ATI Technologies Inc. F3Q06 (Qtr Ending May 31, 2006) Earnings Conference Call Transcript (ATYT)

Jun.29.06 | About: ATI Technologies (ATYT)

ATI Technologies (ATYT) F3Q06 Earnings Conference Call June 29, 2006 8:30 AM ET

Executives

Zev Korman - Manager, Investor Relations

Dave Orton - President and Chief Executive Officer

Patrick Crowley - Senior Vice President, Finance and Chief Financial Officer

Analysts

Ed Pang - Credit Suisse

Dan Gillies - CIBC World Markets

Shawn Webster – JP Morgan

Simona Jankowski - Goldman Sachs

Devan Moodley - Scotia Capital

Chris Caso - Friedman Billings Ramsey

Padma Yanamandra -Deutsche Bank

Andrew Lee - TD Newcrest

Paul Howbold - Desjardins Securities

David Hodgson - Genuity Capital Markets

Deepak Chopra - National Bank Financial

Bruce Krugel - Blackmont Capital

Kenneth Hui - Lehman Brothers

Dennis Fong - MGI Securities

Quinn Bolton - Needham & Company

David Wu - Global Crown Capital

Tayyib Shah - Longbow Research

Krishna Shankar - JMP Securities

Satya Chillara - American Technology Research

Sidney Ho - Merrill Lynch

Dayle Hogg - GMP Securities

Operator

Good morning ladies and gentlemen. Welcome to the ATI Technologies 2006 third quarter results conference call. (Operator Instructions) I would now like to turn the meeting over to Zev Korman, Manager of Investor Relations. Please go ahead, sir.

Zev Korman

Thanks, Stephanie. Good morning everyone and welcome to ATI’s conference call for the third quarter of fiscal 2006, ended May 31, 2006. Before I turn the call over to Dave Orton and Patrick Crowley, let me remind you that the discussions that follow contain forward-looking statements about ATI’s objectives, strategy and operating results.

These forward-looking statements, and in particular statements pertaining to our outlook for the fourth quarter of fiscal 2006, are based on current expectations and entail various risks and uncertainties. Our actual results may materially differ from our expectations, if known and unknown risks or uncertainties affect our business, or its estimates or assumptions proven accurate. Therefore, we cannot provide any assurance that forward-looking statements will materialize.

Material assumptions that were applied to making these forward-looking statements and material factors that could cause our actual results to differ materially from these forward-looking statements are disclosed in today’s press release. Additional information concerning risks and uncertainties is contained in our filings with Canadian and US securities regulatory authorities, in particular in the risks and uncertainties section of our annual information form, and our annual MD&A for fiscal 2005. We assume no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or any other reason.

Also, let me remind you that we are reporting in US dollars and under Canadian GAAP. In order to ensure that everyone on the call that wishes to ask a question today has the opportunity to do so, we’re restricting the number of questions each caller may ask to one.

At this time, I will turn the call over to Dave Orton.

Dave Orton

Good morning, and welcome to ATI’s Q3 fiscal 2006 conference call. Our focus in Q3 remains much the same as the priorities we defined three quarters ago as we entered fiscal 2006. These are:

  • driving growth in our PC business through product leadership and innovative platform and technology advances;
  • building on our design win momentum to accelerate the growth in our consumer business;
  • delivering margin expansion;
  • improve our operational systems to enhance predictability and enable us to scale our business; and
  • tight expense management.

In fiscal Q3, we continue to deliver on these five goals as ATI has delivered $652 million in sales, a 23% growth year-over-year. Our top of the line RADEON 1900 XTX took on all competitors and won, further strengthening our reign as king of the hill. We continue to innovate on multiple fronts as reflected by our team’s filing and being issued over 40 patents in Q3.

In a seasonally slow quarter, we delivered record revenues and unit shipments for our handheld, DTV and chipset businesses while competing aggressively on our GPU segment with leadership products, and maintaining our number one market share position.

We continue to invest in operational systems and translated this into improved business performance as we surpass 55 million units shipped in the quarter, and reduced our inventories by over $50 million. Patrick will elaborate on the financial and operational details later in the call.

Now, let’s recap Q3. I think the key highlight in our business is our consumer products. If you look at consumer plus our game console and royalties business, we hit an important milestone this quarter. We not only exceeded 100% growth year-over-year, and approached 50% gross margins in this business, but we also exceeded $150 million in revenues for the quarter; a run-rate of $600 million for the year.

On May 4, we announced a strategic relationship with Nokia, covering all areas of multi-media and 3D. Based on our partnership, ATI and Nokia are already working together to align roadmaps and deliver both a software architecture, innovative multimedia and 3D hardware solutions for the Nokia mobile phones.

Two days earlier the BitBoys acquisition was announced. This acquisition brings to ATI, OpenGL ES 2.0 and 3D graphic technologies and OpenVG 1.0 Vector Graphics Cores that enhance ATI’s product offerings. Additionally the BitBoys teams bring a very skilled R&D presence in Europe.

In Q3, we demonstrated our industry leading mobile DTV technologies. We are the only company offering a complete end-to-end mobile TV solution. We’re the only company at 3GSM delivering real world, live broadcast demos. Currently, in customer demonstrations in Europe, our WTD 100 is picking up crisp, clear images of the World Cup and is broadcasted by key systems.

