LSI Corporation Q3 2008 Earnings Call Transcript

LSI Corporation (NASDAQ:LSI-OLD) Q3 2008 Earnings Call October 22, 2008 5:00 PM ET

Executives

Sujal Shah - VP of IR

Abhi Talwalkar - President and CEO

Bryon Look - EVP and CFO

Analysts

Kaushik Roy - Pacific Growth Equities

Hans Mosesmann - Raymond James

Eric Ghernati - Banc of America Securities

Shawn Webster - JPMorgan

James Schneider - Goldman Sachs

Suji De Silva - Kaufman Brothers

Craig Berger - FBR Capital Markets

Brian Yurinich - Craig-Hallum Capital Group

Arnab Chanda - Deutsche Bank

Sanjay Devgan - Morgan Stanley

Blayne Curtis - Jefferies

Operator

Welcome to the LSI Corporation investor relations conference call. (Operator Instructions).

As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Sujal Shah, Vice President of Investor Relations at LSI. Please go ahead.

Sujal Shah

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

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

I also want to remind you that today's remarks will include forward-looking statements. Our actual results could differ materially from those suggested by the statements made today. Information about factors that could affect our future results is contained in our Quarterly Report on Form 10-Q for the quarter ended, June 29, 2008 and our Annual Report on Form 10-K for the year ended December 31, 2007.

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

Abhi Talwalkar

Thank you, Sujal. Good afternoon, and welcome. LSI again delivered strong financial results in Q3, marking the 5th consecutive quarter of earnings that exceeded expectations. We delivered non-GAAP gross margins over 48%, exceeding our guidance range and non-GAAP operating margins of 14%.

Our storage semi business grew over 9% sequentially, driven by increased shipments of SoCs and preamps to our lead customers, and we entered into new licensing agreements to increase our IP licensing revenues. I am very pleased with our continued progress and remain encouraged by the strong design win momentum that we expect to fuel future growth in our storage and networking businesses.

We have done an excellent job of managing our balance sheet and have $1.2 billion in cash. We believe our cash balance, combined with our anticipated positive quarterly operating cash flows, will enable us to continue to invest in our leading edge products to grow our business.

Since we are in a challenging economic environment, with uncertain end market demand, we will be vigilant in managing expenses, driving improvements in our product cost and monitoring the demand environment of our customers and end market. There are several key takeaways that I would like you to get from this call today.

We delivered solid results in Q3 in a difficult economic environment. The strategic decisions we have made over the past 18 months, combined with our strong balance sheet, positions us well for the future. We will be highly disciplined in controlling expenses in this uncertain demand environment, while continuing to invest in our future products to drive long-term growth. We have one significant design with multiple customers, including IBM and another tier 1 customer for storage systems and software, Dell, Fujitsu Siemens, IBM, Intel, NEC, and Sun for 6-gig SAS, Hitachi and Seagate in HDD along with a new SSD design win, and finally, Huawei, Nokia Siemens, and Nortel in networking.

I want to review with you the business highlights for last quarter in our storage and networking businesses. I'll start with storage semiconductors, which include SaS, SAN and HDD. Since the inception of SAS, LSI storage controller ICs and software have been the solutions of choice among many of the industry leading servers and external storage OEMs, and to-date LSI has shipped over 10 million SAS 3-gig components.

Last quarter, Dot Hill selected LSI's 3-gig SAS controller to power its first SAS-based external storage offering, and we also recently announced our 16-port storage processor and controller-based security solutions, which were integrated into IBM's xSeries server line.

Moving on to SAS 6-gig, we are pleased to announce that LSI has extended its 6-gig SAS and RAID leadership at six OEMs of selected LSI for their 2009 server platforms. Dell, Fujitsu Siemens, IBM, Intel, NEC, and Sun Microsystems, have all selected our 6-gig SAS RAID-on-Chip solution to enable next generation entry to enterprise server platforms. These selections underscore the broad market acceptance of LSI's SAS solutions.

As we previously mentioned, based on our RAID software stack, product line breadth, and performance and power advantages, we expect to provide 6-gig SAS solutions to all top 10 OEMs. We expect initial ramp of our SAS 6-gig products in Q1 of 2009, with the ramp to high volume expected in the second half of 2009, when the ecosystem is fully in place.

Success in this space requires a broad product line of silicon products, plus a complete software stack. LSI expects to offer the broadest array of 6-gig SAS products, including storage processors, controllers, RAID-on-Chip controllers, MegaRAID software, SAS to SATA bridges as well as expanders. We fully expect that LSI will remain the clear performance in volume leader in SAS silicon solutions. We are building our technology lead and putting more distance between LSI and the rest of the market.

