LSI Logic Q2 2007 Earnings Call Transcript

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 |  About: LSI Corp. (LSI)
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LSI Logic Corp. (NASDAQ:LSI)

Q2 2007 Earnings Call

July 25, 2007 5:00 pm ET

Executives

Abhi Talwalkar - President & CEO

Bryon Look - EVP & CFO

Sujal Shah – VP, Investor Relations

Analysts

Alex Gauna - UBS

Craig Berger - Wedbush Morgan

Romit Shah - Lehman Brothers

Seogju Lee - Goldman Sachs

Tayyib Shah - Longbow Research

Sumit Dhanda - Banc of America Securities

Josepha Osha - Merrill Lynch

Paul Kim - Omega Advisors

Adam Sander - Deutsche Bank Securities

Dan Burkery - O’Connell

Shawn Webster - J.P. Morgan Chase & Company

Presentation

Operator

Ladies and gentlemen, thank you for calling. Thank you for standing by. Welcome to the LSI Corporation investor relations conference call.

At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time (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 are Abhi Talwalkar, President and Chief Executive Officer, Bryon Look, Executive Vice President and Chief Financial Officer, and Phil Brace, Senior Vice President.

We'll begin the call with opening remarks from Abhi and then Bryon will provide second quarter financial results and guidance for the third quarter. Abhi will then provide highlights on each of our businesses and we will open the call for your questions. Our press release is available on our website.

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

I also 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 quarterly report on Form 10-Q for the quarter ended March 31, 2007 and our annual report on Form 10-K for the year ending December 31, 2006.

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

Abhi Talwalkar

Thank you, Sujal. Good afternoon and welcome. At the end of June, we issued an update to our second quarter outlook. While this revision was disappointing, it was related to softness in our markets and inventory burn at our customers. Based on information from our customers and improvements in demand, we have confidence that June will represent the bottom of revenues and that our business will improve through the remainder of the year.

Our actual results were $670 million in revenues, $290 million in non-GAAP operating expenses and a non-GAAP loss of $0.02 per share. Our business remains fundamentally strong. We continue to win key designs with industry leaders in our target markets and will remain confident in the long-term value we can create in this business.

During our earnings call in April, I outlined a three-phase business acceleration plan to help you understand how we plan to move the company forward. The three phases were merger integration, earnings acceleration and revenue acceleration.

In the June quarter, we made significant progress in phase one of this plan including organizational integration following the Agere merger, executing a solid process to drive cost reduction and signing a definitive agreement for the sale of our consumer business.

Today, we are taking another major step with the announcement of our long-term manufacturing strategy. These key steps are all a part of the blueprint to transform LSI into a clear leader in the markets where we choose to focus.

Our business is organized into two segments, Storage Systems and Semiconductors, which includes mobility, networking and storage semiconductors. The leadership teams are in place, the organizations are set and I'm very pleased that the integration has gone smoothly with clear focus on customers and execution.

In June we announced a broad restructuring and acceleration of our cost savings plan, including the reduction of 900 employees. The net results of these actions will allow us to exit 2007 at a quarterly non-GAAP operating expense run rate of between $245 and $255 million. The December OpEx level is inclusive of all portfolio decisions we have announced up to this point.

As part of our portfolio review, we have agreed to sell our consumer products business, which is currently part of our semiconductor segment to Magnum Semiconductor. After exploring a full-range of strategic options we determined that the sale represented the best alternative for LSI.

As we continue to work to reshape LSI, we will evaluate our businesses in terms of scale, deep sustainable incumbency, and sustained leadership. The businesses that we focus on going forward must have clear differentiation within our market segments and key customers and must have sufficient size and scale to invest at the necessary levels to drive long-term sustained growth.

The decision we have made for our consumer business is a clear sign of our commitment to focus our resources and R&D investments on those opportunities where we can create the greatest value for our shareholders. As part of our ongoing efforts in phase one, we have made a change to our manufacturing strategy where we will move to 100% third-party manufacturing plan for all assembly and test operations.

We have agreed to sell our Thailand assembly and test operations to STATS ChipPAC who will continue to run the facility as a fully functional assembly and test operation. LSI will also transition assembly and test operations currently performed in Singapore.

Finally, we will outsource systems manufacturing in Wichita by partnering with a major contract manufacturer. Through this transition, we do not anticipate that customers will experience any changes in order entry, order fulfillment or shipping lead times.

Portions of our existing Singapore product portfolio are already dual sourced and qualified through manufacturing partners. We expect that the net effect of the change in manufacturing strategy will be a reduction of over 2,100 employees, an improvement of long-term gross margins, and a reduction in capital expenditures, which will have a positive impact on cash flow.

As can you see, we continue to take bold steps to shape LSI and position the company for long-term profitable growth and are confident in the long-term opportunities that we have to move the company forward. During the month of July, we completed our $500 million stock buyback authorization as a clear sign of confidence in our business.

Now, I'll turn the call over to Bryon who will take you through our results and provide guidance.

Bryon Look

Thank you, Abhi. With our first full quarter closed since the merger with Agere Systems, we're excited about our prospects as we move forward as a new combined company. The transaction closed on April 2nd at the beginning of our second quarter so the results that I will discuss reflect a full quarter of combined performance post-merger.

