Emulex Corporation F1Q10 (Qtr End 09/27/09) Earnings Call Transcript

Oct.23.09 | About: Emulex Corporation (ELX)

Emulex Corporation (NYSE:ELX)

F1Q10 (Qtr End 09/27/09) Earnings Call Transcript

October 22, 2009 5:00 pm ET

Executives

Jim McCluney – President and CEO

Mike Rockenbach – EVP and CFO

Jeff Benck – EVP and COO

Analysts

Glenn Hanus – Needham & Co.

Hemant Hebbar – Wedbush Securities

Jason Noland – Robert W. Baird

Rajesh Ghai – ThinkEquity

Min Park – Goldman Sachs

Munjal Shah – Jefferies & Company

Paul Mansky – Canaccord Adams

Operator

Good day and welcome to this Emulex Corporation first quarter fiscal year 2010 conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the President and Chief Executive Officer, Mr. Jim McCluney. Please go ahead, sir.

Jim McCluney

Thank you, operator. Good afternoon everybody and welcome to Emulex’s first quarter fiscal year 2010 conference call. I’m Jim McCluney, President and CEO of the company, and with me today are Jeff Benck, our COO; Mike Rockenbach, our CFO; and Steve Daheb, our Chief Marketing Officer and SVP of Business Development.

Mike will start off with prepared remarks for the first quarter 2010 results, I will follow with my comments on the quarter and a discussion of our markets, and Jeff will talk about our progress on the company’s operating goals. I will conclude our prepared remarks with some summary points and then we will open the line for questions. Over to you Mike.

Mike Rockenbach

Thanks Jim. By now, you should have Emulex’s first quarter 2010 earnings release, which we issued earlier this afternoon. If you do not have a copy, the press release is available in the Investor Relations section of our website at www.emulex.com.

The press release in this presentation contains forward-looking statements including but without limitation statements regarding Emulex’s business, operations and anticipated financial results for the second quarter of fiscal 2010 and beyond.

These statements are subject to risks and uncertainties and our actual results may differ materially from those discussed in the forward-looking statements. Those risk and

uncertainties include economic conditions, market growth, IT spending patterns, changes in technology, evolving industry standards, competitive pressures, pricing pressures and fluctuations in OEM ordering patterns, the estimated total available market size, the ability to address these markets with available technology in a timely fashion, research and development activities, the inability to achieve the expected benefits from our globalization initiatives, and the risk and uncertainties described in Emulex’s SEC reports filed under the Securities Exchange Act of 1934, including Forms 8-K and under the heading Risk Factors in Emulex’s most recently Annual Report on Form 10-K and quarterly reports on Form 10-Q.

We undertake no obligation to update the forward-looking statements. Investors should also be aware that Emulex will not disclose in its Q&A or in conversations afterwards any material data that was not already disclosed in its conference call or its press release.

During the call, when we use any historical non-GAAP financial measure as defined by the SEC and Reg G, you will find a reconciliation to the most directly comparable GAAP financial measure in our press release available on the Investor Relations website. All of the references we will make today will relate to our non-GAAP results unless stated otherwise.

Today’s conference call is being webcast and a recording will be available on the Emulex website through October 2010. I would also like to remind participant that if you decide to ask a question, it will be included in both our live transmission, as well as any future use of the recording.

Now let me review our results for the quarter. Sales for the first quarter ended September 2007 – ended September 27, 2009 totaled $86 million, a sequential increase of 8% and a decrease of 23% from the prior year’s quarter. Revenue exceeded at the high end of our guidance of $78 million to $82 million provided in August.

Fully diluted earnings per share for Q1 totaled $0.08, exceeding the high end of our guidance of $0.03 to $0.06 for the quarter. EPS was down 11% from the $0.09 reported in Q4 and decreased 64% from the $0.22 reported in the first quarter of the prior year.

Taking a look at revenues by product line, I’ll begin with host server products or HSP, which consists primarily of Fibre Channel Host Bus Adapters or HBAs, 10-gigabit Ethernet converged network adapters or UCNAs, mezzanine cards for blade servers and ASICs used in server applications.

HSP revenues totaled $64 million, an increase of 2% sequentially and a decline of 21% from the first quarter of last year. Revenues for host server – for HSP board level products including standalone HBAs, CNAs and mezz cards increased 4% sequentially, but were down 21% compared to a year ago. The average selling price for board level products decreased 2% from the fourth quarter and a modest 6% from the first quarter of last year.

Dual channel revenues increased 14% on a sequential basis and increased to 64% of our HSP forward-level product revenues. Mezzanine card revenues increased 39% sequentially and grew 28% year-over-year. Our CNA products exceeded our goal of doubling sequentially hosting growth of over a 160% than the fourth quarter. Finally, HSP ASIC revenues increased 3% sequentially but were down 20% year-over-year.

Our second product line, Embedded Storage Products or ESP, encompasses SATA bridges and routers, fibre channel embedded SOCs and root switches, as well as single and multi-protocol embedded controller products for enterprise class storage systems. ESP revenues for the first quarter totaled $21 million, representing an increase of 30% sequentially but a decrease of 30% from the prior year’s period.

While some of this maybe replenishment of artificially low inventory levels, based on backlog and our customer forecast for December, we are becoming increasingly confident that we have formed a new base to build from in this business.

The geographical and customer breakdown for our revenues is available in the supplemental information in our press release.

As we further discuss the income statement, I would like to remind you that we will be primarily discussing our non-GAAP results unless otherwise noted. You will find in our press release, a reconciliation of the difference between our GAAP and non-GAAP earnings, as well as a discussion of why we believe the non-GAAP financials are a relevant measure of our business for investors.

First quarter gross margins of 67% exceeded our guidance of 66%. Gross margins were down from the 68% reported in Q4, but were flat with the prior year. As we discussed in our August conference, margins in the June quarter benefited from a program to reduce our ongoing warranty expense. We anticipate gross margins for the second quarter will again be strong coming in flat with Q1.

