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QLogic Corporation (NASDAQ:QLGC)

F3Q10 (Qtr End 12/27/09) Earnings Call Transcript

January 26, 2010 5:00 pm ET

Executives

Simon Biddiscombe – SVP and CFO

H.K. Desai – Chairman and CEO

Analysts

Aaron Rakers – Stifel Nicolaus

Amit Daryanani – RBC Capital Markets

Keith Bachman – Bank of Montreal

Min Park – Goldman Sachs

Katie Huberty – Morgan Stanley

Rajesh Ghai – ThinkEquity

Munjal Shah – Jefferies

Mark Moskowitz – JPMorgan

Kaushik Roy – Wedbush

Jason Noland – Robert Baird

Douglas Ireland – JMP Securities

Operator

Good day everyone. Welcome to the third quarter fiscal year 2010 QLogic earnings announcement conference call. (Operator instructions) At this time, I would like to turn the conference over the Simon Biddiscombe, Chief Financial Officer. You may begin, sir.

Simon Biddiscombe

Thank you. Good afternoon, and welcome to QLogic’s third quarter fiscal year 2010 earnings conference call. Joining me on the call today is H. K. Desai, our Chief Executive Officer. I will begin the call with a review of the third quarter financial results. H. K. will follow with a discussion of the current state of our business, and progress on our strategic initiatives. Afterwards, we will open the call for questions.

Certain of our comments today will include forward-looking statements regarding future events and/or projections of the financial performance of the company based on our current expectations. These comments are subject to significant risks and uncertainties that could cause our actual results to differ materially from those expressed in these forward-looking statements.

We refer you to the documents QLogic files with the SEC, specifically our most recent forms 10-K and 10-Q. These documents identify important risk factors that could cause our actual results to differ materially from expectations. We do not intend to update these forward-looking statements that we make today.

In our third quarter earnings press release issued earlier today, we reported both GAAP and non-GAAP results. A reconciliation of GAAP net income to non-GAAP net income and a summary of the non-GAAP adjustments are included in our earnings press release. All of the references we will make on our call today relate to the non-GAAP results, unless otherwise stated.

Turning now to our financial results for the third fiscal quarter ended December 27, 2009.

Our revenue in the third quarter was $149.1 million, a decrease of 9% from the same quarter last year. This revenue represents a sequential increase of $17.7 million or 13%, and significantly beat our forecasted range of $134 million to $140 million provided during our second quarter earnings conference call, and exceeded our preliminary third quarter results announced on January, the 12th of $147 million to $149 million.

Revenue exceeded our expectations primarily as a result of a 17.5% sequential increase in revenue from host products. Our third quarter revenue from host products, which are comprised primarily of Fibre Channel host bus adaptors and converged network adaptors was $110.4 million, and decreased 1.5% from $112.2 million recorded in the third quarter of last year.

Third quarter revenue from network products, which are comprised primarily of Fibre Channel and InfiniBand switches, was $27.4 million and decreased 16% from $32.8 million recorded in the third quarter of last year.

Our third quarter revenue from silicon products comprised primarily of Fibre Channel and iSCSI protocol chips was $8.7 million, and decreased 47% from $16.5 million recorded in the third quarter of last year. Silicon products also include chips for embedded applications for converged networks.

Our revenue from royalty and service was $2.6 million.

Our third quarter gross margin of 66% declined from 68% recorded in the third quarter of last year, primarily due to lower volume to absorb manufacturing costs and unfavorable product mix. Our gross margin was consistent with our forecast provided during our second quarter earnings conference call.

Next, I would like to cover our quarter operating expenses. Total operating expenses were $53.2 million, down 3% from $54.6 million reported in the third quarter last year. Operating expenses were below our expectations.

Engineering expenses in the third quarter of $29.5 million, increased 1% from a year ago and increased as a percentage of revenues from 17.7% to 19.8%. We expect future engineering expenses as a percentage of revenue to be in the range of 18% to 21%.

Sales and marketing expenses in the third quarter of $16.9 million decreased 10% from a year ago and decreased as a percentage of revenue from 11.5% to 11.3%. We expect that future sales and marketing expenses as a percentage of revenue will range from 11% to 14%.

G&A expenses in the third quarter of $6.8 million were consistent with a year ago and were 4.6% of revenue in the December quarter. We expect that future G&A expenses as a percentage of revenue will be approximately 4%.

Operating profit in the third quarter was $45.2 million, which was 30.3% of revenue. Interest and other income was $1.7 million in the third quarter.

Our income tax rate for the third quarter was 22.8%, which was better than our expectation as a result of certain discrete items during the quarter.

Our third quarter net income was $36.2 million, and represented a net profit margin of 24.3%. This net income represents a sequential increase of $11.1 million or 44% from the September quarter.

Our third quarter net income per diluted share of $0.31 significantly beat the high end of our forecasted range of $0.22 to $0.24 provided during our second quarter earnings conference call, and exceeded the $0.29 to $0.30 provided in our preliminary third-quarter results announcement. This represents the 58th consecutive quarter of profitability for QLogic.

Turning now to our balance sheet, the company’s cash and investment securities were $349.2 million at the end of the third quarter. We continued to maintain a strong cash position and have no debt.

