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Executives

Scott Wylie - VP, IR

John Daane - President, CEO and Chairman

Tim Morse – CFO1

Analysts

Randy Abrams - Credit Suisse

Uche Orji - UBS

James Schneider - Goldman Sachs

Glen Yeung - Citigroup

Tim Luke - Barclays Capital

David Wu - Global Crown Capital

John Barton - Cowen and Company

Christopher Danely - JP Morgan

Mahesh Sanganeria - RBC Capital Markets

Sumit Dhanda - Banc of America

Adam Benjamin - Jefferies

Ashley Hartson - Raymond James

Altera Corp. (ALTR) Q1 2009 Earnings Call April 21, 2009 4:45 PM ET

Operator

Good day everyone and welcome to the Altera First Quarter 2009 Earnings Results Conference Call. Today's call is being recorded.

At this time, I would like to turn the call over to Mr. Scott Wylie, Vice President of Investor Relations for Altera Corporation. Please go ahead, sir.

Scott Wylie

Good afternoon. Thank you for joining this conference call which will be available for replay telephonically and on Altera's website shortly after we conclude this afternoon.

To listen to the webcast replay, please visit Altera's Investor Relations web page, where you will find complete instructions. The telephone replay will be available at 719-457-0820, and use code 258712.

During today's call, we will be making some forward-looking statements and in light of the Private Securities Litigation Reform Act.

I would like to remind you that these statements must be considered in conjunction with the cautionary warnings that appear in our SEC filings.

Investors are cautioned that all forward-looking statements in this call involve risks and uncertainty, and that future events may differ from the statements made.

For additional information, please refer to the company’s Securities and Exchange Commission filings, which are posted on our website or available from the company without charge.

With me today are John Daane, our CEO and Tim Morse, CFO. Tim will open the call with a financial overview, before turning the call over to John.

After John concludes his remarks, we will take your questions. Prior to the Q&A session, the operator will be giving instructions on how you can access the conference call with your questions.

I would now like to turn the call over to Tim Morse.

Tim Morse

Thank you, Scott. My commentary today will cover first quarter results, second quarter guidance and an updated view of 2009 operating expenses. Beginning with our typical headline metrics; first quarter revenue of roughly $265 million declined 16% sequentially and 21% from prior year. Operating margin contracted to 19.5% including 2 points of unavoidability related to the previously announced restructuring charge of $5 million.

Lastly return on equity registered 40% for the trailing 12 month period remaining well above our target greater than 30%. Although revenue finished at the favorable end of both original and updated guidance, the quarter was heavily influenced by three specific dynamics that represent a temporary yet meaningful departure from recent history.

First, having entered the quarter with a sizable drop in back log 1Q turns business compensated for that week start by touching in to the low 60% range for the first time in more than a year. Absent a clear sign of a sustained economic recovery, customers have clearly been ordering on and as needed and when needed basis.

Second, while China 3G was unquestionably the biggest driver of the improvement within the quarter, the remainder of our business did gain momentum in each successive month as well. Excluding China the March acceleration was particularly strong especially when compared to December.

The third and final dynamic that set first quarter apart from historical norms was the mix of our larger and small customer categories. Large customers declined 8% for the period, with the top 20 subset being flat sequentially. In start contrast, our smaller customers declined 34% as you might expect the margin profile for smaller customers is substantially richer than that of larger customers.

From a market segment perspective, we experienced a more pronounced pull back in our highest margin segments than we had anticipated in our mid quarter update. Broadcast, military, test, medical and broadbased industrial all declined roughly 30% or more, sequentially. Combining the affects of the unusual customer dynamics with unfavorable market segment mix, gross margin dropped 2.5 points from mid-point of guidance to 64.5% for the period, 0.8 point of the drop resulted from customer mix and 1.7 points was attributable to the adverse market segment movements.

Structurally speaking, the other forces impacting gross margin rates were relatively quite in 1Q, with our cost basis and pricing substantially unchanged from prior quarter nothing new emerged to blunt the impact of mix. However, we anticipate both customer and segment mix, to naturally regain historical equilibrium over the coming quarters and for gross margin to improve proportionately. In addition, we continue to work on underlying advances in costs of good sold that will benefit gross margin over the medium and longer terms.

Turning to operating expenses, first quarter ended at roughly $119 million including the previously announced restructuring charge of $5.2 million embedded in both guidance and actual results were a few puts and takes laid by the termination of our retiree medical plan that netted to $3 million of primarily non-recurring savings.

All-in-all our under run of the original $122 million OpEx expectation reflected substantial contributions across a wide variety of functions and line items.

Most importantly however the first quarter result was consistent with our long-standing and ongoing efforts to improve the cost profile of the company. That work now enables us to update our total year 2009 operating expectation to a range of $490 million to $495 million split by $231 million to $233 million for SG&A and $259 million to $262 million for R&D.

It’s noteworthy however that none of the OpEx favorability for the quarter or for the year is a result of lesser spending and product development activities. The roll out agenda for 40 nanometer and other products remains solidly on track.

Continuing down the income statement, other income was $2 million roughly $1 million below guidance. Capital preservation remains our primary objective in this environment so we will continue to invest conservatively and accept lesser returns as the price of that strategy.

On the tax line, our core tax rate registered 14.5% for the quarter and we expect that to be the case for the remaining quarters of the year.

In first quarter however there was an additional one-time unfavorable impact of $2 million resulting from the recently enacted change in California State Tax Law. In total therefore, our effective tax rate for 1Q was 18.2%.

Net income for the quarter was $44 million or $0.15 per share including roughly $0.02 impact from the one-time restructuring and tax charges compared to prior year net declined 48% in dollar terms and 45% in EPS.

