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Standard Microsystems Corporation (NASDAQ:SMSC)

F1Q10 Earnings Call

June 25, 2009 5:00 pm ET

Executives

Chris King - President, Chief Executive Officer

Kris Sennesael - Vice President and Chief Financial Officer

Carolynne Borders - Director of Corporate Communications

Analysts

Christopher Longiaru - Sidoti & Company

Vernon Essi - Needham & Company

Unidentified Analyst

Operator

Good afternoon ladies and gentlemen, and welcome to the SMSC first quarter fiscal 2010 conference call. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen-only mode. Following managements discussion, we will open the conference up for questions and answers, and instructions will follow at that time.

I’d now like to turn the conference over to your host, Ms. Carolynne Borders of SMSC.

Carolynne Borders

Good afternoon, and thank you for joining us today for SMSC’s first quarter fiscal 2010 conference call. You should have all received the copy of our press release issued this afternoon. Please note there is also a slide presentation that accompanies today’s call.

The press release, slide presentation, and a replay of today’s call will be available in the Investor Relations section of our website. Representing management today are Chris King, President and CEO, and Kris Sennesael, Vice President and Chief Financial Officer. Following management’s discussion, we will open the call to a Q&A session. If you are participating in our online webcast, please move on to slide two for a quick note on our Safe Harbor statement.

Certain matters discussed in this teleconference are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected or forecasted. Such risks and uncertainties include, but are not limited to, those discussed in this teleconference and those found in the company’s Form 10-K, 10-Q, and other filings with the Securities and Exchange Commission. I’d also refer you to the forward-looking statement language contained in today’s press release regarding risks and uncertainties.

Today’s presentation also includes non-GAAP financial measures, which should not be considered in isolation or as an alternative to results of operations data or any other measure of performance derived in accordance with US GAAP. However, these non-GAAP financial measures are presented because the SMSC believes they provide useful supplemental information for management and investors and allow them to perform meaningful comparisons to the company’s past and present results.

With that, I’ll ask you to advance to slide three in a presentation, and I’ll turn the call over to Chris King.

Chris King

Thank you all for joining us today. We are very pleased once again to have an opportunity to provide a business update in a climate that is showing continued signs of recovery. Customer forecasts have become stronger since the last time we spoke, and we’ll walk through the reasons that we’re feeling increasingly confident in the success of our business objectives.

PC inventories are back to normal levels at about 2 weeks, and while consumer product inventory had been slow to work down, we expect that to normalize this current quarter. We see some improvements in automotive orders with sales up approximately 16% from the fourth quarter of FY09. While we’re not back at historic automotive run rates, we expect sequential quarterly improvements to continue. The industrial market remains sluggish, particularly in Europe. Asia has led the recovery followed by North America. Europe and Japan have lagged primarily due to their exposure to the automotive and consumer markets; however, we are seeing positive trends in both geographies and expect Q2 sequential sales increases worldwide.

From a product standpoint, we continue to see improving end-customer demand for commercial and low-end notebooks as well as smartphones. The net book space has become very interesting with a new CULV being identified and the cellphone contingent calling their products smart books. For us at SMSC, these labels don’t matter mach as we sell the same components into all categories.

During Q1, we received a fair number of rush orders, particularly for our analog products. We believe this order activity supports the view that true demand is improving since this is not consistent with inventory restocking. We have heard some concern about the market becoming overheated, especially in Asia. While we are watching the situation carefully, we do not believe there is any double ordering occurring.

Let’s proceed to slide 4. Our Q1 financial results were better than we originally anticipated. Revenue was $62.5 million, a 22% sequential increase but down 33% year over year. The primary growth driver was the PC segment which was up over 60% sequentially. We’re seeing this growth in both North America and Asia. Our channel checks indicate that our revenue run rate in Q1 was driven by true demand after inventory levels were driven down in Q4. We also improvement in automotive sales of approximately 16%, off the low level in Q4. Consumer sales were flat while some inventory positions remained, and industrial revenue was down as the correction in this segment lagged behind the rest of the market.

