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QLogic (QLGC)

Q3 2006 Earnings Conference Call

January 18th 2006, 5:30 PM.

Executives:

HK Desai, President, Chairman and CEO

Tony Massetti, Vice President and CFO

Analysts:

Aaron Rakers, A.G. Edwards

Andy McCullough, CSFB

Harsh Kumar, Morgan Keegan

Kaushik Roy, Susquehanna

Sheldly Heraisy, Cottmen Brother.

Henry Naah, Lehman Brothers.

Royal Rivera, Goldman Sachs

Dan Renouard, Robert Baird.

Paul Mansky, Citigroup

Tom Curlin, RBC Capital Market

Clay Sumner, Friedman Billings Ramsey

Glenn Hanus, Needham & Company

Keith Bachman, Banc of America

Presentation

Operator

Good day everyone and welcome to the QLogic Corporation Third Quarter Fiscal Year 2006 Earnings Conference Call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Mr. HK Desai, Chief Executive Officer and President. Please go ahead, sir.

HK Desai, Chairman, President and Chief Executive Officer

Thank you operator. Good afternoon and welcome to QLogic's Third Quarter Fiscal Year 2006 Earnings Conference Call. I am HK Desai, CEO and President, and with me Tony Massetti, Senior Vice President and Chief Financial Officer. Today, Tony will begin with a review of the third quarter financial results, and I will continue with a general discussion of the state of our business. After that, we will open teleconference for questions. Tony?

Tony Massetti, Senior Vice President and Chief Financial Officer

Thank you HK, good afternoon. By now all of you should have seen our press release and associated financial information. In addition to reviewing our financial results, some of the comments today will include forward-looking statements regarding future events and our projections of the financial performance of the Company based on our current expectations. These comments contain significant risks and uncertainties that could cause our actual results to differ materially from those expressed in these forward-looking statements. We refer you to the documents that QLogic files with the SEC, specifically our most recent Forms 10-K and 10-Qs. These documents identify important risk factors that could cause our actual results to differ materially from expectations. We do not intend to update any of the information contained during the forward-looking statements that we make today.

Today's conference call is being webcast, and a replay will be available for 12 months on the QLogic website at www.QLogic.com under Investor Relations. An audio replay will be available through February 1st by calling 719-457-0820, pass code 2886486. Please be aware that if you decide to ask a question, it will be included in both our live transmission, as well as any future use of the recording. Copyright law, international treaties protect this conference call report. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio for today's call is not allowed without express written permission of QLogic.

In our third quarter earnings press release issued earlier today, we reported both GAAP and non-GAAP results. In the third quarter of fiscal year 2006, the difference between the results relates to acquisition related non-cash compensation charges at an insurance recovery. And accounting at this difference is included in our press release. The difference in our non-GAAP diluted earnings per share for continuing the operations as compared to our GAAP results is relatively minor, only $0.1 per diluted share in the third quarter, was $0.38 per share non-GAAP versus $0.39 per share on the GAAP basis. All the references we'll make today relate to the non-GAAP results for the periods noted, unless otherwise stated.

As announced in late August, we entered into a definitive agreement to sell our hard disk drive controller and tape drive controller business to Marvell Technology Group for $225 million. We closed this transaction on November 4th and recognize a pre-tax gain on the sale of $213.9 million. As a result of this transaction, we have presented the financial results of this business as discontinued operations and the financial statements for all periods included in our earnings press release. Our discussion today will focus on our financial results from our continuing operations, unless otherwise noted.

Our revenue in the third fiscal quarter ended January 1st, 2006 was a record $129.2 million, an increase of 11% from the same quarter last year and 9% sequentially. This exceeds the high end of our guidance of a $121 to $125 million given during the second quarter earnings conference call. Our revenue from SAN infrastructure products, which are comprised of HBAs, switches and silicon grew 14% to $120.4 million from a $105.6 million reported in the third quarter of last year. Sequentially, revenue from the SAN infrastructure products grew 9% from the September quarter. The increase in our revenue from SAN infrastructure products was primarily driven by HBA revenue growth of 16% from the comparable quarter last year and 9% sequentially.

Our switch revenue grew 35% from the same quarter last year and 15% sequentially. Our revenue from management controllers decreased 35% to $6.1 million from $9.3 million reported in the third quarter of last year. Sequentially, our revenue from management controllers decreased $1 million in the December quarter. As we discussed in previous earnings conference calls, we expect revenue from management controllers to continue to decrease overtime. Other revenue, which is comprised of royalties and service revenue, was $2.7 million in the third quarter.

Our December quarter gross margin of 71.4% decreased from 71.6% reported in the third quarter of last year and increased from 70.6% in September quarter. The sequential increase in our gross margin was due to a favorable product mix and manufacturing efficiencies and was better than our expectation. Consistent with our previous guidance, we expect our gross margin during the next 12 to 18 months to be over 65% depending our product mix. During the December quarter, we experienced that ASP reduction on like-for-like products in our HBA business of 1.6%. This is consistent with the amounts experienced in the prior quarters and within our expectations.

Next, I would like to cover third quarter operating expenses. Total operating expenses were $43.7 million in the third quarter, up 17% from $37.5 million reported in the same quarter last year. On a sequential basis, operating expenses were up 6% from $41.2 million reported in the second quarter.

