Texas Instruments, Inc. Q3 2008 Earnings Call Transcript

Oct.21.08 | About: Texas Instruments (TXN)

Texas Instruments, Inc. (NYSE:TXN)

Q3 2008 Earnings Call

October 20, 2008 5:30 pm ET

Executives

Ron Slaymaker - Vice President

Richard K. Templeton - President, Chief Executive Officer, Director

Kevin P. March - Chief Financial Officer, Senior Vice President

Analysts

John Dryden - Charter Equity

Glen Yeung - Citigroup

Cody Acree - Stifel Nicolaus & Company, Inc.

Srini Pajjuri - Merrill Lynch

Joanne Feeney - FTN Midwest Securities Corp.

David Wong - Wachovia Capital Markets LLC

[Mark Lippicus] - Morgan Stanley

Christopher Danely - J.P. Morgan

David Wu - Global Crown Capital

Steven Smigie - Raymond James

Ross Seymore - Deutsche Bank Securities

John Pitzer - Credit Suisse

Doug Friedman - Amtech Research

Tore Svanberg - Thomas Weisel Partners

James Covello - Goldman Sachs

Tim Luke - Barclays Capital

Uche Orji - UBS

Ron Slaymaker

Thank you for joining our third quarter 2008 earnings conference call. As usual, Kevin March, TI’s CFO, is with me. We also have a special guest today, TI’s CEO Rich Templeton, to share his perspective given the economic environment. For any of you who missed the release, you can find it on our website at www.ti.com/ir. This call is being broadcast live over the web and can be accessed through TI’s website. A replay will be available through the web.

This call will include forward-looking statements that involve risk factors that could cause TI’s results to differ materially from management’s current expectations. We encourage you to review the Safe Harbor statement contained in the earnings release published today as well as TI’s most recent SEC filings for a complete description.

Our mid-quarter update to our outlook is scheduled this quarter for December 8. We expect to narrow or adjust revenue and earnings guidance ranges as appropriate with this update.

In this call all of our financial results will be described for continuing operations including historical comparisons unless otherwise indicated.

In today’s call we’ll address key questions such as: What are the factors behind the drop in TI’s profit margins? Specifically, what impact has our inventory reduction had on profitability? What actions can TI take to reduce operating expenses further if we enter a period of prolonged weakness? We’ll also discuss details of the actions we announced today regarding our wireless business.

In July we described that we had a cautious perspective of the overall economic environment and therefore we were also being cautious with our own forecast and operating plans. That approach served us well as our markets and our revenue for the quarter were in fact weak and revenue came in and the middle of our range of expectations. Yet even so we were able to get ahead of the curve with operating expense reductions as well as to achieve a significant reduction in inventory.

Considering today’s increased economic uncertainty and our weakening order trends in the third quarter, we expect revenue to decline in the fourth quarter and have taken additional actions to reduce our expenses. Also, we will pull back further on capital expenditures as additional capacity is not required in this period of softer demand. Finally, we will accelerate our inventory reduction in the fourth quarter.

Let me start by describing the actions that we are taking to reduce expenses in our wireless business. The total savings will be about 1/3 of our current wireless investment or about $200 million on an annualized basis once the actions are complete. We will stop investing in merchant cellular baseband chip sets and are actively pursuing the sale of our merchant chip set product line. Even so we will continue to support select custom baseband programs. We will focus our wireless investments on our OMAP applications processors.

You have heard us talk for some time about the good opportunity that we believe is ahead of us in Smartphones with our OMAP applications processors. The Smartphone market is fast growing and TI is well positioned. Handset makers are focusing their own R&D activities on user interfaces and applications in order to maximize their product differentiation. From a semiconductor perspective, this points to the application processor as the best opportunity in the handset. Looking ahead we will concentrate our wireless resources on OMAP and our intent on extending our lead in this market.

Let me now walk through the impact on our financials. The sale of our merchant baseband operations including the LoCosto and eCosto product lines would have the biggest near-term impact. This business is expected to produce revenue in the range of $350 million to $400 million in 2008. The specific timing of the potential sale is undetermined although we should know this outcome within the next few months.

If a sale does not occur, we will continue to support existing customer engagements and will take additional action to remove almost all the operating expense associated with this revenue. In this scenario we would expect this revenue to decline over several years. Either approach should provide us a reasonable return on the business.

For the remaining baseband revenue which is about $2.3 billion this year from sales of custom products, we will continue to support our largest customers. We expect this revenue to decline in the years ahead as the previously discussed programs with Erickson bubble platforms continue to wind down through the end of this year and as our largest customer implements its multi-supplier strategy. As a result we are adjusting our operating expenses to align with this reduced expectation.

In total the reductions we are implementing over the next three quarters will result in annualized savings of more than $200 million with about 85% of that in R&D, 10% in cost of revenue, and 5% in SG&A. We expect to take restructuring charges of about $110 million as the actions are implemented.

Let’s now shift to our quarterly results. Revenue was $3.39 billion, a decline of 8% from a year ago and an increase of 1% from the second quarter. There was some impact to revenue from actions we took with our distributors late in the quarter to reduce inventory in the channel in consideration of the weakening environment. As a result distributor inventory was reduced by about $35 million or about 5% and is now below eight weeks. While this negatively impacted our quarter, it was the right decision and we will benefit by keeping inventory in our channel lean in this environment.

Our revenue results by product category are described in our release and I won’t repeat them here.

At this point I’ll ask Kevin to review profitability and our outlook.

