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Diodes Incorporated (NASDAQ:DIOD)

JPMorgan Global Technology, Media and Telecom Conference Call

May 14, 2013 2:10 pm ET

Executives

Richard D. White – Chief Financial Officer, Secretary and Treasurer

Analysts

Shaon I. Baqui – JPMorgan Securities LLC

Shaon I. Baqui – JPMorgan Securities LLC

All right, good afternoon everybody. I hope everybody had a good lunch out there. For those who don’t know me, I’m Shaon Baqui. I’m the other half of Team Danley here at JPMorgan.

And next up we have Diodes, and for those guys who aren’t familiar with Diodes, they’re a primary provider of standard logic discrete and analog semiconductors. And they’re actually one of the better stories in the sector this year. The stocks up about 40% year-to-date; they just acquired really co-company called BCD Semiconductor, and they’ve shown some nice growth outside of the core standard logic and discrete business over the last few years.

And with us here is their CFO Mr. Rick White. He is 25 year TI veteran and have been with Diodes since 2009, I believe…

Richard D. White

2006.

Shaon I. Baqui – JPMorgan Securities LLC

2006?

Richard D. White

Yeah, CFO since 2009.

Shaon I. Baqui – JPMorgan Securities LLC

Yeah. Okay. So thanks again for joining us and I think you wanted to read some…

Richard D. White

Yeah, so we have a Safe Harbor statement, which I’ll refer to you in our SEC documents. We’re invoking that for this meeting as well.

Shaon I. Baqui – JPMorgan Securities LLC

Okay, great. And for those of you in the room who aren’t as familiar with the Diodes story, could you kind of just walk us through some seeing your product portfolio and end markets you serve?

Richard D. White

Sure. So first of all, can we just have a raise of hands, how many people in here know Diodes, have heard others are familiar with us? Okay, so for those of you that aren’t, Diodes has been around since the 50s and we were reconstituted a couple of times, we’re a public company on the NASDAQ have been basically the same company from the 1970s up till about the first part of the 2000s. We focus on what we call application specific products, standard products and when we talk about an application, we’re talking about specifically cellphones or LED panels, those types of applications rather than a specific application in a device.

The company focuses on high volume, high growth markets. So therefore if you look at our the major penetration in the market sectors, consumer is first at about 30%, computing is second at about 30%, actually industrial and communications are about neck and neck at 19% and 17%. Industrial has grown a little bit when we bought Zetex in 2008.

Our strategy is profitable growth. We focus on not only growth, but producing profit and we’ve – we’ll get a little more into the details of how we achieve that growth. But over the last 10 years, Diodes’ SAM are served available market, which is about $25 billion to $30 billion has grown about 4% and Diodes’ compound average growth rate of 19%. From a profitability standpoint, we’ve been profitable for the last 22 years in a row. So we believe that we’ve achieved both profitability and growth.

Shaon I. Baqui – JPMorgan Securities LLC

Okay, great, thanks for the introduction. I guess speaking along those same lines of growth. One of the things you’ve had a heritage of is really trying growth through M&A and along those same lines just a quarter, made a pretty major acquisition in BCD Semiconductor, so that haven’t closed early March?

Richard D. White

Right.

Shaon I. Baqui – JPMorgan Securities LLC

Can you give us an update kind of now that you’re about a quarter end of how that integration is going and what your plans are so far this year?

Richard D. White

Sure, okay so BCD was a semiconductor that was a semiconductor company is in analog business, which is one of the major areas we focus on as Shaon said, we have three major product areas. We’re in the discrete business, we got into the analog business in 2005 and we got into the standard logic business in 2010.

So over time, I’ll step back a little bit, we’ve grown the company through the internal growth and also through M&A. Our whole goal in life is to increase our SAM to get into new markets, increase our product penetration in the markets we’re in. And so you can see that we’ve bought Anachip, which was an analog company in 2005.

We bought APD Semiconductor in 2006, which was a company that had SBR Technology, Silicon Barrier Rectifier Technology. We bought Zetex, which is European company in 2008. Last year, we bought PAM and they were in the audio amplifier business LED Drivers.

And then as Shaon said in March 5, we bought BCD Semiconductor, a Chinese located company, they’re actually a public company on the NASDAQ under BCDS. We acquired a 100% of them for cash and paid about $155 million. They were entirely in the analog business; their customer base was basically local Chinese companies where Diodes customer base is more EMS and large distribution based.