Looking at operating expenses; during the first quarter OpEx decreased to $48 million, compared to $45 million in the fourth quarter. However as a percent of revenue coming in at 57%, expenses increased less than 0.5% sequentially. Compared to a year-ago, first quarter operating expenses decreased by over $1 million representing a 3% reduction in quarterly expenses.

Operating expenses is one area where we continue to make difficult trade-offs in order to balance both our short-term and our long-term goals of increasing shareholder value. The increase in expenses during the first quarter were primarily due to the reintroduction of some employee benefits that we believe are critical to attract and retain the high-quality talent we need to be successful.

We also made meaningful investments in technology and go-to-market capabilities when our OEMs didn’t deliver and launch new products. We continue to drive an OEM business model which ultimately has a significant amount of operating leverages revenue grow.

In order to gain market share in our core business and leave the market and have a convergence is essential that we have the right team and the right motivators for that team to execute on our design wins. These design wins are the foundation for future revenue growth and ultimately increasing shareholder value.

We remain committed to controlling our expenses and making sure that for every dollar we spend, there are several dollars coming back in return. Consistent with this goal, we exited the quarter with 772 employees compared to 768 employees at the end of Q4.

Q1 operating income of $9 million was down 7% sequentially, coming in at 10% of revenues compared to 12% in the fourth quarter. Other income increased sequentially coming in at $347,000 primarily due to exchange gains offsetting lower interest income. We anticipate a similar level of other income in Q2.

First quarter net income was $7 million, down 9% sequentially and down 52% from the prior year results. Our tax rate for the quarter was 24%, however we are still modeling for a full-year rate of approximately 22%.

Our net profit margin for the quarter was 8%, which was down from 10% in the prior quarter, and also down from the 16% reported in the first quarter of last year. For the first quarter on a GAAP basis, we reported an operating loss of $6 million and net income of $4 million or $0.05 per share. As a reminder, a detailed reconciliation between GAAP and non-GAAP income is included in our earnings release.

On a GAAP basis, Q1 R&D expenditures increased 3% sequentially to $31 million. Quarterly R&D spending will vary depending on the timing of new product development expenses and Q1 R&D also included $2 million of stock-based compensation.

First quarter GAAP sales and marketing expenses increased 9% sequentially to $13 million compared to $12 million in the fourth quarter. Q1 sales and marketing expenses included approximately $500,000 of stock-based compensation.

Sequentially, GAAP G&A expenses decreased 21% to $12 million compared to $16 million in the fourth quarter, primarily due to lower expenses associated with Broadcom’s unsolicited takeover proposal.

For those of you who they are following us for a while, you may recall that we are preparing to expand our Costa Mesa headquarters with a construction of a fourth building. With the breadth of the economic slowdown over the past year, we have shelved those plans for this expansion indefinitely, which resulted in charge of approximately $1 million in G&A during the first quarter. Additionally, first quarter G&A expenses included $2 million of stock-based compensation.

Looking forward to the December quarter, we expect to see the stock-based compensation charges fairly comparable to the results from the September quarter. And our controllable expenses, the charges associated with the building is now behind us and we do not anticipate an increase from the spending levels we saw in this area during the September quarter.

Turning to the balance sheet; we exited the first quarter with total cash and investments of $271 million, which was a decrease of approximately $30 million for the quarter. As we discussed on our August call, we used $80 million during the quarter to repurchase 2 million shares of our common stock at an average price of $9.12 per share. We did not make any additional purchases of common stock in the quarter.

In early July, we used $20 million in cash as part of an IP licensing agreement in support of some of our future products. This increased our intangible assets during the quarter and will be amortized as part of our GAAP expenses going forward.

First quarter inventory levels remained flat at $11 million and our receivables also remained unchanged at $52 million. For the first quarter, depreciation was flat with Q4 at $5 million and capital expenditures were down from the prior quarter coming in at $1 million.

Before I discuss our targets for the second quarter of fiscal 2010, I want to again remind everyone that there are numerous risks that can affect our future performance causing actual results to differ materially from forward-looking statements. These risks are noted in our public filings with the SEC and the Safe Harbor statement at the end of our earnings release. As a result of these risks and uncertainties, we are unable to predict with accuracy what future quarter results might be, and there is no guarantee that business will reach our expectations or goals.

While we don’t give specific guidance by product line, I want to provide a little color on trends we are seeing in the business. Based on the very strong September results and September for ESP, we are expecting sequential growth but at a much more modest level in the December quarter.

For HSP, the second quarter has historically been the strongest quarter for sequential growth in our board level products. Based on increases in our customer forecasts and the recent server refresh cycle, we are expecting solid revenue growth in HSP during the December quarter.

Based on these factors, we believe that revenue for the second quarter ending December 27, 2009 could amount to approximately $88 million to $92 million or an increase of 3% to 8% over our first quarter results. As I mentioned earlier, we have an earlier model that delivers significant operating leverage as revenues increase.

If we can achieve revenue growth in the range, hold our gross margins flat and operating expenses are flat-to-down from the first quarter levels, we anticipate non-GAAP earnings per diluted share of $0.10 to $0.12 or a sequential increase of 25% to 50% assuming a comparable tax rate at approximately 82 million shares outstanding.

Now, let me turn the call over to Jim, who will give you more color on the quarter and an update on the company’s strategy.

Jim McCluney

Thanks, Mike. The Q1 results had a great start to our fiscal 2010. But before I can enter a discussion on the state of the business, I would like to provide a few comments on the recent litigation brought by Broadcom, alleging patent infringement by Emulex.

Given the pending litigation, I can’t go into too much detail, but there are a few points of clarifications I would like to make. First, we have done a preliminary assessment of the patents and Broadcom’s complaint and based on the allegations; it appears that none of these patents are specifically being accepted against their core light pulse fibre channel architecture which is used in our HVAs and mezzanine cards. Also, none of these patents appear to be specific to SUV.

