AU Optronics Q2 2006 Earnings Conference Call Transcript (AUO)

Jul.25.06 | About: AU Optronics (AUO)

AU Optronics Corp. (NYSE:AUO)

Q2 2006 Earnings Conference Call

July 25, 2006 8:00 am ET

Executives

Julie Chan – Senior Manager, Finance Division

Max Cheng - VP, CFO

Dr. David Su - VP TV Display Unit

Dr. Paul Peng - VP and General Manager Information Technology Display Unit

Dr. Hui Hsiung - EVP

Analysts

Tejinder Sandhu - HSBC

Chung Ong - JL Capital

Bernard Sarmea - Daiwa Securities

Ivan Goh - Dresdner

Helen Huang - Goldman Sachs

Frank Wang - Morgan Stanley

Nick Teo - Macquarie Securities

C.J. Muse - Lehman Brothers

Mark MacKenzie - Sanford Bernstein

Operator

Welcome, ladies and gentlemen, to the AU Optronics Company second quarter 2006 results conference call. This conference call will be recorded and webcasted at the request of AU Optronics. Any objections, please hang up now. A copy of the presentation for AU Optronics' second quarter 2006 results announcement can be found and downloaded from its website at www.auo.com under Investors.

(Operator Instructions) Now I would like to turn the presentation over to your host for today's call, Ms. Julie Chan, Senior Manager of Finance Division. You may proceed, ma'am.

Julie Chan

Thank you. Good morning and good evening to all participants. This is Julie Chan. On behalf of AUO, I would like to welcome everybody to AUO's second quarter 2006 earnings conference call.

Joining me here we have Mr. Max Cheng, CFO; Dr. Hui Hsiung, Executive VP; Dr. David Su, VP and General Manager of Consumer Electronics Display Business Group. We also have Dr. Paul Peng, VP and General Manager of Information Technology Display Business Group.

We will spend the next one hour or so reviewing our second quarter earnings results. We will discuss some of the performance highlights, trends of the industry; and conclude with our outlook for the quarter. After that, we will open the floor for your questions.

Before we begin, I would like to state that management's comments about AUO's current expectations made during this conference call are forward-looking statements subject to significant risks and uncertainties, and that actual results may differ materially from those contained in the forward-looking statements.

The financial results we are discussing today have been prepared on a consolidated basis in accordance with ROC GAAP. You should be cautioned that these accounting principles differ in many respects from the U.S. GAAP. Information as to those factors that could cause actual results to differ materially from AUO's forward-looking statements may be found in AUO's annual report on Form 20-F filed with the U.S. Securities and Exchange Commission.

AUO undertakes no obligation to update any forward-looking statements whether as a result of new information, future events, or otherwise. Please do take a few minutes to read the disclaimer.

Now, please turn to slide number 3 of your presentation material. We believe the growth characteristics of the TFT-LCD industry are still intact and solid. However, we have greater than expected industry-wide panel price declines across monitors, notebooks, TV segment which, on one hand, would help drive demand; but on the other hand has temporarily impacted our profitability.

For second-quarter 2006, AUO's unaudited consolidated revenues totaled NT$60.9 billion, equivalent to US$1.9 billion, represents an 8.1% Q-over-Q decrease. While second-quarter '06 panel shipments are aligned with the Company's guidance revision on June 6, large-size panel shipments increased 8% to 10.1 million. Small, medium-size panels also rose by 14.3% post 18.1 million.

ASPs, however, experienced larger than expected declines in the quarter, with ASPs by area declining by about 14% QoverQ. Directly, it has resulted in the Company's second quarter profit. This higher than expected panel price decline was mitigated by a reduction of output in response to ease inventory pressure, better product mix, and best cost control by the Company.

Gross margin for second quarter '06 declined 8.2 percentage points to 8.5%. This brought the operation margin to 2.2% and EBITDA margin to 21%, and our basic EPS to NT$0.03 per common shares and US$0.01 per ADS for the quarter.

On the balance sheet highlights, during the quarter cash and short-term investments decreased by 15.8% QoverQ from NT$25.9 billion to NT$21.8 billion. In order to support the much longer in-transit of TV business model and reducing air freight to sea freight, inventory in the absolute dollar amount increased almost 30% QoverQ to NT$25.6 billion. Inventory turnover days increased to about 40 days from 35 days. Finished goods increased to about 17 days. During the quarter, AUO kept its loading rate to about 85% and managed its inventory carefully. AUO's debt-to-equity ratio for the quarter was 63.6%. Net debt-to-equity ratio was 51.1%. Both increased slightly from the previous quarter.

Cash flow highlights. During the quarter, AUO generated NT$15.6 billion operating cash inflow, mainly from net income of NT$182 million; depreciation and amortization of NT$11.4 billion; remaining about NT$4 billion were due to net changes in working capital.

Net cash used in investing activity totaled NT$24.5 billion, mainly for the capital expenditure of NT$23.8 billion. The net financing total of NT$4.7 billion was attributed by the insurance of NT$4.6 billion in net debt. As a result, AUO ended the quarter with a net cash outflow of NT$4.2 billion.

