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Fairchild Semiconductor International Inc. (NASDAQ:FCS)

Q2 2009 Earnings Call

July 16, 2009 9:00 am ET

Executives

Dan Janson - Vice President of Investor Relations

Mark S. Thompson - Chief Executive Officer

Mark S. Frey - Executive Vice President and Chief Financial Officer

Analysts

Terence Whalen - Citigroup

Ross Seymore – Deutsche Bank Securities

Romit Shah – Barclays Capital

Shawn Webster – J.P. Morgan

Steve Smigie – Raymond James

Parag Agarwal – UBS

Tristan Gerra – Robert Baird

Kevin Cassidy – Thomas Weisel Partners

Brendan Furlong – Miller Tabak

Bill Ong – Merriman

Craig Berger – FBR Capital Market

Operator

Good day and welcome to the Fairchild Semiconductor second quarter earnings conference call. Today's conference is being recorded. At this time, I’d like to turn the conference over to Dan Janson.

Dan Janson

Thank you for dialing into Fairchild Semiconductor's second quarter of 2009 financial results conference call. With me today is Mark Thompson, Fairchild's President and CEO; and Mark Frey, our Executive Vice President and CFO.

Let me begin by mentioning that we're attending the Canaccord Adams Investor Conferences in Boston on August 11th and the Deutsche Bank Tech Conference in San Francisco on September 15th.

We will start today's call with Mark Frey, who will review our second quarter financial results and discuss the current status of third quarter business. Mark Thompson will then discuss our product line results, end markets, and operational performance in more detail. Finally, we'll reserve time for questions and answers. This call is scheduled to last approximately 60 minutes and is being simultaneously webcast from the Investor Relations section of our website at fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days.

Fairchild management will be making forward-looking statements in this conference call. These statements, including all statements about future results and performance, are made based on assumptions and estimates that involve risks and uncertainties. Many factors could cause actual results to differ materially from those expressed in forward-looking statements. A discussion of these risk factors is provided in the quarterly and annual reports we file with the SEC.

In addition, during this call, we may refer to adjusted or other financial measures that are not prepared accordance with Generally Accepted Accounting Principles. We use non-GAAP measures because we believe they provide useful information about the operating performance of our businesses that should be considered by investors in conjunction with GAAP measures that we also provide. You can find a reconciliation of our non-GAAP to comparable GAAP measures at the Investor Relations section of our website at investor.fairchildsemi.com. The website also contains 2009 Q2 fact sheet, a financial section with updated unaudited financial highlights, including detailed break-outs of segment and regional revenues, gross margins, EBIT and EBITDA.

Now I'll turn the discussion over to Mark Frey.

Mark S. Frey

Good morning and thank you for joining us. Fairchild reported solid improvement in virtually all aspects of our business in the second quarter. Of particular note was our ability to drop 64% of our Q2 incremental sales to adjusted gross profit. We expect this fall through leverage to moderate to a still very healthy level of 50% in the second half of this year, assuming that we hold internal inventory flat. We also reported strong free cash flow, or cash from operations minus capex, of $47 million for Q2 and $51 million for the first half. Despite the difficult macroeconomic environment, we delivered the highest first half cash flow since the year 2000.

For the second quarter of 2009, Fairchild reported sales of $278 million, up 25 percent sequentially and 34 percent lower than the second quarter of 2008. We further reduced distributors’ inventory of our products by approximately $24 million sequentially which impacted second quarter sales. Gross margin on a GAAP basis was 23.2%. That included $3.7 million of acceleration depreciation as well as a $600,000 inventory write-off related to our previously announced fab closures. Adjusted gross margin excluding these items was 24.8%, up nearly 10 percentage points from the prior quarter due primarily to higher sales, higher factory loadings, favorable product mix, and the realization of ongoing cost reduction efforts such as manufacturing overhead optimization, yield improvement, improved material costs, and more competitive subcontractor pricing. This was offset by somewhat weaker customer pricing.

R&D and SG&A expenses were $69.3 million, up slightly from the prior quarter as we continued to main tight controls on spending. OpEx spending in Q2 increased compared to Q1 due to fewer enforced vacation days and higher equity compensation, offset by the impact of headcount reductions. In Q2, we recorded an $11.3 million charge for restructuring and impairments.

Net interest and other expenses on a GAAP basis were $5.7 million in the second quarter and included an $800,000 gain on debt retirement and a net $2.1 million loss on the impairment of equity investments. Excluding these items, adjusted net interest and other expenses were $4.4 million in the quarter, down from $5.3 in Q1 due to continued decreases in borrowing costs.

