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Standard Microsystems Corporation (NASDAQ:SMSC)

F3Q09 Earnings Call

January 6, 2009 5:00 pm ET

Executives

Carolynne Borders - Director of Corporate Communications

Christine King – President, Chief Executive Officer

Aaron Fisher – Senior Vice President, Products & Technology

Analysts

Jed Dorsheimer – Canaccord Adams

Christian Schwab – Craig Hallum Capital Group

Richard [Sidero] – Kennedy Capital

Christopher [Longario] – Sidoti & Co.

Vernon Essie – Needham & Co.

Operator

Good afternoon ladies and gentlemen and welcome to the SMSC third quarter fiscal 2009 results conference call. (Operator Instructions) I will now turn the conference over to your host, Carolyn Borders of SMSC.

Carolynne Borders

Good afternoon and thank you for joining us today for SMSC’s third quarter fiscal 2009 conference call and web simulcast. Representing management today are Chris King, President and CEO and Aaron Fisher, Executive Vice President.

Before we begin this afternoon I wanted to take a moment to invite you to listen to Chris King present at the 11th Annual Needham Growth Stock Conference in New York at the Palace Hotel tomorrow, January 7, at 3:30 p.m. ET. If you are unable to attend in person a live and replay audio, as well as slides from this event will be available under the Investor Relations section of our website at www.smsc.com.

If you haven’t already received a copy of our press release issued this afternoon you may also find it on our website. If you dialed in on the phone line, please note that there is also a slide presentation that accompanies today’s call which can also be found in the Investor Relation section of our website.

If you are participating on our online web cast or following along with our slides please move on to slide two for a quick note on our Safe Harbor statement.

Certain matters discussed in this teleconference are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected or forecasted. Such risks and uncertainties include, but are not limited to, those discussed in this teleconference and those found in the company’s Form 10-K, 10-Q and other filings with the Securities and Exchange Commission. I would also refer you to the forward-looking statement language contained in today's press release regarding risks and uncertainties.

Today's presentation also includes non-GAAP financial measures, which should not be considered in isolation or as an alternative to results of operations data or any other measure of performance derived in accordance with US GAAP.

However, these non-GAAP financial measures are presented because management believes they provide useful supplemental information for management and investors and allow them to perform meaningful comparisons to the company's past and present results.

Guidance is presented on a non-GAAP basis only, given that the GAAP basis charges for equity-based compensation related to stock appreciation rights cannot be projected reasonably. GAAP and non-GAAP numbers along with a reconciliation of the two are available in today's press release and in the appendix of this presentation.

During today’s call, Chris King will begin with a review of our third quarter operating results, outline our main business drivers and highlight our differentiating products and opportunities. Aaron Fisher will follow with a more detailed review of our product line results and opportunities. Chris will then discuss our recent announcements, provide an update on operational activities, review other financial results and provide our outlook for the fourth quarter.

As usual we will conclude the call with a question-and-answer period. I will also note that a replay of today’s call will be available on our website.

With that I’ll ask you to advance to slide three in the presentation and I’ll turn the call over to Chris King.

Christine King

Thank you for joining us on this call and web cast today. Since I joined SMSC almost three months ago I have continued to be impressed with our product portfolio, extremely capable people and a host of exciting market opportunities. That being said, we find ourselves in an unprecedented industry decline. In fact, during my 35 year semiconductor career I have never witnessed such broad based weakness in end customer demand.

The PC and automotive markets are particularly troubled and with roughly 50% of our Q3 revenue exposed to these areas and a decline across all products and geographies, we expect a significant decrease in revenue in our fiscal Q4.

As in other downturns, the PC market is leading the way and we are feeling the effect of its decline. In addition, overall weak or nonexistent end customer demand there has been an inventory build up particularly in the PC and automotive channels and we are monitoring them closely.

However, our current visibility is extremely limited and we do not expect it to improve until the end of our fiscal year because a great number of our customers, particularly in the automotive and PC ODM areas, are shut down for extended periods over the holidays and beyond.

Despite the decline in revenue we do not believe we are losing critical market share and design activity continues to be healthy.

Now let me turn to the results of our fiscal Q3 and expectations for Q4.

As noted on slide three, our revenue during the third quarter of fiscal 2009 was $84.3 million representing a sequential decrease of 13.3% and 19.5% compared to the prior year which was within the updated guidance range we provided in mid-December. Our fiscal third quarter is typically our seasonally strongest quarter but it was weaker this year across all product lines and all geographies due to the prolonged global economic challenges as well as the major inventory correction in the PC and auto markets.

EPS for the third quarter of fiscal 2009 was $0.41 per diluted share compared to $0.36 per diluted share for the same period in fiscal 2008. This EPS improvement was primarily due to the benefit of favorable foreign exchange rates during the quarter and a $1.5 million tax credit due to Congress’ recent extension of the Domestic R&D tax credit. Non-GAAP EPS was $0.39 per diluted share.

Looking ahead to our fiscal fourth quarter we currently anticipate revenue to be in the range of $45-51 million, down approximately 47-40% [sic] sequentially as the current macro economic environment remains very challenging as we continue to work through the inventory correction. I would like to caution, however, that the recent and ongoing difficult economic conditions and sharp decline in visibility continue to hinder our ability to provide guidance.

