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Fairchild Semiconductor International Inc. (NASDAQ:FCS)

Q3 2008 Earnings Call

October 16, 2008 9:00 am ET

Executives

Steven Leibiger - Investor Relations

Mark Thompson - President and CEO

Mark Frey - EVP and CFO

Dan Janson - VP of Finance

Analysts

Ross Seymore - Deutsche Bank

Craig Ellis - Citi

Romit Shah - Barclays Capital

Shawn Webster - JPMorgan

Steve Smigie - Raymond James

Kevin Cassidy - Thomas Weisel Partners

Tristan Gerra - Robert W. Baird

Craig Berger - FBR Capital Markets

Eric Ghernati - Banc of America

Brendan Furlong - Miller Tabak

Operator

Good day, everyone, and welcome to the Fairchild Semiconductor Third Quarter Earnings Call. Today's call is being recorded. At this time, I would like to turn the conference over to Steven Leibiger. Please go ahead, sir.

Steven Leibiger – Investor Relations

Thank you. Good morning and thank you for dialing into Fairchild’s third quarter of 2008 financial results conference call. With me today is Mark Thompson, Fairchild’s President and Chief Executive Officer, and Mark Frey, our Executive Vice President and CFO, along with Dan Janson, our Vice President of Finance.

Let me begin by mentioning, that we are attending the Raymond James IT Supply Chain Conference in New York on November 18th.

We will start today's call with Mark Frey, who will review our third quarter financial results and discuss our forward guidance for the fourth quarter of 2008. Mark Thompson will then discuss our product line results, end markets and operational performance in more detail. Finally we will reserve time for questions and answers.

This call is scheduled to last approximately 60 minutes, and is being simultaneously webcast from the Investor Relation section of our website at fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days.

Fairchild's management will be making forward-looking statements in this conference call. These statements including all statements about future results and performance are made based on assumptions and estimates that involve risks and uncertainty. Many factors could cause actual results to differ materially from those expressed in the forward-looking statements.

A discussion of these risk factors is provided in the quarterly and annual reports we filed with the SEC. In addition, during this call, we may refer to adjusted or other financial measures that are not prepared according to Generally Accepted Accounting Principles. We use non-GAAP measures because we believe they provide useful information about the operating performance of our business that should be considered by investors in conjunction with GAAP measures that we also provide.

You can find a reconciliation of non-GAAP to comparable GAAP measures at the Investor Relations section of our website at investor.fairchildsemi.com. The website also contains a 2008 Q3 fact sheet and a financial section, with updated, unaudited financial highlights, including detailed breakouts of segment and regional revenue, gross margins, EBIT and EBITDA.

Now I will turn the discussion over to Mark Frey.

Mark Frey

Thanks, Steve. Good morning and thank you for joining us. I'm sure most of you had a chance to review our earnings release, which was issued earlier this morning, so I'll focus on just the key points.

For the third quarter of 2008, Fairchild reported sales of $428.3 million, up 2.3% sequentially, and 0.4% higher than the third quarter of 2007. Gross margin was 29.9%, up a 130 basis points from the prior quarter, due to higher factory loadings, cost decreases related to product insourcing, lower material costs, and favorable currency exchange rates in Asia. We also reduced internal inventory by over $7 million during the quarter.

R&D and SG&A expenses were $83.8 million, down $5 million from the prior quarter and better than our original expectations, due to rigorous cost management, reduced equity compensation costs, and a non-recurring credit of approximately $0.5 million. We recorded a $1.8 million charge for restructuring and impairments, primarily related to streamlining of warehousing operations. Net interest and other expenses were $5.4 million in the third quarter, which is a $0.9 million decrease from Q2, primarily due to lower debt balances and one-time fees related to our Q2 debt refinancing.

Now I'd like to review third quarter highlights for our sales and gross margin performance, for each of our product groups. In our PCIA group, total sales decreased slightly from the prior quarter. Strong sequential growth in excess of 14% in power conversion products was offset by mid single-digit declines in automotives and high voltage MOSFETs. Gross margins improved three points relative to Q2, due primarily to better cost leverage from higher factory loadings in the prior quarter. Our MCCC group saw an 8.6% sequential increase in sales, driven by the low voltage, ultra portable, mobile power, Interface, IntelliMAX and signal conditioning product families.

Overall, MCCC gross margins were essentially flat compared to the prior quarter at about 35.2% as internal inventories were significantly reduced throughout the quarter. Standard Product group sales were down 3% and gross margin was up 50 basis points compared to the prior quarter, also due to the higher factory loadings.

Reviewing our balance sheet; we reduced internal inventories by more than $7 million, resulting in a three day decrease from the prior quarter to 72 days. We continue to maintain one of the leanest inventory levels in the industry. DSOs increased about two days to slightly over 42 days. Cash and marketable securities decreased $17 million to $419.3 million in the second quarter, which reflected cash flow from operations of $48.9 million, capital spending of $44.5 million, and net stock purchases of $12 million.

