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Greg Lang – Chief Executive Officer

Analysts

PMC-Sierra Inc. (PMCS) Bank of America Merrill Lynch Technology Conference Transcript May 8, 2012 6:30 PM ET

Unidentified Analyst

… afternoon session. Delighted to have Greg Lang, CEO of PMC-Sierra joined us for a fireside session. Again, with most of the presentations as we have done this morning like to keep it as interactive as possible, so please feel free to jump in, ask questions.

With that, Greg would you like to just jump into Q&A? Are there any opening comments anything or should we just?

Greg Lang

Yeah. Let’s go ahead and jump in the Q&A. We’ll cover in that.

Question-and-Answer Session

Unidentified Analyst

Okay. Thanks. So, maybe at a very high level, what we have seen from the earnings season so far is, people calling Q1 sort of the bottom of the cycle, Q2 is expected to be up for most of the semiconductor players. But then visibility in the second half, right, sort of mix, right, for some players, they are just not feeling confident about giving any second half visibility. How do you see it from your perspective as you look at your end markets, you look at your customer engagements?

Greg Lang

Yeah. I would say that some of those feelings and views of the outlook are very similar to our own. We clearly see Q1 as kind of the bottom of this particular cycle and what we view is kind of the correction after the over buying from the tsunami last year.

We see that just in the form of kind of big reduction from run rates from a couple of major customers that indicate that they were burning off some inventory, obviously, as well as some direct conversation there. So, for us Q2 outlook is improved. It’s actually solid…

Unidentified Analyst

Yeah.

Greg Lang

… progress we think on the storage of the equation. However, the carrier part of our business, if we kind of break it into storage, it serves more the data center part of the environment, and then the mobile and optical part of our business, which is more carrier focused.

That is still soft. We do expect to be up a bit on the mobile side this quarter. But, the signs are not as robust and not as strong as we like to see. And so, my opinion, that’s why you are seeing some hesitation in the second half guidances.

We really haven’t seen kind of the strength in the carrier side that we like to see and actually, if you go back and I think about when it first started to appear, we -- it’s almost a year now, by the time we get to the end of Q2.

Unidentified Analyst

Yeah.

Greg Lang

So, it’s been a very long and extended kind of period of weakness. I think we all like to see some more strength there, before we say, feel better about, how the business will improve in the second half.

Unidentified Analyst

Right. So, Greg, when I look at your business, so storage is almost two-thirds of the business and then you have optical and mobile, the other two focus areas for you. Why is it that, in general, telco spending has lagged when what we hear is bandwidth consumption has not really slowed and there is a move to these advanced smartphones and tablets? You think this telco spending pause, is it really a pause, is there something more that we need to worry about, or what are you hearing from your customers?

Greg Lang

Yeah. So, on the first part of your comment on the storage part, the storage of the business, and I realize this wasn’t the direct question, has been actually remarkably resilient…

Unidentified Analyst

Yeah.

Greg Lang

… throughout the, if you go back to late 2008, the financial market meltdown and the gyrations since then, there’s been a lot of good solid health in that part of the business. The carrier business on the other hand is had this, volatile kind of swings both good and bad.

My view today is that, what we are seeing is, is really a pause, because some of the fundamentals behind what needs to get done are still real, I mean, the smartphone penetration continues to grow, continues to attacks the network, most of the 2.5 and 3G base station backhaul solutions that are on out deployed in the field today are based on T1/E1 technology.

T1/E1, which is a 1.5 megabits per second, you can group those together and make a bigger pipe, but that is ancient technology relative to what we are capable of delivering today with the packet network. And so my view on the mobile side of the equation is that they absolutely will move to a packet based network coincide with LTE rollouts, some -- in some cases before, I don’t think its question if, yeah, that’s really a question number one.

On the Metro part of the business where I think the phenomena there is similar in the sense that they need to move from TDM type of technology to a packet technology and the packet technology being OTN or optical transport network.

