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OmniVision Technologies, Inc. (OVTI)

Q4 2013 Earnings Conference Call

May 30, 2013, 17:00 PM ET

Executives

Arnab Chanda - Director of IR

Shaw Hong - Chief Executive Officer

Ray Cisneros - Senior Vice President, Worldwide Sales and Sales Operations

Hasan Gadjali - Vice President, Worldwide Marketing and Business Development

Anson Chan - Chief Financial Officer and Vice President of Finance

Analysts

Harsh Kumar - Stephens Inc.

Paul Coster - JPMorgan

Raji Gill - Needham & Company

Andrew Uerkwitz - Oppenheimer & Co.

Hans Mosesmann - Raymond James

Dan Scovel - Tokeneke Research

Operator

Ladies and gentlemen, thank you and welcome to the OmniVision Technologies Conference Call for the Fourth Quarter of Fiscal 2013. At this time, all participants are in a listen-only mode. Later, we will open up the call for your questions. Instructions for queuing up will be provided at that time. As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Arnab Chanda, Director of Investor Relations at OmniVision Technologies. Please proceed.

Arnab Chanda

Thanks very much. Good afternoon, everyone, and welcome to our fiscal fourth quarter conference call. Joining us today are Shaw Hong, Chief Executive Officer; Ray Cisneros, Senior VP of Worldwide Sales and Sales Operations; Hasan Gadjali, VP of Worldwide Marketing and Business Development; and Anson Chan, Chief Financial Officer.

During the call, we may make forward-looking statements regarding our business, including statements relating to revenues, earnings targets and our product plans. This is based on information as of today, May 30, 2013. Actual results may differ materially from those set forth in these statements.

These and other forward-looking statements involve assumptions, risks and uncertainties that could cause actual results to differ materially. For a discussion of these risk factors, you should review the forward-looking disclosures in the earnings release we issued today as well as the risk factors and other disclosures in OmniVision's SEC filings and reports, including the most recent annual report on Form 10-K and recent quarterly reports on Form 10-Q.

During today's call, we will also discuss certain GAAP and non-GAAP financial measures, the latter of which excludes stock-based compensation expenses and the related tax effects. A reconciliation between the two is available on our earnings release posted on our website.

With that, I will turn the call over to Mr. Shaw Hong. Shaw?

Shaw Hong

Thanks Arnab. Welcome to all of you joining the call and webcast. Earlier this afternoon, we issued a press release describing our fiscal Q4 2013 results. We reported Q4 revenues of $336 million which was up 54% year-over-year.

I'm pleased to say that even though historically fiscal Q4 was similarly slow for OmniVision, in fiscal Q4 2013 we saw steady sales in the China region for mobile handsets, which offset the seasonal weakness in other regions.

We also saw significant mixed improvement for our high resolution sensors. During the quarter, we shipped 188 million sensors. On a non-GAAP basis, gross margin was 17.7% and net income was $17.5 million or $0.31 per diluted share. Our cash balance was $212 million comparable to Q3.

Before I turn the call over to our management team to provide details on our Q4 financial results and the outlook, I'd like to make a few comments on our business. We are proud to report that we have passed a significant milestone in fiscal 2013. We reported a record $1.4 billion in revenues.

We also shipped over 855 million sensors in fiscal 2013, which grew 39% over fiscal 2012. We believe this is the testament to our ability to work closely with our vendors to supply the large volume necessary in consumer image sensor markets.

I will also like to recognize all our hardworking employees making fiscal 2013 OmniVision's first $1 billion revenue year by delivering the high performance products that our customers expected.

Throughout fiscal 2013, we have executed our strategies [vigorously] in for fulfilling our goals. Our goals remain to provide image sensors of choice to all customers, continue to improve our financial performance and ultimately bring benefits to our stockholders.

As we continue to satisfy these goals, our priorities continue to reflect the commitment to technology leadership, market diversification and growth and the cost structure improvement. Our first and foremost priority is technology development and the improvements.

In particular, we are well accomplished in the development of pixel technologies. In the last few years, as customers have demanded and the market has witnessed, we have designed, produced and delivered in high volume, high performance CMOS sensor products that are based on our BSI family of technology.

In addition to the pixel technology, OmniVision continues to develop innovative applications for sensors by coming lens and the camera technology. One of OmniVision's key innovations is camera-cube chip. Camera-cube chip is a wafer-level technology for low resolution cameras that integrate sensor and lens into a low cost solution. Going forward, we believe that this technology will enable us to be very competitive for applications such as front-facing cameras.

We will not stop here. As we continue designing and producing image sensor products based on BSI as well as FSI pixel and the camera-cube chip technologies, we will explore and take advantage of our expertise to develop technologies that will allow us to improve our product performance and hence improve our financial metrics.