In SAN, we continue to see healthy growth in Fibre Channel silicon shipments. All of our 8-gig Fibre Channel HBA and switch silicon solutions are now in production. In the coming quarters, we expect to grow additional shares in SAN custom silicon, with the ramp of these 8-gig Fibre Channel products. Also we are in development of Fibre Channel over Ethernet silicon designs and expect to ramp at major HBA and switch companies in 2009.

Now turning to hard disk drives, we continue to win new designs and are well positioned for long-term growth not only with our existing customers, but with new customers as well. Last quarter, we delivered the world's fastest read channel achieving 4-gigahertz data rates for enterprise disk drives. This was the world's first 65-nanometer iterative decode read channel and establishes a new benchmark for performance.

We are over one year into development with our customers in integrating this read channel into enterprise SoCs. At Seagate, we continue to solidify our position as the leading supplier and expect to increase our share in the future. Seagate has awarded LSI multiple mainstream desktop and notebook hard disk drive SoC design wins for platforms expected to ship in 2010 and 2011 time frame. These SoCs were awarded solely to LSI. Seagate has also awarded LSI an SoC design for future solid state drive products. These wins are in addition to two future generations of SoC designs targeting the enterprise space that were awarded to LSI and are expected to ship in 2010. We believe that these awards clearly prove the point of our strategic relationship with Seagate and reinforce our expectation of future revenue growth at this customer.

We continue to strengthen our position in Hitachi for SoCs and preamps. We are now pleased to announce that we have secured next generation SoC wins in Hitachi's notebooks and enterprise platforms. To go along with our existing win in their next generation desktop platform, Hitachi continues to work with LSI to incorporate next generation preamps into notebook and desktop platforms as well, expanding on our successful enterprise preamp product launch.

Finally, we have introduced new notebook, desktop and enterprise preamp products to deliver high performance and low power solutions that satisfy the requirements of next generation drives. We continue to grow share as we have expanded from our strong desktop preamp presence and are now qualifying and shipping into notebook and enterprise segments at all HDD customers.

To date, LSI technology including SOCs, controllers, read channels, and preamps, had shipped in more than 1.7 billion hard drives across our customer base, and we are well positioned for the future.

I would now like to discuss storage systems, where we have continued to deliver year-over-year growth in each quarter of 2008 and recorded 8% growth versus Q3 '07. We continue to see increased adoption of our new flagship mid-range XBB2 platform. We are pleased to announce that IBM is shipping the 7900 technology under the DS5000 product line.

LSI is enabling IBM to deliver a feature ready midrange disk solution that delivers enterprise class service and support, unprecedented levels of performance, high availability, enhanced security and energy efficiency, while providing significant investment protection for existing DS4000 customers. You can also expect to see other OEM partners of LSI announce this class of product in the immediate future.

One of our key values of the 7900 architecture is its ability to seamlessly adapt to evolving IT infrastructure changes to the support of different storage network interfaces, such as Fibre Channel, iSCSI, Fibre Channel over Ethernet, and InfiniBand. The reception for the 7900 has been very positive, and we expect it to be a strong product cycle for us.

We continue to experience solid growth in our entry level products and believe that we remain the worldwide leader in iSCSI storage system units based on the aggregate shipments of our OEM customers. We are pleased that a key customer selected the LSI Storage Virtualization Manager, known SVM, software suite to enable delivery of advanced data management functionality for a mid-range product line.

SVM is an advanced services platform that enables centralized storage management and multilevel data protection for distributed heterogeneous storage environments. Today's environment further justifies the growing need for these capabilities by decreasing the total cost of ownership and increasing data center utilization.

Now I'd like to review the networking business where our investments are aimed at delivering products and software to enable intelligence, security, and control, for voice, video and data traffic. We generated over 35% year-over-year revenue growth in our investment areas in Q3 '08 and continue to have strong design win momentum, demonstrating our progress in this business.

We are shipping our StarPro Media processors into three of the top four networking OEMs for media gateway, GPRS-based stations and Enterprise Voice over IP applications. These media processors are widely deployed in trials and we expect to see accelerated shipments as these OEMs go into production. In addition, we have extended our success with Huawei and our StarCore DSP product line within the wireless space and expect this new program to be in production in 2009.

We are pleased to announce that Nokia Siemens networks has now started shipping the LSI APP3 advanced communication processor and software with a new mini DSLAM platform. This platform addresses the need for fibre-to-the-building applications over VDSL2, enabling service providers to offer over 100 megabits per second of bandwidth for application such as HDTV.

We also continue to make progress in gateway applications. Nortel has announced the general availability of its new business services gateway platform. These multi-service business gateways contain significant LSI silicon content, including Link Layer processors, network processors, Voice over IP SoCs, and [Ethernet 5s].

