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Executives

Mary McGowan - Investor Relations

Shaw Hong - Chief Executive Officer

Ray Cisneros - Senior Vice President, Worldwide Sales and Sales Operations

Hasan Gadjali - Vice President, Worldwide Marketing and Business Development

Anson Chan - Chief Financial Officer and Vice President of Finance

Analysts

Raji Gill - Needham & Company

Daniel Amir - Lazard

Paul Coster - JPMorgan

Hans Mosesmann - Raymond James

Betsy Van Hees - Wedbush Securities

OmniVision Technologies, Inc. (OVTI) F3Q13 (Qtr End 01/31/2013) Earnings Call February 28, 2013 5:00 PM ET

Operator

Ladies and gentlemen, thank you and welcome to the OmniVision Technologies conference call for the third quarter of fiscal 2013. (Operator Instructions) I would now like to turn the conference call over to Mary McGowan of Blackburn Communications.

Mary McGowan

Thank you very much. Good afternoon, everyone, and welcome to our fiscal 2013 third quarter earnings conference call. On today's call will be Shaw Hong, Chief Executive Officer; Ray Cisneros, Senior VP of Worldwide Sales and Sales Operations; Hasan Gadjali, VP of Worldwide Marketing and Business Development; and Anson Chan, Chief Financial Officer.

During this conference call, we may make forward-looking statements regarding our business, including statements relating to revenues, earnings targets and our product plans. This is based on information as of today, February 28, 2013. And actual results may differ materially from those set forth in such statements.

These and other forward-looking statements involve assumptions, risks and uncertainties that could cause actual results to differ materially. For discussion of these risk factors, you should review the forward-looking disclosures in the earnings release we issued today as well as the risk factors and other disclosures in OmniVision's SEC filings and reports, including the most recent annual report on Form 10-K and recent quarterly reports on Form 10-Q.

During today's call, we will also discuss certain GAAP and non-GAAP financial measures, the latter of which excludes stock-based compensation expenses and the related tax effects. A reconciliation between the two is available in our earnings release posted on our website.

With that, I'll now turn the call over to Mr. Shaw Hong.

Shaw Hong

Thank you, Mary, and welcome to all of you joining us on the call and webcast. Earlier this afternoon, we issued a press release describing our results for the third quarter of fiscal 2013. For those who have not read the release, I will provide you with a recap of our financial results.

Our Q3 revenues, a recorded high for OmniVision at $424 million, and that was from a shipment of 252 million image sensors during the quarter. On a non-GAAP basis, gross margin was 17.1% and net income was $31.5 million or $0.56 per diluted share. Our cash balance increased by $80 million to $220 million. As we mentioned during our last earnings call, a lot of accounts receivables became due in Q3 and the timely collection increased our cash balance.

Before I turn the call over to our management team to provide details on our Q3 financial results and our outlook, I would like to make a few comments on the business. I am proud to report that we have set a new record for OmniVision in Q3, in both dollar revenues and unit shipment. Our revenue is at the high-end of the guidance that we provided last November.

It is also the fourth consecutive quarter that we have posted high revenues. Our employees have worked hard to deliver the high performance components that our customers demanded and to capitalize on the seasonal trends of our fiscal Q2 and Q3. We all take great pride in this achievement.

Once again, the mobile phone and the entertainment markets are the main driver behind our revenue growth. As we indicated last quarter, growth in the smartphone category has not shown any sign of slowing down, and the tablet category was further fueled by the proliferation of multiple form factors. Even with the seasonal strength, OmniVision remains focused on the goal of providing image solutions of choice to all customers and partners, enhancing our financial performance and bringing value to our stockholders.

To fulfill this goal, we are committed to continue to execute our strategy of: first, the improvements and development of our technologies; second, the improvement in cost structure; and third, the expansion of market applications and capitalizing on the emerging trends fueling market growth over the next several years.

The differentiator for OmniVision has always been technology improvements and development, and no doubt that technology has been and always will be the cornerstone of our company. It is the enabling factor for the strong financial results we posted today. Being the first to commercialize BSI technology and then continuously producing high quality and high performance products that are based on our improved BSI technology process is testimony to our success in our technology development strategy.

