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Executives

Jim McCluney - President and CEO

Mike Rockenbach - CFO

Mike Smith - EVP of Worldwide Marketing

Analysts

Harsh Kumar - Morgan Keegan

Keith Bachman - Bank of Montreal

Kaushik Roy - Pacific Growth

Brian - Goldman Sachs

David Cahill - RBC Capital Markets

Clay Sumner - FBR

Aaron Rakers- Wachovia

Emulex Corp. (ELX) F3Q08 (Qtr End 01/30/08) Earnings Call April 24, 2008 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to this Emulex Corporation third quarter conference call. Please take note that today's call is being recorded. And at this time for opening remarks and further introductions, I would like to turn the conference over to the President and Chief Executive Officer, Mr. Jim McCluney. Please go ahead, sir.

Jim McCluney

Thank you, Operator. Good afternoon everybody and welcome to Emulex' third quarter conference call. I am Jim McCluney, President and CEO of the Company and with me today as usual are Mike Rockenbach, our CFO; Mike Smith, our Executive Vice President of Worldwide Marketing; and Steve Berg, our Senior Vice President of Corporate Development.

Mike Rockenbach will start off with prepared remarks with the third quarter fiscal 2008 results. I will follow with my comments, including progress with our products during the quarter, and a discussion of our view of the overall health of the industry. At the conclusion of our prepared remarks, we'll take questions.

Mike?

Mike Rockenbach

Thank you, Jim. By now you should all have Emulex' third quarter earnings release, which was issued earlier this afternoon. If you do not have a copy, the press release is available in the Investor Relations section of our website at www.emulex.com.

The press release and this presentation contains forward-looking statements including, but without limitation, statements regarding Emulex' business, operations, and anticipated financial results for the fourth quarter of fiscal 2008 and beyond. These statements are subject to risks and uncertainties, and our actual results may differ materially from those discussed in the forward-looking statements.

Those risks and uncertainties include economic conditions, market growth, IT spending patterns, changes in technology, evolving industry standards, competitive pressures, pricing pressures, and fluctuations in OEM ordering patterns, the estimate of total available market size, the ability to address these markets with available technology in a timely fashion, research and development activities, and the risk and uncertainties described in Emulex' SEC reports filed under the Securities Exchange Act of 1934, including Forms 8-K, and under the heading, Risk Factors, in Emulex' most recent annual report on Form 10-K, and quarterly reports on Form 10-Q.

We undertake no obligation to update the forward-looking statements. Investors should also be aware that Emulex will not disclose in its Q&A or in conversations afterwards any material financial data that was not already disclosed in its conference call or its press release.

In addition, during this call when we use any historical non-GAAP financial measure as defined by the SEC and Reg G, you will find reconciliations to the most directly comparable GAAP financial measure in our press release available on our Investor Relations website. All of the references we will make today relate to our non-GAAP results unless stated otherwise.

Today's conference call is being webcast and a recording will be available on the Emulex website through April 2009. I would also like to remind participants 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.

Sales for the third quarter ended March 30, 2008 totaled $127.8 million, an increase of 6% over the prior year's quarter and a 2% decline from fiscal Q2. Q3 fully diluted earnings per share of $0.31 increased by 15% over the $0.27 reported in the third quarter of the prior year; however, EPS was down 9% sequentially from the $0.34 reported in the prior quarter.

Our topline results of $127.8 million were within our third quarter guidance of $127 million to $131 million. And our fully diluted EPS of $0.31 exceeded the high end of our guidance of $0.28 to $0.30.

I should note that the current quarter results benefited by approximately $0.03 from the favorable resolution of several outstanding tax matters during the period.

Now, let me discuss the revenue results for the quarter by product line. Beginning with our Host Server Products, or HSP, which consist primarily of standard host bus adapters, custom form factor mezzanine products for Blade servers and ASICs used in server applications. HSP revenues totaled $85.1 million, a decline of 2% from the third quarter of last year, and down 10% sequentially.

Revenue from board level products for the third quarter declined 1% year-over-year; however, units grew 10% and ports grew 20%. The average selling price for board level products, including both standalone HBAs and mezzanine cards, declined by 10% year-over-year, which was less than our expected annual ASP decline rate of 12% to 15%.

Our results for the quarter benefited from the increased mix of dual-channel adapters, which increased 35% year-over-year, and partially offset by the lower ASP of mezzanine cards. Sequentially ports for our HSP board level products declined by 8%. And units and revenues both declined by 11% from the second quarter. ASPs, however, remained essentially unchanged.

We continue to experience strong revenue growth with the transition to 4 gigabit mezzanine cards for the Blade server market, with revenue growth of 21% sequentially and 117% year-over-year. With our Blade server mezzanine cards continuing to show significantly faster growth in the market, we believe these results are a clear indication that we're building momentum for share gains in this important market.

Finally, HSP ASIC revenues grew more than 50% sequentially, partially offsetting the decline in our board level products, as one of our OEM customers completed a server refresh during the quarter.

Our second product line, Embedded Storage Products or ESP, encompasses SATA bridges and routers, Fibre Channel embedded SOCs and route switches, as well as single and multi-protocol embedded controller products for enterprise class storage systems.

ESP revenues for the third quarter totaled $42.5 million or 33% of total revenues, representing an increase of 18% sequentially and 29% over prior year's period. This is the highest contribution from this group of products since we have started reporting them separately.

