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Executives

Sujal Shah - VP, IR

Abhi Talwalkar - President & CEO

Bryon Look - EVP & CFO

Analysts

James Schneider - Goldman Sachs

Parag Agarwal - UBS

Blayne Curtis - Jefferies

Srini Pajjuri - CLSA

Daniel Amir - Lazard Capital Markets

Craig Berger - FBR Capital Markets

Kaushik Roy - Wedbush

Sumit Dhanda - Bank of America

Sukhi Nagesh - Deutsche Bank

Harlan Sur - JPMorgan

Sanjay Devgan - Morgan Stanley

Christian Schwab - Craig-Hallum Capital Group

LSI Corporation (LSI) Q2 2010 Earnings Call July 28, 2010 5:00 PM ET

Operator

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

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

Sujal Shah

Good afternoon and thank you for joining us. It looks like we had some technical difficulties to start the call, so we apologize for that. But we're going to get going I knew some folks are still dialing in as we speak, but with me today are Abhi Talwalkar, President and Chief Executive Officer; and Bryon Look, Executive Vice President and Chief Financial Officer. Abhi will begin the call with some opening remarks and highlights from our business and then Bryon will provide results and guidance for the third quarter of 2010.

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

At that site, you will also find the copy of the earnings release and a presentation, which highlights the key points from today's call and provides an overview of our business. This may be particularly useful to investors who are new to LSI.

I want to remind you that today's remarks will include forward-looking statements. Our actual results could differ materially from those suggested by the statements made today. Information about factors that could affect our future results is contained in our annual report on Form 10-Q for the quarter ended April 4, 2010 in our annual report on the Form 10-K for the year ended December 31, 2009.

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

Abhi Talwalkar

Thank you. Good afternoon and welcome. In Q2, our revenues were 639 million representing a slight increase from Q1. Also in Q2 and on a non-GAAP basis, gross margins were at the high end of the guidance range above Q1 levels and above our business model goals.

Operating expenses came in below the midpoint of guidance, and we generated operating income expansion. We also have solid cash flows eliminated our debt, and we're active in buying back stock during the quarter. I'm pleased with how our team executed in Q2 delivering non-GAAP EPS at the midpoint of the guidance range even with revenues at the low end of the rand.

Now, I would like to put our near-term revenues in perspective. Our Q2, in Q2 we had solid year-over-year growth across all our businesses and grew faster than the majority of the end markets we participated. Our server-related businesses, which includes SAN, SAS and server blade solutions in aggregate, grew 40% year-over-year well ahead of server unit growth rates for the same period.

Our total networking business grew 23% year-over-year exceeding respective end market growth with investment areas in networking growing in excess of 50% year-over-year. And our systems business grew 13% year-over-year, also exceeding end market growth.

There are three dynamics of our influence in our sequential revenues in Q2 and Q3. First, we outperform some of our markets in our Q1, and are seeing in inventory adjustment from several customers in Q2 and Q3 as a result. Second, in the HDD business we saw a softening in demand late in Q2.

While the softening seems to have stabilized, we have seen a reduction in industry TAM and build plans particularly in desktop which commonly drives a higher portion of LSI's SoC revenues. This soften reach to more modest growth expectations in Q3, lastly we expect to see sequential declines in our non-investment areas in networking this quarter.

To drill down further our semiconductor revenues were up 9% sequentially in Q1 which was considerably higher growth than most of our peers and proxies for the end markets we participate in.

In retrospect, our out performance in Q1 was partly driven by our SAN and SAS customers building inventory ahead of technology transitions. This led to unit shipment reductions in SAS and SAN in Q2 and continued weakness in SAN shipments in Q3 to bring supply in line with end demand for those customers.

While our hard disk drive revenues are primarily from the desktop segment today, our recent SoC wins will expand our OEM base to customers more exposed to the faster growing notebook segment.

We believe these wins are our major step towards achieving our long-term goal of greater than 40% share of the ACD SoC market in the future.

Our Q2 results and Q3 guidance are simply reflections of these dynamics and not any loss of share in any of our businesses. In fact based on our year-over-year performance we have gained share in most of the markets we share.

As we look forward into Q4 based on our current industry projections for the HCD server and storage systems markets combined with near term inventory adjustments we expect to realize high single digit percentage revenue growth in Q4 of this year from Q3 levels.

Going forward the management team is committed to making continued progress towards our business model target of 17% non-GAAP operating margins. While we can't control end demand or the ordering patterns of our customers, we will take action on things we can control to improve operating leverage.

Earlier in the year we said that we would grow non-GAAP expenses at approximately 1 to 2% per quarter. Our goal now is to maintain expense levels below $230 million per quarter in both Q3 and Q4 of this year representing a reduction from Q2 levels.

We continue to expect full year non-GAAP gross margins to above our operating model target of 47% and our targeting non-GAAP operating income expansion for this year.

The long-term fundamentals of our businesses are solid, our design momentum is robust and we continue to deepen our engagements with market leading customers. During the quarter, we secured meaningfully design wins with customers like Dell and Cisco.

We remain confident and in our ability to grow our businesses at a rate exceeding the growth rate in the markets we serve. In addition, we recently completed a litigation settlement and cross-licensing deal with Samsung which we believe increases the certainty and visibility into our near term IP revenues.

Now, I want to review with you the business highlights for the last quarter. I will begin with storage systems which includes both external storage systems and server RAID adapters and software.

Our overall external storage systems business grew slightly ahead of the market from a year-over-year standpoint. We continue to expand our business to a new platform introductions OEM partnerships and design wins.

In this business we are uniquely positioned to respond to often shifting OEMs, partners, internal investments and storage with a range of solutions from turnkey storage systems to high value software controllers and high density drive enclosures. This approach has enabled our systems business to expand its customer base with consistent growth while navigating the constantly changing storage systems landscape, evolving roadmap and investment strategies of our OEMs.

