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Applied Micro Circuits Corporation

F1Q09 Earnings Call

July 30, 2008 5:00 pm ET

Executives

Robert G. Gargus – Senior Vice President & Chief Financial Officer

Kambiz Y. Hooshmand – President & Chief Executive Officer

Analysts

James Schneider, Ph.D. – Goldman Sachs

Allan Mishan – Oppenheimer & Co.

Sandy Harrison – Signal Hill Group LLC

Christian Schwab – Craig-Hallum Capital

Sanjay Devgan – Morgan Stanley

[Brian San – Bainbridge Capital]

Operator

Welcome to the Applied Micro Circuits first quarter 2009 earnings results conference. (Operator Instructions) Now, for opening remarks and introductions I would like to turn the conference over to Bob Gargus, Chief Financial Officer.

Robert G. Gargus

On the call today with me is Kambiz Hooshmand, our President and CEO. Before turning the call over to Kambiz, I want to remind you that the forward-looking statements discussed on this call, including guidance that we will provide on revenue, non-GAAP gross margin, non-GAAP operating expenses and certain other financial targets are based on the limited information available to us today. That information is likely to change. There are numerous risks and uncertainties that affect our business and may affect these forward-looking statements, including product demand and mix, product development and introductions, design wins, manufacturing, the impact of workforce reductions and the integration of new or moved operations, risks relating to macroeconomic conditions, markets and other risks that are set forth in our SEC filings, including our Form 10K for the year ended March 31, 2008.

Our actual results may differ materially from these forward-looking statements and AMCC assumes no obligation to update forward-looking statements made on this call. I want to point out that AMCC has several analysts that cover the stock and this creates a range of variability relative to the Street financial models. When we say Street estimates, we mean the consensus of the major analysts’ models and not necessarily the guidance that was given by the company.

With that, I’m going to turn the call over to Kambiz.

Kambiz Y. Hooshmand

Shortly, I’ll give you our vision and perspective of the business fundamentals and then Bob will discuss the financials in detail. Today, I am pleased to share with you two strategically important additions to our senior leadership team. We announced the appointment of Dr. Paramesh Gopi as our Senior Vice President and Chief Operating Officer. Paramesh joins us from Marvell Technology where he was Vice President and General Manager of the embedded and emerging business unit. While at Marvell he built a multi $100 million revenue stream in consumer, wireless and embedded applications. He was also primarily responsible for Marvell’s vertical market strategy. At AMCC Paramesh will focus on market strategy, product strategy, product development and business development. I will focus on company stakeholders including investors, customers and employees. My top priorities will be company vision, corporate strategy and AMCC’s worldwide growth and positioning.

I’m also pleased to announce the appointment of Hector Berardi as Vice President of Operations. Hector comes to AMCC with over 20 years of experience in manufacturing, operations and quality in the technology sector. He holds a Bachelor of Science in Electrical Engineering and an MBA from Santa Clara University.

During the May earnings call we pointed out that we entered the June quarter with a record backlog. We guided for revenues to be up 2% to 4% sequentially. I am pleased to announced that we delivered 3.5% sequential revenue growth. As we announced recently AMCC has received an award from Corporate Legal Exchange for intellectual property management practice. This award validates our truly ‘Best In Class’ IP management process that we embarked upon about one and a half years ago. This program is intended to proactively manage valuable IP creation, enabling AMCC to generate leading edge products while at the same time enabling us to monetize our IP.

Building on this program, as we recently announced, we evaluated our existing patents and were successful in selling some non-core patents for a total of $33 million spread over the next three years. Even more importantly we expect this new ‘Best In Class’ IP program to begin to generate new revenue streams in the next two to three years. Therefore I emphasize that we expect IP revenues to be a permanent addition to our revenue portfolio.

Now let me crystallize our vision for you. Internet bandwidth continues to grow at a torrid pace, 50% to 150% annually. As this trend continues for the next several years the internet data center and the carrier central office will go through a massive upgrade cycle. 10 gig Ethernet followed by 100 gig will be the collapsed infrastructure over which all services will be transported. Packet processing will be required at every node in the network from the home to the office to the internet’s core and storage at [paths] to the internet will grow 10 fold each year.

This means 10 gig Ethernet physical technologies, especially SFP+ will grow rapidly. 10 gig Ethernet moves in the wide area network and OTN replaces older voice centric technologies like SONET. Packet processing and traffic management will be required at every node. Serial storage, specifically SATA and SAS, replace older and more expensive parallel technologies in the internet data center. And finally energy costs, power dissipation and cooling considerations become a huge factor in the architecture of the next generation internet data center. AMCC is a proven technology and market leader in each of these categories. I will point out multiple examples of this throughout our prepared market remarks today. So I emphasize that AMCC will grow as these trends take hold.

