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Agere Systems Inc. (AGR)

Q2 2006 Earnings Conference Call

April 25th 2006, 8:30 AM.

Executives:

Sujal Shah, Director of Investor Relations

Richard Clemmer, President, Chief Executive Officer

Peter Kelly, Executive Vice President, Chief Financial Officer

Analysts:

Charlie Glavin, Needham & Company

Arnab Chanda, Lehman Brothers

Allan Mishan, CIBC World Markets

Jeremy Bunting, Thomas Weisel Partners

Seogju Lee, Goldman Sachs

Ross Seymore, Deutsche Bank

Bill Lewis, JP. Morgan

Srini Pajjuri, Merrill Lynch

Mark Edelstone, Morgan Stanley

Operator

Ladies and gentlemen, good morning, thank you for standing by. Welcome to Agere Systems 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. If you require assistance during the call, please press ‘*’, followed by ‘0’. And as a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Sujal Shah, Director of Investor Relations at Agere Systems. Please go ahead.

Sujal Shah, Director of Investor Relations

Good morning and thank you for joining us. With me today are Rick Clemmer, President and Chief Executive Officer; and Peter Kelly, Executive Vice President and Chief Financial Officer. This morning they will discuss the highlights of Agere's results for the second quarter of fiscal 2006 and then we will open up the call for your questions.

Copies of our press release and other supporting financial data are available on our website. We will be using the term non-GAAP to describe certain financial measures that we previously referred to as pro forma. All income statement measures on this call with the exception of revenues will be non-GAAP revenues unless we indicate otherwise.

Today's earnings release describes the differences between our non-GAAP and GAAP reporting. You can find reconciliations of our non-GAAP financial measures to corresponding GAAP amounts on our website at www.agere.com/webcast.

Also as previously announced we have made changes to our operating segments, and you can find historical financial statements showing the new structure in the supplemental financial information on our website. A replay of today's call will be available on the Company's website.

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 annual report on Form 10-K for the fiscal year ended September 30, 2005 and our Form-10-Q for the quarter ended December 31, 2005.

Now I would like to turn the call over to Rick Clemmer.

Richard Clemmer, President, Chief Executive Officer

Good morning and welcome. At our earnings call in January, I shared with you the turnaround plan for our company. This three phased plan included first: stabilizing the business; second: quickly driving improvements in earnings per share; and third: growing revenues consistent with our market and peers.

And I would like to begin by stating that we are pleased, very pleased with our results for the second quarter. Here are some of the highlights. Earnings per share were $0.10. Our operating expenses were $169 million, well under the $175 million suing we got it to in January.

Our revenue for the quarter were $397 million. And we repurchased $59 million of stock in the second quarter. Financial results are only part of the story. We are also excited by the progress we are making with our key customers. For example, following years of collaboration, Samsung has selected Agere for a series of 3G phones to be launched later this year. We are very pleased that this award was given by KT Lee, President and CEO of Samsung Electronics Telecommunication Network Group. In addition, we have solidified our relationship as a top supplier to Seagate, and believe that we have secured Seagate's desktop, notebook and consumer drives for the next round of designs through our alliance with STMicroelectronics.

Now let me give you a more detailed update on the progress on our turnaround plan. On our last call I told you about the changes we made in the management and organization structure as part of our assessment and stabilization of the business. This time we have implemented addition positive changes for Agere, allowing us to simplify our business processes, better align investment dollars and reduce expenses.

First, we have embedded our sales and marketing groups directly into each business unit and create a customer centered account teams. With this change, we are taking a more streamlined, responsive approach by giving our storage, mobility and networking businesses, end-to-end responsibility for improving design win execution, increasing efficiency and delivering long-term revenue growth.

Our focus on process, now embedded in each organization is allowing us to take additional expenses out of the business. At the same time, the leadership team is focused on growing revenue. We continue to pursue becoming more effective in all aspects of the business as well as working with a number of key vendors to improve our joint performance. We have challenged people at all levels throughout our organization to eliminate unnecessary expense and improve overall effectiveness.

Over the past months, our people have taken a hard look at their projects to ensure they can grab profitable growth. We are now using this philosophy to more closely monitor our projects going forward.

Our focus on process improvement has reduced operating expenses for many of the organizations. And Peter will address these improvements in the financial portion of the call. Each actions we are taking to address overlaps the job functions, improve effectiveness and better align our resources to areas of growth going forward. Our future investments in consumer and networking technologies will be linked by a common vision and strategy. We are developing an overall model for engaging growth markets to offer differentiated silicon and software to support innovative products for the mobile consumer as well as for home and business networking.

Our strength in mobility storage and networking provide us with a solid platform from which to introduce innovative solutions targeting the reliable delivery and experience of multimedia services.

Finally, as I promised you on our last call, I want to take a few minutes now to describe the changes we have made to our networking business, which combines our former telecom and enterprising networking businesses. After examining the various product lines and roadmaps for the organization, we found major opportunities in growth market areas with common investments. We also found and eliminated pockets of repetitive and overlapping development, and found that a significant percentage of R&D investments were being made in areas of declining revenue.

