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Executives

Abhi Talwalkar - President & Chief Executive Officer

Bryon Look - Executive Vice President, Chief Financial Officer

Sujal Shah - Vice President of Investor Relations

Analysts

Allan Mishan - Brigantine

Parag Agarwal - UBS

Suji De Silva - Kaufman Brothers

James Snyder - Goldman Sachs

Kaushik Roy - Wedbush

Sukhi Nagesh - Deutsche Bank

Romit Shah - Barclays Capital

Craig Berger - FBR Capital Markets

Daniel Amir - Lazard Capital Markets

Hans Mosesmann - Raymond James

Robert Maina - CRM, LLC

Sanjay Devgan - Morgan Stanley

Eric Ghernati - Bank of America

LSI Corporation (LSI) Q4 2009 Earnings Call January 27, 2010 5:00 PM ET

Operator

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

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

Sujal Shah

Good afternoon and thank you for joining us. With me today are Abhi Talwalkar, President and Chief Executive Officer; and Bryon Look, Executive Vice President and Chief Financial Officer. Abhi will begin the call with some opening remarks and highlights from our business and then Bryon will provide fourth quarter and full year 2009 financial results and guidance for the first quarter of 2010.

During this call, we’ll be mentioning non-GAAP financial measures, which we may refer to as results excluding special items. Today’s earnings release describes the differences between our non-GAAP and GAAP reporting. You can find reconciliations of our non-GAAP financial measures to corresponding GAAP amounts on our website at www.lsi.com/webcast.

At that site you can also find a copy of the earnings release and a presentation which highlights the key points from today’s call and provides an overview of our business. This may be particularly useful to new investors. I want to remind you that today’s remarks will include forward-looking statements.

Our actual results could differ materially from those suggested by the statements made today. Information about factors that could affect future results is contained in our Quarterly Report on Form 10-Q for the quarter-ended October 4, 2009 and our Annual Report on the Form 10-K for the year ended December 31, 2008.

I would also like to mention that LSI will be hosting in Analyst Day on March 17 in New York City. This will include presentations from Abhi and Bryon as well as the leaders of our businesses. We will also running technology demos that showcase the products which we expect to contribute the future growth. Additional information and registration details for this event can be found on the Investor Relations section of our website.

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

Abhi Talwalkar

Thank you, Sujal. Good afternoon and welcome. While 2009 was a challenging year in a difficult environment we continue to make significant progress in each of our businesses and are at the front edge of seeing the benefits of the successful transformation we began several years ago.

For Q4 revenues were at the high end of guidance with overall sequential growth of 10% and a systems business that generated record quarterly revenues and grew 24% sequentially. Our fourth quarter non-GAAP operating margins were 14.5% reflecting revenue growth and gross margin expansion and we generated positive operating cash flow of $77 million.

Before I talk about our businesses, here are the key takeaways that I would like you to get from this call. First, LSI is at a key inflection point of being able to benefit from a successful transformation over the past several years. Secondly, 2009 was another year of record design wins fueling future growth for the company. Third, storage capacity and network traffic are both forecast to grow significantly.

LSI represents and differentiates investment opportunity to capitalize on this growth. Over the past quarter I have emphasized that had LSI is a very different company then it was several years ago. Over the past three to four years we underwent a significant transformation much of which has taken place below the surface and I believe we are now at an inflection point with the company.

We have recast this company in just about every single dimension and our product lines are now completely rebuilt and highly competitive. Today our businesses are at scale with differentiated products, technology leadership, and wins with the market leaders. In addition, the revenue headwinds that have impacted the company’s overall growth rates over the past several years are now largely behind us.

Going forward, there will be far less drag on the ability of our business to grow. I am very pleased with our execution and the focus of our employees and driving the business forward. Even through a difficult environment in 2009 we are able to deliver on a number of things we said we would. We successfully expanded our customer base in HDDs, ramped 6-gig SAS solutions with nine out of the top ten server OEMs. We secured volume design wins with Intel and Cisco and networking and we have continued to expand the footprint of an already successful storage systems business.

In summary we laid a foundation for future growth. I also believe we have chosen the right markets to participate in. Storage capacity and network traffic are both forecasted to grow significantly driven by new mobile devices such as the iPhone other smartphones, netbooks and smartbooks applications’ restraining today’s networks and the demand is out pacing infrastructure build outs.

This flood of data and the drive towards IP based networks will provide great opportunities for LSI storage and networking products and we’re uniquely positioned with solution that is span this universe. Now I would like to review with you the business highlights for the last quarter in our storage and networking businesses. I will begin with storage systems which includes both external storage systems and server rate adapters and software.

Our systems business recorded its highest ever quarterly revenue with sequential growth of 24% driven by increased shipments of mid-rage and high-end storage systems and server rate solutions. Our growth reflects continued recovery in IT spending, successful and ramping new products, and solid field sales execution with our customers. We saw broad strength across our OEM customers in the channel and in all geographies with revenues growing 9% year-over-year in the fourth quarter.

In our storage systems business we experienced a strong ramp of our new 4900 mid-range platform with increased shipments to IBM and Sun. We also generated record shipments of our flagship 7900 storage system with new capabilities including solid state drives. In entry storage systems we’re in the final stages of releasing a family of new 6-gig SAS storage platforms.

With these new systems combined with our leadership in SAS silicon and board solutions LSI is enabling the full storage ecosystem migration to the performance and scalability advancements of 6-gig SAS. In our server rate business we continue to see revenue growth driven by increased server shipments, ramp of our 6-gig SAS MegaRAID products and share gains at key customers. We continue to benefit from server share gains at IBM and growth in our indirect channel business including 3ware.

