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Executives

David Climie – VP, Marketing Communications & IR

Mike Zellner – CFO

Greg Lang – President and CEO

Analysts

James Schneider – Goldman Sachs

Romit Shah – Barclays Capital

Sandy Harrison – Signal Hill

Srini Pajjuri – CLSA

Ruben Roy – Pacific Crest Securities

Kevin Cassidy – Thomas Weisel Partners

Mark Lipacis – Morgan Stanley

Allan Mishan – Brigantine

Cody Acree – Williams Financial Group

Eric Ghernati – Bank of America/Merrill Lynch

PMC-Sierra, Inc. (PMCS) Q1 2010 Earnings Call Transcript April 22, 2009 4:30 PM ET

Operator

Good day. And welcome to the PMC-Sierra 2010 Q1 earnings release conference call. Today's conference is being recorded. Today is Thursday, April 22, 2010. It is now my pleasure to introduce, Mr. David Climie. Please go ahead, Mr. Climie.

David Climie

Thank you. Good afternoon, everyone, and thank you for attending our investor conference call. With us on the call today is Greg Lang, President and CEO; and Mike Zellner, Vice President and CFO. Please note that our first quarter 2010 earnings release was disseminated today via Business Wire, after market close, and a copy of the release can be downloaded from our website.

Before we begin I would like to point out that during the course of this conference call, we'll be making forward-looking statements that involve a number of risks and uncertainties. These risks and uncertainties include, but are not limited to, product demand, inventory levels, pricing, exchange rates, taxation rates and other risk factors that are detailed in the company's Securities and Exchange Commission filings. Actual results may differ materially from the company's projections.

For further information about these risks and uncertainties, please read the company's SEC filings, including our forms 10-K and 10-Q. If you're asking a question during the Q&A session of today's call, we request that you limit yourself to one question, if you'd like to ask a second question, please re-queue with the operator.

Thank you. And I'll now turn the call over to Mike Zellner.

Mike Zellner

Thanks, Dave. I'll review our first quarter 2010 results and financial position then turn it over to Greg to discuss our business activity in detail.

PMC-Sierra had a strong first quarter and reported its fourth consecutive quarter of sequential growth. Revenue in Q1 was $152.8 million. This exceeded a high-end of our guidance for the quarter and reflects an increase of $13.3 million or 9.5% over Q4 and is our highest revenue quarter since 2001.

On a year-over-year basis, revenue increased by over $50 million or 49%, compared with $102.6 million in the first quarter of 2009. Our turn’s business, meaning those orders booked and shipped within the same quarter was 17% in Q1, compared with 23% in Q4 of last year. By reason, Asia continues to generate strong results in this quarter.

In Q1, we have one customer that represented greater than 10% of our revenue, calculated on a rolling 12-month basis. Gross margin in first quarter of 68.1% was at the high-end of our guidance and consistent with the 68.2% in Q4 of last year.

On a non-GAAP basis, operating expenses increased from $54.5 million at Q4 to $59.3 million in Q1. This is in line with our outlook on expenses provided on our last quarterly conference call.

Quarter-over-quarter, approximately half of this increases arises structurally with the payroll related reset of employee benefits at the beginning of the calendar year, and the effect of foreign exchange on our foreign operations.

The other half relates primarily to a combination of higher takeout related expenses in Q1, and the completion of plant hiring and other investments and high potential R&D projects, including the purchase of related intellectual property.

In Q1, we maintain our non-GAAP operating margin at 29%, which is at the high-end of our targeted operating margin range of 25% to 30%. The non-GAAP tax provision was $2 million in the first quarter as guided and similar to the amount for Q4 at $1.9 million.

Non-GAAP income for Q1 was $43.5 million or $0.19 per share on a diluted basis, representing a $4.3 million or 11% increase over Q4 non-GAAP net income of $39.2 million. On a year-over-year basis, non-GAAP net income increased by $31.1 million or over two and a half times the $12.4 million generated in Q1 of 2009.

Q1, GAAP diluted net income per share was $0.12 versus $0.06 in Q4. The increases in net income and the dilutive net income per share on both GAAP and non-GAAP basis were driven primarily by the higher revenues partially offset by higher operating expenses.

The comparable GAAP measures for each gross margin, operating expenses, operating income, provision for income taxes and net income are reconciled to the related non-GAAP amounts in our reconciliation of GAAP to non-GAAP measures included in our press release today.

The primarily reconciling items for Q1 are as follows. 9.8 million amortization of purchased intangible assets, $5.4 million in stock-based compensation expense, $800,000 of non-cash interest expense and $300,000 of net expense related to foreign exchange, income taxes and other item as described in the press release.