I view the challenge there is really one of, this is a big transition, this is the biggest transition that they have gone through since adopting SONET back in the ’90, and I think basically we under estimate or we forget how long it takes to actually kind of go through a major technology transition like that.

So, I’m hopeful that that actually starts to come back together, because at the end of the day the fundamental drivers of essentially the digitization of everything from images to video, to audio, et cetera and being able to distribute across the globe and view it on smartphone, PCs, et cetera is not going to slowdown, so we need to have the networks to support it.

And so for all those reasons, I believe this is a pause and not any fundamental other event going on it, its still there, the drivers are still there.

Unidentified Analyst

So, maybe let’s go through the different end market, you touched upon storage has been one of the more resilient end market out there. What’s driving that resiliency and we have seen Intel come out with the new several products Romley. And different vendors have had different feeling, some say that it was delayed slightly but now that’s it there, that is just going to lead to some level of upgrades in the data center. What are you seeing from your advantage point as to, first of all what’s driven the resiliency of spending in the data center and secondly, can Romley start another upgrade cycle.

Greg Lang

Yeah. Well, on the first question on resiliency, I think that those same drivers that we talked about earlier in terms of network bandwidth requirements, also play into storage requirements, digitizing everything has to be put some more storage, somewhere whether at scientific data or MRI, in the medical field or video for entertainment, they all needs to be put somewhere. And I think that’s why the demand for storage has continued decline this because we continue to put things out there to be stored.

The second part of your question and by the way, I think that phenomenon actually plays what the last question you asked which is, so putting, it’s happening over here, eventually the carriers are going to have to catch up and actually deploy the technologies needed to move it around.

But the second part of your question on Romley. Romley was delayed. I think the -- I think the -- I don’t know it was public or clear goal, I think by Intel’s to get it out at the end of last year that didn't happened in production any ways and it really didn’t come out until March, April this year.

I also noticed that, compared to the last big transition -- last big Intel transition, some customers, like I remember HP in the last big transition, they transition their entire portfolio at -- essentially at once, and so it was very radical type of disruption.

Right now, with Romley, they’ve just kind of targeted their high-volume SKUs and so they are kind of taking more of a staged approach. So that might be part of the slower ramp that people are describing.

I think PMC stands the benefit as other company's will if the Romley -- the Romley technology actually does push people into a -- whether it’s an upgrade or just deploying more capabilities with the new platforms that are out there. It appeared to me that the server market slowed a bit towards the tail-end of last year and maybe in, some pent-up demand for this one.

So we’ll see, I think it’s early to tell. Not enough platforms have transitioned, but it’s good to see at underway and we will see how kind of benefits it brings in the next couple of quarters.

Unidentified Analyst

Got it. And maybe to bring sort of everyone on the same page. As you look at the data center, maybe you can give us an overview of the products that you support and then especially, how you see the competitive landscape, because LSI is a major competitor.

Greg Lang

Yeah.

Unidentified Analyst

They always say that, look, we are taking share across the number of different players and HP seems to be the one big area for overlap. So, first of all, just for, people who are not as informed about the PMC story, what are your major product focused areas in the data center, what are LSI is right and where is the overlap in the competitive differentiation for you?

Greg Lang

Okay. So as a quick backdrop. So, PMC entered the storage marketplace, probably in the range of six to seven years ago. We entered the market with some big -- I’ll call it glue, some (inaudible) products and some other miscellaneous products.

We follow that with generation one SAS product and what this do is basically connect all the drives into the system and basically provide switching of the data in between those drives.

Today our portfolio is basically of those SAS products. We call them expanders. It basically expand the number of discs that you can connect, as well as the controllers that provides more intelligence, can run a rates stack, run an encryption stack, et cetera, in terms of kind of a complete chipset between the expanders and the controllers.

And in each of those areas, there are applications in both the server side of the business where HP, IBM, Dell, everybody knows those guys, as well as the storage system side, PMC, Hitachi, NetApp, those type of customers. And they have similar needs, but they are also somewhat, there can be very different requirements in those different segments.