The third quarter benefited from the initial product launch of most of remaining unannounced design wins we first discussed over a year ago. After tremendous performance during the March quarter, we expect ESP revenues in the fourth quarter will decrease as our customers begin to develop experience around the route demand for their newly launched product offerings.

Our fourth quarter modeling also takes into account that the last two unannounced design wins that we were targeting to launch in the fourth quarter have recently been moved out by our customers to the back half of the calendar year. We expect to provide further updates on the ESP funnel at our analyst event at the end of May.

The balance of revenue came from our Intelligent Network Products or INP, and other, and it was not a significant amount of revenue for the quarter.

We have provided the geographical and customer breakdown for our revenues as supplemental information in our press release.

As we further discuss the income statement, I'd like remind you that we will be primarily discussing our non-GAAP results unless otherwise noted. You'll find in our press release a reconciliation of the difference between our GAAP and non-GAAP earnings, as well as a discussion of why we believe non-GAAP financials are a relevant measure for our business for investors.

Third quarter gross margins of 67% increased 2 percentage points from the 65% reported in the comparable period of last year, and was down slightly from the 68% reported in the prior quarter. While we saw significant growth in lower margin mezzanine cards in Embedded Products, we saw only a 40 basis point sequential decline in our third quarter gross margins, as we continue to make improvements in our supply chain.

Looking ahead to the fourth quarter, we are modeling for gross margins to return back into the 68% range, largely from a favorable mix of HSP products relative to ESP products.

As we previously discussed, over the next several years, we expect our Embedded Products and our mezzanine cards will grow faster than our standard HBAs. And we expect that over time our gross margins will trend down as these lower margin products become a larger portion of our revenues.

However, we expect that the near-term strength in gross margins will continue as our supply chain initiatives and the shift to dual-channel standard HBAs offset some of this downward margin trend.

Turning to operating expenses. During the third quarter OpEx increased 9% sequentially to $51.6 million. Expenses increased as a percent of revenue to 40% compared to 36% in the prior quarter.

As you may recall from our comments during our January earnings call, payroll taxes starting over at the beginning of the calendar year accounted for about $1.4 million of the sequential increase in expenses this quarter. We exited the third quarter with a total of 829 employees, a net increase of 13 people from Q2.

With March being a seasonally weak quarter, combined with higher operating expenses including the increase in payroll taxes, Q3 operating income of $34.4 million was down 16% sequentially to 27% of revenues. However, on a year-over-year basis this represented an increase of 3%, as our gross margin improvement offset the increase in operating expenses.

Operating margin for the third quarter declined 4 percentage points to 27% from the 31% reported in Q2, and decreased 1 percentage point from the prior year's results of 28%.

Although our cash and investments increased during the quarter, the significant cuts in short-term interest rates had a meaningful impact on our interest income. Non-operating income in the third quarter decreased $600,000 to $2.9 million compared to $3.5 million in the prior quarter.

Third quarter net income was $25.7 million, an increase of 8% over the prior year results, and a 9% decrease sequentially. Offsetting the previously mentioned negative impact on the lower interest rates during the quarter, we did benefit from the favorable resolution of several outstanding tax matters, which gave us an effective tax rate of 31% for Q3. We are budgeting for a tax rate in the 37% range for Q4.

Our net profit margin for the quarter was 20%, which was essentially flat with the prior year's quarter, but down from the 22% reported in the second quarter of this year.

For the third quarter on a GAAP basis, we reported operating income of $19.5 million, net income of $15.5 million, and undiluted earnings per share of $0.19. The difference between GAAP and non-GAAP income in the third quarter is primarily attributable to amortization of intangibles and stock-based compensation.

FAS 123(R) expenses reduced GAAP earnings by approximately $0.06 per diluted share this quarter. On a GAAP basis Q3 R&D expenditures increased 5% sequentially to $33 million compared to $31.5 million in the second quarter. Q3 R&D included $3 million of stock-based compensation.

Quarterly R&D spending varies depending on the timing of new product development expenses, however, while we expect absolute dollars to grow year-over-year, we continue to focus on reducing R&D investment as a percent of revenue.

Third quarter GAAP sales and marketing expense was at $15.6 million compared to $13.7 million in the prior quarter. Q3 sales and marketing expense includes $1.4 million of stock-based compensation. GAAP G&A expenses increased sequentially to $9.7 million from the $8.8 million reported in Q2. And this includes $2.3 million of stock-based compensation.

Turning to the balance sheet, we exited the third quarter with total cash and investments of $332 million. And this represents an increase of approximately $24 million from the end of the second quarter.

We reduced third quarter inventories by $2.4 million sequentially. And our inventory turns of 12.2 exceeded our target range of 8 to 10 turns. We expect inventory turns will be at or above the high end of our target range for the June quarter.

Our Q3 receivables decreased sequentially by $4.4 million to $67.5 million. Depreciation in the third quarter was approximately flat with the second quarter at $4.7 million. And capital expenditures during Q3 decreased to $4.4 million compared to $7.9 million in the second quarter.

Before I discuss our targets for the fourth quarter of fiscal 2008, I want to again remind everyone that there are numerous risks that can affect our future performance, causing actual results to differ materially from forward-looking statements. These risks are noted in our public filings with the SEC and the Safe Harbor statement at the end of our earnings press release.