Revenue breakdown by product application. In the second quarter '06 AUO's sales for Consumer Electronics was 48%, approximately equal to the sales supported by Information Technology Display, 49%. Both TV and monitor accounted for 34% of our total revenue in the quarter. Notebook was 15%. Small and medium-sized business were 14% of revenue. The remaining 3% of the revenue was supported by general display and other.

Unit shipments and blended ASP on AUO's large-size panels. The unit shipments of the large-size panels had a 7.7% increase to 10.1 million in this quarter from 9.4 million in the previous quarter. Blended ASP declined sharply by about 16.5% sequentially to US$162.

The ASP analysis on large-size panel. ASP for the PC panel experienced a substantial 18% decrease from US$145 to US$119 due to the supply/demand imbalance in the quarter. At the same time, ASP for TV also experienced about 30.6% sequential decline from US$404 to US$349.

From the per square meter perspective, shipments increased by 7% QoverQ, while blended ASP per square meter experienced a substantial 14% QoverQ decrease to US$1,628 in the quarter.

Small and medium-sized panel in this quarter improved 14.6% sequentially in shipments and post 18.1 million with revenue of NT$8 billion.

AUO's monthly capacity by fab. For the September quarter, we expect AUO's estimated monthly capacity by each generation to be for Gen 3.5, combining the three facilities, we would have 5K supporting low-temperature polysilicon and 120K amorphous silicon technology; where Gen 4 will remain at 60K monthly. For Gen 5, the three fabs together, we would have monthly 225K. For Gen 6, monthly of 120K.

For the December quarter, the new AUO -- that is AUO consolidated with QDI -- estimated monthly capacity by each Gen will be:

  • for Gen 3.5, we would have 20K monthly supporting low-temperature polysilicon and 150K for the amorphous silicon.
  • For Gen 4, remain at 50K.
  • For Gen 5 combining the four facilities together we would have monthly 310K.
  • For Gen 6 combining two fabs together, AUO and QDI, monthly capacity will be 180K.
  • For Gen 7.5, ramping schedule remains unchanged to commence on October with monthly of 10K by year end.

For more details, please do to refer to our slide number 11.

Now lastly, based on current business outlook, let's look at management's expectations for AUO's third quarter performance. For large-size panel shipments, we expect it to increase by mid-teen percentage points. Among PC shipments, we do expect it to increase by about 10% QoverQ. For TV shipment, we do expect it to increase by high-teen percentage QoverQ. For small and medium panel shipments, we do expect it to increase by about 15%.

Blended ASP QoverQ we do expect PC panel price to experience low single-digit percentage decline, and blended ASP for TV to decline by mid single-digits due to the support of better product mix. The overall loading rate expects to be more than 95% for the quarter.

This shall end my presentation for today. Operator, please open the floor for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Tejinder Sandhu from HSBC.

Tejinder Sandhu - HSBC

Thank you for taking the question. A couple of questions here. I just needed some clarification on the CapEx. I read on the newswires that the CapEx plan is still unchanged.

Max Cheng

This is Max Cheng. Yes, we are not going to change any CapEx amount for year 2006. However, we tried to delay our CapEx for year 2007 for our new Gen 7.5 and Gen 6.

Tejinder Sandhu - HSBC

Thank you, Max. Does this number included Quanta Display? Or are their CapEx plans different from this number?

Max Cheng

For the year 2006, I guess the total number for the two companies would be around NT$120 billion.

Tejinder Sandhu - HSBC

Okay, NT$120 billion. I think on the last conference call you said that potentially the Quanta Display 6G, you wanted to ramp it to 120,000 substrates a month.

Can we just discuss about the schedule you have for the 6G in Quanta Display, and also the 7.5G scheduled for the next year?

Max Cheng

For the Quanta Display's Gen 6, by end of this year we are going to have 60K. By end of next year, we're going to have a 90K, and then jump to a 100K, 120K, by end of year 2008. That is for the Gen 6 of QDI.

Then Gen 7.5 by end of this year we are going to have a 10K. By end of next year, we are going to have 60K, which is our first fab of a Gen 7.5. Then year 2008 we are going to take another 30K or maybe another 60K; that will depend on the market situation.

But the new fab of Gen 7.5, we call that the L7B. That will be year 2008 schedule. That could be 30K and might be 60K.

Tejinder Sandhu - HSBC

So, Max, the actual cut for 2007 on the CapEx, what has it changed? Has it changed the 7.5G installation? Is that what has been reduced?

Max Cheng

That is right. We will take until year 2008 to move in those equipment. Then also the QDI's Gen 6, supposedly we should have 60K now in '08, postponed 30K to the year 2008.

Tejinder Sandhu - HSBC

Thank you for that clarification. A couple other things if I may, just in terms of the second quarter, the profitability of the panels. Would you be able to kind of give me some ranking in terms of three or four panels which were the most profitable? Which were the least profitable? Especially the 32-inch TV panel and then potentially talking about the 19-inch monitor and 17-inch monitor panel?

