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Emulex Corporation (NYSE:ELX)

F2Q10 (Qtr End 12/27/09) Earnings Call

January 21, 2010 5:00 pm ET

Executives

James M. McCluney - President, Chief Executive Officer, Director

Michael J. Rockenbach - Chief Financial Officer, Executive Vice President, Secretary, Treasurer

Jeffrey W. Benck - Chief Operating Officer, Executive Vice President

Steve Daheb - Senior Vice President and Chief Marketing Officer

Analysts

Paul Mansky - Canaccord Adams

Amit Daryanani - RBC Capital Markets

Min Park - Goldman Sachs

Sammy Wilson - JMP Securities

Rajesh Ghai – ThinkEquity

Aaron Rakers – Stifel Nicolaus

Keith Bachman - Bank of Montreal

Harsh Kumar - Morgan Keegan

Presentation

Operator

Good day and welcome to the Emulex Corporation second 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 President and Chief Executive Officer Mr. Jim McCluney. Please go ahead, sir.

James M. McCluney

Thank you, operator. Good afternoon, everybody, and welcome to Emulex's second 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 CFO, and Steve Daheb our Chief Marketing Officer and Senior Vice President of Business Development.

Mike will start off our prepared remarks with the second quarter 2010 results and I will follow with my comments on the company's progress, and Jeff will then talk about the company's operating performance. I'll conclude our prepared remarks with some summary points and then we'll open the line for questions. Over to you, Mike.

Michael J. Rockenbach

Thank you, Jim. By now you should have Emulex's second quarter 2010 earnings release which was 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 statement and this presentation contain forward looking statements including, but without limitation, statements regarding Emulex's business, operations, and anticipated financial results for our third quarter of fiscal '10 and beyond. These statements are subject to risks and uncertainties and our actual results may differ materially from those discussed in these forward looking statements.

These risks and uncertainties include economic conditions, market growth, IT spending patterns, changing in technology, evolving industry standards, competitive pressures, pricing pressures, and fluctuation in OEM ordering patterns, the estimate of total available market size, the ability to address these markets with available technology in a timely fashion, research and development activities, the ability to achieve the expected benefits from our globalization initiative, and the risk and uncertainties described in Emulex's SEC report filed under the Securities Exchange Act of 1934 including Forms 8-K and under the heading risk factors in Emulex's most recent 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 its conversations afterwards, any material data that was not already disclosed in this conference call or its press release.

During the call when we use any historical non-GAAP financial measures defined by the SEC and REDg, you will find a reconciliation of the most directly comparable GAAP measure in our press release available on our investor relations website. All of the references we will make today relate to our non-GAAP results unless they did otherwise. Today's conference is being webcast and recorded and will be available on the Emulex website through January 2011.

I would also like to remind participants 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 second quarter ended December 27th 2009 totalled $108 million, a sequential increase of 27% and remains relatively flat from the prior year's quarter. Revenue exceeded the high end of our guidance of $88-$92 million provided in October and that's the high end of our preliminary results released last week.

Diluted earnings per share for Q2 totalled $0.18 exceeding the high end of our October guidance of $0.10-$0.12 and our preliminary results of $0.16-$0.17 for the quarter. EPS was up 125% from the $0.08 reported Q1 and decreased 22% from the $0.23 recorded in the second quarter of the prior year.

Taking a look at revenues by product line I'll begin with our host server products or HSP, which consists primarily of fiber channel host bus adapters or HBAs and mezzanine cards for Blade servers. 10 gigabit Ethernet conversion network adapters or CNAs and mezzanine cards, and also an (inaudible) used in server applications.

HSP revenues totalled $82 million, an increase to 28% sequentially and an increase of 1% over the second quarter of last year. Revenues for HSP board level products grew 30% sequentially and increased 3% compared to a year ago. The average selling price for board level products decreased 1% from the first quarter and a modest 7% from the second quarter of last year.

Dual channel revenues increased 34% on a sequential basis and now account for roughly two-thirds of our HSP board level product revenues.

Mezzanine card revenues increased 33% sequentially and grew 50% year over year. Revenues for our 10 gig fiber channel over Ethernet CNAs increased 57% sequentially, and in addition to our FCoE revenues, we also began to see revenues in the December quarter from our recently announced win at IBM.

Our second product line embedded search products, or ESP, encompasses data bridges and routers, fiber channel embedded SOCs and route switches, as well as single and multiprotocol embedded controller products for enterprise class storage systems. ESP revenues for the second quarter totalled $26 million representing an increase of 24% sequentially, but a decrease of 4% from the prior year's period.

As we have discussed over the last several quarters we've been seeing declining revenues in some of our legacy products in ESP, particularly the route switches. However, continued strong demand for our SOCs and bridges during the December quarter more than offset this decline. Based on current backlog and our customer forecast we expect ESP revenues to be flat to slightly down in the March quarter.

The geographical and customer breakdown for our revenues is available as supplemental information in our press release, however I did want to make one comment on our geographical mix. For those of you that have followed us for awhile, you'll recall we have been highlighting the significance of taking a global view of our business. During the quarter we saw meaningful sequential growth in all geographies led by APAC revenues which grew at roughly double the growth rate of the US (inaudible).

With international revenues accounting for almost 70% of our business we are seeing significant benefits on the bottom line from our international restructuring we completed in 2008. Based on our current expectations we are now modeling for a 20% tax rate for the balance of fiscal 2010.

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

Second gross margins of 66% were down from the 67% reported in Q1, but were up from 65% in the prior year. We anticipate gross margins for the third quarter will remain relatively stable coming in flat with Q2.

