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QLogic Corp. (NASDAQ:QLGC)

F1Q11 (Qtr End 06/27/2010) Earnings Call

July 22, 2010 5::00 PM ET

Executives

Simon Biddiscombe – Chief Financial Officer

H. K. Desai – Chief Executive Officer

Analysts

Paul Mansky – Canaccord

Amit Daryanani – RBC Capital Markets

Aaron Rakers – Stifel Nicolaus

Min Park – Goldman Sachs

Brent Bracelin – Pacific Crest

Mark Moskowitz – J.P. Morgan

Keith Bachman – Bank of Montreal

Rajesh Ghai – ThinkEquity

Katy Huberty – Morgan Stanley

Kaushik Roy – Wedbush

Munjal Shah – Jefferies

Operator

Good day. And welcome to the First Quarter Fiscal Year ‘11 QLogic Earnings Announcement Conference Call. Today’s call is being recorded.

And now at this time, I’d like to turn the conference over to Simon Biddiscombe, Chief Financial Officer. Please go ahead.

Simon Biddiscombe

Thank you, Anthony. Good afternoon. And welcome to QLogic’s first quarter fiscal year 2011 earnings conference call. Joining me on the call today is H. K. Desai, our Chief Executive Officer.

I will begin the call with a review of the first quarter financial results. H.K. will follow with a discussion of the current state of our business and progress on our strategic initiatives. Afterwards, we will open the call for questions.

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

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

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

Turning now to our financial results for the first fiscal quarter ended June 27, 2010. Our revenue in the first quarter was $142.6 million, an increase of 16% from the same quarter last year. This revenue was within our forecasted range of $140 to $146 million, provided during our fourth quarter earnings conference call.

Our first quarter revenue from Host Products, which are comprised primarily of fibre channel adapters and converge network adapters was $102.5 million and increased 16% from $88.3 million recorded in the first quarter of last year.

First quarter revenue from Network Products, which comprised primarily of fibre channel and InfiniBand switches was $25.6 million and increased 3% from $25 million recorded in the first quarter of last year.

Our first quarter revenue from Silicon Products, comprised primarily of fibre channel and iSCSI protocol chips was $11.9 million, consistent with our expectations and increased 60% from $7.4 million recorded in the first quarter of last year. Silicon Products also include chips for embedded applications for converge networks.

Our revenue from Royalty and Service was $2.6 million, and that consists almost entirely of service revenues.

Our first quarter gross margin of 66.5% improved from 65.5% recorded in the first quarter of last year, primarily due to higher volume to absorb manufacturing costs. Our gross margin exceeded our forecast provided during the -- during our fourth quarter earnings conference call primarily due to product mix.

Next, I’d like to cover our first quarter operating expenses. Total operating expenses were $54 million, up 4% from $52.2 million reported in the first quarter of last year. Operating expenses were slightly below our expectation.

Engineering expenses in the first quarter of $29.7 million increased 2% from a year ago and decreased as a percentage of revenue from 23.7% to 20.8%. We expect feature engineering expenses as a percentage of revenue to be in the range of 18% to 21%.

Sales and marketing expenses in the first quarter of $18.3 million increased 8% from a year ago and decreased as a percentage of revenue from 13.9% to 12.8%. We expect that future sales and marketing expenses as a percentage of revenue will range from 11% to 14%.

G&A expenses in the first quarter of $6 million or 4.2% of revenue. We expected future G&A expenses as a percentage of revenue will be approximately 4%.

Operating profit in the first quarter of $40.8 million increased 44% from a year ago and increased as a percentage of revenue from 23% to 28.6%. Interest and other income was $1.4 million in the first quarter. Our income tax rate for the first quarter was 17.7%, which was slightly better than our expectation.

Our first quarter net income of $34.7 million increased 45% from a year ago and represented a net profit margin of 24.3%. Our first quarter net income per diluted share of $0.30 was significantly better than the $0.20 we achieved last year and at the high-end of our forecasted range of $0.27 to $0.30 provided during our fourth quarter earnings conference call. This represents the 60th consecutive quarter of profitability for QLogic.

Turning now to our balance sheet. The company’s cash and investment securities were $348.6 million at the end of the first quarter. We continue to maintain a strong cash position and have no debt. During the first quarter, we generated $30.6 million of cash from operations.

During the quarter, we purchased $52.5 million of the company’s common stock at an average price of $18.81 pursuant to our stock repurchase program. Since 2003 we have used $1.5 billion to repurchase 95.4 million shares of the company’s common stock.

Receivables of $74.6 million at the end of the June quarter increased sequentially from $73.3 million at the end of the March quarter.

DSO at the end of the June quarter was 48 days, compared to 46 days at the end of the March quarter. We expect DSO in the future will range from 45 to 55 days.

Inventory at the end of the June quarter was $24.4 million and increased sequentially from $19.4 million at the end of the March quarter. Annualized inventory turns for the June quarter was 7.8 compared to 10 turns for the March quarter. The increase in inventory is entirely associated with advanced purchases of silicon to maintain flexibility due to long lead time.

Turning now to our outlook for our second quarter, we expect total revenue for the September quarter to be in the range of $143 to $147 million. We expect gross margin for the September quarter to range from 65.5% to 66%.

Based on this outlook combined with planned operating expenses of approximately $55 million, projected annual tax rate of approximately 18% and diluted share count of approximately 112 million shares, we expect to achieve non-GAAP earnings per diluted share of approximately $0.29 to $0.32 in the September quarter.

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

I’ll now turn the call over to H.K. H.K.?