Now let’s go into each of the product sections starting with transport. 10 gig optical port shipments are expected to begin growing rapidly in 2009 as smaller form factor SFP+ transceivers are deployed and cost per port decline. SFP+ also allows for much higher density 10 gig line cards. During the quarter our 10 gig data center initiative received a significant boost. Our SFP+ design was qualified at a major OEM where we edged out a competitor. This has put us in a strong position for multiple SFP+ design wins at this OEM.

We have a superior optical compensation also known as EDC and noise cancellation technology and it has been validated by a key OEM. This endorsement has also elevated our position in a number of other accounts. For example, at a major storage opportunity we now have the lead position for SFP+ designs. During the June quarter we also saw large sequential growth in our 10 gig X2 module business. Another important accomplishment during the quarter was that our 10 gig Ethernet data center products performed well in an IEEE standard sponsored plugfest for backplane 10GBASE-KR applications as well as 10GBASE-SR/LR.

As we stressed in prior calls we also expect good growth in 10GBASE-KR backplane applications where we have secured key design wins. As the data race increase in the next general data center and carrier central office we expect 10 gig followed by 100 gig to dominate backplane designs where we have excellent traction. Our previously announced Pemaquid product with its industry leading forward error correction, commonly called FEC, and integrated 10 gig I/O is still registering high value design wins for AMCC. The strength of this product has been evident in its wide spread acceptance in the market.

This past quarter we announced interoperability of Pemaquid with Marvell’s Prestera switch via a hardware platform that demonstrated Metro Ethernet applications and OTN capability. Additionally we also successfully achieved interoperability with Menara Network’s 300-pin optical module, further illustrating the strength of AMCC’s OTN product line. Finally, BTI Systems, a leading provider of packet optical edge solutions chose AMCC’s transport products for their next generation carrier Ethernet WDM solutions.

As I mentioned before there’s a fundamental shift that is happening from Legacy SONET network to the next generation OTN networks which are optimized for carrying Ethernet traffic. As Ethernet extends out from the data center into the wide area network OTN becomes much more critical at the transport layer where AMCC is the best position to take advantage of this trend. Our Pemaquid design win traction is a testament to our leadership position and I expect it to provide AMCC with the next growth phase along with 10 gig in the data center.

Overall, transport revenues declined 2% sequentially in the June quarter. This was due to slight declines in the service provider space. This past quarter the decline was primarily the result of supply constraints. These supply constraints are related to packaging and test where we have a large supplier with lengthened lead times by approximately three weeks. This issue relates to flip ship capacity. This issue is being addressed and we do not anticipate problems moving forward.

Moving on to the processor business, the processor business grew 10% sequentially in the June quarter. The growth was broad based driven by strong product shipments into the wireless and wired packed processing applications. In the June quarter we announced two high performance embedded PowerPC products: the 460SX and the 460GTx. The 460SX doubles the throughput of our previous generation storage processor, the 440SPe. The 460SX is a storage processor that integrates a 1.2 GHz 460 core second generation PCI Express connectivity and a specialized set of storage processing accelerators. The 460SX is specific to design to meet the requirements of six gig SAS and eight gig fiber channel based environments for both server direct attached and external storage applications. The 460GTx combines a 1.4 GHz 460 core with second generation PCI Express interfaces, high speed DDR2 memory interfaces and quad gigabit Ethernet ports. The 460GTx is a higher performance counterpart to AMCC’s 460GT processor and offers a significant performance boost while delivering below 10 watt power dissipation.

As I mentioned before, energy costs, heat dissipation and cooling issues are forcing new designs where power is the most important consideration. Our lower power dissipation of the gigahertz frequency range continues to distinguish us from our competitors and is leading to accelerating designs. Today, our PowerPC revenue continues to be driven by the 405 family and our mid range 440 family of products. The 405 family continues to win designs in many networking and pervasive applications.

Our mid range processors, the 440 and 460 families, are getting strong traction in switching, routing, wireless infrastructure and printing applications. Our 405 and 440 design wins are ramping in production while our new 460 base products are enabling us to win new designs. The 460EX, aimed at the imaging market, and the 460GT, aimed at the networking market, were first sampled to customers in December of last year. Demand for evaluation kits for these devices continue to grow as they chalk up significant design wins in a diverse set of applications. In just four quarters our processor business has rebounded from the June 2007 low by almost 76%. Overall I’m very pleased with the strength of our processor business.