In summary, we have expanded our leadership position in SAS by adding Dell, Fujitsu Siemens, IBM, Intel, NEC, and Sun to our SAS 6-gig customer base. In addition, we further secured an HDD, Seagate and Hitachi engagements as well as a new SSD win are expanding our preamp presence into the notebook space. We have a strong leadership position in storage systems with the new mid-range product cycle and ramp of the IBM DS5000 and continued success in entry level systems. In networking, we are ramping a new access and gateway applications and are seeing good year-over-year growth in our investment areas. All of these new wins underscore our confidence in the future.

Our results over the past five quarters reinforce that our strategy is the right one. While no company seems completely immune to the current economic conditions, the composition of our customer base, our global footprint, our focus on storage and networking and a solid balance sheet position us well to weather this environment.

Now let me turn the call over to Bryon who will take you through our results and provide guidance.

Bryon Look

Thank you, Abhi. LSI had another solid quarter, exceeding several of our guidance metrics. We continue driving towards greater profitability, in both GAAP and non-GAAP earnings per share, while continuing to realize the financial benefits of the strategic and operational decisions we have made.

Over the past 15 months, we successfully completed the divestitures of our consumer and mobility of businesses, along with restructuring our semiconductor and systems manufacturing operations to align with a more variable cost structure and to help drive significant improvements in gross margin. In addition, we moved to a much lower operating expense structure.

Before getting into specifics on the quarter, I'd like to make a few comments about the macroeconomic environment and our overall financial performance. Our execution to-date has been solid, in terms of meeting and/or exceeding our commitments. Visibility in our end markets, however, is lower than in previous quarters.

With this in mind, we continue to drive efficiencies and have tight controls on our spending, while maintaining a strong balance sheet. Our net cash position, or cash and short-term investments, in excess of convertible debt, remain very strong at $458 million. In terms of cash and short-term investments, the vast majority is held in the United States. We continue to maintain excellent liquidity in high quality investments. In addition, our operating cash flows have consistently remained positive. We are confident our financial position today will allow us to continue investing for the future.

Moving to highlights for the September quarter, they include the following: revenues were $714 million; consolidated gross margins, excluding special items, increased to 48.3%; operating expenses, excluding special items, were $243.7 million; net income, excluding special items, was $94 million, or 13% of revenue, representing a $50 million improvement year-over-year; earnings per share, excluding special items, was $0.14, up $0.08 per share year-over-year.

Turning to a more detail discussion on revenues, revenues for Q3 were $714 million, which is sequentially up 3% and up 14% on a year-over-year basis, net of consumer and mobility revenues, businesses which we divested last year. Semiconductor revenues for Q3 were sequentially up 8% to $500 million and up 16% on a year-over-year basis, net of the mobility and consumer revenues.

Our storage semiconductor revenues, which include hard disk drive silicon, SAS standard components, and storage area network ICs, were $335 million, representing 47% of total revenues in the third quarter. Revenues were up $29 million or 9% sequentially, primarily due to seasonality.

On a year-over-year basis, storage semiconductor revenues in Q3 were up $43 million or 15%, primarily due to increased sales of hard disk drive SOCs, preamps, SAS standard components, and storage custom silicon. Q3 revenues in our networking business were $142 million, representing 20% of total revenues for the quarter and up 1% sequentially. On a year-over-year basis, networking revenues were up $8 million or 6%, primarily due to increased revenues from networking standard products in our investment areas, partially offset by declines in legacy products.

Revenues for the IP business in the third quarter were $23 million, up from $16 million in Q2. We continue to focus and build momentum around our IP business and drive significant value from LSI's intellectual property portfolio.

Turning to our storage systems business, systems revenues were $214 million in Q3, sequentially down $16 million or 7% from a very strong Q2. We experienced lower than expected systems revenues, primarily due to order softness which we began to experience towards the end of Q2, primarily with two of our largest OEM partners.

On a year-over-year basis, revenues were up $17 million or 8%, primarily due to increased sales of our entry level products. Storage systems segment represented 30% of LSI's total revenues in the third quarter. Combined revenues from storage systems and storage semiconductors amounted to $549 million or 77% of LSI's total revenues in Q3.

Moving next to gross margins, LSI's consolidated Q3 gross margin, excluding special items, was 48.3%, which was sequentially up 40 basis points from Q2. The sequentially improvement in gross margin was driven primarily by the growth in our semiconductor revenues during the quarter.

Semiconductor gross margins, excluding special items, increased approximately 40 basis points from the second quarter to approximately 52.5%, primarily due to higher than expected networking product revenues. On a year-over-year basis, semiconductor gross margins, excluding special items, improved 690 basis points from the third quarter of 2007.

Storage systems gross margins, excluding special items, were another area of solid performance in the quarter at 38.7%, a slight sequential decline of 80 basis points, primarily due to lower absorption of fixed costs.

Moving to operating expenses, R&D together with SG&A expenses, excluding special items, totaled to $243.7 million in Q3, at the midpoint of our guidance range and flat sequentially. Operating expenses excluding special items declined $18.4 million or 7% year-over-year. Interest income, and other net of interest expense, excluding special items, was $0.7 million for Q3.