H. K. Desai

Thanks, Simon. My remarks today will focus on the current state of our business followed by quality update on strategic initiatives. Our revenue in the first quarter was $142.6 million, a sequential decrease of 2% and approximately at the midpoint of our guidance.

On a sequential basis, revenue from Host Products declined 1% and revenue from Network Products grew 14%. Revenue from Silicon Products was consistent with our expectation. We achieved an operating margin of 29% and net profit margin of 24%, includes solid gross margin, careful operating expense management and a lower tax. During the first quarter our net income per diluted share was $0.30 at the high-end of our forecasted range of $0.27 to $0.30, provided during our fourth quarter earnings conference call.

Turning now to the current state of our business. We are encouraged by the plans we experienced during the first fiscal quarter in both our Host and our Network Products families. The several this cycle that began in calendar 2009 is continuing and we expect increasing benefit to our business in the second half of calendar 2010 as our OEM customers complete the introduction of the Nehalem-EX based servers.

We continue to believe that the new Nehalem-EX based Servers will drive incremental attach of our high performance fibre channel and converge networking products as end users optimize network configurations to maximize the advantages of this very powerful bandwidth-intensive processors.

QLogic is strongly positioned through a broad product portfolio and leadership positions in the storage area and converge networking market and will be a significant beneficiary of this server of this cycle.

Now I’ll provide an update on our strategic initiatives. During our first quarter we continue to make significant progress on three strategic initiatives that we have previously discussed, specifically, converge networking, fibre channel and InfiniBand.

Our investments to date have resulted in new design wins, improved market share and revenue from new markets. We are continuing to invest aggressively in each of these initiatives.

In the converge networking we made our first major announcement regarding our converge network switching technology with recent unveiling of the new HP Virtual Connect FlexFabric 10Gb/24-port module. Our key element of HP’s converge infrastructure portfolio. HP can now converge Ethernet, Fibre Channel and iSCSI on a single virtual connect module.

The new QLogic converge network switching ASIC, code name Bullet features industry first flex port technology that enables sports to be dynamically allocated to support Fibre Channel, iSCSI or FCoE data.

This highly innovated network convergence technology provides variable connectivity options and complex flexibility enabling protocol shift as and when required by users. This important achievement tangibly demonstrates the broadness and depth of our converge networking technology leadership. Our end-to-end portfolio enhances our position as a strategic supplier of converge network to our OEM customers.

In April, we announced that our 1800 Series converge network adapters are available from Hitachi Data Systems and its authorized reseller worldwide. The 1800 Series are fully qualified and interoperable with the comprehensive Hitachi portfolio of storage systems including the mid-range adaptable module storage 2,000 family and enterprise-class Universal V and VM platforms.

Also in the quarter Oracle begin revenue shipments for 8100 Series CNAs. We are using the complete server portfolio spanning Oracle Spark M Series Enterprise Servers. Oracle Spark T-Series mid-range and entry level servers and Oracle x64 platforms.

QLogic is a long-time supplier and development partner of Sun Microsystems, now Oracle and primary provider of the SAN Host products. The addition of QLogic’s converge network adapters with the common fibre channel stack enables Oracle customers to build reliable highly efficient and affordable unified networks.

We have now successfully deployed our converged networking solutions with all leading server and storage vendors, including IBM, Systemax, IBM Blade Center, NetApp, EMC, IBM Power Systems, Dell, HP, Cisco, Hitachi, Oracle and our QLogic branded version of our worldwide channel partners.

These customers are now providing and useful -- and there are the useful benefits of network convergence by deploying QLogic’s fully qualified and OEM deployed storage and Ethernet stack with QLogic’s own cost effective highly integrated single chip ASIC technology.

Our early investment and clear time to market advantage has resulted in converged market leadership. During the first fiscal quarter, our revenue from products serving the converge networking market, which include all products based on 10-gig Ethernet connectivity was $10 million.

The vast majority of this revenue is included in our Host Products and a small amount included in our Silicon Products where we sold ASIC for Host applications. This $10 million revenue excludes our very minor amount of revenue from our converged networks switching parts. Dell’Oro Group estimates that this market will be approximately $200 million in Canada, 2010, growing at a compound annual rate in excess of 40% for the next four years.

Turning now to Fibre Channel. According to the Dell’Oro Group, calendar Q1 2010 SAN report, the most recent report published QLogic extended its market leadership in SAN adapters. With 55.2% revenue market share for Fibre Channel adapters, we increase our market shared by 2.1 percentage points over the prior quarter and increase our lead to a total of 19.1 percentage points ahead of our nearest competitor.

We maintain our number one positions in every adapter category including Standard, Mezzanine, 4-gig and 8-gig adapters. In a move designed to expand its addressable market for high performance enterprise class storage systems, Oracle also selected QLogic over 8-gig Fibre Channel adapter supplier for its Sun Storage 7000 systems, also known as Amber Road. We continue engage with Oracle with a broad portfolio product offerings.

Turning now toward InfiniBand initiative. In May we announced that our QDR InfiniBand Host Channel adapters will be available from Voltaire as part of the portfolio of end-to-end QDR InfiniBand solutions. Voltaire is offering a 7300 Series HCAs alongside its Grid Director line of QDR InfiniBand switches and software.

This ensures that QLogic HCAs are interoperable with an increasing number of high-performance computing cluster configurations and provides greater flexibility for InfiniBand customers. This also marks the continued expansion of our InfiniBand Solutions in HPC marketplace.

In May we also announced our InfiniBand Fabric Management Suite version 6.0. This important release integrates industry leading intelligent features for InfiniBand network management and optimisms for high performance work loads at scale with minimal intervention from system administrators with a goal of improving efficiency of both people and hardware ultimately leading to greater productivity.

