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Advanced Micro Devices, Inc. (NYSE:AMD)

Q2 2006 Earnings Conference Call

July 20, 2006 5:30 pm ET

Executives

Hector Ruiz - Chairman of the Board, Chief Executive Officer

Dirk Meyer - President, Chief Operating Officer

Robert J. Rivet - Chief Financial Officer, Senior Vice President

Thomas M. McCoy - Executive Vice President, Legal Affairs, Chief Administrative

Henri P. Richard - Executive Vice President of Worldwide Sales and Marketing

Mike Haase - Director, Finance and Investor Relations

Analysts

Tim Luke - Lehman Brothers

Adam Parker - Sanford C. Bernstein & Company, Inc.

Mark Edelstone - Morgan Stanley Dean Witter

Eric Gomberg - Thomas Weisel Partners

Joseph Osha - Merrill Lynch

Krishna Shankar - JMP securities

Mark Lipacis - Prudential

Michael McConnell - Pacific Crest Securities

Michael Masdea - Credit Suisse First Boston

Jim Covello - Goldman Sachs

Glen Yeung - Citigroup

David Wong - A.G. Edwards

Shawn Webster - JPMorgan Chase & Co.

John Lau - Jefferies & Co.

Presentation

Operator

Good afternoon, ladies and gentlemen. My name is Jeanie and I will be your conference facilitator today. At this time, I would like to welcome everyone to the AMD second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer period.

(Operator Instructions)

It is now with great pleasure to turn the floor over to your host, Mr. Mike Haase, Director, Finance and Investor Relations. Sir, you may begin your conference.

Mike Haase

Thank you, and welcome to AMD’s second quarter earnings conference call. Our participants today are Hector Ruiz, our Chairman of the Board and CEO; Dirk Meyer, our President and COO; Bob Rivet, our CFO; and Henri Richard, our Chief Sales and Marketing Officer.

This call is a live broadcast and will be replayed at amd.com. The telephone replay number is 877-519-4471. Outside of the United States, the number is 973-341-3080. The access code for both is 7600579.

The telephone replay will be available for the next 10 days starting at approximately 5:00 p.m. Pacific Time tonight. In addition, I would like to call to your attention that our third quarter 2006 earnings quiet period will begin at the close of business Friday, September 15th.

I would also like to remind everyone that our next Analyst Day is scheduled for the morning of December 14th in New York City. We will provide you with more information closer to the event.

Before we begin today’s call, I would like to caution everyone that we will be making forward-looking statements about management’s expectations. Investors are cautioned that our forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from our current expectations as set forth in the forward-looking statements.

The semiconductor industry is generally volatile and market conditions are particularly difficult to forecast. Because our actual results may differ materially from our plans and expectations today, I encourage you to review our filings with the SEC where we discuss in detail our business and the risk factors that could affect us.

You will find detailed discussions in our most recent SEC filing, AMD’s quarterly report on Form 10-Q for the quarter ended March 26, 2006.

With that, I will turn the call over to Dirk Meyer.

Dirk Meyer

Thank you, Mike. In spite of our continued strong year-over-year growth, the second quarter leaves us unsatisfied as we did not meet our sales objective.

On the positive side, we achieved 53% year-over-year sales growth, 57% gross margins and recorded the 12th consecutive quarter in which the year-over-year microprocessor sales growth exceeded 20%.

Even in this challenging market environment we saw significant progress towards our goal to expand and strengthen our relationships with our largest global customers.

Highlights of that progress include:

  • Dell announced their intention to offer dual-core AMD Opteron based servers by the end of the year;
  • Lenovo announced plans to offer AMD powered ThinkCentre commercial desktops;
  • Fujitsu Siemens computers launched two new AMD-based commercial offerings;
  • Sun Microsystems launched AMD powered commercial clients; and
  • We continue to enjoy strong commercial growth across all product categories with Hewlett Packard.

Our strong gains with our biggest global customers were due in large part to the continued adoption of AMD Opteron processors.

Once again, we set a record for AMD Opteron revenues, with increases of 26% sequentially and 141% year-over-year.

ASP has increased and we believe we continued to gain unit and dollar share, as the server market continues to embrace AMD solutions across a broader industry footprint.

We made further progress in manufacturing, allowing us to efficiently balance customer demand with the unique dynamics of our industry. More specifically, Fab 30 operations continued to perform at industry-leading levels. Fab 36 is ramping ahead of plans.

We commenced shipment of products out of chartered semiconductor, and we are on plan to ramp 65-nanometer production in the second half of this year. We expect to do so at mature yields.

Furthermore, we have announced plans to further expand production capacity at Fab 36, convert Fab 30 from a 200-millimeter to a 300-millimeter toolset, and accelerate our processor technology roadmap with an aggressive transition to 45-nanometer within 18 months of 65-nanometer production.

AMD also received a non-binding, $900 million cash incentive package from the State of New York to build a wafer fabrication facility in Luther Forest, New York. On behalf of AMD, our customers and partners, I want to thank the State of New York for its tremendous commitment.

In early June, many of you attended our technology analyst day, where we detailed our Torrenza strategic initiative. Torrenza represents a significant shift for our industry. It is the industry's first open x86 innovation platform, enabling processor and hardware vendors to innovate within a common ecosystem.

For our customers and partners, Torrenza will create an opportunity for differentiation and value that is unprecedented in our industry.

Leveraging the scalability of the direct-connect architecture, we also plan to demonstrate our next generation microprocessor core in a native quad-core implementation before the end of the year.

In summary, while we cope with short-term disruptions in the market, we did not and will not lose our focus on executing our long-term strategy. Our global customer base is growing, supported by our industry-leading manufacturing execution and truly game-changing technology.

