LSI Corporation Q3 2009 Earnings Call Transcript

Oct.28.09 | About: LSI Corp. (LSI)

LSI Corporation (NASDAQ:LSI)

Q3 2009 Earnings Call Transcript

October 28, 2009 5:00 pm ET

Executives

Sujal Shah – VP, IR

Abhi Talwalkar – President and CEO

Bryon Look – EVP, CFO and Chief Administrative Officer

Analysts

Romit Shah – Barclays Capital

Sukhi Nagesh – Deutsche Bank

James Schneider – Goldman Sachs

Blayne Curtis – Jefferies

Daniel Amir – Lazard Capital Markets

Suji De Silva – Kaufman Bros

Craig Berger – FBR Markets

Hemant Hebbar – Wedbush

Hans Mosesmann – Raymond James

Sumit Dhanda – Bank of America/Merrill Lynch

Allan Mishan – Brigantine Advisors

Sanjay Devgan – Morgan Stanley

Operator

Ladies and gentlemen, welcome to the LSI Corporation Investor Relations conference call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question-and-answer session. Instructions will be given at that time. As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Sujal Shah, Vice President of Investor Relations at LSI. Please go ahead.

Sujal Shah

Good afternoon and thank you for joining us. With me today are Abhi Talwalkar, President and Chief Executive Officer, and Bryon Look, Executive Vice President and Chief Financial Officer.

Abhi will begin the call with some opening remarks and highlights from our business and then Bryon will provide third quarter 2009 financial results and guidance for the fourth quarter of 2009.

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

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

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

Abhi Talwalkar

Thanks, Sujal. Good afternoon and welcome. After weathering the economic storm of the past several quarters I'm encouraged that our end markets seem to be getting healthier and our results reflect the solid execution and commitment of our employees in driving our business forward.

For Q3, revenues exceeded the high-end of our guidance range with sequential growth of 11%. Earnings also exceeded guidance reflecting improved gross margins and continued tight controls on operating expenses.

We also continued to effectively manage our balance sheet and generated positive operating cash flows of $69 million. While there are still some concerns with the economy, our end markers are stabilizing, the demand for information technology is stronger and all indicators point to the fact that the bottom is essentially behind us.

Before I talk about our businesses, here are the key takeaways that I would like you to get from this call. First, our Q3 results and guidance for Q4 are a proof point of the successful transformation of LSI and the execution of our strategy. Secondly, we're at the front edge of seeing tangible results from the changes we have driven over the past several years in our position to grow at above market rates across most of our product categories. Lastly, with over 80% of our revenues tied to business IT spending, LSI represents a differentiated investment opportunity as business spending improves.

On our last earnings call and in various investor forums over the last quarter, we have talked about how LSI is a very different company than it was several years ago when we were spread across many markets, had some product lines that were subscale and were staring at multiple revenue headwinds in our ACD and networking businesses that were multi $100 million in size.

Over the past several years, we have significantly transformed the company and are well-positioned to grow faster than the markets can serve and drive increased earnings growth. The visible changes include significant operating expense reductions, divestitures of volatile businesses where we didn't have scale and outsourcing of manufacturing operations.

Below the surface we've implemented a new strategy and are now seeing the results of successful execution to the strategy. We narrowed our customer focus to established market leaders and large, established and growing applications where LSI can provide differentiated solutions.

We achieved sufficient scale and emerged as a technology leader in our targeted storage and networking product segments with new wins at tier one companies like Cisco, Intel, Dell, HP, Huawei and IBM, to name a few. All these will contribute to revenues in 2010 and 2011.

In addition, I'm pleased to announce that we have secured a new SSC design win with the new leading Asian HD manufacturer further expanding our customer base and we're not stopping here. Because of our focus on market leading customers and established applications, our design win conversion rate, which measures the amount of design wins that we expect to reach production and materialize into revenue, is considerably higher today than it was several years ago. This gives us more confidence in future growth.

Even with the progress we have made in storage and networking, we are far from saturated in the areas we serve with approximately 20% aggregate share. This leaves significant room for growth and expansion with what has been a winning recipe.

Moving forward, as our revenues grow, we are focused on maintaining operating leverage and driving towards our business model. Following a soft spending environment in the first half of 2009, IT managers have started to loosen their grip on spending especially for storage and servers. This is being driven by the need to upgrade infrastructure and also by new product cycles such as Intel's Nehalem server platform.

Going forward, our business fundamentals remain strong with storage capacity and net worth traffic both forecasted to grow over 40% per year for the next several years. With more than 80% of our revenues tied to business IT spending, LSI represents a differentiated investment opportunity as businesses increase spending on information technology.

Now, I want to review with you the business highlights for last quarter in our storage and networking businesses. I would like to begin with storage systems which includes both external storage systems and server rate adaptors and software.

This overall segment grew 17% sequentially, driven by increased shipments of mid range storage systems and server rated solutions. IT spending showed clear signs of improvement in the quarter as data centers needed to add storage capacity to meet demand for data storage in management while also taking advantage of newer server technology.

We also benefited from server RAID share gains at IBM from new ramping products, growth in our server RAID channel business, including 3ware and a start of several new LSI product cycles.

During the quarter we successfully launched the 4900 mid range storage system with fiber channel and iSCSI host connectivity that is designed to complement service consolidation using VMware. IBM released DS5020 storage system based on it technology in September and Sun released the 6180 earlier this month. We expect others to announce products based on the LSI 4900 system before the end of this year.

