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QLogic Corporation (NASDAQ:QLGC)

2012 Bank of America Merrill Lynch Technology Conference Call

May 09, 2012 02:00 PM ET

Executives

Simon Biddiscombe – President and CEO

Jean Hu – SVP and CFO

Analysts

Scott Craig – Bank of America Merrill Lynch

Scott Craig – Bank of America Merrill Lynch

Let's get started here. Good morning everyone. I am Scott Craig here, Bank of America Merrill Lynch. I cover the IT Hard Storage and distribution sectors. We're pleased to have QLogic with us next. To my left I am sure most of you know Simon, President and Chief Executive Officer and Gene the Senior Vice President and Chief Financial Officer and with that we're going to quick off right into the Q&A.

First Simon we'd love to get sort of the brief overview, focus, your thoughts on the story here and then we can kick into the Q&A portion.

Simon Biddiscombe

First of all thank you for your time this morning. We appreciate it. The business has historically been very fiber channel focused and the success we’ve enjoyed have primarily been associated with server side connectivity for fiber channel through the sale of adaptors in that market. We continue to gain share. Actually last year we had approximately 55% of the market. That market itself is a very robust market, about $700 million market. We expect it to continue to be very stable over the course of the coming years as enterprises who have deemed that fiber channel is the right technology on which to move data from storage to applications continue to buy that technology and it's been far more robust than many people who thought it would be over an extended period of time when we think it will continue to be robust moving forward.

The move from fiber channel into converged infrastructure from fiber channel to FCOE and therefore the move very naturally into Ethernet based technology is something that's been going on over the course of roughly five years at this point in time. We've been shipping FCOE products for about that time frame. That market hasn’t taken off at the rate people expect it to for a whole series of different reasons associated with technology, associated with the macro environment and so on. But we continue to have a long-term belief system around FCOE and in fact we've seen a very significant growth in demand for those products on a year-over-year basis every quarter essentially. So FCOE continues to be an important technology that is a focus for us and then 10 gig Ethernet as a standalone technology continues to be important to us as well. And is incrementally more important at this point given that server you buy today will 10 gig connectivity as opposed to server you bought last year which would have 1 Gig connectivity. The logic didn’t play into 1 Gig Ethernet world. We do play with a 10 Gig Ethernet world and we've curved out a number two position for ourselves in 10 Gig Ethernet. That is behind only Intel at this point in time.

So the focus remains to be not to lose sight of the fiber channel market. It's very important to us we continue to gain share and continue to expand the market we serve through convergence and 10 Gig Ethernet connectivity. That's on the host side.

On the switch side, we have a fiber channel switch business as well. The strategy is to enable ether switch benders who are not fiscal and who are not brocade to be able to deploy converged capabilities, switch level by using an Ethernet basic and I will have a fiber channel in converged chip or a cellular module or cellular full blade on top of that switch. But you are marrying somebody else's Ethernet switch to our converged in fiber channel capabilities to allow you to go side by side against CISCO by way of example.

Historically HP has been the largest customer who uses our technology in that way. We've actually yesterday and that's extreme is using the technology as well in that way, extreme end is using the technology in that. There is a whole series of other leading Ethernet switch vendors who have to use our technology because it's the only place you can get that technology.

And then the third place we're focused is very much on the target side of the market. So that was a market that was historically dominated by PMC see it, what PMC chose not to invest in 16 Gig. That forced an opening up in every one of those opportunities on the target side and we've done a very good job carving out at a very strong position for ourselves across the target size of the market that tends to take a lot longer to get productions, so that will be two phase and then count to 13 and beyond.

So the focus remains fiber channel, converged Ethernet and host network and target related opportunities.

Scott Craig – Bank of America Merrill Lynch

May we start on the fiber channel side? It kind of feels like the mainframe market years and years ago, everyone said it's going to go away, it's going to go away and it never has. It's been kind of flat over the past 10 plus years. Is that what the fiber channel market feels like to you? Is it a flattish type of a market where you are still making good profits, good cash flow and that helps to fund some of the other business?

