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Analog Devices, Inc. (NASDAQ:ADI)

Q3 2006 Earnings Conference Call

August 10, 2006 4:30 pm ET

Executives

Jerald G. Fishman - President, Chief Executive Officer, Director

Joseph E. McDonough - Chief Financial Officer, Vice President-Finance

Maria Tagliaferro - Investor Relations

Analysts

Michael Masdea - Credit Suisse First Boston Corporation

Sumit Dhanda - Banc of America Securities

Joseph Osha - Merrill Lynch

Steve Smigi - Raymond James & Associates

Adam Parker - Sanford C. Bernstein & Co., Inc.

Tore Svanberg - US Bancorp Piper Jaffray

David Wu - Global Crown Capital

Ross C. Seymore - Deutsche Banc Securities

William C. Conroy - Sanders Morris Harris

Bill Lewis - J.P. Morgan

Mona Eraiba - Rosetta Group Research

Terence Whalen - Citigroup

Louis Gerhardy - Morgan Stanley Dean Witter

Presentation

Operator

Good afternoon. My name is Ian and I will be your conference facilitator. At this time, I would like to welcome everyone to the Analog Devices third quarter 2006 earnings conference call. All lines have been placed on mute to prevent any background noise. After the opening remarks, there will be a question-and-answer period with our analyst participants.

(Operator Instructions)

Ms. Tagliaferro, you may begin your conference.

Maria Tagliaferro

Hello, everyone, this is Maria Tagliaferro, Director of Corporate Communications here at Analog Devices. If you do not yet have our third quarter 2006 release, you can access it by visiting our website at www.analog.com, and clicking on the headlines displayed on our home page.

This conference call is also being broadcast live on the Internet. From analog.com, you can select investor relations and follow the instructions there. That will take you to the online webcast.

A recording of this call will be available today within about two hours of today’s call, and it will remain available via telephone or Internet playback for about one week.

Participating with me today are Jerry Fishman, our President and CEO, and Joe McDonough, VP for Finance and CFO.

We estimate this call, including Q&A, will take about 60 minutes, but we will be flexible in that regard and stay on as long as we have questions. We will begin in a moment with comments from Mr. Fishman, and then the remainder of our time will be devoted to answering questions from our analyst participants.

Analysts participating via telephone today can press star, one now at any time during the call, and you will queue up for questions.

There is an important announcement that I would like to make today. The financial results for the third quarter fiscal year 2006 being discussed today have been reported in our press release, which is found on the website at analog.com. The results reported are in accordance with GAAP, and include approximately $19 million of stock option expense, expenses of approximately $5.7 million associated with previously announced restructuring actions that are related to the closure of our California wafer fab, expenses of approximately $6.2 million associated with previously announced acquisition related actions, and tax benefits of approximately $16.8 million.

In order to help investors compare current results to our historical results, and thereby better understand the underlying trends in our business and our ongoing operating results, our comments during today’s call will at times make reference to non-GAAP results, which exclude these items.

We have included in our press release details of the stock-option expense, restructuring and acquisition related items for all quarters, from the fourth quarter of fiscal 2005 through the third quarter of fiscal 2006, and estimates for the fourth quarter of fiscal 2006.

Investors can download that information in spreadsheet form from the investor relations page of our website.

In addition, please note that the information that we are about to discuss includes forward-looking statements. For purposes of the Safe Harbor provision under the Securities Litigation Reform Act of 1995. Such statements include risks and uncertainties. The company’s actual results could differ materially from those discussed here-in.

Factors that could contribute to such differences include, but are not limited to those items noted and included in the company’s SEC filings, including our most recent quarterly report on Form 10-Q.

The forward-looking information that is provided by the company in this call represents the company’s outlook as of today, and we do not undertake any obligation to update the forward-looking statements made by us.

Subsequent events and developments may cause the company’s outlook to change. Therefore, the conference call will include time-sensitive information…[background noise]…this live broadcast, which is August 10, 2006.

With that, let’s begin with the opening remarks from Mr. Fishman.

Jerald G. Fishman

Good afternoon to everybody. During Q3, there were many moving parts that impacted our GAAP results. During the quarter, we announced two acquisitions. We are absorbing costs related to previously announced restructuring moves. We finalized the tax settlement with the IRS, and we are absorbing charges, of course, related to stock-option expense.

As Maria said, we have included a supplemental table with our press release describing the details of all those items for Q3, and we have also provided forecasting these items as far as we know as of today, for Q4.

