PMC-Sierra CEO Discusses Q3 2010 Results - Earnings Call Transcript

Oct.21.10 | About: PMC - (PMCS)


Q3 2010 Earnings Call

October 21, 2010 5:30 pm ET


David Climie - VP, Marketing Communications & IR

Greg Lang - President and CEO

Mike Zellner - Vice President and CFO


James Schneider - Goldman Sachs

Ruben Roy - Pacific Crest

Srini Pajjuri - Calyon Research

Mark Lipacis - Morgan Stanley

Sandy Harrison - Signal Hill

Harlan Sur - JPMorgan

Kevin Cassidy - Stifel Nicolaus

Mike Burton - FBN Securities


Good day and welcome to the Q3 2010 PMC-Sierra earnings call. As a reminder, this conference is being recorded. Today is Thursday, October 21, 2010. It is now my pleasure to introduce your host, Mr. David Climie. Please go ahead, Mr. Climie.

David Climie

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

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

For further information about these risks and uncertainties, please read the company's SEC filings, including our forms 10-K and 10-Q.

Thank you. And I will now turn the call over to Greg Lang.

Greg Lang

Thanks, Dave. As you may be aware, we issued two press releases this afternoon, one relating to our third quarter 2010 earning results and the other announcing that we signed a definitive agreement to purchase Wintegra.

I'll first review our quarterly earning results for Q3, give an outlook for Q4 and then ask Mike Zellner to provide details on each. And then I'll finish with comments on the strategic benefits around the Wintegra acquisition. In the third quarter this year, we generated $162 million in revenue, up slightly from the prior quarter.

Revenue improved sequentially in our microprocessor and enterprise storage market segments, the latter primarily due to a full quarter of revenue from the Adaptec storage channel acquisition in Q2 this year. The growth was in part offset by declines in our WAN infrastructure market segment.

On the earnings front, we generated approximately $44 million in non-GAAP operating income in Q3, and we achieved a 27% non-GAAP operating margin in the third quarter. During the last four quarters the company has generated solid cash flow which has resulted in our cash plus investments on the balance sheet increasing by $136 million to $555 million by the end of September this year.

So now let's talk about the results by end-market segment. In the Storage market segment, the enterprise IT spending environment remained healthy in Q3. In the Server market segment, our six gig radon chip business increased again in Q3 and recorded our best ever quarter.

Our fiber channel products were flat quarter-over-quarter, while our SAS devices were down slightly, as we completed the digestion of a small amount of 3 gig SAS inventory during the quarter. We expect to see our top two storage customers continue to ramp their new 6 gig SAS platforms in Q4 and into next year.

Our design wins improved in the enterprise storage for the third quarter in a row and we're now seeing Hitachi's virtual storage platform go into production with our 6 gig SAS expanders and controllers.

In June, we closed the purchase of Adaptec's channel storage business and the operation is now being fully integrated into PMC, including a full quarter of revenue. Without this incremental channel revenue, the OEM portion of our storage business was down slightly due to inventory consumption.

In the Wide Area Network infrastructure market segment, which includes both our wireline and wireless infrastructure products, activity declined in Q3 as many of our customers worked on inventory levels during the quarter. While we had anticipated this going into Q3, we did not expect it to be as broad-based.

As a result, our WAN infrastructure activity in both North America and China were each down sharply. Japan and Europe on the other hand saw improved activity quarter-over-quarter in Q3.

In Q4, we will start shipping our 10-gig and 20-gig Hi-Fi devices for Optical Transport Networks, or OTN platforms into the metro and aggregation equipment. While it's still a very early stage of deployment, we're very encouraged to see the beginning of convergence into packet-centric network architectures.

PMC is unique in that we've targeted our solutions in the most difficult areas of the OTN deployment, namely, the high volume aggregation and metro areas of the network where carriers require end-to-end multi-service OTN switching. Our Hi-Fi chips enable this aggregation of multiple services, as well as OTN switching in a single device with very low power.

We expect OTN deployment to be a long term secular growth driver, and we look to improve our share in this market segment over time. Based on design wins secured year-to-date, we believe we will be the leading OTN ASSP provider, as our customers ramp their designs over the next couple of years.

In broadband access, our Fiber to the Home business in Q3 was flat to a strong Q2. NTT continued to add customers and extend its fiber network into more regional areas, and in addition our Fiber to the Home business in Korea improved sequentially in the third quarter. This is offset by the China business being softer, as both China Telecom and China Unicom delayed their second-half bids.