Simon Biddiscombe

Absolutely, so we are absolute believers in 32 Gig fiber channel. If you go back at various points through the development of fiber channel, people have believed that it would go away. It hasn’t. In fact we should promote ports over the course of the last two years than ever before. So last year we shipped 3.4 million ports, the year before we shipped 3.2 million ports. That's more ports than ever have shipped in the fiber channel industry. So the demand for the product remains very robust. So applications that need that type of performance, I expect it to be a three year 16 Gig cycle and then I expect there to be a 32 Gig cycle and for the first time I actually saw 65 Gig fiber channel written away on somebody else's PowerPoint presentation. It was somebody who doesn’t even do fiber channel. So I think fiber channel is going to have a long life associated with it. So people who need the performance characteristics and acquisitions that need that set of capabilities.

Scott Craig – Bank of America Merrill Lynch

Okay. And take us through the STO, you sort of alluded to the fact that maybe hasn’t taken off as quickly as what some people have thought. But your growth has been pretty good over the last few quarters in that business. So take us through historically why you think it hasn’t taken off and why all of a sudden you think the growth has started to accelerate.

Simon Biddiscombe

I think part of it is all about 10 Gig connectivity. I mean it took to run (inaudible) is just today, is 8 Gig fiber channel moving on a 10 Gig ether wire. That's what I see here. So you needed that 10 Gig wire and until this point in time , and so we bought really only had 1 Gig connectivity so we had to upgrade to the 10 Gig capability and so on. Today when you buy that server, it's got 10 connectivity and it makes the deployment of FCOE far more obvious than it has been any point in the past when the server only had 1 Gig connectivity. That's reason number one.

Reason number two is, as with any new technology, there isn't always agreement as to how the technology should be deployed. So as the entire ecosystem so if you think of a target choices, there were very few targets today that are FCOE capable that tend to be still fiber channel or NAS. They don't tend to be FCOE capable at this point in time. But with the next generation of targets, you're going to have before FCOE capability associated with those products as well. And I think the switches in 10 to 2 major switch providers and how you should deal with FCOE traffic hopping from switch to switch and so on. So you need the entire ecosystem to be in place. You need 10 Gig wires. You need to be able to buy host products and switch product and target products all of which are for FCOE capabilities. They haven't been able to do that and then you need absolute agreement between all participants on how things were working.

Scott Craig – Bank of America Merrill Lynch

Okay and take us through the 10 Gig Ethernet market. It's clearly that where the focus on a lot of the growth is going forward and there's maybe some skeptics out there where they would say you are going from sort of a two player market in the fiber channel area to a four player market and a 10 Gig Ethernet market. But take us through that market and how you think it evolves and how you think the competitive positioning is there.

Simon Biddiscombe

Yes, they don't need to be skeptical. It is the reality of that market. There are four of us in the market. In fact today there are many more than four participants if you include all of the much smaller companies at various points have introduced the point solution that solved a specific problems, somebody who was trying to solve. So I'm very pleased with our position in the 10 Gig ether market. As I said, on the adapter side, we're number two, behind only Intel and then everybody else folds off after us essentially. We've carved out that partly because of the importance of convergence and the fact that we offer the OEMs a way to deploy FCOE as well as Ethernet technology from essentially the same adapter. And that's attractive. If you are an OEM, that's attractive because you don't want to have to qualify and manage the sale of multiple different, that does do the exactly the same thing at the end of the day right. So we've carved a very strong position for ourselves across the OEMs with 10 Gig capabilities be they FCOE or be they pure Ethernet base. And I think whilst we have a different compelling advantage for the end user and for the OEM then I mean then Intel goes with a little compass. What we bring to the table is going to be of increasing value moving forward as networks do converge.

Scott Craig – Bank of America Merrill Lynch

And how large do you think that market is ultimately?

Simon Biddiscombe

I think last year we think it was about $400 million. Most of the research that was 400 million. If you take that 400 million last year and if you look at the 1 Gig Ethernet market in the datacenter, there was probably another $600 or $700 million. You've got a $1 billion worth of Ethernet connectivity in the data center. And we don't play it one [Multiple Speakers] for us. That's a $400 million market going to north of a $1 billion just through the substitution of 1 Gig. And we expect to play in the full $1 billion opportunity moving forward. That's the focus.

