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Executives

Dan Janson - Vice President of Investor Relations

Mark S. Frey - Chief Financial Officer, Executive Vice President, Principal Accounting Officer and Treasurer

Mark S. Thompson - Chairman and Chief Executive Officer

Analysts

Mike Chu

Terence R. Whalen - Citigroup Inc, Research Division

Christopher Caso - Susquehanna Financial Group, LLLP, Research Division

Christopher Rolland - FBR Capital Markets & Co., Research Division

Tristan Gerra - Robert W. Baird & Co. Incorporated, Research Division

Christopher B. Danely - JP Morgan Chase & Co, Research Division

Aashish Rao - BofA Merrill Lynch, Research Division

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc., Research Division

Shawn M. Harrison - Longbow Research LLC

Michael McConnell - Pacific Crest Securities, Inc., Research Division

Fairchild Semiconductor International (FCS) Q1 2013 Earnings Call April 18, 2013 9:00 AM ET

Operator

Good day, and welcome to the Fairchild Semiconductor First Quarter 2013 Earnings Conference Call. Just as a reminder, today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Dan Janson. Please go ahead, sir.

Dan Janson

Good morning, and thank you for dialing in to Fairchild Semiconductor's first quarter 2013 financial results conference call. With me today is Mark Thompson, Fairchild's Chairman and CEO; and Mark Frey, our Executive Vice President and CFO.

Let me begin by mentioning that we'll be attending the Baird Growth Conference on May 8 in Chicago, the Deutsche Bank Semiconductor 101 Conference in San Francisco on May 9, and the JPMorgan Tech, Media and Telecom Conference in Boston on May 15.

We'll start today's call with Mark Frey, who will review our first quarter financial results and discuss the current status of the second quarter business. Mark Thompson will then discuss our product line results, end markets and operational performance in more detail. Finally, we'll reserve time for questions and answers. This call is scheduled to last approximately 60 minutes and is being simultaneously webcast from the Investor Relations section of our website at www.fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days.

Fairchild's management will be making forward-looking statements in this conference call. These statements, including all statements about future results and performance, are made based on assumptions and estimates that involve risks and uncertainties. Many factors could cause actual results to differ materially from those expressed in forward-looking statements. A discussion of these risk factors is provided in the quarterly and annual reports we file with the SEC. In addition, during this call, we may refer to adjusted or other financial measures that are not prepared according to Generally Accepted Accounting Principles. We use non-GAAP measures because we believe they provide useful information about the operating performance of our businesses that should be considered by investors in conjunction with GAAP measures that we also provide. You can find the reconciliation of non-GAAP to comparable GAAP measures at the Investor Relations section of our website at investor.fairchildsemi.com. The website also contains a variety of useful information for investors, including an extensive financial section to facilitate your investment analysis.

Now, I'll turn the discussion over to Mark Frey.

Mark S. Frey

Thanks, Dan. I'm sure most of you had a chance to review our earnings press release, so I'll focus on just the key points in my comments. We recorded better than seasonal sales growth for the first quarter while reducing internal and distribution inventory by a combined $12 million sequentially. This impacted gross margin in the first quarter, but we expect a recovery in gross margin as sales grow across 2013. Let's review some of the details starting with the income statement.

For the first quarter of 2013, Fairchild reported sales of $343 million, up 3% sequentially and 3% lower than the 14-week first quarter of 2012. This is well ahead of normal seasonality of flat to down 2%. Adjusted gross margin was 28%, down 2 points from the prior quarter due primarily to continued reductions in internal inventory and nearly 1 full point of incrementally higher 8-inch wafer fab qualification costs. We expect gross margin to improve significantly with increased factory loading and better product mix as we progress through 2013.

R&D and SG&A expenses were $94 million in the first quarter, which was higher than forecast due primarily to increased R&D and selling expense to support sales growth, in addition to the expected increase in payroll-related taxes and equity compensation. Although we are holding headcount flat in second quarter, we are guiding OpEx up at $4 million to $6 million sequentially due to effective higher accruals for variable compensation. These accruals are based on our expectations for strong EBIT growth during the remainder of the year. We believe the current order rate, sell-through and inventory levels support our financial expectations, but rest assured that if this view changes, we can rapidly scale back spending in variable compensation accruals as we have in the past.

First quarter adjusted net loss was $2 million and adjusted EPS was a negative $0.02. This adjusted net loss excludes the $12.6 million litigation charge reversal related to the recent favorable court ruling on the First Power Integrations lawsuit. Our adjusted tax expenses was $1.5 million. Now I'd like to review the first quarter sales and gross margin performance for our 2 major product groups.

Sales were up 7% from the prior quarter for our PCIA business, driven by a broad-based strength in both high-voltage end markets. Sales into the automotive market were up more than 26% sequentially. The industrial and appliance demand improved significantly during the quarter as well. PCIA gross margin was down 3 points from the prior quarter at 26% due to inventory reductions and about 2 full points of incrementally higher 8-inch startup costs.