Max Cheng

Well, I have to say usually we do that internally, we do not provide a gross margin report because that would highly depend on which fab we would produce those products. That is kind of a given issue. So for some products they have a state-of-the-art fab to produce them and the costs would be lower. So usually we don't provide the gross margin profile for each segment. But usually, you know, we also have internal numbers such as the contribution margin.

For the second quarter, notebook will be the product. It is kind of a more difficult contribution, a better contributor, better contribution margin. While all the other is quite similar.

Tejinder Sandhu - HSBC

You have been involved in Quanta Display now for a while. Do you see a lot of difference between the cost structure there and the cost structure at AU? I mean, I'm thinking from a perspective of fourth quarter, do you think that would be a drag on your margins, or do you think that that is not an issue?

Max Cheng

I guess that is not a main issue for us, because we also believe some of their designs are also quite good. We can fit in their designs to our product. So basically from a cash cost viewpoint, they are also good on some models.

But of course some of that, we need to change the design and change the whole build materials to match AUO's cost structure. I guess that would be the case.

Tejinder Sandhu - HSBC

Okay, my last question is, on the inventory. There has been a lot of talk that while the dollar value of the inventory is not going up, in reality a lot of the product is being held as unfinished panels, probably at the sell level. Could you give me a breakdown? What is the inventory in terms of finished goods and work in-process and raw materials?

Max Cheng

40% of our inventory would be finished goods; while WIP would be another 55%; raw materials would be around 5%.

Tejinder Sandhu - HSBC

Has that shifted considerably in the second quarter, or this is normal?

Max Cheng

It is kind of normal compared to Q1.

Tejinder Sandhu - HSBC

Okay, great. Thank you very much.

Julie Chan

Operator, before we take the next question, I would like to make an adjustment on the guidance. For the panel shipments, for PC shipment, expect to increase by about 10%. TV shipment expect to increase by high teens. Together, total size panel expect to increase by low teens, instead of mid-teens, QoverQ. Thanks. Operator, can we take the next question please?

Operator

Our next question comes from Chung Ong - JL Capital.

Chung Ong - JL Capital

For the small panel shipments, is the margins higher than the corporate margins?

Max Cheng

Well, this is Max again. Yes for Q2 small/medium-sized margin could be better. It is kind of stable for this segment. But again, you know, the gross margin for the Company is not a ratio that we usually use, so it is not very fair to compare that to other products.

Chung Ong - JL Capital

Right. It is grown quite a bit; can you tell us what the driver is behind this?

Max Cheng

You mean the driver for --?

Chung Ong - JL Capital

Small panel.

Max Cheng

I'm sorry, could you say it again?

Chung Ong - JL Capital

The driver for the small-panel shipments.

Max Cheng

Dr. Su can explain more on that.

Dr. David Su

Yes, this is David Su. For the smaller size, the volume growth actually is coming from two areas. One is from the general AV, and that is mainly due to the seasonality. Now it is coming back. So the volume has increased in small and medium-sized.

In addition to that, for the handset for the mobile phones, the quantity also increased. The major two areas, the volume drivers.

Chung Ong - JL Capital

Right. Do you see these two areas slowing down in 3Q?

Dr. David Su

In Q3, those two areas still, like we stated in the guidance, the quantity of QoverQ will be around 15% growth in the volume.

Chung Ong - JL Capital

So it will be still driven primarily by these two areas?

Dr. David Su

Yes.

Chung Ong - JL Capital

Right. The other thing I need to check is what is the EBITDA margin for 2Q? What are you guiding for 3Q?

Max Cheng

I'm sorry, usually we do not guide the EBITDA margin.

Chung Ong - JL Capital

Right. So what is it in 2Q?

Julie Chan

2Q was 21%.

Chung Ong - JL Capital

Last thing, I just want to check on the inventory. The inventory that is on your book now, has it taken into account the sharp ASP decline in 2Q?

Max Cheng

I'm sorry, could you say your question again?

Chung Ong - JL Capital

Yes, the inventory on your book now, has it taken into account the sharp ASP decline in 2Q?

Max Cheng

Yes, I guess, for the accounting we also need to evaluate those inventories by the market value. So usually we have to record the LCM, lower of cost of all market prices. So we have to re-evaluate that by the existing market price.

Chung Ong - JL Capital

Right. You are going to bring down the inventory in terms of TV in sizes?

Max Cheng

I'm sorry, I am afraid I cannot give you this number, because I do not have the breakdown at this moment.

Chung Ong - JL Capital

Right, okay. Thank you very much.

Operator

Our next question comes from Bernard Sarmea – Daiwa Securities.

Bernard Sarmea - Daiwa Securities

This is Bernard from Daiwa. The first question is on your cost reduction target for third quarter and potentially for fourth quarter. What type of cost reduction target per square meter basis are you looking at for next two quarters?

Max Cheng

For the whole year, we try to hit a target of 10% cost down for PC products, where for TV we tried to have a high single-digit, a 20% target. So far, we stay in line with that target. For each quarter, I guess it would be maybe like 3% cost down for PC and TV at this moment.