As a result of these risks and uncertainties, we are unable to predict with accuracy what future quarter results might be, and there's no guarantee that business will reach our expectations or goals. Based upon current market conditions, our customers' public comments and their most recent forecast, we believe that revenue for the fourth quarter ending June 29, 2008 could amount to approximately $118 million to $123 million, which represents a sequential decline of 4% to 8%, and a decline of 3% to 7% from the prior year's fourth quarter. If we achieve revenue in this range, we anticipate non-GAAP earnings per diluted share of $0.24 to $0.27, assuming a 37% tax rate.

We expect GAAP charges of approximately $0.11 per diluted share in the fourth quarter. The difference between our GAAP and non-GAAP figures are primarily attributable to expected amortization of intangibles and stock-based compensation recognized under FAS 123(R).

I would now like to turn the call over to Jim, who will give you an overview of our progress with our products, color on the quarter, and an update on the Company's growth strategy.

Jim McCluney

Thanks, Mike. Good job. As you just heard, revenues for the quarter came in at about $120 million, which was within our guidance of $127 million to $131 million. This represents a year-over-year increase of 6%, and a sequential decline of only 2%, both of which reflect solid performance for the March quarter.

As we have discussed over the past couple of years, SANs had become the defacto standard for high-end server deployments. As such, SANs in general, and more specifically Emulex' HSP products, have taken on more of the seasonal characteristics of the server market, wherein top of this normal seasonality is the uncertainty in the financial services vertical specifically impacting higher end data center products, and also more recent concerns about the broader IT spending environment. All of these factors, we believe combine to result in a weaker than normal close to the quarter for HSP.

While these crosscurrents presented some challenges for us, I'm pleased with the results for the third quarter. Having said that, we're taking a cautious stance looking forward and assuming that these challenges will continue into the June quarter.

Recent CIO and economic surveys continue to model for growth in calendar 2008, but the projected rate of growth in these surveys has been trending down for the last six months. For example, the IT spending survey published by Goldman Sachs in March highlights a near-term slowdown of the full-year growth for 2008. This trend is reflected in the third quarter results and fourth quarter expectations.

On a combined basis, first half 2008 product revenue could be up 1% to 3% over the first half of calendar 2007. While this is less than a desired rate of growth, it is consistent with the general market sentiment.

We remain very confident, however, in our prospects for the back half of the calendar year and into 2009, as we execute on strategies to gain share in our existing markets, diversify our revenues into higher growth adjacent markets, and continue to make investments to position Emulex as the leader in the emerging converged technologies of tomorrow's data centers.

A highlight of our income statement again this quarter was our operating margins. Our supply chain initiatives delivered gross margin expansion of 2 percentage points year-over-year. In addition, our inventory levels came down again this quarter, and our turns increased over 12 times. Most important, we've accomplished these results while continuing to deliver high-quality products on time to our customers.

Now let me give you some color on the progress we made within our product lines this quarter. Looking at our Host Server Products, both dual-channel adapters and mezzanine cards for Blade servers showed strong results. More specifically mezzanine cards for Blade servers increased 21% sequentially and 117% year-over-year. At the board level, HSP port growth was 20% year-over-year, which we believe is faster than the market growth rate.

Overall, however, HSP revenue performed somewhat below our expectations during the quarter, showing a decline of 10% sequentially. While we anticipated some level of seasonality in the March quarter, we believe softness in demand for products that go into high-end environments had a larger than usual impact during the quarter. Based on comments from our leading customers, we see this as a near-term event and expect stronger growth in the back half of the year.

This quarter the most significant announcement for HSP was the availability of our LightPulse 12000 family of 8 gigabit Fibre Channel products. On our call in January, we highlighted 13 8 gig design wins. And I'm pleased to report that in addition to launching general availability, we have expanded our design wins to 22 during the past three months, and we have more in the pipeline.

We're well-positioned for this link speed transition, and see design win momentum continuing over the next few quarters, followed by revenue ramping in fiscal year 2009 as these design wins go into full production.

We also announced that our 8 gig HBAs are supported in Oracle, VMserver virtualization software, and in Microsoft Windows and SQL Server 2008 environments. And it shouldn't go unnoticed that our hardware solutions are supported by application software partners even before our OEM customers have completed their testing. Application software is a key enabler with the SAN ecosystem, and our partnership with the leaders in the market is essential to our success.

Emulex' 8 gig HBAs have also been selected to provide SAN connectivity for Oracle's Enterprise Technology Centers. As part of these technology centers, Emulex HBAs will be used to support in-depth customer workshops, proof-of-concept tests, hosted demonstrations, and customer testing, and consulting in real world environments. This is solid proof of who Oracle trusts in the data center.

Finally, during the quarter we announced that Emulex Cisco and VMware have integrated NPIV functionality into VMware's VMotion, allowing users to maintain the same virtual port ID, while migrating live virtual machines from one physical host to another.

Let me conclude HSP by adding that for several quarters now we've been talking about the fact that our port growth has been faster than our competitors, driven by both our market share gains in Blade servers and increased mix of dual-channel adapters.

While our share may change from quarter-to-quarter, we believe over the long-haul ports are a meaningful metric of future revenue market share. In the most recent report from Dell'Oro covering calendar year 2007, our share of ports shipped is up about 5 percentage points, putting us in a competitive dead heat for market share at 45%.