Turning to the balance sheet, we entered the quarter with over $486 million of cash and cash equivalent short-term investments and investment securities. Our cash position at quarter end net of the $68.3 million face value of our convertible note was our $418 million reflecting an increase of $32.8 million in first quarter this year.

Again in Q1, we generated strong cash flow from operation of $28.8 million, in Q4 of last year we generated $31.2 million. Cash generated in Q1 was driven by the $43.5 million of non-GAAP net income in the quarter. Offset primarily by $9.5 million increase in accounts receivables and higher sales and $12.7 million change in current and deferred income taxes, including a one-time tax payment.

In addition, we received cash employee related stock issuance of 5.7 million. And net capital expenditure of $1.5 million. As mentioned, accounts receivables increased $9.5 million to $60.2 and reflect 36 days of sales outstanding based on a quarterly sale volumes. This was slightly higher in terms of days than we had in the previous quarter but remains a very healthy collection profile.

Our net inventory at the end of Q1 was $32.9 million, an increase of $1.4 million from prior quarter. More importantly, our net income turns on an annualized basis were at a targeted level a six times, compared with 5.6 times in Q4.

I'll now turn the call to Greg for his briefing.

Greg Lang

Thanks. As Mike noted we generated a $152.8 million in revenue in the first quarter this year, which was up 10% from Q1 and what is typically a soft seasonal quarter. It's also interesting to note that our revenues were about 10% higher than our peak quarter in 2008.

More importantly, we believe each of our end markets is healthy and end market demand at or about 2008 levels. On the earnings front, we generated approximately $45 million in non-GAAP operating income in Q1, which is up $4 million or 10% higher than the prior quarter and payroll tax reset and negative foreign exchange impact we achieved 29% non-GAAP operating margin, matching the same operating margin level as Q4 '09.

As I mentioned earlier our target operating range is 25%, operating income range is 25 to 30%. So it's good to be at the high-end of this range when we leverage the business model that we have.

So, now, let's talk a bit about the results by end market for the first quarter. In the Wide Area Network Infrastructure market, which includes both our wireline and wireless infrastructure product. We saw broad based recovery that include North America, Europe and Asia and produced most of our sequential growth.

We're seeing a steady improvement in metro access and metro transport activity and requirements. Remember, that 70% of our WAN infrastructure business is generated from our devices going into wireline infrastructure and currently many bottlenecks and exhaustion points that are occurring carriage network today especially given the significantly higher levels of mobile data and video traffic.

In addition, there are many new transport platform that come to market over the next year as OTN, the Optical Transport Network begins to be deployed in North America and PTN or the Packet Transport Network begins to be rolled out broadly in China.

As we talk before, the toughest challenge in these new multi-service transport platform is the availability to aggregate the various protocol in the 10 and 20 gig transport pipe and then move to converge IP and TDM traffic around efficiently and that's exactly what our industry leading Hi-Fi metal devices are design to do. We are working closely with many OME’s in getting great design win traction for our new OTN transport product in these markets. These wins will start producing revenue late in Q4 of this year.

On the wireless infrastructure side, again we experienced improved broad based activity in Q1, after a slow second half in China last year, the carriers are now moving to the next phase of their planned build-out as well as significantly upgrading their wireless backhaul network albeit at a lower level.

Please note that while China is a very important market to us, during the first quarter, when infrastructure business for the China OEMs represented about 10% to 11% of current revenue and about one half of that is expected to be out of China, excuse me, exported out of China. So we would say that only about 5% of our total revenue is exposed to domestic China wired and wireless network build-out.

In the enterprise storage market, we experienced better than seasonal activity levels in the first quarter of the year and we’re up slightly on a sequential basis, but up 100% on a year-over-year basis. Our fiber channel business was basically flat Q4 to Q1 while our SAS devices, at three gig and six gig, improved slightly.

In the external storage system market, we are expected our six gig SAS products to improve each quarter throughout 2010 as our storage customers ramp their new platforms in this part of market. As we mentioned previously, we've been end-to-end product solution in six gig SAS with both controllers and expanders and some new key customers in this segment.

With the regard to our six gig radon chip product that is shipping into HP servers, we got a good start in Q1 and continue to believe it will be approximately $30 million to $35 million of additional revenue in 2010 compared to 2009 for this device shipping into HP alone.

For the balance in the server market, we're expecting to start shipping our full solution in the next three to four months with meaningful revenues in Q4 this year. In broadband access, our Japanese EPON business was slightly lower as expected in the first quarter and it was offset by increased revenue in China.

NTT in Japan is targeted to add more than $2 million new subscribers this year, as they move in more subscribers from video (inaudible) to EPON. And NTT will be building out additional OLT capacity in the central offices to accommodate this upgrade. As we've seen seasonally in the past, the second quarter is typically a stronger quarter for our EPON business in Japan as they kickoff their broadband services subscriber campaigns in the first fiscal quarter of Japan.