We do about 80% of our business in Asia, about 10% of our business in Europe and about 10% in North America but the customer base that we got in BCD was different than the customer base we had. With, we also were able to get a separate product line that we didn’t have in the AC-DC converters for chargers, Diodes’ already had the DC-DC converters, but we didn’t have any products to address this AC-DC area.

We bought them in March, the integration has started. The first thing we’ve done is to, first of all we kept all the people, we’ve made their CEO, a guy named Chieh Chang. He is managing the analog business along with our current Analog Manager or prior Analog Manager Julie Holland. We’ve integrated the sales and marketing functions and we’re starting on the integration of their products into our assembly test facility in Shanghai.

We have a large capacity assembly, test facility there. They do all their subcontract, all their assembly test outside of the company. So, we’ve started the process of qualifying their product in our assembly test facility. We believe that, that’s a three month period to six month period that conversion will start in fourth quarter and in first quarter of 2014, we think it will be fully converted for at least those products that we can convert.

They have some older style packages like TO92 that we don’t produce, so of course we’ll just leave those with the subcontractor.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. Great. I know you talked about the synergies with their back, with your own backend facilities moving, since they don’t have their own internal facilities, they’re outsourced. But there is also a synergy in the sense that you can sense some of your logic over to their fabs correct?

Richard D. White

Oh yeah, sure. Some of our analog products, we buy all of our analog wafers externally, and part of the purchase was that, we got two 6-inch wafer fabs, they have an older fab called Fab 1, and then they had just started a new fab called Fab 2A, which was – both of these were located in Shanghai near our assembly test facility.

The startup of Fab 2A started in January, so it’s just in the initial ramp up phase, so one of the synergies that we see from this is that, we’ll be able to take the wafers we’re currently buying externally at foundries, and bring those in-house and help them load their wafer fab more fully, and to utilize their wafer fabs better giving us a better cost, and also on our side capturing the profit that would have gone to the subcontractors themselves.

So we think that’s synergistic from our standpoint, also from an assembly test, we have the deal that we’re underutilized right now in our assembly test facility, I think we talked about that on the various earnings calls, loading them into our facility will help with utilization, which will help Diodes’ profitability as well as capture the profit that they’re paying to their subcontractors.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. And I know it’s little early to talk about timelines, and all that with the front-end moving over to BCD, but is it safe to say, it’s slightly later than 1Q ‘14 next year?

Richard D. White

Well the wafer fab is a little tougher, because you have to get customer qualifications, if the customer is already qualified the chip, and it’s going into a different package, that’s easier, that’s probably a three to six month process.

Shaon I. Baqui – JPMorgan Securities LLC

Okay.

Richard D. White

We’re qualifying a new wafer fab process for your customers’ longer-term processor.

Shaon I. Baqui – JPMorgan Securities LLC

Okay great, great and I guess – let’s just switch gears a little bit and talk about the – talk a little bit about your latest quarter and the guidance you gave last week. I think one of the things that investors have been really focusing on is a fact that your gross margins have been showing a really nice securely increase going back to I guess Q1 of last year when they are on 20%, now you’re driving back to that 30%, which is kind of what’s been talked about for long time. Can you talk about some of the different – the different levers that of – that you’ve pulled to get the margins close to that 30% lever and what kind of leverage you have left in the model from here?

Richard D. White

Sure, so let’s step back a little bit. If you look at Diodes history from the middle part of 2009, let’s say third quarter 2009 through the first half of 2011 Diodes margins were in the 31%, 32% actually got its highest 38% in the fourth quarter 2010.

And then if you step back and looked at the 2011 time period and 2012, the first half of the year seem to be pretty strong, Diodes invested money in assembly test area to get packaging capability ready. And then both of those years, the market kind of tailed off and so at the end of 2012, we ended up with about 30 billion units of capacity and we were using about 24 billion units of capacity.

So over time, that’s hurt our GPM, we’ve worked on productivity, the gold prices have gone down. We worked on copper wire conversion from gold wire conversion, we’ve tried to improve the product mix, the – we mentioned in our earnings call that the transition during the Chinese New Year period was better than we had expected.

So a lot of those things has impacted the first quarter and will continue, like if you think about gold price is going down, it’s kind of a phased in thing, you’re buying gold at $1,700, $1,800 an ounce and if it goes down to $1,600 that’s not an immediate impact. It just starts to fading an over a period of time.

