LSI Corp. Q2 2008 Earnings Call Transcript

Jul.23.08 | About: LSI Corp. (LSI-OLD)

LSI Corporation (NASDAQ:LSI-OLD)

Q2 FY08 Earnings Call

July 23, 2008, 5:00 PM ET

Executives

Sujal Shah - VP and IR

Abhi Talwalkar - President and CEO

Bryon Look - EVP and CFO

Analysts

Kaushik Roy - Pacific Growth Equities

Suji De Silva - Kaufman Bros

James Schneider - Goldman Sachs

Craig Berger - Friedman, Billings, Ramsey & Co.

Shawn Webster - J.P. Morgan

Mark Heller - Merrill Lynch

Blayne Curtis - Jefferies

Hans Mosesmann - Raymond James

Arnab Chanda - Deutsche Bank Securities

Christian Schwab - Craig-Hallum Capital Group

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the LSI Corporation Investor Relations Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. As a reminder, this conference is been recorded. I would now like to turn the conference over to host Mr. Sujal Shah, Vice President of Investor Relations at LSI. Please go ahead sir.

Sujal Shah - Vice President and Investor Relations

Good afternoon and thank you for joining us. With me today are Abhi Talwalkar, President and Chief Executive Officer; and Bryon Look, Executive Vice President and Chief Financial Officer. Abhi will begin the call with some opening remarks and highlights from our business and then Bryon will provide second 2008 financial results and guidance for the third quarter of 2008. During this call, we will be mentioning non-GAAP financial measures, which we may refer to as results excluding special items.

Today's earnings release describes the differences between our non-GAAP and GAAP reporting. You can find reconsolidations of our non-GAAP financial measures to corresponding GAAP amounts on our website at www.lsi.com/webcast. At that site you can also find a copy of the press release and a presentation, which highlights the key points from today's call and provides an overview of our business. This may be particularly useful to new investors.

I also want to remind you that today's remarks will include forward-looking statements. Our actual results could differ materially from those suggested by the statements made today. Information about factors that could affect our future results is contained in our Quarterly Report on Form 10-Q for the quarter ended, March 30th, 2008 and our Annual Report on Form 10-K for the year-ended December 31st, 2007.

With that, it is now my pleasure to introduce Abhi Talwalkar.

Abhi Talwalkar - President and Chief Executive Officer

Thank you, Sujal. Good afternoon and welcome. Our continued strong financial results reflect the success we have had in transforming LSI into a leading storage and networking company. We have now delivered four consecutive quarters of revenues and non-GAAP earnings that have exceeded expectations. Our Storage Systems business grew 14%, sequentially with increases in both entry-level and mid-range systems. Our growth in networking was driven by increased worldwide shipments in our focused networking applications and strength in legacy products. While, I am obviously pleased with the progress we have made, I am even more encouraged by the strong design win momentum that we expect to fuel future growth in each of our businesses.

Our success with customers is ultimately shaped by delivering innovative and best of breed products. To further strengthen our value proposition, we have deliberately taken a platform approach across each of our four businesses where we deliver an unmatched breadth of technologies and products with the end system application in mind. In Storage Systems, we have the broadest OEM offering of rate sub systems encompassing server host RAID, entry-level external RAID, and module or mid-range external RAID systems, all supported with a growing offering in data management software.

In hard disk drives, we have all the critical technology building blocks to provide complete solutions, including read channels, interface controllers, SoCs, and preamps. In standard storage components we have the broadest end-to-end SAS product offering along with RAID software. In Networking, we have network processors, digital signal processors and content processors combined with a custom product capability for providing differentiated solutions. Taking this approach enables unique system level features and accelerates time to market for our customers, while giving us unique and defensible position and confidence in our future growth.

While the economic climate remains uncertain, we continue to benefit from the need to store, protect and transport data. With an unparallel silicon-to-systems portfolio of storage building blocks and a sharpened portfolio of leading networking building blocks geared to enable intelligent, real-time and secure networks, LSI is well positioned to continue to capitalize on the growth in digital content and the proliferation of connected devices and real-time services.

There are some key messages that I'd like you take away from this call. First, we continue to deliver solid and consistent results. Our earnings growth in phase II of our business acceleration plan is a result of successful execution to increase operating leverage. Second, we're a diverse storage and networking company with worldwide presence and tier 1 customers in every product category. Our strong Q2 revenues reflect 24% year-over-year growth in storage systems in growth and networking. Next, our unique platform in customer centric strategy has resulted in design win momentum that has been unprecedented in recent years. And finally, we have established catalysts for both near-term and long-term growth.

Now I want to review with you the business highlights for the last quarter in our Storage and Networking businesses. I will start with storage systems where LSI is well positioned with the full range of products that address the storage needs of a broad spectrum of customers. We had solid performance in the systems business with broad strength across all our products, growth in emerging markets and increased sales to our large OEM customers. In addition to our existing tier 1 customers expanding their footprints, we've successfully expanded our customer base with emerging OEMs.

In the quarter we also saw continued expansion of our entry-level systems software and product margins. We continue to experience solid growth in our entry-level products with iSCSI showing a three-fold increase in sequential shipments. When industry analysts report Q2 unit shipment data, we expect to be the worldwide leader in iSCSI storage systems to the aggregate shipments of our OEM customers. We're also experiencing continued growth in software sales driven by customer's needs for data protection solutions.

In the second quarter we introduced the Engenio 7900, HPC storage system, the first variant of our new flagship mid-range XPB 2 architecture. This system combines leading edge performance for compute intensive applications in high bandwidth workloads with features providing high system availability for applications requiring uninterrupted data access. We've already secured design wins with our OEM partners and successfully deployed the product at a number of high performance computing customers. One of the key values of the architecture is its unique ability to seamlessly adapt to evolving IT infrastructure changes through the deployment of different storage network interfaces such as 8 Gig Fiber channel, 10 Gig iSCSI, 40 Gig InfiniBand as well as fiber channel over Ethernet. A number of OEMs are at various stages of qualification when plans to launch our new modular mid-range platform across a broad base of enterprise storage applications in the second half of 2008. We expect this to be a strong product cycle positioning us well for continued growth in storage systems.