At the same time, we have many moving parts in our overall business. I am going to concentrate my opening comments this afternoon on ADI’s business strengths.

As noted in the press release, our revenues are about $664 million, which was up 14% from the same period last year, and up about 3% sequentially. Our converter, amplifier and general purpose DSP product sales to industrial, consumer, and communication infrastructure customers were up sequentially, essentially on the plan we had when we began the quarter.

Sales to our wireless handset customers were approximately flat to Q2 levels, while our sales to computer customers declined slightly from the second quarter. Both the wireless handset and the computer sales results being relatively flat, or below the original plan we had for Q3.

We experienced continuing strong performance from our diverse base of instrumentation, measurement, and medical equipment customers. Automotive revenues also increased slightly sequentially.

Automatic test equipment revenues, which were also part of the broad category of industrial products, declined from Q2 levels as one of our large customers had a major order cancellation by a significant semiconductor manufacturer, whose business strategy changed during the past quarter, and therefore did not need that testers.

Aggregate sales to our broad base of industrial customers, which includes industrial, instrumentation, semiconductor test equipment, automotive, and defense electronics, increased 16% year over year and also 3% sequentially.

Overall in Q3, our sales to industrial customers were approximately 42% of our overall sales, which is very similar to last quarter.

Our sales to communications customers grew 26% year over year, and were up 6% sequentially, and represented approximately 30% of our total sales. Within communications, our sales to our wireless base station and networking customers were particularly strong sequentially.

As I mentioned earlier, our sales to wireless handset manufacturers, which represented approximately 12% of our sales in Q3, were flat on a sequential basis and up year over year.

Our base station business, which today represents approximately 11% of our sales, was up 13% sequentially and 28% year over year.

Our sales to consumer customers grew 14% year over year, and 3% sequentially. Strong sequential growth in advanced TV and audio products was driven by LCD and plasma TV applications, where ADI supplies a wide array of analog components, and also home AV components, where ADI’s sharp DSP has become a de facto industry standard.

Our sales to digital camera customers declined sequentially, in line with normal seasonal trends, and also in line with our plan, but grew on a year over year basis. Our market position remains very strong with leading camera manufacturers, as we increase the content that ADI could supply to the newer models of the largest camera companies. As a result, we expect a strong seasonal recovery in our digital camera products in Q4.

Consumer customers represented 17% of total sales in Q3, similar to last quarter.

Computer applications represented approximately 11% of our sales in Q3. Our revenues from computer customers actually declined slightly sequentially in Q3. General weakness in the computer market coupled with product transitions within ADI’s audio and power management product lines were the primary causes of lower-than-expected growth to these customers in Q3.

I will say a little bit more about the power management products a little later in my comments.

Now I will move over to talk briefly about our revenues by the product groups.

During Q3, our analog product sales grew 15% year over year, and were up 4% sequentially. Within the overall analog category, converters were up 12% year over year, and 4% sequentially. Amplifiers were up 20% year over year and 5% sequentially.

In combination, converter and amplifier products comprised 64% of our total sales, and the most recent market share data again indicates that ADI’s market share remains extremely high in these product categories.

Power management sales were up 5% year over year and approximately flat sequentially.

Our strategy to focus on portable and server applications was impacted by a general weakness in the computer market and also by our deliberate strategy to continue to withdraw from product areas in power management, where the margins are inadequate.

Our sales of other analog products, which includes micro-machine products, radio frequency products, and clock IT products, grew 3% sequentially and 22% year over year.

Power management as a grouping represented approximately 6% of our sales, and other analog products were approximately 14% of our sales in Q3.

During Q3, DSP revenues were flat sequentially and up 11% year over year, and totaled 16% of our total sales. Excluding the divestiture of our DSL-DSP-based ASIC business a few quarters ago, our DSP revenue was up 3% sequentially and 20% year over year.

Our general purpose DSP products grew 11% sequentially, and 15% year over year, representing approximately 7% of our total sales.

On a geographic basis, our sales to European customers grew the strongest sequentially. Our sales to U.S. and Japanese customers were approximately flat compared to the just prior quarter, and we had an increase in sales to the rest of the world, which of course includes China and Southeast Asia predominantly.

All the relevant financial information for Q3 is contained in our press release in great detail, so I am not going to repeat all of that information.

I would, however, like to comment on our cash flow and our use of cash for the quarter.

Our cash and our short-term investment balance at the end of the quarter was approximately $2.5 billion. Our business generated $215 million of positive cash flow for the quarter, which was approximately 32% of our revenues.