What’s happened in the last, it’s probably three or four years, since there's been a big transition from SAS-1, which was a 3 gig technology for SAS-2. PMC on the SAS-1 generation of technology, we got about 30% share, that was our first real foray into, call it real silicon in the storage world.

But in the SAS-2 generation, we did quite well and we’ve kind of won something on the order of two-thirds of the business on the storage system side, and we won the largest, probably on HP, on the server-side.

So over the last three years, the share gains or share shifts have clearly come towards PMC and that continues to be the case today where we have customers and more -- maybe the most recent which is, IBM is moving off of Engenio, which were formerly owned by LSI platforms onto PMC-based platforms over the next 18 months.

So, we are continuing to see that. So, I’m not sure where they would see gain share, though, the one example that you gave was HP, where they actually were awarded kind of a fringe socket where there is, there was no alternative from PMC at the time. We still have 90. We have over -- have always had over 90% share in HP since we started and we will grow our share inside of HP with this Romley transition.

So there really hasn't been any type of share shift at that customer or for that matter at any customer in the direction towards them, it’s been all the opposite, we’ve built about a $400 million business over the last five years, to a large extend about 60% or 70% of that from share gains in the marketplace.

Unidentified Analyst

Got it. And the 12-gig SAS cycle, when does that start, I mean we have started to hear about it.

Greg Lang

Yeah.

Unidentified Analyst

But when does that actually start becoming meaningful and I think you acquired some assets from Maxim also…

Greg Lang

Yeah.

Unidentified Analyst

… to expand on that opportunity.

Greg Lang

Yeah. So I talked about SAS-1 and SAS-2, 3-gig to 6-gig. The next stack is 12-gig. People have products out today, both LSI and ourselves have products today at 12-gig that are in, we’ll call them engineering or evaluation stage.

There is a whole ecosystem that needs to come together for 12-gig to really work. It needs to be the silicon from us, cables, connectors, drives to plug into. And we think all that will come together by, probably the earliest at the end of next year, but more likely, probably around this time next year, maybe Q1 of next year is probably when we will see the first real revenue and kind of the completion of the ecosystem for 12-gig SAS.

So that’s coming out relatively quickly and I think that we'll see good healthy competition between the companies. I think the companies are very competitive with one another, but I think one of the really good things about this market is, not only is it a solid-based market, but essentially the market is served by the two of us.

So, essentially a bit of a duopoly, which I think allows us both to reinvest and continue to provide compelling solutions, as well as derive healthy returns for this part of business.

Unidentified Analyst

And how do you see the market share dynamics playing out and probably playing with?

Greg Lang

Market share for 12-gig, first of all, remains to be seen as, there is still a lot of Socket C1. But if I had to project forward, I think that PMC will continue to be the stronger supplier of the storage system side where we have, as I mentioned earlier about two-thirds of the sockets today.

And I don’t expect the big change on the server side either which is, we will have a strong position in HP, we will have a strong position at the next couple of guys and then we will kind of find it out at some of the smaller accounts and then some of the big data center customers.

So, no major step functions shifts one way or another. I think we’ll find it out around the fringes and probably be in a similar position, the year from now as we are today.

Unidentified Analyst

Got it. I’ll pause there, and see if there are any questions from the audience. Sorry, Mike, just one second.

Unidentified Analyst

I was just curious, is there any SAS functionality embedded into Romley that maybe comes from LSI.

Greg Lang

No. There was originally a plan by Intel this goes back two or three years to try to do essentially a Southbridge offering if you take it that way with SAS ports and it was essentially run a LSI. I think it was essentially a software rates stack.

LSI pulled the plug at least a year ago, a year and a half ago, and Intel canceled the program and really no OEMs have adopted in anyway. So, I don’t know all the technical details why didn’t work, but it basically is kind of there on the binary stage?

