PMC-Sierra Q3 2007 Earnings Call Transcript

PMC-Sierra, Inc.  (PMCS)

Q3 2007 Earnings Call

October 18, 2007  4:30 pm ET

Executives

David Climie – Vice President, Marketing Communications

Mike Zellner – Vice President and Chief Financial Officer

Bob Bailey – Chairman and Chief Executive Officer

Analysts

Sandy Harrison – Signal Hill

Shawn Webster – J.P. Morgan

Allan Mishan – CIBC World Markets

Ruben Roy – Pacific Crest Securities

Kathryn Buergert – A.G.  Edwards

Seogju Lee – Goldman Sachs

Jeremy Bunting – Thomas Weisel Partners

Romit Shah – Lehman Brothers

Presentation

Operator

Good day and welcome to PMC-Sierra's Third Quarter 2007 Earnings Release and Conference Call.  Today's conference call is being recorded.  At this time, I would like to turn the conference over to Mr. David Climie, VP, Marketing Communications.  Please go ahead, sir.

David Climie – Vice President, Marketing Communications

Thank you, operator.  Good afternoon everyone and thank you for attending our investor conference call.  With us on the call today is Bob Bailey, Chairman and CEO and Mike Zellner, Vice President and CFO.  Please note that our third quarter 2007 earnings release was disseminated today via Business Wire after market close, and a copy of the release can be downloaded from our website.

Before we begin, I would like to point out that during the course of this conference call, we will be making forward-looking statements that involve a number of risks and uncertainties.  These risks and uncertainties include but are not limited to product demand, inventory levels, exchange in taxation rates, and other risk factors detailed in the company's Securities and Exchange Commission filings.  Actual results may differ materially from the company's projections.  For further information about these risks and uncertainties, please read the company's SEC filings including our Forms 10-K and 10-Q.

If you are asking a question during the Q&A session of today's call, we request that you limit yourself to one question at a time and then simply re-queue with the operator.  Thank you and I'll turn the call over to Mike Zellner.

Mike Zellner – Vice President and Chief Financial Officer

Thanks, Dave.  I'll review our third quarter 2007 results and financial position and then turn it over to Bob to discuss our business activity in detail.  Q3 was a strong quarter for PMC-Sierra.  Our book-to-bill was greater than 1.1.  Revenue for the quarter was $117.5 million, representing an increase of $12.8 million or 12% versus Q2.

As a reminder, we began to defer international revenue in Q2 associated with our largest distributor, reflecting our global agreement with them.  Excluding this one-time impact in deferral in Q2, our quarter-over-quarter revenue growth in Q3 versus Q2 would have been 8%.  This increase in revenue was primarily the result of improved activity in our wireline business.

Our turns business, meaning those orders booked and shipped within the quarter, was 33% of revenue in Q3 compared with 28% turns in Q2.  In Q3, our two largest customers, EMC and Cisco, each exceeded 10% of overall revenue for the quarter.  No other customer accounted for more than 10% of revenue.

Quarter-over-quarter revenue growth was strongest in Asia with a vast majority of this growth coming from our largest OEM customer in China.  By region, Asia continued to generate strong results in the quarter with the geographic breakdown as follows:  Asia 67%, North America 20%, Europe 10%, and other geographies 3.

On a non-GAAP basis, gross margins in Q3 increased to 66.3% versus 64.5% in Q2.  This was primarily due to stronger wireline business in the quarter, which has higher gross margins.

The company's operating expenses reflected continued savings as a result of the restructuring announced in Q1.  On a non-GAAP basis, operating expenses were down $8 million to $51.9 million in Q3 versus $59.9 million in Q2.  Operating expenses continued to decrease primarily due to our focus on controlling costs from our previously mentioned restructuring efforts combined with decreased photomask and wafer costs on fewer tapeouts in the quarter.  We do expect increased tapeouts in Q4.

Breaking down operating expenses, non-GAAP R&D was $31.8 million in Q3 versus $37.2 million in Q2 and non-GAAP SG&A was $20.1 million in Q3 versus $22.7 million in Q2.

Non-GAAP operating income in Q3 was $26 million or 22% of sales, which aligns with our targeted operating margin levels.  Net interest income of $2.7 million in Q3 was up slightly from Q2 due to our increased cash balance.

Our non-GAAP tax rate was 32% for the quarter.  This came in higher than expected primarily due to the ongoing impact of our FIN 48 liability.  In addition, we generated increased income in relatively higher tax jurisdictions due to product mix.  Although it's difficult to predict a quarterly tax rate due to the impact of our FIN 48 position, we expect the tax rate will remain in the low 30s until we resolve the outstanding matters.

Non-GAAP profit after tax for Q3 was $19.1 million, or $0.09 per share on a fully diluted basis.  For detailed reconciliation between GAAP and non-GAAP results, please see our press release issued today.