Scott Craig – Bank of America Merrill Lynch

Okay. And then touching the target market a little bit. A year ago we weren't even really talking about this market. So take us through how that evolved and clearly there was a player there who has now the market kind of wide open. So there's probably some questions around why would someone do that. So kind of take us through your thought process on that market and how you are expected play there?

Simon Biddiscombe

So I think people understand that it was PMC here who owned that business, actually it was all the way back to HP and so. So what we are talking about just to be clear is if you think about a storage system you buy from an EMC or NetApp, the connectivity that takes you back to the network and service, that connectivity from a fiber channel perspective was historically provided from PMCs here. I may decide to stop investing in 8 Gig, so why did they stop it? Why did they decide to stop? There's a couple of reasons. Number one is, that's by and far the smallest part of the overall fiber channel market. The switches are still the biggest part, after the second biggest, this is the smallest piece of the market. And you come forward to invest for only that part of the market.

The other issue is that the solution that you sell into that market is no longer just a fiber channel solution. The solution we sell is a single product but off this fiber channel FCOE, iSCSI and Ethernet connectivity and can see doesn’t have all the IP necessary to be able to deliver all of the protocol that somebody like QLogic is able to provide. So you are right. A year ago we weren't talking about it. And part of the reason is that design cycles associated with this were extraordinarily long. They are very sticky when you have then because the OEM have to actually write the software to operate with their operating system and have a products, right. So whether it's an EMC or NetApp or an XIV or three power or whoever does a specific operating systems, that they have to be written to deal with what is usually a sole supplier arrangement, unlike adapters which is typically ourselves dynamic across the board. On the storage side its one supplier friendly individual platform.

So as I said, we think that's roughly $100 million market at this point in time its growing at least consistently with the storage rates of growth which are higher single digit and servers and then we've carved out an extraordinarily good position for ourselves based on the fact that the competitor can't deal with iSCSI to wait weekly with iSCSI. And that's extraordinarily compelling to an end user.

So to be clear, that benefits us from a revenue perspective no sooner than very late this year. So it's very late this year and then through 2013, as those storage systems providers introduced their next generation platforms.

Scott Craig – Bank of America Merrill Lynch

Okay, talk a little bit about Romley. It seems like and correct me if I am wrong, but the quarterly conference call for both yourself and Emulex, there was a little bit of a disappointment in sort of what people looked at as what should be the wrong DRAM. So let's focus there for a few minutes. For starters from high level, do you think Romley is like what in Halem was to this server market where you saw, it was an extremely compelling upgrade for an Halem. Is it as compelling on Romley and sort of take us through maybe a little bit of a lumpiness that we are seeing right now in your revenue stream.

Simon Biddiscombe

Yes after the Halem, this is Romley piece first. I've said on several occasions that we didn’t necessarily believe that Romley is a compelling value proposition as Halem was from a technology upgrade perspective. That is what it is. The Halem cycle hit at the perfect time. Because it hit essentially as we were coming out of the macro to a moral very late 2008 and first part of 2009. And people hadn’t spent any money or servers, right. It was a very weak environment generally. So you have a very weak environment.

You're not spending any money on servers and then a next generation technology appears. So you can buy the next generation technology, okay.

We haven't been going through that kind of environment over the course of last year. The server markets been okay. We therefore don't expect to see the same inflection around server demand because it is not that vacuum in demand that we had in late 2008, 2009. Now I will say, I think there was a vacuum in demand last quarter. Okay I think as people finally accepted the fact that annually March they'd be able to start the by-product. You saw something of a vacuum in demand for Halem based solutions and that's Intel for the same (inaudible). So why was there disappointment?

We have said time and time again that from the first OEMs introducing servers based on Halem, to the last OEMs introducing the last platforms based on the Halem was roughly a six month process. I think what everybody heard was Romley shipping. They didn't actually think, Romley shipping from Intel but is Dell shipping? Is HP shipping? Is IBM shipping? Is super micro shipping? Is Quantum shipping? Is (inaudible) shipping? And so on and so on and so on. And you literally have to go through a line by line to understand which OEMs are shipping which platforms. So what we've said all along is it will take six months from the first to the last is typically a six month process and I don't think it's going to be any different. And that continues to be the case today. You've got OEMs today who start shipping Romley based platforms. Stark reality and that does create something of a disconnect between what people have expected from my business and what I expect the business to deliver.

