product, incorporating our baseband and power management solution.

Wireless combo solutions continue to grow on both the dollar and as a percentage of total revenue basis. A few highlights include, all five of our announced wireless combo solutions are now shipping, which is a bit ahead of schedule. Second, we've extended our traditional strength in the notebook standalone wireless LAN market into the netbook space, with four of the top five leading netbook vendors now shipping our wireless LAN solutions. We are also shipping wireless LAN and Bluetooth combination cards solutions into the netbook space and expect to ship to all of the top five netbook vendors shortly.

Finally, our Bluetooth and wireless LAN connectivity solutions continue to find their way into consumer electronics, such as Blu-ray players and digital TVs. Many of these products are on store shelves today and we expect more this holiday season. Broadcom's ability to provide the video processing along with both wired and wireless connectivity provides us with a solid road map.

Looking forward, we'll soon be announcing the new family of Bluetooth headset products that will dramatically improve the user experience. These are the first Bluetooth headset products developed in 65-nanometer, providing twice the battery life as current headsets. Fully integrated active power management will allow headsets to charge their batteries five times as fast as what's available today, and will be first integrate ROM-based wind noise suppression.

That concludes our prepared comments. Now, we're ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

First question comes from Adam Benjamin from Jefferies & Co.

Adam Benjamin - Jefferies & Co

Scott, a little clarification on the netbook side of wireless LAN. You indicated four of five are now shipping wireless LAN. I'm assuming those are N, but if you can clarify that would be helpful. Then as it relates to the Bluetooth and Wi-Fi combo, do you expect to be shipping those soon. Can you just talk about your share, is it just one-off models, is it material within those OEMs? If you can give more color that, would be helpful.

Scott McGregor

The four of five I believe is a mix of both G and N. It's not exclusively N. Out of the five of five, those are material design wins in those customers. Those are not design wins in those customers.

Adam Benjamin - Jefferies & Co

Obviously, everyone's going to ask about the guidance. Can you just give a little color as to what you're thinking? Everyone's a little concerned about the constraints that the industry is seeing leading to stretching lead times and potentially some double ordering out there and eventual cancellations. What have you seen so far? Have you seen any cancellations and what are you thinking in terms of your flat guidance here?

Scott McGregor

We don't generally believe there's double ordering in our customers. There always might be a little bit here and there, but we don't believe it's significant, so that's certainly factored into our thinking here. I think Broadcom did better than many of our peers in terms of being able to supply in the second and third quarter, so we don't believe there is any aberration as a result in the order book from that.

Adam Benjamin - Jefferies & Co

As it relates to any specific product segment that you're seeing particular weakness in the sense of being down, some up, some down, or is it mostly all flat, if you can give a little more color, that would be great, too?

Scott McGregor

It's approximately flat for all three of our areas and our concern is that the economy is still not out of the woods yet, and it will be a little uncertain what's going to happen around Christmas with consumer demand. We're not economists, so we can't forecast this as well as maybe some of them can, but there's a little bit of concern about whether Santa's coming this year or not.

Adam Benjamin - Jefferies & Co

I just have one last question for Eric. Obviously, gross margin's been a big topic of conversation. You guys had a really strong quarter there. You have some tailwinds into next year, given the higher base that we're talking about finishing this quarter with, how should we be thinking about going into next year? Does that trend continue, I assume?

Eric Brandt

Adam, we said that we took the drop in gross margin very, very seriously. We've taken significant initiatives to improve the cost of the parts, to improve the overall purchasing prices, we're getting. I think we're seeing benefits both on the cost side, as well as on the mix side. Beyond that, as we roll into next year, I think you're going to see new lower costs, smaller die parts, which will improve the margin for us as we go forward.

I think the other thing to look at, to give you a sense again, similar to Q2 if you look at Q3 gross margin is up 220 basis points and while it may look as though it's principally driven by the mix shift, ENG, bear in mind that ENG grew about $70 million and mobile and wireless excluding licensing grew about $120 million and we were still able to post very good margin increase.

Operator

(Operator Instructions) The next question comes from Ross Seymore from Deutsche Bank.

