National Semiconductor Corp. F2Q09 (Qtr End 11/23/08) Earnings Call Transcript

| About: National Semiconductor (NSM)

National Semiconductor Corp. (NSM) F2Q09 Earnings Call December 8, 2008 2:30 PM ET


Mark Veeh - Investor Relations Manager

Brian L. Halla - Chairman, Chief Executive Officer

Donald Macleod - President, Chief Operating Officer

Lewis Chew - Chief Financial Officer, Senior Vice President - Finance


Analyst for Tory Svanberg – Thomas Weisel Partners

Chris Danely - J.P. Morgan

Douglas Freedman – American Technology Research

Uche Orji - UBS Securities

Sumit Dhanda – Banc of America Securities

Craig Hettenbach – Goldman Sachs

Analyst for Craig Berger – Friedman, Billings, Ramsey & Co.


Welcome everyone to the second quarter fiscal year 2009 conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions)

Mr. Veeh, you may begin your conference.

Mark Veeh

Thank you. I’d like to welcome everyone to National Semiconductor’s second quarter fiscal year 2009 earnings call. Joining me on the call today are Brian Halla, Chairman and Chief Executive Officer; Lewis Chew, Chief Financial Officer and Don Macleod, President and Chief Operating Officer.

In today’s call I will provide a recap of the second quarter financial results. Brian Halla will give an overview of the business environment and an update on the company’s focus and priorities going forward. Lewis Chew will expand on the second quarter results and provide the background to our outlook for the third quarter of fiscal year 2009. Lastly, Don Macleod will then discuss market trends and products in more detail. We will then take questions until approximately 2:30 p.m. Pacific Standard Time.

As a reminder, this call will contain forward-looking statements that involve risk factors that could cause National’s results to differ materially from management’s current expectations. You should review the Safe Harbor statement contained in the press release published today as well as our most recent SEC filings for a complete description of those risks.

Also in compliance with SEC Regulation FD, this call is being broadcast live over our Investor Relations website. For those of you who have missed the press release or would like a replay of the call, you can find it on National’s IR website at

Now moving on to our second quarter results as follows.

Sales were $422 million, down 9% from $466 million in the previous quarter and down 15% from $499 million in last year’s second quarter. Gross margins for the quarter were 65.6% down from 66% in the prior quarter and up from 64.4% in last year’s second quarter.

Operating expenses in the quarter were $164.1 million down from $174.7 million in the prior quarter. Note that for this quarter other non operating expense of $12.3 million consisted of a drop of the value of employee deferred compensation investments that are held in a trust on behalf of the employees. A corresponding credit of $12.3 million is included in Q2 SG&A expense. This credit represents the corresponding change in the liability associated with the employee deferred compensation plan due to the change in the market value of these securities. You can find a description of this deferred compensation plan and related disclosure on page 53 of our fiscal 2008 form 10K.

Also included in our GAAP financial results this quarter was a $28.1 million expense for severance and restructure primarily associated with severances in connection with our previously announced actions on November 12, 2008.

So now moving on to the rest of our income statement, net interest was $14.9 million and the income tax expense for the quarter was $23.5 million. Included in this number is approximately $7 million of discrete tax expense that has been highlighted in today’s press release. As a result, National posted GAAP net earnings of $33.9 million or $0.14 per fully diluted share in Q2 fiscal 2009. The fully diluted share count for the second quarter was 234 million shares.

Before I turn it over to Brian I would like to remind everyone that our fiscal third quarter 2009 will contain one additional week versus the company’s physical 13-week quarter.

With that I will now turn it over to Brian.

Brian Halla

Thank you Mark. Good afternoon everyone. A lot has changed since most of us met in September in New York for our annual analysts meeting so let me try to ease into this commentary by making an assumption about why you decided to join us today on this call.

First, obviously you would like to find out what is happening in our business given this environment and if National has been affected by this environment how so and what are we doing to respond? And what does all this say about our future? Finally, what is our company’s progress against our National 3.0 initiatives?

I’ll try to respond to these questions and others by using a metaphor of one of my favorite spaghetti westerns, The Good, The Bad and the Ugly. I’ll add a category that I’ll call the best.

So let’s start with the good. Of course you are all entitled to your own assessment but National Semiconductor over the years has become a very good company. We have rock solid fundamentals. I believe in many ways we have gotten ahead of our peers with our repositioning of the company last year to National 3.0.

Also as a result of our corresponding focus on new emerging markets which I will discuss in a minute, we have successfully abandoned the silicone by the pound commodity markets and dramatically improved the value add of our technology and building block products.