So HSP is in a solid position for success in the upcoming 8 gig transition with both our OEM design wins and the strategic partnerships with application vendors, which will continue to drive market share gains.

Our second product line, Embedded Storage Products or ESP, grew revenue in Q3 by 18% sequentially and 29% year-over-year. In addition to strong revenue performance, we achieved a couple of significant milestones during the quarter.

First, the total number of full gate ports shipped live today is approaching 5 million. And second, for our Fibre Channel to SATA routers shipments surpassed 1 million ports in a single quarter.

With our recent product launches over the past two quarters, we have high expectations for ESP this quarter, and we exceeded our goals. While we don't provide specific details for the various products within ESP, I can add that I'm pleased by both the depth of the product line and the breadth of OEMs shipping our products.

During the March quarter, we showed solid execution on our diversification strategy, with ESP accounting for one-third of revenues, with very little drag in gross margins. Except for the launch of two design wins, which were pushed out a quarter or two by our customers, all of the design wins discussed over the past year are now shipping.

Further, as Mike mentioned, we are modeling a decrease in ESP revenue for the fourth quarter. The biggest impact on Q4 is some slowness in orders coming after a spate of initial product launches.

Historically, we have seen it can take a couple of months after initial product launch for end customer demand to normalize. We expect the impact of this normalization to be a little more pronounced than in the past due to all the recent launch activity. Again, we see this event as short-term in nature.

Looking at the next wave of opportunities for ESP, we see the prospect for solid future growth as we move up the food chain from being an ASIC supplier to providing board level solutions for our customers. This is not only a larger addressable market for us, but can help drive design wins and provide a greater degree of product integrations with our customers. Stay tuned for more of this in the near future.

Moving to INP, we've made a lot of good progress. In April, with our partners Cisco and EMC, we introduced and demonstrated the LightPulse 21000 family of converged network adapters or CNAs. Emulex has been at the forefront of driving Fibre Channel over Ethernet or FCoE, not only the thought leader, but in bringing technology to the market.

For those of you unfamiliar with the standard, FCoE combines the efficiency of the Fibre Channel protocol with the ubiquity of the Ethernet networks, creating a compelling solution, which we believe will drive broad-based acceptance of this technology over time.

Our CNA utilizes 10 gig Enhanced Ethernet Networks, running FCoE protocol to enable both network and storage traffic to run simultaneously on a unified network. As a technology, Fibre Channel has provided unmatched performance and reliability to network servers and storage and data centers for more than 10 years.

The benefits of these few proven Fibre Channel products are so meaningful to CIOs that we expect Fibre Channel will remain dominant in the core data center for many years to come.

Over time we believe the FCoE could extent of the use of SAN-based storage into the mid-tier and front-end server applications. And as such it remains at the top of an investment portfolio.

Worth noting is that once unified networks start to be deployed, we expect other complementary IP protocols, such as iSCSI, could gain traction in the small and medium enterprise markets.

Experience counts, and we believe the 5 million port installed base demonstrates our expertise in meeting critical needs in a data center, and is also a significant competitive advantage against incumbents coming into the market.

Without a doubt this type of technology transition is more complex than that of a standard link speed increase, and it will likely take even longer for this technology to enter the mainstream. But from our prospective, Emulex' suite of tried and true drivers, along with our system level interface, or SLI, will go a long way towards smoothing that transition and mitigating end-user concerns.

Our CNA product family is now shipping. In addition, we have made excellent progress on our customer beta programs in tests environments with end-users in both the financial and technology sectors.

To close out the INP discussion, I am going to point out a year ago we announced that we intended to deliver samples of our FCoE products to customers in the first half of 2008, followed by production in the second half of the year. As you can see from our recent announcement, we lived up to our commitments.

So our strategy is simple, continue to leverage our technical strength and market position in network storage, along with our innovative 10 gig Ethernet technology to create world-class products.

I covered a fair bit of ground today, so let me conclude with some key summary points. While our March quarter results were towards the lower end of our guidance, we delivered solid operation results, both in terms of the income statement and the balance sheet.

Our June quarter guidance of $118 million to $123 million in revenue and $0.24 to $0.27 in EPS is not as strong as we would typically anticipate, due to weakness in the high-end Host Server Products and a slowing in orders of some of the newer ESP design wins.

In our view these challenges are short-term in nature, and we expect a rebound in the second half of the year. We do not anticipate any changes to our overall business strategy. And we remain committed to profitable revenue growth, combined with a balanced investment in our existing products, as well as investing to ensure we lead new trends for the data center that take advantage of our expertise.

That concludes our prepared remarks. And with that, we have time to take questions. So, operator, please go ahead and open the line.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from Harsh Kumar with Morgan Keegan.

Harsh Kumar - Morgan Keegan

Hi, guys. Can you hear me okay?

Jim McCluney

Sure.

Harsh Kumar - Morgan Keegan

A couple of questions. Sort of concerned about your HSP revenues being down 10%. I'm hoping you could give us some color on that. That seems like a little bit more than your normal seasonality. I understand your commentary about financials in particular. Was there anything specific that happened, any sort of area that you saw more weakness than the other?