Due to these factors, we expect our revenue driven by North American PC makers to drop approximately 50% sequentially in Q4. In addition, based on automotive sales projections and despite additional content and design wins our automotive revenue is expected to be down approximately 30%. While we did not see a large drop in our Asian and Japanese demand in Q3, we expect revenue from these geographies to decrease significantly in the current quarter.

Finally, Q4 is traditionally a weak seasonal quarter for SMSC and our IP licensing revenue from Intel came to an end in Q3.

Turning to slide four, to respond to these market and revenue challenges we plan to manage our favorable balance sheet to a neutral cash position going forward and will focus on our cash generating capabilities. Although this will require decisive actions [inaudible] model, low capital intensity and a debt free balance sheet are working to our advantage.

We continue to believe that SMSC has some tremendous opportunities going forward and we intend to maintain our investment in areas we can gain market share and have differentiated products. In the past SMSC has made prudent decisions to drive profitability in core product lines while investing in emerging technologies and markets. This strategy has created a diverse portfolio of new product opportunities.

In addition, our operational excellence and fiscal management have left us in the enviable position of having no debt and strong cash reserves. To accomplish our product and revenue goals we have organized our product lines to address our core business in three growth areas.

Currently our core business, which serves the computing and connectivity markets, generates approximately 2/3 of our revenue. Given the precipitous drop in PC sales we will be focusing this business on new devices that differentiate our customer’s products. We believe that we have identified three additional areas that have excellent growth prospects and are a good match for SMSC’s skills, intellectual property and capabilities.

First, our automotive products which represented about $13 million of revenue in Q3 and are centered around the successful MOST platform continues to be an attractive opportunity based on design wins and the additional products we plan to introduce.

Our analog products and technology generated almost $10 million in Q3 and drove almost 20% year-over-year growth based on our expanding portfolio of ASSP’s. Finally, our portable products were responsible for $5 million in Q3 and are based on expanding USB content in Smart phones and other mobile devices.

We believe this product structure and focus will allow us to optimize our core business while operating our growth businesses in an entrepreneurial manner.

On slide five you can seen that our revenue by vertical market during the third fiscal quarter of 2009 was relatively in line with the same period a year ago demonstrating the diversity in our business. Due to the overall weakness in PC sales and inventory correction, revenue from PC’s declined during the third quarter.

I would also note that the industrial and “other” sectors captures embedded Ethernet revenues that have a longer life cycle as well as server sales and also includes the quarterly Intel IP payment which ended at the close of Q3.

I’d now like to turn the call over to Aaron Fisher for a more detailed review of our product line results and opportunities. Aaron?

Aaron Fisher

Thanks Chris. We are now on slide six. As I am sure most of you are aware the worldwide automobile market is experiencing an unprecedented downturn. Although SMSC has limited exposure to the U.S. auto makers, our European and Asian customers are also severely affected. In the face of these economic challenges, most car makers both in the U.S. and abroad are extending the duration of their normal production holiday shut downs. We expect the combination of high inventories, negative consumer sentiment and the ongoing credit crisis to suppress demand into the near future.

Our expectation is for visibility to remain unclear until at least the end of our fiscal year. While these market issues are significant the automotive business has long design-in cycles and we are focused on continuing to win new vehicle platforms and providing technology to address new applications such as driver assistance systems.

The work we are doing today to lock in new designs with our MOST technology for model production several years out is laying the groundwork for highly attractive future annuity. We continue to work with auto makers and their sub-system suppliers to deploy the newest generation of MOST technology, MOST-150. This new speed grade has been very well received with market leaders most of whom are seen to transition from MOST-25. We are currently on track for initial deployment with the first cars starting to roll off the production lines in model year 2012.

Finally, I’d like to highlight our most recent MOST design wins to reach production. The new Audi Q5, BMW X6 as well as the new BMW series 7 models. For those of you following along, these cars are shown on slide six. With these role outs MOST is now adopted across the majority of Audi and BMW vehicles.

Let’s turn now to slide seven and I’ll discuss our products serving the portable market. SMSC has spent the last six years building our Analog 6 profile and today approximately 80% of our units contain mixed signal content. Our analog high speed USB transceiver devices serve applications such as Smart phones, personal navigation devices, ultra mobile PC’s and personal media players to name a few.

We entered this market enabling high speed content transfer in these data intensive devices but we quickly discovered that since USB port is used for power functions such as battery charging and detecting accessories our USB five content could be augmented with additional functions to provide a lower power, lower cost and small foot print solution for our customers. This market differentiating technology has enabled us to form tight partnerships with many of our customers which enhances and drives our road maps and competitiveness. Our portables business is one of the fastest growing product lines for SMSC and we expect to build meaningful market share as the result of the functional advantages we provide.

Today SMSC’s devices are designed into approximately 40 different portable SKU’s. Although we do not discuss our customer’s future plans, industry tear downs of the BlackBerry Storm, the TMobile G1 and the Sony Erickson Experia Excelon Smart Phones have all noted SMSC content.

