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Freescale Semiconductor (NYSE:FSL)

Q2 2006 Earnings Conference Call

July 20th, 2006, 4.30 pm EST

Executives:

Mitch Haws, Vice President, Investor Relations

Michel Mayer, Chief Executive Officer

Alan Campbell, Chief Financial Officer

Analysts:

Jim Covello, Goldman Sachs

Joe Osha, Merrill Lynch

Glen Yeung, Citigroup

Sameer Doctor, JPMorgan

Vinit Sethi, Greenlight Capital

Douglas Freedman, American Technology Research

Ron Lee(?), UBS Warburg

Presentation

Operator

Good afternoon and welcome to the Freescale Semiconductor's 2006 Q2 financial results conference call. Operator instructions. I will now turn the conference over to Mr. Mitch Haws, Vice President Investor Relations. Sir?

Mitch Haws, Vice President, Investor Relations

Thank you and welcome to our Q2 2006 conference call. With me today as usual are Michel Mayer, our CEO, and Alan Campbell, our CFO. The earnings release and financial statements discussed today are available at the investor relations section of our website at Freescale.com. This call is being webcast live at our site as well. We will today make certain forward-looking statements. These statements are based upon our current expectations and assumptions, and we cannot assure you that these expectations will be correct due to inherent risks and uncertainties. Our actual results could differ materially from these statements. Please review our filings with the Securities and Exchange Commission for a detailed discussion of the factors that could cause our results to differ from the statements made today as well as other factors that could affect our future results. This presentation is being made on July 20, 2006. It includes time-sensitive information, and the company undertakes no obligation to correct or update any information presented on this call. During the call, we may also reference certain non-GAAP financial measures that we believe provide useful information about our operating performance. You'll find on our website the required reconciliations to the most directly-comparable GAAP number. With that, I will turn the call over to Michel.

Michel Mayer, Chief Executive Officer

Good afternoon. Welcome to our Q2 2006 earnings call. With me as always Alan Campbell, our CFO. This week marks the second anniversary of our IPO. And I can tell you that for the team here, those two years went very fast. In those two years, we've been working hard to achieve operational improvements and to get our portfolio to drive growth and to make us more competitive. There is still much work to do, but today's results demonstrate another quarter of solid improvement. Our sales for the quarter grew 9% over last year to $1.6 billion. But if you exclude Apple and the other discontinued businesses, our sales grew 14% year over year. The growth was driven across all three segments with particular strength in transportation and standard products and wireless, a six-year high for both segments. We continue to expand gross margin, increasing to 46% for Q2. And that of course is inclusive of option expense.

Revenue growth, the margin improvement and the operating expense control drove an operating margin of 15.7%, which for those of you who like statistics, is the highest since the early 1980s. These results I believe again underscore the value of our diversified revenue model. So let me talk about our three businesses, and I will start with TSPG, transportation and standard products. Our Q2 revenue was $697 million; operating margin was 21%. In automotive, we saw double-digit year-on-year growth in analog and sensors for the fourth quarter in a row, driven by advanced safety systems for vehicles around the world. In addition, we're seeing strong growth in our 16-bit S12 family of microcontrollers, which are the heart of these systems. Our Japan and Asia-based auto business that you might remember we've been focusing on for a while, while starting from a small base continued to grow with both increasing approximately 20%. Worldwide demand continues to look solid with projected vehicle growth still between 3 to 4%. Total big three vehicle inventory is slightly above target levels. However, normal summer production shutdowns and incentives will likely bring levels down within the quarter. The focus on improving our product portfolio and engaging more closely with distribution is generating significant results.

In particular, TSPG's distribution revenues increased significantly, led by microcontroller products. And for total Freescale, they grew by over $30 million sequentially. Our automotive business continued to garner recognition in the quarter. For a second year in a row, Freescale received the General Motors Global Supplier of the Year Award. We are the only semiconductor supplier to receive this GM award in its 14-year history. After the 2006 International Engine of the Year Award in Stuttgart, Freescale's customers came out on top again with eight out of the 12 winning engines using Freescale microcontrollers, including the Best in Show winner from BMW. We continue to gain momentum in both high-growth regions and applications within automotive. At a recent Original Equipment Suppliers Association meeting, it was predicted that 34% of the global auto industry's growth will come from China by 2010. Freescale's automotive systems lab in China is already securing design wins with transnational and indigenous customers, many of whom were among the 2,000 attendees at the Freescale Technology Forum in Shanghai this past May. Incidentally, our design wins in Asia-Pac for TSPG are up 50% across the whole portfolio year to date.