Ross Seymore - Deutsche Bank

Just a question on that gross margin side of things. Eric, can you give us a little more clarity on the write down in E&O that you took in the quarter in gross margin, and should that go away in the fourth quarter? I think you said there was about a $10 million one-time charge in the third.

Eric Brandt

Ross, you may recall that when we went through this, we analyzed what happens with E&O and we said that it typically troughs or peaks as a charge about one quarter past the trough, and that we expected things would start to turn around. In fact, aside from the one item in DTV, which was about $10 million, it did. In fact, the impact of E&O this quarter, even with that $10 million, was only about 10 basis points. So we received actually quarter-on-quarter about a 60-basis point benefit just on E&O. I expect that now that we've sort of washed through those major items, we should see the pattern where E&O begins to drift down over time.

Ross Seymore - Deutsche Bank

So if you had some offsetting things in the third quarter then the $10 million goes away, wouldn't that mean the fourth quarter should be up by at least $10 million less COGS because of the E&O dropping?

Eric Brandt

No. E&O in this quarter, was actually a charge of about $1.8 million. So we actually had $10 million hit from DTV and about $8 million of release in the quarter from other places. So net, net, it's essentially flat with zero in the quarter. As you know, when we forecast, we tend to forecast with E&O being roughly neutral across the quarter. So to the extent there is additional E&O release, we should see some gross margin upside.

Ross Seymore - Deutsche Bank

Really quick on the OpEx side of things, can you just walk us through to the extent you can, how the OpEx should scale with either revenues, profitability or cash flow? I assume that it stays flat sequentially since you're guiding everything to be relatively flat in the fourth quarter, but if revenues end up growing, does OpEx have to pop up again?

Eric Brandt

No. Where we are is we've done our normal planning of the portfolio this summer. We are in the process of rebalancing resources. I think the DTV reduction that Scott mentioned is part of that, and we are putting resources on the highest ROI opportunities. So, as we look into next year, we are very focused on driving leverage through the P&L, which means growing profitability faster than revenue, and therefore, as we look at next year, the operating expenses should not grow at the rate of revenue. So we're trying to be very tight as we move forward into next year as well.

Operator

The next question comes from Craig Ellis from Caris & Company.

Craig Ellis - Caris & Company

Scott, you mentioned that you're getting some nice design wins with combo chips in netbooks, so it looks like you guys have done real well on handset products and netbook. Can you help us understand what some of the other applications are that you are targeted for your combo solutions?

Scott McGregor

Games is one area that we see as an opportunity. Certainly games are becoming far more connected, and so that makes it a richer environment for us, a richer opportunity for us. I think consumer electronics is a real area that we're going to see growth in. We're seeing things like wireless LAN and Bluetooth going into TV sets, Blu-ray players, set-top boxes and a lot of the portable handheld electronics devices as well, media players and whatnot. We believe that's an interesting opportunity. That's a good market for us because we're able to provide the video processing as well as the connectivity side and offer a combined chip in many cases, certainly a good story of how they work together.

Craig Ellis - Caris & Company

I know in the last quarter, combo chips were 10% of revenue. Can you help us understand how big they might be as we look out into the back half of 2010?

Scott McGregor

Well, we're certainly not going to update that number all the time, but combo chips have done very well. As we start to bring on new technologies, such as GPS, that significantly broadens the footprint for combo chips and we'll try to bring on other technologies there as well. So we think that's a pretty good opportunity.

Eric Brandt

The other thing I would add, Craig, the two largest selling chips, individual chips within the company are combo chips.

Craig Ellis - Caris & Company

Eric a follow-up for you, just away from combo, but thinking about the guidance, I just want to check on foundry availability. Is that an issue for you? Should we think about how you guide the company? Are there any constraints at 65-nanometer that you're seeing?

Eric Brandt

We've had some spot issues, which unfortunately are painful for our customers, but as a percentage of our total revenue, it's not a major influence in terms of our revenue looking into Q4.

Operator

The next question comes from Craig Berger from FBR capital.

Craig Berger - FBR Capital

As you look at your enterprise business, which was up so strongly in the third quarter, is some of that in anticipation of a fourth quarter budget flush and how should we be thinking about that business as we move into 2010?