In our MC Cubes, business, sales were down 2% sequentially, driven primarily by weak computing and consumer demand, which was partially offset by better-than-seasonal mobile demand. Gross margin decreased slightly to 34% due primarily to inventory reductions for computing and consumer-related products.

Turning to our balance sheet. We decreased internal inventory by more than $10 million or 4% sequentially to 85 days. This level gives is one of the leanest supply chains in the industry while maintaining our ability to support ongoing sales growth. Days of sales outstanding, or DSOs, increased to 44 days as we took more customers direct. Payables were 40 days, down 5 days from the prior quarter. Free cash flow was a negative $24 million, which was driven by lower net income in payables, as well as higher receivables. We ended the first quarter with total cash and securities exceeding our debt by $124 million.

Turning now to forward guidance. We expect sales to be in the range of $355 million to $375 million for the second quarter. Our current scheduled backlog is nearly sufficient to achieve the low end of this range. We expect adjusted gross margin to be 30% to 31% due primarily to improved factory utilization and better product mix.

We anticipate R&D and SG&A spending to be $98 million to $100 million due to the annual merit increase, higher variable compensation expenses and some equity vesting that occurs just in the second quarter of each year. The adjusted tax rate is forecast at 15%, plus or minus 3 percentage points for the quarter. Consistent with our usual practices, we are not assuming any obligation to update this information, although we may choose to do so before we announce second quarter results.

Now I'll turn the call over to Mark Thompson.

Mark S. Thompson

Thank you, Mark, and good morning, everyone. We delivered solid sales growth in the first quarter and are guiding for a larger improvement in revenue in the second quarter. There are a number of growth drivers enabling this performance and we will discuss a few today. We are excited to see our efforts to focus on faster growing markets and past investments and new products pay off now in stronger sales growth.

I'll wrap up my prepared remarks with a review of some current quarter results and operational metrics.

First quarter sales and second quarter guidance are both well ahead of normal seasonality, and we expect to continue this strong momentum through 2013. Looking for robust through the first quarter and so far, through Q2 at about $400 million quarterly rate. These strong order rates are especially evident for our direct OEM business, which is booking at the highest level since 2010. Last year, we grew our Mobile and Automotive business, while our Industrial and Appliance segment was down substantially as the industry worked through a prolonged inventory correction. I'm happy to report that this inventory correction appears to be behind us and the customers are reordering at a brisk pace to keep up with demand. We believe this combination of recovering demand in the Industrial and Appliance segment, coupled with continued growth in Mobile and Automotive could accelerate our sales through 2013. These key end markets now account for 74% of our total sales, the highest level in our history.

I want to take a few minutes to discuss some of the great new products and design wins enabling our success in these markets. The Industrial and Appliance sector accounted for 36% of our first quarter sales as customer demand picked up significantly. This was particularly evident for our high-voltage Smart Power Modules or SPM which reported 8% sequential sales growth and even higher order rates.

During the last 1.5 years, as the industry worked through the cycle, we've focused on expanding our penetration of discrete prior management products and highly integrated SPMs into a broader base of appliance and industrial customers. We see strong demand from many of these design wins in the first and second quarter and expect this trend to continue through 2013.

Our larger customers also increased order rates and are adding capacity -- we are adding capacity for certain package types to keep up with demand. In the solar end markets, we saw improved demand for our highly efficient IGBTs and expect the sector to continue to recover in 2013. We also gained share in the telecom and networking markets as customers push for greater power efficiency in mid- and high-voltage applications.

Fairchild is uniquely positioned with a full range of power management products, both integrated and discreet, to support mid- and high-voltage applications. Our Automotive business posted record sales in the first quarter, driven by a 26% sequential increase in shipments of our industry-leading power discrete and module solutions. This business now accounts for 11% of total company sales. Our customers are increasingly interested in adopting the advance powertrain technologies our products enable, as they strive to improve efficiency. We have a great pipeline of new products and design wins that we expect will drive continued strong sales growth. We grew sales of our products into the mobile segment by 8% sequentially in what is typically the weakest quarter of the year for the -- in this market.

Mobile sales accounted for 27% of total company revenue in the first quarter. Our strategy to broadly penetrate the mobile sector helped us to grow despite weakness in the leading customer. We gained content in some new high-volume smartphones and tablets, which helped to drive growth in our mobile analogue segment. These new designs incorporated Fairchild's latest voltage regulators, analogue switches, power conversion solutions and MOSFETs. Our growing content in a number of leading Chinese mobile customers through our direct design wins, as well as reference design wins, also contributed to our success.

We also benefited from increased demand from a couple of previously dominant customers that launched new models recently. The smartphone and tablet end markets continued to grow at impressive rates and Fairchild is well positioned to capitalize on this trend. We're also excited about the development of a whole range of wearable mobile devices that have the potential to drive the next leg of growth in this segment. Extremely efficient analogue, discrete and sensor solutions are needed to enable a feature set and a battery life acquired to make this product successful.