Now, I’d like to review second quarter highlights of our sales and gross margin performance for each of our product groups. In our MC Cubed business, sales jumped 34% from the prior quarter, driven primarily by solid recovery in MOSFET demand for computing. Overall, MC Cubed adjusted gross margins were up nearly 17 percentage points sequentially to 32% due to the higher factory loadings primarily for low voltage MOSFETs, partially offset by pricing and mix pressure in certain end markets. Sales were up about 17% sequentially in our PCIA group as we significantly increased shipments of our power conversion products due to higher computing, consumer, and industrial demand. Adjusted gross margins increased nearly two percentage points to 21%, due primarily to higher factory loadings and a more favorable product mix.

Standard discrete technology and standard linear product sales increased roughly 19%, and adjusted gross margin improved 8 percentage points compared to the prior quarter, also due primarily to higher factory loadings. The manufacturing of these products is more heavily outsourced than our other product lines, and so gross margins are somewhat less susceptible to changes in sales volume.

Turning to balance sheet, we reduced internal inventories by more than $8 million or 19 days to 87 days of inventory. If we calculate days of inventory using the actual sell through from the distribution channel plus our direct sales to OEM and EMS customers, we ended the quarter at about 79 days. We aggressively managed our collections process resulting in a DSO decrease of 8 days to 38 days. Our reductions in costs, aggressive inventory and working capital management coupled with lower capital spending enabled us to sequentially increase cash and securities by $36 million to $423 million in the second quarter, despite paying off $16 million in debt.

Turning now the current status of third quarter business, our scheduled backlog for third quarter shipments is currently about $300 million which is roughly $50 million higher than at this point a quarter ago. Included in this amount is approximately $25 million of backlog that we booked in the first 2-1/2 weeks of this quarter. Assuming we continue to record positive backlog fill consistent with the current order patterns, we believe sales in the range of $300 to $325 million are possible for the third quarter.

For this range of revenue, we anticipate adjusted gross margin to be between 25-27%. We expect R&D and SG&A spending to be approximately $70 million. Interest expense for the third quarter is expected to be $4.5 to $5.0 million, while our tax expense should be approximately zero. We anticipate recording approximately $4 million in restructuring charges and $3.6 million of accelerated depreciation in Q3 associated with previously announced cost reduction actions.

As with last quarter, we are not assuming any obligation to update this information, although we may choose to do so before we announce third quarter results.

Now I will turn the call over to Mark Thompson.

Mark S. Thompson

I’d like to begin with a brief review of the strong sales and margin growth we saw in the second quarter. Let’s start by looking at the details behind the performance, and how despite growing sales 25% from a quarter ago, we were still able to reduce channel inventory in Q2. Recall that a quarter ago we outlined our expectations that consumption demand for our products would be about $295 million in Q2 and that we expected to undership consumption by a bit more than $20 million.

As the quarter progressed and order rates and sell through continued to improve, it became evident that consumption demand would be higher than we originally planned. Our Q2 results reflect this improvement as we reported $278 million in sales and nearly a $24 million reduction in channel inventory. This puts Q2 consumption demand at a minimum of $200 million. I want to emphasize this point. Our strong sales growth in Q2 is primarily a result of realigning our shipments with actual consumption demand and comes even as we reduced both internal and channel inventory again this quarter.

Remember than Fairchild and most of our peers experienced a 40% or greater decrease in sales during this cycle, while the end-markets we serve as expected to correct only 10-15%. I-Supply recently updated their 2009 forecast for the major semiconductor end-markets to decrease just 10% compared to 2008. Fairchild entered this cycle with one of the leanest inventory positions in our peer group, so clearly our sales could not remain so far below end demand for long.

Looking forward to Q3, we expect another significant increase in sales, due to a higher backlog position as we ship more in line with actual consumption demand which is expected to be up modestly. We also expect to maintain or further reduce inventories in the third quarter.

Moving to the rest of our Q2 results, order rates improved across a broad range of end-markets with the greatest strength in the computing, handset, and consumer markets. Geographically, Asia continued to be our strongest region. North America appears to be stabilizing with some early signs of improvement, and Europe remains weak. We’ve also seen a solid recovery in our direct sales into the OEM and EMS channel, with starting scheduled backlog for the current quarter up 15% from the first quarter.

Overall product pricing was down about 3% sequentially which is slightly weaker than prior quarters, but we expect the trend to moderate as order rates improve. Factory utilization increased to about 67%, up from roughly 50% in Q1, and we maintained lead times within a stable range of 5-6 weeks during the quarter. The factor consolidation program which we announced in Q1 remains on schedule to deliver substantial savings with the full impact expected to begin Q3 of next year. We also expect to realize steady cost reductions from depreciation and amortization roll off as we spend substantially less of Capex going forward than in the previous years. We anticipate the depreciation run rate to decrease by about $1.5 million per quarter by Q4 of this year and another $3 to $3.5 million a quarter by the fourth quarter of 2010.