Unidentified Analyst

How do you think about the use of SSD in the data center? There are many different alternatives that have come up, is that a possible area of growth for you or will it mean something inorganic that you might have to do, if you get more serious in that?

Greg Lang

Yeah. So, I think, it's clear that SSDs are one of the most disruptive technologies in the storage space to come along for a very long time. Just given the performance possibilities with an SSD connection, we’ve been talking about 12-gig. Reality is, is that hard disks in the spinning mechanism that they have can't keep up at 12-gig.

So it is kind of no real value. The real value is in SSDs and kind of unlocking some of the performance it’s still possible when you are talking a solid state drive and the flash chips that are on that. So, I think that 12-gig is an important step to continue to unleash the power of flash in the data center.

However, one of the challenges with flash technology is each shrink, each process shrink when you go from 14 nanometer to 28 to 22 and down. The complexities are trying to get adequate life, useful life region rates out of that flash go up dramatically. And so one of the key technologies, there is doing just that, extending the life of that flash.

And we've actually, we have some interesting technology that we are actually working with some flash vendors and some large OEMs right now that extend the life of MLC Flash to five years on the latest technology notes and provide performance levels that are today unmatched.

So, I think that you’ll likely to see something from us later in the year around this. And it’s something that we are doing organically and are getting close to releasing. So, it’s really exciting and I think that will be a good solid growth vehicle for us next year, 2013, not this year, probably next year.

Unidentified Analyst

Is that something where you think looking outside helps in terms of accelerating your traction in the market?

Greg Lang

It could and we do investigate and evaluate those possibilities. But today, we’ve chosen not to pull the trigger on any outside systems.

Unidentified Analyst

And then maybe staying on this storage side, can you talk about the channel business, Adaptec, how that’s coming along?

Greg Lang

Yeah. So, Adaptec, we acquired kind of the remaining assets of Adaptec about a year and a half ago. And they've integrated very nicely as a company and gave us basically the ability to take the products that we were already building to a large extent and actually offer them through the reseller channel. And the reseller channel, if you think about what they serve is, in this part of the business what they are serving is actually white box server manufacturer or integrator towards trying to build a solution for.

It could be a medical operation and it could be a small data center or could be a big data center. And so it’s opened up a lot of good avenues that business for us before the hard drive issues kind of hit in Thailand, had grown about 20% from the time that we’ve had pick them up little over a year earlier. So it’s very nice growth.

Last quarter was not a great quarter given some of the drive issues because the channel guys are the last ones on the list to get new job availability. But we see that coming back this quarter and getting back on our growth curve. So, we’re excited about the possibilities of what we can do and being able to serve both big data center customers as well as the smaller white box and integration type of customers in the channel.

And we picked up a good -- I think a very good experienced team of Adaptec to do that.

Unidentified Analyst

Maybe on, switching gears to your optical business. It was very interesting to -- okay, you said on the call that you’ve seen some delays in the adoption of OTN. So, maybe for everyone's benefit, if you could describe what optical transfer network, what OTN does for the network. And I was always under the impression that it is way to consolidate networks as the way to lower costs.

So, why would you see delays elsewhere? If there are delays, does it mean that they're just buying more of the legacy SONET/SDH or like, what trends are you seeing there?

Greg Lang

Yeah. So, first, a brief description. At a high level of the optical transport network, is a general descriptive for a set of standards and really, what that does, what that kind of standard does is, it defines how you can take multiple different data types. It could be SONET, could be T1/E1, Ethernet, video et cetera and put it all in one package on a packet-based network technology. And that packet network technology is which, really critical to actually run to get the bandwidth increases that we need and kind of leverage more than Ethernet model than the old TDM model.

So it’s a very important set of standards to help carriers move into that model world, essentially networking. However, it is a big change. It is a big shift in terms of how they are going to protect their network. The comments that I made earlier, we are very general but I think very applicable which is, when we think about ourselves if we were rewiring our own house, so were putting a new stereo system for our own house or something like that. You take sometime to think about, what it is that you really want to accomplish and think about what the right thesis are, how you set it up and how you connect things together, how you build in redundancy.