In summary, our focus in the right set of strategic initiatives is yielding tangible results which will continue to benefit us for the remainder of fiscal 2011 and beyond. First, the serve update cycle which commenced in 2009 is continuing and will benefit us as a result of our market leading positions in Fibre Channel adapters.

Second, our Network Products are experiencing revenue growth and capturing market share for Fibre Channel and InfiniBand switches.

Finally, in the converge networking market, based on our time-to-market advantage, technology superiority end-to-end portfolio and the broad adoptions by Tier 1 OEM customers, shipping our products today we expect to further extend or lead as enterprise transition to converge networks.

This concludes our prepared remarks. Operator, now we’re open for the questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We’ll hear first from Paul Mansky with Canaccord.

Paul Mansky – Canaccord

Great. Thanks for taking the questions. I want to dig a little bit deeper on the Host side of the business. I think I heard you say you did 10 million in converge products, presumably HCAs uptick on a year-over-year basis given the Voltaire business, which basically has Host looking like its flat versus June 2009. I guess, A, am I looking at that correctly, and, then, B, how are you thinking about the EX upgrade cycle, the timing of it relative to any potential disruptions as we go through this Q3 period? Basically I’m asking did we -- are we looking at pushing revenue into calendar Q4?

H. K. Desai

I think, I don’t know, why you mentioned $10 million. That’s what the converge network revenue. You mentioned $10 million. I don’t think that’s correct. The $10 million revenue we talk about is for the converge network solutions.

Simon Biddiscombe

Paul, if what you’re trying to do is rationalize back to what was the performance of the core Fibre Channel business and if you were trying to imply that was flat, no, that’s not correct. The core Fibre Channel business grew very nicely on a year-over-year basis.

As did the IB business on the Host side, as did the converge network adapter business on the Host side as well. So on the Host side, as we look at it, we saw very strong performance across the board on a year-over-year basis.

Paul Mansky – Canaccord

Okay. And then on the potential disruption in Q3 getting pushed into Q4?

Simon Biddiscombe

I think a lot of the server platforms that we expect to benefit from across the major OEMs have now been introduced and have throughout the course of the most recent quarter started to ship in production. We’ve spent time over the course of the last few weeks looking across each of the various platforms of each of the major OEMs and at what point did those role into production, at what point did we start to see a benefit or when we start to see a benefit associated with the transition to transition to 8-gig. And clearly we expect people to deploy 8-gig as they deploy next generation sort of that are going to be in the data center for the number of years or we expect them to deploy 10-big based converge networking technology. So, we think that essentially everybody is in the market with a full set of products at this point in time and they’re going to ramp as we move through the second part of the year.

Paul Mansky – Canaccord

Maybe if I can approach this, slightly different at this – slightly different angle, 145 being, the midpoint to the revenue guide that’s under 2%, say sequential, one could probably argue what is traditional seasonality for QLogic, for the rest of this call. But certainly that relative to obviously consensus and general expectations, that is a bit light on a sequential basis. Can you maybe frame up for us some of the puts and takes relative to how you kind of rolled up that revenue guide?

H. K. Desai

So, I think, yeah, I think that’s a question you ask related to our guidance, so normal seasonality is approximately 3% of our business in the September quarter. This is where essentially our high-end of the guidance is.

Even though July is off to a really good start, we are a little conservative due to the concerned about Europe and the macro. I think that’s the reason we are a little conservative and what we are seeing in the business.

And if we expect that people expect that server unit growth will be approximately 7%, 8%, 9% in the September quarter, then I’m sure we’ll perform better than what the guidance is. But we want to be slightly conservative than what normal update cycle provide us the growth.

Paul Mansky – Canaccord

Okay. Great. Thank you for that.

Operator

We’ll hear next question from Amit Daryanani with RBC Capital Markets.

Amit Daryanani – RBC Capital Markets

Thanks a lot. Good afternoon, guys. I just want to go back to the whole segment, looks like it was down about a 1% sequentially. I think last quarter the guidance where it should be up about 3%. Could you just talk what drove that delta over expectations?

Simon Biddiscombe

Yeah. What we actually said, if you go back to what we said very specifically on it. What we said is we expected a combination of host and network to grow by 3%, okay. Now, that to be fair was then interpreted to be an expectation, Host business would also grow by 3%. But what caused the Host business performance to not be quite as strong as we’d expected it to be last quarter, really there was a couple of things.

We did see something of a slowdown in Europe at the very end of the quarter and I’d characterize that as being just the last month of the quarter specific to the Host business and then we also saw weakness with one specific OEM as well. So, whilst server trends that we’ve seen from those OEMs we managed over the course of the last three months have been very positive. And whilst there were trends with those OEMs have been very consistent with their sort of a server performance, that’s not true across the board. So we’ve got one OEM but did drag down the performance on a sequential basis a little more than we’d expected them to.

H. K. Desai

And Europe.

Simon Biddiscombe

And Europe, yeah.

Amit Daryanani – RBC Capital Markets

Got it. And then, secondly, intra-quarter, (inaudible) announced they buying server engines and essentially bring the ASIC I guess in-house with FCoE. I would imagine one of the benefits you guys have had, that you owned your own ASIC for a while. So just going forward with server engines being a part of emulate. Do you see a competitive advantage that you shrink and how do you think new wins will shake out going forward?

H. K. Desai

So we have -- if you look at our second generation of the product, the 18100 Series, ASIC we had to be qualified with all Tier 1 Server with the storage of OEMs. We started shipping the products. We saw about $10 million in revenue vast majority is coming from the adapters.