Going forward, we remain committed to improving DSI as well as FSI technologies for the development of an array of our CMOS sensor product. We have not stopped at only developing and improving CMOS image sensor technology. Our strategic goal is to form an arena of advanced complimentary technology such as camera-cube chip to support and strengthen our technology position in the industry.

With the strong technology position we are able to deliver to our customers and partners innovative applications that capitalized on emerging trends in our industry. Over the last couple of quarters, we have been addressing our need for cost improvement. This quarter, we reported an incremental improvements in our cost.

To be sure, we are not yet where we want to be. However, we will continue to execute on available opportunities, including continue to streamline our supply chain vendors, better manage logistics and increase design efficiencies to improve gross margins, while meeting our customers' needs.

We are pleased with our continuing revenue achievements in the smartphone and the tablet categories. And our strategy remains to expand market applications based on our technologies, and to capitalize on the emerging trends in various markets. One of our market applications expansions has been in the automotive.

In the past quarters, we have had many designs and shipment of products into this market. While Ray and Hasan will provide more details in their respective section about our product, I would like to highlight, first, that our high performance automotive products are meeting our customers' demands. This is again demonstrated by several recent design wins with major OEMs in North America and Europe in fiscal Q3.

We remain committed to develop products and innovative applications in this market based on our technologies and meeting customers' expectation. In addition, we are seeing the tier-1 smartphone OEMs in China have expanded to overseas market with their new products on top of satisfying their ever growing domestic market.

We believe brand name companies in this region will being to capture market share around the world. And OmniVision is ready to capitalize on that trend as we are a part of their supply chain and ecosystems.

Before I turn the call over to Ray, who will provide an update on the quarter's sales activity, I would like to say that I am proud that our sensors are greatly accepted by our customers, and we have the brand reorganization as a leading image sensors provider with advanced technology.

With that, Ray?

Ray Cisneros

Thank you, Shaw. We are pleased to report another record quarter in terms of sales and volumes shipped. The combination of a strong seasonal quarter in conjunction with the competitive rates in the smartphone and tablet markets fueled our demand.

In our third quarter we shipped a record 252 million units as compared to 249 million units in our prior quarter. The average selling price in our third quarter was $1.68 as compared to $1.56 in the prior quarter. The step-up in average selling price was due to a shift in resolution sensor product mix in particularly 5 megapixel and 8 megapixel resolution products.

In the third fiscal quarter, unit sales of sensors 2 megapixel and above represent approximately 39% of total shipment as compared to the 31% in the prior fiscal quarter. The increase was driven by continuous strong shipment trend of our BSI-2 and BSI-1 based 8 megapixel and 5 megapixel sensors, in particular for smartphone and tablet products during the holiday season.

Unit sales of 1.3 megapixel sensors represent approximately 45% of total shipment, a slight decrease from 48% for our prior quarter. We remind you that in this category we incorporate our HD sensors, which is a dominant form factor in this category. Both BSI-1 and BSI-2 based HD sensors were shipped in very high volumes for the smartphone, tablets and notebook markets.

Lastly, unit sales of sensors that were VGA and below represented approximately 16% of total shipments as compared to 21% in the prior quarter. In terms of product markets, our mobile phone sales represent approximately 61% of our revenues in the third quarter as compared to 59% in our prior quarter.

Our entertainment segment represented 26% of sales that compares to 29% in our prior quarter. Our sales of sensors into the notebook and webcam segment were approximately 7% of sales as compared to 6% in our prior quarter. Other categories balanced out the remainder.

In the mobile market, the Christmas and Chinese New Year holiday seasons fueled a highly competitive smartphone race, which in turn drove strong sales across our product line up. In particular, 8 megapixel and 5 megapixel sensors saw continued strong shipment volume in this segment for camera design, where self-view cameras, our best-in-class BSI-2 based HD sensor product line also shipped in very high volumes.

As 2012 calendar year came to a close, we believe we maintained a strong global footprint in the mobile market segment with many tier 1 brands, including North America, China, Taiwan and Japan. The smartphone space has quickly segmented into various price point levels to serve a broader customer base.

We believe our products served well through the entire range of smartphone categories. One noteworthy point to make is a rapidly emerging trend of Chinese OEM brands, making further in-roads into a smartphone space for domestic as well as the export sales.