Fairchild is one of the few companies technologically capable of meeting the challenges of this emerging mobile segment. We also recorded strong order rates for our mid-voltage power management solutions, reporting performance computing, data center and telecom applications. While still a small portion of the telecompany revenue, this relatively high-margin business continues to grow steadily.

Turning now to Q1 results for our sales channels and other operational performance. Sales into distribution were up 1% sequentially and we further reduced the channel during the first quarter. Sales into the OEM and EMS channels were up about 7% due to stronger mobile and automotive demand, as well as our efforts to bring more customers direct.

Factory utilization improved sequentially to the low 80s. The lead times remained short for virtually all our businesses. Overall product price in Q1 was down less than 2% from the prior quarter and we expect similar performance in the second quarter.

Finally, we were gratified by recent federal appeals courts ruling our long contested litigation with Power Integrations. The court found that there was no basis for finding Fairchild liable for induced patent infringement and vacated almost all the previous $12.9 million damage awarded against us. The court also, threw out the lower courts findings of willful infringement and reversed some interpretations of the meaning of Power Integrations' patent claim.

in each of these respects, the Appeals Court validated positions we have asserted since is the start of this litigation 8 years ago. We're willing to fight and win court battles as necessary, including by successfully defending our own proprietary technologies against infringements by Power Integrations, as we showed last April. However, this recent ruling should serve as a reminder that there are more efficient ways to resolve differences over intellectual properties than spending millions of dollars a year at legal costs.

In closing, we're off to a strong start in sales and expect this momentum to continue in the second quarter. If we continue to book at roughly $400 million quarterly rate in the second quarter as we did for all of Q1, then the second half demand sales will increase to these levels to meet customer demand.

Over the years, we've increased our focus on faster growing industrial, appliance, automotive and mobile end markets. Fairchild is one of the few companies in the industry with the technological capability for the transition by these markets to significantly more power management -- more efficient power management solutions. After nearly 2 years of inventory corrections, it is especially encouraging to see solid recovery in industrial and appliance demand. While margins were lower than expected in the first quarter, we are confident that this will improve significantly as we progress through the year. We expect higher sales and continued product mix improvement to enable steady progress toward our target business model.

Thank you, and I'll turn it back to Dan.

Dan Janson

Thanks, Mark. we'll now open the call to questions. I would ask that in order to allow more of you to ask questions, we limit each person to 1 question and 1 follow-up. Thanks, and let's take the first question, please?

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Ross Seymore with Deutsche Bank.

Mike Chu

This is Mike Chu for Ross. Question is on the $400 million in bookings. I just wonder if you could provide some color on what end markets or perhaps, geographies are driving the growth there that you're you seeing in bookings currently?

Mark S. Thompson

So the booking progress is very broad based. There's essentially all geographies and all markets. There's more granularity, of course, around customers. But we can't really provide that, the details, as it's obviously sensitive and proprietary to our customers. But very broad based, very consistent, very linear. So one other thing I would add to that is, we watch very close, particularly in distribution sales as to whether backlog is actually growing or not because when -- at an inflection in the cycle, when order rate increases and backlog increases, it's one of the markers for speculative buying. One of the reasons why we feel pretty comfortable about the information that we put out in its robustness is that we have not seen growth in backlog in the Distribution business. So it stays steady. So in other words, people are ordering it and it's going right back out the door again. So it's not a speculative order pattern.

Dan Janson

And as we said in the call as well, our direct OEM bookings are the highest level since 2010. So we're seeing very strong demand from OEMs.

Mike Chu

Okay, great, that's helpful. And as my follow-up, just on the expense side, I was wondering if there are any one-time items in your gross margin guide for the second quarter. How should we think about maybe the out quarter beyond that? Should we start to see some leverage coming back into the model? And then on the OpEx side, do we expect that to be growing from here or from the second quarter or is that kind of leveling out from there?

Mark S. Frey

So I'll talk about the gross margin first. Obviously, as we've said, one of the biggest one-time items is the almost 200 basis points in the qualification costs for the 8-inch line in Korea. That'll extend through the second quarter, so it's included in our guide for the second quarter. That will then taper off in the second half of the year as we bring that facility online. Obviously, when you're reducing inventory, then underutilization and inventory charges become the biggest influence on margin. They were certainly the biggest influence in the Q1 margin. And in Q2, there is still inventory costs that are baked into the 30% to 31% guide. So yes, you would see a positive progression after Q2, even simply if we produce at the same level. But if we continue to ramp up our production, then obviously, you'll have more leverage. And in terms of the OpEx, the progression after Q2 would depend on the level of profitability. So there's not much from a spend standpoint built into future expectations. Equity actually trails off a little bit because of this special feature that we have in our plans that fully vests in Q2. But the variable comp, obviously, if we start logging more and more EBIT, then we'll log more and more variable comp and there will be -- but obviously, that's sort of a virtuous cycle.