Unidentified Analyst

Your longer term gross margin is I guess like 64% to 66% I think. In the last couple of quarters you've been like pretty well above that. So just longer term, what would put pressure on your gross margin or is that a conservative target?

Jean Hu

Yes, when we talk about our longer-term growth margins, we're on the 66 to 63%, that's probably about 18 month's goal. So long has been working very hard to protect our gross margin. If you look at our fiscal '12 which ended March quarter, our gross margin is close to 69%. So to me by selling the Ethernet business there how to improve our gross margin by 100 basis point. We guided the gross margin to be 68% for the current quarter. We continue to think we're going to do everything on a manufacturing cost side, everything will improve gross margin. But over time the revenue mix is 10-Gig Ethernet fall back revenue will drive the gross margin coming down a little bit. We continue to model about it, 100 basis point for a year because the revenue mix from the Ethernet to fall back.

Unidentified Analyst

I mean from a capital perspective, obviously with a (inaudible) business, on the balance sheet is even stronger than it was and there was a pretty good balance sheet. So I think for your thought process on buybacks, clearly everyone is focusing a little bit more on dividends and stuff like that that may have been historically. So take us through your thought process on how strong a cash flow generation company can be over the last couple of years and how that all plays.

Simon Biddiscombe

It's quite remarkable, free cash flow last year was $133 million, we've got $540 million of cash. So what we are doing? Number one is, we have increased the level of organic investment. There are some interesting opportunities that we wish to continue to pursue. Some of them are innovative new technologies that we'll bring to market over the course of the coming, actually it was an excellent this quarter. Others are just opportunities that are created by the shifting competitive landscape and others are opportunities that I see in the future. So organic investment is something that we've clearly stepped up over the course of the last year because we've got a belief system and some incremental opportunities we wish to go to.

The second is always thinking about the M&A environment. That's less obvious because we don't gaps in the product offering at this point in time that we have to go fill but we're always thinking how can we expand the markets that we serve through acquisition. And then in the absence of those, I think we're doing a good job on the organic investment side, the M&A environment isn't ripe with opportunity for us at this point in time. When I think about it within the context of how do we use the excess cash business, we return to shareholders through the buyback. We scratch overheads on dividends. We don't think that's the right thing to do for QLogic partly because we always remind you that significant proportion of cash is not here in the US, its offshore and therefore isn't necessarily available for dividend or buyback. So that certainly improves the (inaudible) business all of that cash is here in North America. But buyback will be the way we continue to use the excess cash in the business.

Scott Craig – Bank of America Merrill Lynch

And you talk about the investment side of things a little bit there, so let's focus on that a bit. But from an operating expenses basis you guys have done a pretty good job and there is going to be leverage going forward as the revenue starts to ramp. So there is obviously some pushes and pulls there but how do you see the operating expense playing out from a near term and longer term as the revenue starts to ramp.

Simon Biddiscombe

So we haven't changed the operating model. I still want us to drive to business around 30% operating margin but I am also very cognizant that there are significant opportunities and trends and data sets that I want us to take advantage of. So this quarter we said we would spend approximately $59 million. If you send it around 60, you get a $240 million number for the year roughly, plus or minus a little bit. That feels right to me to able to prosecute everything we are trying to do. And then we'll see top line expansion as some of these investments, manifest themselves as revenues, both organic and the organic in the new markets and then just find the channel on target, so on and so on. So we continue to drive for that 30% operating margin, we have that in the goal that for in a second. We're getting there as the revenue growth, it's not about cutting expenses.

Unidentified Analyst

So going back to the gross margin, I know you guys don't break it out necessarily by products but could you give us an idea of the based on the difference in gross margin between your converged and what that bears?

Simon Biddiscombe

No.