In our fiscal third quarter, we capitalized on this trend with very strong sales into this region through our broad product offerings and strong sales channel. We sold all categories of sensor resolutions into this market, including 8, 5, 3, 2 and HD sensors.

Going forward, the smartphone space is under significant competitive pressure for all major OEM brands. We are in collaboration with some tier 1 brands on highly customized image sensors for next generation products that we'll launch in the coming quarters. Additionally, our cost driven designs and our broad assortment of technology platforms using FSI, BSI-1 or BSI-2 allows us to pick and choose the most cost competitive product for our customers.

In the entertainment segment, the tablet market continue to grow at an incredible pace. In the holiday season, just ended, many major OEM brands launched new tablet product that contained OmniVision sensors. We believe we are in the strongest position for this rapidly growing segment.

Many tablets designs contained two cameras, a main camera for highest quality image capturing and a self- view camera for video conferencing. For both camera designs, the gamut of our product portfolio was used, from an 8 megapixel sensors down to a VGA resolution. Additionally, in the third quarter we ramped up significant volumes and two BSI-2 based products, the 5 megapixel OV5693 or a main camera application and 1 megapixel OV9760 for self-view camera application.

In the notebook and webcam segment, those are steady level of shipments of our best-in-class BSI-1 based HD sensor, the OV9726, for the holiday season. It is difficult to say how much more of the tablet market will continue to affect the sales of the notebook PC market. There is now constant shuffling of the OEM ranking, and all are under extreme pressure to develop competitive strategy against the tablet segment.

Currently, major OEM brands are evaluating a host of highly innovative imaging solutions as part of their integral strategies to compete in this new marketplace. For OmniVision, this represents a potential new upside opportunity for the notebook and webcam market.

In the automotive space, we scored several major design wins in our fiscal third quarter with major OEM. In North America, we continue to win designs with OV3955 for the rearview camera application that is quickly becoming a standard car feature. In Europe, our leadership position and surround-view imaging allowed us to win new designs for next-generation concepts in surround-view application.

A latest generation sensor for surround-view applications is the OV10635 continue to ramp up in our fiscal third quarter and will soon become the de facto benchmark for the industry. Additionally, the highly successful surround-view concept that originated in Europe is now quickly being embraced in North America, and we stand to benefit from our leadership position.

In summary, we are very pleased with our fiscal third quarter results. Going forward, our goal is to continue to deliver imaging solutions that add value to our customer products.

Shaw Hong

Thank you, Ray. I will now turn the call over to Hasan, who will provide an overview of the company's marketing efforts and opportunities.

Hasan Gadjali

Thank you, Shaw. As Ray mentioned, we are seeing strong market demand for our 5 megapixel and 8 megapixel primary camera sensors. We bolstered our BSI+ and BSI-2 markets positioning. The market is huge for these two resolutions, with an estimated TAM for 2012 of approximately 800 million units. This includes a one-quarter-inch optical format or 10 devices, and a one-third-inch optical format for high performance product. And we have a complete product line to address these form factors.

Characteristic of the ever-changing technology landscape, we are seeing some OEM eager to move beyond 8 megapixel resolution. For that we already offered our 12 megapixel sensor, the OV12830, with additional high resolution products coming soon. In addition, with the objective of providing our customer with low light performance technology, we expand our BSI-2 products offerings to include a new 2 micron pixel OV4688 during the third quarter. This 2 micron pixel product delivers 40% better sensitivity that our 1.75 micron pixel.

Moving on to our emerging markets, I'd like to talk about progress we have made in the automotive market. We continue to grown and strengthen our position with more design wins using our OV7955 for the rear view/backup cameras. More and more OEMs would have the rear view/backup cameras for their models introduced in 2014.

Last quarter, we also announced the OV480, a companion chip that offers electronic image distortion correction to enhance performance in wide scale of view automotive vision system. We have received very positive response for this companion chip as OEM continue to search for solutions to correct lens distortion in the wide angle view.

Another new achievement is our new emerging product is the high-definition LCOS panel. In January, we announced our first high-performance high-definition LCOS solutions for pico projection systems. This new two-chip solution consist of the OVP7200 single-chip LCOS panel, which display native 720p HD video and the OVP921 companion chip, which provide advanced image processor.