I would like to ask Bob to review the results of the quarter, as well as to provide the outlook.

Bob Rivet

Thanks, Dirk. As we stated in our press release, and as Dirk just commented, we are disappointed that we did not hit our top-line guidance. However, we were very pleased with several elements of the quarter.

As a result of the Spansion IBO, my comments comparing the second quarter of 2006 to the second quarter of 2005 do not include the results from what was our memory product segment.

Second quarter sales of $1.22 billion were down 9% compared to the first quarter of 2006.

Sales were up 53% compared to the second quarter of 2005, driven by growth in all segments. Geographically, processor sales were sequentially higher in China, offset by lower sales in North America and Europe.

Consistent with normal quarterly seasonality, our total microprocessor unit shipments were down 4% sequentially, driven by lower shipment of client units and lower client ASPs.

High-volume desktop processor ASPs were challenged in the quarter due to deep discounting in the marketplace. In some cases, we walked away from that business that did not make sense.

We were pleased by the growth in our server processor business, recording a sequential double-digit percentage unit growth and single-digit percentage ASP growth. We believe we once again took market share in the server space, with 141% year over year AMD Opteron sales growth, and sequential growth of 26%.

We are well on our way to achieving our year end goal of more than 30% server market share.

Gross margin was a solid 56.8% and was within our long-term guidance, down slightly from the record of 58.5% in the first quarter of 2006. This was largely due to lower desktop processor ASPs.

Total operating expenses, which include R&D and SG&A, were up 13% from the prior quarter, primarily due to the extra week of operations in the quarter and increased marketing expenses in support of our long-term goals to acquire new customers, expand business with existing customers, and increase commercial sales.

Operating income of $102 million was down from the prior quarter and an increase in the second quarter of 2005.

Net income for the quarter was $89 million or $0.18 per share. These results included:

  • Non-cash employee stock-based compensation expense of $18 million, or $0.04 a share;
  • A $12.5 million loss, or $0.02 per share associated with our 38% ownership in Spansion LLC; and
  • A net gain of $10 million, or $0.02 per share associated with Spansion LLC’s repurchase of its 12.75 senior subordinated notes.

Now let me turn to the balance sheet.

Our cash balance was $2.5 billion in the quarter, down $100 million from the first quarter, due largely to increased capital expenditures associated with investments in Fab 36.

Inventories increased $68 million as planned from the first quarter, driven by the outstanding ramp of capacity and mature yields of Fab 36.

Days of inventory ended the quarter at 76 days.

Now, let's talk about the outlook.

AMD's outlook statement for the balance of the year is based on current expectations. The following statements are forward-looking and actual results could differ materially, depending on market conditions.

AMD expects demand for its products to be seasonally strong in the second half of 2006. We expect third quarter sales to increase sequentially.

As a reminder, we will return to our typical 13-week quarter for third quarter.

Operating expenses for the third quarter are expected to be flat from the second quarter.

Non-cash stock-based compensation expense in the third quarter is expected to be approximately $20 million at the current share price.

Depreciation and amortization will be approximately $200 million in the third quarter, and $800 million for the year, down slightly from our guidance of 2006 of $825 million.

We expect 2006 capital expenditures will remain at our prior guidance of approximately $1.7 billion. 2007 capital expenditures are expected to be approximately $2.5 billion, as we expand Fab 36 capacity capabilities and start investing in our conversion of 300-millimeter of Fab 38.

In summary, we are confident about the second half of the year and we continue to focus on the successful execution of our strategies.

Now I will turn it over to Hector.

Hector Ruiz

Thank you, Bob. In this past quarter, we have entered into a new stage of industry transition. The world has spoken and it is really a new world that is about differentiation. It is a world about choice, about fair and open access to market. It is not about benchmarks.

However, it is about innovation -- innovation beyond the transistor and beyond the core. Innovation based on customers and their needs. I believe this transformation is irreversible.

The company, with its strongest leadership fundamentals, will emerge as the partner of choice.

We continue to expand our platform footprint with the world's most discerning customers -- top-tier global OEMs like Acer, HP, IBM, Lenovo, Sun and soon, Dell.

With truly innovative offerings in site, like our Torrenza open innovation platform, our upcoming four-by-four Enthusiast solution and the industry's only native quad-core, we will continue to provide a new path to differentiation and sustained value creation for companies starved of this choice.

We are scaling our capacity to meet the growing number of companies wanting to work with a more customer-centric partner. Our Dresden and State of New York announcements secure our ability to meet significant increases in demand for our world-class products.

Our commitment to Internet-enable 50% of the world's population by 2015 took another step forward this quarter with our agreement with Microsoft to support flexible business models in the emerging markets.

Our industry has recognized that one business model, one technology does not fit all. We continue to be a magnet for the world's best and brightest technical minds. It is because of our exceptional collection of talent that I am confident in our ability to no longer just survive these industry disruptions, but thrive in them.

Our industry is one of the most important in the world and, as such, we have a responsibility to evolve and transform along with the needs of our partners, customers, and markets.

This quarter, we witnessed a few aftershocks from this transformation, as our new approaches to innovating technology and serving customers continue to take hold. We are fully confident and look forward to being able to thrive in this environment and continue our momentum to gain share.

Finally, I would like to thank AMD employees everywhere for their commitment and excellence. Even in a challenging quarter, they remained focus on our most important objective -- delivering customer-centric innovation that enables our customers and partners to win in their markets, on their terms.

Now let me turn it over to Mike Haase to start the question-and-answer period.

Question-and-Answer Session

Mike Haase

Thanks, Hector. Operator, if we could start the polling, please?

Operator

Thank you.

(Operator Instructions)

Your first question is coming from Mr. Tim Luke with Lehman Brothers. Please go ahead.