During the third quarter, we generated $44 million of cash from operations. During the quarter, we purchased $39.8 million of the company’s common stock at an average price of $18.24 pursuant to our stock repurchase program. We expect to purchase common stock with a total value significantly in excess of free cash flow in fiscal 2010. Since 2003, we have used nearly $1.4 billion to repurchase 89.5 million shares of the company’s common stock.

Receivables of $86.1 million at the end of December, increased from $75.2 million at the end of the September quarter. DSO at the end of the December quarter was 53 days compared to 52 days at the end of the September quarter. We expect DSO in the future to range from 45 to 55 days.

During the quarter, we continued to make significant progress with regard to inventory. Inventory at the end of the December quarter was $21.8 million and decreased sequentially from $23.3 million at the end of the September quarter.

Annualized inventory turns for the December quarter was 9.3 compared to 7.8 turns for the September quarter.

Turning now to our outlook for our fourth fiscal quarter, we expect total revenue for the March quarter to be in the range of $140 million to $144 million. We expect gross margin to be approximately 65.5%.

Based on this outlook, combined with the planned operating expenses of approximately $56 million, a sequential increase primary due to employment costs associated with the new tax year, and a projected quarterly tax rate of approximately 25%, we expect to achieve non-GAAP earnings per diluted share of approximately $0.24 to $0.26 in the March quarter.

Actual results for future periods may differ materially due to a number of factors, including those outlined during the course of this conference call, in the company’s filings with the SEC, and in the disclaimer statement at the end of our earnings press release.

I will now turn the call over to H.K. H.K.?

H.K. Desai

Thanks, Simon. My remarks today will be focused on the current state of our business, followed by a quarterly update on our strategic initiatives. We are very pleased with our strong financial performance in the third fiscal quarter.

Revenues of $149.1 million, up 13% sequentially, significantly beat our originally forecasted range of $134 million to $140 million provided during our second quarter earnings conference call. On a sequential basis, revenue from host products grew 17.5% and revenue from NetWare products grew 12%.

We are very encouraged by the breath of our revenue growth with each of the four major server OEMs growing between 21% and 23% sequentially. We're also very pleased to have achieved our targets of 30% operating margin and 20% net profit margin through increased revenue, a sequential improvement in gross margin, careful operating expense management, and a lower tax rate.

During the third quarter, our net income per diluted share was $0.31 and significantly beat our originally forecasted range of $0.22 to $0.24 provided during our second quarter earnings conference call.

Net income for the third quarter increased sequentially by 44% on a revenue growth of 13%, demonstrating the significant leverage that exists in our model. We continue to be optimistic given the trends we are seeing in our business. We are encouraged by the improvements we experienced in order patterns and shipments during the December quarter, and the forecast we are receiving from our OEM customers for the March quarter.

We are clearly benefiting from the server upgrade cycle that is underway, and is expected to continue through calendar 2010 driven by the transitions to Intel Nehalem-EX based servers increasing the adoption of VMWare and other high providers and the shift to Windows Server 2008 R2.

We expect to benefit from an improved IT spending in 2010. QLogic is strongly positioned with a broad product portfolio to be a significant beneficiary of this server update cycle.

Now, I will provide an update on our strategic initiatives. During the third fiscal quarter, we made significant progress on the three strategic initiatives that we have previously discussed, specifically FCoE or converged networking, Fibre Channel, and InfiniBand. Our focus and investment in this strategic initiative is as important as ever to ensure that we are optimally positioned for continued growth and market leadership.

In converged networking, we further extended our lead as the premier supplier of single chip fibre channel or Ethernet converged network adapters or CNS. In October, we announced that IBM Power System has chosen our single chip 8100 CNS for native FCoE connectivity and Ethernet niche [ph] requirements, repeat Ethernet niche requirements in the IBM Power System portfolio of tower, rack-mount and blade servers.

With additional power system for large-scale Unix and Linux deployments, we continue to expand our leadership positions in FCoE. And this is a significant milestone that represents an expanded market opportunity for QLogic. Until this achievement, we have not had access to the IBM Power System SAN connectivity market. Revenue shipments began in October right after the announcement.

In November, we announced that we were first to achieve full VMWare vSphere 4 certification with our 8100 Series adapters. VMWare vSphere 4 is the industry's leading platform for datacentre virtualization for both FCoE and 10-gig Ethernet publications. The powerful combination of our 8100 CNS with vSphere 4 enables customers to achieve a high degree of datacentre efficiency where thousands of virtual machines supporting enterprise business application, around a densely packed server or converged, unified networks.

In December, we announced that Dell is shipping our 8100 Series CNA across a broad range of Dell Poweredge Servers, including Intel Xeon 5500 Nehalem (inaudible) servers, tower servers, and blade servers. Dell has deployed our products for both Ethernet niche requirements and storage network in niche. By reducing infrastructure requirements for Dell customers, our CNS enables organizations to streamline the datacentres, while optimizing performance for both application and environment.

Our announcement marks another key milestone in our long-standing history of providing networking solutions for Dell servers and storage. Earlier this month, we announced that our 8100 CNA certification and was immediately available for HP ProLiant DL and ML servers. The 8100 Series CNA ensured continued availability of the same Pro and QLogic Fibre Channel stack broadly in use by HP customers today.