Bernard Sarmea - Daiwa Securities

How many percentage of those cost down will come due to the redesigning, and how many percentage will probably from the productivity improvement? How many percentage because of the cost per meter is coming down?

Max Cheng

Okay, I guess a 3% to 5% would mainly come from redesign of our product. Of course, part of that would be support by our vendor to give us the lowest cost of the component. Further utilization of cost that would help us also a lot, especially for Q3, when our loading rate is better, much better than Q2. Hopefully we also can lower our manufacturing cost due to that change.

Bernard Sarmea - Daiwa Securities

Are you going to use the lesser number of driver IC or, say, CCFL lamps going forward?

Dr. David Su

This is David. In response to your question for this cost reduction, certainly we are doing the redesign of the products such as reduce the lamps you use or reduce the optical feed we use in the bigger units; and certainly to have more channels use this number of chips is also one of the approach we are using now. So all of our efforts is try to reduce the material cost used in TV products.

Bernard Sarmea - Daiwa Securities

Mainly for TV, thanks. One question is if I take out margins from small and medium-sized panels, do you think that you were profitable on the operating level in the second quarter?

Julie Chan

I'm sorry, can you repeat that question again?

Bernard Sarmea - Daiwa Securities

If I exclude your profit from the small and medium-sized panels, are you profitable in large-size panel on the operating level in second quarter?

Max Cheng

I do not have that breakdown; but I believe, even without the small and medium-size that we still maintain that operation in positive level for large-sized business.

Bernard Sarmea - Daiwa Securities

Okay, thank you very much.

Operator

Our next question comes from Ivan Goh - Dresdner.

Ivan Goh - Dresdner

Good evening. Thank you for taking my question. A number of questions. The first one is, I would like to find out for your third quarter how much visibility are you having today on TV panel demand and PC panel demand? Is that visibility kind better than what is typical for this time of the year, or slightly worse than this time of the year?

Paul Peng

This is Paul. I would like to report the PC demand status. In the notebook side, it has been stabilized; so our quantity could be a 2% increase in Q3. However, in the monitor side, the demand is getting much stronger compared to Q2; so it could be more than 10% increased. Also I think that it is quite firm that monitor price will adjust also. So the visibility in the PC panels is very clear right now.

Ivan Goh - Dresdner

Okay. TV, please.

Dr. David Su

This is David. For the TV quantity visibility, actually for Q3 the visibility will be much better than Q2, even though because the Q2 was the World Cup season and too much expectation from that. In Q3 now, most of our customers is [inaudible], and they have good market positions. So the visibility actually is much better than Q2, and they expect the volume growth will be around high teens for Q3.

Ivan Goh - Dresdner

Okay. One question I have is regarding your capacity pushback plans. If you look at LG Philips, what they have done is actually cut CapEx this year and pushed out capacity that was supposed to come out this year. However, in your case you seem to have pushed back capacity that was originally expected to come next year into 2008.

It seems to suggest that you are less bullish on 2007 than you were previously, even though that is a pretty long way away and visibility is obviously almost nil. Can you, perhaps, talk through what's the thinking behind your capacity expansion pushback that was supposed to come on in 2007?

Dr. Hui Hsiung

This is Hui Hsiung answering your question. Actually, we are not that bullish about 2007. I think 2007 continues to be a high-growth year for TV. I think the reason we cut down the investment is in terms of the overall capacity share globally, we are now really among the top three; actually within 1%, no more than 2%, so it is really close.

So we think it is necessary to invest, to do the excess investments. We look at the total capacity versus the total demand. We think by postponing to 2008 it will be a more suitable extension relative to the total demand. So basically, we tried to avoid overcapacity situation for next year.

But in terms of the market share, this slowness will not substantially reduce our share in terms of total capacity.

Ivan Goh - Dresdner

Okay. I have a question regarding QDI's inventory. Basically, can you maybe talk about your specific plans in resolving the inventory that QDI has built up? Perhaps how also is your view of your old inventory? Do you think that 40 days is what is normal going forward? Is it better that you reduce your inventory from 40 days?

Dr. Hui Hsiung

I think QDI inventory actually was generated in Q1; I think that the actual demand came down, but due to the new capacity they did not slow down immediately their input production. So it does take a few months to digest those extra inventory. So the way we deal with that has been to reduce the loading of the 3Q at the fabs. So that unfortunately Q2 reduction is still insufficient, so Q3 will continue to reduce the loading among those fabs. But I think toward the end of Q3 that we can start to pull up the capacity loading. Entering Q4 it should be quite normal capacity loading.

Ivan Goh - Dresdner

The other question would be, can we normalize a long base in the future?

Dr. Hui Hsiung

Yes, I think we will use the same standard managing the inventory as we're using now. So I think hopefully, Q4 will be more normal. We will see. As a whole, the new AUO as a whole, you will see a more normal capacity at the inventory level.

Ivan Goh - Dresdner

What would you consider normal?