Looking at operating expenses, during the second quarter OpEx increased to $55 million compared to $48 million in the first quarter. However, as a percent of revenues operating expenses came in at approximately 50% of revenue representing a decrease of six percentage points from the September quarter. Although our revenues have benefited from increased IT spending, controlling our operating expenses and achieving the leverage benefit of our OEM business model remains a priority for us. The increase in expenses during the second quarter were primarily due to the reintroduction of employee benefits that we had eliminated or reduced during the prior year. We also continue to make investments in our go-to market capabilities with our OEMs to deliver and launch new products. With a significant level of overachievement in our revenues, we also saw higher variable compensation during the December quarter.

Finally, we incurred approximately $2.6 million of legal expenses associated with the patent litigation from Broadcom which is included in both our GAAP and non-GAAP results for the quarter. Q2 operating income of $17 million grew 97% sequentially coming in at 16% of revenue compared to 10% in the first quarter.

Second quarter net income of $14 million more than doubled sequentially, but was down 24% from the prior year results. Our tax rate for the quarter was 17%, and as I previously mentioned we are modeling for a tax rate of 20% for the remainder of fiscal 2010. Our net profit margin for the quarter was 13%, which is up from 8% in the prior quarter, but down from the 17% reported in the second quarter of last year.

For the second quarter on a GAAP basis we reported operating income of $6 million and net income of $9 million or $0.11 per share. A complete reconciliation between GAAP and non-GAAP income is included in our earnings release. ON a GAAP basis, Q2 R&D expenditures increased 1% sequentially to $32 million and quarterly R&D spending will vary depending on the timing of new product development expenses. Q2 R&D included $1.2 million of stock-based compensation.

Second quarter GAAP sales and marketing expenses increased 22% sequentially to $16 million compared to $13 million in the first quarter. Q2 sales and marketing expenses include approximately $867,000 of stock-based compensation.

Sequentially, GAAP G&A expenses remained relatively flat with the first quarter at $12 million, primarily due to lower expenses associated with the Broadcom unsolicited takeover proposal offsetting the increase in patent litigation legal expenses. Q2 G&A expenses included $1.2 million of stock-based compensation.

Looking forward to the March quarter we are modeling for stock-based compensation charges and patent litigation expenses that are comparable to those in the December quarter.

Second quarter inventory levels remained flat at $11 million and combined with the higher revenues for the quarter, our inventory turns increased to over 15 times per year. Depreciation was unchanged in Q1 at $5 million and capital expenditures were $3 million.

Before I discuss our targets for the third 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 press release. As a result of these risks and uncertainties we're unable to predict with accuracy what future quarterly results might be and there is no guarantee that the business will reach our expectations our goals.

Based on the forecast from our customers, the improvement in IT spending and our market share gains, we are modeling for revenues of $100-$103 million for the third quarter ending March 28th 2010 or a sequential decrease of 5%-8%. This represents a 27%-31% increase from the comparable quarter of last year.

While we don't give specific items by product line, I want to provide a little color on the trends we are seeing in the business. Based on the very strong results in December for HSP we are expecting revenues to be flat to slightly down in the March quarter as continued in SOCs and bridges offset the anticipated decline in our legacy route switches and router products.

For HSP the second quarter has historically been the strongest quarter for sequential growth. Coming off of significantly higher revenues in the December quarter, we're modeling for a modest decline in March, with continuing gross in our CNAs offsetting some of the seasonal declines in our fiber channel products.

Although we are modeling for a decline in sequential revenues, we are expecting gross margins and operating expenses as a percent of revenue will be flat with the second quarter results. This also assumes that expenses for patent litigation are comparable to the Q2 actuals. Using a 20% expected tax rate and roughly 81 million shares outstanding, we anticipate non-GAAP earnings per diluted share of $0.18.

Now let me turn the call over to Jim who will give you an update on the company's progress.

James M. McCluney

Thanks, Mike. Our December quarter results were an outstanding finish to a transformational year for Emulex and provides a validation that the company is executing well on its winning strategy. Let me take this opportunity to review with you the key points we've been messaging over the last 12 months.

Starting with our 30th anniversary event in February last year we began to articulate a vision for data centers of the future and of strategy for Emulex to be the market leader in converged networking. With the announcement of One Connect, the industry's first CNA or UCNA, on one command Emulex's framework for network management would fundamentally change the landscape for our competition by offering a truly unique product and approach for implementing converged networks. Our solution meeds the demands for improved performance while eliminating complexity and loading costs for the converged networks of the future.

Also in the first half of the year we will experience the impact of an increased vivid level of uncertainty in near-term IT spending. That made us take a hard look at our business. We made a lot of difficult decisions on where to make investments, but we remained committed to a few core principles and these are firstly, the companies with vision and conviction to invest in innovation and product development through a slowdown will be better positioned for successful growth during the recovery. Emulex has the courage of its convictions and the strength of a balance sheet to do just that.

Second, our customers and our opportunities for growth are global. Investing in sales and marketing within high-growth markets will drive share gains in a core business and increase profitability. Thirdly, thought leadership in new and emerging markets will make us more relevant to customers and will ultimately give us incremental growth opportunities on top of our current business. And finally, you must also have the right team to win. And while the near-term business climate made this more challenging, our execution during the past year is validation that we've build an outstanding team that has created a strong foundation for the future.

Midyear we started to articulate the market opportunities for our products and while the competition was dismissing some of our strategies, our customers were embracing them. The customer interest was validated by an accumulated of design wins for our UCNAs across NIC, iSCSI, and FCoE protocols.

During our August earnings call we shared with you our increasing confidence that IT spending had reached the bottom, and while we expected the recovery would be modest, we were modeling for our core business to see some growth in the first half of fiscal 2010. After exceeding our guidance for the September quarter we held an analyst day in October where we raised the competitive bar again with the launch of our second UCNA and the rollout of a pay as you go model for convergence.