Q3 GAAP loss per share was $0.03.  The primary reconciling items for Q3 are as follows:

First, stock option expense or FAS 123R of $8.1 million, amortization of intangible assets $9.8 million, and significant FX movements in the quarter drove a net unrealized foreign exchange loss of $6.8 million related to our foreign denominated FIN 48 liabilities.

Restructuring charge of $1.6 million.  Again in March of this year, we announced a corporate restructuring of approximately 175 people or 14% of our workforce.  The total costs and charges associated with this restructuring were estimated to be between $12 and $14 million, of which $12.4 million has been expensed to date.

Turning to the balance sheet, we ended the quarter with $328 million of cash and cash equivalents.  Free cash and cash equivalents net of our $225 million of convertible debt increased $29.7 million to $103 million, up from the net cash position of $73.3 million in the prior quarter.

The primary reasons for the increase in the company's net cash position were as follows:  Positive non-GAAP cash flow from operations in the third quarter of $25.9 million and cash received from ESPP and stock option exercises of $6.5 million.

Offsetting these increases were outflows of $2.7 million associated with capital expenditures and intangible assets.

Accounts receivable increased $4.6 million to $41.4 million, which equates to 32 days' sales outstanding based on our quarterly sales volumes.  Our net inventory at the end of Q3 was $30.5 million, an increase of $2 million from the prior quarter.  Net inventory turns on an annualized basis were 5.2, down slightly from the prior quarter's 5.3 turns.

I'll now turn it over to Bob for his briefing.

Bob Bailey – Chairman and Chief Executive Officer

Thanks, Mike.  PMC's revenues in the third quarter climbed 8% sequentially following revenue growth of 5% in the second quarter.  Our Q3 revenues of $117.5 million exceeded the high end of the revenue outlook we'd estimated for the quarter, as our turns activity was slightly better at 33%.  The company's book-to-bill ratio at the end of the third quarter was strong at over 1.1.

In general, the markets that PMC-Sierra serves continue to improve as we are still in the very early stages of a triple-play deployment trend.  At the same time, there are general access and transport network upgrades in the wide area network and storage system upgrades in the enterprise ongoing.  We expect to see continued capital investment in the access and metro transport networks of the service providers as well as improved capital spending on enterprise storage systems as multimedia content and applications become more mainstream.  The downloadable economy driven by new web applications and the iPod generation is driving this new wave of capital investment.  We also see certain of our telecom customers, where PMC has significant content, gain share, in turn increasing PMC-Sierra's market share.  This is particularly apparent in the transport segment.  This is happening at the same time our efficiencies with respect to fixed costs have improved as a result of initiatives announced earlier in the year.  As well, operating cash flow was robust.  Inventories are at a healthy level within the supply chain.  Demand appears to be strong as evidenced by healthy backlog going into the current quarter.

During the third quarter, our telecom business picked up rapidly in the August timeframe based on increased Asian service provider contract activities and as a result, we experienced strong booking activities.  Our enterprise storage business improved again in Q3, while the fibre-to-the-home business was slightly down, and our MIPS related microprocessor business experienced a modest seasonal decline in Q3 as expected.

We had a good quarter of design win activity.  In Q3, we believe the inventory levels will work down on the supply chain, and for most of our customers we believe we are shipping into consumption levels.  Unless there is an abrupt slowdown of bookings, we expect continued growth into Q4 of this year.  Overall, our visibility is good and we expect to grow sequentially, while at the same time we'll continue to focus on our overall expense structure.

We have done a good job completing key development projects in Q3 while implementing the cost reduction program ahead of schedule.  From a geographic perspective, China showed continued improvement during the third quarter of this year, significantly outpacing North America and Europe as Mike reported earlier.

During Q3, we introduced a number of new products including our highly integrated WiMAX radio frequency IC.  This chip we call the WiZIRD is the first chip with two transmission-out/two transmission-in MIMO capability supporting downlink rates of 63 megabits per second and uplink rates of 28 megabits per second.

The WiZIRD device is targeted at femtocell base stations, customer premise equipment, mobile base station designs, and laptop air cards, and its multi-band capability covers all licensed radio spectra worldwide.  We announced a partnership with a private company to provide mobile WiMAX OEMs with a comprehensive solution.  Our reference design combines the baseband MAC solution with our WiZIRD RF IC and requisite software.  We launched this product at WiMAX World USA at the end of September.  We had more than 20 customer meetings there.  Many of these meetings resulted in agreements to evaluate our platform.  We expect to close several design wins in the coming months.

At this trade show and through these evaluations, we are having confirmed by the industry's leading wireless OEMs that this is the highest performance WiMAX RF IC available today.  We have already secured Asian design wins based on the reference design that is currently available, so we are very pleased with the early stages of this program.  We are very excited about WiMAX as a technology.  We believe it will become mainstream wireless technology that will complement our fibre-to-the-home program as the access technology of the future at the expense of cable modems and DSL.