The disproportionately healthy trends of those products within our portfolio is a testimony to that decision. We have become quite profitable as a company as the result of the success of our five-year 60/30/30 march and corresponding repositioning of our company into a pure play high performance analog company. These profits allowed us to achieve five straight fiscal years of ROIC above 20%. We have outstanding engineering and manufacturing resources and last month’s action allowed us to cut costs and at the same time put the right level of resources of the company firmly behind the arrowhead we call National 3.0.

So let’s talk about the bad. After achieving peer group status as a high performance analog company, one thing became quite clear immediately. This sector appears to have been under performing for some time. By that I mean the stock prices of all these companies haven’t moved in five years. The PE ratios of these companies have been knocked down from the 30’s to the low teens even before the current market meltdown.

The popular market demand drivers such as the cell phone have seen ASP erosion unable to be offset by the volume growth of those products. So National a year ago last fall decided to move on beyond the easy money and we were determined to meet the new mega trends which would become the volume drivers in the next cycle with systems and application solutions. Solutions which would be derived based on innovation within and collaboration across our analog, standard and linear product lines. This focus is now beginning to bear fruit.

So that brings us up to the ugly. What started as a sub-prime debacle which many of us through would be an inch and a half wide and a mile and a half deep and leaving our consumers largely unaffected has now begun to have its deleterious consequences on consumer confidence worldwide?

We put in place cost cutting actions which included a nearly 5% reduction in headcount, consolidation of some design centers which primarily supported the more traditional standard linear product lines and we reallocated resources strategically to support our new thrust.

Going forward National is also using additional aggressive variable cost controls in the areas of restricted discretionary spending and selected shut down and official vacation days. The tea leaves are right now difficult at best to try to read. So going forward we are guiding down approximately 30% plus or minus depending on the level of turns orders received during the quarter.

Some of you may be trying to compare this recession with the most recent bursting of the dot com bubble in 2001. That was a relatively short-lived recession. It was a period of time in which consumers kept consuming and U.S. semiconductor and system suppliers had to hunker down and ride out the time it took for the excess inventory in the channel to work itself off.

This is not that type of recession as it was not caused by excess inventory in the channel. Instead, consumers have all but stopped consuming. For those of you asking when this cycle is behind us tell me when consumer confidence will return. When this credit return is the lubricant that drives the world’s economic engine as we knew it, so this is not a hunker down recession. This is a time to invest recession.

Which brings us from the good, the bad and the ugly to the best. This is the best possible time for National to put even more emphasis on the transition to National 3.0. The old demand drivers as we knew them will not pull us out of this recession. The semiconductor industry has always seen the major up cycles driven by new markets and new demand drivers. The first boom cycle was the DRAM driven market which replaced ferrite core magnets in the back of mainframe computers. The second cycle was driven by the PC. The third cycle by the connected PC or the Internet and the one behind us driven by cell phones and many consumer goods and gadgets.

Never has a new boom cycle been launched only by the prior cycles innovation or demand drivers. So National’s strategy is to drive our own recovery by being early in building solutions to support the needs of the new mega trends. Let me keep going on the best.

This is the very best time to be a leader in power efficient solutions such as our PowerWise high performance circuits. We are focusing these circuits and systems such as our recently announced SolarMagic which can return up to 50% of the power to the solar power stream suffering from shade or debris. We can use these same power efficient circuits to manage battery technology to make electric cars more viable. We also focus these circuits on driving much more power efficient LED lighting systems. This same family of PowerWise products will enable medical instrumentation which can distribute healthcare into the home instead of the current centralized model which bears characteristics similar to the old mainframe computer’s centralized compute model.

These are the same power efficient circuits that can also allow data centers to consume much less power for servers and corresponding air conditioning and reduce CO2 emissions by millions of tons in the process.

Improvements in personal productivity through personal mobile device enhancements and new innovations in sensor technology are now also targets for our company’s R&D dollars going forward.

So we will move on from the bad and the ugly with PowerWise driven solutions to the new mega trends we believe will drive the next cycle for our industry and we welcome our peers to follow. This is not a hunker down recession. It is time for our industry to drive its own recovery.

Over to you Lewis.

Lewis Chew

Thanks Brian. So as you have all heard by now the revenue outlook we are guiding for the third quarter is down about 30% sequentially plus or minus depending on turns. The punch line is our opening backlog was down significantly and our guidance is not anticipating any snap back in turns orders in the quarter.

So on my portion of the call today I will provide more depth on the basis for this revenue outlook and then I will discuss the implications of how we run the business model technically here in the near term until the level of business picks back up again.

When I refer to the business model I am mainly referring to a few, key topics. Factory activity which impacts gross margin and inventories, operating expenses which we are planning to bring down and cash management. Later on in this call Don MacLeod will talk more about our growth initiatives.

