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LSI (NASDAQ:LSI)

Q3 2011 Earnings Call

October 26, 2011 5:00 pm ET

Executives

Sujal Shah - Director of Investor Relations

Bryon Look - Chief Administrative Officer, Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Abhijit Y. Talwalkar - Chief Executive Officer, President and Director

Analysts

Craig Berger - FBR Capital Markets & Co., Research Division

Brian Peterson - Raymond James

Kaushik Roy - Merriman Capital, Inc., Research Division

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

Harlan Sur - JP Morgan Chase & Co, Research Division

James Schneider - Goldman Sachs Group Inc., Research Division

Srini Pajjuri - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Betsy Van Hees - Wedbush Securities Inc., Research Division

Sujeeva De Silva - ThinkEquity LLC, Research Division

Matthew Bryson - Avian Securities, LLC, Research Division

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the LSI Corporation Investor Relations Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Sujal Shah, Vice President of Investor Relations at LSI. Please go ahead.

Sujal Shah

Good afternoon, and thank you for joining us. With me today are Abhi Talwalkar, President and Chief Executive Officer; and Bryon Look, Executive Vice President and Chief Financial Officer. Abhi will begin the call with some opening remarks and highlights from our business, and then Bryon will provide results for the third quarter and guidance for the fourth quarter of 2011.

During this call, we'll be mentioning non-GAAP financial measures, which we may refer to as results excluding special items. Today's earnings release describes the differences between our non-GAAP and GAAP reporting. You can find reconciliations of our non-GAAP financial measures to corresponding GAAP amounts on the Investor section of our website at www.lsi.com/webcast. At that site, you can also find a copy of the earnings release and a presentation highlighting the key points from today's call and providing an overview of our business.

Earlier today, we announced the acquisition of SandForce. A presentation highlighting this acquisition is also on our website.

I want to remind you that today's remarks will include forward-looking statements. Our actual results could differ materially from those suggested by the statements made today. Information about factors that could affect our future results is contained in our Form 10-K for the year ended December 31, 2010, our second quarter 10-Q and today's earnings release. With that, it is now my pleasure to introduce Abhi Talwalkar.

Abhijit Y. Talwalkar

Good afternoon, and welcome. I'd like to begin by discussing our announcement to acquire SandForce, a leading provider of flash storage processors extending LSI's industry-leading position and breadth in storage technology solutions. There were several drivers that motivated us to make this acquisition. The acquisition greatly enhances LSI's competitive position in the fast-growing server and storage PCIe flash adapter space, where our family of WarpDrive products already uses SandForce in compete with solutions from companies such as Fusion-io. Secondly, the complementary combination of LSI's custom products and SandForce's standard product offering catapults LSI into an industry-leading position for the rapidly-growing, high-volume flash storage pROCessing market for Ultrabooks, notebooks and enterprise SSD and flash solutions. PCIe flash-based adapters and flash storage processors will together represent a greater than $2 billion TAM expansion for LSI in the next several years, extending LSI's exciting growth opportunities.

With this acquisition, LSI now has a complete portfolio of storage products, including SAS, ROC, processors and controllers, ACD [ph], SoCs and preamps, custom and standard flash storage processors and PCIe flash adapters and acceleration software, giving us breadth and capability that exceeds any competitor in this space. We believe that SandForce is on track to generate approximately $60 million of revenue in 2011, and we expect continued growth that will be captured in our 2012 numbers. We expect to close this transaction early in Q1 2012 and expect the deal to be neutral in 2012 earnings per share.

I now want to address the current environment and more importantly, how to view LSI in light of current conditions. There continues to be a cloud of economic uncertainty and this has now been magnified by the significant disruptions of the industry supply chain from the severe flooding in Thailand. Our customers have talked about the disruption to our -- to their factories, logistics, power and availability of labor. Some of LSI's subcontractors in Thailand land have been similarly impacted and the effects of this have been factored into our outlook for Q4. Our guidance for the current quarter assumes $35 million to $45 million of primarily supply-related constraints, which are mostly affecting our Hard Disk Drive business. Due to these manufacturing constraints, we're assuming that our Hard Disk Drive business declines over 10% sequentially, which is also consistent with the guidance outlook provided by our largest HDD customer. We continue to work with our suppliers to mitigate risks and execute on alternative plans to maximize our ability to supply to our customers.