The biggest OEMs in the industry continue to choose and rely on QLogic to deliver single-chip native FCoE and Ethernet networking connectivity, repeat Ethernet networking connectivity for the servers and high-density storage systems. Since our initial 8100 Series announcement less than 12 months ago, we have announced and are shipping second-generation converged network products to IBM System x, IBM BladeCente, NetApp, EMC, IBM Power, Dell, and HP as well as our worldwide channel partners.

These customers are taking full advantage of convergence by deploying QLogic’s fully qualified and OEM deployed storage and Ethernet networking software stacks. The broad benefits of convergence, including power savings and spares cut across all lines of business and have been broadly accepted and started being deployed globally by an increasing number of end-users.

During the quarter, our revenue from converged networks adapters grew in excess of 75% sequentially, a rate significantly in excess of our principal competitor’s growth.

Turning now to Fibre Channel, according to the Dell'Oro Group, calendar Q3 2009 SAN report, the most recent one published, QLogic extended its undisputed market leadership in SAN adapters. While the calendar Q4 2009 Dell'Oro is not available yet, the combination of the published Q1 through Q3 reports and public announcements regarding Q4 performance lead us to conclude that the Q4 data will show that QLogic again widened our shared leadership in Fibre Channel adapters for calendar year 2009.

This would mark the sixth consecutive year, where we grew Fibre Channel adapter share, and maintained the number one share position. During the December quarter, our revenue from 8-gig Fibre Channel adapters again grew very strongly at a rate in excess of 60% sequentially, now represent more than 30% of our revenue from our Fibre Channel host products.

We believe this was driven primarily by the higher performance in Intel Nehalem-based server platforms and the increasing adoption of VMWare and other hypervisors. In the expanding blade server market, we continue to have more than 70% revenue market share for all Fibre Channel mezzanine cards.

In December, we announced that Hitachi Data Systems had selected our 8-gig Fibre Channel Switches and iSCSI Intelligent Storage Routers to provide new connectivity options for Hitachi's comprehensive portfolio of storage systems, including the flagship Universal Storage Platform, and channel-optimized, midrange Hitachi Adaptable Modular Storage 2000 family.

We made several critical advances in our InfiniBand initiative during the quarter. In November, at the Supercomputing ‘09 conference, we announced that HP has selected our portfolio of end-to-end 40-gig per second QDR InfiniBand products to be a part of the HP Unified Cluster Portfolio. The HP Unified Cluster Portfolio makes standard based cluster easy to configure and manage or QDR Host Channel Adapters, directors, edge and blade switches when coupled with HP ProLiant and BladeSystem C-class servers deliver industry-leading scalability and performance with a reduced total cost of ownership in high-performance cluster in a broad range of applications.

Also at the Supercomputing ‘09 conference, we announced an expanded OEM agreement with IBM for our QDR InfiniBand directors, edge switches, and Host Channel Adapters into its System x servers makes servers for HP application like the IBM System Cluster 1350 and IBM iDataPlex. Our solutions allow IBM to deliver pre-tested easy to deploy solutions.

Dell also joined the expanding list of OEMs deploying QLogic’s QDR InfiniBand director, edge switches, and Host Channel Adapters for the 11G PowerEdge servers. Finally, we announced a new agreement with SGI for the resale of our QDR InfiniBand directors and edge switches as part of its CloudRack and Rackable HPC Servers and Clusters.

Our InfiniBand business is better positioned today than at any point in the past. Our products offer superior performance, superior scalability, enhanced reliability and power efficiency. Combining this with our relationships at IBM, HP, Dell, SGI and our worldwide channel partners positions us to continue to increase our share in this market. In closing, we are very confident that we have been and remain focused on the right set of strategic initiatives, which will benefit us in calendar 2010 and beyond.

First, our server upgrade cycle is clearly under way, and will benefit us as a result of our market leading positions in Fibre Channel adapters. Second, in the converged network adapter market, our time-to-market advantage, technology superiority, and the significant number of publicly announced Tier 1 OEM customers shipping our product, position us to significantly benefit as enterprises transition to converged networks.

Finally, our network products are better positioned to experience revenue growth and capture market share for both Fibre Channel and InfiniBand switches than in the past. This concludes our preferred remarks. Operator, now we're open for questions.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from Aaron Rakers with Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

Yes, thanks guys for taking the question. I guess the first question that sticks out to me is, you know, the gross margin guidance, 66%, going to 65.5%. Maybe you can help us bridge the gap of why we might see a contraction in gross margin, and maybe talk a little bit about that here as we move into the next fiscal year. Do we anticipate 65%, or do we see 66.5%, 67% come back into the model at some point?

Simon Biddiscombe

So, Aaron, this is Simon. As we look at the expectations for the coming quarter, it's kind of two-fold. Number one, is we actually have a lower expectation for the contribution to the revenue stream from the royalty and service line, and obviously that on the royalty side it is essentially 100% gross margin, right. So, a lower expectation of contribution associated with the royalty and service part of business.

And then once you get beyond that, there is obviously a volume impact as a result of the revenues ticking down a little from the number that we delivered in the December quarter, and then there is a mix impact as well. Unfortunately, it is at levels of granularity that below the headline levels that you can see within the context of a press release or that we can give you color on. So, lower royalty and services, the primary piece of it and then other volume and product related mix issues as well.