Now turning to storage, during the June quarter we introduced our entry level four port SAS controller and we continue to increase our traction. Total SAS unit volume grew 67% sequentially. In the next general internet data center, serial technologies SAS and SATA will play a dominant role. We continue to be a number one in panel for SAS and SATA RAID controllers. AMCC is one of only two companies that has the necessary IP elements to succeed in this market: mainly advanced ASICs, mature RAID code, and management software and board level integration. This positions us very well.

Overall the storage business was down slightly, above 1% over the prior quarter. The core fundamentals of the business remain strong. Unit volume grew 4% in our most competitive quarter to date. The increasing recompetitive landscape contributed to slightly declining June quarter ASVs. During the quarter we took various channel and pricing initiatives but right now we do see a buildup in the RAID channel inventories. We expect to burn this off during the September quarter and therefore would expect the storage business to decline 3% to 6%.

On the distribution front, as expected, Ingram Micro’s first full quarter contribution to storage revenue was strong. We expect the contribution to increase as we transfer more product knowledge and participate in collaborative programs.

With that, let me turn the call over to Bob to go over the numbers.

Robert G. Gargus

First quarter revenues were $74.1 million, up $2.5 million or 4% compared to the prior quarter and up 48% from the same quarter a year ago. Processor revenues were $33.9 million. Transport revenues were $27.3 million and storage revenues were $12.9 million. Sales to North America accounted for 41% of total revenue, sales to Europe contributed 19% and sales to Asia contributed 40%. No single direct customer represented 10% or more of the June quarter revenues.

Turning to the P&L, our first quarter non-GAAP net income was $7.7 million or $0.12 per share compared to the non-GAAP net income of $6 million and $0.09 per share for the prior quarter. Our non-GAAP net operating margin as a percentage to revenue was 8% compared to 5.5% for the prior quarter. The June quarter non-GAAP gross margin was 58.1%, up approximately 250 basis points from the prior quarter and is the result primarily of product mix and the resolution of one time manufacturing issues we mentioned last quarter.

Looking forward to the September quarter we are expecting that gross margins without IP revenues will be around 57.5%. Non-GAAP operating expenses were $37.1 million compared to our guidance of $36.5 million to $37.0 million. This is a sequential increase of $1.3 million or 3.6%. The increase relates primarily to the internal ERP upgrade, ramp up of our operations in Vietnam, some key personnel hires and accrued bonuses. The June quarter non-GAAP R&D expense was $22.1 million, up $0.6 million sequentially while the non-GAAP SG&A expense was $15.0 million, up $0.7 million sequentially.

I will pause here to mention that we are expecting, as the year progresses, to receive somewhere between $2 million and $3 million of NRE from our customers. In fact, we had $250,000 last quarter. We expect these to be an op ex offset but the accounting rules for this are complex and it will be either an op ex offset or revenue. We will advise accordingly. The other reason for mention this is that we may incur op ex in a different quarter than the quarter the credit is received. This may cause a bit more variability in our op ex than we have had historically. In other words we could have expenses in one quarter for which we don’t receive an offset until one or two quarters later.

Nonetheless, getting these NRE credits is a good thing and clearly indicates the high regards that our customers have for our technology. This number excludes the impact of $3.4 million of other-than-temporary impaired charges that we took on certain securities within our investment portfolio. Unless market conditions continue to deteriorate further, we do not expect to have any additional charges relating to our investment portfolio. However, at this time we can not predict if there will be any additional impairments to our cash portfolio.

The share count for EPS purposes was 65.1 million shares. We are expecting the September share count for EPS purposes to continue to be in the range of 65 million to 66 million shares. In terms of op ex guidance for the second quarter we are expecting expenses to go up slightly to the $37.5 million to $38.5 million level as we continue to accrue for bonuses and additional head count and the incurrence of expenses in an advance of NRE credits. Interest income is expected to be $1.9 million to $2.1 million, reflecting lower returns due to depressed market conditions offset by an increase in our cash balances. Our tax rate continues to be projected at 3% for the next several quarters. Overall, relative to the Street models, we have essentially accelerated our revenue and EPS projections by one quarter or more.

Turning to the balance sheet, our cash and investments totaled $199.6 million at the end of the quarter. This includes approximately $5 million of investments that are shown as non-current assets on the balance sheet. This is up $4.8 million from the end of the fourth quarter. We generated $11.1 million of cash from operations and used approximately $3.5 million for capital expenditures. You can refer to our cash flow statement in the earnings release for more information. Our working capital is in excess of $222 million and we have no long term debt. DSO remained flat at 36 days. We expect future DSO to range from 36 to 40 days. Net inventories were $33.9 million, down approximately $4 million from the prior quarter and inventory turns were 3.7 compared to 3.4 last quarter. We expect inventory turns to continue to improve and our targeting to be around four turns by the end of the fiscal year 2009.