In the distribution channel, sell through was up nearly 14% sequentially, and inventory decreased about $24 million resulting in a 3-week sequential reduction to 11.3 weeks of channel inventory. Based on current booking trends and discussions with our distribution customers, we expect mid single digit growth in sell through in Q3 compared to the second quarter.

Turning now to our product line results, MC Cubed sales rebounded strongly from the prior quarter driven primarily by higher demand for low voltage MOSFETs for the computing market and analog products supporting the handset sector. We continue to gain share with our growing portfolio of analog products targeted at handset and ultra-portable applications.

Our advanced analog switches are the preferred solution used by major handset customers to transition to standard USB ports and provide both signal detection and switching capabilities in a single device. In mobile power, we are expanding our market for high frequency voltage regulators to address the top power consuming functions within the handset. We’re also expanding our customer base for these products, and we recently added another high volume account.

We continue to transition our low voltage MOSFET portfolio to our new Power Trend 7 fab process which enables smaller dye size and smaller packages and lower costs while providing better performance and power efficiency in applications such as notebook and netbook PCs. These PT7 devices are designed to provide optimal performance in the Montevina and Capella notebook platforms.

PCIA sales were up 17% sequentially with the strongest growth coming from analog power conversion products supporting computing, consumer, and industrial end markets. Fairchild remains on the forefront of proving power management solutions that greatly improve the efficiency of virtually all electronic appliances and applications.

Our proprietary primary side regulator or PSR products enable standby power consumptions as low as 30 milliwatts while reducing part count in low power batter adapters such those used to charge handsets. Just a few years ago, chargers barely achieved 1 Watt standby power consumption, and now we’re pushing the envelope to 30 milliwatts—a 97% reduction in energy waste. We’re also uniquely positioned to offer the only 30 milliwatt standby power solution for notebook PC batter chargers using a multichip package capability we’ve developed over the years. We continue to expand our innovative use power factor correction in computing, industrial, and consumer applications to enable greater efficiency and lower operating costs.

In closing, I think there are a few key points you should take away from this discussion. First is that our strong sales growth is the natural result of bringing our shipments back in line with true consumption demand. We delivered this growth even as we significantly reduced inventory throughout our supply chain, and we continue to be biased towards running as lean as possible. Second, our still relatively low shipments and utilizations levels provide a great deal of leverage on our operating model to turn incremental sales into earnings. We’re committed to holding the line on costs both above and below the gross profit line to deliver strong earnings growth as sales improve. Third, these lower costs and reduced capital spending coupled with effective inventory and working capital management position us to generate strong cash flow in 2009 and into the future. Finally, we continue to invest in innovative and analog and power management products which have enabled steady share gains in our target applications. We believe the growing demand for greater energy efficiency and the continued advancement in wireless convergence devices will provide attractive growth opportunities for Fairchild well into the future.

Thank you, and I will turn the call back to Dan.

Dan Janson

We'll now open the call to questions. I would ask that in order to allow more of you to ask questions, we limit each person to one question and one follow-up. Thanks, now let's take the first question.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question today comes from Terence Whalen – Citigroup.

Terence Whalen - Citigroup

My question relates to the sustainability of the end-demand and the strong order pattern that you’re seeing for computing. I know that the builds particularly around notebook and some of the CULB platforms have been generating good order strength for you. What are some of the leading indicators you’re looking at to determine whether you get carry-through phases of orders as ODMs restock on that and can you just talk a little bit about your expectations and what you see in your rolling forecast and ordering patterns to give us any information regarding the texture of end demand heading into the September/October time frame.

Mark S. Thompson

We have first of all conversations through the entire supply chain for computing, starting with microprocessor, with the OEM in the middle and then the ODMs at the production level. It’s a very lean supply chain right now, and so I think the visibility is low but the inventory circumstances I think are pretty healthy, and our lead times are quite short, so we have the ability to adjust our production to align with whatever the demand happens to be, but the ability, I don’t think anyone is really in the position to provide a lot of long term visibility to that marketplace.

Terence Whalen - Citigroup

What is your expectation for distributor inventory in the third quarter embedded in your guidance?

Mark S. Thompson

Embedded in our guidance is an expectation that we will reduce it further but probably not dramatically, something in the $5-$10 million range, which if you take the estimate that we offer to the mid single digit increase in point of sale would land us somewhere between ten and eleven weeks.

Operator

Your next question comes from the line of Ross Seymore – Deutsche Bank Securities.

Ross Seymore – Deutsche Bank Securities

I guess from the revenue guidance side of things you gave a lot of math versus consumption etc, but if I look at last quarter, you had about $250 million in backlog and you ended up shipping turns of close to $30 million bucks roughly, and you burned a lot of inventory. Why are you assuming that the turns right would slow from an absolute dollar perspective heading into the third quarter?