Tim Luke - Lehman Brothers

Thank you. Bob, I was wondering if you could give us some framework for some of the different splits and takes we should think about with respect to the gross margins as we move into the third quarter.

Bob Rivet

Obviously, we forecasted we think sales will go up, so you have to play that through the equation. Fab 36 will continue to ramp, but all of the inventory will be valued. It is ramping flawlessly, as I said.

We do not give a forecast on gross margin, but to me, everything is moving in the right direction.

Tim Luke - Lehman Brothers

With respect to the sales being up, if you could remind us how you perceive seasonality and whether, within that, we should expect this mix of maybe lower ASPs balanced by strong years in everything other than Opteron, or whether after such a strong ASP in Opteron in the second quarter, we might expect that to moderate some in the going forward. Thank you.

Henri P. Richard

I think it is clear the environment will probably remain challenging in the desktop. However, I am confident that our brand positioning and the positive impact of the dual-core Turion launch will help us in the mobile space.

As you pointed out, we should also expect some offset with the strong continued success of Opteron.

Tim Luke - Lehman Brothers

So units at the desktop and mobile are up, with both having ASPs lower, and possibly…

Henri P. Richard

No, no -- I would say units in both mobile and servers up, with solid ASP. Frankly, the market is uncertain on the desktop, as we have seen in the second quarter. I will not make a projection there.

Tim Luke - Lehman Brothers

Is it fair to say you have seen your large competitor as aggressive in the early part of this quarter as they were at the end of last quarter?

Henri P. Richard

The issue that we are seeing in the marketplace is not so much the level of aggression but the way it is being communicated and how it is disruptive to the partners.

Tim Luke - Lehman Brothers

Thank you very much.

Operator

Your next question is coming from Mr. Adam Parker with Sanford and Son. Please go ahead.

Adam Parker - Sanford C. Bernstein & Company, Inc.

Sanford and Son, I think that is a TV show.

Anyway, I know you do not want to talk about benchmarking, Hector, but can you just talk to us about, or Henri, can you talk about your technology in the desktop business a little bit? How do you think your products stack up against Intel in the desktop space as we kind of head into comparing ourselves to Conroe? What can you do to gain share in desktop here in the next six months?

Henri P. Richard

You know, Adam, it is very clear that our customers have a much better knowledge than I do of both the existing and future products that AMD and our competitor are offering.

All I can tell you is that I continue to see a strong trend of increasing the number of AMD platforms we will offer to the market, so that tells me that more than ever, we are the smarter choice.

Adam Parker - Sanford C. Bernstein & Company, Inc.

Is that predicated on superior technology, or pricing or both? To what do you attribute that?

Dirk Meyer

Maybe I can provide some insight there. It is interesting from my perspective the performance crown in the microprocessor business is something that has been passed back and forth several times over the past 10 years, and I expect that to continue.

Interestingly, who has the performance crown at a given instance is relevant really to a pretty small fraction of the marketplace. That fraction is one we refer to as the enthusiast market.

Interestingly, our four-by-four platform initiative we think is going to continue to hold the hearts, minds and wallets of the enthusiast in the industry.

But more relevant really to our business is the so-called mainstream market, where we have always -- and will continue to -- provide technology solution that meets the needs of that marketplace, and we do so, frankly, without the monopoly tax of our competitor.

Our customers understand that. Their customers understand that. They all want choice and they are making that vote. They have made that vote, and we think they will continue to make that vote.

Adam Parker - Sanford C. Bernstein & Company, Inc.

Lastly, can you talk about how this extra week impacted your revenue in Q2 and how you expect it to impact your revenue in Q3? What is embedded in your guidance here about the one less week on the sequential basis in Q3?

Bob Rivet

Clearly, we did not get any up-lift for the extra week in the quarter, in the second quarter, from that standpoint. Clearly, we had the cost-side of the equation for the depreciation, payroll, et cetera, associated with the extra week.

The third quarter goes back to the normal 13 weeks and we expect to grow from second to third, period.

Cost will come down, which is why we are forecasting flat quarter on quarter, because we lose that extra week.

Hector Ruiz

Let me just add a couple of points there.

One is, as Bob pointed out and I want to highlight it, we expect our revenue to be up in the third quarter, despite the 13 weeks, one less week of work.

But in addition to that, as we said in our press release, we expect the second half of the year to be seasonably strong for us. The reason we feel that way, I think it is important to note, this is not just an analysis at a pretty high level -- this is based on the inputs from our customers, as Henri and Dirk pointed out, that are telling us that the way they see our product roadmap plans, availability of product, et cetera, they feel very bullish about their expectations of acquiring products from us.

We feel very positive about the second half of the year. As a matter of fact, I believe that in the third quarter, we will be able to be above seasonality.

Adam Parker - Sanford C. Bernstein & Company, Inc.

The reason I was asking is because you talked about share gain in server, and then you did not mention what you think happened to share in both desktop and notebook in the second quarter.

If Intel is guiding to 7.5% growth in Q3 and you guys are guiding to growth, but you have one less week in Q3, I was just trying to figure out if you were taking out that extra week in Q3, do you really think you are going to grow in-line with the market or faster and kind of continue to be a share gainer on the client side in Q3…

Henri P. Richard

It is clear -- probably two or three of us want to make a comment here, but it is pretty clear that we feel very bullish on the server side. It is pretty clear the numbers are big -- 26% sequential growth and 141% year on year, we are gaining share.

Adam Parker - Sanford C. Bernstein & Company, Inc.

Right, in the desktop and notebook…

Henri P. Richard

We will continue to do that.