Now in China, our Fiber in the Home business was up slightly in Q1 as forecasted. We're encouraged by the recent policy changes there are being undertaken by Chinese government. In a report titled, Recommendations on Promoting Fiber Optic Broadband Network Construction, they describe a plan to convert broadband access networks and plan to have $80 million fiber broadband access ports by 2011 from a base that's less than $20 million today. With this ambitious policy, we don't expect any immediate benefits, but it's encouraging to see such strong direction and continued emphasis on building out world class infrastructure coming from the Chinese ministries.

This year, we are starting to China telecom launch its first half 2010 build out program where it's targeting to add $6 million to $8 million EPON subscribers. This fits well within their full year plans. In China telecom and China mobile, we also expect to see a small GPON trial deployment in 2010. While this is a small piece of overall business, we're also bidding to supply this part of the requirements as well.

Now with regards to China Unicom, the other large wireline carrier in China, they just recently completed a major restructuring of their management ranks so we hope now they're in a position to proceed with increased competition coming from China mobile and China telecom as we've been anticipating new planning goals and PON build-out plans for China Unicom for a few quarters now.

Now in our microprocessor business, the high – the end markets remain healthy after recovering in the second half 2009. We experienced a slight increase in Q1, which was positive given the seasonality as usually a slower period in the laser printer market. We're also encouraged to see inventories in this area remain in good shape and activity in the enterprise networking market increased slightly.

Now for the second quarter outlook. Based on our backlog and bookings to date, we currently expect PMC-Sierra's revenue in the second quarter 2010 to be in the range of $155 million to $160 million or approximately 1% to 5% growth on a quarter-over-quarter basis. Once again, we anticipate this growth to be broad based with WAN infrastructure, storage and fiber to the home, each improving in Q2.

The Microprocessor business is expected to be down in Q2 after experiencing a better than seasonal first quarter. Strong bookings continue through Q1 and we once again have a solid backlog position with book to bill over 1.1. In the second quarter, we're calling for a very low level of turns to meet our revenue outlook range, about 5%, which is the same as last quarter at the time of the call.

As you're aware, the foundries and the supply chain remain tight so we are entering the quarter with higher visibility and backlog and turning less. Some shortages in the semiconductor supply base will continue and as a result, customers are booking farther in advance to make sure they meet lead times. As a result, we're already booking orders into the third quarter.

Now inventories, we believe are in good shape and we're very pleased to hit our target turns rate of six times in Q1. We also believe that channel inventory remain healthy and we're not seeing any inventory builds at our disti [ph]. In fact, both our average monthly disti inventory as well as our quarter-end disti inventory were both down slightly in the first quarter compared to Q4 last year, which is very solid given a growing business climate.

In summary, PMC's financials are as strong as ever. Revenue has grown five straight quarters and projected to grow in Q2 for a six. Q1 was 10% above the peaks of 2008. And we've been producing in our target operating income range for the past four quarters straight and at the high end of that range for the pass two, the best top and bottom line results we've seen in about ten years.

It's also important to point out that our customers are doing well. Nearly all of our major customers are at or above peak levels from 2008. We believe the infrastructure markets have largely recovered from last year's recession. For example, in storage, we see market leader EMC already back at their peak quarterly revenue levels and we see NETA well beyond their 2008 peak with continued growth on Snapshot [ph] data storage. We also see the server market back to peak levels with strong results just announced at IBM for their X 86 servers and a positive outlook for HP's server business for the quarter as well.

And in the carrier business, with see AT&T increasing their CapEx budget year-over-year and Verizon moving to a packet network while emerging markets continue their infrastructure focus. Even with China's year-to-year drop in wireless infrastructure, our China base customer purchases are well above healthy 2008 spending levels. We believe this is rapid recovery in our core infrastructure markets is driven by the fundamentals we've been talking about for the past couple of years.

The digitization and distribution of nearly every kind of media is driving network traffic and storage infrastructure growth. Enormous video files, digital images, digital music, all needs to be stored and moving it around electronically requires more bandwidth and more efficient packet networks. And the proliferation of mobile devices means this traffic explosion is happening on the cellular network as well.

These fundamental drivers are well underway and are driving infrastructure growth that will continue for several years to come. With our strong market position and leadership products, PMC-Sierra is in a great position to benefit from these fundamental drivers.

So with that, I'll turn the call back over to Mike for more details on our outlook for the second quarter of 2010.