On the balance sheet, cash and investments finished 1Q at approximately $1.2 billion with cash flow from operating activities contributing $44 million for the quarter.

Although inventory declined from 3.6 months supply on hand to 3 months and generated $21 million of positive cash flow. That effect was more than offset by an increase in accounts receivable from $83 million to $182 million.

March gross billings to distributors were $107 million higher than December gross billings therefore creating timing related impact on AR and cash flow.

Moving to our second quarter 2009 outlook, we expect revenue to grow in the range of 2% to 7%. We entered 2Q off a book-to-bill ratio well above one and a substantial increase in our current quarter backlog.

The midpoint of guidance implies a churns requirement in the low 50% range, comfortably within recent historical benchmarks.

In recognition of the limited visibility in our end markets and customers, we are initially assuming constant mix between 1Q and 2Q and therefore a flat gross margin rate at 64.5%.

If customer end market segment mix were to improve within the quarter we would expect that upside to fall through proportionately. As a result of the mixed dynamic, we put second half gross margin in the 64.5% to 66.5% range.

Operating expenses should total roughly $125 million in the second quarter with a range of $56 million to $58 million for SG&A and $67 million to $69 million for R&D. 2Q R&D spending reflects a substantial increase in product development costs consistent with prior guidance and our long established roll out plans.

Rounding out guidance, we anticipate other income to be roughly $1 million for 2Q and to stay at that level for the remainder of the year.

Our core tax rate is expected to be constant in the 14% to 15% range and share count should be approximately 296 million shares. Our pipeline inventory MSOH target of three to four months is unchanged.

With that I will turn the call over to John.

John Daane

Thank you, Tim and good afternoon everyone. Q1 revenues decreased 16% sequentially at the better end of our guidance range. The previously announced $42 billion spend by China's three communications carriers through 2010 was a primary driver for our telecom and wireless growth and improve results in Q1 and we expect this to be a growth driver for the company in Q2.

We have changed our vertical market segmentation to break out revenue more evenly in the more closely aligned with end customer products and product requirements.

Wireless and telecom continue as a category. Networking has been combined with computer and storage. Industrial, military and automotive have been pooled and other includes broadcast,consumer, medical and test.

Quarterly historical data starting from Q1, 2008 for both the new and old market segmentations is in the Q1 2009 quarterly results press release. By vertical market for Q1 we have forecasted all end markets to decrease.

However, telecom and wireless increased 2% with wireless up sequentially on 2G and 3G deployments in Asia. Telecom was down sequentially but much less than expected due to demand for backhaul equipment for the wireless networks.

[Wideway] was 12% of revenue in the quarter, result of the strong wireless growth and decline in our other markets. Networking computer and storage decreased 14%. Industrial military and automotive decreased 30% and the other category was down 33%.

By product category for Q1, our new products were down 8% sequentially. Stratix IV revenue exceeded $1.5 million, higher than our $1 million forecast. Stratix IV continues to be the fasting ramping product in our history. Stratix III increased 17% and Cyclone III 21%. Stratix II decreased 18%, cyclone II 2%, Arria 12% HardCopy 12% and Max II 27%.

We expect Stratix IV to continue its stats revenue ramp and forecast $3 million in revenue in Q2 and close to $10 million in revenue for Q3 with much of this already in backlog.

In Q1, we tapped out our first 40-nanometer Arria II chip on schedule and shipped our first 40-nanometer Stratix IV GTs to samples with industry-leading 11 gigabit per second transceivers to customers to complement Stratix IV GX that started shipments in Q4 of 2008.

Moving to Q2, we are forecasting 2% to 7% sequential growth with most of our market stabilizing and wireless continuing to grow. Telecom and wireless should increase on continued 2G and 3G network builds in Asia. We also expect automotive, industrial and military the grow driven by military. Computer storage and networking and other should slightly decline.

The book-to-bill was over 1 for Q1 and turns required to make the Q2 guidance midpoint are in the low 50%, well below our historical high 50s to 60s percent range, and also well below the first quarter's 60% range.

In summary, we are very pleased with our near-term revenue results. Our industry-leading 40-nanometer product execution and our ongoing efforts to improve operating efficiency without sacrificing our product roadmap, the key to our long-term revenue growth.

Design wins in 40-nanometer are well ahead of any previous generation of products as we benefit, both from an acceleration of ASIC and ASSP replacement and our core infrastructure markets and/or having industry-leading high-density, high-performance and low power FPGAs.

With that, let me now turn the call back to Scott.

Scott Wylie

We would now like to take questions. Please limit your questions to one at a time, so that we give as many callers as possible the opportunity to ask questions during the call.

Operator, would you please provide instructions and poll for questions.

Question-and-Answer Session

Operator

Yes sir. (Operator Instructions). We will take our first question from Randy Abrams, Credit Suisse.

Randy Abrams - Credit Suisse

Okay. Yeah, thank you. Could you elaborate on the guidance for low 50s turns. The last few quarters has been more like high 50s. Talk about whether there is some conservatism in bookings have that slowed down in the last few weeks to make it bit more conservative on the returns expectation?

John Daane

Randy, this is John Daane. We do have two things. One is, yes, we are trying to be a little bit conservative in this environment. Number two, in some cases we have had some customers late in a little bit on that backlog associated with the fact that we have had very high turns, some expertise going on for product on very short schedules. So those two things combined have led us to provide hopefully, what is a very conservative guidance.

Randy Abrams - Credit Suisse

Okay. And on the gross margin, could you clarify, I think you mentioned a 170 basis points from mix and 80 basis points from the customer factor, what was the other element just if we go back to the December 69% margin. If you could characterize the remainder of the gross margin delta from fourth quarter to first quarter?