We also announced enhancements to our flagship 7900 system that included a high density SATA drive enclosure, solid state drive support and native iSCSI host interface support. The integration of ONStor is proceeding well.

With this acquisition, LSI is now positioned to address the rapidly growing NAS space, which is a large $3 billion TAM operating opportunity for our OEMs with attractive forecasted growth rates. We're now in a strong position to enable our OEMs to address the space primarily served by companies like EMC and NetApp.

We are also increasingly seeing storage solutions deployed in cloud computing environments by large companies like Amazon and Microsoft. MegaRAID host RAID controller products have been deployed in a number of large data centers and our external storage technology is a component of IBM's cloud burst initiative.

I'll now turn to storage semiconductors, which includes SAS, SAN and HDD. IDC estimates that server shipments will grow approximately 8% sequentially in the third quarter reflecting a healthier business spending environment. In SAS we're now in production on the industry's highest performance, 6 gig solutions and expect to maintain our leadership as the customers we already serve represent over 65% of the server market.

Reinforcing our leadership, LSI 6 gig SAS mega rate products are now shipping across IBM's new system X servers, enabling new levels of performance, flexibility and scalability.

We also have been awarded multiple designs at Cisco in their unified computing system for our SAS Rocks and MegaRAID software, which have already begun ramping.

In addition, we expect to benefit as SAS sees greater adoption in external storage systems, which we believe is an emerging multi $100 million market over the next several years.

Based on recent data from Gardner, LSI is the leader in the distribution channel for RAID, HPA solutions, demonstrating the breadth of our solutions we announced a collaboration with super micro, the world's number one white box server manufacture to enable end-to-end 6-gig SAS solutions for channel customers.

Overall, with a breadth of products, growing customer base and expanding applications of SAS we do expect our SAS revenues to grow year-over-year from 2009 to 2010.

In SAN, customers continue to see the value of our IP offering as well as the time to market benefits we enable. We have talked in the past about 8-gig fiber channel design wins and we now expect to see a cross over in shipments in Q4 '09 where 8-gig fiber channel IC shipments exceed our 4-gig shipments.

Turning to hard disk drives where we had solid unit shipments for SOCs and preamps in Q3 reflecting an improving market environment, growth as Seagate and Hitachi as well as strong execution.

Earlier this year we delivered the industry's first 40-nanometer low density parity check or LDC as it referred to, read channel and feedback has been extremely positive. LSI is the only Company that has this today and I'm pleased to report that we now have a 40-nanometer SOC working in a customer's hard disk drive.

We continue to believe that we have a strong technology lead versus our nearest competitor which is allowing us to make progress at the remaining HD customers where we do not currently have SOC business.

We have now expanded our customer base by securing an SOC win with the new Asian OEM for a mainstream ACD platform ramping in 2011. This shows significant proof point of the dual supplier evolution taking place and the SNR benefits of our 40-nanometer LDPC read channel.

In solid state drives we continue to make progress and will be supplying flash, custom controllers to two leading enterprise HDD customers and a leading SSD flash manufacturer for enterprise SSDs beginning in 2010. Last quarter, we added to this momentum by displacing a competitor in a volume SATA SSD controller for notebook applications.

Now I'd like to turn to our networking business and provide a brief summary of the design wins we've secured in the wireless and wireline service provider space as well as in the enterprise segment.

In the service provider wireless infrastructure space we continue to build momentum with top OEMs and announced DSP wins with both Huawei and ZTE. In addition, we have secured custom silicon wins in wireless base stations which is one of the largest service provider infrastructure segments.

Today, our networking products are shipping with three top OEMs for wireless base stations and by the end of next year we expect to be in production with all of the top five wireless base station OEMs.

In service provider wireline infrastructure, LSI and Accton announced the availability of a production ready, low cost broadband access platform that delivers IPTV and next generation rich media applications. This solution is going into production with the market leader for broadband access DS Lamps [ph].

In addition, Eriksson recently announced a major contract with AT&T to deliver broadband access solutions. Our network processor is in full production with Eriksson solutions in this some space.

In the enterprise space we continue to make progress with the leaders in the industry. Earlier this year, we talked about winning a key DSP socket with a leading enterprise networking customer and we're now shipping in Cisco's Next Generation ISRG2 platform.

We've also begun shipping custom gigabit Ethernet solutions in the first of numerous programs with the leading provider of PC and server chip sets. In addition, our LSI Trory [ph] deep packet inspection technology will be ramping in HP servers early next year. As you can see, we continue executing on our strategy and believe it will deliver positive results as we go forward.

Now let me turn the call over to Bryon who will take you through our results and provide guidance.

Bryon Look

Thanks, Abhi. During the third quarter we continued making solid financial progress while consistently delivering to our commitments. We exceeded guidance on several key financial metrics, showing double-digit sequential revenue growth, a significant expansion of gross margins and lower than expected operating expenses. Collectively, this resulted in strong improvements in operating and net income results.

Additionally, in Q3, we reported a $65 million tax benefit or $0.10 per share, which primarily related to the settlement of a multi-year foreign tax audit. The significant sequential improvement in net income together with solid working capital management drove another quarter of positive operating cash flows and an expansion of net cash.

Now some highlights from the recent quarter. Revenues were $578 million exceeding the top end of our guidance by $8 million. Consolidated gross margins, excluding special items were 45.5% exceeding the top end of the guidance range by 50 basis points.