As I said, safety applications are a key growth driver for automotive. FlexRay, an automotive networking protocol that we helped pioneer, is gaining international support as the automotive networking protocol that will enable OEMs to build cars with next-generation safety critical features. After introducing the industry's first automotive qualified FlexRay device last year, we announced another industry first this May, the 32-bit PowerPC Microcontroller with embedded Flash and integrated FlexRay protocol. This combination of features on a single chip support the higher data transmission rate and full tolerance needed for advanced automotive control, such as steer by wire and collision avoidance systems. For consumer and industrial, which is the other major focus segment for TSPG, in Q2, we continued to execute on the controller continuum strategy we announced last quarter. This is a microcontroller roadmap, featuring pin-to-pin compatibility from 8-bit to 32-bit going through 16. We believe it will ease performance migration with common peripherals and development pools and is gaining significant momentum with our customers.

In May, we announced the first product built on the recently-announced RS08 core. This 8-bit KA family of products from the ultra-low-end entry point to our controller continuum with a sub-50-cent solution for applications with extreme space and price constraint. It's small enough to fit in the head of an electric toothbrush and is ideal for applications, ranging from motor control to healthcare products. This product family launch is setting records in Freescale for design wins, opportunities, Web information downloads and training seminar attendance. We were surprised at the reception we got in the marketplace for that product. It is the first of a wave of upcoming products in the 8-bits and microcontroller space. I've told you for several quarters that we have decided to fight back in that space; we are. Our distribution revenue shows that, and we are going to continue to get momentum in that space I am convinced.

Looking ahead for TSPG, we expect that the typical seasonality in automotives, driven by the shutdowns and vacation schedules in the US and Europe will impact Q3 revenues. But the impact should be somewhat mitigated by our consumer and industrial growth initiatives. Let me now switch to networking. That business generated revenue of $1,270 million(?), while delivering record operating margins of 28%. The transition of the Apple business is essentially complete with the actually zero revenue in those Q2 results. But if you look at those results with that in mind, the momentum in our networking business more than offset the impact of Apple and the divested clocks business. In fact, if you adjust for these items, revenues grew 13% sequentially, 9% versus the same period last year. Q2 revenues, both year-over-year and sequentially, benefited from strength across all sub segments, including wireless and wireline infrastructure, enterprise and home SOHO. When I say strength, I mean strength for Freescale. So in some cases, it is strength at the industry level. But in some other cases, it is more market share gain and our own strength.

Consistent with Q1, we are seeing growth in GSM infrastructure build-outs for us, which is driving our SVSP(?) communications processor revenues. In addition, we're trying to see revenues materialize from our wins in high-end printing with our host processors. The latest addition to our communications processor family, the PowerQUICC III, is growing revenues at a very strong pace, nearly doubling last quarter's level in applications, such as switching, routing infrastructure, base stations and DSLAMs. On the design win front, our PowerQUICC processors continued to gain traction in the consumer and server space. We teamed with three software partners to create three new SOHO consumer solutions built around new flexible MPC8349E, PowerQUICC II Pro reference platform, including a digital home reference center with Axentra, an Office in a Box with Jungo and a Media Server in a Box with Mediabolic. I apologize for our naming. But when you have more than 10,000 products to name, it's difficult to do something else than numbers. Residential gateway deployments led by carriers are accelerating demand for higher performance and integration. In May, at our Freescale Technology Forum in Asia, our networking business announced the MPC8323E family of PowerQUICC II processors, a product line optimized for the unique communications processing and connectivity requirements of residential and SOHO gateway applications.

We also introduced the industry's highest performance, fully-programmable digital signal processor, the MSC8144, a new quad-core DSP that delivers performance equivalent to a 4 gigahertz single-core DSP. It not only helps to make it possible for users to adapt media sessions as they change location, it's also well-suited for enterprise networking video applications, things like surveillance for instance, that are poised for growth. Our networking team received the Impact Supplier of the Year Award from Lucent for excellence in supply agility, technical support and best-in-class customer service in our relationship. And we're also honored for technical performance, quality service and responsiveness with the Most Valued Supplier Award from Huawei in China. Industry consolidation continued this quarter as evidenced by the recently-proposed merger of Siemens and Nokia's networking business, which follows the Alcatel-Lucent. These companies are both good customers with little overlapping product portfolio. Therefore, we do not expect a negative impact from this consolidation.

Looking ahead for the networking segment, as you know in 2004 and in 2005, we experienced significant declines in the second half. While we might expect modest pressure in Q3 this year, it should be much less pronounced than 2004 or 2005. Finally, let's take a look at wireless and mobile solutions. Our revenues there were $514 million, they grew 2% sequentially, 23% year over year. Operating margin in Q2 was 5%. While this compares favorably to a slightly negative margin a year ago, we are clearly far from our model product segment. That is reflecting our investment to develop our market position and maintain and increase technology leadership. Revenue growth this year have been driven by strength at both of our top two customers across our entire portfolio of base bands, power management, RF and power amps. The growth rate in power management has been particularly strong since Q4 2005, as we have ramped our historically-low share position to match higher levels of penetration. Even the higher share position that we have now attained, the pace of ramp will start to moderate in the second half of 2006. We also started shipping RF EDGE products to Sagem and another handset provider. In addition, our i.MX processor and power management parts began shipping to Toshiba in Q2, and we expect that revenue to ramp of course next quarter.