Our DTV business set record revenue and unit shipments in Q3, now six sequential quarters of record revenue. On the strength of our Xilleon 240 processors, we expanded our position in nine of the top 11 LCD OEMs. Two key areas for innovating in DTVs are displaying superior image quality, and system on the chip integration, both areas where ATI is excelling in the very fast growing market.

HDTV sets containing ATI Xilleon chips continue to dominate image quality tests and product reviews. As an example, on a recent Sony Bravia review, which occurred in Business Week, the Bravia delivered beautiful, crisp, life-like high-definition images right out of the box.

Our PC team demonstrated innovative leadership from day one of the quarter. We’ve launched the CrossFire Xpress 3200 chipset on March 1. This is the first chipset to offer unrestricted dual X 16 PCI express performance. We follow this by the first workstation graphics card with the 1 gigabyte frame buffer offering, our FireGL V7350. It was recently awarded a 4.5 out of five by the 3-D Professor, and editor’s recommendation for high end professional graphics.

In the midst of all this, a check patch appeared and it immediately drew attention to the unbelievable jump in image quality obtained when running high dynamic range, also known as HDR, and ATI Xilleon together, a feat only possible on Radeon’s graphics processors and the ATI GPU in the Xbox 360.

Throughout the quarter, Intel used ATI’s GPUs to demonstrate Conroe, their next generation CPU that is expected to set the new gold standard for high performance processors. ATI was in every Intel Conroe system at WinHack, and in almost every system at Computex, because Intel knows that ATI GPUs provide the best gaming experience with Conroe.

One of the other technology highlights at this year’s COMDEX was our demonstration of a powerful gaming physics with the combination of CrossFire and Conroe. Writers endorsed our vision of balanced gaming.

DX1900 XTX was launched January 24 and remains the undisputed king of the hill in single GPU performance. Others are now forced to double up processors for cards to attempt to grab the single slot title.

The combined power of the CrossFire 3200 and dual 1900 are continuing to set new performance records and it’s led CrossFire and 1900 to design wins. Dell is now shipping the 1900 in their top of the line XPS, and Gateway was the first OEM to bring CrossFire to market. More will soon follow.

Mobility Radeon maintained a strong hold in the notebook GPU market. Numerous design wins came through this quarter, including HP, Acer, Asus, Toshiba, Dell, Fujitsu Siemens, and this is just to name a few. CrossFire notebooks are just around the corner.

Now I’ll turn the call over to Patrick, to review our Q3 financials.

Patrick Crowley

Thank you, Dave and good morning, everyone.

Revenues for the third quarter of fiscal 2006 were $652 million, and within the range of the guidance provided in our Q2 report. Q3 revenues represented a 3% sequential decline. Seasonality in the PC GPU segment was largely offset by growth in the ITP and consumer businesses. Considering that seasonal weakness in this year has been more pronounced than usual, we’re pleased with our financial performance in the quarter.

The broad based demand for our product in Q3 has also been reflected in our volumes, which hit a new quarterly unit record. In terms of revenue split, the PC segment represented $500 million or 77% of total revenue in the quarter. As a rough gauge, Desktop Discreet amounted to about 35% of total company revenues; chipsets increased to more than a quarter of revenues, and Notebook Discreet was around 15% of revenues.

Revenue from Discreet products was down more than 10% sequentially, again reflecting the seasonality seen in the market and some added softness in the notebook market.

Our chipset business enjoyed another strong quarter with record sales and unit demand. We continued to show positive margin improvement in the business. Sequential revenue growth

was north of 5% on a combined basis, and margins improved to nearly 20%. The mix of chipsets was tilted slightly in favor of desktop.

The consumer segment, which includes handheld DTV, NRE and royalty revenues accounted for $132 million of revenue, or 23% of total company revenue in Q3. Consumer revenues were up more than 15% sequentially in what would also normally be considered a seasonally down quarter.

It was another record quarter for handheld with shipments of about 25 million units and revenues up nearly 10% sequentially on continued penetration of the mainstream feature home market.

DTV had a fantastic quarter. Revenue in units were both up more than 50% sequentially. We’re seeing especially strong demand for the Xilleon 240 as Dave mentioned an integrated product and continued to land broad based new design wins, including wins with nine of the top 11 LCD TV OEMs.

Handheld and DTV accounted for more than 20% of company revenues. Royalties from our game console business, which includes royalties from both Microsoft and Nintendo, totaled approximately $10 million in the quarter. NRE was about $5 million in the quarter.

Moving on to gross margins, consolidated gross margin percentage was 30.1% for the third quarter as compared with 28.2% last quarter, and in line with the guidance of 30%. Desktop Discreet margins improved substantially quarter-over-quarter, but were not in the PC gross margin model in Q3. Corporate gross margin also benefited from continued improvement in our chipset gross margins, which I said were nearly 20%. The strong consumer margin percentage overall remains steady.

Operating expenses were $153 million, which was up 10% sequentially and a bit below guidance due to some higher than anticipated investment tax credits. As a percentage of sales, R&D and SG&A were also in line with our model targets of 13% to 15% and 8% to 10%, respectively.

GAAP net income for the quarter was $31.9 million or $0.12 per share diluted. Adjusted net income, which excludes stock option expense, amortization of intangibles, and other charges was $42.5 million or $0.16 per share diluted. Stock-based compensation in the quarter was $12.9 million.

The effective tax rate was 8% this quarter. That’s due to a one-time adjustment, which is not expected to recur. There is no change in our expected average tax rate of about 18% on a forward-looking basis.