We continue to believe that long term picture is bright in China, with necessary infrastructure growth to support ongoing modernization and the Chinese government's convergent policy for telcos, cable companies and content providers. We believe that carriers will be planning for growth in Chinese subscribers in 2011 somewhere in the range of 25% to 30% higher in 2010, which should bode well for equipment deployments and orders.

In Q3, we secured two key GPON ONT design wins with tier-1 customers, and we're moving into the 10-gig EPON evaluation stage in Japan next quarter. For the cable markets in both North America and China where the physical plans for cable is getting exhausted, we've demonstrated 1-gig and 10-gig EPON interoperability for video distributions into residences as well as multi dwelling units. And recently we've been selected to join the cable lab standard specification body.

So with that, let's now take a look at the fourth quarter outlook. Based on the backlog in bookings today, we currently anticipate PMC-Sierra's revenue in the fourth quarter of 2010 to be lower by -4% to -9% compared to the prior quarter. This decline in revenue is driven by continued inventory consumption by our WAN and printer customers as well as slower central office loyalty demand for Fiber to the Home products in Japan.

We anticipate that the enterprise storage of OEMs and channel business to be flattish with a strong Q3. This does not include any partial quarter revenue that we expect to receive from the Wintegra acquisition. We believe our customers will largely work through their excess inventory by the end of this quarter so we can get back to normal business levels in 2011. We also believe that demand remains healthy in our end markets as we enter the first quarter of 2011.

So with that, I'll now hand the call back over to Mike for more details on our third quarter results as well as our fourth quarter outlook.

Mike Zellner

Thanks, Greg. I'll review our third quarter 2010 results and financial position and provide detail on our fourth quarter outlook and then turn it back to Greg to discuss our Wintegra announcement. PMC-Sierra generated revenues of $162.3 million in the third quarter representing an increase $1.6 million or 1% over Q2 revenues of $160.7 million. And a 24% improvement over the $130.9 million in Q3 of last year.

Our turns business, meaning those orders booked and shipped within the same quarter was 14% in Q3 and excluding the effect of the channel storage business, our turns were 8%. This compares 14% with and 11% without the effect of the channel storage business in Q2. In Q3, we had one customer that represented greater than 10% of our revenues calculated on a rolling 12-month rolling basis, namely HP.

Gross margin in third quarter was 67%, compared with 69% in Q2. The decrease of 200 basis points was largely anticipated and discussed on our previous quarterly conference call and breaks down as follows. 120 basis points due to the full quarter of the channel storage business and related integration cost including fair value adjustments to inventory and 80 basis points due o change in product mix including lower revenues fro the Wave infrastructure market as customers worked down their inventories.

On a non-GAAP basis, operating expenses increased by $3 million from $62 million in Q2 to $65 million in Q3; this increase relates mainly to having a full quarter of the channel storage operations in Q3 and continued investment in R&D projects as planned. In Q3, our non-GAAP operating margin was 27% compared with 30% in Q2 and remains within our targeting operating margin range of 25% to 30%.

Non-GAAP tax provision was as expected in the third quarter as $1.6 million slightly lower compared with $1.7 million in Q2. Non-GAAP net income for Q3 was $42.9 million or $0.18 per share on a diluted basis, representing a $4.7 million or 10% decrease from the $47.6 million or $0.20 per share generated in Q2. On a year-over-year basis, non-GAAP net income increased by $8.4 million or 24% from the $34.5 million generated in Q3 of 2009.

Q3 GAAP diluted net income per share was $0.06 versus $0.13 in Q2. The comparable GAAP measures for each of gross margin, operating expenses, operating income, provision for income taxes and net income are reconciled to the related non-GAAP amount, and our reconciliation of GAAP to non-GAAP measures included in our press release issued today.

The primary reconciling item for Q3 are as follows: $5.9 million at amortization of purchased intangible assets, $5.3 million in stock based compensation expense, $800,000 of non-cash interest expense, $800,000 of acquisition related cost, $4.9 million of impairments of intangible assets and $9.6 million of income tax related adjustments as described in our press release.

Turning to the balance sheet, we entered the quarter with over $550 million of cash and cash equivalent, short term investments and investment securities. Our cash position at quarter end net of the $68.3 million face value of our convertible notes was $487 million, an increase of $54 million from Q2. The increase primarily relates to the $42.9 million of non-GAAP net income generated in the quarter, adjusted for non-cash items plus $7.2 million cash from employee-related stock issuances, offset by $6.4 million for IP and capital expenditures.