Dr. Hui Hsiung

Right now, we are still making some adjustments. To be honest, in the past, our main business was PC-related applications. The inventory in transit is quite low. Even between Taiwan and China, less than a week of inventory in transit.

But since the increase of TV ratio quarter by quarter, that will change at some point, the reason being due to the import duties. So the TV set production will be mostly in Europe, for the Europe market; or in United States, for United States market.

So because of this remote manufacturing, we have to ship a certain percentage of panels to Europe or to North America, and this will create a larger percentage of inventory in transit. Those are actually active inventory because those are based on customers' POs.

Just take for example, from Taiwan or China to Europe, in transit it will take six weeks and then additional one week on the land; so it is almost seven weeks of in-transit inventory. That percentage will increase in the near future. So that tends to increase the total base of inventory somewhat. We are still figuring out what will be the normal. So it really depends on total percentage of production in Europe.

Ivan Goh - Dresdner

Thank you very much.

Operator

Our next question comes from Helen Huang - Goldman Sachs.

Helen Huang - Goldman Sachs

I have two questions. The first question is regarding 7.5G and second question regarding inventory. First of all, if I remember correct, the 7.5G plan was 3Q06 pilot run and 4Q06 mass production. So why is there NT$300 million 7.5G pilot run expense in the second quarter?

Also, if the mass production is starting 4Q06, wouldn't you miss out most of the Christmas sales, since TV panels I thought needed to be shipped say somewhere no later than September/October?

Dr. David Su

I think for the Christmas season, actually, we will start to ship some of our products from Gen 7.5 in Q4. But because this is in the initial ramp-up stage and the product we produce for 42-inch I think the quantities are suitable for our current customers' needs. Certainly, the move to these 42-inch products, I think they will contribute some of our volume for the second half this year.

Helen Huang - Goldman Sachs

But if you start production in October, then can you still make it in terms of volume for Christmas sales for your customers?

Dr. David Su

Certainly not on the volume. Partially some of the volume can contribute for Christmas; and even because this 42-inch product, the major region is still in North America. So even after Christmas in January, there is still a demand because there is a football game there. So that will still have some contribution even after Christmas.

Helen Huang - Goldman Sachs

Regarding the pilot run expense, I am just a bit puzzled. Why is it a NT$300 million pilot run expense in 2Q? Or if you already started pilot run in 2Q, then why do you need to pilot run for two quarters? Because I thought typically it takes around one quarter for a pilot run, and then moving to mass production in the second quarter. Is 7.5G being much more difficult?

Dr. David Su

Actually, Helen, the second quarter we move in equipment; Q3 we pilot run; in Q4 we ship. Also, those 42-inch actually we started to produce already in Gen 6 line. We now targeted for starting up the customer design in the mobile business. That will ensure a quick ramp-up. As long as we start our production in Gen 7.5, actually the volume can almost immediately to be consumed. So, so far it is on schedule.

Helen Huang - Goldman Sachs

So where is that NT$300 million pilot run expense coming from in the second quarter?

Max Cheng

Well, we have had to assign a whole bench of headcount to there to do the tests of those new equipment. Also in those facilities, that is all part of the NT$300 million. Also they will spend a lot of cash to test the equipment. So that is usually what happens before we really ramp up the fabs.

Helen Huang - Goldman Sachs

Okay, okay. For inventory, I understand the LCN for finished goods inventory. Do you also mark-to-market for materials and WIP for falling component prices?

Max Cheng

Yes, definitely, especially for those slow moving items or obsolete; we would definitely do the same thing to those things.

Helen Huang - Goldman Sachs

Okay, on the same topic on inventory, I understand you mentioned the change of business model, because of LCD TV, that potentially in the future that the normal inventory would probably be higher. So if TV panels are now more and will continue to be more working capital intensive, don't we need to expect much higher TV profit margins than PC, so that your return on capital won't decline over the time?

So should we essentially assume higher TV profit margins than PC panels across cycles? Thank you very much.

Dr. Hui Hsiung

I think in general, yes; I think that for consumer electronics, in general, because it is more commodities, especially the top brand of customers, they tend to be more custom-made, more degree of custom-made. What hopefully ultimately it has a higher margin compared to, for example, a monitor.

However, I think we are still in the early stage of this business; so everybody is still ramping up the capacity and the product. I think right now, I wouldn't say it is a stabilized situation. So what you said hasn't happened in this quarter, but actually in previous quarters, the TV enjoyed a pretty healthy margin relatively to monitors.

I think recently the players still basically kept too much inventory. That kind of hurt the panel price. I think not only AUO; I think the players within the industry need to be more controlled about their panel inventory. I think that will stabilize the price.

Helen Huang - Goldman Sachs

Thank you.

Operator

Our next question comes from Frank Wang - Morgan Stanley.

Frank Wang - Morgan Stanley

I just wanted to check that traditionally in the past few years the third quarter for small and medium-sized, normally you have about 50% in terms of shipment growth. Why are you having a lower growth rate for third quarter this year?