Turning to our results, Q3 financials provided a proof point of the strength of our share gains in new product cycles, as well as the operating leverage we have worked hard to create. Despite the deteriorating demand environment, we grew revenues 9% sequentially and expanded non-GAAP operating margin by nearly 300 basis points to 15%. While we witnessed deterioration in demand as we moved through the third quarter, particularly in Hard Disk Drive and wireless markets, we correctly anticipated this softness and factored it into our Q3 guidance back in July. While we cannot control the demand environment, we are positively influencing the factors we can control, including execution of new products, further penetration into market leading accounts, expense control and pursuit of new growth drivers in product cycles.

Going forward, we believe LSI is well positioned in large, growing markets with solid fundamentals and we expect to benefit from growth in the deployment of servers, storage and networking equipment for data centers, commercial and private clouds and mobile networks.

Now I want to review additional business highlights for Q3. I'll begin with our server and storage businesses which include our SAS, ServeRAID adapter and software, flash, SAN and HDD businesses. As we mentioned last quarter, for SAS and servers, we expanded customer base to include all top 10 server OEMs with the award of a 6-gig controller design on HP's next generation of servers. We expect to begin shipping products early next year in conjunction with the rollout of Intel's Romley platform.

Going beyond Romley and building upon our time-to-market leadership, LSI was the first in the industry to sample the next-generation 12-gig SAS ROCs, controllers and expanders to major server OEMs earlier this year. As a proof point of our technology leadership, we broke the 1 million IOPS performance barrier with a single 8-port 12-gig SAS ROC controller at Intel's developer forum in September. We believe we are now 9 months ahead of our nearest competitor. We continue to make progress with external storage systems customers following the divestiture of our Systems business. In fact, Dot Hill, has selected LSI 12-gig SAS silicon and software for their next-generation external storage products.

In the flash space, we're expanding and increasing focus on storage and server application acceleration, bringing the performance advantages of NAND flash to enterprise server and storage in networking applications. We are developing and delivering both software- and hardware-based solutions, and the acquisition of SandForce significantly enhances our position in this space.

LSI's CacheCade software, which accelerates application performance by intelligently placing more frequently used data into higher performance SSD layer, is now being offered by both Dell and IBM, and Intel and several channel customers are shipping our second-generation CacheCade product.

We continue to build momentum with our WarpDrive PCI Express flash adapters and expect to start ramping at a major Tier 1 storage vendor at the end of this quarter. Also with our WarpDrive solution, we've won multiple designs at a Tier 1 server OEM, displacing 50% of the incumbent competitor's opportunity. We won based on our superior architecture and portfolio, as well as a natural extension of our current server engagement.

We believe that there are several key differentiating factors to the LSI solution. We have an architectural advantage with our on-board industry-leading SAS controller, which delivers high application performance and low latency without attacking the server CPU resources. This is critical in all application but especially in virtualized server environments. Our solution also utilizes LSI's enterprise hard and SAS firmware, allowing customers to take advantage of the large, established and familiar LSI storage product line.

Lastly, we have a solid roadmap that will include the SandForce flash portfolio and have begun sampling the next-generation PCIe flash adapters supporting SoC flash for applications requiring performance and durability and MLC flash for applications requiring low cost and high density. We have numerous large opportunities and engagements across server OEMs and Web 2.0 data center customers and expect WarpDrive to be a key growth driver in 2012.

In Hard Disk Drives, we saw our unit time expand by approximately 6% from Q2 to Q3 and saw the materialization of significant share gains in Seagate's client platforms and continuing ramp of enterprise SoC is expected. In fact, we set new quarterly unit and revenue records for both SoCs and preamps in Q3. On the development side, all programs continue to be on track with both existing and new customers.