Engineering expenses in the third quarter increased 17% to $22.6 million versus a year ago and increased as a percentage of revenue from 16.6% to 17.5%. On a sequential basis, engineering expenses in the third quarter increased 6%. We will continue to support existing in future technology development with engineering expenses as a percentage of revenue ranging from 16% to 19%.

Sales and marketing expenses in the third quarter increased 16% from a year ago to $16.1 million and increased as a percentage of revenue from 12% to 12.4%. On a sequential basis, sales and marketing expenses increased 3%. We expect that future sales and marketing expenses as a percentage of revenue will range from 11% to 14%.

G&A expenses in the third quarter of $5.1 million increased 17% from a year ago and increased as a percentage of revenue from 3.7% to 3.9%. G&A expenses were up $0.9 million sequentially. We expect that future G&A expenses as a percentage of revenue will range from 3% to 4%. We continue to focus on improving efficiency in our operating expenses while investing in critical new development programs for existing and new technologies.

In the December quarter, QLogic generated an operating profit of $48.5 million an increase of 6% versus last year. The third quarter operating profit margin of 37.6% decreased from the third quarter level last year of 39.3%. On a sequential basis, operating profit increased $5.7 million with 13%. The operating profit margin of 37.6% in the December quarter increased from 36% in the September quarter. Interest in other income was $5.2 million in the third quarter, an increase of $0.7 million versus a year ago and a decrease of $1 from the September quarter.

The income tax rate for the third quarter was 31.5% this represents an increase when compared to the 37.7% tax rate in the September quarter, which benefited from a favorable revolution of a routine tax examination. The annual income tax rate for the remaining quarter and the full year of fiscal year 2006 is expected to be approximately 40%.

Our third quarter income from continuing operations decreased 7% to $31.4 million or $0.38 per diluted share from the third quarter of last year, when the company recorded income from continuing operations of $33.8 million was $0.36 per diluted share. On a sequential basis, income from continuing operations increased $0.9 million from $30.5 million or $0.34 per diluted share reported last quarter. Our income from continuing operations as a percentage of revenue in the third quarter was 24.3%, compared to 29.1% reported in the same quarter last year and 25.6% in September quarter. Our third quarter diluted net income per share from continuing operation was $0.3 above the high end of the forecasted range of $0.32 to $0.35 per share provided during the second quarter conference call. This represents the 42 consecutive quarter profitability for QLogic.

Our GAAP net income for the third quarter, which includes the results from discontinuing an operations and gain or sale of our hard disk drive controller and tape drive controller business, was a $166.2 million, are up $2.04 per diluted share. Our financial position continues to be strong especially with regard to our cash flow. During the third quarter, we generated $37 million of cash from continuing operations. The Company's cash and short-term investment balance was $719 million at the end of the third quarter.

In November we completed our previously announced acquisition on Troika Networks to $36.5 million in cash. During the third quarter, we repurchased $130 million of our common stock in the open market. Hence fiscal year 2003 we repurchased a total of $560 million of the Company's common stock under programs authorized by our Board of Directors. During the fourth quarter we plan to continue to execute against our current stock repurchase program and make the estimated tax payments associated with the gain recognized on the sale of our hard disk drive controller and tape drive controller business. Third quarter receivables of $70.5 million were up $6.1 million from the $64.4 million at the end of September quarter. The DSO rate for December quarter was 50 days compared to 49 days in September quarter.

With a growing trend towards hub arrangements with our OEM customers and greater contribution from our distribution channel, we continue to expect upward pressure on our DSO performance. Based on current customer and channel mix, we expect DSO in the future will range from 45 to 55 days. Annualized inventory turnover in December quarter was 5 turns compare to 5.5 turns in the September quarter. Inventory at the end of the third quarter was $29.8 million, an increased from the $25.2 million at the end of the September quarter.

Our long-term outlook for our core business remains favorable. Based on a foundation of design wins in existing markets as well as the emerging markets expect to see continued growth in our revenue for SAN infrastructure products. Based on a traditional seasonality with our OEM customers in the March quarter we expect total revenue to be in the range of $126 million to $129 million. Due to the potential variation in product and technology mix, we expect gross margins for the March quarter to be approximately 70%.

Considering above revenue and gross margin expectations, combined with plant operating expenses, infrastructure investments and projective tax rate, the current outlook is to achieve diluted earnings per share from continuing operations of approximately $0.35 to $0.38 in the March quarter. Actual results for future periods may differ materially due to another fact is including those outlined during the course of this conference call and the company's filings with the SEC and the disclaimer statement at the end of our third quarter fiscal 2006 earnings press release.

I would now like to turn over this conference call to HK Desai, our CEO and President.

HK

HK Desai, Chief Executive Officer and President

Thank you, Tony. Thank you again for joining us today on our third quarter earnings conference call. I am pleased to announce QLogic's 42nd consecutive rough quarter of profitability as well as new record for revenue and diluted earning per share from continuing operations. The revenue for the third quarter ended January 1st 2006 was $129.2 million of 11% year-over-year and 9% sequentially. Our third quarter diluted earning per share from our continuing operations was $0.38 which was an increase of $0.02 over the year ago quarter, and increase of $0.4 sequentially.

Based on the October SAN infrastructure forecast from Gartner, the most recent HBA and switch forecast from IBC and QLogic estimates for the products not check by analyst the total available market for our SAN infrastructure products in 2009, will reach $3.6 billion and is expected to grow at Gartner in the high teams. The HBA portion of our TAM which includes both Fibre Channel and iSCSI HBAs is anticipated to grow at a Gartner for 14%.