So we have created a strategy and structure for our networking business that is designed to drive overall growth and sharpen execution. This business offers a major core competency that differentiates it from the rest of our competitors, which is the reliable delivery of real-time multimedia services to the mobile user. Leveraging this baseline capability and our unique strength in switching signal processing, traffic management and quality of service, we are developing the building blocks for one network to serve multiple applications. This converge network is based on a common communications and services platform, and allows carriers to offer high value multimedia mobile services to their customers on-demand anytime, anywhere.

Purchase in the carriers base in the system vendor arena such as AT&T and BellSouth and Lucent-Alcatel will accelerate this trend and benefit Agere. I am sure we can exploit growth opportunities based on these new services; we have taken significant steps to align this business accordingly. Working under a single vision and strategy, the networking team has reduced investments in technology areas where we saw minimal return in market leverage and have reallocated R&D dollars to areas that support this vision. The impact of these changes in networking will be a more effective use of our R&D and SG&A investments.

By providing integrated system level solutions, we can expand our addressable market and capture a larger percentage of the building materials. Beyond our current set of roadmaps, we have put clear guidelines in place to focus our investments on profitable revenue growth. We have shared this new strategy for networking with many of our top customers, and the response has been resoundingly positive. In the coming quarters, we will be making announcements to provide more detail on the technologies and product portfolio we will target for this organization and its customers.

So, rapid changes are being made throughout the corporation and are producing absolute results. We have largely completed our stabilization phase, and are now starting to see real results in our earnings growth phase. We are reducing costs faster than expected, and I am confident that our efforts are bringing us closer to our interim goal of 15% operating income.

While we are in the earnings growth phase, I want to take a moment to put the third phase of our turnaround plan: revenue growth, in perspective. We currently have underlying growth being driven by a number of key solutions. We are gaining back significant share and preamps at a very fast rate, and growing our business with Seagate. We continue to increase shipments in GPRS handsets, and are now seeing high volume demand for EDGE. We are growing our networking business in areas such as our Framer/Mapper products, storage area networking and network processors.

While we have solid areas of growth, there have been areas of decline that impeded overall growth for the total company. However, our ASIC business with NEC and Apple has now come to a close, and our platforms at Maxtor are expected to ramp down over the next several quarters. The point is not to say that we are growing except for our areas of decline, but rather to illustrate that we have a solid portfolio of products and opportunity from which to drive growth in fiscal year 2007 and beyond. I will now turn the call over to Peter to take you through our results and guidance for the June quarter.

Peter Kelly, Executive Vice President, Chief Financial Officer

Thanks, Rick. This morning we reported quarterly net income of $17 million, or $0.10 per share, which was at the high end of the guidance range we provided in January. Our revenues were $397 million with Seagate, Samsung and Maxtor, all those 10% customers. This quarter we have made some product line changes within our operating segments. I'll walk through the Agere revenue results based upon the old segmentation, but we’ll provide our guidance based upon the new segmentation.

The website Sujal referred to earlier will help you understand this transition, as it includes revenue information prepared on the basis of the new operating segments for each quarter of fiscal 2005 as well as the first quarter of 2006. Now turning to the results for the quarter ending March. Our storage business bucked the usual trend of seasonal softness, and on the back of continuing strength in preamps delivered revenues of $171 million, roughly flat from the previous quarter.

Mobility revenues were $81 million, an increase of 11% over the $73 million reported for the December quarter with EDGE solutions representing a growing percentage of shipments. Enterprise and networking revenues, as expected, decreased $18 million sequentially to $84 million, driven by reductions of core logic shipments to Apple.

Our telecom revenues increased $6 million sequentially to $61 million, driven by increased shipments of DSPs for wireless infrastructure. Now let me give you revenue figures for the new operating segments. We have moved our satellite radio business into mobility to better leverage our capabilities and the IP we have developed in these areas over the past few years. Including satellite radio chipsets, our mobility revenues were $95 million in the March quarter. Revenues for networking in March were $131 million. Storage revenues are the same at $171 million.

In the March quarter, our total revenue from licensing intellectual properties was $31 million. And the breakdown of IP revenues in our new operating segments was $12 million in storage, $7 million in mobility, and $12 million in networking. Our gross margin as a percent of sales was 48.4%. This was a little lower than expected due to inventory writedowns for the two major customer transitions.

Our operating expenses were $169 million in the March quarter as we implemented the process changes Rick referred to. Our operating profits at $23 million, was 6%. In the quarter, taxes were $6 million, interest expense was $6 million, and other income was $6 million. On a GAAP basis, we had a net loss of $21 million, or $0.11 per share.

During the quarter, we recorded $30 million of GAAP restructuring charges and related costs. This was higher than I discussed on the last call and was driven by the acceleration of severance actions and $3 million of additional depreciation associated with the exit of office space in our Union Boulevard facility here in Allentown.

In addition, we recorded a $3 million gain related to the sale of assets. As part of our process to reduce expenses throughout Agere, we have taken steps to reduce our workforce. And although I don't intend to give a detailed forecast, I would like to give you an idea of the number of people impacted by the various charges we have announced on the last few calls.

Excluding Orlando, the total number of people impacted in 2006 is just over 400 people, of which about 80% are in North America. Approximately 125 people have left already, and most of the balance will leave this quarter. Clearly, taking these kind of actions was very painful for everyone involved. We're moving quickly to a more competitive expense level and focused R&D investment strategy is critical to our turnaround plan.