So I think we have a big time to market advantage and I think we’re going to continue to benefit that. We also have [I know engine server] product coming out in the December quarter. So I think we have a good roadmap and it’s going to be a multiple supplier playing the markets and we’ll be definitely strong one of the suppliers.

Amit Daryanani – RBC Capital Markets

Just a final one from me and I’m going to hop off. Just on the switching side of things. Let say it was up rather strongly as well. Was that the HP recent relationship kind of starting to kick into gear this quarter or were there other factors that helping you out there?

Simon Biddiscombe

Amit, there were couple of things, certainly part of it was driven by HP. There was also an important part that was driven by InfiniBand as well. So if you remember the InfiniBand business performed below our expectation if you go back to the March quarter and we said that that was primarily due to transitional issues. If you go little back to the November timeframe we introduced a whole new series of products and announced a whole new series of OEM relationships, specifically around HP, which was entirely new broader relationship at IBM, a broader relation with Dell.

We really started to see the benefit of that activity here in the most recent June quarter. So there’s a part of the switch performance and the strength in the switch business, which was attributable to InfiniBand. And I think we’re doing very well in the InfiniBand market. I think we’re successfully taking share away from the competition there and I think we expect to continue to invest aggressively and we expect to continue to execute the competition.

Amit Daryanani – RBC Capital Markets

Great. Thanks. Thanks a lot, guys.

Operator

And we’ll hear next from Aaron Rakers with Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

Yeah. Thanks, guys. Couple of questions as well. First question, I understand that the comment on the $10 million contribution from the convert solutions in this quarter, just as kind of as we look at our models, can you give us any color of what that contribution looked like in the prior quarter?

Simon Biddiscombe

No. No, we’re not breaking that out in detail there.

Aaron Rakers – Stifel Nicolaus

Okay.

Simon Biddiscombe

We don’t see a need to do that. We’ve given you the growth rates sort of been experienced in previous quarters. We’ve got to the point now where we’re comfortable that that part of the business has a sustain ability associated with it. We’re comfortable that there is a scale associated with it, that won’t result and it being whip-sawed around by individual activities.

So, we always said that when we got to a scale that we were comfortable within a sustainability that we will comfortable. We’d tell you what it was. And now we’re at that point. We’re telling you it’s $10 million. We don’t see a need to go back and tell you what it was in previous quarters.

Aaron Rakers – Stifel Nicolaus

Okay. I had to ask. The following questions for me, I guess, first of all, just a clarification on the model, and how we should think about the tax rate going forward with what we saw this quarter. And then I will have a final follow-on?

Simon Biddiscombe

That’s fine. So the tax rate in the most recent period was 17.7% and I would say in full year 18%. So if you put 18% in every quarter for the remainder of the year, you’ll get 18% for the full year essentially and that’s where we expect it to be.

So this is a lower number than we had previously provided. Previously we told you we expect that the tax rate for the year to be 20%. Now we say, we’re expect it to be 18%. That’s partly attributable to the fact that there’s a little more mix offshore. It’s partly attributable to the fact that we had certain discrete items that benefited the tax rate.

Aaron Rakers – Stifel Nicolaus

Great. And a final question for me just because I’ve got it from some people today is that, obviously it’s not really a direct competitor but Mellanox talking about migration away from cars in the InfiniBand business actually to just chips and that impacting their topline revenue growth. How do you guys look at that transition, as it relates to your overall business on either be at the HBA side overtime or this CNA side of the business, as well?

H. K. Desai

You know, if you look at in the time of the iSCSI or the Fibre Channel, you always have get this question, anyway. And same thing we have on the converge network. There is going to be some business which is a chip down, is a LOM. It is a fibre channel or it is Ethernet or it is IB. And we play this thing and a lot of business is going to be the adapters, so we play on both of them and it is going to be chip down, it is going to be mass card and is going to be the adapters. And that’s where we are playing the Fibre Channel. That’s where we are playing the converged network and that same we will play into the IB.

Simon Biddiscombe

I think we’ve always broadly communicated the expectation for the impact of that on the business here and that’s not new news as it relates to converged LOMs specifically for the convergence technologies.

Aaron Rakers – Stifel Nicolaus

And could you give us – Can you give us a delta between actually card and a chip? I’m just trying to – It just seems a little bit with these architectural platform changes at the server vendors that – I’m concerned that maybe we could see a chip transition over time. It doesn’t sound like you’re concerned at all with that.

H. K. Desai

That always happens in the technology. And as we play in both market, you’re fine.

Operator

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

Min Park – Goldman Sachs

Yeah. Thank you. Just a couple of quick questions. First, given the positive commentary on the server refresh cycle from Intel, just wonder if you are seeing a greater percent of high performance servers using others storage connectivity, is shifting away from Fibre Channel at all.

H. K. Desai

No. We’re not seeing that at all. I think is more benefit, because whenever this high performance overcome, are always going to be a high performance 8-gig Fibre Channel adapters or is going to be Converged Networks. So it benefit us, it does not go out. What we’re saying is that on our host side I think there is a couple of things that we had issue, with one of the OEMs – There is a broad – it got broad product line and the second, Europe where we are about 9% sequential decline, about (inaudible), on the Europe side I think that’s what our worst business.

Min Park – Goldman Sachs

Okay.

Simon Biddiscombe

If you look at the numbers sequentially and you look at Europe very specifically, you’ll see that Europe declined in excess of 9% on sequential basis and that actually attributed – It was responsible for a reasonable amount of the total difference versus the guidance that you might have or versus a performance that you would characterize as being a server performance.