Based on our results for the first quarter, we believe that the products we have specifically identified as allegedly infringing and their complaint amounted to less than 7% of our net revenues over the last year. Additionally, based on Broadcom’s specific allegations, more than half of the patents appeared to only be (inaudible) against one of our in-speed products in the embedded business. This particular product has been shipping for more than five years and represents the vast majority of the 7% I referred to.

Let me close in this topic by reiterating the comment from our press release that we will vigorously defend against these allegations concerning our IP and our products.

Now let me talk about our current business, we had a terrific quarter on a number of runs, a stronger than expected recovery in our embedded products complemented a solid summer quarter in HSP, we reported 67% gross margins as operating efficiencies offset a larger contribution from more margin ESP products, which grew 30% sequentially.

Our operating expenses were essentially flat as a percent of revenue, and we exceeding the high end of our revenue gross margin and EPS guidance. Finally, we are providing revenue and EPS guidance for the December quarter that’s considerably higher than current consensus estimates.

As Mike discussed earlier, ESP showed significantly better than expected sequential growth. New product launches from similar other key embedded customers combined with some new design wins are giving us confidence that we will be able to return to sustainable growth in this product line.

Once again, focused execution across the organization during the quarter was the key to delivering earnings of $0.08 per diluted share, which exceeded the high end of our guidance.

Now, let me talk about the current IT spending environment going into for what has historically been our strongest quarter for sequential growth. Not only are we seeing signs of a recovery in our business, but more third-party data is pointing to increasing confidence and IT budgets are returning to growing albeit still quite modest.

A recent BofA CIO survey of 200 IT hardware buyers across multiple geographies and industry indicated that 72% expect that IT spending in the second half of 2009 to increase over the first half of the year. Looking forward, we anticipate their budgets to show further growth in 2010.

Both of these metrics were up from the some survey in June leading the survey to conclude that the trend in IT spending sentiment has clearly moved off the bottom and is showing signs of growth. This same survey asked respondents to rank their top seven IT hardware investment prodigies and topping the list were security enhancements, server consolidation, and server virtualization.

Let me now share with you how Emulex is benefitting from our investments in each of these areas. From our first adapter introduced in 1996, we have understood the deep integrity and protection of cable space for mission-critical datacenters. With more than 7 million ports deploying in storage area networks to date, our field probe and fibre channel stack is trusted by the most demanding IT professionals to build a mission-critical datacenters around the globe.

Earlier this week, we raised the competitive bar in data protection again by demonstrating the Emulex secured HBA at the RSA Conference in London. This enterprise class 8-gigabit fibre channel HBA features the latest standards based team management interoperability protocol. Using an AES 256-bit encryption, we provide a unique unbreakable host based encryption security that protects data not only the rest on the disk, but also in flight across the entire network.

This week, we also announced our security collaboration with IBM to deliver key lifecycle manager, which will change the way enterprises secure data by providing a cost effective, easy-to-use solution that protects data outside the server. This solution is a powerful standards-based (inaudible) for providing optimized security for both virtualized and closed environments.

Server consolidation continues as our top trend for our end-user customers. I will be looking for ways to reduce spending and prove the efficiency, simplify management, and get the most out of their technology investments. Server virtualization is a key enabling technology that allow server consolidation without impacting network performance.

Converged networking will take us a step further by allowing consolidation of both LAN and SAN traffic on a single wire. Emulex is in the forefront of these disruptive trends providing I/O solutions for these new markets.

In September, we announced the first of our OneConnect Universal Converged Network Adapter or UCNA design win with IBM. The Emulex virtual fabric adapter for IBM BladeCenter provides flexible virtual I/O capability to maximize the efficiency of this 10-gigabit Ethernet solution.

IBM customers are seeing a 36% reduction in initial deployment costs and ongoing reduction in per consumption of 45% when compared to a non-virtual fabric chassis. IBM’s virtual fabric solution is a great example of our Emulex’s enabling our customers to provide superior virtualization capabilities.

The IBM 10-gig Ethernet Virtual Adapter allows up to eight virtual NICs pair adapter allows up to eight virtual NICs pair adapter each with flexible bandwidth. This announcement demonstrates the first true point that Emulex is establishing itself as a provider of high performance 10-gigabit Ethernet to Tier 1 OEMs.

While it’s still early in terms of the adoption of converged networking technology, I am particularly pleased with the demand for our CNAs exceeded our plans in the September quarter. We are seeing an increase in activity as OEMs extended requirements for converged network connectivity to more of a next-generation servers and storage solutions.

We continue to increase our 10-gig Ethernet platform design wins with our OneConnect products, which are rapidly becoming the gold standard for I/O connectivity and the datacenter. The competition is scrambling to bring compatible solutions to the market to this point. We believe we have a significant time to market advantage as new server platforms are launched and the new convergence market evolves.

Returning to near-term operations, the December quarter is starting off strong and that has reflected in our guidance of $88 million to $92 million in revenues. Stable gross margins and our focus investments to drive future growth combined with increasing operating leverage from our OEM business model will allow us to deliver earnings of $0.10 to $0.12 per share.

Now let me turn over to Jeff, who will share more operational details and provide an update on some of our strategic initiatives. Jeff?

Jeff Benck

As you have heard from Mike and Jim’s comments, operationally we really hit on all cylinders this quarter as we exceeded our goals for revenues, gross margins and earnings. We also made solid progress with our technology investments, executing on our product strategy and improving our competitive position in the market.

I am excited to share some highlights with you in these areas. Our revenues of $86 million handily exceeded the high end of our Q1 guidance. Our Embedded Storage Products showed particularly strong sequential growth of 30%, totaling $21 million, and we expect continued growth in the December growth. A combination of improving revenues and rightsizing our R&D investment in ESP has been a key objective for the past several quarters, and I am pleased to report these efforts are starting to pay off.

Recently, we announced that LSI has selected our InSpeed SSC 422 embedded storage switch and the VR 2401 bridge products into their Engenio DE6900 high capacity disk enclosure. In the current economic environment, high Q leaders are looking for lower cost per gigabit storage and reduced power requirements without having to compromise on performance.

