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Jabil Circuit, Inc., (NYSE:JBL)

Q3 2006 Earnings Conference Call

June 21, 2006, 4:30 p.m. ET

Executives:

Beth Walters, VP IR and Corporate Communications

Forbes Alexander, CFO

Tim Main, President, CEO

Analysts:

Steven Fox, Merrill Lynch

Scott Craig, Banc of America

Thomas Dinges, JP Morgan

Lou Miscioscia, SG Cowen

Kevin Kessel, Bear Stearns

Michael Walker, Credit Suisse

Brian White, Jeffries & Company

Matt Sheerin, Thomas Weisel Partners

Alexander Blanton, Ingalls & Snyder

Shawn Severson, Raymond James

Presentation

Operator

Good afternoon, my name is Meredith and I’ll be your conference operator. At this time I would like to welcome everyone to the Jabil Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. If you would like to ask a question during this simply press “*” then the number “1” on your telephone keypad. If you would like to withdraw your question press the “#” key. Thank you. I would now like to conference over to Beth Walters, Vice President of Communication and Investor Relations, please go ahead mam.

Beth Walters, VP IR and Corporate Communications

Thank you. Welcome to our third quarter earnings call. Joining me today on the call are our President and Chief Executive Officer, Tim Main, and our Chief Financial Officer, Forbes Alexander. This call is being recorded and will be posted for audio playback on the Jabil website in the investor section along with today’s press release and a slide show presentation on the third quarter and fiscal year.

During the course of this conference call we will make forward looking statements including notes regarding the anticipated outlook for our business, our currently expected fourth quarter and full fiscal year 2006 results, our first quarter fiscal year 2007 revenues and core operating margins, and our long-term outlook for our Company, our industry, our business sectors, and our potential realignment of our manufacturing capacity and the related cost and timing.

These statements are based on current expectations, forecasts, and assumptions involving risks and uncertainties that could cause actual outcomes and results to differ materially. These risks and uncertainties include but are not limited to fluctuations and operating results, the results of the review of our past stock option grants being conducted by a special committee of our board and government authorities, the accuracy of the stated dates of our historical option grants, and whether all proper corporate and other procedure were followed, the impact of any restatement of financial statements of the Company or other actions that maybe taken as required as a result of such reviews. Risks and costs inherent in litigation including that related to the Company’s stock option grants or any restatement of the financial statements of the Company, whether we will realign our capacity and any such activity will adversely affect our cost structure, our ability to service customers and labor relations, our ability to effectively address certain operational issues that have adversely affected certain of our U.S. operations, changes in technology, competition, anticipated growth for us and our industry that may not occur, managing rapid growth, managing any rapid declines in customer demand that may occur, our ability to successfully consummate acquisitions, manage the integration of businesses we acquire, risks associated with international sales and operations, retaining key personnel, our dependence on a limited number of large customers, business, and competitive factors generally affecting the electronic manufacturing services industry, our customers and our business, and other factors that we may not have currently identified or quantified and other risks, relevant factors, and uncertainties identified in our annual report on Form 10-K for the fiscal year ended August 31, 2005, subsequent reports on Form 10-Q and Form 8-K and our Securities filing. Jabil disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

As previously announced, the Company’s board of directors have appointed a special committee of the board to review the Company’s stock option grant practices in response to a derivative loss suit filed concerning stock option grants. This special committee of the board is in the process of conducting its investigation and analysis to the claims asserted in the derivative action. Subsequent to the filing of the derivative action, the Company was notified that the Securities and Exchange Commission of an informal inquiry concerning the Company’s stock option grants. Jabil has since received a subpoena from the U.S. Attorney’s office for the Southern District of New York requesting certain stock option related material. The Company is cooperating fully with the board’s special committee, the SEC, and the U.S. Attorney’s office. However, because this is an ongoing investigation, we cannot comment further at this time and will not be taking questions on this matter during the call today.

Turning to the results for the quarter, please turn to slides 2 and 3 if you are following along with the slide show posted on the Jabil website. Results for our third fiscal quarter of 2006 on revenues of $2.592 billion, our GAAP operating income increased 6% to $77.3 million. This compares to $73.2 million in GAAP operating income for the same period in the prior year. Core operating income excluding amortization of intangibles and stock-based compensation for this quarter was $93.4 million or 3.6% of revenue, as compared to $84.7 million or 4.4% for the same period in the prior year. Core earnings per share were $0.36.

On a year-over-year basis, the quarter represents a 34% growth in revenue and a 9% growth in core operating income. On a sequential basis, revenues increased 12%, core operating income declined 3%. As announced last week, the decline in core operating income was driven primarily by operational issues within our repair and electromechanical services operations and certain operations in the Americas region. We will provide further update to the resolution of these issues on today’s call.

Please turn to side 4 for a discussion of results of the quarter looking at revenue by sector. Our third quarter revenues were towards the upper end of our previous guidance which was an increase of 12% from the second quarter. Production levels in the automotive sector increase 13% from the prior quarter, reflecting higher than anticipated demand for assemblies in Europe, which was offset by lower than expected U.S. volume. Our computing and storage sectors increased 9% from the second quarter as a result of higher production levels than forecast. The consumer products sector increased 24% in the quarter from the seasonally low second quarter. This growth reflects a ramp of existing and new products with our two largest customers in this sector.

Instrumentation and medical sector increased 20% from the second quarter, reflecting the ongoing growth of assemblies across multiple customers in this sector. The networking sector levels of production decreased by 21% from the previous quarter. This decrease reflects the result of our partnering with one of our communications customer in a new lean manufacturing initiative. The peripheral sector increased by 11% over the previous quarter. The telecommunications sector decreased 10% sequentially, reflecting the end of production for Lucent. Excluding this the sector actually increased 15% as compared to the second fiscal quarter.