Kevin P. March

Gross profit was $1.64 billion in the quarter or 48.5% of revenue. Gross profit was down $341 million from a year ago with most of this due to lower revenue although our inventory reduction also impacted factory utilization resulting in unutilized manufacturing costs impacting the current quarter’s cost of revenue. As a reminder, the year ago quarter also included a $39 million gain from the sale of the DSL product line, all of which was included in the gross profit.

Gross profit declined $106 million from the second quarter. Most of this decrease was attributable to the lower factory utilization due to our stepped up efforts to produce inventory in the third quarter. The cost of this underutilized capacity was expensed in the third quarter in turn increasing cost of revenue versus the second quarter. In total utilization dropped by about 10% points in the quarter from the mid-70s to the mid-60s.

It’s helpful to put this into historical perspective. If we look back to the fourth quarter of 2002 when we were at similar utilization levels, our gross margin was about 13 points lower in that quarter. The progress that we’ve made in improving our portfolio and our manufacturing operations is quite evident.

Operating expenses in the quarter were down $74 million or 8% from a year ago with reductions in both SG&A and R&D expenses. Sequentially expenses were down $19 million or 2% due to lower SG&A expense. As a result operating profit for the quarter was $746 million or 22% of revenue. Other income and expense declined to $10 million mostly due to lower interest income.

Income from continuing operations was $563 million or $0.43 per share. Income includes a $34 million discrete tax benefit that was primarily due to adjustments that we identified as we completed some prior years’ tax returns.

This tax benefit was largely offset by $44 million of charges that were incurred in the quarter and were associated with impairments of long-lived assets and site consolidations. For example, we did some site consolidation in Japan and also had some asset impairments associated with converting our former Kilby wafer fab into the recently announced Kilby labs. The breakout of these charges is as follows: $17 million in cost of revenue, $23 million in R&D and $4 million in SG&A.

I’ll leave most of the cash flow and balance sheet items for you to review in the release. However let me make just a few comments. Cash flow from operations was $1.05 billion in the quarter and we ended the quarter with $1.99 billion in total cash. We used $429 million to repurchase 17.1 million shares of TI common stock and paid dividends of $131 million in the quarter. As a reminder, in September we announced an increase in our dividend by 10% which will be effective with the next dividend payment in November. This was the fifth consecutive year for TI to raise our dividend. At recent stock prices our dividend yield is now about 2.5%.

Inventory of $1.58 billion at the end of the quarter was reduced $76 million from the end of the prior quarter. We have sharply reduced wafer starts in the quarter and as a result expect inventory to decline even faster in the fourth quarter or by more than $150 million. Inventory days declined to 81 from 93 last quarter.

TI orders in the quarter were $2.23 billion, down 9% from the year ago quarter and down 7% from the prior quarter. Product orders trended sequentially lower each month in the quarter.

As a result of these order trends and the increased uncertainty in the economic environment, we expect revenue to continue to decline in the fourth quarter. We expect total TI revenue in the range of $2.83 billion to $3.07 billion. Our assumption that semiconductor revenue will decline in a range of about 10% sequentially and that our calculator revenue will have its normal seasonal decline in the quarter.

We expect earnings per share to be in the range of $0.30 to $0.36. The EPS estimate includes a $0.05 benefit from the reinstatement of the federal research tax credit which was signed into law in October and was retroactive to the beginning of the year. This reinstatement along with a lower profit estimate for the year should result in an annual effective tax rate of about 28% for the year. Including the cumulative adjustment for the first three quarters, we expect the tax rate in the fourth quarter will be about 18%. The quarter will also include about $0.01 of charges associated with our wireless actions.

With that let me turn it over to Rich for his perspective.

Richard K. Templeton

Many of you have heard the term “it’s an uncertain economy,” but the fact is we’re pretty certain that it’s serious.

I’ve spent quite a bit of time in the last month, a couple weeks ago in Europe particularly in Germany, a couple weeks before that in Taiwan. We see customers that are observing slowing demand from their market places, I think we have a number of customers that fear more reductions as they look at the overall economic environment, and I believe we have a number of people starting to guard against getting caught with inventory. I think we see people reacting and starting to react pretty quickly.

We see it in general across all regions, across all end markets even though certainly the logical end markets have been more impacted; automotive for example more impacted and at the other end of the spectrum things like the base station, our infrastructure market place doing better. We’ve seen that through the balance of the last three weeks of September where ordinarily you’d be seeing a building demand for the holiday season. We in fact had a slowing demand, and that has been held through the first 20 days of October accordingly.

As Ron and Kevin both commented, we entered the third quarter cautious. We continued to take actions as we saw things being softened, and as a result we very simply believe it’s not a time to be waiting for perfect data. It’s a time to be acting and continuing to be diligent on this. The second point to make is that actions are underway. They will continue. The fact is we believe we will also have to adjust these actions as we learn more about where the economy really wants to go.

Kevin and Ron both described well that we have an operating plan that is assuming that fourth quarter will be down about 10% from a revenue perspective in semiconductor, and we’re assuming a further drop in the first quarter. I will emphasize even though it will probably be not heard very well, these are assumptions that we’ve made; not a forecast. Assumptions allow us to drive operating plan changes and take action to get a different result in the future.

Wafer fabs are now operating at a level that is consistent with these assumptions and if they’re able to hold, we’ll be able to run utilization pretty steady through the fourth quarter and into the first quarter. Kevin pointed out that these actions have had a major impact to margins in the third quarter but having been in the business a long time, history shows that taking these actions earlier are always merited. And I think we’ve gotten ahead on this one and we’ve taken pretty tough actions accordingly.