Our second priority of equal importance with technology improvement is our strategy aimed at new market applications and the geographic diversification into emerging markets. As always, we are pleased with our revenue generation in our core market, especially in the smartphone and tablet categories.

However, to continue to fulfill our goal and move us to the next level, we must consistently go beyond developed markets and to be a part of the emerging markets ecosystems so that we can capitalize on the growth trend in these markets.

One of the markets we are particularly excited about is automotive. We believe that we are at an inflection point in camera penetration for cars. Applications such as the rearview, surround view as well as mirrorless applications are driving significant camera adoption in cars.

Over the next few years, many automobiles will have significant number of image sensors. We believe OmniVision has gained market share at key automotive customers in Europe and North America. Automotive with its long product cycle and the better margins promises to be an attractive market for OmniVision.

In addition to our efforts on new application market expansion, we also have a strategy for geographic diversification and the revenue growth across core market applications. According to industry observers, future smartphone and tablet growth in emerging markets is likely to be much stronger than in mature developed markets.

In particular, China has emerged as the world's largest in mobile phone market and our position there is extremely strong among the tier-1 smartphone OEMs. In addition, one of the key emerging trends has been the continuous success of China-based vendor in penetrating both domestic Chinese as well as export market in Asia, Africa and Latin America.

Also, as emerging markets continues to transition to smartphones, demand for better quality in the higher resolution cameras is becoming stronger. We have seen our China OEM business outperform developed markets, a trend we expect it to continue.

The still priority and indispensible component of our strategy is to improve our gross margins. This quarter we reported a slight increase in our margin. However, to get to where we want to be, we must remain focused in executing cost improvement actions. We have set our near term as well as long range trends to reduce our cost structure.

In the near term, we are focusing on our supply chain to reduce costs and to optimize our manufacturing process and product designs. We believe therefore the long term, continued technology improvement and product innovation will drive our margin expansion.

Before I turn the call over to Ray who will provide an update on the quarter's sales activities, I would like to reiterate that I am proud of our accomplishments for fiscal 2013. As we are going into fiscal 2014, we remain committed to design and deliver high performance image sensors and solutions to our broad based customers based on our technologies and innovations.

With that, Ray?

Ray Cisneros

Thank you, Shaw. We are pleased to report that our revenues exceeded the high end of our guidance. As we had expected in February, fiscal Q4 was seasonally slow in developed markets. However, stead smartphone growth in emerging markets offset developed market weakness and is said to drive our growth for our upcoming fiscal Q1.

In our fourth quarter, we shipped 188 million units as compared to 252 million units in our prior quarter. The average selling price in our fourth quarter was $1.79 as compared to $1.68 in the prior quarter. The improvement in average selling price was due to a better product mix.

While 8 megapixel and 5 megapixel shipments remained strong in fiscal Q4, HD sensor shipments declined. In fiscal Q4, unit sales of sensors 2 megapixel and above represented approximately 50% of total shipments as compared to 39% in the prior quarter. We saw an increase in 8 megapixel sensor shipments and consistent shipments of 5 megapixel sensors driven by emerging market demand. Both of these resolutions shipped in strong numbers in both BSI-1 and BSI-2 based technologies.

Unit sales of 1.3 megapixel sensors represented approximately 33% of total shipments as compared to 45% for our prior quarter. HD sensors formed the bulk of this segment and BSI-2 based HD sensors declined during the quarter.

Finally, unit sales of sensors that were VGA and below represented approximately 17% of total shipments as compared to 16% in the prior quarter. As digital VGA products continued to decline in absolute dollars with the transition to HD resolutions, our product mix will improve. In terms of target markets, our mobile phone sales represented approximately 65% of revenues in the fourth quarter as compared to 61% in the prior quarter.

Our entertainment segment represented 17% of sales as compared to 26% in our prior quarter. Our sales of sensors into the notebook and webcam segment were approximately 8% of sales as compared to 7% in our prior quarter. Other categories balanced out the remainder.

In the mobile phone market, we saw seasonal weakness in developed markets. On the other hand, in emerging markets such as China demand remains strong. The China region has emerged as an enormous market opportunity for OmniVision. China is now the world's largest mobile market and is on the early phase of the smartphone transition. China demand is largely being fulfilled by multiple Chinese tier-1 OEMs.

Additionally, the same OEMs are expanding to both developing and developed international markets, including the U.S. Due to our traditionally strong sales channels in China, we are beneficiaries of this success. If the China market demands are well balanced, it makes the resolutions due to the smartphone feature specs.

In addition, we also shipped critical sensors to multiple tier-1 customers in developed markets that launched flagship products during our fiscal fourth quarter. The improvement in resolution mix that we have seen over the past fiscal year continued in the fourth quarter. 8 megapixel shipments increased nicely, mostly driven by BSI-2 based 8 megapixel sensors while BSI-1 based 8 megapixel sensor shipments remained consistent.