Non-GAAP gross margins were 47%, which was a 150 basis point improvement over Q4. While product mix was unfavorable due to shipping more of our analog products which have gross margins slightly below the corporate average, we gained the benefit of more activity and the cost reductions we have completed. It’s still our expectation to deliver over 50% non-GAAP gross margins in the second half of our fiscal year.

Non-GAAP operating expenses decreased by $3.2 million due to our cost reductions and cost control. This resulted in an operating loss of $5.4 million and an EPS loss of $0.15. Our goal in Q1 was to be cash breakeven before restructuring. Without the restructuring impact, we were able to improve our cash and investment position by $9 million during the quarter. Including the $4.2 million in restructuring expense, cash and investments increased $4.8 million to $171.2 million.

We drove inventory down another $8 million in Q1 to $45.5 million, which is a total reduction of $13 million in the last two quarters, resulting in turns slightly under 3 times. This is back to our pre-crisis inventory level. Due to our testing move which I will talk about more in a moment, we will increase inventories slightly in Q2; however, we expect to reach our goal of less than $40 million in inventory by year end which is approximately 4 turns.

We are expecting further improvement in Q2 with revenue being up 12% at the mid point driven by growth in all 4 of our product areas. Q1 book to bill was over 1.2, and OEM backlog coverage at the end of the first quarter was 70%. Bookings have remained healthy during the first 4 weeks of the current quarter. Looking ahead, our analog and portable product line should exit the second quarter at record revenue levels. This in addition to improving automotive sales and a relatively healthy PC market should lead to sequential growth in our first third quarter.

Today, we are announcing an initiative to drive costs lower and implement a more efficient supply chain for our customers which is detailed on slide 5. SMSC is a fables company purchasing wafers primarily from Chartered and PSMC. We have always outsourced assembly, but we’ve conducted most of the test function at our facility in New York. We have spent the past several months thoroughly evaluating our production infrastructure, and in light of the current economic conditions, we have put in place a plan for outsourcing the majority of our production test operations to Asia.

This move will allow us to be closer to the manufacturing supply chain and ultimately deliver products with shorter cycle time. This will also offer greater scalability of our production capability. The relocation of the test production will occur in multiple phases and is expected to be completed by the end of fiscal 2010. It’s our estimate that this transfer will result in an improvement of at least 100 basis points in non-GAAP gross margin when completed by the end of fiscal 2010. The accounting charges associated with our test outsourcing are estimated at $3 to $8 million of which $2 to $3 million is cash, spread over the next three quarters.

Let’s move on to slide 6 for an update on our product lines. The acceleration SMSC’s sales of commercial and low-end PCs is coming from end-market improvements as well as market share gains. We’re working closely with approximately 15 net book customers and we’re in 5 reference designs for these products. We’re continuing to enjoy success with smart phone customers as we expand our presence into new models. One of these design wins was the Samsung Omnia I910 which was features in a May industry teardown. In addition, we recently announced that our MOST networking technology has been selected for the new Prius—Toyota’s popular hybrid car model which is distributed worldwide. This design win marks the first high-volume hybrid vehicle to adopt the MOST technology and also expand SMSC’s presence in Toyota’s mid tier line of vehicles that are sold globally. With the recent Prius and Lexus RX design wins, MOST is now adopted in more than 70 car models on the road today.

Slide 7 features our recent product launches, the most exciting of which is our official entrance into the capacitive sensing market with our RightTouch line of products. While these products are initially being rolled out for notebook computers, LCD monitors, and printers, we expect them to be integrated into consumer product devices as well as white goods. Our family of products is establishing a new standard for capacitive sensors due to superior noise immunity. The RightTouch architecture inherently rejects analog noise which yields a higher signal to noise ration and makes fine tuning touch thresholds easier. This results in a more simplified development process for our customers.