In enterprise storage, the ongoing trend towards mid-range and low-end storage systems is driving strong growth in 4-Gig fibre channel disk array interconnect requirements and increasing customer demand for PMC's cut-through loop switch and enclosure management processor product family.

Industry checks are indicating a positive trend in storage IT spending for Q4 of '07, with sequential growth expected for our Tachyon storage controllers as well as our disk interconnect products.  Following the ongoing industry-wide adoption of SAS and SATA technology, tier I storage OEMs are beginning to introduce enterprise-class storage platforms based on 3-Gig SAS/SATA architectures using the SAS expander disk interconnect switches from PMC.

Notably, Network Appliance's FAS 2000 platform and Dell's PowerVault MD3000 were recently introduced using PMC-Sierra's SAS expanders, enclosure management processors, and system firmware.  We continue to secure additional design wins involving 4-Gig fibre channel and 3-Gig SAS/SATA with our North American and Asian OEM customers.  In the third quarter, once again our enterprise storage design win dollar content exceeded that of our telecom products.

In the wireline market, we continue to see increasing demand largely driven by deployment activities from Chinese OEMs.  This activity is associated with service provider requirements and large contracts for metro optical transport equipment.  Many of the OEM platforms being selected today for deployment contain PMC devices that were designed into those platforms between 2004 and 2006.

PMC's China business is also benefiting from improved activity in low-end routers and wireless infrastructure as well as Chinese OEM wins in the international markets.  We continue to see momentum on the design win front with our CHESS metro optical product line where we achieved wins with Huawei and FiberHome in China during this past quarter.

Wireless base stations and backhaul is also an area of strength as well as for design wins for several of our products.  Most of our telecom OEM customers placed orders with sufficient lead times during Q3, so backlog going into Q4 is strong.  As a result, we are expecting our turns business to be a little lower in Q4, and we are watchful of the typical feast-and-famine cycle of the telecom capital investment cycle.  But for now, we are benefiting from this cycle.

In fiber-to-the-home, we saw business in Q3 slightly down due to it being a seasonally slower quarter.  Japanese activity in the third quarter did increase, however, with our three major OEMs improving.  In addition, two of our Japanese OEM customers were awarded additional EPON ONU business using our parts with NTT targeting at the video PON market, which is cable TV over PON.  This will result in additional revenue contributions in 2008.  In Korea, Korea Telecom has slowed its initial fiber-to-the-home deployments.  With regard to fiber-to-the-home in China, we continue to demonstrate interoperability with our leading edge end-to-end EPON solutions, and some field trials of EPON fiber-to-the-home are now starting.  We have won approximately 15 different designs in China with our EPON ONU solutions, all addressing different provinces and deployment schedules.  We are expecting revenues in the millions in 2008 in China in EPON.

In North America and Europe, we are engaged with equipment manufacturers on GPON solutions for end customers in those markets.  We have a GPON ONT reference design, and we'll be announcing additional GPON products featuring our GigaPASS architecture, which is deployed in the Asian EPON markets.  Several evaluations are ongoing.

Now for the outlook.  Based on our backlog and bookings to date as well as expected levels of capital spending in the end markets that we serve, we expect PMC-Sierra's revenues in the second quarter of 2007 to be in the – I'm sorry, the fourth quarter of 2007 to be in the range of $122 to $126 million or a sequential growth rate of 4% to 7%.  In terms of anticipated business activity, we are expecting enterprise storage to grow in Q4 compared to the third quarter based on the growth in 4-Gig fibre channel as well as some of our SAS products.

With regard to communications, we are expecting continued growth in Q4 largely driven by strength in Asia and recovery in the North American markets.  However, as mentioned, lower turns are expected in this area.  Fiber-to-the-home is expected to increase slightly and our macro processor business is expected to be shipping at a similar rate in the fourth quarter as compared to the third.

I believe PMC is well positioned in the growth markets that we serve and that we are gaining market share in many of those segments.  In addition, we are now starting to benefit from the cost reduction initiatives that we launched in Q1 of '07.  Given our strong design wins so far this year and many of our new product initiatives such as our WiMAX RF IC and our server-based RAID controller product, I feel very positive about PMC's performance.

Thank you.  I will now hand the call back over to Mike for more details on our outlook for the fourth quarter.

Mike Zellner – Vice President and Chief Financial Officer

Thanks Bob.  I'll now provide more information about our Q4 2007 outlook.  Judged shipped and shippable backlog at the beginning of Q4 was approximately $98 million compared to $78 million at the beginning of Q3.  As of today, judged backlog including shipped plus shippables is approximately $107 million.

Based on this information, considering the current levels of demand and general uncertainty as to booking rates throughout the quarter, we estimate that potential revenue for PMC-Sierra for Q4 is in the range of $122 to $126 million.