Moving now to the balance sheet, we ended the quarter with inventory of $366 million or about 79 days based on Q3 revenues. We committed last quarter to bring our inventory down below $400 million, and we did. We continue to work to further improve our inventory management processes.

Our financial position remains strong with cash and cash equivalents at quarter-end of $518 million. The key drivers for the sequential decline in cash were: a reduction in payables and accruals; the repurchase of about 1.5 million shares under the normal course issuer bid for a total of $24.7 million; and $37.2 million on the acquisitions of XGI and BitBoys. We’re certainly very pleased with the progress of those two transactions.

As Dave mentioned earlier, Q3 was a tough quarter for the industry, and we feel that the macro market is in a temporary lull before growth resumes later in the calendar year. Nonetheless, we see some near-term uncertainty and weakness in that macro market, which is reflected in our guidance.

For the fourth quarter, we expect revenues to be between $620 million and $660 million. We still expect to expand gross margins, and should see gross margins percentage in 31% to 31.5% range in the fourth quarter.

Operating expenses, excluding stock option expense, amortization and other charges, but including the impact of foreign exchange, are expected to be between $155 million and $160 million.

You should also be aware in calculating adjusted earnings per share; you should factor in an additional $3 million for RSU expense per quarter, based on the RSUs that were issued during our Q3 just completed.

We see a number of catalysts on the horizon that should result in a strong second half of the calendar year. With a number of new processors, platforms and transitions on the way, there is some near-term customer uncertainty, but these will actually help to drive the industry forward later this year. In the meantime, we remain very confident in the trajectory of our business and committed to the goals we set with respect to margin expansion, operational improvement, and inventory and expense management.

Now, I’ll hand the mike back to Dave for a look ahead.

Dave Orton

Thanks, Patrick. I appreciate that.

For this quarter, we remain committed to the five priorities outlined earlier and that Patrick just described. First, a tight expense management, continuing to scrutinize and control expenses; improve our operational business systems to support our scale and improve our predictability will continue to be a key focus of business, as well as continuing to focus on inventory management.

Margin expansion is paramount and continues to be a top priority for the Company. We expect margin percentage to improve in Q4, and again over the fall quarter. We have aligned the entire company around this platform.

We continue to focus on building design win momentum to accelerate the growth in our consumer business. Demand for LCD DTVs in very strong, particularly in Europe right now, and we expect Xilleon to set a new revenue and unit shipment record in Q4. Our next generation Xilleon is ramping with designs hitting the shelves this fall. This new Xilleon will redefine image quality benchmarks and deliver features reserved in the past for separate, specialized chips. Image quality is such a critical criteria now for digital TVs that OEMs are now asking to use the ATI logo on upcoming designs as a competitive differentiator.

Momentum continues to build for the multimedia handsets as well, and users are now clamoring for higher resolution cameras, video recording, CD quality mp3 playback, and soon, digital TV. ATI’s Imageon 2282 is the media co-processor of choice for devices in the second half of 2006.

Motorola, LG, Panasonic, and HTC will soon introduce Imageon 2282-based multimedia phones. Panasonic and HTC will utilize 2282 in their next generation 3D platforms, and will be available worldwide.

Our relationship with Qualcomm continues to grow. The MSN 7500, Qualcomm’s first chip to utilize our Imageon technology, is now in designs with a number of Qualcomm customers, and volume is expected to start in calendar Q4. Qualcomm remains a very strategic customer and partner as we look forward to continuing to expand business opportunities with them.

Then, number one, growing our PC business through product leadership and innovative platform technology advances. We will launch new Radeon products in the second half of 2006 and reinforce our commitment to single GPU leadership. In Q4, the powerful combination of CrossFire, the 1900, and Intel’s Conroe will set new standards for gaming performance.

On June 18, enthusiasts cited NordicHardware covered Overclockers as they set new benchmark records on the 3Dmark 06, 3Dmark 05, and 3Dmark 01 SE, all utilizing the power of Conroe, CrossFire and 1900.

Historically, when Intel launches the next generation products, PC demand is increased, but Conroe will do more. It will drive strong GPU sales through higher end platform sales, and through the combination of Conroe and CrossFire.

Finally as we enter the second half of calendar 2006, both IDT and Gartner have upwardly revised their second half PC shipment forecast, citing improvements in the market.

Though our guidance remains a bit cautious, we are at the same time optimistic as Intel moves forward to Conroe, AMD moves to AM2 Socket. The market prepares for HD DVDs and Blue Rays on PCs, and then Vista Ready graphics and video solutions are being launched by ATI this fall. With the many technology advances about to hit the market, ATI is primed for yet another period of accelerated growth.

At this point, we are ready to take your questions; and remember, please, one question each. Thanks.

Question-and-Answer-Session

Operator

(Operator Instructions) Your first question is from Ed Pang - Credit Suisse.

Ed Pang - Credit Suisse

Yes, good morning, thank you. Dave, I think it’s not much of a surprise that the PC market is weak. You also talked about some near-term market uncertainties due to macro trends.

I was wondering if you had any visibility beyond the August quarter, or really what you are seeing from customers that gives you the confidence that we’re going to see a pretty good rebound in the second half on PCs.

Dave Orton

I think as we all see March, April, May and even June have been slow in the market, and to some extent some of that is I think a pent-up waiting for these platform transitions that are coming.

When we work with our customers, there is a lot of excitement around back-to-school, and that really starts to pop in the middle of July and drive through September. In Europe they call it the University and then holidays, so they actually have three bumps, but we think of it generally as the fall and holiday cycle.