Let me turn to the special items we recorded in the third quarter, which netted to $83 million. Special items, primarily non-cash, included $60.5 million in amortization of acquisition-related items, $16.9 million of stock-based compensation expense, $1.7 million in write-downs of investments, and $1.6 million in net restructuring cost and other items. The tax provision for the third quarter on a GAAP basis was $10.2 million. The non-GAAP tax rate was 8%.

On a GAAP basis, third quarter net income was $11.4 million or $0.02 per share, which was up $0.04 per share, compared to Q2 2008. On a year-over-year basis, GAAP earnings improved by $152 million from a loss of $0.20 per share. This was primarily due to restructuring charges one year ago associated with the sale of the mobility business. Net income, excluding special items, improved sequentially to $94 million, or $0.14 per diluted share, and was up from $0.06 per diluted share in Q3, 2007.

Turning now to the balance sheet and cash flow, we continue to drive positive operating cash flows with a third quarter at $56 million. Our balance sheet remains strong. Our cash and short-term investments ended the September quarter higher, at $1.2 billion. As I mentioned earlier, our net cash position at the end of the quarter increased to approximately $458 million. Cash and cash equivalents represents roughly two-thirds of our portfolio, and predominantly investments in over a dozen high quality money market funds. Cash equivalents also include cash balances held with some of the world's banking institutions. Short-term investments represent roughly one-third of our portfolio and are invested primarily in AAA rated securities. We do not own any auction rate securities or CDOs.

Continuing with the quarter, we reduced inventories by approximately 13%, or $31 million, compared to Q2, primarily due to reductions of the buffer stocks established to facilitate our manufacturing transitions. Depreciation and software amortization for Q3 was $22 million, and capital expenditures were $14 million.

Given the macroeconomic environment, our visibility is more limited than it has been in the past, causing us to be fairly cautious with our guidance. With this in mind, the following is our guidance for the December quarter: revenues in the range of $670 million to $710 million; sequentially, we expect our networking semiconductor business to be down due to Legacy declines, and our storage semiconductor business to be slightly down due to declines in end market demand for servers and PCs. We expect storage systems however to be sequentially up due to seasonality, as we tend to experience stronger revenues in the final quarter of the year.

We expect IP revenues to be flat compared to the September quarter. Consolidated gross margin, excluding special items, is expected to be in the range of 45.5% to 47.5%. Semiconductor gross margin is expected to be approximately 50%, and systems gross margin is expected to be approximately 40%, each excluding special items.

Operating expenses are expected to be in the range of $235 million to $245 million, excluding special items, with the midpoint improving as compared to Q3. In addition, we expect interest income and other and interest expense to net to an expense of $2 million, special items netting to approximately $70 million to $90 million, GAAP tax provision to be approximately $10 million, and the non-GAAP tax rate of approximately 8%.

We expect our GAAP and non-GAAP tax provisions to continue to vary quarter-to-quarter based on profitability in different geographic tax jurisdictions and certain discrete items. Going forward, we expect the non-GAAP tax rate to be closer to 15%. We expect Q4 GAAP net income per share in the range of $0.07 loss to $0.03 profit, EPS, excluding special items, in the range of $0.08 to $0.14 per diluted share, and share count of approximately 647 million shares for GAAP and 651 million shares for non-GAAP purposes. In addition, we expect depreciation and software amortization of approximately $20 million and capital expenditures of approximately $10 million.

In summary, we have demonstrated solid financial performance, both sequentially and year-over-year, and continue to generate positive operating cash flows. I'd like to point out that, compared to a year ago, we have grown revenues in our core businesses by 14%, delivered on significant strategic initiatives which have contributed to the expansion of gross margins, excluding special items from approximately 43% to approximately 48%, and reduced operating expenses quarterly, excluding special items, by $18 million per quarter.

Our higher revenue levels, improved gross margin profile, and lower operating expense base have resulted in a substantial year-over-year improvement in net income, excluding special items, as a percent of revenues from 6% a year ago to 13%, while we also successfully balanced investments in addition of growth engines. Our balance sheet and cash position remains strong, allowing us to maintain course on our longer-term investment strategies in networking and storage businesses.

Now let me turn the call back to Abhi.

Abhi Talwalkar

Thank you, Bryon. Before we go to your questions, I want to provide some more perspective on our business and markets, in light of the economic downturn, and what we can expect going forward. The economic climate remains uncertain with limited visibility, and this is reflected in our guidance for Q4.

The less than anticipated seasonal growth we are seeing seems to be directly tied to economic factors that are impacting our markets and customers. While we are expecting storage systems to be up in Q4, the level of expected growth is well below typical December seasonality.