Jim McCluney

Yeah, Harsh. I think as I mentioned on the call, even though we saw 20% year-over-year core growth, our growth was significantly weighted towards the dual-core HBAs and mezz cards, where we expected to gain share in these platforms, and I think we've done that.

Further, what we did experience was that our single channel high-end HBAs were weaker than we would have expected, when taken into account the typical seasonality that we've seen in March quarters. We think this is at least partially due to our dominance in the high-end environments, which have more exposure to areas of the financial verticals, which may have been weaker than normal.

We saw some of this coming from some of our key customers as well, who expressed some weakness in the high-end of the product line. So I think our concentration there and our dominance in the high-end contributed to more than normal seasonality in the March quarter for HSP.

Harsh Kumar - Morgan Keegan

Got it. And that's very helpful. That is pretty fair. Would you expect, Jim, that your HSP business would come back in the June quarter? You sounded like you were pretty comfortable that your overall business will bounce back in the second half. I guess I'm curious what gives you that comfort level? Is there something you are seeing? And then secondly and specifically, would HSP come back in the June quarter?

Jim McCluney

Yeah. We're seeing HSP come back. There is some last customer product launches. We're still being very cautious though. We don't see it -- what we would have normally have seen in a June quarter, and we'll model that into our guidance.

As we look out again on the back half of the year, we're listening very closely to our customers. And we get our forecasts, and we're seeing business returning to normal. We expect a seasonal very strong December quarter as well.

And as I mentioned, we're seeing nice growth in HSP in the June quarter. What's impacting June more so is this kind of one quarter slowdown in ESP business. That's more of the impact in June than HSP.

Harsh Kumar - Morgan Keegan

Got it. And a last question for me and I will jump back in the queue after this, Jim. Embedded business, how much do you expect that to be down? Could you help us out with maybe some breakdown of your revenue line items for the June quarter?

Mike Rockenbach

Yeah, Harsh, this is Mike. Why don't I take that one and give Jim a break. I think we really kind of look at the macro business and really give total guidance. So I think we do expect that HSP will be up sequentially. And historically that has kind of trended over the last couple of years in the single-digit range in terms of growth, in HSP and general.

So we do expect ESP to be down. It's a little bit early to see exactly where that's going to end up, but we did launch quite a few number of design wins in a very short period of time. So I think you do see that's ordering process come into play.

So still pretty early in the quarter, but I think we'll be in a better position to really talk about overall guidance where we're at today and then a little bit more of a breakdown by product line as we get to the end of the quarter.

Harsh Kumar - Morgan Keegan

Very helpful, Mike and Jim. Best of luck. I'll jump back in the queue. Thanks.

Jim McCluney

Thanks, Harsh.

Operator

Now, let's move on talking our next question now which will come from Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

Hi, guys. Thanks. I want to jump back into the embedded side of the business. The HBA side, given what we're hearing out of IBM and going to hear out of Sun, not as much a surprise there, but I wanted to hear little bit more about the embedded side.

Is it part of a product slowdown at your largest customers or is it spread around across a number of customers? And the corollary is what gives you the conviction, or the comments that you see some return to growth in the back half of the calendar year? And then, I have a couple of follow-ups. Thanks.

Mike Rockenbach

Sure, Keith. As we kind of look at the forecast today, I don't think it's any one customer. As we look at the growth in Q3, a very strong quarter at $42 million. And that too wasn't any one customer, it wasn't any one platform. We had quite a number of launches. Some that were late in the second quarter, so we got the full benefit of that in that third quarter, and others that launched in the third quarter.

So as we look out into the June quarter, I think that's what gives us some level of comfort that it's more than normal cycle of ASIC deployment within an embedded array, as opposed to something atypical of any one customer.

So I think as we look at that business, we're not losing the design wins. These design wins are very binary, it's winner take all.

Keith Bachman - Bank of Montreal

Great.

Mike Rockenbach

And so we feel pretty good about that. But I do think in general these are new platforms. A lot of them coming to market relatively close together from a number of different OEMs. You kind of combine that with -- while there is nothing definitive, but definitely some uncertainty about IT spending, certainly over the next quarter or two.

So I think we're seeing some of that being reflected in the forecast from our customers as well, as they get that experience curve going on how these will be deployed by end-users over the next quarter or so.

Jim McCluney

Yeah. I think it's also important to note, we're not seeing necessarily any slowdown in demand for external storage. I think this is just a kind of product release, design release cycle. It kind of hit us last summer a little bit. And this is --.

Keith Bachman - Bank of Montreal

Jim sorry for interrupting, but that's what is a little bit concerning, because you got a little bit surprised by NetApp. So my question is how much visibility do you actually have into your customers' demand versus their inventory levels, because that's what came back last year?

Jim McCluney

We certainly have much deeper understanding than we had last year. We're getting longer term forecasts in from them. We're modeling more to the growth of external storage. And we see what the disk drive guys are doing. We see the trends in external storage. So we're feeling that this is very much a one quarter blip, and we will get back to normal -- normalized demand and growth in the second half of 2008.

Keith Bachman - Bank of Montreal

All right. I'll sneak one more, and then I will cede the floor. Mike, my favorite subject, if it is a blip, what about the buyback opportunities?

Mike Rockenbach

Sure. I would have been surprised if you didn't ask that question. Well, I think I can pretty much stick with the answer that we've had the last few quarters, and I think it holds true today. We definitely see our primary objective and our goal with our cash is to increase shareholder value, and that is best served by diversifying our business.

