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LSI Logic Corp. (LSI)

Q4 2006 Earnings Conference Call

January 24, 2007 5:00 pm ET

Executives

Tom Tran - Director of Investor Relations

Abhijit Talwalkar - President and CEO

Bryon Look - Executive Vice President and CFO

Analysts

Mark Edelstone - Morgan Stanley

Suji De Silva - Cathay Financial

Shebly Seyrafi - Caris

Sumit Dhanda - Banc of America Securities

Phil Zhu - Wedbush Morgan Securities

Tayyib Shah - Longbow Research

Hans Mosesmann - Moors & Cabot Capital

Seogju Lee - Goldman Sachs

Michael Cody - B. Riley and Company

Presentation

Operator

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the LSI Logic's fourth quarter and full year 2006 conference call. During today's presentation, all parties will be on a listen-only mode. [Operator Instructions]. This conference is being recorded, Wednesday, January 24th of 2007.

I would now like to turn the conference over to Tom Tran, Director of Investor Relations. Please go ahead, sir.

Tom Tran

Good afternoon and thank you for joining us for the LSI Logic fourth quarter and full year 2006 conference call. Our earnings release has crossed the news wire today at approximately 1:10 p.m., Pacific Time, and has been furnished to the SEC and posted on the LSI Logic website.

The telephone replay of this call will be available after 4:30 p.m., Pacific Time. The replay phone numbers are 1-800-405-2236 in the US and 303-590-3000 for all other locations. The pass code is 11081403. The telephone replay will be available for 48 hours. The webcast replay will be archived on the LSI Logic website for one year.

We will start the call with brief opening remarks from LSI Logic President and CEO, Abhi Talwalkar; followed by Bryon Look, our Executive Vice President and CFO, who will review the fourth quarter and full year 2006 financial results and comment on the guidance for the first quarter of 2007. After Bryon, Abhi will provide his perspective on the current business environment and outlook. We will then open up call for questions.

I would like to remind you that during the course of this conference call we will make forward-looking statement about LSI Logic's business outlook. We caution you that such statements are predictions, are subject to risks and uncertainties, and do not guarantee future results, level of activity, performance or achievement. Actual events or results may differ materially from these statements. For a detailed description of these risks and uncertainties, please refer to the documents the Company has filed from time to time with the SEC over the past 12 months, including our most recent Form 10-K and 10-Q. Our forward-looking statements and all other statements that are not historical facts reflect our beliefs and prediction as of today. Also, LSI Logic is not obligated to update the forward-looking statements made during this call to reflect events or other circumstances after the date of the call.

During this call, we will also be citing GAAP results as well as our results excluding special items. A reconciliation between the GAAP to non-GAAP results, which excludes specials items, and can be found on the homepage of our website, "lsi.com."

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

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Abhijit Talwalkar

Thanks, Tom. Good afternoon, everyone, and thank you for joining us today. I am sure all of you have had a chance to quickly glance at our earnings press release. As we look back at 2006, I'm very pleased with the tremendous progress we have made as a company.

We stayed focused and executed according to our plan to successfully transform from a technology driven company to a market driven company closing the year with the announcement of the intent to merge with Agere Systems. I will be providing a brief update on that transaction later on in the call.

On the financial side, Q4 was a solid quarter for us, driven by strong performance in our storage business, both semiconductor and system storage, with a revenue growth of 10% sequentially quarter over quarter and 16% growth over prior Q4 2005, including a record revenue for our systems business, which saw a 22% sequential growth and 8% growth over prior quarter in 2005.

For the full year, storage semiconductor and system revenues grew at a healthy double-digit rate of 14% and 12%, respectively. And we closed 2006 with $0.58 per share on non-GAAP earnings, which represented a 38% growth over 2005 levels. Overall, a very strong financial performance for the Company.

Now, let me move on to the product side of our business. Let's talk first about consumer. Q4 was a very busy quarter for our consumer group. As a part of our ongoing strategy to maintain and enhance our leadership in the consumer market segment, LSI acquired Metta Technology to enhance its DoMiNo and ZEVIO platform initiatives.

The Metta team is experienced in video processing algorithms and is based in Pune, India, which also allows us to maintain a competitive R&D cost structure for the highly competitive segment.

We stayed focused on maintaining our leading market segment share position in DVD recorders, while opening up new opportunities in the consumer market. To address the geographic requirements as the world transitions from analog to digital, we announced the availability of new DVDR and iDTV set-top box products, such as the DoMiNo 8604 and the DoMiNo 8833.

What's notable is that DoMiNo 8604 won the EDN award for innovation in consumer electronics competing against 131 products across 74 different countries. We introduced the ZEVIO 1020 multimedia application processor, the first LSI standard product IC based on the ZEVIO architecture, which announced last year at CES, is it's just targeted at low power, portable devices such as electronic toys, entertainment products, and other digital consumer appliances.

The first product based on ZEVIO, VTech's Vflash home entertainment console started shipping at major retailers during the third quarter and was in US retail for the Christmas selling season.

We also introduced our Domino[X] architecture in October, which then subsequently received a prestigious CES Innovations Award for enabling technologies. Domino[X] is ideal for products that utilize MPEG-2, H.264 and BC1 compression for decoding, encoding and transcoding of high-definition digital video content. Products based on Domino[X] are expected to ship towards the latter part of 2007.

