The Daily Magic Formula Stock for 01/23/2009 is Emulex Corp. According to the Magic Formula Investing Web Site, the ebit yield is 27% and the EBIT ROIC is 50-75%.
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Kevin M. Dotts
Thanks and welcome everyone to our call. This morning Iâ€™m joined by Earthlinkâ€™s Chairman and CEO Rolla Huff and our Vice President of Corporation Communications Michelle Sadwick and our Vice President of Investor Relations [Lewis Alterman] to discuss our third quarter results. Following our comments there will be an opportunity for questions.
Before we can continue I would like to point out that certain statements contained in our earnings release and on this call are forward-looking statements rather than historical facts that are subject to risk and uncertainties that could cause actual results to differ materially than those described. With respect to such forward-looking statements the company seeks the protection afforded by the Private Securities Litigation Reform Act of 1995.
These risks include a variety of factors including competitive developments and risk factors listed in the companyâ€™s SEC reports and public releases. Those lists are intended to identify certain principle factors that could cause actual results to differ materially from those described in the forward-looking statements but are not intended to represent a complete list of all risks and uncertainties inherent to the companyâ€™s business.
In an effort to provide useful information to investors our comments today also include non-GAAP financial measures. For details on these measures including why we use them and reconciliations to the most comparable GAAP measures please refer to our earnings release and the Form 8K that has been furnished to the SEC both of which are available on our website at www.Earthlink.net. Now, I will turn things over to Rolla.
Rolla P. Huff
Iâ€™m pleased to report that today we announced a solid quarter of operating performance. I think most of you would agree that the current business environment is causing most companies to reassess their cost structures, deleverage their balance sheets and focus on cash generation. As our investors know, Earthlink began following that script in August of last year and it looks to be serving us pretty well.
Our performance has come through our people and in my judgment the most remarkable thing about our performance has been the ability and willingness of our people to stay focused on customers while simultaneously doing the things necessary to create shareholder value. But, Iâ€™ve got to tell you itâ€™s not been easy for them but they are the key reason that weâ€™re creating the shareholder value thatâ€™s being created today.
As Iâ€™ve said before thereâ€™s no silver bullet in this business. We create value through a thousand little things and we do it with a team of dedicated people who clearly understand our business priorities. Our top priority is to solve for extending the we call it the tail on our access business for as long as possible while continuing to use better business processes as well as new technology to find creative ways to run our business more efficiently.
Weâ€™ve aligned compensation structures with business priorities to make sure everyone is pulling in the same direction. As a result of all of the above, Earthlink is in a good position at a time when underleveraged high cash flow businesses have greater relative strength and value in the technology sector. We are well aware of the substantial volatility in the capital markets. We also recognize this has begun to spill over in to the broader economy.
Iâ€™m pleased to tell you that at least as of right now our consumer business has not felt any meaningful impact from the uncertain economic environment. Neither churn nor bad debt has moved outside of historical ranges and weâ€™re actually reporting higher average revenue per subscriber. But, itâ€™s early and we donâ€™t have complete clarity around whether the more difficult economic environment will help or hurt our business.
As weâ€™ve been doing weâ€™ll just continue to watch these metrics very closely. More importantly, well continue to run our business with the discipline we have been with a focus on driving cash flow and an eye towards strategic opportunities that can help us create incremental cash flow through future growth prospects. As I just indicated, our consumer business is operating in bands consistent with and in some cases above our expectations and historical trends.
Revenue continued to be slightly above our expectations due to better than projected organic customer additions. Importantly, broadband now represents 52% of our overall revenue. We know that tenured broadband customers have lower churn rates than tenured dial up customers but they also have lower gross margins. Clearly, our ability to continue to save our dial up customers to our broadband platform rather than simply losing them to a competitor is a key strength of the Earthlink business model.
Itâ€™s also a reason that we continue to believe that the tail on our business will be longer than most people give us credit for. We continue to benefit from operating process efficiencies and cost of revenue improvements despite the expected overall decline in reported revenue. We continue to improve our financial performance by our efforts to limit sales and marketing spend to only those activities that create positive shareholder return.
As a result of the above, we reported better than expected adjusted EBITDA, free cash flow and net income. Because weâ€™re currently seeing nothing in data that would suggest that our operating performance will materially reverse in the near term, weâ€™re increasing both the low end and the high end of the 2008 guidance. Iâ€™d like to provide a bit more commentary on some of the drivers of our operating results and then Kevin will walk everyone through a more detailed review of our financial performance in the quarter, our revised 2008 guidance and our preliminary guidance for next year.
As anticipated, new subscriber additions continue to decline quarter-over-quarter but are attracting ahead of our plan which weâ€™re pleased to see given our tight controls on marketing spend. Overall, churn for the quarter was 4.25 down from 4.3% in the prior quarter and 150 basis points better than the prior year third quarter. We continue to see our lower price value dial People PC service account for a disproportionately large part of our churn. These subs represented 48% or nearly half of our overall subscriber decline even though that product comprises only 29% of our total subscriber base.
Value dial churn in this past quarter was 6.5% which represents a 220 basis point improvement over the year ago quarter. For the third quarter, value dial represented 17% of our consumer access revenue while our higher value or premium dial base of customers represented 31% of our consumer access revenue. Average monthly churn for premium dial narrow band improved to 3.7% which was 120 basis points better than the third quarter of last year.
As I previously mentioned, broadband now represents 52% of our overall revenue with our two largest broadband products being cable and DSL. Total broadband churn was 2.8%, down from the prior year quarter. While DSL and voice rates have improved over prior year, the cable product which has historically run in the low 3% churn range is now a larger percentage of our base of broadband subs.
As you can see, churn continues to improve across our consumer product lines as the mix of our customer base continues to shift towards increasingly tenured subscribers. At the end of the third quarter 64% of our consumer access customers had been with us for two years or more and had an average churn rate for this tenure cohort of 2.89%. Moreover, 28% of our entire base of access customers have been with us for over five years and that cohort has an average churn of 2.125 this quarter.
These tenure percentages have continued to increase and we expect this aging trend to continue. More importantly, as of the third quarter over 85% of our premium dial subscribers have been with us for more than two years and are churning below 3%. For DSL almost 70% of our subscribers have been with us for more than two years and are churning at approximately 1.5%. These two examples speak to the point that the highly profitable premium dial and DSL basis are well tenured and stable which should provide strong cash flow for the foreseeable future.
Now, let me spend a few minutes talking about our graphical ad, search and we security business. We saw average ARPU from these value added services increase from $2.75 per average subscriber to $2.85 per sub over the prior quarter. This was due in part to our launching our own targeted subscriber advertising engine. Our ad targeting implementation also allowed us to pass through a 17% price increase in our direct sold graphical advertising in Q3 from Q2.
Additionally, ARPU per sub was up in search and subscription due to a 9% higher RPM in our search business. Search ARPU was $0.84 per average sub up from $0.78 in the second quarter. Subscription ARPU from security and other products rose to $1.78 from $1.71 in the prior quarter demonstrating our ability to monetize our subscribers in a variety of ways. Another function of our more tenured customer base has been a notable reduction in the number of refunds, credits and charge backs and thatâ€™s contributed to our lower overall support cost structure.
Non-cost of revenue operating expenses improved from 52% of revenue in the third quarter 2007 to 34% at the end of this quarter. I think thatâ€™s particularly notable given that weâ€™re seeing a negative scaling in our business because of the subscriber declines that we had planned for. So, we feel pretty good about that. Itâ€™s important to point out that while weâ€™re driving more cost efficiencies in to the business weâ€™re not doing so at the risk of our customers.
Our overall network services availability is tracking on target at 99.8%. Weâ€™ve put additional measures in place to prevent fraud and abuse which has helped our bad debt. For the quarter, customer support experienced the lowest calls volumes in several years as well as the best quarterly results in our recent history for customer satisfaction, sales close rates and cost per subscriber.
Weâ€™ve seen our combined customer and technical service contact rates for consumer services come down 40% on a per subscriber basis since this time last year. Overall our cost to support a subscriber is at its lowest point ever, down 10% versus just this past second quarter. Further cost efficiencies are coming from a variety of areas again, a thousand little things. Things like line migration to more cost effective transport networks, lower rate per minute contracts with outsourcing partners, broader level system consolidation and simplification.
Weâ€™re now well down the path of having reduced the complexity of our prior business model. In my experience taking complexity out of a business model generally results in lower cost and high quality and I think that idea is generally working out to be the case here at Earthlink. Joe [Wexel] and his team are certainly proving that point. Weâ€™ve reduced sales and marketing expenses by nearly 70% versus the year ago quarter. As we gained increase insight in to the effectiveness of our many loyalty and retention efforts we have the ability to make sure weâ€™re getting better returns on the investments we make in these programs.