So let me move on to discussing the basis for the revenue outlook beginning with how the second quarter transpired. When I look back at the first few weeks of September we were getting a relatively decent amount of new orders. Recall also that we started off Q2 with a higher opening backlog. But near the end of September we saw a steep drop off in order rates across the board as the economy was deteriorating and our customers as well as distributors began to behave much more cautiously.

Then in early November we saw yet another decline in the level of orders as companies made even further adjustments to what they planned to build in for the holiday season. Ultimately our total bookings in Q2 were more than 30% below what they were in Q1.

This decline was also reflected in turns orders which are orders placed with delivery requested in the same quarter. We started off Q2 with good turns orders for the first few weeks, but for the remainder of the quarter net turns all but disappeared as any new turns orders were essentially offset by negative turns due to push outs and cancellations. The largest market we serve is the wireless handset market and this is where we saw the largest adjustments. In other words bookings drop off and negative turns activity.

We also saw decreasing order rates in our distribution channel where resale’s were down sequentially in Q2 by nearly 10%. In a more typical year the distributor resale’s would be up seasonally in our November quarter. Turns orders from the distribution channel were positive but were lower than we had originally expected at the beginning of the quarter.

Distributor inventory dollars were down quarter-over-quarter and weeks of distributor inventory at the end of Q2 were about 9.5 weeks. Based on the input we received, we anticipate that distributor resale’s will likely be down again in Q3 and distributor inventory dollars will be reduced even further.

So with all that background it boils down to the fact that opening backlog is down significantly and this is the main factor driving our revenue outlook for Q3. Turns orders are difficult to predict with precision in this economy. How is that for an understatement? So our revenue outlook assumes a modest amount of turns, below the level we saw in Q2. We are also assuming that overall booking rates will continue to run at suppressed levels in Q3 until our customers gain more confidence and visibility in the real level of in-demand. With the significant decline in revenue here in the short-term we are lowering our manufacturing activity significantly.

Our wafer fab utilization was about 66% in Q2 and we are planning to drop that to below 40% in Q3. Our inventories grew by about $6 million in Q2 mainly because of the revenue miss but in Q3 we are planning to hold inventory flat to slightly down.

Our gross margin was about 65% in Q2 and that is expected to drop to a range of 54-55% in Q3. This decline in gross margin is mainly due to the lower capacity utilization as we currently manufacture well over 90% in house.

We will control our production spending through a combination of ways including factory shut downs, work furloughs and shift reductions. We will continue to improve the overall cost structure in a way such that gross margins will be incrementally better at comparable revenue levels when business picks up again.

In November we announced an action to reduce headcount and lower the company’s operating expenses on a go forward basis. The total targeted savings from this action is about $12 million per quarter. In addition to that headcount reduction we are also using other more temporary ways to control expenses in the third quarter such as shut down days and restrictions on discretionary spending.

So here are the estimated expenses for Q3 and in these projections I have now incorporated the impact from all of our cost saving measures for Q3 as well as any offsetting impact from the extra week that falls into the quarter this year.

R&D is anticipated to range from $80-82 million. SG&A is estimated to range between $78-80 million. Earlier in the call you heard Mark explain the credit we had in the Q2 SG&A which I am not projecting to repeat in the Q3 SG&A.

Other income expense is estimated at $1 million of expense. Interest expense net is projected to run from $16-17 million and this is higher than the $15 million we had in Q2 mainly because of the extra week in Q3. So the net interest expense should decline in Q4.

The income tax rate is projected to range from 30-31%. Embedded in the figures I covered are stock compensation expenses of approximately $21 million in Q3.

Here is a breakout by the various line items impacted. Cost of sales $5 million, R&D $7 million and SG&A $9 million.

Let’s move onto the balance sheet.

Our capital expenditures in Q2 were about $35 million. In Q3 we anticipate capital spending will be around $20 million as we continue to work on the 8” conversion projects in our Texas and Scotland wafer fabs.

Our days of inventory at the end of Q2 were about 97 days, up from 86 days in Q1. The actual inventory dollars were up about $6 million from $149 million to $155 million and as I mentioned earlier we plan to hold inventory dollars slightly down in Q3.

Our days of receivables at the end of Q2 was about 27 days, which was at the low end of our range due to the timing of sales being higher in the earlier part of the quarter.

Our past reserves ended Q2 at $786 million compared to $693 million in Q1 as we generated significant cash from operations during the quarter.

During Q2 we bought back $23 million of stock which is lower than what we have typically done in past quarters and that is because we are managing our cash a bit more conservatively to give us more flexibility in light of the ongoing global credit crisis.

Operating margin in Q2 was about 24% down from 29% in Q1 and this excludes the impact of the one-time severances and SG&A credit and return on invested capital was about 17% in Q2 versus 23% in Q1. Both of these measures include the impact of stock compensation expense.