We also saw consistent shipments of 5 megapixel sensors predominately for the quarter-inch optical format, driven by emerging market demand. We also continued to see increasing shipments of full 1080p HD format sensors for the front-facing camera and smartphones. We expect the trend of HD replacing VGA for front-facing cameras to continue to benefit our mix. Lastly, we also ramped our BSI-2 based 12 megapixel sensor to key customers.

Going forward we expect that the smartphone will continue to drive major growth for our imaging solutions. In addition to Chinese OEMs, we are positioned well with key customers across other regions. In fiscal 2014 we expect that OmniVision camera solutions will be featured in several major consumer device launches.

In our entertainment market, both the tablet and the gaming segments saw a slowdown. The tablet segment, the largest portion of the entertainment market, saw a significant seasonal decline. In the tablet segment, our quarter-inch BSI-2 5 megapixel sensors in our 720p HD BSI-2 and BSI-1 sensors saw the largest declines.

Going forward we expect the tablet segment to return to growth and we are engaged with a broad base of customers for next-generation products that serve all the major operating systems.

OEMs also started to introduce smart TVs with built-in cameras, and in this emerging smart TV market our quarter-inch 5 megapixel BSI-2 sensor saw consistent shipments. We expect embedded cameras in smart TVs to represent another emerging opportunity and we'll support multiple applications.

In the notebook and webcam market sales declined in line with market weakness. Our legacy BSI-1 based 720p HD sensor, the OV9726, continued to ship in steady volumes to tier-1 OEMs. Given low visibility it is difficult to predict if this represents the bottom for our PC and PC-related market.

However, many of our new sensors are designed into upcoming next-generation products with our tier-1 OEMs that are expected to launch in second half of calendar 2013. We have also gained significant success in design wins for multiple innovative concepts around the PC, notebook platform. Many of the new concepts revolve around using sensors to develop human interface solutions, such as gesture and eye tracking control for PCs.

In our emerging market category, we continue to see the growth in our automotive segment. Due to the long design cycles in the automotive industry and our design win success, we expect continued growth for several years. We believe we have one of the strongest image sensor product portfolios tailored for the automotive market. Most of our current shipments go to European tier-1 OEMs and we continued to experience design win success at these customers.

We have also begun to see strong success in design wins at North American OEMs. The resurgence of the Detroit automotive market and our superior product offering will broaden our automotive growth.

The security market is experiencing an inflection in growth expectations after a period of stagnation. The growth in IP cameras coupled with the transitional sensors from analog or CCD to digital CMOS is opening new opportunities for OmniVision. Given the increased focus on security from governments worldwide, we expect that security will become a robust market for OmniVision in the medium term.

In summary, we are very pleased to start a new fiscal year driven by a broad base of customers' end markets.

Shaw Hong

Thank you, Ray. I will now turn the call over to Hasan, who will provide an overview of the company's marketing efforts and opportunities.

Hasan Gadjali

Thank you, Shaw. In our core markets, we launched two new products that further expanded our strong offering of high definition video solutions or secondary cameras. At only one-sixth of an inch, the new OV2724 is our smallest full 1080p HD camera chip sensor designed to fit into ultra slim camera module, it is ideal for high performance next-generation mobile and portable devices.

The OV2724 utilizes 1.34 microns advanced BSI-2 pixel to capture 1080p HD video at 60 fame per second. With best-in-class high dynamic range and low-light performance, the OV2724 delivers high quality video recording even in the most difficult high and low lighting. It is well suited for HD quality video chat and conference application on mobile devices.

The OV9728 is another strong addition to our HD product portfolio. This low power, cost efficient HD camera chip sensor is designed specifically for secondary cameras used in notebook, tablets, smartphones and smart TV. The OV9728 is very thin and capture high quality 720p HD video at 30 frame per second.

Using OmniVision's 1.75 micron BSI+ pixel architecture, this new sensor delivers high quality HD video performance [connectivity], Microsoft links and Skype premium specification for video quality. With the addition of these two new HD camera chip sensors, we continue to provide exceptional HD camera solutions to a wide variety of consumer markets including smartphones, tablets, notebooks, smart TV, game console and so on.

One of OmniVision's key initiative is to develop new emerging markets for image sensor. For automotive markets we are working closely with several large OEMs on multiple new products to get towards the next-generation of automotive vision systems. That includes advanced driver assistant function. In these systems, high dynamic range cameras have now become one of the important requirements.

OmniVision's products such as the OV10635 are well positioned to benefit from this trend. We are also seeing strong adoption of our security and surveillance products, even by continued growth of IP camera market. At the recent Security and Surveillance ISC West, we saw strong interest in our security focused sensor that have exceptional low light sensitivity. We consider the security market a long-term growth area.