Now, let's see when the third party’s numbers come out in a few weeks, relative to the client, because frankly, Adam, if you look at the numbers right now, it would be very hard for us not to conclude that we might have held -- or perhaps even gained -- share on the client, despite the rather challenging environment that we saw in the second quarter.

I want to remind you of what we all have said, is that our plan is to always gain share across the board. That has been our goal. Our goal is to break the monopoly, and we continue to have that goal.

We have had 12 consecutive quarters of growing more than 20% year on year for 12 consecutive quarters. Our plans are to continue to do that. So I feel good.

Adam Parker - Sanford C. Bernstein & Company, Inc.

Thank you for your time.

Operator

Thank you, Adam Parker, from Sanford Bernstein. Your next question is coming from Mr. Mark Edelstone with Morgan Stanley. Please go ahead.

Mark Edelstone - Morgan Stanley Dean Witter

Good afternoon. A couple of questions, if I could. The first one I guess is for Bob or Hector. What does the mix look like in Q3 between 300-millimeter wafers and 200? Then, what does that look like in Q4?

Dirk Meyer

Rather than give you the specific mix, why don't I just give you the overall ramp of Fab 36, and you can deduce from that.

We started the ramp roughly at the end of '05, and we will complete the ramp to the full 20K per month level, roughly end '07. It is a pretty linear ramp across those eight quarters.

Mark Edelstone - Morgan Stanley Dean Witter

Fair enough. Then, maybe for Henri or again for Bob, perhaps, I think your op-ex growth in Q2 ended up being more than you had expected. I think the guidance was 8, if I remember correctly. Can you talk about some of the programs you put in place? What, if anything, was the surprise to drive the overall spending levels above what you had initially anticipated?

Bob Rivet

Yes, I will give you just a high level and then I will turn it over to Henri, and he can get into more specifics.

Basically, we did a fair amount of investing in the future, particularly in the marketing area, to continue to power our way through this environment with our eyes still set on the market share gains that we have laid out for us in all the different product categories.

To give you a little more color and specifics, I will turn it over to Henri.

Henri P. Richard

Thank you, Bob. Mark, we have always had an aggressive plan to penetrate the commercial segment in 2006. We made no secret of that.

Fundamentally based on customer feedback, the increasing number of platforms that will be available on the revision F of our Opteron server platform, which is coming out next month, and the opportunity in front of us in the second-half of the year to continue to accelerate our momentum in the enterprise, I made the decision to also accelerate our spending.

I am sure you have seen our Power campaign and some of the other campaigns that we have put in place. We felt it was the right time to invest in the success of our enterprise penetration. The bulk of our spending is in that area.

Mark Edelstone - Morgan Stanley Dean Witter

Two very brief ones, if I could. One is, what do you expect ASPs to do in the third quarter?

Then, Hector, you talked about seeing seasonal strength in the second half of the year. How much of that strength do you think is coming from normal seasonality versus share gains?

Hector Ruiz

Mark, we believe that because the environment we call challenging in the second quarter is going to continue in the third, and probably likely even into the fourth, that we are going to be facing the second-half where ASP projections are going to be challenging to make, due frankly to the uncertainty of what our competitor is going to do in the desktop space, where a lot of the challenge has been.

[inaudible] we are planning to say the ASPs are going to be reasonably flat. ok.

As far as our reasons for optimism relative to growth, frankly because our customers are telling us that they expect the demand for our product -- so this is not a statement of the market, this is the demand for our product is healthy. That, combined with what we believe are some customer acquisition strategies for the second-half of the year, because we still have customers around the world that are not yet purchasing AMD products, the combination of that makes us feel optimistic.

Translate all that to be -- we are going to gain share.

Mark Edelstone - Morgan Stanley Dean Witter

Thank you.

Operator

Thank you. Your next question is coming from Mr. Eric Gomberg with Thomas Weisel.

Eric Gomberg - Thomas Weisel Partners

Did you say that you actually expect to be above typical season in the third quarter? If so, what is typical seasonality?

Henri P. Richard

No, we do not know what seasonality is going to be this quarter. Frankly, it changes every year. It ranges from -- Lord knows what number. The average is probably in the…

[Multiple Speakers]

Whatever the seasonality is this year, which is a function of so many things, if this year happens to be a third quarter that is seasonably up X percent, we expect to do better than that.

Eric Gomberg - Thomas Weisel Partners

Could you talk about where you expect inventory on your balance sheet to be exiting the third quarter? Also, what you think the status of channel inventory is right now?

Bob Rivet

Our plan is to build inventory in the third quarter in anticipation of an even stronger fourth quarter, probably at a slightly lesser rate than we did in the second.

Fab 36 will be where that build will all take place. We have been running at full capacity in Fab 30. Fourth quarter will drain that off. So the typical pattern is build in second, build a little bit in third, and drain off inventory in the fourth. We are pretty consistent on that pattern and that is where we are going.

This year might change in the fourth, depending on how the customer input comes in for the start of the '07 period of time.

Eric Gomberg - Thomas Weisel Partners

As far as where the channel sits today?

Bob Rivet

Henri, do you want to comment on that one?

Henri P. Richard

Sure, I would be happy to. The channel is obviously where most of the unrest has taken place in the second quarter, so consistent with our general practice, we have kept our inventories as low as possible, and did not build inventory during the quarter in the channel.

Eric Gomberg - Thomas Weisel Partners

Given Intel's behavior in the channel, would you expect to continue to walk away from low-end business this quarter, or do you expect that to moderate?

Henri P. Richard

Hector has always been very clear that our goal is to make profitable growth. We are going to take business that makes sense for our customers and for us. We are not going to go chase what I call lighting a cigarette in front of a gas leak.

Eric Gomberg - Thomas Weisel Partners

Thank you.