Operator

And we'll take our next question from Terence Whalen with Citigroup.

Terence R. Whalen - Citigroup Inc, Research Division

The first question has to do with the appointment of your COO and President about 7 or 8 months ago. Now that we're a couple of quarters, and I was wondering if perhaps DJ or other management could share what some of the early observations and assessments have been, and also just to help us understand what milestone, DJ specifically, will be helping the company with?

Mark S. Thompson

Sure, Terence, let me -- so the first part of that, we will certainly give some exposure to the investment community to DJ at some appropriate point, in the not-too-distant future. In terms of what he's doing for us, I think we -- I've said and it's still true that it'll take a full year to 1.5 years of his arrival before we start to see sort of some meaningful things that are going to happen. I mean, he's intensely, focused on the product piece of our business, which is from opportunity identification by application, all the way through volume production and he brings a unique strength in sort of every aspect of that. So we've got the big things that are going to be emerging later this year. One of the most interesting one is the absolute best-in-class 6 degree of freedom center target at mobile applications, which will set an entirely new benchmark in terms of power efficiency, for example. So there's a series of things like that, that win, they're ready and they are starting to go to customers, it will be a very appropriate time for us to show what we are doing as opposed to what we don't want to do and show what we're going to be because I think that's a little bit of a hollow exercise. So expect some things out that are specific prior to our departure up to 2013.

Terence R. Whalen - Citigroup Inc, Research Division

And maybe I'll ask, in a couple more quarters -- the calls that I had was to what degree are your customers actually influencing the decisions that you're making about your manufacturing strategy? Specifically, I'm wondering if mobile customers are kind of steering you towards lithography levels that are perhaps below what you would have in-house. I'm trying to understand whether that would mean that you would actually adopt the model over time?

Mark S. Thompson

So absolutely, our customer helped us select our process technologies. We already have many of our new mobile designs that are at nodes below those that we manufacture ourselves and they go through foundry. Increasing the fractions of the build and the designs that we do, particularly in mobile. We will be at nodes that we don't intend to do internally. So inevitably, what that would mean is that as those businesses grow, that we'll have a larger and larger fraction that will be fabless and that's built into our model, that's built into our capital model. And so that, again, we should expect -- that it is happening now and we expect it to accelerate in the second half of the year and into next year.

Operator

We'll take our next question from Chris Caso with Susquehanna Financial Group.

Christopher Caso - Susquehanna Financial Group, LLLP, Research Division

I wonder if you could give some additional color on the handset market. You talked about that running better-than-seasonal in the first quarter. What do you see going into the second quarter for that as well, and whatever color you can provide?

Mark S. Thompson

The picture that we see for our share in mobile is we're very -- feel good about our gains across the year. And so while you can never exactly predict exactly what the various customers will do or -- we have share gains sort of everyplace you'd look. And so we expect each quarter to be better than the previous one with some pretty exciting things particularly happening in Q3 and Q4.

Christopher Caso - Susquehanna Financial Group, LLLP, Research Division

Okay. And I guess just following up on some of your earlier comments, perhaps you could comment on sort of how the weekly run rates progressed as you went through the quarter, maybe both on orders in terms of bookings, how they progressed into early April. And just following onto that, you had mentioned that if they kind of stay at these levels, we do imply -- infer that you should be sort of in the 400s in terms of revenue run rates in the second year if things stay in the same trajectory.

Mark S. Thompson

That's correct. So in terms of linearity, it has been the most linear year that I've seen in at least 5 years. So -- and part of it is that, again, we worked through -- the industry has worked through, and we, in particular, were quite exposed to some of the industrial and appliance stuff in China, which had a severe inventory build in 2011. And we talked about that in the past. So as that's come off, that's been one piece of it. But we've also done a lot of upgrades to our sequencing system, how we place orders, how we commit to them. And so that's also contributed to linearity. But so far, it's been a very straight line, as I commented, the run rate is roughly $400 million a quarter, we are booking -- we booked just a tick under, it was $395 million total that we booked in the first quarter. We're running a little bit about that so far in the second. We are starting backlog position. In the second quarter, it was about $25 million ahead of our starting backlog position in the first quarter. And as of my last check on yesterday's numbers before the call this morning, it continues on almost perfect straight line.

Operator

We'll take our next question from Christopher Rolland with Frederic (sic) [Friedman], Billings and Ramsey.

Christopher Rolland - FBR Capital Markets & Co., Research Division

As you guys look out over the next quarter here, how do you guys sort of rank order your segments, mobile, auto, appliance, compute, across those?

Mark S. Thompson

Rank order in...

Christopher Rolland - FBR Capital Markets & Co., Research Division

In terms of improvement, in terms of, call it, sequentials, however you want to look at it?

Mark S. Thompson

So everything but computing, we have -- we expect; to see to make progress across the year. It's hard in sort of core notebook, which isn't really very important to us anymore in single digits. That one is tough to call, but it's hard to make the case for improvement there. So I think that one is probably sideways to down. With everything else, we expect to show significant revenue growth across the year.