The LCOS panel offer customer a low-power ultra-compact and very easy to integrate complete display system solutions for next-generation projection system in automotive and mobile application. While the majority of our customer currently remains smartphones OEMs, we are able to generate significant interest with OEMs through focus expanded to automotive vision systems to our LCOS pico projection system to our medical imaging design and to many other potential target market.

In all of our emerging markets, we continue to make meaningful progress, often times striving to become a first mover. Mid-to-long term we continue to view emerging markets, as significant and sustainable growth opportunities.

Shaw Hong

Thank you, Hasan. We'll now turn the call over to Anson, who will discuss our third quarter financial performance and provide guidance for our fourth quarter of fiscal 2013.

Anson Chan

Thank you, Shaw, and good afternoon everyone. For the third quarter of fiscal 2013, we're reporting revenues of $423.5 million, up 8.6% sequentially and up 128.7% on a year-over-year basis. Direct sales OEMs and buyers accounted for 85.2% of our revenues in the third quarter of fiscal 2013, the same as our prior quarter. The remainder of our revenues came from sales through our distributor channels.

Our fiscal 2013 third quarter GAAP gross margin was 16.9% compared with 16.6% that we reported in our prior quarter. Excluding stock-based compensation expense of $0.9 million, including cost of revenues, our non-GAAP gross margin was 17.1% compared with 16.8% in the prior quarter. The incremental increase in our gross margin reflected primarily a favorable change in product mix.

In the third quarter of fiscal 2013, we recorded approximately $1.4 million for the sale of previously written down inventory and $5.5 million as an additional allowance for excess and obsolete inventories, with a net $4.1 million of unfavorable impact on our gross margin. In the second quarter of fiscal 2013, we recorded approximately $2.8 million for the sale of previously written down inventory and $6.5 million as an additional allowance for excess and obsolete inventories, with a net $3.7 million of unfavorable impact on our gross margin.

This quarter we reported only an incremental improvement in gross margin. We are taking more time to digest our higher quality inventory than we had anticipated. And as Shaw has indicated, we are definitely not where we want to be yet, and will continue to work with our supply chain vendors to reduce our production cost.

R&D expense in the third quarter of fiscal 2013 totaled $27.4 million, a 9.8% decrease from the $30.4 million in our fiscal 2013 second quarter. The decrease in R&D expense was driven by decrease in take-outs and other non-recurring engineering expenses. It seem fairly quite significantly from quarter-to-quarter based on our engineering schedules. We currently expect that our R&D expense in fourth quarter of fiscal 2013 to increase to a level more comparable to our first fiscal quarter.

R&D expense in the third quarter included approximately $3.7 million of stock-based compensation expense. Excluding stock-based compensation expense, third quarter R&D expense was $23.7 million as compared to $26.2 million in the second quarter of fiscal 2013.

SG&A expenses in the third quarter of fiscal 2013 remained stable, totaling $18.2 million, only a 0.5% increase from the $18.1 million in our fiscal 2013 second quarter. For our fourth quarter of fiscal 2013, we expect SG&A expenses to decrease slightly. Our third quarter SG&A expenses included approximately $3.2 million of stock-based compensation expense. Excluding stock-based compensation expense SG&A expenses from the third quarter recorded $15 million compared to $14.8 million from the second fiscal quarter.

The third quarter amortization expense for our acquired patent portfolio was $2.3 million, the same as our prior quarter. Our GAAP operating income in the third quarter totaled approximately $23.6 million as compared to operating income of $13.9 million in the prior quarter. Our GAAP pre-tax income in the third quarter totaled $23.8 million as compared to pre taxing sum of $14.6 million in the prior quarter.

Our GAAP tax provision for the first quarter is $2.5 million. This compares with $4.2 million in the prior quarter, included in our GAAP tax rate for the third quarter was a significant one-time adjustment, stemming from the administrations retroactive extension of federal R&D tax credit in January, which provided an additional tax benefit to the company of approximately $3.2 million in the third quarter.

Excluding the effect of stock-based compensation expense, our non-GAAP provision for income taxes for the third quarter was $97,000 compared with $4.4 million for fiscal 2013 second quarter. For the fourth quarter of fiscal 2013, we expect our GAAP and non-GAAP tax provision to be in the low $2 million range.