In Q3, cash flow generated from operations remained strong at $53.4 million, our highest in nearly a decade. Accounts receivable decreased $3.1 million to $76.8 million. We had 43 days sales outstanding based on a quarterly sales volume. This was slightly higher in terms of days, primarily due to the integration of the acquired channel storage business, and remains a very healthy collections profile.

Our net inventory at the end of Q3 was $36.1 million, an increase of $1.2 million from the prior quarter. Net inventory turns decreased to our targeted level of 6 times, compared with 6.5 times in Q2. Lead times from our foundry partners have held steady.

Now I'll provide more information about our Q4 outlook. Considering current levels of demand and our expectation of booking rates through the balance of the quarter, we estimate that the potential revenue for PMC-Sierra for Q4 is in the range of minus 4% to minus 9% from Q3, as Greg mentioned. Just shipped and shippable backlog at the end of September was approximately $119 million, and as of today is approximately $128 million indicating that we would need approximately 21% turns from the end of September and 15% turns from this day to get to the midpoint of our revenue guidance for Q4.

Excluding channel storage business, we expect turns of 14% from the end of September and 10% from now, which is consistent with historical levels. On a non-GAAP basis, we expect our overall gross margin percentage to increase from 67% in Q3 to 68.5%, plus or minus basis 50 basis points in Q4. With the expected improvement quarter-over-quarter, this level of gross margin is considered more typical now with the acquisition-related integration of the channel storage business essentially complete and the expected product mix in Q4.

Non-GAAP operating expenses in Q4 are expected to be in the range of $67 million to $68 million, increasing from the $65 million in Q3. This increase results from the continued R&D investment in Q4 across various new product initiatives, as well as higher tapeout activity in the quarter.

On a general note, depending on the number and timing of tapeouts which do vary from period-to-period, our expenses could be affected by a couple of million dollars in any given quarter. We expect non-GAAP net other income to be at about $0.5 million, which is primarily net interest from our cash position, offset by servicing our outstanding convertible notes.

We expect the non-GAAP tax provision in Q4 to be between $1.5 million to $2.5 million. As a reminder, the tax expense can be impacted by a number of variables associated with our ASC 740, formerly FIN 48 liabilities, including but not limited to, a change in foreign income and product mix.

Regarding the share count, we ended Q3 with a diluted share count of $234.3 million. In Q4, our diluted share count is expected to be approximately $235 million. For the upcoming quarter, we plan on the following significant GAAP to non-GAAP reconciling items.

First, amortization of purchased accounting costs associated with past business acquisitions. Second, stock based compensation expense. Third, FX gains or loss on our net foreign tax liabilities. And fourth, income tax effects of the above adjustments and other tax items as specified in our reconciliation of GAAP to non-GAAP measures included in our press release issued today. Additional non-GAAP items associated with restructuring our other costs, positive or negative are always possible.

I would now like to turn the call back over to Greg for his briefing on Wintegra.

Greg Lang

Before we get into Q&A, I thought it would be good to spend a couple of minutes and describe what we think is some of the strategic aspects around the acquisition that we announced today of Wintegra.

Wintegra is a leading provider of highly integrated silicon and software solutions optimized for the mobile backhaul equipment market. As we know, mobile networks worldwide are reaching a breaking point, as more capable mobile internet devices are proliferating around the world. According to a recent CISCO report, mobile data traffic is expected to increase 10 times in the next three to four years, driven primarily by these more capable devices.

The existing mobile data infrastructure was built with voice technology. Carriers are upgrading their mobile backhaul networks, and next will transition from TDM to packet-based platforms, in order to manage the increasing demand for bandwidth. As a result, mobile backhaul equipment is the fastest growing segment in the wireless infrastructure market.

Based on a forecast by Infonetics Research, the Ethernet packet-based mobile backhaul equipment segment is expected to grow 35% annually from $1.2 billion last year to $5.5 billion in 2014.

I believe that Wintegra is the best positioned company in the industry to serve this major transition based on the design win traction and product portfolio. Wintegra's WinPath network processors and field-proven networking software are enabling the migration and integration of new and existing networks, so carriers can move from TDM to a hybrid TDM and IP solution onto an all-IP network in the future.

Wintegra's solutions are used today in many applications including 3G/4G base stations, fiber and microwave backhaul and aggregation equipment as well as radio network controllers deployed in the central office. Wintegra has won designs at four of the top five equipment vendors providing equipment in the mobile backhaul market segment.

We've been partnering with Wintegra over the last couple of years on wireless infrastructure solutions. Their network processors are already working right beside many of our framers, mappers and multiplexing chips in equipment that is being designed and shipped today.