Christopher Rolland - FBR Capital Markets & Co., Research Division

So one is stronger than the rest?

Mark S. Thompson

In dollar terms? Probably industrial/appliance with SPM and mobile would be the 2 that we expect to see the biggest dollar gains in.

Christopher Rolland - FBR Capital Markets & Co., Research Division

Okay. Also, you guys mentioned your wearable mobile devices. Is that coming from a number of different OEMs, or is it perhaps one key innovator or just a few, and maybe you can talk about what sort of solutions you guys are providing there and more details would be helpful.

Mark S. Thompson

So it's still in a very early stage, and that there really aren't any dominant solutions yet, but there's a lot of work going on in wearables in several categories. Some of the most interesting ones are health monitoring and sort of availability of display and interface for your phone, which you don't have to walk around looking like you're holding a gun. And so those are the 2 most interesting ones and there's at least half-dozen different implementations that are going on. And so I think it's very much in an experimental mode right now and it will be another leg of -- I think the way things have progressed in mobile, which is a lot of interesting ideas that float out into the market and then some things will turn out to really catch and then those will become the next wave. So we're still in the very early phase of that. The biggest issue for those is all about power management and efficiency and particularly in sensing. If you look at the sensor elements that are in today's phones, they're actually switched off most of the times because they're so power-hungry, we really can't use them. And so what that really does is it makes them a lot less useful than they can be, especially for things like health and activity monitoring and gesture and some of the things that look like they will be really important. So driving, motion, Gyro, position, down in order of magnitude of power, opens up a whole set of really, really interesting things that could happen. And that's what we're targeting our sensor activities. As I commented, we expect we'll see the commercial light of day towards the end of this year. So this will be a real premium on space efficiency, timeliness, energy efficiency, battery life and as I said, advanced sensing. So all have to coalesce in a really unique way.

Operator

Our next question comes from Tristan Gerra with Robert W. Baird.

Tristan Gerra - Robert W. Baird & Co. Incorporated, Research Division

You mentioned on the call that you haven't seen any backlog sales yet at distributors. When do you think that happens and is there any reasons why you think backlog hasn't built yet, are they -- is your sense that there's been a cautious view in terms of demand, any color you could provide on that?

Mark S. Thompson

Yes. So I think it is likely the case that there's still some residual caution that's built into their, at least the order rates we see, and that'll be a close watch point. What's interesting is, typically, it's fairly early in the replenishment cycle that you see backlogs start to climb. And we have not seen that. In fact, backlog is still slightly trending down in the distribution space. So, but clearly, that will be a watch point and one of the things that we'll keep an eye on for signaling when it's not going to go up anymore and that we should plan accordingly.

Mark S. Frey

And Tristan, lead times are still pretty restrained. So they haven't expanded yet. So I don't think there's much nervousness on the part of distributors for getting backlog on the books.

Tristan Gerra - Robert W. Baird & Co. Incorporated, Research Division

Sure. And I think you had mentioned last quarter that distributor inventories were below 10 weeks. The first question is, are we, I guess, below 9 weeks now, are we seeing at about the same level as last quarter? And secondly, how much of that reduction of internal inventories, which impacted your margin in the quarter was expected a quarter ago?

Mark S. Frey

In terms of the external inventory, it's down modestly in dollars and that translates to about the same days of inventory, which is -- and it's a number of days we're very comfortable with. It's slightly higher than the lows we hit in 2010. But it's a good bit lower than generally what we operated with over the last several years. In terms of the internal inventory, as we said, that was $10 million. And I would say, about 1/2 of that was not necessarily anticipated when we gave our original guidance, which accounts for the fact that we did report margins a bit lower than the guidance range. We're at 85 days there, so -- and we're certainly, by standards of our peers, we're probably one of the leanest guys in the industry now. And if we achieved just midpoint of Q2 guidance, that will be 80 days. So essentially, that would be an internal record.

Operator

Our next question comes from Chris Danely with JPMorgan.

Christopher B. Danely - JP Morgan Chase & Co, Research Division

So assuming that we continue on the sort of $400 million of bookings rate and we're looking into the second half year here, what do you think your utilization rates would look like, and then, when do we need to start worrying about adding capacity or how do you think that the channel is set up for that, assuming the business conditions stay fairly benign?

Dan Janson

So our utilization rate coming out of Q1 was in the low 80s. So obviously, we'd expect to increase factory loadings going from here, but from the low 80s, we put quite a bit of headroom. As we talked about in the prepared remarks, there are a couple of package types that we are having to add capacity on right now, especially around some of the smart power modules. And as we've said, that business is rebounding quite strongly right now. So there will be some selected areas where we'll likely have to add some capacity, Chris, but for the most part, we've got plenty of room to expand our sales.