Operator

Thank you. Your next question is coming from Mr. Joseph Osha with Merrill Lynch. Please go ahead.

Joseph Osha - Merrill Lynch

Lighting a cigarette in front of a gas leak, huh?

I have a sense as to how Fab 36 is going to ramp. You said 20K a month by the end of '07, right? As I get beyond that and I think about the Fab 30 coming down and then coming back up, can you give me a sense of that end of '07 run rate, what is going to happen? Will 30 be coming down during '07 and coming back in '08?

I am just trying to get my arms around the total output.

Bob Rivet

Yes, at the high level, what happens is we ramp Fab 36 to 20K, and then actually beyond that in '08. In '07, we start to take down Fab 30 and convert to a 300-millimeter toolset.

In addition, we have chartered semiconductor, which is ramping now.

Joseph Osha - Merrill Lynch

So is Fab 30 off-line by, say the end of '07?

Bob Rivet

It never really goes off-line. It is a conversion.

Joseph Osha - Merrill Lynch

Okay, but it is a whole different toolset. I would think it effectively come down.

Bob Rivet

Think of it this way, Joe -- we will probably never go below 50% utilization in the facility. As we continue to flip out tools, what we are actually doing is building a separate building to actually augment the capacity to be able to flip the tools through the system. We will never actually go below about 50% utilization of the facility in the worst quarter of time.

But again, we also have charter to fill in the blank from that period of time. We see continued capacity expansion through the '07-'08 period of time -- not exactly linear, but darn close.

Joseph Osha - Merrill Lynch

So let's just imagine it is the end of '08 and I have 36 running at, let's call it 25,000 wafers a month, maybe the retrofit of Fab 30 at 20,000 and could charter be -- is charter ever going to be that big, or would it be maybe 10 or something like that?

Bob Rivet

It will be modulated.

Joseph Osha - Merrill Lynch

But you could be in enterprise with mid '08, 50,000 300-millimeter wafers a month, right?

Bob Rivet

Yes, sir.

Joseph Osha - Merrill Lynch

Okay. Thank you.

Operator

Thank you. Your next question is coming from Krishna Shankar with JMP Securities. Please go ahead.

Krishna Shankar - JMP Securities

Yes, can you comment about the [inaudible] environment shares so far in July? Do you feel that some of this was based just on your competitor blowing out obsolete inventory, or [inaudible] getting obsolete? Will we see a more rationale environment in the channel going into Q3 and Q4?

Henri P. Richard

I think there were several factors, but probably the biggest factor was the fact that it seems the competition decided to throw away one of their brands and completely reposition Pentium. That had a very negative contribution to the environment, particularly in the channel.

It is a little early now in July to give you a forecast of what is going on. Our checks indicate that there is still a lot of inventory out there, and that is why in my previous comments, I was fairly optimistic about the mobile space and the server space and cautious about the desktop space, because that is where the bulk of the channel business exists.

Krishna Shankar - JMP Securities

My follow-up question is, everybody read the reviews on the competitor's new product line. Do you folks have any comment on what you have seen in terms of the trade reviews and what your upcoming AMD two socket will do in terms of the advancement in performance and power?

Henri P. Richard

Of course we are looking at all of those reviews. As you know, the main feature that the AM2 socket is bringing to the market is the support of DDR2 memory. We have never presented it as a performance improvement.

We are going to continue to provide faster products to our partners. I am not going to disclose at this point in time our Q3 and Q4 plans. We are looking at what the competition is doing and they seem to be innovating at the core. We are going to continue to innovate, both at the core and at the platform level.

Hector Ruiz

I would just like to add that when we launched Turion, the first launch of Turion was very successful, if you remember back to the days. We actually stated that was the most successful product launch we had and fastest ramp.

We're now, when we are introducing the X2, actually it is doing even better than that. The reaction from our customer base is very, very strong towards our product.

Krishna Shankar - JMP Securities

My final question is Dell -- when will Dell actually start to ship the Opteron server-based products in volume?

Henri P. Richard

You should ask them. What they publicly stated is their plans are to have a product by the end of the year on the server.

Krishna Shankar - JMP Securities

Does that mean that there's other products to come through? You seem to be hinting at a broadening of a relationship with Dell.

Henri P. Richard

Our hopes are always to broaden our relationship with all of our customers. We used to be mainly a desktop supplier to HP. We are now a broad-based supplier to HP. That is our plan, our intent, our desire.

It is no different with Dell, but at this point in time the only product they have openly announced is the launch of a server by the end of the year.

Krishna Shankar - JMP Securities

Thank you.

Operator

Thank you. Your next question is coming from Lacey Higgins with Prudential. Please go ahead.

Mark Lipacis - Prudential

Actually, it is Mark Lipacis from Prudential.

A couple of questions. Dirk, I thought in the beginning in your comments, you talked something about a native quad-core, and I missed that. Would you be so kind as to review what you were talking about? Is that a change of the production schedule for quad-core?

Dirk Meyer

High level is not really a change. It is really an amplification to what we said at the analyst conference in June. We have a new core under development. The first instantiation of which will be in a quad-core form, to be launched roughly mid '07. What I said is we will demonstrate that by the end of the year.

Mark Lipacis - Prudential

Thank you. Bob, for the $2.5 billion in cap-ex for '07, what is the expectation for funding that through cash flow from operations, or through some other means?

Bob Rivet

No, current cash on the balance sheet and cash flow from operations.

Mark Lipacis - Prudential

Last question, as you guys are ramping Fab 36, could you give us a framework for understanding how we should think about the cost structure on products that are coming out of Fab 36 versus Fab 30 right now? Thank you.