If you could please turn to slide 5, our sector information for the quarter in percentage terms was as follows: automotive 5%, computing and storage represented 12%, the consumer sector represented 38% for the quarter, instrumentation and medical was 18%, the networking sector was 9%, the peripheral sector was 8% for the quarter, telecom was 6% for the quarter, and our other category represented 4% of revenues for the quarter. As a result of the lower than expected income levels from our operations in the United States and Western Europe, the tax rate on core earnings on a year-to-date basis fell from 16% to 15% at the end of the third fiscal quarter. This has resulted in a year-to-date true up in the reported quarter or a tax benefit of approximately $3.6 million. The tax rate on core earnings for the fourth quarter and full fiscal year is estimated to be 15%.

I’ll now turn the call over to Forbes Alexander.

Forbes Alexander, CFO

Thank you, Beth. I would ask you to please turn to slide 6. The Company’s sales cycle in the third fiscal quarter was consistent with that of the previous quarter at 19 days. Inventory turns to the quarter were 8. In absolute dollar terms inventory increased in the quarter by $240 million. Of this increase, approximately $49 million was associated with our partnering with one of communications customers and a new lean manufacturing initiative. The $50 million is associated with the acquisition of Celetronix completed during the quarter along with the pre-positioning of inventory for our continuing strength and demand in the upcoming fourth fiscal quarter.

On a comparable basis for last quarter, inventory terms were consistent at 9. Day sales outstanding improved by 2 days as compared to the end of the second quarter at 40 days. Accounts payable increased by $259 million, an improvement of 2 days as compared to the end of the second quarter of 67 days. Our return on invested capital was 16% in the quarter, as compared to 18% from the same period in fiscal 2005.

Please now turn to slides 7 and 8. Cash and cash equivalents were $855 million as compared to $919 million at the end of the second quarter. Cash balance is net of the $150 million of cash used to acquire the Celetronix operations during the third fiscal quarter. Cash flow from operations was approximately $120 million in the third quarter, our 22nd consecutive quarter of positive cash flow.

On a year-over-year basis, we continue to maintain efficient control on capital deployed, while increasing our revenues and operating earnings. Our capital expenditures during the quarter were approximately $64 million. Fiscal year-to-date capital expenditures were approximately $184 million. Depreciation for the quarter was approximately $44 million. Amortization was $7.3 million. EBITDA in the quarter was approximately $137 million. In the first nine months of fiscal year we have generated approximately $270 million of operating cash flow while growing the business at 33% over the same time period.

As we move into the final quarter of the fiscal year and beyond, we continue to be well positioned to generate incremental operating cash flow. Based upon the strength of our current and expected future annual cash flows and as a commitment to working capital discipline, we announced the quarterly dividend on May 4, 2006, of $0.07 per share. This was paid on June 1, 2006. We are extremely well positioned to produce operating cash flows in excess of our investing activities in fiscal 2006.

I would now like to turn and make some comments with regards to our operations. As we announced last week, our operational execution in the quarter did not meet our expectations. I would like to take a few minutes to provide you more details on the challenges we face within the operations concerned. During the past year we have been establishing a 100 plus people strong electromechanical tooling operation at our Austrian site. As we discussed in our 2005 analyst meeting, we entered into this tooling capability to support the customer in the production of tools for injection molded parts. We have experienced delays in the ramp up of production due to resolvable technical issues in management process software. During the quarter, the operations were not reimbursed by the customer for the cost associated with this operation. This operation will continue to incur a cost in the fourth fiscal year in the range of $6 million to $7 million and will remain dilutive to our earnings until such time as we see demand levels flow through for tools.

This operation is expected to break even by the end of our second fiscal quarter 2007 versus the previous expectation of contributing to our earnings in the fourth fiscal quarter. This operation is expected to contribute to operating earnings during the remainder of fiscal ’07. Secondly, we face operational execution issues in certain U.S. operations, experiencing strong demand and ramping programs. This resulted in approximately $6 million of lost operating income. We have operational development teams currently reviewing and assisting local management and improving operational processes at these sites. Appropriate management changes have been made and we expect to have these operational issues resolved within the next two fiscal quarters. However, during the fourth fiscal quarter, we expect continued dilution to overall core operating earnings as a result of these issues.

Within our repair and warranty operations in the Americas region, we also experienced approximately $6 million to $7 million of higher material and labor cost associated with the ramp of a new program for an existing customer. This program will continue to have operational challenges throughout the fourth fiscal quarter and is targeted to provide appropriate levels of return towards the end of the second fiscal quarter of ’07.

Within our repair and warranty organization senior management attention is being directed to these operations with appropriate local management changes having been made. We believe that an appropriate operating margin return for our repair and warranty revenue stream is in excess of our targeted Company average. We are committed to returning this portion of our revenue stream to such return levels over the course of the next few quarters.

With regards to acquisitions, on March 31, 2006, we completed the acquisition of Celetronix excluding its memory business in India. During the quarter we began the process of integrating the acquired Celetronix operations and capabilities in India. We are positioned for continued growth in this region with the additional capability and management talent in India. We welcome our new employees to the Jabil team and look forward to your contribution and Jabil’s success in the years ahead. These operations will remain dilutive to our earnings in the fourth quarter as we continue to integrate the sites into Jabil. We expect contribution to earnings in the first half of fiscal ’07.