Finally, LSI concluded a very successful CES 2007, where we showcased our latest technologies and products based on DoMiNo, ZEVIO and Domino[X] to our existing and future customers with strong positive reception.

Clearly, however, second half was a challenging half from a consumer revenue perspective, as we were dealing with some expected decline on our portable audio player business and some expected softness in the DVDR market, as we've discussed in the last earnings call.

From a storage standpoint, Q4 was seasonally strong for us across all our storage product lines. And I want to just highlight some of the more notable milestones. We announced and completed the acquisition of StoreAge, which expands our data management and copy services software offerings to customers continuing and executing to our strategy to increase the value we deliver to our customers in our systems business.

Performance for the systems business was driven by a very broad and strong demand for our Midrange Systems, including our newly 3994 integrated 4-gig Fibre Channel external array. And our supply chain and production capacity fully met customer demand in the quarter, and we're well positioned going into Q1, continuing to meet our customer demands.

We announced the first new members of our entry external rate array product line. This is really targeting at the price band 1 to 3 in December and in early January. These new products, which represent a whole new segment for LSI, are targeted for the fast -growing entry segment, which is growing at greater than 20% per year levels.

These products support fast and Fibre Channel coast connectivity with fast hard disc drives. These products are designed for customers who need to grow beyond internal storage or enterprise and departmental customers that want an affordable easy-to-manage storage area network solution with improved availability and performance for data consolidation. These platforms from LSI round out one of the most broadest portfolios of fast solutions in the industry from silicon-to-systems.

In the fourth quarter, we also announced the sampling of our second-generation MegaRAID software as well as RAID-on-Chip SAS adapters. These new products provide high performance internal RAID solutions supporting RAID 6 for entry level server and small office environments.

We've been talking a lot over the last several calls about the SAS ramp. The SAS ramp continues to be very strong. Over 70% of our standard product shipments in the second half of 2006 were SAS compared to Ultra320 scuzzy. We shipped over 1.5 million SAS controllers in the second half of '06, again reflecting a very broad support of our products in the acceptance of SAS in the marketplace.

SAS based external arrays are now starting to hit the marketplace with our introduction as well as some of our lead OEMs coming to market with various skews. That will also be another driver to these SAS based storage technologies in the market.

On the server and storage connection to the fan, we continue to see strong demand in Q4 of 2006 for circuits used in 4 gig Fibre Channel host bus adapters and the industry transition to 4 gig Fibre Channel ports will continue as prices move toward parody point with 2 gig products. In addition, we saw the continued growth of 4 gig Fibre Channel bridge products used for adapting SATA drives to Fibre Channel based storage systems. Overall, a very solid quarter and I'm pleased with the progress on all fronts.

Let me now hand it over to Bryon to provide you more details on our financials.

Bryon Look

Thanks, Abhi. Fourth quarter 2006 financial results continued a positive trend we experienced throughout the year. Q4 revenues and non-GAAP earnings per share were at the high end of our guidance range, while GAAP EPS exceeded our Q4 guidance. Full year 2006, non-GAAP operating income was $233 million, which is up 17% compared to the prior year on a revenue increase of 3%.

Here are some of our fourth quarter highlights. Revenues for the quarter were $524 million, an increase of 6% over the prior quarter, and a 3% improvement over Q4 a year ago. GAAP operating income was $44.1 million. GAAP EPS for Q4 was $0.14 per diluted share.

Non-GAAP operating income was $67.8 million, up 8% from Q3, and our best performance since Q4 of the year 2000. Non-GAAP EPS was $0.18 per diluted share. Cash and short term investments at the end of Q4 were over $1 billion, after repaying $272 million of convertible notes.

Fourth quarter revenue from our storage system segment increased $40 million over Q3 to a record $220 million. This increase represented sequential growth of 22% over the third quarter and 8% versus Q4 a year ago.

Demand for our high performance storage systems continues to be very strong, and we introduced our entry level price band 1 to 3 products in the quarter, as Abhi mentioned. All product lines grew significantly in Q4 with particularly strong demand from IBM and Sun. Storage systems represented 42% of total LSI Logic revenue in the fourth quarter and 38% of the total 2006 revenue.

Now let me turn to the three markets that comprise our semiconductor segment. Our storage semiconductor revenues were $189 million, down 1% from Q3 and 27% higher than Q4 last year on the strength of our SAS controller business. Storage semiconductors represented 36% of total Q4 LSI Logic revenue.

Combined storage semiconductor and storage system revenues grew 16% compared to the same quarter a year ago. Combined storage semiconductor revenues and storage systems revenues totaled 78% of LSI revenues in Q4, and 73% of the total 2006 revenue.

Consumer revenues were $40 million in Q4, declining 15% from Q3. Cable and set-top box shipments were lower due to customer inventory positions. We remain excited about ZEVIO and Domino[X] platforms and continue to make progress in these areas. Consumer semiconductors represented 8% of total LSI Logic revenue in Q4 and 11% of the total 2006 revenues.