Turning now to guidance; we expect fourth quarter revenue to be down 6% to 12% sequentially. At the start of the quarter, we had approximately 88% of the sales guidance booked and scheduled to ship. Order rates were below expectations in September, resulting in a sequentially lower starting backlog position. We expect that gross margins will be approximately flat sequentially, as we offset lower factory loadings, with insourcing cost benefits, and favorable foreign currency and raw material cost trends.

We expect to continue to increase our ratio of insourced packaging during Q4, as the majority of our assembly and test production cuts will be on outsourced volumes. We expect R&D and SG&A expenses to be approximately $80 million to $83 million, and net interest and other expenses to be about $6 million to $6.5 million for the fourth quarter.

We expect the macroeconomic environment to remain challenging over the next six plus months, and therefore we intend to be very disciplined in spending controls and asset management.

Now I will turn the call over to Mark Thompson.

Mark Thompson

Thanks Mark. Let me start by following up Mark's last point, with a few general comments about how we are proactively managing the business in the current environment. We’ve demonstrated strong supply chain management in the last two cycles, and we are particularly focused on maintaining lean inventories and short lead times in this market.

We reduced our internal inventories to their lowest point in two years and close to the lowest point ever at the end of the third quarter. This gives us some cushion to selectively rebuild die inventory in some of our fastest growing new products, as well as some areas that we have depleted.

Channel inventory is at the midpoint of our target range, and we continue to ship in to match consumption. Our lead times remain relatively short, which enables us to be responsive to demand changes and opportunities to capture upsides in the quarter. We intend to hold market share in our base line business, while gaining share on our focused applications by accelerating new product design wins.

We posted record sales for our latest high frequency voltage regulators, analog switches, analog video filters, and new generation of power conversion solutions for battery chargers. This should allow us to grow at least as fast as our server markets. We are aggressively managing our manufacturing and operating expenses as evidenced by our significant spending reduction in the third quarter. We believe we can maintain and improve on this trend in the fourth quarter.

Let me summarize our current results. Revenue grew sequentially as we gained share in a number of key customers with our higher value products, but end market demand softened during the quarter, especially in the computing area. Sales of our products in to the industrial end market were also seasonally lower, while sales into the consumer electronics market increased compared to the prior quarter. Our sales into the OEM channel were up 3%, relative to Q2, driven primarily by new product sales.

This growth is enabled by offering higher value analog and power management products, coupled with a responsive global supply chain to service fast growing large customers. In the distribution channel, sell-through was up more than 1% sequentially in Q3 and our inventories at the midpoint of our target range. Overall, average product selling price is down between 1% and 2% sequentially, which is within normal expectations.

Lead times were in the six to eight week range during the quarter, and we expect to maintain them in this range in the fourth quarter. Advanced wafer fabrication capacity increased by nearly 8% in Q3, as the new 8-inch line in our main analog fab began to ramp. Overall factory utilization improved during the quarter, as we adjusted starts to meet product demand.

Now turning to our product line results. In our MCCC business, we posted strong overall quarter-on-quarter sales growth of close to 9%. In the handset arena, voltage regulation is growing at a compound annual rate of 13%, and our high frequency DC/DC regulators are the most energy efficient available. We believe that our revenue growth for these mobile power products can significantly exceed the overall market growth, as we focus on key industry leading customers.

In the third quarter, we saw our mobile power sales increase 40% sequentially, as we ramped our latest DC/DC regulator products. Other MCCC products with notable sequential revenue growth in the past quarter were IntelliMAX, analog switches and video filters.

Our PCIA group provides key technologies to both convert and save energy. For the third quarter, sales were essentially flat at $160 million. A key growth area for this business segment is Primary Site Regulation or PSR for low power applications. These are used in small, highly efficient AC to DC converters, like the ones used to charge mobile phones and MP3 players. PSR uses less power and also requires fewer components, and has a smaller form factor than traditional secondary side regulation.

As legislation and economics drives such power adapters toward higher efficiency methods, such as PSR are required and silicon content increases.

In Q3, our PSR sales increased sequentially more than 40%. We also saw greater than 40% quarter-on-quarter sales growth in IGBTs for industrial and automotive applications and power factor correction.

We continue to manage our Standard Products Group, SPG with cost discipline to maximize overall cash generation. For the quarter, revenue decreased about 3% to $94.7 million.

In summary, we are aggressively managing the variables within our direct control to maintain a lean response to the supply chain while reducing expenses. We expect to hold share in our core business while gaining share in our focus applications to enables to grow at or above the market rate.

Finally, we believe our focus on fastest growing wireless mobility and energy efficient markets will drive a solid long-term growth in our business.

Finally, Fairchild announced two days ago that it filed a new patent infringement lawsuit against Power Integrations. The lawsuit alleges that certain Power Integrations' pulse-width modulation products integrated circuit products infringe one or more claims of three US patents owned by Fairchild's subsidiary System General.

Fairchild is seeking monetary damages and injunction preventing the manufacture, use, sale, offer for sale or importation of Power Integrations products found to infringe the asserted patents.

Thank you. I will turn back to Steve.

Steve Leibiger

Thanks, Mark. We will now open the call to questions. I would ask that in order to allow more of you to ask questions, we limit each person to one question and one follow-up. Now, let's take the first question.

