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Executives:

Sujal Shah, Vice President of Investor Relations and Corporate Communications

Richard Clemmer, President, Chief Executive Officer

Peter Kelly, Executive Vice President, Chief Financial Officer

Analysts:

Seogju Lee – Goldman Sachs

Ross Seymore – Deutsche Bank

Lee Cooperman – Omega Advisors

Mark Edelstone – Morgan Stanley

Charlie Glavin – Needham & Company

Arnab Chanda – Lehman Brothers

Bill Lewis – JP Morgan

Srini Pajjuri – Merrill Lynch

Jim Poyner – Hapoalim Securities

Shelby Seyrafi – Caris & Company

Jeremy Bunting – Thomas Weisel Partners

Jack Sneider(?) – Golden Capital

Ambrish Srivastava – BMO

Suji De Silva – Cathay Financial

Agere Systems Inc (AGR) F4Q06 Earnings Call October 31, 2006 8:30 AM ET

Operator

Welcome to the Agere Systems investor relations conference call. Operator instructions. I’d like to turn the call over to your host, Sujal Shah, Vice President of Investor Relations and Corporate Communications at Agere Systems. Please go ahead.

Sujal Shah, Vice President of Investor Relations and Corporate Communications

Good morning and thank you for joining us. With me today are Rick Clemmer, President and Chief Executive Officer, and Peter Kelly, Executive Vice President and Chief Financial Officer. They will discuss highlights of Agere's results for Q4 fiscal 2006, then we'll open the call for your questions. Copies of our press release and other supporting financial data are available on our website. All income statement measures on this call with the exception of revenues will be non-GAAP measures unless we indicate otherwise. Today's earnings release describes the differences between our GAAP and non-GAAP reporting. You can find reconciliations on our website at www.agere.com/webcast. A replay of today's call will be available on our website. I want to remind you today's remarks will include forward-looking statements. Actual results could differ materially from those suggested by the statements made today. Information about factors that could affect our future results is contained in our 10-K and our Form 10-Q for the quarter ended June 30, 2006. Now I will turn the call over to Rick Clemmer.

Richard Clemmer, President, Chief Executive Officer

Good morning and welcome. This earnings call marks my first full year as Agere's President and CEO. While I'm not one to dwell on anniversaries at all it's definitely worth noting the progress we've made in the past year. For fiscal 2006 Agere reported GAAP net income of $0.12 per share. As a result, 2006 is the first full year that Agere has been profit on a GAAP basis since becoming a public company. This milestone is the product of hard work by everyone at Agere to execute the turnaround plan. Our goal is to get our financial performance to levels that our shareholders expect and deserve.

The first phase of that plan involved leadership changes, foremost among those were dynamic new leaders for our storage, mobility, and networking businesses. We also organized around these three core businesses, reduced and reallocated our investment dollars, and transferred responsibility for our sales and marketing activities into each business for complete end-to-end accountability. Lastly, we created a vision and point of differentiation for Agere. That vision, which I shared with you in July is perfecting the connected lifestyle. This is more than a clever marketing claim.

We believe Agere is better positioned than any company or competitor to bring high reliability and quality of service to businesses and consumers any time, anywhere. In the second phase of our turnaround plan, we focused on earnings growth. To accomplish this, we targeted our investments on those markets and opportunities where we can win and lead the industry. We also instituted a process to reduce expenses. As a result, our quarterly operating expense run rate is now less than $150 million, down from $174 million in December 2005.

We have increased our operating margin to double digits and have a sustainable quarterly earnings base of about $0.20 a share. We have established a strong foundation from which to execute on Phase III of our plan, revenue growth and we expect fully to deliver that growth beginning in the second half of 2007. In storage, we have strengthened our position at Seagate, turned around our pre amplifier business and expanded our customer base. In mobility our core 2.5G standard products have grown steadily over the past year and mobility is now a positive contributor to our results.

Worldwide, 135 million cell phones have been sold that use our chips and we have delivered our first low-cost 2.5G and 3G solutions to Samsung. Under the TrueONE banner, our networking business is able to deliver unique carrier-class reliability for voice, video, and data services to public, business, and home networks. We successfully expanded our business with Ericsson, NEC, Alcatel, Nortel, and others for system-level solutions, and we grew share in our network processor business. We accomplished a great deal in a relatively short time. We have executed on our plan. We aligned our costs with our long-term objectives and focused resources.

We have created a firm foundation from which to profitably grow revenues and achieve our 15% operating margin goal. Now I will turn the call over to Peter who will review our results and provide guidance.

Peter Kelly, Executive Vice President, Chief Financial Officer

Thanks, Rick. This morning we reported quarterly net income of $51 million, or $0.30 per share, exceeding the guidance range we provided in July. While revenues were $388 million, with Seagate and Samsung as 10% customers. Storage revenues were $146 million, up 8% from the June quarter. The increase was driven by SOCs and preamplifier shipments to multiple customers.

Mobility revenues of $104 million were essentially flat sequentially. As expected our satellite radio business was down, but our handset revenues delivered a solid 5% growth. EDGE shipments continued to strengthen and now represent more than half of our handset business. Networking revenues of $138 million were down 3% as expected. In the September quarter, our total revenue from licensing intellectual property was $33 million.