Turning now to the balance sheet. Our working capital management continues to be positive. Inventory closed at $132 million, with inventory turns of six. Receivables were $227 million and accounts payable were $188 million. I said on the last call that our changing cash, excluding stock purchases, will be positive for the quarter. And I'm pleased to report that this was the case.

In the March quarter, our cash balance decreased by $29 million to $620 million, primarily driven by the repurchase of Agere stock. In the March quarter, we purchased over 4.3 million shares for the total price of approximately $59 million. Since we announced the stock repurchase plan in October, we bought back over 7.8 million shares for the total price of approximately $100 million. We continue to believe that our stock is undervalued and, to date, we've spent about half of the $200 million our board authorized in October 2005. Therefore, we have the ability to buyback another $100 million of stock and, based on current valuations, we expect to continue to repurchase our stock.

Capital expenditures were $18 million, lower than expected due to lower spending on facilities and IT following a complete review of our capital investment plan. Our total debt was $372 million, at the same level as the previous quarter. This amount represents our convertible notes due in 2009.

Depreciation and amortization expense in the March quarter was $29 million, of which $26 million are related to ongoing operations and $3 million was, as mentioned earlier, related to the consolidation of our Allentown office space. Capital expense related to equity compensation was $10 million for the March quarter. And you should note that our stock-based employee compensation expense will not be tax effective due to recording of a full valuation allowance against U.S. net deferred tax assets. I would now like to turn to our guidance for the June quarter. Our total revenue is expected to be in the range of $390 to $410 million.

With strength in preamps, modulated by the uncertainty around the business impact of the Maxtor merger, we are planning our storage revenues to be flat to possibly down single digits. On the other hand, driven by shipments of EDGE products, we continue to expand our handset footprints at Samsung and Amoi. And as such, we expect our mobility business to be flat to up single digits.

Also of note, we expect revenue from EDGE and GPRS handsets will be roughly equal in the June quarter. Networking revenues are expected to be roughly flat in the June quarter with a ramp down in Apple ASICs being offset by increases in network processes, mappers and framers. Total licensing revenues are expected to be approximately $28 to $33 million. We expect gross margins to be approximately 49 to 51%.

As Rick alluded to before, we have accelerated our expense improvements by at least one quarter. I now believe that operating expenses will be no higher than $165 million for the June quarter. And as we continue to drive improvements, we now expect operating expenses to approach $155 million in the fourth quarter of fiscal 2006. I'm very pleased with the progress we are making on expense management, and it's clear our business model has substantial leverage at the OI level.

We see $620 million as a very achievable annual operating expense level, allowing us to grow revenue substantially without adding additional investments. We expect to post net income in the range of $0.13 to $0.18 per share. Including stock compensation expenses and net restructuring and other charges, our GAAP net income results are expected to be in the range of breakeven to a profit of $0.05 per share.

Net restructuring charges and related costs excluded from non-GAAP net income are expected to be approximately $10 to $12 million. Of this amount, approximately $6 million is driven by the decommissioning of the Orlando FAB; $3 million is for the additional depreciation associated with the consolidation of our offices in Allentown; and $2 million represents estimated pension settlements for people who left the business in the first quarter.

We expect equity compensation expenses to be approximately $11 million. Excluding any purchases of Agere stock in the quarter, we expect our total cash balance to decline about $35 million, representing a voluntary pension contribution. This contribution helps to maintain our funding flexibility going forward. We expect to make total contributions of approximately $70 million in fiscal 2006, which is slightly less than estimated in our last 10-Q.

Assuming no changes to the current law, we would expect any required payments in future years to be minimal, if any at all. We expect taxes to be approximately $7 million, interest expense to be about $6 million, and we expect other income to be about $7 million. We expect capital spending in the June quarter to be approximately $28 to $33 million, mainly for additional assembly and test capacities.

Clearly, we are very pleased with our cash management and the progress we are making in getting to competitive expense levels. As we begin to exit the stabilization phase, I'm convinced we will demonstrate significant earnings growth in the short-term. The whole leadership team is now focused on driving long-term revenue growth, allowing us to exploit the significant leverage in our model, which our lowered expense levels and asset-light model provides. Now let me turn the call back to Rick.

Richard Clemmer, President, Chief Executive Officer

Thanks, Peter. As I've already addressed the changes taking place in our networking business, let me now take just a few minutes to review some of the significant news, products and design wins for our storage and mobility businesses.

In storage, we continue to see the Seagate-Maxtor merger as a large long-term positive development for Agere. We believe that we have secured SoC wins for Seagate's desktop, notebook and consumer drive designs for the next round of designs. Our alliance with STMicroelectronics has proven to be a very significant differentiator in the storage market, where true second source offerings are a critical part of our current and future tier one customer strategies.

Agere's alliance with ST augments, and is built on Agere's tremendous technology offerings such as perpendicular recording, as well as rechannel and preamplifier technologies that provide solutions in every segment of the market. We've talked to you in the past about our leadership position in one-inch drives for portable consumer electronics. The growing popularity of video applications is increasing the need for high capacity storage and a small form factor. We are rapidly expanding our presence in the 1.8 inch drive segment.