Continuing our successful partnership with IBM, in Q2 we solidified road map commitments to extend LSI solutions into 2011 and beyond. In the entry segment, IBM just launched the DS3500 series to a solid end customer reception. In the midrange segment we are on track to release later this year and early next year several new software extensions and new family members to the popular DS5000 midrange storage family.

Additionally in our mid range business we saw growth in our 4900 storage system platform, new OEM wins and high performance computing, expanding sales in our 60 drive high density enclosure as well as solid sequential improvements in our sales to Oracle.

Based on our analysis of IDC's storage systems tracker for the first quarter of 2010 we remain the number one provider of entry level external storage system shipments through our OEM customers. Entry level remains the fastest growing storage system segment and IBM, Dell and SGI are all now ramping our new volume and performance entry platforms that enable midrange performance at highly competitive price points. Teradata and Cray are also ramping the new platform as part of their integrated solutions for data warehousing and high performance computing.

As we mentioned in the last quarter, a key expansion opportunity for us in entry level systems is in the white box market segment which is a $1.6 billion a year segment that we are not currently serving. In the second quarter we introduced the CTS2600 as a configurable storage building blocks which not only add to our growth prospects but also unable us to further diversify the business.

Now shifting to our server rated after business, we experienced significant year-over-year growth, well ahead of end market growth rates. Our share gains came from fully ramping across IBM's xSeries servers while firmly maintain our RAID solutions in nine of the top ten server OEMs.

We also gained share in the white box reseller channel through the combination of our MegaRAID and 3ware product families. Last month we announced that Gartner ranked LSI first overall in worldwide host bus RAID controller units for the third year in a row.

I'll now turn to storage semiconductors which include SAS, SAN and HDD. In SAS we have the broadest portfolio of solutions and continue to extend our leadership. Last quarter we mentioned that our next generation SAS Rocks and RAID software have already been chosen by two of the top three x86 server OEMs for their 2011 Intel Romley Generation Servers.

These wins position us well to secure Romley Generation wins at the other to server OEMs. We believe that we have established a significant lead over the competition. In fact a recent press release by one of our competitors confirms that LSI is nearly seven months ahead with our solutions. Based upon the claims and our competitor's press release, LSI will remain the clear performance leader for server solutions.

Regarding the PCIe flash solution we announced earlier this year, we have over 50 samples in evaluation and validation and more than 20 customers. Testing and feedback has been very positive regarding the product's performance and efficiency in comparison to other PCIe flash solutions in the market. We will be ramping production throughout the second half of 2010.

Turning to hard disk drives we are solidly positioned to grow SoC share as our solutions are increasingly deployed by customers. We recently announced the production shipments of the industries first low-density parity check or LDPC solution.

With Seagate we have enabled the industry's first hard disk drives with LDPC SoCs in 65 nanometer technology. The long standing relationship between Seagate and LSI has delivered innovative, best in class solutions over many technology generations.

As a further proof point of successful execution in the HDD arena, we have now shipped first silicon for four unique 40 nanometer LDPC SoCs to three different HCD customers. We are pleased that we're executing to our engineering milestones with all the programs we have in development. The HCD industry will be moving towards 40 nanometer and LDPC, and LSI is in a leadership position with this technology.

It is worthwhile to point out that many of our large notebook, many of the large notebook OEMs in the HCD space are currently sole sourced with our competitors. As the industry move towards the dual source model, we expect that our notebook penetrate increases from current levels fueling our growth.

Now I'd like review the networking business where we continue to expand our position with the industry's leading OEMs and the service providers, and enterprise networking infrastructure segments. Our investment areas and networking grew over 50% year-over-year in the second quarter illustrating our continued traction with market leading customers in the product areas that will drive future growth.

The wireless infrastructure segment is in particular focus for LSI where we are in production with all of the top five OEMs and continue to benefit from the demand for 3G and 4G wireless networks. Adding to our progress, the new AXIA communication processor began sampling in Q1, and we announced that one of the top two wireless infrastructure OEMs chose AXIA for their next generation wireless platforms.

In Q2, we secured multiple new AXIA design wins including a win with a leading wireless infrastructure structure OEM for 3G and 4G applications. Our unique ability to blend custom and standard solutions allowed us to secure a design win with ZTE on their base stations.

In addition, our new generation of multi-core media processors was selected for one of the industry's highest volume wireless media gateway platforms. Overall, customer traction and engagement with our enterprise networking products is extremely strong. We have conveyed our design win momentum at Cisco with our DSP products, which have now entered production on multiple platforms.

We continue to expand our design win momentum at Cisco in other areas such as data center switching, routing and security applications that leverage both our custom silicon and unique multi-core product portfolio. We also continue to make meaningful progress with custom solutions in the Ethernet connectivity space.

Our previously announced custom gigabit Ethernet 5 designs have been shipping in volume in client applications at the key customer. In addition, we now have intercepted the 10-Gig E data center transition by ramping a 10-Gigabit Ethernet laying on the motherboard and server blade solution with an emerging leader in this segment that has solid traction with a number of tier-one server OEMs.

We've also won a Next-Generation NG based T custom design for server applications with the same customer. Now I'll turn the call over to Bryon who will take you through our results and provide guidance.

Bryon Look

Thanks Abhi. Let me start by summarizing some key bullets highlighting our progress in delivering solid financial results and driving actions design to further expand shareholder value. On a year-over-year basis, revenues improved 23%, and we are well poised to benefit from design wins ramping in the near future.

Non-GAAP gross margins expanded by 630 basis points. We continued to focus on a variety of initiatives to expand margins, which have contributed substantially to this improvement. In addition, we have delivered above business model performance for non-GAAP gross margin for three consecutive quarters.