Min Park – Goldman Sachs

I see. And then if you can give us your thoughts on – 10-gig and its market and the opportunity for QLogic in the back half of the year better. I know you talked a lot about the converged market but [for it is silicon takes after that piece] of business as well?

Simon Biddiscombe

The answer is yeah. I think we have always been believers in the broader networking market. And from the onset, it has always been our desire to participate in that much broader market than the small subset that is the true Fibre Channel Ethernet converged market. So one of our principal strategies was to make sure that we were successful in the very storage-centric part of the converged market, where our softwares back had the greatest leverage where we have historically have had significant incumbency and tremendous credibility.

And then as we have explained in the past, the objectivity would be move right of that path of the converged market, into the much broader converged market which includes 10 gig Ethernet and Converged Network Adapter type technologies. So, as we’ve executed on the converged technologies and as our Ethernet stacks have become qualified, proven, hardened and ultimately deployed by end users, we have been able to establish credibility as a supplier for that technology and it becomes a logical extension to the OEMs of everything what we’re doing with them. So we do expect to be a participant, a very important lead within that much broader market called, as we characterize it converged market which is any product that runs on 10-gig Ethernet connectivity.

H. K. Desai

So I think the key really is that we played in 10 gig Ethernet connectivity market, I think it’s a 10-gig Ethernet. It can be CNA, it can be iSCSI. It doesn’t matter what the software protocol is, as long as the 10-gig Ethernet connectivity, we play in that market.

Min Park – Goldman Sachs

Okay. Great. And then just lastly, to what extent does (inaudible) LOM win with HP’s new G7 server platform impact your ability to sell adapters into that platform?

Simon Biddiscombe

Doesn’t impact it at all.

Min Park – Goldman Sachs

Okay.

Simon Biddiscombe

We’ve looked at it in detail and our expectation is that we won’t lose any share to the principal competitors, as a result of their long wins. I think over time what you’re going to say, Min, is that we’re both going to have an extensive number of converged long wins, because are going to have extensive numbers of mass card wins. And both are going to have extensive numbers of standard adapter wins. We already have wins. We just don’t talk about them until they’re actually in production with OEMs. That’s the way we go about our communication strategy generally.

H.K. Desai

We have a multiple design win and tier I saw OEMs and it doesn’t mean that we are going to get 100% of mass card adapter business and they will happen in fibre channel, it won’t happen in any other technology anywhere so

Min Park – Goldman Sachs

Right. Okay. Thank you very much.

H.K. Desai

Thanks.

Operator

We’ll hear next question from Brent Bracelin with Pacific Crest.

Brent Bracelin – Pacific Crest

Thank you. H.K. I want to go back to this earlier question around kind of transition that one of your competitors is seeing, adapter card, silicon. I clearly understand your position to market and having a diversified portfolio with silicon adapters and mass card kind of business, but obviously depending on the mix of those segments, there is an impact on the model, impact on the ASPs and march gin. My question is, is the pace of the shift relative to what you’re seeing out there on the MEZ side or the lump silicon side, is it accelerating towards silicon in the short run at a faster pace than you would expect. Is this transition happening in line with the timing that you would expect? Give us an update relative to…

H.K. Desai

You’re talking about the IB, right?

Brent Bracelin – Pacific Crest

I had talked about IB and Converged Fibre Channel Ethernet

Simon Biddiscombe

There is really no change in the timeline. If you think about the design cycles associated with server platforms and the introduction of those server platforms. We know an extended period in advance of an announcement or introduction of a platform, what long will be. Okay. So is it straight Ethernet LOMs, is it converged LOM. Is there IB down on the mother board. Those aren’t decisions that our OEM customers are making today and implementing tomorrow.

Those are decisions that are getting made a year-plus in advance. So we’ve known for an extended period what rate we expected LOM, converged LOM adoption occurred. Those are decisions that are getting made. A year plus ion advance, so we’ve known from extended period, what way we expected or converged LOM adoption to occur. I know that hasn’t accelerated. It’s very consistent, with the expectation that we’ve had for an extended period of time, in fact probably a year to 18 months.

H.K. Desai

Remember, to take example, for example, 1-gig Ethernet market, there is always a LOM. There was always a LOM and there is a lot of adapter business. Intel has a lot of revenue coming from the adapter business. I think that will continue. Now it is a LOM and the mass card and adapter. I mean, CNS.

Simon Biddiscombe

There’s no excuse for being surprised by the conversion from adapters to LOM. Those are decisions that OEMs make way in advance of any product introduction announcement.

Brent Bracelin – Pacific Crest

Well that is very helpful color. My last question and again this is another kind of high-level question, but if I look at just kind of the trends on a sequential basis or a year-over-year basis and the Host products and then I kind of map that, try to map that against the trends that we’re seeing on a sequential basis in the server market, it does. There is a little bit of a disconnect there and certainly your business is growing slower than overall kind of server, industry market is. What is the delta there, is there just more and more servers going into these large Internet server farms that aren’t using Fibre channel, that’s skewing the data. How do we kind of reconcile this difference between the trends, we see in serve have data and then the trends we’re seeing in your business. Again, I understand you are sitting this quarter but while the last three quarters, what is the difference there.

Simon Biddiscombe

So Brent, if you look in the most recent quarter, the last number I saw was the Gartner number that was published middle of June. I think you made publish something else, yesterday or today, haven’t seen it yet. The Gartner number in the middle of June said that server units this quarter were going to be down 2.5% sequentially I think it was. And our Host business in total was down 1% sequentially. Okay.