Now I'd like to provide an update on new developments in our Networking business, where we benefit from wireless infrastructure buildouts from mobile networks, growth in video traffic and upgrades to enterprise networks. We continue to be successful in increasing LSI's footprint in base station and wireless backhaul infrastructure and offer a complete portfolio of products from multi-core processors to custom silicon solutions. Our Axxia multi-core communications processor has been adapted by Ericsson, the leading wireless equipment provider, expanding our footprint from network processors serving data plane functions to multi-core solutions that provide both data plane and controlled plane functions in a single device. We're also seeing success in the sampled or custom silicon solution for the baseband function, which sits alongside the data plane, controlled plane device and integrates DSP functionality. We expect to have a combination of standard products and custom product solutions shipping into base stations at 4 of the top 5 wireless equipment OEMs next year.

In the enterprise space, we have a number of initiatives to drive future growth. We are already seeing traction as we extend our Axxia multi-core communications processor into products such as data center switches, enabling further growth beyond wireless base station applications. In custom products, we have begun ramping silicon for 1-gig Ethernet controllers, integrating Mac and PHY functionality for server platforms at a leading processor OEM. This adds to our existing shipments of Gigabit Ethernet PHYs into client and server applications.

Before I turn the call over to Bryon, I just want to reiterate that we are well-positioned with share gain opportunities and new product cycles to enable us to outgrow the storage and networking markets we serve going forward. Now let me hand the call over to Bryon.

Bryon Look

Thanks, Abhi, and good afternoon, everyone. As noted earlier in the call, we announced today the signing of a definitive agreement to acquire SandForce for approximately $322 million in cash, net of cash assumed, and we'll assume approximately $48 million of unvested stock options and restricted shares held by SandForce employees. We expect the transaction to be neutral to 2012 non-GAAP earnings per share. We expect to close in early Q1 2012 and consequently, our guidance for Q4 is not affected by this transaction. We will provide additional information regarding the transaction after the deal closes.

Now onto Q3 results and the Q4 outlook. LSI delivered a solid quarter consistent with the guidance we provided in July despite the challenges in the macroeconomic environment. Revenues increased sequentially by 9.2% to $547 million. Non-GAAP gross margins expanded to 52.2% or 20 basis points higher than midpoint of guidance. We continue to carefully manage expenses with non-GAAP operating expenses of $202.6 million, just under midpoint of guidance. And we delivered non-GAAP EPS at midpoint of $0.14 per share. Moreover, the company drove double-digit year-over-year growth in both the revenues, as well as operating income. Compared to the same quarter a year ago, Q3 revenues were up 21% and non-GAAP operating income was up 38%. Non-GAAP operating margins have now expanded to 15.2% of revenues.

Now turning to a more detailed discussion of our financial results for the quarter beginning with revenues. Q3 revenues were $547 million, sequentially up 9.2% from $501 million. Our server and storage semiconductor revenues, which include products from our ServeRAID adapter and software, flash, SAS, SAN and HDD businesses, were sequentially up $44 million or 12% to $403 million. Server and storage semiconductors represented 74% of total revenues in the third quarter. Q3 revenues in our Networking business were $117 million, relatively flat sequentially and represented 21% of total revenues for the third quarter. Revenues for the IP business were sequentially up $3 million to $27 million.

Moving next to gross margins. LSI's Q3 gross margin, excluding special items, was 52.2% or 20 basis points above the midpoint of guidance. Gross margins increased sequentially by approximately 30 basis points primarily due to higher revenues and improved product mix and partially offset by higher commodity costs.

In terms of operating expenses, R&D together with SG&A expenses, excluding special items, totaled $202.6 million in Q3, just below the midpoint of guidance. Non-GAAP operating margin for the quarter increased sequentially by 280 basis points to 15.2% or $83 million. Interest income and other net of interest expense, excluding special items, was $8 million for Q3, approximately 1/2 of which was related to income from transition services associated with the sale of the External Systems business. We expect most of these service arrangements to be completed by the end of the year.