I will now turn to storage semiconductors, which includes SAS, SAN, and HDD. In SAS we’re in production on the industry’s highest performance 6-gig solutions and continue to extend our technology leadership. In December we began sampling our next generation rate on ship IC to customers. This dual core high performance solution supports the forth doming PCI express 3.0 specification, provides higher SAS performance and is optimize to exploit flash based early-stage storage.

Further reinforcing our leadership NEC launched LSI’s 6-gig SAS MegaRAID card solution and Fujitsu chosen LSI 6-gig SAS expanders and lots for a new server product line. This builds upon our recent momentum as last quarter with announce that LSI 6-gig SAS MegaRAID products were shipping across IBMs new mainstream system X, sliver line.

We also have multiple SAS design wins and development across a host of telecom and networking companies as storage and networking converge. Last quarter we announced that we have been awarded multiple designs at Cisco in their unified computing system for SAS, Ross and MegaRAID products. In addition, we have design wins for embedded storage in networking equipment at Erickson GTE and way.

With our breadth of products growing customer base and expanding applications of SAS and external storage, we do expect our SAS revenues to grow year-over-year from 2009 to 2010 and expect to maintain our leadership.

Now turning to hard disk drives, we continue to gain traction at new customers based on the industry’s first 40 nanometer low density check or LDPC solutions. We have a strong technology lead versus the competition and this continues to translate into new wins with customers where we haven’t traditionally had SoC business.

Last quarter we talked about securing in SoC win with a new Asian OEM for a mainstream HDTV platform ramping in 2011. We’re very pleased with the progress we’re making at the remaining two HDD OEMs and clearly positioned to grow SoC share as our customer base expands. In preamps we are positioned to continue to gain share as our latest offering boasts a common architecture that can be used across desktop, notebook, and enterprise applications.

Our latest preamp is being evaluated by all customers and allows them to qualify a single device across all platforms. I would like to now provide an update on our progress and addressing opportunities in flash storage. This week we announced a new offering into the solid stage storage market with a PCI express based solution for datacenter and cloud computing environments.

This is a board level complete solution that OEMs can readily plug into existing server designs. It operates under our SAS drivers which are the most widely used in the industry so OEMs can leverage that proven infrastructure. We are collaborating with Seagate supplying the solid state drive technology to LSI so we can provide the complete solution in the market place.

LSI and Seagate bring decades of enterprise level experience in the design, manufacture, and support of storage products for critical applications. Having two recognized leaders with proven capabilities and trusted brands will help pay the way to broad enterprise adoption. We also continue to build upon our design win momentum for solid state drives.

We previously stated that we will be supplying custom flash controllers to two leading enterprise HDD customers and a leading SSD flash manufacturer in enterprise SSDs beginning in 2010. In the fourth quarter we added to this momentum by displacing a competitor in a volume SATA/SSD controller for notebook applications which would begin ramping later this year. We have also now secured an enterprise SSD win with a leading Asian flash manufacturer further increasing our footprint across the solid state drive market.

Now I would like to review the networking business and the market trends that point to future growth for LSI in this segment. Recent announcements from Apple and Google continue to reinforce the ongoing growth in smartphones and the related database services that accompany them. We are well-positioned to benefit from the impact these devices will have on netbook infrastructure capabilities and related build outs.

The wireless infrastructure that was initially built for voice is being in-undated by data traffic and real time services. This demand will only increase with the introduction of more wireless devices and applications for those devises. Some time ago LSI identified and anticipated these trends and the need to migrate to IP based networks to solve bandwidth issues created by the rapid deployments of wireless applications.

Today we are well positioned to capitalize on network deployments with DSPs for Voice over IP, video and base band applications. Network processors for traffic management and quality of service, and multi-service processors for the IP migration and packet backhaul, in service provider wireless infrastructure we continue to build momentum with the industry leaders.

Erickson is now shipping our Next Generation Network processors in their access portfolio. Nokia Siemens networks is shipping our multi service and network processors in their radio access portfolio and all way is in mass production with our DSPs in wireless applications. In service provider wireline infrastructure we have secured broadband access wins with our network processors at Alcatel Lucent and also continue to benefit from the broadband access build out with industry leaders such as Erickson.

Finally in the enterprise space we continue to expand our presence at Cisco. Last quarter we talked about shipping DSP’s in Cisco’s next generation ISR G2 platform we have now secured additional DSP wins of Cisco for multi-media applications that additional router applications. As you can see we have identified the key trends, selected the right markets, and invested in vital technologies to deliver solutions that connect people and information.

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

Bryon Look

Thanks, Abhi. We closed the final quarter of our 2009 fiscal year showing strong results providing momentum going into 2010. Our results for Q4 demonstrated strong sequential improvements in revenue, gross margin, operating income, and cash. Before getting into specifics on the quarter, I would like to provide a few highlights and perspectives for the full year.

We closed the year with consolidated revenues at $2.2 billion recording two sequential quarters of double digit revenue growth in the second half of 2009. Gross margins excluding special items were 47.4% in Q4, an improvement of 470 basis points from the first quarter of the year.

Operating expenses excluding special items were $841 million for the full year 2009, which was $117 million lower than 2008 demonstrating our continued commitment to managing costs and creating efficiencies. In addition, one of our key focus areas during the downturn was to maintain and grow our net cash position while driving efficient working capital management.