Bob Rivet

Right now, Fab 36 is a premium, meaning costing more than Fab 30 because we are still, to Dirk's point, quite a ways away from the appropriate asset utilization in that space.

To decode what Dirk said, we will go out of this year about 50% utilized from a wafer start standpoint. The 300-millimeters, as we all know, yields about a 30% advantage compared to a 200-millimeter wafer. We will start crossing to Fab 36 as cheaper at the same technology node in the fourth quarter timeframe.

Mark Lipacis - Prudential

Great. Thank you.

Operator

Your next question is from Mr. Michael McConnell with Pacific Crest. Please go ahead.

Michael McConnell - Pacific Crest Securities

Thank you. Looking at your competitor's balance sheet yesterday, we saw inventory up 22% sequentially. They are now at record inventories. Your inventory on your balance sheet is up 20%. You are both giving indications you are going to raise inventory on absolute dollars again in Q3 -- both saying you are going to be gaining share.

Why shouldn't we be worried that this could get even uglier right now as we progress into the second half of the year?

Henri P. Richard

I believe the situations are quite different. It is clear from the actions taken in the second quarter that there is an awful lot of aging inventory that needs to be dealt with. We recognize that is going to be a challenge and creates this very challenging environment that we talked about in the second quarter, that we think will continue in the third quarter.

We are not building aging inventory. We are building inventory like Turion X2, which is highly desired by our customers. Our Opteron demand is strong. We have shipped everything we built in the second quarter in Opteron.

Our view is somewhat different. Even if our competitor is building inventory on the new products that they have announced, they still have the very large aging inventory that they have to deal with. I believe these are two very different things.

Similarly, when we look at our capacity plans and expansion, they are based again on the input our customers give us on their wishes and desires to participate in the products that we build.

I said in my opening remarks, we believe very strongly, is if the see-change in the industry is that customers really have embraced the idea of choice. They want and need AMD to be a major player and a major supplier.

I believe our performance over the last few years has earned us the right to be a major supplier to our customers. We believe that is going to increase in the footprint with each of them, it is also going to increase.

I believe our plans are sound. Our expansion capacity is very sound and based on planning, based on customer needs. From our end, we are not worried about having too much capacity.

Michael McConnell - Pacific Crest Securities

Looking in September, there is some indication that your competitor is going to be changing their pricing strategy, at least traditionally, with the rebate activity with the OEMs versus the channel.

Understanding you are taking some share at the OEMs currently, but looking at the channel, that has historically been a very strong segment for you. With them now looking at potentially evening out the pricing between the channel and the OEMs, are you still comfortable with that change that you can still take share in the third quarter, as well as the fourth quarter?

Henri P. Richard

The information that you are referring to is supposedly being implemented by the competition on the 24th of July price move, but all our indication in the market are that this is a story or smokescreen, and that there is no fundamental change in the price structure of OEMs versus distribution.

Michael McConnell - Pacific Crest Securities

Thank you very much.

Operator

Your next question is coming from Michael Masdea with Credit Suisse First Boston. Please go ahead.

Michael Masdea - Credit Suisse First Boston

Thank you. I guess this is the one question to follow-up with what you said already about the competitive environment. It sounds like the real battleground is on the desktop area. The whole idea of going after profitable growth, is there some tipping point at which you say that the share loss is too much and you are willing to play that game?

With Fab 36 ramping up, can you get more aggressive, or is that always going to be the case where you will walk away from too aggressive desktop business?

Dirk Meyer

I will start and I think Hector will want to add.

First of all, our high level approach is to build capacity based on the demand signals that we get from our customers and, within a capacity context, make decisions and maximize the gross margin dollars that we get for the business. That is what we will continue to do.

Relative to the pricing dynamic in the marketplace, from my perspective, it is kind of interesting. We have always had price competition across the entire front of our business. I think what is changing is in Intel has not always had price competition across the entire front of its business, but is beginning to feel that change.

Frankly, the idea of continued price competition does not bother us because it is nothing new to us.

Hector Ruiz

The only thing I would add is a minor modification, which is important. You said the desktop will be the battleground. I think what I will add to that is right now, this challenging environment is the desktop in the channel. As Dirk pointed out, we welcome competition and we thrive on figuring out ways in which we can thrive in that environment.

The one thing I do want to point out that Dirk and Bob alluded to in earlier comments, they are so important that I want to make sure they do not get missed, is that we managed to achieve in the first and second quarter a gross margin performance that between 55% and 60%, which is quite strong and frankly, levels we had not achieved in our company for a long time.

We have managed to do that being at 200-millimeters, 90-nanometer technology, and a factory that was small in the relative terms. By the way, that was prior to us participating strongly in the server space, therefore our ASPs were even lower.

We are now moving in this second half of the year aggressively toward 300-millimeter, as we pointed out, aggressively ramping 65-nanometer, and because of our stronger participation in both the server space and the commercial space, improving ASP outlook once we get past this nightmare of a challenging environment.

Everything we are doing now is in the direction of goodness, based on an already strong performance, based on the parameters I just mentioned. We believe our opportunity to continue to be very competitive, even in this very challenging desktop environment, is only going to improve and get better.

Michael Masdea - Credit Suisse First Boston

Thank you. Then, kind of in that vein, you had you significant wins in the commercial market on the desktop side of Lenovo and the thin client Fujitsu. Walk us through how you kind of got over that hurdle to get into those commercial markets. How do you get these OEMs, and some of the ones you have not gotten so far, to expand their commercial offering so you can have more access to those higher ASPs?

Henri P. Richard

We have always told you that for us, the challenge is not the demand at the end-user level, but the fact that the market would be offered the choice. It is very clear to me that it is increasingly obvious to companies in our industry that offering choice is a competitive advantage for them -- their sales force talking to their customers.