Let me now turn to storage semiconductors, which includes SAS, SAN and HDD. Since leading the introduction of SAS in 2006, LSI has shipped over 10 million SAS 3 gig components. Today eight of the top ten server OEMs use LSI's 1078 RAID on Chip otherwise known as ROC, silicon plus our MegaRAID software for the RAID solution. And nine of ten use the 1078 ROC as the foundation of their RAID product lines. Moving forward, our SAS 6 gig silicon has begun sampling and customers indicate that we have significant advantages on both performance and power. Based on our RAID software stack, product line breadth, performance and power advantages we expect to provide SAS 6 gig ROC plus MegaRAID solutions to nine of the top ten OEM's over time and expect to win SAS 6 gig business at the tenth OEM. We expect initial ramp of our SAS 6 gig products in Q1 2009 with the ramp to high volume expected towards the end of 2009 when the ecosystem is in full place. We fully expect that LSI will remain the clear performance and volume leader in SAS silicon and solutions as success in this space is not only about silicon, but about the silicon plus the software stack.

In SAN, LSI was named the Strategic Supplier of the Year by Brocade. This award is evidence of our ability to support premier data center OEMs and speaks of the superiority of our LSI technology and service. In addition, we have been successful in extending our fiber channel leadership with first generation Fiber Channel over Ethernet designs at major infrastructure companies and second generation designs are activity in development.

Now, turning to hard disk drives, we continue to win new designs and expect to achieve our goal of becoming Number 1 in the world as an HDD supplier. Last quarter we completed the acquisition of Infineon's Hard Disk Drive Semiconductor business, which has increased our share in HDD's for 2008. We are well positioned and confident that we'll become the leading supplier to Hitachi as we move forward. Also, we secured the next two generations of enterprise SoCs at Seagate, which are expected to ramp in 2010, extending our position as Seagate's leading supplier of SoC's. We have secured additional design wins since last quarter across multiple segments to drive future growth.

In addition, we continue to grow sales of our preamp products, we recently qualified our preamps for notebook platforms at Seagate and Western Digital. We now have preamp business and key design wins in all hard disk drive segments and continue to gain share in this area. Tying together our storage capabilities, LSI is in a strong position to capitalize on new solid-state drive opportunities in both enterprise and notebook applications as they develop, given our unique position as a silicon-to-systems supplier to the storage industry. We are programs underway in core silicon development with both custom silicon products as well as standard products that we expect to offer to the industry. We are working on optimizing our rate controllers and software stacks.

On our systems side, we are working rapidly to validate and optimize our solutions for SSDs and are investigating architectures that are more optimized for this new medium. We are looking at the entire system and in some cases down to specific applications to understand the impact of SSDs on end product performance and how we can build better products to meet end-user demand. As with any emerging product category, things will be... things will take time to develop to their full potential. We're confident of our position in this space going forward and view SSDs as a clear term expansion opportunity for our storage business.

Now I'd like to review the networking business where our investments are aimed at delivering products and software for content processing and voice and video processing, advanced traffic management and data center connectivity at faster data rates. This enables our customers to develop more secure networks with greater intelligence and real time services. We continue to see strong design win momentum demonstrating our progress in this business. Our new design wins in networking include our second significant custom Gigabit Ethernet Five win at a major networking silicon provider where we have displaced intense competition. We also were awarded custom silicon wins at sound for next generation Ethernet switches and selection by HP as their modem data card supplier for the majority of their notebooks for 2009.

In addition, LSI's multi-service mapper framer SoC is now shipping with Cisco's service aggregation routers. During the quarter, LSI expanded its Starpro DSP portfolio for high quality voice and video media gateway applications. We introduced new system-on-a-chip solutions that offer lower power consumption for voice channel and video transcoding for mobile, video and enterprise collaboration services. This was the second major product announcement in 2008 and illustrates LSI's progress in the DSP space.

For content processing, LSI announced the Tarari 8400 series of PCI Express "plug-and-play" content processor boards designed to meet the high-performance needs of network security and telecom OEMs. This new series offers scalable performance up to 12 gigabits per second at half the price and one-fourth power of current solutions. LSI now has expanded Tarari technology to the telecommunications market for in-line security applications complementing our network processor and DSP solutions.

Overall, I'm very pleased with the speed with which we have transformed LSI into a successful storage and networking company.

The momentum we have in each of our businesses and the strong financial results we have posted for the last four quarters, service approved point of our strategy. We have demonstrated strong earnings growth in phase 2 of our business acceleration plan and our goal remains to strike a balance between driving improvements to earnings and making targeting investments to generate and acceleration of long-term revenue and earnings growth. We are reinforcing our leadership position in storage systems, maintaining our leadership position in SAS 3 gig and 6 gig and making clear progress towards our goal of becoming the number one HDD supplier while expanding our design win base in networking.

Now let me turn the over to Bryon, who will take you through our results in more detail.

Bryon Look - Executive Vice President and Chief Financial Officer

Thanks, Abhi. LSI had a solid June quarter exceeding several of our guidance metrics including revenue, gross margin and non-GAAP earnings per share. We continue realizing the financial benefits of the strategic and operational decisions we have made over the last year. Highlights for the June quarter include the following: revenues were $692 million, consolidated gross margins excluding special items increased to 47.9%. Operating expenses excluding special items were $243 million. Net income excluding special items was $83.4 million or 12% of revenue representing a $98 million improvement year-over-year. Earning per share excluding special items was $0.13, up from $0.10 per share in Q1. During the quarter we also completed the acquisition of the hard disc drive semiconductor business of Infineon Technologies.

And now turning to a more detailed discussion on revenues. We experienced stronger than expected revenues for the second quarter. Revenues for Q2 were $692 million, which is sequentially up 5% and up 24% on a year-over-year basis net of consumer and mobility revenues, businesses which we divested last year. Semiconductor revenues for Q2 were $462 million, which is up sequentially 1% and up 24% on a year-over-year basis net of the mobility and consumer revenues.