I will also comment that distributor inventories were down in dollars for the non-storage portion of our business. Capital expenditures for the quarter were $3.5 million and capital depreciation was $1.7 million. The increase was related primarily to some investments in computer hardware and software in ramping up the design center in Vietnam and system upgrades in the U.S.

Turning to GAAP, as you know our non-GAAP financials excludes certain items required by GAAP such as amortization or impairment of purchased intangibles and goodwill, stock based compensation expenses and restructuring charges. The timing, occurrence and magnitude of such items can be difficult or impossible to estimate for future periods. Our net loss on a GAAP basis was $5.2 million versus a net loss of $86.3 million last quarter. The difference in our first quarter GAAP net loss of $5.2 million and our first quarter non-GAAP net income of $7.7 million is a delta of $12.9 million. The $12.9 million is primarily comprised of: one, net restructuring benefits of $0.3 million; two, $3.4 million relating to an other-than-temporary impairment charge relating to certain securities in our investment portfolio; three, $3.2 million of stock based compensation; and four, $5.9 million of amortization of purchased intangibles.

I will point out that only the last two items, the stock based compensation charges and the amortization of purchased intangibles are recurring and can be expected to recur in subsequent quarters. The other items may not repeat in the September quarter. Looking forward to the second quarter we expect certain known GAAP charges such as the $5.9 million of amortization of purchased intangibles and an estimated $2.5 million to $3 million of stock based compensation. A complete reconciliation between GAAP and non-GAAP financials can be found in our earnings release which can be found in the investor relations section of our website. Please note that there is no reconciliation for forward-looking non-GAAP measures.

I must also point out that in June, the U.S. District Court for the Northern District of California entered a final judgment approving our settlement in the stock option related shareholder derivative lawsuit. A similar case pending in state court was dismissed in February. Also as we have previously reported, the SEC and DOJ have both closed their investigations of the company. Therefore we are happy to report that in the September quarter we will be free of all stock option related investigation and litigation.

That concludes my remarks and I’ll now turn the call back to Kambiz.

Kambiz Y. Hooshmand

Overall, near term market conditions remain uncertain. While we’ve had strong demand for our transport products for three quarters I will remind you that carrier deployment can be lumpy. We are seeing some softness in the order patterns from some of our large telecomm customers as concerned in their recent earnings calls. We also continue to be concerned about the macroeconomic conditions. We are guiding revenues to be up 3.5% to 5.5% including IP revenues for the September quarter. Our products cycles, business fundamentals and general business conditions continue to improve nicely.

The fundamental drivers for each one of our businesses remains unchanged. Transport is driven by the transition to 10 gig Ethernet and 100 gig in the data center and carrier central office and the corresponding transition to OTN from SONET. In the processor business, energy costs and power dissipation in the data center and carrier central office have emerged as a key decision factor. Our packet processors lead in power dissipation. Our newest high performance gigahertz processors pack performance while not compromising on power. In storage the internet data center continues to add mass storage in the form of serial technologies SATA and SAS. Our product traction in SAS is gaining momentum and the transition from parallel SCSI to SAS continues.

The next generation internet data center and carrier central office needs higher speed 10 gig Ethernet followed by 100 gig and very low power multi gigahertz packet processors. AMCC is delivering these products and will emerge as a leader in this space.

Now let me turn the call back to Bob for Q&A.

Robert G. Gargus

This concludes our formal remarks.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question today from James Schneider, Goldman Sachs.

James Schneider, Ph.D. – Goldman Sachs

First of all, Kambiz, on the geographic front: what did you see from your different comms customers during the quarter? If you could just still, go through that a little bit please.

Kambiz Y. Hooshmand

We actually saw strengths in North America. In the June quarter, we saw strength in Asia. So overall for transport this was a, for the comms market, this was a pretty strong quarter. As I mentioned in the prepared remarks we do see some softness right now and I think that softness is pretty much across the board. Some of it is relative to specific build outs that are going through a transition phase. For example, there is a build out in India that the first phase of it has completed and the second phase will begin sometime in the near future. So overall we don’t see a macro pattern but a specific carrier customers having specific build out requirements but we have seen some weakness in the past few weeks in our telecomm business.

James Schneider, Ph.D. – Goldman Sachs

Is it fair to say given those comments, that linearity worsened coming into the end of the quarter and in July?