Our InSpeed switch product provides further in fibre channel connectivity and our SATA to fibre channel bridge allows connections of up to 60 terabytes of low-cost high-capacity SATA drives in a single enclosure. With over $60 million embedded ports shipped over the past seven years, our enterprise proven storage components and hard and software stack provide a field proven reliability and performance that external storage systems require.

Last week, we also unveiled our next-generation InSpeed bridge designed to support SATA hard disk drives in native SAS environment. SAS hard disk drive in fibre channel environment and solid-state disks or SSDs in both fibre channel and SAS environment. Our trusted abstraction layer isolates the storage system from the idiosyncrasies of different interphase protocols enabling enterprise storage OEMs to take advantage in latest advances in drive technology.

SSD represents a paradigm shift providing read/write performance that is orders of magnitude faster than mechanical drive, and they will dramatically change the architecture and design of future storage and server systems. Emulex has anticipated this technology shift in our new bridging solutions to provide OEMs with the flexibility to start using ultra high-performance SSD in their high-end storage and server blade systems. We already have SSD design wins with its exciting new bridge technology.

Now, let me update you on the progress in HSP. Revenues for the quarter came in at $64 million, led by our board level products which grew 4% over the June quarter. We saw particular strength in our mezz cards for blade servers, which grew nearly 40% sequentially. Our 8-gig fibre channel products are gaining momentum as well, and now account for over 20% of our HSP product revenues.

Volume shipments have driven cost differentials for 8-gig HBAs down significantly. And now that the price premium for 8-gig is largely behind us, we expect end users will take advantage of the higher performance as they virtualize their server environment. Furthermore, many customers are beginning to move forward with server purchases based on the new levels of price performance achieved by the most recent processor refreshes. Based on our expanded set of design wins, we are positioned to gain share during this important speed transition.

Our new converged networking products had several key milestones during the quarter. Our CNA revenues more than doubled as OEMs expanded their offerings in the market and customers began adopting top of the rack SUV based network solution. In August, we announced the patent cross-licensing agreement with IBM to accelerate the integration of our OneConnect UCNA within IBM’s high-performance servers including IBM system P, system X, and BladeCenter product offerings.

In fact last month, we announced one of our OEM design wins for our OneConnect UCNAs with IBM BladeCenter. As part of this design win, IBM became the first OEM to announce support for our SUV capability on the same OneConnect 10-gig Ethernet adapter. This is an exclusive design win for Emulex adapters in IBM’s virtual fabric solution and leverages new technologies jointly developed by Emulex and key partners. This solution creates a virtual fabric from our blade mix through IBM’s enhanced Ethernet blade switch which will optimize blade deployments and server virtualization.

Our OneConnect architecture features not only industry-leading 10-gig Ethernet technology, but our adapters are still upgradable to fibre channel over Ethernet with a simple software update, enabling us to provide the industry’s first Pay-As-You-Go I/O. This new Pay-As-You-Go business model enables OEMs to create new revenue streams from 10-gig Ethernet mix that are converged networking ready. It provides IT managers with an unprecedented level of flexibility and investment protection.

Now, let me share several key trends that are laying the foundation for network convergence into datacenter. First, the server virtualization which continues to drive I/O bandwidth the demand on servers. According to IDC, the number of virtual machines will grow from three to 12 per CPU core with Nehalem EX in 2010. Second, the Intel server refreshes including the high-end Nehalem EX and high-volume west mirror server platforms will drive 10-gig Ethernet adoption through mix and integrated 10-gig solution.

Third, the rapidly growing blade server market is already positioned to support 10-gig Ethernet based offerings, and these platforms are a natural for server consolidation and network convergence. Fourth, the ecosystem for converged networking is rapidly maturing with major switch, server, and storage vendors announcing plans or support for 10-gig Ethernet, iSCSI, and FCoE. All of these elements are providing the foundation and the demand for deploying network convergence in the datacenter. And Emulex is uniquely positioned to capture this expanding market opportunity.

At our 30th Anniversary Technology Launch back in February, we established ourselves as industry thought leaders when we outlined our vision for converged networking and introduce the technology to deliver it. Emulex’s server-centric approach to network convergence provides a single architecture and product portfolio that enables network convergence with the 10-gig Ethernet transition.

We have a series of upcoming events beginning even next week where we will continue to share our progress and vision for this very dynamic and important space. I highlighted just a few of the recent efforts the team has made as we continue the transformation of Emulex. We have got a busy year laying the groundwork for the future as we gear for the next phase of 10-gig Ethernet deployment. Over the next couple of quarters, you will see additional true points of our accelerating momentum with a slew of OEM announcements aligning to the new Intel and AMD processor introduction as they become available from server OEMs.

We are creating new opportunities to grow the company and increase profitability as we gain mind share and traction with our customers and partners. We also continue to realign our operating investments to maximize profitability and increase shareholder value.

Let me conclude with some key points before I pass it back to Jim. First, we are increasing our global investments in sales and marketing particularly in faster growing regions to improve our market share in our core business and to establish leadership in 10-gig Ethernet and network convergence.

This will increase our TAM and accelerate our revenue growth. Lastly, we are rightsizing our R&D investments and our legacy products to enable us to invest for bringing new products to market to provide the security, reliability and performance that server and storage OEMs rely on to meet the demand of a mission-critical enterprise datacenters.

I will look forward to updating you on our continued progress on our next call. With that, let me pass it back to Jim.

Jim McCluney

Thanks, Jeff. Let me conclude with some summary points. We had a great quarter in September and we see an increasing number of industry data points that support I believe that we have seen the bottom of this cycle and we are poised to see a return to growth in IT spending. But we expect this growth will start off slowly and pickup more momentum throughout calendar 2010.

Although the spending environment is improving, CIOs remain cautious and are prototyping their investments on solutions that provide the best price performance. Emulex has been investing in products that are targeted at the areas at top of their product list including security, virtualization, and server consolidation.