The same can generally be said about our efforts to optimize sales and partner relations. The sales and marketing teams have worked hard to test and then retain only those sales programs and partnership arrangements that yield the best acquisition economics. State conversions from narrow band to broad band as well as stronger than expected new subscriber adds in both our cable and our DSL product lines contributed to broadband now accounting for over half our access revenue.
While we are very proud of the highly profitable dial up business that we have, those who believe we are only a dial up business are simply wrong. In early September we announced that we expanded our broadband cable Internet footprint in the Los Angeles and Dallas markets to an additional 5 million households. Nationwide, our high speed Internet services now reach more than 74 million households with cable, DSL and some satellite.
Our ability to migrate many of our customers to a broadband platform, if they require that and if they want that, combined with the reality that not everyone needs or can afford broadband much less a triple or quadruple play price point is a key reason that we believe the tail in this business might be longer than some believe. Longer than some of the people on this call believe actually. Itâ€™s also a reason we believe weâ€™re the best consolidation platform for the dial up industry.
Operating this business for a richer mix of tenured customers and a focus on positive lifetime value ultimately generates meaningful cash flow. Our free cash flow has increased to $72 million in this quarter, up from $28 million in the year ago quarter on $67 million less revenue. Kevin will provide more insight in to this metric in just a few minutes. I want to briefly talk about our business services division primarily comprised of our New Edge network subsidiary. As youâ€™ll recall when I arrived a little less than a year and a half ago New Edge was a hot topic of conversation with all of you because it was consuming meaningful amounts of cash and was a drag on our EBITDA.
I told you that the highest priority for us was to first stop the consumption of cash and neutralize the negative EBITDA impact it had on a consolidated Earthlink business. Put another way, essentially we needed to stop the bleeding. That was paramount. We have executed on that strategy. We believe our small and midsize business customers are however, more exposed to a big downturn in the economy than our very tenured consumer base which is not yet showing, as I mentioned earlier, a noticeable impact from that economic downturn.
Weâ€™ve seen our retail business customers downsizing their business locations at an increased pace which puts pressure on revenue churn. On the other hand, weâ€™re seeing a positive impact on ARPU in this segment as we continue to gain traction with our new MPLS class of service over our DSL product platform. 34% of all new installs in the quarter were on this platform versus our legacy products. We believe this product represents an attractive price point for prospects who are trying to cut costs.
Given the economic downturn and its impact on small business this seems like it should be the right product at the right price at the right time. To that point weâ€™ve just recently booked a significant new contract in the quarter with UFPC, or Unified Food Service Purchasing Coop, the exclusive central procurement organization for more than 17,000 Yum! Brand restaurants which include KFC, Pizza Hut and Taco Bell. New Edge has been selected as the preferred provider of private high speed wide area networks for UFPC so weâ€™re really pleased with that.
But, to be clear, while our sales teams are gaining some momentum, especially with the new products that I just mentioned, New Edgeâ€™s top line growth will remain under pressure. Weâ€™ll continue to work aggressively on the cost side of this business to keep expenses in line with the revenue trends. So, while our business services group is currently generating positive EBITDA and is modestly cash flow positive, we expect that things are not going to get easier or materially better over the next several quarters.
Clearly, this part of the business has not been the central part of our strategy or our future outlook. My objective for our business segment will continue to keep it at last neutral to our operating results while we ride out the current economic storm. When this storm passes I believe this business will be much healthier. Our business segment in fact could have real realizable value to our shareholders. Now, more than ever we have to continue our discipline of focusing on cash results in that business.
One last point Iâ€™d like to make before I turn the call over to Kevin for a more in depth review of the financial results. Iâ€™d like to underscore our very strong cash position. We ended the quarter with $485 million in cash. Thereâ€™s no question that our cash balance is a strategic weapon especially in this market environment. Now, letâ€™s turn the call over to Kevin who will take you through the details or our financial performance this quarter and our guidance for the remainder of 2008 and next year.
Kevin M. Dotts
Over third quarter and year to date results are recognition of the successful execution of our strategy launched in mid 2007. Over the past 12 months of more we have greatly simplified the consumer access business and eliminated several cash draining initiatives. We have focused our demand creation activities on channels where we can be confident we can add subscribers who tenure and value will be greater than the payback period needed to cover their acquisition costs.
We continue to maximize ARPU and the associated profit on our customer acquisition offers and [inaudible] offers to ensure we are acquiring and maintaining lifetime value positive customers. We have been able to successfully manage our cost structure to keep pace with the decline in the revenue curve. As a result we have increased profitability compared to prior year results and while we have realized results better than we expected coming in to this year we expect that aggregate subscriber revenue and profitability will continue to decline in to the foreseeable future.
Our current objective is to maximize the cash generated by keeping our EBITDA margins generally consistent with these results while we determine if there strategic opportunities available to use that will increase shareholder value. Our overall revenue for the quarter was $230.8 million, a 22.5% decrease from the third quarter of last year and a $14.8 million decrease from last quarter primarily driven by declines in narrow band subscribers.
As the company continues to transition through this group of early life higher churn subscribers that Rolla spoke about earlier we expect to realize further revenue contraction. As churn attenuates we also expect to see reductions in our passive subscriber gross additions. We believe that as a result of subscriber declines revenues could decrease in the same relative range through the next quarter.
While variable costs such as cost of revenue, customer support and bad debt should also decrease to offset some of the revenue declines. As we look forward to 2009 we expect the decline in revenue to attenuate. We also expect our cost structure declines to attenuate as variable costs become a lower percentage of our total cost structure. Related to the improvements in monthly subscriber churn that we previously discussed we continue to see the underlying quality and predictability of our subscriber base perform as expected.
As the maturity or our customer base continues to grow, these customers tend to be more engaged and use more of our service offerings. We were pleased that our value added services which includes search graphical advertising and security products on a per subscriber basis improved to $2.85 per month from $2.68 per month in the third quarter of 2007. The company should benefit from the increased tenure and predictability of the customersâ€™ behaviors and our ability to further monetize our interactions with them helping to offset some of the expected revenue declines.
Earthlink continues to maintain a high quality network access experience while simultaneously reducing network costs. However, gross margin did decrease approximately $10 million in the third quarter compared to the second quarter of 2008. We expect that our gross margin will continue to decline in the coming quarter in a similar range in rate. Earlier on the call Rolla spoke about the continued expected reductions in gross subscriber additions.
This is directly related to the significant reduction in sales and marketing expense which is down to $22 million for the third quarter, a 14% decline from second quarter of 2008 and down $49 million from the third quarter of 2007. However, going forward for the next several quarters as we see the level of gross adds moderate we expect a commensurate decline in sales and marketing expenses as success based bounties are expected to make up the greatest percentage of our spending in this area.
For the third quarter of 2008 this strong and ongoing focus on support costs reduction coupled with the reduced sales and marketing expenses resulted in adjusted EBITDA of $74 million, a $27 million improvement from the third quarter of 2007. As a result of the improvement in adjusted EBITDA this quarter Earthlinkâ€™s income from continuing operations was $55 million, or $0.49 per share compared to a loss from the continuing operations of $48 million or -$0.39 per share in the prior year third quarter representing a positive swing of $103 million year-over-year.
The prior third quarter results also included at least $42 million of equity losses for our proportionate share of [HELIO] operations which are no longer applicable to our 2008 results and $34 million of facility exit and restructuring costs related to our 2007 corporate restructuring plan. For the third quarter of 2008 Earthlink generated net income of $55 million or $0.49 per share compared the net loss of $79 million or -$0.65 per share in the third quarter of 2007. We used $2 million for capital expenditures and cash payments.
We used $2 million for capital expenditures and cash payments for subscriber based adds in the quarter compared to $19 million in the third quarter of 2007. Combined with the increase in adjusted EBITDA we generated $72 million of free cash flow during the third quarter 2008, up significantly from the $28 million generated in the third quarter of last year. Because of the free cash flow we generated offset by the $23 million used to repurchase 2.5 million shares our common stock we experienced a cash increase of $43 million in the third quarter 2008.
We ended the third quarter of 2008 with $485 million of cash and marketable securities. We will now provide an update on our outlook for 2008 and preliminary 2009 guidance. I will remind you that these statements are forward-looking and actual results may differ materially. The company undertakes no obligations to update these statements. Earthlink is revising and increasing its previously issued guidance for the remainder of 2008.
For the year, the company now expects to generate $290 million to $300 million in adjusted EBITDA. This adjusted EBITDA should also translate to $270 to $290 million of free cash flow as we now expect to incur between $10 million and $20 million of capital expenditures for the full year of 2008. Additionally, for 2008 Earthlink expects record income from continuing operations of $200 million to $210 million.
Now, I would like to provide our preliminary thoughts on 2009 given the secular trends in the access business, the macroeconomic environment and what we believe is the possibility given our ability to manage the cost structure of the business. Throughout 2008 Earthlink has realized financial results that were above our initial expectations. Much of this was driven by the fact that we entered 2008, we had little experience on what to expect from our customers and our people in a significantly simplified access business focused on maximizing cash flow.