Leveraging the technology from the CommASIC acquisition last year, we announced a highly-integrated i.MX21 applications processor and LP1070 wireless LAN baseband processor solution. These (IEEE LDS 11 ABG?) wireless platform is intended for video and audio conferencing, video streaming and voice and video over IP applications, VoIP of course. Additionally, we announced the latest generation of ColdFire audio processors. This is a processor that reduces chip count and allows for the creation of even smaller form factor audio devices, such as CD and HDD-compressed audio players.

In addition to design wins that we are seeing, of course, I'm very pleased that Sandeep Chennakeshu joins us this quarter from E&P to lead our wireless business. Most of you know that he is one of the most respected executives in the wireless industry. You'll get to meet him next week at our Freescale Technology Forum and Analyst Day in Orlando. As I'm talking by way of those Freescale Technology Forums, I mentioned the one in Shanghai, the one in Asia Pacific. We're doing a few of them throughout Europe, and the one for the Americas is next week in Orlando. More commercial for those of you who have not signed the RSVP, you can still do it by the way. But, we are gaining momentum in those technology forums. All together this year, we're getting close to nearly 10,000 designers, partners, engineers attending those forums worldwide. And this year is becoming quickly a major way for us to interact with our ecosystem and the design community. I'm very proud of what we're building here in terms of collaboration interaction with the marketplace. So, to conclude on our wireless business, the first half was seasonally stronger for the wireless market in our business compared to what we've seen historically. We expect wireless revenues in Q3 to be flat to maybe slightly lower than Q2.

So if you look at our overall Q2 performance and our outlook, you can see that the diversity of our revenue base continued to provide us with stability and somewhat predictability in an economic environment where visibility is a little bit blurred. The strong reserve that we demonstrated in the first acquisition works well for another year of solid performance. Our growth initiative, we have been saying for two quarters now are starting to generate reserves as we get into the second half of the year. And our earnings growth continues to be strong. To put things in perspective, the first-half revenue growth excluding discontinued businesses was now 11% and our earnings per share nearly doubled over the previous year. But while we still have a lot of work to do, and I know that you must be tired of me saying that, but I'm not satisfied. I think that we can do better than what we're delivering here. With that being said, we believe our performance with yet another quarter of sequential improvement in revenues, net income, gross margin is a good way to mark the two-year anniversary of our IPO. With that, I would like to turn the call to our Chief Financial Officer, Mr. Campbell.

Alan Campbell, Chief Financial Officer

As our results show, we continue to make solid progress in driving financial improvement. Taking quarter revenues again were $1.6 billion, representing a 9% increase from the same period last year and a 5% sequential increase. Both TSPG and WMSG improved on a year-on-year basis as well as a sequential basis. As Michel mentioned, without the impact of the Apple transition, NCSG also increased. Our orders for Q2 were $1.57 billion, representing a 0.98 book-to-bill ratio. I will say that this is consistent with our historical seasonality with networking and transportation above one and wireless below one. Our gross margins were 46%, up 500bps from Q2 of '05 and up 70bps from last quarter. This improvement was driven by a combination of revenue growth, segment mix as well as product mix. But distribution revenues, which have historically represented higher margins, increased again for Q2 and represented 15% of our total sales, up from the 14% last quarter and 13% a year ago. Net income was 16.3% of sales or $260 million. This performance compares very favorably to the 122 million or 8% of sales in the same period last year as well as to Q1 of $212 million. Keep in mind the Q2 results do include a favorable discrete tax event of $14 million, which I will discuss later.

Our operating expenses in total were $484 million. Stock option expense in Q2 was $11 million, split across SG&A and R&D, exclusive of the $4 million of expense included in our gross margin. Our SG&A as a percentage of revenues was essentially flat with last year and last quarter. We do continue however to invest and go to market in sales activities. And as a result, the absolute dollars increased slightly compared to last year. Our R&D was 18.7% of revenue, which on a percentage basis is down from last year and last quarter on a dollar basis is relatively flat. We do continue to execute on our strategy of adding resource primarily in low-cost regions. Our net interest income in Q2 was $8 million compared to income of $1 million a year ago and $12 million last quarter. The sequential decline was driven by a change in returns associated with a retiree healthcare plan. An increase over last year was driven by a combination of increased cash and increasing returns. Operating margins, again as Michel mentioned, were 15.7, which is the highest level in the last two decades. But depreciation and amortization represented just under 10% of sales, and this compares to 12% a year ago and 10.5% in the last quarter.