For the benefit of those listeners who may not be as familiar with the lineup of the new LSI, I'll include a brief description of our businesses as I review our financial performance.

Revenues for the second quarter were $670 million. Again, LSI has two reportable segments for financial reporting purposes, Semiconductor and Storage Systems. Our Semiconductor segment revenues were $485 million and our Storage System segment revenues were $185 million.

Let me start by talking about our Storage Systems business. We offer a broad range of open, modular, external storage products comprised of complete storage systems, subassembly and related storage protection and management software.

The second quarter revenues of $185 million from our Storage Systems segment represented 28% of LSI's total revenues. The Systems segment experienced softness in IT spend resulting in lower than expected shipments of our midrange system products; partially offset by increased shipments for our ramping entry level products.

Now let me turn to the four businesses that comprise our Semiconductor segment. These are storage semiconductors, networking, mobility, and consumer.

Our storage semiconductor business includes hard disk drive silicon, SAS standard components and storage area network ICs. Our storage semiconductor revenues were $255 million, representing 38% of total revenues in the second quarter. The business was impacted during the quarter by general market softness and consumption of inventory in the channel.

Storage revenues continue to be a significant percentage of LSI's total revenues. Revenues from storage systems and storage semiconductors combined represented 66% of LSI's total revenues in the second quarter.

Now let me turn to the networking business. Our networking business includes standard and custom products for wireless, wireline, and access applications, along with connectivity products for enterprise and PC applications.

Q2 revenues in our networking business were $112 million, representing 17% of total revenues for the quarter. We experienced lower demand for legacy products at several customers, lower shipments of connectivity solutions and some supply chain modifications which reduced buffer stock.

Next, I'd like to move on to discuss our mobility business, which included a broad portfolio of cellular handset solutions for GSM-based technologies, which serve more than 80% of the world's mobile phone subscribers.

Q2 revenues in mobility were $91 million, representing 14% of total revenues in the second quarter. During the quarter, we experienced a reduction in targeted inventory levels at our key customer, partially offset by increased demand for Edge solutions.

In our consumer business, revenues were $21 million in Q2, representing 3% of total revenues. The business experienced lower demand for both digital video and audio products throughout the quarter.

Now, I'd like to talk about our IP business and the impact of merger-related accounting. As a result of the acquisition with Agere, we are not able to recognize revenues associated with the Agere IP contracts existing prior to the date of the close of the transaction, even though we continue to collect the cash associated with those payment streams.

Revenues recognized in our financial statements relate to existing LSI agreements and new agreements entered into after April 2, 2007. Revenues for the IP business in the second quarter were $6 million. If not for merger-related accounting, we would have expected to have recorded approximately $15 million in IP revenues in the quarter.

Now moving on to gross margin. Consolidated Q2 gross margin excluding special items was 41%, which is within our original April guidance range. Semiconductor margins excluding special items were approximately 43% in the second quarter, primarily due to lower than expected revenues, inventory-related charges and product mix. We expect the Semiconductor margins to improve in the third quarter.

Storage Systems margins excluding special items improved to 35% and we continue to expect these margins to return to the high 30% range in the second half of the 2007 for our Storage Systems business.

We continue to drive efficiencies in the organization and maintain tight controls on our operating expenses which totaled $290 million in Q2 excluding special items. This is approximately $10 million lower than the mid-point of our original April guidance range on non-GAAP operating expense.

As we move forward, we expect to realize improvements to our cost structure as a result of the announcements made at the end of the second quarter relating to our restructuring and to the sale of the consumer business, as well as continued tight controls. Interest income and other net of interest expense excluding special items was $4.1 million in the quarter.

Now let me turn to the special items we recorded in the second quarter which relate primarily to the acquisition of Agere, and which netted in total to $363.7 million. It's important to note that the majority of the merger-related accounting items do not impact cash flow.

Special items included $22.8 million of stock-based compensation expense, $78 million in amortization of acquisition-related items, $47.9 million in a charge to inventory related to the purchase of Agere, $25.9 million in severance and other restructuring costs relating primarily to the sale of our consumer business, and the restructuring activities announced at the end of the second quarter, and $176.4 million write-off of in-process R&D relating to the purchase of Agere. And finally, $2.4 million loss associated with the sale and write-down of certain equity securities.

The tax provision for the second quarter on a GAAP basis was $12.5 million and on a non-GAAP basis, the tax provision was $2.2 million. On a GAAP basis second quarter net loss was $377.8 million, or $0.50 per share. Net income excluding special items was a loss of $14.2 million, or $0.02 per share.

Turning now to the balance sheet and cash flow. During the quarter we generated positive operating cash flows of $30 million. Cash and short-term investments were $1.2 billion and our net cash position at the end of the quarter was $439 million.

Now, I'd like to talk about the expected financial impacts of the manufacturing initiatives that we announced today. As part of our three-phase business acceleration plan, we have signed a definitive agreement to sell our semiconductor assembly and test facility in Thailand to STATS ChipPAC for approximately $100 million.

We expect the transaction to be margin neutral in 2007 and expected in the longer-term to achieve greater cost efficiencies through the increased adoption of a variable cost structure and scalable capacity without the need for additional capital investment. The transaction is expected to close in the next 90 days subject to the satisfaction of customary closing conditions and regulatory approvals.