Scott McGregor

We don't see it as a budget flush. Certainly the enterprise market was down severely in the first and second quarter. We believe Q2 was a trough. Q3 represents what we believe is a return towards a more normal ordering pattern, but again, we aren't guiding that business down in Q4. We think we'll certainly see that business sustaining into Q4.

Craig Berger - FBR Capital

Just as a follow-up, can you tell us what you're seeing in the set top box market, cable and satellite, kind of what typical trends would be as we move into the first quarter? What seasonality is for Q1 in that business?

Scott McGregor

It's a little hard to predict the seasonality right now, given the uncertainty around the capital cycle that typically drives that market and the availability of capital will certainly determine how aggressively a lot of the MSOs and carriers push the products there. We are seeing a lot of promotion right now from the various groups. We're seeing significant technology upgrades, analog reclaim in the cable space, a lot of marketing for additional HD channels and so forth, and marketing promotions in the satellite space. Then the emergence of the IP space, IP set top boxes as sort of a new segment for us. So there's a lot of activity going on there and we believe over the course of next year, those are all very positive trends for the business.

Craig Berger - FBR Capital

Last one, are there any pockets of excess finished good inventory out there, do you think there's excess PC inventory out there ahead of Windows 7 launch or any other pockets?

Scott McGregor

Certainly there are probably pockets. We try to talk with our customers to understand it, but we don't see significant inventory in the channel, and as Eric mentioned, our turns were 8 turns in the quarter. So, we certainly don't have any kind of inventory situation at Broadcom. We're in great shape on inventory point of view. So, I think it's pretty clean, which gives me a little hope that we're not looking to see any kind of sell-off or stuff like that. We could be surprised, but frankly we're not seeing it when we talk to customers.

Operator

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

Tristan Gerra - Robert Baird

Any particular product area where your products have been most depleted from an inventory standpoint and when do you expect internal inventories to return to more normal levels?

Eric Brandt

Tristan our inventory is at more normal levels. Normally, we target our inventory at 7 to 8 turns. We're at 8 currently, which may be a little bit higher than we would like. So our internal inventory is in pretty good shape. Do we, as Scott mentioned, have some spot places where we're tight? Yes, we do. I do think part of the benefit we had in Q3 certainly was the fact that we had really strong work from our operations team in meeting the demand of our customers. So I think we're managing this pretty well and I think relationships on the partners we have are being very helpful for us to do that.

Tristan Gerra - Robert Baird

What was the percentage of your mix at 65-nanometer?

Scott McGregor

It's approaching 40% of revenue.

Operator

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

James Schneider - Goldman Sachs

Maybe just a follow-up on the OpEx question, I know half of the $20 million increase for Q4 is due to legal, as you said, but can you give us some kind of idea about the kind of puts and takes, the reduction in the DTV business and any incremental customer support needs to support the baseband business going forward? How should we think about OpEx on a run rate basis ex-legal costs going forward?

Eric Brandt

The other of the remaining roughly half, half of that is tapeouts, and as you probably know, relative to the guidance we gave, again, excluding the bonus accrual issue, we were below the guidance we gave. The tapeout number is probably below the guidance we gave, so it tends to snow bowl over into the next quarter. So we have a significant number of tapeouts planned for Q4 and naturally also organizationally, people have objectives to get a number of tapeouts out by the end of the year, so we're hopeful that we get those out and I think that's good news.

Of the remainder, which was mostly employee-based costs, some of that related to people we added in Q3, principally in the area of wireless connectivity to respond to increased demand and very high ROI opportunities for combo chips. So there's a rollover effect of that. I think in terms of the DTV, you'll get a piece of the benefit in Q4 and a piece of the benefit in Q1, but that's sort of the best color I can provide, unless, Jim, you have a different or more specific question related to those two pieces.

James Schneider - Goldman Sachs

Do we expect it to come down? With less bonus accruals or anything like that, I mean is there anything, besides legal that would cause that to come down more materially?

Eric Brandt

What happens is, the way the bonus accrual works is when you step up like this, you have to catch up from the first half of the year. So the $16 million, it's really $17 million, $1 million is actually in cost of goods. Of that money, that catch up is split evenly between Q3 and Q4. So there's no step up. It's dead flat across the two quarters. To the extent that our performance isn't as good as the industry in Q4, because we measure ourselves on a relative basis, it might even come down, but it's dead flat on a bonus perspective Q3 to Q4.