Mike Zellner

Thanks, Greg. I'll now provide more information about our Q2 outlook. Again, considering levels of demand and our expectation of booking rates throughout the balance of the quarter, we estimate the potential revenue for PMC-Sierra for Q2 is in the range of $155 million to $160 million, as Greg mentioned. Just shipped and shippable backlog at the beginning of Q2 was approximately $139 million. And as of today, it is approximately $150 million, indicating that we will need approximately 12% turns from the beginning of the quarter and 5% turns from this date to get to the mid range of our outlook for Q2. We believe this low level of turns makes sense, given the early bookings we're receiving from our customer base in response to the relatively tight supply chain, as Greg mentioned. This is a similar pattern to what we experienced in Q – in the first quarter.

On a non-GAAP operating basis, we expect our overall gross margin percentage in Q2 to be in the range of 68% to 68.5%. Non-GAAP operating expenses in Q2 are expected to be in the range of $61 million to $62 million, increasing from the $59.3 million in Q1. Of approximately half of this increase is from items that are structural in nature, such as annual performance increases and the effects on foreign exchange on our foreign operations. The balance relates to planned hiring and other incremental R&D investments in a number of growth areas, as Greg described, including Optical Transport Networks, Enterprise Storage and Wireless Backhaul Infrastructure.

On a general note, depending on the number and timing of take outs, which do vary from period to period, our expenses could be affected by a couple million dollars in any given quarter. We expect non-GAAP net other income to be in the $700,000 range, which is primarily net interest from our cash positions, offset by servicing our outstanding convertible notes.

We expect the non-GAAP tax provision in the second quarter to be $2 million to $3 million. As a reminder, the tax expense can be impacted by a number of variables associated with our FIN 48 liabilities, including but not limited to, a change in foreign income and product mix. Regarding share count, we ended Q1 with a diluted share count of 233.7 million. In the second quarter, our diluted share count is expected to be between $236 million and $238 million. For the upcoming quarter, we plan for the following significant GAAP to non-GAAP reconciling items.

First, amortization of purchase accounting associated with past business acquisitions, stock option expense as required under FAS 123R, FX gains or losses on our net foreign tax liabilities. And the income tax effect of above adjustment and other tax item as specified in our reconciliation of GAAP to non-GAAP measures included in our press release issued today. Additional, non-recurring item associated with restructuring or other costs, positive or negative are always possible.

With that, we'd like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We'll go ahead and take the first question from James Schneider with Goldman Sachs.

James Schneider – Goldman Sachs

Good afternoon. And thanks for answering the question. I guess first of all, many of your peers as well I think, Greg you mentioned it too, are seeing increase visibility given the tightness in supply chain. Could you maybe share with us what your view is potentially going into Q3, how those bookings are shaping up and maybe given the puts and takes of what you expect in the back half from China and your Chinese customers, as well as the upside from storage, kind of how you expect the back half of the year to trend?

Greg Lang

Yeah. Good question. The first part of your question on the supply line and kind of how Q3 is shaping up, we're already ahead of where we would expect to be in a normal environment for Q3. But that's not unusual, I think as you said a number of companies are seeing that, because I think customers realize, a lot of times the lead time on some of these parts when you start from scratch can easily be, 4 to 5 months, so customers are trying to respect that and give us more lead time. So they have got a better assurance of getting parts when they need them. That's the good side.

The bad side is there will be at some point, I think when supply catches up, there will be I think a, I'll call it a shallow or a brief adjustment while people kind of consume some of the extra that they might have picked up. The important part to me is that the end markets are very strong, so I see this, is going to be a relatively quick and relatively efficient correction if you will, or adjustment in the marketplace.

So now to the second part of your question, I think that could happen in the back half of the year. It could flatten out. What might otherwise be a growing quarter for example in Q4, but I think it will again be a small adjustment or correction in the market given the strength of the end markets. You also asked a question about some of the China content in our business. As I mentioned about 5% of our business there, actually stays there and there's a lot that's exported. So we believe that this year will be a, I'll call it a more linear year than last year in China. And partially because it was very overheated in the first half.

While the business is strong, as we start this year, it's not as overheated as behavior. And the order rush if you will, it's much more normal I'd call it. So we're expecting for a more linear year although nothing is ever purely linear, but we would expect a good second half in China, certainly better than kind of the first half, second half of last year.

Operator

We'll go next to Romit Shah with Barclays Capital.

Romit Shah – Barclays Capital

Hey guys, I was, on the EMC call earlier this week and one of the things that they talked about was the fact that this year, from a storage standpoint, could be more front end loaded. In order words, Q1 would probably represent a higher percentage of full year revenue. And I wanted to get your perspective on your own storage business, would you expect storage to exhibit a similar profile?