Now with several quartersâ€™ worth of experience we can reflect on the better performance of passive subscriber additions, certain sales channels, the stable trend churn performance of our tenured customers, the cost benefits of a significantly tenured customer base and our peoplesâ€™ ability to reduce variable and fixed costs. Thus far the company has been successful in eliminating additional back office support costs to compensate for the declines in revenues and gross margins resulting in strong EBITDA performance.
On a go forward basis we do not anticipate the ability to implement the type of large scale reduction opportunities that we have seen over the past 12 months or so. Additional revenue and gross margin decline will continue to put pressure on Earthlinkâ€™s EBITDA compared to the levels the company has generated over the past three quarters. In addition we are currently in a very challenging and uncharted economic environment.
While the core consumer access business has not demonstrated any concerning trends to date our business services segment is seeing some moderate churn impact. As we look forward to 2009 our goal is to manage our adjusted EBITDA margin rate to be generally consistent with 2008 results. Our 2009 preliminary view is that we expect to record $210 million to $225 million in adjusted EBITDA. This adjusted EBITDA should translate to $180 million to $205 million of free cash flow.
For 2009 Earthlink expects income from continuing operations of $135 million to $155 million which includes a tax expense of $20 million to $25 million as a result of the utilization of net operating loss carry forwards. Actual cash taxes related to the alternative minimum tax will be $8 million to $10 million and monies paid under this simply extend our tax asset on a regular basis going forward. In early 2009 when we discuss 2008 final results weâ€™ll revisit these preliminary views for 2009. I would now like to turn the call back over to Rolla for some concluding remarks.
Rolla P. Huff
I wanted to spend a few minutes providing a little more insight in to how weâ€™re thinking about 2009 given the guidance that Kevin just shared with you. As he mentioned, we expect to deliver between $210 million and $225 million dollars in adjusted EBITDA next year. This guidance range reflects a few important points, primarily it represents our intention to keep our EBITDA margins generally in line with 2008.
Itâ€™s also based on the belief that churn will continue to be within the historical bands that we have been reporting. In taking in to account the volatility in the overall macroeconomic environment, we believe itâ€™s prudent to build in some potential for increased pressure on the revenue side in two specific areas. First, in a more difficult economy we see potential for increased potential for increased pressure on ARPU. We havenâ€™t seen it yet but we believe thereâ€™s clearly that potential.
The second area is within our business services division as I had mentioned earlier in my remarks. While we donâ€™t see any impact on churn currently on the consumer side we are already seeing it within our business services segment where our customer bankruptcies accounted to 30 to 40 basis points of increased churn in this quarter in the business services division. Weâ€™re preparing and accounting for the eventuality that this trend may continue in the year ahead.
At a high level next yearâ€™s focus is actually the same as this yearâ€™s focus, keeping our cost structure in line with revenue trends. Let me make one final point on that, if you recall I started my remarks today attributing our operating performance to the efforts of our employees. I think itâ€™s significant to note that during this third quarter we notified approximately 100 of our people that their positions would be eliminated in the coming months. We continue to make the difficult but essential decisions for our business and weâ€™re doing so by treating our employees with the respect that they have earned and deserve.
We treat our people the right way while they are with Earthlink and we treat them the right way in the event that we need to separate them from the business and weâ€™ve worked hard to create a transparency with our people and with you about what our business currently is and what itâ€™s not. You canâ€™t get through these situations and these times with spend. Our people know that weâ€™re not currently a growth business but that we are a business that has the potential to create meaningful value for them and for our shareholders if first and foremost weâ€™re aligned around taking care of the customers that we have while also being focused on the profitability.
Our people understand that we are not and will not be a venture capital fund regardless of our cash balance. They understand because we talk about it all the time and we talk about it very openly. Iâ€™m taking the time to tell you this because you should know that this is the cultural that is sustaining Earthlink. This is the culture thatâ€™s allowing us to post the results that we have today and providing us the opportunity to realize the meaningful long term cash creation that exists in this access business.
Itâ€™s a culture that I suspect a great many companies are going to have to learn to develop to survive the next several years. I guess you could say that we were blessed with being forced in to this by our business model to get a bit of a head start on this emerging reality. We continue to believe in the value and inevitability of consolidation in the narrow band segment. While we clearly believe Earthlink is the best position and most logical consolidator we support consolidation whether weâ€™re a buyer or a seller because the reality is itâ€™s the best way to maximize shareholder value with these kinds of assets.
But to be clear, until others in the industry are prepared to accept that reality there will not be consolidation and we believe the various shareholder groups will likely realize less value than they otherwise could have. We think thatâ€™s unfortunate for all shareholder groups. Earthlink will continue to aggressively exploration adjacent industries that that when combined with our business model and core competencies could create real operating synergies in shareholder value.
I hope by now no one doubts our commitment to running our business with discipline and in a way that creates shareholder value. Through stock buybacks weâ€™ve already returned a meaningful amount of cash to shareholders just in the past 12 to 16 months. Weâ€™ve been disciplined in our use of cash. Weâ€™ve not been out doing deals that create a risk reward profile that destroys long term shareholder value and believe me, those opportunities have been presented to us.
Weâ€™re taking the prudent steps to consider the strategic leverage our cash position creates especially in this time of financial crisis. The world has changed over the past month I think you all would agree, our relative equity valuation gap with others and adjacent industries has been substantially reduced while the relative strength of our balance sheet has substantially increased. Those two realities have expanded our options but have not at all changed by view about the need for us to be disciplined in our approach.
Again, if we can find no alternatives that provide scale, operating synergy and most importantly an acceptable risk adjusted return in a reasonable time frame, weâ€™ll happily pursue the process of continuing to return cash through stock buybacks and/or a more structured dividend process. Given the volatility debt markets the equity markets and actually the overall economy, I have to tell you I feel no rush about making decisions around deals or capital structure changes.
As I said on the last call weâ€™ll update you about our thinking on our year end call and I do expect to have at least a little more firmness around our plans at that time. With that, operator why donâ€™t we go ahead and open up the lines for any questions that might be out there.
Leveraging our expertise and experience in networking and I/O technology, we have approached the storage market opportunity with a networking perspective to maximize the performance and management capabilities of our solutions. We believe the performance results of our products are among the highest in the industry. Furthermore, our products support high performance connectivity features to enhance data integrity. Lastly, our products offer investment protection for our OEM customers, who often develop specialized software to interface to our adapters, as we have maintained a stable application programming interface (API) since our first generation of HBAs was introduced in 1996. More recently, we have expanded the functionality in our products to deliver high availability and remote centralized management that may be embedded in OEM and independent software vendors (ISV) SAN management products.
Our ability to compete depends in part upon our ability to protect our proprietary information through various means, including ownership of patents, copyrights, trademarks, and trade secrets, as well as through contractual provisions.
We have a number of issued patents and pending patent applications in the U.S. and abroad. Most of our issued patents and pending patent applications relate to our storage and networking technology or products. We maintain an active program of obtaining patent protection for our inventions as development occurs and as new products are introduced. As a result of the rate of change of technology in our industry, we believe that the duration of the patent protection available to us for our products is adequate to cover the expected market duration for such products.
All of our software, drivers, and firmware, which are embedded within or provided exclusively for use with our hardware products, are marked with copyright notices listing our company as the copyright owner. We have been granted a number of registrations of trademarks in the U.S. and abroad. We also have a number of pending trademark registrations in the U.S. and abroad. We maintain an active practice of marking our products with trademark notices. We have an active program of renewing trademarks so that the duration of trademark protection is maintained for as long as needed. Additionally, we rely on trade secret law and contractual provisions to protect unique intellectual property we possess which we have determined unnecessary or uneconomical to patent or copyright, or which is not otherwise capable of more formal protection.
Engineering and Development
At June 29, 2008, we employed 511 engineers, other technicians, and support personnel engaged in the development of new products and the improvement of existing products. Engineering and development expenses were approximately $129.2 million, $117.8 million and $89.7 million in 2008, 2007, and 2006, respectively.
Selling and Marketing
We sell our products worldwide to OEMs, end users, and through other distribution channels including value added resellers (VARs), systems integrators, industrial distributors, and resellers. As the storage networking market is dominated by OEMs, our focus is to use sales specialists to expand opportunities with our existing OEMs, as well as to develop new OEM relationships. However, we are also expanding our distribution efforts, leveraging worldwide distribution channels through technical distributors such as VARs and systems integrators, to complement our core OEM relationships. In some cases, OEM partners leverage the distribution channel to deliver solutions to end users, making our distribution efforts complementary with our OEM focused strategy.