So we think that some of these things along with these improvements that we talked about in BCD, wafer fab and assembly test loadings will help. Plus if you think about as your utilization improves in your facilities, you have a range of products from high margin products to low or even negative margin products, and if you are trying to fill up your assembly test area, you may decide to take a lower margin product because it still going to generate GPM dollars, which is our goal and life is to generic GPM dollars.

We’re not in the push to get from 33% margin to 38% margin to 42% margin like some companies are. We believe that that push to increase margins will cut-off the growth and if you remember our strategy, it’s profitable growth. So we will, as the facility improves, the utilization, you’re able change your product mix to sell only a higher group of products that have higher margins, right.

Shaon I. Baqui – JPMorgan Securities LLC

Okay, thanks. And I think one of the things you’ve talked about in Q1 was the end markets that competing was a little stronger, even though the sector in general was soft?

Richard D. White

Yeah.

Shaon I. Baqui – JPMorgan Securities LLC

Can you talk a little about what happen there in Q1 and how you see that trending throughout the rest of the year?

Richard D. White

Well, I think that if you look at where we live or die, we live and die in the consumer business and the computer business. Some people talked about automotive and industrial, industrial has grown a bit but the 3Cs, computer, communications and consumer are important to us.

We don’t think there is a lot of strength in computer in general, everybody knows that PCs aren’t selling, but our view is that and our product is able to be used, if you’re using it in a cellphone and the smartphone piece of the cellphone business is faster growing then we’re going to be involved in that fast growing piece and same thing in the computer business. Tablets, we put tablets in consumer, but people are buying tablets and ultrabooks and things like that which are the fast part of the business and we’re in those areas as well.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. And in terms of automotive industrial, you’ve had several people not only during earnings, but just this afternoon just reiterate the fact they are kind of strongest end markets out there right now. Are you guys kind of seeing similar order patterns there in strength?

Richard D. White

Yeah, sure, we talked about in our earnings call that we had strength in North America and Europe and that’s what you get in North America and Europe are the industrial and automotive markets especially in Europe for automotive. But again as I said that’s 20% of our business.

Shaon I. Baqui – JPMorgan Securities LLC

Sure, sure. Let’s step back again, I guess, to 3Cs, can you talk a little bit about what your content is today in standard cellphone or tablet versus where it was maybe two, three years ago and kind of where you see that going with the BCD acquisition?

Richard D. White

Well, first of all, we don’t know exactly what our content is because we don’t sell to the end customer. We sell to the cellphone maker and he just buys product, and what he’s put it in, we don’t know whether it’s a cellphone, smartphone, tablet, who goes to…

Shaon I. Baqui – JPMorgan Securities LLC

Sure.

Richard D. White

And those kinds of things right. So if you want to know the content, Diodes average sales price per unit is about $0.02, $0.025 and so if you got a few products in a cellphone then you can multiply it up. Stepping back though, our portfolio has changed significantly. Six or seven years ago, Diodes didn’t have any products that we could sell to a cellphone manufacturer or LED manufacturer.

And when Dr. Lu came in, his whole goal in life was to get Diodes from being a small distribution type company, resell type company to a full line semiconductor with manufacturing in wafer fab, assembly test, R&D, because we’re firm believers and that you in the semiconductor business, you need to try to control your own destiny and you need to be big enough to be able to withstand the shocks of the cyclical nature of the business.

And so we got into the analog business by purchasing Anachip that allowed us to increase our TAM significant or SAM significantly and it gave us an opportunity to start selling into cellphone makers for instance. Anachip had hall sensors, which are the little buttons on your phone that move the cursor around to magnetic sensor. It’s also is used in (inaudible) closure, cellphone, it turns off the screen.

So that allowed us to get into the cellphone guy and say, “Hey here is the nice product. And then once you’re in there, then you can talk about battery management, UBS switches, those kinds of products.

Same thing can be said for the LED, LCD panels. We didn’t have a product that would be very good for that market. And so Zetex had MOSFETs. We got SBR technology that allowed us to get into those higher power devices and we’ve grown from there.

And then in 2010, so we were in the discrete business, we got into the analog business and our whole go in life was to expand our SAM and then Dr. Lu said, we’re going to get into the logic business and so we developed our own internal set of products for the logic market. Expanded our SAM again and allowed us to address other products within our current customer base.

Shaon I. Baqui – JPMorgan Securities LLC

Okay great and what the consumer business and gets little bit softer in Q1, did you see that kind of bottom there and what can we see into the rest of the year?