Our storage semiconductor revenues which included hard disk-drive silicon, SAS standard components and storage area network ICs were $306 million representing 44% of total revenues in the second quarter. Revenues were down $16 million or 5% sequentially, primarily due to expected seasonal softness in our HDD silicon sales. Revenues in this part of our business are expected to increase in Q3 on a year-over-year basis, storage semiconductor revenues in Q2 were up $51 million or 20% primarily due to increased sales of SAS, standard components, but also driven by growth in hard disk drive silicon and SAN ICs.

Q2 revenues in our networking business were $140 million representing 20% of total revenues for the quarter and sequentially up $18 million or 15% primarily due to increased worldwide sales of networking standard products, particularly in Asia and better than expected revenues from legacy networking products. On a year-over-year basis, networking revenues were up $28 million or 25%, primarily due to increased sales in both networking standard products and personal connectivity solutions.

Revenues for the IP business in the second quarter were $16 million, up 13% sequentially and more than doubled on a year-over-year basis. As these results demonstrate, we continue to build momentum around our IP business and drive significant value from LSI's leadership intellectual property portfolio. Turning now to our storage systems business, systems revenues were $230 million in Q2, up sequentially $28 million or 14% from a seasonally low Q1.

On a year-over-year basis revenues were up $45 million or 24% primarily due to continued strength in our entry level and midrange system products as well as continued growth in software sales. The storage systems segment represented 33% of LSI's total revenues in the second quarter. Storage revenues continue to be a significant percentage of LSI's total revenues. Combined revenues from storage systems and storage semiconductors amounted to $536 million or 77% of LSI's total revenues in Q2.

Moving next to gross margins. LSI's consolidated Q2 gross margin excluding special items was 47.9%, which was sequentially up 190 basis points from Q1. The improvement in gross margin was driven by lower inventory charges, higher volumes, which drove improved absorption of fixed, cost and by favorable product mix. Semiconductor gross margins excluding special items increased approximately 250 basis points from the first quarter to approximately 52%. And this is primarily due to lower inventory charges, improved fixed cost absorption and a favorable product mix with higher than expected networking product revenues.

On a year-over-year basis, semiconductor gross margins improved 890 basis points from the second quarter of 2007 primarily due to our increased focus on higher margin products, supply chain cost improvements and lower inventory charges.

Storage systems gross margins excluding special items were another area of strong performance in the quarter, increasing 160 basis points from the first quarter to 39.5%, primarily due to lower inventory charges and improved fixed cost absorption. Non-GAAP gross margins in this segment have improved 450 basis points year-over-year due primarily to our focused initiatives to drive down product cost.

Moving to operating expenses, R&D together with SG&A expenses excluding special items were $243 million in Q2, within our guidance range. Operating expenses excluding special items declined $47.4 million or 16% year-over-year, primarily due to the sale of our mobility and consumer businesses in 2007 along with synergies associated with the Agere merger and other restructuring activities. Interest income and other net of interest expense excluding special items was $2.1 million for Q2.

Now let me turn to the special items we recorded in the second quarter, which netted to $97 million. Special items primarily non-cash included $58.6 million in amortization of acquisition-related items, $20.7 million in net restructuring costs and other items, and $19.6 million of stock based compensation expense. The tax provision for the second quarter on a GAAP basis was $2.5 million and the non-GAAP tax rate was 8%.

On a GAAP basis, second quarter net loss was $13.6 million or $0.02 per share, which was essentially flat compared to Q1 2008. On a year-over-year basis, GAAP earnings improved by $364 million from a loss of $0.50 per share primarily due to acquisition-related costs realized during the second quarter of 2007. Net income excluding special items was a profit of $83.4 million or $0.13 per diluted share and was sequentially up by $19 million. On a year-over-year basis, net income excluding special items improved by $97.6 million from a loss of $0.02 in Q2 2007 to a profit of $0.13 in Q2 2008 per diluted share.

Turning now to the balance sheet and cash flow, operating cash flows for the second quarter were $27 million following a seasonally strong Q1 primarily due to timing of movements in components of working capital and strong first quarter account collections. Year-to-date operating cash flows are above comparable 2007 levels and we continue to expect expansion of cash flows in the second half. Cash and short-term investments were $1.15 billion at the end of the June quarter, which includes cash paid in Q2 for the acquisition of the Infineon Hard Disk Drive Semiconductor business. Our net cash position at the end of the quarter was approximately $431 million.

During the quarter, inventories decreased approximately 7% or $18 million compared to Q1, we expect inventories to continue decreasing throughout the year as we complete working down our inventory buffers required to fully transition the assembly and test activities, previously announced for our systems and semiconductor businesses. Depreciation and software amortization for Q2 was $20.6 million and capital expenditures were $14.3 million.

The following is our guidance for the September quarter. Revenues in a range of $695 million to $725 million. This represents a sequential increase of approximately 3% from a stronger than expected second quarter and excluding the mobility and consumer businesses approximately 13% growth compared to the same quarter last year. We expect storage semiconductors to be sequentially up from Q2 due primarily by increased hard disk drive semiconductor sales and networking to be sequentially down in the September quarter, primarily due to decreased sales in legacy networking products. We expect storage systems to be sequentially up, mostly due to seasonality, as we tend to experience stronger revenues in the second half of the year. And we expect IP revenues to increase slightly, relative to the June quarter. Consolidated gross margin, excluding special items is expected to be in a range of 45.5% to 47.5%. Semiconductor gross margin is expected to be approximately 50% and systems gross margin is expected to be approximately 30%, each excluding special items.

Operating expenses are expected to be in the range of $238 million to $248 million, excluding special items with the mid-point being flat to Q2 on higher expected revenues. Our forward looking guidance for OpEx includes, incremental investments in strategic product development areas and increased sales efforts associated with systems products, partially offset by certain operating efficiencies.

In addition we expect interest income and other and interest expense to net to zero, special items netting to approximately $70 million to $90 million, GAAP tax provision of approximately $6 million and non-GAAP tax rate of approximately 8%. We expect our non-GAAP tax rate to be approximately 8% for the year and continue to vary quarter-to-quarter based on our profitability in different geographic tax jurisdictions and certain discrete items.