Non-GAAP operating margin expanded from 2.5% in Q2 of 2009 to 12.1% in this most recent quarter. We have now delivered three consecutive quarters of double-digit non-GAAP operating margin. Shifting to operating expenses, we continue being diligent on spending delivering a non-GAAP operating expenses below the midpoint of our guidance for the second quarter and we expect to maintain this focus as you will see in our guidance.

In terms of cash and the balance sheet, operating cash flows improved by $114 million or nearly tripling in the first half of the year compared to the first of 2009. This performance contributed to a 28% improvement in our net cash balance on a year-over-year basis even after our recent share repurchases.

We have also been active in buying back shares using $81 million to repurchase 14 million shares in the first half of 2010. At our current stock price we continue to view share buybacks as a good use of cash and a way to return value to shareholders.

In addition, during the quarter LSI repaid it's only remaining debt obligation and we are now debt free. Now some highlights from the recent quarter, revenues were $639 million within our guidance range and relatively flat to Q1, 2010.

Consolidated gross margins excluding special items were 48.4% improving sequentially by 70 basis points. Operating expenses, excluding special items were approximately $232 million. Operating margin, excluding special items sequentially improved by 40 basis points to 12.1%, non-GAAP earnings were $0.11 per share which is at the mid-point of our guidance range.

Operating cash flows were $68 million and finally we close the quarter with $670 million in total cash and short term investments. Now turning to a more detailed discussion on the quarter beginning with revenues, semiconductor revenues for Q2 were $417 million sequentially flat to Q1.

Our storage semiconductor revenues which include hard disk drive silicon, SAS standard components and storage area network ICs were sequentially down $14 million or 5% to $272 million. As noted earlier in the call this decline was primarily driven by inventory builds and customer buying patterns in Q1.

Storage semiconductors presented 43% of total revenues in the second quarter. Q2 revenues in our networking business were $122 million sequentially up $7 million or 6% and represented 19% of total revenues for the quarter.

Revenues for the IP business were up in the second quarter at $23 million. Turning now to our storage systems, business which includes both external storage systems and server RAID adaptors and software.

Storage systems delivered another strong quarter in terms of revenues which were sequentially up 1% to $223 million. In addition, this represented a 26% improvement in systems revenues as compared to Q2, 2009.

The storage systems segment represented 35% of LSI's total revenues in the second quarter. Moving next to gross margins, LSI consolidated Q2 gross margin excluding special items was 48.4% and sequentially up 70 basis points from Q1.

This result included a favorable impact resulting from the termination in the quarter of a supply arrangement which improves consolidated non-GAAP gross margins by approximately 90 basis points.

Semiconductor gross margins excluding special items sequentially increased 200 basis points from the first quarter to 54.0%. Approximately 140 basis points of this improvement was due to the supply arrangement I just noted as it related to our semi conductor business. Storage systems gross margins for the second quarter excluding special items sequentially declined 210 basis points to 37.7%, primarily due to higher period costs and mix.

Moving to operating expenses, R&D together with SG&A expenses, excluding special items totaled $232 million in Q2, approximately $1 million below the mid point of our guidance, non-GAAP operating margin sequentially improved by 40 basis points to 12.1% or $77 million. Interest income and other net of interest expense, excluding special items was a gain of $3 million for Q2.

Now let me turn to the special items we recorded in the second quarter which netted to $64 million. Special items, primarily non cash included $40 million in amortization of acquisition related items, $18 million of stock based compensation expense and $5 million of net restructuring costs and other items.

Moving next to tax, for Q2 we recorded a provision of $9 million for both GAAP and non-GAAP which was consistent with the guidance we provided in April. As a reminder our tax provision on both a GAAP and non-GAAP basis can vary significantly from quarter-to-quarter based on our profitability in different geographic tax jurisdictions and discreet items.

On a GAAP basis, second quarter net income was $7 million or $0.01 per share. Net profit excluding special items was $71 million or $0.11 per share. Share count for the period was 662 million shares for both GAAP and non-GAAP purposes.

Turning now to the balance sheet and cash flows, operating cash flows in the second quarter were $68 million, and were $173 million for the first half of the year. The positive operating cash flow was driven primarily by operating performance, coupled with our continued focus on efficient management of working capital.

During the quarter we repaid the remaining $350 million of outstanding convertible notes and ended the period debt free with a cash and short term investments balance of $670 million. Our cash position and balance sheet remains strong and we are well positioned to support the business going forward. Finally with respect to Q2 results, depreciation and software amortization was $26 million and capital expenditures were $13 million.

The following is our guidance for Q3 2010; Revenues in the range of 625 to $655 million. At the mid point, this is sequentially flat to Q2. This is primarily driven by a couple of key areas in our semi conductor businesses.

First are the accelerated customer buying patterns and resulting inventory builds we experienced in the first half of the year, primarily in our SAN and SAS businesses which will get worked down in Q3. Second, our expectations for the HDD business are fairly consistent with the trends in that market with our business being currently influenced by a heavier exposure to desktop HDDs.

Given this we expect storage semiconductors to be sequentially flat to slightly down in Q3. We expect networking semiconductors to be sequentially down, primarily due to declines in legacy product sales. We expect our storage systems business to be sequentially noted.

As Abhi noted, based on current industry projections for the HCD, server and storage systems market combined with near-term inventory adjustments, we expect to realize high single-digit percentage revenue growth in Q4 of this year from our Q3 levels.

Consolidated gross margin excluding special items is expected to be between 46.5 and 48.5% in the third quarter. We expect gross margins excluding special items to be approximately 52% for the semiconductor segment, and approximately 39% for the systems segment.

Operating expenses including special items are expected to be in the range of $223 million to $233 million. At a midpoint of 228 million, this would represent a 1.6% sequential decline in our operating expenses. This reflects our continued efforts to invest while being efficient which contributes towards the progress on business model and operating income expansion.