The forecast for Fibre Channel switches which includes storage services platform and multi protocol routers as a Gartner forward 25%. We continue to out phase the market with our growth. Late by 4-Gig requirement our HBA business achieved new records in both revenue and port shipments. Our switch business also continued to grow, an achieved new records in both revenue and both shipments. For the third quarter our revenue from SAN infrastructure products grows $120.4 million. The SAN infrastructure products revenue grew 14% from the year-ago quarter and 9% sequentially. In the third quarter revenue from our non-core management controller products was $6.1 million. Other revenue which includes royalties and service revenue was $2.7 million in the third quarter.

QLogic continues to expand its market sale due to our other Fibre Channel HBA supplies. They allow our groups third quarter calendar year 2005 SAN report shows QLogic continue to expand its revenue market share lead from 43% to 44%. Total Fibre Channel and iSCSI HBA port shipments which exclude Fibre Down products for blade servers grew 38% from the year-ago quarter and 17% sequentially. Our HBA product revenue grew 16% over the year-ago quarter and 9% sequentially. Our HBA revenue for the first nine months of fiscal 2006 compare to the same period last year grew by 21% which has resulted in continued market share gain.

QLogic's stackable switch architecture combine which is use obvious features and reliable operation continues to gain new support. In the third quarter both shipments of our SANbox 5000 series of switches and blade switches grew 128% and 49% respectively compare to the year-ago quarter. On our sequential basis, port shipments of our SANbox 5000 series switches and our blade switches grew 7% and 39% respectively. Although still early in the adoption phase QLogic's SMB switches or 3000 series experience sequential port growth of 36%.

Our continued market share growth has resulted in a 35% increase in switch revenue from the year-ago quarter and 15% sequentially. Our continued strength in the channel combined with our expanses into the leading OEM, should continue to help drive the revenue growth for this SAN infrastructure. The channel business continues to be an important growth driver for QLogic. The Channel accounted for 24% of our SAN infrastructure brought revenue in the third quarter. Overall Channel revenue for the SAN infrastructure product was up 18% year-over-year and 1% sequentially.

The recent enhancement of our global channel support model which provides key wide regions with local language and local time zone support demonstrates our ongoing commitment to channel partners and customers. Our Channel revenue growth for the first nine months of fiscal 2006 compare to the same period last year grew by 32%. We recently announced a series of innovative technology advancements that we believe Lucent's QLogic to deliver our better 4-Gig HBA. In our recent press release, we announced the industry's highest performance with our new QLA2440 and QLA2460 Families of enterprise 4-Gig HBAs. Based on independent side-by-side testing the QLA2440 series HBA achieved two of that in 2000's and also the second read performance and 150% faster write performance then the enterprise called HBA tested from the primarily comparative.

The high end QLA2460 series HBA achieved even higher performance with axiomatic 340,000 hours per second. Our 4-Gig HBAs are designed from the ground up to meet the increased performance demands of multiple application, running on virtualized servers. Additional benefits of delivering a better 4-Gig HBA has the ability and reliability enhancements. For scalability QLogic provides the SAN support. This QLogic exclusive allows a single HBA to read the SAN in fact hence I get stand from our fiscal MBS switch. As a result QLogic HBA can support multiple distance each with the completely isolated fabric apology instead of fabric services.

Finally for reliability, QLogic delivers overlapping protecting domains. This QLogic exclusive insured that data is not left unprotected by implementing our unique ferity and iSCSI journalism and checking scheme. These features support to the industry leading and MTB allow QLogic to deliver the industries only 5 year warranty. The better 4-Gig HBA attributes just mentioned above as an instrumental in the customer design means. Qualifications and shipments announcement we have made. In January we announced the availability of our SANblade 4-Gig Fibre Channel PCI Express HBAs for Hp. The Hp branded version of QLogics 4-Gig PCI express HBA are used for connecting Hp provide servers to high performance Hp storage works, Xp, EVA other than Windows and LINUX environments.

Also in January we announced at our enterprise class 4-Gig Fibre channel HBA for PCI Express and PCIX204 are available from SUN Microsystems. This QLogics 4-Gig HBAs connect both Sun ultra spark and the NB Optron based Sun fire servers and Solaris, Windows and LINUX operating system environments. These two announcement complete our 4-Gig HBA qualification, with EMC Dell, IBM Hp SUN HBA another. In addition QLogic recently introduced the fast 4-Gig Fibre channel HBA that support MAC OS stand.

The availability of QLA2460 series HBA deploying conjunction with the SANbox 4 Gig switches allow made power users in video and graphic environments to stream data at twice the speed of existing 2-Gig storage networks. On 4-Gig revenue including switches HBA and silicon is of 136% from the previous quarter. From a sequential basis Fibre channel 4-Gig HBA revenue is up 258% and 4-Gig switch revenue is up 92%. Driven by PCI Express, PCIX 2.0 and robust compliance we believe that 4-Gig HBAs will represent more than 50% of the HBA volume by the end of 2006. QLogic continues to expand its footprint in the Fibre channel switch market place.