Hector talked about a change in the industry and there is a tipping point. Frankly, the penetration of Opteron in the enterprise space has helped us give those customers confidence that there was true demand for AMD products. Now we have to continue to ensure we penetrate all of these OEMs and offer a greater number of sku’s, and that will drive a greater market share.

It is all about having access to the market and breaking the monopoly.

Michael Masdea - Credit Suisse First Boston

Great. Thanks a lot.

Operator

Thank you. Your next question is from Mr. Jim Covello with Goldman Sachs. Please go ahead.

Jim Covello - Goldman Sachs

Good afternoon, thanks so much. Quick question on the cap-ex. I understand today you do not believe you have or are you adding too much capacity. I understand your '06 and '07 cap-ex budgets are a sign of your confidence in the business. But there comes a point at which if you were to miss numbers a couple of quarters again in a row, the capacity and the cap-ex ramp would become a problem.

The question is at what point would you think about scaling back on the cap-ex, understanding that today you do not believe there is a problem? Under what scenario would you think about scaling it back?

Bob Rivet

I am not sure I would lay out at this point a scenario, but hopefully we have demonstrated historically to date, we are pretty flexible in this area. It is not just a bill it yourself, build it and damn the torpedo kind of issue. All of those numbers are flexible - to flex them up or down depending on the needs in the marketplace based on the signals we are getting from our customers.

Jim Covello - Goldman Sachs

Do you think there is a scenario that the cap-ex could be adjusted -- the 2007 cap-ex plans could be adjusted within 2006? Or do you think it would need to be a longer time frame over which you would need to see weakness relative to your plan in order to adjust the planned cap-ex?

Bob Rivet

We think we can affect future periods at any moment in time by pushing and pulling on those numbers. We could be in '07 and affect '07’s numbers just like we are in '06 affecting '06 numbers, because we pulled it in and actually have accelerated our spend to put more capacity in place.

We are pretty flexible in that term. In addition to that, we have the toggle of charter semiconductor to flex up or flex down.

Jim Covello - Goldman Sachs

Right. Final question, same topic -- how much near-term pain are you willing to withstand in terms of cap-ex, or depreciation increasing in a weaker revenue environment? How much of a near-term decision is it versus a two- or three-quarter decision?

In other words, if you started losing money, would that alone be enough make you cut your cap-ex plans for the future, or even then, would it be dependent upon what your future outlook would be?

Hector Ruiz

Frankly, we hate hypothetical questions, because we do not know what the environment is going to be when one of those parameters gets met.

I think we are prudent in what we do. We have demonstrated that in the past. As Henri pointed out, our commitment is to profitable share growth. We are careful with that.

Having said that, we are not going to let a quarter or two of a challenging environment detract us from our long-term vision of breaking the monopoly. We will put in place and shoot ahead of the duck.

The only thing that can keep the duck from getting there is the monopoly.

Jim Covello - Goldman Sachs

Thank you very much.

Operator

Thank you. Your next question is coming from Mr. Glen Yeung with Citigroup. Please go ahead.

Glen Yeung - Citigroup

There was a question earlier that asked whether or not there was some share level at which point you would capitulate. Maybe ask the question another way -- is there some margin level at which point you say, you know what, I do not want to go below that margin level and that is all there is to it?

Hector Ruiz

Again, these are hypothetical questions that have way too many parameters.

First of all, we have strategic customers. We have strategic partners. We have regions of the world where we have a strategic intent to do certain things. Those are a rather complex mixture of challenges.

In relation to that, we have brands that we have created that address different segments, different markets.

It is not a simple answer. I think what I would like to leave you with is we have a competent executive team here that manages the cause, manages the brand, manages the relationship with customers. I think we do it well.

Frankly, I think that is one of the strengths going forward -- that is just not going to change.

Glen Yeung - Citigroup

Good point. The next question I have is, and this may sound a bit odd, given the environment that we are in, but I will ask anyway -- do you actually sense that given where you are today as compared to where you were a quarter ago, and recognizing that there was not a lot of things that you necessarily knew were going to happen in the next 90 days a quarter ago, do you actually feel like your visibility now is a little bit better?

You live with a quarter of Intel's craziness. You have some interesting share gain opportunities coming up for you this quarter. Seasonally, it looks a bit better. Does it feel a little more certain to you? Maybe just your sense on that.

Henri P. Richard

First, let's remember that the second quarter in our industry is always the toughest. So for me, to give you visibility to the third quarter and the fourth quarter, where you have back to school -- you talk about the consumer market -- back to school in the third quarter, Christmas season in the fourth quarter -- things become a little more predictable because those are stronger quarters inherently, assuming industry seasonality would be the usual one.

Secondly, there are only so many brands that a competitor can throw away. Our competition has destroyed, in less than six months, two of the strongest brands they have ever built -- Intel Inside and Pentium. I do not know how many brands they are going to throw away, but they are going to run out of them.

Therefore, as a result of that, there is a little bit of a clearer picture in terms of what could be the strategy.

Frankly, the issue that we are dealing with is that all of this disruption is not expending the market. There is not a lot of elasticity in some of the pricing action that has been taken, as demonstrated this last quarter in the channel.

The partners are a little bit confused. I think it is time to settle down and give them long-term guidance, and that is what we are doing. We do not want our partners to be worried about what they are doing putting our products in the market place. We want to be the predictable, reliable partner. We are going to be that in the second half of the year.

Glen Yeung - Citigroup

That is actually a very helpful answer, thank you.

I just have one last question, which may be a little esoteric here, but I actually wanted to get an update on your [ZRAM] technology, and if there has been any progress there.

Dirk Meyer

We are continuing to evaluate that technology internally and are not prepared to comment further.