In terms of Q1, there are a whole bunch of puts and takes in Q1. The accrual would go back to 100%, so it would come down off of that stepped up rate. We have our annual merit increase, which will probably happen in Q1. We have this strange downward slope in fringe costs. We'll get the benefit of the DTV piece. So I am not trying to defer. There are just so many moving pieces right now that we'll try to talk more about it on Analyst Day and certainly as we provide guidance going into Q1 at the end of Q4.

James Schneider - Goldman Sachs

Then if I could just ask one question on the enterprise networking business, you mentioned the strength in China and across a number of areas. Is that strength mostly confined to China, to what extent do you see strength in the US customers as well?

Scott McGregor

It started out last quarter as a strength in China, but it's really broadened to more worldwide. We see enterprise customers using it for virtualization and beginning to spend more and that was something we're definitely looking at. We're seeing port count going up, just in general there, so we believe it's more of a flow across the whole market and not just China driving it, although China is still a significant influence on that as they look to put backhaul in for a variety of broadband and 3G backhaul.

Eric Brandt

And Jim another data point to help you out there a little bit, as you take a look at our enterprise networking business, really looking at switching, about half of our switching revenue does come from the service provider space and the datacenters.

Operator

The next question comes from David Wu from GC Research.

David Wu - GC Research

What is the rough backlog coverage at this point on your guidance for Q4?

Eric Brandt

If you're asking whether we're expecting a significant amount of turns, we generally don't. We enter the quarter pretty much with what we expect to do in the quarter, so that's pretty much where we are this time. We haven't changed our assessment of where we are. I do think we still remain cautious and partially because we all forget what happened last Q4 in terms of the holiday season. So rather than perhaps be a little bit more aggressive, perhaps some other people are doing, we're remaining cautious until we see how the consumer sell-through goes and how the (inaudible) quarter goes in terms of what customers are doing. We think that with Analyst Day on December 15, we'll be able to give you a much better picture after the Thanksgiving holiday and most of the Christmas shopping has sort of rolled through.

David Wu - GC Research

I was just wondering whether there were any comments from many speculative customers that will make you be more nervous about, hopefully not a repeat of last year, but that they really have little or no visibility of how their business will be through Q4, which leads to some (inaudible) guidance at this point about Q4 revenues?

Eric Brandt

I think we're not hearing anything in particular. I think we just have general macroeconomic concerns that don't give us the confidence to forecast that we're going to power through Q4 and into Q1. So I think we're being a little cautious there.

David Wu - GC Research

Any cutbacks from the wireless customers and there is some talk about one of your customers, or one big customer out there cutting back on their wireless chipset for the phones business.

Scott McGregor

I think you hear that every so often around a particular customer and sometimes it tends to wrap around their fiscal year end as they manage the balance sheet. Whether that's real in terms of their overall belief of where demand is, it's very hard to say. Again, I think that we've given what we think is a reasonable view of the market and until we can sort of see how the Thanksgiving holiday comes through, which with the order patterns we'll remain somewhat cautious in terms of what we provide in terms of guidance.

Operator

The next question comes from John Pitzer from Credit Suisse. Please go ahead.

John Pitzer - Credit Suisse

I hate to ask it again, but I think I understand your concern over the macro and how that's helping to color the Q4 guidance. I guess relative to the commentary that everything is looking sort of flattish, is that just as well being colored by the macro, or can you help me get some understanding from bottoms-up perspective, whether you are more concerned about consumer, more concerned about corporate relative to that flat guidance?

Scott McGregor

We certainly do a bottoms-up analysis looking into our quarter. We also try and take into account what we think is going to happen in subsequent quarters and do the best we can at looking at our customers' customers as well, and so we do a composite of that and we try and also take a finger in the wind sense of what's the economy doing and that's how we create our guidance. So on that basis, we feel that the right way to call it is approximately flat going from Q3 to Q4 and approximately the same across all our businesses, no meaningful variation between one versus the other.

John Pitzer - Credit Suisse

My only other question is, and I know you're not going give me absolute numbers and I'm not looking for them, but can you help me understand, when you look at the gross margin of the collective silicon you guys are selling into the cellular market today, how much room for improvement do you have over a longer period of time, whether that's through cost downs, increasing integration, or just share gains, as that market suppliers becomes more rational, and is that sort of the biggest opportunity to get gross margins up for the overall corporate?