And it feels like that’s what happening right now because there is not a lot of spend in SONET, there is not a lot of spend in OTN. It’s weak in general and in going back and surveying our customers directly, the OEMs that are building equipment as well as some of the carriers that we have relationships with. It feels like they are in a formulation stage where the customers who build equipment have taken longer to get that equipment to finalize because it’s a new area. It’s not just another level of density for a SONET card, but a whole new technology.

And the carriers at the same time are taking more time evaluating it and thinking about how they deploy it in network. So, we are hopeful that this actually is a relatively temporary analytical period where we can see some more active deployments.

When we did this survey a lot of our customers were actually projecting or anticipating that we'd be through this trial phase by Q4 in this year. So, it remains to be seen and I think that and that give us some encouragement that this is a temporary pause and they should be back doing more aggressive deployment later in the year.

Unidentified Analyst

Got it. Broadcom recently acquired BroadLight and so one of key players and GPON, they had I think Teknovus before relative to the EPON opportunity. Have you seen a big change in the competitive postioning in your FTTx, opportunity after Broadcom’s acquisition?

Greg Lang

No big change. I think I actually think the acquisition is good, maybe a little expensive, but at least good in the from market sense, because there is frankly too many people competing for two little business in that space right now, beyond those two or if we were now one there is also Marvell and Qualcomm and Cortina all competing at different sockets, different levels, but frankly their business every step forward in the unit volumes seems to be gobbled up with ASP erosion and we never make any progress. I think that’s a symptom of having just too many people in the market place.

I think for PMC that way we viewed it is consolidation to happen to make this a more normalized place if you want to taking at that way. We are actually very pleased that we have -- we continue to maintain a very strong footprint in Japan, which is the healthiness of all the markets. We have majority share there and I think that’s helping us reinvest and continue to lead last quarter, we announced our 10 gig chip set.

The only company in the industry with kind of for silicon for 10 gigs a metric operation, which is kind of the next stop, certainly in Japan and perhaps China as well. So we -- it’s good to see consolidation, but there is still needs to be some more before I think they gets into healthier place.

Unidentified Analyst

Correct, if I am wrong. Japan is still more EPON right although China has becoming more GPON. So you think you have good capabilities in both these technologies or is it still more EPON focus?

Greg Lang

In Japan, it’s primarily EPON and then going to 10 gig EPON, yeah. And in China interestingly enough and I think this has been pressured by one of the large equipment guys there, who has their own silicon on GPON pushing the telcos, is adopting more and more GPON maybe as much as 30% or 40% GPON in China, which in a interesting way it’s actually giving us kind of another opportunity to go penetrate the China market, because there are fewer players with GPON than there are with EPON solutions pushing the price pressure.

We might see a bit of an uptick by penetrating some of the local players with GPON product even though that’s not where they started, not where we started but they could create a good opportunity for us.

Unidentified Analyst

And you think pricing wise it’s in the right place that you will need it to be?

Greg Lang

For GPON?

Unidentified Analyst

Yeah.

Greg Lang

No. I think all the pricing is messy in this space, I mean that’s where the consolidation needs to happen. So, the reality is I don’t think anybody is making any money in the China market for that matter of the Korea market. I think the only place for the pricing is reasonable is in Japan right now, and we are fortunate to be strong there.

Unidentified Analyst

And you think in the U.S. the stakes are (inaudible) -- Verizon had a big FiOS build but now it seems to us stabilized somewhat?

Greg Lang

Yeah. It seems to be stabilized at a sleepy level. I know AT&T has done some BPON and later some GPON. Verizon has done some. I haven’t in my house but not enough people do to make it exciting in North America. The reality is if the CapEx required for PON in the U.S. market and this is going to also be true in Europe. There has -- someone has to dig up the ground and put fiber in the ground and makes it kind of a difficult and slow proposition.