In addition, we intend to transition our semiconductor and storage systems assembly and test operations performed at company-operated facilities in Singapore and Wichita, Kansas, to third-party contract manufacturers. The transition of these operations is expected to be completed in the first half of 2008.

We expect the transition to be margin neutral to the businesses in 2007, and with longer-term benefits associated with and increased variable cost structure and enhanced flexibility to scale and reduce capital expenditures.

The following is our guidance for the September quarter. Revenue in the range of $675 million to $705 million. In addition, we expect all of our ongoing businesses to be sequentially up moving from Q2 to Q3.

Consolidated gross margin excluding special items in the range of 42% to 44%. Operating expenses in the range of $255 to $265 million excluding special items. Interest income and other net interest expense of zero. Special items netting to approximately $100 to $120 million.

Expecting a GAAP tax provision of approximately $5 million and a non-GAAP tax rate excluding special items of approximately 20%. GAAP net loss in the range of minus $0.15 to $0.09 per diluted share and EPS excluding special items in the range of $0.02 to $0.05 per diluted share. Diluted share count for GAAP is expected to be approximately 725 million shares and for non-GAAP approximately 730 million shares.

In summary, we remain confident that the opportunities we have in each of our businesses will translate into long-term profitable growth. We expect to see revenue growth throughout the second half of 2007 and expect to realize cost and expense savings resulting in gross margin and operating expense improvements.

Now, let me turn the call back to Abhi.

Abhi Talwalkar

Thanks, Bryon. Next, I will review the highlights of our businesses for the quarter. We continue to win new engagements and to strengthen our position at major customers. I would first like to provide an update on our Storage and Semiconductors which we view as three businesses, hard disk drives, SAS standard components and storage array networks.

In the hard disk drive space, we made major progress in expanding our customer base, winning a new SoC design with another major drive maker. This win represents a foot in the door at a new customer. It was made possible by the combination of world-class rechannel and hard disk controller IP that would not have been possible by either LSI or Agere alone.

Including the enterprise win we discussed in April, this is now the second major win we have attained in the hard disk drive space made possible by the merger of our two companies. Also, during the quarter, our hard disk drive business sampled the industry's first 65-nanometer rechannel N5 for notebook and desktop hard disk drives.

The Anaconda rechannel is the first in the industry to use the intergroup (ph) decoding at this technology node. Not only does this new channel increase data storage capacity but it also cuts power consumption by 20%, thereby, enabling extended battery life in notebooks. Both parts have been favorably received by our customers and are working in their labs.

We continue to make progress in preamps as well. We increased our market penetration by successfully ramping our leading-edge silicon geranium preamps into key new desktop new sockets.

We won major new designs in both the 250-gigabyte per platter and 334-gigabyte per platter drives with our industry, leading 2.5-gigabyte per second, silicon geranium preamps, positioning us well for continued growth.

In addition, we expanded our customer base by adding another enterprise hard disk drive preamp customer. This win was achieved through leading silicon performance and ease of system integration.

In SAS, the inner components we are continuing to ramp our fully integrated third generation SAS Raid-on-Chip, or RoC, that is used by major OEMs in their new server platforms. Previously, these server platforms featured a SAS controller and a standalone processor. Our SAS RoC integrates these functions into a single chip reducing OEMs footprint and cost while increasing LSI's total content.

Meanwhile, we're seeing strong bookings for our SAS components into the external storage array market for entry systems. These systems that generate market pool for our SAS controllers and expanders, as well as SATA bridge devices which are part of our Silicon Store acquisition.

In the SAS HBA space, we have won several new key opportunities, Hewlett-Packard by leveraging our staff technology. Additionally, we were recently selected by Sun Microsystems as their sole supplier of SAS HBAs for their new ST2500 SAS storage array.

These wins are a further reflection of our expanding leadership in the rapidly-growing SAS component space. To date, we have shipped more than 4 million SAS standard components. Last week, we announced the shipment over our 1 million SAS RoC unit setting the pace for the industry.

Also, we continue to progress toward shipping LSI SAS RoC plus our Mega RAID host RAID solutions across seven of the top 10 server vendors in the second half of this year.

In storage systems, Terra Data chose LSI to provide business critical data protection for its next-generation backup to disk system for data warehousing customers. This win further cements LSI's 15-year relationship with Terra Data.

Also in the quarter Storage Systems continued to ramp volume on our entry level external storage platforms as three major OEMs are now in production. LSI had enabled our customers to get out ahead of the curve in this segment.

As of June 30th, we had shipped more than 21,000 units, which includes both SAS and fiber channel storage solutions. In this new product line for LSI, we expect volume to continue to grow in the third quarter as we launch new products and OEM demand grows.

In our networking business, we have made significant progress in analyzing our markets, products and applications to determine the best strategy to move this business forward. Based on a combination of strengths and network processing and signal processing, we will sharpen our focus in both the wire and wireless access segments, along with the service-enabled media and business gateway markets.

The highlight of the quarter was Nortel's selection of our advanced payload plus technology for deployment of a new family of gateways to deliver enterprise-grade performance at FMB prices by providing superior levels of silicon integration. We are already seeing momentum as these products are proceeding to end user trials with a major U.S.-based telecom service provider.