Back in the March quarter we received a significant design win, in which our SoC will be used in a new 40 gigabyte 1.8 inch drive from a major Japanese storage manufacturer. This win along with 1.8 inch designs with Seagate and others clearly shows that we are executing in this phase, and are doing what it takes to win business in the highest growth areas of storage.

The storage preamplifier opportunity is estimated to be $418 million for 2006, according to IDC. And we will nearly quadruple our share exiting 2006 compared to the beginning of 2005. In the second quarter, we achieved eight preamp design wins across four disk drive customers. For example, our low powered preamp is sole sourced in Samsung's new 2.5 inch drives, which began shipping in February. These drives, part of Samsung's SpinPoint M60 series, rely on our preamp's performance and battery savings deliver up to 120 gigabyte of storage capacity for notebook and enterprise applications.

Our penetration in Samsung's 2.5 inch programs builds on our success in their 3.5 inch designs, where we are shipping preamps for their high volume P133 and P120 desktop drives. We continue to deliver SoC designs with increased capacities and lower power requirements.

This quarter, we announced a new 90-nanometer rechannel that targets 2.5 and 3.5 inch drive applications, and offer the industry's lowest power consumption. The channel covers a broad range of data rates in a variety of applications including desktop and notebook PCs, consumer electronics and enterprise applications such as blade servers. This allows manufacturers to use a single high performance channel to develop drives for the largest volume storage application. This new channel IP has already been selected for next generation drives being developed by two of the leading disk drive manufacturers.

In mobility, we have talked about our 3G baseband and protocol stack for some time, and clearly 3G represents the next growth catalyst for the industry. We continue to expand our presence at Samsung, and we are very pleased to announce that Samsung has selected Agere for a series of 3G phones to be launched later this year. We believe this is a strong testament to the relationship we have with Samsung, and the superior technology that we provide. We continue to seek strength from Samsung shipments. We have a solid position in their Gumi design center, and recently expanded our designs in their Suwan operations and have solutions in approximately 20 phone models currently shipping from Suwan. Our chipsets are being used in a number of new innovative phone designs.

Samsung recently introduced a new family of slim handsets using Agere's EDGE chipset. These include a flagship model, E900, and a credit card size, P300. Also introduced at CTIA, Samsung's new T719 phone uses Agere's EDGE chipset and is the first to integrate RIM's Blackberry email interface and text keypad design in a clamshell form factor.

We continue to rollout our vision handset platform, which enables high-end phone features such as MP3 playback and video streaming in mainstream EDGE handsets without the need for a separate applications co-processor. In fact, we have begun production shipments of our BX115 chipset to Amoi.

We have also announced support for the Microsoft Windows Media audio format on the vision platform. This capability will allow users to quickly and easily download digital music using one of the most popular formats available, and benefits both handset manufacturers and network operators as users upgrade their phones and subscribe to these new services. Agere has quickly established itself at the forefront of HSDPA development with our recent hardware and software announcements.

We are now sampling our 3.6 megabyte per second chipset to customers. Called the X455, Agere's solution offers service providers and handset manufacturers an easy upgrade path from current wideband CDMA networks and gives users a 10-fold increase in download speed compared to current 3G solutions.

We also announced breakthrough HSDPA receiver technology that significantly improves data connectivity and call quality for mobile handsets operating over these new networks. Cell phones equipped with Agere's new enhanced receiver will experience fewer dropped calls, a 25% increase in transmission range and provide network operators with the advantage of extended cell capabilities.

Most importantly, innovations in this receiver technology, as well as other efficiencies in the chipset, are providing us with a very low bill of materials cost, enabling handset designers to create HSDPA feature phones and Smart phones with the network advantages I previously mentioned at price points of $150 or less.

I would like to now recap the key points of our discussion this morning. We expect the revenues for the third quarter of fiscal 2006 to be in a range of $390 to $410 million. We are committed to driving higher earnings per share performance in each quarter of fiscal 2006. We are implementing changes that will improve every facet of our processes, roadmaps and competitive position.

We remain focused on increasing shareholder value. In support, we are on track to meet our interim goal of 15% operating income. It is clear that we have significant earnings leverage and as we grow our revenue, our earnings growth rate will be much higher than our revenue growth rate. Now let me turn the call back to Sujal.

Sujal Shah, Director of Investor Relations

Thank you, Rick. At this point we will begin the Q&A portion of the call.

Question-and-Answer Session

Operator

Operator Instructions One moment please, for the first question. Our first question comes from Charlie Glavin with Needham & Company. Mr. Glavin, your line is open.

Q - Charlie Glavin

Thank you. Just out of curiosity, guys. Is the balance sheet and the details for that included in a separate supplemental -- I'm not sure I saw it either in the press release or on the site yet, Sujal?

Q - Sujal Shah

I believe it should be on the website now. I think its posted around 8:15, Charlie.

Q - Charlie Glavin

Okay. They might have to refresh it, I'm not sure. Rick, in regards to taking a look at some of the businesses and some of the synergies. Certainly decrease in the OpEx is a great step. It would seem to also imply there were a couple of areas that you may have looked at as not being a strategic focus relative to where Agere wants to go, maybe you've had success but not necessarily fast growers. Can you give a little color as far as some of the areas that you may have determined to not be strategic in terms of growth or hitting return in guidelines?