We told you that 10 gig Ethernet would be the enabler for network convergence and this is coming true. Our momentum to become the thought leader for network convergence has been validated throughout the past year and positions us for growth in 2010 and beyond. Without the backdrop, let me talk about the operational momentum we have been demonstrating.

Over the past two quarter we have seen demand for our core products accelerate beyond a modest recovery in IT spending that we first discussed with you during our August earnings call. We'll have to wait for the third-party industry analyst reports to come out in a few weeks to tell how much of a performance is due to higher than anticipated spending. But with 14 out of 15 customers showing double-digit sequential growth, it's clear that our investment in sales and marketing during the past year is beginning to pay off by driving market share gains in our core business.

During the quarter operating expense did increase, but even with these increases we delivered on our goal of leveraging our OEM business model, the most significant of which is the ability to deliver earnings growth that exceeds the revenue growth, and you saw this in our December results.

Our diluted earnings per share more than doubled over September quarter compared to the 27% increase in top line revenues.

Before I turn things over to Jeff to provide more color on the company's operational performance, I want to refer back to one more point from our analyst day in October. If you recall, the financial model we shared with you for calendar 2010, we talked about our target of improving operating margins to the 15%-16% range for the full year. And it shouldn't go unnoticed that we're already at these levels going into 2010 and we have not even hit or stayed on the contributions we expect from our UCNA design wins. I'll talk more on my perspective for calendar 2010 in my closing remarks, but first let me pass it over to Jeff for some highlights on an outstanding quarter. Jeff?

Jeffrey W. Benck

Thanks, Jim. Let me start off by saying I'm proud of the team for their execution again this quarter. Our revenues of $108 million far exceeded the high end of our October guidance and for the third quarter in a row we have exceeded our earnings guidance. Our operations team performance in responding to increases in customer demand within the quarter was simply outstanding.

Next, I am confident we gave share in HSP based on our strong sequential growth rates in our core fiber channel business, while at the same time we experienced continued rapid growth in our new 10 gig Ethernet products. Lastly, we saw solid demand in ESP as we grew revenues again in the December quarter.

As we previously discussed, we have right-sized our investments and embedded storage products to improve their profit contributions to the company.

Let me now share some highlights across our business and provide an update on our strategic imperatives. The continued growth in our ESP business was well distributed across our storage customer base as many of the storage OEMs experienced a positive impact of some pent up demand now that broader IT spending is returning.

A new opportunity for our ESP bridging business that has us very excited is our ability to enable solid state disk OEMs to quickly provide solutions to server and storage manufacturers. SSDs represent a new category of storage devices and are experiencing positive growth in the market. Our new set of bridges are in late-stage qualification with several storage OEMs are and are also being qualified by several SSD supplies.

Now let me update you on the progress in our host server products. Revenues for the quarter came in at $82 million and grew 28% sequentially, led by our board products which grew 30% over the September quarter. We were particularly pleased with the performance of our 8 gig offerings. We enjoyed 59% sequential growth and they now represent 26% of our HSP business. Clearly our aching adoption in the marketplace is accelerating as server virtualization and consolidation are driving both bandwidth and performance that 8 gig is trying to address. We look for this growth trend to continue, particularly supportive by the upcoming X86 sever refresh cycle corresponding with new multicore Intel processor introductions.

We were also pleased with our greater than 25 sequential gross in our fiber channel HBA sales in the X86 server segment. Our better than market growth rate is clear indication that we gained significant share over the competition.

As you can see from the aforementioned details of our 2Q performance, our growth in the December quarter came predominantly from our core product lines. That being said, we also continue to make solid progress on our goal of building a high growth 10 gig Ethernet converged networking business.

Our 10 gig Ethernet FCoE CNA products experience very strong sequential growth at 57% quarter to quarter and positioned us to continue our market share lead in this new segment.

Our strategy for 10 gig Ethernet has remained very consistent since we introduced it to the industry a year ago. First, we will participate in all form, factors, and styles, of 10 gig technology. On this high-performance 10 gig technology foundation we will deliver industry leading virtualization capabilities allowing customers to carve up our 10 gig pipes to meet their specific application needs. Once virtualized we then have the ability to support the widest range of storage protocols in the industry including tow, FCoE, and iSCSI, all running on an enhanced Ethernet wire. Then to further differentiate our offerings we are allowing customers to enjoy a pay as you go pricing model on our base 10 gig adapters. This strategy enables our OEM partners to provide outstanding investment protection, flexibility, and future proofing to end users. Customers' feedback for offerings that allow them to only pay for what they use has been positive, particularly in this current economic environment.

Another key milestone the team achieved in the quarter was the announcement and shipment of our full range of second generation single chip Emulex branded UCNAs and our one command integrated IO management framework. This includes our 10 gig NICs, iSCSI adapters, and FCoE UCNA. We also had our first Ethernet win come to market with IBM making generally available our Emulex virtual fabric adapter for eServer Blade Center. The 10 gig product space will be busy for us over the next quarter as we have an unprecedented number of design wins coming available through our strategic OEM customers.

Concurrent with our OneConnect UCNA adapter product shipping, a new performance takeoff was completed by IT Brand Pulse that demonstrated that Emulex's CNAs blow away the competition in IOPS and transactional throughput. In IT Brand Pulse testing the Emulex One Connect UCNA achieved 919,000 IOPS on a single port, more than tripling the 250,000 IOPS performance achieved by our largest fiber channel competitor with their second generation single chip FCoE adapter. This performance is indicative of the benefits we provide in application environments, and with some additional tuning we can easily imagine bursting through the 1 million IOPS barrier. Using our solutions, customers can achieve significant cost savings by consolidating more virtual machines on fewer servers, or by taking advantage of our superior performance and high-demand transaction processing environments.