Now let me turn to the special items we recorded in the third quarter which netted to $51 million. Special items, primarily non-cash, included $29 million in amortization of acquisition-related items, $12 million of stock-based compensation expense and $11 million of restructuring costs and other items.

Moving next to tax. Our tax provision on both a GAAP and non-GAAP basis can vary significantly quarter-to-quarter based on our profitability in different geographic tax jurisdictions and certain discrete items. The tax provision for Q3 was $8 million.

On a GAAP basis, third quarter income from continuing operations was approximately $32 million or $0.05 per share. Third quarter GAAP net income, which includes income from discontinued operations, was $29 million or $0.05 per share. Non-GAAP income from continuing operations was $83 million or $0.14 per share. The weighted average share count for the period for both GAAP and non-GAAP purposes was 581 million shares. This includes the weighted average benefit of purchasing approximately 11 million shares during the period under our share repurchase program. Year-to-date, we have repurchased a total of 68 million shares and utilized approximately $472 million of our current $750 million buyback program. Our share buyback program remains in place with $278 million remaining in our authorization.

Turning now to the balance sheet and cash flows. Cash and short-term investments ended the September quarter at approximately $879 million. We continue to operate with no debt on our balance sheet. Operating cash flows for Q3 were $45 million and are $191 million year-to-date.

Finally, with respect to Q3 results. Depreciation of software amortization was $15 million and capital expenditures were $10 million.

Next is a discussion of our guidance for continuing operations in Q4 2011. As noted previously, we've been focused on the recent flooding in Thailand and the impact on employees, customers and suppliers in the region. We are grateful that our employees are safe, but the situation continues to be challenging and adds volatility to the business near-term. Our exposure from a supply chain perspective relates primarily to third-party services associated with packaging and tests and from our customers' ability to meet end demand. We continue working to size and mitigate exposure and providing guidance, taking into consideration our best estimates at this time.

With that said, we expect Q4 revenues in the range of $500 million to $550 million or sequentially down about 4% at midpoint. This assumes approximately $35 million to $45 million of primarily supply-related constraints, which are mostly affecting our Hard Disk Drive business. Due to these manufacturing constraints, we're assuming that our HDD business declines over 10% sequentially, which is also consistent with the guidance outlook provided by our largest HDD customer. We expect our server and storage semiconductor revenues to be sequentially down in Q4, driven by HDD declines. In addition, we expect our Networking semiconductor revenues to be flat-to-down slightly, benefiting from some last-time buys of legacy products. Gross margin, excluding special items, is expected to be 51%, plus or minus 1%. Operating expenses, excluding special items, are expected to be roughly flat or in the range of $198 million to $208 million. Interest income and other and interest expense, excluding special items, is expected to net to income of approximately $5 million. Special items are expected to net to approximately $35 million to $55 million.

The GAAP and non-GAAP tax provision is expected to be approximately $13 million for Q4. We expect Q4 GAAP income per share from continuing operations in the range of negative $0.04 to a positive $0.08, and non-GAAP income from continuing operations in the range of $0.06 to $0.14 per share. This share count is expected to be approximately 580 million shares for both GAAP and non-GAAP purposes.

In addition, we expect depreciation and software amortization of approximately $16 million and capital expenditures of approximately $12 million.

In closing, we delivered solid revenues and non-GAAP operating margins in Q3, and demonstrated solid year-over-year progress on operating income expansion and EPS growth. We remain focused on driving operating leverage and continue to partner with our key suppliers and customers to work through the business challenges associated with the flooding in Thailand.

Now let me turn the call to Sujal.

Sujal Shah

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Kaushik Roy.

Kaushik Roy - Merriman Capital, Inc., Research Division

Congratulations on the quarter; you made it, and more importantly on the SandForce acquisition. Gross margins, Bryon, why is it coming down so much? Hard drives have lower gross margin and if those are down 10%, that should help your gross margins, no?