As noted earlier, our goal for Q4 is to keep non-GAAP operating expenses below 230 million. Interest income and other, and interest expense is expected to net to income of approximately $3 million. Special items are expected to net to approximately 50 to $70 million. The GAAP and non-GAAP tax provision is expected to be approximately $8 million for Q3.

We expect Q3 GAAP net income per share in the range of negative $0.03 to positive $0.06 and EPS excluding special items to be in the range of $0.08 to $0.14 per share. The share count is expected to be approximately 655 million shares for both GAAP and non-GAAP shares.

In addition, we expect depreciation and software amortization of approximately $26 million and capital expenditures of approximately $15 million. Let me close by saying, we're well positioned with our customers and the markets we serve. And our focus for 2010 remains consistent.

Continued progress towards business model drive cash generation and maintain a solid balance sheet, and drive continued design win momentum for future growth. And now let me turn the call back to Abhi.

Abhi Talwalkar

Thank you, Bryon. Before we go to your questions let me reinforce a few things. We are performing very well relative to the end markets we serve. Majority of our businesses are growing faster than these end markets. We've made progress against our business model this quarter, and that will remain a key focus throughout this year.

We are taking additional actions to reduce OpEx in the second half. And finally, the long-term fundamentals of our business are solid. Our design win momentum is robust, and we continue to deepen our engagements with market leading customers giving us great confidence in the future.

And let me hand the call back to Sujal.

Sujal Shah

Thank you, Abhi. At this point, we will begin the Q&A portion of the call. Michelle, will you please give the instructions for the Q&A session.

Question-and-Answer Session

Operator

Ladies and gentlemen to ensure that all participants have an opportunity to ask a question, each person will be limited to one question and one follow-up during this Q&A session. (Operator Instructions). Your first question comes from the line of James Schneider.

James Schneider - Goldman Sachs

Good afternoon. Thanks for taking my question. I guess starting on the inventory situation. I believe you mentioned that in your SAS and SAN areas, you saw some excess inventory; you expect that to get bled down in Q3 and then grow again in Q4. Have you asses your confidence level around that, and if you could also assess whether you see that any access inventory in the hard drive or systems supply chain, that would be very helpful.

Abhi Talwalkar

Yeah this is Abhi relative to SAN and SAS yeah based on the visibility that we have had relative those inventory pockets which really contain within two to three customers. We do feel like those are have been worked through in Q2 and what's remaining will work through in Q3 and just based on end market forecast and in particular server forecast in our confidence is relatively high and certainly that's factored into our forecast as well as our statement relative to how we expect Q4 to behave relative to Q3 levels.

And then in terms of inventory I think systems you ask at least at this point in time that doesn't seem to be a concern. Most of that systems business is generally configured to order, we get orders and we ship them out and there really aren't any inventory pockets throughout that supply chain.

James Schneider - Goldman Sachs

Thanks that's a very helpful color. And maybe just a follow up. On the networking business you mentioned you expect a legacy decline in Q3. Can you give us a sense of the magnitude of that decline and legacy business and then whether you think how much you think there is more to go on legacy declines going forward as it goes through the next year?

Bryon Look

Well as we came into the year we said that we would legacy business to decline to tune of about 100 million or so and as we have been actually 50 to $70 million I am sorry and as we have been coming through this year, legacy behaved the bit better than anticipated in terms of what we see into the second half it's probably in the order of about $25 million is I think what people should expect.

James Schneider - Goldman Sachs

In terms of total annual?

Bryon Look

In terms of a total annual decline, yeah versus the 50 to 75 we had guided at the beginning of the year.

James Schneider - Goldman Sachs

And then so we should expect that to go down further in 2011 or does that kind of bottom out there?

Bryon Look

No there will be some further declines in 2011 but it's getting to a point that's becoming insignificant.

James Schneider - Goldman Sachs

Perfect. Thanks very much.

Sujal Shah

Okay. Thank you Jim, can we have the next question please?

Operator

Your next question comes from the line of Parag Agarwal with UBS.

Parag Agarwal - UBS

Hey guys thanks for taking my question. First question on your systems business, given the sense in the corporate IT spending, could I get some sense in your systems business but it looks like it is flat this quarter. So, any color on that will be very helpful.

Bryon Look

Yeah I mean its flat quarter-to-quarter and I would say it's fairly consistent with historical seasonality; it's really the second half of the year that we start to see the systems business grow nicely relative to our Q2 performance. It is a very strong quarter and posted 13% year-over-year growth which was slightly ahead of the market place in terms of the entry and midrange segments that we participate in.

Parag Agarwal - UBS

Okay and coming back to your hard disk drive business. Can you update us on the status of the design win in Amstat, Seagate and Hitachi and also what this wins has offset any weakness you see on the desktop side. In other words, how should we model incremental revenue contribution from these wins for the reminder of the year?

Bryon Look

Parag, I certainly won't get into a lot of granularity I mean we are often ramping new SoCs across some one like a Seagate or Hitachi just given the number of SoCs that we have. Generally on track to ramp up the SoCs that we announced several years ago that are going into production. We expect our share at Seagate continue to grow over the next one to two years for a horizon and equally you can say the same thing relative to Hitachi.

All right meanwhile we're very busy executing to the SoCs that we won across the remaining three and sort of alluded to in our prepared remarks where we were at relative to some of that silicon.

Sujal Shah

Okay, thank you Parag. Can we have the next question please?

Operator

Your next question comes from the line of Blayne Curtis with Jefferies.

Blayne Curtis - Jefferies

Hey guys, a couple of questions. Abhi, going back to the hard drive inventory, obviously well known weakness that came about in Q2. Your main customer there is expecting growth in Q3. So I was just wondering, obviously there is some inventory (inaudible). I'm wondering if you can quantify that as far as how you developed confidence that you will be through it in Q3?