Mark S. Thompson

Ross, I guess maybe the best way to put it is, we’re not really assuming anything. We’re really trying to calculate outcomes of certain events so if you look at the book ends of the estimates that we offered, we simply flipped the amount we booked so far which is about two and a half weeks, added that which is about five weeks, and if this was a normal Q3, you would expect that most of your bookings would have occurred in the first five weeks of the quarter. And now, we also know that the environment of course is still a bit odd, and we are trying to figure out the new pattern, and it is a seasonal industry, so we acknowledge the possibility, although we have not seen in the order patterns that there could be a role off that would occur if people saw that their on re-sales for example weren’t occurring, so it’s a very lean supply chain, and I think people are reacting rapidly to any disequilibrium, so it was really a framework for outcomes, not a prediction of the future.

Ross Seymore – Deutsche Bank Securities

As far as the framework goes, what’s your normal seasonality to the extent normal even applies right now for the fourth quarter, and what would be some of the relatively unique dynamics that could influence that especially things like Windows 7 and end-demand and those sorts of things that we should think about albeit I know you’re not guiding for the fourth quarter specifically?

Mark S. Frey

To start with, just a reminder on Q3 sell through would typically be up 4% from Q2 to Q3 and then down slightly in Q4. Again, it’s hard to comment on Q4, but obviously if the back to school sales are on the high end, and if manufactures are optimistic about Christmas, then they will come back in October and place additional orders.

Ross Seymore – Deutsche Bank Securities

I guess from that perspective a lot of other companies have gone from the burning of inventory stage to actually rebuilding some in the channel. It seems like you commentary for the third quarter is that you have no plans to rebuild whatsoever. Is it just getting back to the equilibrium for you or do you believe in the lean commentary that some retail at some point is likely to occur?

Mark S. Thompson

Ross, I think there’s a couple of things. First is that we do think that in general it’s good to operate with as little inventory as possible, and so we are continuing to drive in a lean direction, but the other side to it is that we certainly have seen the actual point of sale increase as well steadily across the year, so that’s a clear indication that the OEMs are building products, and a couple of other I guess metrics for that because there are linkages between what the direct business as the OEM and the distribution business is that the OEM business is up 14% starting backlog to starting backlog, so I think that’s also an indication that point of sale we expect to continue to grow, and so we’re using both small amounts of undership in anticipation of increased sell through to take the channel down in the 10-week range, and once we are at about 10 weeks, it’s not likely that it would make sense to go lower than that, so then I think we would try to track retail as closely as possible. One other thing I think is worth offering is as we all try to figure out what’s going on out there is we did book more than $350 million of orders during the second quarter, and so that gives some indication again with short lead time environment and nobody putting speculative business out there, so a sort of going back to the framework of thinking about the third quarter and a transition to the fourth. That’s the data point that also I think helps suggest a pretty solid opportunity to drive all the parameters in the right direction in the third quarter.

Operator

The next question comes from the line of Romit Shah with Barclays Capital.

Romit Shah – Barclays Capital

Mark, just on the incremental fall-throughs well above 50% in Q2 and based on my numbers, it’s dropping down into the mid 30s, is there anything unusual hitting the gross margin line or in Q3, and what is a good assumption to make in future quarters for incremental gross margins?

Mark Frey

The fall-through is sort of a cumulative function. It doesn’t happen linearly quarter to quarter. In Q2, we did get a little more than we originally expected, and in Q3, we’re expecting and planning for continued internal inventory reductions, so that obviously lowers production volume. We think the function is obviously something that will degrade as the revenue line goes higher, but we think that fall-through amount is good up to the mid 300s in revenue, and then the impact of Mountain Top would be in addition to that.

Romit Shah – Barclays Capital

Is the 25 to 27% gross margin guidance number, is that an adjusted gross margin number?

Mark Frey

Yes, it is. It excludes the accelerated depreciation.

Romit Shah – Barclays Capital

Mark Thompson, just a quick question for you on your comment about running as lean as possible. Just looking at some of your competitors, they tend to manage channel inventories below 10 weeks. Is there a reason why you guys are carrying inventory in the channel a couple of weeks above that?

Mark Thompson

We set our targets based on service levels, and it winds up really being a function of the mix both geographic mix and also a product mix, and so I think if you make it on an equivalent complexity analysis, I think we’re are as good as anyone is. For example, the big chunk of our business in Asia, the fulfillment distribution piece aimed at computing, we run consistently less than 10 weeks, and I think we could probably get that to 9 or even less, whereas European industrial business, for example, is much lower turning and more granular in the product families and portfolios, and so you’ll have turns there that are less than 3, but that doesn’t indicate lack of help. We do benchmark it carefully on an equivalent complexity performance, and we do think that we’re in the range of as good as anyone out there in terms of our ability to deliver a certain service level from a dollar of channel inventory.