Kambiz Y. Hooshmand

Linearity did not worsen at all in the June quarter. The softness that we see is more in the July timeframe; what we’ve seen so far in July.

James Schneider, Ph.D. – Goldman Sachs

With respect to the guidance, could you just clarify the amount of IP revenues you anticipate recognizing in the September quarter and then if, I think you talked about in your 8K that that would be about $3 million and can you confirm at midpoint for guidance that’s roughly flat excluding IP revenues?

Kambiz Y. Hooshmand

Yes, we expect to see $3 million of revenue for the September quarter and we’re roughly flat to up $1 million in absolute dollars for the quarter.

Robert G. Gargus

Yes, if you take the midpoint of the guidance you’d probably be around $74.5 million excluding the IP revenue and that’s exactly where the Street models were previously.

James Schneider, Ph.D. – Goldman Sachs

Lastly, could you comment on your backlog position and whether that grew in the quarter?

Robert G. Gargus

So we won’t call any comment that our book-to-bill was positive.

Operator

Next we’ll hear from Allan Mishan, Oppenheimer and Company.

Allan Mishan – Oppenheimer & Co.

You gave the outlook for the storage business. What are you expecting for processor and for transport?

Robert G. Gargus

We don’t give out the guidance by individual product families. In this case we did for storage only because due to some competitive pressures there were some pricing changes that occurred in the quarter, we were late in getting those out into the channel and as a result some inventory that the channel took didn’t sell through and we are very sensitive to the channel inventory, so we’ve told you guys whenever that’s a buildup. So we had a little bit of a buildup, hence the 3% to 6% decline in storage for the quarter. The buildup was only in storage; the ICP channel inventory was actually down in dollars.

Allan Mishan – Oppenheimer & Co.

Can you dig in a little bit more to the increase you saw in gross margin? Your mix by one business unit to the next didn’t seem all that favorable because I think your processor gross margins are about at corporate, so what exactly drove the increase in gross margin?

Robert G. Gargus

It’s individual products, it’s product types inside the families but also we mentioned last quarter that we had about a point or more of the one time manufacturing issues and we told you guys it wouldn’t recur in this quarter. So if you remember, we guided you guys to about 57.5% so we’re about a half a point above what we guided you to. Part of that is just maybe we’re a little conservative in the guidance and the other half is nothing significant other than product mix within the families

Allan Mishan – Oppenheimer & Co.

The SFP+ win with the major OEM that you referenced; when would you expect to get meaningful revenues from that?

Kambiz Y. Hooshmand

In 2009 and I want to be clear; we said that we are in a strong contention position for several SFP+ design wins at this OEM so far gated by the qualification that has now occurred. So I want to be clear that we have not won a, it is not a clear win yet but we are up for several design wins.

Allan Mishan – Oppenheimer & Co.

Are their other vendors that you’re aware of that are qualified as well, competing for design wins at this point?

Kambiz Y. Hooshmand

There were a total of four vendors in this account vying for this and AMCC and one other vendor are the two that are qualified at this point.

Allan Mishan – Oppenheimer & Co.

Last one for me: the 10 gig KR. Can you discuss how much revenue that could be for you this year or is it more 2009 and how do you expect that to ramp up?

Kambiz Y. Hooshmand

It could be revenue in December but I would expect most of it to be recognized in 2009. It’s in a blade server application going into the data center and depending on the success of the customer of their blade server architecture, this could be pretty significant volumes for us that would materially increase our Ethernet revenues. This one design though alone is probably one of the largest that we have received so far.

Operator

Next, from Signal Hill, we’ll hear from Sandy Harrison.

Sandy Harrison – Signal Hill Group LLC

As far as trying to model now, Bob, as far as IP versus non-IP and its impact on the P&L, you’ve given us a couple different touch points onto what the September quarter will look like. How would you recommend that we come at this as far as modeling with the changes in your NRE as well as the revenue recognition. What’s a good handle to make sure that we’re all on the same page?

Robert G. Gargus

So for the IP revenue, I think for the rest of this fiscal year you can assume something approximately in the range of $3 million in the quarter and we’ve told you guys before that for every $2.00 we can add to our gross margin line we would consider, not necessarily do, but consider reinvesting $1.50 back into the business and letting the other $1.50 drop to the bottom line so effectively, you could consider half of that $3 million perhaps going back op ex and the other half dropping to the bottom line in terms of your model.

And what was the other question, Sandy?

