LSI Puts New Look to the Test

The reinvented company faces a tough battle with a new focus on hard-drive chips.
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SAN FRANCISCO -- The ghosts of 2007 still haunt

LSI

(LSI) - Get Report

and its shareholders.

Last year, the chipmaker saw its shares collapse 41% in the wake of the $4 billion merger with

Agere Systems

and investor fears about grim prospects for the broader semiconductor industry.

By most estimates, the chip industry's outlook has only gotten worse. But LSI Chief Executive Abhi Talwalkar reckons the company's future is brighter than ever.

Having completed the

challenges of integrating Agere

,

shedding unwanted product lines

and moving to fully outsource its manufacturing operations, LSI is ready to showcase the benefits of its metamorphosis.

LSI Re-Invents Itself

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"We have been aggressively and decisively repositioning the company," says Talwalkar.

Quarterly operating expenses are almost $60 million lower than before the restructuring, and the company is now focused exclusively on the storage and networking markets.

And after last year's shellacking, Talwalkar says LSI's stock is now outperforming many of its peers. LSI shares, which closed at $4.96 Friday, are down roughly 5% year to date, compared with the double-digit declines suffered by the

Nasdaq Composite

, the

Dow Jones Industrial Average

and the

Philadelphia Stock Exchange Semiconductor Sector Index

so far this year.

To truly prove its mettle though, the Milpitas, Calif., chipmaker will have to take on a couple of formidable foes that presents Talwalkar, and his reinvented LSI, with its biggest test yet.

In the market for PC hard disk drive chips, which is now among LSI's key product lines, the company is contending with heavyweights

Texas Instruments

(TXN) - Get Report

and

Marvell Tech

(MRVL) - Get Report

. The latter has risen to become the No. 1 provider of hard-drive SOCs, or systems-on-a-chip, which include the read-channel that decodes the bits of data stored on a disc drive.

"Marvell has always been the engineering guru with the best engineers and design team, led by

co-founder and CEO Sehat

Sutardja," says Friedman, Billings, Ramsey analyst Craig Berger.

But Berger and other analysts believe that LSI will give Marvell a tougher fight now that it has combined its technology with Agere's and sharpened its focus on hard-drive chips. LSI now offers a full menu of hard drive chips, manufactured, like Marvell's chips, with 65-nanometer circuits -- the industry's leading edge.

"It gives the customers a little more confidence in order to use them

LSI for the long term, because these customers want roadmaps and things like that," says Berger.

Hard-drive companies may also see a benefit in diversifying their supply base, similar to the way cell phone makers have begun to

work with chip firms besides Texas Instruments

for the handset's baseband processor.

"I don't think anyone's a lock longer term," says Kaufman Brothers analyst Suji de Silva, who rates LSI a buy. "Original equipment manufacturers would like to look for competitive solutions to make sure that they themselves are gaining share."

As it stands, LSI is tight with hard-drive maker

Seagate

(STX) - Get Report

, while Marvell counts

Western Digital

(WDC) - Get Report

and virtually all the other hard drive makers in its camp of customers.

That gives LSI plenty of market share to go after, although the nature of the business means that any gains may take 12 months or more before they show up on LSI's income statement.

LSI also is looking at inorganic ways of gaining market share, such as

its recent purchase

of

Infineon's

(IFX)

hard-drive chip business, which will deliver hard-drive maker

Hitachi Global Storage Technologies

as a customer.

And CEO Talwalkar says the company is evaluating new markets like flash memory-based solid state hard drives (see video).

Wall Street is currently taking a wait-and-see attitude about LSI's turnaround -- 8 of the 15 analysts covering the company rate it a neutral.

One cause for concern is LSI's networking business -- a large chunk of that product line is considered long in the tooth. And at 14.5 times estimated 2008 earnings, the stock is cheap, but not dirt cheap.

"It's a wash for me," says Friedman's Berger, who rates Marvell a neutral.

Like any tech company these days, LSI is facing a bumpy road ahead as a slowing U.S. economy threatens sales of computers, software and other digital goods. Analysts expect spending on technology -- from consumer purchases of gadgets to corporate expenditures on capital equipment -- to slow in 2008.

But with about 80% of its revenue tied to storage, LSI may enjoy some stability in a bad economy. While flat screen TVs, smartphones and MP3 players are all purchases that consumers can hold off on when money is tight, email and Internet-based content continues to shape modern society -- the need to store data, particularly among corporations, isn't going away.

That said, a recent survey by Goldman Sachs found that enterprise hardware -- a category that includes PCs, servers and storage -- was the top pick of corporate information technology managers looking for ways to cut costs in the next 12 months.

"No segment is totally recession-proof from a tech standpoint, but I would argue that storage ... is going to continuously require upgrades," says Talwalkar.

LSI has undergone its own upgrade under Talwalkar. Now investors will get a chance to judge the improvement.