In conclusion, we believe the emerging market such as automotive and security will provide significant profitable growth opportunity for OmniVision toward the medium to long term.

Shaw Hong

Thank you, Hasan. I will now turn the call over to Anson who will discuss our fourth quarter financial performance and to provide guidance for our first quarter of fiscal 2014.

Anson Chan

Thank you, Shaw, and good afternoon everyone. For the fourth quarter of fiscal 2013, we are reporting revenues of $336.2 million, down 20.6% sequentially and up 53.8% on a year-over-year basis. Direct sales OEMs and buyers accounted for 78.4% of our revenues in the fourth quarter of fiscal 2013, a decrease from 85.2% in the prior quarter. The remainder of our revenues came from sales through our distributor channels.

Our fiscal 2013 fourth quarter gross margin was 17.5% compared with 15.9% that we reported in our prior quarter. Excluding stock-based compensation expense of $0.9 million, including cost of revenues, our non-GAAP gross margin was 17.7% compared with 17.1% in the prior quarter. The incremental increase in our gross margin was primarily driven by a favorable change in product mix.

In the fourth quarter, we recorded approximately $0.8 million for the sale of previously written down inventory and $6.2 million as an additional allowance for excess and obsolete inventories, with a net $5.4 million of unfavorable impact on our gross margin. In the third quarter, we recorded approximately $1.4 million for the sale of previously written down inventory and $5.5 million as an additional allowance for excess and obsolete inventories, with a net $4.1 million of unfavorable impact on our gross margin.

For Q4 our gross margin has continued to experience incremental improvements. As we have indicated during our last earnings call, our cost reduction efforts were hampered by our need to first digest some of the high cost inventories that were built in earlier quarters. Looking at regional progress in shipping out these old inventory items, we will continue to work with our supply chain vendors to lower our production costs. In the near term however, product mix may remain the primary driver for gross margin improvements.

R&D expense in the fourth quarter totaled $26.6 million, a 2.8% decrease from the $27.4 million in our third quarter. The decrease in R&D expense was driven by decrease in take-outs and other non-recurring engineering expenses. We currently expect that our R&D expense in the first quarter of fiscal 2014 will increase by more than 10% close to our spending levels during the second quarter of fiscal 2013.

R&D expense in the fourth quarter included approximately $3.7 million of stock-based compensation expense. Excluding stock-based compensation expense, fourth quarter R&D expense was $22.9 million as compared to $23.7 million in the third quarter. SG&A expenses decreased from $18.2 million in the third quarter to $17.9 million in the fourth quarter. We expect SG&A expenses in the first quarter of fiscal '14 to increase by about $1 million.

Our fourth quarter SG&A expenses included approximately $3.3 million of stock-based compensation expense. Excluding stock-based compensation expense SG&A expenses in the fourth quarter totaled $14.6 million compared to $15 million in our third fiscal quarter. The amount of amortization for our acquired patent portfolio remained at $2.3 million per quarter.

Our GAAP operating income in the fourth quarter totaled approximately $11.9 million as compared to $23.6 million in the prior quarter. Our GAAP pre-tax income in the fourth quarter totaled $12 million as compared to $23.8 million in the prior quarter.

Our GAAP tax provision for the fourth quarter was $3.1 million. This compares with a GAAP tax provision of $2.5 million in the prior quarter. Excluding the effect of stock-based compensation, our non-GAAP provision for income taxes of fiscal fourth quarter was $2.3 million. This compares to our non-GAAP tax provision for fiscal third quarter of $97,000.

For the first quarter of fiscal 2014, we expect our GAAP tax rate will be in the mid-teen percentages and our non-GAAP tax rate will be in the low teens. In the fourth quarter, our GAAP net income was $8.9 million or $0.17 per diluted share basis. This compares to $21.3 million or $0.40 per diluted share in the third quarter.

Excluding stock-based compensation expense and the related tax effects, our non-GAAP net income for the fourth fiscal quarter was $17.5 million or $0.31 per diluted share. This compares to a non-GAAP net income of $31.5 million or $0.56 per diluted share in our third fiscal quarter.

Let me now turn to the balance sheet. We ended the fourth quarter with cash, cash equivalents and short-term investments totaling $212.3 million. This compares to $220.3 million at the end of the third quarter. The slight decrease in our cash balance was caused by our build-up inventory during the quarter offset by good collection from customers from sales recorded in our third fiscal quarter.

At the end of our fourth quarter, inventory totaled $430.3 million, an increase of $57 million from the 373.3 million balance at the close of our third fiscal quarter. Our yearend inventory balance represented an annual inventory turn of 2.6 times or 138 day sales. We first began preparing inventory for Q4 about six months ago. The buildup in inventory at yearend was caused by a slower than expected Q4 when compared with our expectations from six months earlier.