Mark S. Thompson

Two things that I think, to embellish what Dan said, is that, one is that the BK 8 -- if you go back to my comment on where the biggest revenue growth could be, which was in mobile and the SPM high-power stage, both of those are actively accommodated in the way we're building our supply chain. So as I commented earlier, we're outsourced on most of the growth platforms in mobile. So that will increase our build at foundry, but we're not capitalizing that period. And that's true for the front-end production, as well as the chip scale side of that. If you look at the high-power piece of that, BK 8, which is our big 8-inch conversion in Korea, which has a lot of capacity associated with it, is in square at that market. So both of those are fully aligned in the plans that we've put out and the capital estimates that we've put out. So to Dan's point is that we can support numbers well into the $400 million without really changing any amount of capitalization versus what our current run rates and testaments are.

Mark S. Frey

And just to be clear, the 80% Dan talked about, doesn't include the capacity in the 8-inch in Korea because it has not come online yet. So it somewhat understates the leverage we have available to us going forward.

Christopher B. Danely - JP Morgan Chase & Co, Research Division

And as my follow-up, as I'm just looking through my notes, I think that it's now been 5 out of 6 quarters, when you guys have missed your gross margin guidance, and it's for a variety of reasons. So I mean, have you guys been able to sort of pinpoint what's going on there, any way you can give us confidence that you're going to be able to start hitting your gross margin milestones and get some leverage?

Mark S. Frey

Well, we have a lot of confidence in the projections we're giving. I think if you would pick one thing, I would say that this kind of double downturn in a row has been a challenge for us and we have typically started quarters with a bit more expectation and we're primed to not let inventory become a problem. So if we see a problem, we're going to attack the inventory and that has impact on our margins.

Mark S. Thompson

So I think that generalization would be, as Mark said, is there's been an unusually protracted inventory correction not just for us, but for the industry. It's a lot harder to be right in a down cycle. It's a lot easier to be right in an up cycle.

Operator

Our next question comes from Aashish Rao with Bank of America Merrill Lynch.

Aashish Rao - BofA Merrill Lynch, Research Division

A question on the consumer end market. I think you noted that you expect this business to grow in 2013. When I look at our model, sales fell about 30% last year and then you were, beginning the year in the first half down about 10%. And so if you expect this to grow, that would imply a very robust second half. I mean I think it's like 20% to 25% grow. I mean, are there any specific products or customers that could cause this Consumer business to rebound sharply?

Mark S. Thompson

So the consumer for us at this point is pretty heavily concentrated in advanced display. And so we wouldn't expect that to get a lot stronger this year, but it's also a relatively small part of the mix.

Aashish Rao - BofA Merrill Lynch, Research Division

Okay, got it. And then any -- following up on Chris's question earlier, I mean, the capacity you've had is close to $450 million or so. And now with the 6- to 8- inch conversion essentially ending, what kind of capacity do you think you will have exiting this year?

Mark S. Thompson

So it's -- foundry is always -- I mean, it's not unbounded, but it's what you're willing to pay for. So is your question looking at the internal capacity?

Aashish Rao - BofA Merrill Lynch, Research Division

Yes. Just trying to calculate, because I think in the prepared remarks or one of the earlier questions, somebody mentioned that there could be underutilization charges depending on how much you're able to load these converted fabs. So just trying to gauge what kind of leverage you're going to see on incremental gross margin front exiting the year?

Dan Janson

So Mark and I can take a stab at that one. So the way you need to think about this, Aashish, is usually that looking forward, we've got the 8-inch line coming up in Korea. What we've told you guys is that the costs associated with running that fab won't be any higher than what we're already absorbing in our P&L. And so Mark said a minute ago, we would expect that we would start getting some of that charge, some of those expenses to come off the P&L and become a tailwind to us in the second half. So it isn't going to get any worse, basically, from here. As far as what our revenue generation capability will be, it will be something north of $450 million. Now depending on how strong the market is, as Mark Thompson was saying earlier, that capacity coming online is pointed squarely at the high-voltage and mid-voltage market, which the bookings demand is quite strong for right now. So if we can roll that factory up, that new line up, then we have the ability to generate revenue well in excess of $450 million. And if we find that business is quite a bit slower, we've got a 5-inch line in Korea and that will be one of the things that we would eventually do is to start minimizing our 5-inch loads and running them at 8-inch and we'd get a cost advantage by doing that. So we've got a couple of different ways that we can run that going forward. But it isn't going to be any worse from a P&L perspective going forward. It can only get better.

Mark S. Thompson

I'll try to quantify a little bit. On the current trajectory, we're shipping north of -- shipping/building north of $400 million a quarter. We would expect, in the second half, to be back in solidly in mid-30s in gross.