Dr. Hui Hsiung

In the past, we had a very low market share, so our growth was much higher than the industrial growth. So you remember very well. But this year, in terms of medium and small size, we are entering the top five market share now. So overall, the growth is not 40%, 50%. So we are probably growing more according to the market now.

There are some chances we have a higher market growth in the area of mobile phones. I think that in the coming quarters, there are certain quarters we will expect a higher growth in that market.

Frank Wang - Morgan Stanley

In terms of inventory level, will your inventory go up again in the third quarter?

Max Cheng

This is Max Cheng. It is still hard to say that at this moment, because the Company's policy is to try to continue to reduce the inventory level. We still try to trim that to a certain base or a certain amount. But it is very difficult to say at this moment, because we still haven't finalized what kind of an inventory level we should build in those warehouses that are located in Europe and in North America. So at this moment, I guess we need some more time to see what kind of an inventory level we should achieve for the Company.

Frank Wang - Morgan Stanley

Can you also talk about your TV customer mix? Maybe by geography or in terms of maybe the branded versus the tier two names? How are you expecting that to change in the second half?

Dr. David Su

For the panel shipment destinations, roughly around 40% plus/minus to the European area; and the destination in the States probably around 30%; and others in other areas.

For the top brand ratio for the second half, probably around 60% to 70% will be coming from the brand-name customers.

Frank Wang - Morgan Stanley

Is that ratio the same in your second quarter and for the second half?

Max Cheng

The ratio compared with Q2 and Q3 certainly is in the second half. Certainly the second half will be, the brand name will be higher than Q2.

Julie Chan

Next question please, operator?

Operator

Our next question comes from [Nick Teo] from Macquarie Securities.

Nick Teo - Macquarie Securities

Good evening. I have a couple questions. One is regarding the utilization rates. I am just wondering if you can give us a sense where utilization rates were in the second quarter? I know that you made an effort to reduce it because of weak demand. Also, can we get a sense of what the non-operating expenses look like in the third quarter?

Max Cheng

The loading rate for second quarter was around 82% to 85%. We reduced the utilization to reduce our inventory level.

For the non-operating expenses for Q3, I guess the only item I am pretty sure would be at interest expenses, that could be another NT$500 million to NT$600 million. That would be the only item I am able to disclose at this moment. All the others are subject to the market price for our long-term investment. Maybe even some other exchange gain or loss which I don't know at this moment.

Nick Teo - Macquarie Securities

Okay, thanks a lot, Max.

Operator

Our next question comes from C.J. Muse - Lehman Brothers.

C.J. Muse - Lehman Brothers

Quick questions. First off, I guess I wanted to clarify comments regarding CapEx. For 2006, are you saying it is unchanged at NT$100 billion and that also QDI is unchanged at NT$20 billion?

Max Cheng

Yes, that's right. About NT$95 billion and another NT$20 billion for QDI. So the total would be NT$120 billion.

C.J. Muse - Lehman Brothers

Looking to 2007, can you help me know what your budgets are for both companies?

Max Cheng

Okay, at 2007 there will be only one company. We call that the new AUO. We do not have the target yet, but basically we try to maintain that amount below our cash flow from depreciation that would be around NT$80 billion.

So that is the reason why we reduced the new Gen 7.5 and also did a one 30K of QDI that they have at this moment. So hopefully, we can maintain the CapEx amount in the year 2007 around NT$80 billion, plus or minus. But again, we haven't finalized it yet.

C.J. Muse - Lehman Brothers

Got you. Bigger picture in terms of your philosophy here, you've got a couple guys building Gen 8; you have Sharp already talking about Gen 10, skipping Gen 9 for 2008. What are your thoughts here in terms of delaying a Gen 7.5 line and falling behind in the larger size TV displays? Is this the right area for you to focus? Do you think you can get cost down at Gen 7.5 to supply those markets? Or are you seeding those markets for now?

Dr. Hui Hsiung

Actually Gen 6 and Gen 7 very specifically -- Gen 6's main focus is on 32-inch to 37-inch and Gen 7 for 42-inch to 47-inch range products. So very well-defined, most optimized for those sites.

As a matter-of-fact, we believe this range from 32 to 47, this product range will be the mainstream of LCD TV size for many years to come.

Granted, there are some high-end markets for large panel, large screen TV. In particular for the North American market it is 50-inch and above. But the LCD TV needs to compete with plasma TV as well as the rear projection TV. From what we can estimate now, we think Gen 8 or Gen 10 TFT fab right now is still difficult to compete face to face against those two other technologies.

The reason we kind of postponed the new generation, we don't necessarily start with Gen 8, we probably jump to a higher generation. But the reason we are kind of postponing it is for two obvious reasons:

One, the market itself does not warrant a rush. We don't think that market will suddenly become very large. Second, we think there is plenty of room for technology development, for better cost structure in terms of production costs, as well as product costs.

So there are some new progress we believe we can phase in, in the new generation. So we would rather take it more cautiously, so that when we decided to invest that will be the competitive investment.

So basically, we believe at least the timeframe we are talking about we think is relatively safe. Before 2008, we don't see the reason for a rush in investment.