In wireless infrastructure QualWay selected LSI's advanced payload plus NPU as well as linked layer product SOCs for its Quidway router. Also, for the second consecutive year LSI received the Excellent Supplier Award from QualWay besting 21 of our competitors for the honor.

During the quarter, our mobility business recently took a step to expand its customer base by signing a contract with Tech Phase (ph) a large Chinese handset ODM that works with a number of major brands including Motorola and Nokia.

Samsung's new Ultra Edition 2 Thin Phones continues to do well in the marketplace. As we've noted before, we are the sole base stand provider for these GPRS EDGE phones. In addition, Samsung launched the new J600 phone. It is based on LSI's excellent 22 device which integrates an exciting array of multimedia features provided in the phone.

Additionally, Amoy launched the M500 phone, which is a feature set, rich-EDGE phone targeted at the local Chinese market. This is another example of how LSI's enabling high-end phone features in mass market phones.

We are confident that we are shaping our businesses and products to drive long-term growth of revenues and profitability. In the process, we continue to drive an innovation pipeline aimed at securing LSI as one of the clear leaders in our market segments.

In storage systems we are first to market with entry level SAS external systems and are now shipping with multiple Tier 1 OEMs. In hard disk drives we are the first in the industry to ship 65-nanometer rechannel device, a source of clear differentiation with our key customers.

In SAS standard components we are shipping our third generation of Raid-on-Chip solutions while our competitors are just now coming to market or sampling their first generation.

In networking, we are in trials with major U.S. service providers with a new family of gateway solutions. And in mobility, we're supplying the core base span technology and protocol stat software that drives Samsung's leading Ultra Edition Thin Phones.

Before we go to your questions, I want to conclude with some key points of the progress we have made in an incredible short amount of time. We successfully merged two fairly large, complex companies. We bought back $500 million of stock in this quarter. We entered a contract to sell our consumer business.

Additionally, we took a major step and redefined our global manufacturing strategy, including the sale of our Thailand facility for $100 million. We implemented a plan to increase and accelerate cost savings. We took significant steps to reduce our headcount by 3,000 employees over time.

Finally, we secured a number of strategic design wins leveraging the combination of the two companies. We have done all of this while managing our costs in the current quarter and driving successful execution of programs in play and we're confident that the bold steps we are taking to shape LSI will translate into long-term shareholder value.

I would like to now turn it back to Sujal.

Sujal Shah

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Alex Gauna with UBS. Sir, your line is open.

Alex Gauna - UBS

Yes. Thank you. I believe you mentioned sharpening the focus in your networking IC development. And I'm wondering if you could give some color on what you mean by that? What a timeline might be for some of the fruits of that sharpened focus.

Abhi Talwalkar

Well some of that sharpened focus is certainly contributing to the OpEx reductions that we've talked about and we announced in late June. We continue to make progress in terms of refining the strategy as to what segments we will invest in, what segments we will divest or certainly reduce or curtail investments.

And Alex, our objective is to provide that clarity next week at our analyst event where we'll have ample time to share with people our overall strategy and some of those decisions that we have made.

Alex Gauna - UBS

Okay. And if I could ask a follow-up then. With regard to what's happening on the storage side of the business and you've got improving gross margins here in the near-term expected, what's really driving the leadership in that category right now?

Abhi Talwalkar

Well, I mean the leadership is being driven across a number of our, basically all of our storage segments. If I look at hard disk drive in terms of growth in the second half, we're starting to feel more optimistic, or certainly cautiously optimistic in terms of growth because of the dynamics around enterprise spending, PC spending, service and storage being up.

In terms of long-term leadership, it's because of we've brought two companies together with a very strong IP portfolio and a number of key differentiators that has enabled some very significant wins in a very short order of time.

In SAS we have been the leader on SAS on this first generation out of the great early aggressively, we're a market leader, we continue to innovate and we have a very strong software position across that. In systems, another strong element there has been, again, first to market relative to a new category of entry systems where we're shipping with a number of Tier ones that are ramping aggressively.

Alex Gauna - UBS

Okay. Thank you.

Sujal Shah

All right. Thank you, Alex. Could we have the next question please?

Operator

Craig Berger with Wedbush Morgan, your line is open.

Craig Berger - Wedbush Morgan

Good afternoon. Thanks for taking my question. Wanted to dig into how much of some of the weakness in Q2 is driven by end market weakness versus some of the inventory hub things that have been going on at some of your customers. You kind of mentioned it in passing without really addressing it.

Abhi Talwalkar

Well, I don't know how to partition how much of it was end markets and how much of it was inventory related but, clearly, both played a meaningful role. You know in terms of end markets, I think consistent with other peers in terms of the supply side or even some of our system vendors, I think everyone certainly has experienced a level of softening in the U.S. IT spend, certainly in terms of year-over-year growth being softer than historical.

There was certainly a level of inventory that was built up over the course of probably late Q4 into Q1 in some of the storage segments and some of our customers and a lot of that had to be burned off in Q2, which certainly played a role in the depressed revenues.