Aaron Rakers – Stifel Nicolaus

And then if I could follow up, just looking to, you know, I guess in my model, taking more or less the midpoint of your guidance, it seems like you're calling for you know, I wouldn't say a big increase, but some increase in the OpEx here, you know, a couple of million, you know, maybe up to $5 million sequentially in the quarter. Is there some one-time items in the OpEx line flowing through the March quarter?

Simon Biddiscombe

Aaron, Simon again. I hope there was no confusion. So, we expect OpEx in the March quarter to increase by approximately $2.8 million. There was no difference between the high-end of the revenue range than the low-end of the revenue range in terms of how we characterize the OpEx. So, we said OpEx would be $56 million and in the most recent December quarter, we delivered $53.2 million. So, this $2.8 million more OpEx and that's almost entirely associated with employment costs as a result of the reset of the payroll tax here.

Aaron Rakers – Stifel Nicolaus

And final question from me, can you quantify – I understand you grew significantly in the CNA business, but can you give us some color on you know, how big that might be as either percentage of revenue or absolute revenue contribution at this point?

H.K. Desai

No, Aaron, I think that's too early to say that. It's a new technology and we have a great performance. We grew 75% sequentially in the converged network adapters. We expect continued growth going forward in the calendar 2010, but I think it's difficult to really project because the new technology and new markets is going to take some time before we start realizing what the number is.

Aaron Rakers – Stifel Nicolaus

Thanks, guys.

H.K. Desai

But we have a really good growth in the December quarter.

Aaron Rakers – Stifel Nicolaus

Great, thanks.

H.K. Desai

Thanks.

Operator

And the next question will come from Amit Daryanani with RBC Capital Markets.

Amit Daryanani – RBC Capital Markets

Hi, guys. You know, guys I guess one of the questions I think everyone is trying to figure out is your HBA business grew by about 17% sequentially, and I think Emulex reported 28% growth in the quarter. From your perspective, could you just help us understand what could be the drivers beyond market share that would explain the big delta in Q4 growth? And I realize you mentioned you gained share for the full year of '09. Curious how do we think of that Q4 '09 number specifically?

H.K. Desai

So if you look at – let me just repeat few things I said in the script. Our 8-gig fibre channel sequentially grew more than 60%, which is better than our nearest competitor. Our converged network adapters grew more than 75% sequentially, which is better than our competitors. Our top four server OEMs grew 21% to 23% sequentially. I think only areas we believe we did not perform well is the channel revenue grew only slightly for us, and I think that's the explanation really.

Amit Daryanani – RBC Capital Markets

All right. And then I guess we're looking at sales to be down about 5% sequentially in the March quarter, the midpoint of your guidance, any big variability between the HBA business and the network side?

Simon Biddiscombe

No, not really. I mean, we expect if I gave you the color by product family essentially, I think both the host and network products are going to decline sequentially. I think silicon products are going to be roughly flat, and I think the royalty for – the revenue from royalty and services I said earlier in response to the gross margin question is going to come down to roughly $2 million. So, I think no significant variability between host and network.

Amit Daryanani – RBC Capital Markets

Yes, and then just finally, Simon, could you talk about your operating model as we get into calendar 2010? You know, sounds like we'll get a good refresh cycle that should help revenues out for everyone. When you look at you OpEx line, do you think you could maintain in this $55 million, $56 million range over the next few quarters, or is there some big step-up in R&D or SG&A that you need to account for?

Simon Biddiscombe

No, there isn't and our expected (inaudible) really hasn't changed Amit. I mean this would typically be a high seasonal quarter because of the payroll tax reset that we have to bear and every organization has to bear. QLogic is no different in that regard than any other company. So, we continue to drive forth to deliver the 20% plus net income, 30% operating margins that we have laid out to be in the targets. If you take the midpoint of the guidance, we are very clearly going to deliver in excess of the 20% operating margin target that we’ve laid out, and as we move forward there is an expectation that OpEx probably stays around the 220 kind of number, and you look into 2011 on a fiscal year business, fiscal 11 kind of thinking around 220. That really hasn't changed from the number we've suggested recently.

Amit Daryanani – RBC Capital Markets

And how was sales in fiscal ‘11 again?

Simon Biddiscombe

Let me tell you again. No significant increase in sales and marketing or in R&D expenses over the course of the next year.

Ask me that question, and what was your second question Amit?

Amit Daryanani – RBC Capital Markets

How do you think about the sales growth in fiscal ‘11 since you gave us OpEx numbers?

Simon Biddiscombe

We'll let you guys figure that one out.

Amit Daryanani – RBC Capital Markets

Thanks a lot.

Operator

And our next question comes from Keith Bachman with Bank of Montreal.

Keith Bachman – Bank of Montreal

Hi guys. A couple – Simon, you've mentioned over the course of a few quarters that gross margin was sensitive to revenue levels, and yet in December quarter you had material up side in revs, and yet you were basically spot on your gross margin estimate. So, why wasn't there more gross margin upside in the December quarter? That's my first question, please.