We expect Q3 GAAP net income in the range of a $0.03 loss to a $0.04 profit per share. EPS excluding special items in the range of $0.11 to $0.15 per diluted share and share count of approximately 650 million shares for both GAAP and non-GAAP purposes. In addition, we expect depreciation and amortization of approximately $20 million and capital expenditures of approximately $15 million.

In summary, we have demonstrated solid financial performance both sequentially and year-over-year and continue to generate positive operating cash flows. I'd like to point out that compared to a year ago, we have grown revenue in our core businesses by 24% growing past 2007 mobility and consumer divestitures, we have reduced operating expenses excluding special items by $47 million per quarter, we delivered on significant strategic manufacturing initiatives which have contributed to material improvements in gross margin and we completed the repurchase of approximately 147 million shares while maintaining a cash balance of over $1.1 billion. Our higher revenue levels, improved gross margin profile and lower operating expense base have resulted in substantial year-over-year improvement in net income excluding special items to 12% of revenues, while we also successfully balanced the need to continue investing in additional growth engines.

And now let me turn the call back to Abhi.

Abhi Talwalkar - President and Chief Executive Officer

Thanks Bryon. Before we go to your questions, I wanted to provide some perspective on our business and markets and what we can expect going forward. The status of the US economy as well as the global economy is uncertain and it remains to be seen whether the macro economic effects will impact our end markets. Based upon recent market data and announcements from our key customers, the PC and server end markets appear to be holding up and we continue to expect favorable seasonality for our storage-related businesses in the second half of 2008. While each of the customers indicate limited visibility unit demand continues to look favorable. In storage systems we continue to expect increased shipments of both entry level and mid range systems further aided by new product cycles. In networking we expect to see declines in legacy products following a stronger than expected June quarter. And despite [inaudible] macro effects enterprise networking spending seems to be stable.

Reinforcing the strength in our business, our June quarter revenues exceeded our expectations and our guidance for September represents a 13% year-over-year revenue growth adjusted for the divestures of mobility and consumer in 2007. Our financial performance and strong design win momentum are the result of the decisions we have made and the plans we have executed to. While I'm pleased with what we have accomplished over the last 12 months, I'm even more encouraged by the opportunities we have to grow revenues in the future across all our businesses.

Now let me turn it back to Sujal.

Sujal Shah - Vice President and Investor Relations

Thank you, Abhi. At this point, we'll begin the Q&A portion of the call. Stacy, will you please give the instructions for the Q&A session.

Question and Answer

Operator

Thank you. [Operator Instruction]. Our first question comes from Kaushik Roy of Pacific Growth.

Kaushik Roy - Pacific Growth Equities

Thank you. Congratulations on another great quarter. Let me just ask you about a couple of concerns that have come up throughout the last quarter and the question on the share loss to [inaudible] I know it's been talked about for the last one year, but can you just remind us what are your expectations, going forward in the second half, would it be offset by some of the Infineon business and then I could…if I could ask another follow up.

Abhi Talwalkar - President and Chief Executive Officer

Kaushik, thanks. As we've said before there are a number of puts and takes that we're contending with within the enterprise business, but bottom line is the acquisition of the Infineon business into Hitachi more than offset any decline that we might experience and then subsequent to that I would like to point out that we've won the next two generations of enterprise SoCs at Seagate.

Kaushik Roy - Pacific Growth Equities

And there has been another concern about some kind of share loss to PMCS at HP on SAS 2.0, can you comment on that?

Abhi Talwalkar - President and Chief Executive Officer

Well, our business in SAS continues do incredibly well, we are clearly the market leader today and very confident in the overall road map, product offering and our position, as we go into the SAS 2.0 or SAS 6 gig generation next year. So now with that said and specific to HP, HP's traditionally had a strategy of having multiple suppliers across their product line and in fact the SAS generation itself, the first generation it was LSI and Broadcom and we were the volume and performance leaders within that particular generation. So we have very high confidence in our overall product line and the competitive advantages that we are starting to see and comment back from our OEMs.

Kaushik Roy - Pacific Growth Equities

Thank you.

Sujal Shah - Vice President and Investor Relations

Okay. Thank you, Kaushik. Could we have the next question please?

Operator

Yes. Our next question comes from Suji De Silva of Kaufman Bros.

Suji De Silva - Kaufman Brothers

Hi guys, nice job in the quarter as well. In terms of the... I know, Abhi, you have talked a quite about the storage systems business and how you expect the strength there, but can you talk about what's giving you the confidence underneath that given the macro uncertainty, is it the new products primarily or is it some share gain potential?

Abhi Talwalkar - President and Chief Executive Officer

Well, I mean I think... I think demand seems to be holding up. I haven't had time to completely look through the EMC announcement recently but as probably another indicator the demand is holding in there. So I think demand is a piece we... I believe our customers are experiencing some share gains both on the backs of very strong products but also some of the actions that they have been taking. As you know IBM had a very solid quarter overall and they commented specifically on strengthened disc and mid-range and entry growing very nicely quarter-to-quarter and year-over-year. So I think that is playing a role as well and we do have some product cycles in the second half.

Suji De Silva - Kaufman Brothers

And then Bryon, if I heard you right, did you say systems gross margin will be 30% next quarter?

Bryon Look - Executive Vice President and Chief Financial Officer

It's 39%. I may have misspoken, 39% on the systems side.

Suji De Silva - Kaufman Brothers

That makes more sense. Okay. And then in the entry level... entry part of the products, how is that as a percent of systems, has that become a material part and where do you expect that to track relative to the overall systems business?

Abhi Talwalkar - President and Chief Executive Officer

It's starting to become a material element. It's helped us diversify our customer base as well and we continue to see more growth ahead for that business. We are very pleased and excited about the types of growth that we are seeing in the iSCSI space, which clearly is addressing sort of the small and medium business local department segments where the growth has been just fantastic.

Suji De Silva - Kaufman Brothers

Great. And then the last question, and I was being concerned about the hard drive business with the [inaudible] but can you talk about how much this quarter was the Infineon acquisition, just to understand, sort of, the offset there?

Abhi Talwalkar - President and Chief Executive Officer

We don't... we don't break out specific customer revenues per se, but I think we've been talking about that overall acquisition to provide about $100 million in overall revenue. Nothing has changed, I think that still remains sort of the right number for people to think about.