Turning to capacity, as we have announced in our press release, we intend to realign our manufacturing capacity in certain higher cost geographies, to properly size our manufacturing sites with current market conditions. We will begin consultation with employees in the coming weeks, take our Board of Directors approval, and finalize these plans. Out of respect for our employees, their families and their representatives, statutory and consultation periods require, we will not be providing details this evening on specific planned sites under consideration. We currently estimate that the realignment should result in approximately $200 million to $250 million of charges, which would involve plant closing and head count reductions. It is currently estimated that a significant portion of these charges would be recorded in the Company’s fourth fiscal quarter. The cash cost of such charges is currently estimated to be in the range of $150 million to $250 million over the course of the next two fiscal years.

Now I would like to turn to business updates and would ask you to turn to slide 9. We estimate our fourth fiscal quarter of 2006, our August quarter, to be in the revenue range of $2.75 billion to $2.95 billion, an increase of 6% to 14% from the third quarter. $150 million to $200 million of this increased revenue is a result of material passthrough on certain program where we now retain full ownership for materials and the associated supply chain.

Core earnings per share for the August quarter are expected to be in the range of $0.30 to $0.35. Research and development costs are expected to be consistent with the third fiscal quarter at approximately $9.5 million, reflecting our ongoing investment in design-related programs with existing and new customers.

Intangibles amortization and stock-based compensation are both estimated to be $8 million or $16 million in total. Capital expenditures in the fourth quarter are estimated to be $60 million to $90 million giving a range of $240 million to $275 million for the full fiscal year. As previously stated, tax rate on core earnings are now expected to be 15% for the quarter.

Turning to revenue by sector for the fourth quarter, I ask you to turn to slide 10. The automotive sector is estimated to decrease by 5%, reflecting seasonal lower levels of production. The computing and storage sector is estimated to have consistent levels of production for the third fiscal quarter, as is the consumer sector with consistent levels of production. Instrumentation and medical sector is anticipated to increase by 5% in the fourth quarter, reflecting the ongoing growth of assemblies within this sector across multiple customers. The networking sector is expected to increase by 100% from the third fiscal quarter. This is the result of our partnering with one of our communications customers in a new lean manufacturing initiative as advised last quarter. Excluding the revenues associated with this lean initiative, we expect this sector to increase by approximately 15% from the third fiscal quarter. The peripheral sector is estimated to decrease by 5% in the quarter, and the telecom sector is estimated to be consistent with the third quarter.

Please turn to slide 11. As you as aware, our strategy has been and continues to be to position the Company to capitalize on the trend to outsourcing. Fiscal ‘06 to date has demonstrated this to be the case and we now estimate our revenue to as follows as across industry sectors we serve: for full year fiscal ’06 automative is 5%, computing and storage 12%, consumer 36%, instrumentation and medical 17%, networking 13%, peripherals 7%, telecom 6%, and other 4%.

As a result, we’re revising our revenue estimates up from fiscal 2006 from $9.9 billion to a range of $10.1 billion to $10.3 billion. Core earnings per diluted share will now be in a range of $1.47 or $1.52. This revised guidance represents a 35% growth in revenues and a 15% to 20% growth in core earnings in fiscal 2005.

Looking into the first fiscal quarter of 2007, we see continued revenue growth and believe we’ll hit revenues in excess of $3 billion for the quarter. Operating margins should recover nicely and before percent or above. Despite our disappointment over the near term challenges, the opportunities of outsourcing continue to be strong, and I’d like to hand the call over to Tim Main.

Tim Main, President, CEO

Thank you, Forbes. From an earnings perspective, our third fiscal quarter was a disappointment. We had achieved an excellent track record of meeting or exceeding our guidance for 22 consecutive quarters. Our intent now is to renew that track record beginning with fiscal fourth quarter.

As discussed in our call last week and further by Forbes this afternoon, several issues emerged late in the quarter that significantly impacted earnings. We have identified the issues and are working diligently to rectify those specific issues. We expect to have them resolved over the course of the next two quarters. The issues are not associated with loss of a major customer, chronic or widespread, nor are they associated with a drought of growth opportunity. We take this very seriously and will correct the issues, but I also think some perspective is needed.

We have growth, cash flow, earnings, returns above our cost of capital, and a bright long-term outlook. We intend to rationalize our footprint predominantly in certain high cost geographies, but this may appear to be reactionary to this quarter’s result; it is not. We are rationalizing to position ourselves for competitiveness in the next three to five years. In years past, customers frequently asked for the low cost production locations to be supplemented by higher cost sites, which would execute new product introduction and play the role of global air traffic control. In some cases, we have maintained high cost sites which were largely dedicated to one or very few total customers. In the past, this made sense in the customer relationship and in the overall financial performance of the business. Today, we increasingly see new product introduction, design, and global coordination being done within our low cost footprint obviating the need for supplemental high cost location support. Under this condition, the financial burden associated with maintaining some of the higher cost locations can no longer be accommodated.

We see our high cost locations moving to high customer count, high complexity and configuration services largely supporting industry sectors requiring specialized expertise for locality. Our expectation is that the level of specialization will result in margins accretive to whole, otherwise the investment and location cannot be justified. We remain committed to a well-diversified portfolio of industry sectors and believe in the merits of a full scale global footprint. However, we will need fewer high cost locations to achieve our objectives. Ou rationalization plan will take some time but in the end it will simplify the business and make it healthier long term. The conservative approach would be to limit all of our comments to the past quarter in the next 90-day period. However, we believe this will be misleading and even more unsettling than we should be.

Looking into our first fiscal quarter, we see many reasons to be optimistic. Among them, we expect over $3 billion in revenue in core operating margin recovery to 4% or better. This will be a great start to fiscal 2007, which we expect to be another year which will place us among the S&P 500s leading growth companies.

Beth Walters, VP IR and Corporate Communications

Operator, we’re ready to begin the question and answer period.