In the second quarter we announced that the NC will resell QLogic SANbox 3050 Fibre channel switches. Today we announced that the NC has qualified QLogics SANbox 5602 4-Gig and 54 to 2-Gig Fibre channel stackable switches as part of its EMC select program. The QLogics stackable switches are available as individual products on his part of bundles of reasons with the NC network storage systems. In summary we are pleased with our performance this past quarter. Our strategic focus on the SAN infrastructure components market as been rewarded by market share gains in both the Fibre channel HBA and Fibre channel switch markets.

The reasons of storage services platform from technology from Troika and iSCSI to Fibre channel multi-protocol routers will expand both our market penetrations and our ability to grow market shares. We are confident there our strategies are working in our ability to execute to this plans should result in our continued success. Operator we are open for questions now.

Questions and Answers

Operator

Thank you. Operator Instructions. We will take our first question from Aaron Rakers, with A.G. Edwards

Q - Aaron Rakers

Yes thanks, hi guys nice quarter. Couple of quick questions firstly can you provide us with some color in terms of how dilute Troika was in the December quarter and kind of update us on the expectations going forward and then also if you can talk a little bit about the fact that we did see inventory up pretty meaningful in the quarter 18% sequentially, can you kind of walk us through what's going on there and what presenting specific behind the access sequential increase.

A - Tony Massetti

Sure with regard to Troika we talked about on the September earnings call that we expected about a half a penny impact to the December quarter and that is what we saw and going forward we talked about a $0.1 to $1.5 impact in the March quarter and that’s what we are expecting as well and its still tend to the guidance that we provided with $0.35 to $0.38. And with regard to inventory we did see increase in inventory, the primary driver there is, in our transitioning contract manufacturing for our switch products and that resulted in a temporary increase in inventory, we expect to work that of over the next third quarter or two. It’s a larger finished goods and software in it.

Q - Aaron Rakers

Great and if I could follow on real quickly, last quarter you kind of a eluted to us that you know we are working through transition for your embedded solutions for great servers. I would pre-design once I believe last quarter announced. If you kindly update us there and additionally on the switching side looks like some positive wind throughout the December quarter. I think there was still some expectations that we would see another meaningful Q1 OEM announcement here shortly, any updates there in regards to the switching business.

A - HK Desai

On the liquid and so in the blades switch blade for the blade servers we say that we have most of our revenue came from and most of our growth was from IBM on the 2-Gig and we announced the 4-Gig designed winds. We also announced the design wind on the 2-Gig for Hp and Dell and we are working with them and also on the 4-Gig we don’t announce anything and we don’t get the design, we don’t let they out anywhere, so I think that most of our growths really is coming from IBM and some revenues coming from the other two customers. On the switch side we announced today for example our 5602 4-Gig and 5202 2-Gig stackable switch qualification with the EMC for the select programs, and that’s one we talked in the last quarter that we have one more announce, we also still working the couple of more values and we don’t know when we are going to have the designing on that.

Q - Aaron Rakers

Thanks.

Operator

We take our next question from Andy McCullough with CSFB

Q - Andy McCullough

Thanks guys, question on the customer trends, just in terms of what the trends required, can you top ten customers during the December quarter, how may where up, how many are down, how many are flat and what your expectations are for the March quarter.

A - HK Desai

So far if you remember after we balanced our dis-control business, the last quarter we said that we really look at the 5 top customers because we are not concealed for this tax any more, so if you can get the top five customers in the December quarter 58% of our revenue came from the slight up customers and all those 5 grew sequentially. Now going forward in the March quarter this is not for most of the large OEM's so we give our guidance which is $126 million to $129 million which is expect about flat to about 1% to 2% declines and we expect for the same trend with most of the customers.

Q - Andy McCullough

Okay and then just a question of four year transition. I made a mistake but did you give us 4-Gig mix this quarter and then how so you thinking about the margin implications of the 4-Gig transition as you get the 50% of expect the shipments by the end of '06.

A - HK Desai

We did not give any breakdown in the 4-Gig but we say that we have a 258% sequential growth in the 4-Gig HBA and about 92% sequential growth in the 4-Gig switches, so we have pretty good quality as far as 4-Gig is concerned, we also mentioned that we have a qualification done on all 7 mid OEMs EMC Dell, IBM, Hp, HBAs that have so we have done with all the qualifications, we only start shipping some of them in the December quarter, and some of them start in the March quarter. But the key we said in the credit is that, I am just wanted to go and happen because is a 4 driver unique for the 4-Gig one is the 4-Gig PCI Express, PCIX 2.1 draws compliance, so this is the reason we believe that the trends can do faster than what happen on 1 to 2-Gig transitions. I don’t see there is any margin implication setting that, you always see a little better margin in the beginning but as the revenue start swamping up margin will remain same as the 2-Gig.

Q - Andy McCullough

So what is, I know it’s a fairly that was a 5% of shipments and in December or is below that.

A - HK Desai

I don’t able to look at that number I think.

Q - Andy McCullough

Okay, thanks.

Operator

Will take our next question from Harsh Kumar with Morgan Keegan

Q - Harsh Kumar

Hi guys first of all congratulations on strong revenues and also very good guidance. Couple of questions for you. HK and Tony this is the most bullish I have seen you guys in terms of body language as well as I assist guidance in general. I guess the question is what are you seeing with your, from your customers I make you so excited or maybe you can give some color on what's driving the guidance here.