Fred B. Cox
Chairman Emeritus of Emulex 74
Michael P. Downey(2)(3)
Private investor and executive consultant 61
Bruce C. Edwards(1)(2)
Executive Chairman Emeritus of Powerwave
Technologies, Inc. 55
Paul F. Folino
Executive Chairman of Emulex 63
Robert H. Goon(2)(3)
Don M. Lyle(1)(2)
Principal of Technology Management Company 69
James M. McCluney
Chief Executive Officer and President of Emulex 57
Dean A. Yoost(2)(3)
Financial Advisor 58
MANAGEMENT DISCUSSION FROM LATEST 10K
Certain statements contained in this Annual Report on Form 10-K may constitute â€śforward-looking statementsâ€ť within the meaning of the Private Securities Litigation Reform Act of 1995. We may also make forward-looking statements in other reports filed with the Securities and Exchange Commission, in materials delivered to stockholders and in press releases. In addition, our representatives may from time to time make oral forward-looking statements. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as â€śanticipates,â€ť â€śin the opinion,â€ť â€śbelieves,â€ť â€śintends,â€ť â€śexpects,â€ť â€śmay,â€ť â€świll,â€ť â€śshould,â€ť â€ścould,â€ť â€śplans,â€ť â€śforecasts,â€ť â€śestimates,â€ť â€śpredicts,â€ť â€śprojects,â€ť â€śpotential,â€ť â€ścontinue,â€ť and similar expressions may be intended to identify forward-looking statements.
Actual future results could differ materially from those described in the forward-looking statements as a result of a variety of factors, including those discussed in Managementâ€™s Discussion and Analysis of Financial Condition and Results of Operations set forth below, and, in particular, the section entitled â€śRisk Factorsâ€ť in Part I, Item 1A of the Annual Report on Form 10-K included elsewhere herein. We expressly disclaim any obligation or undertaking to release publicly any updates or changes to these forward-looking statements that may be made to reflect any future events or circumstances. We wish to caution readers that a number of important factors could cause actual results to differ materially from those in the forward-looking statements. In light of the uncertainty of the economy generally, and the technology and storage segments specifically, it is difficult to determine if past experience is a good guide to the future and makes it impossible to determine if markets will grow or shrink in the short term. In the past, our results have been significantly impacted by a widespread slowdown in technology investment that pressured the storage networking market that is the mainstay of our business. A downturn in information technology spending could adversely affect our revenues and results of operations. As a result of this uncertainty, we are unable to predict with any accuracy what future results might be. Other factors affecting these forward-looking statements include, but are not limited to, the following: slower than expected growth of the storage networking market or the failure of our Original Equipment Manufacturer (OEM) customers to successfully incorporate our products into their systems; our dependence on a limited number of customers and the effects of the loss of, or decrease or delays in orders by, any such customers, or the failure of such customers to make payments; the emergence of new or stronger competitors as a result of consolidation movements in the market; the timing and market acceptance of our or our OEM customersâ€™ new or enhanced products; the variability in the level of our backlog and the variable and seasonal procurement patterns of our customers; the effects of terrorist activities, natural disasters and any resulting political or economic instability; the highly competitive nature of the markets for our products as well as pricing pressures that may result from such competitive conditions; the effect of rapid migration of customers towards newer, lower cost product platforms; possible transitions from board or box level to application specific computer chip solutions for selected applications; a shift in unit product mix from higher-end to lower-end or mezzanine card products; a decrease in the average unit selling prices or an increase in the manufactured cost of our products; delays in product development; our reliance on third-party suppliers and subcontractors for components and assembly; any inadequacy of our intellectual property protection or the potential for third-party claims of infringement; our ability to attract and retain key technical personnel; our ability to benefit from our research and development activities; our dependence on international sales and internationally produced products; the effect of acquisitions; impairment charges; changes in tax rates or legislation; changes in accounting standards; and the potential effects of global warming and any resulting regulatory changes on our business. These and other factors which could cause actual results to differ materially from those in the forward-looking statements and from historical trends and are in addition to other factors discussed elsewhere in this Annual Report on Form 10-K, in our filings with the Securities and Exchange Commission or in materials incorporated therein by reference.
Emulex creates enterprise-class products that connect storage, servers and networks. We are a leading supplier of a broad range of advanced storage networking infrastructure solutions. The worldâ€™s leading server and storage providers depend on our products to help build high performance, highly reliable, and scalable storage networking solutions.
We rely almost exclusively on OEMs and sales through distribution channels for our revenue. Our OEM customers include the worldâ€™s leading server and storage providers, including Dell Inc. (Dell), EMC Corporation (EMC), Fujitsu Ltd. (Fujitsu), Fujitsu Siemens Computers (Fujitsu Siemens), Groupe Bull (Bull), Hewlett-Packard Company (Hewlett-Packard), Hitachi Data Systems (HDS), Hitachi Limited (Hitachi), International Business Machines Corporation (IBM), LSI Corporation (LSI), NEC Corporation (NEC), Network Appliance, Inc. (Network Appliance), Quantum Corporation (Quantum), Sun Microsystems, Inc. (Sun), Unisys Corporation (Unisys), and Xyratex Ltd. (Xyratex). Our distribution partners include Avnet, Inc. (Avnet), Bell Microproducts, Inc. (Bell Microproducts), Info X Technology Solutions (Info X), Ingram Micro Inc. (Ingram Micro), Macnica Networks Corporation (Macnica), Netmarks Inc. (Netmarks), Tech Data Corporation (Tech Data), and Tokyo Electron Device Ltd. (TED). The market for storage networking infrastructure solutions is concentrated among large OEMs, and as such, a significant portion of our revenues are generated from sales to a limited number of customers.
We believe that growth and diversification by investing in next generation storage networking infrastructure solutions is required in order to grow revenue, increase earnings, and increase shareholder value. Our growth and diversification strategy within our single business segment is driven through two market focused product lines â€” Host Server Products (HSP) and Embedded Storage Products (ESP). HSP includes both Fibre Channel based connectivity products and converged Fibre Channel and Ethernet based products. Our Fibre Channel based products include LightPulse Â® Host Bus Adapters (HBA), custom form factor solutions for Original Equipment Manufacturer (OEM) blade servers and ASICs. These products enable servers to efficiently connect to storage area networks (SANs) by offloading data communication processing tasks from the server as information is delivered and sent to the storage network. Our converged products include LightPulse Â® Converged Network Adapters (CNAs). CNAs efficiently move data between local area networks (LANs) and SANs using Fibre Channel over Ethernet (FCoE) to map the Fibre Channel protocol directly into the data layer of Ethernet networks.
ESP includes our InSpeed Â® , FibreSpy Â® , input/output controller (IOC) solutions, embedded bridge and embedded router products. Embedded storage switches, bridges, routers, and IOCs are deployed inside storage arrays, tape libraries, and other storage appliances, delivering improved performance, reliability, and storage connectivity.
Our Intelligent Network Products (INP) mainly consist of contract engineering services and our Other category mainly consists of legacy and other products.
We believe the product lines will benefit from the overall visibility and access to our total customer and market base, as well as our ability to leverage our core technology platforms to create products that are tailored to meet the specific requirements of their market. We plan to continue to invest in research and development, sales and marketing, capital equipment, and facilities in order to achieve our goal. As of June 29, 2008, we had a total of 853 employees.
2008 Global Initiatives
During the latter part of fiscal 2008, we continued to implement our global initiatives by creating an Irish subsidiary to expand our international operations by providing local customer service and support to our customers outside the United States. In addition, Emulex granted an intellectual property license and entered into a research and development cost sharing agreement with a newly formed subsidiary in the Isle of Man. The terms of the license requires, among other matters, that the subsidiary make prepayments of expected royalties to Emulex, the first of which was paid before the end of our fiscal 2008 in the amount of approximately $131.0 million, for expected royalties relating to fiscal years 2009 and 2010. The second payment will be paid during fiscal 2009, for expected royalties for fiscal years 2011 through 2014. Subsequent royalty payments or prepayments will be made relating to fiscal year 2015. Additionally, the cost sharing agreement became effective during the fourth quarter of 2008. While these global initiatives are expected to significantly reduce our effective tax rate beginning with fiscal year 2010, the first prepayment and cost sharing agreement expenses, including the tax expense recorded in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 48, â€śAccounting for Uncertainty in Income Taxes â€” An Interpretation of FASB Statement No. 109â€ť (FIN 48), resulted in an incremental tax expense of approximately $58.5 million and increased our effective tax rate to approximately 109% for fiscal 2008.
Our cash balances and investments are held in numerous locations throughout the world. Once our global initiatives are implemented, the cash and investments held outside of the U.S. are expected to increase, primarily in our Isle of Man subsidiary. Substantially all of the amounts held outside of the U.S. will be available for repatriation at any time, but under current law, repatriated funds would be subject to U.S. federal income taxes, less applicable foreign tax credits.