Question-and-Answer Session

Operator

Our first question is from Ross Seymore from Deutsche Bank.

Ross Seymore - Deutsche Bank

A couple of questions here. First, on gross margin, we think about how that could trough versus your prior trough. Can you just walk us through the puts and takes of mix cost cutting, inventory, etcetera and how that might work out over the next couple quarters?

Mark Frey

Well, clearly the biggest potential negative and the biggest unknown is the load in volumes, that somewhat mitigated because we do have outsourcing of some packages and therefore, why I think we have done a better job this time of balancing the production losses that we seen so far at subcon rather than inplant.

The pluses, as I mentioned in the script, are the in-sourcing cost reductions that we’ve already put in place, plus some favorable trends we have seen in currency and input costs with gold being the biggest unknown. And as you know, gold continues to vacillate pretty wildly.

Mark Thompson

Ross, the other thing I would add to Mark's comment is that we continue to have significant new product launches every quarter, and that's a steady favorable contribution to the mix as well.

Ross Seymore - Deutsche Bank

I guess as a follow up more on that revenue line that you talked about with the loading side of the equation, have you seen any change after the weak September? Have things gotten worse? Stayed about the same? Gotten better? in general with your guidance, is there a specific sub-segment in your three that will do better or worse?

Mark Thompson

In general, I would say we've seen things stay about the same. The characteristics of the market are generally relatively little visibility and they manifest itself by last minute orders, expedite and so forth.

So all those things I think are, the end customers are being selective about the business that they are going after when they see an opportunity they are very aggressive, but I think there is a higher level of selectivity out there in the business. That's the way I would characterize it today.

Ross Seymore - Deutsche Bank

And then as far as the sub-segments?

Mark Thompson

The sub-segments have the one that's probably degraded the most versus what I would say a normal trend is automotive. And then after that it would be computing and industrial and consumer as well.

Ross Seymore - Deutsche Bank

Sounds like, pretty broad base.

Mark Thompson

Well, that's right. Handset has degraded the least, I would say.

Ross Seymore - Deutsche Bank

Okay, thank you.

Operator

Moving on, our next question comes from Craig Ellis from Citi.

Craig Ellis - Citi

Thanks for taking the questions. The first one is a follow-up on the trough gross margin level. If we're guiding down a midpoint 9%, I think utilization was expected to be somewhere in the mid to low 80s percent in the third quarter. Wouldn't we be expecting utilization to drop back into the mid to high 70s by early next year?

Mark Frey

Well, Craig, of course, it would depend on how the volume picture continued to evolve. But, utilization at the fab level was just above 90%. And in fact, we've had shortages in some areas. So we've directed our capacity at those areas and actually drawn down die inventories as a result. So we are in a very good position with lot of our inventory reduction has been in die.

So we think we can maintain the fabs in the 80s somewhere. And again in packaging, we were in the mid-80s and would expect that to come down. But it depends again on the product mix, because certain product mixes can be made internally and some we rely on subcons. But I think it's safe to say, it would be a bit less than what we have seen in the past.

Mark Thompson

I guess to build on that were among other things, the changes that we made a couple years ago when we began to put more structure and discipline in our new product development.

One of them obviously was pursuing higher quality business, but the other one was making sure that all the high runners had the ability to manufacture either in-house or out, which causes them to have a much more flexible trajectory as we apportion in and out when we go through one of these.

Again, we can't predict exactly what the cycle will look like, but I can predict that we will perform better in it than we have historically.

Dan Janson

Craig, this is Dan, just another point to add to that. As we said in the script, and as we have cut our loadings to adjust to the revenue lines, we are taking more out of our subcontractors in the backend, which also is cushioning us a little bit on the utilization line.

Craig Ellis - Citi

A number of things working together to try and keep utilization near where they’ve been in the last few cycles rather than what happened after 2004. Switching gears a little bit. Yesterday, we had a company give us an outlook that had a bottoms up component to it and then a big top down haircut that was also an element in the guidance.

Can you just help us understand how you approach this quarter's guidance versus the way you would approach guidance in a more normal environment? Is there a particular allowance for the uncertainty that we have in the global economy today?

Mark Thompson

No, we didn't use a different process, but we weigh dimensions of the process. So we have always used a statistical and a trending approach, plus direct conversations with our key customers, including distributors and which we then add on in uncertainty factor. I think if you look our range is broader than typical.

The low end was not one that was generated from a model of the business that exists today, but rather as a reflection of the uncertainty. Again it wasn't a change in process. It was just a greater waiting for the uncertainty factor to create the downside of the model.

Craig Ellis - Citi

Okay. Thanks, Mark.

Operator

We will take our next question from Romit Shah from Barclays Capital.

Romit Shah - Barclays Capital

On the factory loadings, just with the reduction that you have taken thus far in the last 30 days, is it fair to say that we will see the impact to the P&L and specifically gross margins in Q1?

Mark Frey

You will see some impact, although it's not as big as it was, say last year. The swing really hasn't been quite as much. Frankly, the underlying cost performance has been a bit better. So you won't, I think what you are implying is you get costs that roll over in to Q1 from the production volumes in Q4. And that won't be really as much the case this year.