Q4 revenues in communications and other markets were $76 million. Communications revenue continues to be steady compared to Q4 a year ago. For the fourth quarter, communications and other markets represented 15% of revenue and 16% of total 2006 revenue.

The geographic revenue split for the company in the fourth quarter was as follows. North America represented 51% of revenue, Pan Asia was 37%, and Europe was 12%. In 2006. North America represented 49%. Pan Asia 40%, and Europe 11%. The total geographic distribution of revenue was similar to 2005. Q4 gross margin, excluding special items, was 43.6%, which was in line with our guidance and prior-quarter results.

Semiconductor segment gross margin was 49.9% in the fourth quarter, up from 48.2% in the third quarter and 46.7% in the fourth quarter a year ago. This improvement is the result of our continued focus on product cost reductions. We have successfully transitioned to a fabless company during the year and continue to work with our supply partners to drive down costs.

Storage systems gross margins declined by 150 basis points to 34.8% in Q4. While we've also seen productivity improvements in our storage systems business, strong demand at the end of the year required us to expedite suppliers for which we paid one-time premiums.

In the fourth quarter, we also began to experience some new system product startup costs, and we expect these costs to last through Q1 as we finish the retooling of our factory for these new ramping products.

Q4 operating expenses excluding special items totaled $160 million, up $7 million from Q3 and slightly above guidance as we closed two acquisitions during the quarter in addition to some normal variation in spending. For the year, we met the majority of the efficiency targets that we set for ourselves.

In 2006, annual non-GAAP SG&A expenses improved as compared to 2005. On a percentage of revenue basis, total non-GAAP operating expenses declined for the full year 2006 compared to 2005 and for the fourth quarter 2006 compared to Q4 of 2005. For the quarter, non-GAAP R&D expense was 20% of revenue, and SG&A expense improved to 11% of revenue.

Interest expense combined with interest income and other, excluding special items, netted to $8.7 million of income for the quarter. Costs and expenses associated with special items for the quarter totaled $19 million.

These special items included a $10.9 million expense for stock-based compensation associated with the adoption of FAS 123R, $3.6 million in amortization of acquisition-related items, a $4.2 million write-off of in-process R&D related to our Q4 purchases of Metta and Storage and $5 million in severance and other restructuring costs, all offset by $4.7 million of gain on the sale of investments.

The FAS 123R expense was allocated as follows: $1.2 million to cost of sales; $4.3 million to R&D; and $5.4 million to SG&A. The taxes for the fourth quarter on a GAAP basis were a benefit of $1.5 million. On a non-GAAP basis, the tax provision was $1.5 million. The tax provision for Q4 was favorable to our prior guidance due to the geographic mix of profitability during the quarter.

And for Q1 2007, we expect the effective tax rate for non-GAAP to be 15% and 21% for GAAP purposes. On a GAAP basis, fourth quarter net income was $59 million or $0.14 per diluted share, which was an improvement of $0.03 per diluted share from Q3. Net income excluding special items was $75 million, or $0.18 per diluted share, up $0.02 per diluted share from Q3.

Our diluted share count of 437 million for Q4 on a non-GAAP basis includes the weighted average dilutive shares associated with the 2003 convertible notes, which are due in 2010.

And turning now to the balance sheet and cash flow, we had another strong quarter with operating cash flows of $51 million and full year cash from operations of $247 million. Cash and short-term investments ended the year at over $1 billion after the repayment of $272 million of convertible notes during the quarter.

Our inventory increased by $26 million from the prior quarter to 210 million as we built some inventory to enable a product transition with a large customer. And we're phasing out of a supply relationship with the buyers of our previously owned [Scubafab].

Storage systems also had increased inventory in expected response to the introduction of new products. So to summarize, Q4 was a strong quarter and 2006 was a strong year as we continue to grow revenues and earnings per share year over year.

For the full year of 2006, revenue grew $63 million to 1.982 billion. On a non-GAAP basis, we reported profit of $236 million, 42% higher than the prior year and earnings per share of $0.58 as compared to $0.42 in 2005. On a GAAP basis, we reported a profit of $170 million or $0.42 per share in 2006, compared to a loss of $5.6 million or $0.01 per share in 2005.

The following is our guidance for the first quarter: revenue in the range of 460 to $480 million, consistent with normal seasonality; consolidated gross margin, excluding special items, in the range of 41 to 43%; operating expenses in the range of $158 million to $162 million, excluding special items, interest expense, net of interest income and other of $5 million of net income.

Special items netting to approximately $20 million, including $10 million of expense related to adopting FAS 123(R), and $5 million of amortization of acquisition-related items. We're guiding to GAAP EPS in the range of $0.03 to $0.05 per fully diluted share and EPS excluding special items in the range of $0.08 to $0.10 per fully diluted share.

At this point, I'll turn the call back over to Abhi, who will comment on our end markets and the business environment.

Abhijit Talwalkar

Thanks, Bryon. Let me take a few minutes first and give everyone an update on the progress of the merger between LSI and Agere.

Since our investor call in December to discuss the LSI merger, we have made considerable headway on our merger plans, specifically Rick Clemmer and I have met with key customers, major stakeholders and employees of both Agere and LSI. And I'm pleased to say their reactions to the merger have been very positive.