Greg Lang

Well, there's a couple of different factors there. I actually, EMC, this is the only customer I've heard that from. I'm not sure how much they would weight in that regard. But the other thing that we have going on is, we also have growth in our server business, we have growth in all parts of our storage business. So let me kind of refresh that a little bit. So on the server side, I think most people are aware that we've had basically a six gig revenue coming from HP, but we really didn't have some, we could sell the rest of the market without the rest of the software stack.

That will be put in place actually, it's done. We're basically on our, call it our gold candidate, if you will, from software standpoint. So we expect that to go into production in the next quarter and we expect real revenue to start showing up in the fourth quarter. Real revenue means, let's say break into the millions of dollars type of marks. So that we think is coming in the second half. And then we also have the transition of SAS, from SAS 1 to SAS 2 happening in the infrastructure which is really still in its early stages. And we've talk before about expecting something on the order of 15 to 15 plus million of growth this year, just from that part of the transition as well.

So we do have a couple of other non-up and down with the market type of drivers in our storage business that could help us grow in the second half. And the last piece, probably the smallest of the three we also see a transition from 4-gig to 8-gig fiber channel which also will have some ASP up forces. I think, if there is slower second half, we have some counter items that are both share, primarily share growth also some transition growth on the eight gig, that can help offset that.

Operator

We'll go next to Sandy Harrison with Signal Hill.

Sandy Harrison – Signal Hill

Thanks. So Greg, you talked about your prepared remarks some of the stuff that's going on in the OTN markets. Could you talk a little bit, I know some customers have introduced products and not all of them may put it under the header of OTN. And call it, maybe you can talk a little bit about, who's doing what with OTN who's talked about having products, who's shipping today? And then again as you said, you look for revenues in this product the back half. Where it is, we can look to start seeing that for you guys?

Greg Lang

Yeah. So there are and I'll, maybe I'll just comment briefly on both kind of from a component stand point. I think that was part of your question but also a carrier standpoint. On the OTN front, so OTN has been around, people have been working on this standard. For actually, probably around ten years I think it's just come together in a form that one carriers can deploy it. We also have the traffic drivers that are kind of forcing a change to infrastructure. And last but not least we also now have silicon level solutions that are making it more cost and power affordable to actually build this equipment.

So OTN, even though the standard have been worked on for a long time, it's really just now coming together to be really deployable. Some of the first products, some of the first places that we've seen OTN deployed is in the long haul and that's not unusual. They typically will adopt high speed technologies like 100 gig. They'll first to adopt 100 gig, for example in the telecom network. And there are some people that provided some products, like AMCC and Cortina products for the long haul market.

The next wave and where the volume starts to pick up is when the metro carriers start to pick up and deploy this equipment in earnest. We really think that Verizon is one of the early catalysts of getting this going and we think that they're going to start deploying aggressively later this year. So that's really – I think the point that we'll see this take hold in some big numbers. And that's also fortunately where we will have a chance to intersect with our products which I would consider them second generation products, dramatically higher levels of integration, dramatically lower power, dramatic easier to design in, fewer SKUs, et cetera.

So we are in the right place, I think at the right time. I think carriers, starting with Verizon, will start to deploy late this year and picking up steam in 2011.

Operator

We'll go next to Srini Pajjuri with CLSA.

Srini Pajjuri – CLSA

Thanks. Mike, on the OpEx side, you're forecasting some increase here. I'm just wondering how we should think about for the rest of the year. And then also the accounts receivable and given that you're leads times have stretched out and you're getting visibility into Q3, I would have expected AR to come down actually. So I'm just curious why it's up a bit here.

Mike Zellner

I'll answer the first question first. We do believe that it's – we'll operate the company in the model that Greg this mentioned between 25% and 30%. We feel that we're fully capable of doing that and we've demonstrated it. So kind of depending on where our business goes, I guess would impact it to some degree.

But if you assume businesses is strong, then there could be say another couple of 1 million bucks that we could end up spending in investing into some higher growth R&D opportunities for us, in the coupling quarters that way. So we'll see. We feel like we have our hands on the controls that way and we'll deal with it as appropriate allowing us to continue to operate in the model that we described.

There are – in terms of our days obviously there are still sort of best in class in the mid 30s that we feel very comfortable that way. There are some of our customer, a larger customers that request days of 45 and things like that we still think are reasonable, so that impacts us a bit that way. But we certainly feel like our receivables profile is extremely healthy and we don't have any collection issues with it at all.

Srini Pajjuri – CLSA

Okay. And then maybe one for Greg. Greg on the RAID-on-Chip that the full system opportunity that you mentioned, that you expect to see revenues in fourth quarter. How should we think about that business, not just for this year but also looking out to the next year?