A - Richard Clemmer

Yeah. So, what we’ve really done Charlie is, we focused our investments more than actually driving that. The specifics of the areas we haven't talked about but -- and are not really talking about in level of detail at this point, we are well underway of going through that process and we'll be rolling out the communications associated with that in more detail as we move forward. But I think it's -- as we talked about in the earnings call, there were areas where we were making investments that were redundant or we were focusing areas with a declining market. And we have to be sure that we're focusing our R&D investments in areas where we can play to win and where we can ensure that we're going to grow and we can ensure that we're going to be in a leadership position. We don't want to be investing in areas where we're going to be number four or five in the marketplace. It doesn't give us the potential to be effective. But we'll talk more about the specifics of that over the coming period. Charlie, I think the key is as we venture that process, we are in the process of rolling out the strategy. We've had our first discussions with customers. We've received very solid feedback from that and feel very comfortable with the networking strategy and the rollout associated with that. In the storage and mobility business, we've been through that, we've focused on how we upgrade our resources and ensure that we have a very competitive team going forward. And that's really been the focus associated with those areas as well.

Q - Charlie Glavin

Rick, if I could, then, have you made any fundamental changes in terms of -- as far as these teams and accountability, in terms of some of the other infrastructure, for example, within the sales force, some of the independent reps certainly seem to be getting a larger share. Have you decided to cut some of the direct sales force in some of the areas? And if so, are there any particular areas where you are going to retain it for penetration within certain OEMs? And are there other areas where you've opted to go with more the independent reps?

A - Richard Clemmer

We really have put a lot of effort into our processes as we engage with the marketplace, and we have changed where we are engaging more with reps on a broad basis. We’ve focused our resource deployment to ensure that we can be in line to have the design wins that are required to really drive the future growth going forward. So -- More of the specifics of that will obviously become more apparent as we move forward. But we have definitely put a different model in place. It's allowed us to reduce our expenses, and we believe, improve our engagements with customers to drive more significant design wins going forward.

Sujal Shah, Investor Relations

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

Operator

Our next question comes from Arnab Chanda from Lehman Brothers. Mr. Chanda, your line is open.

Q - Arnab Chanda

Thank you. I have a couple of questions. First of all, historically you've done a lot of ASIC business or custom business, in some cases, in more recent business such as in storage -- or network storage. Are you defocusing from that or is there any update on that? Or are you going to still continue to do it on a opportunistic basis? And a follow-up please.

A - Richard Clemmer

Our focus is really on places where we have a key core competency that allows us to drive a unique position. A good example of that is our Sardis (phonetic) capability, where we've really established a leadership position. The HBA design wins that we have with Q-Logic, which are ramping very significantly. We have some design wins with Alcatel on the IT front, that will yield significant value. So I wouldn't say that we're defocusing. I would say that we're being very selective in focusing on those areas where we can drive a significant return on investment. And clearly, we're trying to ensure that we have the opportunity to leverage into ASSPs more so than in the ASIC format itself. It gives us a better ability to leverage our investments across a broader front. And that's our strategy and what's really been key in implementing in our networking business. We already are in that basis, obviously, in the disk drive business with our SoCs. And clearly the same thing in the mobility side from a baseline.

Q - Arnab Chanda

Thanks, Rick. Just one follow-up. In the mobility business, given the investment needed for doing high density any adds etc. based on. Do you think that you can get the returns you need by basically just everything Samsung? Or do you think, for the proper returns, you do need another significant customer? Another top tier customer? Thank you.

A - Richard Clemmer

Our business is going to be focused clearly on the baseline and software stack. We think that's where we provide a differentiate solution that gives us a competitive advantage. We are focused, not only with Samsung, but also have a significant volumes that we are shipping at Amoi, where we represent clearly more than the bulk of their capabilities, as well. So our focus is on those select customers. Our business model is built around a basis where we have the opportunity to achieve model profitability over a reasonable period of time based on just those customer engagements. But clearly we're focused on other customer engagements as well. We've talked about Chi Mei, who has an actual 3G handset that's been developed and is in testing, which they plan to engage with. They're an ODM to some of the tier one customers, and they plan to try to win a phone design. We're not counting on significant upside volumes from that in our business model, but clearly it's an opportunity for us and one that we will focus on. But again, we're going to base our business model on the fundamental engagements we have such that we can drive a profitable place that is associated with that in our handset business.

Sujal Shah, Investor Relations

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

Operator

Our next question is from Allan Mishan with CIBC World Markets. Mr. Mishan, your line is open at this time.

Q - Allan Mishan

Hi, guys. Nice job with a tough set of circumstances. A couple of questions on Maxtor. How much of a hit do you expect to take in this quarter we're in currently? And then for revenue modeling purposes, which quarters of the year do you think will be the ones where sort of the most revenue declines result from that?

A - Richard Clemmer

I think it's important to realize that the current announcement associated with the transaction -- they'll close that in May, and as they move forward what will happen is the actual volume at Seagate will continue to transition. And they will transition over to their platform as rapidly as they can. But they've talked very specifically about their customer support. And so we'll expect to see volume throughout the next few quarters, but it's going to drop significantly. Peter, would you like to make some comments on that?