Bryon Look

Yes, product mix always factors into our gross margins. We provided a range in terms of our guidance relative to those gross margins. But, yes, at midpoint, the reason for that, first of all, you've got overall revenue volumes in the fourth quarter. In addition, there are some other mix considerations that factored into our guidance for those margins. For example, we had a strong quarter in terms of IP revenues in the prior quarter. That's expected to be maybe slightly down in the fourth quarter.

Kaushik Roy - Merriman Capital, Inc., Research Division

And then as a follow-up, Abhi, if you can comment a little bit on the inventories or what are your expectations for Q1 at this point? I understand Seagate is not telling anything about Q1, but what are you hearing from your OEMs?

Abhijit Y. Talwalkar

Well, I mean, Kaushik, as you can appreciate, there are so many moving parts and uncertainties still. We're about 10 days into this flood -- at least 10 days into when factories had to go offline and so forth, and everyone from our customers to ourselves were working diligently to find alternative sources for our -- everything from test capacity, assembly capacity to substrates and so forth. So there's still a lot of unknowns and everyone's right now focused on Q4, in maximizing output for Q4. I think it's impossible to predict what's going to happen in Q1. It's going to be a function of how fast factories come back online, supply lines come back online, as well as what happens to some of the demand that doesn't get fulfilled in Q1 and then obviously, inventories likely are going to get heavily depleted through this quarter with this situation and will likely require some recovery in Q1. But all of those puts and takes, it's really impossible to call Q1 today.

Operator

Your next question comes from Sujee De Silva.

Sujeeva De Silva - ThinkEquity LLC, Research Division

Congratulations on the acquisition. Could you talk about SandForce's margins and, perhaps, if there's operating expense synergies as you put the 2 solid-state drive teams together?

Abhijit Y. Talwalkar

I think you're asking about questions that we can't disclose at this juncture and we'll certainly provide much more detail post-closing. In terms of margins, flash storage processors that are out there, in general, have margins that are going to be at or above LSI's corporate margins. I think that's probably the most I can provide at this juncture since the deal was just announced today and we're not going to close until early January.

Sujeeva De Silva - ThinkEquity LLC, Research Division

Okay, that's helpful. And then actually, I think you mentioned something about having people on the ground in Thailand as well. Can you recap kind of what your footprint is in Thailand or if you're just talking about partners there?

Abhijit Y. Talwalkar

Well, it's really -- we do have some employees in Thailand but it's a very small employee base associated with sort of purchase order processing, as well as some employees relative to our subcon, but our major subcon out there, a third-party provider for assembly and test operations, is where the impact has been. And there is water surrounding the factory, as well as water within the factory. Like any other factory that's out there that's been impacted, we had to vacate the location about 5 to 7 days ago, and we're just waiting for the water to recede. We'd already taken a number of steps before the flooding got extreme in terms of moving finished goods out as much as we could, moving finished goods and test equipment up into the second floor and so forth, and we're obviously anxious to get back into the factory to take advantage of some of the finished goods inventory that we have there. But we're not stopping; we've been working very hard the last 10 days, erecting alternative sources for primarily a test and assembly capacity gap that we have.

Sujeeva De Silva - ThinkEquity LLC, Research Division

One quick question on the HP, with their 6 gigabyte, would that be sole sourced to you guys as they cut over to Romley or would be sharing the HP platforms there?

Abhijit Y. Talwalkar

No, I think as we've described before, it's not a sole source. HP has a number of different applications for SAS controllers and ROCs across its server product line, but we see it as a meaningful first step into HP's server business or back into HP's server business, especially at a point in time where we believe we have an extremely competitive position and roadmap and have a very clear time-to-market advantage. So we think it bodes well to earning more of their business.

Operator

You're next question comes from Craig Berger.

