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Executives

Jean Hu – Senior Vice President and Chief Financial Officer

QLogic Corp. (QLGC) Deutsche Bank dbAccess Technology Conference Call September 13, 2012 11:50 AM ET

Jean Hu

Good morning. Thank you very much for joining us this morning. Before I start, just a quick reminder, our comments today may contain forward-looking statement, so they are subject to our Safe Harbor statement. You can read on the screen.

I want to start this presentation with some key messages about QLogic. The first one is certainly market opportunity. So what we have seen is a tremendous growth opportunity ahead of QLogic. Our traditional Fibre Channel market continued to be very solid and stable. Fibre Channel technology continued to be the choice for enterprise mission-critical applications.

Now what we have seen is a significant growth opportunity in 10-gig Ethernet and converged market. There is a secular technology trend happening in data center, the technology transition from 1-gig to 10-gig Ethernet and the converged network.

QLogic participated in this market from both the host side and switching side. So our market opportunity would double in next several years in this space, it’s very exciting. Then last week, we also announced a new technology. This new technology really combine our high performance I/O adapter card with industry-standard flash technology to bring the server-side caching to storage area network. It’s very exciting and it opened additional adjacent big opportunity for us.

Secondly, QLogic is very uniquely positioned to capture those opportunities, and our competitive advantage really comes from our strong IP portfolio, deep expertise in high performance I/O in data center, and also the key differentiator is really the battle-hardened software, firmware we have been with during the last decade and tested for a long time. And the other advantage we have certainly is our strong incumbency. We have shipped over 12 million Fiber Channel adapter ports for the last decade. We established the strong brand preference for our product in the data center. CIO’s really know QLogic product very well on the interconnect side.

Of course, the third thing is execution. As a company, we are very focused on execution, in delivering quality and innovative product and also execution in delivering a good business model and shareholder value. If you look at our financial model, we have consistently delivered strong financial performance over many, many years. The business generate a very strong cash flow. We also have returned $1.8 billion cash to shareholders through stock buyback, so we’re very committed to shareholder value creation.

On the market leadership side, just a quick highlight, right, we are the leader in Fiber Channel market. We have 55% market share, and we gained market share each year during the last eight years. In the emerging Fiber Channel over Ethernet market, again, we are number one. We have 54% market share. This is a emerging new market, the market is still very small, but leverage our Fibre Channel adapter leadership, but we have again the similar market share. In the 10-gig Ethernet, including FCoE adapter card in 2011, we’re number two just next to Intel. So in this new market opportunity, we really carved out a nice position for ourselves.

For some of you who are not familiar with QLogic, just two quick slide about our product and the customers. Our host product include Fiber Channel adapters, the 10-gig adapters, converged adapters, and iSCSI adapters. Typically, they sit inside of the server or it could be in the storage array from the end, it accounts for about 77% of our revenue, so it’s really the major business of QLogic.

And then our network product include Fibre Channel switches, Fibre Channel over Ethernet switches, and the intelligent storage routers. The revenue is about 13% of our overall revenue and also we provide silicon product, ASIC to customers when they need just ASIC product. Most of the silicon product actually belong to the host category. Silicon products tend to be around 10% of our revenue. We have a very OEM-centric model traditionally. If you look at our top six customers that we have, top four server OEMs, HP, IBM, Dell and Oracle and also we have two top storage OEMs, EMC and NetApp, those are our top six customers.

Channel business is around 20%, but even some of the channel business really is for demand fulfillment for OEMs. So overall, it’s a very OEM-centric business. And if you look at our end customers, they tend to be big enterprises like AT&T, Federal Express, Intel, but also we serve web giant like Amazon and other Web 2.0 companies, too.

Now I want to talk quickly about the fundamental demand drivers for QLogic’s technology and the product, the major technology trends happening in the data center. All of us know there is significant explosion of data. We created so much data, like 90% of digital data in the world has been created during the last two years. And this trend will continue, because there’s a continued explosion of devices, applications, social media, every one of us really wants to get instant access to information, and every business now really need a competitive advantage by instant access to information, data, business intelligence, analytics.

So all those factors really end up creating more and more volume data, that’s why the big data terminology come into play. All the data created need to be processed by servers. They also need to be transmitted. So there will be like 4.8 zettabyte annual global IP traffic by the end of 2015, and also other data needed to be installed.

So if you don’t know the zettabyte, there is the definition there, you can see, it’s still very harder to comprehend how big that data is. But in any sense, what you need today in the data center is that you need really high performance servers, you need a high performance network, and also you need a high performance storage.