We delivered on this commitment common demonstrating positive operating cash flows the order of $204 million for the full year. Our total cash balance including short term investments returned to nearly $1 billion even after using approximately $244 million to redeem convertible notes and successfully completing two strategic acquisitions during the period.

Now some highlights from the recent quarter. Revenues were $638 million exceeding the midpoint of our guidance by $13 million and sequentially up 10% from Q3 2009. Consolidated gross margins excluding special items were 47.4%, improving sequentially by 180 basis points and exceeding the midpoint of our guidance by 90 basis points.

Operating expenses excluding special items were approximately $210 million, about $5 million below the midpoint of our guidance range. Non-GAAP earnings were $0.18 per share, which is above the high end of our guidance range. We recorded a $31 million tax benefit in Q4 or $0.05 per share, which primarily related to the settlement of a multiyear foreign tax audit.

We recorded in Q4 is inclusive of this tax benefit. If not for this favorable tax settlement we would have reported non-GAAP EPS of approximately $0.13 per share at the high end of our guidance range. Finally, operating cash flows were positive at $77 million total cash and short term investments increased to $962 million, and net cash or cash and short term investments net of total debt increased to $612 million.

Now turning to a more detailed discussion on the quarter beginning with revenues, semiconductor revenues for Q4 were up $9 million or 2.4% sequentially to $381 million. Our storage semiconductor revenues, which include hard disk drive silicon, SAS standard components and storage area network ICs, were sequentially up $8 million or 3% to $275 million.

Storage semiconductors represented 43% of total revenues in the fourth quarter. Q4 revenues in our networking business were $95 million representing 15% of total revenues for the quarter and sequentially flat. Revenues for the IP business were slightly up in the fourth quarter at $11 million.

Turning now to our storage systems business which includes both external storage systems and server rate adapters and software, systems revenues were a record high of $257 million in Q4 sequentially up $50 million or 24% from Q3 2009. In Q4 we experienced growth across all systems product categories.

Mid-range and entry level systems grew sequentially and we recorded significant growth in server rate adapters and software through our OEMs as well as our indirect channel business. The storage systems segment represented 40% of LSI’s total revenues in the fourth quarter.

Moving next to gross margins, LSI’s consolidated G4 gross margin excluding special items was 47.4% which was sequentially up 180 basis points from Q3 ‘09 and slightly below the high end of the range we provided in October. We delivered sequential gross margin expansion in both our semiconductor and storage systems businesses.

Semiconductor gross margins excluding special items sequentially increased 190 basis points from the third quarter to 51.9%. The sequential margin improvement was primarily driven by higher revenues and improved absorption along with lower inventory related charges. Storage systems gross margins for the fourth quarter excluding special items sequentially improved 320 basis points to 40.6% primarily driven by higher revenues and improved absorption, mix, and lower inventory related charges.

Moving to operating expenses, R&D together with SG&A expenses excluding special items totaled $210 million in Q4 at the low end of our guidance range. This represents a 10% decline on a year-over-year basis. We continued to run below more normal spending levels in part due to better than expected savings related to vacations and shutdowns within the period.

In terms of operating profit, non-GAAP operating income as a percentage of total revenues for the quarter improved to 14.5% or $92.2 million. Interest income and other net of interest expense excluding special items was $0.6 million for Q4.

Now let me turn to the special items we recorded in the fourth quarter, which netted to $59 million. Special items primarily non-cash included $43 million in amortization of acquisition related items, $14 million of stock based compensation expense and $2 million of net restructuring costs and other items.

Moving next to tax, our tax provision on both a GAAP and non-GAAP basis can vary significantly quarter-to-quarter based on our profitability and different geographic tax jurisdictions and certain discreet items. Such a discreet item occurred in Q4, where we resolved a multiyear tax audit in a foreign jurisdiction. This settlement was included in the $31 million tax benefit we recorded in the quarter versus the $8 million tax provision we guided to in October.

On a GAAP basis fourth quarter net income was $65 million or $0.10 per share, net profit excluding special items was $124 million or $0.18 per share. Keep in mind that both the GAAP and non-GAAP results recorded in Q4 include the above mentioned $31 million tax benefit.

Share count for the period for GAAP purposes was 663 million shares and 689 million shares for non-GAAP purposes. The reported non-GAAP share count was higher than GAAP primarily due to the requirement that we include 26 million shares relating to our outstanding convertible debt, when calculating EPS for the period.

Turning now to the balance sheet and cash flows, we continue building a solid cash position. Fourth quarter operating cash flows were strong coming in at $77 million. The positive operating cash flow was driven primarily by our net income performance in the quarter, coupled with our continuous focus on efficient management of working capital.

Our cash and short term investments increased and ended the December quarter at approximately $962 million. LSI’s net cash position at the end of the quarter improved sequentially by approximately $55 million to $612 million.

Finally, with respect to Q4 results, depreciation and software amortization was $26 million and capital expenditures were $14 million. The following is our guidance for Q1 2010. Revenues in the range of $590 million to $620 million, at the midpoint this is sequentially down approximately 5%, which would be better than typical seasonality.

We expect both our storage semiconductor and storage systems businesses to decline sequentially, while our networking semiconductor business is expected to be slightly up in Q1. Consolidated gross margin excluding special items is expected to be between 45.0% and 47.0%.

We expect gross margins excluding special items to be approximately 51% for the semiconductor segment and approximately 37% for the systems segment. The sequential change in margins is primarily driven by mix along with seasonally lower revenues and less absorption.