Sandy Harrison – Signal Hill Group LLC

As far as you’ve said, Bob, that on an apples-to-apples basis in the core product your revenues of 74.5, the midpoint of your guidance was simply the delta of the 3.5 to 5.5 sequential is the addition of the IP revenues.

Robert G. Gargus

Well, we did 74.1 this quarter. The midpoint of our guidance would have the product revenues going from the 74.1 to 74.5 and then you have the $3 million of IP revenue getting you to 77.5 and I think that’s the midpoint between the 3.5% and 5.5%.

Sandy Harrison – Signal Hill Group LLC

Just as far as some of this stuff, other IP opportunities. I mean this obviously sounds like it’s one that you could have easily captured. What are some of the, is there a lot or significant amount behind it in other areas you could capture or is this the first one out of the block and see where it takes you?

Robert G. Gargus

We’ve always had some IP revenue, probably in most quarters but it’s been small. We actually looked at the fact that we had a large number of patents a couple of years ago and we just didn’t feel like we were monetizing those so we started pursuing whether or not to license those, whether to try and sell some of the non-core ones. There are also models out there where you can sell them but have profit sharing. There’s a whole slew of models out there. In the end we got an offer that we couldn’t refuse, on this particular one, but it also indicated, and we went through that process that this was an area that we were not monetizing properly.

So we came up with a program, we won an award for that program, that program is intended to create on an ongoing basis IP revenue. The exact timing of that could be a little bit hard to predict but in a reasonable time frame, meaning about two years from now, we would expect that that program could start to generate recurring revenue so that by the time this program starts to roll off we would hope to have other programs that would be filling in for it. Hence our assertion that we think IP revenue will become more of a permanent event relative to our revenue stream.

Sandy Harrison – Signal Hill Group LLC

Kambiz, I heard in your prepared remarks a couple comments about the importance of lower power and how the carriers specifically in the data center are demanding that. Is that a change in what the industry’s been driving for and would that have any potential impact for accelerating upgrading networks, not only because of performance but also the power footprint is so much lower on the operating expense line that it doesn’t make sense not to do the upgrade?

Kambiz Y. Hooshmand

This is a change that’s been in progress for some time but accelerating now at a more rapid pace because as you’re putting in higher density racks into the carrier central office or into the internet data center, you’re just having a very hard time delivering the power to that rack, having a very hard time cooling that rack and also the energy costs going up. So the whole trend is accelerating to the point that I can confidently say today that a lower power processor, a lower power FI, a lower power device will win the design even if it’s more expensive, even if it’s significantly more expensive than a higher power device because power, energy costs and energy dissipation is becoming such a key factor.

So yes, I think people are going to accelerate their upgrade cycles and yes, power becomes the number consideration in going forward and it really plays nicely into our hands because our architecture has always been lower power and we’re going to continue to thrive on that advantage and continue to design to that advantage on next generation processors even lower power.

Operator

Next we’ll hear from Christian Schwab, Craig-Hallum Capital.

Christian Schwab – Craig-Hallum Capital

Can you, on the PowerPC, can you just estimate what you think your market share was actually in 07 and update us on your thoughts of where you think it’ll be exiting 08?

Kambiz Y. Hooshmand

Sure. 07 for the PowerPC we had a pretty difficult quarter, the June quarter of 07. So, we’re talking about calendar 07 right?

Christian Schwab – Craig-Hallum Capital

Correct.

Kambiz Y. Hooshmand

So the June quarter of 07 was a pretty difficult quarter for us on PowerPC because of the transition that was going on between Nokia, Siemens and other mergers, such large mergers and also the inventory correction that was going on in the distribution channel. So, overall in 2007 we think that we probably lost a point or two of share but nothing really significant. Our share is around 11% to 12% in the processor market in 2007. My guess is, and of course it’s too early to call it with any degree of certainty, but my guess is in 2008 we’ll gain two to four points of share but it’s too early to call in 2008.

Robert G. Gargus

The problem sometimes with market share is the way the Linley and the other people view it, is they do it based on revenue dollars and there’s no doubt that our revenue dollars for processors as well as most of product families was down in 2007. But, if you remember, we commented that we didn’t believe we’d lost sockets, that it was an inventory correction in burnoff and some technology transitions. I think everything that we told people would happen has occurred. The V shaped recovery has occurred almost on plan exactly as we laid out and so we would expect to not only be back to our share that we were before but add to that as can be syndicated.

Kambiz Y. Hooshmand

Also, adding to Bob’s comment, the way different analysts divide the market into embedded versus server processors versus communications processors. It’s very different. We tend to use IDC’s data more than other people. It’s not that any one analysis is more correct than the other. It’s just that we’ve got to stay consistent otherwise the variability between the way that different analysts caught the data is rather large.