Craig Berger - Wedbush Morgan

On the gross margin guidance for Q3, 42% to 44% it's kind of a big range. How should we be thinking about that or maybe what are the factors that might drive it toward the lower-end or the higher-end?

Bryon Look

Hey, Craig. This is Bryon. So there's a number of factors, obviously to drive that. One of the more significant ones is the fact that we are expecting revenue growth in the quarter, we are expecting to see some benefits relative to the cost structure of our products that will take hold as well.

Might point to the Storage Systems business, in particular, where we have continued to drive improvements in our margins as a result of the hard tooling that we've implemented within our factory.

You've seen the benefit of that here in Q2. That would expand into both the third and the fourth quarters, so that's certainly another factor driving that. And then always product mix factors into that as well.

So we've given a range in terms of our revenue outlook for the third quarter and, again, depending on those volume levels, you might expect to see, you know, obviously, a higher end revenues are going to drive higher margins for us.

Craig Berger - Wedbush Morgan

Last question on the mobility side. Some of the new programs you're pursuing with Tech Phase and some of the others, when might that generate revenues or what could be the earliest possible time for revenue generation? Thanks.

Abhi Talwalkar

Those are likely 2008. The strategy was certainly Tech Phase and we're doing this with others as well is to jointly go approach Tier ones as well as mobile operators, Tech Phase being an ODM and us supplying a standard product with much of the software done, really enables a turnkey and the cycle times can be anywhere from 10 weeks to 15 weeks. So we're off to the races in terms of that relationship having dialogue with a number of prospects.

Sujal Shah

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

Operator

Yes. Our next question is from Romit Shah with Lehman Brothers. Sir, your line is open.

Romit Shah - Lehman Brothers

Going back to Q2 as it relates to this quarter, I know you guys were surprised at how, I guess, June did not materialize the way you expected and you've described Q2 as being back-end loaded. Is that the same dynamic going on here in Q3 or would you say that your visibility is better in this quarter versus last quarter?

Abhi Talwalkar

You know, I'd say visibility is definitely starting to improve. I think both our customer sentiment, market sentiment relative to IP spending is showing signs of life and improvement, supply chains certainly appear to be tightening up. There was a considerable amount of burn in Q2.

If I look at sort of just the last week or two of June, we finished the quarter strong across a number of segments, we finished the quarter strong in systems, which started off a little bit soft early in the quarter. So all the indicators certainly are a lot more positive at the beginning of this quarter than they were at the beginning of Q2.

Romit Shah - Lehman Brothers

Okay. And just as a follow-up and I'm sure you'll elaborate on this at the analyst day, but just looking at the mobility business I mean from a high level it seems you have a lot of similar characteristics to the consumer business in terms of it being volatile and not profitable relative to some of the other segments. What's the long-term strategy with your wireless business?

Abhi Talwalkar

Well, I would characterize the mobility business slightly different than the consumer business because of the software content, the extensive validation and core competencies around validating products relative to the operators themselves, our strong position with Samsung. And we have great capability. It's an attractive market from a growth standpoint.

Now with all that said, we're certainly not blind to the fact that the market is incredibly challenging, very competitive, requires a sufficient amount of scale to win consistently and so we are obviously evaluating our ability to win long-term and the different options, in mobility as we are with other businesses, as we go through the phase one of our merger integration plan.

Sujal Shah

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

Operator

Seogju Lee with Goldman Sachs, your line is open.

Seogju Lee - Goldman Sachs

Thank you. You've been very busy with a lot of those actions, if we could just go into the latest action that you announced today, help us think about it in terms of how the expenses, I'm guessing it's just a shifting in terms of the cog line, essentially it’s shifting from a fixed cost to variable cost model for. And then just how it flow through the P&L on timing standpoint?

Abhi Talwalkar

Right. I'll give you my high level and Bryon can certainly add some of the color on financials. I think we've have been fairly consistent relative to our manufacturing strategy as an LSI management team. There are companies out there in the world that are proficient at high volume, high velocity or even high mix, low volume business that do that for a living.

My objective is not to spend capital or spend R&D on things that we can readily get with predictable high-quality partnerships and suppliers. And so our objective here has been to align our manufacturing strategy to leverage that third-party contract base, which will give us variable scale, variable cost structures.

There’s certainly, we expected to have an improvement benefit relative to gross margins for our systems business, relative to assembly and test of our components, given the assembly and test is the smaller portion of the overall product cost. This is more of a neutral to very slightly positive element relative to product margins.

I’ll let Bryon comment further or financials if you want to. Bryon?

Bryon Look

Yes, I think that’s the right way to think about the transaction. Obviously it's a very significant operation for us on a very successful one that we had in Thailand. If you think of the other elements on the financial side, we have historically spent, $20 million to $25 million or so in capital relative to our combined investments here in the assembly and test space.

So, from a cash perspective and cash flow perspective and a focus perspective, I think there’s certainly going to be some benefits there. Ultimately with respect to the P&L, I would say the cost-of-sales are just the margin would be neutral to slightly beneficial to us going forward.

Seogju Lee - Goldman Sachs

Great. And then just my follow-up question. In terms of the share repurchase program, I think you did about $400 million this quarter and I think you're coming close to, if not completing your authorization, so just as I look at the cash on your balance sheet, just the thoughts there going forward. Thanks. Good luck.