Mark Thompson

So, Romit, one other thing that I would add to Mark's comment is that we did a significant architectural upgrade to our planning system partly through this year. I think you heard us talk about it, and in fact we took some impairment charges for converting from what we call the three engine to one engine. We had such a complex product family that we couldn't really run it all in one planning system. We converted mid-year to a single engine model which we run more frequently.

So as a result of that, we are able to do much more frequent adjustments to our loading plans. That's really architecturally what's behind Mark's comment of saying that the ups and down swings that we've seen in the past have been chunkier than we expect them to be in the future because we update the plans once a week now.

Romit Shah - Barclays Capital

What I think we are trying to gather that one of the reasons why Fairchild stock is underperformed, is that people assume that if revenues are declining, earnings are going to decline at a faster rate than their peers because you guys are a Standard Products company and traditionally we've seen more marginal leverage. So if you could help us sort of frame what the operating model, gross margins would look like, operating margins if?

And I'm just putting a number out there, if we were to say shave 10%, 15% off of the revenues that you've guided to for Q4, what would gross margins look like? Would the company still be profitable? Thank you.

Mark Thompson

So, let me try to get it, I guess if I get at the highest level or lowest level depending on your point of view, question is that I certainly can't guarantee profitability. Business gets bad enough. Everybody is going to be unprofitable. So what I would say, however, is that if you look at the peak-to-trough progression, it's been a steady improvement in mix and business process as well as cost structure.

So if you look at sort of the huge swings of 10 points peak-to-trough that the company experienced say five years ago, those were driven, of course, by very large inventory swings by and large, which we were able to correct by operating the company on a sell-in basis.

Now in the meantime, we dramatically simplified our product portfolio in the same period of time from say 2005 to presently. We have gone from almost 50,000 part numbers down to around 15,000 part numbers, that is more than a factor of three. We've changed the planning system. We've improved the cost structure. I mentioned earlier the ambidexterity between our key products being able to be manufactured in-source or out.

The quality of the mix, the multiple sourcing characteristic of most of those elements have improved steadily over the last three years. Every one of them contributes to a more stable profile, which I think you described it perfectly, is that ideally you would have your earnings linearly track your top line.

I wouldn't say we are at the point where we would say categorically that if they can track the top line, what I can say is that we are healthier in that dimension than we were a year ago and our improved mix continues to drive us in that direction.

Mark Frey

More specifically to your question, if we lost another 10% from guidance, I think we would be above breakeven. That's not guidance. That's just modeling.

Romit Shah - Barclays Capital

All right. Thank you.

Operator

Our next question today will come from Shawn Webster from JPMorgan.

Shawn Webster - JPMorgan

Can you expand a little bit on the pricing environment and maybe expectations specifically for this quarter? Is there any activity on the competitive front you are seeing where you're seeing any kind of incremental desperation? Or how do you expect pricing to evolve for the next quarter or two?

Mark Thompson

In the third quarter as we reported, the aggregate pricing was within the normal bounds. We would expect pricing to get more aggressive in certain segments as the people are less concerned about supply and more concerned about costs. Computing is probably the most sensitive to that, in general.

We've started to see a little bit more competition in some applications. That's the one I would expect would be most responsive to that if the computing market continues to deteriorate.

Shawn Webster - JPMorgan

Okay. And then what do you expect for taxes?

Mark Frey

The basic structural expectations aren't different about 15% on an adjusted calculation.

Shawn Webster - JPMorgan

Then you commented that you could take advantage of what's happening to builds and inventory. Can you give us a sense of magnitude and how much you would like it to come up?

Mark Frey

In the number of places, particularly fast growing products, we had turns that were up in the 8, 9 range for a couple of product families which causes us to start to worry about service levels. So they are all driven by service level concerns.

Mark Thompson

But in terms of looking forward, obviously there is a lot of unknowns in Q4. But as we looked at it and modeled it, we have not factored in inventory growth into our thinking. So, obviously that's going to develop with time.. But our guidance wasn't dependent on some belief that will run the factory with inventory growth scenario.

Mark Frey

I think that's a key point that Mark made which is again if you look at the trajectory across the year, we've been taking, we've reducing our inventories every quarter and we are going to continue to run them as lean as we possibly can. And selectively replenish where only where returns are at sufficient level that we were about service.

Shawn Webster - JPMorgan

Okay. So flattish, I guess is what I should assume. Coming out of the Y2K kind of period, can you remind us where your utilization rates were troughing back down. I know that you are a different company now and things may be different this time. But just to get a sense of how it was back then?

Mark Thompson

Dan, do you have any recollection? This kind of predates current management.

Dan Janson

Yeah, I think we are looking at low 80s to high 70s, somewhere in that range for fab utilization.

Shawn Webster - JPMorgan

Okay. And then last one, did you have any 10% customers in the quarter?

Mark Thompson

No.

Shawn Webster - JPMorgan

Okay. Thank you very much.

Operator

We will move on to Steve Smigie from Raymond James.