The breakdown of IP revenues in our operating segments was 11 million in storage, 9 million in mobility, and 13 million in networking. Our gross profit as a percent of sales was 49%, down from our Q3 level due to a reduction in finished goods inventory levels and product mix. Our operating expenses were $141 million in the September quarter, a significant improvement over our previous quarter. The improvements were driven in large part through lower payroll and benefits cost.

There were, however, $4 million of nonrecurring credits, including an employment tax refund. Our operating profit of $48 million was 12%. We remain committed to achieving 15% operating margin, and are pleased with the earnings leverage we have implemented in our business model. In the quarter, taxes were a net credit of $2 million. Interest expense was $6 million, and other income was 7 million. The net credit on taxes was related to the combination of two German subsidiaries.

On a GAAP basis, we delivered net income of $13 million, or $0.08 per share. During the quarter, we recorded $22 million of GAAP restructuring charges and related costs which was higher than our July guidance. As part of our Phase II earnings growth efforts, we identified additional cost savings and capitalized on this opportunity. The majority of those charges were related to support and operations functions across the organization. For fiscal 2006 revenues were $1.57 billion, compared to $1.68 billion in fiscal 2005.

Even with this revenue decline, EPS were $0.69 in fiscal 2006, a 68% improvement from the $0.41 recorded in fiscal 2005. On a GAAP basis, net income was $0.12 per share versus the loss of $0.04 per share in fiscal 2005. Turning now to the balance sheet, inventory closed at $116 million down from 135 in the previous quarter as we brought inventories down to a more normal level. Receivables were $243 million, and accounts payable were $152 million.

I continue to be pleased with our working capital management. During the quarter, we purchased over 3.6 million shares for a total price of $55 million. We also made $31 million of voluntary pension contributions. We paid $16 million in restructuring and spent $7 million on capital expenditures. As a result, our cash balance decreased by $84 million to $406 million. Our total debt, all of which is convertible notes due in 2009, remains at $362 million. Depreciation and amortization expense for the September quarter was $29 million, of which $27 million was related to ongoing operations. $2 million represented the final quarter of additional depreciation related to the consolidation of our Allentown office space. GAAP expenses related to equity compensation was $10 million for the September quarter.

I'd now like to turn to our guidance for the December quarter. Our total revenue is expected to be in the range of 365 to $390 million. In storage, in the December quarter we expect revenues to be down 5 to 10% as Seagate phases out the Maxtor based platforms. Counter to our typical decline in December and building on the strength we have seen in 2006, we expect our mobility business to grow 10 to 15% with strength in handsets. Networking revenues are expected to be down 5 to 10% with a drop-off in shipments of legacy products, including VSPs for our wireless infrastructure customers.

IP licensing revenues for the December quarter are expected to be 25 to $30 million. As I mentioned last quarter, we expect IP revenues to increase beginning in 2008, driven by our strong 802.11 component and systems-level patent portfolio and an aggressive approach towards litigation and contract enforcement. We continue to expect gross margins to be approximately 49% to 51% with the range driven by variation in mix. In light of our recent cost reductions, we now expect operating expenses to run at a reduced level in the December quarter. It will be in a range of $145 million to $149 million, and believe that operating expenses in fiscal 2007 will be at or just below $600 million.

In the December quarter we expect to post net income in the range of $0.18 to $0.23 per share. Our GAAP earnings are expected to be in the range of $0.08 to $0.13 per share. With major restructuring now behind us, we believe that we will remain profitable on a GAAP basis going forward. This quarter the net restructuring charges and related costs excluded from non-GAAP net income are expected to be approximately $4 million to $6 million. The majority of these costs are related to the ongoing de-commissioning work at our Orlando facility. We have entered into an agreement to sell our Orlando facility and may close on the transactions by the end of December. If this occurs, it would likely have a positive impact on GAAP EPS results but is not included in our guidance.

Excluding any purchase of Agere stock and receipts from the sale of Orlando, we expect our total cash balance to increase by $40 million to $50 million in the quarter. We expect capital spending in the December quarter to be approximately $8 million to $10 million, and estimate restructuring related payments at approximately $10 million. We expect taxes to be approximately $4 million, interest expense should be about 6 million, and we expect other income to be about $5 million. Clearly, we're very pleased with the progress we're making in improving our operating income and getting to competitive levels of profitability.

We have executed strongly on the turnaround plan we outlined earlier in the year and are well positioned to execute on the third phase of our plan, revenue growth. Rick will now cover the progress we are making in each of our three businesses that drive growth. Let me turn the call back to Rick.

Richard Clemmer, President, Chief Executive Officer

Thanks, Peter. Let me first begin by talking about storage. Our storage business performed as expected in the September quarter. Unit shipments were in line with seasonal factors and end market demand remained relatively healthy. We did a good job managing our business despite near-term challenges posed by the Seagate Maxtor merger. While the industry is still working through the effects of the merger we are confident it will be a long-term positive development for the HDD industry and for Agere.

We are particularly pleased with the turn around of our pre amp business. Fiscal 2006 revenues increased nearly 140% from fiscal 2005. We are now in a leadership position at a number of OEMs and command a share of preamp sales of about 25% in total, up from 9% a year ago. Our preamp resurgence clearly demonstrates that we can execute and grow in competitive markets. We also continued to expand our customer base in the storage market. During the quarter Samsung announced a new hybrid drive, using Agere's rechannel technology. Through our collaboration with Samsung we have delivered an advanced cost effective solution that will enhance the performance of HDDs and mobile computing.