Please join me on slide eight for a snapshot of our analog business. One area where we have seen particular success is with thermal management devices. These devices serve the computing, embedded and consumer end markets and we have had particular success with products optimized to support advanced CPU processor geometry in 45 nanometer technologies. Our products are aimed at providing customers with the high accuracy and reliability necessary to enable them to design effective thermal management control systems.

In a mobile computer better thermal management enables longer battery life. As in a server or a desktop computer where the overall CPU performance can be enhanced. We are currently doing advanced work with lead customers today that has the potential to reduce the power dissipation of these thermal management sub-systems by as much as 50%. We expect this new technology to find application across the computing spectrum from mobile computers to high performance compute servers.

Finally, our designers have developed advanced capacity sensing devices that lower cost and improve reliability. Our broad penetration into the PC, consumer and automotive ecosystems is giving us a ready sales channel for these new products. We’ll see the first deployment later in the year in the mobile PC arena with products targeted at other devices soon to follow. We remain bullish on our analog business and believe it has the potential to drive significant revenue and margin contribution in the years ahead.

Lastly, on slide nine we highlight our computing and connectivity markets. If you recall, our first indication of the downturn came from our PC customers. With the credit crisis ballooning and large financial institutions failing the commercial portion of the PC market took a nosedive. As a result, our PC product sales declined by about $10 million from Q2 to Q3 primarily due to revenue from North American PC makers. Industry analysts continue to report that inventories in the PC channel remain at high levels. That is consistent with our view as well and we expect the larger revenue decline in Q4.

We are carefully monitoring the inventory pipeline to better predict demand. Simply stated, demand visibility is still very poor and we do not expect to have a better view until at least the end of our fiscal year. On the bright side, design activity for both mobile and desk top PC’s remains normal. In many cases we are supplying multiple chips per platform and commanding an attractive premium for the value we provide.

On the connectivity side our USB hub, hard reader and fast Ethernet devices continue to win designs in consumer and industrial applications and this business is expected to continue to be a solid contributor to revenue in the years ahead.

Our strategy to enhance our value proposition by integrating micro controller technology along with USB and Ethernet interfaces is being well received by customers. As an example, one of these new micro programmable products is currently being designed into several LCD monitors. As our connectivity product road maps progress, we anticipate more and more micro controller and software content being combined with our mixed signal interfaces.

With that I’ll turn the call back over to Chris.

Christine King

Thank you Aaron. Now turning to our operations on slide ten we are currently taking a number of necessary precautions and proactive measures to improve our performance during this difficult economic environment.

First, to maximize our supply chain we have been working closely with our suppliers to aggressively manage our costs and push out some orders. Fortunately most suppliers have been cooperative on both fronts and material purchases represent typically almost 80% of cost of goods sold.

In addition we have put in place an aggressive inventory reduction program across all product lines. This includes extensions to our normal holiday shut downs around Thanksgiving and Christmas, reduced material purchases from our fab and assembly partners and we have shut down a portion of our New York test capacity while in sourcing almost all of our tests. We currently anticipate these actions will help us exit the fiscal year with inventory lower than when we entered fiscal 2009.

I am happy to report that in addition to these aggressive inventory reduction actions we have been exceeding our yield customer delivery and quality targets during the second half of fiscal 2009.

Turning to slide eleven, I would like to take a closer look at our financial results during the quarter. Cost of goods sold during the third quarter fiscal 2009 was 47.4% of revenue which is roughly flat sequentially. Operating margin was 6.9% in the third quarter of fiscal 2009 compared to 10.3% in the previous quarter and 13.6% for the third fiscal quarter of 2008. The primary drivers behind the decline in operating margin include reduced revenue as well as executive transition expenses of $1.8 million offset somewhat by a significant reduction in stock based compensation expense.

On a non-GAAP basis operating margin for the third quarter of fiscal 2009 was 6.3% compared to 13% in the previous quarter and 19.7% in the prior year. Please note that all guidance is presented on a non-GAAP basis only. Given that the GAAP basis charges for equity basis compensation related to [SARS] cannot be projected reasonably.

Our effective tax rate during the third quarter was approximately 3% and on a non-GAAP basis it was approximately 1%. This dramatic quarter-over-quarter decline was due primarily to Congress’ extension of the U.S. R&D tax credit during the quarter. GAAP net income for third quarter fiscal 2009 was $9.1 million or $0.41 per diluted share compared to an income of $8.7 million or $0.36 per diluted share for the same period in fiscal 2008.

This EPS improvement was primarily due to the benefit of favorable foreign exchange rates during the quarter and the $1.5 million tax credit. Non-GAAP net income for the third quarter fiscal 2009 was $8.7 million or $0.39 per diluted share. This compares to $12.8 million or $0.53 per diluted share in the third quarter of fiscal 2008.

As you can see on slide twelve, our capital position remains strong. During the quarter we generated operating cash flow of $21.3 million. This brings our cash, cash equivalents and long-term investments at the end of the quarter to $176.6 million, a sequential decrease of $2.4 million. In addition, the number of net diluted shares outstanding declined as we reinvested free cash flow through the repurchase of 497,000 shares for $11.4 million. This brings our total share repurchases during the first nine months of the fiscal year to roughly 1.1 million shares of stock for approximately $28.6 million.