In 2009, Wintegra's revenues were at $28.6 million approximately, and this year the company expects to roughly double that number. Their quarterly revenues have grown sequentially over the last three quarters from $8.5 million in Q4 last year to approximately $15 million in Q3 this year.

In their second quarter report, Wintegra's revenue was $14.2 million, gross margins were approximately 70%, and the company was profitable with operating margins at 24%. We're expecting similar revenue and operating metrics in Q3 and Q4 this year, and greater than 20% growth in 2011.

The transaction is expected to be immediately accretive to PMC's earnings. Under the terms of the deal, the net purchase price for Wintegra is $213 million in cash, and this will be funded from PMC's cash on its balance sheet. We're anticipating the transaction could be closed before the end of November subject to the customary closing conditions and regulatory approvals.

Also, under the terms of the agreement, there is an opportunity for an additional $60 million of consideration to be paid in cash to Wintegra if certain revenue growth and performance milestones are reached by the end of next year. To achieve the maximum earn-out, the business would need to grow beyond 2010's revenues and generate $80 million in revenue into 2011.

Wintegra has a total of 165 employees with approximately 130 located in Israel and 25 in Austin, Texas. We know Wintegra's founders well, Kobi Ben-Zvi and Robert O'Dell and I'm pleased to say they'll be joining PMC-Sierra, bringing with them an exceptional team in silicon design, networking software and system integration.

I am excited about this acquisition because it fits so well with our mission to be the premiere internet infrastructure solution provider in the semi industry. We see three major fundamental drivers to our business over the next several years.

Number one, the digitization of everything, music, pictures, books, movies and TV is driving an explosion in storage and network bandwidth requirements across networks. Number two, the rapid growth of more capable mobile internet devices such as smartphones and tablets that will drive enormous network traffic growth over the wireless networks. And number three, file computing, which is built on the presumption of substantial bandwidth in and out of the datacenter as well across the network.

These fundamental drivers will force a technology transition from TDM to packet-based network equipment, and no semi company is better positioned than PMC to usher in these new networks.

PMC is the number one provider of 6-gig SAS solutions for storage systems, and number two in server storage. With three years of product leadership under our belt, PMC is also the number one supplier of TDM silicon and metro access networks, and based on the design wins starting to ramp this quarter, we will be the number one silicon supplier for OTN switching equipment as carriers transition their metro access and aggregation equipment to OTN over the next few years.

PMC is the number one supplier in the next generation residential broadband access technology, with our Fiber to the Home product lineup. And with the purchase of Wintegra, PMC is positioned to be the number one semiconductor provider in mobile backhaul within a couple of years.

Leadership in enterprise storage, residential access, mobile access, metro aggregation and metro core applications puts PMC in a great position to benefit from the network transition and transformation in front of us just when the industry needs it most.

So with that summary, I'd like to now turn the call over to the operator for Q&A.

Question-and-Answer Session


(Operator Instructions) And the first question comes from James Schneider with Goldman Sachs.

James Schneider - Goldman Sachs

I was wondering if you could sort out and maybe give us a breakdown of what the WAN revenues are at this point on a run rate basis and then maybe give us an update on the inventory situation at your customers outside of the WAN space in the storage, printer and the PON markets?

David Climie

Jim, it's David Climie. I just wanted to get back to you. So if we combine our existing wireless infrastructure and wireline infrastructure piece together, which is the combined WAN infrastructure piece, it's running just slightly under 30% of our Q3 revenue.

James Schneider - Goldman Sachs

I was wondering if you could give me an update on the inventory situation at your customers outside of the WAN space, so storage and Fiber to the Home, printer, et cetera?

Mike Zellner

As we mentioned in the last quarter's call, we had seen some inventory burn-off happen in the storage business in Q2, a bit more in Q3, a little bit more in Q4. So it started a little earlier and it seems to be coming in at a lower rate than in the WAN business. We think we'll be largely done with that in Q4. So that seems to be in pretty healthy shape in the enterprise storage business.

The printer business has been coming on strong all year, had a big quarter last quarter. But I think the combination of kind of catching up with the in-market demand as well as replenishing some of their inventory levels, we're expecting that to be down several million dollars this quarter quarter-to-quarter.

So it probably won't take longer than that to work the inventories back to normal levels, but we'll definitely take a hit this quarter from the printer part of our business.

And then last, but not least, I think the WAN business, as we've talked about, there has been an impact. We think that we're going to be working through a lot of the inventory issues in that business as well in Q4. So as I mentioned, we're cautiously optimistic that we'll get back to normal end market levels by Q1 of next year.