In the third quarter, our GAAP net income was $21.3 million or $0.40 on a per diluted share basis. This compares to a GAAP net income of $10.3 million or $0.19 on a per diluted share basis in the second quarter of fiscal 2013. Excluding stock-based compensation expenses and the related tax effects, our non-GAAP net income for the third fiscal quarter was $31.5 million or $0.56 per diluted share. This compares to a non-GAAP net income of $18.6 million or $0.33 per diluted share in our second quarter of fiscal 2013.

Let me now turn to the balance sheet. We ended the third quarter with cash, cash equivalents and short-term investments totaling $220.3 million. This compares to $139.6 million at the end of the second quarter of fiscal 2013. The increase in cash was primarily attributable to our collection from sales recorded last quarter, of which a significant portion became due during Q3. Accounts receivable at the end of our third quarter, net of allowances was $171.9 million, a decrease of 31% from the $249.3 million at the end of our fiscal 2013 second quarter.

Our day's sales outstanding decreased to 37 days in the third quarter as compared to 59 days for our prior quarter. As of January 31, 2013, inventory totaled $373.3 million, a decrease of $25.4 million from the $398.7 million balance at the close of our fiscal 2013 second quarter.

Our quarter and inventory balance represented an annual inventory turn of 3.7 times or 98 day sales. Our cash conversion cycle has also improved significantly during the quarter. Our cash conversion cycle in the third quarter was 95 days compared to 117 days in the second fiscal quarter.

And with that I will turn to our outlook for the fourth quarter of fiscal 2013, which ends on April 30, 2013. We currently expect our fiscal 2013 fourth quarter revenues will be in the range of $300 million to $330 million. This guidance reflects a seasonal trend of business with a typical sequential decrease in revenues in Q4.

This year the step down is going to be more pronounced as we come off of an extremely strong Q3. Our GAAP EPS is expected to range from breakeven to a $0.15 per diluted share. Excluding the estimated expenses and related tax effects associated with the stock-based compensation, we expect our non-GAAP earnings will be in the range of $0.14 to $0.29 per diluted share.

Shaw Hong

Thank you, Anson. We are extremely pleased with our revenue growth year-to-date and we continue to work hard to improve all of our financial metrics in the coming year. These past few months we have a worked hard to capture design wins for customers' devices to be announced this calendar year. We continue to have high expectations for our OmniBSI-2 technologies, and for the new applications that we have yet to introduce.

We are now ready to take questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Raji Gill with Needham & Company.

Raji Gill - Needham & Company

Just a question on the gross margins, Anson, can you elaborate what you're seeing when you indicated that you need more time to digest the high cost inventory. I think it's been almost six quarters where this issue has occurred. When you started to see margins start to fall off starting kind of back in January of the '12 and then it carried through most of fiscal year of 13. Maybe you could describe little bit more on what's going on there and why is it not recovering faster?

Anson Chan

So first of all I want to point to our guidance for Q4. As you can seen we are experiencing some softness out there in the market. And so with that said, obviously it's going to take more time for us to digest what we have in stock as of January 31. And in automotive there is also relatively high cost inventory that we've build a while back. In fact, if you look at it right, we have $373 million that we reported at end of the quarter.

And look at our guidance it's no way we'll exceed to $300 million for shipments, right. So that's where we said, it was going to take more time for us to digest all these higher cost inventory build before. But I want to remind you that the inventory build was a strategic decision that we made a while back in order for us to capture the revenue opportunities that we saw at that time, ultimately resulted in the Q2 and Q3 results that we reported on. So we continue to stand by that decision, it's just that when we're coming to Q4 there is some softness out there. And so it would take us little bit more time.

Operator

And your next question comes from the line of Daniel Amir with Lazard.

Daniel Amir - Lazard

So couple of questions here, first of all, on your smartphone opportunity here. I mean, how do you see the current competitive environment now that the BSI-2 is shipping for a number of quarters already. Your yields are probably up to par. So how do you see it playing out here as your competitors probably have comparable products in the market here as well?

Ray Cisneros

I think in regards to the BSI-1 and BSI-2 generations I believe we're in the third year of shipping this kind of technology platforms, the 8-inch technology platform, the 12-inch technology platforms. And we're now past the seasonal mark of last year's calendar year season, seasonal cycle where our customers are competing themselves in the marketplace with these kind of technologies. And given our revenues and our volume shipment, my projection is we'll have a very good market share worldwide in the smartphone area now. That sets the stage for 2013.