Steve Smigie - Raymond James

Great, thank you. Just a one quick item on the guidance for the R&D, SG&A expenses, I assume that's including the impact of option expenses and as to how much would be the potential option expenses in the quarter, fourth quarter?

Mark Frey

Well, Steve, as you can see from the release, our equity oriented expenses improved from Q2 to Q3 by about $1.9 million. Looking into Q4, it ought to go back up a little bit $0.5 million to $1 million, which is actually a little higher element in our thinking. But I think obviously, it's going to ultimately depend on the stock prices, stock at these levels obviously drives to lower overall equity expenses. This is 's not a situation I'm looking forward to.

Steve Smigie - Raymond James

I know you guys don't give guidance at this point for Q1, but you have taken guidance revenue here for Q4 is below seasonal obviously. Would Q1 expect to be then seasonal down from that? Or do you think given the sort of outlook you laid out here that you wouldn't expect Q1 to be down as much traditionally as you have already sort of taken hit, if you will?

Mark Thompson

Steve, one of the things that we talked to our big customers when we think about guidance, and I would say that the general lack of visibility is one that starts with the OEMs and there is I think it's a very uncertain economic environment and nobody is going to even try to predict what something in 2009 looks like at this point.

Steve Smigie - Raymond James

Okay. Looking at the gross margin guidance again here actually seems pretty decent considering the decline in revenue and I guess, I would say I think you probably answered this to a certain extent. But do you feel like that's a result really of all the different things you've talked about on the call about the stuff you put in place, or as you are discussing, you had some adjustments you were making in terms inventory?

As a result you're able to run stuff a little bit more fully loaded as anticipated and so there is a potential that, with an extra next quarter, things continue to deteriorate then you start to lose maybe one quarter or two quarter benefit you had from that inventory stuff that you are changing?

Mark Frey

No we don't, we didn't reverse our inventory reserves or stuff like that. We think we've got a pretty conservative balance sheet and hopefully that insulates us from those kinds of shocks. I think it's the factors that we've mentioned going forward. And the biggest unknown is what the loadings will open [really be].

Steve Smigie - Raymond James

Okay, right. Thank you very much.

Operator

Our next question today is from Kevin Cassidy from Thomas Weisel Partners.

Kevin Cassidy - Thomas Weisel Partners

How about in the supply chain, are you seeing any disruption related to the credit issues?

Mark Thompson

From a supply point of view, none that I have seen. I mean we pay attention to the health of our subcons and we've been consolidating our subcons away from some of the ones that were smaller and more unstable. So that may explain why we haven't seen it.

We've seen some concerns on the distribution, some of the small private distributors. It looks like some of them are struggling a little bit with that in Korea and in Asia, in China particular. So from an outbound point of view, we have seen more of it than an inbound part of the supply chain.

Kevin Cassidy - Thomas Weisel Partners

Also related to automotives, I guess you say that's degraded the most. Is there credit issues involved there or is it just because of the demand drop-off?

Mark Thompson

No, I think it's just flat demand. If you look at our customers in automotive have no credit issues. They are all very strong players. It's just that automotive volumes are down more than any other volumes are down and that's being reflected in their take rates.

Kevin Cassidy - Thomas Weisel Partners

Okay. And in the prepared comments, it is mentioned that you are preparing for a six-month slowdown. Is there any particular reason why six months or anything else?

Mark Frey

I said six plus.

Kevin Cassidy - Thomas Weisel Partners

Okay.

Mark Frey

We are not approaching this as a blip. As we said many times before, we control the things we can control and so we are going to control asset management, the execution of new product programs and spending controls. It's not a bridge to some rebound that we see out there.

We've put a number of cost control measures in place for this quarter and they will remain in place and some of them are good ideas in all economic environments and will probably continue in place indefinitely.

Kevin Cassidy - Thomas Weisel Partners

Okay. Thank you.

Mark Frey

That's all we meant. Obviously, nobody wants to predict what ultimately the cycle is going to play out to be.

Operator

And we will go next to Tristan Gerra from Robert W. Baird.

Tristan Gerra - Robert W. Baird

Good morning. Given that your utilization rates was about 90% in the quarter, fair to assume that near term 30% gross margin is actually a peak gross margin. The question is, at what level of utilization rates do you decide on cutting expenses aggressively enough to the point where you will be considering cutting capacity or potentially closing fabs?

Mark Thompson

So there is a couple of different things, choices that you have. The first step in a reduced demand environment is you can use selective shutdowns, which isn't quite as good as a full closure, but to some extent it looks like one in the sense that you have no operating expenses at all, and of course you are not taking any material in.

Certainly, we are modeling one of the characteristics of a very uncertain environment like this. As you know, every year as part of our normal planning, we update our breakeven models and so forth. Obviously, this year, I think, we are probably doing what everyone else in the world is doing, which is saying, "Well, if it got this bad, what would we do?"

Certainly, there are scenarios where we elect to close a fab, but it would be a very drastic reduction from where we are today before that would be required in order to maintain acceptable financial performance.

Tristan Gerra - Robert W. Baird

Okay. Thank you. Then could you remind us percentage of revenues now that you will consider as being in somewhat commodity?