And here is the gap we have, right. On the network traffic side, the growth is 32% in next several years, and the storage capacity need growth will be 50% in next several years. But we all know what’s IT spending and the annual growth will be, it’s around 7%. And most of the CIO’s would tell you, they don’t even have that kind of a budget.

So what you are facing is a huge gap, that’s where all the technology come into play is to try to do more with less money and every, we offer those technology trend QLogic play a very critical important role in those technology trends. The first one certainly is virtualization. We are very familiar with virtualization right now. When you have a virtualized server, you have a very powerful multi-core CPUs that can process many virtual machines and handle a lot of applications and the workload.

So what it means is you create more network traffic. You need a more high performance, high bandwidth I/O to pass the traffic from server to storage and back to the server. So QLogic today will provide 8-gig Fibre Channel solutions, which is going to transition to 16-gig. We also provide a 10-gig Ethernet converged solutions of the 10-gig market. Certainly next step is going to go to 40-gig and 100-gig. So we are the I/O provider for the data center. So this incremental need for I/O really benefit QLogic going forward.

On the cloud side, it’s the same thing. You have public cloud, then you have private cloud, or some kind of a hybrid cloud. So the public cloud today is really using 1-gig Ethernet technology, and we never participated in the 1-gig Ethernet, but we have been investing in the 10-gig and the converged technology. So when the transition from 1-gig to 10-gig happens, QLogic will have a new opportunity here to address the cloud market, too.

And then third one is that we call the information access optimization. So what it really means is everybody want fast access to information, time is money, it’s really true here. So we provide high performance I/O, Fibre Channel side, 8-gig, 16-gig, and going to 32-gig and Ethernet side, certainly 10-gig, 40-gig going to 100-gig. But also it’s true is there is a flash technology used in the data center to accelerate application everywhere on the storage side. On the server side, we also announced this new technology last week is really, we combine our high performance I/O adapter card with flash technology and create a shared cache on the server side among even the servers. So we can bring the server side of the cache into storage. So that’s really a critical technology for the future data center.

And then converged network, so in the past, we all know data center is very complicated. It has separate storage network and separate Ethernet network. So today going forward really to get the cost low, you need to simplify the network. We have been hearing a lot about the flattening of network, converged network. So we provide converged I/O solutions, multi protocol, multi-personality connectivity both on the host side, also on the switching side. So if you look also the major technology trend in the data center, QLogic’s product touch every part of the data center. We are the high performance I/O provider and it’s really critical when you process data, install data, you have to make move with the data in the data center, that’s where QLogic’s net technology come into play.

Now I will get into little bit of detail about our concrete market opportunities and our competitive positioning and why we think we will win. So the host market, this is the one we have majority of our revenue today, it’s probably when you add the host business adapter card side and the silicon side, it’s about 85% of our business.

The market we serve is on the Fibre Channel adapter side, that’s the traditional market that we have. It’s about a $700 million opportunity in 2015. The market is very stable and flat and we have 55% market share and our market share has been steadily going up during the last eight years. So we are very confident about this market and the cash flow we would generate from this market.

The second market is a 10-gig Ethernet and converged market. This is really the market that we have start to invest 60 years ago, because we know there is a technology transition, it’s going to happening in the data center. After many years of investment, right now, we are really, we are able to participate in this market opportunity, which are growing from close to $400 million last year, $500 million this year to close to $1 billion in 2015. There is a tremendous opportunity here.

And then, the last one is a storage target ASIC market opportunity. So this is really storage connectivity side. Again it’s actually a new market for us, because one of the incumbent player decide not to move to next generation technology. So it opened a great opportunity for us. It’s about $160 million market opportunity in fiscal 2015. So if you look at this market, overall, it’s about $1.8 billion opportunity and it has double-digit CAGR going forward.

So let me give you a little bit more color about each market, the particular dynamics and why QLogic will win. So the Fibre Channel market there have been a lot of discussions even five, six years ago basically said, okay, Fibre Channel market is going to be bad. But if you look at even today, Fibre Channel technology continue to be the choice for mission-critical applications in enterprise. So it’s a very stable market. The industry actually shipped record number of Fibre Channel parts in both 2010, 2011. This year because of the macroeconomic situation, it may be a little bit different.

This market actually, there’s a very strong brand preference. That’s why QLogic has been able to keep our 55% market share for a very long time, because the key differentiator is really the firmware software, you have to deal with it for a long time, the management tools the data center has. So it’s a very sticky. And also of course, the nature of it, it’s enterprise, so you have shared storage, it’s very reliable, it’s tested for to work with any operating system, any hypervisor and any software you have in your data center. This is for us, there is longevity in this market, and for us it’s also a strong cash flow generator of the business.