Simon Biddiscombe

Yes, Keith. So, as you correctly pointed out the gross margin was consistent with the guidance even though the revenue was higher than we'd expected to be. There is ample of things, right. Number one is you've got lower revenues in absolute dollars and as a percentage obviously. Therefore from the silicon business and the silicon business does tend to carry the highest gross margins that we experience. So that was a meaningful contributed gross margin, not be higher than the 66%, and then beyond that you've got the inventory work down that we continued to see impact the business, and you've got some mix that didn't work in our favor at a more granular level then you can see within the context of the headline numbers as I said.

So those three factors, lower revenue from silicon and absolute dollars, and therefore obviously as a percentage of revenues it was lower, lower impact on volumes, because we continue to work inventory down and then other mix issues that you can't see.

Keith Bachman – Bank of Montreal

Okay. Well, if we keep going on that line of reasoning, you mentioned that silicon would be about flat in March. Is that a run rate that we should anticipate going forward?

Simon Biddiscombe

Yes, that's reasonable.

Keith Bachman – Bank of Montreal

And then others, too?

Simon Biddiscombe

Couple of million dollars per quarter.

Keith Bachman – Bank of Montreal

Okay. And then the tax rate, you got a little bit of help this quarter, and you mentioned 25% for June. Is 25% the right run rate?

Simon Biddiscombe

25% for the March quarter.

Keith Bachman – Bank of Montreal

I mean the March quarter. Excuse me. But is that the right run rate for June and thereafter?

Simon Biddiscombe

No, we are not offering a perspective on the period beyond 2010 at this point in time Keith, and in the past we've told you to continue to model something that's a 29% kind of number, which is where the business has historically been.

Keith Bachman – Bank of Montreal

Okay.

H.K. Desai

Then we always give you end of the year like in the May, when we have conference call, we give you the perspective of the whole FY 2011 what will be our tax rate.

Keith Bachman – Bank of Montreal

Okay, one for you, H.K. I think there is still some suspicion on what share shift occurred during the December quarter. How would you anticipate the March quarter playing out between yourselves and your friends down the road?

H.K. Desai

I mean, it's – you're talking about my good friends down the road.

Keith Bachman – Bank of Montreal

Yes.

H.K. Desai

Okay, so we have, you know, we have like, you know, it's going to change from quarter-to-quarter. It's – if you look at the way we look at it is you can't really go and give any perspective. It is only give and take on every quarter, but if you look at the whole full-year in 2009 data available, we grew about – we will be growing our share and that will be about six years in a row. We grew our share for the 5% (inaudible). I think we will continue doing that.

Keith Bachman – Bank of Montreal

Okay. Thanks very much, guys.

Operator

And next we'll hear from Min Park with Goldman Sachs.

Min Park – Goldman Sachs

Yes, great, thank you. Just a couple quick questions please. First, if you could give us your thoughts or your estimate about HBA growth for X86 servers in the quarter?

H.K. Desai

I don't think we have that number, even if you want it, we don't have that number anywhere. Only thing I can tell you is that when we have, like I said the four top server OEMs, they all grew between 21% and 23%. So, we had tremendous growth on HBA and most of them are X86.

Min Park – Goldman Sachs

Okay, and then as far as the December quarter is concerned, clearly Emulex benefited from the P-series, and you were probably hurt a little bit with Sun's server revenue kind of declining as a percentage of revenue. If you kind of look forward for the rest of 2010, at least when you look internally, do you expect Sun to become a 10% customer again in the next year, or in the next six quarters or so?

H.K. Desai

So, if you look at the sun, it is one of the four customers who grew sequentially between 21% and 23% anyway. So, Sun performed extremely well for us. I don't think we have a data on what is Sun revenue for this quarter, right. It is better, their contribution is – go ahead.

Simon Biddiscombe

So, Min, last quarter we said that Sun was 8% of the revenues and that we expect to decline as a percentage of revenues. It was actually better than the 8%. So, it performed better than we'd expected it to. Now, whether or not it gets back to be a 10% customer, only time will tell, but I think as we look forward toward the close of the transaction with Oracle, we are optimistic that that will free up what we perceive to be pent-up demands for products that exist today, and there will be a beneficiary out there.

Min Park – Goldman Sachs

Okay, and then lastly, if you can just give us an update on the NetXen integration and what the next steps are, are you pretty much where you need to be for the next generation platform?

H.K. Desai

We are done with integration, so the people and the product and we are very happy what's going on.

Min Park – Goldman Sachs

So no more code needs to be ported onto the silicon at all?

H.K. Desai

No, we are – that is done.

Min Park – Goldman Sachs

Okay, great, thank you.

Operator

And our next question comes from Katie Huberty with Morgan Stanley.

Katie Huberty – Morgan Stanley

Thanks, good afternoon. What's your view as to whether QLogic and/or the industry met all of the demand on the HBA front in the quarter? And just generally, your view on visibility in the pipeline for 1Q. It sounds like you're guiding to normal seasonality, but just some more details on that.

Simon Biddiscombe

I think we are. You're absolutely right Katie. I mean if you look at normal seasonality for the March quarter for QLogic over the last six years, its average about 6%, 5.7% or so and that the midpoint was down 4.8%. So, it was slightly better than normal seasonality at this point in time, and obviously we have given consideration to all of the trends that we are seeing in the business at this point in time within the context of the guidance we have given.