A - HK Desai

So, I don’t know how did you see my body language, I was not dancing here so. But I didn’t cutely like December quarter is always the stronger quarter, even if you look at the last two years December quarter is always strong, strong quarter because now the OEMs are very, very strong in the December quarter. I think the little surprise for us also is that the forecast we saw from all items of 126 to 129 based on the forecast these all from the OEMs particularly in the channels so, I think we are little bullish from that prospective compared to normally you see a more decline in the March quarter, because this is not a deep sizing the forecast and the OEMs looking better easier in the March quarter.

Q - Harsh Kumar

So you are saying that’s coming from the OEMs but not the distributed channel made.

A - HK Desai

Yes of course.

Q - Harsh Kumar

Okay got it. And then second question I think somebody try to bring it up earlier, can you comment whether you are now should bring to the fiscal itself in terms of switch business.

A - HK Desai

We cannot make any comment about our current customer or the future customers about anything.

Q - Harsh Kumar

Okay got it. Question for Tony and then I will move on. Tony your tax rate is 40%. I know you talked about bringing that down in the future, can you just take us in terms of modeling by as what we should be expecting maybe going out into the next fiscal year.

A - Tony Massetti

Sure Harsh. Tax rate for 4Q and full year is expected to be 40% that’s inline with the guidance that we provided all year. We got 39% to 40% for fiscal '06. It’s a little early to provide guidance for fiscal '07, at this point Harsh we'll update you on the March earnings conference call but I have seen many of the models with tax rate going down in the range of 37% to 37.5% for fiscal '07 and we are comfortable with that at this point.

Q - Harsh Kumar

Okay got it thank you guys, congratulations once again great quarter, great guidance.

A - Tony Massetti

Thanks Harsh.

Operator

We will go next to Kaushik Roy with Susquehanna

Q - Kaushik Roy

Congratulations again on blade server, when do you expect the blade server OEMs to introduce 4-Gig HBAs and assuming that that’s the point you will provide the whole mezz card.

A - HK Desai

We have -- for example we announce the one design been on the 4-Gig mezz card and the 4-Gig switch plate which is IBM. And we are working with the two other customers but we don’t know when they are going to announce those products.

Q - Kaushik Roy

Okay then on the HBAs single channel, when do you think you may get the whole, and when would you know that whether you are getting the whole HBA business or would will be just get the replacement for take on.

A - HK Desai

We know that now I can mix some comment on that, it’s a good question. We have on the Hp UX relative to board design wheel on the 2-Gig. We also have a 2 port design wheel on the HBAs for the 4-Gig and now we have a design wind for a single channel card where we will be supplying them the silicon and they would be building their own on HBA. So we have a design wind for the single channel HBA is right now.

Q - Kaushik Roy

Okay that’s good and then for Tony on the operating margins jumped quite nicely so what are your expectations going forward.

A - Tony Massetti

We have targeted 35% operating margins Kaushik, it really depends on looking our gross margin product mix, we have guided gross margins down over time as we mix more towards the switch business and more towards lower margin businesses but again at the very gradual gross margin decline in our 50 deputy quarter without sort of thing, so as we move more towards lower gross margins, we are still targeting 35% operating margins in the future.

Q - Kaushik Roy

And since you mentioned margin, so gross margin where did most of the improvement come from. Did it come from the HBAs or from the switches?

A - Tony Massetti

Sure, was favorable product mix as well as manufacturing efficiencies, we talked about in the script. And also we saw a better royalty number in the quarter then we expected that was up the other line, the other category revenue was up above $1.2 million sequentially and it was very good gross margin on that. So that contributed to the margin increase.

Q - Kaushik Roy

So for royal peak, for modeling purposes what -- why should we take that going forward?

A - Tony Massetti

For the March quarter, you can model flat to us slightly down for the other line.

A - HK Desai

Other income.

A - Tony Massetti

Right. That as a revenue.

Q - Kaushik Roy

Yes, that I will think so, okay thanks very much.

A - Tony Massetti

Okay.

Operator

We will take our next question from Sheldly Heraisy with Cottmen Brother.

Q - Sheldly Heraisy

Yes thanks, congratulations as well, this ASP works single channel awareness that’s great news for you but it sorts out it still it kind of currently with a lower ASP. Might it more than to a mezzanine card in some point and drive more meaningful revenue.

A - HK Desai

Only thing I can talk but we tell you in the life to life products and we talked about HPUX which they have a two channel in the single channel card, for the 2-Gig and for the 4-Gig when we talk, we talk about the single channel card not the mezz card.

Q - Sheldly Heraisy

Okay, and how concerned are you about the March quarter your guidance and one of the fact that historically in the HPT business, doing very well or have the seasonality in the March quarter. And how concern are you about the downside risk, to your March quarter.

A - HK Desai

We give a guidance of $126 million to $129 million and I think that’s the guidance is based on current forecast from our OEMs and from the channel partners on your side. I think we are risk comfortable for the guidance and what we have seen so far in January. I think these are track all over the forecast is, so far we are comfortable, if you look at severe track records out of 40 second quarter only one quarter we have missed the guidance and all of the 41 either be matter or if did this still expectation.

Q - Sheldly Heraisy

And finally from me you are keeping your gain share in the December quarter in HBA.

A - HK Desai

You can't only I can tell you that if you look at they already report for the third quarter we see the September quarter, we gain share on the HBA from 42% to 44%. So we can share with the third quarter, I know that, I don’t know about the December quarter.