By combining flash memory with a hard disk drive, Samsung has improved the overall end user experience by reducing overall boot time, increasing reliability, and reducing power consumption. Turning to networking, we continue to make progress with our TrueONE system level solutions that enabled delivery of higher revenue generating carrier-class services based on a superior packet processing technology. I am pleased to report that a number of design wins we mentioned in July are beginning to ramp into production. In wireline infrastructure, Ericsson's new IP DSLAM was named best access network technology and service product by the International Engineering Consortium.

This program is now beginning to ramp, and we expect it to be a revenue contributor during the second half of fiscal 2007. We also landed new business with NEC to provide advanced framing and mapping solution utilizing both our system-level software and hardware capabilities for the Company's next-generation transport equipment. In wireless infrastructure, NEC will soon ramp production of its 3G equipment with one of the largest Japanese wireless operators. This advanced system makes extensive use of Agere's high-reliability packet processing with the APP-300 network processor, system, and application software, plus wireless reference designs.

In storage area networking we continued to support QLogic's production ramp for 4-gigabit host bus adapters. We are also pleased to announce that we have secured another design win at QLogic for their next generation HVAs leveraging our best in class SerDes technology. In the SMB market we have secured another gateway win with a major telecom equipment supplier. This is in addition to the SMB gateway win we mentioned last quarter with Nortel. Nortel has also integrated the Agere TrueONE solution into their metro Ethernet access demonstration at the 2006 Advanced Technologies Summit in October. We also extended our coverage into the SoHo segment with multiple design wins for our ET 2k family of Ethernet switching solutions.

Together these wins will allow Agere to address a significant share of these developing applications. Overall, our networking business is taking a unique approach by engaging and working with service providers in our design win strategy. Sprint, Verizon, British Telecom, and Bell Canada are all echoing our vision of deploying next-generation services for home, small to medium business, and public networks with high quality and reliability.

In fact, one of the larger North American operators has begun testing Agere TrueONE solutions in its labs, and we expect other service providers to do the same. As you can see from our results our mobility business had a particularly strong Q4 and we expect that momentum to continue in the current quarter driven by the success of Samsung's ultra thin edition phone series. Our success is due to our ability to deliver solutions aimed at the sweet spot of the cell phone market which includes both entry level and feature-based handsets. While the prices of these handsets will vary by manufacturer and market, they generally fall in the $50-150 price range. Our goal is to provide differentiated highly integrated cell phone platforms that enable many multimedia features at the lowest possible price points.

To that end, we announced our TrueNTRY line of products which enable a high level of features at a competitive bill of materials for basic, entry level, and low cost phones. Our first TrueNTRY product, the X125 chipset is the industry's first entry level platform that delivers integrated CD-quality music when coupled with memory the X125 gives cell phone users quick and easy access to several hundred songs played at CD quality comparable to popular MP3 players such as the iPod. The platform already selected for use in at least four handsets by one of our major cell phone customers is a viable and differentiated competitive alternative to mass market MP3 players.

The demand for cell phones equipped with CD quality music capable is likely to dwarf that of MP3 players, and Agere is in a leadership position. There is a low incremental cost to add music capability to cell phones because the display, battery, and other components are already built in. In the feature-based segment, we announced the launch of our X115 product in six handsets built by China-based Amoi electronics. The platform equips Amoi's new feature and smartphones with CD quality sound, high quality video, and a 2 megapixel camera and the power to enable e-mail and Office document viewing applications. All of this can be performed without using a costly applications processor or multimedia companionship.

Turning to 3G I'd like to share more on our strategy and progress. 3G technology provides not only the higher data rates but also greater voice call capacity than previous generations. Because of this, operators like T-Mobile recently acquired 3G spectrum to focus on expanding their voice call capacity. Low-cost voice centric 3G phones are required by T-Mobile and other 3G operators to take advantage of the spectrum benefit. Agere is in a leadership position with solutions targeted squarely at entry level 3G phones. These phones will relieve operators of the burden of high handset costs while still enabling them to gain from positive user experiences with data services.

As a clear indication of our progress in this mark, Agere successfully passed functionality and performance testing of our 3G solution with five tier one infrastructure equipment vendors. A prerequisite for acceptance of our 3G solutions by network operators. Network operator field testing of our customers wedge handsets is near completion and we expect to begin production this quarter. In addition, we now have a working 3G cell phone developed with Chemai which we are jointly marketing to multiple tier one OEMs.

In conclusion, Agere had a good quarter and a good year. We have come a long way in the past 12 months, and we are clearly a different organization than we were a year ago. We are leaner, more focused, and more results oriented. Most important, we have the design wins in place to begin growing revenue in the second half of the fiscal year, and we're committed to delivering on it. I'd like to now turn the call back to Sujal.

Sujal Shah

Thank you, Rick. At this point we will begin the Q&A portion of the call. Will you please give the instructions of the Q&A session?

Question-and-Answer Session

Operator

Operator instructions. Your first question comes from Seogju Lee with Goldman Sachs, please go ahead.

Q - Seogju Lee – Goldman Sachs

Rick, just in terms of, you mentioned the expectation that you will drive revenue growth in the second half of the fiscal year. Just what is that contingent on and how are you measuring that? Is that for second half of next year versus second half of fiscal 2006 or are you looking at sequential? Any clarification would be great.