Eric Brandt

Again, just if you look at the quarter with 220 basis points of improvement, and obviously, as I mentioned, some 60 basis points, 65 basis points of that relates to an E&O amount. Our mobile and wireless sector was up $120 million excluding licensing. That's up the most in terms of dollar amounts than any other segment in the company and the gross margins actually increased in the face of that. So that's number one.

Number two, we are actually very excited about a variety of cost downs second and third and even fourth generation chips in the wireless connectivity and combo space area, which we think will help margins. We also think that there are cost down opportunities in the mobile space, as well as, as the mobile business begins to ramp further, there are overhead absorption opportunities. So we do believe that there are opportunities to increase the business area gross margin over time as we ramp across next year.

Scott McGregor

Also in terms of the amount of silicon that we're going to likely sell into the handsets, I think that's going to go up dramatically. Let me give you a couple of examples. We're still seeing Bluetooth continue to increase its penetration, but I think the two things that are going to really drive this forward are GPS and wireless LAN, just really making great strides, double-digit increases in penetration into the cellular phone space.

We believe we can get a significant piece of that market. Then of course, our multimedia processors, cellular basebands, power management, and so forth, are doing quite well. Just to give you a little bit of a sense there and Eric mentioned earlier what our top two selling products were, they were combo chips, our third top selling product in Q3 was a cellular baseband chip. So just to give you a sense that we see dramatic pickup in that market and that has some (inaudible) to it.

Operator

The next question comes from Mahesh Sanganeria from RBC Capital.

Mahesh Sanganeria - RBC Capital

Question on the switching side. Have you thought of getting revenues from Metro Ethernet switches on carrier, and is the competition finally ASIC type in that market and how will that market shape going forward? Can you give us more color on that one?

Scott McGregor

Do have revenue from the Metro space from our earlier acquisition. It's not a huge percentage of our business, but we do see that definitely growing. We also have some ASIC business in that space as well. We work with some of the larger carriers in that space and we do have a bit of ASIC business. Generally Broadcom doesn't have a lot of ASIC business, but we do have some in that space.

Mahesh Sanganeria - RBC Capital

Can you give us some idea of what kind of size that market will become in next two or three years?

Scott McGregor

No, I don't have numbers to quantify that for you. Sorry.

Mahesh Sanganeria - RBC Capital

A quick one for Eric. When does your raise become effective, and is it fair to assume a 5% kind of average raise?

Eric Brandt

If I tell you, then I've told the entire company, but I would just say normally it was Q2. I think this year since we didn't do a raise in 2009, we'll consider doing it in Q1. So, I would assume roughly halfway through Q1 and then historically it's run about twelveish million dollars a quarter when it's fully loaded and in. So six, seven, eight probably for Q1, starting point, till I have some more information and we finalize our budget.

Operator

The next question comes from Srini Pajjuri from CLSA.

Srini Pajjuri - CLSA

Scott, historically your wireless business had a nice Q4 and you are still ramping lot of new products. I'm somewhat surprised by the fact that you're guiding for flattish in that business. So my question is, looking at the combo chips and the baseband are there any other segments within the wireless that are offsetting the growth in new product ramps, or is it generally flat across the board?

Scott McGregor

Srini, no there aren't any things that are offsetting there, or causing it to go down. I mean I can give you maybe something that would be helpful is that we are not forecasting share loss going into Q4, so if that's helpful to you in terms of how we see that.

Srini Pajjuri - CLSA

On the baseband business, you mentioned that you're starting to ramp Nokia. In general, at a high level, how should we think about this business as we enter 2010 and in terms of the trajectory and the growth prospects?

Scott McGregor

We believe it will be a major growth driver for Broadcom next year. We have growth in the two customers that we've talked about and potential for growth in other customers. So we do believe that's one of the major revenue drivers for us next year.

Peter Andrew

Srini to kind of give you a starting point, if you look last quarter, our cellular revenue was approaching $100 million. That should give you a starting point.

Srini Pajjuri - CLSA

Is that a quarterly number, Peter?