The market, of course, is a transition actually is going through its own technology transition from 8-gig to 16-gig, and we also see 32-gig technology coming in the next several years. The second market, this is a 10-gig Ethernet and the converged market. As I said earlier, it’s going to be about $1 billion market opportunity. Because it’s a high growth market, you’d certainly attract many players. So the market is fragmented, and there are a lot of competition. You do have big companies like Broadcom, Intel also are trying to participate in this market.

The market is also different in the sense is Ethernet technology is deployed everywhere, it’s not only deployed in major enterprise, it’s also deployed in the cloud. So within this big market there are lot of segmentations. There is a need for low-latency Ethernet. There is also a need for multiple protocol with converged traffic.

So where QLogic really has its strength is that we come from the storage side of the market. Our strength is to understand the storage market and to move the traffic from server side to storage array. So we have the number one market share leadership in the Fibre Channel over Ethernet market. Of this particular segment, we have 54% market share. That’s really where our strength will come from how we compete.

So last year, in 2011, in this new emerging high growth market we actually carved out a really good position for ourselves, so we were in number two with 15% market share last year. And of course, the other thing is Ethernet is going to be a prevalent technology in the data center, so from the speed side it’s going to migrate from 10-gig to 40-gig or even 100-gig. Then storage ASIC market, again here, QLogic leverage our investment in the Fibre Channel side and also in the 10-gig Ethernet and converged side.

So what we have done is we can provide multi-protocol ASIC to the storage OEMs. So those products sit in front of the storage array, talk back to network, so the key thing is really, you need to be able to talk to either Ethernet network or Fibre Channel or FCoE, and our ASICs can really handle all the protocols; Fibre Channel, FCoE, iSCSI and the 10-gig Ethernet.

And the nature of this business is, I love this business because it has very long design cycle. You need to really work with each OEM and because they each have a different requirement for their own product. So it take a long time to get into the design, but once you get into it, it’s very difficult to replace, replacement cost is really high.

So from CFO’s perspective, this is almost like annuity business. If you can get into it, you get constant cash flow for a very long time. So this is the initial progress that we have made in this market. Again, you can see, we leverage our leadership and technology. We have again a lot of the design wins in this market with all the major OEM. If you look at market participant, seven OEMs probably account for 90% of this market.

We have again majority of design wins here, and we are going through the qualification and the testing process, certainly the revenue will come in different time over the next several years. But there is a long cash flow going forward in that next decade. And I’ll just spend a few minutes to talk about the new technology announcement we had last week. Again, this is another example is we leverage our existing technology IP to address new applications and create innovative solutions.

So here what we have done is we used our QLogic’s high performance I/O adapter card and combined with industry-standard flash technology, and so we use the common server, the same software driver for all the different servers. So literally you can create the caching, shared caching among different servers. And so bring the caching side on the server side to the storage. Today, the key differentiation we have from the existing product is really the server side of caching today is captive only on one single server. To share the caching is extremely difficult, so today a lot of enterprise-critical applications really cannot utilize the flash technology.

If you look at the applications, 79% of enterprise applications are clustered. So it’s very easy to understand it, so when you have an enterprise, everything is shared and clustered, the database that you need to use, somebody else from another part of your business also need to access. But today’s solution really is only on one server, it’s a very limited application. And our solution really can address much more enterprise-critical clustered applications. That really expands the market and will make the flash technology more useful to data center.

And why QLogic can do this and why it’s so unique? If you look at our tradition, we come from the storage area network side. Our expertise really in handling the traffic, move the traffic from server to storage area network. We have built firmware and software to move those traffic for past decade, and we also have sold 12 million parts in the marketplace. And then last five, six years, we have been working with the major OEMs to help them to migrate the data within data center and also from traditional storage infrastructure to the new storage infrastructure.

So we develop this data migration software to help OEMs to migrate data within the data center. With those two foundation technology, that’s how you can view the shared cache among different servers working with flash to bring this server side of caching to the storage market, so it’s very critical to have those software, the key technology developer, so we can build it into this new technology and hopefully next year, we’ll have the product announcement, then we’ll see more revenue opportunity.

The last one is our switching business. On the switching business side, we participate both the Fibre Channel edge switch business and also we participate in the Fibre Channel over Ethernet side. The strategy here is really to leverage our Fibre Channel technology, work with the major OEMs, they all have Ethernet switching capability, but they don’t have the Fibre Channel side of the technology, and also they compete typically with Cisco, Brocade. So we become a technology enabler for our OEMs to provide a converged technology in the marketplace.

