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OmniVision Technologies, Inc. (NASDAQ:OVTI)

Q3 2009 Earnings Call Transcript

February 26, 2009 at 5:00 pm ET

Executives

Shaw Hong - President, Chief Executive Officer, Director

Ray Cisneros - Vice President of Sales

Bruce Weyer - Vice President of Marketing

Anson Chan - Chief Financial Officer

Brian Dunn - Investor Relations

Analysts

Unidentified Analyst

Doug Freedman - American Technology Research

Tristan Gerra - Robert W. Baird & Co., Inc.

Quinn Bolton - Needham & Company

Dunham Winoto - Avian Securities

Betsy Van Hees - Caris & Company

Analyst for Hans Mosesmann- Raymond James

Operator

Thank you for your patient. Your third quarter 2009 OmniVision Technologies earnings conference call will begin shortly. Again, thank you for your patient and thank you for standing by.

Good day ladies and gentlemen and welcome to the third quarter 2009 OmniVision Technologies earnings conference call. My name is Demolie and I will be your operator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s conference, Mr. Brian Dunn. Please proceed.

Brian Dunn

Thank you, Demolie. Good afternoon everyone and welcome to our fiscal 2009 third quarter earnings conference call. After the market closed today, OmniVision issued an earnings release reporting our financial results for our third quarter. You can access this release from the Investor Relations section of our website at ovt.com. Please be advised that this call is being webcast live and is also being recorded for playback purposes. Both the live webcast and replay can also be accessed from the Investor Relations section of our website.

Before we begin, we wish to remind you that certain information discussed in this call, in particular our revenues and earnings targets and our forward-looking product plans, is based on information as of today, February 26, 2009 and contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those set forth in such statements.

For a discussion of these risks and uncertainties, you should review the forward-looking statements disclosure in the earnings release we issued today as well as OmniVision’s SEC filings including our Annual Report on Form 10-K for fiscal year 2008 and our Quarterly Reports on Form 10-Q and other reports filed from time to time. During this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in our earnings release posted on our website.

And with that, I will now turn the call over to OmniVision’s President and Chief Executive Officer, Mr. Shaw Hong. Shaw?

Shaw Hong

Thank you, Brian. I would like to add my welcome to everyone who is participating in our fiscal 2009 third quarter conference call today. Joining me today are Anson Chan, our CFO; Ray Cisneros, our VP of Sales; and Bruce Weyer, our VP of Marketing. I will begin with an overview of our results for the quarter and then provide my perspective on our comparative positioning. I will ask Ray to present our overview of sales activity and outlook, and then Bruce will discuss our technology advantages. Finally, Anson will discuss detailed financial results for the third quarter and provide our outlook on the fourth quarter. We will conclude as usual by answering as many of your questions as time permits.

Let me begin our regular agenda by providing an overview of our financial results for the third quarter. Revenues were $80 million. Our GAAP net loss was $0.36 per share. Our non-GAAP net loss was $0.24 per share and our cash and short term investments at quarter end remained strong and totaling about $264 million.

The guidance we gave you in December and the results we posted today, the fact that these are the most turbulent times in our Company’s history. OmniVision is one of thousands of companies affected by this US global economic downturn.

The OEM essential market we serve including mobile phones, notebook PCs and automotive are some of the most impacted in the industry. Our near term financial performances has clearly been affected by the dramatic decline in consumer demand, and while this is true that we do not get to choose our economic environment. We do get to choose how we manage our business. To that end, beginning in November of last year, we made a decision to implement near term cost reduction measures. Those measures included two Companywide shutdowns and the elimination of certain discretionary spending.

Together, these measures in part reduced our operating expenses during the third quarter by more than 10% compared to the prior quarter. This use the strength and financial benefits of our published model. In these difficult times our model could be a major advantage over certain of our competitors. However, even though we have taken such near term measures to reduce our expenses. We are being very careful not to sacrifice our long term opportunities.

As the economic environment recovers from the current situation we want to be in the best possible competitive position. We also want to remain competitive now and also fulfill our long term goal to be the leading total image providers across multiple industries. I certainly believe that it is essential to execute our current spread strategy, efficiently and effectively.

As I have discussed in prior quarters, we have four key strategies they are: investing wisely in technology development, producing new products based on our leading technologies, and developing and expanding our presence in all markets. Managing supply chain efficiently and effectively and managing and controlling operating expenses.

Our first core belief is that innovation must never stop. We believe that our strong designed abilities allow us to introduce some of the most advanced imaging technology in the world. We are committed to continuously create new technologies that are designed to lower cost, increase the product footprint, reduce hand to the market and improve picture quality.