Scott McGregor

Yes, that is correct.

Srini Pajjuri - CLSA

One final question for Eric. Eric, you said you're not including the D&O benefit in OpEx guidance. Do you have I mean some idea as to when that might actually hit you in terms of when you might see the benefit, and also, how long that might last?

Eric Brandt

Well, it's a one-time recovery of D&O and it was in an 8-K, with $118 million less money we received, less the money out for the plaintiffs attorney, so net to us it should be about $60 million to $63 million. The court is expected to hear that on December 14, and given the vagaries of the end of the year and verdict in the court, we didn't count that. If that happens, we would go from an up 20 to a down 40 number for Q4.

Srini Pajjuri - CLSA

It's going to be one-quarter impact whenever that happens?

Eric Brandt

Right. It would just be a one quarter effect.

Operator

The next question comes from Mark Lipacis from Morgan Stanley.

Mark Lipacis - Morgan Stanley

Eric, how should we model options expense going forward?

Eric Brandt

It's coming down. I think if you look at what we granted this year, it's about half of what we granted in 2007, and so as you plug it into whatever consensus number you have for next year, you can see that this number is moving down from the 12% to 14%, and we just take the number we granted, and plugged it in as a full number for next year, you would be in the vicinity of 6%. So we are moving very quickly down to that 4% number. However, we do have the legacy costs, which will come off over time.

I think depending on the timing of the grant and the price of the stock at the time we grant it, Peter has said sort of fiftyish million dollars, it might be $30 million to $50 million next year down. We'll have a better picture of that again on Analyst Day and I'll update you at that point.

Mark Lipacis - Morgan Stanley

On the baseband business, two questions here. Are you ramping one customer in volume, or is it two customers in volume? Then the second question is what's the risk that you start ramping somebody and then all of a sudden they say, "Okay, we don't like the product and we're going to stop doing this?" Could you help us understand that risk?

Scott McGregor

Sure. We're in quite high volume with Samsung at this point in both in 2G and 3G. We've begun to ramp at Nokia, so just to make that more clear. Most of our revenue at this point is from Samsung. In terms of can they get into the product and decide they don't like it? Sure. That's always the prerogative of a customer, although we've invested many years together of R&D on this. So, I don't think there's anything surprising to our customers about what our product is and what it does. So, I would think that's unlikely.

Operator

The next question comes from Uche Orji from UBS.

Uche Orji - UBS

When you describe your cellular business, you were talking about being in smart feature phones, should I understand those to be kind of lower end and if so, does that have margin implications and what would it take to be more in the higher end of this smart phone business? I have a follow-on on that.

Scott McGregor

When we say smart feature phones, we're referring to probably the high end of the EDGE market, the highest end of the EDGE market, so that would be an EDGE phone that had, for example, a touch screen, applications capability, push email, things like that. The Samsung Star is probably a good example of one of those phones to a low end 3G model, which would, a low end smartphone, a 3G model. So it would have, again, many of those same features. It's not quite as high end as the top end of the smartphone market, but it's certainly not a low end phone.

Uche Orji - UBS

In terms of getting to the high end market, just one question, you've kind of said you are not interested in selling branded application processes and is that a constraint in getting to the high end of the market, and if so, is there any reconsideration of that strategy?

Scott McGregor

That might keep us from getting in the top 1% of the market, but I don't think that's in any way constraining what we're doing right now. In fact, if you look at our products, we bundle in right now to our basebands, they have a coprocessor. There are two processors in them. They have one arm processor that supports the baseband and they have another arm processor that's totally dedicated towards applications. So what that has done is, it has made Broadcom the most cost effective solution for these low end smartphones, high end feature phones, if you will, where you want pretty good overall capability, and good battery life, and good cost capabilities, but you just don't need that super-high end, multi-gigahertz processor, which again is a verified part of the market, so we believe we've hit the sweet spot of the market there.

Uche Orji - UBS

Just a different question on connectivity, lot of your competitors, TI as it was reported earlier and they made comments about gaining share. I'm not sure how and who is losing in this market. Everybody seems to be doing quite well. Do you have a sense as to where your market share might be\and any comments as to what the comments made by your competitors will imply for you?