Abhi Talwalkar

We completed the 500 million and that's right, we did approximately $400 million in Q2 and then the remainder we have completed this quarter. So, we are done with that. Certainly we're not announcing anything today in terms of repurchase.

We just finished $500 million, we packed it very quickly. Based on our belief that the stock was undervalued and the company is going to continue to deliver long-term shareholder value. We still have that belief. We still believe we're in a very good position based on balance sheet as well as cash flow to continue to look at that as a tool to deliver shareholder value

Sujal Shah

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

Operator

Tayyib Shah with Longbow Research, your line is open.

Tayyib Shah - Longbow Research

Hi, guys. Abhi, can you talk about where you guys are in the ramp of the entry level tourist system is that ramp substantially complete now or do you still have some ways to go in second half of the year?

Abhi Talwalkar

No, in fact on a positive note, we're in the early stages of the ramp. We have a number of, I think I said if I didn't, I'm going to say it now, three Tier ones that are shipping the product. They're shipping several variants of the product that are based on SAS, all SAS drives but also SAS and fiber channel host connect.

We have a number of additional products that will come to market in the family itself that will continue to enhance the overall competitiveness and value proposition in customers, so we very much believe we're at the early phase of the ramp and as I noted, we've shifted 20,000 systems which, is a pretty meaningful number already.

Tayyib Shah - Longbow Research

Okay. And then if you can also talk about the SAS silicon opportunity and servers, where you are in that ramp in light of the server update cycle. And I know you talked about Raid-on-Chip growing nicely here. When does it get to a stage where it becomes a meaningful growth driver for your storage component for revenues?

Abhi Talwalkar

Well, I would say it's already a meaningful growth driver and we're still far from getting full penetration of the SAS RoC into the line share of the server vendors and as I noted, we're working with seven out of ten to get this product into their server families in the second half of this year. So we'll see continued growth around the RoC.

But it is certainly been a meaningful contributor to our year-over-year growth and our SAS business which, certainly has been very solid, well in excess of double digits and it has been a contributor. In terms of SAS and servers, I would say that SAS is very well-penetrated across servers.

The growth opportunities in SAS as we look forward now are in external storage where we have expanders and well as SAS controllers and as that SAS systems ramp increases, which it will, we will see benefits there. We will see continued growth in terms of SAS RoC and SAS RoC penetration. And we have made an acquisition in the recent past relative to bridge devices around SAS SATA that will start contributing to our overall growth and SAS infrastructure products.

Tayyib Shah - Longbow Research

Thank you.

Sujal Shah

Thank you, Tayyib. Can we have the next question please?

Operator

Sumit Dhanda with Banc of America Securities. Your line is open.

Sumit Dhanda - Banc of America Securities

Yes, hi, Abhi, the first question for you. The design win you are talking about on the storage side, I missed this is on the enterprise side and could you help us understand whether it's going to be a second source here or are you going to expect significant penetration of this OEM?

Abhi Talwalkar

You're talking about hard desk drives, Sumit?

Sumit Dhanda - Banc of America Securities

Yes.

Abhi Talwalkar

We didn't clarify as to what segment and at this point, based really on confidentially with our customer, I won't do that and will not also disclose who that customer is, but it's a very meaningful and significant design and we expect very meaningful penetration.

Sumit Dhanda - Banc of America Securities

Okay. The second question I have was Bryon, any chance you can give us some type of a breakout within your networking business and your, I guess your storage semiconductor business of the relative of Agere and LSI contributions?

Bryon Look

First of all, at this point in time, we're started to integrate it in terms of the operations organizationally and we're kind of viewing them as one. So really, really not breaking out the revenues that way. I think Abhi if you have any color you want to add to just what the...

Abhi Talwalkar

No, we have done the merge, we're one company, we're going forward and we're going to focus as a single company relative to all the businesses.

Sumit Dhanda - Banc of America Securities

Okay, then just one last one, the IP business you said, the actual run rates, the streams that has the run rates about $15 million a quarter, do we expect that kind of a run-rate going forward? Will it accelerate from here?

Abhi Talwalkar

Well, we expect, as Bryon alluded to, all of our businesses are up relative to what we projecting and that is inclusive of IP the $15 million is a cash flow number and I think Bryon explained that earlier.

Sumit Dhanda - Banc of America Securities

Okay. Thank you.

Abhi Talwalkar

Okay, thank you Sumit. Could we have the next question please.

Operator

Josepha Osha with Merrill Lynch. Your line is open.

Josepha Osha - Merrill Lynch

Hello, guys.

Abhi Talwalkar

Hi, Joe.

Josepha Osha - Merrill Lynch

Hi. First, Bryon since segment, the source systems and semis the reportable segment, are you able to give us that operating income number? I believe that is reportable as well. By segment, if that was in the press release. I missed it.

Bryon Look

So for Q2, we were profitable relative to our systems business and we were unprofitable for semi based on the near-term pressures that we felt on revenue. In both, businesses were expecting improvements and those into the third quarter.

Josepha Osha - Merrill Lynch

Do you have an operating margin number for either of those or do we have to wait for the 10-Q for that?

Bryon Look

We'll wait for the Q, but it's in the single-digit range, Joe.