We also worked closely with distribution during the quarter as Ron pointed out. Despite the fact that we actually had resale increase slightly in the third quarter, we worked closely with our distributors to reduce inventory. Again on that front history shows that taking proactive steps to get ahead of an inventory situation in a softening economy are also merited.

Capital spending or capital expenditures have also been brought down. You should see in the release that the annual spend rate has been reduced from $900 million to $800 million. At this point that’s obviously just an adjustment to the fourth quarter and the simple reason is because we don’t need them from a capacity and a manufacturing perspective. Yes, we will be able to continue to keep those at low levels if we continue to see soft demand.

Expenses are being reduced using a lot of the classic techniques that you will do in this type of time, and we will also be very, very targeted on our hiring, in fact being focused primarily on new college hiring only as we move forward right now.

We are also prepared to adjust further if things change because I believe we’re in a market place and an economy that the assumptions that we made will not be precise, but we make them anyhow so we can act.

The last point before we open it up to questions is I’ve been through a lot of these in my time in the semiconductor industry. The greatest news to me is that these are absolutely opportunities for companies to get stronger, and that’s exactly what we’re doing and will be doing as this moves on.

As we’ve talked to investors for about a year and a half now, we are very focused on analog and embedded processing. We think they are literally the two best opportunities in the semiconductor market in terms of both size therefore growth opportunity, margins and also cash flow just looking at the manufacturing assets and manufacturing bases they use.

The changes that we announced today on wireless are consistent with the strategic direction that we’ve been describing for about the past year and a half as well on the wireless market, and they too will lead to TI becoming a stronger company with those actions taken.

The great news is that many of the actions and many of the decisions over the past three and four years that we’ve made have all driven us to a position of having both strong cash flow but also a very strong balance sheet, and that really is a great asset in these times.

We will continue to be active in our search of additional small acquisitions to strengthen our position in both analog and embedded processing and maybe most importantly to be paying very, very close attention to customers as we increase the chips per board and the great growth opportunity we have around the world. That is where the great strategic progress can be made in these times, and we intend to stay very focused accordingly on that front.

With that let me turn it back to Ron.

Ron Slaymaker

Operator, you can now open the lines up for questions. In order to provide as many of you as possible an opportunity to ask your questions, please limit yourself to a single question. After our response we’ll provide you an opportunity for an additional follow up.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from John Dryden - Charter Equity.

John Dryden - Charter Equity

Ron, can you discuss application specific analog both near term and long term, the impacts of the weakening demand and more importantly long term on consolidation in the overall wireless industry and your merchant baseband exit?

Ron Slaymaker

I think as we’ve discussed, what we’ve seen in terms of longer term expectations for application specific analog are unchanged and specifically the opportunity that we see there. Near term I think you’ll see even in third quarter we saw both high performance analog and application specific analog basically trend sequentially although application specific analog was down from a year ago. That’s pretty consistent I think with what we’ve described as that revenue that has declined basically would bottom out and then the expectation being that we could see growth drive forward maybe a couple or a few quarters out from there.

Again, we’ll have to see what the economy holds but again no change in our expectation for the opportunity for us to accelerate growth in our application specific analog business.

Do you have a follow up?

John Dryden - Charter Equity

Sure, for Kevin. Long term investments were down about $50 million. Was any of that an increase in liquidity for your auction rate securities?

Kevin P. March

Actually a little bit of that was we had some of those auction rate securities redeemed in the quarter and we’ve also been notified to expect more redemptions in the fourth quarter. You’re beginning to see the effect of that on the long-term security line.

Operator

Our next question comes from Glen Yeung - Citigroup.

Glen Yeung - Citigroup

Maybe a question for Rich. When you look into Q3, quarter reported, how much of the wireless business do you think was affected by a slowing end market versus share loss in that quarter?

Richard K. Templeton

Let me let Ron comment on the near term on that front. I think environmentally we feel pretty good about where we stand right now. Ron can cover the specifics.

Ron Slaymaker

As we said and described before, the E&P revenue continues to decline. We don’t break it out and report it quarter-by-quarter so I guess in that single case you could characterize that as share loss but as we’ve seen actually over a number of quarters now, wireless results were mixed by customer. As those customers report or have already reported, you’ll see they’re performing at differing levels and in fact our shipments into those customers have varied accordingly as well. I would say overall we believe the wireless market is weak associated with the overall economic environment but again it’ll be the specifics will mixed somewhat by customer.

Do you have a follow up?

Glen Yeung - Citigroup

Yes. The other question I have is thinking about the OMAP business as kind of a stand-alone business. As we think about the direction of chips that go into handsets over the coming quarters and years, what risk is there in the OMAP business that the app processor gets integrated and in fact having a baseband is a necessity?

Ron Slaymaker

We’ve played in the OMAP business now for pretty much as long as the applications processor as existed in the handset and our experience has been and our conclusions today even with the actions that you’re seeing is that we believe integration is very low risk. It really comes down to customers want to maintain software flexibility. The applications processor is a much different type of component in terms of their reliance upon that for differentiation of their handsets through the user interfaces, through the applications and services that you see them deploying, and we believe because of that software flexibility they will keep those as separate components as opposed to trying to drive them into an integrated solution.

Operator

Our next question comes from Cody Acree - Stifel Nicolaus & Company, Inc.