It's rare that we see such a difference in performance in the same technology generation, but these results are a testament to the superiority of our unique Ethernet based multiprocessor architecture. There is little debate in the IT analyst community that 10 gig Ethernet has arrived and it is poised for rapid growth in 2010, particularly with the upcoming X86 server OEM product line refreshes. With our set of 10 gig offerings, this unique performance advantage and the breadth of our X86 OEM design win, we are very confidence our overall business will see a significant contribution from these products by the second half of 2010. When you couple this opportunity with the return to growth in our core fiber channel adapter and embedded storage solutions, Emulex is well positioned to outperform the market.

Let me summarize with some key points before I pass it back to Jim. First, we have the only CNA design wins in the market that are being used to service both the Ethernet NIC requirements as well as the storage networking needs of the OEMs. Other competitors that ares shipping FCoE CNAs are only able to address the storage connectivity requirement because they lack a complete certified and hardened Ethernet staff to support demand in server requirements.

Second, we have an unprecedented number of iSCSI, NIC, and FCoE design wins with Tier 1 OEMs that have started to ship in Q2 and will continue to roll out through the first half of 2010. Next, with the addition of our large set of new 10 gig Ethernet products we are now participating in an emerging market that will enable us to more than double the size of our (inaudible).

Our priorities for the team for the next six months are superior execution on our design win, continued focus on our investments in new emerging business areas, and solid expense management as we target expansion of the earnings leverage in our business model.

Lastly, we are prioritizing our investments in support of upcoming OEM launched and helping to build brand awareness of Emulex as the leader in 10 gig Ethernet based network convergence. I look forward to sharing more exciting news of our continued progress on our next call. With that let me pass it back to Jim.

James M. McCluney

Thanks, Jeff. Great job. Well, what a difference a year makes. And as we sit here in early 2010 I can say with a high degree of confidence that we have made significant progress and that the worst of our economic war appears to be behind us. Having said that it's too early to declare victory as we've a lot of work to do over this year to meet our strategic performance goals and solidify Emulex's position of leadership in a network convergence. However, our guidance for the March quarter is indicative of a great start for Emulex in 2010.

A recent survey I saw from the Enterprise Strategy Group showed that more than 50% of respondents expect to see their IP spending shift out of a cost reduction mode and into cost containment for 2010. I've been asked to prioritize the investments. One third of the company is indicated increased spending and server virtualization would be the number one priority for the year. The upcoming X86 server refresh cycle that Jeff references is going to benefit from this focus by offering increased virtualization capabilities combined with significant cost savings. More importantly for Emulex, the majority of our 10 gig design wins are going to launch with this service.

So let me conclude the call with a few thoughts on what you can expect to see from Emulex in 2010. First, we're going to continue to expand on our recent success in gaining market share in our core business through superior execution. Second, we're going to continue to increase our addressable markets with new innovative product offerings in both our core business and network conversions. Third, we're going to accelerate our revenue growth through the back half of the year and beyond. Over the next two quarters we will launch more than half of our 10 gig design wins which will build on our recent market share gains and X86 platforms. And lastly we will remain diligent in our own cost containment efforts, balancing the needs for near-term profitability and long-term sustainable growth and innovation.

We look forward to reporting our progress to you throughout the next year and with that let's open your lines for questions. Operator?

Question-and-Answer Session

Operator

(Operator's Instructions) And your first question will come from Paul Mansky with Canaccord Adams.

Paul Mansky - Canaccord Adams

Thank you for taking the question and congratulations on a solid quarter. If I can go back to gross margins for a moment, 66.3% on a non-GAAP basis this quarter. Given your earlier comments relative to mix and obviously the clear volume implications here, I would've thought that we might've seen a little bit more strength on the gross margin side, can you talk to that for a few moments? And then I have a followup a swell.

Michael J. Rockenbach

Sure, Paul. This is Mike. We've got a mix of quite a few different products. Our first generation UCNAs have lower gross margins, also we had pretty strong gross in mezzanine cards which have lower gross margins on a relative basis as well. So when you look at in total we were actually only down about 600 basis points from last quarter. I think it was 66.9 versus 66.3 so there really wasn't too much a difference on the gross margins in terms of where we were in Q2 versus Q1.

And then looking forward we're actually anticipating a little bit lower revenues, but actually maintaining our gross margins.

Paul Mansky - Canaccord Adams

Okay. And then shifting gears a bit to the operating margin line, I believe you provide some high level commentary relative to how we should be thinking about OpEx in the March quarter, can you reiterate that for us please what you were you saying?

Michael J. Rockenbach

Yeah. A couple of things and I realize there's a lot of moving parts, but you may recall about a year ago or so we made a number of tough choices in terms of our benefits for employees and then obviously other expenses including some headcount reductions. And as we've come into fiscal 2010 we've now reinstated essentially all of those employee benefits so there is some incremental expenses associated with that. And then certainly we had just a terrific quarter and exceeded our targets and goals so there's some variable compensation increases within those expenses as well. And then one of the things we mentioned in our prepared remarks is we had about $2.6 million of legal expenses specifically associated with the patent litigation that are included in our operating expenses both on a GAAP and a non-GAAP basis. So looking forward into Q3 we start over pay well taxes again in Q1 which would actually put some increased pressure on operating expenses, but we're going to fully absorb those and we're not expecting to have as much variable pay so we'll see some lower expenses there. And we are assuming that we have roughly the same amount of patent litigation expenses so in terms of overall operating expenses we're expecting operating expenses will be down sequentially because we're going to be able to maintain the operating margin percent we have even though revenues are coming down in Q3 so hopefully that helps.