Greg Lang

Well, actually just to clarity. We'll see revenues in the third quarter. I was commenting on the fourth quarter that it will be, it will get become more substantial in the fourth quarter, that we'll see revenues start in the third quarter. I think the way to think about this part of the business is outside of one very large customer, the rest of the market requires a more complete solution. And so that part of the business is a part that we don't participate in today.

And it's probably on the order of 65 or 70% of the total available market for server RAID-on-Chip opportunities, RAID solutions. So there's a lot of potential upside for us, if we're able to win some businesses in OEMs or at some point enter into the channel where there's a good chunk of the business is also sold to the reselect channel.

So there's quite a bit of business to for us to grow into and at some point, our goal is to be the market leader in this base and we've got a lot of work and a lot of upside in we can achieve it.

Srini Pajjuri – CLSA

Do you think this business as a potential to be as big as HP business?

Greg Lang

It’s a bigger.

Srini Pajjuri – CLSA

Okay.

Greg Lang

I mean keep in mind that HP is buying only the silicon, they do all their own software and they glue it onto their own motherboards, where a lot of the rest of the market is a board level product with the rate stack and software with it. So the rest of the market is quite a bit bigger.

Operator

We'll go next to Ruben Roy with Pacific Crest Securities.

Ruben Roy – Pacific Crest Securities

Thank you, Greg. On that last point I have follow-up and then one other question. When you assess the opportunity for the new RAID-on-Chip the full solution, when you look at 2011 and you compare that to how HP ramped in its first year of a full kind of ramp. You probably got half of the opportunity in that first year, is that kind of the way you would think about 2011 for the IBM ramp?

Greg Lang

Yeah. That's a good follow-up question. Because the HP ramp was quite fast because it, we want to socket with the helm, under the helm transition and so when they as their servers transition in the helm, which they drove very aggressively. The value proposition was very good for customers. We benefited from that on a one-to-one basis because of the design in it that we had there.

Most of the rest of the market, I think the transition will be slower. I think it's going to be one, we have to win a number of different opportunities that have never been with customers. And then they won't necessarily be tied to a big transition on a one-to-one basis, like it was at the helm. So I think it's going to be a slower burn for when the rest of it I wouldn't not count on that kind of ramp. It will probably take us a few years to get to the kind of market share that we think we can earn there.

Ruben Roy – Pacific Crest Securities

Okay. And then quick follow-up. Given the 3G auctions started now finally in India. Are you seeing any buzz around that or any update on how you're looking at potential opportunities related to wireless infrastructure in India?

Greg Lang

There's been a lot of buzz for a long time. It's kind of the like a repeat of the when is it going to happen in China story. It took years to come together. I mean keep in mind, even with the size and scale of China, the total wireline and wireless participation we have for the company is on the order of 5%. India is going to be substantially smaller than that. So for us, it will be nice when it comes. It will be great. We'll participate, but it's not going to be a huge swinger for us one way or another.

Ruben Roy – Pacific Crest Securities

Okay. Thanks, Greg.

Greg Lang

Yeah.

Operator

We'll go next with Kevin Cassidy with Thomas Weisel Partners.

Kevin Cassidy – Thomas Weisel Partners

Hi, thanks for taking my question. I was wondering if you could talk about fiber to home deployment in other areas around the world, even maybe India and Australia. Are you participating in bids there?

Greg Lang

We're pursuing business in – yeah, in every part of the globe that we are able to participate. As you're aware that we actually tend not to sell directly to the carrier but through an OEM wholesaling to the carrier. So we're trying to reach out to the people who are positioned to win in those bids and make sure that we are positioned to win their business as they win the bids. So and that includes every market around the world.

There has been some, I think pretty recent interesting news coming out of Europe, some – France has recently kind of cleared the way, some of their regulatory issues that we think we're going to see some deployments happening this year in France. The U.K. seems to be getting more aggressive. So we are seeing some interesting signs around the globe. And we're working hard to participate in those. Today, there's nothing as large as China or Japan. And then behind those two big guys, you probably have North America and Korea as the only other places that have any deployments of scale to today.

But I do think there's others coming. It seems like we may be getting to a breakthrough point where there's a more – I'll call it a more balanced, more diversified mix of revenue in the PON business in maybe in the next 12 to 18 months and that will be good. It's fairly lumpy for us right now, as you know, because they're such a small part of the globe that's participating. But I do see some good signs right now.

Operator

We'll go next to Mark Lipacis with Morgan Stanley.

Mark Lipacis – Morgan Stanley

Great. Thanks for taking my question. Can you talk about the lead times? Have you seen any changes in the lead times for getting wafers from the foundries or putting dyes through the package and testing process?