On October 2, 2006, we acquired 100% of the outstanding common shares of Sierra Logic, Inc. (Sierra Logic), a privately-held supplier of embedded products for storage networking equipment located in Roseville, California. We accounted for the acquisition using the purchase method of accounting in accordance with FASB Statement of Financial Accounting Standards (SFAS) No. 141, â€śBusiness Combinations.â€ť The aggregate purchase price was approximately $171.3 million, including approximately $137.6 million of cash for convertible preferred stock and common stock, approximately $7.4 million in assumed vested stock options and other transaction costs of approximately $2.0 million, and approximately $24.3 million in contingent consideration released from escrow in fiscal 2008. This aggregate purchase price did not include approximately $8.3 million in unvested stock and approximately $1.1 million of assumed unvested stock options that is being recognized as compensation expense post-acquisition. Final purchase price revisions for income taxes have been recorded during fiscal 2008.
On May 1, 2006, we acquired 100% of Aarohi Communications, Inc. (Aarohi), a supplier of intelligent data center networking products with principal product development facilities located in San Jose, California and Bangalore, India. We accounted for the acquisition of Aarohi under the purchase method of accounting in accordance with SFAS No. 141, and recorded approximately $17.3 million of purchased in-process research and development (IPR&D) expense during fiscal 2006.
The fair value of the net assets received by us in the Aarohi acquisition exceeded the purchase price to be allocated. Consequently, contingent consideration of approximately $1.0 million was recognized and was included in accrued liabilities during fiscal 2006. Certain performance targets were not achieved and thus, the contingent consideration of approximately $1.0 million previously recorded was reversed in fiscal 2007. The final purchase price revisions were also recorded in fiscal 2007 which resulted in changes to the fair value of assets acquired and liabilities assumed as well as a reduction to IPR&D expense in the statement of operations of approximately $2.6 million. We have finalized the purchase price allocation to the assets acquired and liabilities assumed at estimated fair values as of the end of fiscal 2007.
On November 13, 2003, we completed the cash tender offer to acquire all outstanding shares of Vixel Corporation (Vixel). On November 17, 2003, we completed our acquisition of Vixel. We acquired Vixel, a leading supplier of embedded switch ASICs and subsystems for the storage networking market, to expand our Fibre Channel product line and paid approximately $298.4 million in cash for all outstanding common stock, preferred stock, and warrants of Vixel. We also incurred acquisition related expenses of approximately $6.7 million in cash. In addition, we assumed Vixelâ€™s stock options outstanding by issuing approximately 2.2 million of our stock options with a fair value of approximately $47.5 million and kept the original vesting periods for a total acquisition value of $352.7 million. We calculated the fair value of the approximately 2.2 million stock options issued at the date of acquisition using the Black-Scholes-Merton options pricing model.
Since the completion of the acquisitions, the operations of Sierra Logic, Aarohi, and Vixel, have been integrated into our operations and are included within our one operating segment, networking products.
Convertible Subordinated Notes Offering
In fiscal 2004, we completed an approximately $517.5 million private placement of 0.25% contingently convertible subordinated notes due 2023 (Notes). Interest was payable in cash on June 15th and December 15th of each year beginning June 15, 2004. Under the terms of the offering, the Notes could be convertible into shares of Emulex common stock at a price of $43.20 per share at the option of the holder upon the occurrence of certain events.
The Notes provided for a scheduled maturity date 20 years following issuance and were not callable for the first five years. Holders of the Notes had rights to require us to purchase the Notes for cash by giving written notice within the 20 business days prior to each of December 15, 2006, December 15, 2008, December 15, 2013, or December 15, 2018 or upon a change in control.
On November 15, 2006, we announced the commencement of the put option period for holders of our Notes to surrender the Notes for purchase. Each holder of the Notes had the right to require us to purchase all or any part of such holderâ€™s Notes at a price equal to $1,000 per $1,000 of principal amount plus any accrued and unpaid interest, including additional interest, if any, to, but excluding, the date of purchase. At the end of the put option period on December 15, 2006, all such Notes were surrendered and we paid approximately $236.0 million to retire these Notes. No gain or loss occurred as a result of the retirement of these Notes. Thus, as of July 1, 2007, there were no Notes outstanding.
Results of Operations for Emulex Corporation and Subsidiaries
The following discussion and analysis should be read in conjunction with the selected consolidated financial data set forth in Item 6 â€” â€śSelected Consolidated Financial Data,â€ť and our Consolidated Financial Statements and notes thereto included elsewhere in this Annual Report on Form 10-K. All references to years refer to our fiscal years ended June 29, 2008, July 1, 2007 and July 2, 2006, as applicable, unless the calendar year is specified. The following table sets forth certain financial data for the years indicated as a percentage of net revenues.
Engineering and development expenses for fiscal 2008 compared to fiscal 2007 increased approximately $11.4 million, or 10%. Approximately $12.0 million and $12.9 million of share-based compensation expense were included in engineering and development costs in fiscal years 2008 and 2007, respectively. As a result of our ongoing growth and diversification strategy, we invested significantly in new product development and related headcount growth. Engineering and development headcount increased to 511 at the end of fiscal 2008 from 446 at the end of fiscal 2007. This expanded headcount resulted in an increase of approximately $7.9 million in salary and related expenses. The remaining incremental increase in engineering and development expenses during fiscal 2008 were primarily related to increases in expensed software costs of approximately $1.5 million, prototype expenses and third-party fees paid to consultants of approximately $1.2 million, and fiscal 2008 included a full year of the Sierra Logic acquisition. We will continue to invest in engineering and development activities and anticipate gross dollar expenditures will continue to grow in this area.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Certain statements contained in this Form 10-Q may constitute â€śforward-looking statementsâ€ť within the meaning of the Private Securities Litigation Reform Act of 1995. We may also make forward-looking statements in other reports filed with the Securities and Exchange Commission, in materials delivered to stockholders and in press releases. In addition, our representatives may from time to time make oral forward-looking statements. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as â€śanticipates,â€ť â€śin the opinion,â€ť â€śbelieves,â€ť â€śintends,â€ť â€śexpects,â€ť â€śmay,â€ť â€świll,â€ť â€śshould,â€ť â€ścould,â€ť â€śplans,â€ť â€śforecasts,â€ť â€śestimates,â€ť â€śpredicts,â€ť â€śprojects,â€ť â€śpotential,â€ť â€ścontinue,â€ť and similar expressions may be intended to identify forward-looking statements.
Actual future results could differ materially from those described in the forward-looking statements as a result of a variety of factors, including those discussed in Managementâ€™s Discussion and Analysis of Financial Condition and Results of Operations set forth below, and, in particular, those in the section entitled â€śRisk Factorsâ€ť in Part II, Item 1A of this Form 10-Q included elsewhere herein. We expressly disclaim any obligation or undertaking to release publicly any updates or changes to these forward-looking statements that may be made to reflect any future events or circumstances. We wish to caution readers that a number of important factors could cause actual results to differ materially from those in the forward-looking statements. In light of the uncertainty of the economy generally, and the technology and storage segments specifically, which have been in a state of uncertainty, it makes it difficult to determine if past experience is a good guide to the future and makes it impossible to determine if markets will grow or shrink in the short term. In the past, our results have been significantly impacted by a widespread slowdown in technology investment that pressured the storage networking market that is the mainstay of our business. Recent disruptions in world credit and equity markets and resulting economic uncertainty for our customers may result in a downturn in information technology spending that could adversely affect our revenues and results of operations. As a result of this uncertainty, we are unable to predict with any accuracy what future results might be. Other factors affecting these forward-looking statements include, but are not limited to, the following: slower than expected growth of the storage networking market or the failure of our Original Equipment Manufacturer (OEM) customers to successfully incorporate our products into their systems; our dependence on a limited number of customers and the effects of the loss of, or decrease or delays in orders by, any such customers, or the failure of such customers to make payments; the emergence of new or stronger competitors as a result of consolidation movements in the market; the timing and market acceptance of our or our OEM customersâ€™ new or enhanced products; the variability in the level of our backlog and the variable and seasonal procurement patterns of our customers; the effects of terrorist activities, natural disasters and any resulting political or economic instability; the highly competitive nature of the markets for our products as well as pricing pressures that may result from such competitive conditions; the effect of rapid migration of customers towards newer, lower cost product platforms; possible transitions from board or box level to application specific computer chip solutions for selected applications; a shift in unit product mix from higher-end to lower-end or mezzanine card products; a decrease in the average unit selling prices or an increase in the manufactured cost of our products; delays in product development; our reliance on third-party suppliers and subcontractors for components and assembly; any inadequacy of our intellectual property protection or the potential for third-party claims of infringement; our ability to attract and retain key technical personnel; our ability to benefit from our research and development activities; our dependence on international sales and internationally produced products; the effect of acquisitions; impairment charges; changes in tax rates or legislation; changes in accounting standards; and the potential effects of global warming and any resulting regulatory changes on our business. These and other factors which could cause actual results to differ materially from those in the forward-looking statements are discussed elsewhere in this Form 10-Q, in our filings with the Securities and Exchange Commission or in materials incorporated therein by reference.