Craig Berger - FBR Capital Markets & Co., Research Division

I just wanted to ask on the SandForce deal, I mean, that's a lot of money to spend. What type of growth rates or contribution should we expect in years forward? I think, you said it's about $60 million of revenues or roughly 6x sales. And then as part of that, can you just help us understand your internal sort of R&D allocation processes to help us understand why you weren't already investing in those types of controllers or why your internal technology wasn't sufficient?

Abhijit Y. Talwalkar

Yes. Let me -- I mean, those are all good questions, but let me make sure you've got the full picture. First of all, let me give you a sense for why we're making the acquisition and the strategic rationale behind it. First and foremost, it significantly enhances our competitive position in the very fast growing server and storage PCIe flash adapter space, which is a marketplace that certainly has been created by companies such as Fusion-io. We are also very active in that product category now and we'll have a very comprehensive product line, and having a flash storage processor capability such as SandForce's only solidifies our competitiveness. Secondly, LSI's engineering investment and focus in SSDs has been more aimed at a custom implementation for those SSD and NAND providers that are using sort of a custom approach for flash storage processors within their SSDs. SandForce has been focused on delivering a complete standard product with all the firmware product ties as well. The combination of the 2 companies, I think, absolutely positions us to be a market leader as SSD is for Ultrabooks, notebooks and enterprise flash base solutions grows. And so that's the second big objective. And then back to your question around growth. We believe the aggregate sort of market, which is composed of flash-based processors for all types of SSDs, as well as the PCIe flash adapter market, is going to be at least $2 billion, and we believe we're very conservative based on what others are saying here in several years and the market in aggregate is growing 40% to 60% annually. So this positions us much more strongly to participate in a very fast-growing market.

Operator

Your next question comes from Harlan Sur.

Harlan Sur - JP Morgan Chase & Co, Research Division

Congratulations on the SandForce acquisition. So with the acquisition of SandForce combined with LSI's core competency in HDD, right, we're hearing a lot more about hybrid drives being a bigger part of the mix next year kind of as a bridge solution between HDD and SSD. So does the SandForce acquisition combined with your expertise kind of help you guys get a better foothold in this hybrid HDD market? Maybe you could talk a little bit about that.

Abhijit Y. Talwalkar

Yes, I believe it does. I mean, first of all, I think I need to remind everyone, we're already sort of well positioned relative to the hybrid market. Seagate has been sort of the drivers of the hybrid HDD drive, and our SoCs are a part of their solution today, so we're already participating albeit the market's small, but we do expect the market to grow very rapidly. And yes, Harlan, you're correct in that the synergies between LSI's HDD SoC, as well as rechannel expertise, combined with the expertise of SandForce in flash management that they have will certainly allow us to do tailor-oriented solutions for hybrid drives.

Harlan Sur - JP Morgan Chase & Co, Research Division

And then my follow-up question, Abhi, and this is obviously very characteristic of the enterprise storage market that you guys are already obviously playing in is that software and firmware is such an important -- it's a sticky thing once you get into a customer, and so you guys obviously have the software and firmware capability from an overall enterprise storage capability. I'm just wondering, what is the software and firmware differentiator that the SandForce guys bring to LSI?

Abhijit Y. Talwalkar

Well, I think, they have a very similar stickiness and footprint relative to their firmware in the implementation of their flash storage processor into the SSDs that they're shipping into today, both in the form of client-oriented SSDs, as well as enterprise. So I think the DNA is identical to that of LSI's. And we also believe the combination now of that flash storage processor, along with our investments that we're making in PCIe flash adapters and the software that we have that sits even above on top of that, whether it's caching or tiering software, I think positions us even better in the software space.

Bryon Look

Both to drive revenue opportunities, margins, but also as you point out, the stickiness.

Operator

You're next question comes from Srini Pajjuri.

Srini Pajjuri - Credit Agricole Securities (USA) Inc., Research Division

Abhi, your comment about the HDD issue kind of having $35 million to $45 million impact, that's about 20% of your HDD business, if I did my math correctly here. So I'm just wondering, do you think the TAM for Q4 for is about 10% more than Q3? Is that how you're getting to that number?