We are providing strong December quarter guidance of $88 million to $92 million in revenue and $0.10 to $0.12 in diluted EPS. And this is reflective of the fact that we are starting to see some improving traction in the market. Finally, we have a significant number of exciting announcements in the pipeline over the next several quarters that will reinforce our leadership position in convergence.

Stay tuned for more information at our Analyst Day next week in New York. The best is yet to come. That concludes our prepared remarks. And with that, we have time to take questions. So operator, please go ahead and open the line.

Question-and-Answer Session

Operator

Absolutely. (Operator instructions) And we will take our first question from the line of Glenn Hanus with Needham & Co. Please go ahead.

Glenn Hanus – Needham & Co.

Good afternoon, guys.

Jim McCluney

Hi, Glenn.

Glenn Hanus – Needham & Co.

Could you – on the UCNA revenues, could you maybe just give a little more color, is that monthly fibre channel over Ethernet adapters or is that 10-gig Ethernet, what’s kind of the rough mix there in the revenues? And over the next few quarters, where do you expect to see most of the revenues? And are we on to the production level cards at this time?

Jeff Benck

Okay. This is Jeff. I will take a stab at that. UCNA revenue as we mentioned strong growth quarterly, we predicted that, but we did it little better than we even thought we would when we started we gave our guidance. Most of that revenue was fibre channel over Ethernet focused on that. As we continue to rollout new offerings based on 10-gig Ethernet like this straight 10-gig NICs, we will see contribution in upcoming quarters from some of the based 10-gig Ethernet offerings. But the majority of the revenue today was fibre channel over Ethernet.

We also announced on the virtual fabric adapter that is 10-gig Ethernet base, but also has SUV upgrade capability, so that’s when you will start to see some of the contributions from OEM offerings in this space as we go through time.

Jim McCluney

Yes, I think Glenn, it’s Jim here. As we – we have tied our universal converged network adapter obviously to the server refresh cycles, they’re coming up and that’s what we’re getting our launches to and as most of them are going to really start coming to light over the option to June quarters there and that’s where we will start to see more and more contribution from 10-gig Ethernet based UCNA.

Jeff Benck

We also had some announcements coming in the next week here at our analyst event and such that we will give you further color on this.

Glenn Hanus – Needham & Co.

All right. Do you foresee any component availability issues out there with just the general pickup in demand, is – are there any constraints from a component standpoint that maybe impacting anybody’s guidance or things clean in that regard?

Jeff Benck

We can’t speak to anyone else, but really to ourselves. I think the operations team has done a really nice job of staying in front of that. We ensure we have supply flexibility when we think about looking at forecasts in the OEM environment you kind of be – you have to be ready to respond to upside and that’s what we’ve positioned ourselves to do.

We have seen an increase in demand, so in some cases we got to pay attention to this, but hasn’t really been a problem for us and it’s our intention to be able to ramp that as we see demand coming back stronger each quarter.

Glenn Hanus – Needham & Co.

Okay, thank you.

Operator

And we will take our next question from the line of Kaushik Roy with Wedbush Securities. Please go ahead.

Hemant Hebbar – Wedbush Securities

Thank you. This is Hemant Hebbar for Kaushik Roy. Can you shed some light on the growth fee in the ESP business and your plans to invest further in that part of the business?

Jeff Benck

Yes, so we mentioned that we had just outstanding sequential growth of 30% quarter-to-quarter. We do believe some of this was a replenishment of some pretty low inventory levels in the supply chain, so some of that was – again we have to credit to that. But we are also guiding for further growth in that business in the current quarter. So that’s off of a much higher base.

We do have several new design wins that we expect to ramp in calendar 2010. In fact some of those are even in pretty exciting new areas like solid-state disks where we’ve already got a couple of design wins enabling SSDs to move into storage and server infrastructure with our bridging technology. We’ve made some bridging announcements just over the last couple of weeks here about those new bridge technology.

We’re also now with the new LSI came to market with their DE90 – 6900 I mean high-capacity disk enclosure that leverages both our SOCs as well as our bridges, so it’s good to see that product come to market. We are pretty excited about that. As part as where we are focused on ESP business, you are going to see us – you are going to see a shift or focus less on fibre channel SOCs and more on the SATA protocols which are growing in the marketplace of course and then SSDs which are pretty exciting technology with the kind of performance they bring.

So if you are looking towards where we might be investing, you are going to see us continue to balance our investment there and the maturing fibre channel business we’re going to be careful about investment there and watching the return carefully, but then still looking for some of these new areas where we are getting new design wins and we will see more ramping through 2010.

Hemant Hebbar – Wedbush Securities

Okay. And so, in terms of the growth again, sort of expect continuous invest in this area?

Jeff Benck

Like I said before, we are going to bounce the investment. We are going to be smart about it, because of the business is maturing. We have talked about switches maturing there. So we are being smart about the investments and making sure that we are increasing our profitability to allow us to invest into new areas, but we are also at the same time bringing new bridge products to the market that are going to allow us to continue to see growth in our ESP business.

We are a little cautious in the current guidance. We did show growth, but we had very big sequential growth, so we think some of that did replenish some inventory level. So you see us just being a little careful in the current quarter growth production.

Hemant Hebbar – Wedbush Securities

Yes, that’s very helpful. Thank you.

Operator

And we will go next to the line of Jason Noland with Robert W. Baird. Please go ahead.

Jason Noland – Robert W. Baird

Yes, thank you. Maybe a first question at the OpEx line, if – Mike, if you can talk a little bit about the sequential gain – sequential increase in the SG&A, is that almost entirely due to employee benefits, and then starts going forward from here?

Mike Rockenbach

Yes, there was a couple of things. The – there were some increase in SG&A and also in engineering from reinstating some of the benefits that we had taken out last year. But the one thing that was in – those expenses they’re continuing. We didn’t do it just for the quarter, we’ve done that going forward. And we think that’s a critical part of retaining the talent we need to execute our business.