Tim Morse

Yeah, hi Randy. This is Tim. Recall, we talked about that in January for the fourth quarter call, there was roughly 1.7 points of non-recurring favorability in the fourth quarter resulting from probably the $6 manufacturing variances from 3Q that ended up getting amortized over a much lower revenue base in 4Q, so it had that propping up effect.

So at the time I talked about it as, yeah the reported number is 69.3%, but it's really more like 67.5% that is the kind of the steady state level of our gross margin. So from that 67.5%, we knew there was going to be some customer mix issues of about a half point coming into the quarter, so we put our guidance at 67.

And then from there you go down the additional 0.8 points for customer mix, and the 1.7 points for the pullback in the high margin segments. So that's the whole gross margin chain right there.

Randy Abrams - Credit Suisse

Okay. Thanks for that.

Scott Wylie

Thank you very much, Randy. Next question please?

Operator

The next question comes from Uche Orji with UBS.

Uche Orji - UBS

Thank you very much. Two questions. First, let me ask you about the mix, especially with regards to China. You said China will grow again next quarter, what do you think happens in terms of their ramp beyond next quarter?

How low long do you think that ban will continue? And also any specific drivers, we should be for as to what will drive some of the smaller customers, which of course was big drop to your gross margin for this quarter. And I have a follow-up.

John Daane

Uche, this is John Daane. First question for China recognize that this is a, where they have called a $42 billion spend over two years and so we are just beginning in this process, we are seeing our business increase this quarter Q2 but it is simply too early to call Q3. Many of these customers are ordering product on Altera at the same point that they get orders themselves, therefore we have seen a very heavy turns environment and lot of expedites but their visibility is extremely limited.

So, I do know that we have a very strong communications outlook because of China and also remember that is part of the US stimulus package, there is $7.2 billion for rural broadband which has been carved out ultimately to be spent over the next 18 months which would also be additive to China.

So, long term I think communications, both this year and next year, should do quite well, on a quarterly basis in this environment is simply too difficult for us to call because we have no visibility. So, we would like to take it simply one quarter at a time.

In terms of the broadbase customers, what we hear from our distribution partners is that the decrease that we have seen is a combination of both end demand decreasing for some of these customers as well as some inventory reduction. Remember many of these companies may operate on credit or in order to continue to build, credit is difficult to get in this environment. So, naturally what they are doing is depleting inventory and purchasing product only when they get orders themselves. So, probably part of the reason that part of this is attributed to an inventory decrease.

But there again since there are so many customers and so many different markets and we don’t have contact all of these individuals ourselves, very difficult for us to predict exactly what they are going to do on a quarterly basis.

Longer term we would expect to see growth out of our broadbase customers similar to the growth that we see and the top customers and to an extent as Tim has pointed out growth in top customers is partially tied to the fact that communications group and communications is concentrated in our top customers.

Uche Orji - UBS

Sure and then just to be clear, in terms of your 40 nanometer, what kind of yield are you seeing now, is there any impact of that on your gross margins and when do you think this on the ramp you have that the yield will be a quarter yield for the company?

Tim Morse

Uche this is Tim. The yield is actually in many respects running ahead of where we expected to be at this point, so it’s not impacting the gross margins at all. Where you look at again the impacts to the gross margins, we really doesn’t go by product it goes much more by where the products are selling into and Stratix IV in general is selling into some pretty good margin segments and it had some success as John noted in his note, in his comments. 1.5 million bucks for the quarter is pretty good. So, yields so far look actually very good and the mix of market segments looks even better.

Uche Orji - UBS

Okay, thank you very much.

John Daane

Thank you very much. Next question, please?

Operator

Next question comes from James Schneider with Goldman Sachs

James Schneider - Goldman Sachs

Good afternoon and thanks for taking the question. I was wondering if we can first start off on the end-market mix a little bit, can you talk about what you are seeing specifically with respect to your industrial customers both in Q1 and can you talk about what you are seeing in terms of orders and the mix of those orders so far in Q2?

John Daane

Jim we can’t break out what we are seeing in Q2 so far other than to say at the top level, business is tracking to our range and our book-to-bill so far in this quarter is about 1. In terms of the industrial customer base, industrial is categorized by a few large companies, Spencer’s, General Electric and Siemens but also industrials made up of many-many thousands of small customers as well. And as I had noted earlier in the comment many of the smaller customers we don’t talk too directly. So we relied on distribution and I had provided some comments there.

I think generally one could surmise in the short run industrial is going to under perform just the broad industrial base, simply because if there is a lot of manufacturing capacity available in all the industries today, due to the broad economic downturn then there is going to be a slowdown in capital orders for factory automation. Within that category, however, we do expect military to grow for us year-on-year. We do expect it to be up this quarter very strongly and I can expect military to be up year-over-year. And there is also chances as we have mentioned in the last conference call three months ago that there is a good chance wireless will be up year-over-year for us.

James Schneider - Goldman Sachs

Great, that’s very helpful. And as a follow-up, can you talk a little bit about some color around the telecom, wire line and networking segments and what you saw there?

John Daane

I am sorry the telecom wire line and networking. So, networking actually did fairly well in the quarter. It's significantly, the overall segment of networking, computer and storage was down, but networking did very-very well similar to telecom sort of slightly down, sequentially. I would say that probably is the result of Altera taking some market share because I expect the actual category was probably down more than us. So, that was relative good news. We expect it to probably be flattish to perhaps slightly down this quarter.

In terms of telecom, again the strength in telecom is really related in Q1 to backhaul equipment for the wireless networks we expect that to continue this quarter certainly because of the strength in wireless.