Operating expense excluding special items were approximately $211 million, about $5 million below the midpoint of our guidance range. Non-GAAP earnings were $0.18 per share, which is above the high end of our guidance range, inclusive of the previously mentioned tax benefit. And finally, operating cash flows were positive at $69 million and net cash or cash in short-term investments net of total debt increased to $557 million.

In terms of our continued efforts to capitalize on strategic M&A opportunities, we announced and closed in July, the acquisition of ONStor. We've substantially completed our integration activities on both ONStor and 3ware, which we acquired earlier in the year and continue to see strong momentum in both businesses.

We expect both acquisitions to be roughly neutral to our non-GAAP EPS in 2009 and we have included the financial impact of these transactions in our Q3 results and Q4 guidance.

And now turning to a more detailed discussion on the quarter, revenues for Q3 were $578 million, which is up $58 million or 11% sequentially. Semiconductor revenues for Q3 were up $28 million or 8% sequentially to $372 million.

Our storage semiconductor revenues, which include hard disk drive silicon, SAS standard components and storage area network ICs were sequentially up $36 million or 15% to $266 million with significant improvements in enterprise server and HDD markets. Storage semiconductors represented 46% of total revenues in the third quarter.

Q3 revenues in our networking business were $95 million, representing 16% of total revenues for the quarter and down $5 million or 5% sequentially. Growth in networking investment areas partially offset declines in legacy networking product revenues

Revenues for the IP business were sequentially down in the third quarter to $11 million. IP revenues tend to vary quarter-to-quarter. Certain transactions which we were expecting to close in Q3 pushed out of the quarter. We do expect IP revenues to increase in the fourth quarter.

And turning now to our storage systems business, which includes both external storage systems and server RAID adapters and software. Systems revenues were $207 million in Q3, sequentially up $30 million or 17% from Q2 '09. We experienced strong growth in both mid range and entry level system sales as well as significant growth in server RAID adapters and software through our OEMs as well as our channel business. The storage systems segment represented 36% of LSI's total revenues in the third quarter.

And moving next to gross margins, LSI's consolidated Q3 gross margin excluding special items was 45.5%, which was sequentially up 340 basis points from Q2 '09 and above the high end of the range we provided in July.

We delivered sequential gross margin expansion in both our semiconductor and storage systems businesses. Semiconductor gross margins excluding special items sequentially increased 460 basis points from the second quarter to 50.0%.

As we noted in our call last quarter, Q2 margins were a bit lower than expected due to the carryover affects of some fixed costs along with some intellectual property litigation costs. In Q3, we experienced a more normal gross margin results with more typical mix and absorption and consistent with the guidance we provided in July.

Storage systems gross margins for the third quarter, excluding special items sequentially improved another 160 basis points to 37.4%, primarily driven by improvements in overall absorption of fixed costs due to higher revenues along with mix.

And moving to operating expenses, R&D together with SG&A expenses excluding special items total $211 million in Q3 at the low end of our guidance range. In addition, this represents a 13.4% decline on a year-over-year basis. Our performance on operating expense demonstrates our continued focus on cost efficiencies while also continuing to deliver to customer commitments.

The resulting non-GAAP operating income as a percentage of total revenues for the quarter improved to 9.1%. Interest income and other net of interest expense excluding special items was $1.3 million for Q3.

Now let me turn to the special items we recorded in the third quarter which netted to $66 million. Special items primarily non-cash included $43 million in amortization of acquisition-related items, $15 million of stock-based compensation expense and $8 million of net restructuring costs and other items.

Moving next to tax, our tax provision on both a GAAP and non-GAAP basis can vary significantly quarter-to-quarter based on the geographic distribution of our profitability and certain discrete items. One such discrete item occurred in Q3, which was the resolution of a multiyear tax audit in a foreign jurisdiction. The settlement was included in the $65 million tax benefit we recorded in the quarter versus the $6 million tax provision we guided to in July.

On a GAAP basis, third quarter net income was $52 million or $0.08 per share. Net profit, excluding special items was $119 million or $0.18 per share. Keep in mind the GAAP and non-GAAP results recorded in Q3 include the above mentioned $65 million tax benefit.

Turning now to the balance sheet and cash flows, third quarter operating cash flows were strong coming in at $69 million. The positive operating cash flow was driven primarily by our net income performance in the quarter, coupled with improving inventory turns and continued strong collections.

Our cash and short-term investments balance increased ending the September quarter at approximately $907 million. LSI's net cash position at the end of the quarter improved sequentially by approximately $33 million to $557 million. Our cash balance puts us in a solid position to continue supporting our businesses and investing in our future while continuing to optimize our capital structure.

Finally, with respect to Q3 results, depreciation and software amortization was $24 million and capital expenditures were $11 million. The following is our guidance for Q4.

Revenues in the range of $605 million to $645 million. Sequentially, we expect our networking semiconductor business to be relatively flat to Q3. We expect both our storage semiconductor and storage systems businesses to continue growing sequentially primarily due to expected seasonality. We expect IP revenues to be sequentially up compared to the third quarter.

Consolidated gross margin excluding special items is expected to be between 45.5% and 47.5%. We expect gross margins excluding special items to be approximately 51% for semiconductor and approximately 39% for systems. The sequential improvement in margins is primarily driven by mix, along with higher revenues and improved absorption.