Cody Acree - Stifel Nicolaus & Company, Inc.

Rich, while we’ve got you on the line, you mentioned specifically an appetite for smaller tuck-in acquisitions with the kind of decline in the market cap we’ve seen with some of these companies and the decline in health, have you increased an appetite for maybe a slightly larger acquisition?

Richard K. Templeton

We’ve talked in the past with a lot of the investor base. First on the smaller acquisitions, we think those are great leverage. It really brings about the wonderful use of a sales team and an applications team that we have built around the globe that a lot of these smaller companies don’t have so it’s a great amplifier for really good teams through a really good sales outlet. As we said, we’d press on with that.

When it comes to the larger acquisitions, I still go to a statement that again you’ve heard. Something would have to just fundamentally make you stronger, not just bigger. That’s how we would always have to judge something or look at accordingly. Valuation is not necessarily the driver but strategic ability to be able to do more things in front of our customers is what we would focus on.

Cody Acree - Stifel Nicolaus & Company, Inc.

With the sale of the LoCosto and eCosto product, what’s any hindered participation in some of the emerging markets? Obviously a lot of the growth in wireless unit volume has been in those emerging markets and I know your OEMs, your partnered OEMs, are still playing there. But does this hinder some of your participation in that growth?

Richard K. Templeton

In fact if you look at it, it is highly, highly independent and what I mean by that is as we’ve built sales offices and sales channels throughout India, throughout China, you’re in working with a lot of the local companies throughout the industrial, consumer, medical, different customer base. So whether or not you have a commercial chip set is somewhat irrelevant because that tends to be narrowed on really a handful in some ways of five OEMs and maybe at the most 10 when you start to get to some of the regional players.

Operator

Our next question comes from Srini Pajjuri - Merrill Lynch.

Srini Pajjuri - Merrill Lynch

Rich, a question for you. If I look at your custom wireless business, it looks like you do anticipate losing some share and even taking a couple of years of view it looks like that business is going to decline. I’m just wondering what you’re thinking behind exiting the merchant side of the business and staying in the custom business?

Richard K. Templeton

I think Ron said it really quite well, and that is that we’ve got a really well-run custom business anchored with a great solid relationship and we’re going to continue to operate it and continue to operate it very well with those couple of customers. It’s a business that runs well. We can run it to make good money. We provide a great cost, great quality, great operation support to our customers, and we think simply we’re going to be able to continue to do that yet at the same time make sure we can size investments appropriately for what that revenue looks like.

Srini Pajjuri - Merrill Lynch

Just looking at your 10% guidance, can you talk about some of the trends you are seeing in different end markets?

Ron Slaymaker

We don’t break out outlook down into individual end markets but I will comment this is not being driven by any particular end market. It is a very broad-based decline that we saw in orders as we moved through third quarter and therefore outlook in the fourth quarter. So think of it in terms of being broad-based as opposed to a specific market, and frankly that’s probably as you would suspect given that our statements that we believe it’s economically driven.

Operator

Our next question comes from Joanne Feeney - FTN Midwest Securities Corp.

Joanne Feeney - FTN Midwest Securities Corp.

On wireless, if you could talk about perhaps the main consequence there. Is it mix primarily or units that you’re seeing drop off?

Ron Slaymaker

You need to give me some clarification. Are you talking about in fourth quarter or are you talking about in third quarter?

Joanne Feeney - FTN Midwest Securities Corp.

Yes, looking for the trend so emerging from the third quarter going into the fourth quarter. We’ve been hearing about units holding up relatively well but mix shifting towards the lower end. You guys have more exposure to the Smartphone market. I’m just wondering if you could clarify for us the mix issue versus the aggregate trend issue.

Ron Slaymaker

Maybe what I can do most accurately is describe the historical trend as opposed to the forecast. In third quarter you saw that our wireless revenue was up 1%. First of all, let’s break that down.

In terms of mix we saw growth probably think of it in terms of not double-digit growth but single-digit growth in 3G so therefore we saw some offset to that in the mid-range or the low-end type of a handset. So since 3G our content tends to be much higher than what it would be in the mid-range or low-end handsets, clearly from a units perspective probably total units were down but again we benefited from the higher ASP and frankly higher units specific to the 3G. Again that was third quarter.

I don’t want to try to project how that’ll carry forward into fourth quarter but at least that’s a bit of history.

Joanne Feeney - FTN Midwest Securities Corp.

On gross margin, in order to drive inventories down by it sounds like twice the amount you did in the third quarter, how much room do you have to do that through your foundries or how much do you do that along with your in-house manufacturing? In other words, where should we expect past utilization and gross margin to go for the next couple of quarters?

Kevin P. March

I think Rich commented that we were taking down our starts through the quarter, and we expect those starts in the fourth quarter to be less than what we had in first quarter. To say it another way, utilization will be less in the fourth quarter than it was in the third quarter by at least a few more points. That certainly has the potential to weigh on us gross margin-wise but we expect that utilization or that start level to hold pretty constant for the fourth quarter and the first quarter.

On the top level you would expect to have a little bit of utilization pressure continuing going into the fourth quarter. At the same time we’re taking steps as well to try to reduce our expenses as we go into the fourth quarter to try to keep the overall bottom line impact minimal.

Ron Slaymaker

Just to clarify, in fourth quarter utilization will drop by a few points. In third quarter we actually saw roughly a 10 point drop. Is that correct?

Kevin P. March

Right.