Suji De Silva - Kaufman Brothers

Great thanks. Nice job guys.

Abhi Talwalkar - President and Chief Executive Officer

That's a per year number.

Suji De Silva - Kaufman Brothers

Right, per year, thanks.

Sujal Shah - Vice President and Investor Relations

Thank you, Suji. Could we have the next question please?

Operator

Thank you. Our next question comes from James Schneider of Goldman Sachs.

James Schneider - Goldman Sachs

Good afternoon and thanks for taking my question. When you look at the enterprise storage business, broadly speaking Abhi, could you talk about the bias of your customers' back half forecast relative to what you consider to be a normal seasonal year and can you address the order patterns you've seen so far in July?

Abhi Talwalkar - President and Chief Executive Officer

You are talking specifically to storage systems?

James Schneider - Goldman Sachs

Not just...anything in the enterprise related as opposed to more PC or consumer related?

Abhi Talwalkar - President and Chief Executive Officer

Well, I mean... let me answer it in terms of the overall composition of the business, I think we've said a number of times that, we're a not too much exposed to consumer-oriented purchases, so 85%, 90% of our business is exposed to businesses spending and as we all know the second half is favorably up from a seasonality standpoint across storage, certainly storage and we see some of that in networking towards the end of the year as well. It's hard to say as to where things are going to fall relative to seasonality this year. It's certainly going to up, I think, what we're all trying to assess is how strong is that seasonality given the macro economic sort of backdrop. Right, I think I'll leave it at that, as we are not guiding beyond the third quarter.

James Schneider - Goldman Sachs

Fair enough. And then maybe one for Bryon. Could you talk about the... I mean, you talked about gross margin guidance for Q3, but can you talk what we might expect going into Q4, you obviously have some strength due to the networking businesses, but how we think... how do you think that should trend through the rest of the year?

Bryon Look - Executive Vice President and Chief Financial Officer

Well, there are a lot of factors that drive the... and have driven the significant progress we have made in terms of our gross margin performance, obviously the revenue growth that we've been demonstrating quarter-over-quarter is going to continue to be a factor going forward. And Q4 historically has been a very strong quarter in terms of volumes. So certainly that will be a contributing factor. Mix always plays into it, I think one of the reasons why we had the strength beyond our expectations relative to the current quarter Q2 was in fact mixed, so we benefited from stronger than expected networking legacy revenues. We noted that in Q3 the networking revenues are expected to be down a bit and so that's going to affect our margin mix as well. And then just looking at overall progress that we've made, we've also been benefiting from significant manufacturing related initiatives to take down our product cost and those are paying off for us as well.

James Schneider - Goldman Sachs

Perfect. Thanks very much.

Sujal Shah - Vice President and Investor Relations

Okay. Thank you Jim. Can we have the next question please?

Operator

Thank you. The next question comes from Craig Berger of FBR.

Craig Berger - Friedman, Billings, Ramsey & Co.

Thanks for taking my question. Just as a follow-up on the gross margins with the Q3 guidance, why do you expect the chip gross margins to come down so much and can you just clarify that the systems gross margin guidance for next quarter is 40% not 30%?

Bryon Look - Executive Vice President and Chief Financial Officer

We're guiding to 39% gross margins for our systems business in Q3.

Craig Berger - Friedman, Billings, Ramsey & Co.

39%?

Bryon Look - Executive Vice President and Chief Financial Officer

And roughly 50% on the semiconductor side. To your question about Q3 versus Q2, you should have to understand where we stand relative to the second quarter gross margins, and that clearly we performed higher than expected levels and there were three contributing factors to that in the quarter. One of those was lower than normal inventory charges, okay, so that may not repeat in the third quarter. And the second thing is higher volume of course and that will be a factor in Q3 agenda. We are forecasting a higher revenues, which will help our margins. And then there is product mix between the third quarter and the second quarter, which also result in some changes. So overall, I think we are pleased with progress that we've made. I think there is more opportunities that we have to continue to drive gross margin performance on a longer-term basis, while we also work against various challenges in terms of raising cost that everybody is seeing in terms of the supplier base. Some of the key initiatives that I want to remind people we have spoken about this in prior quarters. We executed on initiatives to outsource our assembly and test operations both on the semiconductor side and nearing completion of that on the system side, but also we are going to benefit going forward from continued increases is our IP revenue stream that grew nicely quarter-over-quarter. Software sales grew, that will be a contributing factor as well. But long-term, I think there are opportunities and I will leave it with that.

Craig Berger - Friedman, Billings, Ramsey & Co.

Just as a follow-up on these lower shipments of networking products for third quarter, are you guys seeing some slow down in Asia following the Olympics? I mean it seems like networking shipments have been pretty strong thus far, are we going to see some lumpiness there in the second half, what is your view on that?

Abhi Talwalkar - President and Chief Executive Officer

I think our decline in networking is largely dominated by a legacy decline. So we definitely experienced very strong sales in Q2, especially in the legacy space because of build outs both in GSM in India as well as some of the build outs in China. A lot of people have been talking about a big run-up ahead of the Olympics as well and I think we did benefit from that. So we are seeing that legacy drop off contributing to most of that decline.

Craig Berger - Friedman, Billings, Ramsey & Co.

Thank you.

Sujal Shah - Vice President and Investor Relations

Okay. Thank you, Craig. Can we have the next question, please?

Operator

The next question comes from Shawn Webster of JPMorgan.

Shawn Webster - J.P. Morgan

Hi, good afternoon. The restructuring charges that you took in Q2, what is that composed of? I thought that we were pretty much past a restructuring part.

Bryon Look - Executive Vice President and Chief Financial Officer

There's a number of elements that contributed to that. We continue to have these related expenses. There are still opportunities that we have to consolidate our facilities. We took a number of those actions in the quarter, which resulted in some expenses in the lease and real estate area. There is also some continuing severance charges that we took in the quarter as we continue to again optimize overall. So those were among the key restructuring related charges that we reported in Q2.

Shawn Webster - J.P. Morgan

How much do you expect there to be in Q3?