So in the near term it is clear the drop in revenue levels have a negative impact on our operating margins. I have already discussed some of the key things we are doing to lower our expenses and reduce our production. At the same we have continued to prioritize the company’s investments to focus on selected markets that have good potential for growth and which play to our strengths in energy efficiency?

To talk more about that here is Don MacLeod.

Donald MacLeod

Thank you Lewis. First I’ll talk about our progress on some of our National 3.0 initiatives. Then I’ll talk about market and product related trends that are reflected in our results in the quarter.

First our new initiatives focused on the energy efficiency and energy conservation mega trend. Our most visible initiative here is in the area of solar energy efficiency. Our SolarMagic solution. We are on schedule to realize first sales from this initiative in the first half of calendar year 2009.

We just completed our second set of major field trials with a market leading U.S. based solar installer. In these trials we are further validating the benefits of our SolarMagic solution. In modest trading situations our SolarMagic recaptures over 50% of the energy loss in effective solar panels and can demonstrate greater than 30% energy gains for the whole array on sunny days. This is actually a greater energy gain than demonstrated in the first set of our field trials.

To enable us the market launch and product proliferation of our SolarMagic solution we have hired a team of experienced business development and sales executives from the solar industry. We plan to hire additional experienced sales and channel staff to enable the market roll out in the U.S. and Europe over the first half of calendar 2009.

Another energy conservation area of focus for us is in powering LED lighting. Here our design win momentum is continuing. As of the end of Q2 we had double the potential future revenue of our design win pipeline over the equivalent of revenue at the end of the last quarter.

We have design wins at about 150 customers across an increasing spectrum of applications from automotive lighting which covers forward lights, rear lights and break lights; small format backlighting for displays; street lighting; projector and entertainment lighting.

We have also been designed into our JP LED backlighting solutions a newly launched notebook PC’s from Sony and Dell through a Korean display provider.

We are also seeing early market acceptance for our new dimming solution from traditional lighting companies as they transition to LED applications.

Calendar year 2009 should see good revenue momentum for National Semiconductor in this LED lighting space as all these applications proliferate.

Another new energy efficiency opportunity for National Semiconductor is in the area of battery charging. Here I’m not just talking about the traditional, plug in the wall charger for portable systems. On one hand we are working with OEM’s to enable them to bring to market wireless charging solutions, i.e. inductive charging solutions for portable devices such as mobile phones that do not require wires to charge the battery.

We solved the earlier efficiency and heat generation obstacles with our new non-contact power supply system solution that is now sampling to customers. The newly formed Wireless Power Consortium is working on setting standards to ease the development of a wireless charging infrastructure to enable us to potentially move away from the wasteful charger in every box solution that exists today.

More tactically in the battery charging energy efficiency area in the quarter we won a design with a leading Japanese battery OEM to replace existing digital cell camera charging solutions with a much more compact and efficient solution that is expected to ramp up in production volumes in the middle of calendar year 2009.

In addition we are focused on evolving our SolarMagic technology to provide system solutions for much faster and more accurate charging for large lithium ion battery packs in electric vehicles. Our energy efficiency and PowerWise expertise has many potential applications. It is in fact our current jewel at National. The challenge is to apply that expertise to new fast growth market opportunities.

Even in today’s large volume mobile phone market the challenge is to find faster growing and value niches and not get seduced by the increasing commoditization in the high volume portions of that market.

In the last quarter Rim launched two new Blackberry models, the Storm and the Bold phones, and a number of our power management devices included. Specifically, the Storm includes another win for our power management unit that significantly improves the efficiency of the 3G transmit power amplifier.

In addition, we can now add Broadcom to the list of mobile phone chip set reference design providers who recommend our analog power management units in their complete reference design. By the way, I mention Qualcomm, Erickson and others at our last analyst presentation at the end of September.

Beyond energy efficiency and personal mobile devices another mega trend that is a focus for us is in sensing and detection applications. In the past we have viewed sensor products and applications as being somewhat outside the domain of our standard linear catalog portfolio. Our amplifiers may have taken input from various sensor types but we would leave it at that.

As our focus now moves to more application specific signal path system solutions we are much more interested in enabling the whole solution including the sensor that inputs to the analog front end. For example the amplifier or data converter.

In the quarter we launched a new web based customer application called Web Bench Sensor Designer that enables customers to best match their sensor needs to the appropriate National Semiconductor building block or system solution. To do this we have partnered with key sensor suppliers in a new way for us and in doing this we find ourselves talking to a whole new customer base.