Glen Yeung - Citigroup

Thank you.

Operator

Your next question is coming from Mr. David Wong with A.G. Edwards. Please go ahead.

David Wong - A.G. Edwards

Thank you very much. 65-nanometer roll-out, can you give us an update on when you expect that to be?

Bob Rivet

We will start ramping the factory in the second-half of this year, and ship into the market our first parts by the end of the year.

David Wong - A.G. Edwards

Great. With charter, you mentioned charter a couple of times. Can you give us some feel for the growth margin and profitability, a profile of stuff that you ship from charter?

Bob Rivet

I do not think we want to be specific as to, you know, profitability and gross margin numbers. The commentary I will provide is that we are shipping and planning to continue to ship a mix client products from charter semiconductor.

Hector Ruiz

The only thing I would add, I think it is appropriate to say that we are very, very happy with charter and their management team. They have done an outstanding job and the yields and quality of the product is very good.

David Wong - A.G. Edwards

But could we assume that the gross margin of charter would by definition be lower than in-house, or we cannot assume that?

Bob Rivet

No, that is a true comment. They need a taste of the action to be in the game. We have no capital investment in the charter semiconductor business, so we have to pay for the cost of capital and the wafer. But it is all marginally good. It is incremental margin dollars to the company to run the charter semiconductor business. If it wasn't, we would not do it.

David Wong - A.G. Edwards

My final question, I was interested in your comment that you have marching orders not to take any unprofitable business, and also about shooting at the duck. If you had a big, particularly important strategic duck that was quacking at you, would you take unprofitable business?

Hector Ruiz

The marching orders are we have to be prudent in the things that we did and we had to have profitable growth. Sometimes, you know, addressing a unique particular need with a customer who is very strategic, could be a very narrow segment that may not be profitable in totality. That customer segment or market has to be profitable.

David Wong - A.G. Edwards

Great. Thanks very much.

Mike Haase

Operator, we are going to take two more questions, please.

Operator

Thank you. Your next question is coming from Mr. Chris Danely with JPMorgan.

Shawn Webster - JPMorgan Chase & Co.

This is Shawn Webster for Chris. I had a question on the operating expenses. Can you expand a little bit on why they might be flat sequentially, compared to a 14-week quarter? Then I have a quick follow-up.

Bob Rivet

We lose a whole week. So a whole week, just pick your number, but in round terms, that is a 7% issue, so there is a 7% of cost that goes away when you transition from a 14-week quarter to a 13-week quarter.

Basically, we are saying we will have a 7% increase in natural cost offset by the 7% decrease of the extra week.

Shawn Webster - JPMorgan Chase & Co.

Can you maybe characterize it then, what is driving the sequential, assuming there is a 13-week in Q2, what is driving the growth there?

Bob Rivet

Continued expansion in Fab 36 and continued investment in strategic programs, both in R&D and in Sales and Marketing to continue to capture customers, expand the market, et cetera.

Shawn Webster - JPMorgan Chase & Co.

Within your spending profile, you have talked a little bit about how charter is flexible capacity and you have some leeway there in terms of your capacity growth, depending on the demand and order environment.

Can you talk about what you are spending for charter to enable profits reporting and the design work that is happening for charter processes, et cetera?

Bob Rivet

No, we do not disclose that type of information.

Shawn Webster - JPMorgan Chase & Co.

Then can you give, on the capacity front, in the past you have talked about unit processor capacity for 2007 I think in the range of 65 million to 70 million units. Are you still in that range today looking forward? Can you give us an update there?

Dirk Meyer

I think in the past what we have communicated is unit capability in the 2006 timeframe in the 60 million-ish area, and an intention to go more to the 80 million-ish area next year, and 100 million the year before that. That guidance stands.

Bob Rivet

We still have flexibility to push and pull on that. Of course it is dye-size dependent, but that is still a good guidepost at this moment in time.

Shawn Webster - JPMorgan Chase & Co.

Is charter still representing the 5 million and 15 million units within those two years, as far as the flexibility?

Bob Rivet

Yes, it is going to be 10% of that kind of number, upwards of 20. It kind of depends on a given quarter.

Shawn Webster - JPMorgan Chase & Co.

Thank you.

Operator

Your last question is coming from Mr. John Lau with Jefferies & Co. Please go ahead.

John Lau - Jefferies & Co.

Thanks for taking my question. I wanted to ask you again, Henri, Dirk, circling back to servers, there has been a lot of focus there. With the competition on the Woodcrest launch, have you noticed any recent pricing action that has been a little more aggressive? Can you give us some color as to how that is entering the market, especially in the area that you are very strong in? Thank you.

Henri P. Richard

John, it is a little bit early to see what Woodcrest is going to be. Frankly, there is not that many out there.

It has always been a very competitive environment in the two-piece space. We are seeing a lot of growth in the four-piece space, which is very good for us, given the scalability of our platform.

I expect that of course the competition will want to be very aggressive in that market. As you know, those are bids-driven type of pricing environment, and so it is very difficult to derive how with a few days of availability, any sort of trend.

John Lau - Jefferies & Co.

As a follow-up, Henri, can you characterize what your ratio split is between 2P and 4P right now?

Hector Ruiz

I really do not want to give you that level of granularity. I am happy to tell you that the 4-piece space is growing nicely and we are going to make sure it continues that way.

John Lau - Jefferies & Co.

Thank you.

Mike Haase

That will conclude the call. Thank you very much for your participation.

Operator

Thank you. That does conclude today’s AMD second quarter earnings conference call. You may now disconnect your lines at this time. Have a wonderful evening.

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Source: Advanced Micro Devices, Inc. Q2 2006 Earnings Conference Call Transcript (AMD)
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