Similarly, our storage semi business is expected to be down due to macro concerns. We also anticipate networking to be down due to an expected drop off in Legacy business. Excluding this anticipated Legacy decline, the midpoint of our guidance would have been roughly flat with Q3 levels. While our outlook for Q4 is lower than we anticipated, it would be earlier in the year, our competitive position at our key customers and design win momentum across our business is strong, and I am confident in our opportunities for future growth as we move past this economic downturn.

While end market demand is uncertain, we will be vigilant in managing expenses, driving improvement in our product costs, and understanding the demand environment of our customers and markets. I want to stress that over the past year, we have established a strong track record for execution and earnings growth, and I am very pleased with the progress we have made in transforming LSI into a successful storage and networking company.

Our goal remains to strike a balance between driving near-term improvements to earnings and making targeted investments to generate an acceleration of long-term revenue earnings growth. We expect to continue the benefit from the fundamental need to store, protect and transport data.

Now let me hand the call back, Sujal.

Sujal Shah

Thank you, Abhi. At this point, we will begin the Q&A portion of the call. Erin, would you please give the instructions for the Q&A session?

Question-and-Answer Session

Operator

(Operator Instruction). Our first question will come from Kaushik Roy with Pacific Growth Equities.

Kaushik Roy - Pacific Growth Equities

Can you comment on the overall demand environment, what you saw in terms of linearity for the quarter, and how does October look so far? And what you are seeing in the channel and OEM inventories?

Sujal Shah

You are talking about both Q3, as well as coming inventories?

Kaushik Roy - Pacific Growth Equities

Correct.

Abhi Talwalkar

Well, I think consistent with what you probably heard a lot of our peers as well as customers allude to, we did see a deceleration in orders in the last two to three weeks of the Q3 quarter, and we've seen some of that softness in terms of bookings and fill rates continuing into Q4. Clearly we factored that into our guidance and outlook for Q4.

In terms of inventories, I can certainly speak to our inventories. Our inventories are down considerably quarter-over-quarter and are in pretty good shape versus last year this time.

Kaushik Roy - Pacific Growth Equities

And then recently you made an announcement about SoC design wins at Seagate desktop, notebook segment, and I think you mentioned in the call it was solely LSI so far. So can you comment, what does it mean that Marvell is ruled outward in desktop notebook altogether in 2010-2011, or your competitors may still get some design win?

Abhi Talwalkar

Well, I think, first of all, our relationship with Seagate just continues to enhance, and I think that's evidenced by not only our progress this year, but by some of the announcements that we made earlier this week relative to additional and multiple design wins in the desktop and notebook space.

I think the comment relative to solely LSI is more so associated with the alliance that exists between LSI and ST. These particular design wins were awarded specifically and only to LSI.

Kaushik Roy - Pacific Growth Equities

Okay, great. Thank you.

Sujal Shah

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

Operator

That will come from Hans Mosesmann with Raymond James.

Hans Mosesmann - Raymond James

Thanks. Regarding IP, the 23 million was a significant sequential increase. How sustainable is that going forward? I know you've got it flat, but beyond that and how much of the increase is coming from LSI-specific IP, rather than the older year? Thanks.

Abhi Talwalkar

Hans, first of all, we are very pleased with the performance of our IP licensing business. We set a pretty aggressive goal at the beginning of the year. We are on track to meet that goal, so we are well on our way to rebuilding this revenue stream. We continue to make a lot of progress in terms of building new franchises.

Specific to your question around the LSI IP base, we are not going to break out the split, but I would say the majority of this licensing revenue is still based on the uglier portion of the patent base. So I think the opportunities continue to exist to build this IP licensing base further, and our objective certainly is to grow it in 2009 above 2008 levels.

Hans Mosesmann - Raymond James

Okay. That's it. Thanks, and good job in a tough environment.

Abhi Talwalkar

Thank you.

Sujal Shah

Thanks, Hans. Could we have the next question?

Operator

We will hear from Sumit Dhanda with Banc of America Securities.

Eric Ghernati - Banc of America Securities

Hi. This is Eric Ghernati for Sumit Dhanda. Just a few economies first. We understand this is a very difficult market, of course, but given that your forecast for systems to be up sequentially in Q3 didn't come to fruition, what is giving you the confidence the systems will grow in Q4? That is my first question.

Abhi Talwalkar

Well, I think if we look at the Q3 performance, clearly we had softness towards the latter part of the quarter, and some of that softness was obviously tied to overall pressure that is coming under IT spending and the macroeconomic conditions. I think there is another factor as well, in terms of the introduction of our mid-range platform.

That introduction, which was in the third month of the quarter, also caused a little bit of a pause also in the midst of an overall economic sort of climate where people are watching their expenses.

And so that's what we attribute the overall slowdown in the third quarter. We do expect that there will be seasonality in the fourth quarter, but the seasonality will be at significantly lower levels than historical which is what is factored into our guidance.