I think that the combination of the new technologies and some of the macro -- not that there have been extra macroeconomic challenges, but the pause that I think the industry is seeing. The beliefs there from the OEMs and actually from the end customers in many cases, the retailers, are that the back half should be quite a bit stronger.

Ultimately it is going to have to result in uptakes in system demands. But the initial views, the initial forecast and geographic excitement seems to be there.

Ed Pang - Credit Suisse

Can I just have one clarification please?

Dave Orton

Sure.

Ed Pang - Credit Suisse

I think in the press release you mentioned that Desktop Discreet gross margins were down?

Dave Orton

Year-over-year, yes, not quarter-over-quarter. Sequentially they improved significantly, Desktop GPU margins, but year-over-year they were down slightly. In the press release we have to pick up quarter-over-quarter and year-over-year.

Operator

Our next question comes from Rick Schafer - CIBC World Markets.

Dan Gillies - CIBC World Markets

This is actually Dan Gillies calling in for Rick. Just looking at the margin improvement you've had, you mentioned it came from chipsets and Notebook Discreet this time. Looking forward next quarter, could you talk a little bit about what is driving the margin improvement there?

Dave Orton

If you look at what Patrick described, there is a slight improvement in revenues on our consumer business. The notebook market right now looks just a little softer than what we would have projected say six months ago, moving through the summer. The desktop we expect to be pretty flat as we move into Q4.

So first you want to get the product mix right. But on the chipset business, we do expect a little stronger mix in desktop than in notebook on the chipsets, and that will actually, that is a margin negative for the Company. But the overall product margins across the board will improve in Q4.

So if you look at any particular segment: desktop integrated, notebook integrated, desktop GPU's, we expect all the PC gross margins by product to improve in Q4. We expect consumer to be basically the same, about flat quarter-over-quarter. So the blend of all that, the combination of that with product mix is where it would drive now that 1 to 1.5 point improvement projected in Q4.

Operator

Our next question comes from Shawn Webster, JP Morgan.

Shawn Webster - JP Morgan

Good morning. Thank you. Can you give some more clarity on the order trends that you experienced in the May quarter and some commentary on your bookings linearity? What did your orders do quarter-over-quarter? Could you give us an update on the composition of your inventory? Thanks.

Dave Orton

Wow.

Patrick Crowley

Why don't I talk about the inventory? I think when we look at the inventory -- and we made a conscious decision, Shawn, to drop our inventory -- and we did that in two ways to not only continue to meet our sales target range, but also to cut back on the amount of raw materials that we were bringing in.

So what you will see when we talked last quarter about the inventory, we said that there were a couple of things that were driving that up. One was substrates. Substrates are well down from what we saw last quarter.

The second thing that we had was a lot of North bridges on chipsets but no South bridges to match up to them, and that created a bulge. That is now gone.

The third component of that was some of the ATP inventory and that has moved as well. So I think our inventories are in reasonably good shape, but I think we still have a way to go to reach our overall target.

Dave Orton

Then the question on bookings throughout the quarter, it is amazing because our business is so OEM centric, the actual billings are very linear. From a bookings standpoint we actually did see some softening in bookings as you moved through the quarter. So I think the OEM part of the business started to pull back a little bit, and the caution around April, May and June.

We started to see some improvement in June, but again, I think what we are cautious about is the ramp as we move back into the back-to-school market on the OEM side. Again, a big part of our business is OEM driven. So it is really looking at the OEMs and the end OEM channel and when that starts to pick up. But we are bullish, but cautious right now particularly over the first month-and-a-half of this quarter.

Operator

Our next question comes from Simona Jankowski - Goldman Sachs.

Simona Jankowski - Goldman Sachs

Thanks very much. Looking at your August quarter guidance can you maybe just outline some of the assumptions behind that in addition to the macro market as far as maybe your market share and ASPs? Also, what would be the typical linearity of the August quarter as far as how back-end loaded should we expect it to be?

Dave Orton

Again, because our business is primarily OEM driven ASPs would typically be fairly consistent if you look across handheld DTV. The only area really where you see some movement would be the desktop channel. I think as Patrick described, ASPs in Q3 were down slightly. We had a good unit quarter, a little stronger mix in the low end in our Q3. So we would expect ASPs to pick up some in our Q4 from a desktop channel standpoint.

Across the rest of the business fairly similar, we will see a slight decline in ASPs and chipsets as we move from a notebook to a desktop mix as well. But I think other than that ASPs will hold pretty steady.

In terms of linearity again, we do expect just typical linearity in these quarters are that June is the softest of the three months, and then it continues to build through July and August.

Operator

Our next question comes from Devan Moodley - Scotia Capital.

Devan Moodley - Scotia Capital

I just want to follow-up on Simona's question and get you to give us some sense of direction with respect to your guidance for PC versus consumer. Can you just split your assumptions up between PC and consumer? What do you expect for the consumer business?

Dave Orton

Yes, we can. No problem. We would expect consumer to have a slight improvement in Q4 over Q3. There have been some changes in some of our customer forecasting processes, and that caused a little bit of a pullback.

We actually are not out looking, but we are optimistic that that will shift back to a normal course of business. But it's actually more of a process change than anything.

Then on the PC side we would expect, as we described in Q3, our chipset business will go down in Q4. Some of that was as Patrick described, we had this bubble coming into Q3 of North bridges. We had a fab excursion back in December/January. That created a wave of South bridges to line up with our North bridges in our fiscal Q3.