Operating expenses excluding special items are expected to be in the range of $218 million to $228 million, which is up from Q4 primarily due to the reinstatement of certain compensation and benefit items we moved from our expenses earlier in 2009. In addition, Q4 was also below more normal spending leveling due to shutdowns, something which we’re not currently planning on doing in 2010.

Interest income and other and interest expense is expected to net to an expense of approximately $1 million, special items are expected to net to approximately $45 million to $65 million. The GAAP and non-GAAP tax provision is expected to be approximately $8 million for Q1. We expect Q1 GAAP net income per share in the range of negative $0.06 to positive $0.03 and EPS excluding special items to be in the range of $0.04 to $0.10 per diluted share.

Share count is expected to be approximately 658 million shares for GAAP and 667 million shares for non-GAAP purposes. In addition, we expect depreciation and software amortization of approximately $25 million and capital expenditures of approximately $15 million.

In conclusion, we are emerging from the economic downturn well positioned and excited about our prospects to drive growth going forward. Our focus for 2010 remains consistent. Continue to drive cash generation and maintain a solid balance sheet, deliver sustainable top and bottom line growth to drive continued progress towards our business model, and drive continued design win momentum for future growth.

Now, let me turn the call back to Abhi.

Abhi Talwalkar

Thanks, Bryon. Before we go to your questions, I would like to reiterate that I’m very pleased with the progress we continue to make on our financial results and design win closures at key customers. I believe that LSI is at an inflection point with reduced revenue headwinds and solid positioning in the storage and networking markets with over 80% of our revenues tied to business spending we are benefiting as businesses of all sizes increase purchases in information technology.

As we begin 2010, I am confident that the solid foundation we have built and our strong position in the markets we serve will continue to generate opportunities for future growth. I encourage to you join us in March for our Analyst Day, where you will get further insight into our businesses and a better understanding of our technology and key products, which we expect to continue to contribute to future success.

Now, let me hand the call back to Sujal.

Sujal Shah

Thank you, Abhi. At this point, we’ll begin the Q-and-A portion of the call. Kera, will you please give the instructions for the Q-and-A session.

Question-and-Answer Session

.

Operator

(Operator Instructions) Your first question comes from Allan Mishan - Brigantine.

Allan Mishan - Brigantine

Quick question on storage semis, if I look at your major customers, Seagate, Emulex, QLogic, etc., they all had very strong sequential results Q3 to Q4 and storage semi revenues for you guys were up only 3%. What do you think is disconnect between those two things?

Abhi Talwalkar

I don’t think there’s disconnect. You have to break the storage semi business into its composition. So it is it consists of SAS business, HCV business, as well as our Fibre Channel, SAN business. So in the SAS space we had significant growth that was consistent with server unit growth quarter-to-quarter in the teens.

Relative to Fibre Channel space Q3 was a very strong quarter and just in terms of linearity with some of our customers there, we saw decline in Q2 to Q4 and nothing to do with share loss or share gain, purely just supply chain alignment, relative to our HDD semiconductor business.

Keep in mind, units are what you should be looking at relative to a comparison and units in aggregate for some of our customers and the HDD market grew about 6% to 67% quarter-to-quarter, so factoring in units as well as a contractual ASP erosion that comes with this business like most businesses quarter-to-quarter, as well as linearity with our shipments, it came in where we sort of expected it to come into.

Allan Mishan - Brigantine

Then on the storage systems side, obviously you had a big surge in the quarter. As you look to 2010, will the growth there be primarily based on the existing customers that you have or do you expect any major new customers to come online there to help boost that?

Abhi Talwalkar

We continue to cultivate new customers as well as new channels for our storage systems, and remember the storage systems business has three elements to it. There’s an external systems sort of business. There’s internal RAID, which is associated with server shipments and server units and we also have a level of software attached in terms of advanced data management.

So we clearly expect growth with our existing customers as we work with them to grow share. We saw some of that in the second half and we expect that to continue this year, especially given new product cycles, and then we are at cultivating new business in terms of the indirect channel with building blocks for our products. We’re also cultivating sort of what we call our equipment OEMs, which are a number of customers around the world that we have been working with to grow that base of business, in particular for our external storage systems.

Allan Mishan - Brigantine

If I could just sneak one last one in on the networking business, can you offer any kind of range for what the legacy decline will be for the full year of 2010?

Abhi Talwalkar

As we committed last quarter, I think what people should be using is a range of about $50 million to $70 million of legacy decline in 2010. That compares to an actual decline of about $110 million in 2009, on a projection that we had provided about $100 million in ‘09.

Operator

Your next question comes from Parag Agarwal - UBS.

Parag Agarwal - UBS

Just wondering about your design wins and many of them are going to ramp in 2010. Just wondering how we should think about revenue? Looks like most of that would be back end loaded, if you can provide color on that that will be very useful?

Abhi Talwalkar

Parag, as you know, we’re not going to provide guidance for the full year, but we have many new ramping customers and products in 2010 and even a greater level in 2011 based on the design win closure that is we’ve had over the past 24 months.

Parag Agarwal - UBS

In the HDD space as you’re talking to the other two remaining OEMs, what are the key concentrations for you forgetting the design win? I mean if you were to point to one the most important factor in meeting the designs with remaining two, what would that be?

Abhi Talwalkar

I think there are two or three factors and as we discussed the environment is ripe for penetration into the remaining two. It is about technology leadership, which we have. It is about HDD OEMs diversifying their supplier base to manage risk and have technology assurance, and I think both of those elements are absolutely there. Both of those elements played a factor in terms of winning the first of the three, and as I said in the prepared remarks, we’re very happy with the progress we’re making.