GAAP EPS was $0.61 per share, which didn't include $0.03 of option expense as well as a $0.03 favorable from a tax item I discussed earlier. Excluding that, the tax items diluted earnings per share for Q2 were $0.58, which compares obviously very favorably to last year and last quarter, where EPS was $0.29 and $0.50 per share respectively. During Q2, the company recorded 14 million in onetime, non-cash tax benefits associated with reducing its valuation allowance by 10 million in one of its foreign entities and a $4 million tax benefit associated with changes in tax legislation in the state of Texas. Our estimated annual effective tax rate excluding these items is currently at 5% with a cash tax rate approximately half of that. Our tax rate continues to benefit from the utilization of the deferred tax asset in the US. We expect this to continue for the remainder of 2006, and we haven't yet determined when any reversal of our deferred tax assets we occur. Or for modeling purposes, we expect the 2007 rate to be in the mid-20 range. In Q2, we continued to execute on our share repurchase program and we bought back an additional 3.2 million shares. The fully diluted share count is 424 million, down from 425 million last quarter. In addition to the share repurchase, we completed the redemption of a 400 million of floating rate notes this week. This is another prudent use of our cash as we manage our capital structure. The bonds were redeemed at 102. And inclusive of fees, there will be a $15 million charge to interest expense in Q3 associated with this transaction. Net interest expense is expected to be favorably impacted by approximately 3 million per quarter as we go forward.

Now let me just briefly summarize some of the key metrics associated with our segments. Transportation and standard products reported a Q2 revenue of 697 million, which was up 7% sequentially and on a year-on-year basis. The supply challenges that we experienced in Q1 are largely behind us, but they still exist across a few selected technologies. We are working our way through these, with capacity coming online both internally and out of boundaries over the next few months. Operating margins for Q2 was 21%, compares very favorably to the 12% reported in the same period last year and last quarter's 20%. The revenue growth and continued improvements in our portfolio mix including higher distribution sales drove most of the margin improvement. Our networking revenues were $370 million, which represented a 6% sequential increase, but was down 4% versus the same period last year. Q2 operating margin was stronger than usual at 28% compared to 22% last year and 23% last quarter, again driven by optimal product mix within the networking portfolio as well as the previously-discussed operational improvements.

Lastly, our wireless revenues in Q2 were $514 million, which is up 23% a year ago and essentially flat sequentially. The Q2 operating margin was 5%. This compares favorably to last year and is a slight decline from last quarter. Margins were slightly impacted by the product mix, continued ASP pressures and as Michel mentioned earlier our continued investment in the business. If I can now discuss briefly some of our balance sheet items, cash or short-term investments and marketable securities balance at the end of Q2 was $3.2 billion dollars, which grew by $121 million from the last end of last quarter. That also includes $100 million in share repurchase, and it also includes a larger than historical capital expenditure amount. We continue to execute well on our working capital. Our DSOs and payable days in the quarter were 54 days and 62 days respectively. And this compares to 32 and 62 in Q1. Inventories continue to be well-managed. We did increase slightly by 11 million. Our days dropped to 72 days from 74 days in the last quarter. As we enter into the seasonally weaker third quarter, particularly in TSPG, we remain diligent on managing the supply chain in terms of waiver starts both internally and the foundry partners. As we stated earlier, sales into our distribution channel increased significantly and re-sales remained strong. Distribution inventories are slightly down from their historical averages and remain below the nine weeks of sales.

Our capital expenditures were $227 million or 14% of sales in the quarter. As we mentioned last quarter, we are increasing capacity in certain technologies in response to strong demand signals in various markets. We would anticipate that capital investment as a percentage of revenues will continue approximately at this level for another quarter or two before falling back to the near 10% level. Looking ahead into our third quarter of 2006, we expect revenues to be in the range of $1.52-1.625 billion. With the seasonal slowdown in revenues, we would expect gross margins to be essentially in line with the same level that we experienced in Q2. Our Q3 2006 results will include approximately 14 million or $0.03 per share of expense associated

with the redemption of the 400 million of the Company's floating rate notes. So that concludes our remarks. Now, we will be happy to pass over to the operator and entertain your questions.

Questions and Answers

Operator

Operator instructions. Your first question comes from Jim Covello of Goldman Sachs.

Q – Jim Covello, Goldman Sachs

Good afternoon guys, thanks very much and congratulations on continued very good results. A couple of questions and I apologize because I had to hop off for a second in the middle of the comments. But over the last several years, you have been highlighting that the big growth opportunity for the company going forward was going to be in the wireless space. Can you comment a little bit on that if the plans have changed at all, given the relative growth rates that we've seen in wireless versus the growth rates that we've seen in the other segments? And then I have a quick follow-up. Thanks.