Josepha Osha - Merrill Lynch

Okay. Thank you. Second question, looking at the target for Q3, you referred to is $70 million to $80 million special item at the gross margin line. Is that a recurring one-time item or a real one time-one time item. What is that? Is that intangibles amortization?

Bryon Look

Right. The intangibles amortization recorded this quarter was about $78 million and it's going to remain about that. Approximately that level. For the books next quarter.

Josepha Osha - Merrill Lynch

Okay. That in fact is something we should model in forward basis.

Bryon Look

Yeah, there are certain assets, right, that have different lines and then we have different sort of schedules of that amortization going forward. So I'm not implying by that that it's always going to remain or remain for a substantial amount of time at that level but that would be the way for the near term.

Josepha Osha - Merrill Lynch

Okay. And then last Abhi for you. At one point, there was an ethernet buy business, you know, with gear head one and the old, LSI business. LSI Is there any thought of trying to get back into that in your networking business?

Abhi Talwalkar

Again I think Joe, we have made a quite a bit of progress around the sharpening of our focus in networking. We'll provide much more clarity next week.

Josepha Osha - Merrill Lynch

Okay. Thank you very much.

Sujal Shah

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

Operator

Paul Kim with Omega Advisors, your line is open.

Paul Kim - Omega Advisors

I just want to follow-up on the question of the share buybacks. For the second quarter it seems like the average shares outstanding were 751 million and you're guiding for $725 million to 730 million. So can you just reconcile for third quarter? Can you kind of reconcile that for us and secondly, strategically, are we looking at the flash at all?

Abhi Talwalkar

Bryon.

Bryon Look

yes. Relative to that, that is an average for the quarter. It's going to be effected by the pattern we had in terms of the repurchases during the quarter. That is our best estimate as to what the share count is pointing to going forward for the quarter. Relative to the breakout of the share repurchase, approximately 400 million of that occurred in the course of the second quarter beginning, I believe, it was in late April. End of April and we completed the authorize is with -- authorized amount in the beginning of this quarter. That the additional 100 million.

Paul Kim - Omega Advisors

Okay, so basically it's right now it's, today, you're basically at serve 25 million.

Bryon Look

Sure. We ended the quarter something like 728 million shares.

Paul Kim - Omega Advisors

Okay. And flash?

Abhi Talwalkar

Paul, relative to flash, flash intercepts a number of ourative rent businesses and we see Flash as a growing opportunity. We're definitely evaluating in many regards. Today, we participate in might be ride hybrid drives. In fact, we're in some of the early hybrid drives that are shifting today. Absolutely they will intercept some of our storage system strategies and potential product offerings in the future for certain applications. It will take benefits. So it's clear lesomething that we're evaluating and clearly something we believe we're well-positioned for a core competency standpoint as well.

Paul Kim - Omega Advisors

Great. Thank you.

Sujal Shah

Thank you, Paul. May we have the next question please?

Operator

Adam sander with Deutsche Bank. Your line is open.

Adam Sander - Deutsche Bank Securities

That's Deutsche Banc. A couple of questions. A simple question for Bryon. In the Q3 guidance, can you assume the business is already gone or are you assuming lingering effect to that?

Bryon Look

That is a good question. Folks who have modeled assumptions, they were moving quickly to take that transaction the -- that we announced to a close and tree to get that done as quickly as we can. You can think of that in the very near future and so given that, the revenues you model with the state would be the end of July when we closed that as an example. You will -- you would have one-third of the actual revenues in the quarter and also a different profile relative to the expenses for the quarter. So, using that ex~ -- example, you might model something that was perhaps, you know, 10 million or less of revenue for Q3. Again, it's dependent on the actual close date.

Abhi Talwalkar

And our guidance for the quarter reflects that.

Bryon Look

Yes.

Adam Sander - Deutsche Bank Securities

Okay. And actually a quick follow-up to that. Does that mean your expenses will also, you're assuming a third of the quarter of expenses and that will be, that won't be there the following quarter?

Bryon Look

I think the expenses are baked into the guidance we have provided as well. It doesn't exactly map. There is traditional expenses and so forth.

Abhi Talwalkar

There are some variability but we try to factor that in when we establish the guidance on expenses in late June and reconfirm that.

Bryon Look

I guess, I'm sorry to be, maybe I'm not getting it properly, but what I'm trying to figure out is kind of the ongoing beyond Q3, so it's not enough to take 1/3 of the revenues and the equivalent expenses in the Q3 and take yet out of Q4, that's what you're saying, right? It's not equivalent. Yes, that's correct.

Adam Sander - Deutsche Bank Securities

Okay. And then last question, maybe for Abhi. I know you're talking about networking, you want to discuss your focus. Seems like the majority of the business for Agere, has been a legacy ASICS. You why -- are you as profitable as can you in that business and going to be declining or are there areas can you grow there and there is potential for bitter operating profit out of that segment?

Abhi Talwalkar

We clearly focused on driving better operating profit and better OI on that particular business. That is absolutely focused and one of the objectives around the overall refiner of the strategy and part of the rationalization process.

Adam Sander - Deutsche Bank Securities

Thank you very much.

Sujal Shah

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

Operator

Dan Burkery with O'Connell, your line is open.