In this new sensor application area is an example of an earlier application specific capability in our new bio sensor analog front end evaluation board which is now being evaluated for solutions in the home and security area. These fast growth applications and market areas such as solar energy efficiency improvement, power LED lighting solutions, new battery charging applications including those for electric vehicle applications, personal mobile devices and sensing and detection systems are all good examples of National 3.0 type initiatives that will distinguish us in the future as a very different company than our standard linear, catalog building block or broad market heritage.

Moving onto my second topic, market and product trends you saw in the quarter. In our largest end market which is for mobile phones and other personal mobile devices again accounting for about 30% of our sales in the quarter, we did not see the usual strong seasonal up tick that we experienced in past years.

Our sales to that market were down 10-12% sequentially and our sales to the traditional top five mobile phone customers were also down about 15% in aggregate while our sales grew to the two most visible Smart Phone providers.

Based on current backlog and customer forecasts we expect to see a greater than normal seasonal reduction in shipment rates to these top five mobile phone customers in our post-holiday season third quarter. Sales to communications and networking customers, which accounted for about 12% of our sales in the quarter, were flat sequentially and were up about 13% on last year’s second quarter again driven by infrastructure build out in China and outgrowing wireless station business with the two largest local Chinese customers. Here we also expect a slower third quarter as we await new orders from the recently awarded Phase II TDS CDMA contracts in China.

Looking at our business trends in other markets such as the industrial, automotive, medical and military/aerospace markets which in aggregate make up about 35-40% of our sales shipments were down about 10% in the quarter. Here sales in to distributors were the main factor with Europe being impacted most. In Europe our business to automotive customers in particular slowed down as customers implemented factory shut downs.

From a product perspective there were no material changes in the mix of our revenues by industry product category in the quarter. They all showed reductions of roughly the same rate. Average selling price, or ASP, increased again 6% year-over-year and was about flat sequentially. Here we were able to offset the negative sequential impact of the weakened Euro against the U.S. dollar with continuing portfolio value improvement.

This also contributed to our margin in the quarter which although offset by lower capacity utilization of factories kept our gross margins above 65% and if you will note Q2 of last fiscal year on revenues of $499 million, i.e. 15% higher than this second quarter, our gross margin was 64.4%.

So to wrap up our business model fundamentals held up well in a quarter where customer demands slowed down at an unexpected rate. Going forward we are also looking at an anemic backlog of customer orders and uncertain customer demand forecasts going into what is already traditionally for us a seasonally slow quarter.

We have taken action to keep the integrity of the business model. We have already actioned significant fixed and variable cost reduction efforts. In the meantime we will invest and reallocate more and more of our R&D and business development dollars in our National 3.0 initiatives and look for the resultant differentiated revenue growth from these initiatives when we get to the upward stage of this industry and economic cycle.

Over to you Mark for Q&A.

Mark Veeh

Thanks Don. At this time I will ask the operator to open up the line to the question-and-answer session. We will answer questions until approximately 2:25 p.m. PST to allow time for our listeners to transition over to our competitors’ updates starting at 2:30 p.m. Please limit yourselves to one question and one follow-up so that we can accommodate as many people as possible. Operator can we please have our first question?

Question-and-Answer Session


(Operator Instructions) The first question comes from the line of Analyst for Tory Svanberg – Thomas Weisel Partners.

Analyst for Tory Svanberg – Thomas Weisel Partners

I was just wondering if you can comment on your projected operating cash flow going forward?

Lewis Chew

What do you mean comment on it?

Analyst for Tory Svanberg – Thomas Weisel Partners

I was just wondering if given the revenue down trend whether there could be a reduced operating cash flow you would expect?

Lewis Chew

I think at 30% down revenue clearly it will affect our operating cash flow. If you are asking if we are still driving for that operating cash flow to be positive the answer is yes.


The next question comes from Chris Danely - J.P. Morgan.

Chris Danely - J.P. Morgan

Lewis can you just comment on what you expect opEx to look like after this quarter and how you guys can get back to profitability assuming another down quarter?

Lewis Chew

We have a couple of puts and takes in our back quarter. Obviously one of the minuses is we have to absorb an extra week of all the normal things that affect our opEx like depreciation, salary and all that. But on the other hand we are taking vacation days and other measures into account. So I would say that going forward we would look to manage the opEx conservatively but the level we are at in this quarter I don’t know you should expect it to decline much in Q4 per se because of the fact we are using some techniques this quarter to offset the extra week.

For example if you take the Q2 opEx and just take out that one $12.3 million credit you can kind of see from my guidance we are expecting opEx to go roughly in the neighborhood of $18 million from Q2 to Q3. We would like to hold kind of at that level if we can but as we have shown in the past if we need to make adjustments we will.

Chris Danely - J.P. Morgan

So if it takes awhile to get back up to the $400 million level there is potential or possibility for further reductions there? Like taking three quarters out?