Q - Sheldly Heraisy

Okay thanks a lot.

Operator

We will take our next question from Henry Naah with Lehman Brothers.

Q - Henry Naah

Hi guys I was wondering if you talked little bit about growth in the switch business, you guy said is the 4-Gig products is up 92% sequential this quarter. Soon if you talk is that growth was it just strong amount existing customers with their new customers involved?

A - HK Desai

So if we said, if we look at our overall switch revenue for December quarter. We grew about 15% sequentially and 35% year-over-year. So the 15% sequential growth is came from the business strong demand for the Blade server for this embedded switch, and there also demand for over 5000-series product I think it’s came from just too many of this product. We also grew only one SMB product, which were 3000-series of products. So I think it was all different product line, we had a growth in the December quarter, and its really its, either its, although all the OEMs which we already had before for the new OEMs, and also the channel was always very strong for us on the stack on the switches in the Blade so.

Q - Henry Naah

Okay great, and then Tony with the tax rate 40% I mean any thoughts on how you guys can over that overtime?

A - HK Desai

We talked on previous call Henry that we do have the opportunity to lower that as we bring up offshore operations. When we talked about opening post permanent center Ireland in the June quarter, moving our contract manufacturing to Asia, well of that US all of that investment in fiscal '06, can be used offset US income for, as we start to get revenue running through that structure in future periods. There was the opportunity to bring down that tax rate and I think its you see that reflecting some of the models out there, as we talked about earlier tax rate coming down to 37 and 37..5% but, we will up each on the next earnings call as to what the guidance for the fiscal '07.

Q - Henry Naah

Okay thanks guys.

Operator

We’ll go next to next Royal Rivera (ph)with Goldman Sachs

Q - Royal Rivera

Thank you, couple of things, that shouldn’t going to be commenting any specifics about fiscal partnership on switching side, may be you can talk a little about what you are seeing in the overall switch business and how you see growth in that business playing out over the next several quarter particularly since you do have this partnership, and have you think gross in this areas been compared in normal seasonal switch growth. And I guess will ask you anything specific about differentiating between your fiscal and non-fiscal business that they know you want answer, and then I have another question.

A - HK Desai

So if you, I mean if we’ve talking about last couple of quarter lower that, but we expect more growth coming in our business in the switch area in '05 or '07 and beyond anyway. We expect 20 plus growth in this switch business going forward, and that’s going to come from other embedded Switch blade or is going to come from our stackable switch or follow partnership and we talking about anyway. So I think it’s going to be coming for everything on the switch side. If you look at on March quarter what we have seen so far in the forecast is that. We will tell our Box business, we expect all switch business to be same either flat to despite the client for the all switch business. But we expect the Box business to grow in the March quarter, and we expect our Blade which because of wanted your quarter decline. So overall the switch business is about to flat declines of the currencies anywhere I think match with the HBA for the switches, for the Box we partly update in the March quarter.

Q - Royal Rivera

Okay great and just one last thing and that is you had a really good balance quarter the strength across the board and apart from the market share gain and was telling us about your own business. Is there any message that you can take away, that we should take away that perhaps reflective of the overall storage market in straight there?

A - HK Desai

The only thing I can see, I can say that is that we have a very good trend we have seen last couple of quarter in the storage market. On December it’s little difficult to predict what's going to happen in the future, but we also see projections in the March quarter which is better been what we have seen last two years particular for at the SAN infrastructure product. I think we have seen the March quarter better than what we have seen two years in a row.

Q - Royal Rivera

Exactly pretty much across a fairly wide range of OEMs or is it isolated or what?

A - HK Desai

No it’s a fairly wide range.

Q - Royal Rivera

Thank you.

Operator

Then we will take your next question from Dan Renouard with Robert Baird.

Q - Dan Renouard

Hi thanks, two questions one just on the buyback. Did you repurchase any shares after Jan 1 prior to this call? And then secondly just on the cash this year you got some taxes do etc. what's kind of the rough expectation for cash levels at the end of March along with that what would you expect your expositional buy back where we expect the normal share count to be. Thanks

A - HK Desai

Sure Dan, we kindly talk about buyback activity subsequent to the end of the quarter at this point was correct to.

Q - Dan Renouard

I don’t mean going forward, I mean since the quarter

A - HK Desai

Yeah, I know. We can talk about that through follow. We did that last quarter some just that’s it. Thank you Dan.

Q - Dan Renouard

Yes well we are not in position at this time

A - HK Desai

As far as the buyback and we were very aggressive on buyback over the last three four months repurchasing roughly $360 million of stock. So I don’t expect that will be as aggressive going forward, and probably more inline with what we repurchase prior to the $350 million stock repurchase that we announced in the August timeframe. And as far as the uses of cash as we talked about the stock buyback is an excellent use of cash at this stock price level as well as even smaller technology acquisitions light strike a $36.5 million in the quarter. And then the normal operational cash needs such as tax payments we have a large tax payment due for the gain of sale of the hard disk drive business that you seen on the balance sheet, which really will be negative against the cash that we see there, so those of the needs for cash going forward.

Operator

And moving on, we will take our next question from Paul Mansky with Citigroup

Q - Paul Mansky

Actually most of my questions have been answered but I did want to touch on a couple of the answered questions previously after I don’t think we are actually fully answered. First where do we expect the Gardner share account for Q1 to be? And then second what you generates slightly excluding any upcoming share repurchase activity your cash balance, do you would like it in end of the quarter.