A - Richard Clemmer

I think the growth is both. It's comparable to second half of fiscal 2006 or on a sequential basis either one. When we look at the second half of fiscal 2007 the key for us is the design wins we have in place. We have demonstrated the growth associated with our mobility business and clearly we think there's opportunity for that to continue to grow at a very healthy rate. The design wins that we have in networking that will begin to materialize in the second half of 2007 focused on the small to medium business market on the network access with delivering our packet process leadership position is clearly a significant factor for us in the networking business to be able to deliver. Finally, in our storage business, clearly the customer expansion that we have will add to and contribute to the expanded basis that we believe Seagate has the opportunity to take advantage of. So the design wins are in place, the customer relationships are intact, and we feel very comfortable with ability to look at actually the third phase of our turnaround plan, which is the revenue growth that should start in the second half of fiscal 2007.

Q - Seogju Lee – Goldman Sachs

And just to clarify, in terms of the full year revenues, it doesn't look like that will grow? Is that what's implied as well?

A – Peter Kelly

I'm not sure what the question is, Seogju. Are you talking about 2007?

Q - Seogju Lee – Goldman Sachs

Yes.

A – Peter Kelly

We don’t give full year guidance.

Q - Seogju Lee – Goldman Sachs

Okay. And then just in terms of capex planning for next year any thoughts on that?

A – Peter Kelly

I'd assume about $50 million, five-oh, for full year 2007.

Operator

Our next question comes from Ross Seymore – Deutsche Bank.

Q - Ross Seymore – Deutsche Bank

Thanks, guys. First of all, congrats on the Op Ex management, pretty impressive. Really quick, on the Maxtor business you talked about that going away, and that being a part of the reason your storage business was dropping quarter over quarter. Can you give us an idea of the size of that business and when you expect to reach some sort of equilibrium or if Maxtor just simply becomes Seagate?

A – Peter Kelly

Yes. Ross, it's Peter, in the last quarter, so the quarter ending September we shipped about $25 million worth of product. It will be down to about, I don't know, $5 million in this quarter, so effectively really from last quarter, it's gone, but there's a very, very small amount in the December quarter.

Q - Ross Seymore – Deutsche Bank

Okay. And then as the one follow-up, again, on the Op Ex side it looked like a pretty impressive cut, you said it was about $141 million, and if I add back in that $4 million to get to about $145 million. Can you talk about what the delta was in this quarter that allowed you to get there, and does there come a point in your revenue growth where you need to start ratcheting up Op Ex again to either support these design wins, support new customers?

A – Peter Kelly

The biggest part of the drop down to 145 was a reduction in payroll and benefit costs. As I mentioned, we actually spent more than we'd originally planned on restructuring this quarter because Rick had talked on a number of other calls about the process we have to manage our expenses. We really thought we were at the point where we were tweaking, but the team came up with some other opportunities that we just really had to take advantage of. In terms of growth of expenses, yes, sure, once revenue really takes off, I would expect that expenses would increase, but I think there's a long way to go before we're talking about any increase in expenses, and even then it would always be for quite awhile a reduction in expenses expressed as a percent of revenue.

A - Richard Clemmer

I guess the only thing I would add to that Ross, is that the most significant factor that could push up our expense level is our short-term incentive plan, and I'd look forward to the opportunity to be able to pay more short-term incentive plan based on the growth of revenue.

Operator

Your next question comes from Lee Cooperman – Omega Advisors.

Q - Lee Cooperman – Omega Advisors

Thank you. Good morning. I gather you said we spent $55 million to buy back 3.6 million shares, which is an average price of $15.28. Rick mentioned on the call that you had solid operating earnings of $0.20 a quarter. So if I multiply by four, divide by $0.80, we're paying 19 times to buy back shares. On the surface it doesn't seem a particularly attractive trade-off so I'm saying to myself there must be some combination or one of three factors that you're thinking. One, that earnings are still well below normal, and there's a lot of operating leverage ahead. Number two, growth that we're anticipating as a company is higher than the Street has incorporated into their expectations. Or third, the underlying asset value is greater than reflected in the stock price, and we're buying back assets attractively. Since this is probably the largest investment decision you're making, certainly much larger than capex, I'm wondering if you could articulate the rationale of the buyback, and also just where are we in the program? How much is left in the authorization?

A – Peter Kelly

Lee, it's Peter. Yes, I think if you look at our results for Q4, and you take out some of the benefits we saw from tax and those one-offs, we delivered a good $0.24, maybe $0.25 of earnings. The $0.20 that Rick refers to is really a base that we'd like to suggest, because I think in the past you have seen the Company perform well in one quarter and then fall off. If you look at the leverage that we have in our model, we clearly think the Company is capable of making a lot more than $0.20 per share. In terms of the buyback itself, we have about $145 million left of the last $200 million that the Board approved at the last Board meeting.

Q - Lee Cooperman – Omega Advisors

How many actual shares are outstanding at the end of the period as opposed to the average?

A – Peter Kelly

Do you have the number, Mark? I think it's about 170 million, roughly.

Q - Lee Cooperman – Omega Advisors

Okay. That's actual outstanding shares?

A – Peter Kelly

Yes. We'll look it up.

Q - Lee Cooperman – Omega Advisors

Terrific. Good luck and thank you for the very strong performance.

A – Peter Kelly

Sorry, it's 168.5, Lee.

Q - Lee Cooperman – Omega Advisors

Thank you. And thanks again for the very strong performance.

Operator

Your next question comes from Mark Edelstone – Morgan Stanley.