Operator

Our next question comes from David Wong - Wachovia Capital Markets LLC.

David Wong - Wachovia Capital Markets LLC

Just a clarification. When you said that you’re going to continue to support your custom business, but it will drift down over the years. Do you expect to eventually exit the business or do you expect it to go down to a fairly constant level and that you’ll retain one or two customers at that level?

Richard K. Templeton

We will focus on those couple of customers and really the one large customer. We provide what guidance we can, which is that business will probably get smaller over time just because of the said direction if you listen to some of these customers about looking more towards a generic chip set in the merchant market over time. We we’ve made that assumption that it’ll trend down. Obviously if these large customers wanted to continue to work with us closely the way we have, we’ll continue to work very closely with them.

Operator

Our next question comes from [Mark Lippicus] - Morgan Stanley.

[Mark Lippicus] - Morgan Stanley

First question is for Kevin I guess. Going beyond the next couple of quarters on the gross margins, can you give us a framework for thinking about what it will take to get the gross margins back up? I’m trying to understand in the second half of last year your gross margins were 54%. Assuming a static mix if you get to that revenue level, is there any reason that we should assume that the margins don’t get there or could go above that?

Kevin P. March

There are several things actually I think that are important to keep in mind as you look out into the future for our margins. We did mention about a year ago, I guess about May of ’07, that we had set a goal for being able to put together a portfolio that would operate at about 55% gross margin and 30% operating margin.

On our way there what we’re looking to is an increasing portion of the mix of our revenue to be coming from both analog and a better process in which both deliver those kinds of operating results and at the same time for our high performance analog, the subset of the analog piece, to continue to improve in its overall profitability as the quality of the products in that portfolio continue to improve.

Kind of tailing in behind that and this leads back into a comment that Rich made about our capital spending is that our cap ex has come down. In fact over the last 12 months worth of revenue our cap ex is running about 6% of that revenue and our depreciation’s been running about 7%. So when your cap ex is running below your deprecation you’re going to expect to see depreciation continue to decline as you go out over the next couple of years.

The final thing that you’ll continue to see is just these portfolio adjustments that we continue to do. Recall in 2005 we sold the LCD commodity driver business. That took on a low margin business. Last year it was the DSL business. This year you’ve heard us talk about our merchant chip set business that we’re going to go ahead and take action on. In all three of those cases those were elements of our portfolio that averaged down our overall gross and operating margins, so by removing those again that gives us some lift going forward.

So there are really three or four moving parts inside and we remain quite optimistic as to how this portfolio shifts over the next few years and works us toward those kinds of profit goals.

Ron Slaymaker

I think just a more near-term impact, there are two things that are affecting our gross margin. One is declining revenue in fourth quarter and the other is just the impact especially as we saw in third quarter of inventory reduction and the impact that had on lower levels of utilization. In the near term when we get the inventory reduction complete, that will tend to provide a lift on utilization and therefore margins. The other consideration is whenever revenue would start to grow again, certainly that will be a benefit as well.

[Mark Lippicus] - Morgan Stanley

Perhaps a question for Rich. It sounds like your channel inventory is around eight weeks at the low end of the historical range. The assumptions that you’ve made on your revenues in Q4, do you think that would be an accurate reflection of the real consumption of your components by the end market or do you think that the channel’s in the process of taking the inventories below even the current low levels that we see?

Richard K. Templeton

I think by asking that question you’re on the key thing about taking action, and that is that channel inventory metrics are usually trailing metrics, not leading. That’s why in all my experience in all my history, getting out ahead of this thing is usually merited. That’s why even with an increasing resale number in third quarter we just looked at the overall size and said that this is the time to be getting back ahead of this thing. We feel good on a relative basis the real question that you’re after is what’s the absolute target you need to get to, and it’s going to take time to know.

Operator

Our next question comes from Christopher Danely - J.P. Morgan.

Christopher Danely - J.P. Morgan

Probably a couple questions for Rich. You guys are restructuring the wireless business but it looks like the part that is left is not going to grow and we all know it has lower profitability than your base business. In the past when this has happened, whether it’s DRAM or [CON] business or S&C, you’ve exited those businesses. I guess my question is why are you not exiting the entire wireless business?

Richard K. Templeton

That’s an interesting question but let me break into a couple of things. First off, when you say the piece of wireless that’s left, there are a few pieces in there. One is you have a tremendous opportunity with application processors with what’s happening in the Smartphone world. That is one where if you get with Greg and his whole team, you take a look at the customer and the customer adoption of these products, we really are pretty excited about where this thing wants to go, economies aside. So that’s why you invest aiming forward, and in this case aiming forward is about aiming at the Smartphone and the application processor business.

The flip side of that is what do you then do with the called baseband business or in this case the remaining element which is the custom baseband business, and that’s where you have to sit down and you just have to run that in the smartest way you know how. The smartest way that we know how is to be able to support customers at minimized costs and investments on that front, and as a result you can generate the best value for shareholders over the long term. It’s how we always tend to look at these and in this case run an ad on the inside is the best choice.

Christopher Danely - J.P. Morgan

Switching to the analog business, was any of the gross margin reduction due to analog pricing? And I guess Rich, looking out you said you wanted to get a little more aggressive in your analog growth rates. Are you willing to trade off margins for growth or how do you look at that?