We remain confident that with our complimentary product offerings and greater resources to invest in our businesses to combined Agere/LSI Company will be better positioned to drive sustainable growth in revenue and shareholder value than either company could have on its own.

In addition, the combination promises substantial cost savings in the current year, as well as fiscal 2008 when we estimate the savings will be at least $125 million. And we continue to expect the combination to be meaningfully accretive to non-GAAP EPS in 2008. Moreover, the combined balance sheet of the two companies will be stronger and our revenue will be spread over a more diverse base of customers and products.

I would like to provide a brief update on a timeline of the acquisition. The US antitrust filing was submitted on December 18th, and the waiting period expired on January 18th. This means that the US antitrust authorities raised no objection to the merger. And we have completed one of the principal regulatory hurdles to the combination of the two companies.

On December 22nd, we filed a preliminary joint proxy statement prospectus with the SEC and we are tentatively targeting a shareholder meeting for Thursday, March 29th, with the closing date for the transaction shortly thereafter.

In January, I announced the go-forward leadership team of the combined company once we have our formal close, which includes a blend of experience from both Agere and LSI. The response here from employees and customers has also been very positive and the integration planning teams between the two companies are working well together.

Now, let's talk a little bit about our businesses going forward. In the consumer space, the worldwide DVD recorder market grew slower than originally expected during the second half of 2006. And ended up around 17 million units for 2006, which is up from about 14 million units in 2005.

LSI continues to be the leader in DVD recorder processors with Domino R, DVD record -- record processors shipping in one out of every three DVD recorders worldwide, including those sold by Daewoo, JVC, LG, lighton, Phillips and a whole host of customers.

Going into 2007, LSI expects the DVD recorder market to continue to grow over 20% per year to between 20 million and 22 million units worldwide. As discussed in the Q3 call, we took some actions in Q4 in order to ensure that we are focused on the emerging higher growth markets, such as the BD and HD as well as HD set-top box and etoys market segments.

These actions included the acquisition of Metta based in Pune, India. We also initiated a collaboration on front-end servo technology to help better leverage our R&D and improve our overall cost structure. We are going to continue to take actions here to drive profitable growth of this business.

Notable, however, is that we are -- we were able to replace the good portion of the expected decline in consumer revenue and as a company we're able to come up at the top of -- end of our revenue guidance reflecting overall strength in other parts of the company.

Relative to storage, you know, the fundamental demand drivers for the storage marketplace remained very strong. This is consistent with discussions with end customers, with our direct customers as well as industry analysts. All the drivers that we've discussed over the past year continue to be strong and we expect the -- the storage budgets within IT organizations in 2007 to be fairly consistent with 2006, which is a pretty good year.

We are well positioned on our storage growth initiatives at LSI. Although, we were pleased that we launched the initial skews of our new external entry SAS and Fibre Channel arrays in Q4, it was later than we expected simply due to the complexities associated with introducing an entirely new family of products and hardening SAS data for enterprise environments.

As a result, the overall front of the ramp is just now beginning with several of our lead OEMs, with more variance to this product line and additional OEMs coming to market later this quarter and into Q2. As noted earlier, this is an entirely new segment for us and a new growth opportunity that is growing at better than 20% per year. This will also help establish a wider customer base.

We are already heavily engaged with a number of our major storage customers on increasing LSI's software value add with data management and copy services technology, which we acquired through our acquisition of storage networking technologies. Development of our MegaRAID and RAIDON ship solutions to increase our footprint within RAID solutions that are within servers or gas oriented environments continues to be on track.

We absolutely expect our overall footprint in silicon as well as RAID software within the server and gas market segments to grow throughout this year. Development progress also continues with our customers in bringing LSI SAS expander silicon to the marketplace. This is also another expansion of our components for storage.

And, finally, we are making steady progress increasing our shareholder wallet within our customer base given unique silicon systems value proposition that we've been driving within the company. So overall, Q4 was a great quarter for us. Both from a revenue and EPS perspective. And we're looking forward to continued progress going into 2007. With that, why don't we open it up for questions? I'll hand it to Tom.

Tom Tran

Yeah. Thank you, Abhi. Operator, let's open the call up for questions.

Question-and-Answer-Session

Operator

[Operator Instructions].

Our first question will come from Tim Luke with Lehman Brothers. Please go ahead with your question, sir.

[Operator Instructions].

We'll move to the next question from Mark Edelstone with Morgan Stanley. Please go ahead.

Mark Edelstone - Morgan Stanley

Thanks a lot, guys. Abhi, I wonder if you could just give a little bit more insight into the storage IC business that you were seeing. You guys had a pretty strong third quarter as I recall and the fourth quarter's down 1% sequentially. Can you say about what drove that? And then, also, does that suggest that the seasonal weakness in Q1 might be somewhat less than normal and I've got one other follow-up on the systems business.

Abhijit Talwalkar

Well, I think -- you know, the relative to -- some of the storage IC segments in terms of Q3 and Q4, I think some of that was because we ramped many, many new customers. And the whole ramp associated with some of the new X86 server platforms, which began at the beginning of Q3.