You know, we hear the same things you hear. You know, it's rumored that other product shortages that impact server vendors. It certainly wasn’t necessarily a shortage of anything associated with HBA technology or anything that QLogic delivers with, very well positioned from a supply chain perspective, but you know, we hear the same things as you do with regard to other product shortages that impact server sales and server shipments at the end of the December quarter, and we would expect those to flow through in the March quarter and beyond.

Katie Huberty – Morgan Stanley

And is there the potential that with the new Nehalem processors due out I think late March, could that drive some better than normal seasonality around mid-year, or is it too early to tell?

Simon Biddiscombe

It's too early to tell at this point in time, Katie. I think we’ve been pleasantly surprised by the impact of Nehalem, the first generation of all the Nehalem solutions has had over the course of the last six months on the business, and we're optimistic as we move forward.

H.K. Desai

I mean what the – you are seeing the same data, which we’ve from the analyst, and we expect because of this upgrade cycle, the server unit growth would be around 9% to 10% anyway. So, I think if you look at this thing, we expect a pretty good year 2010 or even 2011 from that perspective, because there is a lot of upgrade cycle coming, EX coming and two and four and eight and all this thing anyway. So, I think there is a lot of activities going on. Timing always depend on what happened with OEMs, but in general we are encouraged with what's going on in the market for us.

Simon Biddiscombe

I think what I would add to that Katie as well as, you know, typically the HBA business does, the host business generally does outperform the server market, and I think we'd probably saw that in the December quarter. I think the preliminary Gartner information says that server units were probably at 15.5% and our business grew by 17.5%, albeit in revenue dollars right. So, I think we're seeing the trend that we believe for an extended period exists, which is they typically will outperform server units very slightly.

Katie Huberty – Morgan Stanley

Okay, and then just one last question on inventory. Would you expect that work-down to continue into the first half of calendar 2010, or is it largely complete?

Simon Biddiscombe

Yes, I think it's going to be plus or minus a little at this point in time and what we saw last quarter was $1.5 million decrease in absolute dollars, but 5% decrease in percentage terms, right. So, I think we continue to work hard and I think we will continue to benefit from these efforts as we move forward and it's not the question, we won't see some further reduction.

Katie Huberty – Morgan Stanley

Okay, thank you.

Operator

Our next question comes from Rajesh Ghai with ThinkEquity.

Rajesh Ghai – ThinkEquity

Yes, good afternoon. In the past you have mentioned that you foresee the FCoE CNA market picking up in the second half of calendar year 2010, and you have projected kind of a $50 million number for the total market. Do you – based on what you saw this quarter and what you're seeing with the server (inaudible), do you still stand by that projection or do you have an update for that?

Simon Biddiscombe

I think, Rajesh, it's Simon. We actually kind of softened the language in a positive way last quarter. So, we stopped talking about late 2010 as being the time where we saw CNA adoption rampant clearly with 75% growth sequentially. Things are moving very quickly at this point in time and faster than we have seen other technologies move at this stage in their adoption.

So, we are incrementally more optimistic about our converged network adapter business on a day-to-day basis, and that showed up in the performance last quarter. We don't have anything that causes us to change the $55 million market that we think exists for CNAs in 2010 at this point in time. That was the (inaudible) number that came out middle of last year or so. So, nothing in our hands that caused us to think the market strategy be different than that, but suffice to say we are preliminarily pleased with the progress of the market. I'm extraordinarily pleased with our position within that market.

H.K. Desai

And if you look at what – we haven't give out the absolute number but our 75% sequential growth and what we have seen with our closest competitor, and if you look at their numbers, I don't think $50 million is out of question for 2010. I think it's going in that direction.

Rajesh Ghai – ThinkEquity

So the 75% quarter-on-quarter growth number, I know that Emulex kind of combines the 10-gig number with the CNA number. Could you do that in this quarter?

H.K. Desai

We are just starting with the converged network adapters, yes.

Rajesh Ghai – ThinkEquity

Okay, only the FCoE part.

H.K. Desai

No, it's both.

Rajesh Ghai – ThinkEquity

Okay. Combines both.

H.K. Desai

Yes, (inaudible) probably is a converged network adapter, both.

Rajesh Ghai – ThinkEquity

Okay, and you know, just one question on the trends as far as SAN connectivity is concerned. In this early refresh cycle, do you sense a transition away from (inaudible) SAN you know, using 10-gig Ethernet? Do you see that in any form when you talk to your customers?

H.K. Desai

No, we haven't seen that at all. So, it's still fibre channel and then either it's a fibre channel people are going to – I'm talking about the enterprise network particularly, the enterprise data center. I think it's the fibre channel and then going to the converged network.

Rajesh Ghai – ThinkEquity

Okay, great. Thank you so much.

H.K. Desai

Thanks.

Operator

And our next question will come from Munjal Shah with Jefferies.

Munjal Shah – Jefferies & Co.

Hi guys. A couple of questions, one, H.K., for you, you definitely highlighted 10-gigabit Ethernet wins. Could you just compare and contrast regards as to what's going on in that market where you're winning. And definitely a competitor also claims to have a good strategy there. So, if you could just give some color there that would be helpful.