Operating expenses excluding special items are expected to be in the range of $210 million to $220 million, which is up from Q3, primarily due to the timing of tape-outs to support new design wins as well as a full quarter of operating expenses associated with the ONStor acquisition.

Interest income and other and interest expense is expected to net to approximately zero. Special items netting to approximately $50 million to $70 million. GAAP and non-GAAP tax provision to be approximately $8 million for Q4.

Now as a reminder and consistent with our experience in Q3, our tax provisions can vary quarter-to-quarter based on profitability, different geographic tax jurisdictions and certain discrete items. We expect Q4 GAAP net income per share in the range of negative $0.04 to positive $0.05.

EPS excluding special items in the range of $0.07 per diluted share to $0.13 per diluted share. Share count of approximately 663 million shares for GAAP and non-GAAP purposes. In addition, we expect depreciation and software amortization of approximately $22 million and capital expenditures of approximately $15 million.

In summary, our focus remains consistent, maintain a solid foundation in our cash position and overall balance sheet, continue driving efficiencies in our cost structure and deliver sustainable top and bottom-line growth.

With that, I'd like to turn the call back to Abhi.

Abhi Talwalkar

Thank you, Bryon. Before we go to your questions I would like to close by stating that I'm very pleased with the progress we continue to make on our financial results and key program execution. LSI has come a long way in a short time and we're now clearly on the front edge of seeing the benefits of our strategy and storage and networking.

With 80% of our revenues tied to business spending, we are benefiting as businesses of all sizes increased purchases in information technology. We have won key designs across all our businesses with market leaders in the industry and have begun ramping many of these designs in a production. Even with the progress we have made, we're only 20% representative of the markets we serve and I believe we have strong opportunities for future growth in revenues and earnings.

Now let me hand the call back to Sujal Shah.

Sujal Shah

Thank you, Abhi. At this point, we'll begin the Q&A portion of the call. Casey, will you please give the instructions for the Q&A session?

Question-and-Answer Session

Operator

(Operator instructions) And our first question will come from Romit Shah with Barclays Capital.

Romit Shah – Barclays Capital

Thanks, guys, nice quarter. Abhi, just on the guidance and you’re forecasting a pretty solid Q4, but if I look at your semiconductor business it's still down about $100 million from the peak quarter in Q3, that's about 20% while a number of other companies are talking about getting back to parity this quarter. So just trying to understand that the delta. Is it attributable to just having a higher mix of enterprise exposure? Can you talk about legacy product roll-off, any thoughts there will be appreciated?

Abhi Talwalkar

Yes, I think there is a couple of things that contribute to that. As you know, not all companies are equal in terms of business composition, so you're right that the part of this is explained by our richer enterprise composition with 80% of our business influenced by enterprise or service provider or demand which we certainly saw a very strong pickup in the third quarter. And I think another contributing factor is certainly our legacy business in the networking space. I would say those are the two primary contributors to that. But in terms of our guide and how our guide compares with good proxies in the marketplace relative to enterprise on spending I feel really good about how we're guiding the fourth quarter.

Romit Shah – Barclays Capital

And then just in terms of your enterprise exposure, do you feel like this segment has some momentum going into next year and is it possible that we could potentially see better than seasonal guidance in the first half of 2010?

Abhi Talwalkar

Well, it's tough to call. I mean, we definitely expect a level of seasonality in the first quarter. And as our historical experience has been, we've seen a seasonal drop in the 8% to 12% range in Q1. Clearly, this environment is very different than the past. Hard to really determine exactly how it's going to play out. On the whole, relative to 2010, as we continue to see a gradual recovery in the economy, there are some positive elements that are developing and there's been a lot of discussions around Windows 7 and its potential benefit largely mid-2007 and beyond lot of companies discussed that as they've evaluated the product.

Storage demand continues to grow. There is, in general, a very aged population of infrastructure out there whether it's servers, whether it's networks that are over prescribed and as I said, storage continues to grow. So as this recovery sustains itself, clearly, that's question everyone is asking. I think enterprise spending will do fairly well because of those factors.

Romit Shah – Barclays Capital

The business seems like it's obviously throwing off a lot of cash in your cash balances now approaching a billion dollars, with the CapEx spend remaining very low, how are you guys thinking about future use of this cash?

Bryon Look

Well, yes, we've been continuing to manage our cash very carefully. I think that translates into some good performance numbers with our working capital performance and so forth. We'll continue to look at the various uses for our cash. We do have convertible notes that are coming due in May 2010, so we watch that carefully and we also look for other opportunities whether that might be small strategic M&A to further our long-term growth opportunities or any other potential uses relative to the business.

Sujal Shah

Okay. Thank you, Romit. Can we have the next question, please?

Operator

Our next question will come from Sukhi Nagesh with Deutsche Bank.

Sukhi Nagesh – Deutsche Bank

Thanks. Congrats on a very good quarter, guys. I have a question on the margin front if I may. Bryon, you had talked about your storage systems businesses at a $200 million run rate, probably doing about 40% in gross margin. You said that this quarter and yet your gross margin for that business was below 40%. Can you help reconcile how we should be looking at that?

Bryon Look

I think we've consistently said that we would expect a target gross margin for that business in the high 30s to maybe as high as 40%. And so we've been demonstrating that sort of growth as we've had the revenue growth with a fairly typical mix. There are some headers that can always help I think those gross margins whether that's sales more in terms of the mid range part of the product line or more softer and so forth, but I think we're comfortable with our gross margin performance. We're guiding for that to improve going from Q3 to Q4 and as we take those revenue levels north of that $200 million range.