So, I’m not sure there is a disconnect between the underlying server market and our business at this point in time. What we are seeing, as I said in my comments earlier, when I look at the major OEMs and the announcements that they have made, let’s say over the course of the last 90 days about their server business performance. Our performance with each of those OEMs essentially is very consistent with the numbers that they have talked about, right? So it’s a - We do their revenues and if they tell us their units that is even more helpful. If you look at change they have experienced in the units and revenues versus the change I’ve seen in my Host business, it is actually very tightly correlated.

H.K Desai

We look at what Simon is saying, we look at the year-over-year numbers for the unique growth from the server OEMs, the Tier 1 OEMs we’re talking about and last two or three quarters, if you look at where your unit growth exactly matched, with our year-over-year growth with that particular OEMs, as well as that one is concerned. So we completely match what we have seen in the past.

Brent Bracelin – Pacific Crest

Okay. Good. That is helpful information and thank you for taking my question.

Simon Biddiscombe

Appreciate it. Thank you.

Operator

We’ll take our next question from Mark Moskowitz with J.P. Morgan.

Mark Moskowitz – J.P. Morgan

Yeah. Thank you, good afternoon. I want to stay on the LOM discussion point. Maybe we can try to understand it in a different way. Can you refresh it from the average ASPs for these LOMs and how we should think about may be, QLogic and emulates the IBM displays spends over time, what will be your dollar content per server? Are we going to see some false currents or there are going to be some major headwinds over time?

H.K Desai

You have to look at it. I think you should compare this really with one gig or the previous technology on the Ethernet side. And if you look at these things, those are tremendous revenue coming from the adapter side and this will, same will continue in the 10-gig. There will be a LOM and mass card adapters and there is going to be a three-component of this revenue. And if you look at the data, it’s going to be, according to them, the LOM revenue is only about $60 million or something in 2013 or something. Exact, I don’t remember exactly but it is very minimum component of the total revenue for that market.

Mark Moskowitz – J.P. Morgan

I guess. Go ahead.

Simon Biddiscombe

What I was going to say is that we don’t talk about ASPs specific for the chip versus the card. And that’s not something I see us do. I think what you have to look at the total market sizing, okay? And when we look at the total market sizing for the adapters, within the converged market, this year that’s roughly, let’s say it is a $200 million market and that is still our most recent number that H.K. made reference to, okay? The 10-gig adapter market in the first calendar quarter was $50 million. So the $200 million trajectory feels very appropriate and that is expected to grow in rate specs as a 40% over the course of the next four years and you end up with a market that is roughly 8 to $10 million when you get to 2014. Okay.

We’re very comfortable with that sizing of the market. We understand the ASP assumptions. We understand the unit assumptions. Okay? So let say it is $800 million when you get out to 2014. As H.K. said, when you look at the converged chip, converged LOM opportunity that exists when you get out to the same time frame, it is a small fraction of the total adapter revenue. So there is still going to be an enormous back to market that is well in excess of the expectation for the chip market when you move forward over the course of the next few years.

Mark Moskowitz – J.P. Morgan

Sure. What I concern about those is the trim line. Because some folk will talked on the field for these LOMs and sell for around $50 and when we think about the standard HBA, the compressions that we’ve seen in the last ten year particularly after the mass card came out. It doesn’t read well from interconnect perspective. Especially since the chip, the process powers are so huge now. Maybe they don’t need to rely on additive interconnecting. They can do lot more themselves, maybe with a LOM, I guess LOM are going forward. I’m just trying to think you guys, take us through.

H.K. Desai

Yeah. But that’s I think they are still with the adapters and the mass card. There is still a lot of connectivity. They always run out via connectivity, all the times in the servers.

Mark Moskowitz – J.P. Morgan

Getting back to the near term reality, can we just talk little bit more about the kind of linearity in the quarter, with the major OEMs. I know you said one OEM kind of has some disruption that refreshes and what have you. The linearity in the quarter and how is the run rate been since the close? Are you seeing any sort of disruption or?

Simon Biddiscombe

H.K. actually said in his answer to one of the questions, when he was asked. July has started very nicely indeed. And we’re very comfortable with how July has played out to date.

Mark Moskowitz – J.P. Morgan

Okay. Just one last question, if I could. As far as Nehalem-EX, what have you seen so far in the early stages with the demoing and the lab work? Are folks actually deploying you less HDAs or are they deploying maybe a more of lower entitled HDA card versus previous?

Simon Biddiscombe

Everything is going to the 8-gig MEZ card or the HBA.

Mark Moskowitz – J.P. Morgan

Okay. Thank you.

Operator

Our next question comes from Keith Bachman with Bank of Montreal.

Keith Bachman – Bank of Montreal

Hey, guys.

H.K. Desai

Hey, Keith.

Keith Bachman – Bank of Montreal

Simon, the inventory.

Simon Biddiscombe

Yeah.

Keith Bachman – Bank of Montreal

Can you tell, again, what it is and related, what will turns be, you think, at the end of September?

Simon Biddiscombe

Yeah. Sure. So, I won’t give you the turns number. What I’ll tell you is that -- I don’t won’t give you the turns number because that will allow you calculate my expectations precisely for revenues but we do expect to see inventory tick-up very slightly again in the September quarter. And that is obviously positioning inventory to the expected seasonal activity that we see in December, right?

So I think inventory will tick up, again. But very specifically, it was all associated with chip purchases and those chip purchases are for long lead time items. And they give us the incremental flexibility that is necessary to deliver to customers upside forecasts, if they come through or to be able to deliver to shorter lead time requests from customers.

Keith Bachman – Bank of Montreal

Forgive my [night duty] then, you’re talking about less than seasonal growth and then you’re talking about ordering inventory for upside.