Q - Mark Edelstone – Morgan Stanley

Good morning. Nice job on the results. Wanted to see, first, Rick, if you could give us a since on the mobility business. What's driving the growth here in December, and maybe you can break out your comments a little bit from volume versus content in handsets going forward?

A - Richard Clemmer

Yes. So thanks, first off, for your comments, Mark. The key thing for us is we have continued to strengthen our position with Samsung on the 2.5 G on the ramp-up associated with EDGE, and when you actually look at all the marketing momentum that Samsung has put behind their ultra thin edition, where they anticipated the, as they have talked about publicly, regaining some of the share that they had lost in the first half of the year, based on this platform, we're really the key technology provider associated with that. We've shown you the ultra thin phone which is actually thinner than the RAZR, which has actually enabled, through our package on package capability, that we're in a sole source position associated with that unique package ability. So the momentum that Samsung has is really the different factor for us. We're really excited about what's being created there, the increased volumes, and continue to be pleasantly surprised as they come in and update us relative to that volume. Clearly we're in a very good position from a supply chain basis with Samsung and it continues to perform very well, but it's really based on that ultra thin series of phones right now, although they're finding good acceptance on a broad base of phones as well. So the technology we're providing is enabling them to go back and aggressively take share in some of the regions of the world, specifically Europe and Asia where there seem to be a little bit stronger position.

A – Peter Kelly

If I could answer that, Mark, I think there's really three things, and it's difficult to separate them out, but clearly Samsung is gaining share, we're gaining share at Samsung, and then our content is growing as we ship more EDGE-based technology as opposed to GPRS.

A - Richard Clemmer

I think as we go forward the ability to position the technology so that we can actually offer them a lower cost of materials with actually delivering more through the integrated solution that we drive is a significant factor, but it's really not as significant for the current quarter and maybe even the next quarter but will be out in the second half of 2007 as that really begins to ramp into high-level volumes. Mark.

Q - Mark Edelstone – Morgan Stanley

Okay. Great. Also, when you guys look into the growth drivers here for the second half of fiscal 2007 and into fiscal 2008, given the fact that you have got relatively easy comparisons to work off of here for this year, how likely is it that we can get to some low double-digit comparisons by the end of fiscal 2007 and carry that into 2008?

A - Richard Clemmer

Well, we don't talk about projections for fiscal 2007 at all but clearly our intent for Phase III was to get back in a position where we felt like we could grow at or above the marketplace that we're serving. So if you look at the general marketplace, that's in a position where it's growing at 20% annually. So we will not feel like we've been through and completed Phase III until we're in a position where we're growing at that level on an annual basis.

Operator

Your next question comes from Charlie Glavin – Needham & Company.

Q - Charlie Glavin – Needham & Company

Maybe going back to a question that Lee had on a different one in terms of the pension funding and the cash usage, you mentioned these were voluntary contributions. Correct me if I'm wrong but I thought about a year ago you guys had taken a pretty aggressive pension funding that was going to fully fund it through fiscal 2007. Given some of the Op Ex changes and certainly some of the interest rate changes that have gone on in some of these assumptions, can you kind of give an outlook? Are you done? And how far out have you fully funded your pensions right now?

A – Peter Kelly

Well, our policy, Charlie, is to fully fund on ERISA, which takes you to about 90% funding, and we did make a contribution in 2005 and a contribution in 2006. We expect the contributions in 2007, if any, to be minimal. The one thing we're not sure of at the moment is the impact of any changes from some recent legislative changes.

Q - Charlie Glavin – Needham & Company

Okay. And just housekeeping, tax rate kind of going forward in terms of a lot of the changes and the lack of R&D credit, how are you looking at that for 2006, 2007?

A – Peter Kelly

On taxes, you can't really think of it as a rate. I think you ought to think of it as an absolute amount in dollars, and you should probably think about 20 to $24 million for the full year.

A - Richard Clemmer

We used up our $1 billion tax loss carry forward.

Q - Charlie Glavin – Needham & Company

Well, let's try not to repeat that then. Rick, in terms of the storage, if I back out the impact of Maxtor, storage would be up fairly nicely, which would imply two quarters of pretty decent storage growth at the same time that the industry has been extracting a good five million units from the industry. Where, in particular, in the second half of this calendar year, taking out the impact of the Maxtor roll off have you been seeing it? Has it been the market share gains more within Maxtor, or are we also seeing some of the newer platforms both at Samsung and Seagate kick in, or are there any other factors?

A - Richard Clemmer

For fiscal 2006 Samsung from an HDD customer basis clearly grew, but was not a significant contributor to our bottom-line revenue. It will clearly be a much more significant contributor going forward. Our revenue base was basically with an expansion and preamps, as we talked about, which was a significant contributor to our bottom line results, then the remainder of the fundamental growth in the business was just associated with Seagate shipments into the marketplace.

Operator

Your next question comes from Arnab Chanda - Lehman Brothers.

Q - Arnab Chanda - Lehman Brothers

A couple of questions. First of all, you definitely reduced operating expenses pretty significantly. I guess you have done that in the past too, but this is probably a little more significant than in the past. Can you talk a little bit about, there has to be certain reallocations where you're not focusing on any more where some of the businesses could be more legacy. For example, you haven't talked about Ethernet in a long time. I'm just curious, as to, can we assume that this expenses is kind of a base and you don't have much legacy any more where the R&D is going to start paying off, or that you will see some things decline because you're just not investing in that? Give us a little bit of a sense qualitatively on that. Thank you.