Mark Thompson

So the products that are pure commodities are standard product. If you just took the low $90 million range for that, so around 25% of our business is absolutely pure commodity. Then the rest of the business is a notch-up from that in the sense of there are ranges from having a few suppliers of a given product to single source at the other end of that.

So I guess by definition a single source can't be a commodity. So I think that would be the partitioning in that category.

Tristan Gerra - Robert W. Baird

Okay. So in terms of outside of first tender product, what will be the estimate of products that are multi-sourced and is that adding maybe a 10% to your total revenues in terms of exposure there?

Mark Thompson

It's hard to answer that question. So a majority of products for us and all like companies are at least dual sourced. And in fact, if you look at sort of rules in cellular for example, is you are not allowed to have any volume until its dual sourced, and in fact there are a lot of reasons why you don't want to be sole sourced as a manufacturing company.

We have been moving the mix heavily toward dual sourced as opposed to multiple sourced. But I don't have the exact breakdown on what stuff is dual sourced versus three or four suppliers. I would say less than half is all the way to dual source at this point of the remaining down.

Tristan Gerra - Robert W. Baird

Okay. That's very useful. Thank you.

Operator

We will go next to Craig Berger from FBR Capital Markets.

Craig Berger - FBR Capital Markets

Thanks for taking my questions. First, on the OpEx. Q3 OpEx was a lot better than the guidance and Q4 is even better than that. How sustainable is that into 2009? When do you do annual raises? How should we be thinking about that line item going forward?

Mark Frey

Well, we typically tick up in Q1 as we have for several years because merits, payroll matching kind of kick in. There is generally less vacations. And of course, the bonus plan will change depending on year. We actually still are maintaining a modest bonus scenario in our numbers, even though we obviously control them on the low end of expectations.

So, we don't expect an upturn the way we saw last year. Obviously, the equity expense is going to depend on what the stock price is when we our next grant. We will continue the measures that we've put in place and in Q4, as I said earlier, typical things like hiring freezes, travel bans, very selective on any resources.

I would expect it to pick up a bit, but then still pretty much get back to the ranges that we've been talking about. Again, that was sort of behind my commentary around expectations that there is a lot of uncertainty. This covers the kinds of things we can control and we will control.

Craig Berger - FBR Capital Markets

All right. Can we talk a little bit about your 8-inch fab ramp? How far into that process are we? What's the additional capital required to get that up and running and the timing for production there?

Mark Thompson

We had the process that we've been using is, there are two parts to it. One is to convert existing 6-inch to 8. And those are the most cost effective but logistically the most difficult to execute because you have to take a lane down before you bring it back up in 8.

So what we've done is a 4, 6-inch lanes that we have running in South Portland fab, we've converted two so far. What we've then decided to do for a security of supply reasons is then the next one which we are in the middle of is an addition of a new lane, which will make it much more straightforward to convert the subsequent ones.

So of the total plan to convert, if you look at the numbers that we presented at our Analyst Day recently that would be four converted and two new lanes. So you could say that we are at this point exiting Q4 halfway through that conversion process, having converted two of the existing 6 and added one new 8-inch length.

Craig Berger - FBR Capital Markets

Is this the type of project you guys want to be spending money on in a waning demand environment? Is it possible to slowdown or speed up the conversion process?

Mark Thompson

So if you look, for starters even when I say a new lane, this doesn't benefit an equipment manufacturer. We buy, use, lots of high quality used 8-inch equipment out there. Wherever possible we look like any other good analog company, and we buy used equipment. So the conversions themselves are pretty cost effective. In fact, if you really look at it, there is many aspects, so it's really de-bottlenecking process that we use. So you do a single conversion and then you upgrade the various bottlenecks in the line.

So it's a very, it's not, don't think of it as a very large chunk of money that you spend and then regret spending. It's important to think about it as six incremental events and of which two are gross additions of the line and four are just think of them as 1.6 times a six-inch line. It's a granular process, we can slow it down, we can stop it and it's quite flexible in response to the demand environment.

Craig Berger - FBR Capital Markets

Last question.

Mark Frey

Hi, Craig, let me add one other item to that. So we've talked a lot about the transition to be much more of an analog company. We needed to take the main fab utilization rate to be more in line with what we traditionally see with an analog company, something around 80% utilization. So the 8-inch conversion is really integral to that. Frankly, I think given the environment that we are in right now, it actually gives us an environment that is a little more conducive to finishing the transition.

I mean when you are absolutely full as we have been for over a year in that fab, it really makes it difficult to do the kind of transition work we need to do to make the leap from 6 to 8-inch. So this actually is going to give us a little bit of breathing room.

And ultimately on the other side of this, we are going to end up with an analog fab that's going to look like the best analog fabs in the world, running out of utilization rate that is going to make it much easier for us to be responsive to our customers.

Craig Berger - FBR Capital Markets

The reason I had asked is your depreciation has been going up and your revenues are going down?

Mark Frey

So let me make a general statement. The depreciation is going up because we have been in-sourcing a part that, it costs more from a subcon. So we are just turning an outside service that costs $0.07 to depreciation that costs $0.01 plus additional costs. So that's the ratio.