We did have a good quarter in cash. When you look at the full-year, about 40% of the cash that we generated this fiscal year we have used for buyback, albeit that was at the beginning of the year.

Keith Bachman - Bank of Montreal

Great.

Mike Rockenbach

We've got about six months or so left on the existing repurchase plan. There's still about $40 million remaining. And we do expect that we will be completing that before it expires in November.

So our goal, as I say, is diversification and revenue growth. But to the extent that at a minimum we do want to eliminate the incremental creep from equity compensation shares coming in the market, and we have done that over the last two years, and that's going to be our intent going forward as well.

Keith Bachman - Bank of Montreal

Okay. Thank you, guys.

Jim McCluney

Thanks.

Operator

Let's now move on to Pacific Growth, Kaushik Roy.

Kaushik Roy - Pacific Growth

Thanks. Sorry but another question on the embedded. You're saying that you think it will be come back in the second half, but can you give us any color, like what is the growth rate for that segment for the next 12 months or so? Is it like mid-teens or is it like high single digits? Or any kind of color will be helpful.

Mike Rockenbach

Sure, Kaushik. When we had our analyst day last May, and we did take a look at our various different product lines and gave some guidance around that. I think as we sit here today there's probably more uncertainty than there is information available. As we see how industry reports have come out over the last couple of years, kind of in that timeframe, we start to see that information.

So I don't want to not answer your question, but I do think at our analyst day in about another month or so, we're going to be in a much better position to talk, not only about the near-term, but the longer-term prospects for all of our product lines. And so I would really like to defer until May to give you some detail on that.

Kaushik Roy - Pacific Growth

On OpEx, $1.4 million was because of the payroll taxes. So in Q4, is it going to be less? Should we model maybe close to $50 million or -- if can you give us some color on the OpEx for Q4?

Mike Rockenbach

Sure. That payroll tax is calendar-based, so we start to max out on that as we do throughout the year. So that incremental piece of $1.4 million that we saw in the March quarter will be down in the June quarter, be down further in the September quarter as well.

Having said that, I think there is certainly a couple of dynamics going on, and we are cognizant of those. It's a bit of an uncertain market right now. Our investment in spending is predominately directed at products that aren't going to come to market for a year or two. Our expenses really don't vary a lot depending on near-term revenue.

We certainly see what's going on in the market and we think there is some uncertainty in the near-term. But the fundamentals of our products, our product line and the areas that we invest in still look strategic for the end-users. And so we think we need to be prudent in terms of how we're investing and managing our expenses.

And one of the ways we're doing that is ramping up the India office, as we set out to do. I think we are well on our way of doing that. We have gone up about 65% in the last year. Our goal is 100 employees by the end of this fiscal year. And we think we will be right in that range by the time we get to the summertime.

So we're clearly focusing on prudent investment, but I think all the data we see today says that we're on the right track. Our business strategy and the areas that we're focused on in the market are the right way to go. And we're going to continue to invest.

So our objective is with -- even though revenue is down a bit in Q4, our goal is to hold that pretty much flat on a sequential basis. And really focus in on executing on the opportunities that we've got.

Jim McCluney

Well said, Mike. I think if we stay focused we will get through this Q4. And we will put the right strategies in place, as I mentioned on the call, and tailoring our investments accordingly. Obviously, we're very prudent. We're usually fiscally quite conservative. We like to produce good results and we intend to keep doing that moving forward.

Kaushik Roy - Pacific Growth

So you don't have to invest in FCoE. So can you comment on your relationship with Nuova, Cisco. Are you having to pay any royalty for the converged network adapter, how much it could be? And what is the gross margin implication if you are having to pay some kind of royalty to Nuova?

Mike Smith

This is Mike Smith. I'll take that. You are asking about the go-to-market plan for our converged network adapters. You probably saw an announcement earlier in the month. We are tracking with the testing of this product. Nuova, Cisco is a great partner of ours. They were kind of a development partner of ours. They are a marketing partner of ours. We're working closely with them to ensure interoperability testing and so forth.

But I don't expect any impact of -- that relationship is really a development partner relationship, it's not a commercial relationship. So it won't have any impact on gross margins or pricing or anything like that.

Kaushik Roy - Pacific Growth

Okay. Thank you.

Operator

Moving forward we'll take a question now from Min Park with Goldman Sachs.

Brian - Goldman Sachs

This is Brian in place of Min. I have two questions. The first one was could you tell us more -- more color around the linearity of the quarter? And the second question is you said OpEx will be flat quarter-on-quarter. Is it in terms of absolute amount or in percentage of revenue? Thank you.

Mike Rockenbach

This is Mike. Let me take those. First, I think in terms of Q4 spending, I was talking flat in terms of dollars on a non-GAAP basis. Then in the first…

Jim McCluney

Could you repeat first question?

Mike Rockenbach

You were talking about the linearity of our business in the March quarter?

Brian - Goldman Sachs

Yes, that's correct.

Jim McCluney

Well, March is pretty typically a very back-ended quarter, and this one was no exception. Obviously, as we said, our HSP products didn't quite come into the level that we had anticipated there. And I think we have gone through some of the reasons for that. And our ESP stuff tends to be a little bit more linear in business. But March tends to be quite back-ended.