Paul Mansky - Canaccord Adams

Yeah, it does indeed. And just to clarify, back at the analyst meeting you mentioned 20% as an internal target exiting calendar 2010 I believe, from an operating margin perspective. I guess A, does that still hold or can we even possibly be thinking about maybe hopefully pulling that thing forward a touch.

Michael J. Rockenbach

Well, I don't know that we got that specific in terms of what we were modeling for internally within the context of calendar 2010, but certainly we want to get back to a 20% operating income. What we did say was we were looking at the full calendar year being in the 15%-16% range, and at the time we were modeling for operating income going into 2010 and obviously in the 12%-13% range so obviously we would be exiting the year higher than that to average 15%-16% for the full year. And then the main point that Jim was trying to make was we're entering the year now at 16% and that includes the litigation expenses as well so we're clearly going into the year in a much stronger position than we had been modeling for even as recently as the last 90 days. We're not quite ready to give you some updates to those numbers, but I think you can feel out a progress just with the fact we're going in at the rates we expected to average for the full year.

Paul Mansky - Canaccord Adams

Indeed, great. Thanks very much.

Operator

Your next question comes from RBC Capital Markets. We'll hear from Amit Daryanani.

Amit Daryanani - RBC Capital Markets

Thanks, all. Congratulations on the quarter as well, guys. Maybe just to stick on the OpEx question just a little bit, if I look at year-over-year trends your sales are roughly flat, but your operating margins are down about 500 basis points. I get a couple hundred basis points is due to the litigation, can you just tell me what's the rest of the delta and what sort of revenue run rate does it take to get us to 20% down the road?

Michael J. Rockenbach

Well, as I said we have had a pretty significant overachievement in terms of our result compared to where we were forecasting so there was some more variable compensation within the expenses as well. And then there's always timing differences. We've got a lot of activities although we're very focused in terms of what we're investing in our product development. We've talked about the number of X86 10 gig launches that we've got coming up over the next couple of quarters here and there's a lot of development activity and expenses associated with getting those ready and getting into market, and then we have the analyst day and the launch of our Emulex branded 10 giga products during the December quarter and we certainly didn't have anything like that last year. So there was a lot of moving parts, but I like to think that they were all moving favorably in the right direction for us.

Amit Daryanani - RBC Capital Markets

And I guess, Michael, what sort of revenue run rate would you need to get back to 20% margins on their own?

Michael J. Rockenbach

Well, maybe you could look at it as if there was no other changes in gross margins or operating expenses. We're probably maybe 10%-15% below the revenue number, but we're really focused on managing operating expenses and making the right investments as we go forward and it's really going to depend on what the gross margins are in terms of our business, but I think we're well on the way to be able to make continued progress towards our goal.

Amit Daryanani - RBC Capital Markets

Got it. And then just a quick question on the embedded side of the business of it. It was up quite a bit, do you have any sense if you could parse out how much of that do you think was sort of inventory restocking the channel versus true end demand uptick that drove it?

Jeffrey W. Benck

Yeah, this is Jeff. You know, we have had some inventory swings in this part of the business that can be pretty volatile so we're watching it pretty closely. We do think that this business dropped off obviously quite a bit further than our broader business with the economic downturn and now we see it coming back and certainly the business is stabilizing. We're encouraged though because we have a broader customer set now that we're dealing with. We're not quite as concentrated in the number of storage customers that we're selling to and our portfolio is broadening as well. In fact, we talked in this call about the addition of solid-state disks as a new opportunity there.

But as far as the business level goes, we kind of see this new level and some modulation off of that and we're paying attention to inventory. It's a concern for us that people don't drive to inventories as IT demand picks up and it's something that we've got to focus on as we go forward.

Amit Daryanani - RBC Capital Markets

Got it, thanks.

Operator

From Goldman Sachs we'll talk a question from Min Park.

Min Park - Goldman Sachs

Great, thank you. Just a couple of quick questions, as we get closer to more design-win announcements, can you just provide a little bit more color on the margin characteristics of your UCNA, 10 gig mix for the near term and how you expect that to change as well you're speaking (inaudible)?

Michael J. Rockenbach

I'm sorry, could you repeat the beginning? Was it the margin you were asking about?

Min Park - Goldman Sachs

Yeah. So you're going to announce more design wins over the next couple of quarters so we just want to get a little bit more clarity on the margin characteristics of those design wins in the near term and also how you expect those margins to change as volumes wrap?

Michael J. Rockenbach

Sure. Let me take that and then Jim and Jeff can add on. I think when you look at the markets that we're focused on and what makes us really unique going into this market is that we've got the right platform to go after both the Ethernet market as well as the traditional storage market that we've always done well in today with our fiber channel cards. So when you're in the data center those have higher ASPs, they have higher gross margins, and in a pure Ethernet NIC environment it's got lower gross margins out of the door, but with our strategy of being able to pay as you go, upgrade that in the field as you want to move up from a standard Ethernet NIC network configuration to a FCLE platform, we're going to have the opportunity for those gross margins to be better obviously as it's implementing an FCLE upgrade.

I think as we look over the next couple of quarters in the launch you're going to see our gross margins fairly stable. I mean, I think they're going to trend down a little bit as these products are revamping because they do have lower gross margins than our current business, but on the operating margin side we're going to get a lot of leverage because we're using a single platform to go after these multiple markets. After that it's really going to depend on how quickly 10 gig in general gets traction in the market. Now we expect that the network market itself, the Ethernet net market is going to ramp first and it's going to be the platform for convergence down the road so we expect that we're going to see these gross margins trend down as that business ramps up, but kind of slowing down or mitigating that decline is we had a terrific quarter in December with gaining market share in our traditional fiber channel business and our goals and our efforts are focused on continuing to do that so I think that can mitigate some of that as we go forward. And then clearly on higher revenues holding our operating expenses down the line we've got just real great OEM models that leverage and delivers faster EPS growth as our business grows.