C.J. Muse - Lehman Brothers

Great, that's helpful. One last question for me. You talked about loadings 82% to 85% in Q2; and that that would grow to 95% in Q3. When do you anticipate reaching that 95%? Is that July, August, or September?

Dr. Hui Hsiung

In July, already, close to that number; the reason being really a high demand in September in Europe. But as I mentioned earlier, there is a transit time; it costs too much. Almost we are producing some of the in-transit panels, the TV panels, we are already producing at this point.

So they may not count for this month's revenue, but some of it will count as September revenue. But unfortunately, we prefer to use the sea freight rather than air freight, so that that lead time we have to take care of. So to answer your question, right now there already is a high fab loading.

Paul Peng

This is Paul Peng, I'll just mention the PC business actually demand is very strong at this moment. So we are kind of a little bit difficulty to get all the capacity for the business at this moment.

C.J. Muse - Lehman Brothers

I guess I lied; one last follow question. Given that you are running up to higher utilization rates, and I imagine other panel makers are doing the same, are you seeing any tightness on materials or components?

Dr. Hui Hsiung

So far it is okay, we don't see any component we have a difficulty to get enough volume for our manufacturing.

C.J. Muse - Lehman Brothers

Okay, great. Thank you very much.

Max Cheng

Again, the reason we can immediately load up our fab is relatively our inventory level is low. So we don't have to first deplete our inventory, so that accounts for the reason why we start to load up in July.

Operator

Our next question comes from Chung Ong - JL Capital.

Chung Ong - JL Capital

Sorry, I've got two follow-up questions. I just wanted to check with you regarding your utilization rate, because I understand in May there was a cut in utilization, and in June there was a ramp again. Is that correct?

Max Cheng

That's correct. You are right.

Chung Ong - JL Capital

Then, is there any reason why there is such a huge swing in just like one month's time? What actually happened?

Dr. Hui Hsiung

Let me answer that. The thing is we actually started from May; we already reduced loading. In June, we anticipated a better Q3, but at that time, we checked with our customers knowing there is a lead-time in the transit, we checked whether they are willing to take our order.

But throughout June, I think our customers are conservative, so they didn't want to commit. So for that reason, it is our philosophy when our customer doesn't have a relatively firm forecast, we don't produce. So we actually reduced the loading.

But that changes toward the end of June, and the beginning of basically the past two weeks. The customers are coming back, requesting strongly for us to produce both for PC and TV panels. So that's a little bit quick swing, but basically that is our philosophy. We just follow how the demand flows. We think it is too dangerous when we don't have a firm demand and we start to produce.

Chung Ong - JL Capital

Right, so it is not related to your competitors not having utilization, while you cut yours?

Max Cheng

I'm sorry, could you say it again?

Chung Ong - JL Capital

Yes. So it is not related to your competitors not cutting their utilization while you cut yours?

Max Cheng

No, we don't look at our competitors, because our competitors they can load; even very low demand they can load 100%. So we don't do that.

We produce based on our actual demand from the customer. So that has been our management guideline. So it could swing within one month or two or even half a month, but those are all market swings. It is not controlled by AUO alone.

Chung Ong - JL Capital

Right. Can I also confirm there is a shift in loading from QDI to actually AUO?

Max Cheng

The actual shift in loading part takes some lead-time. Actually, during the second quarter, when we announced the merger, actually we already take some action in terms of planning QDI's fab into the new AUO in Q4.

That requires some product design-in and qualification, especially on the customer's side as well. So that takes five to six months of lead-time. That is why we cannot do an aggressive shifting in loading in Q3, but I think in Q4 some of this action taken earlier can start to contribute to the loading of QDI.

Chung Ong - JL Capital

Right, okay. My last thing, is Gen 6 actually profitable?

Max Cheng

Yes, Gen 6 has been profitable almost from the beginning.

Chung Ong - JL Capital

On the operating level, right?

Max Cheng

Yes, that's right.

Chung Ong - JL Capital

All right, okay. Thank you.

Operator

Our next question comes from Tejinder Sandhu - HSBC.

Tejinder Sandhu - HSBC

Just some clarification on the guidance for the selling prices. PC panels to decline by low single-digits, and TV panels by mid single-digits?

Dr. David Su

Yes, that is correct, although that is a blended ASP. For the flat panel, it is a very strong product. We think the monitor panel actually has increased relative to June. Compared to September versus June, I think the panel price increased 5% to 10% depending on what size.

TV panel will continue to drop 5% to 10% in terms of unit price but the reason we tied the blended ASP in mid-teens for TV panel is because of product mix change. We have a higher percentage of larger-size TVs.

Tejinder Sandhu - HSBC

Okay, thanks for the explanation. So when I look at second quarter, we had the large unit panel ASPs drop about 16%; but actually on a square meter basis, the drop was only 14%. So essentially what you are saying is that roughly on a square meter basis, the drop will be like maybe 2% or 3%; so nothing very big.

Dr. David Su

Tejinder, that product mix has dramatically changed and the two blended ASPs will have a big difference.