We lose that bubble in Q4 so we actually are a little tighter particularly in the front half of the quarter on capacity, but we expect capacity completely cleared up as we enter our August month. So chipsets will be down.

We also expect -- and this is not news to us -- in working with Intel over the last year they described that as Conroe comes to market, the 965 will come to market, that will take some of the mid, higher end part of our desktop chipset business and drive our desktop down a little bit, both in units and lower ASPs. So that has been planned for in our chipset business.

Then GPUs, flat, this is the cautious area. We could be more bullish and it's just really a question of the macro market. The pick-up of the system SI and the sell through of that will really drive any potential upside in the quarter on our desktop channel.

Operator

Our next question comes from Chris Caso - Friedman Billings Ramsey.

Chris Caso - Friedman Billings Ramsey

I wondered if you could clarify something you said earlier and maybe give a little more color on the consumer part of the business. You talked about some changes in customer forecast, does that refer to the handset business or the digital TV business or maybe a bit of both?

Just give some more granularity as to what you're seeing in that business. I think typically your August quarter is typically quite strong in consumer from past quarters.

Dave Orton

Yes, we actually see consumer pick up in late April, so May is also very strong. It is really kind of a combination of OEM and ODM process changes that we are working on and just our hubbing model.

So it is across the board in the handheld and one or two customers in the DTV space. So in those changes, the combination of that, we pulled back a little bit. And it's probably a balancing of inventory in the supply chain as much as anything, so we pulled back a little bit so that is why we are a little more cautious on consumer this quarter than I think what you would see historically.

Operator

Our next question comes from Padma Yanamandra -Deutsche Bank.

Padma Yanamandra -Deutsche Bank

It seems like SLI still has virtually the whole multi GPU market. Can you guys talk about what breaks that stranglehold and give us a feel for the traction you're getting with CrossFire 3200? In the past you've mentioned a 40% market share target; can you give us a timeline on that and talk about the progress you're making on it?

Dave Orton

I think if you happened to attend Computex, that would be a kind of a revelation on the acceptance of CrossFire across the ODM part of the market. What is driving it really is Conroe. Conroe brings out, and we bring out the best in Conroe really for the gamer market, so the combination of Conroe and CrossFire 3200 was demonstrated very broadly at Computex. We continue to market that very effectively as we prepare for the launch of Conroe this summer.

In addition, we demonstrated at Computex a new technology. Now it is really from a volume standpoint we say it its maybe nine to 12 months out, but conceptually you can see what physics and gaming can do together. CrossFire provides the capability to leverage a second GPU in the system to really fully enable the capabilities behind real physics and gaming.

Throughout the summer you're going to see more and more SIs bring to market CrossFire solutions, based on ATI chipsets as well as based on Intel chipsets with Conroe, the 975. So it will be driven by both of those.

I would just say continue to monitor large gamer SI sites and we will update you in the fall.

Operator

Our next question comes from Andrew Lee - TD Newcrest.

Andrew Lee - TD Newcrest

Does the Q4 guidance factor in your Discreet business reaching the target model of 32 to 35? If not, what is holding that back considering you have refreshed your product line?

Dave Orton

The answer is no, it has us improving gross margins in our desktop GPU business, but it does not reach the model in Q4. That is driven by a few things. There continues to be some inventory that will be selling out -- very limited, but still some inventory -- that I would say we are selling out with net realizable values that are fairly low margins. So there is some overhang on that.

I think in combination with that as the market is aware, in the performance segment of the market we have been late with some of our new products. Those are going to come later in the summer. So we've been filling that segment of the market with products that obviously will be at lower gross margin as well. So I think the combination of those are driving the margins down somewhat.

Very good yields on 90 nanometer, initial yields very successful on 80 as well. We continue to see progress on our desktop GPUs, and I think as we enter fiscal '07, you will see us start to approach the margin model for desktop GPUs.

Operator

Our next question comes from Paul Howbold - Desjardins Securities.

Paul Howbold - Desjardins Securities

Just a clarification. Did you say the handheld business for the third quarter was up 10% sequentially in revenues or units, and DTV 50%? What also was the split between the two of those?

Dave Orton

The split in general is, I think of it still as about two-thirds one-third. Sequentially DTV did grow about 50% quarter-over-quarter, Q2 to Q3. Handset was up about 10%, Q3 from Q2. That was revenues, not units.

Paul Howbold - Desjardins Securities

That's revenues. And has there been any change with the ASP?

Dave Orton

In terms of ASPs, no not significant changes in ASPs in Q3 over Q2.

Operator

Our next question comes from David Hodgson - Genuity Capital Markets.

David Hodgson - Genuity Capital Markets

Thank you. Just getting back a little bit to gross margin, I am still trying to gauge it. Your consumer businesses is in the high 40s, your chipset business is approaching 20% I guess that infers that GPU -- my math has it between 27% to 28%.

You have said that you worked through most of the legacy inventory. Can I infer here that you are way below where your competitor is, and yet you talk about the strength of your product stack.

Is it the case that you're not refreshing your product stack until the fall and therefore you're having to sharpen your pencil on the pricing on a number of individual sub-segments of Desktop Discreet in order to move product? Just trying to rationalize why you are still at just 27% to 28%. Thanks.

Dave Orton

I think first you have to look at mix, Dave, and again, we have a significant OEM mix and a significant Notebook Discreet mix in our product line. OEM as I think everybody is aware, has a lower gross margins in general than the channel. You've got to get down into the mix of the product lines I think to some extent.