After years of strategic planning, last year we introduced our award winning BSI technology. This month we announced our new CameraCube technology, together, these technologies represent a series of industry first. As you know, our BSI technology is a revolutionary approach to digital imaging, which allows us to deliver a number of performance improvements over the traditional approach.

Our CameraCube technology is a total cameral solution that contains in a single stand alone unit, OmniVision’s image sensor, embedded image processor, and new proprietary wafer-level optics.

We believe that our CameraCube technology combats with our industry leading BSI architecture puts as well ahead of the competition. These innovations ensure we have the industry strongest lineup of digital imaging products and allow us to gain market share from our competitors.

Next, it is our firm commitment to providing the most advance products to our customers and expanding our presence in all markets. The success of the strategy is evidenced by a wide-range of product introductions and new design wins.

Our engineers focus on reducing the problem die size and optimizing product feature sets to ensure we meet customer demands in cost performance and quality. Through this approach and in collaboration with our marketing and sales folks, we work to gain market share in the mobile handset and notebook PC and continued to expand emerging markets, such as medical, surveillance and automotive markets, as Ray and Bruce will discuss later in more detail. Despite the current economy environment, we continue to obtain design wins for our 1.4 and 1.75 micron-pixel BSI products across multiple expectations.

Our CameraCube products have already achieved several design wins across several markets. CameraCube’s early success has been driven by a commission of small phone factor cost and the performance benefits, in addition, because of the high environmental tolerance levels, CameraCube products are well suited in applications where extreme environmental conditions exist.

I believe we have been and will continue to be successful in identifying and in meeting the needs of a particular market and developing innovative solution in products such as the BSI and CameraCube devices to meet those demands.

Our third key strategy is to continue to work closely with our supply chain partners, TSMC, VisEra, GemTech to deliver and even more cost effective and value added product to our customers. The CameraCube products as well as BSI are examples where new manufacturing processes and technologies were jointly developed with our partners to make these technologies possible.

We will not stop here. There will be more innovative and cost effective products to be manufactured in meeting our customers’ needs. We will continue to work closely with our partners to improve our year throughout the production process, more too small-like, smaller languet to increase the number of that. Migrate to 300 millimeter wafer production and impose the efficiencies of automated final testing equipment.

Our fourth key strategy is our continuous effort to manage expenses. While cost reduction efforts have been successful in the third quarter, we will continue in the current quarter and beyond to monitor carefully and manage our operational spending.

Even though we are in this economic slump, I believe there is growth on the horizon and we are positioning ourselves well by providing the very best solution industry wide and confidence that our strategy is sound and continues to fit our near term and long term needs and goals. We are committed to investing wisely in new technology, providing the best quality products and at the same time identifying and developing all markets, and as always we place the interest of our customers and stockholders first.

With that let me turn the podium over to Ray who will provide an update on the quarter’s sales activity. Ray?

Ray Cisneros

Thank you, Shaw. During the third quarter, we shipped approximately 56 million units down from the prior and reflect the continuing difficult market environment. ASP per quarter was $1.43. Two of the hardest hit markets for us were the mobile phone business and notebook PCs. Though there are some indications that the industry surplus channel inventory is clearing, we are seeing a conservative approach from customers to replenish these cleared inventories. Having said that we are still optimistic about our long term outlook, we continue to experience traction with new designs in a variety of end markets and regions.

During the quarter, we have multiple design wins for both our 1.4 micron and 1.7 micron BSI products. These wins included Tier-1 customers in multiple applications, multiple geographic regions and across all sense of resolutions. We are very enthusiastic about the reception we have seen for BSI and have received in-customer validation on our leadership and image quality. We believe that revenues from these BSI wins will begin to ramp in the first quarter of fiscal 2010.

As for our CameraCube products, we have locked down several design wins in Tier-1 OEM customers over several regions. CameraCube products will begin to contribute to revenue starting in April 2009 and ramp significantly thereafter.

In other positive news, interests in our higher megapixel offerings and continues to grow. This was initially driven by the smart phone market but is now picking out in mainstream handset as well. During the quarter approximately 20% of our unit volume was driven by sensor they were 2 megapixel and above, a slight increase compared to the prior quarter.

During the quarter, mobile phone sensors were approximately 70% of sales while notebook PCs were just over 20% of sales. The balance represents our emerging markets such as automotive, medical and surveillance, and while these markets are still small, we have recent to be optimistic about their prospects. In the automotive market, we won multiple designs with some of Europe’s top large car manufacturers and have made meaningful attraction with some of Asia’s top Tier suppliers.