James Schneider - Goldman Sachs

And then maybe as a follow-up on Wintegra, can you give me a sense of what cost synergies there may be with respect to OpEx between the two companies, if you can quantify those and what they might be?

And then second, I think traditionally if I look at DS1, the traditional backhaul segment for Wintegra is about two-thirds of the business with the other third being composed of broadband access or in base station or in (inaudible) parts. Do you see those other two parts as being strategic to the business and you want to continue those as well?

Mike Zellner

Let's take the first comment. We don't view this transaction as a consolidation type of transaction where there is a lot of overlap. It was a lean organization. We really view this as a growth opportunity. They have a wonderful position, and we're going to try to leverage that. So I don't expect there to be a lot of OpEx synergies, and that isn't the real focus of it. So I don't have a good number for you there. It's really about growth and about capitalizing on this new market opportunity.

The second part of your question, their wireless-oriented business, I'll say wireless transport as well the R&C part of it, which is also essentially transport connecting things to the network, is roughly 90% of their business today. They have gone through a pretty substantial transition of their business and their customers over the last two years.

Today, it's heavily weighted into the broader wireless arena. And that's where we'd expect to continue to focus, although there is clearly applications for the technology on that in some lower end router applications as well as some other aggregation and carrier using that application. So at least in the near term, a lot of focus on the wireless mobile backhaul market.

James Schneider - Goldman Sachs

And if I could just sneak one last one in, just a housekeeping question may for Mike. I know the deferred revenue has jumped quite a bit in the quarter. Is that just the Adaptec channel business coming through or is there something else going on there?

Mike Zellner

First of all, as you know, we do account for it on sell-through basis. So there is nothing there. We've taken the revenue. Same thing is with our OEM customers. There is a little bit of inventory digesting going on there. So that accounts for $5 million of that. So there is a bit of digestion that's going on there, just like with our OEMs. So that's what I'd say it is more than anything else. But again, it's not in our revenue.


(Operator Instructions) And the next question comes from Ruben Roy of Pacific Crest

Ruben Roy - Pacific Crest

Greg, can you expand a bid on the Fiber to the Home business, specifically as it relates to China and what you think might have caused the delayed bids at the two carriers you mentioned? And also, you talked about 10-gig EPON evaluations in Japan. Are you doing the same in China at this point and what is the competitive landscape looking at the 10-gig node?

Greg Lang

Fiber to the Home, we've hoped this pattern would break over the last few years, but it still seems to be a first half-loaded phenomenon in China and then second half comes in at a lighter level as inventory gets burned through. And it appears that that's going to be the same scenario this year. But that's at a high level just in terms of how revenue comes in, but it is interesting that the second half award hasn't been placed. We're not sure why.

So I think that's a CVD reduced thing. The demand is still there. There is clearly a lot of infrastructure to be built there. So we think that will come back. But at this moment, it's a little bit of a mystery for us as well.

The second part of your question on 10-gig, Japan definitely lead the world on EPON, but I think the gap will definitely close with 10-gig. Japan has really concrete deployment plans right now, and I think China will be pretty close behind in terms of 10-gig trial plans as well. So I do think in 2011 we'll see 10-gig trials at a minimum next year, and we expect to be a part of that.

On EPON basis, I don't expect the competitive dynamics to be much different. I think it will be ourselves and Teknovus, now Broadcom, who will be the big providers there. It's just like in the 1-gig market.

Ruben Roy - Pacific Crest

In terms of the inventory work down, you mentioned both North America and China slowed for you and both of the geographies had the inventory builds. In Q3, did you see that at the same time or it was one geography earlier than the other? And also, when you look out into Q4 and you're cautiously optimistic that you're going to see the flush kind of complete by the end of Q4, do you expect it for both geographies, or is one behind the other?

Greg Lang

It was pretty close. I think we saw signs of it first in China, but the dollars of decrease were actually larger out of North America. So they're both down meaningfully and North America is leading that race.

One of the reasons that we feel like this will be kind of the bottom, if you will, for this part of the business is just the sharpness of the decline. And if you go back and look at the run rate from last year and where we came in at this year, we feel like we are going to work a lot of this through this quarter and hopefully be back to the normalized rates in Q1.


The next question comes from Srini Pajjuri with Calyon Research.

Srini Pajjuri - Calyon Research

If I look at your WAN business, I think it's back to almost December 2009 levels. Just curious as to why customers built so much inventory in the first half of this year I guess. And also, why do you think this is pretty much inventory as opposed to a demand correction?