Greg Lang

Yeah. Things are tight, but there really hasn't been a change in the last couple of months because they've been tight. So it's holding steady and depending on the process, depending on the package, it's probably on the order of anywhere from – on some of the easier technologies or older technologies 10 weeks to 16, sometimes little bit longer weeks to get it all through the pipeline. So the short answer is no real change because things have been tight for a few months now.

Mark Lipacis – Morgan Stanley

Okay. And then a follow-up question. With Broadcom acquiring, Teknovus, have you seen any change in the competitive environment in that market? Thanks.

Greg Lang

Yeah. This is – I probably just give you the same response as last time is no. And we don't really expect one. I think the market wants and expect to have two strong players in this space and they are now our two. Teknovus has done a good job frankly, with leading very low prices to get probably around 40% of the market in China. And we have something on the order of 55%.

And so I think our position there is strong. Our position in Japan is very strong, much stronger. And I think Broadcom will be a good aggressive competitor. But I don't expect any short-term or mid range changes in the competitive position or dynamics there.

Mark Lipacis – Morgan Stanley

Thank you very much.

Operator

We'll go next Allan Mishan with Brigantine.

Allan Mishan – Brigantine

Hey, guys. Thank you for breaking out the China WAN business at 10 to 11%. Can you tell us what that business did sequentially versus Q4?

Mike Zellner

Yeah. I don't want to get into that breaking that out in detail. But what I can you, is it's up double digits from Q4, so it's up very nicely back to – I think I also referenced earlier that it's actually running better than the numbers that we had in 2008, which was actually a very good year is when they started the first phase of this wireless build out. So it's even though their CapEx numbers are down year-to-year, everybody knows that and sees that they're still running at a very healthy level.

Allan Mishan – Brigantine

I'm sorry did you say that business was actually up year-over-year versus Q1 of '09?

Greg Lang

No. No. The comparison I'm making is with 2008. Everybody knows that the CapEx levels are down from 2009 to 2010. But if we go back another year and look at the first year of deployment in 2008, it's running stronger than 2008. So it's good. We're, kind of, in between where 2008 was and 2010 or 2009 and that's a very solid way. I think it's a very solid level of business out of China.

Allan Mishan – Brigantine

Great. And then on the rated adapter side, have you already achieved the tier one design wins that you were shooting for or is that something that still needs to take place?

Greg Lang

No, those design wins are things that we will be fighting for. We'll be fighting for design wins for the rest of our life in this business since that's just the nature of the business and so yeah, we've won some and there's many more that we'd like to win. So that will be an ongoing fight.

Allan Mishan – Brigantine

Okay. And then last one for Mike. You talked about the structural increases in OpEx, what kind of structural increases are there out there for the second half or do you possibly see structural decreases with payroll taxes rolling off, et cetera?

Mike Zellner

And so going – Q2 over Q1, there's a bit of an increase, I talked about that, that has to do with annual market or merit increases and things like that. I would say in the back half of the year, we're still sort of dealing with a continuing strengthening of – as you know, we have quite an operational profile in Canada. So we're still dealing with a little bit of FX that will probably occur in the back half of the year, that's something that certainly I characterize as structural. There could be a little bit of help, usually happens in Q4, associated with folks – FICA being out, if you will or the benefit things so there could be a little bit of help on the way in Q4 as well.

Allan Mishan – Brigantine

Okay. Thanks very much.

Operator

We'll go next to Cody Acree with Williams Financial Group.

Cody Acree – Williams Financial Group

Hey, guys. Thanks a lot. You've been one of the first that have talked about a correction, even if it is a relatively small correction. With shortages and constraints and inventory in the distribution channels being relatively small, can you give some color around what you expect in the second half?

Greg Lang

What we expect from revenue in the second half?

Cody Acree – Williams Financial Group

No. Just the impact of any correction that might be driven by the shortages and the constraints that are happening today that would lead to an inventory or (inaudible) build.

Greg Lang

I think, there's a couple of things. So a big part of this depends on how companies manage the inventory in their pipeline and we have some control of that. We clearly we don't have all the control that we'd like to because once it gets put in – built into a system at our end customers, there's a – we basically lose visibility there. Having said that, the correction, especially with the strength that we see in the end markets, will probably feel more like a pause than a big dip or a big valley, if you will. And I'm saying that because, number one, as I think our inventory and our pipeline is actually – is pretty clean and we're watching that closely. The end markets are very strong.

So we're really talking about people who may – let's say they might grow in a seasonal strong fourth quarter instead of ordering a few more parts and having some seasonal growth, maybe we see a more flatness than we would like in the fourth quarter but it really depends on a lot of variables that we don't have the answers to yet, meaning how long does it last, how well is the inventory controlled in the channel, what other kind of growth is happening underneath it at the same time. So it's a bit hard to predict but I would think it of it more as a pause as opposed to a valley.