Abhi Talwalkar

Yes, Sukhi, I don't ever recall is pinpointing a 40% gross margin at a $200 million revenue level for that business. We consistently as Bryon said, talked about the high 30s to potentially we've certainly demonstrated 40 and even north of 40 when we get into the revenues of $240 million and above.

Sukhi Nagesh – Deutsche Bank

Got it. Okay, that's very helpful. Just on the OpEx front, at the same time last year, I recall that you guys instituted a bunch of temporary OpEx reductions, something like salary, suspensions, freezing up pension plans, etc., I think at that time, Abhi, you talked about the benefit you would be having of about $20 million a quarter, starting in December '08. As you look into next year, how should we be looking at your OpEx on a quarterly run rate basis if any of these temporary cuts that you instituted will that be coming back?

Abhi Talwalkar

First of all, $20 million is quite high, because some of it's a freeze and some of its cost avoidance and so forth and so I wouldn't focus on that number because I don't think that's an accurate number. But your question in terms of these temporary adjustments or freezes or avoidance of increase in comp and benefits, as you can probably appreciate, we're not alone in this particular situation. All companies are facing, restoring various aspects of comp and benefits that either temporarily froze or curtailed for an indefinite period of time.

We've made no decisions at this point in time. However, as revenues grow and profitability continues to improve, it is safe to assume that some of these benefits will be added back, certainly with the progress towards operating model, clearly in mind. So, we expect to begin adding back some levels of compensation and benefits as we move through 2010, the specifics of which haven't been decided. We remain very focused on preserving operating leverage and would certainly add back expenses, but at a lower rate than revenue growth than operating income improvement. And as we get more clarity, we'll certainly factor that into our guidance as we move out over the quarters.

Sujal Shah

Okay. Thank you, Sukhi. Could we have the next question, please?

Operator

Our next question will come from James Schneider with Goldman Sachs.

James Schneider – Goldman Sachs

Good afternoon and thanks for taking my question. I guess on the first part, there has been a lot of talk about the strength in server purchases. Is there any way of pinpointing or isolating how much of the upside you saw on Q3 was driven by server purchases either directly or indirectly and then how much of the incremental increase in Q4 might be due to that?

Bryon Look

When you say directly or indirectly, are you referring to OEM versus sort of white box reseller channel?

James Schneider – Goldman Sachs

Well, OEM and also the storage components, the semi components that would go into like a HBA or something like that, fitting into a server, that would have a pretty good attach rate with it?

Bryon Look

We've seen growth across all forms of products that end up in a server, right? So our silicon will end up in a server many different ways, putting aside enterprise hard disk drives for a second, we'll end up in a server through SAS implementations down in the mother board on mezzanine adapters in RAID adapters. There is a full breadth of products that will make it into a server. I'd say the primary underlying driver is raw server unit growth, end growth, end demand growth in deployments from Q2 to Q3 and that drags everything else with it and we're seeing that obviously through our OEM channels, but we also saw pretty good strength in our reseller channel where we sell in the distribution that sells to thousands and thousands of server and PC resellers around the world.

James Schneider – Goldman Sachs

Fair enough. And then maybe as a follow-up, in the networking area, given the pipeline of design wins you see out there that are going to roll in during 2010, do you think there is a chance that your networking revenues for 2010 could come close to what they were in 2008?

Abhi Talwalkar

No, I don't think that's going to happen. I think we continue to deal with the legacy element. That is something we'll provide some more clarity on probably in the next call, a quarter from now, in terms of how people should be thinking about our legacy business in 2010. But what I do feel very good about is the year-over-year growth relative to our go-forward businesses in 2010 and certainly even stronger beyond that.

Sujal Shah

Okay. Thank you, Jim. Can we have the next question, please?

Operator

Our next question will come from Blayne Curtis with Jefferies.

Blayne Curtis – Jefferies

Hey, guys. Great quarter. Abhi, just wanted to pars into the storage semi business a little bit. You saw hard drives significantly up in Q3. As you look at the guidance, do you expect all of your businesses to be up and as you see in PC production had a pretty sharp back in Q3 as you look to Q4 virtually for the HDD business, what kind of assumptions are you baking in there?

Abhi Talwalkar

Well I mean relative to the HDD business, I think we certainly saw significant TAM growth quarter-to-quarter in terms of overall units for HDD, I think if we listen to our HDD customers and how people are thinking about the TAM in the fourth quarter its sort of flat to possibly up a couple percentage points. So a lot of the HDD growth was really more of a Q2 to Q3 growth and we'll certainly see some growth in the Q4 but more muted than the Q2, Q3 cycle again because of the overall PC build cycles.

Server strength continues to look good into the Q4 consistent with sort of typical seasonality where Q4 is quite a bit stronger than Q3. And, yes, we are guiding storage systems up, storage systems generally has a very strong quarter so we are definitely seeing seasonal benefits but also continued benefits through new product cycles. Some of our top customers are gaining share in the market based on our experience in the third quarter. We're certainly working with them to continue that momentum into the fourth quarter as well.

Blayne Curtis – Jefferies

And then on the gross margin side, you've made good progress with the semi gross margin. Backing history you were able to do mid-50s, but you had a significant portion of pretty high margin legacy business. As we look forward for the semi gross margin what kind of ranges can we be looking at?