A - Peter Kelly

Yeah. I think maybe the way to think about it, Allan is, we've modeled it a 50% drop going from this quarter to next quarter. And who knows what the fourth quarter might be? And as we mentioned in our guidance, the issue we have for the storage business, although it's very, very strong in preamps and in Seagate and our other customers, we really are not sure of the business impact of the Maxtor transition.

Q - Allan Mishan

Okay, was that a 50% drop from June to September, or from March to June?

A - Peter Kelly

March to June.

Q - Allan Mishan

I see.

A - Richard Clemmer

So it's going to continue to be choppy. I think we have reflected that in our overall projections for the HDB business for the next quarter. But it will continue to be choppy, but still very significantly positive for us over the long-term. And Seagate continues to be positive about their participation in the markets, specifically driven by the consumer space and gaming, as well as, in the mobility side.

Q - Allan Mishan

Okay, and if I could ask another question, sort of in the same neighborhood. If I'm not mistaken, I think you guys still supply a hard disk controller for Maxtor's Enterprise drives. Do you see that as being at risk once this merger closes? And if so, when do you think that one winds down?

A - Peter Kelly

I figure after Seagate that will –

A - Richard Clemmer

I think that's all to be determined as they go through their integration. They'll work through the details of that, Allan. And I don't know that the actual revenue of that is all that significant in any case.

Q - Sujal Shah

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

Operator

Operator Instructions Our next question comes from Jeremy Bunting with Thomas Weisel Partners.

Q - Jeremy Bunting

Thanks very much. Could you just give us a brief discussion on what the relative margins are in the handset baseband space for GPRS, EDGE and 3G? And what the relative ASPs are? And I do have a follow-up to that. Thank you.

A - Peter Kelly

We don't declare that kind of detail, Jeremy. But, as you would expect, there is a difference, but we're not going to go into that level of detail.

Q - Jeremy Bunting

Okay, Peter. And then, Peter, as well. Could you just comment on -- from an operational expense standpoint, you implied that most of the headcount reductions would be being made in the current quarter. Do you anticipate further expense reductions going into September and beyond? Thank you.

A - Peter Kelly

Well, what I said was that we would expect by Q4, we could be down as low as 155. And then we see that as a -- although we don't really like to give guidance, we see that as a reasonable level for 2007. So yes, there are some costs that will get out of business. If you look at it from Q1 through to Q4, it's very, very roughly about $20 million reduction. And I would say something below 50%, maybe 40% roughly is hedged. We’ve saved about 15% in IT and rents. And then the biggest part of the reduction is really just how we manage a lot of our third party costs, whether it would be reduction in masks through better verification and use of MPWs, the relationship we have with some of our third-party vendors such as the cab guys, insurance, etc. etc. So it's not simply a reduction in heads and cutting out programs. There has been quite a lot of work on third-party costs which don't affect our -- would not affect any of our programs anyway.

A - Richard Clemmer

If I could just add to that, Jeremy, so if you really look at what we have done, the focus has really been on how we improve our processes and how we align our investments with our strategy. And so it wasn't setting percentage reductions that were across the board. This was actually driven from each one of the functions in each one of the businesses as they focused on improving their processes and getting to a position where they felt like they could be competitive and focusing their investments in areas where they can be in a leadership position. So it's result that's positive for the business that contributes to the overall aspects of that, and is really the critical element of how we have implemented the specific cost actions that we've talked about to drive the reduction in operating expense.

Q - Jeremy Bunting

Okay. Thank you very much.

Sujal Shah, Investor Relations

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

Operator

Our next question comes from Seogju Lee with Goldman Sachs. Your line is open.

Q - Seogju Lee

Thank you. Just, Peter, quickly, just to clarify on the OpEx target. The $155 million, that is excluding SoCs?

A - Peter Kelly

Yes.

Q - Seogju Lee

Okay. And then in terms of, there was mention of a design win efforts on the storage side. The SoC into Seagate's next gen program and also the SoC in the 1.8 inch drive with the Japanese manufacturer. In terms of timing, can you just elaborate there? Is the SoC program at Seagate, I'm guessing you are referring to is the 320 gig per platter? Is that correct?

A - Richard Clemmer

Well, we don't talk about the specifics of that. You know we have to rely on Seagate. And you know it's like all typical disk drive designs. The process flow, the actual design wins that we are engaging today are actually revenue at about a couple of years from now. Two, two and a half years from now, as they go through all the electronics, the integration and the media side. So you know the actual design of the disk drive and bringing it into the marketplace takes an extended period of time for all of the disk drive manufacturers. Frankly, that's the reason why we feel as good as we do about our storage business and the solid position we have, because we have those design wins that we've lock-in in the past that give us the revenue confirmation for the next couple of years as we move forward. So I think the key for us is being in an extremely solid position with Seagate through our alliance with ST, and continuing to affirm that with this actual design win that took place.

Q - Seogju Lee

Okay, and then on the 1.8 inch for the Japanese, I would assume that would be more imminent though?

A - Richard Clemmer

Yeah, but it's still in implementation. It takes a period of time and they have to go through the design wins and the design process and the integration. So it's not like it's going to be revenue next quarter. It will be at –

A - Peter Kelly

But I think, you know, you can get into specific design wins. I think the more important thing is if you look at our storage customer base. Obviously, with the exception of Maxtor, every customer has shown very significant growth first half to second half. So that business is looking very, very good, actually.