A – Michel Mayer

I'm not sure that I understand what you mean by has the plan changed. If you look at wireless, it did grow 23% I think year over year, so it is our fastest-growing segment out of the three clearly. Now if you are saying that we're also growing clearly in particular in TSPG in analog, in consumer and industrial and in those faster growing segments if you want that complement of commodities, yes absolutely. We never said that we only want to grow in wireless. It happens that historically and I guess because of our association with Motorola, people tend to focus more on our wireless business and that's something that's normal. Now as everybody understands, our largest business is TSPG. And we've been repeatedly saying that we will have the initiative in analog, in consumer and in industrial, in distribution for microcontrollers, in fighting back microchip that we're going to generate some growth. So wireless remains clearly a priority. As I said, we are investing to develop that business. We're gaining share at a major customer, but we continue to be committed to growth outside. But at the same time, we clearly have profitable growth opportunities in these other businesses and we're very focused on it.

Q – Jim Covello, Goldman Sachs

Then just sticking on the wireless business for a second, obviously, your biggest customer had very significant growth in the quarter. Your sequential growth was not as robust as it has been the last couple of quarters. Obviously, it has been very good the last couple of quarters. Is there some inventory drawdown going on in the part of your customers or is there another dynamic at work there?

A – Michel Mayer

Obviously, as I've said repeatedly, given the current concentration that we have in that business, there's so much I can give in terms of detail. But, if you observed the historical pattern, we've not always tracked directly what Motorola is doing for obvious reasons there are that they need to buy the components before they build the phones and then they sell them. All-in-all, if you sit back and look at the patterns over several quarters, we do track them. If you look at the growth in volume, we do track pretty well what they are doing. And then you have things like inventory build and things like that but nothing that is of concern to us at this point.

Operator

Your next question comes from Joe Osha of Merrill Lynch.

Q – Joe Osha, Merrill Lynch

Good afternoon gentlemen. Great numbers, thank you. Two questions. You've talked a lot about sort of the individual trajectory of margins for your businesses, which is fine. But as I looked at the total, I'm just wondering what type of longer-term targets you have. You've made great progress in particular with TSPG, but that's a 20% margin business now and network computing is even higher. So my first question is, is there some operating margin leverage left for you other than in wireless?

A – Michel Mayer

The short answer is yes. Let me ask Alan to elaborate a little bit, and then I'll complement maybe what he's saying.

A – Alan Campbell

This question interestingly was asked last quarter. And we said last quarter, we continue to raise the bar. Michel mentioned in his commentary that we continue to be dissatisfied. And second quarter, we continued to improve on our operating margins. I always talk about operating in building blocks, and we've achieved another building block. We really do believe there is opportunity in these businesses to continue to improve, particularly in their transportation business. So, I think it's important to say that we did give guidance of 200 to 300 basis points improvement in margin at the end of the fourth quarter, and we believe that we are making good traction to continue to achieve that.

Q – Joe Osha, Merrill Lynch

Obviously, there are companies out there like microchip and comparable businesses with 30% operating margins in that division, could we see TSPG at a 30% operating margin someday?

A – Michel Mayer

I don't think so because we have a large automotive business that - I mean Microchip as we all know has a much larger business going through distribution. But something in between is not out of line as we grow Microchip comparable business if you want. So the growth initiatives that we have in TSPG are all focused on segments that are above current TSPG margin. As the relative weight of those businesses grows, yes, you have some further potential improvement. And of course as you mentioned obviously in wireless, we are clearly in an investment mode and I think everybody understands that. This is not our target model, and so that is going to generate as we get closer to a steady-state model. Over time, this is going to generate perhaps a margin improvement. But if you think back a little bit and look at the corporate level and forget about the various businesses, there are still ongoing opportunities for efficiencies in margin improvement. As you benchmark us with the values best in class out there in the various businesses where we play, you can have a feel for the fact that we can still improve. Now, are we going to get going forward the same rate of improvement that we've had in the past two years? Probably not. Otherwise we would deserve a much higher multiple. But we have good improvement in front of us.

Q – Joe Osha, Merrill Lynch

Then I will go away this last question. You are hearing great news from your distribution partners, which is great. Experience tells me that when I see industry unit growth declining and distributors are happy, that's a preface to them handing you a nasty surprise. So perhaps for Alan, how are you staying on top of these guys, especially in terms of your revenue recognition policies to make sure you don't get handed a nasty surprise here?

A – Alan Campbell

We've said again and I think you are aware since the IPO, we recognized revenue on a ceiling basis and we do feel comfortable with that. We have a tremendous amount of detail and granularity we look at. But one of the key metrics is to ensure that the inventories do not go out of control within our distribution. In fact, if you look at inventory in Q2, even despite the fact that revenues significantly increased, the Q2 inventories of distribution are down on average 6 to 8% from the historical last year. So, we feel very comfortable actually, we continue to manage and closely watch it.