Accounts receivable at the end of our fourth quarter, net of allowances were $166.5 million, a decrease of 3.1% from the $171.9 million at the end of our third fiscal quarter. Our days sales outstanding in the fourth quarter was 44 days as compared to 37 days for our prior quarter. The increase in DSO was driven by product shipments skewing towards the end of Q4.

With that, I'll turn to our outlook. For the first quarter of fiscal 2014, which ends on July 31, 2013, we currently expect our 2014 first fiscal quarter revenues will be in the range of $355 million to $390 million. Our GAAP EPS are expected to range from $0.21 to $0.38 per diluted share. Excluding the estimated expenses and related tax effects associated with the stock-based compensation, we expect our non-GAAP earnings will be in the range of $0.35 to $0.52 per diluted share.

Since we're at the beginning of a new fiscal year, I'd also like to make some comments about what we currently think about the seasonal cycle. Last year, fiscal 2013, the seasonal cycle was somewhat unique in the sense that it was a transitional year for us from a product sales perspective. And the first time adoption of our BSI-2 based products was significant. With that said, even though visibility is still somewhat limited, we believe our fiscal '14 seasonal cycle will likely be less pronounced when compared with the seasonal trend that we experienced in fiscal 2013.

Shaw Hong

Thank you, Anson. We are very pleased with the $1 billion revenue milestone that we achieved in fiscal 2013. Although we have important design wins in 2013, our key [smartphone] and the tablet platforms have major customers. We will not stop here. We will continue to strive for technology for improvements to design and deliver the right products to customers, to continue to expand our market applications and to follow the growth trend in emerging markets. Our intention is always to bring the company to the next level.

With that, operator, we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Harsh Kumar with Stephens Inc. You may proceed.

Harsh Kumar - Stephens Inc.

First of all, congratulations; tremendous quarter, tremendous guidance, great gross margin improvement. First question is you're – again, if I look at the guidance, Anson, the gross margins look like they're going up very nicely much more than the 40 or 50 basis point that you've indicated historically. I'm curious what's the biggest driver in the July quarter guidance for gross margins going up that nicely? Is it your foundry negotiations or is it something else?

Anson Chan

Hi, Harsh. Thank you for the comment. I guess I have to go back to my prepared remarks. I can't confirm the exact [quantify that] improved in the margin but in the near term, any improvement that you'll see in modeling or in the projected forecast will be coming from product mixed improvements. If you look at inventory and balance at yearend, it's still pretty high. So I will have to say that even though we made reasonable efforts in cleaning up some of the old inventory with the high cost basis, it is still quite substantial in the balance at the end of the year. So, we'll continue work on that, right, with the strong Q1 guidance, we have high level confidence that we can move those inventories. But in the near term, like I said in the prepared remarks, I think product mix will still be a primary driver.

Harsh Kumar - Stephens Inc.

Great, thanks. And as my follow-up, your revenue guidance is pretty stellar in the July quarter and it seems just listening to you that in the April quarter, it was a lot of China business. What are the drivers would you say? Are you seeing orders in the July quarter from some of your North American customers as well as China or is it just mostly China again?

Ray Cisneros

Hi. This is Ray Cisneros. I think for our current quarter Q1, we got a pretty good balance of orders across regions and across customer basis and across markets. So I would say it's pretty well balanced but definitely in terms of quarter-on-quarter, China does show a good improvement in terms of growth for us. But when you look at the entire picture – of our total top line guidance, it's a good balance on the whole.

Harsh Kumar - Stephens Inc.

Thanks and congratulations. I'll get back in queue.

Operator

Your next question comes from the line of Paul Coster with JPMorgan. You may proceed.

Paul Coster - JPMorgan

Anson, I think this is going to be the second of many questions around gross margins, I do apologize. But you said that it is product mix that's driving margins midterm and then you went on to say that it's the inventory that needs to be burned off. Which is it? I mean is it – once the inventory is burned off, are you going to then start to enjoy lower cost of goods sold?

Anson Chan

That's the intension. It is why we've been saying for the longest time that we're working with our supply chain vendors to come with a better cost structure, but typically for our BSI-2 based products. As we continue to procure new inventory, some of these better cost basis type inventory will start to come in, albeit from the backend. So we still have to ship out some of these old inventories first. Now we did saw some margin improvement in Q4. That was basically coming from the mixed improvement, because despite the high cost basis, the margin profiles do vary by a resolution and by technology generations. That was the primary driver looking for improvements. That will likely continue to be the primary driver in terms of product mix for near term, mostly because of the high inventory level that we've built up.