So overall I would say wireless up this quarter. Telecom may be flat and maybe networking slightly down but again very hard to call these exactly particularly in this environment, because its customer's forecast are fairly unreliable at the moment.

James Schneider - Goldman Sachs

Understood. Thanks very much.

Tim Morse

Thank you, Jim. Next question, please.

Operator

Next question comes from Glen Yeung with Citi.

Glen Yeung - Citigroup

Thanks. I noticed that in thinking about second half gross margin you are kind of guiding 64.5 to 66. And I was wondering if you could talk about what gets you to that range on one end and then maybe more directly what limits it from getting above 66% particularly noting that over the last five years your average gross margin is 67. Is there something in there mix or something out that prevents you from driving the 67?

Tim Morse

Hi Glen its Tim, I think it just a little bit the mix impact this quarter was very targeted, but very substantial and frankly more substantial than I would have personally would have thought could happen within three months period. But these are volatile times and very tough to kind on the visibility side.

So when I look at in the second half the first thing I should say is just like I said for the last couple of calls is the visibility still is not good. I will tell you that we still do not have second half wafer pricing improvement baked into that outlook. So that is something that very obviously could help us and take us above that 64.5% to 66.5% range.

I could see us being on the lower half of the range if the small customers of that broad base of customers and industrial that John talked about and other places. We are talking about we have about 13,000, 14,000 customers.

We are talking about putting 13,800 of them being the very broad base. Very tough to know when they are going to come back. They will come back just depends on how long we bump along the bottom here. And so if they don’t come back in the next couple of quarters.

I could see the year being at the low end of that 64.5% range, if I see them come back in the second quarter and remain with us in their normal proportion of business, we be in the higher part of that range. Its just extremely difficult to tell and I think it will probably continue to be a little bit noisey by quarter as well, so I can absolutely picture in a coming quarter going up 3 or 4 points from where we are and then depending on mix again and the volatility there coming down a few points.

So I think its got a bounce a little bit Glen, but structurally I think the good news is there is really nothing any different from what we are seeing from most of last year and we are as I said continuing to work on not only better wafer pricing for second half and for 2010. But a few other cost of goods sold cost out projects that will unquestioningly benefit us. So for right now I think just prefer to stay a little bit on the conservative side but definitely the big think I will be looking for is the smaller customers. Those bottom two categories Cat 3 and Cat 4 for us to come back.

Glen Yeung - Citigroup

Okay it’s helpful and then maybe any thoughts you have on where distributor inventories are today and what your level of comfort that, they are kind of tracking closer to you in consumption rate?

Tim Morse

Yeah I would say that distributor inventories certainly for us are low in terms of dollars. They came down about 22% in fourth quarter and 7% in dollar terms in first quarter. So we have taken a big chunk out of our distributor inventory. The sales have obviously come down kind of commensurately so you still see us hanging on to basically a 1.0 month MSOH intensity.

So for us that’s a pretty good level. There are couple of these that we have their above that a few that are below that, we are continue to kind of work that inventory down but I tend to believe as far as distributors go we are on the lean side and as that has implications on our differed income and therefore our cash flow, I would have trouble believing that inventory would go down because of demand much more from where we are. Has much more of an opportunity to go up and again the sale should go up to so kind of maintain that ratio of MSOH.

John Daane

I would like to remind everybody that we recognize revenue when we ship product from distributors to contract manufactures or OEMs. So ultimately the level of inventory in distribution really does not directly impact our overall revenue results.

Tim Morse

Yeah, that’s a great point and that’s exactly why we have this big differed income account on the balance sheet. That reflects what we sell in to distributors. We do not drain out of the differed margin account and tell it actually goes to end customers.

Glen Yeung - Citigroup

Great, thanks.

John Daane

Thank you, Glen. Next question please.

Operator

Our next question comes from Tim Luke with Barclays Capital.

Tim Luke - Barclays Capital

Couple of quick things just with respect to the change in the segments John, Tim maybe you could give some color on what you were trying to achieve with leaving networking out of the com area to yesterdays computing, that’s storage area. And what was some of the and we’re moving consumer as a category. And then John it sounds like you were saying with respect to China that you think that there are significant ongoing greater opportunities. But you think that people should be planning for this for a flatter second half that given short ramp? And lastly just with respect to mix pressuring the gross margin, I think you also just inferring that, because of this mix it's an industry issue as opposed to an Altera. If you say you would be surprised if your peers were not seeing similar impact on margin? Maybe you could just comment on that, Tim? Thank you.

Tim Morse

Yeah I will take. Hi, Tim. This is Tim. I will take that first. I have no idea what will happen with our competitors. But I would definitely confirm your comment that it is not an Altera thing. There is, as I have said nothing structurally different for us. It is just where the world is right now in terms of the small customers kind of going away, and stand pretty shy and the larger customers doing not well, I would never say well, but on a relative basis it's pretty good.

So, really there is nothing structural for us, and it will bounce as soon as we return to this normalized equilibrium that I talked about in my script. But the thing about gross margin for us, or for anyone else want to speak up, there are so many different forces between your cost basis and your pricing policies and the mix of customers, and the mix of industries et, cetera that for me to make any kind of guess that what's going on with someone else it would be wrong.

Tim Luke - Barclays Capital

Is there anything else you can add there, is it more wireless, more China that's impacting and less industrial in military or its quite a big shift in your guidance for the second half as this shift is going to sustain, that's why I asked that.

Tim Morse

In my guidance, as I told Glen, it's just very conservative. I would fully expect the mix to write itself. And in so doing, would absolutely have a proportional impact upward that is to mirror the impact downward that you saw this quarter.