A – Michel Mayer

The way we manage it is very clear. We monitor line by line the resale at distribution, and so we don't blindly sell to them. We know exactly what comes in, what comes out, and we monitor their inventory level. When we see the re-sales grow at faster or equivalent sales to what our sale to them is and we're satisfied that we're not building a bubble and we also have, I mean as we monitor the success of some of those products in the field and look at the engagement on a qualitative basis, if you want, I think we have a pretty good feel that we are gaining action in some of those spaces. And we understand the applications. We understand where in China for instance or in Asia-Pacific, we know we can rationalize where we're getting share back. I mean none of the indicators at this point, point to over hitting or double booking or some other traditional things. Now can we have a slowdown in front of us at some point? Of course. We all share the same crystal ball. But we clearly don't see it at this point.

Operator

Your next question comes from Glen Yeun of Citigroup.

Q – Glen Yeun, Citigroup

Sometimes, you give us your backlog coverage at the end of the quarter. I would love to know what that is and maybe any commentary around order trends over the course of the quarter.

A – Michel Mayer

Alan, go ahead.

A – Alan Campbell

Yes, the backlog at the beginning of the quarter historically is in the range of mid-80s to mid-90s. We haven't seen any change as we've entered into Q3 for that backlog. Also, the seasonality of our shipments over Q2 by month was very typical of what we've seen in prior quarters. So there hasn't been any real change in backlog coverage relative to our historical levels.

A – Michel Mayer

Our book-to-bill is better this year than it was last year at the same time. And if you look at the segments I think can give maybe some color. I think it's fair to say that we are seeing some strength in our networking order rate and backlog here, which is somewhat good news. Because as I said, if you remember, we had a pretty significant reduction in revenue in that space in both 2004 and 2005 Q2 to Q3. It clearly doesn't point at that this year.

Q – Glen Yeun, Citigroup

Michel, maybe just asking you to step back as the CEO of a major company in just in the world of general, forget about semis. And maybe give us your sense as to how you see the end market shaping up. And I am most interested to hear what you're thinking about on handsets. I think you've explained to us a little bit about networking. I would like to hear that as well but certainly enhances how you think the end markets look from your vantage point?

A – Michel Mayer

I'm going to try to give you a generic view, which is what you want. So, I want to make sure you all understand that I'm trying to…

Q – Glen Yeun, Citigroup

Industry view, right?

A – Michel Mayer

Yes, stay away from what's happening specifically at Motorola as usual. But we participate (in general?). I think the handset market is okay in a sense that it is probably - again, my Crystal ball is worth what it's worth. But I mean is it worth 930, 950 million handsets or something like that? So it's going to be pretty when you sit back and look at it both from a year-over-year and I think it's going to be a relatively healthy market. Now, was there a little bit of expectation built in the first half of the year that it could even go beyond that? Maybe. Has there been a little bit of overheating in the supply chain? A little bit. A little bit of correcting of the autopilot of the supply chain. I think, by the way, somewhat healthy in a sense that I think if you observe the corrections of the supply chain end-to-end, it's happening a little bit faster than it's happened in the prior year. But I think it's a positive because I don't believe that there is much inventory building at any point in the chain. A little bit here and there. But I think again, the auto autopilot is correcting pretty quickly. So, I think I mean it seems okay. Clearly 3G, WCDMA continues to - I don't want to say be anemic but to not grow as fast as people maybe were expecting. As you know because you and I have had the discussion several times, I continue to repeat the same thing over and over, which is that it's going to take off when a 3G handset will cost the same thing as an existing 2 or 2.5G handset. And when that comes, people will buy that because why not? So there is increased volume. It's good business but there's not a hockey stick yet on that. But I think it's nothing wrong. So I think it's the handset I see as okay. I think we are all - you and us in the industry - a little bit cautious on what could or would happen to the consumer in the second half of the year and watching very carefully the impact of oil and CTI and all those things. I mean we all follow the same thing. But frankly, in terms of reality in the marketplace so far, we do not see signs of that potential slowdown at this point. Now I'm careful and cautious and I think we are all watching, and visibility is certainly not that great for fourth quarter. But it's in part because a lot of the actors again on the supply chain are a little bit cautious and trying to read. But again in the reality, it doesn't feel like it's nose-diving at all. Did I give you…

Q – Glen Yeun, Citigroup

Yes that's very helpful; I appreciate that.

A – Michel Mayer

Color again, okay, thanks. Operator, next question?

Operator

Your next question comes from Chris Danely of JP Morgan.

Q - Sameer Doctor, JP Morgan

This is Sameer for Chris Danely. Great results, guys. Just had a few questions, the first one primarily on microcontrollers. You know you mentioned about competition in 8-bit and in the cross industry also. Other competitors besides Microchip are trying to encroach into your leading positions in 32-bit and 16-bit. Could you help us understand what are the strategies that you are looking towards defending those positions? And then I have some follow-ups.