So Q3 may have been a little bit stronger, which might have muted some of the potential growth in Q4. I don't know if that's what you're referring to. But we did see some of that across some of our accounts. Relative to Q4 to Q1, I mean if we look at the overall LSI business we're down about 10%, which is as Bryon said earlier, pretty consistent with what we've seen across enterprise segments.

Mark Edelstone - Morgan Stanley

Is there -- I guess -- but given the -- you know, sort of the plateauing if you will in the fourth quarter, does that suggest -- or I guess when you look at your backlog, does your backlog suggest that down 10% in storage ICs, is it the right call and is that really more of a market-related phenomenon or inventory, or what seems to be driving that type of decline which would seem -- maybe at the upper end of seasonality, especially after a relatively flat fourth quarter?

Abhijit Talwalkar

I mean, I don't -- I don't see a real inventory issue. I mean we do have in certain customers that are ramping some new products, which, you know, can be playing a factor into that relative to some of the strength in Q4 across some of these customers versus what's happening in Q1. So there's always a little bit of a guessing game in the midst of transitions. There's some of that going on. But it's not large enough to impact the overall sort of dynamics of our storage business. So we feel the business is pretty consistent with past experience and seasonality.

Mark Edelstone - Morgan Stanley

Okay. Fair enough. And then on the systems gross margin, can you just talk about what the shape of the recovery might look like there especially taking into account the changing mix as you go through this year and where might we see those margins go as we go through the year?

Abhijit Talwalkar

Bryon, do you want to comment and I can certainly add to it?

Bryon Look

Yeah. I think what we're seeing right now in the storage system business is the -- the ramps of these new products. You know, we haven't been able to get all the hard tooling in place for those products. That will happen -- that will certainly be positive to the margins going forward.

Also, as you know in that business we'll continue to try and add more value with what we can deliver to our customers and so overtime. You'll see more software content. That will also help the margins.

We just had I think -- we had strong demand certainly in the fourth quarter in that business, record quarter for us, quite honestly it was very back-end loaded and we ended up needing to expedite, pay overtime to get some of the products manufactured, things like that, which took our margins in that business down to roughly the mid-30s but 35% kind of range.

I'd expect it to be kind of hanging in that range for the next quarter as we go through the -- the initial ramps for these new products. And then, you know, improving from that point.

Mark Edelstone - Morgan Stanley

Yeah. And we continue to aim into the high 30s for this business and is consistent with what we've discussed in the past.

Abhijit Talwalkar

Okay. And reasonable that you might have decided to get there before sometime the end of this year.

Bryon Look

Well, I mean we demonstrated the ability last year to do that and absolutely. I mean whether it's -- it's driving to higher volumes across these new products and getting them into hard tooling, which drives cost structures down to what we're trying to do with storage and increasing our value to increasing our footprint within host-based rate software as well as just a continued focus to drive our overall manufacturing and bond cost down now that we've got even more scale to work with. Yeah, we're --

Mark Edelstone - Morgan Stanley

Okay. Thanks a lot, guys.

Bryon Look

Thank you.

Operator

Thank you. Our next question will come from Suji De Silva with Cathay Financial. Please go ahead.

Suji De Silva - Cathay Financial

Thanks. Hi, Abhi. Hi, Bryon. With seasonality expected in the first quarter, can you talk about -- you know, without guiding the rest here obviously. Can you talk about the outlook for the rest of the year, what should we expect seasonality in storage, or should some of the new products help to provide you a strength above seasonal?

Abhijit Talwalkar

Well, I mean seasonal we're really talking about -- typically Q1 and Q2 look like versus the second half?

Suji De Silva - Cathay Financial

Sure. Yes, just the rest of the year. I mean my main question is really are the new products -- like new product cycles going to help, you know, to give you above seasonal potential performance?

Abhijit Talwalkar

Our -- you know, I don't -- I don't anticipate any share loss anywhere. And I -- we're growing and expanding through the growth initiatives that we've discussed. So our goal is to continue to drive this overall storage business at healthy double-digit rates.

Suji De Silva - Cathay Financial

Okay. Great. And then the price band went for three products, how do you expect that to track through '07? Will there be a second half of the year growth through that or how is that going to play out?

Abhijit Talwalkar

Well, I think a lot of that's just dependent upon getting all of our customers out all of the -- the family out. We've got two of the major skews for this family out, which is the SAS and fiber channel, host connectivity products with SAS. We're working on more variance and just bring even more comprehensiveness to the product line.

And we've got several OEMs now that have been announced. And we're all busily working and driving this whole new category and ramp. So I think the better part of Q1 and Q2 will be focused on ramping all those customers and all those product skews.

Suji De Silva - Cathay Financial

Okay. Thanks. That's helpful. And then a last question on DVD-R. You gave an outlook for '07 for the market. Do you have a sense of whether your share should be consistent with '06, or do you expect to gain share there? What are your thoughts on that? Thanks.

Abhijit Talwalkar

Well, I think our -- based on -- this design win activity over the following several quarters, we expect our share position -- segment share position to be consistent.

Suji De Silva - Cathay Financial

Okay. Great. Thanks, guys. Good luck.

Abhijit Talwalkar

Thank you.

Operator

Our next question will come from Shebly Seyrafi with Caris. Please, go ahead.