On a non-GAAP operating basis, we expect our overall gross margin percentage in Q4 to remain consistent with Q3.  We expect non-GAAP Q4 operating expenses to be approximately $1 to $2 million higher than Q3 levels primarily due to increased tapeout activities.  We expect non-GAAP net other income to be approximately $2 million.

As previously noted, we expect that tax rate will remain in the low 30s due to our FIN 48 liability.  As a reminder, the effective tax rate can be impacted by a number of variables associated with our FIN 48 liabilities including but not limited to a change in product mix and a potential full or partial resolution of the underlying tax matters.

Finally, as we end Q3 with a basic share count of 217 million and a diluted share count of 219 million, our basic share count is expected to be between 217 and 219 million in Q4 and our diluted share count, which will likely be impacted by dilution associated with our convertible debenture is expected to be between 225 and 230 million.

For the fourth quarter of 2007, we plan for the following significant GAAP to non-GAAP reconciliation items.  First, amortization of purchased accounting costs associated with past business acquisitions, stock option expense as required under FAS 123R, FX gains or losses on our FIN 48 liability.  Additionally non-reoccurring items always are possible associated with other activity, positive or negative.  Now, let me turn it back over to Bob for his closing comments.

Bob Bailey – Chairman and Chief Executive Officer

I would now like to provide some commentary on the second press release that the company issued today regarding my decision to retire as CEO of the company.  As most of you probably now know, I have announced my intention to retire.  As a result, the Board of Directors is in the process of launching a search for my successor.  Both internal and external candidates will be considered.  I will stay on in my current role as CEO until a successor is appointed and in place.  I will continue to serve as Chairman of the Board.

There is a search committee of which I am a part.  There will be no changes in my work schedule, there will be no change in how we work.  There is much work to do and I am as motivated as ever to make sure that this work is accomplished as effectively as possible.

This was my decision.  The combination of PMC-Sierra having relatively good momentum as well as my wanting to pursue some personal endeavors made this the right time to make my decision and to commence a search and transition.  The Board and I want this to be a transparent and orderly process, which is why we are announcing my intentions now.  I am not seeking nor interested in any other job.

I have worked at PMC-Sierra since 1993.  The Board, the employees, and I helped our customers to build the first generation Internet.  It is something we are all very proud of.  But the thing I am most proud of is the competitiveness and technical prowess of the company despite having gone through the most dramatic down-turn in the semiconductor industry's history.  PMC-Sierra is now thriving as evidenced by our profitable growth and healthy new product offerings.  We know what we have to do.  We have our fate in our own hands; in this business this is all you can ask for.

In early 2001, we booked negative bookings in Q1, not a book-to-bill below 1, negative meaning cancellations exceeded new bookings.  Our revenues dropped 80% within four quarters.  In retrospect, there was approximately three years of excess inventory in the supply chain at the time.  We were going through what Andy Grove called a strategic inflection point.  The world was now different.  PMC's business was vastly North American-centric, telecom-centric, and had customers that were shrinking at an alarming rate.

We had to change our top 10 customers.  We had to diversify our product mix and markets served.  We had to dramatically reduce our fixed costs, and we had to change our culture.  I don't want you to think for a minute that we think we are done.  We have much work to do, but today we have two-thirds of our revenues in Asia.  Our headcount is almost half of what it was in 2000 even after two large acquisitions.  We are 50/50 telecom and enterprise in revenues and 7 out of the top 10 of our top customers are different since 2002 while becoming solidly profitable.

In fact, we are at model profitability today.  And I believe PMC-Sierra's employees are of a more competitive culture.  We have ingrained a culture of execution and accountability that runs deep and is self-sustaining.  I want to take this opportunity to thank the Board of Directors and the long-term investors for having the patience to see this metamorphosis through.  I want to especially thank the employees who have had to endure much uncertainty while executing in a world-class manner.  Of all of our accomplishments, it's the professionalism and competence of our employees that makes me the most proud.  So I am not going anywhere soon.  It is business as usual.  Now we can take some of your questions.

Question-and-Answer Session

Operator

Thank you, sir.  Ladies and gentlemen, if you would like to ask a question, please press "*" "1" on your touchtone phone.  To withdraw your question, please press the "#" sign.  If you are using a speaker phone, please lift the handset before entering your request.  Please standby for the first question.

The first question comes from Sandy Harrison, Signal Hill.  Please go ahead.

Sandy Harrison – Signal Hill

Well, Bob, I just wanted to say thanks for the wild ride.  It's been some fun times.

Bob Bailey – Chairman and Chief Executive Officer

Thank you, Sandy, and best of luck to you.

Sandy Harrison – Signal Hill

As far as talking about what you guys are looking at from a fiber-to-the-home perspective, you talked a little bit about the fact that you've made some inroads into the cable area over in Japan and in the NTT world.  Is this something that you think you can continue with the momentum made in some of the other areas such as Korea and China? Is this sort of a unique opportunity that you've got to the Japanese market?  And specifically when you look at China building out its infrastructure not only from a fibre-to-the-premise but also building out some of its digital cable for perhaps providing the service for the Olympics, how does that sort of fit into the grand scheme of things for this market segment?