In addition, this quarter we announced TrueAuto ethernet controller and the industry’s first USB hub plus card reader for automotive applications. We also rolled our the industry’s first combination USB 2 hub and 10/100 ethernet controller and introduced our first USB product with a high-speed interconnect interface which is attracting a lot of interest. Finally, we expanded our Ethernet portfolio with the addition of a new low power 10/100 transceiver.

Slide 8 speaks to revenue by our target vertical markets. Revenue in the first quarter was driven primarily by PC sales which were 44% of total revenues and up 64% sequentially. Automotive revenue was up 16%, while consumer sales were approximately flat. The industrial segment was the only end-market that was down, declining 7%.

Breaking down performance by product line, on slide 9, our core computing and connectivity line was 65% of total revenues or $41 million. We are seeing strength in both notebook and desktop sales in the commercial segment and designs utilizing our USB solutions are also contributing to the uptick in this product line. Automotive sales contributed 13% of sales or $8.1 million. Global inventories are starting to clear, and we also have several new design wins ramping such as the latest Toyota models.

In our analog product line, we believe we are gaining market share, augmented by a strong recovery of the consumer PC market. Revenue from this product line contributed 15% or $9.2 million of total SMSC sales. Finally portable product sales totaled $4.2 million, equating to 7% of sales. Each of our product lines except portables was up sequentially in revenues. Portable sales were roughly flat due to a temporary customer inventory issue, but we are winning many smartphone designs which leads us to expect record revenue for the product line this fiscal year. For the next quarter, it is our expectation that all product lines will drive sequential growth in line with the anticipated semiconductor market improvement.

Slide 10 depicts our sales our geography, reflecting design win locations. Sales in Asia were strong, up 56% sequentially, followed by North America which was up 38%. In fact, Asia sales were up 5% year over year. Revenue from MEA and Japan were both down approximately 10%, but both are expected to recover in Q2.

I’ll now hand the call over to Kris Sennesael for a review of our financial highlights.

Kris Sennesael

If you’re following online, we are on slide 11. We were very pleased with revenues of $62.5 million in the first quarter of fiscal 2010, which were up 22% sequentially. We improved our non-GAAP gross margin by 150 basis points from 45.5% in the fourth quarter to 47% in the first quarter. While mix worked against us this quarter due to a shift towards analog products, we benefited from higher activity coupled with our cost reductions. It is still our plan to get back to non-GAAP gross margin above 50% in the second half of our fiscal year. This will be driven by several items. First, we expect to have higher absorption associated with increased sales activity. Secondly, a mix shift towards higher margin products should start to work in our favor, and lastly we expect to realize gross margin improvements from cost savings related to the test outsourcing and cost reductions in our supply chain including lower wafer and assembly prices.

In Q1, we reduced our operating expenses by 8.5% to $34.8 million. Going forward, we expect modest increases in the quarterly Opex run rate for the remainder of the fiscal year as we continue to invest in our product roadmaps. Our operating loss narrowed to $5.4 million versus $14.7 million in the fourth quarter of fiscal 2009, as more than 82% of the increased revenue fell through to the bottomline. The better than expected sales results coupled with our tight cost control made is possible for us to reduce our non-GAAP net loss per share to $0.15 versus a loss of $0.54 in the fourth quarter.

Let’s move on to slide 12. Clearly the industry downturn has taken its toll on our quarterly sales run rate; however, with the bottom behind us and signs of continued demand improvements, we expect to get back to seasonal patterns which typically result in strong sales in our second and third fiscal quarter. As a result, we anticipate that the third quarter sales will exceed that of the second quarter.