Operator

Our next question comes from Steve Smigie with Raymond James.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

I was hoping you could talk a little bit about OpEx in more detail. I know you addressed it a little bit earlier, but it seems like the R&D spending is up quite a bit -- I mean, you're looking at about $43 million in June, even if I go back to when you had somewhat higher revenue like $433 million, you were below that. Since some of that's equity, you mentioned it's going to come off. But should we be thinking that you're sort of got a higher R&D level now given some of these new products you're working on. Because it looks to be 1 or 2 points higher than it has been in the past, or should that sort of work its way back down, say, as we get into September and December?

Mark S. Frey

Steve, that's exactly right. We do have a little more because of the equity comp. The growth is deliberate and it's invested in our sensor technology development, our silicon carbide technology development. And if you really go back in time, since Mark joined the company, we've roughly doubled our R&D investment as a percentage of revenue. It's been difficult because the cycle has been prolonged, but we have made choices to maintain those investments. And, at the same time, we've been lowering our SG&A.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Right. So should I think R&D sort of 11-ish percent, 12% going forward?

Mark S. Frey

I think 11.5% is our model. Now it depends on which product lines are growing because each product line has a different appropriate R&D level. But if you weight our product lines right now, 11.5% is about what I come up with.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Okay, great. And then you talked about new direct-to-OEM model, you're increasing that. Can you talk about some more implications to P&L and other aspects that you mentioned a little bit on the balance sheets for impacts? But does this change the overall revenue recognition profile also?

Mark S. Thompson

Well, I mean, inevitably, it will shift the revenue rec profile because revenue rec for direct business is pretty -- is simple in a sense that it goes out and then you never have to catch up, with the like you sometimes do with channel inventory. So we certainly will continue to do a portion of our business through distribution. We are actively shifting that, however, especially for some key mobile accounts and places like that where we simply can provide better service levels. And so it's really a supply chain model rather than trying to drive a shift in P&L. It has a transient effect on cash generation, but in the end, the cash generation should be the same. So it'll have a little bit of lumpiness as we make the conversion, but on the other side of it, it shouldn't look different than you're used to.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Okay, okay. And then just last one, so you talked about a lot of strengths in the high-voltage businesses. That's great to see that happening again. I see there's big seasonal lift that you guys get some of those air conditioners going into China. But it sounds like orders are continuing to be very strong. What is it that -- I guess I would've thought it would slow down a little bit after that seasonal uplift. So what's happening there that's allowing those orders there to stay healthy?

Mark S. Thompson

So there's a couple of things. There's a number of new designs that are occurring. But the other thing to remember is that the penetration rate of brushless DC motor in general and most parts of appliances, it's still a small minority of what people are building. So I just finished the survey of some, I'm assuming through Asia, some of our big appliance customers there, and they are all aggressively pursuing increasing share of brushless DC applications in their appliances. So it's continued share gain and none of the major players are north of 50%, 20%, 30%, for a lot of these applications is where the current penetration rate is. So there's tremendous amount left to convert. So it's not something in the context of the end market, which to your point can tend to be front half loaded, but that could be swamped by a couple of key platforms that convert across the year.

Operator

Our next question comes from Kevin Cassidy with Stifel, Nicolaus.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc., Research Division

There's a trend in the market of very low cost tablets and smartphones. Is this a trend that's helping Fairchild? And then my second question is how is it benefiting you, and is there any concern that this price pressure continues with these product of the low-end suppliers start to be competitors to you?

Mark S. Thompson

So it's the case that the -- what I'll call the attractive content that exists in a tablet is higher for us than it is actually in a standard notebook computer in large part because it's been highly standardized and highly commoditized in the notebook. But the fact that it's much smaller and typically lighter actually drives more demand on efficiency, and there's the tremendous focus on, for example, charge time right now, which creates a lot of very interesting content all the way from the innovations of the adapter, all the way through the battery management side of it. So the fact that they're so small and thin creates a lot more demand for much higher spec power management capabilities along that whole charge path. And so that's, from our viewpoint, the way we look at that. It's -- inevitably, if designs become static and standard, then there will be the trends on commoditization. So far, as far as the eye can see, there's tremendous pressure on increasing battery sizes and decreasing charge times, all of which actively work against both of those trends. So we see it continuing to be a very attractive space and one that we've got some of the best technology offerings in the world.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc., Research Division

And it's still your innovations that are helping the OEM bring their costs down to these sub-200 dollar price points?

Mark S. Thompson

Yes.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc., Research Division

And just one other questions about the bookings, with your lead times, are you getting orders outside your lead times, or are they just booking right through your lead times?

Mark S. Thompson

No. That -- we're not, and I think that's partly contained in the comment that backlog is not going up right. So typically, when the backlog is fine, people are booking well beyond lead times. So people are booking to lead times and then taking the order. So they're not speculative. So far, a very healthy dynamic.

Operator

The next question comes from Shawn Harrison with Longbow Research.

Shawn M. Harrison - Longbow Research LLC

I just want to clarify from you, finally, just on the incremental 8-inch fab cost. From my perspective at least, it sounds like maybe you had an extra 100 basis points earlier than expected this quarter, but there's no change to the subsequent quarters. You need to still probably expect, at least in the back half of the year, is those initial costs fall off some incremental start-up costs to be there, but nothing kind of out of the ordinary, in aggregate now, from the kind of last quarter?