Bob Bailey – Chairman and Chief Executive Officer

Well, Sandy, they have -- these different cable MSOs have different architectures.  This one was very specific.  It's more of an overlay because it's -- I don't think it's a retrofit.  And it's a small piece, although, we'll take it.  It's additive as I pointed out.  But I will tell you that most of the cable operating companies including the ones in North America are looking at PON as a technology.  They're trying to figure out how to use it because it's predictable if you want to run 100 high-definition channels simultaneously that the coax plant runs out of gas, it doesn't have enough bandwidth.  And so these are opportunities that we are looking at and are pursuing, but they're less mature than the one in Japan.

Sandy Harrison – Signal Hill

Got you.  And then just a quick follow up and I'll pass the call.  Gross margin, you saw that a couple quarters back when the com business -- telecom business slowed down you saw the hit to the gross margins and you have seen that come back with a rise in the contribution of telecom.  Looking in your crystal ball, do you think that these levels of gross margins are sustainable realizing we have sort of come back to them? Or do you think we'll have some more truing up as fiber-to-the-home and some of the MIPS picks back up early next year?

Mike Zellner – Vice President and Chief Financial Officer

It's Mike.  I mean, we are suggesting that our margins should stay in the 60% to 65% range and for sure, there are some pressures on those.  We obviously continue to do everything we can to maintain our margins and pricing in those areas where there's a little more pressure on them.  But we are predicting that it will stay the same.  Certainly, the strength in wireline helps that, and there is no reason to believe that that's going to drop off (inaudible) any time soon.  So we think that we can kind of continue in that range.

Sandy Harrison – Signal Hill

All right.  Thanks guys.  I'll go back in the queue.

Operator

The next question comes from Shawn Webster, J.P. Morgan.  Please go ahead.

Shawn Webster – J.P. Morgan

Yes.  Good afternoon.  Thanks for taking my questions.  And, Bob, good luck with your search and good luck in retirement.

Bob Bailey – Chairman and Chief Executive Officer

Thanks.

Shawn Webster – J.P. Morgan

The -- if I am calculating it right, it looks like turns is about 20%, 21% for Q4.  Is that right?

Mike Zellner – Vice President and Chief Financial Officer

That's correct.

Shawn Webster – J.P. Morgan

Okay.  So can you help us understand your mindset on why you are taking a little, or maybe a lot of judgment?  What are you hearing, what are you seeing in terms of linearity that's making you cautious?

Mike Zellner – Vice President and Chief Financial Officer

Yeah, I mean, lead times are coming – are pulling back, and they are getting normal.  I think that when we -- as I mentioned when I talked about the outlook, there is definitely some variability in the bookings in the current quarter and we kind of see that.  So we just thought it was appropriate to consider that and we did in fact.  Obviously the bookings, the backlog is strong, as you have observed, but we think it's the right thing to do to kind of consider that.

Shawn Webster – J.P. Morgan

I see.  And can you quantify or talk a little bit more about lead times?  What they did, where were they exiting Q2, where they are now, and where do you think they are going?

Bob Bailey – Chairman and Chief Executive Officer

Well, it's very specific to technologies.  But as an average lead time, they were stretched out beyond the norm last quarter and as a result, we got a lot more backlog, and now I think, I don't know if they are quite to normal yet, but they are getting to normal levels, and that's why we expect lesser turns as a result.

Shawn Webster – J.P. Morgan

And is that because you were able to bring supply online or what's the dynamic there?

Bob Bailey – Chairman and Chief Executive Officer

Yeah, it's – well, the – our suppliers caught up with demand.

Shawn Webster – J.P. Morgan

Okay.  And in terms of the com supply chain, you said things appears pretty lean, can you give any detail like how do you see the wireless infrastructure supply chain, the traditional telecom and enterprise? And yeah, well, I guess, start with there.

Mike Zellner – Vice President and Chief Financial Officer

Well, we track our own -- we don't report it, but we track our own trading partners' and distributors' inventories as well as our own of course, and we are at approximately model level right now, whereas when things were not going that well we were not at model level.

Shawn Webster – J.P. Morgan

I see.  Is there any area in the supply chain that looks particularly lean, like telecom, enterprise, wireless?

Bob Bailey – Chairman and Chief Executive Officer

Not really.

Shawn Webster – J.P. Morgan

Okay.  Things are normal?

Bob Bailey – Chairman and Chief Executive Officer

Yeah.

David Climie – Vice President, Marketing Communications

Shawn, it's Dave Climie, can we -- you have had two or three questions, would you mind if you have one quick one, and then re-queue, and so we can let others in on the call?