Romit Shah – Barclays Capital

So comparing your 11 weeks to On at like 8 or 9, it is not necessarily an apples to apples comparison?

Mark Thompson

May not be. You have to recognize that there is a different revenue recognition model there as well.

Operator

The next question comes from the line of Shawn Webster with J.P. Morgan.

Shawn Webster – J.P. Morgan

What do you expect your utilization rates to do in Q3?

Mark Frey

Mid to upper 70s.

Shawn Webster – J.P. Morgan

And do you expect them to continue to go up in Q4 as well at this point.

Mark Frey

Well, obviously we don’t know what the demand is going to be in Q4, but by driving to as efficient inventory as possible, we would expect that we wouldn’t have to continue to burn inventory in Q4, so we are trying to balance Q3 and Q4, but we’re not offering guidance on Q4.

Shawn Webster – J.P. Morgan

Doing the math and tying together what you guys have been talking about in terms of end consumption, is it fair to say that as of this quarter you should be shipping to end consumption?

Mark Thompson

I think the aggregate of what we offered up is that we would still expect to slightly undership consumption this quarter. If you look at the progression, we undershipped consumption by 50-ish in the first quarter and well under 25 in the second, and as I commented earlier in the 5 to 10 range in the third quarter, so the trajectory would be by fourth quarter that we would be pretty well in line with consumption.

Shawn Webster – J.P. Morgan

So would that mean that end consumption, you expect it to go up 10% sequentially in Q3?

Mark Frey

Mid single digits.

Mark Thompson

The point of sale is mid single digits. The OEM is 14%, so that gets you to the high single digits for sure.

Shawn Webster – J.P. Morgan

In terms of the end markets, what are the strongest end-markets you expect in Q3?

Mark Thompson

Q3 is pretty broadly healthy from what we see with the exception, and then we commented on the regional piece is that Europe is still pretty dead. The US is showing some modest recovery, and Asia has been pretty strong. In terms of market, again it’s pretty broadly based with the exception of automotive which is still very dead, but everything else is corrected for a reduction in broad demand level from 2008, have all recovered to a reasonable level.

Shawn Webster – J.P. Morgan

It seems like your lead times came up slightly in this quarter versus the last quarter. Are there any areas where you’re experiencing product tightness or end markets?

Mark Thompson

Well, there are always a few packages that are a little bit tight, clearly on the fab side, we are in pretty good shape. There’s a couple of commuting packages that are a little bit tight right now, but not problematic.

Shawn Webster – J.P. Morgan

In terms of the restructuring and the cost and the closing down of your facilities, when should we expect those other charges like the $11 million charge and the $3.5 million charge in cost of goods sold to stop?

Mark Frey

Well, even though we announce the program in Q4 and Q1, you take the charges when you actually trigger some of the events, and therefore they’ll continue in a declining amount throughout the end of the year and even into early next year.

Shawn Webster – J.P. Morgan

The accelerated depreciation charges, should those continue into next year as well or will they stop after Q3?

Mark Frey

They will stop after Q3 of next year.

Operator

(Operator Instructions). The next question comes from the line of Steve Smigie with Raymond James.

Steve Smigie – Raymond James

I was curious if you could talk about where you might see peak gross margin at this point given the closing of Mountain Top and reduced depreciation expense.

Mark Frey

Obviously, we’ve added a lot of leverage into our system. We’ve taken fixed costs down, and we have taken our footprint down. We haven’t seen the impact of that over a larger sales base, but we do believe it provides an opportunity to take our margins up higher than our historical averages. As you know, we had prior to this cycle a high 30% goal. We’ve not updated that goal for the new environment yet, but we’re working on that model strategically this summer, and would expect to get longer term, not guidance but model expectations in front of people sometime this fall.

Mark Thompson

What we expect to show Steve is that the opportunity to drive to higher margins than historically. We’ll have a higher target, and we’ll achieve them at lower revenues.

Steve Smigie – Raymond James

On the MOFSET side when we talk about PT7, can you talk about your view of market share and competitive advantage at this point? Clearly, this has been an unusual environment, but how do you guys see yourself positioned coming out of this? European competitors may have been somewhat weaker through this, so where are you now relative to that, and how do things evolve here over the next year or so?