Parag Agarwal - UBS

What role does the price play in the design win process? Are they out of the OEMs variances intent on the price cuts or how does you…?

Abhi Talwalkar

You certainly have to be competitive, and I feel we are competitive.

Operator

Your next question comes from Suji De Silva - Kaufman Brothers.

Suji De Silva - Kaufman Brothers

On the margins you should be near or at target gross margins and operating margins are still below the 17% target. Is getting to that level simply revenue growth or are there more OpEx leverage you can pull at this point?

Bryon Look

We’re kind of continued to operate on all fronts. You’ve seen some nice gross margin expansion from us through the course of the year, and we’ll continue to drive that in a positive direction. Yes, I think achieved in business models of functions of revenue growth and we’ve been talking about the opportunities that we see based on the tremendous design win activity we’ve had and some of those designs ramping.

Relative to the operating expense question, I think we’ve done a good job and continuing to manage those expenses tightly as we work through both the economic downturn and even through the revenue growth as we saw in the back half of 2009. Those savings that we derived were from both structural, as well as some temporary actions that we took.

So one would expect to see some of those operating expense levels return to more normal levels in the year 2010. We’ll continue to make that progress driving for 2010 towards that business model and just as a reminder that model would have us at gross margins consolidated at 47% and bottom line target business models of 17% operating income.

Suji De Silva - Kaufman Brothers

Perhaps a question for Abhi here, can you help us understand, Abhi, it sounds like solid drive is starting to have momentum in the marketplace. How is that going to show up in your financials? Does it make a difference in financials in terms of margins and revenue or something just layers in there with what you’re doing now?

Abhi Talwalkar

I think it’s early. There’s obviously been a lot of hype on flash the last two years. We’ve been very calculated in terms of our entry, points of entry and timing and timing of OpEx spend. I feel really good about the fact that we didn’t get ahead of ourselves two years ago and spend ahead of the curve. I think we’re timing our entry just right.

You can see by what we discussed in the preferred remarks the footprint that we established across enterprise SSD controllers as well as now in the client space and then we’re very excited about the announcement that we made in collaboration with Seagate around flash PCI based flash solutions. So I think this will take time for this market to develop, but we feel very good about our products, our offering, and our ability to participate in a meaningful way.

Operator

Your next question comes from James Snyder - Goldman Sachs.

James Snyder - Goldman Sachs

I guess if we start off on the storage business, you mentioned that both the low end and mid range shipments were up nicely and clearly IBM had a very good quarter. Could you talk about, which one was stronger on the margin? Was it the mid range, much stronger than low end and if you can talk about what’s really driving the low end storage systems business that would be great?

Abhi Talwalkar

James, we don’t breakout that level of detail. We saw growth across all categories. We’re very happy with also the mix relative to the mid range and the high end. We saw mix recovery in Q2. We saw that continue in Q3 and Q4, and then clearly the other part of our systems business is the internal server RAID sort of product line, which saw tremendous growth because of the pull that’s out there for servers, and server deployments.

Clearly IBM and our share gains there played a role in terms of the growth and not to forget, we’re seeing and have seen very good activity and pickup relative to our indirect channel business, which is servicing 10,000 to 15,000 system builders around the world and that’s including our 3ware product. So there’s been a lot of activity there as well.

James Snyder - Goldman Sachs

Maybe Bryon, one for you, if you look at the OpEx you’re guiding to pretty substantial up tick for Q1 as you reduce the salary reductions and benefit reductions, etc. Can you give us a sense that how that profile OpEx is likely to go throughout the year and what run rate we should expect to be at exiting 2010?

Bryon Look

I think you can expect we’re going to continue to manage our expenses carefully as we go back, as we got through the year 2010. Let me explain the deltas for you. Q4 came in at as know that the low end of our expectations or guidance and we did benefit from better than expected saving.

As you move from Q4 to Q1, you start to see the reinstatement of more normal compensation and benefits less vacation activity and so forth, and so we guided relative to Q1 operating expense levels to this rage of 218 million to 228 million. We will continue to see some variability based on this based on timing and also based on business conditions.

I will say as I noted earlier that our design activity remains very row robust and as those designs move through various design milestones, that takes with it some increases in terms of spending to support these very attractive wins with our customer base. So as we go through 2010, we’ll continue to make progress towards our business model, carefully managing the operating expenses, but do expect to see some of those expenses come back into more normal ranges.

James Snyder - Goldman Sachs

Can you give us any range about, how much it would be up exiting the year?

Bryon Look

We really don’t provide that guidance. Again, it is I function of a lot of different factors there.

Operator

Your next question comes from Kaushik Roy - Wedbush.

Kaushik Roy - Wedbush

Can we go back to the hard disk drives? It seems like Seagate’s units were up 8% sequentially, ATLS seems like they’ve done well. Can you give us more color, I mean is it the ASPs that came down a little bit more than expected or possible share shift or can you give us a little bit more color on that?

Abhi Talwalkar

If I recall some of the details around Seagate, yes, 7% to 8% or so, they had about 14% to 15% unit growth in the enterprise space, which we did not participate in at all as you know. We don’t enjoy any business enterprise space. So some of that growth that was there we did not participate in. Again, I think it is much more oriented towards linearity in terms of shipments as well as the ASP sort of typical contractual erosion we see quarter-to-quarter. We also had a very strong Q3 with Seagate in terms of unit growth.

Kaushik Roy - Wedbush

Their guidance was down, let’s say, 2% sequentially down, so can we expect the similar linearity in the March quarter or for the HDDs or something else there?