Richard K. Templeton

Nothing changed in terms of our strategy for pricing in analog. You kind of have to look at the analog businesses separately. The high performance analog price is very low on our customers’ list of priorities and considerations. It’s much more driven by technology, support, those types of considerations. On the high volume analog side, it is more of a competitive market dynamic and pricing is more of a factor but frankly those are probably more considerations that are made when a customer is initially engaging with the supplier, because again much of that business will tend to be custom type of products.

So once you get into call it near-term environmental changes such as we’re seeing today, you tend not to see analog pricing move around with that near-term environment. Frankly, when things get better we certainly don’t go out and raise prices on our customers either. Where we do see some price movement with the environment is in areas like our standard logic or our commodity logic product line.

Keep in mind that is a very small percentage, probably 5% if not less than our total revenue today and in that commodity area, yes you’re seeing some pricing pressure as you would expect. But again it has very little impact on TI overall.

Operator

Our next question comes from David Wu - Global Crown Capital.

David Wu - Global Crown Capital

Rich, while I have you on the phone, can you help me with two things? Number one is given the fact that you are exiting the merchant baseband business and the custom baseband business is going to go south, are you maybe recalibrating your top line growth goal for the next five years, the one that you set back in May of this year? The other one is, it sounded like the merchant baseband business you are talking to potential buyers. Are we close to some kind of a deal or are we still in a preliminary stage of talking?

Kevin P. March

Let me go ahead and answer that. I think the quick answer is no, it does not affect the overall top line growth that we talked about. We talked about back in May putting together a portfolio that in a semiconductor market that’s growing on average 8% compounded annually, which has been the long-term average here in the last dozen or so years, that in that kind of market we would expect our portfolio to be able to generate an average of around 10% annual growth rate. Along with that by the way about a 15% compound annual growth rate in earnings.

We don’t expect the changes in the merchant chip set that we just talked about or the custom business to affect that. In fact we have been comprehending these kinds of market changes all along when we actually gave that guidance.

Richard K. Templeton

Are you close to a deal by having announced it?

David Wu - Global Crown Capital

We hadn’t talked about that. Usually companies are fairly close to a deal before they even mention something like that. So I assume that’s the practice at TI as well.

Kevin P. March

I would just comment that we are in discussion with several interested parties and that’s probably all I should say at this point in time.

Richard K. Templeton

Part of our announcement also is just driven by the need internally to make some disclosures because we do have broader actions that are taking place inside of our wireless organization overall.

David Wu - Global Crown Capital

With $100 million of restructuring charges, we should see it in the quarterly numbers right? [Inaudible] this year and the first two quarters the next year.

Kevin P. March

That’s correct. We’re expecting right now over the next three quarters and in the fourth quarter estimate we’re expecting approximately $0.01 of charge with the balance to occur in the first and second quarter of ’09.

Richard K. Templeton

I just wanted to follow up. Kevin gave the exact right answer on the growth targets. We look at the opportunity with analog $36 odd billion market; embedded processing $16 billion market; while we’ve got great share it can be just a lot greater. So the growth opportunities that we see in front of us are the same ones we talked about really back in May.

Operator

Our next question comes from Steven Smigie - Raymond James.

Steven Smigie - Raymond James

I want to make sure I’m connecting the dots right. I think you indicated that revenue might be down again in Q1 but that you would expect utilization to be about flat relative to Q4. If that’s the case, does that mean then you’re not reducing inventory at that point, you’re shipping back to demand? Is that how I should look at that?

Kevin P. March

Actually what we are expecting is that what you said, revenue would be down in fourth and first and that inventory will decline as we’d already mentioned by about $150 million in fourth quarter and there probably would be some incremental decline in first quarter. That’ll be somewhat subject to what our expectation is on the 2Q revenue outlook which will moderate that a little bit when we get to that point in time.

Steven Smigie - Raymond James

If you’re inventory’s coming down again and revenue’s coming down, how does utilization stay flat?

Kevin P. March

Keep in mind it’s a function of when you start your wafers and how long it takes that to run through the factories. Your average cycle time’s going to be call it two to 2.5 months to run through. So if you just kind of map out the cycle time of the wafers from when they start to when they come out, they don’t come out faster enough to actually start growing inventory if your revenue is in line with what we’re expecting. So you’d see your inventory decline further.

Richard K. Templeton

To me, the simpler one is I think it emphasizes how hard we’ve gotten after this thing in the third quarter. That’s how you do it. You end up bringing the utilizations down by the time we were leaving the quarter as Kevin or Ron talked about 10% points. We left the quarter a couple, three or four points below that and we’ll run that level theoretically through 4Q and 1Q reducing a lot of inventory; some in Q3, a lot more in Q4 and then a little bit more in Q1. So it’s a magnitude statement about the aggressiveness of action.

Operator

Our next question comes from Ross Seymore - Deutsche Bank Securities.

Ross Seymore - Deutsche Bank Securities

A question for Rich. On the guidance that you gave, how much of that is bottoms up versus top down conservatism or caution given what you’re seeing in the end markets?

Richard K. Templeton

I think that’s a great question and I want to be really careful of anybody hearing the word that our 10% down number is a cautious outlook. I say that because I think we’re just literally at a steep part of that curve and the ability to draw a line is very difficult. So we see customers currently making changes to their backlogs and their demands. What we did was we got very aggressive actually during the third quarter to start putting some tough operating plans in front of us. Our best estimate at this time is that down 10% but I think we’ll have to see exactly where that comes out.

Ross Seymore - Deutsche Bank Securities

When you talk about the first quarter revenues being down as well, is that more of a statement on what you see in the end markets now, normal seasonality or something else?