Richard D. White

Well that’s what everybody asked and basically if we had to answer – we probably would, we would be able to do a lot better. I think that current market is – we said that pricing is stable. So for us, the stable or normal means that it goes down, about 2% a quarter but there is no, at some point some time in the past, we’ve had 5%, 6% drops per quarter in pricing.

The market seems to be not cold and not hot, so we don’t and will be in cautious about where we are now based on the exuberance that we and another people may have had in 2011 and 2012 about the first few months of the year, everybody seems to think it’s fine and then it tails-off in May, June, July time period.

Shaon I. Baqui – JPMorgan Securities LLC

Yeah, I guess you brought up an important point that we’ve seen kind of seen this nice uptick in the first half 2012 and 2011 and really materialize in the second half. Can you kind of compare and contrast where we are this year versus maybe last year and year before in the business cycle and maybe more broadly speaking what’s the difference between your customer engagements this year versus last and what gives you confidence for the second half?

Richard D. White

Well, so first of all, I would say we’re trying to be more cautious this year as I mentioned earlier, we invested in assembly test capacity in 2011, 2012 and ended up with extra 6 billion units. So, we’ve announced that we’re going to reduce our CapEx as a percent of revenue from our normal side model, a 10% to 12% of revenue to more in the 5% to 9% of revenue so, we’re taking a more wait and see attitude. The on-load of BCD products from their sub-cons into our assembly test facility will help with that.

Shaon I. Baqui – JPMorgan Securities LLC

Sure.

Richard D. White

So, we think that’s going to start in the fourth quarter so, we’re taking a more cautious view of it going forward.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. Okay. And in terms of distributors behavior right now, it looks like they’re running, still running pretty lean, do you see them taking up inventories a little bit into Q2, maybe in anticipation of a stronger second half or they still kind of comfortable where things are?

Richard D. White

Well, so, right now in the first quarter, we are sell-in and we call-it POP and the sell through we call POS and so our POS in the distribution area was up about 8%. So, from our standpoint that was good because they were selling their product and they were buying more product from us. And so we thought like the distributors did a good job of buying product.

From an inventory standpoint, they had spent the last two to three quarters reducing their inventory, especially in the U.S. and Europe. And we think that some of this was in the first quarter was inventory restocking with inventories went up about 4% we think. But overall, we think that the distribution business because of the POS, we saw was stronger sign.

Shaon I. Baqui – JPMorgan Securities LLC

Okay, pretty good and…

Richard D. White

But we do think the distributor inventories are still less than 90 days, which is kind of our view of good versus bad.

Shaon I. Baqui – JPMorgan Securities LLC

Okay, right. And in terms of geos one thing as we noticed in your earnings call was that North America and Europe are strong and the first part wasn’t a huge surprise, second part was little bit of surprise to us, can you kind of walk us through what was going on in Europe?

Richard D. White

Europe?

Shaon I. Baqui – JPMorgan Securities LLC

Yes.

Richard D. White

Well, Europe is automotive and industrial.

Shaon I. Baqui – JPMorgan Securities LLC

Okay.

Richard D. White

So they were benefit of that strong industrial and automotive market.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. And can you kind of describe what’s going on in China and Asia right now, what you’re hearing?

Richard D. White

Well, we sell a lot of our product to major guys, right. And so we’re not as dependent upon the China market as you might expect. So PCD is and BCD kind of has the same, it’s not hot, it’s not cold type of view.

Shaon I. Baqui – JPMorgan Securities LLC

Great, great. And you talked a little bit about maybe modulating CapEx down this year to that, I think 5% to 9% range is that correct?

Richard D. White

That’s correct, yeah.

Shaon I. Baqui – JPMorgan Securities LLC

How does that compare to historical averages and maybe do you have any room to raise it up or lower more depending on what demand looks like in second half?

Richard D. White

Sure. We historically, our model has been 10% to 12% of revenue, if you read our earnings calls and read our press releases, we talked about excluding Chengdu, which is our new assembly test site, the reason we did that is that if you are showing high facility, the buildings and the infrastructure was put up by our partner and we lease them from our partner, our Chinese partner in that and so in Chengdu, we own the building, so we didn’t believe that those building infrastructure CapEx numbers were part of our 10% to 12%, so that’s why we excluded those.

We have got the buildings up, they’re putting in the power now, we will have plenty of capacity available or plenty of space available, should the market require it? We have a pallet line there now that is producing few hundred million units, basic for training the people, training the managers and getting the quality in the right place and once the decision is made to outfit the Chengdu buildings and we’ll move that pallet line and then it’s like any other manufacturing exactly what we did in SIT, you have a big space and you can put in a certain number of 200 million units of one product, a 100 million of another product and so it’s not like you have to go outfit this thing.