Let’s advance to slide 13 for a look at the bottomline results. The non-GAAP net loss for the quarter of $3.3 million or $0.15 per share compares to an EPS loss of $0.54 in the fourth quarter of fiscal 2009 and a profit of $0.39 in the first quarter of last year. The GAAP net loss for the first quarter of fiscal 2010 was $9.2 million or $0.42 per share. The non-GAAP net loss excludes stock-based compensation in the amount of $5.4 million, amortization of acquired intangible assets in the amount of $1.5 million, a restructuring charge in the amount of $200,000 associated with the cost reduction actions announced on January 14, 2009, and a charge of $2.1 million related to the anticipated settlement of the Opti patent infringement case.

If you will join me on slide 14, we will review our capital position. SMSC has continued to maintain a strong balance sheet. As Chris already mentioned, we exceeded our goal of cash breakeven in Q1 before cash outflow restructuring. After the expected restructuring expense of $4.2 million, cash and investments increased $4.8 million to $171.2 million or nearly $8 per share, as compared to $166.4 million at the end of the fourth quarter of fiscal 2009. This was the result of careful working capital management, favorable adjustments to our auction rate securities’ temporary impairments, and favorable FOREX impact on the balance sheet.

During the first quarter, our exposure to auction rate securities was reduced by $8 million, redeemed at par, as well as an additional $850,000 to date in the second quarter. As a reminder, these securities are primarily invested in high grade government backed programs.

Slide 15 captures SMSC’s current inventory and receivable position. We further reduced our inventory by $8 million in the first quarter. With the planned relocation of our production test operation, we expect a temporary increase in inventories during the second quarter of fiscal 2010; however, it is still our plan to exit the fiscal year with much leaner inventories at approximately 4 turns. DSOs increased slightly to 53 days as a result of the increase in revenue.

Turning to slide 16, I will review our guidance for the second quarter of fiscal 2010. Based on our current booking trends and backlog levels, we expect revenues to be in the range of $68 to $72 million, which would be 9-15% higher sequentially. We currently anticipate the non-GAAP gross margin to be up 50 to 150 basis points sequentially. Non-GAAP operating expenses are expected to be approximately flat with the first quarter of fiscal 2010. This leads to a bottomline expectation of a non-GAAP loss per share of $0.08 at the low end of the guidance and $0.00 per share or breakeven at the high end of the guidance range. The cash and investment balance is expected to be flat sequentially except for nonrecurring items.

So, now I’ll turn the call over to the operator for the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Christopher Longiaru - Sidoti & Company.

Christopher Longiaru - Sidoti & Company

Talking about the cost reductions that you mentioned going out, what type of an impact do you think this will have? I think you said it’s starting in your fiscal 2011. Is that correct?

Chris King

We expect the transfer to be done by the end of this fiscal year, and we expect to at least be able to improve gross margins by 100 basis points.

Christopher Longiaru - Sidoti & Company

Will that be immediate?

Chris King

Yes. It will start and we will expect to achieve the 100 basis points as we get to the end of that period because that’s when we will have moved all our testers. So somewhere around the beginning of next year, calendar 2010.

Christopher Longiaru - Sidoti & Company

With the net books, how much of that business do you think will cannibalize existing business? I would think that some people would just go and buy the net books or the smart books or whatever it is in lieu of buying a laptop. I am wondering how much of that growth do you think will cannibalize some of the notebook business.

Chris King

The larger portion is not cannibalizing the notebook business, but I would say somewhere in the 20-40% range will cannibalize the notebook business. So what we’re seeing a new set of customers emerging in North America, but primarily in Asia as well, and we continue to believe a large portion of the very healthy demand is as the result of the stimulus package in China which we believe are reaching new customers.

Christopher Longiaru - Sidoti & Company

You said the inventory for PCs about two weeks. What was it running at typically before things got as bad as they got?

Chris King

We would say that before pre-crisis, they were probably running 3 to 4 weeks. During the crisis, they obviously got a lot higher, and what we saw coming into this quarter was a little bit higher than 2 weeks, and as we exited the quarter and today we see them at a really lean 2 weeks. Because of the fact that we entered the quarter at about the same inventory levels as we exited the quarter, we do believe the strong recovery we saw was the result of true demand, but of course that’s off a much lower base in our fiscal Q4 where the inventory was being driven down.