Abhijit Y. Talwalkar

No. Let me correct a couple of things. So I think your comment that it's 20% of our HDD business, I think that's a little bit -- that's high. And then in terms of TAM for the fourth quarter, I think our TAM sort of projections are sort of consistent with what the rest of the industry is starting to converge on based on all the data that's out there, around the shortages in supply chain disruptions, which is the TAM's probably going to be in the order of 40 million units short to sort of a 170, 175 million unit unconstrained TAM.

Srini Pajjuri - Credit Agricole Securities (USA) Inc., Research Division

And then at Seagate, you've obviously had a very strong quarter on backup share gains. I'm just wondering, are you complete -- I mean, are you done with the share gains on the client side? Or do you think there's more to gain here? And also, because of the floods, I mean, the 2 guys that got impacted the most I think are WD and Toshiba where you do have design wins in the past. You gave us second half of 2012 as kind of approximate timing. I'm just wondering, given the flood situation, if there's going to be any change, any impact on the timing.

Abhijit Y. Talwalkar

Relative to Seagate and client share, I mean, right now, our share gains at Seagate are going to be predominantly in the enterprise space, which will continue to ramp as we ramp the new enterprise SoC. In terms of the other designs and other customers, as far as we know, all the activity continues to be on track, and we haven't seen any change in focus whatsoever.

Operator

Your next question comes from Daniel Amir.

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

A couple of questions here. First of all, on the networking business, you guided the business to be flat to slightly down. That's actually much better than a lot of your peers that compete with you in the networking space. So can you give a better clarity, what's really impacting that business here in the fourth quarter? You mentioned legacy. Is that really what's happening? Or is there something else?

Abhijit Y. Talwalkar

Well, I think there's several factors. We have some last-time buys that are taking place in our legacy business, which are certainly helping that business to be the flat to slightly down that we characterized. So that is one certain driver that is setting us apart from others that are out there. I would say that our declines for, let's just say, not in the life-based sort of business, we are declining, and I would say the decline is probably not as significant as others that have guided for Q4. But that's also partly because we have seen the benefits of product cycles and share gains in our go-forward networking business. Does that help?

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

How do you see the inventory situation in the industry right now?

Abhijit Y. Talwalkar

From an inventory standpoint, I mean, obviously HDD is a whole different matter in itself, so that's a difficult one there to really address. In terms of the server space, we felt as if we sort of exited the quarter and entered Q4 very well aligned to sort of national demand. I think the same would go for External Storage Systems. So in general, we feel that inventory is fairly reasonably aligned to national demand other than obviously all the moving parts in HDD.

Operator

Your next question is from Jim Schneider.

James Schneider - Goldman Sachs Group Inc., Research Division

I guess, Abhi, just a follow-up on the inventory question. Can you talk about the networking space and whether you're seeing your networking customers continue to bleed off inventory there? And if so, do you think that's going to continue into Q1?

Abhijit Y. Talwalkar

Well, there's some of that, that's been happening in the second half of the year. We saw certainly some of that in Q3, and a little bit has been factored into Q4. At least our best forecast at this juncture is that will sort of end this quarter. But obviously, that's dependent on what the carriers do in terms of CapEx expenditures next year.

James Schneider - Goldman Sachs Group Inc., Research Division

And just a follow-up to continue on networking for a second. Into Q1, given the amount of first -- the last-time buys that you're seeing from customers, would you expect the Q1 seasonality in enterprise networking to be worse just because you get the kind of benefit of the last-time buys in Q4? Or would you expect them to continue in Q1 as well?

Abhijit Y. Talwalkar

We don't expect last-time buys per se to continue in Q1. But again, I don't want to guide to Q1 at this juncture, Jim.

James Schneider - Goldman Sachs Group Inc., Research Division

And then just some follow-up. How are you thinking about buybacks at this point vis-a-vis other potential M&A?