Greg Lang

I think that there has been this behavior not just in this business. I think it's affected multiple areas, perhaps almost every area of the supply chain. And supply has been tight and customers have looked to secure supply and in some cases ahead of demand and in some cases far ahead of demand. It's something that we try to monitor and manage. But frankly it's out of our visibility and out of our control.

So I don't know if any other good reason other than just making sure they have products to support their demand. Supply is loosening up, so we see now an opportunity for people to actually work down their inventory and get back to a call it more normalized bookings rate.

The second part of your question was, are there any other fundamentals? Actually, the reason that we think the business will pick back up is the fundamental growth service, and I mentioned earlier are impacting networks around the world today. It's not a phenomena that's going to happen maybe a year, two or three from now.

We all I think experienced the mobile bandwidth crunch on our smartphones, it's clearly to have thing with video growth on the regular networks. And we see that the next big wave of deployment other than just trying to keep up will happen as people start to deploy OTN networks next year, which really takes a big step function increase and move forward in both bandwidth and efficiency on the networks.

So we think the fundamentals are there for multiple user growth. People need to put in that infrastructure. Then last but not least, there's obviously still a number of emerging (GOs) around the world that just are lacking infrastructure that will need to continue to build out. So for all those reasons we see this is a multi year opportunity for us and one that you know, despite some lumps here and there, up and downs, we think it's a net growth opportunity for us for several years.

Srini Pajjuri - Calyon Research

Greg, just a quick follow-up. On the storage for Q4 you're guiding for flattish growth. My understanding is storage is generally up because of seasonality in Q4. Are you seeing somewhat of a muted seasonality and no budget flux talk or is there inventory there as well? And also finally, if you can quantify the OTN opportunity, just give us some rough ideas to how we should think about it for next year.

Greg Lang

Yes, sure. I think we're seeing a combination of what you said. A little bit of broad level inventory burn off, and it's leading to essentially a muted seasonality. So I think there's a little bit of both. There is kind of the same behavior there, although it seemed to be more modest and started to work itself up sooner. There are some areas that we know there is still some inventory to burn off in storage, but it appears that it's much smaller scale than what we saw on the WAN base.

On the OTN front, we think that the opportunity starts at the end of next year for us, as our product gets into volume production. It obviously depends on what our customers actually start to ramp platforms. But we think it's in the double digit millions for 2011 and should grow from there.


(Operator Instructions) The next question comes from Mark Lipacis with Morgan Stanley.

Mark Lipacis - Morgan Stanley

A question on the Fiber to the Home business. Greg, could you talk about whether or not you think that there's a risk of you loosing share in that business either to competition or to internal suppliers that any of your customers?

Greg Lang

Well, in all of our businesses, there's always risk of loosing share. I don't believe that there's been any material share shifts since probably this time last year when there was some in the China market in particular, we lost some share. The real challenge for us in this business has been one of just end-market growth. And the end-markets have grown slower partially due to the CapEx requirements and increasing the bandwidth.

My first comment was based on kind of competitive ASSP alternatives. The one other place that I think this was announced in Q2 of this year, is while they have decided to build their own ONU device for the EPON and GPON market. So that is actually for us kind of a next year loss to kind of an in-house type of supply situation.

So that's probably the most recent data point. And that will over the next year impact our revenue. However, I think the bigger concern right now for us is just the rate of growth in the marketplace. We'd like to see it grow. I'd point out the flip side is, is there are some challenges there. There is also growth opportunities in GPON. As I mentioned, we won a big tier-1 GPON design win with North America player and also with tier-1 in Europe.

So while there is some places that we may lose some business opportunity there also places that it's growing. So on the whole, we're really looking for this market to grow and kind of break out of this kind of, I'll call it China, Korea and Japan phenomenally, and grow into other parts of the geography or other parts of the world.

Mark Lipacis - Morgan Stanley

If I could a get a quick follow up in, I was just looking at the Wintegra S-1 that they filed at the end of July, and they mentioned their biggest customers being Alcatel-Lucent, Tellabs, Ericsson. I didn't notice any of the China OEMs and the top customer base. And I was wondering if you could share with us your view about whether or not that's an opportunity or that's part of the business that maybe blocked off for one reason or the other.