Min Park - Goldman Sachs

Okay. And then just following up on that, to what extent will IBM Power 6 and P-Series product Refresh help you offset the normal seasonal declines of the March and June quarters? Have you guys put that into your model?

Michael J. Rockenbach

Well we look at the model. As we do forecasts we're looking at a macro level so we try to consider everything that's going on there. Sometimes you have independent announcements that have an impact, but it's sometimes hard to predict exactly when that will occur and how a particular OEM launches the platform and what they might do in front of that. So we engage with our partners and try to account for it , but it's something that we can't always predict completely.

James M. McCluney

At least we see the refresh coming though and it's really good for us obviously because we've got a high percent share there and we stay close to the customers and make sure we've got the inventories in place to support the launches and just as we're positioning to your other question for the 10 gig launches as well they'll be coming over the next six months.

And I'd just like to add something to Mike's statement is that the one benefit as well of the OEM model is we've got a lot of visibility to price and cost data. So we know the gross margins that we'll be operating under, allowing for some mix changes over the next year. And that's why we're really looking at — we think we've got the right rough level of infrastructure in place to manage that business. There's always some pricks and takes on product launches, but I think our stated goal is to get the top line really moving, but get the bottom line moving even faster and deliver those dollars in EPS.

Min Park - Goldman Sachs

Great, thank you very much.

Operator

We'll hear from Sammy Wilson from JMP Securities.

Sammy Wilson - JMP Securities

Yeah. It's Sammy Wilson for JMP Ireland. A couple of just housekeeping questions, I missed what was cash from operations for the quarter?

Michael J. Rockenbach

We ended our cash balances for the quarter, they were actually a little bit down. I think we ended Q1 at about $271 million and we ended Q2 at about just under 270.

Sammy Wilson - JMP Securities

Right, do you have anything for cash from operations?

Michael J. Rockenbach

I don't have that number. December quarter for us, one of the things we've seen historically is that payments seem to be a little bit slower going into the year end. We did have a pretty sizable increase in our receivables, but no change to our customer mix so it's not a question of having a concern about the collectivity of that, but we did see receivables go up by I think about $18 million sequentially and what we've seen historically is the receivables come back down in the March quarter.

And then of course we had legal expenses during the quarter that were a little bit higher than usual and we also provided a bridge loan to one of our partner within the quarter.

Sammy Wilson - JMP Securities

And that's a little bit of my second question, was linearity any different than usual for the quarter in terms of booking?

Michael J. Rockenbach

No. Over the last few years a combination of the ESP business which tends to see purchases a little bit earlier in the pipeline as well as a mix of customers that are now fairly spread out with some of them in our first month of the quarter and a lot of them in our third month of the quarter. We actually see our shipments pretty linear. I think the one thing I would say that was different this September quarter than a year ago was we really saw things start to slow down going into the last few weeks of December and then really slowed down in the first start of the March quarter and we didn't see that this quarter. We saw really nice consistency and I think one of the numbers that Jim had was 14 out of 15 of our OEM customers grew double-digit sequentially. So in that respect from a quality of revenue it was terrific. It's very broad based, it's a lot of customers, it's a variety of different products, so it does pretty well as we come into this year.

Sammy Wilson - JMP Securities

And then just two really small questions; what was the headcount at the end of the quarter and would you expect the 20% tax rate to go ahead and be for fiscal 2011 also?

Michael J. Rockenbach

The headcount I don't know the exact number, but it was flat to maybe down a little bit.

James M. McCluney

I think it was down a little bit.

Michael J. Rockenbach

It's around 770. Actually 766 is what it was. I think it was down a few from the September quarter. And then as far as the tax rates there's a lot of things that come into play in that. One of the more meaningful things obviously is our revenue levels and the geographic mix, but we have seen a combination of it as we are moving the business more to a server centric focus and our design win opportunities in terms of the new products are in a lot of the server guys we have seen that the international piece of our business has been and we anticipate it remaining still pretty high. So I think at this stage that's probably our best estimate. I've got to always throw in the caveat of that's subject to legislation and changes down the road, but I think as we sit here today we'd expect to have a fairly comparable tax rate.

Sammy Wilson - JMP Securities

Got it. Perfect. Thank you so much.

Operator

From ThinkEquity we'll hear from Rajesh Ghai.

Rajesh Ghai - ThinkEquity

Yes, thanks. Question under your guidance, so if I do the math correctly if I take the midpoint of the revenue guidance range and assume that the ESP business is flat in Q3, I see that you probably are modeling a 10% decline in the HSP business. Now considering that the server refresh is picking up and the EX is supposed to come out this quarter and (inaudible) series of refreshes also on the (inaudible). I'm just wondering what are the core assumptions you're making to guide to that 10% decline?

Michael J. Rockenbach

Well, let me start with we're not specifically guiding to a 10% decline in HSP and in fact one of the things we said was our expectation is that ESP will be flat to down after coming up two very strong quarters, but there's a number of different things that we look at. Going into the December quarter we were modeling for $88-$92 million so we significantly overachieved against that target. So I think there's — I look at the $100-$103 million as a very strong quarter and I think there are a lot of moving parts. Certainly there's opportunities with server refreshes coming up and we think that's a great opportunity for the 10 gig business, but that isn't necessarily happening in the March quarter. We see that happening in the first half of the year and as Jim mentioned, we're 100% of the connections in P&I series, but as you look at that that's a big expensive box and IT spending has come back. Certainly terrific improvement in IT spending verus six months ago, but I think we want to be cautious as to how we look at the business and don't want to get ahead of ourselves in terms of what we're modeling for.