In the medical market, we engaged with over a dozen customers with our latest OV6930 medical sensor, and initial customer feedback on the image quality has been very positive. Putting all this in perspective, while sales are still currently slow, I am confident we have the right products to be successful when the market begins to grow again.

Shaw Hong

Thank you, Ray. I would now like to turn the call over to Bruce to discuss our technology and marketing efforts in more detail. Bruce?

Bruce Weyer

Thank you, Shaw. Let me elaborate further the Omni Technologies we are bringing to market. I will begin with OmniBSI architecture.

We are very pleased that our OmniBSI architecture was selected by Electronic Design Magazine of the 2008 Best Image Sensor Technology. The publication’s Annual Best Electronic Design Awards are based on editor’s choice of the most significant designs and innovations introduced throughout the year. OmniVisions’ OmniBSI technology was selected for its revolutionary approach to digital imaging.

The OmniBSI technology delivers industry’s best image quality as measured through low-light sensitivity, quantum efficiency in cross duct. This allows our customers to introduce cameras that deliver sharper images across broader lighting conditions with more vibrant true-to-life colors. OmniBSI also makes it possible to reduce the height of the camera module, allowing mobile phone makers to design even thinner phones.

Another technical highlight this month was the introduction of OmniVision’s new CameraCube technology. CameraCube technology levers our expertise in CSP and wafer-level optics to develop in a total camera solution with the industry’s smallest profile. CameraCube product line is a deal for a small footprint applications such as mobile phones, notebooks, webcams, security and medical applications.

In addition to the size benefit, these technologies significantly simplify supply chain thus offering our customers meaningful costs in time to market advantages. Initially targeted at the value mobile phone market are initial two devices are available in volume productions today.

We expect to introduce additional devices based on this technology throughout calendar 2009 and we have already obtained multiple design wins for our CameraCube technology.

Another major initiative during the quarter was our participation at the Mobile World Congress in Barcelona in which we feature our new products and technologies including CameraCube products and our award winning OmniBSI architecture.

During the show we also announced our latest quarter inch color sensor, the OV3650, which adds to our portfolio of 3 megapixel offerings which is targeted primarily at mobile phone applications. In addition, we demonstrated our latest 8 megapixels solution on Fujitsu Microelectronics Milbeaut M-5MO advanced image signal processor reference platform. Designed to improve time to market and reduce development costs from mobile phone manufacturers, platform features are 1.4 micron, OmniBSI architecture was superior low-light performance with Fujitsu Microelectronics enhanced processing, and distortion compensation.

We will continue to focus our efforts on bringing leading technologies to our customers with best-in-class image quality and functional capabilities. We are proud of our number one market share, an image sensor market, and continually work to widen net margin going forward.

Shaw Hong

Thank you, Bruce. I would now like to turn the call over to Anson to discuss our financial performance. Anson?

Anson Chan

Thank you, Shaw and good afternoon everyone. As Shaw mentioned at the beginning of the call, revenues for the third fiscal quarter of 2009 were $80 million. This is in line with the low end of our guidance and reflects the current market environment. Direct sales to original equipment manufacturers and value-added resellers accounted for approximately 64% of revenues in the quarter, while about 36% came from sales through distributors.

Gross margin for the third quarter was 22.4% compared to 25% last quarter. Excluding stock-based compensation expense of $777,000 included in cost of revenues, gross margin was 23.3% compared to 25.4% reported in the second quarter. The sequential decrease in gross margin resulted primarily from a decrease in average selling prices and the recording of a proportionately larger allowance for excess and obsolete inventories than in the second quarter of fiscal 2009.

For the third quarter, we recognized $5.9 million of inventory allowances, which equals 7.3% of our reported revenues for the quarter. Last quarter, we reported $9.2 million of inventory allowances or 5.6% of reported revenues.

R&D expense in the third quarter was $20.8 million compared to $23.2 million in the second quarter. R&D expense in this quarter includes approximately $3 million of stock-based compensation expense. Excluding stock-based compensation expense, R&D in the quarter was $17.8 million compared to $20 million in the prior quarter. The principal contributors to the decrease in R&D expense were lower NRE-cost; the cost of mask we buy when we release our designs to our foundries and the Company shutdown, as Shaw discussed earlier in the call. As mentioned many times before due to the nature of our business, R&D expense will fluctuate from quarter-to-quarter.

SG&A expenses in the quarter totaled $13.9 million compared to $16.9 million in the prior quarter. Our SG&A expenses include approximately $2.5 million of stock-based compensation expense. Excluding stock-based compensation expense, SG&A in the quarter was $11.4 million compared to $13.9 million in the prior quarter. Similar to R&D expense, the Company shutdown reduced our SG&A expense for the quarter. Also included in SG&A expense is our commission payments to channel partners which has come down because of the lower business volume.