More broadly, obviously we, like everyone else are very carefully looking at our capital expenditures for next year. Just as we are controlling our income statement spending, we were taking a hard look at our CapEx model as well. Clearly, pure capacity projects are being de-prioritized and we will continue to prioritize cost reduction-oriented spending and new product capability spending.

Craig Berger - FBR Capital Markets

Last question, I know you guys are net cash negative, but any thoughts to even a small buyback down here, little goes a long way at $6 a share?

Mark Frey

Yes, we are considering it. We do have some limitations in our term loan in terms how big that could be. We have purchased equity in the last couple of quarters and we continue to look at it.

Craig Berger - FBR Capital Markets

Thank you.

Mark Frey

Pretty compelling.

Operator

Our next question is from Eric Ghernati from Banc of America.

Eric Ghernati - Banc of America

Hi, thanks for taking my question. I just want to circle back to what you said or you provided the reasons why your MCCC gross margins were flat sequentially despite the 9% sequential increase in revenues. You talked about how that was a case because you took down inventories for MCCC products.

Now, if I recall in the second quarter, you had a similar dynamic whereas you took down inventories for MCCC products by one week and your sales were down 3%, yet your gross margins were flat. So I'm not sure why despite you didn't see the benefits from a 9% increase in revenues this quarter? That's my first question.

Mark Frey

Well, because we did have the benefit of the revenue but not the production loading which determines what the average cost of the product would be. We were still working off inventory and that ends up essentially expensing inventory that had been built in some prior periods at a higher cost.

Mark Thompson

I would add that we took more inventory out this last quarter. We actually drained ten days as inventory. So MCCC is now well below the company average for inventory days which is what our plan is.

Eric Ghernati - Banc of America

Okay. Next question again on gross margins. You know last time you talked also about how out of you're the midpoints of your guidance for gross margins, 50% of the improvements was going to come from mix, the rest was going to come from utilization. Again, as I hear your prepared remarks, you are talking benefits coming squarely from utilization, lower material, lower Forex, higher in-sourcing, where is the benefit though you are expecting from the improvements in mix?

Mark Frey

We still see some the impact of higher value products. In this particular quarter, we did take some. Although in the manufacturing area, we had some favorable currency. In the revenue area, we had some unfavorable currency, specifically the euro where our euro-based products translated back into fewer dollars. But we saw a progression, it just wasn't big enough to note in script.

Eric Ghernati - Banc of America

Okay. My last question is, Mark when you walked into the quarter, you were feeling pretty confident about the Notebook segment, and based on everything and your notebook, I mean your PC business in general is down pretty big this quarter, I mean after being down 15% in Q2 and doesn't seem like the PC business was any weaker in Q3 based on Intel's results. So what happened there?

Mark Thompson

There are a couple things. First is, I don't think there is a direct correlation between what goes on in Notebook and what Intel might report.

Eric Ghernati - Banc of America

On the Notebook market in general based on production numbers in Asia was up 26% on a unit basis sequentially.

Mark Thompson

That's not consistent with. Dan, do you have those numbers?

Dan Janson

Go ahead and keep on answering I will figure out you are talking.

Mark Thompson

So I was just saying that the unit volumes that we see are significantly lower than that and so our customers taking down their volume estimates steadily across the third quarter.

Eric Ghernati - Banc of America

So you have no correlation with the performance of the Notebook market. Because again, I ask this because you're normally expecting the benefits from the seasonal growth in notebooks which actually occurred, but you also had expected lot of benefits from new products. And I mentioned quite a few power conversion for adapters, regulators, things like that, so?

Mark Thompson

All the adapter stuff is not reported in our Computing segment, that's reported in our PCIA. If you look at comment that power conversion products were up substantially in the third quarter, that's where all the adapter business is. Maybe I am starting to understand the nature of your question. So that adapter business is reported in PCIA, not in MCCC because the way we partitioned that, and that did grow substantially where we took share.

In the regulation side for the notebook itself, we didn't have a significant new product penetration expectations for the third quarter. We were basically just going to be whatever the market turned out to be and the notebook volume estimates were pulled down as I said every single month across the quarter. Dan, do you have those numbers here?

Dan Janson

Yeah. So I guess a couple of comments. On notebook growth, I think the one thing we had to be careful about is that a lot of the growth has been coming at the notebook -- in the notebook models and clearly those guys have a lower power consumption overall. And if you look at our overall--

Eric Ghernati - Banc of America

But [Dan also in] your last quarter, you also said it didn't matter to you where the growth came from, whether it was notebooks or notebooks that you would participate there no matter what. I'm just unclear as to why things have changed in couple of months.

Mark Thompson

Well, Eric, I think we do participate, but obviously there is going to be less power content with a low power notebook.

Eric Ghernati - Banc of America

Okay. Thank you.

Mark Thompson

All right. And as far as our overall computing experience numbers, our computing numbers were down a bit in the second quarter which is seasonal. That's very normal. And in the third quarter, they were roughly flat quarter-on-quarter.