Abhi Talwalkar

Yeah, our inventory adjustments and most of that conversation is really around our fiber channel SAN customers as well as a customer in our SAS business associated with transitions in those markets, not necessarily a HDD sort of concern, right; from an HDD inventory. My comment earlier on HDD was that we all saw the HDD TAM kind of reset and lower over the last three months versus where people were projecting the HDD TAM three months ago.

Blayne Curtis - Jefferies

Okay, so on the server side, is this just a build ahead of new models or kind of, give us more clarity as to kind of what was the root cause of that?

Abhi Talwalkar

Yeah, the primary root cause relative to the fiber channel SAN space was the 4 Gig to 8 Gig transition on host bus adaptors. The storage systems and switches are already transitioned to 8 Gig. It's really the HPAs that go into servers and these have always been tricky transitions. We work very closely with the two or three players here and it became evident towards the latter part of Q2 that transition lets just say wasn't perfectly timed and played out and created some inventory pockets that we started seeing work through in the latter part of Q2 and into Q3.

Relative to SAS, it's predominantly a customer dealing with the transition from SAS 3 Gig to SAS 6 Gig across their entire product line. And again, I have pretty good visibility that is and has been sort of work through.

Blayne Curtis - Jefferies

Got you. And then just final question. One the enterprise SoC, you mentioned in your preamble, just looking for some, what's the status of that ramp?

Abhi Talwalkar

From an enterprise SSD?

Blayne Curtis - Jefferies

SoC.

Abhi Talwalkar

SoC. That status continues to make progress. It's in sort of the final customer qual stage. So we're certainly anticipating a ramp here fairly soon.

Blayne Curtis - Jefferies

Fairly soon would be this year or next year?

Abhi Talwalkar

This year.

Blayne Curtis - Jefferies

Okay, great. Thanks Abhi.

Sujal Shah

All right thank you Blayne. Can we have the next question please?

Operator

Your next question comes from the line of Srini Pajjuri with CLSA.

Srini Pajjuri - CLSA

Thank you. Abhi, just a follow-up to the previous comments about HDD business not seeing inventory correction. I'm just curious, if I look at the Seagate's TAM forecast on their call, it looks like they -- they forecast about double digits growth in the unit and if I compare that with your guidance, you're guiding for somewhat flattish growth here. Is there anything that I'm missing here or are you just taking a conservative view here?

Abhi Talwalkar

I'm not sure about your double digit comment relative to Seagate. I think their revenue guide has a 5% midpoint. So I'm not sure I buy the double digit comment for one. Keep in mind also relative to our hard disk drive business, its more heavily exposed to desktops and don't necessarily assume that our hard disk drive business is down quarter-to-quarter.

Srini Pajjuri - CLSA

Okay. Thanks for the clarification. And then we've seen margin compression at your customers at Seagate and also at Western Digital. I know historically that hasn't really impact your price. I'm just curious as you look out to the next couple of quarters, do you anticipate any pricing pressures in your drive business.

Abhi Talwalkar

No we don't.

Srini Pajjuri - CLSA

Okay, and then finally on the Q4 guidance Abhi, I'm just wondering given that you're going out one quarter to talk about Q4. Is that because your customers are giving you longer lead times, or it's just assuming that the seasonality will return in Q4? Thank you.

Abhi Talwalkar

I think it's certainly the seasonality. It's based on color that we have relative to some of our end markets. Some of these end markets; we have visibility through sales people that work in partnership with our customers. We believe the server cycle just continues to do well. Storage systems has held up. There is a number of proxies in the form of other peers participating into these markets. I think it's a number of factors as well as I think a fairly good understanding of what influenced the revenue sort of sequential profile of our top line for Q2 and Q3, and how that's getting worked through, right.

Srini Pajjuri - CLSA

Thanks Abhi.

Sujal Shah

Okay, thank you Srini, could we have the next question, please?

Operator

Your next question comes from the line of Daniel Amir with Lazard Capital Markets.

Daniel Amir - Lazard Capital Markets

Thanks a lot. In terms of the Q3 guidance, what is having a bigger impact? Is it the SAN and SAS situation, is there or more of the hard disk drive situation?

Abhi Talwalkar

It's probably more the SAN SAS situation, and then relative to hard disk drives our exposure right now which is more associated with desktops by virtue of R2 biggest customers in the space. That's another factor as well. Desktop sort of units for hard disk drive are actually guided to be flat to slightly down.

Daniel Amir- Lazard Capital Markets

Okay, and then on the networking side in the non-legacy businesses, is that suppose to be offered down, and if it is why is it in Q3?

Abhi Talwalkar

Relative to Q2?

Daniel Amir- Lazard Capital Markets

Yes.

Abhi Talwalkar

Yeah. It's slightly flat to up so I mean we -- I think overall from an end markets standpoint, end markets are probably generally flattish, at least the end markets that we participate in, so we are holding to that. We might see a lit bit of improvement above that because it's got a number of new products that are ramping at any given time based on wins that we've been accumulating over the past several years so.

Daniel Amir- Lazard Capital Markets

Okay, thanks a lot.

Sujal Shah

Thank you, Daniel. Could we have the next question please?

Operator

Your next question comes from the line of Craig Berger with FBR Capital Markets.

Craig Berger - FBR Capital Markets

Good afternoon. Thanks for taking my question. I guess when I look at kind of where revenues were back in mid-2008, it seems like you guys are kind of recovering off those pre-recession levels a little bit slower. You mentioned that networking is one over (inaudible) what other factors maybe causing that worst than pure revenue performance.

Abhi Talwalkar

Well, we probably had $2 million roughly of legacy revenues in that 2008 number Craig, right in terms of that propped up to 2008 sort of top line, and so if you factor that in we are -- we've recovered very well and then some relative to the end markets that we participated.