Shebly Seyrafi - Caris

Yes. Thank you very much, guys. So looking at your segments. All segments for 2006 grew double-digits except the consumer segment, which declined about 40% year-to-year. I'm wondering how much patients you have with that business? What are your plans if this business doesn't really grow and produce enough profitability on -- maybe you can talk -- elaborate on that? Thank you.

Abhijit Talwalkar

Well, I think -- answered a very similar question in the last call. We continue to see growth opportunities. We're focused on driving profitable growth for the Company, double-digit topline as well as double-digit bottomline improvement. And that's what the higher level objective is where we have more of a platform orientation where we have much deeper sort of sustained competitive positions.

At the higher level objective that we have the consumer segment itself certainly has many of those characteristics, recognized as highly competitive. You know, as we said last time, we have a timetable. We've been driving to that. We took some very specific deliberate actions in Q4 to improve the overall cost structure of that business.

And we continue to diversify that to move it away from the high exposure that we had that impacted us this last year, which was one single customer that had too much of an exposure in that particular business, PortalPlayer specifically.

Shebly Seyrafi - Caris

One more if I can. Others have talked about this, but your gross margin recovery. Do you think that toward the latter half of fiscal '07 that you can be in the, say 43.5 to 44% range in gross margins of full recovery in your gross margins as you fix your, I guess, your storage system gross margin issues?

Bryon Look

At the company level.

Shebly Seyrafi - Caris

At the company level?

Bryon Look

You're talking about the company level back around 43 to 44.

Shebly Seyrafi - Caris

Right, exactly.

Bryon Look

I'd say, I mean, we're not really giving guidance here for gross margin for the second half of the year, but I think, you know we can definitely pinpoint what happened with respect to the margins in the systems business. And, again, on the semiconductor side, we saw strength in terms of our gross margin performance here, so no reason to point anything beyond that.

Shebly Seyrafi - Caris

Thank you.

Operator

Our next question will come from Sumit Dhanda with Banc of America Securities. Please go ahead.

Sumit Dhanda - Banc of America Securities

Yeah. Hi, good afternoon, guys.

Bryon Look

Hi.

Sumit Dhanda - Banc of America Securities

A couple of questions. First on the gross margin outlook for Q1, are you suggesting a drop in semiconductor gross margins, too? Because if I just flat line your current gross margins within the systems business, I have a hard time getting to the 41 to 43% guidance.

Bryon Look

Well, you know, clearly there's going to be some effect on the semiconductor side with the lower volumes that we'll see given to the overall revenue guidance that we have for --

Sumit Dhanda - Banc of America Securities

For the fabless business?

Bryon Look

So there's nothing fundamental, I would say, with respect to, you know, the products or our positions or anything like that to suggest a weakness there.

Sumit Dhanda - Banc of America Securities

No. I understand. But from 50% gross margins that would imply close to 48 and given that it's an outsourced manufacturer model, why is it a significant negative leverage?

Bryon Look

You know, I think it comes down to the volume and the mix that basically drives, you know, that sort of gross margin guidance that we've got out there, which is in that 41 to 43% number.

Sumit Dhanda - Banc of America Securities

But your mix should improve with lower consumer business in Q1?

Bryon Look

I've said before, that there is a lot of differences in the product margins across every one of our different markets. So it's --

Sumit Dhanda - Banc of America Securities

So let me switch gears. On the operating expense side, relatively flat on a pro forma basis sequentially. Number one, why is that given that, I mean, I would assume, lower OpEx with seasonally lower revenues. And then, number two, why are we not seeing more cost savings given that your cost savings are supposed to start kicking in Q4 of '06 or Q1 of '07?

Abhijit Talwalkar

Well, we have seen some cost savings as you look at the SG&A line, but if you think about the acquisitions that we announced, they were -- they happened mid-quarter in Q4. We didn't have a full quarter worth of the operating expenses associated with either one of the two transactions that we had announced in the fourth quarter. So that's partly reflected in the first quarter outlook for OpEx.

Sumit Dhanda - Banc of America Securities

How much would you -- how much would you say is incremental from an OpEx perspective as it relates to these acquisitions in Q1 versus Q4?

Abhijit Talwalkar

Let's see, I would say that in terms of if you combine storage and Metta, you're probably talking about adding to our expense on a quarterly basis of about maybe $4 million, something like that. And, again, these you know, came in fairly late in terms of the fourth quarter.

Bryon Look

Yeah, you know, and that number is very consistent with what we said for the last couple quarters around SG&A being at a point where we're driving a $15 million annual savings and seeing and realizing that was then sort of that result annual run rate starting this quarter.

Sumit Dhanda - Banc of America Securities

Right. So this is not the delays --

Abhijit Talwalkar

-- this is why OpEx is staying sort of flat.

Sumit Dhanda - Banc of America Securities

Right. Okay. I understand that. So let's say $4 million quarterly savings that you'd forecasted via your cost savings actions offset by the increase in OpEx as it relates to these acquisitions. But why not lower OpEx given the seasonal fairly short of seasonal decline in revenue as it's for base systems?