Operator

Your next question comes from the line of Vernon Essi - Needham & Company.

Vernon Essi - Needham & Company

Let’s back up and look at the micro here. I like the conjecture on the November quarter growing, and I’m wondering what are you looking at that’s giving visibility and confidence that that’s going to happen? Obviously, it’s always a seasonally strong quarter, but is there anything we can hang our hats on right now today that you see in your order books or that you’re getting from customers that give you that confidence?

Chris King

Sure. What we’re looking at, Vern, is first of all the forecast we’re getting from our PC customers. I always like to look to our customers for the best outlook on our future demand. So the first thing is we see a relatively healthy PC market. Secondarily of course we’re really pleased that we do see an improvement in automotive orders, and we do expect that to continue because there still is a pretty heavy level of inventory out there, so a combination of probably three quarters of the improvements that we’re seeing is from that inventory position being corrected, but secondarily the ramp in new products, and of course we’re particularly excited about the Toyota product. So as we look at the ramp for Toyota and what our automotive customers are telling us in terms of their inventory position, that gives us a more favorable outlook. And then finally and maybe foremost, we’re really happy with the market share gains that we’re making and we predict to make, particularly in the area of our portable products for smartphones, our USB products for smartphones. We continue to add to the collection of smartphones that we’re designed into. So as we look at the outlook for smartphones and then our participation in that market, that’s really promising. And then on our analog product line, there once again, we’re definitely seeing market share gains, particularly in the low end consumer PCs, whatever we want to call them, and we expect that to continue. So those are really the dynamics, and as I mentioned in the call, we’re really happy that our two most emerging product lines are analog products and our portable products. We expect to exit the second quarter at record levels, so better than pre-crisis levels or the levels we were at a year ago, and so then that coupled with the improvements in automotive customer demand and a continued healthy PC market, where I don’t think we’re going to see the growth we saw in the quarter we’re just reporting going forward, but as long as that stays relatively healthy, we feel very confident about our growth going forward in the current quarter Q2 and then the November quarter.

Vernon Essi – Needham & Company

There’s a lot there. If I can just dive into a few of those points—on the analog side, I just want to be clear, what you’re seeing is being driven by the net book products. Is that correct?

Christine King

Yes. I would say it’s our thermal management parts, which have been designed into quite a number of net book and low-end consumer PC, and that’s where a lot of the demand is coming from.

Vernon Essi – Needham & Company

Anything on the server front there?

Christine King

We have some server participation, but I would say that today is not what’s driving growth. That’s a great opportunity for us going forward, but it’s not a big part of our business today.

Vernon Essi – Needham & Company

I want to back up to the PC market. Is there anything specific on marketwise? Are your customers getting visibility with Win-7 or is it just again back to school and consumer. I’m trying to get a feel for whether or not this could be enterprise driven versus consumer driven.

Christine King

I think there are a few things there Vern. First of all, I think that from talking to our customers they do believe there will be seasonality, so that’s number one. Secondly although our customers are not seeing Win-7 being a huge driver, they do think that’ll improve things certainly as well, so I think that we have those two factors. I think one of the surprises for me in the strength in this current quarter was the commercial strength, and so clearly then we’re seeing the enterprise segment of the business environment starting to order PCs again, so that was a pleasant surprise and the improving commercial sales overall, so we expect that to be healthy, although as I said not showing us the growth that we had in this current quarter.

Vernon Essi – Needham & Company

Usually you have given a split on the PC numbers between notebook and desktop. Is that available?

Christine King

Vern, why don’t we get back to you when you get back in the queue because I prefer to give it out on the call here. I don’t mind breaking it down at all, so let me just get back to you on that one if you get back in the queue.

Operator

Your next question comes from the line of [unidentified analyst].