Craig Berger - FBR Capital Markets

As a follow-up you guys have talked about vastly growing design win pipeline. How long do those designs take to ramp to convert into revenues?

Bryon Look

I think it varies anywhere from 18 months to 36 months and a number of those have been contributing. We would not be talking about growing our businesses significantly faster than the end markets that we are participating in if those design wins were not contributing. I mentioned on the call that Q2 over Q2 our server related businesses grew at 43% or a server units over the same period grew 24%.

If I look at the first half of 2010 versus the first half of 2009 for that same category server related products, we grew 60% or our server units grew 25%, same thing relative to networking. We are not growing 50%, quarter-over-quarter. We wouldn't be growing at that rate and substantially above market with design win starting to contribute.

Craig Berger - FBR Capital Markets

You expect any of your new storage hard drive customers to start ramping in 2011?

Bryon Look

In terms of our new relative to the three additional HDV OEMs that we added, at the earliest it will later part of 2011 with one of the lead designs but the majority of that would show up in 2012.

Craig Berger - FBR Capital Markets

Thanks last one, can you just go into the Engenio gross margin little bit, why is that down?

Bryon Look

Sure, first of all you have put this in relative terms to the first quarter; we had a very first quarter as I believe I indicated on the call at that point in time. Some of that was based on lower than normal period costs, this is little bit more normal during the second quarter. You can tell from my guidance for the third quarter at 39% gross margins for that storage systems business that certainly that's very healthy for that business and that we are very close to our business model target. So, I think we are actually quite pleased with how we are doing in terms of managing our cost of sales and driving traction there. We can look forward to typically a stronger second half of the year for that systems business and when you get the volume typically you see some significant growth in gross margin and Q1 was -- that has been a record revenue quarter and again as I said you can see that in the guidance we provide for Q3.

Craig Berger - FBR Capital Markets

Thank you.

Bryon Look

Okay Craig.

Sujal Shah

Thank you Craig, we have the next question please?

Operator

Your next question comes from the line of Kaushik Roy with Wedbush.

Kaushik Roy - Wedbush

Some geographic color, and maybe talk about the linearity on the June quarter what you are seeing now in Q3 and I have a follow-up. Thanks.

Abhi Talwalkar

Yeah from a geographic color standpoint our visibility relative to the different geographies is heavily sort of influenced by our storage sales force that does work with storage systems customer and then whatever color we get from our customers.

The North America continues to do very well relative to storage systems as well as servers; North America has been really a large part of the driver this year relative to those categories, Asia as well.

We as of several weeks ago had not started to see any material softening relative to storage systems in Europe and certainly have not up until this call and have not seen that but we are going into the summer season in Europe so we will probably see some typical behavior there as we have historically seen and I think that's all I can probably offer relative to end market color from a geographic standpoint and certainly I haven't not seen any material slowing relative to Asia in the segments that we participate which are largely enterprise oriented and to your second question Kaushik was around linearity?

Kaushik Roy - Wedbush Securities

Yes.

Abhi Talwalkar

Relative to Q3 itself and how we expect linearity throughout the quarter? I think just consistent with sort of typical linearity, as you know a large part of our business is heavily returns oriented, especially the systems business. For the last probably six weeks, four to six weeks it accounts for 60% of the business but its started off generally consistent, started off maybe a little bit on the slower side given some of the inventory adjustments that we've been talking about. But we've seen a pickup in turns over the past one to two weeks as well, obviously all factored into our guidance.

Kaushik Roy - Wedbush Securities

And it seems the headcount grew by 3% sequentially. One of the biggest issues with investors have been operating margins and it seems like the 17% target is a stretch at this point. So is achievable in the next two to four quarters or do you need to cut OpEx more?

Abhi Talwalkar

Well first of all our OpEx has been I think very tightly management. We're guiding OpEx down. Don't get too caught up in terms of head count. Focus on expenses. Relative to business model performance and 17%, that's job one for us. You know the transformation for this company was done a year ago. It's all been execution and driving top line as well as operating income leverage. We expect to be able to our business model as we sort of approach the 700 to $750 million revenue range obviously depending on where gross margins are that and that's what we're very focused on Kaushik. I think that is really job one for myself and every other employee in this company.

Bryon Look

Yeah, let's go beyond that with a couple of additional comments. While we are continuing to operate in a climate where we have very high level design win activity which does correlate somewhat to the somewhat to the headcount growth but we've been able to offset that through a lot of productivity initiatives we've been driving across the company and then to Abhi's point about the importance for us of getting to business model targets, we would reiterate the comments that we made at Analysts Day which is that we intend to grow revenue and operating income significantly faster than operating expense growth.

Kaushik Roy - Wedbush Securities

Okay, thanks.

Sujal Shah

All right, thank you Kaushik. Can we have the next question please?

Operator

Your next question comes from the line of Sumit Dhanda with Bank of America.

Sumit Dhanda - Bank of America

Yes, hi. A couple of questions Abhi. First in terms of the, sort of the profile of the inventory correction you saw, any detail you could offer and a clarification on that front, is it fair to assume that you have not assumed any component level HDD, component level correction associated with the slowdown or the decline in the HDD TAM. So were that to transpire that would be additional head win to your revenue into the third quarter?

Abhi Talwalkar

No, let me the -- its impossible to predict necessarily how end markets will behave and hopefully will, hope they will behave as we are all projecting; both industry analysts as well as ourselves, our customers and other proxies. But we did see as we said a deceleration lets say of orders in the HDD space starting in the latter part of Q2 as HDD customers recognized that the overall HDD TAM was going to be different for the rest of the year than originally projected, right. So that sort of self correction or correction started in the midst of the quarter and I think started before sort of inventory concerns were created. It is how I would characterize it, right on the margin. That's I think how that played out relative to our SAN and SAS, our Q1 was pretty strong in terms of performance. We were up 9% quarter-to-quarter and we're typically down 8 to 12%, and the majority of that our performance there was certainly some underlying strong seasonal sort of growth, but a lot of that our performance was build up of inventory around the 4-Gig, 8-Gig, transition and fiber channel and then another comp on it was the 6-Gig SAS relative to a customer.