To meet our objective of maintaining our cash position currently it is not our intent to do any further repurchases. However, there are still shares available under the existing board approved share repurchase plan. At the end of the period cash and investments were equal to $8.07 per share.

During the third fiscal quarter we wrote down our auction rate security holdings by $4.5 million to $77.3 million due to a temporary impairment charge. We continue to transition our exposure in auction rate securities to more liquid assets and since the end of Q3 we have redeemed an additional $8.3 million of auction rate securities at par. Most of the remaining auction rate securities are tied to high grade, government backed student loans. To date we have viewed any impairment related to auction rate securities as temporary. However, if markets deteriorate we may have to re-evaluate our position.

Lastly, despite the decrease in revenue we were able to keep our net inventory levels relatively flat and expect to drive levels lower over the next six months. That being said we believe there is still room for improvement in our inventory management and we are focusing on becoming a much leaner operation.

Now turning to slide thirteen, I would like to review our guidance for the fourth quarter fiscal 2009.

As I previously stated we expect our sales to be in the range of $45-51 million. We currently expect cost of goods sold as a percentage of revenue to be up approximately 400-600 basis points due to lower fixed cost absorption. We also anticipate operating expenses to be roughly flat during the fourth quarter. This leads to an expected loss per share in the range of $0.40 to $0.55. We also expect our cash and investment balances to be slightly down excluding any non-recurring charges.

Please note that our guidance assumes stable foreign exchange rates, interest rates and commodity prices and excludes any non-recurring charges. In addition, our guidance is presented on a non-GAAP basis only given the GAAP basis charges for equity based compensation related to [SARS] cannot be projected reasonably.

We currently expect Q4 to be the low point in our sales and revenues. A number of negative factors are affecting the current quarter. It is often our seasonally weakest quarter. The Intel IP revenue terminated at the end of Q3. There is a large inventory build up in the channel and there have been holiday related shut downs of historic length at our customer’s locations.

In addition our book to bill ratio in Q3 was less than 0.7. However, our quarter to date book to bill ratio is now approaching one. Although we can’t make any guarantees in this current economic environment all this and our customer’s current forecast lead me to believe that fiscal Q1 revenue will be sequentially higher.

Now I’d like to take a moment to highlight our priorities for the coming months.

I am happy to report that we completed what I have been calling priority zero since I arrived. We hired a talented CFO, Mr. Kris Sennesael. Kris is here with us today and I am very excited that he has joined our team. He is an outstanding executive skilled in all financial and strategic aspects of international semiconductor operations. Kris joins us from ON Semiconductor, a multi-billion semiconductor supplier, where he served as VP of Operations. Prior to that Kris and I worked together at AMI Semiconductor where he was responsible for operations finance, strategic planning and forecasting and all European financial operations. During his career he has served as CFO for the international division of a large semiconductor and telecommunications company. His expertise in leading operations finance as well as capital market investment and M&A activities will drive the execution of our business plan and position SMSC for future growth.

Unfortunately we now have a new priority and that is responding to this economic environment with appropriate action. This means balancing cost management with the investments we feel are prudent and that will allow SMSC to gain market share and drive future growth. We have already gained significant concessions from our suppliers and have cut back on manufacturing capacity to current demand levels.

We plan to reduce our fixed operation costs to be in line with expected revenue levels and will execute on our aggressive inventory reduction plan. We will also be managing our operating expenses closely including reductions in discretionary spending as well as taking executive compensation action. We expect to take additional actions while maintaining the investments we believe are critical to the company’s future.

Some of these expense reductions will not take full effect until our fiscal Q1. Of course, we will continue to execute on our business strategy. We have a strong product portfolio, a defensible end market position and great customer relationships to leverage. I expect to continue with this plan as well as expanding on this strategy by identifying new organic growth opportunities as well as potential growth through M&A.

Lastly, I intend to increase awareness of SMSC with our customers, industry analysts, business and industry press and Wall Street. We have a great story here and I plan to increase our visibility by highlighting our strengths and differentiators in many forms. I will provide additional details for each of these objectives over the coming quarters as Kris, Aaron and I have more time to work through the details with the rest of the management team.

Before turning the call over to the operator to take some of your questions, I want to take a moment to highlight the other important announcement we made today. Dr. Kenneth Kin, a well known industry veteran who recently retired from his role as Senior Vice President of TSMC where he was responsible for global sales, service and marketing will join our Board of Directors on January 19. I am very pleased Dr. Kin agreed to join our board and we look forward to benefiting from his broad expertise in sales marketing and global logistics as we execute on our growth initiatives particularly in the increasingly important Asian market and seek to drive economies of scale in our supply chain.

With that I’d like to turn the call over to the operator so we can take some of your questions.

Question-and-answer Session

Operator

(Operator Instructions) The first question comes from the line of Jed Dorsheimer – Canaccord Adams.

Jed Dorsheimer – Canaccord Adams

I was wondering you talk about the focus on streamlining the business. Could you maybe quantify what we should expect in terms of the cost savings as we look into next year? Then as a follow-up should we be modeling at a zero percent tax rate for next year?