Operator

At this time, I would like to remind everyone, if you would like to ask a question, please press “*” then the number “1” on your telephone keypad. We’ll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Steven Fox with Merrill Lynch.

Steven Fox, Merrill Lynch

Good afternoon, a couple of questions. First of all, since you’ve been subpoenaed by New York, could you just reaffirm or comment on what you said at the analyst meeting regarding stock options, do that all stand?

Beth Walters, VP IR and Corporate Communications

Steve, we can’t make any incremental comments as I said at the outset because investigation is ongoing, but you can assume that everything we said historically still stands.

Steven Fox, Merrill Lynch

Okay, and then with regard to the drags on this quarter’s earnings, I’m just trying to aggregate how much of the drag will be gone in the next quarter. It sounds like about a third of it would be gone, is that fair to say or I’m not sure if I did my math right?

Forbes Alexander, CFO

Steve, it is Forbes. With regards to the coming quarter, fourth quarter, the drag remains approximately the same. Overall we got our hands around these issues with workloads, but the range of guidance pretty much assumes that the drag is the same. We will continue to work diligently through that and we’ll see how that transpires as we move through the quarter, but it’s roughly the same.

Steven Fox, Merrill Lynch

And then lastly, just regarding the charge, can you maybe make some further comments about the timing of it. Are you saying that this was planned anyway or are you taking the opportunity now to do it given everything else that’s going on in the business?

Forbes Alexander, CFO

No, Steve, this is review of our overall capacity. This is not a reaction to an existing short term hiccup in terms of our operations. In terms of the timing of the charges specifically, it’s very much dependent upon the consultation process that we have to go through or that we’re undertaking with our employees and the representatives and approval of our board, but my expectation is that in terms of the actual charges and how those will fall into fiscal years, we could see anywhere between 50% and 60% of those charges in our fiscal fourth quarter on the balance falling to 2007 or 2008. We would be in a better position to give you definitive bucketing of those costs on our next call in September, but that’s my best estimate at this point in time.

Steven Fox, Merrill Lynch

Thank you.

Operator

Your next question is from Scott Craig with Banc of America.

Scott Craig, Banc of America

Good afternoon. Tim or Forbes, question on the margins, if you look out beyond the next couple of quarters when you think you have the three issues resolved, is there any reason to believe that margins have been “permanently impaired at all” or can we get back to levels that we were at prior to these issues. And then secondly, Forbes, on the restructuring side of things, I know you’ve thrown out numbers for the charges and the cash charge and stuff, but what’s your expected pay back on those…or another way to look at is how much cost savings do you think you can generate from those? Thanks.

Tim Main, President, CEO

Let me answer the margin part and then I’ll turn it over to Forbes for the balance of your question. I don’t think there’s any permanent impairment of our operating margins. I would expect to see operating margin recovery in fiscal first quarter of 2007, and I don’t see any reason why we can’t operate this business in an operating margin range that we’ve seen over the last couple of years and potentially even improve on that record. We’ll need to continue to leverage down operating expenses as we have in the past. We’ll be approaching 3% operating expenses, SG&A expenses, over the next few quarters. So, you’ve seen us go from 5.5% a few years ago to 4% to 3.5% and we’ll be approaching 3%, and as we’ve said our long-term objective is to get SG&A expenses down below 3%, operating in the 2.7% to 2.8% range.

Forbes Alexander, CFO

Scott, with regards to the second part of your question, this realignment we’d expect to take somewhere in the region to $100 million to $125 million of cost out over the timeframe of this realignment. Obviously, we’re not going to enjoy the full benefit of that cost out. A portion of that does get passed to customers as we move these volumes into lower cost site production levels, and obviously the company’s not going to continue to grow over the next fiscal year and beyond. So, summarizing all that I would say over the next couple of years, we are probably looking at a 40 to 50 basis point improvement in the overall operating margin over the next two fiscal years.

Scott Craig, Banc of America

Thanks.

Operator

Your next question is from Thomas Dinges with JP Morgan.

Thomas Dinges, JP Morgan

Hi, just a quick one to start with for Forbes. Forbes, when you look at the revenue for next quarter that comes through because of the shift of lean manufacturing, the additional that you get there, there’s some impact there on the margin because that’s not come. That’s just material passed through that’s coming through there. Can you quantify that at all if there is some impact on the gross margin side? And then I had a quick one on the segments.

Forbes Alexander, CFO

As you say that is a straight material pass through. The impact on the margin, I’ve not done the math on that…10 basis points or something of that nature.

Thomas Dinges, JP Morgan

And then quickly, the instrumentation and medical was quite a bit better than you guys had expected, maybe just help a little bit if that was all related to new program ramps or if there are some other things going on there, and just a little bit more color on the consumer side that was expected to be strong and expected to be kind of flattish for next quarter, just a little bit of color there will be helpful as well.

Forbes Alexander, CFO

On instrumentation and medical, we’ve been in transition over the last two or three quarters and that really continues to grow over the last two or three quarters. That’s one of the larger drivers, but we’re consenting to bring in assemblies into this instrumentation or industrial type opportunities that we’ve benefitting for over the course of the fiscal year. So again in summary, it’s a general growth in assemblies but one of the larger drivers has been this program we’ve been bringing into the company over the last two or three quarters. The second part of your question was with regards to the consumer. As we move into the fourth quarter, we do have some transition of programs going on with one of our larger customers in the quarter, product transitions, some assemblies coming off, new assemblies ramping in the quarter. You often see in the latter portions of the summer remembering that our two largest customers are European OEMs, somewhat of a slow down in the July and August timeframe as we hit the holiday season in Europe. So, nothing extraordinary there and we do expect a strong rebound as we move into fiscal first quarter in the consumer season.