Bryon Look - Executive Vice President and Chief Financial Officer

Well that's within the overall guidance we provided special items for Q3 and if you look at the $70 million to $90 million guidance we are providing you could expect about 58, 60 of that being in this amortization of acquisition related intangibles and probably stock-option expense, remaining about equivalent levels, about $120 [ph] million level. So the delta is really intended to cover potential other restructuring and related expenses.

Shawn Webster - J.P. Morgan

Okay. I understand, thank you. And then for you OpEx, can you may be share your thoughts, flat guidance for Q3 is... it's good to hear that, I am just wondering how you expect to grow your OpEx going forward, I believe in the last call you guys were talking about maybe ramping your OpEx up a little bit, so I am just trying to get a reset on your... on what you're thinking on your headcount and your spending for the next, lets say six to 12 months?

Bryon Look - Executive Vice President and Chief Financial Officer

Well, I would say our overall goal continues to be to stay focused on driving operational efficiencies across the board in the OpEx area as well as in manufacturing. I think we are continuing to carefully manage our spending, our actual results show that we continue to drive quarterly improvements in both R&D, as a percentage of revenues and SG&A, as a percentage of revenues. And as I said earlier we are currently operating at a base level that's about $47 million per quarter lower than we were a year ago. We are guiding to, you know, with higher revenues in Q3, spending essentially being flat quarter-over-quarter to midpoints. So going forward, yes, we have opportunities to make investments, but we have also absorbed a lot of the incremental investments associated with some of those opportunities. For example, in Q3... Q2 we took on of course the support of the Hitachi business that we acquired as part of Infineon deal. That's encompassed within the current spending envelope and we have a full quarter of that in Q3. We've made incremental investments in other growth areas such as SSB Investments, but we have been able to offset some of that by just continuing to focus on operation efficiencies, I mentioned for example, consolidation of facilities, one of those opportunities to take our sort of run rates down in certain areas of the company.

Shawn Webster - J.P. Morgan

Okay. Thank you for that. And then turning to the channel inventories, Abhi, are there... can you give us a sense of where you see channel inventories for your various segments, I guess particularly in the drive supply chain?

Abhi Talwalkar - President and Chief Executive Officer

It's something we have been watching very closely. In regards to drives in particular, we know clearly and Seagate discussed this in their call that they've improved their inventory situation as to... as it compared to Q1. So I think they continued to be focused on that and that is improve from a quarter ago. We don't believe we have any concerns relative to inventory across our server and storage related products nor our networking. So we believe inventories are in line and around expectations.

Shawn Webster - J.P. Morgan

Okay. And then how was your backlog and bookings and orders [inaudible] how was it dispersed I guess over the course of Q2 and into July?

Abhi Talwalkar - President and Chief Executive Officer

Fairly typical for the quarter. We generally have 30-30-40. Third quarter is... third month is always the strongest; depending on business turns are obviously heavier towards the later part of the quarter, but nothing different than typical. We did see some very good strength exiting the quarter in our storage systems business and we are in very good position today at this point in time in the third quarter.

Shawn Webster - J.P. Morgan

Okay. Thank you very much.

Sujal Shah - Vice President and Investor Relations

Okay. Thank you, Shawn. Can we have the next question please?

Operator

Thank you. Your next question comes from Mark Heller of Merrill Lynch.

Mark Heller - Merrill Lynch

Thanks and congratulation on the quarter as well. I had a question, if you could may be quantify what do you expect for networking next quarter, how much of a decline do you expect, how much legacy business do you have left in that business… in that part of your business at this point?

Bryon Look - Executive Vice President and Chief Financial Officer

Mark, we are not breaking that out, you know, in terms of the magnitude of the decline, but we have been helping people get a better handle of the overall decline of our legacy business in networking on a annual basis. We basically guided people to about a $100 million decline this year in the networking business, specifically the legacy decline, and I think that remains sort of the right number to use as compared to last year.

Mark Heller - Merrill Lynch

And looking at sort of the longer-term growth rate for the company on the top line, I mean, excluding the mobility and consumer business, you seem to be growing double-digits year-over-year, do you think that's sort of the long-term model for the company?

Abhi Talwalkar - President and Chief Executive Officer

Well, we believe certainly that's what we need to be aiming at and all the moves and changes that we've made as well as the investments that we are making today are all geared to position us to be able to grow sort of at that double-digit level consistently. Now it is a big challenge given the overall semiconductor structure and the maturity of the semiconductor market, but we believe we are in the right markets and making the right investments to be able to do that. And of large percentage of our business has demonstrated that consistently for a number of years.

Mark Heller - Merrill Lynch

And lastly, any thoughts on the cash balance? At this point I think you have like maybe around 400 million in net cash, how are you thinking about stock buybacks and acquisitions at this point?

Bryon Look - Executive Vice President and Chief Financial Officer

Well, I think we remain in a very strong position relative to being able to do share repurchases. We always looks at the overall set of cash requirements that we have, whether that's for opportunities to drive shareholder value through repurchases of shares, whether that's taken a look at the convertible notes that we have outstanding and servicing those, whether it is strategic opportunities like acquisitions, and we demonstrated that in the last quarter with the closure of the acquisition from Infineon, which is I think a really great move to solidify and strengthen the customer opportunities that we have in the hard disk drive arena. So I think our options are going to remain the same and we are in a very strong position relative to our overall cash levels as well as our cash flows.

Sujal Shah - Vice President and Investor Relations

Okay. Thank you, Mark. Can we have the next question please?

Operator

Yes. Our next question comes from Blayne Curtis of Jefferies.

Blayne Curtis - Jefferies

Thanks. Good afternoon, guys. Abhi, you didn't want to break up the mix between legacy and non-legacy, I'm just wondering if you quantify of the upside, the roughly $20 million you saw in the networking business, how much was driven by legacy? Did the non-legacy business grow or not, is there a way you can break that out?

Abhi Talwalkar - President and Chief Executive Officer

No, it's not something we are going to break out. I mean legacy was certainly a good portion of the strength that we experienced, but our non-legacy business and go forward businesses continue to execute to our expectations.

Blayne Curtis - Jefferies

Perfect. And how should we look at the timing of the opportunities with Hitachi as you move your own SSD into that and replace Infineon is that an '09 event or what's the roadmap there?