Abhi Talwalkar

No. We don’t break that level of detail out, right and again, Kaushik, there are quarter boundaries here, the supply chain boundaries and so forth. It’s too tough to necessarily call and certainly we’re not going to guide at that level.

Kaushik Roy - Wedbush

Second question, can you give us any color on the IP business or IP revenues? Can it stay at these levels for 2010 or do you expect it to grow?

Abhi Talwalkar

As we’ve discussed, it has been a difficult environment. At the same time, we have a lot of confidence in the business, our ability to generate revenues, the patent base we have to work with. We do expect our revenues to grow in 2010 relative to 2009.

Operator

Your next question comes from Sukhi Nagesh - Deutsche Bank.

Sukhi Nagesh - Deutsche Bank

If you recall you guided your semi gross margin to be 51%, and I think your storage systems business to be 39% for the March quarter. That implies kind of…

Abhi Talwalkar

37% for the March quarter.

Sukhi Nagesh - Deutsche Bank

Storage systems business.

Abhi Talwalkar

Systems.

Sukhi Nagesh - Deutsche Bank

Almost 500 basis points decline in the sequential basis?

Abhi Talwalkar

About almost 400.

Sukhi Nagesh - Deutsche Bank

Does that imply almost like double digit decline for systems for the March quarter? Why is that? Why is there such a big drop?

Abhi Talwalkar

We normally have seasonally down quarter in Q1 for that systems business, and so that’s not surprising at all relative to the sequential of the revenue or the impact that has in terms of our gross margins. In fact, if you compare that 37 range of gross margins for this business, that is actually quite strong.

Relative to historical levels, we have made great progress there relative to on the product side as well as manufacturing, so typically we see gross margins grow from that point as we go through to the second half of the year.

Bryon Look

37 for quarters strong.

Abhi Talwalkar

Very strong.

Sukhi Nagesh - Deutsche Bank

So that doesn’t necessarily imply a double digit decline in revenues?

Bryon Look

No. I wouldn’t jump to that conclusion that historically, we’ve had at an aggregate company level seasonality has been 8% to 12%, 10% midpoint from a Q4 to Q1 decline. We’re guiding that midpoint to about 5%. We don’t breakout any of our businesses relative to their respective quarter-to-quarter declines. You can answer some of your questions by just looking at some of our major customers and what their seasonality is and what their guidance is for Q4 to Q1. IBM being a pretty decent proxy it uses.

Sukhi Nagesh - Deutsche Bank

It seem they at least IBM, EMC, so far have at least guided their hardware storage systems to be slightly better than seasonal for the March quarter. How much of that is playing into your guidance here? Are you being a little conservative on your storage systems for the March quarter or any color there?

Bryon Look

For one thing, that business tends to be sort of back loaded in terms of the quarter, so it is really quite early for us to be making that call. We’ll have to see how different factors play out here, but we certainly had excellent momentum with our customers as we exited 2009.

Sukhi Nagesh - Deutsche Bank

Switching to the networking ask a question on that upside, you’re guiding that business to grow in the March quarter. Can you talk a little bit about what you are seeing in the market in general, what your exposure is to maybe the U.S. and China, wireless infrastructure build out going on right now and also how Cisco is tracking particularly for you in terms of the DSP design wins? Thanks.

Bryon Look

I think the growth relative to the networking business is certainly aided by the fact that our go forward networking business continues to grow as we expect it to grow this year and as it has grown in the past two years. We are certainly benefiting from the wireless build out through participation with our network processors across Nokia Siemens access line as well as Erickson’s access line.

We’ve got DSPs that also in several platforms with wall way from a GSM wireless access standpoint as well as DSPs in media gateways across a number of these players in the wireless space, and that certainly is playing a factor. We’re seeing a pretty strong and decent ramp relative to DSPs in the Cisco sort of platform that we announced a win and production shipments in the third quarter and as we said in the prepared remarks that we secured additional wins as well. Those things are playing a factor in terms of the outlook.

Operator

Your next question comes from Romit Shah - Barclays Capital.

Romit Shah - Barclays Capital

I just listening to your presentation you seem pretty enthusiastic about both the systems business and the semiconductor business, but if I look at the performance on one hand you’ve got the systems business that’s at a record level. That business is doing really well where as the semiconductor business is still down about 25% from the peak quarter in ‘08, and I am just trying to understand why the performance between semis and the systems business appear to be diverges?

Abhi Talwalkar

That’s a good question because I think people could benefit from a little bit of granularity here. Remember the systems business has several elements to it. It has an external storage piece and the internal piece which is associated very tightly with our SAS business because it is all servers related it is our position in the server and our market share and our footprint in the server.

So some of that systems business is frankly more tied and associated with our semiconductor business and semiconductor strength. If you know what’s inside of a server, you can appreciate I think what I am trying to elaborate on. I think the other thing that have you to keep in mind is that if you look at ‘08 and you look at ‘09 and you look at the legacy revenue drop that we sustained from ‘08 to ‘09, it is significant.

As you normalize for that legacy drop, our semiconductor business year-over- year, ‘08 to ‘09, actually fared quite a bit better than the market which suggests that we gained share which we believe we did across just about every category of semiconductor products that we ship.

So that’s why you see and hear the level of excitement because the intrinsic semiconductor business and all our go forward businesses putting aside legacy are performing very well.

Romit Shah - Barclays Capital

What did I just take the networking has gone a peak of $140 million down to $90 and if I add that back, the semiconductor business is still down about 15% from…

Abhi Talwalkar

You cannot forget the erosion in the enterprise hard disk controller which is a significant level of business in 2008.