Thomas Dinges, JP Morgan

Okay, thank you.

Operator

Your next question is from Lou Miscioscia with Cowen.

Lou Miscioscia, SG Cowen

Okay, thank you. Tim, with the suggestion for I guess revenue and margins for first quarter of fiscal 2007, I guess when we look to the full year of 2007, does it look like the number that was the prior EPS number on first call, are you comfortable with that or it sounds a little bit like if we start to re-ramp margins back up even from a 4% level and if it’s meaningfully over 4 then probably have to be a little bit more conservative on our bottom line number for fiscal year of 2007?

Tim Main, President, CEO

Lou, I’m sorry I can’t really give you an opinion on guidance and where you should put it for 2007. We’ll start providing more specificity around the full year on the next call, but I think a return to trend line type of growth is a reasonable expectation. I don’t see any reason why fiscal 2007 can’t be on trend line for the company overall. That’s a trend line that’s 10 years old and in spite of hitting a rough patch here in third quarter and fourth quarter, we feel very good about how fiscal 2007 will turn out and that’s why we wanted to give you a little preview into fiscal first quarter.

Lou Miscioscia, SG Cowen

Okay, great. The next question I guess I have is, at the analyst meeting I think a program that you’ve had maybe for about a year now is to try to really fill up these U.S. and European sites with high mix kind of work, would you say that that really hasn’t happened as quickly as you thought and that has been also part of the reason why I guess you’re taken this restructuring at year end; maybe if you can mention how many square feet it might effect? And then just one more quick one to followup.

Tim Main, President, CEO

I don’t know about square feet or that type of thing, but in terms of the Varian acquisition that we made for instance, that’s a very successful model that’s been very good for our business. I think it characterizes for me the style of manufacturing in high cost locations going forward. As I said in my prepared remarks, high cost locations have generally been a mix of NPI centers, global air traffic control centers for global customers, and in some cases fundamentally a subsidized operation from the global business unit as an accommodation to the customer. And as low cost geographies have become more competent at doing new product introduction and providing their own global support and that type of thing, it’s really obviating the need to have particularly repetitive manufacturing high volume applications coordinated or supplemented by high cost locations. It can all be done in low cost areas. So, what we’re going to see is I think a conversion of high cost capacity to the Varian type of model, and we need fewer sites to do that and they will be more specialized, and they should in the end contribute to the Company’s margins accretable. That would be an expectation.

Lou Miscioscia, SG Cowen

Okay, one more quick one, maybe a little bit more on a positive note. Any life kicking in from some of the Japanese OEMs either with new programs or existing programs, moving stuff to out sourcing? Thank you.

Tim Main, President, CEO

Yeah, there has been a lot of great stuff for us going on in Japan both in the automotive and display areas as well as ongoing conversations through our Gotemba facility and our Tokyo office. We would expect to see continued growth with our Japan domiciled OEMs in 2007 and in 2008 and I’m pretty optimistic about how that will go.

Lou Miscioscia, SG Cowen

And then possibly shifting some work or ramping some work with you all in China.

Tim Main, President, CEO

Yeah that will be principally low cost location production -- China, India, maybe some Eastern Europe.

Lou Miscioscia, SG Cowen

Okay, thank you.

Operator

Your next question is from Kevin Kessel with Bear Stearns.

Kevin Kessel, Bear Stearns

Thank you. Just a question again or more of a clarification on the tooling that you spoke about earlier, Forbes. You were mentioning that this operation was expected to be I guess break even in the fourth quarter, now it’s expected to essentially not happen until the second quarter of next fiscal year. You mentioned the technically resolvable management software issues, but what else is it here? It’s sounds like there’s less volume than expected and as a result that’s why these losses will continue.

Tim Main, President, CEO

I think at this point we should simplify the whole scenario there. The operation has taken longer to ramp than expected. So, like any activity whether it’s a tooling operation or a core EMS site. If you install significant capacity head count and there’s a significant delay in the ramp of production, you’re going to run higher operating expenses than anticipated. So that delay has caused us to experience higher operating losses than anticipated. We expected some reimbursement for customers that will not be forthcoming. So, at this point, we are ramping production in the location. We expect it to continue to ramp in fiscal fourth quarter and fiscal first quarter of 2007, and by fiscal second quarter of 2007 begin to reach volumes that will either have the operation break even or contribute significantly to the business. We still think the activity is an important activity in terms of our competitiveness, our position in the market place, and we also expect the operations fully ramped and will contribute significantly to the profitability of the company. This is not an accommodation site, it isn’t a service or an activity that is a sideline, and it’s something that we fully intend and expect to be profitable and make money in the endeavor.

Kevin Kessel, Bear Stearns

Right, I mean in the end I guess the question people have then is at one point Jabil thought it might be reimbursed, now it seems that that’s not the case, is that strictly because the ramp didn’t happen according to plan and maybe it’s something that Jabil’s going to fix and work on to ramp faster?

Forbes Alexander, CFO

There’s probably nothing and I don’t mean to sound glib or dismiss it, but there’s probably nothing that I could say distinctly that would make a hell of a lot of sense to you. I think you just have to take it on faith that we’re a good company, we engage in contracts and customer relationship makes sense. This is something we didn’t anticipate. It surprised us and at this point we just have to move on. We have to move on. We’re going to incur the losses in the fourth quarter. You know, if we have to go back and do this all again and we knew that this would have happened we would have fore warned you, and so we’re going to engage in some activity. It’s going to cost us $6 million or $7 million a quarter in operating income and we’re going to take our earnings down because of it, but it’s going to be great for us long term. All that’s true expect for the fact that we didn’t expect the lesson to be quite as expensive as it’s turning out to be. All that said, it should be profitable in 2007 and still an important activity for us.