Christine King

First of all, I think what we are striving to is to maintain our favorable cash balance sheet so we want to make sure we balance any cost reductions with investing in our future. That being said, I think that there are a number of things we can do to facilitate that. Obviously we will be working down our inventory and reducing purchases with our suppliers which is a substantial part of our costs of goods sold. On the OpEx line across the company we are going to be focusing on discretionary spending, executive compensation as I mentioned and so we feel we have quite a number of levers we can accelerate as we go forth into this environment. Obviously we have got to right size the business. Our objective is going to be to maintain the cash balance sheet given the kind of run rate we are going to have in terms of revenue in Q4.

Jed Dorsheimer – Canaccord Adams

Let me ask the question a different way. Do you expect to be profitable in fiscal 2010?

Christine King

I’m not going to make any comments that far forward on 2010. As I mentioned our visibility is very limited right now. We have got many of our customers on the lengthiest shut downs I have ever seen so it is difficult for us to even talk to our customers let alone make sure we have accurate forecasts for the whole next fiscal year.

Obviously I did say we expect Q4 to be the bottom of our revenue because of the factors I mentioned. Due to the timing of our fiscal quarter we kind of have a perfect storm here accommodating two holiday shut downs by our customers. We have the end of the Intel IP revenue stream and in addition to that we obviously had our customers ordering way ahead of themselves in our fiscal Q2 and even into Q3. So, we do expect Q4 to be the bottom. So, I think fiscal 2010 is a long way to look out there.

I think I want to be clear we are going to right size our business to the revenue level we are at in Q4 and what we expect in Q1. We are going to manage to a cash neutral position and that will be our objective.

Jed Dorsheimer – Canaccord Adams

Do you think you could provide…it sounds like the business is going through a significant change, away from the macro economic environment and the lack of visibility, as the Intel royalties go away and it sounds like there is a structural change in the business here in terms of what revenue levels are needed to achieve a profitability level. It sounds like the targets have changed. Could you update us on what the goals are of the company? Is there a certain revenue level you expect to get to and how will the model start to look on a go-forward basis?

Christine King

First of all, I would like to say the Intel revenue decline was relatively immaterial compared to the drop we are seeing at $3 million a quarter. I think the major factor that is affecting our business right now is the macro economic environment and the build up in the PC and automotive inventory channels. So that is the major issue we are dealing with and that is what we have to right size to and that is our objective. I think I mentioned going forward we feel we have several great growth businesses that have demonstrated until we ran into the problems in end customer demand that have been growing pretty nicely. That includes our automotive where I think we have great design wins that continue to kick in. Number two, is our analog business where we had 20% year-over-year growth in Q3. Then our emerging business in portable devices which has been growing exponentially.

So we feel we continue to have excellent growth engines but the problem we are working through right now is sincerely end customer demand. Now given the fact we do have weak end customer demand we are totally committed to right sizing the business and maintaining our cash balance sheet. So that is our exact and specific objective.

Operator

The next question comes from Christian Schwab – Craig Hallum Capital Group.

Christian Schwab – Craig Hallum Capital Group

Where is the PC inventory? Is that at the PC manufacturer? Is that the Asian motherboard manufacturer? Is that at the distributor level? Who is holding all of the inventory that needs to be reduced?

Aaron Fisher

It is difficult for me to know exactly where the finished goods are but our view is a lot of it is sitting as built computers.

Christian Schwab – Craig Hallum Capital Group

Is there any demand difference that you are noting between notebooks and desktops?

Aaron Fisher

No I think the downturn is affecting both rather equally.

Christian Schwab – Craig Hallum Capital Group

Are you guys seeing an impact on notebook demand from the increased demand in essence a low-cost notebook or a netbook?

Aaron Fisher

We have a lot of exposure to the commercial space and I think the netbook is probably eating into the consumer space a little more.

Christian Schwab – Craig Hallum Capital Group

So you are not designed into any net books are you?

Aaron Fisher

We are engaged with some net book designs. Yes.

Christian Schwab – Craig Hallum Capital Group

On the auto side where is all that inventory sitting?

Christine King

Once again I think the inventory is sitting at the automotive sub-assembly providers and in automotive units. We have all seen in the news cars sitting on the dock and so I definitely think it is a combination. Back on the point you were making about PC’s, Aaron was mentioning we are exposed to commercial PC’s and we all know what enterprise spending has looked like with the down sizing in financial institutions. I think that is clearly taking an effect.

Christian Schwab – Craig Hallum Capital Group

I guess I’m slightly confused on one thing. What is your target run rate on a quarterly revenue basis to be break even from an earnings standpoint, non-GAAP?

Christine King

Let me reiterate. We obviously gave specific guidance of $45-51 million in Q4. I also mentioned we expect that to be the low point so we do expect a sequential increase in revenue going into Q1. Our objective on the bottom line is to remain cash neutral as the kind of run rate we expect to see in Q4. So that is our specific objective and it is also our specific objective to balance making sure we maintain our balance sheet, which we feel is very important and critical for the business with maintaining the investments in areas where we think have great growth potential.

Christian Schwab – Craig Hallum Capital Group

So we should anticipate a pretty meaningful work force reduction?

Christine King

I wouldn’t say that. We are definitely working through appropriate actions. I think we have a lot of leverage in reducing our inventory and reducing CapEx and our discretionary expenses and I mentioned executive compensation. We are working through what specific workforce actions are required. Obviously in this call we haven’t made any specific announcements in regard to that on how we might accomplish the further downsizing that might be needed.