Richard K. Templeton

That is about getting internal operations to take action as opposed to waiting for perfect data in this world. So we’ve got an incremental reduction in first quarter revenue that we put into an operating plan. It goes back to Steve’s prior question on utilization. That’s slightly more than seasonal down. Again it’s not for great wisdom of forecast; it’s for wisdom that says usually making choice to get ahead of these is better than waiting for perfect data to show up.

Operator

Our next question comes from John Pitzer - Credit Suisse.

John Pitzer - Credit Suisse

Ron, quickly just a clarification on your Q4 revenue guidance. Does that include the merchant wireless business or do we take $100 million out quarter-on-quarter? How does that work?

Ron Slaymaker

It includes our merchant wireless business until we announce that that sale has been achieved.

John Pitzer - Credit Suisse

Kevin, you talked a little bit about some of the positive offsets on the analog business margin profile. I’m kind of curious, when you look at the cost actions you’re taking on the wireless business given the $200 million reduction in cost, $400 million reduction in revenue, going forward structurally would that business be more or less profitable on the gross and operating margin?

Kevin P. March

The quick answer is it will be more profitable taking out that much cost. As we’ve talked in the past the wireless business has generally averaged down the overall performance of the company and by taking out this much cost you can see where this will add a little bit more favorable bottom line results going forward.

Operator

Our next question comes from Doug Friedman - Amtech Research.

Doug Friedman - Amtech Research

If I could just clarify, did I hear correctly that you’re thinking that despite the fact that normal seasonality is thrown out the window right now with what we’re seeing macro wise, you’re thinking that Q1 is going to be seasonal or worse than seasonal? Did I hear that correctly?

Kevin P. March

I think what you heard Rich saying is that in this economic environment rather than waiting to find out what the signals tell us, we’re preparing ourselves in the event that it’s worse than seasonal and is actually down quite a bit versus the fourth quarter. The normal seasonal for us if you go back and look over the last 10 years or so was down about 1% versus fourth quarter. We’re preparing ourselves for the possibility that it would be down steeper than that.

Doug Friedman - Amtech Research

Just focusing a little bit on some housekeeping. There is a lot of free cash flow that continues to come out of your business model. How are you thinking about buy-back versus dividend as far as returning equity to shareholders?

Kevin P. March

Actually that’s a good question. We just got Board approval to increase the dividend again this quarter. That’s five years in a row now of increase in dividends to the point where now I believe the yield is 2.5% based upon our recent stock price. You’ve seen us use more dollars for buy-back than for dividend although that mix has changed somewhat especially in the last year as we’ve taken a lot of the excess cash that we had generated from activity over the prior few years and used that for larger buy-backs. Now what you’re seeing is our use of cash for buy-backs and dividends getting a little bit closer to our actual cash flow generation. I think you’d see more of the same going forward.

Operator

Our next question comes from Tore Svanberg - Thomas Weisel Partners.

Tore Svanberg - Thomas Weisel Partners

Going back to gross margin, the way I understand it is that it was down 370 basis points this quarter and we should expect a lower drop than that in Q4 in the actions you’ve already taken?

Kevin P. March

You’ll see it go down if for no other reason because of the seasonality of the calculator business that we discussed. It tends to operate at quite a high gross margin so that revenue alone will reduce quite a bit fourth quarter because of its normal seasonal activity. Then beyond that there’ll be a smaller impact just by virtue of the fact that we don’t expect our utilization to fall quite as sharply in fourth quarter as what it did in fourth quarter. It will still go down some so that will pressure us a bit from the standpoint that we’ll have some fixed costs that won’t be absorbed, but we don’t expect it to fall quite as sharply as what we saw this past quarter.

Ron Slaymaker

So with utilization roughly flat or slightly down a little bit, more of the gross margin trend will be driven by the changes in revenue and whatever falter is associated with that as opposed to the underutilization costs we saw in third quarter. Is that correct?

Kevin P. March

That’s correct. Proportionately more will be revenue driven as opposed to fixed cost driven.

Tore Svanberg - Thomas Weisel Partners

I’m sure in times like this you take a strong revisit at your business and where you’re going to go once we get out of this. In analog and embedded processing you mentioned you expect to gain share. Can you just talk about some of the end markets that you are perhaps penetrating a little bit more than others from a design win perspective please?

Richard K. Templeton

While I get to travel around a lot and you get to sense what the economy and customers think, the thing that I remain excited about is all the customers and the new applications and the designing process that’s taking place. Areas as broad as industrial to motor controls, improving the energy efficiency of white goods or industrial equipment to the impact of what’s happening in medical to even continuing away in market places like automotive. That’s why we remain so fascinated with both analog and embedded processing is that literally you can sell chips to any company in the world that builds an electronic based piece of equipment. So we feel pretty good about it.

Operator

Our next question comes from James Covello - Goldman Sachs.

James Covello - Goldman Sachs

I’ll just touch on the thoughts around the connectivity products. Is there any change in your view on the connectivity products in wireless relative to the divestitures that you’re having?

Richard K. Templeton

Short version is no, meaning that we still think that if you look at the Smartphone world and the functionality going into Smartphones, this is going to be a rapidly growing space and Greg and his team have done some pretty interesting things in that area. So while you hear a lot of the public attention on OMAP and the investments in OMAP, the connectivity business as you refer to it is a pretty impressive business as well.