Eric Ghernati - Banc of America

Okay. Thanks very much.

Operator

Our next question comes from Brendan Furlong from Miller Tabak.

Brendan Furlong - Miller Tabak

Hi, good morning, guys. Most of my questions have been answered. But going back some questions back two or three questions ago, on the SG&A and R&D looking into '09 and you are saying you get a seasonal bump for bonuses and what have you in Q1. And should we then expect the usual kind of decline from there like we have been seeing this year?

Mark Thompson

That will be the pattern.

Brendan Furlong - Miller Tabak

Okay, great.

Operator

And we will take the follow-up question from Craig Ellis from Citi.

Craig Ellis - Citi

Just a follow-up on the operating expense, Mark. The quarter-to-quarter variance was $5 million. You mentioned there were a number of items at play. Can you just give us the order of magnitude of each of those items?

Mark Frey

The equity was $1.9 million. We mentioned in the script about $0.5 million credit that we took in Q3 that won't recur. Then a couple million, $2 to $3 million payroll-related, various related savings. We expect the equity to actually move slightly in the other direction in Q4, but the payroll to continue as we obviously are very careful with headcount spending, plus typical spending controls in travel over time, supplies, etcetera.

Craig Ellis - Citi

Is the payroll savings staff reduction or what is that exactly, Mark?

Mark Frey

It's partly not filling racks, which is staff reduction because almost all of our racks in the non-R&D areas would be in replacement category anyway, but also patterns of vacation and shutdowns.

Craig Ellis - Citi

Okay, thank you.

Operator

And we have another follow-up question from Steve Smigie from Raymond James.

Steve Smigie - Raymond James

Great, thank you. You talked about one of the things that's helping you out here with some new products. Can you talk about new products as a percentage of your mix and how it should change in the next couple of quarters that might help keep margins a little better than in previous cycles?

Mark Thompson

The new product definition that we use, I think is a fairly standard one, which is as a part that's less than three years old. If you look at the MCCC, we've tried to keep that above, we've been migrating that above 50%, toward 60% if you look at our backlog at any given time and we continue to migrate that up. PCIA is the place where you will see the biggest contribution from improvement there, that's been well under 50%. We would seek to migrate it more toward the MCCC model.

We have a number of key programs there. Some of them have been starting to hit now. We talked about a couple of those adapter products, particularly like the primary side regulator. That's something that kind of every small power device, cell phone, MP3 player etcetera that would plug into a wall would use one of those and that's a best-in-class solution. So that's a kind of a 2 billion unit sort of a thing, with a footprint that is so small it can be just molded straight into the end plug. So the work just goes away.

On the sort of notebook side of that then much more efficient adapters and then in the server space itself, moving to 85% and then 90% efficiency, all of those products will be rolling out across the fourth quarter and then into '09 in the PCIA space. Lighting is very rapidly growing. So in all of advanced solutions in LED and control for fluorescent is also very rapidly growing.

So there has been an aggressive refresh that has been going on in those spaces and that will contribute heavily to the progress in '09, sort of regardless of what happens in the market.

Steve Smigie - Raymond James

Okay. And as you mentioned the Power Integrations lawsuit, I am not sure, I think I saw maybe this morning that they might have refuted sort of your claims that you made there. Could you go into a little bit detail about, is this relatively -- I know you put out a press release a few days, but is this the new different patents that you are going after and what was the timing of when your patents came out that you believe they violated the recent, that they violated or (inaudible)?

Mark Thompson

Well, it's always hard to define a timeline on these things. But if you look at, not only did we acquire a significant portfolio IP when we acquired System General, but that is a very inventive group. They continued to develop a lot of intellectual property and advanced solutions for our power conversion.

We concluded what the press release said, which was that IP some of which we had when we acquired the company and some of which they have developed since that some cross-section of the Power Integrations products we believe infringe those patents and as a result filed suit on that. So I don't think there is a lot more that I could comment on specifically.

Steve Smigie - Raymond James

Finally, it seemed like handset business you said I think was sort of one of your relatively speaking more healthy categories. Is that a comment on or and not demand, or is that you are, I think you are picking up share at, I believe it is Nokia, is that helping you more than the average person shipping into handsets and how is that relationship with that customer going?

Mark Thompson

We can't and won't make any customer-specific comments. But in general, we have been investing heavily to broaden our exposure and contribution to cellular and that continues to move. My comments in general were that the existing market, the volume of cellular that we see has held up better than most of the other volumes in the current degradation of business.

So again, we have continued expansion plans for content. And if you look at some of the biggest programs we have hitting 2009 are all concentrated in advanced solutions in handsets. So again, we'll do better regardless of what the handset market does. But so far, relative to say automotive or industrial handset, that has held up better than those other spaces.

Steven Leibiger – Investor Relations

Okay. Thank you, Steve. Operator, that's all we have time for.

Operator

Thank you. Would you like to make any closing remarks?

Mark Thompson

No, that's fine. Thank you.

Operator

Thank you. That does conclude our conference call today. Thank you all for your participation.

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Source: Fairchild Semiconductor International Inc. Q3 2008 Earnings Call Transcript
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