Mark Thompson

We continue to see computing as a very important market for us, and we feel quite good about it, and obviously it’s a very competitive market place, so there are opportunities to gain share and then there are opportunities to lose it if things shift the way you don’t like. Certainly we see netbooks for example as quite favorable to our strategy. If you look at what we have got, we have we believe one of if not the most advanced fine-pitched trench technology out there, so we can go to very small dye. The exciting thing about that is that we can now finally begin to move off the historic big clunky packages like SO8s, for example, and down to some very tiny dual packages like 3 mm x 3 mm packages. Notebooks haven’t been nearly as focused on weight and footprint as you might think as anybody that lugs one around, as we all do know. Netbook is more philosophically like a cellphone. They pay attention to battery life, weight, materials, and so we think a lot of the competitive landscape will not be able to move to smaller packages because they don’t have the technology, and so we think that there is an opportunity to really shift that landscape over the next 12 months, and that’s what our big focus is.

Steve Smigie – Raymond James

That 3 x 3 package, is that something you have in place now in Penang or something like that and ready to go, or is that something that’s coming?

Mark Thompson

No. It’s in production right now and ramping, so it’s real.

Mark Frey

But it’s in Penang.

Steve Smigie – Raymond James

If you could talk a little bit about the success on the analog switch side, what’s giving you the competitive advantage there also?

Mark Thompson

There’s a couple of moving parts to that. First is that we have had historically a very strong position in switch, and that’s been a result of having a very strong engineering group in tight regular communication with the handset customers around the world as they basically demanded more and more from their analog switch from something that not that long ago was just a simple thing that switched to ear buds, and now if you look at what people are trying to do, migrate to standard USB connectors, multi-duty for pins, standard switch mode chargers. All of a sudden, you’re moving data through the connector. You’re switching audio, you’re switching video. You’re managing power and all with a standard USB block, so the humble analog switch has actually become one of the more important aggregation points in the phone for integration of functionality, and so we have been well positioned with that. I think we have done a solid job of aligning the other strategic blocks and capabilities, adding audio now, and so I think that’s going to continue to be really strong place for us, so again we’ve bet on the future in that and power management for example, and those things are really coming to the fore now in having advanced solutions that allow our customers to really migrate their features and the overall rapid design, so those are really the key moving part for that.

Operator

The next question comes from the line of Parag Agarwal with UBS.

Parag Agarwal – UBS

I just wanted to drill down further on the gross margin. Some of your competitors have a higher grow margin than you have, so the question is as you head into 2010 and as lots of costs start to come up, do you expect to close that gap with your competitors in terms of gross margin?

Mark Frey

Yes, we do. As we said earlier, I think we can match our previous gross margins at about $100 million less revenue per quarter than we did before, and I think that’s an indication of the leverage that we’ve built, and as revenue begins to grow in future years, I think it will take us above our average and move us closer to our original strategic target of about 38% or at least interim strategic targets.

Parag Agarwal – UBS

Let me ask the same question in a different way. Previously at 90% utilization, your gross margin was about 30%, so with all the costs coming up, what do you think your gross margin would be at 90% or plus utilization level?

Mark Thompson

We are not ready to give you that model yet. We have been approaching that by advising you on what the fall-through would be, but clearly we think it will be higher at 90% than it was before, and as I said, we’ll try to put something in front of you closer to this fall.

Parag Agarwal – UBS

Lastly, there have been some reports of shortages of components. Are you seeing any change in ordering patterns from your consumers? Are they kind of anxious about any component shortages?

Mark Thompson

I think that there are probably a few places where the supply chain is pretty tight. Given the amount of inventory that’s been taken out of it, that’s pretty natural. What we haven’t seen is any change whatsoever in the aging pattern of our incoming orders and so they are very naturally a portion. We have seen nothing that resembles speculative ordering, and so we very carefully track the distribution of orders as when people are asking for ship dates, and over the last quarter, we have not seen that shift at all to the longer request dates, so all the data we see says that people are, the orders that they are placing are aligned with demand as they see it in the moment and not anticipations or fear.

Parag Agarwal – UBS

Are you seeing orders being placed into Q4?

Mark Thompson

Well, certainly at this point we would naturally see orders placed into Q4. If you look at the beginning of a quarter, normally you’ll see a little less than half of the orders fall into the current quarter and then a little less half would fall into the subsequent quarter and then maybe 10% would land in the quarter beyond that, usually associated with contract awards, and that kind of thing, so that would we a typical first month of the quarter pattern that we would see, and that’s absolutely the pattern that we see now.

Operator

(Operator Instructions). The next question comes from the line of Tristan Gerra with Robert Baird.

Tristan Gerra – Robert Baird

Is the comment that you can reach the same gross margin with $20 million less in revenues and deferral including or excluding the fab closure benefits you announced in Q1 and also what utilization rate gain would you get from the fab restructuring if we assume stable run rates?