Abhijit Talwalkar

Well, we have mostly fixed costs with respect to our operating expenses. I mean there is a component as related to you know, sales commissions. But it's you know, small relative to obviously the total expense. So I wouldn't overplay the sort of seasonal low revenue translating into necessarily seasonally lower OpEx.

Sumit Dhanda - Banc of America Securities

Okay. A couple more questions then I have overstayed my welcome here. But number one, as it relates to your storage systems gross margins, if my -- if my memory serves me right back in Q2 of '06, you'd indicated that the gross margins were unseasonably depressed because of new product ramps. And it seems like it's recurring again. So I guess my question is, is this a recurring scene every couple of quarters, because new product ramps or new programs are just part of the normal course of business. So how should we think about a consistent or normalized gross margin level for your systems?

Abhijit Talwalkar

We still believe that our natural gross margins for this business are in the mid-to-high 30s. I think we've had an unusual year with respect to lots of new product introductions. And, yes, you might argue that we had some execution challenges in doing that through the course of 2006. But I'm comfortable that we understand that well and again, I think we're comfortable with that sort of longer term range for margins in that business.

Bryon Look

Sumit, the other thing that's important is we've made some significant changes in development philosophies as well which will kick into all new products that we launched in the system space relative to the cost structure that we ramp at. And some of those development initiatives haven't completely made it across all our products. And that's absolutely going to happen on all future products that we ramp, which will significantly shorten that NPI sort of cost window dramatically. And the products that we had launched at the end of Q2 and sort of all of Q3 as well as these initial products, aren't fully sort of there relative to this new development philosophy.

So I think our ability to smooth some of this out absolutely is there and that's certainly our intent. And as Bryon said, we want to be able to consistently perform north of, you know, 35 for this business and continue to ratchet that up with the other initiatives that we have.

Sumit Dhanda - Banc of America Securities

Okay. And my last question, you know, you've seen a fast ramp within your SAS controller business, as you indicated 70% of shipments in the second half. Is there a lot more upside to be had there? Because it seems like the transition sort of, curtailing in terms of growth rate here. So--

Abhijit Talwalkar

Well, the couple things. We're just now starting to ship our SAS expanders. And there's many, many customers that we have in the development pipe that are readying their systems and getting them ready to ship. So that's a whole new category. That's out there.

Relative to our RAID-on-Chip. Right now, to a large degree we have one major customer that started ramping in Q3. As I said earlier in the call, we are on track to win seven out of ten of the top server OEMs and those companies are deep in development with us and that development is on track. They will introduce at various rates based on their strategies. But that is a silicon footprint expansion for us and that will also drag in just about every case more MegaRAID software. So that's another example of expansion for us.

Sumit Dhanda - Banc of America Securities

Okay. Thank you very much.

Abhijit Talwalkar

So there's more to SAS than just the socket in the server.

Sumit Dhanda - Banc of America Securities

Okay. Thank you.

Operator

Thank you. Your next question will come from Craig Berger with Wedbush Morgan Securities. Please go ahead. Pardon me, Mr. Berger if your line is on mute, please lift your handset.

Phil Zhu - Wedbush Morgan Securities

This is Phil Zhu for Craig Berger. Just a quick question. What is the inventory level of -- for the storage IC segment for the Q4?

Abhijit Talwalkar

The inventory level for the storage ICs. I mean, we don't breakout the inventory level of that particular business. But we don't see inventory issues across our storage product lines or our customer base, at least based on our visibility.

Phil Zhu Okay. Thank you.

Operator

Thank you. Our next question will come from Tayyib Shah with Longbow Research. Please go ahead.

Tayyib Shah - Longbow Research

Hi, guys. I just wanted to understand why you are seeing return to normal seasonality. You've talked about the fiber channel skews and the SAS skews ramping in the first quarter and second quarter. Why then are you seeing normal seasonality in the storage business? Shouldn’t the ramp mute back to some extent?

Abhijit Talwalkar

Well, the seasonality is driven by expense cycles within IT budgets, right? And, you know, typically most IT budgets out there are on a calendar basis. A lot of that heavy spending is in late Q3 and Q4, which we all see in sort of the high-tech industry and especially associated with medium and large enterprises. And they spend the better part of Q1 getting organized for 2007. And so that has an impact on overall spending patterns. So I don't think that changes anything from a seasonality standpoint.

Tayyib Shah - Longbow Research

So the new product ramp --

Abhijit Talwalkar

For the new product ramp relative to Fibre Channel 4-Gig started at the end of Q2 last year. And that new product ramp certainly had a solid benefit in Q4, right? The strength in Q4 and then Q3 relative to storage was on the back of some of these new products, whether it's components or whether it's the Fibre Channel 4-Gig systems.

Now, as I said earlier on the call, our hope was that we were going to get these new entry segments out more earlier in the fourth quarter so that we could realize a more meaningful ramp associated with that new category, which is a new market that we don't even participate in Q1 -- sorry, starting in Q4 and meaningful in Q1.

And because of some of the complexities and challenges there, those products were introduced very late in the quarter and, hence basically all of Q1 will be associated around just the ramp cycle and driving that new category with our customers.

Tayyib Shah - Longbow Research

So then -- I mean --

Abhijit Talwalkar

-- which we anticipate having a meaningful benefit in Q2.