Between the second and third quarter on a GAAP basis, our total operating expenses went from $47.6 million to $34.8 million. If you recall, however, included in our second quarter operating expenses was non-cash in goodwill impairment charge of $7.5 million. Excluding this one time impairment charge, we still reduce operating expenses by $5.3 million or 13% quarter-on-quarter.

Our GAAP operating loss in the quarter was $16.9 million. Excluding stock-based compensation, operating loss was $10.6 million. Our GAAP pretax loss in the third quarter was $19.3 million. Excluding stock-based compensation, pretax loss was $13.1 million.

Other income expense in the quarter included a noncash charge of $2.7 million, due to the reevaluation of interest rate swap that we entered into in connection with the purchase of our corporate headquarter buildings at the end of fiscal 2007. This noncash charge is directly related to the precipitous drop in a LIBOR rate during the quarter and the requirement for us to apply fair value accounting on interest rate swap. In like manner if LIBOR rates was increased we would record a noncash gain, over the life of the swap, which is 10 years, we believe that the net impact on our income statement will be minimum.

Our GAAP net loss in the third quarter was $18.2 million or $0.36 per share compared to net loss of $5.3 million or $0.10 per share in the previous quarter. Net income in the third quarter of last year was $22.5 million or $0.40 per diluted share. . Excluding noncash stock-based compensation expense, non-GAAP net loss from the third quarter was $11.8 million or $0.24 per share. This compares to non-GAAP net income of $10.1 million or $0.19 per diluted share in the previous quarter, which excludes stock-based compensation expense and the goodwill impairment charge. In the third quarter of fiscal 2008, excluding stock-based compensation expense and related tax effects, net income was $31.1 million or $0.55 per diluted share.

Let me now turn to the balance sheet, we closed the third quarter with cash, cash equivalents, and short term investments totaling $263.7 million. This compares to $282.7 million in the end of the second quarter. Our cash balance was negatively impacted primarily by our investment in additional inventory during the quarter, which I will cover shortly. As far as our cash balance is concerned I will reiterate the point that we have a very conservative investment strategy, all of our funds are invested in highly marketable, highly liquid and low risk securities as such our investments have not been impacted by the current conditions of the financial markets.

Accounts receivable at quarter end, net of allowances was $46.5 million compared to $100.4 million for the second quarter. Our day sales outstanding were 53 days compared to 56 days last quarter. Given the current economic conditions, we are extremely pleased with these results. We did not relax our credit standards to chase up the revenues.

At the close of third quarter, inventory was $146.5 million compared to $127 million at the close of the second quarter. During the quarter we procured a certain high run rate, low obsolescence risk parts to provide flexibility in case demand suddenly spiked. Unfortunately, the demand situation remained depressed during the quarter. In addition, our typical 13-week lead time limits our ability to make rapid adjustments.

Quarter-end inventory represented 217 day sales, which is equivalent to an annual inventory turn of 1.7 times. This is higher than we would like. Into the course of the next two quarters, we will work on bringing inventory balance back to a 75 to 90 day range equivalent to annual turns of four to five times.

Now, I would like to turn to the outlook for the fourth quarter of fiscal 2009, which will end on April 30th, 2009. We currently expect our fourth quarter revenues will be in a range of $60 million to $70 million. This should translate to a GAAP loss of between $0.53 and $0.44 per share. Excluding the estimated expense and related tax effects associated with stock-based compensation, we expect a non-GAAP loss to be in a range of $0.40 to $0.31 per share.

With that, I will turn the proceedings back to Shaw for some strategic commentary.

Shaw Hong

As noted, our financial performance and forecast has been negatively impacted by a difficult economic environment. While it is currently unclear as to how long the world will be affected by the downturn, we are cautiously optimistic about the future with a focus on continued innovation, delivery of innovative and cost effective products, meeting customers’ needs, and the fiscal responsibility. We believe the successful combination of the above will drive our success for the long term.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Mike.

Unidentified Analyst

Actually, this is Mike calling for [40.32]. My first question is, maybe, could you provide us an update on the competitive landscape? I mean do you see any kind of share loss or share gain in any particular resolutions or geographies?

Bruce Weyer

Yes. This is Bruce Weyer, the Vice President of Marketing. We are the leader in the market and primary measurements for calendar 2008 would show we believe that we have retained our market share overall. Certainly, you have seen a one competitor this past year remove themselves from the market. So, there are competitive pressures for those people or those companies that are not as strong in the marketplace. We feel strongly about our technology that we have developed between OmniBSI and CameraCube and we feel very comfortable with our market position going forward.