If you look at the overall market, the Fibre Channel side, it’s very similar, it’s stable, it’s about $400 million opportunity for us. But on the converged side, there will be tremendous market opportunity in next several years, close to $600 million. So overall, it’s about $1 billion market opportunity for us. We have engaged with HP, IBM, and Huawei, and we also have done – announced the design wins that we’re quite excited about future opportunities for us in this market.

So overall, if you look at what we have is our traditional core market continue to be very stable. On top of that, we have built new expansion opportunities for QLogic. If you look at those new expansion opportunities, it will take our overall market opportunity from $2 billion today to about $3.4 billion in the timeframe of 2015. A quick financial update, if you look at our financial model, we have very high gross margin. We have been consistent with about close to 68% to 70% gross margin. It is a reflection of what I just talked before is your IP content and how competitive your product are in the marketplace.

And if you look at the cash flow we generated, we have generated significant cash flow over many years. So this is a good example is, during the past five years, we generated about $800 million free cash flow, and we also have returned over $1 billion to shareholders through our buyback program.

Now, just a quick update on our long-term target model, we continue to target our gross margin to be in the range of 65% to 67%. The major driver of our gross margin is certainly the revenue mix. So going forward, our Fibre Channel market will be quite stable with high gross margins, but some of the expansion platforms like 10-gig Ethernet market, the gross margin is relatively lower. So when we start to grow revenue in the 10-gig Ethernet side, our gross margin will come down little bit, but continue to be really in the high-60s to mid-60s range

So R&D investment, which is very important for us going forward, if you look at the expansion market opportunities we have, really we want to invest in the innovative solutions to capture those market opportunity. So our R&D percentage will be in the range of 25% to 29%, which is very consistent with all the leading technology companies to really try to capture the future growth opportunities.

We’ll continue to manage our sales, marketing and the G&A expense aggressively, really by a streaming line of process, increase productivity to keep the sales and marketing in the range of 11% to 14% and the G&A expense in the range of 4% to 5%. So overall from operating margin perspective, our target is 20% to 25%. In the current year, because the uncertain macroeconomics, the weakness on the revenue side, our operating margin is more around 20%. But going forward when the revenue start to recover, we should be able to go back to 25% quickly. So that’s our target model.

So in summary, going back to what I said earlier is really, QLogic has a great opportunity ahead of us, and also we have a very strong execution track record and we have been investing in innovative product to address the future market opportunities. So we are very excited about the future, what we can do to create more revenue growth and capture more market share.

That’s all I have. Anybody has any questions?

Question-and-Answer Session

Unidentified Analyst

Can you talk a little bit about the server cycle and what does that mean in the near-term with Romleys kind of rolling out right now?

Jean Hu

Yeah. So the – yeah, the question is about our server cycle and the Romley platform. So Romley platform, most of the OEMs have launched Romley platform into marketplace. So the difference between Romley and Nehalem server cycle is, during Nehalem server cycle launching, everybody saw a significant growth and up-tick. And the Romley cycle, as we always said before, it’s a regular server upgrade, what you have seen is the study, people are upgrading, but with the macroeconomics situation, it tend to be a little bit slower.

So that’s what we expect this Romley cycle will be just regular, nothing as exciting as to the previous Nehalem upgrade cycle. And certainly, we think it’s very important for 10-gig Ethernet adoption. We should see the 10-gig Ethernet market and product start to take off next year.

Unidentified Analyst

I’m curious to get your view on the recent acquisitions of consolidation in the industry with the acquisitions of Segoe and (inaudible) and what impact you think that will have on your competitive landscape, if any?

Jean Hu

Yeah, I think this marketplace is very dynamic. There are a lot of changes, right, like the software-defined network, a lot of people start to talk about it. Cisco start to talk about it, and conceptually, it makes a lot of sense, right. You put all the software intelligence in the control panel, take it out of the routers. So for QLogic, it’s very important and will benefit going forward.

On the switching side, we’ll be ready for the software-defined network in next year also with open flow everything. On the host side, the virtualization, the software, if you look at all the different landscapes, our adapter card and the firmware, software has been able to handle all the virtualization, really for us those are the opportunities.

We do think it would take a long time. Right now, it’s a lot of a buzzword, a lot of people talking about it, but data center is extremely complicated, the infrastructure is extremely complicated. It will take time, but it’s certainly the direction to go to make the data center flattening and to make the software get out of hardware, so you can get a cheaper hardware side.

Unidentified Analyst

Okay. Thank you very much.

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