Paul Coster - JPMorgan

Because you have very good visibility to the margin improvement this quarter because you know exactly what your cost of goods sold is, but going out to the next sequential quarter. I know you're not giving any guidance for fiscal 2Q, at that point you expect the lower cost of goods sold coming through from your suppliers to also benefit you. So it gets better and then it gets better again?

Anson Chan

The company's target is to continue to find opportunities to improve the margin profile. As Shaw has indicated in the prepared remarks, that will be our goal regardless of whether or not we can burn through the old inventory that were built up…

Paul Coster - JPMorgan

Okay.

Anson Chan

…because (inaudible) level will be by Q4 but we do have – we're doing everything we can, all cylinders are firing to make sure that we can get to a better margin profile and generate results that our stockholders are expecting.

Paul Coster - JPMorgan

Okay, great. Thank you.

Operator

Your next question comes from the line of Raji Gill with Needham. You may proceed.

Raji Gill - Needham & Company

Yes, thanks and congrats as well. So more clarity on the gross margins. You had mentioned that it's still taking you some time to burn off that inventory, that high cost inventory. And if you kind of look at the cost of goods sold in fiscal year '013 versus fiscal year '012, it seems like the cost of goods sold doubled by about $600 million. And it's taking you probably a year, well over a year, to start to burn through that. If you could frame it, how long will it take to burn through this level of inventory? And what are the factors about – factors that we should think about going through and burning through the excess inventory, is that a function of what? If maybe you could elaborate on that, that would be helpful. Thank you.

Anson Chan

Let me clarify a little bit too. The margin improvement that you basically witnessed in the last three quarters basically implies or there have been improvements in the whole cost structure in and of itself. Now the dominating factor, however, specifically for Q4 the improving margin has to do with product mix. I am not saying that we absolutely made no progress in terms of coming with the better cost structures, so don't get me wrong there. In the near term, because with quite of inventory, we believe the primary driver will still be the product mix. But there is obviously an opportunity for us to have better matching profiles in the future to the extent that we can work through some of these inventory that was built up. It won't be large. It would be a function of how quickly our customers will be pulling down inventory and how quickly will they be buying the newest SKUs from us for the new product years.

Raji Gill - Needham & Company

So when they're buying the newer inventory at a lower cost basis which is I presume still on BSI-2, it's not – we haven't transitioned to BSI-3, is that correct?

Anson Chan

At this point, we have not announced any newer generation pixels yet. So we have to wait for the product release schedules before we can comment further on the pixel technologies.

Raji Gill - Needham & Company

But the BSI-3 let's just say is not on a new fad at TSMC, so you will not experience a potential risk that you experienced last time when you transitioned from BSI-1 to BSI-2?

Anson Chan

Oh, not matter what's going to be, it's likely going to stay on 12-inch. The last time, last fiscal year that significant transition literally was an 8-inch process transitioning into a 12-inch process. So that mandated a lot of equipment upgrade along our entire supply chain. So that primarily caused the high cost inventory running through our cost of goods sold as you've seen in our fiscal Q2 of 2013 where the gross margin drops significantly compared to the first quarter. Going forward we'll likely expand 12-inch for quite a while. So something like this where my entire supply chain of upgrade equipment, that kind of scenario, is probably not going to happen right away.

Raji Gill - Needham & Company

And just one last question on the margin side, does the mix shift – you're saying improving the margins, is it really the mix shift that's kind of 8 megapixel, 5 megapixel and above, because right now I think you [cited] 2 megapixel and above now is 50% of the overall units, so that's a really big increase. Year-over-year is almost 50% increase in terms of those numbers of units. So you're basically saying the 5 and 8 megapixel in China and some of the other markets are really helping the margins going forward?

Anson Chan

That's a correct statement. Like Ray has mentioned in this prepared remarks, we experienced particularly strong demand in the 5 megapixel and 8 megapixel type sensors in the China OEM market. So that has caused a significant boost in our product mix and hence improving our margin.

Raji Gill - Needham & Company

Thank you.

Operator

Your next question comes from the line of Andrew Uerkwitz with Oppenheimer. You may proceed.

Andrew Uerkwitz - Oppenheimer & Co.

Hi, guys, good quarter and excellent guidance. Could you just kind of talk about the competitive landscape for the Chinese market for you guys when you think about the OEMs there?

Ray Cisneros

This is Ray Cisneros. Obviously China is no different than any other market quite frankly. I mean across the world we have competition but I think what China represents is a huge market moving into a very large installed base of manufacturing capabilities. So what you do have in China is attracting, I would say, competitors of ours at all resolutions. So I would say it's quite busy in China just like any other region. And the opportunities are large for all of us. So there's a presence there.

Andrew Uerkwitz - Oppenheimer & Co.

Great, thanks. And then just a follow-up on that a little bit here. Are you seeing any pressure coming from the low end Chinese-based image sensor players trying to move up to value, so to speak?