A – Peter Kelly

Arnab, it's Peter. I think there's a couple of things. One is we really spoke about what we were doing from an investment perspective two or three quarters ago. So we made fairly significant reallocations of our funding. These changes, and I'm not sure I would prescribe them as relatively dramatic compared to what we did early in the year, were really in support functions. So it was IT operations, HR, those kind of things. And, yes, it probably is the kind of base at which we'll operate from here on in.

A - Richard Clemmer

I guess just specifically on your question relative to gigabit Ethernet, we actually talked about extending the coverage in the SoHo market and with a number of design wins in the quarter in our Ethernet switching family of products, so we have addressed that. Clearly we're focused on that more as a capability to be able to drive a unique leadership position than out focused on socket by socket design win basis. But it's clearly an important technology that allows us to really be able to address the overall access viewpoint from the SMB market. So we continue to invest there and continue to have design wins. So I don't think we have talked about it much less. We really talked about the opportunity for growth that when we think about what's going on and the ability to deliver carrier-class capability to small to medium businesses, I think that's really the significant factor, and clearly gigabit Ethernet capability is a contributing factor in that overall capability as well.

Q - Arnab Chanda - Lehman Brothers

Great. Just one follow-up. You have talked about the growth opportunities in storage and mobility and it sounds like your success in design wins will reflect your revenue growth. If you talk a little bit about your strategy in networking, seems like there's a lot of custom ASIC things that you're do doing, and then there are some legacy things, older ASIC technology and DSCs. Could you talk a little bit about how you address that business, how much is standard product versus ASIC and how much is legacy versus growth so that we can get a little bit better understanding of the growth potential there? Thanks a lot.

A - Richard Clemmer

Yes, sure. Our focus is not around ASIC per se as in shipping a bag of gates. What we're really focused on, is, for example, in the QLogic case, where we take our best in case SerDes technology and then customize that for QLogic around it, as a specific example. When we talk about the small to medium business access, as we look at that opportunity, we are actually taking products that exist and taking a customization of software, and that's one of the reasons why it improves our confidence in being able to see a ramp of those design wins in a much more timely fashion measured in months or a few quarters as opposed to if you were doing a custom SOC, system on a chip design, where it would take years before you were actually seeing any significant ramp in revenue. So, really, that's the most significant change that we have done in the networking business, is really look at the very important and very critical technology capability that we have and how we could utilize that to deliver more value for our customers. That's what's driving the design wins that we have across a number of our networking customers and what's really allowing the carriers themselves to get excited about the technology that we can provide that allows them to differentiate their capability as they're all faced with challenges associated with declining voice revenue.

Operator

Your next question comes from Bill Lewis – JP Morgan.

Q - Bill Lewis – JP Morgan

Thank you, and good morning. On the mobility business, this looks to be a pretty strong up tick starting in the December quarter. How are you expecting the mobility business to proceed through the balance of the year? Is this a situation now where with these ramping products, including 3G later in the year, that you should be able to kind of grow this business sequentially each quarter of the year, or could you just talk about how you think it might proceed?

A - Richard Clemmer

Well, we don't talk about revenue projections for next year, Bill, as we mentioned earlier. I think the strong position that we have associated with Samsung and Amoi and others puts us in an excellent position to grow at a very healthy rate. The key for us is being in a position to deliver on that. And then opportunities for even upsides beyond that, with, as we talked about the 3G low-cost handset that was designed in conjunction with Chemai where they put a lot of effort into it, and we're now working with them with tier one handset providers to actually look at securing a specific engagement with one of those customers. But clearly a significant growth opportunity that we plan to take full advantage of.

Q - Bill Lewis – JP Morgan

And on 3G, when do you really see the inflexion point in that business, and also what is the outlook for the satellite radio business?

A - Richard Clemmer

Well, if you look at 3G, I think if you look at some of the industry ramps, I think that part of that has been pushed out somewhat, as a number of the carriers are trying to deal with the handset costs associated with implementing 3G. One of the advantages that we have is in the case of Samsung, enabling their first mass market 3G handset, and the opportunity to go take advantage of a low-cost 3G handset with Chemai. Actually being able to address the market in a different space that is not going to drive significant revenue growth in the next quarter or two but significant relative to those customer engagements in driving growth out in the future period of time. On the satellite radio business in general, it's relatively flat as we transition, we're transitioning to the next generation of products, we've basically, in the process of early shipments associated with that, that won't ramp until second half of 2007.

Operator

Your next question comes from Srini Pajjuri – Merrill Lynch.

Q - Srini Pajjuri – Merrill Lynch

Peter, the growth margin, 49 to 51%, is it completely a function of product mix going forward? You also talked about inventory kind of having an impact last quarter. I'm trying to understand how much of this is product mix issue versus some fixed cost in there.

A – Peter Kelly

About a point of the drop in Q4 from Q3 was really because we reduced our inventory. We reduced our finished goods inventory quite substantially, and as a result, underutilized our factories. But really I would expect most of the variation that we have on a quarterly basis to really be around mix, and you have a few things going on there. You have the networking business, obviously has very high gross margins. IP has very high gross margins, and storage and mobility, although they both have good margins, they're not quite as good as IP and networking.

Q - Srini Pajjuri – Merrill Lynch

Okay. And DSOs went up a little bit. Was it primarily because of linearity in the quarter or something else?