And we started seeing that start to correct itself in the second quarter as well as we moved into the later month of the second quarter. And we are seeing some of that continue to bleed off in the third quarter.

Sumit Dhanda - Bank of America

Okay, and then as a follow-up I guess at a high level when I look at your storage semiconductor business, and compared to even five years ago, the Agere merger, it's really flat maybe even down slightly from that level based on the trajectory to the rest of the year. Help us understand why we should be confident that indeed this it's going to be different as you look at the trajectory of your designs and the revenues that you think will sensibly follow in the next year and a half or three years.

Abhi Talwalkar

I don't have five -- the numbers in front of me or printed in my brain relative to five years ago. Keep in mind five years ago, we were generating $250 million a year actually close to 250 to $300 million a year in enterprise hard disk controller business. When the hard disk controller was discrete and not an SoC, and we lost that business because we didn't have a re-channel capability and at that point in time, the strategy of the company was not necessarily on being a number one or two player in our disk drive space. Since then we've come tremendous ways relative to rebuilding that entire business, rebuilding it to a point where we're incredibly competitive.

We are leading the market from the technology transition standpoint. We won the first round of 65-nanometer sort of SoCs going head-to-head. Those were just now starting to ramp as they are typically two and a half to three year development cycles. We were ahead by 69 months on the 40-nanometer LDPC sort of transition as well. That not only lead to wins at Seagate and Hitachi, but allowed us to penetrate the other three hard disk drive OEMs that we have not penetrated. Our share levels were at about 20 to 22% from an SoC standpoint. We absolutely expect us to grow next year, and continue growing year after that with certainly long-term objective of 40%. It's down to just two players in the SoC space, and we've got better or equal technology. I would argue better technology and that's going to do it well for the market that wants a dual supplier strategy, so it's straightforward.

Sumit Dhanda - Bank of America

Okay, thank you very much.

Sujal Shah

All right, thank you Sumit. Could we have the next question, please?

Operator

Your next question comes from the line of Sukhi Nagesh with Deutsche Bank.

Sukhi Nagesh - Deutsche Bank

Thanks for taking my question. This is a question for Bryon. Bryon, how much cash do you need on a quarterly basis, and I was wondering if you could give an update on what you could do on the buyback front?

Bryon Look

Well, the amount of cash that we need to run the company and obviously it varies. I mean when sitting in my seat you think about the cash requirements for the company, you got certain working capital requirements. You also want to think about what state of the economic environment is really like, and so yes we have much more modest requirements cash-to-date and we have historically when we were a fabs company. We had much for manufacturing related spend relative to the sort of cash position that we have is noted in our performance for this year and for the as you go in back last year. Very strong operating cash flows, the first half of this year, we generated a 173 million of positive operating cash flows and that gives much more flexibility in terms of deployment of that cash even as time when we have not also retired all of our debt.

Relative to Q2, we have repay the $350 million of all the remaining convertible notes and on top of that bough back shares, we spent about $55 million in the quarter to buyback shares which we continue to believe to be a good use of cash and given the strong position that we have in terms of cash flow generation I think we have the ability to continue to do things like that going forward.

Its first time I think also and as long as I can remember where the company has had no debt and we still have $670 million of cash which actually grew; we had net cash I should say built during the quarter.

Sukhi Nagesh - Deutsche Bank

Just curious, how much stock buyback authorization do you have currently?

Bryon Look

Well we were authorized to repurchase $250 million worth of shares to date. We have exercised or spent about $81 million of that, so we still have a fair amount that we can exercise to buyback stock.

Sukhi Nagesh - Deutsche Bank

Got it, okay. And this is for Abhi. Abhi, there is a lot of people out there in the market who talk about who have a secular argument versus the HCD market you think about what's going on in the Apple world these days. How would you calculate those comments and also could you give us an update what do you think the PC markets will do this year? Thanks.

Abhi Talwalkar

When you say secular relative to the HDD and Apple, are you talking about flash?

Sukhi Nagesh - Deutsche Bank

Yes.

Abhi Talwalkar

I mean our perspective is the hard disk drive market is what in the order of 675 million units this year and just based on PC forecast and so forth as well as forecast for other segments that are using hard disk drives whether they are set top boxes, whether they are game platforms, external storage for consumer backup.

Even at 8 to 10% sort of unit growth CAGR for the next three to five years, that's still a huge market and weigh 20 to 22% share of that market.

We have only one way to go which is up, so, flash doesn't concern me at all and meanwhile we are also participating in flash and sort of SSDs.

In terms of the PC market and its growth I mean I would probably go with sort of the consensus that's out there which is probably in the range of 15% or so in terms of year-over-year growth. That's probably the best of visibility we have got and largely based on some of the analysts as well as other major proxies out there.

Sujal Shah

Okay. Thank you Sukhi. Can we have the next question please?

Operator

Your next question comes from the line of Harlan Sur with JPMorgan.

Harlan Sur - JPMorgan

Thank you for taking my question. Abhi I know you have been talking about the design win pipeline and conversion rates and so given some of the probations in the environment whether they will be part of transitions or demand related. Are you seeing any of these new product ramps been delayed at all?

Abhi Talwalkar

No generally no, in fact it's just the opposite. There is a focus to try to accelerate technology, I mean if there are any delays there, they are more the exception and just because of just the complexity of some of these programs is more so the case. Relative to design win cancellations which maybe another question that you might want to ask, in a difficult environment are you going to see and experience more design win cancellations, and if I look back at the last three years of design wins, the cancellations I can probably count on two to three fingers and they have been generally tier-2 sort of design wins or accounts we have not had any cancellations really to speak of in major tier-1 sort of customers or segments.