Kevin Kessel, Bear Stearns

Obviously the confidence is there that it’ll be profitable and I assume if at some point it wasn’t then you would have to make other adjustments relative to that operation?

Tim Main, President, CEO

Yeah we would but at this point we don’t expect that to happen. It is ramping production as we speak.

Kevin Kessel, Bear Stearns

Right, and just from a big picture, I think Forbes addressed this earlier, in terms of the restructuring here in the U.S. that the cost and cash cost, the pay back is expected to happen approximately when, and if I’m not mistaken he mentioned that the impact on operating margins are 40 to 50 basis points over time, is that correct?

Forbes Alexander, CFO

I said 40 to 50 basis points over the next two fiscal years. We require to go through various consultation periods with our employees and their representatives and that will have clearly a bearing on the timing of these actions.

Kevin Kessel, Bear Stearns

So, then when you look at it from a macro level, operating margin model for Jabil the goal was to get it to 5%. You guys were obviously very close to that. Is that still essentially the goal, obviously the near-term goal might be a little bit lower, but Tim I think you just said it was 5%, is it still within the realm here?

Tim Main, President, CEO

I think it’s still a realistic target. Unfortunately, we’ve got a few steps to go through, a few more steps to get there than what we wanted to have. But, a realistic point of view of being back in the 4% operating margin range as early as first quarter 2007 I think is reasonable and we’ll keeping working at it.

Kevin Kessel, Bear Stearns

Last thing is, you typically gave your fiscal year guidance when you reported your fiscal year end in September, is there an expected change to giving fiscal year guidance at this point?

Tim Main, President, CEO

I’m not going to promise you that we’ll provide full year guidance at this point. We’ll have to make that decision over the course of this quarter. We’ll let you know in September.

Kevin Kessel, Bear Stearns

Thank you.

Operator

Your next question is from Michael Walker with Credit Suisse.

Michael Walker, Credit Suisse

I have one quick housekeeping question for Forbes. It looks like the Attorney’s C impact was part of core EPS for the May quarter?

Forbes Alexander, CFO

Yes it was. It wasn’t overtly material, Michael. As we’re looking at the fourth quarter, it becomes more material, but we will try to get our arms around that, but probably in the range of $2 million, something of that nature.

Michael Walker, Credit Suisse

Second question for Tim, can you just talk a little bit about the demand environment right now. I know you made a point right up in the title of the press release that demand is good, but just kind of noticing a couple of changes at the market level where in the consumer business you’re going to show a lot lower second half growth than you have over the last couple years, whereas in the communications business you reported an organic telecom increase of 15% I believe in the May quarter, and then you’re saying if you back out with Cisco lean in the August quarter that part will be up 15% as well, and these are two buckets that have been pretty laggard for you in the last couple of quarters. So, my question is are you seeing at all a shift in terms of growth opportunities, demand opportunities away from the consumer area and towards a more infrastructure area?

Tim Main, President, CEO

I think it’s a great question and I’m not going to say no, there’s no movement away from consumer. I’ll think there will be less reliance on consumer to hit trend line growth rate going forward. We enjoyed a very significant ramp of our consumer business in 2005 and 2006 and networking, communications, computing and storage were kind of sleepy sectors and I think we’ve done some real good for the Company in terms of our business development efforts and our execution actually in those segments. We’ve said all along that the communications business is still something that we are very interested in pursuing and supporting and we have a lot of very strong capabilities in that segment. It isn’t that we de-emphasized anything or overemphasized anything else, but strategy of the company is to have a diversified portfolio of growth opportunities that make us less reliant in any particular segment quarter to quarter, year to year, and if we execute that properly you should see ebbs and flows in any particular segment in terms of being the hot growth this period or this quarter or this year end, and you should see other segments to pick up the slack, and I think that’s what you’ll be seeing. This is why in spite of kind of the negativity around the third quarter and fourth quarter, we really have a positive outlook. I mean to have in this environment…and the best case of a stable to slightly positive end market demand environments, to be growing the business at 35% top line growth and looking forward in the first quarter of 2007 and seeing year-over-year growth that’s outstanding, jeez, all we really have to do is get a couple of these identified issues resolved, identified, put to bed, march through this rationalization process as best we can and come out on the other side of this with a bigger better machine that’s going to continue to print cash flow at some pretty significant levels. So, we actually are very positive and optimistic about quality of our business, the direction we’re heading, and when we see things like networking and telecommunications really start to grow again that gets us even more excited, because it’s even better opportunities for ourselves there.

Michael Walker, Credit Suisse

All right, thanks a lot.

Operator

Your next question is from Brian White with Jeffries.

Brian White, Jeffries & Company

Tim, when you look at the different end markets, you look back 90 days ago, what has really surprised you the most in terms of strength and in terms of weakness in the end markets?

Tim Main, President, CEO

For the last year really consumer has surprised me a little bit how strong it is. I think consistently we have exceeded our initial guidance in the consumer segment, and flat screen TVs and handsets and even set top boxes have been very, very significant growth pools for us. So, historically that’s been the case. Over the last quarter, I really don’t see any surprises from an end market standpoint.

Brian White, Jeffries & Company

Even in networking and telecom?

Tim Main, President, CEO

Well, telecommunications has been showing signs of life and you’re seeing that show up with the other guys too, but that’s really more about market share, customer penetration, new customers. End markets were growing at 3% to 4%, now they’re growing at 20%. No, it isn’t a significant end market change.

Brian White, Jeffries & Company

Okay, and just when you look at the inventory increase, Forbes, ex the lean and the Celetronix acquisition, the $140 million increase, is that tied to the consumer market or is there a specific market it’s tied too?