Christian Schwab – Craig-Hallum Capital

If you look out over the next couple years now that the Nokia/Siemens mess is behind us, do you think that with your product portfolio that you could continue to gain two points of market share plus or minus over the next few years?

Kambiz Y. Hooshmand

Correct and I think that with the emphasis on power over the emphasis on the transition that’s going on in the internet data center that we can actually accelerate that.

Christian Schwab – Craig-Hallum Capital

Accelerate it above the two to four points a year, or above two?

Kambiz Y. Hooshmand

Right. Above the two to four point a year.

Operator

Next we’ll hear from Sanjay Devgan, Morgan Stanley.

Sanjay Devgan – Morgan Stanley

Just wanted to briefly touch on the storage business. In the past, you’ve discussed the strategy of trying to go away from the distribution channel and eventually entering into the Tier 1s and if that were to happen, you talked about licensing your mature RAID stack to the distribution channel. Just wanted to get your take on how that strategy is progressing and if that, per se, was not to happen what your view is for that storage business long term given that essentially you’re reselling a board with your IP as well as your software and your silicon, but you’re also selling other silicon on there so just want to get your thoughts long term for that business, assuming how it’s progressing now with your current strategy and what you’re thinking of longer term.

Kambiz Y. Hooshmand

Sure. Our first step in that transition was to introduce our SAS product and make sure that SAS gains traction. We never felt that SATA was the right transition to go from the channel into the Tier 1 OEMs because SATA has been very strong in the channel but really hasn’t had a significant traction in the Tier 1 market. Tier 1 market prior to SAS was sticking to the older parallel technologies, namely SCSI so SAS was the right transition. We introduced the SAS product in September as we covered with you in our previous earnings calls. We had some interrupted ability issues, some market timing issues because this is a market that involves us working with the backplane provider, us working with the disk drive provider.

Those interrupt issues are behind us. We introduced the four port SAS this past quarter in June and we reached a very good traction on that so the first step is to really get traction on the SAS and then the next step after that is to start penetrating what I call the Tier 1.5 customers, the ones right behind the very big five names and then start penetrating the big names. So I think we’re on track with maybe about a three month delay caused by the interrupt issues that in hindsight, should not have been too unexpected given the complexity of this technology. And we’re already working on our SAS six gig technology which is really something that will take off in 2009.

Robert G. Gargus

In some ways the storage road maps have defined technologies like three gig goes to six gig and that. And in some ways as the speeds go up we actually think it starts to favor more and more of the technology and strengths that we have. So as this goes to six gig and beyond we would expect our product portfolio to strengthen even more.

Kambiz Y. Hooshmand

I’ll build on what Bob said in terms of what we have in the optical space is very high speed connectivity technology on 10 gig. As SAS transitions from 3 gig to 6 gig onto 12 gig we can use our optical technology from our transport product line to really put more pressure on our competitors who don’t have that technology and really deliver an end-to-end solution. So we’re obviously working on those kinds of things and this is a multi year road map that we’re looking at. So pretty optimistic. Yes there’s about a three month delay there, three to four months that we suffered because of the interrupt issues.

Operator

Next we’ll hear from [Brian San - Bainbridge Capital]

[Brian San - Bainbridge Capital]

Bob, should we be expecting on the IP revenue, should those be coming in, more deals like Qualcomm or should they be more little onesie, twosie type things that over time accumulate?

Kambiz Y. Hooshmand

We want to build a very strong patent portfolio and today we’re filing an accelerated rate of patents each quarter so over the past couple years we’ve been filing faster and faster patents each quarter and it’s picking up steam. We want to use that patent portfolio to create innovative products and then turn around and cross license and sell some of the patents that over time are not correlated to our main business.

Right now I would answer you, Brian by saying that we don’t have something that’s imminent in terms of another deal similar to what we just announced but certainly we’re confident that as this revenue stream, which is a $3 million revenue stream over 11 quarters, materializes we are working on additional ideas similar to this one where we will build this into “permanent stream” meaning we can out on this being there long term.

[Brian San - Bainbridge Capital]

And for modeling purposes we should just assume this comes through with an add basically 100% gross margin?

Robert G. Gargus

It will come through at 100% gross margin but there will be some additional op ex costs not only for the reinvestment in the business but the IP program we mentioned will cost a couple more lawyers here and there so to speak to do it properly.

Kambiz Y. Hooshmand

And engineers too so essentially what Bob is saying is assume 100% gross margin but that approximately half of the revenue will get back invested into the IP program itself.