A – Michel Mayer

The strategies are multiples. At the product level, we believe that we have a stronger offering across the board, and that's where our controller continuum strategy is coming from with a 8, 16, 32-bit pin-to-pin compatible ecosystem, and that's something that we believe is a differentiation that our competition does not offer. And again, as I said, we're getting very favorable reception from the marketplace and our customers as they understand that it is a way to preserve (inaudible) investments and have the benefit of a player. You have to sit back and look at the level of revenue that we have in those spaces and therefore the R&D that we can inject and compare that to the equivalent R&D of our competitor and draw your own conclusions on who's going to come out with the most complete product line and when. So it's one thing to fight at the low end on a segment that was a little bit abandoned by Motorola Semiconductor at the time. And it's another thing to fight a battle across 8, 16, 32-bit against a rejuvenated, I think more agile competitor, so product offering and controller continuum. And then from a marketing point of view increase and that's where the rejuvenation comes into play. Across the board I think we are doing a better job. We've increased our steel application engineers in that space significantly. We have improved significantly our season fees, our ease to do business with distribution. And again, you'll find those are steps that we took out of the gate after the IPO but it's taking time, and we are now starting to see the first benefits. So I could go on and on but I'm trying to give you somewhat of a short answer. You said you had a follow-up?

Q - Sameer Doctor, JP Morgan

In terms of just future gross margin expansion, you had elaborated on a few points in the last conference call. Given the fact that your capex is slightly ticking up, you know how many more basis points do you feel you can get with not too great revenue growth?

A – Michel Mayer

Not too great revenue growth is your judgment. We will see what the industry numbers are this quarter and we will compare notes. On the capex side, it's going to be a positive in fact because we are in the business to do profitable growth and to continue to increase our gross margin. And so we're directing our capex for instance at spaces where we make a judgment that we have enough certainty on the demand and the fact that by taking things inside for instance and growing inside – an example, assembly and test for instance where we have our ratio of outsourcing is significantly higher than our competition. There are spaces where we have enough certainty in our demand that by bringing inside, we are clearly going to increase our gross margin. So you should understand that our capital investment in fact is one of the levers that we're going to use going forward to generate further gross margin improvement. And then, I mean, I highlighted several times in the past calls where we still have improvements coming in terms of yields, in terms of operational effectiveness, in terms of R&D effectiveness. We continue to manage our portfolio. We continue to push to grow where it is above depressed gross margin. And so back to your comment on revenue growth, what's more important to me frankly is to have extremely profitable growth than to have growth for the sake of having revenue growth. And that's why we've been walking away from it, when we talk about those continued businesses, we've been walking away from low-margin printers, quasi-foundry type of businesses and things like that. Every day, we're walking away from business that we could take to simply drive the top line up but that's not what we're building here. We're building for the long run a global leader with high margin businesses.

Operator

Your next question comes from Vinit Sethi, of Greenlight Capital.

Q - Vinit Sethi, Greenlight Capital

Two questions, could you comment on the capacity utilization in the quarter? Then second, could you further explain some of the items, which led to the other income being lower sequentially and maybe help us in terms of thinking about how to forecast the other income line?

A – Michel Mayer

Yes, let me turn to Alan.

A - Alan Campbell

The capacity utilization first of all is still in the low 90s, which hasn't moved much from the prior quarter. In terms of the items in the other P&L, there's a couple of items that really show in there that's the utilization variation and the growth facility that we have (for ST and Philips?). There's some corporate R&D and there's some onetime charges. This month, the number was $21 million. And for modeling, I think it's reasonable to expect it to remain at that type of level $21-25 million per quarter.

Q - Vinit Sethi, Greenlight Capital

I'm sorry. I actually was talking about below the operating income line. The interest income gain on sales from investments and

then the other net item, which was a total of 6 million.

A - Alan Campbell

Sorry, I thought you were talking about the other segment. We have another segment. The net interest income was down in the other by $4 million. That was associated with the returns in the retiree health plan that we had. When the whole market went down, the returns also went down. And for certain accounting reasons, they are currently classified as interest. So that was the biggest vxariance from first quarter to second quarter.

A – Michel Mayer

I guess his question is so going forward, what's the model?

A - Alan Campbell

Going forward, what we've said is on from an interest income obviously, it will depend on what our cash projections are and what the returns and interest rates are going to do. As a result of the redemption of the note, we do expect our interest income to improve by about approximately 3 million per quarter. So in that line, you would expect an improvement of 3 million.

Q - Vinit Sethi, Greenlight Capital

But it's 3 million from that item alone, but there should be a reversion back related to the retiree issue in Q3?

A - Alan Campbell

Yes.