Christian Schwab – Craig Hallum Capital Group

So I understand how you can do working capital means to keep cash neutral. I guess at what revenue run rate do you expect to be non-GAAP break even?

Christine King

Our objective is our objective. I think I have said a few times our objective is to be at least cash neutral at the current run rate we project in Q4 and beyond.

Christian Schwab – Craig Hallum Capital Group

What should we assume is a steady state gross margin business? What are the margins going to be looking forward because you are guiding them down pretty significantly?

Christine King

Sure. We guided them down specifically in Q4 to 400 or cost of goods up 400-600 basis points whichever way you want to look at it. It is obviously the major effect there is the fixed cost absorption. Obviously we have been happy with our gross margins in the past and so we are going to continue to manage our gross margins but we are giving specific guidance for Q4 and not beyond that.

Christian Schwab – Craig Hallum Capital Group

Should we anticipate a pretty meaningful gross margin improvement some time in 2010 then?

Christine King

As I said I am not going to comment on 2010. Obviously we are working with a lot of moving parts here. We have got to get our arms around what our demands are and what the demand will be from Q1 and subsequent quarters in fiscal year 2010. In addition to that we have got to work through all the actions we have got to take to achieve the objectives that I mentioned.

Christian Schwab – Craig Hallum Capital Group

Since the inventory correction was caused by a massive decrease in demand, right, and demand recovery is very rarely come back in a V shape recovery like an inventory correction kind of does as you look out over the next couple of years since this is the worst you have seen in the chip environment in 35 years, if I heard you correctly earlier, how do you see the recovery using your experience? Not a prediction of your business, but using your experience of being involved in the industry for a very long time.

Christine King

I don’t mean to stonewall you here but I have to say in my 35 years semiconductor experience there has never been such weakness across all geographies and all end markets. I mean obviously we have seen some pretty tough times in the 2000-2001 time frame and the earlier in the kind of 1970 time frame but I don’t think we have ever seen every geography and every end market down the way it has really played out here. So I think the biggest thing affecting us is obviously the PC inventory build up and the lack of PC sales. That is the biggest thing. Aaron mentioned a decline of $10 million from Q2 to Q3 and an even greater decline going into Q4. So that I think is pretty unprecedented. Then you add to that the automotive decline based on consumer spending. Then subsequent to that as we expect in Q4 we see our revenue declining in Asia as well as Japan based on consumer spending. Things like LCD displays, consumer mobile devices and every single end market and sector that we work in is being affected across all geographies.

So I have to say I don’t think the semiconductor industry has seen a downturn of this breadth and the fact that we have our customers shutting down for these extended periods makes it very difficult to get an accurate forecast. So I think that visibility is limited. I think we will work through this inventory problem. I think one of the good news pieces is that we have seen order cancellations and push outs decelerate in recent weeks. I think that we certainly have gone out there and said we expect Q1 or fiscal Q1 to be up sequentially at least in terms of our revenue we are kind of calling bottom here.

Now getting beyond that I think that end consumer demand is a big question mark for everybody across the globe whether it be bankers, semiconductor executives, you name it. I don’t have that crystal ball. I think we are working through the inventory and I think that we are going to track with the rest of the economic worldwide recovery.

The other thing I mentioned was our book to bill as a hard piece of data has improved and is approaching one. So I think that is kind of good news. If I was the President of the United States I would be hard pressed to say when does this economy recover.

Christian Schwab – Craig Hallum Capital Group

So it is probably safe to assume that Q4 is the bottom and we would expect a slow recovery from there is what you would expect currently.

Christine King

I am being very specific. I am not calling a bottom to the economic downturn. All I am saying is from SMSC specifically we feel that Q4 is the bottom for us.

Christian Schwab – Craig Hallum Capital Group

Would you say it is logical then that the first chance of any potential good news on the PC front would be orders in the beginning of February post Chinese New Years?

Christine King

I think the OEM’s are going to be shut down over Chinese New Years. I do think we will have better visibility specifically for semiconductors as we exit the Chinese New Year period. As I said, our book to bill is approaching one. I think that our customer forecast indicates some small improvement across the board right now. So we will just see what happens.

Operator

The next question comes from Richard [Sidero] – Kennedy Capital.

Richard [Sidero] – Kennedy Capital

On the inventory side given the revenue number you are predicting it looked like your inventory going from this quarter going into next quarter looks about $30 million too high based off of that. So I don’t know where your finished goods or raw materials are but will you have inventory write downs or are you going to have significant ASP pressure on any of those products? How are you guys thinking about the inventory?

Christine King

First of all I think that our inventory is in better shape than you just said. Our inventory is relatively flat, was relatively flat going into this quarter and as I mentioned we expect to reduce our inventory as we exit the fiscal year. I expect that with a great focus on that we are going to continue to work our inventory down. So, I agree that our inventory overall is too high and we need to manage it better. That is a key focus for us.