Tayyib Shah - Longbow Research

Okay. That was my next question. And then, for seasonality, are you seeing that pretty much across the board at the same level or is the consumer much more affected in Q1?

Abhijit Talwalkar

Well, I mean it's pretty consistent. [Modulus], you know, some of the PortalPlayer year-over-year comparisons, right, because that business is more than just seasonality. There is a design win that we lost in Q2 of last year that is still having a year-over-year impact on us.

Tayyib Shah - Longbow Research

Is there still a significant revenue from PortalPlayer in the revenue mix?

Abhijit Talwalkar

Yes. Yes, there is.

Tayyib Shah - Longbow Research

Okay. And, then a question for Bryon. Can you in any way separate the margin impact from one-time events on the systems business? And how should we model that going forward?

Bryon Look

In the systems business, I would expect, you know, the margins to be roughly in the same range. You know, let's say for the first quarter, I would expect it as we put hard tooling in place for some of the products, as we get to, you know, that ramp cycle, typically the margins on those would improve. So again, we should be able to back into that you know, north of 35% kind of range. If you look further beyond the first quarter.

Tayyib Shah - Longbow Research

Okay. Thank you, guys.

Bryon Look

Thank you.

Operator

Our next question will come from Hans Mosesmann with Moors & Cabot Capital. Please, go ahead.

Hans Mosesmann - Moors & Cabot Capital

Thanks. Actually my questions have been answered. Thank you.

Operator

Okay. All right. Our next question will come from Seogju Lee with Goldman Sachs. Please go ahead.

Seogju Lee - Goldman Sachs

Hi. Thank you. Just clarification, Abhi. When you talked about a 10% decline for Q1 for enterprise, you're talking both on a system level as well as a component level, or --

Abhijit Talwalkar

I was making more of a general comment across the overall business. I wasn't breaking it out across components and systems. And it varies a little across in segments. Just overall, enterprise spending, if you look across the marketplace, can drop anywhere from 8% to as high as 15% from a Q4 to Q1 standpoint just based on historicals.

Seogju Lee - Goldman Sachs

Okay. Great. And then -- in terms of this most of my questions have been asked and answered but just a question on the merger. When you had talked about the $125 million in terms of the planned expense savings. Can you give us a little visibility in terms of how you are thinking about that? How it breaks down between a cost of goods sold, operating expense standpoint and what the levers are to that? Thank you. And good luck.

Abhijit Talwalkar

Well, I think how we've answered this over the past 30 days is that the $125 million, which is a '08 overall total. We expect about half of it to come from sort of cost of goods reductions and improvements and the other half to come from just OpEx improvements in synergies that will be realized by bringing the two companies together.

Seogju Lee - Goldman Sachs

Okay. Thanks.

Operator

Thank you. Our next question comes from Michael Cody with B. Riley and Company. Please, go ahead.

Michael Cody - B. Riley and Company

Thank you. In the storage systems business, how does the competitive landscape changed as you move into the market for general products. And do you have any market share expectations by say exiting '07?

Abhijit Talwalkar

We -- on market share -- I mean we certainly have expectations and very clear targets at the same time we don't disclose those. In terms of how the competitive landscape changes, you know, we think relative to us we only grow more competitive because of a broader product line.

Not only is there a mid-range systems family, now there's an entry family and there's also all our RAID technology software and silicon that we have associated with servers. We do have a strong belief that a lot of this low-end storage business will be more server-led.

And we have great relationships with the server side of many of these companies and I think it will certainly bring some interesting competitive dynamics in the marketplace and potentially offer a more strength to the server companies out there, given the server-led motion.

Michael Cody - B. Riley and Company

Okay. And are there any entrenched competitors in that space now?

Abhijit Talwalkar

I think to, I mean there certainly are competitors in that space for our end customers relative to the people we compete with, who compete for dollars from OEM system vendors. There -- there really aren't significant entrenched competitors here. This is a -- a brand-new category for us and to some extent it's a growth opportunity for the market and that's why it's growing 20% 25% per year.

Michael Cody - B. Riley and Company

Great. Thank you very much.

Operator

Thank you, sir. At this time there are no additional questions in the queue and I'd like to turn the conference back over to Tom Tran for closing remarks. Please go ahead.

Tom Tran

Thank you. I like to mention that LSI is planning to participate at a few conferences in the quarter and they include the Bank of America Technology Conference in February, The Goldman Sachs Technology Conference in early March and also the Morgan Stanley Conferences also in early March.

And, I think that's it. Thank you for your participation today. And, but before I end, I'll like to turn the call back to, Abhi Talwalkar to make some closing remarks.

Abhijit Talwalkar

Yes. Just to close, again I think a very strong fourth quarter but more importantly, significant progress in transforming this company around our focus markets. We're making great progress on the previously announced merger with Agere Systems. You'll continue to hear more from us there, as we progress through the quarter.

And the fundamentals drivers remain in place for 2007. And I think we're in a great position in a leadership position across our key focus markets. So thank you all for joining us today.

Operator

Thank you, management. Ladies and gentlemen, at this time we will conclude today's teleconference presentation. We thank you for your participation on the conference. At this time, you may now disconnect and please have a pleasant day.

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