Q - Seogju Lee

All right, thanks. Good luck.

Sujal Shah, Investor Relations

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

Operator

Our next question comes from Ross Seymore with Deutsche Bank. Your line is open.

Q - Ross Seymore

Thanks. Guys could you give us a little more color on the Samsung 3G wins you described, basically on the timing of the ramp, what technology node it's going be? And maybe just a rough expectation of the percentage of revenues, 3G could represent exiting either this fiscal or calendar year? And then I have a follow-up.

A - Richard Clemmer

So you know the design win is for the mass market. So this is really focused on the mass market for Samsung. So it's a key design win for us. The ramp-up of that, it's a design win that takes place, so the ramp up of the volume from that’s out several quarters. It's not something that is imminent. But we'll be clearly shipping before the end of this year. And 3G is still going to represent a relatively small percentage of our volume over the next few quarters, and really won't grow to be a material percentage of the volume until late '07, late fiscal '07 as those ramps take place. But you know the key is EDGE volume. EDGE continues to grow through the 2009-2010 timeframe. And as we've talked about, the models and the positions that we have continues to be very solid for us and continues to support our revenue growth very significantly.

Q - Ross Seymore

Great. And then the follow-up is switching over onto the storage side of things. It looked like you did pretty well this quarter, especially with the preamp ramp. Can you discuss what your SoC business did roughly in the quarter?

A - Peter Kelly

We don't really go into that level of detail, so I guess the answer is no. But SoC continues to be very, very strong.

A - Richard Clemmer

We had a very strong quarter. And you know going through the transition with Seagate's acquisition of Maxtor clearly is going to create some puts and takes as we go through that period of time. I think they are still working through the details of that themselves. So we are clearly there to be in a position to focus them on their customers' requirements and ensure that we are able to do that with still minimizing any costs that we might have as they go through their transition to a Seagate platform.

Q - Ross Seymore

Great, thank you.

Sujal Shah, Investor Relations

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

Operator

Sure. The next question comes from Bill Lewis of JP. Morgan. Mr. Lewis, your line is open.

Q - Bill Lewis

Great. Thank you. Rick, I guess I have a question for you. I know you don't typically provide guidance beyond the current quarter, but I guess looking ahead to the September quarter, it would be my expectation that you would have an opportunity to grow the storage business, mobility business, and maybe start to get some of the revenue growth that you're talking about and get out of this kind of revenue ban that you're currently in. Is that the right way to think about it? Or are there reasons that growth is really going to be pushed out into the next fiscal year?

A - Richard Clemmer

I think you have to draw your own conclusions about revenue beyond the current quarter where we set our expectations. But I can tell you that we feel very comfortable that we are solidly positioned, that the fundamental core of the business is very sound. As we talked about, getting through the finalization of the ASIC product that we had in the transition from NEC and Apple positions us well to be in an area where we can drive growth and drive growth at the market space. That was kind of the phase three of our turnaround, which we talked about being out in fiscal '07. And we clearly believed that we are positioned very well to take advantage of that, Bill, and we begin to see signs of that, but we don't really set specific guidance beyond the next quarter.

Q - Bill Lewis

Okay. And Peter, you know the inventories in days, it looks like we're up around 59 days, which is kind of at the higher end of where they've been. Could you talk about what's driving a little bit of rev, inventory increases and what you're expecting for the coming quarter on inventory?

A - Peter Kelly

Yeah sure. Inventory is up, and I guess once our Q comes out, you will be able to see the detail. But it's all in finished goods. So, if you look over the last, the last three quarters our net inventory was 130, 125, 132, and the finished goods has gone from 36 to 48 to 56. And it's really all about making sure we can take a short-term upsides. I would say it's probably about $5 million higher than we expect. So it may come down to roughly $125 million. But the big thing for the moment is making sure we have enough finished goods to manage surprise upsides, that we are finding really helps at the moment.

Q - Bill Lewis

That's very helpful. Thank you.

Sujal Shah, Investor Relations

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

Operator

Our next question comes from Srini Pajjuri with Merrill Lynch. Your line is open.

Q - Srini Pajjuri

Thank you. Good morning, guys. First question on Maxtor and Seagate and the rest of the storage business. Clearly you are assuming that Maxtor is going to be down 50%. Yet your forecast for the June quarter seems like it's going to be the storage business is going to be flat. I'm just wondering what's driving that kind of strength, is it share gains or is it preamps? And also if you can talk about, if Maxtor was a 10% customer in the March quarter?

A - Richard Clemmer

Yes, we did talk about Maxtor being a 10% customer in the March quarter. The key for us is continuing to be in a strong position across many customers in the storage industry. Clearly our preamp position and the continued growth of share on both design wins as well as shipments in preamps is a significant factor for us. But also Seagate is doing quite well in the consumer space, and continues to be in a very solid position on SoCs. I know in their earnings call they talked about the outlook associated with where they were, but it's a combination of all of that, and really the strength that we have across the disk drive space that drives that confidence for relatively flat to potentially slightly down in the disk drive space.