As far as this quarter goes, it's tough to link it to any one dynamic other than what I have continued to talk about, I mean when you have got great high-margin segments like broadbase, industrial or medical test, military, et, cetera and they drop 30% or more in a quarter, that's going to be hurtful in terms of gross margins.

Again, I see it is a temporary thing, but it's in the quarter that it happen. This quarter, absolutely meaningful. And we are just going to have to see if when the bounce back comes and whether there is a bounce back that comes just, because of demand or for that’s really broadbase of 13,800 customers, have we have been under shipping the demand a little bit there as those guys stay especially lean.

FPGAs in their inventory got to be some of the higher dollar cost items. So, if there are going to get thin on anything, I would assume they get thin on us. So big customers, I wouldn't think that we are under shipping demand, to be honest. But the smaller customers, especially as John noted, we don't talk to them as directly.

So, I personally wouldn't have trouble believing that those smaller customers were, we were under shipping demand a little bit, because they are going to have proportionately much more hurt coming from our times, are high cost parts in there inventory, so they will stay leaner.

Tim Luke - Barclays Capital

Okay.

John Daane

I think, Tim, the other thing to look at that is how much our higher margin segments were down. I mean you have got, category such as other, which include test and medical, which are high margin categories. Overall that category was down 33% sequentially, and then you have got industrial military, which decreased 30% sequentially.

So our highest margin areas were the areas that were down the most, and that clearly is going to have an impact on the overall company gross margin. And I think to the large degree, it's fairly simple from that perspective.

In terms of the category themselves is why we realigned it. If you look at the last page of the press release, and look at the previous market segments, you will see the communications was 56% of revenues, industrial was 28%, consumer was 11%, but remember only half of that was consumer. The other half was broadcast, which we have said it was more like communications equipment, and then computer was 5%.

So we ultimately had really two categories, which dominated it and we didn't think provided a lot of information on the overall company. So we tried to come up with a new segmentation, which more evenly broke out the company's revenues, and to a large degree either represented the types of end companies, themselves or the type of products that they purchase and to come with a mix there.

So telecom and wireless are typically companies that are in the telecommunications industry, are also in wireless. You can think of companies like Ericsson, ALU, Nokia, Siemens, Huawei, you just kind of go down the list. They usually provide, both subset equipment.

In networking, we are now seeing the networking companies to an extent get into computer, and some of the computer companies also reemphasize some of the networking equipments, so we thought that that was good grouping.

The industrial, military and auto companies up into bio industrial grade, higher end products to large degree industrial military, which dominates the category of some of the higher margin elements of the company, so we thought that would good to be highlight. And then we grouped to what was left in the other.

So we felt it gave a much better breakout, a much more even breakout with a little bit better aligned with the end customers. And again, there is nothing hidden here, because we have given you the data going back by quarter all the way through '08. And hopefully that gives a sort of a look at the business. And again if people have questions, we would love to answer, so you feel that the data is transparent, you're getting what you need from the company.

In terms of China, for the second half of 2009, really is far too early for us to call what that's going to be up, down or flat. And the reason is literally we are getting orders from companies for delivery for instance in China that they get orders and they want the product that day. And so in that sort of environment where they have no visibility themselves, it's very hard for us to give much visibility beyond the next 2.5 months. So, we just rather stay with our short-term guidance. That’s where we will be most accurate. I note that there are quite a few companies now no longer even giving one quarter guidance. We are going to stay with that, but it's really in this environment too difficult for us to go beyond one quarter.

Tim Luke - Barclays Capital

Thanks guys.

John Daane

Thank you very much, Tim. Next question, please.

Operator

Next question comes from David Wu with the Global Crown Capital.

David Wu - Global Crown Capital

Yes, good afternoon. Well can you help us do one thing, which is you broke down the first quarter mix, customer mix very well and also the segment mix? If you can help us to go back to Q4 and see what that thing was in terms of large customers and smaller customers. That kind of break down, if you have that, that will be great, if not I just would make a supposition this is, it is yours truly supposing that the big customers were faster on the trigger in terms of cutting off inventory and that it hits you harder in Q4 than the smaller guys. And with time those smaller guys would bottom out and we will see how the end demand goes in the second half.

And on a question of second half, do you see any seasonality at this stage that came in this environment forget about the fact that Europeans, Japanese go on vacation in Q3 and all those things seems to be working in Q4.

Tim Morse

Hi David this is Tim. I can give you a little bit more color on the large and small customer dynamics. I have actually put that in my script these last few quarters, because like in 2Q '07 it was the last time it was kind of an impact on our gross margins. So, something in there for the most part knowing that it is a dynamic that we got to watch.

For fourth quarter for example, the top customers or large customers were down 11.7% and the categories 3 and 4, the smaller customers were down 12.4%, so just about equal for the fourth quarter.

And then obviously as I said in my script just over the while ago the top two customer categories which represent about 75% of our business now went down only 8% while the CAT 3 and CAT 4, the smaller customers went down whopping 34%. So, that kind of puts it in perspective for you I think. And we will continue especially because this has become such a big dynamic this year specifically we will continue to talk about that. I would have to believe for number of quarters to come.

David Wu - Global Crown Capital

Okay.

John Daane

David, in terms of your question on seasonality for the back half of the year, it's very difficult for us to say at this point. We recognized that it would be very valuable to have an understanding beyond one quarter as to how our businesses is going to perform, we would like to have that ourselves. We are not trying to be cagy here we simply don’t have I would say accurate enough information from a customer base to provide to you that we feel will be accurate beyond the quarter.