Scott McGregor

Well, we certainly do a lot of analysis when we see competitor's report and we look at that. I think we've been generally gaining share over the course of this year. It's possible we might have lost a little share in Q3, but I don't see us losing share going forward. I think I mentioned in my earlier remarks, quite a few design wins at some of those customers who are gaining share. So it's little puzzling to me how everybody gain share, as you pointed out. So we'll just have to wait and see what people's results are. I would be a little cautious about using people's guidance to go figure out who is gaining share. I think you should use people's results to figure out who is gaining share.

Operator

The next question comes from Sumit Dhanda from Banc of America. Please go ahead.

Sumit Dhanda - Banc of America

Eric, couple of questions. First, on the tapeouts, you talked about a little bit of an increase on costs associated with that. Anything you could guide us to in terms of what the trajectory of that metric would look like heading into next year?

Eric Brandt

It tends to be lumpy. I think as we go into next year and we see more 40-nanometer tapeouts, we could see the tapeout costs drift up a little bit into next year, but it moves up and down. This quarter is probably about our record quarter I think in tapeouts, or just about. So it could come down a little bit, but again, remember, the mix is going to start shifting. Not on every product, because we're not doing this across the board, but we're starting to shift to a new process geometry, which does cost a little bit more on the tapeout side. In fact, we had a number of 40-nanometers tapeouts, almost 10% of our tapeouts in Q3 were 40-nanometers.

Sumit Dhanda - Banc of America

Then on the legal expenses, any sense or whether you have visibility that this should peak in Q1, or do you think this could drift out to Q2?

Eric Brandt

The other trial begins in Q1. My suspicion is it will be pretty high in Q1. If it ends in Q1, it could come down a little bit I think in Q2, but you have a pretty good picture of what that number is. It should drift down across next year as the large trials come to an end.

Sumit Dhanda - Banc of America

Just a clarification, will it drift down or will it be a step down? I would imagine it would be more of a step down with the trial.

Eric Brandt

It will be more of a step down.

Sumit Dhanda - Banc of America

And then into Q1, do we see a major acceleration in this metric, or do you think are on the same trajectory?

Eric Brandt

I wish we knew. I mean it's very hard to get forecasts from former employees' attorneys. We just don't know.

Operator

The next question comes from Stacy Rasgon from Sanford Bernstein.

Stacy Rasgon - Sanford Bernstein

Just wanted to revisit the gross margins again. I know they were still up in the quarter, where wireless was still up very strong and I think that maybe points to the strength of some of the enterprise. I'm still just trying to reconcile that it would be a long-term margin consequence as based on does become bigger and bigger portion of your mix. I wondered if you could give me a little color on what I should be looking for, for gross margins in the long-term is based on it becomes a bigger and bigger portion?

Eric Brandt

As we've said before, we have not changed our long-term view of gross margins. We certainly went through a difficult patch in 2009 and I think we have responded aggressively. If you look just at sort of Q3 to Q4, for instance, on the old non-GAAP metric, we're 49.4. If you plug into the top end of our guidance, we're 49.9. So we're already within spitting distance of being back within our targeted non-GAAP range. That's with a continual growing of our wireless business. To be a little more direct would be to say I think people's presumptions of what our margins in our wireless business are far worse. I wouldn't say far worse, they are worse than what they really are. We do have a good wireless business. We have a road map for cost reduction and gross margin expansion that we're excited about, and we feel good that even rolling into Q4 that if we have a little bit of tail wind in E&O, we could be back in our targeted range.

Stacy Rasgon - Sanford Bernstein

One quick question on the OpEx. So the $16 million this quarter, which was not forecast, I just want to get a little bit of color on why it was not forecast and what that actually means in terms of relative revenue growth and cash flow. Is that just relative to the market? How do you define that and what does that sort of imply for, either forecast or not forecast further OpEx expenses going forward into the new year depending on what the market does?

Scott McGregor

So as we rolled through Q2, we had an estimate of where we thought we were going to be, where we thought the market was going to be and that triggered a formulaic accrual. Now, the way the accrual works, and there's an 8-K on this is, we take a market estimate, there are three elements to the bonus pool, there is a relative revenue growth, so we measure ourselves on whether we're gaining market share in aggregate, and that means by simply growing faster than the market. We had a cash flow target for the company going into this year. Recall that everybody thought the world was coming to an end and the key was to make sure that in a real heavily recessioned market that cash flow was positive in the company and we had committed to running at least $75 million a quarter and that would have been about $300 million for the year. As you can see, we're already over $650 million for the first half of the year. Now, that scale does slide if the industry growth rate recovered significantly, but it hasn't recovered significantly relative to what the estimates were.