Romit Shah - Barclays Capital

That falls into which bucket?

Abhi Talwalkar

I mean, it is not our legacy networking business, but that is a piece of business because it is sort of where the company was in terms of its ability to compete three, four years ago that was business that we lost at that point in time. Now, in 2007 post merger we won that next generation back and since then we have won just about every single business that we have gone head-to-head with competition in the HCD space, and we are on track to start ramping the enterprise in the enterprise spice with Seagate this year.

Romit Shah - Barclays Capital

I guess as you think about 2010, the market is going to do what it is going to do, but do you see the semi business and the systems business being more comparable in terms of growth?

Abhi Talwalkar

I am not going to guide for the year. At the same time all of our end product categories are growing from 2010 from a demand standpoint. I feel very good about our ability to participate very well in that growth.

Romit Shah - Barclays Capital

That includes networking?

Abhi Talwalkar

From an end product category standpoint, yes, networking still has a legacy component, but we’re sort of towards the tail end of that legacy business. This will be sort of the last year that will be a material level if you will at that $50 million to $70 million range we gave you earlier.

Operator

Your next question comes from Craig Berger - FBR Capital Markets

Craig Berger - FBR Capital Markets

Wanted to know, (a) when do you begin ramping enterprise shipments back into Seagate, kind of the timing of that program, and (b) can you walk us through how your pricing processes work in the hard drive business? Is it annual price negotiations or is it you know do you launch new product? Is it a higher price and you walk it down kind of water falling it like a traditional product? Can you just explain how the process is and how the annual or quarterly prices are determined?

Abhi Talwalkar

I will give you a little color. Let me take the first question first. We expect as we said last year we expect to ramp to start in the first half of 2010, and then relative to pricing, Craig, the way it works is there are sort of different inflection points where hard drive OEMs open up their sockets for the next generation of hard disk drives. We compete for those, we establish an entry price and a certain sort of price takedown over the life of that product, and it sort of entered into a contract.

So the pricing dynamics are largely when you win new designs, and then the erosion of it is generally based on a volume pricing agreement. There isn’t sort of in the middle of that volume that’s being shipped there generally isn’t renegotiations that take place.

Craig Berger - FBR Capital Markets

Just to follow up question. Did you guys kind of help us understand what the magnitude of that Seagate hard drive SoC business is? Is that going to be a sole source? Are you going to split that with Marvel, and how many quarters does it take to ramp up?

Abhi Talwalkar

No, we haven’t provided that level of color.

Operator

Your next question comes from Daniel Amir - Lazard Capital Markets.

Daniel Amir - Lazard Capital Markets

In terms of the server upgrade that we potentially would see here in 2010, can you highlight kind of where LSI is kind of position in potentially this upgrade and what should we be focused on?

Abhi Talwalkar

I believe we’re positioned very well. Server units depending on what analyst you talk to are forecast to grow 8% to 10% in 2010. We are servicing about 65% of the market across our OEM design wins, across our broad reach end of the channel base as well as a large base of OEMs in Taiwan that we sell into as well. That’s both silicon that we have that goes into the server both in the form of RAID-On-Chip, SAS controllers, as well as SAS expanders.

Again we are shipping our RAID solutions, which is both in the form of software as well as rich adapters into nine of the top ten server customers, but also a very broad base indirect channel business into 10,000 to 15,000 sort of resellers around the world, so that’s how we participate in the server market.

Daniel Amir - Lazard Capital Markets

In terms of kind of the guidance on the different areas of system storage, semi and networking, I mean is there an area where if you looked at month and a half ago in terms of the growth for next quarter, that positively or negative surprise to you in terms of the slight declines or increases in kind of the businesses for Q1?

Abhi Talwalkar

I mean I think we’re all pleasantly surprised relative to the improvement to typical seasonality and I think we saw that and realized that over the course of the last six weeks of the fourth quarter, but that momentum continuing into the year relative to our bookings and our turns, and all of that sort of reflected in our guidance.

Operator

Your next question comes from Hans Mosesmann - Raymond James.

Hans Mosesmann - Raymond James

Most of my questions have been answered, but a couple on flash. The flash storage board solutions that you’re selling or you’re getting into for the data center and cloud, how is that business model going to work out? Is that going to be part of your systems business, because it’s actually a board solution, correct?

Abhi Talwalkar

Ye, it’s a board solution, that’s correct. It has software elements it has got LSI silicon as well.

Hans Mosesmann - Raymond James

Do you sell it, or is that Seagate sales organization?

Abhi Talwalkar

We will sell it. The way that will work is we’ve got an LSI flash storage adapter that’s PCI based. LSI will sell it into the server OEMs, but the relationship we have with Seagate is both a level of development that goes on and in integrating the Seagate solid stage storage technology with the rest of our complete solutions silicon software, and then we sell that or sort of the channel into the server OEMs.

Hans Mosesmann - Raymond James

The follow-on is on the custom flash solutions that you’re could go. What are the average selling prices more or less on that kind of device?

Abhi Talwalkar

Hans, we haven’t disclosed that. Safe to say, it’s better than HDD SoCs.

Operator

Your next question comes from Robert Maina - CRM, LLC.

Robert Maina - CRM, LLC

Abhi, one follow-up to an earlier question and one question, I just want to make sure I heard you correctly. The networking business I think you said to assume $50 million to $60 million or $50 million to $70 million decline in 2010?