Tejinder Sandhu - HSBC

Okay, I understand. Third, I'm just trying to reconcile your earlier statement that demand is very strong from customers, people are placing rush orders, PC business is very strong; and on the television side as well you are shipping product; September in Europe is very strong.

Why are we not seeing any kind of firmness on the TV panel side? Or do you feel that from here to the end of December we will always see TV panel prices go down, or at some point in time we will see some firmness in the TV panel price?

Dr. David Su

For TV price, I think for this product we expect a mid single-digit price drop. Actually compared with Q2 this has already slowed down. So we expect that Q4 the drop should kind of stabilized.

Max Cheng

Actually the consumer electronics, including TV, especially in this early stage of new product introduction 25% to 30% annual price reduction can happen. But if you look at a panel price from January to July, actually already we are in this range. We are over that range. We are almost over 30%.

So that really means as far as TV panel is concerned, the price is already in position for the demand, if you convert the panel price into the fab price, we think it is already a very good fab price; sufficient to sustain the demand for Q3 and Q4.

So there is a possibility that TV panel price doesn't change in Q4 or even slightly increases depending on the demand situation.

Tejinder Sandhu - HSBC

So you think that this conventional market talk that consumer electronic components, the prices can never go up, unlike PC panels, you think that will change in the fourth quarter?

Dr. Hui Hsiung

I think it will change entirely, it has already changed. Last year, we had an increase in the 20-inch TV panel price, and so that already happened. I think basically, I said earlier, the TFT-LCD is still relatively young in terms of the TV market. So I think the players tend to overreact sometimes. In terms of price, I think the current price level is lower than it should be.

So I think it is over-corrected price. So when you have over-corrected price, when the demand is there, you can adjust it back to normal. At least, that is still to be seen, but I think there is a possibility there.

Tejinder Sandhu - HSBC

All right, thank you, sir. Just one last question on the balance sheet. The net debt to equity ratio is about 51%. Are we still very comfortable with that? Or is there some concerns that you may probably need to add some more equity here?

Max Cheng

No, I guess unless the net debt to equity shifts maybe like at 75, we are going to cut all our CapEx; or maybe we need to do some like equity funding. At this moment we still feel okay. Because at this moment we try to control our CapEx for the next few years, so I believe the current level still should be all right.

Tejinder Sandhu - HSBC

Okay, thank you very much, Max.

Operator

Our next question comes from Mark MacKenzie - Sanford Bernstein.

Mark MacKenzie - Sanford Bernstein

Thank you for taking my call. You mentioned reducing costs both in processes and in sourcing. Can you give us a little bit more color on both of those aspects? Both where you think the processing and where you think the sourcing, the big levers are for those reductions?

Max Cheng

I guess the easiest way to have cost savings on process would be to improve our loading rate. Such as you know, we can do something in Q3 because the loading rate improved maybe like 20% compared to Q2. Basically we think we can do that.

Of course, you know, we will try to allocate the line for the best cost product that would also improve our process costs. I guess that is pretty much what we can do.

Sourcing, our procurement department they spend a lot of time. But besides that, I will say our redesign will play a very important role for our cost savings.

Dr. Hui Hsiung

I think in the last few quarters, I think our sourcing costs, almost consistently, every quarter 3% to 5% material costs is saved. On top of that, we have introduced new models, cost models. So usually for the past three quarters, we are able to reduce costs over 5% every quarter.

I think that pace almost is necessary to stay alive, hopefully as they become popular pretty soon. But basically, the whole supply chain, the material costs are still 60%, 70% of the total cost. So sourcing and the consistency in the supply chain; reduction is necessary.

Mark MacKenzie - Sanford Bernstein

Excuse me, I'm sorry. Specifically, are the big levers things like backlight units, polarizers, or substrates a lever?

Dr. Hui Hsiung

Right, this is almost a continuous cost reduction that has been done. Still the whole TFT-LCD technology including its material and design, especially with TV, the cost reduction is, I think, we believe at this pace, is still possible.

Although in PCs, Max mentioned about PCs cost reduction is more difficult. The same pace, but I think that is because the price already should be more stable than the TV.

Mark MacKenzie - Sanford Bernstein

Just one other question. Other players in the industry and some of the third parties have talked about 50% area growth for 2006 over 2005. Do you have any perspective on whether that is an appropriate number, or high, or low?

Dr. Hui Hsiung

50%? That seems to be correct, yes. At least the ballpark is a 50% area increase.

Mark MacKenzie - Sanford Bernstein

Terrific, thank you very much.

Operator

Ladies and gentlemen, due to the time restraints we have run out of time for any more questions. So I would like to turn the call back over to management for closing comments.

Julie Chan

Thank you very much for participating in AUO's second-quarter earnings conference call. If there's any questions we have not answered you, by all means please write to us at ir@auo.com. We thank you for your support, and we look forward to seeing you in Q1. Thanks.

Operator

Thank you, ladies and gentlemen, for your participation in today's conference. You may now disconnect and have a wonderful day.

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