Unidentified Analyst

Okay. So, everything is just a reflection of the end market. It is not any share loss or anything like that?

Bruce Weyer

Yes. We would agree with that.

Unidentified Analyst

Okay. Just a couple real quick, did you mention how much one megapixel was as percentage of revenue or units?

Shaw Hong

No. We do not breakout the megapixel as usual. We broke out just the 2 megapixel and above category versus VJ and below.

Unidentified Analyst

Okay. About the inventory, could you provide some kind of trends of the mix or whether it is weighted towards one resolution more than the other or…?

Anson Chan

Yes. I can comment a little bit on that. This is Anson Chan. As I mentioned in the prepared commentary, the investment and inventory are mostly in the high run rate parts with really low obsolescence risks. This pretty much implies that these are in the lower resolution, high volume parts that are used primarily in the value mobile handset arena.

Operator

Your next question comes from the line of Doug Freedman.

Doug Freedman - American Technology Research

If I could just build on the statement that you just made about the inventory that you have, would I not be correct in assuming that the CameraCube product is one that is really targeted for the low end of the market and is there any risk of those products obsolescing some of the inventory that you have on hand to go after the VGA market.

Bruce Weyer

Doug, this is Bruce Weyer again. The CameraCube product is an extension of our sensor. It is actually your ability to build the optical lenses on top of the sensor technology. So, it uses the sensor as part of the fabrication of the CameraCube. So, it does not negatively affect our inventory position. The high propensity of our product is to have a PSP packaging technology that is critical for actually CameraCube technology.

Doug Freedman - American Technology Research

Okay, so you can modify these products and shift them as CameraCube type assemblies. Is that the correct way to view it?

Bruce Weyer

Absolutely.

Doug Freedman - American Technology Research

Okay, thank you. Can you talk a little bit about maybe the pricing pressures that you buy in market whether it is about pixel, megapixel VGA and other ratios still are holding up where if you could give us what those ratios are out in the past you have given them out.

Ray Cisneros

Yes. This is Ray Cisneros. The ratio is still remain the same roughly VGA and then 1 megapixel about 2X and 2 megapixels about two to three X and now 3 megapixel closer to 3X. The issue with the pricing pressure is really a reflection of the economy, and so as you may have noted in our average ASP coming down to $1.43. It is across the Board over our solutions took that hit in terms of the rough economy. That is to be expected obviously when we pull out of this, we hope to bring that back up.

Doug Freedman - American Technology Research

And then can you talk to how much incremental content you will gain with some of the new products and where you stand on the possibility of introducing a complete module and what that would possibly do to your average ASPs?

Bruce Weyer

Well, as we mentioned, we expect the CameraCube already to start shipping in this quarter at the tail end of this quarter in small volumes and then picking up quite rapidly in Q1, in Q2. So, obviously that is going to play a positive spend on our ASPs. We do not know yet how much or how deep but obviously we are looking forward to that and it is going to be across the Board with various resolutions as well.

Doug Freedman - American Technology Research

And my last question, as you mentioned you have got a target of 75 to 90 days of inventory over the next couple of quarters. There is one of that plays to get there. You do not know if there are any new products and you shipped everything from an inventory which given a new product mix, I find that it is going to be challenging or you are expecting really a fairly significant snapback. How much underneath production levels do you think you are possibly shipping today into your end markets? Is it likely you could see revenues go back north of $125 million? Is that the type of snapback that you are looking for to return that to your target base and any help you can offer…?

Anson Chan

It is obviously difficult to have that kind of visibility going out, but we are reducing our production rate and in fiscal Q4 we anticipate to ship more than we will produce and we will continue to work on that through Q1 of 2010. But that is not to say that if there is a new part we are introducing, we are not good any at all. We are just working hard to maintain our control to working capital investment to such a point that we can get back to a four to five times annual turns from inventory.

Operator

Your next question comes from the line of Tristan Gerra.

Tristan Gerra - Robert W. Baird & Co., Inc.

Is it fair to assume that your mix of VGA as a percentage of revenues increased sequentially in the quarter and also if you could give us a sense of your revenue exposure to China as a percentage currently?