Abhi Talwalkar - President and Chief Executive Officer

Well, I mean in terms of subsequent designs or additional designs that we have secured there above the acquisition itself, we have not been specific, but we have talked about incremental revenues in 2009 and beyond, more towards later 2009 and beyond.

Operator

Thank you. Our next question comes from Hans Mosesmann of Raymond James.

Hans Mosesmann - Raymond James

Thanks. Congratulations, guys. Most of my questions have been answered, but Abhi, can you give us more sense in terms of the SSD opportunity, when does that become a large part of your business? And I guess it has to do with the timing of how the industry adopts this, what's your plan or your visibility into this market?

Abhi Talwalkar - President and Chief Executive Officer

Hans, the market is very much in its infancy and the size of the market is directly or indirectly proportionate to the heighten all the debate and discussions. We absolutely believe it's a pretty significant inflection point that’s going to realize some very significant end customer benefits. However, it's very much in its infancy as overall market. We have obviously investments in that space, lots of discussions and very serious activity with customers in the market as well as our own products. I see this being more of a meaningful revenue in 2010. We will probably see some revenues in '09, but nothing of any material nature, more of 2010. I think this is just more indicative of the market versus naturally LSI's position.

Hans Mosesmann - Raymond James

Okay. Thank you.

Sujal Shah - Vice President and Investor Relations

Thank you, Hans. Can we have the next question please?

Operator

Yes. Your next question comes from Arnab Chanda of Deutsche Bank.

Arnab Chanda - Deutsche Bank Securities

Thank you. Couple of questions, either for Abhi or for Bryon about the gross margin, you have a lot of different businesses within it, and I don't expect you to qualify the differences, but can you tell us qualitatively how the sort of gross margins vary within the systems business as well the Tier 1 semiconductor businesses, and whether the improvements or otherwise that we see form here on are going to be mix driven or are there some other things you can do? So I guess those are two questions. Thanks.

Abhi Talwalkar - President and Chief Executive Officer

Well, I'll take a run at this and Bryon can jump in. We can certainly give you a flavor for where some of the gross margins are across the product lines as to whether they are south or north of our business model target, okay? So I think it's pretty safe to say that our systems business itself given system business gross margins are somewhere around 39%, 40%, but we have pretty broad spectrum of margins, because we've got a very broad spectrum... the product line that we cover from the upper end of the mid range which certainly has margins that are north of our sort of corporate margins as well as those that are lower. In our hard disk drive business in general you can expect those margins to be south of the overall business model target. In our SAS and networking, they are well north of that business model target, right. So, in IP, that's a no-brainer in terms of where that will end up in terms of gross margins. That's probably the color that I can provide.

Arnab Chanda - Deutsche Bank Securities

And then one follow-up question if I could. I think it's.. what, this is probably what your third year and you've kind of integrated Urek [ph] acquisition, it seems like you are getting design wins. The growth rates you are talking about for Q3, there seems like some conservativism built into that, I am just curious as to sort of this low double-digit year-over-year, is that a good ongoing base to start off from, is that something that you think... are you driving towards a certain type of growth rate and then is there some flavor of being a little more conservative given the macro environment? Thank you.

Abhi Talwalkar - President and Chief Executive Officer

Well, relative to Q3 specifically in terms of our guidance, yes, there is an element of visibility that we all have to contend with, but at the same time that growth rate that we have talked or at least guided to comprehends the decline in our legacy networking business. So if you peel that away, the growth rate of the rest of the company and rest of the business, it's pretty decent relative to seasonality. And then your broader question in terms of growth, I answered it I think before which is, we are continuing to position the company, make the right investments, make the right choices to be able to consistently grow at double-digit levels and get the whole company to grow at that level.

Arnab Chanda - Deutsche Bank Securities

And sorry, just one last question about the business model, your operating margin targets... do you…have you talked about what type of revenue levels you need to get there or is there... do you need to invest more in expenses to got to that revenues...I'm just curious, thanks.

Abhi Talwalkar - President and Chief Executive Officer

I think we've shared with people our range of $750 million to $800 million in revenues.

Arnab Chanda - Deutsche Bank Securities

Thanks, Abhi.

Abhi Talwalkar - President and Chief Executive Officer

Thank you.

Sujal Shah - Vice President and Investor Relations

Thank you, Arnab. Can we have the next question please?

Operator

Sanjay Dees [ph] from Morgan Stanley.

Unidentified Analyst

Hi guys, thank you so much for taking my question. I just had one question regarding your strategy with your Content Processors that you acquired with the Tarari acquisition. I think in the past you guys have discussed that you were looking to engage with PC vendors to kind of drive those Content Processors into the PCs themselves and I was wondering if you can give us a sense of how those discussions are taking place and moreover if you can give us the sense of the market opportunity for that? That's it. Thank you so much.

Abhi Talwalkar - President and Chief Executive Officer

Well, I mean the applicability of our Content Processors is pretty wide, very broad from servers to storage systems to networking equipment to telecom and we've got a very I think unique go-to-market approach where we will sell and work with customers at really any level of integration from tiny pieces of silicon with IP on it to complete PCI Express boards, the one that we announced in the call today, the 8400. That allows us to participate and target across all these different applications. And yes, we're certainly looking at the PC space as an application target. Security is a clear area that PC companies and certainly end users and IT managers are looking to focus, and PC companies are looking at security at a point of differentiation. I'm not going to announce anything specific here, but those discussions continue to progress well in the PC space. Our primary, initial focus remains in some of the other traditional categories for LSI.

Unidentified Analyst

Thank you.

Sujal Shah - Vice President and Investor Relations

Okay. Thank you Sanjay. Could we have the next question please?

Operator

Yes. Our next question comes from Christian Schwab of Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Great. Thank you. Good quarter guys.

Bryon Look - Executive Vice President and Chief Financial Officer

Thank you.

Christian Schwab - Craig-Hallum Capital Group

The moving parts as far as the revenue strength that you guys talked about in the beginning of the call, if you just had to sum up the strength of the most recent quarter to three things that drove the upside to your previous expectations in Street consensus, what would they be?