Abhi Talwalkar

Well, we're certainly not going to guide beyond the fourth quarter. We absolutely remain focused to keep moving our semi gross margins north, right. And as we increase our scale with the design win momentum that we have and as those things come into the marketplace as well as continue to focus on costs, see the ramp of things like enterprise SOCs for HDDs and so forth, there is a lot of factors that will certainly will help us work towards improving our gross margins. Our overall business model drives us to have at least 50% gross margin for semis and I want to be able to do that for an entire year and do it consistently. That's the focus.

Sujal Shah

Thank you, Blayne. Can we have the next question, please?

Operator

Our next question will come from Daniel Amir with Lazard Capital Markets.

Daniel Amir – Lazard Capital Markets

Thanks a lot. Thank you for taking my call. Couple of questions here. First of all, follow up on to the enterprise side. Could you highlight which areas specifically are you most excited about in 2010 as we look at kind of a potential enterprise corporate upgrade here, maybe starting kind of midyear?

Abhi Talwalkar

Mid next year?

Daniel Amir – Lazard Capital Markets

Yes.

Abhi Talwalkar

Well, I mean, I continue to believe that enterprises will deploy the new Intel-based servers especially as budgets allowing budget support. We are aggressively in our own little experience, we do not spend a lot of money, but meaningful money from an LSI standpoint rapidly deploying these new servers. The ROI is just impressive and in the case of compute servers it's taking out precious time to market cycles. So, I think that value proposition continues to be very good and we'll see that continue throughout 2010. It's anyone's guess as to how strong that will be but I think we certainly see that.

The Windows 7 opportunity that I think all of us in the industry are certainly hoping on being a driver will have a positive benefit to LSI as well with our overall participation in hard disk drives which certainly a meaningful percentage ends up in PCs. On the storage systems side, storage systems is a little bit of a different animal. Utilization levels are generally high because people will use up as much storage capacity and then move to a new storage. It's a little different animal than servers, where historically server utilizations were very low. There is nothing that says that the growth of digital content, digital information is slowing down. That continues to be at fairly high levels. And we do believe that storage systems and of the like will be on the higher end of IT priority list just because they have to continue to add more capacity. We've also got some exciting virtualization technology that LSI and HP is shipping out in the marketplace. I think we're certainly excited about the growth that will bring us next year as well.

And then lastly flash. We've been very metered about how we engage in flash and a lot of our activities are in enterprise oriented flash with not only our existing products supporting flash technology really well, and in some cases, better than our competition as well as new flash oriented businesses coming into play next year. I think it will be more meaningful in 2011, but we'll certainly see year-over-year growth that will be exciting in that area.

Sujal Shah

Thank you, Daniel. Can we have our next question, please?

Operator

Our next question will come from Suji De Silva with Kaufman Bros.

Suji De Silva – Kaufman Bros

Hey, guys. Nice job on the quarter. Can you guys give us some anecdotal kind of thoughts on the IT and enterprise recovery here? Whether some of that is maybe catch-up spending for the first half or perhaps budget flushes or whether there is good sort of circular demand with the hale [ph] and some other things that can drive through the first half of next year?

Abhi Talwalkar

Yes, kind of a repeat of what I just said. What I'm getting anecdotally as well as I talk to all of our sales people and we have a fairly sizable sales force that touches also end customers in concert with our OEMs, we're seeing a lot of the regions in Europe starting to strengthen. We're seeing IT budgets that were sort of in place in the beginning of the year, but were frozen starting to absolutely loosen up. External storage demand has been very strong. APAC in terms of an indirect driver of our demand has been very strong as well. In fact if we look at growth in APAC relative to our storage systems business, lot of our growth came from there.

U.S. was strong also in terms of storage systems. I think EMEA will contribute more so in the fourth quarter as we're starting to see spending there, behave in a similar manner that North America did about three months ago in terms of Europe’s dealing with maybe some improved fundamentals in many of the regions, but more importantly, they're back from their summer holidays and they're spending and they're spending IT budgets that were in place but were frozen for sometime.

So as to the question for 2010, I think the big question that remains for all of us is how is the first quarter to going to shape up. I think people in general have pretty decent confidence in the second half as long as the world's economy is holding together, technology will do well in the second half. The question is the first quarter to and some of that is dependent on sell-through over the next two months, three months.

Sujal Shah

Thank you, Suji. Can we have the next question, please?.

Operator

Our next question will come from Craig Berger with FBR Markets.

Craig Berger – FBR Markets

Hi, guys, nice job. I wanted to dig into the hard disk drive chip opportunity. How much market share do you see yourselves having, how much market share do you see your other big competitor having and how much is left and I guess within that, can you just talk about which big customers are kind of the incremental opportunity for you guys?

Abhi Talwalkar

Yes, let's keep it simple and focus on SOCs in terms of the numbers that I share at least in terms of share as well as opportunity. And preamps, just simply on preamps, we feel very good about our continued growth in preamp share and there is only two players in the marketplace. We have a solid line up and we expect to continue to grow share this year as the year finishes and we expect to continue to grow share next year. Relative to SOCs, our SOC share is somewhere in the order of 22% or so, in terms of SOCs specifically for all categories. We absolutely expect our share to grow over the next one to two to three years, year-over-year we expect share gains. And that's obviously attributable to the design wins that we've accumulated in the last two years.