Simon Biddiscombe

What I now -- be careful. What I said was I ordered inventory for long lead time. So what I’ve seen or we’ve seen as a business is some of the lead times on some of the chips that we have, have extended over some extended period of time now. So we’re putting ourselves in a position of holding inventory that’s in excess of the specific requirements of the business, in a short period of time, in order to be able to deal with the fact that we’re getting very long lead time from some of our ASIC partners.

Keith Bachman – Bank of Montreal

Okay. Moving on to the switching business, can you give us some sense or proportion or direction or quantify, how that could -- the ramp of HP or other OEMs can help or impact the September and December quarters?

Simon Biddiscombe

So there is an expectation of a continued ramp with HP for the products that we introduced in the March quarter. As we look into the December quarter, it’s not something I would characterize as a shifting or a significant increase in activity, Keith. Otherwise, you would have seen the guidance would be better than what it is, right? I would characterize it as being the next step in a programmatic rollout of these products at HP and by the HP sales organization.

So I expect an improved contribution from those products as we look forward. But, what we told you was if we were at roughly a $4 million run rate on a quarterly basis, by the end of the year, then, we would look at that as being success. And that we continue to drive toward that kind of number.

Keith Bachman – Bank of Montreal Okay. And then my last one is, the buyback, exceed the cash flow from our ops this quarter. Is three any reason that -- sparks can be down primarily a lot more earnings. As that can’t continue for the next couple of quarters, any constraints you have on the buy back growth for the buy back relative to your balance over the next couple of quarters?

Simon Biddiscombe

No. Absolutely not. Absolutely not. Absolutely not, the expectation is that we’ll continue the buy back as we move forward. And as you know, H.K. and I have all the flexibility to implement it as best we see Fit and we’ll continue to do that as we move forward.

Keith Bachman – Bank of Montreal

Okay. That’s it for me.

Simon Biddiscombe

Thank you.

Operator

Taking our next question from Rajesh Ghai with ThinkEquity.

Rajesh Ghai – ThinkEquity

Yeah. Thanks. I just want to do drill a little bit more on the performance in the Host business. You mentioned that we have combination of equal Europe and we’ve had an OEM that impacted pickup at the end of the quarter. Can you break up the relative contributions of the two factors in, your underperformance vis-à-vis…

Simon Biddiscombe

Thanks. I don’t think that’s necessary, Rajesh. I think, we’ll leave it as being the EMEA of one-day specific OEM that was weak. I think that’s enough.

Rajesh Ghai – ThinkEquity

And you mentioned, you know, Europe was weak, going by the commentary by Intel in their quarterly call. It didn’t appear that Europe was weak for them. I was wondering what the disconnect is over here.

Simon Biddiscombe

A. You can ask Intel that question. B, I think for us it’s all about OEM activity and you have to bear in mind that my activity is based on ship-to location. Right? So in many circumstances, I am shipping product into markets other than Europe that ultimately ends up in Europe. Now these numbers are always a little tricky when you’re in an OEM model and when you’re using ship-to-related information. But I wouldn’t dream of trying to rationalize of what Intel said against what QLogic can say?

Rajesh Ghai – ThinkEquity

And on InfiniBand, you know, you got to past -- you’ve not heard of an Infiniband is up as moving into LOM and essentially, the common perception was that InfiniBand is going to be restricted to the HPC market and probably could not make it to the data center. Those were -- yesterday’s announcement or yesterday’s information about Mellanox that they have -- they’re moving to LOM. Does that kind of change your view of where demand can be moving forward and does that -- and do you see that in anyway kind of also in changing upon InfiniBand or even that in the future?

Simon Biddiscombe

Let me ask you the first question. One is that, yeah, we are -- when we get in the IB market, we try to hold the packaging options for the Host. I mean, they can be the LOM or it can be MEZ card or it can be HCA. So we play on all these things. I mean, you’ll understand that compared to the Mellanox. We don’t have that much revenue so the impact is really minimum, whatever happening to it. Whatever transition happened, it’s to really impact us at all because this is something new to us any way.

We’re coming from a lower revenue. The second one is we never believe in and we never thought that IB is going to be data center converge interphase. We always see it’s going to be reconnect and that’s why we are investing lot into that converge network market and that’s where our focus is. IB is really, we believe it’s going to be very specific component of the HPC markets and that’s where we are focusing. So our strategy is exactly always like that. And I think we are very focused on the two different markets.

Rajesh Ghai – ThinkEquity

InfiniBand is related to LOM, does that change anything?

Simon Biddiscombe

It doesn’t change anything, no.

Rajesh Ghai – ThinkEquity

Okay. And then lastly, you talked about some LOM design wins, any in InfiniBand or are they mostly in the CNA?

Simon Biddiscombe

We’re talking about CNA there.

Rajesh Ghai – ThinkEquity

All right. Thank you.

Operator

We’ll hear our next question from Katy Huberty with Morgan Stanley.

Katy Huberty – Morgan Stanley

Thanks. Good afternoon. Simon, just going back to the commentary on Europe and one-week OEM, is it fair to assume that your guidance implies those issues continue?

Simon Biddiscombe

Yeah.

Katy Huberty – Morgan Stanley

And then as it relates to the commentary around the strong July, does that suggest that those issues maybe weren’t as nearly the factors that they were in the month of June?

Simon Biddiscombe

I think the strong July, Katy, gives us greater confidence around the guidance that we’ve provided. It doesn’t necessarily result in us thinking that all of a sudden the world is moving up and to the right. I think we do have as H.K. said, some continued nervousness around the activity in Europe. And we do have some nervousness about the macro generally, right?

So there is nothing that I would characterize as concerning us as it relates to ASP erosion. There is nothing concerning us as it relates to market share. We think we continue to execute the business very well.