So we’re not -- given the competitive dynamics as well as kind of CapEx requirements. We don’t expect this part of the business to grow. We expect it to be kind of flattish and paying in their kind of business but not an exciting growth there.

Unidentified Analyst

Got it. So whoever does the next FiOS has got to (inaudible) for a long time (inaudible) cable play, okay. Let me pause again and see if there are better questions. Maybe on wireless, yeah, sorry.

Unidentified Analyst

Thanks, Greg. And I think (inaudible) was about to go there, but maybe talking with the wireless business and sort of as you look at, some, I guess two points one how do you look at product strategy within the wireless business kind of expanding beyond -- what you’re doing with Wintegra over time? And then the second part is do you see opportunities to continue, I mean, sort of the microcell market?

Greg Lang

Yeah. So, two part question -- so Wintegra part of the business, which is focused for us on wireless backhaul for those who are familiar with it. And we have a very solid footprint in this business, however, it’s been impacted by other carrier spending softness that we are seeing. Our business is down. So we’re in the order of 25% to 30% from its peak roughly a year ago.

So, we’re exactly with quarter but it’s down about that much. So when we look at it, we ask ourselves have we lost any strength in the position that we have there. And we really don’t feel like we have. We continue to win, new design wins. We continue to hold the ones that we had.

Just for example, from fiber backhaul standpoint, we have that wins in most of the business for the top five fiber router providers that are out there, cell site router providers in on the microwave side which is people don’t think that we both participate there, but we actually have wins at five in the top nine on the microwave side as well.

So very good footprint and continue to increase share. So the big question is, when that business starts to come back for us. I think it’s timing with the carrier spending, lot of the fundamentals that we talked about earlier in terms of smartphone penetration et cetera are still there. And frankly we’ve had this phenomena happening in the U.S. for a couple of years longer than some other markets, because the iPhone really actually started here and actually those of us that are AT&T customers felt it painfully the first year or two of the kind of the emergence of that product category here in the U.S. that’s happening right now in other geographies.

We think the fundamentals are there. We think our fundamental position is there. This business will grow and we think it will grow nicely as people deploy more packet-based backhaul LTE equipment.

The second part of your question and so we continue to invest and we continue invest in solutions that provide higher performance and higher balance in that area. We think, we can maintain this kind a position for long time because it’s a very sticky, heavy software investment type of design given that it’s network processing platform.

The other things is that if we kind of rollback the clock a couple of years. It was interesting, because when I joined the company I was a little surprise that we were kind of communication infrastructure company, but didn’t really have any meaningful presence in the mobile part of the business, which is two thirds of the infrastructure. So we’ve, kind of, missing two thirds of opportunity.

So that was part of the rationale behind bringing Wintegra in and the position that they had there, but we also have some capabilities, some potentially analog on CMOS or mix signal capabilities in the company where we’ll be bringing out later this years some RF products for the base station -- excuse me -- for the remote radio head macro and micro type of sides that will get pretty interesting.

We think we brought some pretty disruptive technology there not really do announce all yet, but you see that coming from us in the next few months. Come join us at our Analyst Day and we’ll share with you that.

Unidentified Analyst

June 5th.

Greg Lang

June 5th, Boston, Thank you.

Unidentified Analyst

Just to follow-on to that questions, how do you see this role of small cells in the wireless market, because people talk about large cells versus small cells, and people talk about move to smaller size. But I would imagine as we go towards smaller cells, the role of backhaul actually increases, right, because you eventually have the backhaul, a lot of that traffic.

Greg Lang

Yeah.

Unidentified Analyst

So what you see even, when you looking the…

Greg Lang

I think that was the other part of your question. I am just sorry about that. Yeah, first of all just on the general trend and there is layer to this but I am going to focus on that the larger layers are not, what we might found in the home type of environment. We think that delivering the kind of bandwidth that’s possible with LTE especially in congested metro areas is going to drive a lot of small cell activity more than we’ve seen before that’s one of the reason that we’re excited about some of the RF effort that we are join because that’s going to populate on many more cells in that regard.