Ray Cisneros

Right. I mean we have pressures in all resolution categories, low end and high end as well. And low end of course because what China represents is a global manufacturing capacity to deliver low end devices around the world, especially to the emerging markets. So, yes, there is a lot of pressure on the low end. On the other hand, I think innovation goes across the board in all resolutions. We, as you keep track of OmniVision's product release, we release products in all categories. Just this past fiscal quarter, we released – as Hasan mentioned in his prepared commentary remarks, we released two HD sensors. That backs in directly into a lot of different kind of (inaudible) cameras and even also (inaudible) cameras, and some instances low end category products. So innovation is part of our success and we intend to keep that going.

Andrew Uerkwitz - Oppenheimer & Co.

Great. I appreciate the color and again an excellent quarter. Thank you.

Operator

Your next question comes from the line of Hans Mosesmann with Raymond James. You may proceed.

Hans Mosesmann - Raymond James

Thank you for letting me ask a question or two. Going back to the competitive dynamic, if you can provide a little more granularity regarding BSI-2 and what is the value proposition that OmniVision offers the world relative to your other competitors? I think a lot of them already have BSI-2 or were able to catch up? And another follow-up. Thanks.

Ray Cisneros

Sure. The value proposition for BSI-2 I think as we mentioned in prior quarters is the transition to 12-inch wafers and different metallization and smaller design rules. That provides obviously an ability to design higher resolution products, faster products, faster speeds our products are run at, as well as be able to design innovative pixels that will be migrating not just from – they won't just remain at 8 megapixel. Obviously we have other higher resolution products like 12 megapixel, 14 megapixel and 16 megapixel. And so the name of the game of the BSI-2 value proposition is to provide high value products today as well as ability to co-design with our key customers the future generation products which I alluded to in some of my prepared remarks. You should expect to see some very innovative products in calendar 2013 using our most advanced technologies with BSI-2 or other technologies.

Hans Mosesmann - Raymond James

Okay, thanks. And as a follow-up, there are a series of new notebook detachable or tablet like devices with keyboards that are coming out in the next several weeks. Given that, what is your view of seasonality in the notebook space as you entered the summer? Thanks.

Ray Cisneros

Yeah, that's a question we all want to have the perfect answer for. When we talk about the notebook market, it's well known in the industry and plenty of literature also published, the struggling state of affairs for the notebook market. We can't really predict any better than anybody else what will happen with the notebook market. Plenty of reports out there predicts some incremental step down in the notebook market. On the other hand working closely with our customers we do see innovation. I think the way the notebook industry and the PC industry will remain competitive is through innovation and I could tell you directly or from direct experience working with some of our key customers there is a lot of innovation coming out of these OEMs and hopefully that will maintain that particular consumer device segment healthy. But it remains to be seen. And obviously we balanced that out with a very strong position in the tablet market. So, I think it's a win-win for OmniVision either way.

Hans Mosesmann - Raymond James

Thank you very much.

Operator

Your next question comes from the line of Harsh Kumar with Stephens. You may proceed.

Harsh Kumar - Stephens Inc.

Hi, guys. Thanks for the opportunity to ask a follow-up question. Anson, in your commentary you mentioned R&D will be going up by roughly about 10%. I'm just curious. Yes, you're showing very good revenue growth. I'm curious what's driving such a large increase in R&D?

Anson Chan

A lot of that actually has to do with our annual pay adjustment. We do have engineers, we need to compensate. Also we tend to have this lumpiness in the R&D when it comes to our [early] expenses. So all these takeouts, they do add up and they're very lumpy. All depend on engineering schedules. So that all backs into a forecast the R&D expense is anticipated to increase for our fiscal Q1 to something closer to what will happen in Q2 of fiscal '13.

Harsh Kumar - Stephens Inc.

Okay, fair enough. And then Anson, I wanted to ask a question about the megapixel trends. A couple of years ago, 5 megapixel was a prevailing standard. Last one or two years, it's been 8. We've seen one or two phones or a handful of phones (inaudible) with 12 megapixels. Have you started to see a transition in your product lineup? You talked a lot about 8 and 5, what kind of offering do you have for the 12 or the 13?

Anson Chan

I think Ray may be a better person to answer that question.

Ray Cisneros

All right, yes. The 5 megapixel and 8 megapixel is still a very, very large portion of the handset market and the smartphone market. These are in extremely high volumes, not just with OmniVision but in the market itself. Whether these sensors come from OmniVision or from some of our competitors, this is the biggest volume right now if you took a high level view of the handset market and the smartphone market. But on the other hand, there is transition into high resolutions. We do have (inaudible) designs and shipping with our 12 megapixel resolution. There are some product roadmap plans we have going forward in the future. We're not prepared to talk yet, but they will obviously serve the higher resolution categories above 8 megapixel and above 12 megapixel. And from my position we're in very good standings to capitalize on that very shortly in the future as well.