Unidentified Analyst

But Gene maybe along the lines of the gross margin side of things though. It's clear that you guys keep sort of outperforming the gross margin even as you go out a year and you face the 100 basis points sort of pressure on an annual basis but it seems like you are doing a better job there. Is there something from the manufacturing standpoint or from an execution standpoint that you guys feel you are doing a better job at that has prevented the gross margins from going down. Maybe from an expectation standpoint because it seems like every quarter I move out my decline, like another quarter.

Jean Hu

Yes, we actually, we worked really hard to manage our growth margin right and not only you taste the right business revenue side but also in supply chain, the manufacturing cost. So each year we have a target to reduce all those items to improve the gross margin. So overall if you look at our pricing environment is relatively steady, it declined each year but we typically not only would offset to the pricing side of the pressure but also improve a lot from the revenue mix side too. So that's really, we have been doing a good job on that. We're very proud of that and we'll continue to do that. I think in the longer-term it's really the pure internet revenue gross margin is nowhere our corporate average. So that's where the pressure. Once our revenue started to go up on the 10 Gig Ethernet side, you will see the margin coming down little bit. We have been always saying that but it’s the growth margin per dollar which is that we're going to focus on going forward.

Scott Craig – Bank of America Merrill Lynch

Okay, then finally just back to the 10 Gig Ethernet based here, you talked about a bunch of smaller players so being in the market right now, there's kind of four large players that we consider going forward. From that standpoint, how does the market play out over the course of the next handful of years as that market really starts to ramp. These smaller players don't seem to have the ability to ramp revenue or the technology in certain areas as well. So how does that market play out?

Simon Biddiscombe

I actually don't think that market, I don't think those smaller participants get consolidated. I think they just disappear and most of them are small private companies right. I think they just disappear and the reason is typically they introduce the product that had a point solution that solved an issue for an OEM. And as our products and as our competitor's products become more complete as it relates to delivering on some of that point functionality, there's just no need to help those participants in the market. So I think with time they just disappear. I don't think they necessarily are consolidated by Intel or so. So we don't have gaps that were offerings that require us to go by that technology. And that some of them got some cool stuff , there's no doubt about it and they've got businesses they built on some of that stuff but we don't see it as gaps necessarily that we have to fill.

Scott Craig – Bank of America Merrill Lynch

And let's say it goes down to four players which most people expect, where do you think your advantages are in the market for us to relative base?

Simon Biddiscombe

I mean the principal of bondages converge technology. So I've got 55% share in fiber channel. I've got 55% share in FCOE. It's exactly as we always predicted it would. If you use QLogic fiber channel, you're going to use QLogic FCOE. So that becomes what percentage of the total market for Ethernet is going to require FCOE in that market we know what have very high market share and then in the other parts of the market it's going to be about where do we win either because we are incumbent because of FCOE, then you need me for the FCOE as well as the Ethernet. Where do I then jump on based on pricing or whatever it might be?

Scott Craig – Bank of America Merrill Lynch

Okay and then just one last one for me, if there is no others in the audience like the switch market, can you discuss your position there and how you think that market evolves over the next for the while.

Simon Biddiscombe

Yes, it's very interesting actually. So when we decided we didn't want to sell, design and develop direct to class which is at 8 Gig and 16 Gig. When we decided that I would go to market model was going to be very OEM centric with edge and top of rack and blade capabilities. We absolutely made the right decision. So the next level of that decision as I said in my opening comments is about enabling every Ethernet switch vendor with converted and fiber channel switching capabilities so they can go on fight against CISCO. I have no desire to fight against CISCO. So I am enabling HP. I am enabling Extreme to go and fight the fight and we'll continue to sell chips. Subsystems, modules, full blades cases, we'll allow others to go and fight the fight. And that's absolutely the right strategy. I can't fight CISCO, and I can't fight Brocade. I have proven that over the course of 12 years. I can enable OEMs with critical fiber channel and FCOE capability that allows them to go and fight the fight, win the fight and win as a result. That's the way we got that business very much focused at this point in time.

Scott Craig – Bank of America Merrill Lynch

Well Jean and Simon thanks a lot for your time. Appreciate it.

Simon Biddiscombe

Appreciate it.

Jean Hu

Thank you.

Question-and-Answer Session

[No Q&A session for this event]

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