Mark Frey

First of all, it was $100 million per quarter, lower level, and it excludes the phase shift impact of the Mountain Top closure which will be in Q3 of next year. Does that answer your question Tristan?

Tristan Gerra – Robert Baird

Yes.

Mark Frey

On the utilization, our capacity as a moving target, obviously by taking out the 4-inch line and the Mountain Top facility, we’ll lower our wafer output, but at the same time, we’re moving that equipment into other fabs. Our Power Trend 7 is a more efficient processor, so it produces more dye, but we expect our capacity to be closer into the high 300s for today’s equipment set, and then although our capital spending is far lower than it was before, it is still capital spending and it is supplementing our capacity on an ongoing basis.

Tristan Gerra – Robert Baird

What percentage of manufacturing was outsourced in the quarter?

Mark Frey

Around 30%, and I’m talking about back end. We’re largely in-sourced in the front end.

Mark Thompson

Tristan, another I guess element to the analysis that I think you’re trying to do is the sum of the line that we are taking out of Korea plus the Mountain Top facility would amount to a little over 10% of our total revenue. That’s the increment there that can either disappear or reappear in one of the other factories as market conditions require.

Operator

The next question comes from the line of Kevin Cassidy with Thomas Weisel Partners.

Kevin Cassidy – Thomas Weisel Partners

I was interested in the 3% ASP decline, and do you expect that trend to get better in the third quarter? I wonder if you could describe what was happening with the 3% decline.

Mark Thompson

If you look at the mode that everyone in the industry has been in including us, yes, severely under-utilized plans, and you want to fill them, so the first thing you do is you fill your plants and then the next thing you do is you fill them with the best business you can find, so I think if you look at our and other utilization rates are getting back to a healthy level, which means that you can be naturally more selective about the business that you take and so normally that’s how the prices moderate as people become more disciplined about the business that they take and the pricing pressures moderate. They are always there, but they just moderate.

Kevin Cassidy – Thomas Weisel Partners

So there are significant orders and so you went after those, and now we can calm down, I guess?

Mark Thompson

That’s the way to put it.

Kevin Cassidy – Thomas Weisel Partners

In the automotive market, what percentage of your revenue is in a typical year automotive?

Mark Thompson

5 to 7 in a typical year.

Kevin Cassidy – Thomas Weisel Partners

Do you have any heavier exposure to North America versus Europe versus Asia?

Mark Thompson

Actually we have very little exposure to North America. The biggest portion of our automotive business is in Europe aimed at high fuel efficiency direct injection diesel kind of applications, and then the strategic focus area has been Korea.

Kevin Cassidy – Thomas Weisel Partners

The emergence of a hybrid car, do you see any pickup around that?

Mark Thompson

The hybrid volumes are so small that they really don’t amount to much in the grand scheme of things automotive.

Operator

The next question comes from the line of Brendan Furlong with Miller Tabak.

Brendan Furlong – Miller Tabak

On the gross margins, apart from the $3.6 million accelerated depreciation, is there an additional inventory write off that’s baked into your current expectation for September?

Mark Frey

No. We’ve baked in our normal inventory obsolescence experience.

Brendan Furlong – Miller Tabak

As you start to come back to profitability, how should we think about the tax rate going forward?

Mark Frey

Well, that’s obviously going to depend on what the President does. We have a net operating loss carry forward position in the US which as long as we are operating from that position, and I think even as we get into profitability, that would be the case for several years. Our weighted average tax rate should in the 15 to 20% range.

Brendan Furlong – Miller Tabak

You talked about your USB. If you can just give us some more color about what you’re doing around the USB devices?

Mark Thompson

What we’re doing depends by handset manufacturer, but in general, we see many of the major handset makers migrating to a micro USB as the standard connector for the cellphone for everything, so you have charging, you can connect to a PC, and there’s any number of things that you would use that for. You don’t have very many pins in a USB, so you have to handle data, power, and you also have to be able to decide what’s on the pin, and so it’s obviously a tremendous benefit to the handset maker and to user, simplicity of user moving toward standard chargers, but it puts a lot of burden on the IC on the inbound side of that to be able to use a common pin for several things, recognize what’s what, switch seamlessly between the function, and not let anything bad happen as it does that, so it’s really mix of USB transceiver blocks plus analog switch in the broadest sense including video, audio, and then next on the roadmap is likely some integration of audio function as well because that’s a natural place to put audio very close to port and where the earpieces would be.

Operator

The next question comes from the line of Bill Ong from Merriman.

Bill Ong – Merriman

My question is more on the business unit growth rate. What type of growth rate are you forecasting for your products for the September quarter to reach the $300 to $325 million revenue run rate, and also as you get to a more normalized growth rate next year, what type of annual growth rate can we expect from these units?