Unidentified Analyst

On the second half, if the demand grows seasonally, do you expect to outgrow that by the factors you have been talking about, share gains and stuff like that, the way you would couch that for yourselves?

Christine King

Well, I think our second quarter is seasonally up, I would say 10 to 15%, so I think that maybe we are not seeing the full effect of seasonality because I do believe we have some market share gains in there, so you certainly see the range in our guidance, so I would say that seasonality is tracking a little bit lower than it usually is this quarter, and part of that growth that we’re expecting to see is market share gains.

Unidentified Analyst

And then you talked about coverage, I think, being about 70%. What’s the typical range of coverage?

Christine King

That’s typical. In our last quarter call, we entered the quarter with a little bit higher level of backlog, but now because we feel a lot more comfortable in the environment. Right now, I think we are very comfortable with our guidance based on the 70% backlog, which is normal.

Kris Sennesael

In addition to that, we saw strong bookings through the first four weeks of the quarter.

Unidentified Analyst

Lastly, Christine, are you seeing the benefit of non-X86 platforms in the netbook market helping you with the upside? I know you have more content there in the X86s. Is that kicking yet or is it something that’s still something on the cards maybe later?

Chris King

I would say that it’s definitely later. A number of the reference designs that I mentioned are in non-X86 netbooks, so I think the ramp on there remains to be seen, so we are not seeing the effects of that. We would see the effects of that probably in our fiscal third quarter or the November quarter.

Operator

The next question is a followup question from Vernon Essi with Needham & Company.

Vernon Essi – Needham & Company

Just wanted to revisit a point you made in the prepared comments on the portables segment. You had said that there was a customer inventory issue. I missed what that was.

Christ King

We just said that there was an inventory issue with a North American customer and that that was going to be cleared out. That occurred in our fiscal Q1, and we expect that to be cleared out in the current quarter, and so because of that reason and because of the fact that we are ramping quite a few new products, we expect to have strong growth in our portable product revenue this quarter.

Vernon Essi – Needham & Company

Then on the tester relocation, I assume there will be, and maybe you explained this Chris and I apologize, but is there going to be any incremental…are you relocating the equipment itself or is there any capex implications from this that you are going to experience at all?

Chris King

There is no capex implications other than we won’t have to invest capex in the future as we scale our business, and we will be outsourcing some of our tests to a partner who has already set up a test outsource enterprise, and we will then be transferring testers in a phased approach after we get the first outsource testers up and running.

Vernon Essi – Needham & Company

That explains it. Thank you.

Chris King

Sorry, Vernon, I don’t have the answer to your question. I can’t put my fingers on it right now on the desktop versus notebook, but I can tell you that the desktop continues to be less a percent of our total PC revenue, so we did see sales into the desktop segment increase significantly as well as the notebook, but the notebooks grew relatively faster than desktop.

Vernon Essi – Needham & Company

So last quarter was almost a 2:1 ratio, it’s going to be roughly in that range again?

Chris King

It’s roughly in that range, probably a little bit less on the desktop. That’s really a good assumption to make to make right there.

Operator

We have no further questions in queue. I’ll turn the call back over to Christine King for closing remarks.

Christine King

Thank you very much. If we leave you with one message today, it’s that we are highly focused on executing on our market share, operational, and profit objectives. Each quarter, we plan to demonstrate success, and we feel confident that we are well positioned with our product roadmaps and increasingly efficient supply chain to continue growing our business as the market recovers.

If you haven’t registered yet, I hope you’ll join us at our analysts’ day on July 9th in New York City at the NASDAQ market site. You’ll have an opportunity to meet each our product line and operations general managers as well as our new head of worldwide sales. We will be discussing the details of our operating model in addition to key metrics such as market share and design win objectives in order to provide greater visibility into our business and assist you in the development of an appropriate valuation for SMSC. For more information on this event, please contact Carolynne Borders. We look forward to seeing you there and have a great night!

Operator

That does conclude our conference. We appreciate your participation.

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