H.K. Desai

Well, I think what we're seeing in – I mean it's like let's call a converged network CNA market, and what we are seeing is I think people are still interested in you know, people – the OEMs are more concerned about the installed fibre channel of the stack, and I think so there is a lot of opportunity for us and our closest competitor, because we are the one who has probably 90% of the installed base in the fibre channel stack, and I think we are seeing more and more. When the whole market started, people are concerned are there is going to be storage guys are going to be winner or the Ethernet guys, and what they are saying at least at this stage from the top from the OEM side, I think the storage guys are getting momentum.

Munjal Shah – Jefferies & Co.

Okay. So you would say more of your wins are against the traditional Ethernet guys versus your fibre channel competitor.

H.K. Desai

I don't know what it is, but I think that's what we're seeing more storage driven.

Munjal Shah – Jefferies & Co.

Okay, and then another question on the network business, could you give any color on the – whether it was Fibre Channel, InfiniBand, if one was stronger than the other.

Simon Biddiscombe

Yes, both businesses grew on the switch side in the most recent period. The fibre channel business was stronger than the InfiniBand business. And frankly, it was primarily due to 8-gig blade products primarily as well.

Munjal Shah – Jefferies & Co.

Okay, and then Simon, just could you clarify your comment on share buyback versus free cash flow? I missed that.

Simon Biddiscombe

That's fine. So the classification is as follows. Typically, when we’ve talked about the magnitude of the buyback, we talk about it being roughly free cash flow on a fiscal year basis, okay. The problem with that statement as we sit here today is that the free cash flow year-to-date is $75 million, the buyback is already $108 billion, okay. So, with $33 million ahead of free cash flow as of the end of the December quarter. So it's no longer appropriate to assume that the buyback would be free cash flow. This year it would be significantly in excess of free cash flow, okay.

Munjal Shah – Jefferies & Co.

Okay, all right. Okay. Thank you.

Operator

And our next Western will come from Mark Moskowitz with JPMorgan.

Mark Moskowitz – JPMorgan

Thank you. Good afternoon, two quick questions here. Simon or H.K., can you talk a little more about the leapfrog effects in terms of the compression we're seeing. Historically, I've seen in HBAs at least that every two or three-quarters or more where one participant will be a share gainer, and then in this past year we're seeing that with the leapfrog effect that is happening every quarter. Are we getting in a situation now where we're peaking out here in terms of the share gaining potential and you guys may start moving away from your detente pricing and get a little more aggressive on pricing?

H.K. Desai

Yes, I think it is – only thing I can say historically what happened and we have gained the share for six years in a row. We came a low, low number. I mean actually nine years in a row. We are share gaining our fibre channel adapters and we are about 54 points and so on, and normally I had seen in other industries that once you reach about 60% or something, it's just difficult for you to gain the share anyway. So, I think this is still a long way to go and I think we expect two of us to probably control the market for a long time. The pricing never play in the storage adapters, it never play on the (inaudible) and never play in the fibre channel so far anyway. So, we're not worried about – it's a pricing issue.

Mark Moskowitz – JPMorgan

Okay. And then the second question, Simon,just in terms of incremental operating leverage, how should investors think about this year, even next, as you move more and more to 8-gig for the host, and also as the CNA moves to the second and third generation, I believe the bill materials is a little more attractive in terms of the integrated features. Should we think about gross margins seeing maybe a little more upward pressure as we go forward versus what you're guiding to in the near term?

Simon Biddiscombe

We certainly don't see any downward pressure over the course of the next year. Mark, we've always had long-term model that was 65% plus gross margins, okay. So, we gave you 65.5% for the current period. We certainly don't see any downside to that number over the course of the next year, and it's entirely possible it could be better than that. Your observation about 8-gig and the converged network products is absolutely fair. The 8-gig margins are entirely consistent with the 4-gig margins and when we move to converged network adapters, generally they carry kind of better gross margins at this point because it's a very new technology in its earliest adoption phases.

Mark Moskowitz – JPMorgan

Thank you.

Operator

And next we'll hear from Kaushik Roy with Wedbush.

Kaushik Roy – Wedbush

Thanks. Simon, you mentioned royalty in services will be lower in the March quarter. Can you remind us what's in there and where do you see that in let's say 9 or 12 months?

Simon Biddiscombe

So, there are two elements to it, Kaushik. When we sell switches, be they fibre channel switches or InfiniBand switches, typically there are service contracts that are sold along with those, and then we also enjoy a royalty stream for certain of the IP that we have licensed to third parties over the course of the last few years. We are not offering a perspective beyond the current period at this point in time. We are just saying think about it within the – as roughly a $2 million number in the current period. We'll provide you with an update for 2011 as we move forward.

Kaushik Roy – Wedbush

The services will stay, but the royalty coming from Cisco probably is going to go away. Is that the right way to think?

Simon Biddiscombe

Be very careful with that. You know, there is very little royalty in that number associated with Cisco. So, be very careful about how do you think about that.

Kaushik Roy – Wedbush

H.K., it seems like the FCoE market is finally taking off. What's your thought on the TAM for the calendar 2010, for the pure or native FC market and the IB market?