Shawn Webster – J.P. Morgan

Yeah.  I've just one really quick final one then.  What was your com business as a percent of your total sales, and what did it do sequentially?

Bob Bailey – Chairman and Chief Executive Officer

Yeah.  We...

Mike Zellner – Vice President and Chief Financial Officer

Yeah.

Bob Bailey – Chairman and Chief Executive Officer

We don't really break it out to that level of granularity, Shawn.  These guys will go over that with you offline a little bit.

Shawn Webster – J.P. Morgan

Okay.  Thank you.

Operator

The next question comes from Allan Mishan, CIBC World Markets.  Please go ahead.

Allan Mishan – CIBC World Markets

Hey, guys, and good luck to you Bob in the future.  I have a question about the MIPS business and the fiber-to-the-home.  You mentioned that they were down slightly in the quarter.  Is that down excluding the deferral impact, or were they actually down from the revenue that you booked in June in those two businesses?

Bob Bailey – Chairman and Chief Executive Officer

It's really -- it's excluding the deferral.  I mean, you can add to it...

Mike Zellner – Vice President and Chief Financial Officer

Yeah.

Bob Bailey – Chairman and Chief Executive Officer

But it's really excluding the deferral impact.

Mike Zellner – Vice President and Chief Financial Officer

Right.

Allan Mishan – CIBC World Markets

So those businesses actually could have been up versus what you booked in Q2?

Bob Bailey – Chairman and Chief Executive Officer

No.

Mike Zellner – Vice President and Chief Financial Officer

No.  What I am saying is we -- the comments were kind of considering the overall business level going from Q2 to Q3.  So in other words, if you consider that Q2's revenue would have been 1088, so when we talk about the -- the kind of the business level quarter to quarter, we kind of consider the fact that we had a deferral in Q2, and we adjust for it.

Allan Mishan – CIBC World Markets

Okay.  Great.  And two of the big European telecom OEMs had significant negative pre-announcements this quarter.  Did you guys see a slowing in wireless business outside of Asia?  Or are those guys still catching up from when they were reducing inventory?  How do you sew that up?

Bob Bailey – Chairman and Chief Executive Officer

Well, it's a pretty small piece of our business, so we really weren't -- the European wireless stuff, we don't have as a significant percentage of our business, so it really didn't impact us much.  But we also see a lot of our Asian customers seem to be gaining share.

Allan Mishan – CIBC World Markets

Okay.  Fair enough.  Thanks again.

Operator

The next question comes from Ruben Roy, Pacific Crest Securities.  Please go ahead.

Ruben Roy – Pacific Crest Securities

Yeah.  Thank you.  Bob, I was wondering if you would comment a bit more on the FTTH business in terms of the competitive landscape?  One of your smaller competitors announced some design wins in Japan in the NTT network, and I was wondering if you would comment on that and what the competitive landscape looks like in other geographies like Korea and China.  Thanks.

Bob Bailey – Chairman and Chief Executive Officer

Sure.  Yeah, there was an announcement by a competitor that has presumably been qualified to ship some product into the NTT network in the ONU or the subscriber side only.  We have that factored into our business plans and our guidance, and we still have the vast majority of market share.  We have newer products coming out that we don't believe anyone else will be able to match in the EPON space that we are working on as we speak.  And so we feel very strong competitive wise.  I think it is unreasonable for us to expect that in a business that we believe is going to be very strategic and very important to all of the carriers that we will have 100% market share.  So we figured that there would be somebody who would show up and start to get qualified, but we are not too concerned about it.  I mean we always have to try to maximize that share, and we are doing that.

Korea, they are going through, you might have heard of this book Geoffrey Moore did "Crossing the Chasm."  And basically we feel like it's a "crossing the chasm" situation in PON, especially in Korea where you make an initial deployment and then they digest.  They figure out all the bugs and various things, and they slow down and took a rest I guess.  And then it takes off after they really iron out everything.  I don't have any official information to that effect.  It's just -- having seen these cycles before, that's what it looks like.

And then in China, we are -- seem to be running the tables there, and that looks like it's going to be a big EPON deployment starting next year and ramping up.  Could be as big as NTT at some point in the future, not in '08, but possibly '09 or 2010.  So we feel very good about it and as we said, we are starting to engage with some cable companies, we are starting to sample and get evaluations going on the GPON products.  You will hear more about that in the coming months.  So we are making progress.

Ruben Roy – Pacific Crest Securities

Okay.  Thanks.  I just have a quick one for Mike.  The tapeout, increased tapeout activity, is that a one-quarter deal?

Mike Zellner – Vice President and Chief Financial Officer

Well, I mean, obviously tapeouts come about as a result of all the R&D activity we do.  It ebbs and flows a bit.  So the fact that it was particularly minor in Q3 is a little bit anomalous.  But there are quarters where we don't have any tapeouts.  More typically there are at least a few in a quarter, I would say.