Emulex creates enterprise-class products that connect storage, servers and networks. We are a leading supplier of a broad range of advanced storage networking infrastructure solutions. The worldâ€™s leading server and storage providers depend on our products to help build high performance, highly reliable, and scalable storage networking solutions. Our products and technologies leverage flexible multi protocol architectures that extend from deep within the storage array to the server edge of storage area networks (SANs). Our storage networking offerings include host bus adapters (HBAs), converged network adapters (CNAs), mezzanine cards for blade servers, embedded storage bridges, routers, and switches, storage Input/Output controllers (IOCs), and data center networking solutions. HBAs, CNAs, and mezzanine cards are the data communication products that enable servers to connect to storage networks by offloading communication processing tasks as information is delivered and sent to the storage network. Embedded storage bridges, routers, and switches and IOCs are deployed inside storage arrays, tape libraries and other storage appliances.
We rely almost exclusively on OEMs and sales through distribution channels for our revenue. Our OEM customers include the worldâ€™s leading server and storage providers, including Dell Inc. (Dell), EMC Corporation (EMC), Fujitsu Ltd. (Fujitsu), Fujitsu Siemens Computers (Fujitsu Siemens), Groupe Bull (Bull), Hewlett-Packard Company (Hewlett-Packard), Hitachi Data Systems (HDS), Hitachi Limited (Hitachi), International Business Machines Corporation (IBM), LSI Corporation (LSI), NEC Corporation (NEC), Network Appliance, Inc. (NetAp), Quantum Corporation (Quantum), Sun Microsystems, Inc. (Sun), Unisys Corporation (Unisys), and Xyratex Ltd. (Xyratex). Our distribution partners include Avnet, Inc. (Avnet), Bell Microproducts, Inc. (Bell), Info X Technology Solutions (Info X), Ingram Micro Inc. (Ingram Micro), Macnica Networks Corporation (Macnica), Netmarks Inc. (Netmarks), Tech Data Corporation (Tech Data), and Tokyo Electron Device Ltd. (TED). The market for storage networking infrastructure solutions is concentrated among large OEMs, and as such, a significant portion of our revenues are generated from sales to a limited number of customers.
Our Company operates within a single business segment that has two market focused product lines â€” Host Server Products (HSP) and Embedded Storage Products (ESP). HSP includes both Fibre Channel based connectivity products and converged Fibre Channel and Ethernet based products. Our Fibre Channel based products include LightPulseÂ® Host Bus Adapters (HBA), custom form factor solutions for Original Equipment Manufacturer (OEM) blade servers and ASICs. These products enable servers to efficiently connect to storage area networks (SANs) by offloading data communication processing tasks from the server as information is delivered and sent to the storage network. Our converged products include LightPulseÂ® Converged Network Adapters (CNAs). CNAs efficiently move data between local area networks (LANs) and SANs using Fibre Channel over Ethernet (FCoE) to map the Fibre Channel protocol directly into the data layer of Ethernet networks.
ESP includes our InSpeedÂ®, FibreSpyÂ®, input/output controller (IOC) solutions, embedded bridge and embedded router products. Embedded storage switches, bridges, routers, and IOCs are deployed inside storage arrays, tape libraries, and other storage appliances, delivering improved performance, reliability, and storage connectivity.
Our Intelligent Network Products (INP) mainly consist of contract engineering services and our Other category mainly consists of legacy and other products.
We plan to continue to invest in research and development, sales and marketing, capital equipment, and facilities in order to achieve our goals. As of September 28, 2008, we had a total of 794 employees.
Our corporate headquarters are located at 3333 Susan Street, Costa Mesa, California 92626. Our periodic and current reports filed with, or furnished to, the Securities and Exchange Commission pursuant to the requirements of the Securities and Exchange Act of 1934 are available free of charge through our website ( www.emulex.com ) as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. References contained herein to â€śEmulex,â€ť the â€śCompany,â€ť the â€śRegistrant,â€ť â€śwe,â€ť â€śour,â€ť and â€śusâ€ť refer to Emulex Corporation and its subsidiaries.
We continued to implement our global initiatives during the latter part of fiscal 2008 by creating an Irish subsidiary to expand our international operations by providing local customer service and support to our customers outside the United States. In addition, Emulex granted an intellectual property license and entered into a research and development cost sharing agreement with a newly formed subsidiary in the Isle of Man. The terms of the license require, among other matters, that the subsidiary make prepayments of expected royalties to Emulex, the first of which was paid before the end of our fiscal 2008 in the amount of approximately $131.0 million, for expected royalties relating to fiscal years 2009 and 2010. The second payment will be paid during fiscal 2009, for expected royalties for fiscal years 2011 through 2014. Subsequent royalty payments or prepayments will be made relating to fiscal year 2015. Additionally, the cost sharing agreement became effective during the fourth quarter of 2008. While these global initiatives are expected to significantly reduce our effective tax rate beginning with fiscal year 2010, the first prepayment and cost sharing agreement expenses, including the tax expense recorded in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 48, â€śAccounting for Uncertainty in Income Taxes â€” An Interpretation of FASB Statement No. 109â€ť (FIN 48), resulted in an incremental tax expense of approximately $58.5 million and increased our effective tax rate to approximately 109% for fiscal 2008. The second prepayment, which is anticipated to be paid during fiscal 2009, is expected to result in an incremental tax expense of approximately $34.4 million and increase our effective tax rate to approximately 77% for fiscal 2009.
Our cash balances and investments are held in numerous locations throughout the world. Once our global initiatives are implemented, the cash and investments held outside of the U.S. are expected to increase, primarily in our Isle of Man subsidiary. Substantially all of the amounts held outside of the U.S. will be available for repatriation at any time, but under current law, repatriated funds would be subject to U.S. federal income taxes, less applicable foreign tax credits.
Three months ended September 28, 2008, compared to three months ended September 30, 2007
Net Revenues. Net revenues for the first quarter of fiscal 2009 ended September 28, 2008, decreased by approximately $5.4 million, or 5%, to approximately $111.7 million, compared to approximately $117.1 million for the same quarter of fiscal 2008 ended September 30, 2007.
HSP mainly consists of our Fibre Channel based connectivity products and converged Fibre Channel over Ethernet based products. The decrease in our HSP net revenue for the three month period ended September 28, 2008 compared to the three month period ended September 30, 2007 was mainly due to a decrease of approximately 10% in average selling price partially offset by an increase of approximately 2% in units shipped.
ESP mainly consists of our InSpeedÂ®, FibreSpyÂ®, input/output controller solutions, embedded bridge, and embedded router products. The increase in our ESP net revenue for the three month period ended September 28, 2008 compared to the three month period ended September 30, 2007 was mainly due to an increase in units shipped of approximately 13% partially offset by a decrease in average selling price of approximately 4%.
Our INP mainly consists of contract engineering services and our Other category mainly consists of legacy and other products.
Thank you, operator. Good afternoon, and welcome to Emulex's first quarter fiscal year 2009 conference call. I'm Jim McCluney, CEO and President of the company, and with me today are Jeff Benck, our COO, Mike Rockenbach, our CFO, and Steve Berg, our Senior Vice President of Corporate Development.
Mike Rockenbach will start off our prepared remarks with the first quarter 2009 results. I will follow with my comments in the quarter and a discussion of our markets, and Jeff will talk about our progress on the company's operating plan. After that we'll provide some concluding remarks and we'll open the line for questions. Over to you, Mike.
Thanks, Jim. By now you should all have Emulex's first quarter 2009 earnings release which was issued earlier this afternoon. If you do not have a copy, the press release is available in the Investor Relations section of our website at www.Emulex.com. The press release in this presentation contains forward-looking statements including but without limitation statements regarding Emulex's business, operations and anticipated financial results for the second quarter of fiscal 2009 and beyond. These statements are subject to risks and uncertainties and our actual results may differ materially from those discussed in the forward-looking statements.
Those risks and uncertainties include: economic conditions, market growth, IT spending patterns, changes in technology, evolving industry standards, competitive pressures, pricing pressures and fluctuations in OEM ordering patterns, the estimate of total available market size, ability to address these markets with available technology in a timely fashion, research and development activities, the inability to achieve the expected benefits from our globalization initiatives and the risks and uncertainties described in Emulex's SEC reports filed under the Securities Exchange Act of 1934 including forms 8K and under the heading risk factors in Emulex's most recently annual report Form 10K and quarterly reports on Form 10Q.
We undertake no obligation to update the forward-looking statements. Investors should also be aware Emulex will not disclose in its Q&A or in conversations afterwards any material financial data that is not already disclosed in its conference call or its press release.
In addition, during this call, when we use any historical non-GAAP financial measure as defined by the SEC in Reg G you will find reconciliation to the most directly comparable GAAP financial measure in our press release available on our investor relations websites. All the references we make today will be in relation to our non-GAAP results unless stated otherwise. Today's conference call is being webcast and the recording will be available on the Emulex website through October 2009. I would also like to remind participants if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording.