Ray Cisneros

This is Ray Cisneros. Historically, we have not broken out the revenue mix by sensor resolution. You will have to just rely on our data that we typically provide, which is by units. Two megapixel and above is 20% now and trending upwards going forward. As pertains to the China revenue exposure that market in my mind is very deep, very broad, if anything it continues to migrate to more customers, more manufacturing channels there. So, VGA will still remain a significant part of our portfolio, as you can tell even by the CameraCube product, it has been released for the low resolutions for now, but obviously there are plans later for other ideas with that. So, China I think will remain strong. Obviously, it is suffering from the economy as well everybody else, but we expected to snapback with everybody else as well.

Tristan Gerra - Robert W. Baird & Co., Inc.

Okay. So, is it fair to assume that China would be a quarter of your revenues and also is VGA increasing in units as a percentage quarter-on-quarter?

Ray Cisneros

No, we did not. Well I think Anson might have some comments about the percentage of revenue in China but it is more a reflection of the way the supplier channels work. It does not reflect where the end customers are. That is a common statement we typically make and then when it comes to VGA, it is again, VGA is a broad market. It is not going to go anywhere so we have to continue devoting technologies and solutions for that market.

Anson Chan

Same point over here. I think we said many times before in the calls most of the parts got shipped into China simply because that is where things are build but where the end customers are, that is a completely different story. So if you look at the reported numbers in our 10-Q and 10-K filings, China actually represents a fairly significant amount of shipment but that determination is purely based on where we ship the products.

Tristan Gerra - Robert W. Baird & Co., Inc.

Okay and then it looks like your guidance is implying low teens type of gross margin, could you talk about the dynamics today and given that you have a [tablet] model and as such the assumption is that a lot of this is driven by pricing and what should we infer in terms of gross margin recovery in the other quarters?

Anson Chan

I think first of all before you jump in the conclusion that we are implying a gross margin in teens, actually you need to give us a little more credit for our ability to continue to monitor our operating expenses and continue to look at, any spending is not necessary yet but are coming into our muscles. So with that said, there is no doubt that there is pricing pressure out there and we are factoring that into our guidance but overall, again I will say it again the sustainability is limited and that is why we are only comfortable at this point by the guidance on the top line and EPS.

Operator

Your next question comes from the line of Quinn Bolton - Needham & Company.

Quinn Bolton - Needham & Company

I wanted just to ask about the CameraCube technology, just a clarification, did you say that that uses a package dye in that CameraCube [Inaudible]? I just wanted to clarify that.

Bruce Weyer

We do use a CSP type technology in the daubing out of the CameraCube and that is why our product is very transferable from an inventory standpoint because we could move from a bare dye to package license to move into the CameraCube technology.

Quinn Bolton - Needham & Company

Got you, that makes sense. Second question about CameraCube, you mentioned you have already secured most for design wins. Is that coming more from sort of tier one OEMs or more sort of the manufacturing base of ODMs and OEMs in China, just wondering if geographically or by the customers whether there is a stronger interest buys with the leading handset manufacturers or the market in China?

Ray Cisneros

This is Ray Cisneros. It is actually an attraction not just from I would say manufacturer. It really is at home with the OEMs across all regions and even different market spaces so we are extremely pleased with the results. As I mentioned in the prepared script, it is backed in into tier-one customers so we are extremely happy about that.

Quinn Bolton - Needham & Company

And then if you can give us obviously you guys get a higher ASP because you provide more of the solution but to the OEM, I think you remove the flex table. You can put it under their regular manufacturing flow. Any sense you can give us what kind of bomb savings the OEM gets as the result to moving to that type of [gap]?

Ray Cisneros

It is a mix; you get a variety of different approaches from OEMs as you can imagine the design on the handset versus the design on say a notebook versus design on some multimedia device is really going to vary. So how the BOM works out whether the flex is on our side or their side, it is a case-by-case basis but certainly the true value proposition is the CameraCube.

Quinn Bolton - Needham & Company

Okay then just lastly for Anson looking forward to the gross margins of you guys, it looks like took a higher warranty reserve in the third quarter. You talked about inventory days up to 217 actually in the quarter. Are there any assumptions you are making about warranty charges? Will those go up over the next couple of quarters to help you reduce your inventory back to 75 days that could further pressure gross margin?

Anson Chan

It is hard to make that kind of assumption directly because our general company policy is to look at demand over the next 12 months and compare with the on-hand inventory at a point in time and reserve for the access. So what you are really asking me would be okay, what kind of focus I will see three months from now looking out 12 months then and compare it to my on-hand inventory at that point. It is really difficult to go to that kind of estimate but we do try our best to come with an estimate and roll it all to give you all a guidance but to speak to specifically on the reserve itself, it is difficult.