A - HK Desai

So we are 81.5 million diluted fall. You can bring that down slightly for the March quarter I mean some level of buyback, and then cash, we don’t specifically do our cash forecast, so I am not prepared to talk about that, if it’s going.

Q - Paul Mansky

Okay and then lastly its seems like for the last even three or four quarters, we've been talking about either a gradual decline in gross margin. You gotten more specific over the last two thing 55% or greater over the next 12 to 18 months. We are six months ended that payment and then your holding on to 70% level pretty strong. Can you may be put finder points on this specific catalyst that you would expect to see optically break that margin down, that’s more normalized level.

A - HK Desai

Again in the quarter Paul, we had favorable product mix as well as higher royalty payment which grow the margins higher, but as far as the gradual decline in margins that we've been talking about really depends on switch ramp and ramp, iSCSI and some other lower margin businesses. If those businesses ramp progressively and we will see margins start to come down in our substance is that those business the switch for example, what we are ramp over the course of fiscal '07 and put some very gradual download pressure on gross margins, and its bits of the top line obviously its all incremental revenues, so that’s what we planning for while we taken the gains we have.

A - HK Desai

If you look at the bottom everybody seeing is that in a right direction in the December quarters. And we also got iSCSI royalty payment on the December quarter, and the mix was like Tony says that but if you what when we projecting the margins we look forward for the future the creative is the switch mix, which has mid 50 to high 50 margin, if you look at iSCSCI which is the lower margin, if you look at SNP which shouldn’t getting that much gross as everybody expect it was all of those factors if you can start rolling we have been start seeing some hard work pressure on the margin that’s what we give a guidance based on those days. Now we both that happen and towards continue this better much.

Q - Paul Mansky

Okay right great thank you and congratulation on the quarter and the outlook.

A - HK Desai

Thank you Paul.

Operator

And we will take our next question from Tom Curlin with RBC Capital Market.

Q - Tom Curlin

Yeah you mentioned a few drivers for 4-Gig adoption, which had seen but it seems like topic for today it so, though host compliance my question is what OEM’s have kind of drive the low host compliance in nearly near term and may be lot of 2-Gig product is not real host compliance that our 4-Gig. Is that consistent with what you are referring to real host.

A - HK Desai

I think we talked about, when we talked about 4 Gig, you said that the 1 to 2 Gig transition Tom it took about 12 to 18 month, and we expect this is to be little faster and the reason if the driver is not 4-Gig systems. The driver is one of the PCI Express it’s a new servers, which you cannot use all card PCI-X 2.0 which you can only own card and real host compliant is coming in a big role and play a big role of this seems anyway. So there are four different drivers going to this transition and I think what we expect that by end of December quarter in 2006, we might see more than 50% volume will come from 4-Gig.

Q - Tom Curlin

Either of the chipsets already there, with respect to PCI Express where there is something coming good year perhaps and tell me the data also helps to accelerate.

A - HK Desai

No now I think everything is right now you just amount timing getting to accelerate.

Q - Tom Curlin

And also, is it very assume that some of your switch OEM’s may never that you officially announced that relationship.

A - HK Desai

I think this is allotted question I don’t know how to answer that, but I think its not in brand way just they may not want to ever really announced it. My philosophy I don’t care as long as I can appeal from that.

Q - Tom Curlin

That’s what I mean. I mean that’s a possible scenario.

A - HK Desai

That’s a possible scenario that’s fine with us.

Q - Tom Curlin

Okay great thank you

Operator

We take our next question from Clay Sumner, with Friedman Billings Ramsey.

Q - Clay Sumner

Thanks very much, and my congratulations, HK are there you guys are talking about Gartner HBA, Gartner 92 HBA without 14% estimated. My understanding is that didn’t include mezzanine card which you guys estimate yourself, if you do include mezzanine card in that forecast what would be more accurate HBA market cash.

A - HK Desai

Its clear this include, if you get the October forecast and we can see next to me and he said yes and forward forecast we talked about this and that include the mezzanine card.

Q - Clay Sumner

Okay so 14% which I considered to be an accurate HBA market

A - HK Desai

Right. But if you look at our number in the three months, I mean in the three quarters we grew about 21% of HBA.

A - HK Desai

Right

Q - Clay Sumner

And then with that server track record is starting and noticed X86 server market shifting to lower unit shipment of larger servers presumably have a coherently with increasing same in tax rate for X86 server are not just in the Blade server market. I am wondered if you are saying that as well.

A - HK Desai

We have been seeing that

Q - Clay Sumner

Yes, those SAN with typically use cheaper rater and smaller switches or HBAs effectively will coming a bigger percentage of the difficult SAN purchase.

A - HK Desai

Well, You can say that by the way that depends on the segment of the market we are talking about. So if you talked about SMB site for example if you have the midrange and the enterprise midrange of the high and it is going to impact much.

Q - Clay Sumner

But midrange is where most of the growth here as well.

A - HK Desai

It is yes.

Q - Clay Sumner

And then lastly what was iSCSI revenue during the quarter.

A - HK Desai

We don’t break that out right.