With SG&A though, one of the things we had in our prepared remarks was we have been looking at expanding the facility here in Costa Mesa, we have put that on the shelf indefinitely, so there was a $1 million of charges that were one-time charges that hit in the Q1 period that isn’t there for Q2. So –

Jeff Benck

Q2.

Mike Rockenbach

I am sorry, for Q2. So, we should see expenses go down in Q2 from that level.

Jason Noland – Robert W. Baird

Okay, that’s helpful. And then a question on mezz cards, you had a good quarter, good year I think at acceleration in FY ’09 and then a strong sequential gain in FQ1, is that sustainable I guess that sort of acceleration in the mezz card market?

Jeff Benck

Well we were underrepresented in Blade servers and now we’re really aren’t disadvantaged anywhere. In fact, we have got some advantages in the converge network adapters and – so we do think that we can sustain the growth and grow faster in the Blade market, and we fortunate enough that the Blade market is the fastest growing segment.

We are underrepresented and now we’ve got very competitive offering. So we think we see some continued upside there. Some of the strong that we saw quarter-to-quarter was also in converged network adapter products in mezzanine versions of those as well. So we are happy about the Blade performance, more to do there, but we can continue.

Jason Noland – Robert W. Baird

Okay, last question from me, Jeff. Last quarter you guys talked about 8-gig HBA share being about equally split with our competitor, is that – has that trend continued into FQ1?

Jeff Benck

Well, I will tell you we saw from Dell'Oro that we gained 3 points a share in the June quarter. We know that September quarter is a tougher quarter for us. Traditionally it’s a more challenging quarter based on our distribution of customers. We gain share through the first nine months of the calendar year.

When we look at – when we look at the strong forecast that we are putting forth here in HSP business, we believe when the calendar closes, will have gained share. But I will tell you there are puts and takes, there is a lot of back and forth here, it’s a pretty competitive environment with our closest competitor. So we win some, we lose some. But the trends are moving in the right direction for us. And as we focused on a yearly basis, we see an opportunity for gains.

Jason Noland – Robert W. Baird

Understood. Thanks, gentlemen.

Operator

(Operator instructions) We will go now to the line of Rajesh Ghai with ThinkEquity. Please go ahead.

Rajesh Ghai – ThinkEquity

Hello, can you hear me?

Jeff Benck

Yes.

Rajesh Ghai – ThinkEquity

Yes, good afternoon. Jim, question that I wanted to ask you was, can you talk us through your CNA business, considering that you’re not seeing too many deployment of FCoE on the network switch side. I am just wondering do you – are you seeing on along with your competitors’ sales in the CNA market. What exactly are those deployments for, are people future proofing their datacenters for the eventuality that if you will come on board or because I kind of see the clashing that you are going to be getting on FCoE, CNA is a little early given that not much action happening on the networking side?

Jeff Benck

I mean we are seeing a lot of growth, but it’s from the same base. So it is early days in the converged networking space. Lot of excitement, all the switch vendors are participating and putting out offerings there as well as the server guys have certainly stated their intention. We have seen some actual customer, real customer deployments.

We want to try to continue to bring some of that share that with you as we can get those customers to talk about what they’re doing. In the emerging markets, it’s kind of interesting, because many of them leapfrogging and going right to the converged networking in places like China and India and some of the new datacenters going in there, they are just going to bypass some of the traditional architectures.

We certainly see a number of customers in the middle of qualification and making decisions about the technology. But it is going to be a phased approach. We are going to see, we believe we will see top of the rack solutions that will get deployed for fibre channel or Ethernet first before you will see have the adoption in the core switches. And then storage will be the last to go native for FCoE. So it’s going to take time, but I got to say as far as technology adoptions goes this has been a pretty quick one.

Industry’s kind of aligned and we think we have right timed our products here. We didn’t rush out some of there early stuff, just say we were there and as Jim mentioned before, lining up with some of the – some of the 10-gig deployments is really important for us, because we are as much focused on 10-gig Ethernet as the convergence that can be layered on top of it, because we really fundamentally believe that is a much more predictable transition and it’s going to speak to a tremendous amount of growth in the industry, particularly the new server platforms come out with hot core and some of the faster speeds on the server processor, there is more demand on the I/O bandwidth. But we are going to lay down the 10-gig Ethernet whether that be in the a NIC, or a TAM or a mezz card.

And then being able to move converged networking softwares stack on top of that and give customers that converged networking proof or that networking ready, converged networking ready capability, we will give them investment protection. So if they decide continue to deploying fibre channel that’s great, we have been a market leader there. If they want to go to 10-gig Ethernet with converged networking, we are well positioned to exploit that. Jim do you want add?

Jim McCluney

I think the key message I think Jeff hit on the data. I think the difference in strategies between the various companies competing here is that we view this fundamentally first and foremost is a 1-gig to 10-gig and the reasons why we designed or adopt to substance they can be upgraded to SUV in the same piece of silicon set that people can move to convergence when they’re ready.

Just with a simple software foundation. So, I think that's opening up a larger addressable market for Emulex than just a pure FCoE market. I agree with Jeff. I think there’s a lot of tire kicking going on. But I think the infrastructure is coming together and I think with the message that you will start to see more a meaningful revenues in the mid-2010 environment for us as we get these several launches behind us.

Rajesh Ghai – ThinkEquity

And when you think this revenue stream will be meaningful second half of next year or given that you are seeing some early times, this quarter it might be earlier than that?

Jeff Benck

I am not sure that I totally understood the question. Could you please repeat?

Rajesh Ghai – ThinkEquity

The FCoE revenue stream, when does it become meaningful, does it become meaningful –

Jeff Benck

Revenue stream. Yes we said as we see more OEMs launching their platforms in the first half and second half of next year, we kind of said by midyear we would see meaningful revenue. I still think that we believe that as we will able to see we actually pickup from a line with us, because we will become something more – a more significant piece of hard revenue product line and then accelerating into the second half of 2010.