Forbes Alexander, CFO

It’s not tied to any specific market. We’ve given a range of guidance with growth as we move into fiscal fourth quarter without that additional material passed through. Some of it is associated with that obviously as we’ve talked about, but I can’t say it’s specifically consumer or anything else. We got a number of ramping programs across the Company in instrumentation and medical and also within consumer, I talked about that a little bit earlier where we do have some program shift going on in that area, where typically when you do that you tend to have slightly higher levels of inventory as you start to ramp these programs in the quarter, but not specifically tied to any one sector.

Brian White, Jeffries & Company

Just finally on enclosures tooling, at the analyst day you indicated you were thinking about opening an enclosure operation. It sounded like it was going to be small in India. Is that still the case and would that also include tooling?

Tim Main, President, CEO

I think what we detailed was a campus capability that will provide the electromechanical infrastructure for products that we’re building in India. It’s particularly important in India because the electromechanical supply base is relatively underdeveloped and service logistics are difficult. So, it makes a heck of a lot of sense for us to have a campus located electromechanical capability. In the case where we cannot obtain supplier support, we may choose to invest in that activity directly because we must ensure that we have onsite electromechanical capability within a very brief distance, and that’s really what we were talking about. We weren’t talking about launching a large scale new activity doing our enclosures.

Brian White, Jeffries & Company

Would tooling be part of it?

Tim Main, President, CEO

Theoretically, tooling in some cases would be part of it, although that would not be an early investment. That would be potentially a little later down the road. We would certainly specifically identify any ramp associated with that tooling capability and incorporate that into our views on the market.

Brian White, Jeffries & Company

Okay, thank you.

Operator

Your next question is from Matt Sheerin with Thomas Weisel Partners.

Matt Sheerin, Thomas Weisel Partners

Yes, thanks. Tim, I have a bigger picture question for you. Given all the issues you’re dealing with, the three operational problems in the quarter, the option controversy and now the big restructuring, are you concerned about management being distracted from running the core business and continuing to grow the Company over the next few quarters, are there any operational changes that you’re putting in place to help manage this?

Tim Main, President, CEO

Yeah, it would seem that the number of issues that we deal with all have happened with a four- to five-month period. The chances of that would be at a million to 1. So, we’re dealing with a lot of things at the same time. I have been enthralled and captivated and motivated by the looks I see in the eyes of the management team and their commitment to ensure that we get the Jabil train back on the rails moving the direction we want it to move. The level of commitment is so high and so dedicated that it’s very heartening to see. Again, we’re not dealing with a business that’s shrinking. We’re dealing with a business that’s growing very rapidly and of all the challenges that we have business — and every business has its challenges — chief among them is accommodating 35% top line growth in a global footprint. We talk a lot inside our company about let’s stay focussed on the core business and everything else will take care of itself. What’s happened with the options and investigations, I’ve said everything I can say on that. You can go back and look at press releases and what we said at the analyst day; that’s done with. We need to put that in the past. That will take its own time, its own course, and management has no control over that whatsoever. All we control is the business, and fundamentally the business is in good shape because the operational issues are not chronic, they’re not widespread, they’re resolvable, and we have customer satisfaction, a reasonably good shape and a great global footprint and a great reputation, and we’re going out and capitalize on that and make fiscal year 2007 a great year.

Matt Sheerin, Thomas Weisel Partners

Okay great, and then could you tell us how many management changes you’ve made as a result of some of these issues you’re dealing with?

Tim Main, President, CEO

There are plant level management changes and there have been three to five management changes at an execution level.

Matt Sheerin, Thomas Weisel Partners

Okay, thanks very much.

Operator

Your next question is from Alexander Blanton with Ingalls & Snyder.

Alexander Blanton, Ingalls & Snyder

Good afternoon. Tim, one more question on the restructuring. The plant has been the problem, you said strong demand there, is that going to be part of it?

Tim Main, President, CEO

Again, out of respect for people, their families, and statutory requirements, and the need to consult with counsels, we are not going to identify or even imply any operations that might be affected. I’m not trying to dismiss your question. That’s just all we can say at this point.

Alexander Blanton, Ingalls & Snyder

Okay let me put it just another way. Resizing the U.S. where high cost areas implies that you don’t have enough demand to fill the plants up, but this particular plant where there was an execution problem, what is the capacity of utilization there? I mean it sounded as if that particular plant was full and why would it be so unbalanced in the U.S., for example, to have one plant really full and the other one is being restructured?

Tim Main, President, CEO

You can have significant ramp up of new businesses that you underestimated the complexity. You’ve had four material procurement practices, you didn’t file the Jabil cook book in terms of the recipe of launching new programs. It could be mispriced, misquoted. There’s a whole range of potential execution pitfalls that confront a fully loaded operation as much as it can confront a poorly loaded operation, and again this rationalization process, Alex, is really two different things. One is not a result of the other. I think to some extent we’re taking an opportunity here given the environment we’re in to be a little proactive, but I think the role and responsibility of our high cost locations has been changing, will continue to change, and we need to position the company in the right way to compete in the next five years, and the role of a high cost location when you go through all of our sites and what they’re really doing, I think we need to be more affirmative and having them be…again I use this word ‘vary and ask’ in their approach versus doing favors for high volume customers that are principally produced in low cost locations that no longer need new product introduction and air traffic control in the global context. We just don’t do those high cost locations any more. So, we need fewer sites.

Alexander Blanton, Ingalls & Snyder

Okay, I think you’ve done a pretty good job explaining that. I’d like to shift briefly to the lean program at Cisco. You mentioned a figure and I didn’t get it, the amount of additional material passthrough in the quarter was $100 million to $150 million, was that it?