Cody Acree – Williams Financial Group

All right. Great. Thanks guys.

Operator

We'll go next with Eric Ghernati with Bank of America/Merrill Lynch.

Eric Ghernati – Bank of America/Merrill Lynch

Hi. Thanks for taking my question. Just a question first, Mike, on the gross margins going into the second half of 2010 and how should we think about them from this level?

Mike Zellner

Yeah and again we don't guide out into that, into that area, but I think you can think about them, sort of, flattish, in terms of where we're seeing today so obviously very, very healthy margins. Again as I've said in the past, there can be – the odd basic takeout that our customer pays for which is at zero margins. It can influence it a little bit. But I think in terms of getting a sense of a baseline, I think the kind of margins that we're seeing right now are – we think will continue for us.

Eric Ghernati – Bank of America/Merrill Lynch

And then Greg, you talked about how you're seeing this inventory was down. I guess, if you can please reconcile that with the fact that your deferred income is up – around like 14% sequentially?

Mike Zellner

Yes, why don't you let me take that one? We have some – depending on the desti [ph], we have some that are on a sell-through basis, some that are on a sell-to basis. And certainly the overall desti inventory comment that Greg and – I forget if I made it as well, is that they are down and healthy. In fact, if you look – we do a turns calculation on it and the turns calculation is actually up that way. There is on the sell-through side of the model which is the piece that you see in deferred income, there's one particular distributor that has gotten requests from a very specific customer on a new product ramp that asks them to get their inventory levels back up to what they would call normal level. That's really what's driving that as an isolated item but overall, the desti revenues in total are absolutely coming down.

Eric Ghernati – Bank of America/Merrill Lynch

Could you please break out how much these revenues is selling versus sell-through? Thanks.

Mike Zellner

Yes. We can take that one offline for you if you'd like.

Eric Ghernati – Bank of America/Merrill Lynch

Okay. And then, Greg, just one follow-up please, if you don't mind. You've done a very nice job with the OpEx and resizing the business model and as you look out and you see a lot of opportunities ahead of you, particularly in the storage and you're clearly seeing the need to increase your level of OpEx on a go forward basis but from a gross margin standpoint, do you think that's maybe – given that you're up like 68%, it would be fair to give some of that up to generate some new revenue growth opportunities?

Greg Lang

Let me respond in a couple of ways. One is I believe at least in our foreseeable future, the mid to upper 60s that we're operating in is sustainable. And I would point out that we're investing heavily, actually we are probably amongst the largest R&D investors in the semi space, if you look at percentage of revenue and those two actually go together. A lot of markets that we serve are very narrow segments that don't have the same kind of volume of let's say a PC or a handset business. And so to pay for the R&D that's required to serve those markets, you need basically higher margins to do that. So that's why you see that kind of profile in our business, but that is our business. It's – the infrastructure market is very high complexity, high value, high R&D and high differentiation that comes along with that.

So we believe that that is a sustainable model for us for the foreseeable future and plan to continue to invest that way. We also plan to continue to invest in the 25% to 30% range, depending on the revenue profile from an R&D standpoint to continue to drive that kind of innovation and growth in our business.

Operator

We'll go next to Sandy Harrison with Signal Hill.

Sandy Harrison – Signal Hill

Yes, just a quick follow-up. The conversation about broadcom and its investments in EPON and so forth, on the flip side, the North America cable industry is moving with some of its new products, specifically Comcast has introduced or is taking bids on a new product they are calling their C-map device which is their next generation box, within that is EPON. Are you guys seeing opportunities now in North American cable with your EPON that otherwise you haven't seen before, based upon some of these new designs

Greg Lang

Yeah. There is a lot of interest amongst the MSOs in North America to leverage PON technology because their networks are also kind of running out of gas. We do see that as a future application to pursue but we believe that's actually years away, even with the buzz that's going on right now. There's quite a bit of ground to cover before that becomes a commercial reality. But yes, we're actively involved and pursuing opportunities in that area but it is at least a couple years away from real revenue.

Sandy Harrison – Signal Hill

Got you. And your participation in cable has been pretty de minimus to this point so it's basically an opportunity or a market that otherwise you hadn't participated in to date.

Greg Lang

Yes. That's correct.

Sandy Harrison – Signal Hill

Okay. Great. Thanks for the clarification.

Operator

At this time, there are no further questions.

David Climie

Operator, thank you. And thank you for attending our conference call today. We will be scheduling our second quarter 2010 conference call the third week of July. At that time, we will be reviewing quarterly results and providing our outlook for the third quarter. So again, thank you for attending and that ends today's call.

Operator

That concludes today's conference. We appreciate your participation.

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