Obviously, we continue to invest in our R&D, in our product lineups. We are engaged with our customers on very innovative technologies and products before the future generations of calendar 2013 type products. It's still very competitive out there in the marketplace. On the other hand we don't divulge details in terms of our, I would say, roadmaps of technology platforms, but suffice it to say we are pouring back R&D money again for the next round of technologies and products. And we consider ourselves highly competitive. And based on our numbers, we should be one of the leaders.

Daniel Amir - Lazard

And then my follow-up is with regards to the guidance, and kind of the recent quarters, I mean it looks like that you definitely have some lumpiness to your business and you have less visibility into certain quarters like this quarter coming up here. How should we be looking at future quarters here, I mean do you expect growth to reaccelerate of this $300 million to $330 million number to reach the levels that you were last quarter or it really depends on the seasonality and big design wins in the back half for the year?

Ray Cisneros

Obviously, we can't comment beyond our current fiscal fourth quarter guidance. But we can say though is our engagement with technologies and our customers right now, we're engaged with variety of Tier 1 OEM brand names around the world, regionally very strong footprint around the world, next-generation products around the world. And obviously how that fairs out it also depends on how our customers fair as well in their marketplace. And that as you all know is highly, highly volatile right now.

If you look at the OEM smartphone space that is shuffling quite a bit right now as we speak. If you look at the top 10 OEM brand names in the smartphone space, a year ago versus today, it's a different line up, same thing with the tablet market space. On the other hand we have other markets that seem to come and go or actually come an as emerging markets that help us, like for example integrated cameras and TVs, that's a growing marketplace for us. And so we are competitive in that as well. All in all, all I can say we're heavily engaged with our customers. We have fantastic products. We have fantastic projects. And then the rest is up to our customers to see how they do in the marketplace.

Operator

And your next question comes from the line of Paul Coster with JPMorgan.

Paul Coster - JPMorgan

Anson, I've really got to question this sort of this reference to typical seasonality because I don't see in the historic results. And so it comes into question, I think your strategy of just issuing one quarter of guidance as you know consensus expectations for next quarter are very, very much higher than that which you issued. And yet you're issuing guidance that calls for nearly 50% year-on-year revenue growth. And I think here you've penalized for the street not including the seasonality. So is there a someway in which you can provide us with slightly longer-term guidance now and in the future, so that we don't get into this kind of situation again?

Shaw Hong

It's not going to be that easy for us. We've probably covered that before, most of our products are still going into consumer devices like mobile phones and tablets and notebooks, whatnot. And these markets are little volatile. They are very dependent on consumer sentiments. And as Ray just mentioned, right, even how we perform we'd be dependent on these OEM (inaudible) and how their respective products will fair in the markets.

And so for us to provide a longer-term guidance or even an outlook it's not going to be simple, but we are working on though, however, is to continue work on these newer target markets, the emerging markets, with a little further away from (audio gap), and we're talking about medical, we're talking about security. When these target markets get (audio gap). But my point, I'm trying to say is that once these other markets can pick a bigger share of revenues, we may have a chance to have a more stable quarter-to-quarter type performance. And until we get to that point I think we will not really be ready to provide longer-term guidance.

Paul Coster - JPMorgan

Can you talk to us what the gross margins would be normalize, if they didn't have this big inventory overhanging, you were sort of basically had a faster cycle time on the inventory, how much higher do you think the gross margins would be if you're at a normal inventory level?

Shaw Hong

That is a very difficult question. There is no way I can possibly pro forma that out. And frankly until we can work through these higher costs inventory we won't be ready to provide any additional color on gross margin. Frankly, look at what we just reported on our third fiscal quarter, its 30 basis point improvements, so with that kind of miniscule change it's hard for us to really comment on what can or could have happened, should we have fasten our inventory.

Paul Coster - JPMorgan

Moving forward, do you think you can avoid these very heavy commitments to inventory in order to win customer business? It just seems to hurt you ultimately?

Shaw Hong

The decision points will be little bit different going forward compared to in the past, because as we commented couple of quarters back that we have to build up the capacity for us before we can service our customers. So that's why earlier I pointed out that that was a strategic decision that we made to build up all these inventories, so that we can get the revenues. Going forward, a lot that would dependent again how strong demand will be.