Forbes Alexander, CFO

Alex, it was $150 million to $200 million ended fiscal fourth quarter.

Alexander Blanton, Ingalls & Snyder

A $150 million to $200 million, and those are items that previously were on consignment?

Forbes Alexander, CFO

That is correct, yes.

Alexander Blanton, Ingalls & Snyder

So, now they’re going to turnkey and that’s responsible for most of the increase. That’s a very large amount. Your total revenue with Cisco then as a percent of your sales is going to go up a lot I would guess based on this?

Forbes Alexander, CFO

Well, on an annualized basis, yes the revenue stream would increase anywhere between $600 million to $800 million depending on demand labels.

Alexander Blanton, Ingalls & Snyder

Right okay, and you’re not making very much margin on that, someone mentioned that before, right?

Tim Main, President, CEO

Yeah, that’s dilutive to margins. It’s one of the pressures that we have in terms of getting back on this track to 5%, truthfully we have a lot more material content in our revenue stream. It’s not indicative of anything other than that.

Alexander Blanton, Ingalls & Snyder

And finally, it has been said that the Cisco lean program will involve pushing inventory back to the EMS companies, how much of the inventory increase that you expect or have had will result from that, and won’t that eventually go away because isn’t Cisco’s intention to install a pull system in which everybody has lower inventory, isn’t that the idea here?

Tim Main, President, CEO

Forbes wants to answer that question, but first I want to make it very clear to everybody on the call that we’re not talking about Cisco. We’re talking about a customer that’s going through a process with us.

Forbes Alexander, CFO

So associated with our process, we brought about $50 million on to our balance sheet at the end of the quarter we just reported. As we move through the fourth fiscal quarter, I’d expect somewhere in the range of $50 million to $100 million of inventory to be added. I would also state that there will be an appropriate and equal offset at payable, so there won’t be any actual expansion in working capital, but you will see an expansion in absolute dollars in inventory. To your point, Alex, about this process and moving to your pool type basis, yes, that is the ultimate intention. I think it will take a quarter or two which I outlined on last quarter’s call for that process really to bed itself down. We’ve got inventory that we’re bringing on and that has been in place that will be consumed. We will take control of the supply chain and manage that process from here on out, and you will see efficiencies in that but it will take somewhere between one and two quarters to work our way through that.

Alexander Blanton, Ingalls & Snyder

So eventually this bulge here will disappear, that’s what you’re saying?

Forbes Alexander, CFO

That’s correct, yes.

Alexander Blanton, Ingalls & Snyder

And that’s the idea?

Forbes Alexander, CFO

Yeah, we’re efficiently right through the supply chain.

Alexander Blanton, Ingalls & Snyder

Okay thank you.

Beth Walters, VP IR and Corporate Communications

Operator, we have time for one more question please.

Operator

Yes mam, your last question is from Shawn Severson with Raymond James.

Shawn Severson, Raymond James

Thank you and good afternoon. Tim, could you just talk a little bit about kind of what will happen on a controls basis. I mean a lot has happened late in the quarter and obviously we’re surprised, and I understand some of it is sort of the eleventh hour activity but was there something that was missing in terms of the constant feedback throughout the quarter or are these things that are nearly impossible to figure out until things are rolled up in the final numbers?

Tim Main, President, CEO

I don’t think we have significant or material weaknesses in our controls. I mean clearly we were surprised by it and therefore by definition I would have to admit we’ve should have known about it earlier, and we are working on our business planning process internally. We’re getting back to good kind of dashboard type of discipline to make sure that we’re aware of what’s going on through all of our operations and what the financial impact would be. So, we are taking this as a bit of a wake up call to get back to basics but in terms of being out of control on a chronic widespread way, absolutely not, absolutely not.

Shawn Severson, Raymond James

So, maybe it’s more of a human input error, is that what we’re talking about in terms of what people were feeding into the machine, I guess, do you want to look at it that way?

Tim Main, President, CEO

There was an error somewhere…

Forbes Alexander, CFO

These issues are operational, inefficiencies through operational processes, be that through yields or just poor planning of material, expediting material into plants and such like in terms of freight cost, and some of those are pretty difficult to get one’s arms around. You’re in a fire fight if you will in terms of an operational scenario, so it’s certainly not a widespread epidemic control failure by any means. We’re very much in three isolated instances. We’ve got our arms around them and our management attention is focused there, and we will prove these to bed in the next couple of quarters and move forward.

Shawn Severson, Raymond James

Can you just explain to me how a typical repair and warranty contract is structure; I mean, how does it work and the length of term and re-negotiation, ability, and all of that? Thank you.

Tim Main, President, CEO

Yeah, that’s changed over time and I don’t really think I can get into all the nuances of the contracts and that type of thing. It’s not really a contract issue, it’s more of an execution issue and a model change and a new program, and that kind of speaks to the late notice that the something had arrived, something that ramped during the quarter and got worse as the quarter moved along, and I’ll just leave it at. Again, these are issues that we’ll be working through in the fourth quarter and the first quarter looking forward into a very robust, strong first quarter from a growth standpoint and a nice recovery in operating margins as well. So, I think the overall manner of the management group is very optimistic about our outlook in ’07 and we’ll work through these specific issues as diligently and rapidly as we can.

Shawn Severson, Raymond James

Thank you.

Beth Walters, VP IR and Corporate Communications

Thank you everyone for joining us today. Again, playback will be available on Jabil website along with the slide show presentation and press release. Thank you for joining us today.

Operator

Thank you. This concludes today’s conference call. You may now disconnect.

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Source: Jabil Circuit, Inc. Q3 2006 Earnings Conference Call Transcript (JBL)
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