But the traffic haul has to be brought back somewhere as well. And so we think it will benefit our backhaul businesses as well. So we are big believers in that phenomenon and just kind of just delivering the amount of bandwidth that’s possible and especially in dense areas. So we're very much believers now.

Unidentified Analyst

And how is the competitive landscape in silicon for wireless backhaul? Who are the competitors you run into most?

Greg Lang

Yeah. The interesting thing about this is that a lot of the designs that we are competing against today and what we participate in are basically an FPGA plus a switch, generic switch and people kind of wrap their own secrets also around it, which I think is why we’ve done pretty well, but that’s a lot of work to do on your type of thing. And put together essentially some people call out the cell cycle, cell site router.

You hear more and more comments from folks like LSI and Cavium about being in the backhaul business. But it’s actually different point in the network side, I think it’s probably good to clarify that cell site router side router connects into each base station to be a 3G base station 2.5, 4 GLT each one of those has to have an interface back into that cell router. And that’s more of a kind of single technologies, a simpler, essentially network interface card. And that’s where the control plane process for guys like Cavium, and I think it’s call Axium from LSI, are playing in those base station slots and then they connected to what we do on the router side.

So we’re kind of at that router, cell site router box and then the next level to aggregation is hopefully OTN box that we’re providing there. So it’s kind of from the cell site in is where we participate. I think some of these guys are pursuing is that on the base station nick itself.

Unidentified Analyst

Got it. And is there any tradeoff with what the PLD guys are doing? Are they a competitor as you look in -- in this space because they had made the case that the movement towards small cells is additive. It doesn’t really hurt them because the larger base station give you coverage, the smaller base station give you capacity and hence additive to what they are doing but how do you feel, did you believe in that or?

Greg Lang

Yeah. With the general statement is true. I think it is additive. The FPGA position -- I won’t profess to be an expert on what parts of the market they are participating in. What I can say that was the most aggressive career in the first generation of packet base backhaul was China mobile. They came about two years ago and said we are going to spent 50% of our backhaul dollars on packet base backhaul. And so you saw lot of vendor scramble to get something in the market and in fact, this probably surprised a lot of people. Many reports call ZTE the number one backhaul provider in the business that’s because it was very heavily China-based, China-centric.

If you crack open those first generation platforms, they were very FPGA centric. This is why I was mentioning earlier our competition is really FPGA plus a generic switch where they did a lot of their own work. Those are also the designs that we’re replacing right now.

So I think that the early kind of market stuff almost always favors an FPGA socket. When you get into a more established and higher volume market, you’re almost always better off, if you can kind a piece of custom silicon that has low power, low cost, smaller density and less heat.

And I think that’s kind of this next phase of designs. ZTE is an example where our second generation design is moving from that kind of platform to PMC.

Unidentified Analyst

Maybe turning to some of the financial metrics, though a very strong performance in gross margins, I think you’re close to 69% than even guiding up to going above 70% over the next several quarters. So what’s driving that and you think you might be leaving some growth on the table as you go towards these margins or these are two separate issues altogether?

Greg Lang

Yeah. That’s a good question. The short answer is no. I don’t believe we’re leaving growth on the table. And there is a -- I think the gross margin structure in the industry is, we’ll have to shift up for people to continue to invest in R&D and let me explain that a little bit.

A lot of the markets that we serve, if you think about wireless backhaul and the cell site router and if you think about even in storage or segment storage that are relatively small in terms of unit volume when you compare it to a 300 million or 400 million unit notebook/tablet market or billion units handset market. So you’re taking in an increasingly large cost to develop a chip and spreading over fewer units.