Eric Ghernati - Banc of America Securities

And then just a question on the press release that you issued on Seagate. Just correct me if I'm wrong on this. So I understand that you guys are splitting the accounts with STMicro, with Seagate for notebooks and desktops. And does it really suggest that LSI is, I mean, does the press release infer that mix is improving towards LSI as opposed to STMicro? In other words, are you gaining more than 50% share?

Abhi Talwalkar

Well, I think the alliance in particular remains intact for all past obligations and past design wins and awards. The awards that we are specifically talking to, both in this call as well in the press release, are new awards and directed specifically and only to LSI. So I'll let you draw your conclusion as to what that means in terms of long term, but we do expect our share to grow at Seagate going forward.

Operator

We will now move on to Shawn Webster with JPMorgan.

Shawn Webster - JPMorgan

Yes. Good afternoon. Thank you. Can you talk a little bit, Abhi, I guess, or Bryon, on the gross margin outlook? Is it mostly mix that is driving those sequential declines in Q4, and maybe if you can share your thoughts on OpEx and some of the moving parts as we go into the first half of next year, and your expectations on whether you are going to keep it flat, or what should be happening there?

Abhi Talwalkar

Bryon, why don't you take that one.

Bryon Look

Yes, sure. As noted in our comments, we have grown tremendously. I think the gross margins, from a point about the year ago, in fact I think five straight quarters here, [semiconductor] margins are exceeding 52% and systems margins actually coming in very strong as well, in the high 30s. That comes from the combination of many different things, among them strategic decisions that we've made in changing the portfolio of our businesses.

Secondly, a significant initiative on the manufacturing front, both in terms of outsourcing some of the manufacturing activities to partners as well as significant improvement in terms of streamlining our overall cost structures, all have translated into some significant benefits relative to the third quarter. I would say that performance was driven by higher volume as well as the mix that we had in semiconductors, and specifically within semiconductors, a higher than expected level of networking product revenues.

When you think about the fourth quarter gross margins to your question, the mix changes there because. per the guidance, we would expect the systems business to grow in the fourth quarter, it's traditionally the strongest quarter for that business. And even in this environment, we may not grow at the same level, but it should be up in the quarter and that would change the overall mix and still have us be at a nice level in terms of our overall gross margins.

Relative to your question about operating expenses, first of all, from our results in Q3, we managed to hold our expenses basically flat from the prior quarter, while we grew revenues, and this is on top of absorbing additional costs that we have to support things like additional design wins that we continue to build.

And so I think that's a good indication of our ability to have discipline management over our operating expenses. Per our guidance for the fourth quarter, we also continue to maintain that focus in terms of streamlining spending, being very careful about how we make those investments and the guidance we provided, the midpoint of that guidance would be at 240, and so that is below the levels that we reported. It would be an improvement from spending levels in the third quarter by several millions dollars.

Shawn Webster - JPMorgan

Okay. Can you, in terms of the first half of next year, we all recognize that the environment from the demand perspective is quite uncertain for you guys but everybody broadly speaking. Are there any product cycles that you can share with us, or things that are happening in the first half, that could buffer you guys relative to your competition?

Abhi Talwalkar

Well, we've got a number of product cycles. We are in the midst of a ramp on the entire mid-range and high end family of our storage systems business which will bring more customers on. We've got certainly a ramp of SAS 6-gig so forth, but it's just premature to call 2009. We are getting our arms around Q4 itself.

I would like to remind everyone that there's seasonality in our business, and that seasonality historically has been a drop from Q4 to Q1 in the range of 8% to 12%. Last year we experienced 7%, but again too early to call as to how this Q1 will play out.

Operator

We will move on to James Schneider with Goldman Sachs.

James Schneider - Goldman Sachs

Thanks for taking my question. Clearly there's been price pressure on the drive side with respect to your customers. Can you comment on whether any of the pricing pressure has filtered back to the component side and what do you see in terms of ASP pressures this quarter and into next quarter?

Abhi Talwalkar

Actually, we haven't seen that materialize in the ASP pressure on our space, and how we've explained in the past, we have volume pricing agreements with our customers that's spend multiple quarters, and typically the pricing and pricing negotiation occurs at the onset of new design wins that open up, not in the life of a particular SOC when it's in production.

James Schneider - Goldman Sachs

Okay. And then as a follow-up, Bryon maybe can you comment on the uses of cash, specifically as it relates to your convert coming due next year, as well as buybacks given that the stock’s at this price?

Bryon Look

Starting off, we have a strong cash balance. We increased cash during the quarter to almost $1.2 billion, and obviously we are continuing to generate positive operating cash flow. That is a good position to be in. There are multiple uses for that cash, if you look at what has happened in the financial markets, our stock price is down.

We have the ability to take advantage of different opportunities that we have for the strong cash balances, share repurchase is certainly one of those, among other alternative uses for our cash. We do have convertible notes outstanding, which will become due in December of 2009. So that's on our radar screen in terms of different things we might do relative to those particular converts.