Kevin P. March

Just for the broader audience, let’s define what we mean by connectivity. It’s GPS, Blue-Tooth and Wi-Fi, and in those areas TI has especially strong positions in Wi-Fi for the handset as well as discrete GPS solutions.

James Covello - Goldman Sachs

I’ll ask my follow up on the same topic but it can count as my follow up. Relative to those things being integrated, is it enough to integrate them with an OMAP processor or do you really need a baseband processor as the connectivity market moves further toward integration?

Richard K. Templeton

I think what’s going to happen on that is it goes back to I forget who asked the question but Ron answered it. I think you’re going to find application processors remain pretty discreet or stand-alone just because of the software, the programmable nature of those products. As a result there’s not this major integration of devices like Blue-Tooth or GPS. What we could see if you spend time with that team, you’d hear about integration of the connectivity functions. You’ve seen some things so far in life in connectivity where Blue-Tooth and FM came together for example. Maybe you’ll see some partitioning along those lines.

I don’t think we’re going to find all this stuff ends up on a single device be it an application processor nor the temptation to have it integrate on to the baseband because basebands vary as you go throughout the world. Customers are going to want those platforms to be modular so they can adapt their product to different market places.

Operator

Our next question comes from Tim Luke - Barclays Capital.

Tim Luke - Barclays Capital

Rich, just for you. You clarified at the start that you are clearly focused on analog and embedded in the wireless area. You’ve got the run rate business of around $3.6 billion and it seems like you were disposing around $350 million to $400 million of it. Could you just give us a sense of what some of the strategic options are there and maybe just remind us of how large, just in terms of framework percentages, your OMAP piece is that you seem focused on of that $3.6 billion? And remind us, I think it’s somewhat lower this year and maybe when do you expect that business to reaccelerate?

Ron Slaymaker

Let me just kind of go through some of the numbers regarding the strategic options. Roughly and I’m not sure this is a third quarter number as much as generally what we’ve been running last year and maybe year-to-date this year. About ¾ of our wireless revenue has been baseband. Most of the remainder is OMAP application processors although connectivity is part of that as well. Certainly the majority of that, 75% or so, total revenue is baseband.

Richard K. Templeton

Just following up and it’s not to try to sound too simplistic, but our view on this is really one that when you look at the wireless business you want to get your R&D lined up on things that are going to grow. Things that are going to grow is a unit volume statement to where they’re going to grow actually at unit volumes far greater than the total handset growth. Handset market at $1.2 billion a year has only got certain growth capability left given the size of the planet and the number of subscribers.

We want new capabilities that are going to be penetrating in. That’s where Smartphone leads to OMAP leads to connectivity. Those are great things that are going to grow. We’ve been doing our best and continue to do today with today’s announcement is get your investment focused on that. Then on the things that aren’t going to grow and make sure you’re focused on the most value for them.

Tim Luke - Barclays Capital

Two quick clarifications. First, do you remain committed to the non-merchant baseband business or are you evaluating different strategic options there? Given your comment that you wanted to minimize investment there, how is the Motorola customized offering developing in terms of its timeline?

Richard K. Templeton

Simple answer is highly supportive because we’ve got great customers like Nokia and folks, and you’ve got to take good care of them including the custom baseband business because it’s got a lot of years left in it. The fact is the goal in life is not necessarily to just minimize, it’s to align. What I mean by that is where we have customers that want to do more on a project, we get the right people lined up on it and make sure that we have that adjusted to the revenue opportunity that’s there.

Ron Slaymaker

I think the other thing that I just want to emphasize because I know a lot of times whether on this call or just investor questions in general is a question of why don’t you get out of the whole thing. The reality is that baseband business especially the custom side of the baseband business has very good profitability and is valuable to Texas Instruments. That’s not saying we can’t take some expense out of it and make it even more profitable but this is not something you shut down. It carries a lot of value for TI in terms of its earnings contribution and we want to maximize that.

Operator

Our next question comes from Uche Orji - UBS.

Uche Orji - UBS

Rich, in terms of the timing of this announcement, this is a very tough market environment. [Inaudible] is out there trying to sell their wireless business. For the [inaudible] debt market it’s difficult so [inaudible] financial buyers or strategic buyers. It’s just not a very easy environment to contemplate a deal of this size. Why now and what gives you the confidence in terms of the time you laid out that this can get done?

Richard K. Templeton

If you look at the timing of why now, you’ve heard us talk for about a year and a half in terms of where the direction was we were going with the wireless business. We just think it’s at a critical time to make sure we take the next step of focusing the research and development in the right areas. As Ron commented earlier, that includes changing development roadmaps and also considering for sale or putting up for sale that business. I think Ron or Kevin also pointed out that if that doesn’t work or there’s not an interested buyer in that merchant market chip set business, we’re prepared to run it well, support customers and also minimize the investment on that front. I think we can handle either outcome.

Uche Orji - UBS

On that topic, obviously you’ve spoken to everybody involved. What is the feedback from your OEM customers? Is there any preference or contractual or otherwise that would lead that to financial buyer or a strategic buyer?

Richard K. Templeton

I’ll minimize any commentary except that obviously when you consider anything like this, you talk to your customers because they’re the important folks in this process. We’ve let them know what our thinking was. I think we’ve also established a lot of credibility over the years to support our customers either directly or by making sure that a sale would be completed successfully. We’ll continue to operate in that mode.

Ron Slaymaker

With that our hour’s up. Let me tell all of you thank you for joining us. A replay of our call is available on our website. Good evening.

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