Ruben Roy – Pacific Crest Securities

Right.  What I was getting, I am sorry about that, Mike, I was just -- it's an increase that you related to the $1 million to $2 million in higher OpEx to that tapeout activity.  So it sounded like there are some engineering tapeouts that are happening this quarter that may fall off in Q1.  Is that the way to look at it or...?

Mike Zellner – Vice President and Chief Financial Officer

Well, we are not -- we haven't really talked much about Q1.  So, you don't want to go into that yet.  But again, I mean, we do tapeouts regularly, so...

Ruben Roy – Pacific Crest Securities

Right.  Okay.  Well, thank you very much.

Operator

The next question comes from Kathryn Buergert, A.G. Edwards.  Please go ahead.

Kathryn Buergert – A.G. Edwards

Thank you.  Again on the OpEx, it looks like you may have exceeded the restructuring savings if you are targeting $20 million, $24 million on a per annum basis.  Can you talk about that, the OpEx levels kind of going forward and the savings you are achieving?

Mike Zellner – Vice President and Chief Financial Officer

Okay.  So again, I don't want to -- we are not talking about next year here at all.  But for sure, we did a bit better than we had originally predicted, both in terms of the absolute amount of the savings, as well as we actually completed it a bit early.  That is, originally we thought that it would take us into Q4 before we were complete, and we really essentially got it done in Q3.  So it definitely helped us relative to what we had originally thought.  So we are obviously pretty happy about that.  I mean, we continue to focus on saving costs where we can, and that's not something that necessarily is flagged by a restructuring event like we did in Q1, but rather it's really ongoing.

Kathryn Buergert – A.G. Edwards

And when you talk about the absolute level being achieved, you've kind of set the bar at a better level for starters now going forward for 2008?

Mike Zellner – Vice President and Chief Financial Officer

Yeah.  Again, we will talk about 2008 in our next call.  At this point, we aren't talking about it.

Kathryn Buergert – A.G. Edwards

Okay, I got it.  Thank you.

Operator

The next question comes from Seogju Lee from Goldman Sachs.  Please go ahead.

Seogju Lee – Goldman Sachs

Thank you.  Solid execution there.  Just in terms of the margin model, maybe I could ask the question in a different way.  Can we talk about like the -- how you are looking at the target margin model just going forward and what sort of leverage we might expect to see as the revenues grow here and how you are looking at the target model?

Mike Zellner – Vice President and Chief Financial Officer

You are talking about operating margin, I assume.

Seogju Lee – Goldman Sachs

That's correct.

Mike Zellner – Vice President and Chief Financial Officer

Yeah.  So we've said that -- both Bob and I have said that our target is to hit operating margins of between 20% and 25%.  And it depends on which quarter.  Sometimes, we will have quarters where revenues won't be quite as strong, in other quarters they'll be stronger.  But at the end of the day, we believe that we should run -- that we can run this -- should and can run this company at that range.  In terms of any specific quarter we'll see, but that's certainly the target that we are shooting for, and we can -- absolutely believe we can achieve it.  In fact, we did achieve it in Q3.

Seogju Lee – Goldman Sachs

Okay.  And just to clarify, that's a pro forma excluding options expense?

Mike Zellner – Vice President and Chief Financial Officer

That's correct.

Seogju Lee – Goldman Sachs

Okay.  And so now that you are solidly in the middle of that range at this point, and you have just executed some additional operating -- you have completed your cost reduction efforts in terms of the OpEx, is there a possibility or is there a point in terms of when we might start to rethink that target model, or...?

Mike Zellner – Vice President and Chief Financial Officer

You mean -- are you suggesting would the target model go to a higher level?  I am not quite sure what your question is.

Seogju Lee – Goldman Sachs

Yeah, potentially.

Mike Zellner – Vice President and Chief Financial Officer

I mean, Bob can answer.  -- I mean, we still are absolutely a technology company.  So in -- my opinion, running the company much hotter than say 25%, we'd be mortgaging the future at some level.  So I mean, we always look at that, and we will continue to look at it.  But my sense is at least for the foreseeable future, I think it's a reasonable range.

Bob Bailey – Chairman and Chief Executive Officer

Yes, Seogju, it fluctuates.  If you look at the history of PMC, it fluctuates.  And rather than have that be the high watermark, we like it to be -- we would take the fluctuations out if we can, and we'll always have some fluctuations.  And then -- and really be driving top-line growth at that operating margin, that's what I think is our goal going forward.

Seogju Lee – Goldman Sachs

Appreciate that.  And Bob, just in terms of -- you talked a little about sort of ebbs and flow related to fiber-to-the-home, but just in terms of the recent strength that you are seeing in Asia more broadly, it sounds like it is on the telecom side.  How are you thinking about the sustainability of that or -- and what are the key drivers that have been driving this recent strength, and just how are you thinking about potential ebbs and flows?