The other is as Patrick described, we did move a significant amount of AGP business, but in general our AG product line today, its got to hit a price point in the market -- and the market is still there -- but it is margins, and we continue to drive product into the AGP segment, and it continues to be low ASPs.

The channel itself, we are just cautious about the pickup of the channel. It was a slow calendar Q2 in the channel; the more the channel picks up the more upside there is for margins on our desktop GPU business.

The blend, remember, has notebook desktops in there as well. I hope that helps answer that, if not I think our team probably has a call with you later today as well. We can help straighten that out.

Operator

Our next question comes from Deepak Chopra - National Bank Financial.

Deepak Chopra - National Bank Financial

Just follow on the same lines in terms of gross margins. For the Q4 where are you thinking integrated is going to go? Are we going to move to north of 20% and at what point do you think we will hit the 25% to 30% range we've talked about previously?

Dave Orton

Part of the discussion with David just now, Deepak, the mix, the product margins are improving across the board. We had mix working against us in Q4 so we're going to see a stronger desktop mix.

As I talked about earlier as the 965, the 975 come in, our Intel desktop business will actually drop a bit in ASPs. So we're going to see more of a desktop mix in Q4 and probably a little bit of an ASP decline in Q4 on the chipset side.

So overall blended chipset margins might actually go down slightly because of product mix. But still around 20%, so we approached 20% in Q3. I think we're going to still be approaching 20% in Q4 because of mix. But on an individual product basis margins are improving. So that is driving some of that.

In terms of we are just rolling out our new South bridge; we talked about this SB600. That is coming to market. That is ramping quite well. I don't expect margin improvements from that until the fall quarter, because we really need to ramp that.

Then the second phase that really brings the margins to 25% and then as we move through the year we want to be obviously approaching 30%. We have strength of our products as we move to 90 nanometer and actually 80 nanometer and those are doing phenomenally well in the lab right now.

The bringing up of those, so I would say stay tuned to us as we move throughout the summer and we start talking more about our next generation North Bridges in 80 nanometer. But they will not be in the market in our fiscal Q4. They will be late fall, and then we will see some continued improvement there as well. So I hope that helps.

Operator

Our next question comes from Bruce Krugel - Blackmont Capital.

Bruce Krugel - Blackmont Capital

Dave, you've spoken about your ASPs with regard to Intel. Would you mind going into more detail, what your strategy is with the Intel rollout of their Conroe processors please?

Dave Orton

Well, the strategy is obviously multi-fold. Teaming up with Intel to bring Conroe to market on the gamer side with CrossFire is a key part of the strategy, and really addressing the gamer market more broadly and showing what is possible with new levels of performance.

As you move into the channel, the bulk of our chipset business -- I am trying to think here -- probably most of the Intel chipset business will not be based on Conroe. The Conroe systems will be on 975, 965 primarily and our chipsets will be down in desktops and notebooks. As they move that down market over time we expect to be picking up some Conroe business, but most of it is down in the value segment of the market. We've been working with Intel for the last several months on the right positioning of our chipset to support the broad platform.

On the notebook side we are encouraged about the breadth of design wins and the ramps, we have ramps this fall on both desktop and notebook. They don't start ramping really until late August or September, some new design wins that really will be significant volume for us, but that will be in the fall quarter. I think that is the bulk of it.

There is obviously a range of marketing and channel programs both that ATI is doing and ATI and Intel are doing around the launch of Conroe.

Operator

Our next question comes from Arnab Chanda - Lehman Brothers.

Kenneth Hui - Lehman Brothers

This is Kenneth Hui for Arnab. I just had a question if you guys could qualitatively talk about your handset business in terms of the strength or weakness you're seeing going into the second half and if that has changed in the last two quarters?

Dave Orton

It's a good question. I think as we moved through the spring and summer at a macro market level, there are push and pulls. There is this drive to a billion units in the market and I think an opportunity to achieve a billion units or approach a billion units in the calendar year.

Motorola continues to do very well. We have other customers whether it is Panasonic or HTC that I think are having very strong business. So I would say it is pretty much as expected, maybe we are being a little more cautious as we move through the summer, but we are excited about the new platforms coming to market.

I think you will see how handset business ASPs start to actually increase over the next six months as well with some of our new platforms, higher end platforms coming to market.

Operator

Our next question comes from Dennis Fong - MGI Securities.

Dennis Fong - MGI Securities

I was wondering if you could comment on your views of the industry in terms of price competition on the microprocessor side, is that in fact based on the graphics side at all?

Dave Orton

Good question; we were actually discussing that with somebody yesterday as well. It's not so much that it ripples back to price declines on our side of the business for us and then NVIDIA for example, but it does affect mix. Part of this, we will push to a lower end part of our product line. So we do expect mix shifts to occur as I think both Intel and AMD are trying to fuel some excitement in the market through price moves in front of the new processors coming to market.

We clearly see that, some move down market. Even the AGC I'm amazed that some of the sustained volume on the AGC part of the market, driven both by processor pricing and chipsets still in the market there. That does have some negative impact on both mix from a margin standpoint for ATI as well.

Operator

Our next question comes from Quinn Bolton - Needham.

Quinn Bolton - Needham

Just a quick clarification. I just wanted to make sure I heard you right on the new chipset platforms, you're targeting end of the year introduction on the 80 and 90 nanometer.