Q - Srini Pajjuri

Okay. And then one question on the 3G space, Rick. As you look at Samsung, looking longer term, already I guess Qualcomm is the current incumbent supplier, and we've been hearing about Broadcom and maybe Phillips getting in there. Where do you think your longer-term share is going to be in 3G? And also competitively, if you can talk about who else would be supplying to Samsung. And then if you could briefly mention where the pricing is for the 3G solution today?

A - Richard Clemmer

We wouldn't talk about the pricing. But I think it is important to note that we continue to take a stronger position even on 2.5G at Samsung. At Suwan we have now more than 20 models that are shipping and, as we understand that represents something like a 15% share or so of that specific space. So we've significantly gained share in that space, and would expect to continue to do so. The 3G design win for us is a mass market phone. So it's really key because it will drive the volumes that are significant. Clearly, Samsung has an approach where they do best-of-breed in multiple vendors, has been their track record. Historically, Gumi has always used our technology in their handset designs. And Suwan historically, at least on the GSM/GPRS side has always been using Phillips. And the inroads we have made there have been significant. I would anticipate that Samsung, beyond just Qualcomm who really provides the initial 3G solution, that they will have a couple of providers in that. And we would expect to be in a position where we have a significant share of that. And that's really key for us, with the volume. But the relationship we have with Samsung continues to be very solid. We continue to be excited about the opportunity for rollout of new phones in EDGE capability, as well as this mass market 3G win which confirms our overall position in how solid the relationship is moving forward.

Q - Srini Pajjuri

Okay. Thank you.

Sujal Shah, Investor Relations

All right. Thank you, Srini. I believe we have one more question.

Operator

We have one more question right now from Mark Edelstone with Morgan Stanley. Sir, your line is open.

Q - Mark Edelstone

Good morning, guys. Nice job on the execution here. I have two housekeeping items and then one more significant question. Peter, you talked about inventory charges in the quarter. Can you break those out for us, and then can you also give us the IP breakout by segment?

A - Peter Kelly

IP by segment. I'll look it up in a second. If I just go to the gross margin for the moment. It was about $0.03 in the end, about one and took over just over a -- let's say just under 1.5% or one and a half points of gross margin. And it was really associated with both Maxtor and Apple, and it related to WIP that we have in place, but kind of beyond that level of detail, I'm not sure I'll give you any more. In terms of IP, it was 12 million in storage, 7 million in mobility and 12 million in networking.

Q - Mark Edelstone

Okay great. And then the other question is, obviously there are going to be, as you mentioned, lots of puts and takes here as the Seagate-Maxtor merger occurs. And, I guess, Rick, from your perspective as you guys have done some of the scenario planning around it. If you look at what your combined revenues were like before the merger and then look at what you think the combined revenues can look like after the merger has been assimilated, when you look out a few quarters from now, how do you think that plays out? I would guess its probably somewhat of a net decline in the opportunity there, but can you try to put some type of numbers around what type of relative decline there might be?

A - Richard Clemmer

I don't think it's going to be a significant decline, Mark. I think as you look at it -- The overall growth of the disk drive market, especially driven in the consumer space, with the consumer space growing on an annual basis 30%, 35% is offsetting some of the fact that we in fact share the Seagate business with ST versus the declines we would have at Maxtor. I think one of the things that's happening is the ramp-up of Maxtor's 160 gigabyte platter drive, clearly has been different than what they would have anticipated or clearly what we would have anticipated. And so that's been a factor in some of this, is that overall ramp. And they are continuing to support customers with their current production. But I think if you look at it overall, we don't see this transition as having a material impact on our revenue declining over a period of time. It clearly will drive down our revenue somewhat but we think that we have some opportunities in preamps and participation with other customers where we can offset that so that it's not a significant impact on the total business. And you know we anticipate that we'll be back in a growth basis going into '07 with the fundamentals of the market.

Q - Mark Edelstone

Maybe just one last question. You alluded to it in your comments in the press release, that you expect to see the company be able to grow revenues in fiscal '07. Can you just put some type of a range that you think is reasonable for growth for the overall company next year?

A - Richard Clemmer

You know, Mark, we don't do that. I think what we've talked about is as we go into phase three being in a position where we'll grow at the same level as our competitors in those individual market sub-segments. We'll be clearly implementing that as we get through fiscal '07. So we feel very confident that they will be at that level going out at '07. But we'll be transitioning through that during the fiscal year of '07.

Sujal Shah, Investor Relations

Okay. Thank you, Mark. I would like to turn the call over to Rick for some closing remarks.

Richard Clemmer, President, Chief Executive Officer

Thanks, Sujal. I would like to conclude today's call by reiterating that we are well on track with the turnaround of Agere. We’ve made significant progress in Phase one and now have clarity in the strategy for each one of our businesses. We have established a process to drive earnings growth in Phase two and have a solid baseline from which to grow Phase three. Our objective and mission now is to execute. Back to you, Sujal.

Sujal Shah, Director of Investor Relations

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

Operator

That does conclude our conference call for today. Thank you all for participating, have a great day. A replay of this call will be available in approximately one hour. To listen to the replay version you may dial toll free 866-427-6399, or for parties outside the U.S. and Canada, you may dial 203-690-893. The replay will be available until May 2nd, 2006. Thank you everyone and have a great day.

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Source: Agere Systems Inc. Q2 2006 Earnings Conference Call Transcript (AGR)
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