Abhi Talwalkar

$50 million to $70 million is the range that we would like you to use.

Robert Maina - CRM, LLC

If I think about the storage semi business, I know I think your reference the fact there was a significant grows over there in 2009 as the Seagate enterprise business went away. Should we think about anything like that in 2010, or is it fair to assume that what the design activity and the like that it’s organically it’s going to be a growth year for that business?

Abhi Talwalkar

Yes, absolutely. That’s how you should think about it.

Operator

Your next question comes from Sanjay Devgan - Morgan Stanley.

Sanjay Devgan - Morgan Stanley

Just firstly your preamp business, you guys have done a great job taking a lot of share in that space. Just wondering with respect to preamps, how should we view that? Do you still view considerable share gain opportunities there? We kind of like other steady state now and now it kind of grows with the market?

Abhi Talwalkar

No, we’re not at a steady state. We’re going to continue to drive share gains and we expect share gains in 2010.

Sanjay Devgan - Morgan Stanley

Just as a follow-on, if you could just remind us, Abhi, or perhaps Bryon, qualitatively looking at your semi businesses excluding the systems business, if you look at it based on SAN, SAS, HDD and networking, can you kind of stack rank those for us in terms of gross margin contribution?

Abhi Talwalkar

First, one comment on that is the gross margins can vary across any one of those product categories within the product category itself. A lot of the way the gross margin get set quite honestly is the level of IP that we have in the product, the leadership position, which fortunately we’re in a very strong leadership position across virtually all the categories.

So can it vary, I think we have said that historically the networking part of our business tends to be nice margin business and that’s one of the opportunities we have in terms of gross margin expansion going forward is that networking business expands throughout the future years.

Sanjay Devgan - Morgan Stanley

I guess the Genesis of the question is essentially, your semi gross margins kind of ex IP I’m kind of guessing is somewhere in the high 40s, if we strip out the IP component, and I am just trying to one of your big competitors are kind of gross margins for their business are kind of in the high 50s. So I’m trying to see what the potential, is it mix related or what should we look to potentially drive further margin expansion?

Abhi Talwalkar

I think you accounted too much of a gross margin drop relative to the IP business when you dropped it in the high 40s. IP business, I want to put it in context. It’s down to about 2% of our overall revenue or so, just making that comment, but relative to our semiconductor business and where we see gross margin improvement opportunities and ability to keep driving gross margins up in the semiconductor business as Brian said one point is to continue to drive growth in our networking business and have it become a bigger and bigger share of the overall semiconductor revenue.

I think as we continued to gain share in SoC and HDD, SoC, which we believe we will continue to do, that additional scale combined with the rest of our semiconductor business will also give us a better ability for overall absorption, purchasing leverage, and overall better COGS as well and hence improved margins.

Operator

Your final question is from Eric Ghernati - Bank of America.

Eric Ghernati - Bank of America

Can you give us a sense on why the networking businesses guided to be up sequentially?

Abhi Talwalkar

First of all, the network business has different components to it, legacy as well as go forward areas, and as you can note from just the trends we’ve had, it can vary from quarter-to-quarter, so that the overall trend though is, we do have legacy business which declines on a year-over-year basis and we’ve now quantified that to you for 2009 as well as 2010.

Bryon Look

The question is why are we guiding it up from a color standpoint Q4 to Q1, right? I think there are two factors. One, continued growth relative to our go forward business, new ramping products based on design wins the last several years, and I think there’s also a sufficient level of color out there relative to some of our peers that have heavy exposure to telecom and networking that have also guided up quarter-to-quarter. So an end demand environment standpoint it certainly helping, playing a role.

Eric Ghernati - Bank of America

Bryon, one question for you, with respect to the OpEx suggest through 2010 just want to clarify, so you said that you will improve through the year towards your target operating margin model of 17%? Is that’s how we should think about it?

Bryon Look

I think the way to think about it is that we’re not at our normal levels, because we have taken September actions as well as some structural improvements that have enabled us to run at lower than normal levels through 2009, and you certainly saw that in Q4.

Eric Ghernati - Bank of America

I understand, but I guess my question is like all else being equal assuming normal seasonality, is the outlook then that you exit the rates in 2010? I understand it’s going to be difficult in first half, but in the back half, an extra 17%, is that’s how we think about it because all else being equal should be $200 million revenue run rate above your current run rate.

Bryon Look

I don’t think we imply nor do we say that we expect to be at 17% operating income exiting the year. We just haven’t provided that guidance for the full year.

When you think about operating expenses, keep in mind that as the revenues expand through the year, it’s going to carry with it some incremental spending, not to mention the fact that we have had strong design win activity, which doesn’t necessarily translate into revenue in the current year, but does add to spending. I think the overall point to take away from this conversation is that we’re committed to continuing to drive for a business model improvement in 2010.

Abhi Talwalkar

Okay. Thank you, Eric. I don’t believe we have any further questions, so I would like to thank all of you for joining us this afternoon. If you have any additional questions, please call Investor Relations at LSI. Thank you and have a nice day.

Operator

Ladies and gentlemen, a telephonic replay of this conference will be available beginning today at approximately 9’o clock p.m. Pacific Standard Time and we’ll run through 3 a.m. Pacific Standard Time on February 3. The replay access numbers are 1800-642-1687 within the U.S. and 1706-645-9291 for all other locations. The webcast will be archived at www.lsi.com/webcast.

That does conclude your conference for today. Thank you for your participation. You may now disconnect.

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Source: LSI Corporation Q4 2009 Earnings Call Transcript
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