This is going to be a higher turns environment generally I think for the industry, companies are going to try to minimize inventory in order to preserve cash. Companies are going to order product at the last minute. Ultimately therefore, even if they provide us forecast or telling us the forecast are not going to be accurate at all. And so, we have really no ability at this point to accurately call anything in our opinion beyond the next 2.5 months. So, at this point we would like to reframe from trying to predict what will happen in either Q3, Q4 or even into next year.

David Wu - Global Crown Capital

Okay, great. Thank you.

Scott Wylie

Alright, thank you very much. David, next question please.

Operator

Next question comes from John Barton with Cowen and Company.

John Barton - Cowen and Company

Thank you very much. John, you highlighted the successful ramp of 40 nanometer product and specifically Stratix IV and within that product you have, I guess leadership, and [served] these functionality or transceiver. With that being a common bottleneck of design. Can you give us a view how you see the design win wars going so to speak. These will be your large competitors?

John Daane

Certainly, John. Thank you. In term, of the product line we released Stratix GX and GT devices or software to all users in May and we actually had released a software in December of the prior year 2007 to our early access partners. So, this point we have its April we have at least 11 months of leadership of software over the competition and still counting. And that gives us obviously the benefit of winning designs in the newer technology. Once the competition releases their product obviously a larger competitors already announced so we have some understanding what that is. We believe that we will have a number of lasting competitive advantages.

Number one on, power, our power consumption because we have a programmable power architecture, that our competition has not addressed, we should have at least a 50% lower power consumption which is very-very large in the infrastructure markets. Ours is one of the top three things that we hear from customers as a major concern.

Number two, we have transceiver performance advantage today anything over 6 gigabit per seconds an area that is alone to Altera so many of these 40 gig and 100 gig switches that are being developed for communications really we are the only company with the solution both through our GX devices which go up to 6.3 gigabit per second and then our GT devices which go up to 11.3 gigabit per second.

We believe that in the transceiver category we will have leadership throughout the 40 nanometer process node and then we also have advantages in areas like hard copy, as an ultimate cost reductions of the device.

So, right now what we are seeing is the fastest revenue ramp that we have ever seen and I think quite honestly that the industry has ever seen from release of first samples. We are also seeing a record design wins a full one year ahead of any previous family that we have seen and remember in previously families we had anywhere between 40% to 60% market share.

So this puts us well ahead of that mark which is exactly what we wanted to see. And we think to a large degree our advantages will be sustained and that we will see this, this family continue to grow very strongly not just throughout this year but also is it really ramp next year and the year after peeking about probably about 3, 3.5 years from now.

John Barton - Cowen and Company

And then maybe John could you also offer your views on any potential challenges in the foundries re-ramping and what I mean by that is obviously you are not the only one looking at growth for the next quarter. In general the industry is in general semiconductor companies have stripped down their internal inventory as much as they want to and hence wafer starts are starting to rise. I recognize that utilization of the foundries are incredibly low. But as we start to re-ramp that supply chain for you, how are you seeing that happened do you foresee any problems as we go over the next couple of quarters?

John Daane

On the supply chain side some products are wide open, there is lots of capacity but obviously there is a cycle time associated with building the product if you do not have it in stock or have within the line. Other areas capacity is tight and so we had to work with our partners in order to secure capacity like all previous cycles where we have seen up ticks Altera has been able to secure what it needs.

And in this particular case TSMC has been a very good partner provided Altera a number of hot lots in order for us to provide some fast term products for some of the communications customers and some customer in some other areas. And so right now we see really no supply constraints. As Tim pointed out in his note, our inventories are low at three months supply and hence so they came down very quickly from last quarter which is nice.

We are going to try to maintain it in that area at the same time we are going to do everything that we can to service our customers and again our supply chain has done an excellent job in taking care of Altera. Personally I have no concerns there.

John Barton - Cowen and Company

Last question you highlighted some capacity being tight, you highlighted the fact that obviously you have tremendous amount of leverage or appeal to those foundries. But that’s not always the case of all the fables guys are shipping in to your customers. And previous up turns, inevitable we can hold position where there is a one guy cant ship at given part for the entire and hence your customers are coming in and buying from you either. Have you started to see any of that or do you foresee any of that in the coming quarters.

John Daane

It has happened but generally it’s a matter of weeks before it's it works out. So you may see some product push around or try to be pulled in or again pushed out for a couple weeks. But generally we have not seen a lot of product drift across a quarter line. And nothing major where we've seen a revenue shipment that we would have, that would be substantial again be pushed across quarter because another supplier wasn’t able to execute. We'll watch that this quarter and see what happens but so far so good.

John Barton - Cowen and Company

Thank you.

John Daane

Thank you very much. Next question please?

Operator

Next question comes from Chris Danely with JP Morgan.

Christopher Danely - JP Morgan

Thanks guys, on the small versus large customer, set in the shipped, have you ever seen this happen before or do you think it could be just some unfortunate by-product of the credit crunch?

Tim Morse

Hi Chris, this is Tim, we have seen it before, I think we saw in a very pronounced way before I arrived, it was Q3 '05, and then we saw to some degree in 2Q '07 I think they were, those were I can't speak for the first one, the 2Q '07 that was quite different from what's going on here, could it be, the credit crunch which is keeping, the small customers lean on their inventories, I think that’s not a bad theory, I think that’s not a bad theory at all.

Again we have, we have very high cost parts for those guys, and they are going to stay as lean as they possibly can. And just kind of bump along here in the bottom, I wouldn’t have trouble believe in that theory at all.

Christopher Danely - JP Morgan

And I think it bounce back pretty quickly to last two times, right?