Through these challenging times, we would still keep an eye out in terms of opportunities to expand our position relative to strategy, markets and so forth, and so there's potentially the use of cash for accretive M&A transactions as well. And I would be remiss if I didn't say that another possibility is just to be conservative in terms of spending any of the cash, and maintaining the strong cash position until we get more clarity relative to the overall economic environment and how that might impact us in 2009.

Sujal Shah

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

Operator

From Kaufman Brothers, Suji De Silva.

Suji De Silva - Kaufman Brothers

Hi, guys. Can you please clarify again the comment that you made, Abhi, on the networking business, the Legacy, if there was a drop on Legacy, it would be flat? Can you just repeat that comment?

Abhi Talwalkar

Yes. I think if you look at our guidance for Q4 relative to actual for Q3, based on the expected decline on our Legacy business if you normalize for that, the overall Q3 to Q4 business is flat.

Suji De Silva - Kaufman Brothers

Okay. And then also can you help quantify this lower visibility here, somehow other than guidance perhaps a turns or backlog coverage versus historical in the last quarter? Thanks.

Abhi Talwalkar

In the last quarter?

Suji De Silva - Kaufman Brothers

No, the visibility looking forward, backlog cover into the Q4 guidance?

Abhi Talwalkar

I guess the best way to characterize visibility for this quarter is largely driven by where our backlog is across our different product line segments, and where our filler rates are, and it varies across the businesses. The systems business, as you know, is very heavily turns related, but we are guiding that business to be down in terms of expected seasonal growth Q3 to Q4, but it will up, and we'll experience that as we proceed throughout the quarter.

Based on the other guidance that is out there, in terms of peer companies, I don't think we are too far off in terms of what we are expecting. Our networking business typically has a high backlog coming into the quarter, and we feel pretty good in terms of where that is at this point in the quarter. The rest of the business in general, I'd say is a little bit soft, as expected, based on where we ended Q3, but all of that has been factored into our guidance for Q4.

Sujal Shah

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

Operator

We will move to Craig Berger with FBR Capital Markets.

Craig Berger - FBR Capital Markets

Hi, guys. Thanks for taking my questions. Can you help us understand, within your systems business, how big is the low end 1 to 3 price band of the total systems business, and what type of growth prospects could we still see as adoption picks up there in 2009?

Bryon Look

Craig, we don't break out that particular segment, but clearly that segment has grown very nicely for us both quarter-over-quarter as well as year-over-year. Overall, aggregate units for us, not only in the entry, but inclusive of our mid range and upper end of our mid-range product family, we believe our shares continue to grow and expand on a unit basis.

In terms of growth for the entry business, we believe there's more room to grow as our customers get even more aggressive in driving the server-led storage sales that can come with this entry class of systems. I would say there are a number of our customers that are not at sort of the full potential in that product line, and we're going to continue to be focused working with them to drive more aggressive sales, obviously though in a very tough environment.

Craig Berger - FBR Capital Markets

Moving on to the networking business, I know you guys alluded to this already, but what might we expect in terms of an impact for next year?

Abhi Talwalkar

It's really hard to call at this point in time in the Legacy. The Legacy business is made up of a lot of different products at various stages of the overall life cycle. We are certainly trying to get our arms around how this current environment and 2009 might factor into previously expected Legacy declines. I think as we get more clarity in the subsequent quarter, we'll provide that to all of you.

Sujal Shah

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

Operator

That will come from Brian Yurinich with Craig-Hallum Capital Group.

Brian Yurinich - Craig-Hallum Capital Group

Hi, this is Brian. We are wondering what is your unit growth expectation for Seagate in your December quarter guidance?

Abhi Talwalkar

Unit growth is overall going to be down.

Brian Yurinich - Craig-Hallum Capital Group

Do you have a number at all or any thoughts on that?

Abhi Talwalkar

Not something that we would disclose.

Brian Yurinich - Craig-Hallum Capital Group

Thank you.

Operator

Our next question comes from med Arnab Chanda with Deutsche Bank.

Arnab Chanda - Deutsche Bank

Yes, thank you. A couple of questions. First of all, question for Abhi. You talked about your design wins, Seagate design for SoCs, does that mean you are doing the hard drive controller, read channel, everything or is there some IP sharing going on? If you can describe it, that would be great.

Abhi Talwalkar

The design wins that were referred to in this call, as well as the press release, were all inclusive of LSI IP, 100% LSI IP, other than the contribution that Seagate makes as we develop these SoCs with them.

Arnab Chanda - Deutsche Bank

Just a follow-up on that. That is different from the model that's been used in the past, right?

Abhi Talwalkar

Relative to notebook and desktop SOCs with the alliance.