Brian - Goldman Sachs

Thank you.

Operator

Moving on now to David Cahill with RBC Capital Markets.

David Cahill - RBC Capital Markets

Hi, guys. Am I drawing the right conclusion, distribution being weak in the quarter, was that related primarily to the high-end financial services exposure weakness?

Mike Rockenbach

It's a couple of things. One is, yes, I think there is a tendency for more -- or certainly a decent piece of the high-end products to go through distribution. Distribution in and of itself, or the part we list as channel, some of it is standard products, some of it is OEMs that procure through distribution.

So it's not all pure standard HBAs. And also, some of it is embedded products going into Japan. That typically goes through distribution as well. But as you look at the numbers for the current quarter, I do think it was probably more driven by the high-end of the market in the financial vertical than some of the other areas.

David Cahill - RBC Capital Markets

I think in the past you've given the top three OEMs breakout. Do you have that? And any noticeable change in relative contribution there versus historical, or versus expectation?

Mike Rockenbach

I don't have it in front of me, but I can tell you the top three were the same top three, and I think they were probably in the same order. I don't think -- as I think on the quarter, I don't think there's anything unusual in terms of the distribution of those relative to each other.

David Cahill - RBC Capital Markets

Okay. And then just last one. You talked about FCoE and working through the standards bodies there. Any timeframe on the standards ratification process and when you expect some closure there?

Mike Smith

Yeah. This is Mike Smith. Yeah, there is two kind of trains moving parallel here. The FCoE standard is being driven through the NTT 11 committees, and that is tracking well, as near as we can tell, probably moving towards ratification this summer.

The Ethernet standard is driven through the IEEE. That's out in '09. Neither of these has surprised really to anybody in the industry, and I don't expect it to impact product qualifications or launches.

David Cahill - RBC Capital Markets

All right. Thanks, guys.

Jim McCluney

Thank you.

Operator

And we have a follow-up question from Harsh Kumar.

Harsh Kumar- Morgan Keegan

Thanks, guys. Thanks for taking my question. Just a quick question. Would we expect OpEx in absolute dollars to be down, given that there were a couple of onetime -- you mentioned $1.4 million kind of item in the March quarter -- would it creep up on a sequential basis?

Mike Smith

Yeah, Harsh. This is Mike. The payroll taxes, it's not a onetime or a one quarter event. They start over again at the beginning of the year as individuals max out on the contribution, the company match on the contribution goes away. So it starts out at $1.4 million in Q3, and then it declines over the next couple of quarters.

So it's not so much as a onetime thing. There is a number of things that go into expenses. And really probably the biggest variable is NRE in any given quarter. So our goal is to hold expenses flat in the June quarter. And everybody is focused on doing that in terms of absolute dollars.

Harsh Kumar- Morgan Keegan

I got you. Thanks. Thank you for that clarity.

Mike Smith

Good.

Operator

Let's move on now to Clay Sumner with FBR.

Clay Sumner - FBR

Thanks. Jim, in your comments you said it's worth noting that if Fibre Channel over Ethernet takes off, iSCSI could gain some traction in the SME space. I'm just curious what you meant by that. Are you talking about an opportunity or a threat for you guys?

Jim McCluney

I'll let my marketing expert answer that one.

Mike Smith

Yeah. So obviously there is a lot of talk in the industry about Fibre Channel over Ethernet. We see that really as the strong play in the data center, driven around the 10 gigabit Ethernet technology. There is a lot of interest in the industry on iSCSI. We're seeing it today obviously at 1 gigabit. We're seeing it in the lower end of the market, the small, midsize enterprise play.

I don't see any indication that's moving into the data center. I don't see any traction there. We really see a lot of focus on the FCoE for the kind of mission critical data center kind of applications.

Jim McCluney

Clay, as you know, we constantly keep an eye on that market. If we see the need for expanding market for high-performance software, we do have the technology in-house to address the market. But at the moment we are really pretty focused on 8 gig Fibre Channel and FCoE market adoptions.

Clay Sumner - FBR

Okay. Thank you. And then one other question, on the two design wins that pushed out for the SATA router chips, I am just curious if you can -- are those big ones or relatively minor ones?

Mike Rockenbach

It's a bit too early to tell how big they're going to be. So I think we will wait until we get to the launch and see how that market plays out. But they were a couple of the design wins that we had talked about last year on our analyst call.

Clay Sumner - FBR

Great. Thank you.

Operator

Next on our queue we have Aaron Rakers with Wachovia.

Aaron Rakers- Wachovia

Yeah. Thanks for taking my question. I guess one question for me is more on the HSP side of the business, in terms of just the demand trends that you saw late in the quarter. Exactly what was the linearity in the quarter? And was this more of a broad-based slowdown across your customer base, or is this largely the concern driven by just the server platform refreshes that you have talked about?

Mike Rockenbach

Yeah. This is Mike. Why don't I take that one. The March quarter typically starts out slow. You're coming off of a holiday season, and then the first few weeks tends to be pretty slow. So just in general I think the March quarter relative to some other quarters tends to be more backend loaded.

We did the business going along fine, and obviously with the results on the ESP side saw a lot of strength in ESP throughout the quarter. I think we would say that we didn't see HSP pick up as much towards the last couple of weeks of March as we would have normally anticipated.