A – Peter Kelly

Yes, we were a little bit back-ended, but IP tends to have an impact. It's just a question of when you sign the deals. Actually, OEM-type DSOs were pretty flat.

Q - Srini Pajjuri – Merrill Lynch

Okay. And then a couple of questions. You gave us a nice breakdown of Maxtor revenues. I'm just wondering, on the networking side you said that there's some legacy DSP business that will go down in December quarter. How much of that business do you consider legacy? How should we think about it going forward?

A – Peter Kelly

We think of the DSPs that we ship into wireless infrastructure as part of our legacy business. The reduction that we're seeing in the short term we believe is more to do with inventory reprofiling at a major customer rather than anything in the marketplace.

A - Richard Clemmer

At the same time, we have DSP design wins with networking customers that we consider part of our TrueONE portfolio as well. So it's a mix of products, really older generation DSPs versus the new generation of ramp of DSPs.

Operator

Your next question comes from Jim Poyner - Hapoalim Securities.

Q - Jim Poyner - Hapoalim Securities

I was wondering if you could just give us a better idea on preamp revenue in Q4, what that was, how much that contributed to storage revenue, and would kind of dynamic do you see for that in the December quarter versus September? Do you look for some seasonal strength there, or is there something else on top of that? Thanks.

A – Peter Kelly

Jim, we don't split out our preamp revenue specifically. It did grow and continued to grow in Q4 over Q3, and we obviously have very high hopes for it in 2007.

A - Richard Clemmer

I think the safe thing to say is, with 140% growth that we had in fiscal 2006, and getting us to 25% market share from kind of mid single digits a year ago it's certainly a significant contributing factor, and we have broad design wins in virtually all the OEMs across the board. So definitely a contributor in one of the things that is helping us with our overall storage revenue as we transition.

Operator

Your next question comes from Shelby Seyrafi - Caris & Company.

Q - Shelby Seyrafi - Caris & Company

Good morning. Congratulations on the results. I guess I'm a little bit confused about the gross margin guidance increasing in the December quarter. Networking, which has higher gross margins, is guided to decline, you said 5 to 10%. I see that growing less than the combined mobility in storage or consumer segment, so that's a negative gross margin driver. And license, which is obviously high margin, is going from 33 to 25 to 30 million so again, why is the gross margin guided to grow as you've guided? The only thing I can think of is that the capacity utilization is going to increase in your gross margin in your consumer segment is going to increase meaningfully. Maybe you can comment on that.

A – Peter Kelly

Certainly, Shelby. It was about point of gross margin, or 100bps in Q4, really because we reduced our inventory levels and we're not expecting that to happen in Q1, in the quarter ending December.

Q - Shelby Seyrafi - Caris & Company

Okay. One more if I can. You've talked in the past about a 15% operating margin target. You're now nearly 10%. Do you expect to hit that 15% target more in fiscal 2007 or more likely in fiscal 2008?

A - Richard Clemmer

Well, let's be specific, we were about 12% in the most recent quarter that we announced, Shelby. We think we're clearly moving towards that. We have to have a little bit of incremental revenue growth to put us in a position to comfortably deliver on our 15% operating income model, but not significant. So we feel very comfortable with that objective. We think that that puts us in a very competitive position, we'll deliver a very significant return on capital for our shareholders. It's definitely our objective and where we're focused on trying to deliver but the baseline, again, we're already well approaching that as we're 12% plus in the current quarter.

Operator

Your next question comes from Jeremy Bunting – Thomas Weisel Partners.

Q - Jeremy Bunting – Thomas Weisel Partners

Thank you. I have one for Rick and one for Peter. Rick, could you just talk a little bit more about what you think the dynamics are for you in the networking area in the first half of fiscal 2007? You mentioned DSPs down, but how do you view the overall strength of the telecom market for the next six months?

A - Richard Clemmer

So it's very interesting. I know some companies have talked about a weak environment. I think we see a generally positive environment associated with the networking business itself. Clearly in the connectivity side, in modems, it kind of follows a little more of the patterns of the PC business. So it's definitely been a little bit of a more weak environment, and clearly we would anticipate that being the case. But overall, in the networking infrastructure side, we continue to make good progress with customers, have design wins that will begin to ramp later this year, and we continue to see a real positive environment, with one exception of some inventory streamlining associated with a specific customer on DSPs. So we see a very healthy environment. The design wins that we were able to secure last year, putting us in a very excellent position going forward in the networking space, and those being broad based with customers that we talked about, like Ericsson, Huawei, Nokia, and then obviously in the storage area network position with QLogic. So I think that the design wins we have and beginning to realize the revenue ramp associated with those in the second half of fiscal 2007 is the key factor that drives our real fundamental growth, but the general market environment we see as being relatively positive for the next few quarters.

Q - Jeremy Bunting – Thomas Weisel Partners

Thank you. Peter, what is the allocation of stock-based comp between the expense line, and what were the 10% customers during the quarter?

A – Peter Kelly

There were two 10% customers, Seagate and Samsung, and I guess we'd have to look it up, but I think stock-based comp was like a million in gross margin. I'll have to look it up and give you a quick call. It is on the website, though, Jeremy.

Operator

Your next question comes from Jack Sneider(?) – Golden Capital.