Tim Morse

Yeah, it’s a little bit of a rubber band here, on the customer side what I have seen a little bit more of a quick bounce back then on say the market segments, if you recall when our market segments kind of went a little bit south on us. In '07 it took a good couple of quarters to come back and then it came back quite nicely, so it did stretch back to its original position, the customer in 2Q '07 that customer mix right itself in 3Q '07 and 4Q '07.

Christopher Danely - JP Morgan

If I remember correctly, John the 3Q '05 right itself relatively.

John Daane

So, what I say Chris is structurally we don’t think anything long term has changed.

Christopher Danely - JP Morgan

Okay, great. And then as my follow-up on the actual end market mix, you know John, you talked about some of your higher margin end markets such as military, industrial and the other are turning down.

It's unlike what happened last year on your press release from Q1 to Q2, those combined segments really didn't do much. They were kind of flattish and your gross margins went up, so I'm just wondering why they didn't do much back then. And it's turning around right now, are we sort of peeling back the onion a little bit more in these end markets, or am I looking at it wrong?

John Daane

Hi, Chris, it's Tim again. So if you remember in 2Q '07 last year, we did pump up a couple of points. I think it was 65/1 to 67/1 or something, so I think it was almost exactly two points. And it was something that I talked about in my script, in that July script for Q2 2008, I should say. That it was just we knew we have those variances in place, we knew the cost out programs were there and I was just too shy to put them in advance of actually seeing the result as we are coming off of four quarters or whatever of declines and then some gradual pullback, or pull up in our gross margin, so I just didn't want to get out ahead of ourselves.

We had a lot of cost out stuff going on in the first half of last year that made us go up even though I think if you go back to my script you will know the markets segment mix was essentially neutral, but this cost impact didn't take us by surprise, but certainly it was better than guidance just purely, because I was too conservative giving guidance.

Christopher Danely - JP Morgan

Great, thanks guys. That's very helpful.

Tim Morse

Thanks, Chris. And again at a high level nothing is structurally different here. We do expect the smaller customers to come back. We expect those market segments to come back and ultimately as you have seen over a long period of time the margins have been very stable for the corporation, and we expect that to continue. Next question please?

Operator

Our next question comes from Mahesh Sanganeria with RBC Capital Markets

Mahesh Sanganeria - RBC Capital Markets

Thank you very much, and just some more questions on the wireless 3G and wireless. Just to help us understand, can you give us an idea if not quarterly on a year basis how much is the percent contribution from China 3G?

John Daane

We are not breaking out specific geographies or even within wireless specific different technologies. I would point out that the strength that we are seeing in Asia is not just China based, there are other countries that are deploying equipment and it's also not just 3G, it's also 2G as well as the backhaul equipment. So in some countries backhaul would be microwaves and in some countries it will be more of a wire line structure, depending on what they have in place.

So we are seeing a combination of those elements lead to strength. And even in China, where 3G gets a lot of discussion, there is a lot of 2G deployment going on. Obviously within China, you've got a population, which for the most part is much lower income is not going to spend a lot on the phone. So a 2G phone is probably a better solution for them. So we are seeing a lot of 2G strength in that country as well as India and other countries.

So it's not just 3G, we are also seeing growth in 2 and the growth associated in telecom with wireless in general. And again, on longer-term trend between the US and China and other countries, we should see communications actually do fairly well certainly through 2010.

Mahesh Sanganeria - RBC Capital Markets

And the other way to look at this, can we look at the wireless comm. equipment regional distribution, will that be a good proxy to look at your revenue mix or there are some puts and takes that makes the difference in terms of content for CLD or something like that?

John Daane

Usually within wireless, there is a difference between when we ship it and when may of the companies recognize revenue, and that happens in communications in general. In some cases they will install equipment within operator. Operator does not accept the equipment until up to a year later when it's actually turned on in a network.

So, it is going to be very hard to correlate between us and the end systems companies to a large degree. Asia is stronger right now as I pointed out in my script. We will see in my view, because of the stimulus package that US pick up probably beginning at 2010, so I think there are some good growth drivers still and probably many years to come, simply because of the increase in data content and video content within the web is going to drive the need for a lot of upgrades across a lot of different categories.

Mahesh Sanganeria - RBC Capital Markets

And a quick one on defense you had preached on December, did you have very high volatility that did you drop a lot in margin coming back up a lot in June?

John Daane

Military was down for us in Q4, and then down fairly significantly in this quarter as well Q1 as well. We do expect it to start growing again this quarter, and again even on the year-over-year basis, we are expecting it grow.

Military has been growing between 25% to 30% compound annual for us for three years. It was getting close to 10% of revenues on a consistent basis. And again, we are expecting it grow year-over-year for us again. So we should see some solid growth this quarter and the quarters to come.

Mahesh Sanganeria - RBC Capital Markets

Okay. Thank you very much.

John Daane

Thank you very much. Next question, please?

Operator

Our next question comes from Sumit Dhanda with Banc of America.

Sumit Dhanda - Banc of America

Yes. Hi, guys. I hate to go back to this, but the Q1 gross margins, Tim or John, I am struggling with this a little bit, because as I look at the number versus your original guidance provided in early January, did you know you posted about $13 million upside to revenues. But your gross profits, apples-to-apples are only $2 million higher versus what would have been an initial estimate based on the margin guidance.

Help us understand why this is really the case because it seems like infrastructure really work for you in the quarter. Now we assume that reasonably good gross margin business. I understand your commentary on mix and verticals, but the falls from gross margins seem to be particularly poor?

John Daane

No, I mean again our infrastructure was, what was lousy for us in first quarter.

Sumit Dhanda - Banc of America

I meant wireless infrastructure.