H.K. Desai

Again, if you look at this thing, it is like, I mean, we are too concerned, really. I mean, we -- if you look at -- we are too concerned but one is a macro and the second is Europe. These are two concerns. Third concern we have is the timing of the refresh cycles, which is very, very difficult to predict and if you remember the last September quarter, our guidance was a flat to 3% growth and when we end up, we end up about 7% sequence of growth and that’s because the refresh cycles started happening sometime in August-September time frame area.

So this can be, I mean, you can say it’s our controlled guidance and the positive sign is that we are seeing July, which is -- which is since -- and so far into July. So that’s a positive sign. And the server refresh cycle start happening again for the year and sometime in August or September, then I’m sure performance will be better where our guidance is.

Katy Huberty – Morgan Stanley

And lastly, what you expect your market share trend to be sequentially in the June quarter?

Simon Biddiscombe

Well, we obviously won’t know until the principal competitor is named, Katie, but I’m not sure that for one second we believe we’ve lost any share in the most recent period. But we won’t know until we see the numbers.

Katy Huberty – Morgan Stanley

Okay. Thank you.

Operator

We’ll take our next question from Kaushik Roy with Wedbush.

Kaushik Roy – Wedbush

Thanks. Since like the converge market is gaining some traction, can you comment on what kind of margins you’re getting on this adapters?

Simon Biddiscombe

Yeah. Actually, what we said, Kaushik, for an extended period continues to be the case, the average gross margin on our product server in the converge market is around 65% corporate average. Some are higher, some are lower but, yeah, roughly the corporate average is where we expect those gross margins to be for the foreseeable future.

Kaushik Roy – Wedbush

Again, who are you competing mostly, is it all Mellanox or do you see some locate CNA as well?

H.K. Desai

Well, we compete with everybody. I mean, we compete mainly with Mellanox. We compete some with the blockade because they have a product release. We compete with Broadcom, we compete with Intel.

Kaushik Roy – Wedbush

But Broadcom doesn’t have a converge adapter.

H. K. Desai

Yeah. But there is also in 10-gig end market.

Kaushik Roy – Wedbush

And then can you comment when we can see a QLogic chip that includes FCoE and iSCSI off load, is this the one that you are talking about for December or?

H. K. Desai

Well, that product has been in the market for an extended period, Kaushik, the product has been the market. The chip you characterized has been in the market since March 2009.

Kaushik Roy – Wedbush

And can you comment who the 10% customers were or is Sun still a 10% or a top three?

Simon Biddiscombe

In percentage terms we had two customers who represented 10% of revenues.

Kaushik Roy – Wedbush

So Sun -- Oracle is not, not a top three anymore?

Simon Biddiscombe

No. So to be fair, what we said at various points was that Sun Oracle was somewhere in the mid single digits of our revenues.

Kaushik Roy – Wedbush

Last question, there was special charge about $1 million, what was that?

Simon Biddiscombe

So we -- that was associated with headcount reduction and we went through a consolidation of certain R&D efforts in order to drive greater efficiency and productivity from the engineering effort.

Kaushik Roy – Wedbush

Okay. Great. Thanks.

H. K. Desai

Hey, Kaushik, before you go. The question you specifically asked at the beginning, what did you say whether it was iSCSI off load?

Kaushik Roy – Wedbush

Yeah. So the single chip solution that has both FCoE and iSCSI off load?

H. K. Desai

That’s in the fourth quarter, that’s in the fourth quarter of this year…

Kaushik Roy – Wedbush

This is the one you are talking about in December, right?

H. K. Desai

I misunderstood your question. I apologize. Yeah, that’s coming in December.

Kaushik Roy – Wedbush

Okay. Okay. Thank you.

H. K. Desai

I misunderstood you.

Kaushik Roy – Wedbush

Can I -- H. K. can I ask one more. So now that you’re in the switching element for converge market, can we see pizza boxes, Ethernet pizza boxes that FCoE there or you’re not going to stay in that market?

H. K. Desai

No. We are -- I think it was our strategy on the converge network is we’re really playing with OEMs. We have Fibre Channel stack and they like to have the technology for the FCoE market and so we work with OEMs.

Kaushik Roy – Wedbush

Okay. All right. Thank you.

H. K. Desai

Thanks, Kaushik.

Operator

Our next question will come from Munjal Shah from Jefferies.

Munjal Shah – Jefferies

Hi, Simon. How are you.

Simon Biddiscombe

Yeah. Fine.

Munjal Shah – Jefferies

A couple of questions, could you give what the 8-gig mix was in this quarter?

Simon Biddiscombe

40%, Munjal.

Munjal Shah – Jefferies

Okay. And as we looked at the guidance can you give us some puts and takes in terms of how HBA networks and Silicon Products?

Simon Biddiscombe

Yeah. I think what we expect is -- we’ll start at the very bottom of the list, so we expect royalty and service to be roughly $2.5 million. We expect silicon to be roughly flat on a sequential basis at $11 to $12 million. And then we expect that both the Host and the Network businesses will grow.

Munjal Shah – Jefferies

Okay. All right. That’s all I have. Thank you.

Simon Biddiscombe

Thank you.

Operator

And at this time, there are no further questions, so I’d like to turn the conference back over to today’s speakers.

Simon Biddiscombe

Well, thanks for attending our call today. We look forward to updating you on our progress next quarter. Thank you again for your time. Good-bye.

Operator

Again, this does conclude today’s conference call. We thank you for your participation.

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Source: QLogic Corp. F1Q11 (Qtr End 06/27/2010) Earnings Call Transcript
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