Harsh Kumar - Stephens Inc.

Thanks guys and congratulations.

Operator

(Operator Instructions). Your next question comes from the line of Dan Scovel with Tokeneke Research. Please proceed.

Dan Scovel - Tokeneke Research

Thank you. Good quarter and thank you for the questions. Ray in your prepared remarks you commented last quarter on weakness from tablets and games and you fingered a particular device. What was that device again?

Ray Cisneros

Sorry, repeat your question. It's not very clear your question.

Dan Scovel - Tokeneke Research

You said there you saw last quarter you saw weakness in tablets and games and you fingered a specific device. What was that device again?

Ray Cisneros

We didn't finger any specific device. We just made comments about the entertainment segment, mainly driven by the tablet segment. As we all know even today I think from a very high level, a consumer device like a tablet is highly, highly seasonal driven. On the other hand, my prediction is going forward that tablets will stabilize and become something more like a notebook or PC category where yeah, there's still some seasonality but not as severe as we currently had it with tablets looking in rears on how it's driven by the Christmas season.

Dan Scovel - Tokeneke Research

Okay, thanks. Also on the R&D, should that new level be sustained or will we back off from that a little bit in the future quarters.

Anson Chan

We're always looking for more opportunity to design more SKUs and work with our OEM customers closely. So if everything works well, we do want to continue to invest in R&D. We definitely do not want to mortgage our future by cutting back for whatever strange reason, right? So I won't necessary say the R&D will go back to the low level. If I have the opportunity, in fact I probably want to hire more people and so that we have the ability to increase our design capabilities and even more other products for the growing market.

Dan Scovel - Tokeneke Research

Okay. And finally at the risk of following on with gross margins here, with respect to your elderly higher cost BSI-2 inventory, I guess we can assume that you expect to sell it within 12 months because from an accounting perspective, you would have had to written it off any way. Is that a good assumption?

Anson Chan

Definitely because I think we commented on it many quarters ago. Every quarter end, we would go through an assessment and asses for ourselves what will we consider excess. And so we've written down what we need to write down and recorded $6.2 million charge at the end of April. And so we have high confidence that whatever is left the $30 million would be removed in the next 12 months.

Dan Scovel - Tokeneke Research

Okay, great. Thank you. Again, good quarter guys.

Operator

Your next question comes from the line of Raji Gill with Needham. You may proceed.

Raji Gill - Needham & Company

Thanks for the follow-up. Anson, you talked about that the fiscal year '014 seasonality will be less volatile or less pronounced than fiscal year '013. So if you kind of look at historical seasonality, it seems like July is usually an up quarter and then October is the biggest quarter for you and then January quarter's down sequentially and April quarter seems to be flat with January. How do you look at normal seasonality now that you're in a less volatile situation as before? Thank you.

Anson Chan

I think in a more normalized year as part of that.

Raji Gill - Needham & Company

Normalized year

Anson Chan

Right. But we expect first and fourth fiscal quarters to be comparable whereas the second and third fiscal quarters will be higher. The second fiscal quarter will coincide a lot of the highly seasoned bills and OEMs. Then the third fiscal quarter will coincide with a lot of the buildup of inventory in the Asian market. So that's how it will play out. I won't even say that it's typical for Q4 to be comparable to Q3 as you mentioned earlier in your question. So that way I would characterize that as a more normalized year. The reason why I also made a comment about fiscal '14 may not be as the seasonality of – may not be as pronounced as fiscal '13 is mostly because in '13 we had this really unusual situation whereby we tried to introduce BSI-2 and significant first time adoption. And if you remember back in Q1, we even had to pre-build inventory just to capture these revenue opportunities. This is likely not going to happen again. As I mentioned earlier in one of the questions, we're probably not going to introduce something beyond the 12-inch and so you won't run into a significant one-off bump up in demand for a new generation technology all of a sudden. So that's why fiscal '14 is likely not going to be as volatile as you put it as fiscal '13.

Operator

Your last question comes from the line of Paul Coster with JPMorgan. You may proceed.

Paul Coster - JPMorgan

Anson, have you been able to do anything or maybe it's Ray question to diversify your wafer supply?

Ray Cisneros

We actually use a smaller secondary source, it's called Powerchip. Not a significant volume but that indeed is a second source, let's call it that. Most of our wafers are still coming from TSMC. They are our primary buyer.

Paul Coster - JPMorgan

Thank you.

Operator

There are no further questions in the queue at this time. I would now like to turn the call back over to Arnab Chanda for closing remarks. Please proceed.

Arnab Chanda

Thank you all for joining us on this call and webcast. We anticipate holding our fiscal 2014 first quarter conference call on 29th of August, 2013. Thank you and good day.

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