[Brian San - Bainbridge Capital]

And that’s captured in the op ex guidance?

Kambiz Y. Hooshmand

That’ll be captured in the op ex guidance, correct.

[Brian San - Bainbridge Capital]

When you gave the gross margin guidance, Bob, I think you said it was 57.5% and that’s without Qualcomm so we add the IP gross margins on top of that then?

Robert G. Gargus

That is correct.

[Brian San - Bainbridge Capital]

And on the NRE, that’s something obviously you haven’t had for quite some time. What was the origin of people coming to you and agreeing to pay the NRE?

Kambiz Y. Hooshmand

We have some advanced technology in processing noise and high speed and in processing and framing so it gets that high speed and since the network, as I mentioned, is growing at 50% to 150% of bandwidth each year and the speeds are going from one gig to ten gig onto 100 gig, people have recognized that and are coming to us with ideas of things that they want us to implement and because we have the fundamental IP to do that they recognize that we’re pretty much the only ones that can do some of this work, so they’re actually giving us NRE to and assist and move forward on this and create some exclusivity on some special arrangements with them.

[Brian San - Bainbridge Capital]

Does this represent one person paying you this, one of your customers and we can maybe hope for more customers doing that or is this pretty much as good as it’s going to get?

Robert G. Gargus

There are several customers involved in this.

Kambiz Y. Hooshmand

There are several customers that have expressed interest in moving forward with this technology and last quarter we received an IE from one customer but we’re working on more.

[Brian San - Bainbridge Capital]

Finally, on the inventory, obviously the inventories came down this quarter and Bob, I think you said that you made some mention about the channel inventories. Obviously, that’s been a point of concern. What were the aggregate channel inventories for the quarter that was closed?

Robert G. Gargus

So typically when we’ve had this call, Brian, we’ve never really talked about the storage channel inventories. We’ve talked about the ICP channel inventory because if you remember back going about four quarters ago that’s when it peaked like in Q3 of last year. It’s come down for the last three quarters or the last two quarters it was actually down in share dollars here in the June quarter. Now on the storage side, like I said, we initiated some pricing changes if you want within the channel. The channel did take a little bit more inventory that didn’t sell through in the month of June so our best feel for that is somewhere around $0.5 million to $0.75 million built up in the RAID controller board part of the channel inventory.

Kambiz Y. Hooshmand

So to summarize, Brian, in the chip business Bob has referred as ICP, that’s our internal term and may not be familiar with everybody on the call, in the chip portion of our business the inventories in the distribution came down again so the notion out there that inventories went up is absolutely false. The inventories came down again. In the RAID portion of our business, the inventories have been pretty stable for a long time. This quarter we’re being very transparent with using investors that it went up somewhere around $0.5 million to $0.75 million of inventory in the channel for the RAID.

[Brian San - Bainbridge Capital]

But in aggregate then?

Kambiz Y. Hooshmand

In aggregate-

Robert G. Gargus

In aggregate, it’s pretty close to flat, might be up a few hundred thousand but not much more than that. I also might comment that the total sell out from distribution was up so even if the inventory went up a few hundred thousand dollars, in days of inventory on hand it would be down.

Operator

I’ll take a followup question from Allan Mishan, Oppenheimer and Company.

Allan Mishan – Oppenheimer & Co.

Just a housekeeping issue: when you disbanded the non-focus segment what went into the processor category?

Kambiz Y. Hooshmand

There really was …

Robert G. Gargus

Very little. Very, very little. It would be measured maybe in $100,000 or $200,000. Almost all the non-focus was transferred; none was storage, very very little was in the processor side. Almost all of it was transferred.

Allan Mishan – Oppenheimer & Co.

I was just looking back in my notes for the March quarter and it just looked like it was close to $2 million that went into the processor but I can go back and check.

Robert G. Gargus

I’ll double check too and I’m sure we’ll be talking, Allan, so I’ll see if I can get the specifics on that before I talk to you.

Operator

If there are no further questions at this time, Mr. Gargus, I’ll turn the conference back over to you for any additional or closing comments.

Robert G. Gargus

Well, we’d like to thank all of you for your participation today. There will be an audio replay of this call available in the investor relations section of our website. You can also access the audio replay of this conference call by calling (719) 457-0820 and entering the reservation number 9506474. We will also file a copy of this transcript in an 8K with the SEC in a few days. Please feel free to call me if you have any additional questions. Again thank you for your participation on the call today and have a nice evening.

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Source: Applied Micro Circuits Corporation F1Q09 (Qtr End 06/30/08) Earnings Call Transcript
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