Bob Bailey – Chairman and Chief Executive Officer

Well, a couple of things.  One is as I pointed out during my portion of the call, the design wins that are driving a lot of the revenue today happened several years ago.  And we were successful in changing the way our customers develop and bring to market these optical transport boxes, where they are using a lot more of our technology than they ever have, so we are gaining share in the overall market as a result of that.  And that's pretty much all the companies.  I mean, they can't really afford to do things in a vertically integrated manner like they did in let's say the '90s.

Secondly, we believe that these companies in China are gaining share on a global basis.  So one in particular I know, their optical transport business is only about 50% China and 50% the rest of the world, where it used to be all China.  And so they are taking share themselves.  So we are gaining share, and they are gaining share; as a result, this is growing our business, which is good.

Having said that, and we already see a little bit of the signs, some of them are going to order a lot of stuff, and then they are going to soften a bit for a quarter or two.  And we hope that some of our other businesses like the enterprise storage business or the fiber-to-the-home business or whatever will pick up the slack.  That's really the diversification that we hoped would dampen these cycles.

Seogju Lee – Goldman Sachs

Great, thanks, and good luck.

Bob Bailey – Chairman and Chief Executive Officer

Thanks.

Operator

The next question comes from Jeremy Bunting, Thomas Weisel Partners.  Please go ahead.

Jeremy Bunting – Thomas Weisel Partners

Thanks.  Bob, could you just give us an update on, specifically on the SAS RAID products that you announced earlier in summer?  There was talk about ramping with HP.  Has the timeframe for that changed at all, and have you got any other business with any other server OEMs?  And then I have a question for Mike.

Bob Bailey – Chairman and Chief Executive Officer

Sure.  The timeframe hasn't changed that we know of.  It's driven a lot off of the server platforms like thoroughly and -- from Intel and there's an AMD equivalent, the name escapes me right now.  And so that hasn't really changed to date, because we are on schedule on that development.  There are several opportunities that we are pursuing right now, and so I don't want to tip my hand too much to my esteemed competitors.  But hopefully, we will have something to talk about in the near future.

Jeremy Bunting – Thomas Weisel Partners

And for Mike.  I understand the reasons for the near-term higher tax rates.  But in terms of bringing it back below 30%, are we talking a couple of quarters or longer than that?

Mike Zellner – Vice President and Chief Financial Officer

The timeframe is hard to predict because it is underpinned by some FIN 48 liability issues.  There are taxing jurisdictions that come into play and it's -- some of the timing of that is not directly in our control.  We can influence it I guess at some level, but it's not directly in our control.  So it's hard to say or pin it down to a specific quarter.

Jeremy Bunting – Thomas Weisel Partners

Okay.  Thanks.

Operator

Ladies and gentlemen, if there are any additional questions at this time, please press "*" "1" on your touchtone phone.  The next question comes from Romit Shah from Lehman Brothers.  Please go ahead.

Romit Shah – Lehman Brothers

Yes.  Thank you.  Could you just explain a little further how the convert is impacting the share count in Q4 and on a go-forward basis, please?

Mike Zellner – Vice President and Chief Financial Officer

Yeah.  It's above -- once the price of the stock gets above 880, then additional shares come into the market that way.  So obviously, we don't speculate on the stock price per se, and so that will impact where the stock price ends up.  If the stock price ends up below 880, then of course it won't have any impact.

Romit Shah – Lehman Brothers

Could you just -- could you help me out with the math?  I mean, for every point increase in the stock price, what the impact would be to the share count?

Mike Zellner – Vice President and Chief Financial Officer

Yeah.  It's pretty complicated.  So we can go through the details of that with you offline, so you can understand the specifics.  A lot of the details obviously is in the K, but we can go through that with you as well, but kind of to go through the detail on the call...

Romit Shah – Lehman Brothers

Sure.  If I could just lastly, with the strong free cash and the rising cash balance, are you guys thinking at all about paying down the convert or taking a fresh look at your balance sheet?

Mike Zellner – Vice President and Chief Financial Officer

So we -- I would say on a regular basis we talk about the capital structure of the company, and some of the various things we can do with the cash once -- first of all, when is enough cash enough and all that.  So we talk about it, Bob and I talk about it on a regular basis, and I can't talk about it beyond that.  But we certainly consider these various options for sure.

Romit Shah – Lehman Brothers

Okay.  Thank you.

Operator

Gentlemen, there are no further questions at this time.  Please continue.

David Climie – Vice President, Marketing Communications

Thank you for attending our conference call today, and we will be scheduling our fourth quarter 2007 earnings release for the third week of January.  And at that time, we will be reviewing the quarterly results and providing an outlook for the first quarter of 2008.  So thank you, and that ends today's call.

Operator

Ladies and gentlemen, this concludes the conference call for today.  You may now disconnect your line, and have a great day.

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