Dan Burkery - O’Connell

Hi. Two questions. First one, can you tell us what the right or optimal net cashing question is for the company going forward and why you think that is the optimal net cash position and a follow-up.

Bryon Look

I think, first of all, we're going have a lot more discuss on that when -- discussion when we have the time on analyst day to talk about our overall capital structure going forward. Obviously we're comfortable with the position we have had. We have been enjoying net positive cash to debt and I think we can, with some of the moves we made, continue to operate the company efficiently here. The neutral position. Between cash and debt. Not a reasonable position for us based on the dynamics of our business, knowing that we have volatility, seasonal and so forth, with respect to different marks that we participate in.

Dan Burkery - O’Connell

You're saying a zero net debt position is okay? Or are you saying somewhere between zero and what we're at?

Bryon Look

We'll provide more clarity, I think, when I can address this and that will be probably significantly more on analyst day and a week from now.

Dan Burkery - O’Connell

Okay. I guess I'll wait until then. The second equal -- follow-up question k you disclose the cash proceeds of -- if any you'll be referring from selling the consumer business?

Abhi Talwalkar

Since the transaction is not closed, we're not at a position where we can disclose that. As soon as it's closed and fairly eminent, we doll that at that time.

Dan Burkery - O’Connell

You think that will happen before the analyst meeting?

Abhi Talwalkar

As Bryon said, our objective is to close this very soon. We're on track relative to conditions to closing. You know, I think the other thing I can offered is the transaction itself did not trigger HSR. HSR has a threshold of $60 million, so can you think of it as below the threshold.

Dan Burkery - O’Connell

You'll break down if it's all stock or cash.

Abhi Talwalkar

Yes.

Bryon Look

Part cash, part stock.

Bryon Look

We will certainly provide more clarity or transparent than we have until this point.

Dan Burkery - O’Connell

Okay. Great, Thank you for your help.

Bryon Look

The conversation around that is what is the expected source and uses of the cash as we go forward, which is why I think is an extended discussion around cap less structure.

Dan Burkery - O’Connell

Okay. Thank you very much and good luck.

Bryon Look

Thank you.

Sujal Shah

Thank you, Dan. Can we have the last question please?

Operator

Shawn Webster with J.P. Morgan, your line is open, sir.

Shawn Webster - J.P. Morgan Chase & Company

Thank you for squeezing me in. Can I -- can you give us a sense of the order trends. You said most of your segments would be up in systems stormcom and others. Can you tell us how the orders are looking and what areas do you see a relative strength over weakness to your guidance to us for growth and then I have a follow-up, please.

Abhi Talwalkar

You know, I think -- Shawn, it's generally, you know, up across the board in terms of relative strength. Given the majority of our business aside from mobility is associated with enterprise. And like the enterprise, business spending, business IT, whether it's PCs, servers, storage systems or networking equipment, we're seeing a consistent willful of increase-- level of increase quarter-to-quarter. There is not standing out over the other.

Shawn Webster - J.P. Morgan Chase & Company

Okay. So all low single-digit kind of growth.

Abhi Talwalkar

From a standpoint.

Bryon Look

The other side of that is relative to the mobility, which is a little bit different. We did experience during the quarter. Basically some target lower inventory levels with the major customer of ours. We don't expect that to have the same effect as we go forward, again, contributing to continued growth in that business.

Shawn Webster - J.P. Morgan Chase & Company

Okay. And on the customer from -- front, do you have any -- who are your 10% customers in Q2.

Abhi Talwalkar

Seagate, IBM and Samsung.

Bryon Look

Samsung?

Shawn Webster - J.P. Morgan Chase & Company

Abhi, for your headcount efficiency plans, I think you're a little over 9,000 as you exited Q2, how should we think of your employee base evolving as you run through your restructuring programs over the next two, three quarters?

Abhi Talwalkar

I think we talked about roughly 3,000 in total relative to consumers as well as the manufacturing, global manufacturing strategy. And that will be over the course. That reduction will occur over the course of now through the first half of '08. A pretty meaningful percentage of that is manufacturing data.

Shawn Webster - J.P. Morgan Chase & Company

I see. By the middle of '08, you will be at the 6, 7,000 headcount number?

Abhi Talwalkar

What is that?

Shawn Webster - J.P. Morgan Chase & Company

By the middle of 2008, you will be at a 6,000-ish headcount number?

Abhi Talwalkar

Yes, based on these actions.

Shawn Webster - J.P. Morgan Chase & Company

Thanks a lot.

Sujal Shah

Thank you, Shawn. I would like to thank all of you for joining us this afternoon. If you have additional questions, please call investor relations at LSI. Thank you and have a nice day.

Operator

Ladies and gentlemen, the telephonic replay of this conference will be available beginning today at approximately 5 p.m. Pacific Daylight time and will run through midnight on until -- July 27. The replay access numbers are 1-866-357-1423 within the United States. Again, that is 1-866-357-1423 win the United States and 1-203-369-0,115 for all other locations. Again, that is 1-203-369-0115 for all other likes.

The webcast will be archived at http//wwwlsi.com/webcast. That's www.lsi.com/webcast. This does conclude your conference for today. Thank you for your participating, you may now disconnect.

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