Mark S. Frey

I'm not sure of the question, but first of all, let me say that the amount we spent on the qualification is about consistent with what we originally guided. Going forward, the qualification costs consist of essentially supplies and masks, plus engineers. And they all get expensed. When you turn the line on, the engineer is obviously are continuing expense, that you get good products out the back end of the line and therefore, you get leverage on the income statements. The mask section and the supplies that really go in the qualification process out of which you don't get good products, obviously, that goes away. So that changes sort of the profile of the financial impact once you go from qualification stage to ramp up. Now, clearly, when you are in the very early stages of ramp up, you get inefficient yields, you get other growing pains. But we would expect that within 6 months, it'd be pretty much in our groove on that line. Is that what you were asking?

Shawn M. Harrison - Longbow Research LLC

Yes, yes, in a poorly worded fashion. And I guess 3 clarifications. I'm -- some kind of a little bit late. Did you say exactly how much channel inventory, distribution inventory declined sequentially?

Mark S. Frey

We said a modest dollar amount, which lessens the days of inventory about the same.

Shawn M. Harrison - Longbow Research LLC

,

Okay. And then 2, other pieces. There was one -- I missed the update for your CapEx target the year. And then also just on the P&L, I noticed other income jumped up for the quarter quite substantially, I guess. What was the driver behind that?

Mark S. Frey

Yes, for the other expense, it was a $3 million equity investment that we impaired and that's in our GAAP statement. We adjusted that out for our adjusted statement. And what's your first question on -- I'm sorry?

Shawn M. Harrison - Longbow Research LLC

CapEx for the year.

Mark S. Frey

CapEx. $100 million plus or minus $10 million.

Operator

Our next question comes from Mike McConnell with Pacific Crest Securities.

Michael McConnell - Pacific Crest Securities, Inc., Research Division

I understand the lead time environment is still relatively benign, pricing is still benign. But specific to the commodity part of the business, which I know is a smaller part of the portfolio, have you seen any lead time movements in that part and any improved pricing dynamics in those types of product lines, D-PAK or rectifiers, anything like that?

Dan Janson

Lead times have been pretty stable because we're still -- we still have plenty of capacity. And pricing has been pretty consistent for, gosh, quite a while now, Mike. I mean we were between down 1% to 2% this quarter, it's almost identical in the last quarter, and that's how we're setting that for next quarter as well. So you're not really seeing anything unusual in the pricing either.

Michael McConnell - Pacific Crest Securities, Inc., Research Division

Okay. And that's kind of what's keeping the DCs not really building much backlog right now or willing to build much inventory just because they don't frankly need to because the lead times haven't really moved out.

Dan Janson

It seems that way, yes.

Operator

We have a follow-up question from Steve Smigie with Raymond James.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Sorry to beat a dead horse with the gross margin, but, as I out to Q3, I think you talked about a total of 200 basis points coming back from the 8-inch transition. I know you said not all at once, so should we think of that maybe in 150 basis points in Q3, then maybe you get some utilization pick up and is in a better product mix of -- should we be thinking to have at least a couple of hundred basis points in September. I guess there's 2 questions there, should it be at least a couple of 100 basis points and then the other part of the question is, of the 200 that you get back from 8-inch quals going away, can you get the bulk of that right away or is that more evenly spread?

Mark S. Frey

Well, it spreads with the load on the 8-inch line. But I think Mark said earlier, kind of slashing through all this, we'll have positive product mix, we'll have positive utilization, we'll have the impact of turning the line on. And with revenue in let's say with the $400 million on it, that translates to about the mid-30s. Obviously, there's additional leverage after the Q2 guidance.

Dan Janson

And that still has us underutilized, frankly. So we still have room to grow and certainly, in the second half, we turn on the 8-inch line in Korea. We've got plenty of headroom there.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Okay, great. And just another follow-up on -- so actually it's direct to OEM. Is that happening just because you're doing more and more handset/tablet type business, or is that sort of a deliberate decision that, hey, we prefer to do direct because we get better control of the supply chain or something like that?

Mark S. Thompson

It's both. If we look at -- for example, some of the really big handset players, they really want their strategic suppliers to have more control over their supply chains. And so there's that piece and that's probably the biggest piece of it as a kind of delayering of how that works. And again, it, as I said, tried to say earlier, it's not that there isn't a role for distribution, but it's a much more specific role that we're using increasingly. So aiming specifically at that particular a logistics service or something like that. So more menu-based approach to how we manage distribution.

Dan Janson

Okay. We have time for one more question, please. Are we all set, operator?

Operator

We have no further questions.

Dan Janson

Okay. Well, wonderful. Thank you again for all your interest in Fairchild.

Operator

This does conclude today's conference call. Thank you, all, for your participation.

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