Harlan Sur - JPMorgan

Got it, okay and then looking into the second half the year, obviously your enterprise exposure, I would think you guys should be able to continue to benefit from the trends in networking, storage date center upgrades and refresh cycles and so if we just strip out the inventory and product transition glitches that started in Q2, and maybe continued through Q3, and if we kind of set aside the TAM shrinkage on the HDD side, I mean what sort of your overall sense on enterprise demand in the second half of the year?

Abhi Talwalkar

Still relatively positive, having seen indications of a slowdown or change in momentum on the server side, certainly have not seen that in terms of external storage systems, I think some of the recent results from some of the companies that are out there EMC being a good example, certainly continues to act like the same thing in terms of enterprise, IT shops and their bias around buying storage systems.

Harlan Sur - JPMorgan

Okay.

Abhi Talwalkar

I think I can't really add much more to what's already been set out there relative to maybe some early signs, relative to a corporate desktop sort of refresh, or corporate PC refresh.

Harlan Sur - JPMorgan

Got it, all right, thanks a lot, Abhi.

Abhi Talwalkar

Thank you.

Sujal Shah

Thanks Harlan, can we have the next question please?

Operator

Your next question comes from the line of Sanjay Devgan with Morgan Stanley.

Sanjay Devgan - Morgan Stanley

Hey guys thanks so much for taking my question. Abhi I was hoping you might build a kind of a expand upon one of the earlier questions touched on the weakness in the Storage Peripherals |Group and you kind of delineated how the SAS and SANs portion were driving it, more of the weakness due to the inventory issues, basically the hard disk drive business, but as you kind of look at SAS and San can you kind of delineate further and give us, you know out of those two which one is kind of driving a bigger impact?

Abhi Talwalkar

Yeah, firstly Storage Peripherals we use that term more for our HDD business, but I know your question is really focused on Fibre Channel SAN and SAS and which was the greater contributor if you will, relative to inventory, I would say it was more weighted towards the Fibre Channel SAN space.

Sanjay Devgan - Morgan Stanley

Okay great and then I guess just one follow-up question. Have you -- this quarter you got to have nice pickup in your IP revenue. I think you went from around 16 million to 23 million. Any color you can provide there on what kind of drove that, and how we should look through IP revenue going forward?

Abhi Talwalkar

I mean I think we've made great progress of rebuilding the overall IP business in the underlying annuity stream as well. As you recall we had to start all over again, relative to rebuilding that annuity stream and deals and so forth, post-merger and the fact that we are starting to guide towards the 23 to $25 million sort of quarter, that's getting back to sort of those pre-merger levels so we are very pleased with the overall pipeline that we've had, certainly pleased with the deal that we were able to close with Samsung was just -- adds another level of certainty in the foundation of that business as we go forward.

Sanjay Devgan - Morgan Stanley

Okay, great, thank you very much.

Sujal Shah

Thank you, Sanjay. Could we have the next question, please?

Operator

Your next question comes from the line of Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Great, thanks for taking my question. Abhi, at the end of '09 beginning of '10 you were pretty confident that the future for the company looked the best since you joined it, and that was kind of based on significant design win momentum, momentum that was unprecedented over the last two years. And you were going to begin to see that in the second half of 2010, and in given the legacy drops, the networking are much less than what you anticipated yet we're not seeing any meaningful growth at least in your Q3 guidance.

In particular there, and then you also highlighted that you would expect some of the enterprise SoC ramps to begin with Seagate and Hitachi. And I haven't heard a lot of about that. So, I guess I was just wondering how you would characterize your outlook of the company now because of the comments before, we are kind of shaped around not been impacted as much by the macro as if yes you are.

Abhi Talwalkar

My confidence of the company remains equally as strong and even incrementally strong than I alluded to into the latter part of 2009. I think the company is in solid shape relative to growth. I mean don't let our Q3 guidance confused the situation, focus on the overall year-to-date sort of growth relative to the same period or even year-to-year forecast and in particular focus on the end markets that we participate in.

You can't paint every single company with the same brush relative to our end markets and the proxies there are server units, external storage systems, TAM, HDD. But keep in mind right now we have a heavier exposure to desktop HDDs although that's going to change overtime as in the SoCs ramp and then wireless sort of infrastructure. We're growing at for significantly above markets across most of those categories and that's because of the design wins over the last several year have been kicking in, and that will only continue to improve and help us accelerate our growth.

Most of the legacy sort of head wins, that we led to content with the last three years are behind us, and our balance sheet is as strong as ever been with completely rebuilt and strong product lines. If I look at the first half of 2010 in terms of operating margin performance, it's the best first half we've had in the last probably nine years as well, and so I think we're doing certainly well and I would encourage people to look beyond the Q3 [protivation] which is really around inventory adjustments around two or three customers, and focus on our performance relative to end markets, and that's what I do, and that's why I continue to have very high confidence in terms of where the company is at or is headed.

Christian Schwab - Craig-Hallum Capital Group

Great, no other question, thanks.

Sujal Shah

Okay, thank you Christian. I believe there are no further questions. So I'd like to thank all of you for joining us this afternoon. Do you have any additional questions, please call investor relations at LSI. Thank you, and have a nice day.

Operator

Ladies and gentlemen, a telephonic replay of this conference will be available beginning today at approximately 5: p.m. Pacific Daylight Time, and we will run through 9:00 p.m. Pacific Daylight Time on August 4. The replay access numbers are 1-800-642-1687 within the U.S. and 1-706-645-9291 for all other locations. The webcast will be archived at www.lsi.com/webcast. That does conclude your conference for today. Thank you for your participant. You may now disconnect.

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Source: LSI Corporation Q2 2010 Earnings Call Transcript
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