It's a little hard to tell from our perspective on what exactly is driving that. I think we've got some anecdotal information or some thoughts on what people are speculating. And I think as we look at the commentary from our customers, they give full year guidance and they are calendar year customers. So they are early into their year.

In listening to their calls or reading through their comments, they are still -- they sound pretty positive and pretty upbeat on the whole year, but I think the underlying tone and some of the comments that they make really indicate that they are looking for the front half of the year to be slower, with a lot of the growth, if not all of the growth, coming in the back half of the year.

And I think as we look at our business, the front half of '08 versus '07, it seems to be stacking up pretty similar to that. So I don't think it is anything outside of that that we are seeing within our customers specifically, or our platforms within those customers specifically.

Other than we do have a real strong skill set in high-performance applications, and we do think that we are probably more exposed to the financial vertical, which certainly is I think expecting -- or people seeing more of impact near term. But I don't think that holds up for the long-term.

Aaron Rakers- Wachovia

And Mike, if I could follow on to that. Do you have any color, guesstimate with regard to the financial services vertical in terms of a percentage of your revenue?

And I guess the next thing, I'm just trying to understand is how much is broad-based demand relative to -- I'm assuming you're talking about the transition that IBM is going through within their system pServers at the high-end. That should be an event that turns around in this current quarter. So I'm trying to gauge the pushes and takes in terms of that relative weakness that you have seen.

Mike Rockenbach

Yeah. I think that is a fair statement. We do tend to be positioned very well. We're, of course, 100% sole source at IBM p and iSeries, so good business there, or a refresh there is certainly going to have a direct correlation with that.

And then I think we're very well-positioned at EMC, in particular in symmetrics, which also tends to be a high-end box as well. There is puts and takes on that. And anytime you're looking at these things on a real time basis it's real difficult to weed through the sound bites and get to what is really going on. And we'll will probably be better positioned after the fact to look at what happened.

But I think as we look at the business, the main things that we focused on over the last couple of years are still absolutely intact. Win and gain share at mezzanine cards, we're doing that. Get in and gain share and win in Sun, and I think we're doing that. And ramp-up our business from nothing to a nice business at xSeries, and we're doing that as well.

But I think the cycle, we definitely do see the cycle reflected in our business, in particular in IBM pSeries, because that is 100% us.

Jim McCluney

The good news is when it picks up we should proportionally pick up higher because of the level of concentration there. And I think we mentioned to folks, we are saying an uptick in HSP going into the fourth quarter. It's not quite as high as we would normally see, and we're just being very cautious about that.

Aaron Rakers- Wachovia

Yeah, that sounds -- and final question for me is, I believe still one of your larger customers, you still do sell into a distribution channel for them. Can you comment on what the weeks of inventory, if there has been any change in the inventory level, given the demand that we saw exiting the month of March?

Mike Rockenbach

I think we do see a little bit more inventory in the channel and that's really reflected on -- if you look at our business and what we look at in terms of how the channel inventory stacks up, the inventory going into the quarter is reflective of the demand for that quarter.

So by that I mean, as you look at the first couple of weeks of January, you've got New Year's and it's a very slow start, so you would expect we would go into the January quarter with less inventory. And overall, as you saw in distribution in our numbers, distribution was down this quarter.

So I think when you look at it on -- obviously, we don't know exactly where we're going to end up on the quarter, but I think when you look at it on forward weeks, in terms of the inventory in the channel being there to support that quarter's demand, I would say was probably fairly comparable to what we came into the December quarter -- or into the January quarter at -- or into January for the March quarter.

But I think if you look at it in terms of dollars relative to where we came into the March quarter, the dollars is going to be up because our expectation for revenue in the channel is up this quarter.

Aaron Rakers- Wachovia

Okay. Fair enough. Thank you.

Jim McCluney

Thank you.

Mike Rockenbach

I think we've got time for maybe one more question, Operator.

Operator

Thank you. and our last question will be a follow-up from Kaushik Roy with Pacific Growth.

Kaushik Roy - Pacific Growth

All my questions have been answered. Thanks.

Operator

Thank you. That does conclude our question-and-answer session. I would like to turn the conference back over to Mr. McCluney for additional or closing remarks.

Jim McCluney

Actually, Mike is going to give the closing remarks, but thank you.

Mike Rockenbach

Okay. Well, thanks everyone for participating in our call. And we certainly appreciate everybody's questions for our third quarter 2008 conference call.

We did kind of mention in the script, but I wanted to give you a little bit more detail. We are going to be hosting an analyst meeting on Thursday, May 29 in New York. Besides myself and Jim being there to present, the general manners from ESP and INP product lines will be there talking about the approach of that business, the trends we see developing, and what we are focused on for the longer term.

Mike Smith, who joined us on the conference call here, is going to be speaking on the prospects and the business strategies for HSP. And Stuart Berman, our CTO, will be there as well talking about technology trends that are driving our business.

We certainly hope that you are able to attend the event with us. If you are not able to attend the event in person, but would like to hear the presentation, we will be sending out webcast information as we get closer to the event.

And we certainly look forward to talking to analysts and investors there, and as we go through the rest of this quarter. I am hoping any of you can make it to see us. And thanks again for joining us on the call. And I hope you all have a good evening.

Jim McCluney

Thank you.

Operator

And, again, that does conclude today's conference call. Thank you for your participation.

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