Quinn Bolton - Needham & Company

I guess so if I could just follow up on that, I think you said that there are 5.6 points of margin that were associated to the reserve taken. Should we sort of assume a similar level in? Obviously, if you do not have any inventory reserves, gross margins could go up. If you take another reserve, they can get hit pretty hard so you took a pretty big reserve last quarter. You must have had some assumption for gross margins to get to the EPS guidance of $0.53 to $0.44 or non-GAAP $0.40 to $0.31. Are you assuming that it stays roughly flat and any changes could take you out of that guidance range?

Anson Chan

There are a many moving pieces. Certainly, gross margin can be one of those. The other thing is also tax rate, I think last quarter, we talked about how Q3 may potentially have a negative tax rate but if we look at our reported results, we actually recorded a benefit for this quarter simply because of mechanics of recording tax provisions that kind of negative tax rate got pushed out to next quarter. So that also played a little part in the lowering of the guidance. So, it is a mix of different factors actually, more than just a gross margin issue.

And also I talked about earlier in the prepared commentary how NRE charges can also fluctuate. It all depends on the timing of take outs and introduction of new products. So with all that said, we did our best. We gave you the guidance as it is presented.

Operator

Your next question comes from the line of Dunham Winoto - Avian Securities.

Dunham Winoto - Avian Securities

I guess, Anson, let me just try to go back to the guidance again, let me just take another stab at it. So, is it fair to say on the expense line that you are not going to have expenses more than what we saw in the third fiscal quarter?

Anson Chan

We do not anticipate any significant increase if there would be increases. In fact, we are working very hard to try to come up with incremental improvements.

Dunham Winoto - Avian Securities

Okay and can we just use whatever that number is and model that going forward? Will that be fair to do that?

Anson Chan

That is your own model. It is hard to say. Like I said, we are working very hard. We are looking at all our spending in all different areas and we will do our best to bring down generally the incremental improvements. But unlike all our competition, we are not intending to introduce any significant program just to cut 20% to 30% of work force because we want to get a short term financial benefits but we will not do that, that I can promise you.

Dunham Winoto - Avian Securities

Right, okay. Regarding the inventory that you have on-hand, I know that you said most of them are parts that are high velocity going to the entry level on camera phones or even PCs but at some point, I mean if your revenue does not come back to the levels that you want, they will become obsolete. Can you give us an idea of how long that number might be? Are we talking about two quarters, three quarters or is it four quarters then they become obsolete?

Anson Chan

Like I said in the prepared commentary, we are looking at about a two quarter timeframe to get back to a targeted inventory turn level of about 4 to 5 terms.

Dunham Winoto - Avian Securities

Okay and then maybe Bruce or Ray, let me just throw out a question, I know that you guys provisionally do not give out design wins or even name of your customers which is fine but can you give us an idea of your coming design wins that you might have and just give us like a split between VGA versus anything bigger than 2 megapixel and how that has been in the past two quarters?

Ray Cisneros

Sure, this is Ray. We are walking into I think in a very good fiscal year 10th situation. We are happy with the design wins and the customers we have been able to win and it is across various different resolutions including VSI, including CameraCube and various markets and applications. The trending that we see and I think we have been posting this for the past two quarters now that 2 megapixel and above is trending. As far as we can tell just in generalities, it is still will have that trend going forward and I think that is a reflection of our improvement of quality and products to the market place that people have adopted broadly. So we are extremely pleased looking forward.

Dunham Winoto - Avian Securities

Okay, just one final question. Can you also talk about what participation do you have in a Netbook space if any?

Ray Cisneros

Right, the Netbook space is growing extremely fast. Given the position we have in the notebook PC market, very strong position roughly over 70% minimum that puts us in a very good position of capitalizing on those sales channels, those customers and those relationships so we will be having I think a windfall of good business and activity in that space.

Dunham Winoto - Avian Securities

Are you aware of any Netbooks that have like camera?

Ray Cisneros

Not aware of any at the moment but we are aware of imminent plans.

Operator

Your next question comes from the line of Betsy Van Hees - Caris & Company.

Betsy Van Hees - Caris & Company

I just wanted to follow up a little bit and expand on the Netbook comments. In terms of images and resolution, can you tell us what the OEMs and ODMs are designing? Is it VGA 1.3?

Ray Cisneros

Right, this is a very interesting space. It is just not Netbooks but notebooks in general. The requirements or I would say their end consumer needs are slightly different than the handset market that actually bodes well for OmniVision in particular with some of our [edoc] integrated SLC chips where that particular feature is a big attraction for our customers and interestingly enough, they are extremely interested in higher resolutions. So the notebook and Netbook market is actually moving, I would say in a much more creative way than the handset markets. So that, what I am implying there is I think the split of resolutions will be a little more even down in my opinion over the long haul versus the handset.