Rajesh Ghai – ThinkEquity

And you may have addressed this – I joined the call a little late, the gross margin (inaudible) above 9%, do you see that going up as the 8-gig contribution total revenue grows or do you see that kind of trending in the same level going forward in the next few quarters?

Mike Rockenbach

Yes, we had 67% gross margins for this quarter, actually a little bit better than we had modeled for on the August call, we had modeled for 66% gross margins.

Rajesh Ghai – ThinkEquity

Yes.

Mike Rockenbach

And we benefited from higher volumes, we expect those margins to be about the same in the December quarter. I think in terms of the fibre channel HBAs, it varies by configuration, but there is a much of a difference between the 4-gig and 8-gig margin. So I don’t think that’s going to have a dramatic impact in the next couple of quarters.

Rajesh Ghai – ThinkEquity

Okay, great. Thanks.

Operator

And we will go next to the line of Min Park with Goldman Sachs. Please go ahead.

Min Park – Goldman Sachs

Great, thank you. Just a couple of questions, please. First off, I was wondering if you can just tell us with which of your OEMs you think you may have gained a loss share in the quarter, I mean if you can give us any thoughts on QLogic any design impact, AMD for the next-generation adapters?

Jeff Benck

Yes, well we don’t usually give any color on customer market share. I think we use the Dell'Oro report as the barometer on a quarterly basis for that. I think when you look at a few announcement wasn’t surprised. There isn’t – As we mentioned earlier, we've been gearing our UCNA launch tied to next-generation server refreshes which is basically 10-gig base with the opportunity for FCoE and iSCSI and other protocols.

And so I think if that particular customer is looking for a solution a little bit sooner, but I will tell you over time, with this new CNA market, we do expect that things will become multiple source across the OEMs and I think once again with UNIX platforms, those customers tend to be a lot more conservative and I could see them leading the trend in this convergence for this time we have been with the PCs for a decade and will remain with them for the next decade. So – but I think you will see puts and takes as nearly market is different and announcements come and go, I think you will hear some announcements from us next week which will be pretty eye opening, and you will see some more from us as the months and quarters rollout. So I think just stay tuned there.

Min Park – Goldman Sachs

Okay, great. And can you just tell us to what extent the 8-gig product transition is actually helping you gain a larger piece of x86 market and if you can just tell us how your revenue exposure between big iron and x86 has shifted over the last year or over the last few quarters?

Jeff Benck

Yes, we – the x86 server market is growing, but we are also well positioned with sole source position as Jim said with system PE and 8-gig and they are doing pretty well in the UNIX platform, so even though that market isn’t growing as fast share gain has helped them grow there. As far as x86 base goes, we have strong set of launches across all the customers status where in the past, we may have trailed in some of that, so that’s kind of helped us be in a good position for share gain.

We are now seeing over 20% of our revenue from HBAs at 8-gig, so that transition is happening nicely there. And the Blade mezz growth is probably the biggest bright spot for us that we see good opportunity there for us to gain as that transition continues along going there.

And I think more and more are progress in converged networking should have some positive halo effect for our HBA business as we become more strategic to a number of the x86 OEMs. So got a number of things there that can help us, but feeling pretty good so far about the way that 8-gig adoption is rolling out.

Min Park – Goldman Sachs

Okay, great. And just lastly, can you just give us an update on the supply chain inventory levels in the ESP side and try to help us maybe understand how much of a sequential growth was sell through versus more supply chain inventory sell replenishment?

Mike Rockenbach

Let me try and take that. It’s a little bit difficult to kind of get that because we are dealing with a variety of different contract manufacturers, but I think we saw a number of positive data signs within the quarter. Not all of our customers have announced, but some customers had some really strong numbers in fact pre-announcing positive numbers. So we do think there was some level of inventory replenishment, but we have got solid backlog and forecast for the December quarter as well, plus the number of design wins coming out.

Some of the inventory or some of the shipments that we made this quarter were for new platforms like the products we announced with Engenio. So we do feel a little bit cautious in terms of the December quarter in USP because it was such strong growth. But I think there is a lot of positive indicators that demand is picking up and we are also offsetting some declines on the switch side, so – and I think the business is pretty positive. We feel like we have set a new base and we think we are to grow from here.

Min Park – Goldman Sachs

Great. Thank you very much.

Operator

And we will go next to the line of Munjal Shah with Jefferies & Company. Please go ahead.

Munjal Shah – Jefferies & Company

Yes, thank you. Hi guys. A couple of questions here. It seems though – could you – I mean I know you gave a one quarter out guidance, can you comment are give any sense as to if server refresh kind of continues into next year and how we could see next year shaping up in terms of seasonality better than usual or do you see any spillover from this pent-up demand that we are seeing right now?

Jeff Benck

Yes, I think we would say we are cautiously optimistic on the continued IT spending, and Jim talked about the macro trends. Customer surveys would say that customers are starting to believe they are going to spend more in 2010 on IT equipment than in 2009.

But when you talk about actual server refresh, Nehalem launch once that happened earlier like in the May-June timeframe was pretty good in the sense that there have been a couple of years since you saw a lot of new technology coming out in the x86 based servers, and that we saw some benefit from that. But there is some follow-ons in that roadmap as octcore comes out in Emulex in the beginning of next year, you can go get your best view that’s going to be there is a new (inaudible) product, just a new AMD processor or products.

There is a lot of new server technology processor launches happening in the first half of 2010. So from that standpoint, we are paying close attention to that. We are involved in a lot of those platforms. You see a ton of messaging from us because there is so much alignment around, some of that particularly with the 10-gig technology, and some of those solutions that we will bring in the market that are new for us.

Jim McCluney

Yes I think that’s a key point. Even if servers remain relatively flat without a new UCNA strategy, we've got a displacement here we're coming in at 1-gig, so that’s getting some potential for growth that wasn’t there before as a pure fibre channel provider. So I think there is new server refreshers, I think that will give a kick, we should get proportionally a better impact as we bring these and launch these new products in the back of those servers.

Munjal Shah – Jefferies & Company

Okay. And just on the Broadcom litigation, how should do you think the expense that will continue at the same levels going forward or do you have any sense as to how that could trend?