Tim Morse

Wireless we always articulated our communications segment which is in wireless and telecom has been right about at the corporate average of that 65% that we were looking for so that did, wireless did well. Wireless has some very high volume applications in it of course, a more so than most if not all other market segments. So, that is susceptible to a lot of swings in gross margin as well. But in general it will tend to come back to just about that corporate average. So, the high volume applications definitely affected but the big hitters in terms of gross margin for us in terms of being above and well above that corporate average are the, once they both John and I ticked off in terms of military, test medical, broadbased, industrial even broadcast and those were all down 30% or greater. So, that’s really what’s going on. If wireless grows even if it’s right at that corporate margin average of 65%, its never going to bring it up. You just depending on how high volume the applications they can chip away a little bit.

Sumit Dhanda - Banc of America

And as a follow-up on that, the parts you are shipping mainly into China 3G base stations are they mainly Cyclone or they Stratix or they are mix of both, roughly equal mix of both?

John Daane

It's Stratix and Cyclone and MAX and it's a combination of different densities, transceiver and non-transceiver different generations, it depends on the particular company, particular architecture and so it's really a combination of lots of different parts.

Sumit Dhanda - Banc of America

But on an average you can't tell whether it's SKU towards Stratix or Cyclone?

John Daane

I don’t know that I could say. I think it's probably a combination of all of the above.

Tim Morse

Yes, I don’t see anything that’s normal in one spiking out more than other.

Sumit Dhanda - Banc of America

Okay, and then last question, Tim, I know you said that month supply and annual distribution is flatter about a month. The pop in the deferred income line, should we interpret that as the fact that your lower margin business actually ship faster out of the channel as suppose to high margin business which stayed in the distributor books?

Tim Morse

It actually has much more to do with the allowances piece of deferred income and allowances that we brought in those allowances. So, you are collecting cash so the liability is unencumbered by that so it's get bigger.

Sumit Dhanda - Banc of America

Okay. I understand. Thank you.

John Daane

Okay. Thank you very much, Sumit.

Operator

And we will take our next question from Adam Benjamin with Jefferies.

Adam Benjamin - Jefferies

Thanks, guys. I know the visibility is tough right now and the lead times are short but I was wondering if you look out to the summer months which are typically slower. If you can look out over into that horizon and say given the inventories being leaner than historical levels and given the short lead times, do we potentially see a summer months for you guys as well as others that’s potentially more solid as opposed to the kind of depth or go away in business temporarily until there is a better visibility into the seasonal second half?

John Daane

Adam this is John. We simply do not have I would say solid enough information to venture a guess as to what we are going to see going into later in the summer into Q3. We feel comfortable with the guidance that we provided, I think we have given a lot of information around how we came up with the guidance, even there you have to venture out a little bit on a limb because the visibility is simply not there from any of our customers, distributors or even the accounts that are doing well like in communications as we mentioned. So, because visibility is lacking we prefer just to stay within this quarter and talk about the next two and half months because that's really all we know. To hard to venture a guess beyond that.

Adam Benjamin - Jefferies

Okay, maybe just a follow-up to that. If you compare more recent conversation you had with your customers and let's say 60 days ago, can you just give us some resemblance of the tone of those customers and how they are feeling about their businesses. And just in terms of the overall demand.

John Daane

Some are feeling very solid within their business, some are not. Some have a feeling that they bottom, some are feeling its going up, some are feeling it's going down. It really is a mix. To a large degree when we ask for clarity what we get from them is we would love to get that from our customers and we are not. So it's hard for us to provide you any. So, I think again in this environment data is not strong and solid, and so we would like to remain conservative and just talk about the near-term.

Adam Benjamin - Jefferies

Got you.

Scott Wylie

And operator we have time for one more question please.

Operator

And that comes from Ashley Hartson with Raymond James.

Ashley Hartson - Raymond James

Thank you for taking my question. Most of them have already been answered at this point but just wanted to check in with you in terms of your customer Huawei was 12% of sales in first quarter, based on backlog you expect them to be just as larger percentage of your sales in the second quarter. And then I believe you also said you were seeing strength from DTE on the last quarter's call where they still relatively as strong as you expected in the first quarter and what do you think from them going into the second quarter?

John Daane

We've seen not to go through with specific names but we are seeing communications' companies in general, particularly if they are in the field of wireless and they have been winning contracts in China and India for instance as well as other developing countries are doing pretty well. And so we’ve seen an up tick from them the reason that Huawei is above 10% of our revenues is because of the strength in wireless that we are seeing and they are seeing as well as backhaul equipment.

And the fact that many of our other accounts are down. So obviously if business in other areas down you have got wireless up you have got the potential from some of the com customers because they are very concentrated to be about 10% of revenues. Longer term if I were to go out a year I would venture to guess that probably we will go back to having no customer greater than 10% of revenues back to what's really been our norm to other history as some of our other businesses start to grow again.

In the short term we do expect communications to grow again for us in Q2 and therefore I would say there is a pretty high likelihood that Huawei will stay above the 10% customer but the some extent we will just have to see how this plays out.

Ashley Hartson - Raymond James

Okay, thank you very much.

John Daane

Thank you very much.

Scott Wylie

Thank you, Ashley, and as we wrap up today let me note that we will attend two conferences during the quarter, first is the Credit Suisse 13th Annual European Technology Conference, where we will present May 6, that’s in London. And on May 18, we will present at the 37th Annual JP Morgan Global Technology Media and Telecom Conference in Boston.

This concludes Altera’s conference call. Thank you for your participation and interest.

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Source: Altera Corp., Q1 2009 Earnings Call Transcript
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