Betsy Van Hees - Caris & Company

Can you give a little bit more color and clarification on that, in terms of the handsets, in terms of VGA versus 1.3 and 2 megapixel and above, what is the mix in that and then in terms of the notebook market, isn’t it primarily 1.3 megapixel that we are seeing today?

Bruce Weyer

If you look at the handset market, you have to remember that when you look at the entirety of that market, there are still a fair number of handsets that do not even have cameras in them. So by default VGA is still a very important resolution point for handsets when you look at the entirety of resolutions or non-resolution.

The notebook market has actually had a very fast attachment rate this past year. The notebook market has primarily been VGA and one megapixel but in this past year, it also had gone up to two megapixels. We do see interest above and beyond that. At the same time, areas like Netbooks which are very, very price sensitive products, it would continue to focus a fair amount of VGA and lower resolution.

So as Ray mentioned, the notebook market, we think that the distribution could be much more evenly spaced across the resolution actually had a much faster rate than even the handset market achieved.

Ray Cisneros

Just one more point of clarification there, when we say VGA and megapixel in the notebook market, OmniVision has been a frontier leader in these releasing parts that hold I would say higher value of a sensor. In other words, VGA sensor of a handset is not the same VGA sensor for notebook. The notebook actually buys into a much more specialized VGA sensor that gives you high pixel quality, high/low light sensitivity. So in fact the product is actually a bigger chip which means better ASPs for us.

So, you need to take those factors into consideration when we talk about the notebook. MyBook, it is a high value proposition in business base than other markets.

Betsy Van Hees - Caris & Company

Okay great and then I have one last question; I want to circle back on the inventory. You said that you made a bet if I heard you correctly that there was going to be a snapback that is why you guys went out and procured or they had so much inventory of builds to come in. Can you tell us what happened, what are your thought process was when you made that decision and what changed during the quarter than led to where we are today?

Shaw Hong

Well the primary motivation at that time, you put like, mostly coming from a tier-two type market in China because that market can turn on a dime and consequently, without having all the feasibility at the time, we go into the quarter. We said well, we want to maintain the market share there so if there were to be a snapback in that particular market, which tends to be a spot market anyway, we want to have the inventory available so that we will not lose this market to someone else. So that was the decision point made then. But unfortunately, the snapback did not take place and they continued to be conservative in ordering new parts to replenish shelf space.

Betsy Van Hees - Caris & Company

So have you seen an improvement then in order trends stabilization or the last couple of weeks into the February month?

Ray Cisneros

This is Ray. We are watching these channels extremely closely. There are spot indications often on improved activity. Most channels are replenishing their cleared inventories but albeit in a very conservative method or approach. On the other hand, we do see some spot activity improvement in the notebook business which is something that is extremely good news for us. So, on the whole, I would say the environment is very conservative. There are improvements in notebooks and I would say we are taking it week by week. As Anson said, some of these markets are fast paced so what you see today may be a different picture tomorrow.

Operator

Your next question comes from the line of Hans Mosesmann- Raymond James.

Analyst for Hans Mosesmann- Raymond James

This is Ashley calling in for Hans. I apologize if this is already been answered. You talked a little bit about your customers being conservative in terms of replenishing inventory. Can you give us a sense for what you think the inventory levels are like in the channel and then just in terms of your visibility for your guide for this coming quarter, is that better or worse than the visibility you had back at the beginning of December when you gave your guidance?

Ray Cisneros

Right, the sense again I think is more of the reflection of the general economy. Most end customers, most distribution channels, most manufacturing channels are extremely cautious with cash. They are extremely cautious with commitment to material and that is to be expected in this economy. On the other hand, what we do see is no let up in design activity. Going forward business for our tier-one customers and even some of many of our tier-two customers design activity has not stopped. There is still a spirit that this is going to come to an end. It will turn around but on the other hand, no one has that perfect crystal ball. Month-by-month, we are taking it.

Analyst for Hans Mosesmann- Raymond James

Okay and then does your guidance accounts for further ASP declines? Can you give us any color in terms of that, what you are expecting going in this quarter?

Ray Cisneros

Well our guidance takes into account obviously everything, customers commitments, POs and obviously pricing, whether it is a trend towards down, it is hard to say at the moment but we are just about the most we can give for you in terms of granularity on that.

Operator

This concludes our question-and-answer session. You may proceed with your closing remarks.

Shaw Hong

Thank you very much for attending this presentation. We look forward to speaking with you in three months. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a good day.

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Source: OmniVision Technologies, Inc. Q3 2009 Earnings Call Transcript
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