Then the last part, the smallest part relates to just discretionary, whether we are making progress strategically as a company and winning these kinds of design wins and product opportunities that we can. So coming out of Q2, we had a view. Q3 turned out to be much stronger than we thought. As we started to increase our estimates for Q3 and Q4 commensurately, sort of almost in lock step, our growth rate improved meaningfully. So if you look at the numbers, and I apologize for the long answer, I mean just take the guidance we've given on a product basis. The company would be down 6.5%, 5.5% with licensing, and if you look at the industry estimates, Gartner's down 17, In-Stat down 19, WSTS down 20, 21. JPMorgan down 13. Deutsche Bank down 17. I suspect they will get better, but the forecast for the industry as they stand today, which is what we use in terms of estimating our relative revenue growth, and we do adjust for the markets we're in, versus the rest of the industry. We are, we are doing the industry is declining two or more times faster than us, which means we are gaining market share. So as we plug that in, we have a catch up effect for Q1 and Q2, which we didn't see at the time, which is what causes that $16 million hit in Q3, which really winds up being, by the way $16 million in Q3 and $16 million in Q4. So it's really a $34 million OpEx in the second half of the year that was unforecasted in the first half of the year.

Stacy Rasgon - Sanford Bernstein

That's very clear. I appreciate it. That total $34 million is that like a one-time bonus and then you'd have to get more going forward, or does that sustained?

Eric Brandt

No, it's a one-time pickup off of the ongoing number. So there was an ongoing number that was in the bonus pool and the catch-up effect for the year is $34 million and then the bonus pool would revert back to its original numbers for next year, assuming that bonus pool looks about the same.

Operator

The next question comes from Quinn Bolton from Needham and Company.

Quinn Bolton - Needham and Company

Scott, now that you've shown pretty good success in the cellular business, reaching almost $100 million just in the third quarter, can you talk about your plans to begin to expand your reach in terms of customers and reach out to new customers? And to the extent you do that, given the amount of time and money you've invested to-date in cellular, can you ramp a third, a fourth, a fifth customer faster than the first two or will it still take a couple of years to engage with new customers?

Scott McGregor

Those are good questions, and it certainly depends on what kinds of customers, whether they are more ODM in nature or which geography they are. We find that customers in the cellular space some take two years from when you start an engagement to when they ship products. Some take three months. So it really varies a little bit. I would say in general so far, we've been with the customers that take among the longer periods of time, but I'm not going to get more specific than that. I think we're sort of a little shy about forecasting new customers and growth in the cellular space. We'll guide that quarter-to-quarter, but we do expect to, again, grow significantly next year. It's one of the major revenue drivers for the company year-to-year.

Quinn Bolton - Needham and Company

Then just a follow-up for Eric. Can you give us a rough sense of how large the E&O reserve is now and how that compares to a more normal level? Just trying to get a sense of how much benefit you could be taking through the income statement as you get back to more normal levels for E&O reserves?

Eric Brandt

Between E&O and what's called purchase quarter reserve, PO reserves, we are in the $80 million range. It's hard to tell you what it is. As the revenue number grows for the company in terms of we manage our inventory, but that's 80 on an inventory level of 300. So you can see we are over 20% and typically this number has run 10%, 11%, 12%, 13%, 14%. So there is some room for this number to come down.

Scott McGregor

Hearing no other questions. In closing, I would like to leave everyone with a few thoughts. Broadcom had a very strong Q3. We've grown faster than the industry. We've improved our operating leverage, and we're looking forward to additional margin leverage in Q4. Finally, one last reminder, we'll be hosting our 2009 Analyst Day event in Santa Clara on December 15. If you need any additional details on this event, please give Peter a call. With that, thanks, and have a good day.

Operator

Thank you for participating in Broadcom's third quarter 2009 earnings conference call. This concludes the conference for today. You may all disconnect at this time.

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