For those products you said that you're seeing pretty good results in the lab. Were you talking more performance or were you talking more about hitting that mid 20% to even 30% gross margin targets on those new North bridges?

Dave Orton

In our chipset performance, you don't over clock chipsets, so it's not performance per se. It was from the time you receive the blind build silicon from our partner, you plug it in the board and you have graphics running. Typically we think of days -- this was hours. So the phenomenal excitement in terms of how quickly these 80 nanometer parts came up.

So I think it is excitement around the quality of the process; any time you bring a new process up you are cautious about particularly the analog part of the design. The second are the yields, excitement about the yields on these initial runs.

So I think the combination ultimately that will lead to lower costs. So our ability to get to market fast and the ability to deliver lower-cost solutions to the market is what really is driving the excitement in the hallways of ATI around our chipset business right now.

Operator

Our next question comes from David Wu - Global Crown Capital.

David Wu - Global Crown Capital

I have a question and a clarification. The clarification is, Dave, the July 23, 24 price cut by Intel and AMD respectively for desktop, would that cause a pent-up demand in the month of August? If there is upside to the Discreet business, actually are you ready to fill it and make up the August quarter maybe much more of a hockey stick quarter than you normally would get this year?

The other thing I was wondering is in your breakout on your consumer side, the operating margin dropped from the previous quarter into Q3 and not a huge drop, but nonetheless a drop. Should I infer from that that in fact that you're DTV business at the operating margin level is lower than what it is for your cell phone business?

Dave Orton

Could you repeat the beginning part of the second question? So the first question I understand on the desktop and the market there with the pricing; the second question again?

David Wu - Global Crown Capital

In your segment breakdown you breakdown consumer, and if I look at your quarter-to-quarter comparison it appears that it declined, and the only thing I heard was that digital television is a bigger piece this quarter than the last quarter.

I was wondering since digital television typically gives you better gross margin, it must be at a lower operating margin structure than your cell phone co-process business.

Dave Orton

So let me answer both of those, and then Patrick can help fill in some of the gaps. So first in the market with regard to the August quarter, obviously operationally we build pretty linear. We want to keep the factories and the packaging houses moving, and support any kind of ramp. It’s not just the August month, but it is August, September and October are very big months in the industry so we want to be in front of that, so we do want to be ready for upside.

The challenge always is predicting the right mix, but again with the strength of the OEM business you have visibility into that ahead of the channel business from a mix standpoint.

You asked about given the price drops there do we expect this to spawn some demand? We think so. In general there's some elasticity and pricing in the PC business. I honestly believe more of the elasticity is driven around new technologies, new excitement of products that come to market. What we bring to market this fall with graphics, what Conroe does in the market, as AMD drives new technologies into the notebook segment as well.

Now on the consumer business I'm going to turn it over to Patrick.

Patrick Crowley

I think what has happened is that if you look at the overall consumer business, both handheld DTV, nothing has changed significantly there at all. I think what we end up with is just a touch lower in royalties in NRE that might impact the overall percentage and perhaps the OpEx might change that somewhat as well.

Dave Orton

We are taking an OpEx hit with the acquisitions, now it wasn't across much of the quarter, but we did have acquisitions.

Patrick Crowley

That is an operating margin there.

Dave Orton

Yes. So it was really more on the expense side. Margins were slightly up in Q3 from Q2. So from a margin percentage standpoint, that improved. You are right, the product part of the consumer business actually would have seen a margin improvement quarter-over-quarter, but we've had an operation expense hit. That is primarily where we are making our investments today is quite a bit of focus on our consumer business. I hope that helps, David.

Operator

Our next question comes from Tayyib Shah - Longbow Research.

Tayyib Shah - Longbow Research

Assuming that chipset prices were under pressure in the March timeframe, and there was some dumping of low end chipsets in the market as well. Can you talk about how that affects your ability to maintain chipset margins around 20% in fiscal fourth quarter?

If you can provide some color on how your chipset businesses is between low end chipsets and mid to high-end products?

Dave Orton

First in terms of the chipset dumping in calendar Q2, again most of our business -- probably 90 some odd percent of our chipset business is OEM based. So the OEMs in general don't see some of what I will call the channel dynamics that go on in terms of the pricing and some of the motherboard activities going on in the distribution channel.

So we were somewhat transparent to that. We did expect and do continue to expect to see more channel business in our Q4, a slight step up as we improve capacity with the SB600.

We are seeing OEM mix shift from notebook to desktop, a little more of a pop over there, and the OEMs that are coming to market with our products some of the mix in ASPs with those OEMs because of the SKUs they are using, are lower ASP SKUs.

But in general the pricing is fairly stable in the OEM business. It is really on OEM design cycles that you go to battle to win the designs. But once you ramp, you have a fairly predictable decline in pricing, it is a schedule that you work with the OEMs on. So I don't think that is a problem.

The challenge obviously for us is that as Intel brings to market Conroe and the 965 comes to market, we are positioned a little lower segment of the market on our Intel platform chipset business. That will have an impact on ASPs and margins, but we do expect Q4 margins to still be around 20%.

Operator

Our next question comes from Krishna Shankar - JMP Securities.

Krishna Shankar - JMP Securities

You mentioned that the mix shift in Discreet graphics moved towards the lower end. Can you give us a sense for the X1900 SE, how quickly that could ramp up and your efforts to move into the higher margins Discreet graphics space? Also an update on upcoming products that is hopefully coming upstream.