Mike Rockenbach

Yes, this is Mike. The expenses associated with that litigation wasn’t material in the current quarter, we don’t anticipate it being mature in December quarter. Yes, going forward beyond that, we will have to see how it goes out. But at least for the current quarter in December, we are not expecting that to be maturing.

Munjal Shah – Jefferies & Company

Okay. All right, great. Thanks a lot. Good luck.

Mike Rockenbach

Thanks. I think we have got time for one more question.

Operator

And we will take our next question from the line of Paul Mansky with Canaccord Adams. Please go ahead.

Paul Mansky – Canaccord Adams

Last at the least, I suppose. Quick kind of blocking and tackling question on the share count specifically, you repurchased what 2 million shares this last quarter and it’s effectively guiding flat sequentially. What’s going on there that would have us flat versus down on a sequential basis other than the hopes that stock goes to 14?

Mike Rockenbach

Yes, actually, I wish I had a much more exciting answer. But there is actually some changes in the accounting pronouncements increased the share count base on the methodology of how you calculate, so I think that add about 1.6 million shares to the account. So we did repurchases earlier in August, so there was some waiting on that during Q1, but the way the diluted share count calculation is changed that a little bit. So you don’t see as much of a drop as we might have expected just from the share repurchase.

Paul Mansky – Canaccord Adams

And then secondly, I don’t – I am not sure who this is best for – I am sure you will help us with that. But as I think about the revenue guidance maybe on the context of some of the expense reductions you have been putting in place and operating margins, and particularly in context of getting back to a two handle of that operating margin line, are you there some puts and takes relative to the high versus low-end of that revenue range around gross margins and mix more specifically that we need to be thinking about that we need to preclude you from being able to put up that type of leverage, obviously you have been there before comparable or even lower revenue levels.

Mike Rockenbach

Yes, let me kind of start out and I will gladly let anybody else jump in. I think a couple of different things. One is we have talked about ESP that had a terrific quarter in September, so – and I think one other things that we were pretty positive about was ESP tends to have lower gross margins than HSP, but we were still able to keep our gross margins at 67% which is a little bit ahead of our guidance for September.

December quarter historically has been a really terrific quarter for HSP since ESP is coming up of a higher base, we do expect growth, but growth for the quarter. But we really expect HSP is going to be delivering pretty solid growth in the quarter. So higher volumes and in particular in fibre channel HBA should give us some kind of wind in the sales for gross margins.

We are expecting operating expenses to be flat-to-down for the quarter. And so I can’t say that’s going to quite get us all the way to 20% operating income, but I think that’s certainly going to be give us some pretty strong numbers. And I think you really see the reflection of our operating model and the leverage in terms of the difference between revenue growth and EPS growth, we are modeling from $0.03 to $0.08 of revenue growth, but 25% to 50% EPS growth. So we definitely have some leverage in terms of how we run our business.

But we have got a lot of things that we are working and deploying and certainly look forward to announcing over the next couple of quarters, so we are making some investments and expenses, but we’re being really consciences about how we make those investments and making sure that we are getting leverage for those.

Paul Mansky – Canaccord Adams

Great. Thanks for that detail. Last one from me and – obviously one of your larger and large customers reported earlier today and spooked the market a little bit relative to some IT spending discussion relative to 2010, citing that it’s going to grow, but in more measured rates and coming off it was clearly a depressed number in 2009. That did raise an eyebrow or two. As you talk with your customers other than the one that reported this morning, what is your sense relative to that IT spend next year. Do you think we are above trend line and I should probably clarify that 7% was the number that they were referring to as the average 2004 to 2007 IT spending growth.

Mike Rockenbach

I think you got – Jim kind of hit on it before a little bit to not only what is IT spending going to do, but how is our product line evolving. And as we get into some new excitements where we have got sort of Greenfield opportunities and some of the server refresh cycles coming up, and that’s an opportunity for us to better than sort of industry growth rate. But I think it’s anyone’s guess as to exactly how things are going to play out. We are encouraged that we saw a good progress this quarter and our guidance sort of reflect that we see that sort of continuing, but I don’t think if anyone is too euphoric about the IT wallet share opening up like crazy as we go into 2010.

Paul Mansky – Canaccord Adams

And I have got one last quick one. Quad core versus eight core, do you see one versus the other playing an incremental tailwind for Emulex specifically?

Jeff Benck

Well, I mean I just look at the virtualization will be even more important when you have that many cores. And I think we are proving that – one of the notions that that’s resonating with us is let server serve and let networks network. And what that means is use of server processors to run more virtual machines and run your I/O with an engine like ours and that will free up the server cycle to do that.

And as you converge your platforms, because you are virtualizing, you really want rock solid I/O that can save money in a sense that you’re running both sand and land traffic over the same wire. So I think that’s shaken up pretty good for us. I don’t think that the octcore will materially change our HBA businesses looked out, but I do think it will be a good 10-gig Ethernet driver. So from that standpoint, we are pretty excited about it.

Paul Mansky – Canaccord Adams

Perfect, thanks. And congratulations again on a great quarter.

Jim McCluney

Thanks, Paul.

Mike Rockenbach

Thank you Paul.

Jim McCluney

Okay.

Mike Rockenbach

Yes, this is Mike. So, we'd definitely like to thank everybody for joining us for our first quarter 2010 conference call. I just want to note that we are going to be attending quite a number of events in the upcoming months. First one up is next week we are really looking forward to October 27th, we will be hosting an Analyst Day in New York.

We will be at the Goldman Sachs Davis Center Conference in New York on November 11. December 2nd, we will be speaking at the JPMorgan Conference in New York as well. And then we will be rounding out this quarter with the December 11th conference in San Francisco with Barclays. So hopefully, we will see you at one of those events, and thanks for joining us today, and hope you all have a good evening. Thanks.

Operator

And this does conclude today’s teleconference. We thank you again for your participation. You may disconnect at any time. Thank you.

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