We have competitors that that have share levels that are in the low teens and shrinking and we certainly have a big competitor who shares probably in the 50% range, 40%, 50%, 55% range or so. Our business in terms of SOCs is entirely made up of Seagate and Hitachi today, so we've been very focused not only in terms of growing our position there but obviously penetrating the other remaining three HDD OEMs and that's Samsung, Fujitsu and WD. And we believe we have very good technology. I've also said if we had parity technology, just the dynamics of the marketplace will allow us to grow share, we've better than parity technology, we believe we have a lead so we expect to continue to grow share. And our objective is to continue going after the remaining two of the three and we have won one of the three.

Craig Berger – FBR Markets

That's very helpful. Thank you. And just as a follow-up, the markets seem a little worried about Q1 guidance. Have you seen anything unusual in the order patterns, any extra inventory in the channel, any waves or hiccups in recent days or weeks that might sync with what's going on in the market? Thank you.

Abhi Talwalkar

Not really. Nothing significant. Here is the kind of way I think about Q1, aside from some level of expectancies, which means Q1 will be down from Q4, the question is just how much. In terms of our storage systems business and server related businesses, that business has a very different overall supply chain and inventory profile than PC or consumer electronics oriented businesses. So I'm less worried. First of all, we do not have inventory issues that I can point to across any of these businesses today.

Over the course of the quarter, I'm less worried about inventory concerns or build-up concerns with storage systems or servers, because I think the sell-through, we build it, it will sell-through, most of our systems business is almost we're responding to real, hard, firm orders with customer base. There's not a lot of distribution inventory that builds up.

Relative to the PC and handset marketplace, as you know, there is a huge build ahead that takes place and people are banking on a certain level of sell-through relative to the holiday cycle. The good news for us is we've only got maybe 10%, 12% of our business exposed to that risk, if the sell-out does not match the build-up that's been occurring. And so I don't know if that helps, Craig, but that's how I think about LSI relative to the fourth quarter and relative to Q1 and what risks might be there if the sell-through doesn't occur to the levels we all would like it to occur.

Sujal Shah

Okay, thank you, Craig. Can we have the next question, please?

Operator

Our next question will come from Hemant Hebbar.

Hemant Hebbar – Wedbush

Hi, this is Hemant for Kaushik Roy. I had a quick question on the converge data center. Is LSI doing anything on the FCOE front?

Abhi Talwalkar

Yes, we are. We have design wins with obviously the fiber channel players as well as in the past we've announced design wins with FCOE players as well.

Hemant Hebbar – Wedbush

Okay. And on the IP revenue, intellectual property, is that something that's expected to be fairly constant, with a few up and downs but something that you are adding to or something that we should expect to be fairly constant going ahead?

Abhi Talwalkar

Well, I mean, the quarter we just completed it was lower than certainly we had expected and certainly have been driving to. But we have variability in this particular business in terms of quarter-to-quarter variability. It certainly remains a focus for the Company and we expect to certainly grow it over time.

Hemant Hebbar – Wedbush

Thank you. That's very helpful.

Sujal Shah

Okay. Thank you. Could we have the next question, please?

Operator

Our next question will come from Hans Mosesmann with Raymond James.

Hans Mosesmann – Raymond James

Thanks. Abhi, can you comment on the long-term operating margin model and what kind of revenue on a quarterly basis? Do you need to hit that number and will you get there in 2010?

Abhi Talwalkar

Well, Hans, Bryon and I can tag team on this one. We'll take the easy part of this, certainly, I'm not going to guide 2010. It's certainly our in tent and objective to continue to make solid forward progress towards our business model. I think historically we've said that to hit our operating margin sort of targets we need to have revenues in the range of about $700 million or $700 million plus on a quarterly basis.

Hans Mosesmann – Raymond James

Can you refresh our memory what that percentage number is?

Bryon

Yes, we're consistently targeting that business model at 70% operating income and as you can tell by the results and also by the guidance range that we've provided, we're making good progress last couple of quarters in that direction based on looking at the guidance range, we should be moving in at the midpoint of that range to double digit operating income. So we will continue to take the same measures that we have to drive towards that model and that's continuing to fund the long-term revenue growth, continuing to look for opportunities to expand our gross margins and again you've seen significant expansion there, with semi left now at that 50% kind of a level and systems at the high 30s and continuing to be diligent about our operating expenses looking for efficiencies where we can.

Hans Mosesmann – Raymond James

Great. And then a follow-up. I think Abhi mentioned that you had sampled or one of your HDD OEMs were using a 40-nanometer SOC, is that correct?

Abhi Talwalkar

That's correct. This is something we had sampled earlier in the year, the point that I made in the prepared remarks was that we actually have now that 40-nanometer SOC fully functioning in an actual HDD customer's drive.

Hans Mosesmann – Raymond James

Okay. And just to understand that what kind of an advantage do you think you may have there in terms of timing or in terms of performance relative to the competition?

Abhi Talwalkar

Well we believe we have meaningful performance advantage and more importantly, it's a time to market advantage. Right? So all of these hard drive vendors amongst other things are driven by getting to certain capacities or certain cost points and so, a big part of that is the rechannel sort of performance and increasingly we believe the rechannel performance and the SNR gains it provides is going to be an increasing factor and critical factor to driving this density treadmill that the hard drive guys drive. More so than in the past three years to five years. And as a result, if we can continue to stay ahead of our competition and drive a faster cadence, we feel that we can continue to penetrate more SOC or hard drive customers as well as continue to grow our share. And we believe that the time to market advantage that we have today relative to 40-nanometer in LDPC is measured in months and meaningful levels.