Bryon Look

This is Bryon. Our share buyback program is still in place. We've been quite active in terms of the year-to-date buyback of shares. We have a strong balance sheet. We're continuing to generate positive operating cash flows on a quarterly basis for the year. So I think to take away from that is that we continue to have a lot of flexibility relative to the fact that we have a cash balance and are continuing to add relative to operating cash flows. We only had a great opportunity in terms of the acquisition we announced today, to use that strong balance sheet to really strengthen our long-term competitive position and also drive long-term shareholder value. But we'll continue to look at different opportunities for the use of the cash as we go forward, including share repurchase.

Operator

Your next question is from Betsy Van Hees.

Betsy Van Hees - Wedbush Securities Inc., Research Division

I was looking at next year's gross margin, and I know this is really hard to give us a picture on, but you talked about the fact that your subcontractors were severely impacted on there's quite a big disruption in the supply chain. Can we expect that maybe we're going to see some additional costs that could impact gross margin a little bit further to what you guys have already guided to?

Bryon Look

Well, I think if you're referring to some of the uncertainties out there in terms of the current environment, a lot of that, obviously, is serious and so forth, and we're working through that. But relative to the longer term, I think there really isn't anything that's structural that's changed. And therefore, our position in terms of opportunities to expand gross margin and so forth next year are probably intact.

Betsy Van Hees - Wedbush Securities Inc., Research Division

And then my follow-up question is in the External Storage business, in terms of the guidance that you provided, is there anything else in terms of the macro outside of what's happening in the HDD business that is impacting the guidance?

Abhijit Y. Talwalkar

Well, I mean, I think we're absolutely experiencing a sub-seasonal environment. If we think about server unit growth in the fourth quarter historically, it's been as high as 8% to 10%. It's closer to probably 5%. We've seen historically, External Storage Systems see growth rates in the fourth quarter of 15% to even as high as 20%. It's probably in the high single digits, 8% to 10%. I believe EMC also characterized an 8% sort of growth in the fourth quarter. So there's definitely a sub-seasonal sort of environment out there in terms of enterprise or business spending, but there's also some growth and there's also a budget flush, just smaller than it typically is. That's all factored into our guidance, obviously.

Operator

Your next question comes from Hans Mosesmann.

Brian Peterson - Raymond James

This is Brian Peterson stepping in for Hans. Just a quick question on SandForce. Are you planning on keeping some of their parts available in the merchant market? Or are you going to phase them out?

Abhijit Y. Talwalkar

No. I mean, that's, again, something that we can't really comment until we're through closing. But at this point in time, there are no plans to change the business model that they've been operating to.

Operator

Your final question comes from Matt Bryson.

Matthew Bryson - Avian Securities, LLC, Research Division

Just quickly on the guide for the coming quarter. You guided drive-related storage looking down by over 10%, networking of flat to down, the total guidance are down around 4%. By my math, that puts all the storage silicon at roughly flattish. I think you talked about there being a little bit of budget flush there. Is my math correct? Are you just being a little bit conservative? Or am I getting the numbers wrong?

Abhijit Y. Talwalkar

No, I think you're close. We're benefiting from some of the sub-seasonal but nonetheless growth in servers. And they are also continuing to gain share in our enterprise SoC. And then there's some smaller miscellaneous items that are tied to sort of server and External Storage Systems business. So that makes some sort of the rest of your math.

Sujal Shah

Okay. Thank you, Matt. If there's no further questions, I'd like to thank all of you for joining us this afternoon. If you have any additional questions, please call Investor Relations at LSI. Thank you, and have a nice day.

Operator

Ladies and gentlemen, a telephone replay of this conference will be available beginning today at approximately 4:00 p.m. Pacific Daylight Time and will run through 9 p.m. Pacific Daylight Time on November 2. The replay access numbers are 1 (855) 859-2056 within the U.S. and 1 (404) 537-3406 for all other locations. The conference ID number is 14012918. The webcast will be archived at www.lsi.com/webcast. That does conclude today's conference. Thank you for participation. You may now disconnect.

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