Q - Jack Sneider(?) – Golden Capital

Hey, guys, all my questions have been asked, although it's funny, you guys get questions as if you're the old Agere from a few years ago, so I'm just going to take a moment to thank you guys. Rick and Peter and everyone. You have really executed by reducing your expenses and positioned this company for revenue growth where we're really going to see the operating leverage. It's really a pleasure because we always believe this company is dramatically undervalued, and to have this management team in place where you have done everything, and more than everything that you've laid out is just a pleasure as a shareholder, so thank you guys very much.

Operator

Your next question comes from Ambrish Srivastava - BMO Capital Markets.

Q - Ambrish Srivastava - BMO Capital Markets

One question on the three segments, if you look out ahead you talk about growth in the back half of fiscal 2007. Out of the three segments, based on the design wins that you guys have, which is do you think is going to be the biggest driver? And a quick follow-up. On the IP side you talked about growth resuming in 2008 based on 802 IP portfolio. What is the delta there? Smarter IP lawyers? Or how should we think about why that should grow in 2008? Thank you.

A – Peter Kelly

If I take the IP question first of all, I have said that we expect IP to grow from 2008 by at least $10 million a year, and as I mentioned, it's really around our 802.11 portfolio, both systems and our component level. And I guess that's about as much as we'd like to say about it it at the moment.

A - Richard Clemmer

So relative to the growth, we think all of our three businesses are well positioned for growth in the second half of fiscal 2007. The design wins are in place, we've secured those design wins, it's a matter of executing towards those. Clearly mobility with the position it has in the growth of the underlying market will be a significant factor associated with that. The opportunity that we see in several of the networking spaces, or several of the businesses within the networking space, in the storage area network as QLogic ramps their 4-gig HPAs, that would be a significant growth factor for us, the SMB network access box that we've talked about that the carriers continue to be excited about, we'll begin to see shipments take place in the second half of 2007, so a very significant growth opportunity in the networking business associated with it it and at the same time in storage with the combination of customer expansion and continued support of Seagate and then our broad position in preamps is the contributing factor there. So we'd expect all of those businesses to be in a position to continue to perform very well and drive and contribute to our growth in the second half of fiscal 2007.

A – Peter Kelly

Just to get back to Jeremy's question, of the $10 million of stock-based comp, indeed 1 million is in gross margin, and the other $9 million is in the expense line.

Operator

Your next question comes from Suji De Silva – Cathay Financial.

Q - Suji De Silva – Cathay Financial

I think people have asked this question different ways. In terms of your Op Ex and headcount do you think it's where you want it to be and if you continue to increase R&D would it be through redeployment or adding heads since you're going into growth phase? Good morning, Rick, Peter, congrats on the Op Ex here. I think people have asked this question different ways. Let me try it one more way. In terms of your Op Ex and head count, do you think it's where you want it to be right now and if you do increase R&D in any areas would it be through redeployment or adding heads since you're going into a growth phase.

A - Richard Clemmer

We think our Op Ex level is at a very sustainable level to support the customer engagements and the design wins we have. In any semiconductor business I think you have to be careful about saying that you're absolutely fixed. I think that we have our resources aligned, we're very focused on the businesses where we think we can be in an absolute leadership position. But at the same time, I think we have the resources in place so that we will be able to support that growth. You'll continue to have resource redeployment where there may be some critical resources that you add, and we end up having to align our resources in other spaces to be sure that we keep that in an affordable run rate basis. But we're committed to being sure that we have the resources in place to focus on the leadership, our development in the leadership areas that we can participate in, but at the same time maintain the expense level that we've put in place that we think allows us to leverage going forward.

Q - Suji De Silva – Cathay Financial

Great. Thanks. That's helpful. Then a real quick follow-up. On the handset side in the EDGE and 3G area what are you seeing is on the competitive landscape there and how do you think your share is going to be there versus the 2.5 G?

A - Richard Clemmer

It's too early to say on 3G. I think the positive factor for us is being in a leadership position with a low-cost or a mass market handset on 3G is key. I think that the ramp-up of 3G has been pushed back some because the carriers are looking for a solution that doesn't have the same kind of cost premium, and so by being in position where we can work with our customers to deliver that to the carriers represents a significant opportunity for us. But it's not going to be near term. We would anticipate that that ramp would take place more out over a couple of quarters than in the near term. But our confidence in ability to deliver that is very significant for us, and a contributing factor associated with that business.

Operator

Your next question is a follow up from Charlie Glavin – Needham & Company.

Q - Charlie Glavin – Needham & Company

Just a follow-up, guys. Peter, you and Rick have talked about a couple of legacy products that are rolling off and drawdown in the finished goods which impacted your gross margin. And I look at the inventory which has come down 14 days in just one quarter. Is there a flushing out in terms of setting the…

Operator

Actually, it looks like we just lost his line.

A - Richard Clemmer

We lost Charlie. Do you show any further questions?

Operator

No, I show no further questions.

Richard Clemmer

Thanks. So I'd like to thank all of you for joining us this morning. If you have any additional questions please call Investor Relations at Agere Systems. Thank you, and have a very nice day.

Operator

Thank you. Ladies and gentlemen, that does conclude today's conference. If you would like to hear the replay for today's conference it will be available starting at 10:00 a.m. running through midnight on November 6. You may access the replay number by dialing toll free, 1-866-509-3699, international participants may dial 203-369-1911. The call is also available via webcast replay at http://www.agere.com/webcast. That does conclude today's conference. Thank you for your participation, and you may disconnect at this time.

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Source: Agere Systems F4Q06 (Qtr End 9/30/06) Earnings Call Transcript

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