Now to your specific question, today we don’t see any significant inventory write downs. We don’t believe we have a lot of raw material in inventory. In addition to that ASP pressure because of the fact that we are 95% or so single source we don’t have big ASP pressure on recurring products that were shipping so that is not a huge factor. I think overall we have kind of seen ASP’s go down in the last quarter about 5% or thereabouts. Where we are seeing the ASP pressure is in new designs. So there is a lot of tough competition in winning new designs. While I agree with you we need to work our inventory down I do believe that we will be able to do that and I think we are going to be able to work off of our existing inventory as we get into the current quarter and into the near future quarters.

So, basically that is where I think we are in regards to inventory.

Richard [Sidero] – Kennedy Capital

Without knowing this, is the inventory you have is it inventory you guys have and then there is additional inventory in the channel and at a customer or do you account for some of your customer inventories?

Christine King

That is our inventory. That is our inventory and the other thing is we do keep a substantial amount of inventory for our automotive customers. Obviously we are single source there. We didn’t want to shut down any car lines which I don’t think is a risk right now. I think that we have definitely looked at all our inventory policies and I feel very positive we are going to be able to work that inventory down.

Richard [Sidero] – Kennedy Capital

As far as expenses, I think if I read this right you are guiding expenses essentially flat from third quarter to fourth quarter so where or when do we start to see the expense sides cut because you laid out a couple of the items and when does that hit?

Christine King

I think that right now we have already taken actions on things like discretionary spending. Obviously we are going to continue to work that into our numbers with things like travel, consultants, etc. I think as we work through our actions here as I mentioned there are actions we will take which won’t hit us until Q1. I think we are going to work to continue to reduce operating expenses and we have been on the path of what we saw in the future three months ago was we had a lot of great growth segments. Actually we increased our headcount in Q4 based on previous hiring commitments. So now obviously we have to look at the whole picture and I think we are going to be very committed to taking the actions that we need to take and working our opEx down because right now as a percentage of revenue it is too high.

Richard [Sidero] – Kennedy Capital

Do you anticipate the auditors given where the stock is trading to have you write down good will in the fourth quarter?

Christine King

In the fourth quarter that is one of the things we will be looking at and no conclusions obviously as yet but we will look into write downs we may possibly need to take in good will.

Richard [Sidero] – Kennedy Capital

You talked about the fourth quarter being the bottom maybe sequentially up into the first quarter. Would there be any reason that you would not see some sort of seasonal build once you get through the inventory just for modeling revenue purposes past the Q1 going into Q2 and Q3 and the seasonal time? You guys made the statement that basically there is no visibility and no guidance for the year. Is there any reason you wouldn’t normally have the seasonal build again next year and in the third and fourth quarter?

Christine King

I think given the neutral environment we would see a seasonal build. The main thing is how quickly do we run through the inventory situation. To me the two key factors are do we work to the inventory correction and number two do we start to see some consumer spending coming back. I think that is relative. I think in Q1 I think our fiscal Q1 we do see some positive signs but we will see how that continues to play out.

Richard [Sidero] – Kennedy Capital

I know this is a very broad statement that you guys talked about. You don’t feel that you are losing market share. How do we as shareholders feel comfortable that your decline is industry related versus market share related over the next year and are you worried about losing market share because of pricing or any other issues?

Christine King

I think that I do feel strongly we are not losing critical market at all as I stated. I think that we can relate all of our numbers in the declines in the PC segment and in almost specifically the customer units. Once again our customers did order ahead of themselves both in the PC as well as the customer segment. I think one of the interesting things is our Asian revenue actually went slightly up in Q3 but things didn’t catch up in terms of consumer spending until Q4.

On the design win side we do and have won quite a number of design wins in the PC segment as well as in other products that we mentioned. Aaron mentioned the portable products and tear downs where we see SMSC devices. So I think we can point to specific designs in each one of the areas automotive design wins continue to accelerate in that space. The portable components we mentioned. Then our analog ASSP’s which had I think excellent year-over-year growth in the third quarter. All have very positive design win trends. We can characterize the type of designs that we have won to you but I think we are very willing to cite specific declines we are seeing from specific sectors.

Richard [Sidero] – Kennedy Capital

There has been a decent amount of management changes. Can you talk about the vision the new management is bringing to the company? What is different or what is the same and where do you plan on taking the company?

Christine King

From my standpoint I am very excited about the company. I am still very excited about the company. I think that we have tremendous growth areas. The thing I have been really impressed with is the people in the company. The engineering skills and even more so the marketing skills and understanding the markets and what kind of products can accelerate ourselves. What I want to just take the company to the next level. Obviously we have a huge fly in the ointment right here but I think that we have the raw material and so I think my vision obviously is number one job is we have to respond to this economic environment. After that we have to prioritize the programs so that we make sure that we invest in programs and products that give us the most bang for the buck and so that would be my second priority. Then we are going to focus relentlessly on design wins and get those products into production because that is the way we are going to overcome this.

I don’t want to count on the economy getting better itself. I want us to count on gaining market share and winning new designs, executing those designs in production and I do think we can be a lot leaner in terms of our operational capabilities. We are very happy to have Kris Sennesael here. Actually this is his first day on the job so he is sitting here in the room. So we are very happy to have a new CFO. It is all going to be about picking the right products, winning the designs with our customers and then executing both in development and in operations.

So that is my vision. I guess it is just fundamentals but we are going to be enthusiastic about it and relentless.