Abhi Talwalkar - President and Chief Executive Officer

Storage systems, networking, and both elements of networking, both legacy as well as sort of go-forward businesses were probably the two primary drivers of growth.

Christian Schwab - Craig-Hallum Capital Group

And can you remind me how much, given the Infineon acquisition closed inter quarter? You didn't receive a full quarter's benefit of that, did we?

Abhi Talwalkar - President and Chief Executive Officer

No, we did not.

Bryon Look - Executive Vice President and Chief Financial Officer

That closed down, I believe was April, the 23rd. Again, roughly two months out of the quarter of revenue.

Christian Schwab - Craig-Hallum Capital Group

Right. So, we'll get the benefit of full three months plus seasonality strength in the September quarter as well. So, I don’t remember who asked it earlier but would it be appropriate to assume that the September quarter guidance does have a bit of cautiousness to it versus typical seasonality that we would expect?

Abhi Talwalkar - President and Chief Executive Officer

No, I mean we are using the best data that we have available, best insight that we have beside guidance at this point in time. And again I think we are all startled with the level of uncertainty just given all the economic chatter that we have to deal with on a daily basis, and a lot of it is very real so.

Christian Schwab - Craig-Hallum Capital Group

Great, no further questions. Thanks.

Sujal Shah - Vice President and Investor Relations

Okay thank you Christian. Could we have the next question please?

Operator

Your next question comes from Dan Berkeley of O'Connor [ph].

Unidentified Analyst

Hi, two follow-up questions. When we look at the gross margin guidance for the September quarter, should we infer in that some of this that you are not counting on any of the legacy networking and that had some pretty high gross margins and that could explain the difference in guidance versus June actual than I have a harder follow-up question?

Abhi Talwalkar - President and Chief Executive Officer

I think that is… I mean if you think about our second quarter, second quarter seasonally is the softest quarter in the hard disk drive space, okay. And I've... sort of what we experience and than what we had on top of that was very strong networking business, those two businesses are at opposite ends, if you will, not opposite ends but there was a pretty dramatic difference in terms of gross margin. That flips in Q3, because we've got a legacy decline and Q3 is a very strong quarter as it pertains to hard disk drive, right. So, that is absolutely playing a role relative to our gross margin guidance.

Unidentified Analyst

But should we also think of that legacy, your networking product is having some of the highest gross margins in the company?

Abhi Talwalkar - President and Chief Executive Officer

There are higher gross margin but again we've got new networking products that we've been investing in that where in the process of ramping and shipping that have equivalent gross margins levels as well.

Unidentified Analyst

Even this early in the ramp?

Abhi Talwalkar - President and Chief Executive Officer

Yes.

Unidentified Analyst

Okay.

Abhi Talwalkar - President and Chief Executive Officer

Because we've been ramping products and selling products in this space for some time.

Unidentified Analyst

Okay the follow up question and you may or may not be able to or won't answer this, but since you opened it up in the beginning of the call sort of 80% to 90% of your revenue driven by corporations as suppose to the consumer, where do you see financial services or any other industry that might be at risk for cutting the CapEx as part of that 80% to 90% or is that just not have that granularity from your OEMs?

Abhi Talwalkar - President and Chief Executive Officer

As to what percentage of that 90% is comprised of financial services.

Unidentified Analyst

And are there companies that might be at risk for cutbacks?

Abhi Talwalkar - President and Chief Executive Officer

Yes, I don't have that perspective, and sort of anecdotally, based on our discussions with those that we can have discussions with in terms of end user as well as some of our peers, the top 10 users even more so frequently. Lot of the financial services, cut backs certainly don't appear to be in infrastructure as in servers and storage systems, I mean their business is run on technology and I feel a number of companies are actually investing heavily, even in this environment there have been some, certainly some publicized delays of PC's and so forth, but as I said earlier I think that has been generally small has not had an impact on our business.

Unidentified Analyst

Okay. Thank you and good luck.

Abhi Talwalkar - President and Chief Executive Officer

Thank you.

Sujal Shah - Vice President and Investor Relations

Thank you, Dan. Could we have the next question, please?

Operator

Thank you. Your last question comes from Sumit Dhanda of Banc Of America Securities.

Unidentified Analyst

Yeah hi. This is Ed Garnadi [ph] for Sumit Dhanda. Just a few questions, first on the guidance as it relates to the overall business. If you assume that the storage semiconductor, excuse me, if you assume that the systems business grows in line with seasonality following a very strong Q2 and assume the HDD business also grows in line with seasonality, which I assume is low-to-mid double digits plus assuming the benefits of Infineon, which is three months versus two months in the second quarter. Isn't your guidance for the SAN and fiber channel and your Classic LSI enterprise semiconductor business a much muted versus normal seasonality. In other words, I am getting sort of wide-ish enterprise HDD growth for September, is that fair to assume?

Abhi Talwalkar - President and Chief Executive Officer

No, I think keep in mind a couple of things, right. We have a legacy and a little bit [ph] of networking. We also had a very strong Q2 as well.

Unidentified Analyst

I'm not talking about just about the storage semiconductor business? If you just piece out the HDD business, assume that will grow double digits. Unless if you are assuming that your networking business is going to decline double digits?

Abhi Talwalkar - President and Chief Executive Officer

Well, I mean I think, we're not going to get into that level of granularity, but I will say that if we look at our overall aggregate storage business and its growth Q2 to Q3 it's sort of right in there with seasonality. And the seasonality varies because there is a number of different businesses within that storage business. Businesses that ends up in servers, businesses that ends up in PC's because they are hard disk drive content as well as storage systems.

Sujal Shah - Vice President and Investor Relations

Okay. Thank you. I would like to thank all of you for joining us this afternoon. If you have any additional questions, please call Investor Relations at LSI. Thank you and have a nice day.

Operator

Ladies and gentlemen, an audio replay of this conference will be available beginning today at approximately 5 PM Pacific Daylight Time and will run through midnight on July 29. The replay access numbers are 1-866-479-2455 within the US and 1-203-369-1530 for all other locations. The webcast will be archived at www.lsi.com/webcast. That does conclude your conference for today. Thank you for your participation. You may disconnect at this time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!