Unidentified Analyst

So just basically on economics as we have to get paid in the form of gross margin to actually pay the cost of the R&D and each process note that we go from 65 to 40 to 28, the cost of an individual chip is going up. So as the costs go up and the units are kind of staying the same, we need to get more margin dollars to pay for it.

So the other thing that you’ll notice, here we have very good gross margins, we also have a very high percentage of R&D and that’s what paying for that R&D as we have to get paid at that level.

The last two obvious pieces of it which it’s somewhat of our mothers and apple pie, but I believe we live it and breathe, which is we have to deliver guys and customers who will pay us for. And I believe we do. And, two, we have to be tenacious of our driving cost out of our structure from day one. So we can realize the full benefit and again pay for the R&D required to serve the market.

Unidentified Analyst

And it’s interesting you bring that up because I think you had about $78 million or so of OpEx but for second half, you were actually guiding OpEx to go down…

Greg Lang

Right.

Unidentified Analyst

…from this. So how are you balancing this need to go -- like first of all, what are the R&D priorities, which are the key thing and to your spending your next incremental R&D dollar on. And how are you managing to keep OpEx out of control even when you’re going in to three very good growth markets storage (inaudible)?

Greg Lang

Yeah. A couple of things. I think today business for us and for most semi guys is weaker than we all thought it would be a couple of quarters ago. So at the top -- at a high level, we have to be kind of, I call it prudent about where we’re spending and how much we’re spending and in a weaker environment, I want to make sure that we have a line of sight back to get into our -- to get back to our target model, which is 25% to 30%.

I think the spending level allows us to get there with a moderate amount of achievable growth. So that’s kind of one as I feel like the environment right now dictates that we’re prudent about where we spend the dollars. Two is we do have a bid of a spending bubble right now. Bubble is too strong of a word to try some thing bigger than that.

But it’s finishing up 100 gig OTM part, which required some extra dollars. When we finish that up, we can pull that out and basically put that back to the bottom line but not spending it. So make a combination of those things, where we have some natural ways to, kind of, reduce our spending as well as frankly, a natural need to reduce our spending that are putting us there.

In terms of where we invest or where we focus R&D dollars, I think it’s very much along the lines of today’s business mix. We have -- we have a very solid substantial storage business that is established in funding its own growth, clearly our number one business, in terms of size, but also our number one R&D investment.

Second, behind that is the mobile backhaul and in the optical transports base, we’ll look to be reducing our investment there over time because we may have reached the point where the return for the next chip may not be there because of that R&D impact that I talked about earlier. So that’s kind of the high level of where we’re going right now.

Unidentified Analyst

All right. And then finally, you also announced an accelerated buyback recently. So what prompted that decision, like what kind of valuation metrics do you consider when you think about these kind of decisions there. Also as a follow on to that, it’s a dividend on the table, is that something you think about?

Greg Lang

So the impetus behind this actually goes back and we have regular conversations with our Board about cash we generate and the uses of that cash, including dividends, including potential acquisitions, including buybacks. So I think that there is a couple of things that let us here, one is when we look at the possibilities for acquiring technology or acquiring capability. We weren’t really excited about anything in near term in front of us. And so we did feel like there was a strong compelling need for the cash that was essentially in excess.

And at the same time, almost the same time, we also looked around, I think at the beginning of the year, we’re trading in $5.50 range or something like that, which we viewed as very low and we viewed the best place for us to invest that cash is back into ourselves in form of returning it to shareholder.

So I don’t really have anything to comment on at the moment about the dividend down the road but I’m sure that will be having conversations as we go forward. I think that you noticed that we announced this last week that we signed agreement with Goldman Sachs to enter in accelerated shared buyback which allows us to basically get the benefit of that buyback sooner than we would have done on our own.

Unidentified Analyst

If there are no more questions, I want to thank you, Greg. Thanks a lot for taking the time to chat with us, really appreciate your comments and thank you everyone for joining us in this session.

Greg Lang

All right. Thank you.

Unidentified Analyst

Thank you.

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