Greg Lang

It's a good question actually. I probably should have mentioned that earlier. We actually have, turning points, we have a very complimentary target sort of customers. Complimentary is I should say overlapping or very, very similar set of customer. The top guys that they target are the same top guys that we target. However, the success that they've seen, the early success was in Europe as you pointed out. ALU, Cisco, Ericsson are kind of the top guys, may be Tellabs is in there as well. So very European, North America centric. And our strength has not been in Europe, it's been more North America and China.

So I think together we're going to able to leverage each others strength. We should be able to help some of the penetration in China and they should be able to help some our penetration in Europe. So I think that this will actually work to be very positive for us.


The next question comes from Sandy Harrison of Signal Hill.

Sandy Harrison - Signal Hill

If you guys could do a quick update on the Adaptec business and their supply chain and what it is they have from a systems architecture and then some of the silicon you guys have been talking about doing. How are the integrations on that going either for current products? And then same sort of question as far as future products that you alluded to when you did the deal?

Greg Lang

So the product line-up that came over the big challenge they had in their product line-up is they didn't have a 6-gig SAS solution. So the most obvious conclusion is we need to move their rate stack over to our silicon and get a 6-gig product in the market and fill that hole as quickly as possible. So we expect that to happen in the first quarter of next year, probably late first quarter next year. And we expect to see some revenue growth come from that.

The other area where they actually have a industry leadership position is actually in the realm of caching which what this really does is, when you have an environment that's utilizing SSDs, to get the full benefit of the performance of those drives, you can use a technique that allows to use that SSD as a cache and move warm data, let's say data that is being accessed often, you put it in that drive and have the access time speed dramatically reduced, order of magnitude reduced.

And we're seeing something on the order of 26 times the performance levels of non-SSD cache environment. And that's even on a 3-gig platform. So we're moving that to 6-gig. We're actually deploying that in a pilot today in a major datacenter in North America and exploring it with a number of other data centers around the globe as well. So a lot of interest and a lot of opportunity for us to really kind of reset the bar in performance with SSD and hybrid type of environments.

And then the last thing I'll comment on is that there is a very good opportunity for gross margin improvement as we move to PMC silicon for their product line-up. Needless to say, buying the external silicon is a margin hit for them and substantially lower cost. So we'll see that start to impact our financials probably in the second quarter of next year, more so in the second half.

Sandy Harrison - Signal Hill

So I'm assuming that the OpEx that you guys are talking about seeing that Mike outlined for Feb-March seeing increase for tape outs and others just for allow the components that are going into what you just described, Greg?

Mike Zellner

That's a good point. But there is no real growth in the OpEx related to the Adaptec business. This is really into getting silicon out the door. We have an incremental tape out hit this quarter and some additional heads that we brought out last quarter that will hit us for the full quarter this time around. So those are the drivers behind the step up in OpEx.

Sandy Harrison - Signal Hill

You'd mentioned on your prepared remarks talking about the North American cable opportunity. You're seeing some more opportunity in the cable infrastructure here in North America and some other areas, that's a relatively new environment for you guys to participate in. What is driving you into that? is that the market coming to you, or you going to the market?

Greg Lang

Well, I think the market needs new technology. The cable infrastructure is running out of gas. And to continue to expand the bandwidth they offer to their customers and the services they offer to their customers, they need a bigger, richer infrastructure and the natural extension for them right now is to use PON technology to do that. So there is a lot of work to do. This is a couple of years off before there is real products and revenue that come out of the cable space. But there is a tremendous amount of interest from the cable community to leverage PON technology to do just that.

Sandy Harrison - Signal Hill

Is that EPON or GPON based?

Greg Lang

North America will be EPON based, we believe.


The next question come from Harlan Sur with JPMorgan.

Harlan Sur - JPMorgan

I know it's early days, but are you ramping the hi-fi solution here in the fourth quarter with just one customer or with multiple customers.

Greg Lang

Well, parts will be going out to many, many sockets this quarter. The actual revenue ramp will vary by customer depending on how close they are to getting their products into trial. But it's going out to more than a dozen customers this quarter. There are many devices going out as soon as we get the production silicon out of the factory.

Harlan Sur of JPMorgan

And I think you talked about the GPON wins. To my recollection, this is the first time you guys have secured some GPON wins. Is this for OLT or ONU or which side of the fiber are we talking about here?

Greg Lang

Just to update on the history, we have won a number of designs at some smaller ODMs who tend to serve the bigger OEMs. So the names aren't familiar, but the people they serve are. These two, I think you're correct in saying it's probably the two highest profile tier-1 type of customers and they're both OLT. So carrier side related which is kind of the higher barrier and stickier of design wins.