Lewis Chew


Chris Danely - J.P. Morgan

As my follow-up can you comment on where you expect your inventory to go this quarter? I’m trying to estimate when we can see a bottoming in utilization rates.

Lewis Chew

The inventory this quarter we are looking to bring it down a little bit but with this significant fall off in revenue we are a little bit handcuffed there because normally if revenue were trending down historically we would burn off a lot of inventory right away. But we are yanking down production levels dramatically so hopefully some time within this next quarter or two we will see a bottoming out in utilization but that completely depends on the revenue levels.


The next question comes from Douglas Freedman – American Technology Research.

Douglas Freedman – American Technology Research

We don’t know how long this is going to last but at what point do you make changes permanent? How long can you keep taking temporary expense control actions both in the factory and in the R&D and SG&A lines?

Lewis Chew

Let me start with this and then I’ll turn it over to Don and Brian. There are some actions we took this quarter that I would put more in the category of permanent. Not everything we are doing is temporary. The cost cutting actions we took in November were targeting to save $12 of the $18 I just mentioned. So you could almost say 2/3 of what we have done is relatively permanent.

But we are in an environment probably of unprecedented lack of visibility that doesn’t [inaudible] negativity. So we have to watch how things go. Certainly we don’t see a world where suddenly everybody collectively across the world is consuming 40% less than what they were doing before and holding to that level. If that does happen then yes further adjustments will probably have to be made. At some point as the inventory gets burned off in the channel to adjust to everything going on right now there would probably be some level of recovery.

Douglas Freedman – American Technology Research

Can I get a follow-up in since you led me there? 40% down from your run rate, what do you think the actual demand reduction is? How much of this is inventory and how much is demand reduction?

Donald MacLeod

I think you are hitting a good point here. The question is what is the run rate at the bottom for our business. First, maybe a point about the question you just asked Lewis. I think one of the things you have certainly seen at National is that we do take whatever appropriate actions are required to reduce our cost base. We are pretty responsive and pretty quick to do that so over time if the business for some unknown reason does deteriorate further we will take all the appropriate actions whether it includes our factories or any other overhead area.

Back to your point about volume here. Some of what we are seeing here is supply chain consolidation or contraction as our customers reduce their inventories the reaction we are seeing is customers are going into the fourth calendar quarter with the usual beginning of the quarter expectations of a strong fourth quarter. Through the quarter what we saw in the consumer markets especially with customers kept reducing their forecasts and expectations for the current quarter, as Lewis mentioned, the first news of that happened at the end of September and then we saw a second adjustment of that in November.

In each case the customers reduced their forecasts. Clearly they are compressing their needs in the short term and as we approach the end of the quarter these compressed needs took less time to execute on reducing the builds for the holiday selling season. Then in some cases our customers are closing their factories down so we don’t ship in when the factories aren’t working. The second or third point is as we approach the end of the calendar year they want to reduce inventories and not go into what is normally a slower first quarter with excess inventory of either components or finished products.

So some of the reductions we are seeing are tied to them getting those inventories and supply lines adjusted to a lower rate. To some extent I think that will probably roll over for the next 3-6 months in the industry and then we’ll get back to a level that is probably above where we are sitting in this third quarter but not at the levels we saw perhaps before this down turn adjusted.

That is part of the visibility issue for us in setting guidelines for us for revenue going forward. To what extent is it the compression of the supply chain versus real end adjusted demand?


The next question comes from Uche Orji - UBS Securities.

Uche Orji - UBS Securities

My question is about SolarMagic. I know you have talked about that as one of the areas that is actually being the first half of next year, kind of next year. What is the maximum opportunity for this say within the next year? Given the incoming administration planning to spend on improvement of power efficiency in public buildings, do you think you are reasonably positioned to capture the opportunity that will come from that and how big could this be? Related to that with oil where it is now, is it still something compelling in the minds of your customers to pursue?

Brian Halla

I think the solution is certainly compelling. I would say in fairness that there is probably slightly less urgency as a result of the price of oil coming back down. But over time I think we all agree that we don’t want to be held hostage again to foreign suppliers. Clearly the technology has been embraced. The question is how fast will it ramp and how fast will the solar panel guys want to make their panels more efficient and their installations more efficient.

So it is really tough to say what the ramp will be or what the contribution will be but it will start, as I think Donnie mentioned, in the late first quarter of next year.