So certainly there's a lot of focus on execution on our side to continue to gain share that we have and I think equally important be able to execute to the extent that demand is better than we anticipate.

James M. McCluney

And of course with (inaudible) holding of expenses flat to down so we do get a benefit from some launches there and then it'll be good for the company.

Rajesh Ghai - ThinkEquity

Sure. Talking of expenses, you guided to a flat op margin for Q3 and a flat gross margin. So if I do my math again it seems you will probably reduce your OpEx by about $4 million or about $3 million so what gives compared to Q3? Is it going to be variable costs, the variable comp, or something else?

Michael J. Rockenbach

Yeah. As we mentioned, significantly overachieving on the top line there's some performance based pay that was incremental to our expenses in the December quarter and so we're modeling our expenses on compensation in line with the top line revenue guidance we have and so that'll bring down operating expenses.

We also had a lot of activities in sales and marketing around the launches of our new products. We had the analyst day — well, we were in New York, but we actually had it globally and we got a lot of — there's some of these cards that we do as we go into launches as sales and marketing expenses in the December quarter as well so I think the one key thing I guess that is probably worth pointing out is our head count was relatively flat to ever so flatly down so the expense increases that we had in Q2, they weren't headcount based and so when you think about it from that perspective as you add incremental headcount that's kind of permanent expenses that you can go forward.

So there was variable expenses and timing of things that we were doing and engineering sales and marketing as well as G&A that were specific to Q2 and we see the bulk of those being lower in our March quarter.

Rajesh Ghai - ThinkEquity

Okay. At analyst day you had announced a pay as you go 10 gig strategy and so it's been about a couple of months, I'm just curios, has that announcement actually helped you gain shares in the 101 gig NIC market and how do you see the OEM reception in general to that strategy?

Jeffrey W. Benck

Well, we know the response has been outstanding from not only OEM customers, but end users. We referenced the IBM announcement of their virtual fabric adapter for their Blade platform and they've certainly messaged the upgradability for a free to (inaudible) on top of that platform so that's the clear clean endorsement of that pay as you go strategy from a major OEM.

We've talked a lot about the traction and we actually continue to get new design wins. I think that element, the pay as you go, is one piece of our differentiation. Recently we put up some just phenomenal performance numbers that IT Brand Pulse did a survey and some testing and we've got more than triple the performance of our competitors CNA. So that coupled with some of the differentiality in the pay as you go just gives us a huge bit of news to talk about and real value for customers. So far the response has been just great and we're pretty excited about it.

Rajesh Ghai - ThinkEquity

Okay, great. Thank you, congratulations.

Operator

Next we'll hear from Aaron Rakers with Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

Yes, thanks guys. I guess my question probably builds on a prior question. You had talked about the system P refresh, just in context of the guidance that you guys have given, in the past sometimes that can be a bit of a lumpy transition for IBM. Have you baked in some conservatism around that refresh cycle in Q1 or just trying to understand what you've baked in, in terms of that refresh?

Michael J. Rockenbach

Well, we look at the overall business. I wouldn't get down to the granularity of what level of conservative we bake in for a particular platform or a particular customer, but we look at the business as a whole and we like to make sure that we've got some opportunities to protect our business if there's volatility in our numbers. So again I really don't want to get down to specific granularity on different platforms, but we are the provider of fiber channel connectivity to that platform and to the extent that it does better than either we or they anticipate, we're in a great position to benefit from that.

Aaron Rakers – Stifel Nicolaus

Fair enough. And then one last question for me, actually two questions. First part, can you help us understand what type of premium you're currently seeing on 8 gig relative to 4 gig and whether there's then a differential in the gross margin. And then the final question would be I guess recently you announced a relationship with Alacritech. Can you just maybe explain what that relationship is and how that fits into your strategy longer term?

Jeffrey W. Benck

Yeah, in terms of 8 gig I think in general the pricing is fairly comparable, maybe a little bit more than 4 gig, but it's close enough that we're not seeing that as an inhibitor for a ramp of 8 gig. In fact we saw really nice 8 gig ramp sequentially I think it was up I want to say 56%-57% sequentially and it's over 25% of our revenue.

Operator

It looks like Aaron has lost his connection. We'll take a question with Keith Bachman, Bank of Montreal.

Keith Bachman - Bank of Montreal

Hi, guys. I know you were hoping you lost me as well.

James M. McCluney

(Laughs) I'd never say such a thing!

Keith Bachman - Bank of Montreal

I had two if I could. Number one, Mike, just going back to demand that you're seeing versus your OEMs. You guys had a really good quarter, you look at IBMs numbers, your largest customer, and effectively they had a little less than normal seasonality in their Ps and all the other parts of their hardware business and the broader question is how do you see inventory levels help or hurt? Because one of the things that we think about as we're looking at Q4 results, we just hope we don't all get into assuming that the current demand profile has some extra help potentially from a budget flush and that we all might be surprised from the March quarter so I just want to get your take of what you think the status of the inventory levels, ins and outs, that experience here in the December quarter, are included in the channel?

Michael J. Rockenbach

Well, let me start and Jim and Jeff can add on. I think one of the key things to think about from an inventory perspective is we use hubs. They pull the inventory when they need it so they aren't pulling inventory from us to build inventory on their side, they don't need to. We've got a contractual obligation on how much inventory will be there to support their demand so really they have no incentive to build inventory in terms of cards.

I think IBM obviously is slightly bigger than we are and in different areas than we are, although they are obviously a terrific customer for us and I think our lead customer, but one of the things that I think is clear, at least in terms of our results and other announcements or preannouncements we've seen in the market is we did really well and I think when we look within our customers and across our customers we gained share and so they don't have incentive to build inventory. We've got a very consistent and high on time versus their quest dates so they don't have the risk that they won't be able to meet demand because we can't reach our requirements, and we have spent a lot of time and effort to gain market share and we think we gained market share.