H.K. Desai

I think, if you look at the converged network, the CNA market excluding the 10-gig Ethernet, I mean according to Dell'Oro about $55 million for 2010 and that's the only number we have. That's excluding the 10-gig Ethernet, just pure CNA market and I don't think I have any data on the IB side.

Kaushik Roy – Wedbush

And then lastly, can you comment what you are seeing with the customers for those who are using the CNA products, how many of them are using the pure NIC card and how many of them are using it as an FCoE card?

H.K. Desai

So what – we have some cases, we have some end users data available, and we work with our partners in that, and what we have seen is that most of our experience – what we have seen is they are used for both. They are using for both connecting the storage and also the same card. So what they do is they have existing storage adapters and the Ethernet adapters and they are replaced with a CNA and they use both for Ethernet connectivity and storage connectivity. So they are purely used as a CNA.

Kaushik Roy – Wedbush

And lastly, any plans for building an FCoE top of the rack switch?

H.K. Desai

We're not talking about any of our strategy.

Kaushik Roy – Wedbush

Okay, thank you.

Operator

And next we'll hear from Jason Noland with Robert Baird.

Jason Noland – Robert Baird

Yep, thank you. I guess first, just a question on InfiniBand, H.K., it wasn't as recession proof as maybe we would have thought. Do you have any early visibility here into IB, and would you expect it to come back strong in calendar 2010?

H.K. Desai

Yes, I mean if you look at I think the Q4 [ph] that we grew IB revenue in the December quarter sequentially, and I think where we – because we came from behind competitor or competitors and we start seeing the design. It took a long time for particularly on the QDR side, where we have our own switch silicones, and we also have our own HCA now. So, what we start seeing is if you look at lot of momentum on design win activities like we said in the script the HP and IBM and Dell and SGI and so on, so I think we are – the design activity is done in the December quarter. I think it will take about maybe one or two quarter before we start seeing the revenue growth. So, I think in FY11, I expect that we will start growing our IB revenue.

Jason Noland – Robert Baird

Do you expect any changes to the competitive landscape within IB this year?

H.K. Desai

I don't think so.

Jason Noland – Robert Baird

Last question from me, and kind of a follow-up to the previous, should we expect partnerships as it relates to converged FCoE switch?

H.K. Desai

What we are doing is like – I mean what's going on in – what we are very encouraged in our business is, if you look at our overall initiative in the fibre channel adapter, we have very strong positions and we're getting the share every year, and with the server upgrade cycle, I think we are in a great position because we probably are more than 70% share in the x86 market.

So, I think we are very encouraged where we're going in these things. You look at us on the IB side, now we have a lot of design win activities happen on the QDR side. So, I think we have a tremendous growth opportunity going forward on these things. On the fibre channel switch side also, we are getting lot more interest in our fibre channel switching, because what's happening in the industry plus also we are the only one who is – we are the only independent company who has a fibre channel switch stack, which some of the Ethernet guys can use anyway. So, I think we are in a great position partnering with somebody on these areas to grow our business going forward. I think we have the right strategy and we are executing in all cylinders now.

Jason Noland – Robert Baird

Thanks, H.K.

Operator

And our next question comes from Douglas Ireland with JMP Securities.

Douglas Ireland – JMP Securities

Hi, I was wondering – there was a lot of talk at the recent Storage Visions Conference about the opportunity to put solid state and intelligent caching onto the HBA or into the switch, and I was wondering if you have any perspective on that?

H.K. Desai

We have a lot of perspective, but we won't talk about it.

Douglas Ireland – JMP Securities

Okay, thank you.

Operator

And our final question will come from Aaron Rakers with Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

That's an interesting comment. I guess going back on the FCoE opportunity commentary that you guys recently – you had mentioned. I guess I will ask it another way, HP currently in the process of acquiring 3Com, are you telling us that the only way for them to get Fibre Channel over Ethernet from a switching perspective would be to partner with the likes of someone like you?

H.K. Desai

I can’t comment on what they can do or what their strategies, right. I cannot make any comment on those now.

Aaron Rakers – Stifel Nicolaus

Okay. Another question, then. On Cisco and the UCS platform, I think that Cisco rolled out their VNET availability in December. You know, how do you look at that competitively as we see Fibre Channel, or look to see Fibre Channel over Ethernet ramp? Do you see that as a competitor to you guys in FCoE?

H.K. Desai

Cisco, we treat just like, I mean, the true relationship we have with Cisco, they are partner in driving the FCoE market. We worked with them for a long time plus they also is our customer, because they are entering the server market. So, they are just like one of the OEMs where we have opportunity either for the fibre channel or the FCoE.

Aaron Rakers – Stifel Nicolaus

But, correct me, they have the option, they have qualified with the UCS yourself, Emulex, and their own product, correct?

H.K. Desai

Correct.

Aaron Rakers – Stifel Nicolaus

Okay, thank you.

Operator

And we'll turn the conference back to our speakers for additional or closing remarks.

Simon Biddiscombe

Well, that concludes our call for today. We look forward to updating you on our progress next quarter. Thank you for your time and good bye.

Operator

That does conclude today’s conference. We do appreciate your participation.

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Source: QLogic Corporation F3Q10 (Qtr End 12/27/09) Earnings Call Transcript
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