Mark Thompson

If you took whatever the growth rate winds up being, it will be slightly more from the PCIA group than it would be from the MC Cubed group, so if it wound up being say 10%, we might say 6% of that would be from the PCIA and say 4 of it might be from MC Cubed, so that would be the way to partition it, and in terms of thinking about growth rates in 2010, I’m not ready to predict 2010 yet. What I would say is that we feel very as I commented earlier about some of our programs in some major places for example aimed at enabling some very sophisticated user-friendly smartphones, enabling some great power management solutions in netbook, our lighting solutions, industrial power, there’s a whole number of things that we feel very excited and bullish about, and we think that we should be able to outperform the market, whatever the market happens to do in 2010, so we are excited about the year.

Mark Frey

That said, we do expect that standard products will grow very modestly if not at all as we really focus on just generating cash from them.

Operator

The next question comes from the line of Craig Berger from FBR Capital Market.

Craig Berger – FBR Capital Market

I wanted to dig into the gross margins. I know a bunch of questions have been asked. Essentially you guys highlighted $12 million of depreciation that’s going to roll off over the next year. What’s the ongoing cash cost that you’ll be saving from closing your facilities, and can you also talk about any unit cost benefits you’ll get from selling lower utilization product in Q3 that you build in Q1 and Q2 and how you expect that to benefit gross margins as we move forward?

Mark Frey

First in terms of the cash benefits, it’s about $20 million on an annualized basis, and that would be timed with the closure of Mountain Top after the second quarter of next year. The depreciation number you just citied included the Mountain Top falloff which will also happen after the second quarter of next year, and obviously that’s just indicative of the fact that equipment will no longer be in use. In terms of the accounting component you talked about in Q1, yes that is a factor that your expenses this quarter reflect to your lower utilizations from last quarter and on and on because accounting causes you to defer the benefit of lower costs to the point in time where you sell the product, and that’s built into our guidance, and it is overall built into our fall-through models, and that’s why it should expect to accelerate as you continue to put up higher utilization quarters. I think there was a third question in there, but I forget what it is now.

Craig Berger – FBR Capital Market

So $20 million year of cash savings by the end of Q2 and $12 million a quarter is $48 million a year of depreciation, so $68 million a year of total cost savings is the way to think about that, just checking the math?

Mark Frey

Now that’s not all just Mountain Top. Embedded in the depreciation is the general modeling that I think Dan put out there at the last conference. Essentially we are depreciating at about $32 million per quarter, not counting the accelerated depreciation, and we’re investing at closer to $15 million per quarter, so the number we just gave you is the timing. The 32 eventually over time has to go down to 15 depending on how long we can sustain 15 to 20 as the investment rate.

Craig Berger – FBR Capital Market

That was my next question. How do you think about your ongoing levels of capex? I think you guys used to talk about 6 to 8% of sales. Is it now 5%?

Mark Thompson

We’re targeting that Craig strategically and seeing what we can do in the 5 to 6 range, and certainly there is some lower margin products that have offered to make room for higher margin products to allow us to do that, so we will be using that as a forcing mechanism at least through 2010, and I think we can continue to drive that into 2011.

Craig Berger – FBR Capital Market

On the revenues, 275 of revenues in Q2 plus $50 million better backlog kind of suggest the high end of your guidance range for Q3. Is there some conservatism baked into the guidance or how do you view that?

Mark Thompson

All year, we have been trying to avoid predicting the future but really just offering the moving parts. If order rates don’t fall off, so far they have been quite steady, then yes. We would certainly expect to trend to the high end of the estimate range we put out there.

Craig Berger – FBR Capital Market

It looks like you guys are going to be about net cash neutral by the end of the year. Can you just talk about your plans for cash or debt pay-down or how you’re viewing your debt instruments?

Mark Frey

What do you mean by net cash neutral?

Craig Berger – FBR Capital Market

Well, about equal amounts of cash and debt.

Mark Frey

Obviously for the year we expect to continue to generate cash in the second half. As we showed in June, we bought some of our loan back at a discount, and in three of the last four years, we’ve delevered the company, we’ve lowered the amount of debt, and we’ll continue that bias. This cycle I think caught a lot of companies’ management teams’ attention in terms of how you can lose control of your company if you are too highly leveraged, and so we would continue to have a very cautious stance on that. Now the tradeoff on that is potential acquisition opportunities for cash which we’ll have to take them as they come. We actively look at investing in new technologies that we can bring into the company for either cash or stock, and we’ll make those decisions as they present themselves, but overall we’re pretty cautious about the leverage that we accept in the company.

Mark Thompson

That’s all we have time for today.

Operator

That concludes our conference call today. Thank you all for your participation.

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Source: Fairchild Semiconductor International Inc. Q2 2009 Earnings Call Transcript
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