Dave Orton

In terms of calendar Q2, the North American business was pretty reasonable. Europe was geographically was slower. It is typically a slow quarter for them, and it started a little sooner this year. It started in April instead of May, so I think that is what has had some of the impact on the business. The emerging markets, as they come to market it is generally a lower mix. So as we bring on Brazil, India, China, Russia you do see a lower mix of products in those new geographies, and that is just going to have an overall shift in the market there.

We are planning a refresh of our product line as I mentioned in my prepared presentation as we move into the late summer and fall; and we are actually quite excited about that. So I think the combination of the seasons, the geographic mix shifts and the new platforms that will come to market will see a general higher mix of products as we move through Q4 and into our Q1, but I still expect the front half of our Q4 to be more low end.

Operator

Our next question comes from Satya Chillara - American Technology Research.

Satya Chillara - American Technology Research

\ Good morning. Dave, I just wanted to drill down a little more on the cell phone comments you made. You talked about some inventory adjustments during the quarter. Is this more of a demand issue at this point or how do you see this and how long is this going to continue?

Dave Orton

We are actually quite bullish on the end demand. Its really more of a balancing as I mentioned and it probably wasn't warranted. It's just that we are seeing a little bit of supply chain redefinition in a couple parts of our business and its not unique to any one customer or one segment. It happens quite often in the PC business; it is just that its so large and we're not quite as large a player.

In the handset market we got a very high percentage of customer base and market share percentage there. So I think it is just a general supply chain adjustment that is going on.

But in terms of general demand in the market, no we aren't seeing a slowdown there at all. And in some of the chip platform traditions, one of the things we are seeing right in front of us is we do have new platforms coming to market this fall; that creates a transition in effect as you drain down supply of the product of the older platform, you ramp the new one. The ramps of the ones aren't coming quite as fast as maybe we had predicted in the spring, so all that does is it causes a supply chain adjustment to occur.

I think we are phenomenally excited about what is going on in the handset business and we continue to expect to see growth in '07 like we have in '06.

Operator

Our next question comes from Sidney Ho - Merrill Lynch.

Sidney Ho - Merrill Lynch

Thanks. Most of my questions have been answered but I have one more related to Desktop Discreet business. You guys have done a good job on the R580. Macro factors aside, which market segment or channel do you think you have the best opportunity or would you like to see market share gain over the next quarter or two? Do you think you will need to wait until the R600 class product to see the share gain?

Dave Orton

If you think about the desktop market, and people have debates over whether it is three, four, five or ten segments, but if I think about it as five segments, and five let's say is the top segment -- some of the segment 4 and some of segment 3 I would say are weaker segments. Segment 1 and 2 are strong and segment 5 are strong.

So that classic $150 to $250 segment of what I would call board price in the market, I talked about some delays in new product that we have coming later in the summer. So we actually expect to have a very strong fall quarter in our GPU business all in front of the R600. We have a new class of products coming to market in the fall in front of the R600 family of products. We are quite bullish about that.

In combination of that is on the high-end I think there is still an opportunity -- somebody mentioned earlier with CrossFire -- they asked about our penetration there and we are; we are counting on Conroe. We are excited about that and that's going to drive our high-end part of our business stronger than what you call the R580 or 1900 XGX class of product.

So there is more room and opportunity for us there as well, but that $150 to $250 segment is probably the weakest of our stack. I'd hate to use the word weakness, too, by the way.

Operator

Our next question comes from Dayle Hogg - GMP Securities.

Dayle Hogg - GMP Securities

I was wondering if you could talk about your mix between the channel and the OEMs. Compared with NVIDIA, your margin have been weak largely due to that, how do you see that evolving? How do you really address the channel market better than you have to-date?

Dave Orton

Our mix today is 60/40, 65/35, somewhere there, channel versus OEM, but channel also includes retail in that number. So that is retail SI and then broad, what we call inboard channel. So probably in the last quarter maybe it was closer to 60/40 mix range.

I think the opportunity is that if you look at the macro market we would say that the channel is probably two-thirds of the business and OEM is one-third. So there is a big greenfield there of opportunity in the channel. I think as we discussed earlier there is a combination of things that we need to do.

We actually have a very active program going on right now, and we launched in Europe late in May, we again reinforced that at Computex, and it is totally linked programs.

Think about the end customer demand, defining the segments and driving end customer demand and then putting channel programs together all the way through the entire channel chain to drive that. In combination with that back-to-school has been a big focus for us, not just with the OEMs but with what I will call the large SI's, medium SI's in aligning our product lines to attack aggressively the back-to-school and the holiday season.

So it is pricing, it's programs, it's the classic four P's of marketing. Good products, and we have the products lined up and the stack lined up to do that; and then, we are tying the other 3 P's together with that.

So I think the team and the customers are quite excited. We walked away from Computex and our partners were very excited about the program. It is just that right now it is a little slow in the market so we are counting on that to pop back as we move through July and August.

Operator

There are no further questions registered at this time. I would like to turn the meeting back over to you, Mr. Orton.

Dave Orton

Thank you very much, and thank you everybody for your questions today. I appreciate your time as well. I want to personally thank everybody at ATI for their efforts in delivering a successful quarter in what was really a seasonally slow quarter for the industry. We have set ourselves up well – big thanks to our team --for the second half of calendar 2006. I also want to thank our customers and partners for your continued support.

We look forward to updating you on our progress as we report our fourth-quarter results early in the fall. Thank you very much, and have a good day.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. We thank you for your participation, and have a great day.

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