So we will watch and see what the market requires and how that VCD onload into our facility works and we’ll go from there. But if you look at – we were positive operating cash flow in the first quarter, positive free cash flow and so with lowered CapEx and the expectation will be that we would have free cash flow, which we could use for CapEx or wherever we want to use it for.

Shaon I. Baqui – JPMorgan Securities LLC

Okay, so when you talks a little bit of the Chengdu fab, what is your ideal manufacturing footprint once the BCD products get put into your back end and your stuff gets put into their Shanghai pattern?

Richard D. White

Well, also we had assembly test facilities and the big one is in Shanghai. It produces about let’s say it has about 30 billion units of capacity a year. And then we have Chengdu, Chengdu is in central western part of China, so away from the coast, the labor cost are 10% to 20% cheeper than they are in Shanghai, which is one of the reason we went there.

There are other bigger companies there, Intel for instance, TI is right in the general neighborhood. So the build is set and we will move capacity in there as required or at least bill capacity. The plan right now is to make their copper-wire facility. So we’ll have to put copper-wire products and they’re not gold wire products.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. And in general we talk a little bit about, the CapEx piece. Now you done digesting a major acquisition, what are your thoughts on uses of cash, are you certainly looking at more M&A opportunities out there or you can focus more on returning some of that just to shareholders?

Richard D. White

Okay, well so first of all right now there are not plans for dividend and no plans for share buybacks. Dr. Lu is an entrepreneur and he believes in buying companies and we’re at a profitable growth and we don’t believe you can – you use should user money for share buybacks if you’re looking for profitable growth.

For those of you that know him, he is very specific about what he will buy and what he won’t buy and it may take anywhere from one year to two years for him to set a sight on something and finally get it to the right point, where he thinks it’s time to buy it.

I would think in the short-term if we have a lot of extra cash, we pay down debt with it. We did just in January. We get $300 million credit lines through BOA and another set of banks. And as part of that, we used about a $155 million to buy BCD and we had about $40 million on our previous credit lines. So we have about $200 million, $210 million of debt outstanding out of the $300 million that we had in there.

In addition to the $300 million that was an accordion feature in there for another couple $100 million, which we could go back and request the banks to less borrow. We would have to get their agreement and covenants and all that would have to stand-up, but basically that’s available.

So again Dr. Lu is in the acquisitive mode and if he finds the right target and at the right price, and he thinks it meets his criteria. He has a set of criteria, which are, he calls two musthaves, one is it needs to be accretive in one year and the second one is that it has to be synergistic with our packaging technology. So he is not going to buy something that has 150 pins and we could build it internally.

So in addition to those two things then he has some, what he calls nice to haves, which are gets us a new product line like AC-DC chargers, gets us into a new region like Europe or China local and so he has a set of criteria and you can go look at our BCD presentation we made when we bought them, and we had those criteria in there and how we graded BCD in their all ones except for one item, which was a two. So, we think that BCD was a good acquisition for us from, especially from an M&A standpoint.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. Thanks. And if any questions from the audience? I guess just speaking generally about your company. One of things we’ve seen a lot of people come and go from the standard products place. How you manage to pickup share and how over the last few years and that’s what…

Richard D. White

Okay, well. So as Dr. Lu will say, he is interested in GPM dollars, and so when a lot of companies, when the product line doesn’t meet their margin requirements which are constantly increasing, they just exit those, right. But we’re a discrete company. We like the discrete business. We’ve been in the discrete business for a long time, and we have two discrete wafer fabs. We have an assembly test facility that’s built around, assembling, analog, logic and discrete products. So we’re going to stay in the discrete business. Other guys, I don’t know why they get out other than they just think that are better businesses elsewhere.

Shaon I. Baqui – JPMorgan Securities LLC

Fine, Okay. And so, can you compare there, competitive environment today, versus maybe more or less five years ago, 10 years ago?

Richard D. White

Well, you still have guys that are in the discrete business, you got Fairchild and ON and NXP, and so there are still guys out there that are doing it. But everybody seems to be moving to integrated circuits and that not we’re headed. Okay.

Shaon I. Baqui – JPMorgan Securities LLC

Okay. I guess that’s about all we have time for today. Thanks everybody for attending and thank you Mr. White.

Richard D. White

Sure. Thanks a lot for having me. I appreciate it.

Question-and-Answer Session

[No Q&A session for this event]

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