Arnab Chanda - Deutsche Bank

Okay, great. A follow-up question for Bryon. It seems like the source systems has a greater fix component to that. Let me know if that is an accurate observation or not. And if so, can you give a sense of sort of how the gross margin progress with every percent of revenue grow? That would be great. Thank you.

Bryon Look

We made substantial changes in terms of the manufacturing models for each of our busines,s both on the semiconductor as well as the systems side, in general moving to more of a variable model. We have done outsourcing, and we've essentially completed that transition for that systems business the manufacturing to subcontract manufacturing partner.

Relative to what that means in terms of percentage differences, I think it's probably something that I'm not prepared to break out over here. It varies, based on changes in products, on top of just the manufacturing structure.

Operator

Thank you. We'll move now to Sanjay Devgan with Morgan Stanley.

Sanjay Devgan - Morgan Stanley

Hi guys. Thanks so much for taking my question. First question is in your opening remarks you mentioned winning of the next generation notebook drives at Hitachi. I was wondering if you can give us a sense of the timing when you expect those drives to start to ship?

Abhi Talwalkar

We expect sometime in the second half of 2010.

Sanjay Devgan - Morgan Stanley

Okay. And then second question is, as you kind of look at your networking business, I believe last quarter that business showed better than expected strength due to some last time buys ahead of the Olympics. And I was wondering what actually drove the strength this quarter? Because I was under the impression that it would be down, and so I was wondering if you can talk qualitatively what kind of drove the strength this quarter in that business?

Abhi Talwalkar

I think same it was last time buys probably would not be a correct characterization. Clearly, China Olympics built out ahead of that and that was certainly a factor. I think what we continue to benefit from is deployments that carriers are making worldwide, and largely in emerging markets, around 2G and 2.5G, and the GSM class of infrastructure. That's where some of our Legacy products are built into and I think we benefit from that continued sot of deployment. Certainly more so than what we had expected coming into the year.

Sujal Shah

Thank you, Sanjay. I believe we have time for one more question.

Operator

That will come from Blayne Curtis with Jefferies.

Blayne Curtis - Jefferies

Thanks, guys. Abhi, you saw strength in storage semis in Q3. (inaudible) Can you talk about how orders are trended in that business and how comfortable you are with the channel inventory?

Abhi Talwalkar

You were breaking up a little bit. Can you repeat your question?

Blayne Curtis - Jefferies

I'm sorry. In reference to storage semiconductor business, it was up in Q3. Can you talk about as far as the PC end market, how order patterns have trended in that business and how you look at channel inventory?

Abhi Talwalkar

You were talking about, you said PC end market?

Blayne Curtis - Jefferies

I was talking about your HDD business.

Abhi Talwalkar

ACD business.

Blayne Curtis - Jefferies

I think we have a bad connection. I was talking about HDD.

Abhi Talwalkar

HDD, okay. In terms of our inventories on hand exiting Q3, we made significant improvements in terms of our inventories. We believe inventories are in fairly good shape. We do believe that some of our customers also worked on getting their inventories down in light of the current environment and challenges in terms of predicting business into Q4. We do believe that inventories based on again our outlook are in good shape. Obviously, the outlook has to materialize.

Blayne Curtis - Jefferies

And then just how order patterns have trended in that business?

Abhi Talwalkar

It's sort of consistent with order patterns across the other IT segments. We saw a softening in the last two to three weeks of the September quarter, and we saw some of that softening come into this quarter as well.

And I think if you look at the best proxies out there for hard drive business, and what people are looking at in terms of PC and server growth rates are, overall units from Q3 to Q4, and we are driving a fairly consistent outlook to some of those numbers Intel being certainly a good proxy.

Sujal Shah

Thank you, Blayne. I'd just like to turn the call back over to Abhi for some closing comments.

Abhi Talwalkar

Let me just conclude here this call by reiterating some key takeaways. We delivered solid results in Q3 in a difficult economic environment. The strategic decisions we have made over the past 18 months, combined with our strong balance sheet, position us well for the future. We will continue to be highly disciplined in controlling expenses as we have been in this uncertain demand environment, while continue to invest for our future products to drive long-term growth.

And we made a significant progress in terms of high quality design wins across multiple customers, including IBM and other tier 1 customers for storage systems and software, six industry leading OEMs for SAS 6-gig, further strengthening our position at Hitachi and Seagate in HDD along with the win in the SSD segment, and then strengthening our position with design wins at Huawei, Nokia Siemens, and Nortel.

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

Operator

Ladies and gentlemen, the telephonic replay of this conference will be beginning today at approximately 6 PM Pacific Daylight Time and will run through 10 PM Pacific Daylight Time on October 29th. The replay access numbers are 1-888-203-1112 within the US and 1-719-457-0820 for all other locations. The replay pass code is 1724435. The webcast will be archived at http://www.lsi.com/webcast. That does conclude your conference for today. Thank you for your participation. You may now disconnect.