Operator

The next question comes from Christopher [Longario] – Sidoti & Co.

Christopher [Longario] – Sidoti & Co.

Instead of talking about things you can’t control being a demand issue looking at your costs here was it right about $38 million for operating costs through the quarter. Can you just quantify how much, how much you can quickly strip out of that number?

Christine King

I think that we mentioned that we expect cap to be slightly down in Q4. I think that I am not going to give a specific number here but I think we have a lot of room to manage our cost of goods. I think the inventory reduction is a major point. As I mentioned we gained concessions from our suppliers and they have been very cooperative with us and then I think we are going to be aggressive in managing our opEx and I mentioned a couple of things we are doing. So we are going to right size the business to the revenue levels that we are at as I mentioned before.

Christopher [Longario] – Sidoti & Co.

As far as cash flow neutrality goes and managing the business obviously it is not going to happen in February but is this something we will see before the first half of fiscal 2010 cash flow neutrality?

Christine King

We are working on a real time basis so we expect to be making improvements on a weekly basis. We will definitely be reporting to you again when we talk to you but we are going to be working this as priority number one.

Operator

The next question comes from Vernon Essie – Needham & Co.

Vernon Essie – Needham & Co.

I am joining the call late and just looking through these slides I want to make sure there is one point of clarification here. You made some comments about the PC market and inventory build and in the slide you have a North American PC maker who has dropped about 50% sequentially. Is this something we should apply sort of in the macro in terms of a global comment from your customer base or is this just a small portion of it? I’m trying to understand if that is reflective of the overall notebook and desktop bucket.

Christine King

I think obviously we participate heavily in that. I think we have been pretty specific in what we are seeing in terms of drops. We mentioned, I don’t know if you heard, we mentioned a $10 million drop in PC in our Q3 revenue. We also mentioned the fact we expect to see an even greater decrease in the current Q4. I think it is reflective of what our customers bought back in Q2 and how that has tailed off. I can’t relate it because the inventory position of our customers and obviously the ODM’s play a big part of this. But I think we were specific in the drop at SMSC.

Vernon Essie – Needham & Co.

On the tax side I don’t recall there being any specifics on that. What should we be looking at on the tax rate in the fourth quarter. If you mentioned that I apologize. Just for modeling purposes at all to take a stab at it for 2010.

Christine King

Our normal effective tax rate is approximately 30%.

Vernon Essie – Needham & Co.

We should be using that then.

Christine King

Yes. Thank you.

Operator

The next question comes from Christian Schwab – Craig Hallum Capital Group.

Christian Schwab – Craig Hallum Capital Group

In order to get in the next level you are in an enviable position versus many of your semiconductor peers with the cash. Are you going to use cash in stock to grow the company and look for targeted acquisitions to layer in? Should we assume that will be a goal of yours in the next year?

Christine King

We are going to be very smart about that. Definitely. I think obviously we do have a good cash position. There could be some excellent M&A opportunities coming up here in the near future. We have one of our best and brightest people on top of that. So I think that while responding to this environment and controlling and reducing our costs is priority number one we will definitely be looking at smart M&A activity. I think our priorities there are to gain market share, expand our customer base and definitely look at accretive transactions particularly in this environment. So we will be looking at that but we are definitely going to be very smart about it. It could be a very good time for that type of activity. So it is definitely on our radar screen although obviously we have nothing specific to report.

Christian Schwab – Craig Hallum Capital Group

Which core business would be the most logical for you to target to gain the most share or expand your customer base? Would it be computing, connectivity or would it be in the other areas like automotive, analog or portable?

Christine King

Personally I think our analog business is real exciting. Aaron mentioned our focus on mixed signal capability and expertise so I think we would definitely be looking there. I think that I am not writing off the PC sector here at all. I think we have a lot to offer there. We have great relationships with our customers. I think we are in four areas that we intend to stick with. Our computing and connectivity base is expanding our USB footprint that we are applying to the portable segment, our analog I mentioned and I think that progress on the automotive front despite the fact we have a huge decline in units which for the first time I think in the overall industry has really affected revenue. We are really happy with the position we have been able to gain based on our networking products. I wouldn’t rule out any of those products and I particularly like the analog mix type capabilities.

Operator

At this time there are no additional questions in the queue. I would like to turn the call back over to management for any additional or closing remarks.

Christine King

I really appreciate all the questions and comments. I apologize for not being able to be more specific where you wanted me to. I think it is obviously clear from our prepared remarks and your questions that the events unfolding in our macro environment will continue to be challenging. Steve mentioned in last quarter’s call and we commented further today that we are currently in an environment of limited visibility and we expect this to continue until at least the end of our fiscal year. I do want to remind everyone despite these challenges SMSC has an excellent capital structure as we just discussed, good end market diversity, innovative technical resource and great people. These are the reasons I joined the company.

Because of our financial and market position I couldn’t be more excited about this opportunity and I am really looking forward to giving you more detail about our future and speaking in meaning with many of you over the coming months and quarters.

Thank you for your great questions. I appreciate everyone for joining us today.

Operator

That does conclude today’s conference. You may disconnect at this time.

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Source: Standard Microsystems Corporation F3Q09 (Qtr End 11/30/08) Earnings Call Transcript
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