Sujal Shah

Okay. Thank you, Hans. Could we have the next question, please?

Operator

Our next question will come from Sumit Dhanda with Bank of America/Merrill Lynch.

Sumit Dhanda – Bank of America/Merrill Lynch

Yes, hi, good afternoon. A couple of questions. Abhi, in terms of the design wins for your DSPs that you cited that potentially all five major base station vendors, if I heard you correctly, can you talk about the kind of dollar opportunities that poses for you? Specifically what functionality from a competitor you might be displacing on a line card and then when does that really get in general the growth in your new networking businesses get apparent given that there seems to be a consistent drag from the legacy business just rolling off. Lot of questions rolled into one but basically addressing the same theme.

Abhi Talwalkar

Yes, we've been relative to base stations and just wireless infrastructure in general. We've been very focused in the past 18 months to increase our overall content into wireless infrastructure. And that's not only just base stations, but also media gateways and other access-oriented infrastructure. And we've been focused at driving not only DSPs, but also have designs that are in production today in terms of network processors as well as framers and mappers. Our DSPs are used today both in the form of base band, but also in the form of media gateway as well.

And so we continue to see great success, not only with our existing and future network processor offerings, but great success in the DSP space, because as we've said all along our DSPs are really geared towards network traffic and provide a significant architectural advantage and so, we're winning in base implementations but also in media gateways. I'm not going to size the number for you today. That's something maybe in an upcoming analyst meeting we'll provide clarity on exactly what our SAM opportunity is, but we feel really good about our increasing content. I think the contribution from the wireless base is occurring today and we'll see that grow in 2010 and definitely grow in even more meaningful levels in 2011 as more of these designs reach production.

Sumit Dhanda – Bank of America/Merrill Lynch

Okay. And then I guess as a follow-up to that previous question sort of addressed this, but do you think your networking business overall can see growth into 2010, not getting back to the '08 levels, but the legacy business rolling off will be incrementally less of a drag as you look into next year?

Abhi Talwalkar

Well, it's definitely going to be incrementally less of a drag, that's for sure, and it's starting to become insignificant next year relative to the overall Company's revenues and relative to all the growth engines that we've been developing, so that's the good news. I can't predict exactly how our networking business will fair next year. I can tell that you our growth businesses will actually grow and will grow at meaningful levels. It continues to be difficult to predict the legacy business just because it's hundreds of parts and hundreds of applications across many, many customers.

Sujal Shah

Okay. Thank you, Sumit. Can we have a next question, please?

Operator

Our next question will come from Allan Mishan with Brigantine Advisors.

Allan Mishan – Brigantine Advisors

Hi, guys, what are your expectations for the timing of shipping your enterprise SOC for enterprise hard disk drives? When do you plan to ship that?

Abhi Talwalkar

First half 2010 is I think what we've said in the past quarters.

Allan Mishan – Brigantine Advisors

Okay, great. And what did you see out of the China networking channel in Q3 and what do you expect for Q4?

Abhi Talwalkar

There was a bit of buildup in inventory in the second quarter. We feel like the third quarter worked much of that off, inventories in general feel relatively good. There's been a level of burstiness [ph] relative to build-outs, but I think some of that accumulation occurred in Q2 has dissipated.

Allan Mishan – Brigantine Advisors

Okay. Great. And then you mention that 6-gig SAS was shipping. Is that just in servers or are you also shipping expanded end controllers for RAID for 6 gig right now?

Abhi Talwalkar

Yes. All the above.

Allan Mishan – Brigantine Advisors

Okay. Thanks very much.

Sujal Shah

Thank you, Allen. I believe we have one last question.

Operator

Our last question will come from Sanjay Devgan with Morgan Stanley.

Sanjay Devgan – Morgan Stanley

Hey, guys. Thanks so much for squeezing me in. Abhi, I just had one question pertaining to your fiber channel business. Traditionally you've been pretty strong on the host side but I know the switch side is an if area you've been looking to make a push into. Just wondering you talk also about how you believe the inflection or the cross over 4-gig to 8-gig kind of takes place in Q4, how is that helping you and how should we look at that switch opportunity for you going forward for your fiber channel business?

Abhi Talwalkar

Well, we have, I think incrementally improved our switch position in the past year with a win that we had the year before. We did announce an additional win this year as well. So I think in general we feel like we are in a position to grow our switch silicon business over the coming years. Right now, keep in mind it's in general, it's an overall small part of our overall total revenues. Meanwhile, we've been not only securing, but we've been in development for quite sometime, working with our customers around FCOE silicon as well and we've been participating behind the scenes doing silicon also in the 10-gig space.

Sanjay Devgan – Morgan Stanley

Thank you.

Sujal Shah

Okay. Thank you, Sanjay. If there is no further questions, I would like to thank you all for joining us on the call today and have a great day.

Operator

Ladies and gentlemen, a telephonic replay of this conference will be available beginning today at approximately 6 p.m. Pacific daylight time and will run through 10:00 p.m. Pacific standard time on November 4th. The replay access numbers are 1-800-642-1687 within the U.S. and 1-706-645-9291 for all other locations. The webcast will be archived at www.lsi.com/webcast. That does conclude your conference for today. Thank you for your participation. You may now disconnect.

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