Sales for the first quarter ended September 28, 2008, totaled $111.7 million, a decrease of 5% from the prior year's quarter and 1% sequential decline. Q1 fully diluted earnings per share of $0.22 decreased by 19% from the $0.27 reported in the first quarter of the prior year, however EPS was flat sequentially with $0.22 reported in the prior quarter. Our top line results of $111.7 million were slightly above the high end of our first quarter guidance of $108 million to $111 million and our fully diluted EPS of $0.22 exceeded the high end of guidance of $0.18 to $0.20.
Now, let me discuss the revenue results for the quarter by product line. Beginning with host server products or HSP, which consists primarily of standard host adapters, converge network adapters or CNAs, custom form factor mezzanine cards to blade servers and ASICs used in server applications. HSP revenues totaled $81.2 million, a decline of 9% from the first quarter of last year, and down 4% sequentially.
Revenue from board level products for the first quarter declined 9% year-over-year however units increased 3% and ports grew by 11%. Sequentially ports for our HSP board level products declined by 2%, units declined by 3% and revenues decreased by 5% from the fourth quarter. On a sequential basis ASPs declined by 3%. The average selling price for board level products including both standalone HBAs, CNAs and mezzanine cards declined 12% year-over-year which is in line with our expected annual ASP decline rate of 12% to 15%.
Dual channel mix increased slightly on a sequential basis now representing more than 45% of fiber channel HBA revenues. We continue to experience good revenue growth on mezzanine cards for the blade server market with revenue growth of 5% sequentially and over 70% year-over-year. With our blade server mezzanine cards continuing to show significantly faster growth in the market, we believe these results are a clear indication that we are building momentum for share gains in this important market.
Finally, HSP ASICs revenues nearly doubled sequentially, partially offsetting the decline in our board level products as one of our OEM customers continue to show strength from a server refresh during the quarter. Our second product line embedded storage products, or ESP, encompasses SATA bridges and routers, fiber channel embedded SOCs and route switchers as well as single and multiprotocol embedded controller products for enterprise class storage systems.
ESP revenues for the first quarter totaled $30.4 million, representing an increase of 7% sequentially and 8% over the prior year's period. Our embedded products increased to 27% of total revenues coming in slightly ahead of our expectations. This is up from 25% in the fourth quarter and 24% in the Q1 of last year. We have provided a geographical and customer breakdown for our revenues and supplemental information in our press release.
As we further discuss the income statement I'd like to remind you we would be primarily discussing our non-GAAP results unless otherwise noted. You'll find in our press release a reconciliation of the difference between our GAAP and non-GAAP earnings, as well as discussion of why we believe non-GAAP financials are relevant measure for our business for investors.
First quarter gross margins of 67% were in line with our expectations for the quarter and we expect to show comparable margins for the second quarter. As we previously discussed over the next several years we expect our embedded products and our mezzanine cards will grow faster than standard HBAs, accordingly we're modeling business with the expectation that over time our gross margins will trend down as these lower margin products become a larger portion of our revenues. While we expect some benefit from our recent shift to contract manufacturers to Thailand and the continued growth of dual channel HBAs during the December quarter, we expect gross margins will start to trend down as we enter into calendar year 2009.
Turning to operating expenses, during the first quarter OpEx decreased 4% sequentially to $49.9 million. Expenses decreased as a percent of revenue to 45% compared to 46% in the prior quarter. As you may recall from our remarks during the August earnings call it is our intention to keep our expenses aligned with revenue expectations. We did make some changes within the organization that resulted in a reduction of our total headcount. We exited the first quarter with a total of 794 employees, a net decrease of 59 people from Q4. Jim and Jeff will provide more color on these changes.
With our focus on managing our expenses Q1 operating income of $25.3 million was up 2% sequentially coming in at 23% of revenues compared to 22% in the fourth quarter. However, on a year over year basis, operating margin was down about four percentage points resulting lower revenues and higher operating expenses which were partially offset by improved gross margin contribution.
Other income increased slightly sequentially coming in at $2.2 million due to favorable exchange gains offsetting lower interest income. With the goal of principal protection, we continue to invest in short term government backed investments which while secure have relatively low interest rate. With our lower cash balances, we anticipate interest income in Q2 will be approximately $1.8 million. First quarter net income was $17.9 million about flat sequentially and a decrease of 22% from the prior year results.
Our tax rate for the quarter was approximately 35% compared to 37% we modeled in our August call. The 35% reflect the benefit from our international operations which we expect will continue throughout fiscal 2009. Our net profit margin for the quarter was 16% which was essentially flat with the prior quarter but down from the 19% reported in the first quarter last year.
For the first quarter on a GAAP basis, we report operating income of $9.2 million, net income of $7.1 million and diluted EPS of $0.09. The difference between GAAP and non-GAAP income in the first quarter is primarily attributable to amortization of intangibles, stock-based compensation and settlements from associated costs. FAS 123(R) expense reduced $0.06 per diluted share this quarter.
On a GAAP basis Q1 R&D expenditures increased 4% sequentially to $34.8 million compared to $33.4 million in the fourth quarter. Q1 R&D ended at $3.1 million in stock-based compensation. Quarterly R&D spending varies, depending on the time your new product development expenses however with the actions taken in the first quarter R&D spending excluding stock-based compensation was essentially flat.
First quarter GAAP sales and marketing expenses were $14.5 million compared to $15.7 million in the prior quarter, Q1 sales and marketing expenses included $1 million of stock-based compensation. GAAP G&A expenses decreased sequentially to $9.4 million from the $11.5 million reported in Q4, and this includes $2.3 million of stock-based compensation.
Turning to the balance sheet, we exited the first quarter with total cash investments of $294 million, this represents a decrease of $56 million from the end of the fourth quarter. The decrease in cash reflects approximately $41 million [ph] in tax payments primarily associated with our globalization initiatives, we also spent approximately $40 million completing our share repurchase program approved in 2006. We are now expecting our share count to be 82 million shares in the second quarter.
First quarter inventories were relatively flat essentially at $19.4 million, and our inventory turns of 8.6 were comparable to Q4 levels and remain in the low end of our target range of eight to 10 turns. Our Q1 receivables decreased sequentially by $4.7 million to $56.9 million compared to a revenue decrease of only $1 million. Depreciation in the first quarter increased slightly to $5.3 million compared to $5.1 million in the fourth quarter, and capital expenditures decreased in Q1 to $7.6 million compared to $10.1 million in the fourth quarter.
Before I discuss our targets for the second quarter of fiscal 2009, I want to again remind everyone there are numerous risks that can affect our future performance, causing actual results to differ materially from forward-looking statements. These risks are noted in our public filings with the SEC and the Safe Harbor statement at the end of our earnings press release. As a result of these risks and uncertainties we're unable to predict with accuracy what future quarterly results might be and there's no guarantee business will reach our expectations or goals.
Based upon current market conditions our customers public comments and our most recent forecasts, we believe that revenue for the second quarter ending December 28, 2008, could amount to approximately $111 million to $116 million, which represents a sequential change of essentially flat to up 4% and decline of 11% to 15% from the prior year second quarter. If we achieve revenue in this range we anticipate non-GAAP earnings per diluted share of $0.20 to $0.23, assuming a 35% tax rate.
Our press release provides a reconciliation of GAAP to non-GAAP financials. I'll now turn the call over to Jim, who will give you our overview of our progress, some color on the quarter and update on the company strategy.
Thanks, Mike. Overall I'm pleased with what with accomplished during Q1. We executed well in what has been a very challenging environment delivering $111.7 million in revenue and $0.22 of EPS, $0.03 above first call estimates. However, there should be no surprise to anyone for the series of dramatic events in the financial services sector over the past several quarters has had an impact of spending on key market vertical.
In addition it appears that the distress in the credit and equity markets are spilling over into the broader economy causing a drag on IT spending. It is difficult to assess the degree to which the ongoing disruption will impact our business but budget tightening and purchasing delays are already being felt and is likely to extend beyond 2008 and into 2009. The corresponding reduction in visibility across the entire business has led us to increase our guidance ranges for the December quarter.
Looking to our business by product line, HSP revenue of $81.2 million declined 9% from the same quarter last year from 4% sequentially. Although we continue to be impacted by softness in spending, along with the shift in end-user buying patterns leaning more towards server OEMs from storage OEMs, where we have traditionally been dominant, HSP revenues were in line with expectations for the first quarter.
As we discussed in our August earnings call, Emulex has achieved a broader range of qualifications than ever before at key server OEMs, such as IBM, HP, Sun and Dell. In addition over the past several months we have moved to rebalance our resources towards several vendors under corresponding distribution channels. While we still have not reached the point for several OEM revenues increase have fully offset the decline on the storage side, we are making progress. We are highly focused on regaining share in this market and Jeff will discuss this further during his remarks.