Donald MacLeod

To add to that the field trials we are conducting make the value proposition even more compelling and it is kind of hard to walk away from a proposition that allows you to improve the efficiency of let’s call it household solar panel installation by 30%. It is hard to walk past that when all the subsidies and compelling national priorities are also heading in the same direction. Our challenge is to take ourselves into a new market place here. We have started hiring people who have come from the solar industry to help us get to that market. More importantly to help us develop a whole new channel with a whole new customer base that we haven’t dealt with in the past. I think most of the issue here is the opportunity is in our hands. It is kind of up to us to get that ramp. It is not an issue of whether the proposition has value. That is a given. It is just a question of how we can execute on that and I think for the second half of calendar year 2009 you should be seeing meaningful revenues from that especially in the U.S. and in Europe, the two markets we are looking at focusing on first.

I think all these initiatives are focused on energy efficiency do again fit into the national agenda here in the U.S. and we are very pleased to be sitting at the center of that with our expertise in energy efficiency.

Brian Halla

Another thing to add to what Donnie said what we have done with SolarMagic as you can see with the numbers, dramatically improved efficiency of solar panel array. When I talked about this at the announcement I compared it to a big mag flashlight with a lot of batteries. If one of the batteries goes dead we all tend to throw away all the batteries assuming they are all bad. What SolarMagic does is it fixes the panel essentially and maximizes the power of the string.

If you take that same analogy and apply it to car batteries, today electric cars tend to operate at the efficiency of the lowest performing battery which means if you want to drive your [Tesla] to L.A. you have to find a place to stop and have lunch for 12 hours. But what we have done is come up with a SolarMagic derivative that can actually make electric cars much more viable as I mentioned in my commentary.

Uche Orji - UBS Securities

Back to the guidance are you saying this new guidance assumes flat to negative turns? Let me just be sure I heard it correctly. If that is the case, if the utilization rate stays at these levels now I think at 74 should we expect gross margins to also hold at these levels or would there be anything that could take it down further assuming [inaudible]. I’m just trying to get a sense of how to calibrate gross margin assuming [inaudible] for the last six months and utilization at these levels?

Lewis Chew

Just to clarify for yourself and everyone on the call we did not say we are expecting negative turns for the whole quarter. What I said was we didn’t get a whole lot of turns in Q2 and our revenue guidance assumes that the turns will be even slightly below that in Q3. In terms of gross margins going forward we continue to run the model with a very high follow through on the way back up but we are now in a period of such dramatic reduction in production levels we had to take our medicine on the margin side but when revenues come back you will see follow through rates probably in the 80-90% levels.


The next question comes from Sumit Dhanda – Banc of America Securities.

Sumit Dhanda – Banc of America Securities

Lewis I am assuming this is the case, but the extra week in the February quarter should we assume it is really not compliment to revenue given the environment out there? In other words is your organic growth rate closer to down 35 or is this guidance a reflection of the true organic growth rate?

Lewis Chew

I think that is a fair question and I’m actually surprised it waited to number five to get there. In all reality if you actually look at the calendar our extra week was effectively the week of Thanksgiving because normally our Thanksgiving week falls at the very end of our Q1. I’m sorry at the end of our Q2. This year week one of the quarter was Thanksgiving. If you are guessing we didn’t exactly burn up the road with activity on that week you are guessing right. We don’t really see the extra week this quarter as having any extra boost in revenue. I guess if people out there want to mathematically assume it is an extra 7% you are welcome to do that but I just don’t think it is fair to do that this year. I don’t think it really adds a lot in terms of revenue especially in a window where we are seeing declining rates of bookings as people are just trying to figure out what the heck is needed for Christmas.

Sumit Dhanda – Banc of America Securities

The February quarter if you hit the mid point guidance the revenue lines are going to start with [two handle] and it is a little hard to envision. Help us understand. I know you have divested a lot of businesses along the way but this is going to be your third straight year of annual revenue decline if my math is correct. How do we come to the conclusion that all these growth initiatives you have talked about are really going to come to fruition here over the next couple of years?

Lewis Chew

You are starting to sound like the grinch out there. Stop that. Just to clarify, I don’t think this quarter this drop off we see has anything to do with our dispositions. In fact if you look at our quarter we just reported as down 9% or if you want to round up 10% that is certainly not any worse than what a lot of other companies that you would call our competitors are seeing would be their December quarter. So to be fair nobody else has gone out there to February and said what they think they are going to do in the spring quarter.

Now in terms of the growth initiatives, fair point. We ourselves talk a lot about the need for growth and are trying to hold ourselves accountable as much as anyone else would outside the company. All we can do is tell you guys what markets we are going after, what our strategy is. I think the energy efficiency play is a very smart one right now and we continue to identify new emerging areas to point our products towards. This is not a story about ripping off market share from some other analog guy; it is about pushing out new innovative stuff into new markets. So I think it is a fair question but it is not something you can answer with words. You have to answer it with actions.


The next question comes from Craig Hettenbach – Goldman Sachs.