Do we still have enough capacity or not, what do we need to do to catch up to the demands. So those are the questions that we all like to know, but as Ray has pointed out earlier, a lot of that is little difficult for us to see right now, because there is still a solid derived demand for us. So I'm hoping that we won't find the same situation again, but that all depends on the ultimate demand for our products.

Operator

Next question comes from the line of Hans Mosesmann with Raymond James.

Hans Mosesmann - Raymond James

Couple of questions. Can you confirm that the BSI-2 yields are where you need them to be and if not how long will that take for us to see that?

Shaw Hong

I think we are very comfortable with what we have done to date in terms of coming up with improvements on the production yield. So we've talked about before we generally find opportunities to improve the yield over two to three quarters and the BSI-2 is our end production for a while now.

So the yield should not be much of a concern for any one, but I do want to point out is that if in case you want to take this comment to project our next year's performance, likely we will be introducing new SKUs with the producing different parts by then. So essentially, our operation team we have to go through another cycle of yield improvement process.

Hans Mosesmann - Raymond James

And then the follow-up. In terms of guidance, going back to the topic just in a narrow way, do you think its more of a macro issue, is it a customer transitions or it maybe inventories in the channel out there with other competitors products, if you can just give us a little more resolution there, that would be helpful.

Ray Cisneros

All the above, but quite frankly, I looked at our data and I looked at our situation, there is seasonality across regions. We experienced that in the Far East as well as in the Western Hemisphere. As well as, we have to look at our customer mix, obviously we can't comment on that but there are push and pulls of each individual customer and how well they are doing in the marketplace, that's a factor involve here as well.

And then in terms of inventories, that's difficult for me to see because I don't have oversight of every single step point in that typical inventory channel for our customers, but I don't think it's over exposure of inventory. That's not my sense. I think it's mainly seasonality and then the competitive marketplace.

Operator

Next question comes from the line of Betsy Van Hees with Wedbush Securities.

Betsy Van Hees - Wedbush Securities

Anson, I was hoping you could help me understand is the gross margin overhang? Is it due to higher cost inventory or is it due to issues in the supply chain, just to understand what's going on with the gross margin? Was it a combination of the two?

Anson Chan

For the reported Q3 results, it's most primarily due to of the inventory costs that we paid for a while back. So this higher cost for the part, have now been shipped so they show up in the cost of good sold, and ultimately it brought down the reported results.

Betsy Van Hees - Wedbush Securities

So then your supply chain, you've brought down the cost of your supply chain then, so that's really not an issue moving forward, because I think a couple of quarters ago, you guys were talking about issues in the supply chain and higher costs that were impeding your gross margins, but that's behind you now. And this is just inventory that you guys had to buy in advance, is that correct? Am I understanding that correctly?

Anson Chan

Let us work though all these high-quality inventory and until then I think maybe it would be more comfortable commenting on gross margin then that we have to stick to our policy to only providing guidance on the current quarter. And current quarter, quite frankly, we still have quite a bit off inventory to work through as I mentioned earlier, that the balance is still relatively high compared to the guidance.

Betsy Van Hees - Wedbush Securities

And then my follow-up question, going back to the guidance, I understand that you guys have little visibility, but I was wondering if you could help us understand by your reporting segments, is entertainment going to be within the guidance of down 29% to 22% or is it going to be greater, I was wondering if you kind of rank by your end markets to try and help us model the business as to what's going to be down the most?

Ray Cisneros

Within the going forward guidance, I think we can look at these segments proportionally stepping down equally among the three categories we typically like to breakout. So that that backs into some of my commentary about the seasonality, that there is a big after post-Christmas, Chinese New Year hangover here and that's reflecting regionally as well as product categories.

Betsy Van Hees - Wedbush Securities

No that's not, the mobile phones are going to be down greater than your entertainment segments or you your notebook and webcam segment and they're all going to be down kind of equally, is what you're saying?

Ray Cisneros

That's the data, I have right now. It's looking in that light. Yes.

Operator

At this time there are no further questions in queue.

Mary McGowan

Thank you all for joining us on this call and webcast. We anticipate holding our fourth quarter fiscal 2013 conference call on Thursday, May 30, 2013. Thank you and good day.

Operator

Ladies and gentlemen, that does conclude today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.

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