Operator

Your next question comes from Doug Freedman, Am Tech Research.

Q - Douglas Freedman, American Technology Research

Nice results. If I could, can you disclose what percentage of the wireless revenue was from QUALCOMM?

A – Michel Mayer

No, we do not disclose that. Sorry. And that is as much as our customer's request than our own decision.

Q - Douglas Freedman, American Technology Research

I guess can you say if it's changed significantly from time in the last couple of quarters?

A - Alan Campbell

There's not been a material change in the customer profile within our wireless segment.

Q - Douglas Freedman, American Technology Research

Still looking at wireless, I know the long-term goal on that segment is 10% operating margins. Is there a timeframe that we should sort of look for that to start improving? I mean the trend on that has been up. And now, we're seeing it sort of drift down on us a little bit here.

A - Alan Campbell

We haven't given specific timelines on that because I think as we didn't give specifically timelines on the other businesses. But we really do believe that the 10% plus is very reasonable. But again, we haven't given timelines on it. And a lot of it is driven by a function of product mix, as Michel articulated earlier. You know the UMTS, 3G markets have not been taken off, and that's got some nice returns for us. So a lot of it is product mix, and that's partly why the fact that we can't control that market we don't basically give a timeline. But it is our conviction within the organization for continued improvement within the business.

Q - Douglas Freedman, American Technology Research

I guess then moving back over to the transportation and standard products business, I know that you guys have been pushing for pretty aggressive design win programs for distribution. Can you give us some color or clarity on how that is going and if that program is working the way you like and if it's going to continue?

A - Alan Campbell

I actually don't have the data, I probably need to get back to you on the specifics on the data. But I can tell you that design wins in general are increasing, probably at a rate of 10%. But there's other metrics there that I just don't have at my hand, but I'd be happy to get them and get back to you.

Q - Douglas Freedman, American Technology Research

All right, that's perfect.

A – Michel Mayer

What's your question exactly? What color are you trying to get? Let me try to see.

Q - Douglas Freedman, American Technology Research

I know you've been working to improve your percentage of sales through distribution and gain back share in the microcontroller market in general and just wanted to hear if it was going as expected and if it was meeting your expectations.

A – Michel Mayer

So we did cover part of that, that's why we're trying to understand what you mean. But we did see a $30 million increase sequentially on our distribution revenue. And yes, we're very satisfied with the progress in that program. Maybe we didn't state that clearly. But distribution is one of the reasons that our revenue growth is starting to get momentum.

A - Alan Campbell

Yes, distribution did improve from 13% to 15% of our revenue, which is a significant growth. So there's absolutely no doubt that we're getting traction there.

A – Michel Mayer

I'm not sure you followed what we said, so let me repeat it just briefly. At the same time that we've seen a net increase, we've been monitoring re-sales and so our inventory level at distribution have actually gone down slightly quarter over quarter. Operator, can we have the last question?

Operator

Your last question comes from Ron Lee(?) of UBS.

Q - Ron Lee(?), UBS Warburg

Good job. Michel, I'd like to ask you this question about your 2.5G baseband business. Now obviously, Motorola has been doing very well, shipping a lot of units, 2.5G cell phones based on your platform. But you're not benefiting really from it because of the ASP pressure as you're shipping really the same old products to them last few quarters. Do you have a strategy to really improve your cost? Actually lower your cost so that you get better margins maybe by being more aggressive on the yield improvement or shifting more to 90 nanometer and things like that?

A – Michel Mayer

So it's a good question. Let me give you two points. The first point is I take a little bit of an exception to the fact that we're not benefiting. I mean we do have a 20-plus% revenue increase okay year over year. Motorola, if you look at them, also have a 28% I think. I don't have the numbers in front of me. But while they did ship I think 44, 45% units up year over year, the actual revenue was in the high 20s and so we are also in the 20s. So it's not as decorrelated as it might seem at first. But now that being said, I'm not satisfied with our margins on the wireless business. And yes, we are working to accelerate not only 90 but 65 nano in product introduction. And we don't have time here to go into too much details. But if you want, we can pull up off-line. We do have clearly a plan to improve our margins in our wireless business, and those investments related to that again are part of the reasons that we consider we're in investment phase right now. And for instance, we are just one of the numerous things now, as we are ramping up our 65 nano production, we are paying for the cost (inaudible) part of that. That's one of the things that's impacting our margins. But we believe it's important to be as quickly as possible in the most advanced technologies. So thank you very much. I apologize we have to run because we have a whole bunch of interviews lined up, and we are a little bit behind here. So thank you very much, and I hope to see all of you in Orlando. It's going to be hot, but it's also going to be very interesting. So I hope to see you there. Thank you very much. Bye-bye.

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Source: Freescale Semiconductor Q2 2006 Earnings Conference Call Transcript (FSL)
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