Craig Hettenbach – Goldman Sachs

If I can go back to the gross margin line on a long-term basis and you have talked about 65-70% and Brian also talked about just the analog group having performed well in the last five years. Some of that slow of growth as well as gross margin compression do you think there is an opportunity for you guys to reset that target? In other words does it have to be that high especially given what we have seen in the environment here and increasing competition in this space?

Lewis Chew

Let me start with that one first Craig and then I’ll be glad to turn it over to my two brethren here. Absolutely it is worth it. I mean it is very hard to make an argument that anyone is doing better right now by decreasing their gross margins. You know it wouldn’t be fair for me to point out competitors who have tried that and certainly it hasn’t seemed to me to drive any incremental shareholder value. But our products drive their high margin on their own. Make no mistake about it. The reduction in gross margin we are seeing this quarter is from the fact that we manufacture everything in house and this is from manufacturing variances we will absorb. It is not from pricing declines or anything like that. So I think the product if it is high value it will naturally drive margins in the target range you mentioned.

Right before looking at this quarter our revenues were down nearly 10% but the margins held pretty good at 65.5%. I think that is organic margin you are seeing at work there.

In terms of trading off margin to get volume the tricky thing there is it is easy to give up the margin but you rarely get the volume. So as Brian said in his opening comments we moved away from a commodity approach and we are trying to address the growth question Sumit just asked by targeting new emerging markets that will demand energy efficiency types of circuits where we are good at. I think that is the statement right there.

Brian Halla

I don’t think over the last couple of years we have seen any evidence that the pricing on our newer mix of higher value added products has ever held us back. We are probably not getting enough yet but so far pricing has not been an issue. Obviously in the commodities pricing is the only issue. We have hopefully long abandoned the commodities silicone by the pound kind of products and we have been focused on adding much more value. When we do add this value, and by the way we track these products as a category, and ASP’s are dramatically higher. The margins are dramatically higher and now it is just a matter of increasing our overall portfolio to a greater percentage of those kinds of products. But pricing has not been an issue. Where we truly added value we can get paid for it. If we don’t add value shame on us.

Craig Hettenbach – Goldman Sachs

As it relates to handsets you mentioned the difficulty there. It is a fast growing market but there is more pricing pressure there. Is that something we would expect longer term as a percentage of revenue to roll off a little bit as some of these other new growth initiatives emerge? How should we think about your exposure to handsets over a longer period of time?

Lewis Chew

That is a fair point. I think if you look at several of the key markets Don identified in his prepared comments there are some pretty big markets we are going after that if we are successful it is not illogical that percentage would decline. Realistically right now we are sitting here with handsets making up 1/3 of the company and that is the reality we are dealing with. In fact we are continuing to have some growth initiatives aimed at portable mobile devices that go beyond your typical mobile handset. But over time yes we could see that percentage declining but hopefully declining because our revenue in those other markets are growing not just because we are purposefully shunning revenues from the handsets.

Brian Halla

I think Donnie mentioned in his commentary that we had seen positive growth in the two leading Smart Phone providers. That is how you should characterize us going forward. Again adding value that our competitors aren’t adding. You know if all of a sudden phones leveled out and what they do today is what they are always going to do then you could expect to see some decline but going forward we do have a focus on personal mobile devices and doing things in the area of lighting and projection and Smart Charging that should set us apart and allow us to continue to grow.


The final question comes from Analyst for Craig Berger – Friedman, Billings, Ramsey & Co.

Analyst for Craig Berger – Friedman, Billings, Ramsey & Co.

I just want to understand the cause of the drop in SG&A in the second quarter and in terms of your guidance by it increased by $10 million.

Lewis Chew

So the drop in SG&A in Q2 was literally just an accounting artifact. There is a $12 million expense in other income and expense, non-operating that offsets a $12 million improvement in SG&A. They net to zero. Any company out there that has these deferred compensation employee investment assets has the same thing. So you want to take SG&A in the Q2 numbers as we have provided and mentally add back $12.3 million. That is a better picture of what SG&A really was for the quarter. Does that answer your question? That is really the cause of the big drop off, that $12 million credit that is sitting in SG&A that offsets the expense that is down below the line.

Analyst for Craig Berger – Friedman, Billings, Ramsey & Co.

That is different from your other non-operating expense of negative $12.3 million?

Lewis Chew

The two are complementary. So other non-operating expense is an expense and there is a $12.3 million credit or if you want to call it income in the SG&A line. That is the way you have to account for it. So you have to take SG&A and up it another $12.3 million if you want to know what organic SG&A was for the quarter.

Mark Veeh

With that we are now going to end the call. Let me remind you the replay is available on our website and thank you for joining our call today.


That does conclude today’s conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!