Harlan Sur of JPMorgan

And then in terms of the overall declines in the fourth quarter, you mentioned WAN infrastructure, ASICs and Fiber to the Home. Can you kind of, Greg, just rank order these in terms of magnitude of the decline or contribution to the decline?

Greg Lang

The two biggest parts are really the printer inventory correction and it's roughly half, and the other half is roughly NTT pulling down their OLT builds for the end of the year.

Harlan Sur of JPMorgan

I think you threw out some of these numbers and I think we've all been looking sort of that Wintegra's S1, but if you're kind of thinking about 2011 at a high level, I mean $75 million to $80 million in revs, 70% gross margins and about 30% operating margins, is that sort of how we should think about that business?

Greg Lang

It's early to try to pin point a number there. I think if they finish this year in the mid to upper 50s, and I mentioned that we see at least 20% growth there, that gets us up in $60 million, may be $70 million. I also mentioned the top earn-out is at $80 million. So that's probably the high and low of what we would expect next year.

A lot of it also depends on just how this year finishes out. So I would say that range is probably, like I said the high and the low. The operating metrics, I would expect those to improve at the bottom line and I would expect their gross margins to stay in the same zone that they were in, in Q2 of this year. That's when they updated it at about little over 70.

So gross margin is very much in line with our company average, a little bit better. Operating margins, we think we'll also get in line with our company average as well.


The next question comes from Kevin Cassidy with Stifel Nicolaus.

Kevin Cassidy - Stifel Nicolaus

As you're looking at your product line-up, is there a chance of future products using the Wintegra processor using some PMC IP, can you integrate your two product line together?

Greg Lang

I think if you look at some of the designs that we sit next to each other today, it's basically we do the TDM physical layer stuff, if you will, and are doing the network processing. And so there is a very complementary nature in that arena today. We think the next generation has opportunities for some integration in higher-value content.

We also think, as we move further into the aggregation network, there are additional opportunities for us collectively to go after a bigger piece of the aggregation market as well.

The one thing that I'd point out with these designs is because the network processor is very heavily software-centric, they're running a lot of software on the network processor itself, I believe they wouldn't have three actually processors, something on the order of 60 different protocols. They also make the designs very, very sticky. In software generation, there is a lot of leverage in those designs. Our complementary footprint going forward gives us a lot of different opportunities in these segments as well as adjacent segments.

Kevin Cassidy - Stifel Nicolaus

Maybe to follow up further, any other ingredients in the combination of your software that you might still need to become a bigger force?

Mike Zellner

I think a lot of this is within our own ability to handle it organically, and I am sure there are technology pieces that could help us accelerate. But along with this, we can also do organically.


The next question comes from Mike Burton with FBN Securities.

Mike Burton - FBN Securities

Can you describe who are the primary competitors for Wintegra and what's their primary differentiator?

Mike Zellner

Some of the historical competitors in this space are some of the other network processor type of guys, so EZchip, Cavium that historically have been competitors. I think if you go back in time further, Intel and their network processor business, LSI and their processor business, et cetera. So because of all the different protocols that have to be processed, it is a network processor oriented target.

And fundamentally, just at a high level, the reason that they have done so well is that they really built their product not as a general purpose processor, but a very application-specific solution from all the way down at the silicon level, the hardware acceleration that they do, the software applications that they write. It is a very mobile backhaul data path focused part. And that really helps them win a lot of these sockets from the base station all the way through the access navigation spots.

Mike Burton - FBN Securities

For North America and China, did you mention which one you expected to come back first, and have you seen any signs yet that give you comfort that the correction will be over in Q4?

Mike Zellner

Which one will come back first, it's hard to tell. I am not sure that I have a good answer on that. One of the reasons that we are gaining confidence that we'll get through this quarter is we actually see our bookings over the last few weeks in particular start to come back.

There was a transition from early, early bookings in the last couple of quarters to more normalized booking patterns. And when that happens, there tends to be a little valley that you get through. And I think we've made it through that valley and bookings are starting to come back to normal. So it does feel like things are normalizing a bit. And so once we work through this, we're cautiously optimistic we'll be through this quarter.


There are no further questions at this time, please continue.

David Climie

Thank you everyone. Thank you attendees for listening in on our conference call today. We will be scheduling our fourth quarter 2010 conference call through the last week of January. And in that time, we'll be reviewing our quarterly results and providing an outlook for the first quarter of 2011.

So that ends today's call and thank you for attending.


Ladies and gentlemen, this concludes the conference call for today. We thank you for your participation. You may now disconnect your lines. Have a great day.

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