Turning to ESP, revenue came in at $30.4 million up 8% year-over-year and 7% sequentially, performing a little better than we had modeled. Over the past year, the results in this business have been choppy as a large number of new product launches went to market roughly the same time.
In recent quarters we're seeing demand for these new products stabilize somewhat as end user sales rather than stocking orders have become the main driver. Our goals for ESP are to grow revenue by capitalizing on current design wins to take advantage of increasing number of bridging opportunities to support upcoming transitions in disk formats and protocols and to execute on the new systems and solutions businesses that we have won.
Switching topics, let me update you on some of the plans we shared with you last quarter to get the business back on the right track, regain share, and drive long-term diversification and growth.
During the quarter we took action to reduce spending to be more in line with the comp revenue outlook. The more significant and immediate stand we took was to lower head count. Emulex exited Q1 with 794 employees, compared to the 853 we had at the end of Q4. While the reduction in force is tough for any company, it was very well managed and it was the right choice for the health of the business, and also prudent given the environment we are in today. We will remain in close control of variable expenses and tightly manage capital outlays [ph].
We continue to align our business more closely with our customers and opportunities for growth on a global basis. This includes reshaping and expanding our global supply chain and sales and marketing capabilities. We recently opened up a new international headquarters in Ireland to coordinate these activities and we expect the transition associated with this expansion to be substantially completed by the end of the calendar year.
During the first quarter, we also increased our footprint in the Asia-Pacific region, we added a sales office in Japan supporting the key OEM customers. We also recently doubled the space in our Bangalore engineering design center allowing us to expand our international R&D capabilities. These globalization efforts will help us better service our customers, tap into our broader engineering resource space, create a more efficient corporate structure and expand the platform for which to access faster growing emerging markets. And lastly we took steps to improve demand visibility. We're now working even more closer with the customers and manufacturing partners to improve real time access to the data we need to better manage our business.
Now, let me turn to my overall expectations for the coming quarters. As I mentioned at the outset, the IT spending environment has eroded over the past several quarters with some fairly dramatic forecast revisions during recent months. The most common (inaudible) model forecast IT spending budgets to grow 2.3% in 2009, down from the previous forecast of 5.8%. This comes off an already weak 2008 number resulting from a series of downward revisions that started in the back half of 2007.
On the bright side a recent survey I read suggests that storage is expected to be the strongest category of IT spending. So while the near term visibility is challenging, I believe Emulex is well positioned from a marketing perspective to weather the storm.
From a financial model perspective, there are a couple of additional positives. During the past quarter we were active in the open market completing the last $40 million of a share repurchase program we put in place in December 2006. During the past two years we have purchased over eight million shares or approximately 10% of our total outstanding. Looking forward the board has approved a follow-on program which authorizes an additional 100 million [ph] of share repurchases. Our reduced share count and lower effective tax rate resulting from international expansion will be a boost to EPS performance over time.
Looking beyond calendar 2008, we're staying focused on key strategic initiatives. We're investing internally on innovative new business opportunities that will help fuel revenue expansion in the years to come. We are leveraging our global initiatives to tap into high growth emerging markets, better align ourselves with our partners and customers and we are broadening both our customer base and product set to drive diversification. So with that, let me turn this over to Jeff for some more color on the operations this quarter and business opportunities for the rest of fiscal 2009.
Thanks, Jim. The target we set for ourselves last quarter was to make sure that the organization was aligned at three objectives, which are: efficient execution, growth and diversification, and market leadership. The first topic I want to comment on is efficient execution. We completed a significant restructuring across our operations during the first quarter. One objective of the restructuring was the speed decision making and we accomplished this by flattening the organization and removing some management layers. A result of these changes was a 7% reduction in work force.
We managed through this change without disrupting our road maps, customers or performance in the quarter. While there has been some additional erosion in IT spending projections in recent weeks, we believe that we have taken the correct action to keep spending in line with our business model.
A further objective of the restructuring was to create cohesive and dynamic marketing and sales organization. We intend to improve marketing effort by spending our dollars more effectively to provide market share leverage and mind share with IT decision-makers. We recently added resources charged with building more dynamic marketing plans, improving our collateral and revamping our web presence. Beyond these actions we also shifted additional sales head count to our server OEMs and added resources to tap into higher growth emerging markets.
Turning to the topic of growth and diversification, I would first like to share some details on our international expansion strategy. Our plan includes redistributing our operations throughout the world with a specific focus on growing our presence in EMEA and Asia Pacific. From a sales perspective we have had some early success in adding and converting key resellers in Europe to bolster our presence and we expect these relationships to expand with our sales and marketing focus in these geographies.
In manufacturing operations we have moved more of our production closer to where demand for our products is growing. We've been supplying products to benchmark Malaysia for the past several years and during the first quarter we transitioned manufacturing from benchmark Mexico to benchmark Thailand.
At the beginning of October our new international headquarters in Ireland came online with more than 50% of revenues outside of the US including over 30% in the EMEA, this operation is a key part of our commitment to providing regional support to our customers. Our diversification strategy is supported by new efforts that are being incubated internally, and as we have done in the past, we will continue to pursue strategic partnerships to create new solutions in the market.
We also see a unique opportunity with our CNAs to pursue incremental business in the data networking space that is created by convergence. Furthermore, our new system and solutions business allows us to add more value to our storage OEMs offerings and correspondingly grow our business with them.
The third objective I'd like to discuss is market leadership. When I spoke to you last quarter, I commented that a strong product set is essential for accomplishing our goal of market share growth. Emulex continues to have a solid flow of product announcements, qualifications, partnerships and design wins.
We remain well positioned for the fiber channel transition and see deployment and certification momentum continuing over the next few quarters. We expect this revenue to ramp throughout fiscal 2009, as these design wins go into production. In the first quarter we announced that Sun is selling Emulex 8Gb HBAs across its SunFire [ph] enterprise server families and storage tech solutions. We also announced that NetApp is now shipping Emulex 8GB HBAs with its NetApp storage systems and Hitachi data systems is shipping our 8Gb HBAs with its enterprise new range storage platforms.
In that addition, our CNAs are off to a strong start. For end users of converged network, which uses the SCOE protocol translates into less complexity, lower power consumption and lower management costs. We are leveraging our fiber channel technology to allow a seamless user migration path providing for investment protection and allowing the use of existing SAN management tools. We're now shipping first generation LP21000 family of converged network adapters, which were qualified in Q1 by NetApp, EMC and VMware.
Turn to go our embedded storage business, in the first quarter we were pleased do announce Pillar Data Systems has deployed our Emulex embedded storage switches across its complete line of axiom storage systems. We also announced that 3PAR selected our fiber channel bridge for use within three part in serve storage servers.
Over the next several quarters we expect a strong flow of additional 8Gb HBA and mezz card qualifications, embedded system design-ins and CNA launches. We are also working with a number of software partners on security and virtualization solutions. In fact, VMware announced us during their alliance affiliate initiative as the only connectivity partner in the program. As you can see, there is a lot of new activity in this space. Clearly the near-term environment is cautious, but the cost and power savings of the converged network is compelling.
Our investments today in these emerging areas will enable a suite of multiprotocol products and services that will be the drivers for our future growth. While we have accomplished a lot in the past 90 days to strengthen execution, drive expansion and diversification, and improve market leadership, we still have work to do to regain share. While we have gained modest share in the blade server and X86 market, our share still lags the competition.
In response to the shift in buying patterns from storage OEMs toward server OEMs, we are redoubling our efforts to focus on these customers and their global distribution channels. The 8Gb transition coupled with marketing plans should drive gains over the coming quarters.
In summary, we have made progress on some new initiatives and we are moving in the right strategic direction. We will leverage our collective strength across the company from our host product lines to our embedded storage business into new products and markets. We will play a vital role in connecting our clients to their critical information across multiple protocols from server to storage device.
With over 25 years of history connecting servers and storage, our experience and thought leadership will drive innovation. In the coming months we will focus on increasing our brand awareness and share our vision of data center evolution. We are anticipating some new inflection points and we're building the technologies and solutions required to be successful in this new realm. At this point, let me pass it back to Jim.
Thanks, Jeff. Let me conclude with some key summary points. Our September results were in line with our expectations, if not a little better, the December quarter guidance of $111 million to $116 million in revenue and $0.20 to $0.23 in diluted EPS, is reflective of more muted seasonal growth resulting from the challenging marketing environment.
We remain committed and focused on overall business strategy and will continue to ensure the investments we are making deliver value to shareholders. We will maintain a balanced investment in our existing products, as well as in the new trends for the data center that take advantage of our expertise. We are also broadening our product portfolio and expanding our global reach into faster-growing markets, all of which will strengthen our growth prospects and reduce our business risk with a profitable business, with a strong balance sheet, an excellent customer base and loyal employees, all of which positions us to come through this uncertainty in good shape.
That concludes our prepared remarks, and so with that, we have time to take questions. Operator, please go ahead and open the line.