James M. McCluney

Yeah. The second part of inventories into that channel, they're absolutely the right levels they should be going into the March quarter. And the good news is we're seeing sell out from those inventories already in January so it's an indication the end use of demand is there, but we look through things the same way as that we're really watching for inventories out there, but probably the place we'll look most is in our embedded products because we're so far down the food chain.

Again, with flat to slightly down demand in March which would suggest there wasn't a particular big buildup of inventories in the December quarter. So we're optimistic.

Keith Bachman - Bank of Montreal

All right, well just jumping back on the embedded site for a minute because obviously that's been a problem if you look back over the last two or three years. And at this point you see more confidence and does that confidence stem from — you mentioned diversity of the customer base which would help, but do you feel like you have better systems, managements, or better interaction with the OEMs such that you have a better handle on that inventory?

Jeffrey W. Benck

Yeah. I mean it's something we put a focus on and we've been delving in not only to our customers, but to their OEMs and their partners, but it's also a challenging area to really feel like you really understand every single customers, every single relationship. But it has been an area of focus, we try to pay attention to it. But we are a little apprehensive given the rapid kickback up of the business, but it's something we have explicit focus on, we're having discussions with customers on it on a daily basis so it's an area that I think we're doing the kind of things we need to be doing to be able to better predict what's going on there.

I wanted to just circle back on the X86 market. One thing we broke out here was our sequential growth in X86 space. We saw over 25% growth sequentially. I think our largest competitor kind of talked about a number that was half of that s we have a lot of confidence about share gain, independent of what System P and the UNIX platforms do. So I just though t I would make sure you picked up on that on some of your —

Keith Bachman - Bank of Montreal

Yeah, no, I got that. Mike, just on the share — it looks like you bought some stock back during the quarter. I don't have your cash flows so A could you just confirm that, but B, what are you guys thinking here with your cash balance vis-à-vis your share count?

Michael J. Rockenbach

We actually didn't buy back wares in the December quarter. The impact what you're seeing is that we had repurchased about 2 million shares. I think we spent about $20 million in Q1 so that's a weighted number within the quarter.

Keith Bachman - Bank of Montreal

Okay, fair enough.

Michael J. Rockenbach

There are a number of benefits from the full impact of that. Our strategy with cash, I think one of the points that Jim made is cash was a big, big benefit for us over the last 12 months. To have the ability to make decisions and able to support those decisions with a balance sheet to invest in the directions we needed to go, even though it was obviously a very challenging time from an economic standpoint. I think in general our philosophy on cash and the cash balances and what we do with that hasn’t' really changed over the last few years.

We've got about $80 million left available under the existing repurchase plan that's approved by the board. We want to look at our business going forward and our ability to generate cash in the future, but we have used our cash balance to essentially eliminate the creep of share counts over time and use that holding our share count flat to compliment the execution of the business. So I don't think our philosophy has really changed as we've seen that over the last couple of years.

Keith Bachman - Bank of Montreal

Okay. Thank you, guys.

Michael J. Rockenbach

I think we got time for one more question.

Operator

And your final question will come from Harsh Kumar with Morgan Keegan.

Harsh Kumar - Morgan Keegan

Yeah, hi. Hey, guys. Thanks for getting me in right at the end. Question on your ESP business, it's coming off of a pretty low base running up here. Can you talk about your growth prospects in quarters past the March quarter, i.e. any indication of design wins that would make us comfortable that we can see growth just beyond this quarter we're in? And then I've got a followup.

Jeffrey W. Benck

Yeah, Harsh. This is Jeff. We talked already about our (inaudible) bridge technology is actually in qualification number of OEMs. We'll be seeing that role out in the second half of the year. We also started implementing on our SSB subsystems and solutions business there with some OEMs. That's towards the back the end of the year that's going to help us there. And then thirdly we introduced a little bit more detail on solid state disks as an opportunity for us for that bridging for solid state disk manufacturers want to get maybe a fast SSB in the market quicker leveraging that technology and our high-performance bridges us allow that to happen more quickly.

We've got a number of design wins there, probably four design wins there and a number of engagements that could lead to further design wins. And those will also start to actually come to market in the second half of the year. So we've got a pretty good design and pipeline there on the embedded side that we're pretty pleased about. There is some business in route switches as we talked about in the past of just coming down and offsetting it, but it's creating a very nice business, particularly as we looked at expenses in this area to ensure that it's really nicely contributing in profits to the total company.

Harsh Kumar - Morgan Keegan

Got it, Jeff. Very helpful. And then real quick, would you care to break out the size of your CNA business at this point or is it just slow timing?

Jeffrey W. Benck

I would leave it as it's growing really nicely and if the overall business hadn't done so well it would've been a larger percent.

Harsh Kumar - Morgan Keegan

Okay fair enough. Thanks, guys. Thank you.

Michael J. Rockenbach

Thanks. I just want to thank everybody for participating in our second quarter conference call. We've got a lot of conferences we're going to be attending over the next couple of months. February 9th we're going to be at the Thomas Weisel Technology Conference in San Francisco, February 23rd at the Goldman Sachs conference in San Francisco, March 2nd at the Morgan Stanley conference in San Francisco, and then on March 10th we'll be presenting at both the Wedbush and Jefferies technology conferences in New York City. So we look forward to meeting with you and speaking with you then and thanks again for joining us on our call and have a good evening.

Operator

Ladies and gentlemen, that does conclude today's presentation. We do thank everyone for your participation.

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Source: Emulex F2Q10 (Qtr End 12/27/09) Earnings Call Transcript
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