Q - Clay Sumner

Okay, well thank you except to do thing you talked lot of royalty has been high and that was partners responsible for high gross margin the services peace of that other pocket have significantly lower margins also operating margins of these.

A - HK Desai

That is a very small number other revenue category.

Q - Clay Sumner

Okay some numbers to grow.

A - HK Desai

Yes.

Q - Clay Sumner

Alright thank you.

Operator

We will take our next question Glenn Hanus, Needham & Company.

Q - Glenn Hanus

Any color around where we are looking our last quarter, and has its switch transition going on from the old products to new products then you actually guided sort of flattish with this quarter and obviously outperformed very well. Where are we in the overall transition from your older generation to newer generation, could you give us sort of sense there.

A - HK Desai

I don’t recollect that we got flat in December quarter for that I think we say thus we should be up 2% to 5% whatever our guidance was. But I think we say this is the most of the drunken was done in December, and some left and so it all done now for the March quarter, I don’t we have anything left for the old product. It went to slight but its not fix ready minimal.

Q - Glenn Hanus

Any color around where you getting manufacturing efficiencies from and there is a lot more to go on the efficiencies fronts or is that just give me a little bit here now.

A - HK Desai

It's more little bit here in Glenn when you talked about out shore contract manufacturing and that’s contributing of it, but you its smaller driver to the gross margin story we have talked favorable mix and royalty has been the key drivers. When we talked about efficiencies we talk also this scrap and so on. I mean we have great quality of product or the liabilities very high for example we are the only one in the HBA market we have 5 years reliabilities, so we don’t have much scrap. There is not much good returns from lot of thing is played role in this things on the margin.

Q - Glenn Hanus

You mentioned the tax payment on the sale of the HDC business any rough estimates on what that is?

A - HK Desai

The tax payable lying on the balance sheet, that you can see about 121 million so its in that number and I don’t have it broken out with me Glenn.

Q - Glenn Hanus

Alright thank you.

Operator

Okay next question from Keith Bachman, with Banc of America.

Q - Keith Bachman

Hi guys thanks very much. I was wondering if you could just comment on aided in order to mention what the iSCSI revenue was as a percentage sales, but if you can just add some color on, any kind of growth attributes seen for the industry and now you fact with are you expect with unfold and down to calendar year ’06, and what the implication might be to your model.

A - HK Desai

If you look at real tremendous success in our product execution and design made in the iSCSI if you look at the target silicon we have practically every design on the storage subsystem in front for the iSCSI. We have one plate over designed when iSCSI we have couple of HBA qualification on IBM in that out and EMC for the HBA anyway. So practically we don’t have much competition in the iSCSI except for unique card. If somebody want the low performance system, so I mean the question really comment is where is going to when the tax we have in the iSCSI market and we expect really iSCSI to be more effective in the every market and don’t seeing any much growth and as we are the iSCSI or the Fibre IBM takes time on to really claim the people either sending people or even the customer for the SNB markets. I think its will take some time before we start seeing the tracks and iSCSI..

Q - Keith Bachman

Okay let me just follow up with one question we have two people for this was already discussed apologize but and obviously had a great quarter and HBA side 90% on interior growth. And then I just want to hear your thoughts on the growth for ’06 and you think marketable do after your reference previously and it was partner group have to see that was 14% given the strong Q4 at 19% that would seemingly that was suggested either again and how lot of share or those markets HBA just describe by IDC or Gartner group or perhaps to low.

A - HK Desai

I think we said 16% in the December quarter or go 9% sequentially.

Q - Keith Bachman

Ok yes sorry 16%.

A - HK Desai

And I think key quarters for the fiscal ’06 with three quarter we have a 21% HBA growth. So I mean what the new data came into the previous data before was about 19% HBA growth which includes Fibre Channel, iSCSI and the mezz card.

Q - Keith Bachman

Right. You did have came into talked about Fibre Channel, iSCSI, HBA’s and the mezz card is about 14%.

A - HK. Desai

We always outperformed the margin that we did the same thing last year.

Q - Keith Bachman

Obviously have a pretty good backlog even end in the March quarter.

A - HK Desai

So lets I think we have some comment on this.

Q - Keith Bachman

Thanks very much.

A - HK Desai

The IDC Gartner number of 5 year compound annually were not evenly distributed so quite frankly the forecast is higher growth rates in early years still often in end years.

Q - Keith Bachman

Okay thanks very much guys.

A - HK Desai

Okay thanks very much guys

Operator

And there are no further questions at this time. Gentlemen I'll turn the conference back to you for any additional closing remarks.

Tony Massetti, Vice President and CFO

Thank you for joining us for our third quarter fiscal 2006 conference call. We look forward to discussing our fourth quarter in fiscal 2006 results with you at our next quarterly conference call early, May. Also, we have several upcoming conferences that we will be attending. In February, we'll be presenting at the Thomas Weisel Partners Technology Conference and the Goldman Sachs Technology Investment Symposium. In March, we will be presenting at the Morgan Stanley Semiconductor at Systems Conference and Citigroup smaller mid-cap market. Please refer to our investor relations website at www.qlogic.com for any updates to the conference schedule. For any of you that will be attending the conference we look forward to seeing you there. Thank you.

Operator

And that thus concludes today’s conference call. We thank you for your participation you may now disconnect.

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Source: QLogic F3Q06 (Qtr Ending Jan 1, 2006) Earnings Conference Call Transcript (QLGC)
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