We continue to leverage our cash flow to the benefit of our shareholders. We have been aggressively repurchasing ADI stock, and in Q3, the pace accelerated with over 9 million shares repurchased, for approximately $305 million, while we received $20 million from employee stock programs.

Since our $2 billion buyback authorization began, we have repurchased approximately 10% of our outstanding shares on the open market. Approximately $670 million is still available for repurchases under this existing authorization.

During the quarter, we paid $58 million in dividends and in September, we will again pay a dividend of $0.16 a share.

Cash payments of about $15 million were associated with acquisitions, and $38 million for capital spending.

As a result of all those items, when you add them up, our cash balance declined by $177 million for the quarter.

Looking forward, our book-to-bill ratio, as measured by the direct OEM customer orders, plus end customer orders placed through our distribution channel, was approximately 1 in Q3, down from 1.05, approximately in the second quarter.

So in planning for Q4, we considered really the following factors.

On the positive side, the economies in most regions of the world remain strong, despite increased uncertainty over the last few months due to higher interest rates, and of course, higher oil prices.

Capital spending forecast remains strong for the balance of the year, and into 2007, although somewhat muted from earlier forecasts this year.

During the later months of Q4, in particularly in September and October, we typically benefit from stronger sales to consumer and computer customers. I think this year, in fact, buoyed by very strong new product cycles in many of our product areas.

Thirdly on the positive side, our product groups in general are reporting good, forward-looking forecasts from their customers, not only for Q4 but also for our 2007, which begins in November.

On the more cautious side, many of our customers seem more concerned with the inventory level they have than they were three months ago, and that is particularly true with some of our handset customers in Asia.

Overall capacity in foundries is clearly more available than it was just a few months ago, and many of the back-end bottlenecks that we have all been suffering with have been mostly resolved.

As a result, lead times in general have declined industry wide in the last three months. This, of course, has reduced the turns business opportunities in the short-term.

Another thing that makes us cautious is the income order rates, which include turn orders, did weaken during our Q3.

So as we sit around and we stir up the pot, there are many positives. There are also reasons to be cautious, so we are planning for our revenues to be roughly flat in Q4 to Q3 levels. We also believe there is some upside to that forecast if our customers’ forecasts materialize actually into Q4 shipments.

While the inventory cycles that we have experienced in Q3 have introduced some caution for Q4, as we plan for our fiscal 2007, which as I mentioned begins early in November 1st, we are encouraged that our customers remain generally optimistic and that ADI specifically has many drivers to both our top and our bottom-line.

Relative to our top-line, number one, the diversity of applications and the pervasiveness of our signal processing technology, continues to be a very stable foundation to our revenue and likely to provide good revenue growth going forward.

Our converter and amplifier products continue to command very high market share. Our product development teams in these areas are solid, and that should keep ADI at the forefront of these product categories for many years in the future.

We have also, number three, raised our commitment levels to win important product segments of the power management category, which has been over the last year, or 18 months, one of the fastest growing Analog product categories, as portable equipment becomes a larger proportion of the available market for electronics equipment.

Today we have amassed a sizable and an experienced engineering workforce in power management, under the direction of a highly capable leader with a proven track record of success.

With our team, with our technology, with our brand, with our sales channel, our plan is to significantly increase our sales of power management products going forward.

Number four, we are increasingly engaged in providing higher levels of analog maintenance and DSP integration for many high volume markets, such as automotive electronics, and high-end consumer products, which we should begin to see the benefits of in 2007.

Number five, our micro-machine based products are poised to move well-beyond our historical focus in airbag safety systems and to very high-volume consumer products that run the spectrum from portable media devices to cell phones to game consoles.

Number six, our general purpose DSP product portfolio continues to grow. While not yet producing the revenue contribution that we expect and that we need, more design wins move into production each quarter, including significant new applications in consumer, communications, and automotive products.

Number seven, we will also continue to look for relatively small acquisitions to fill in technology voids and also to quickly penetrate new markets.

All these in aggregate should help ADI achieve our top-line growth model of 15% a year.

We also have many programs in place designed to raise our operating margins to 30%, excluding option expense in the near-term, and to a 30% level including option expense in the longer term. Clearly our objective is to keep growing our bottom line faster than our sales.

In moving the bottom line forward, we are now completing our fab consolidation during our fourth quarter, which is by and large on schedule. Compared to 2006, we expect this action will reduce our cost of goods sold by approximately $6 million to $8 million per quarter during the first-half of FY2007.

As we consume the higher cost inventory produced in the existing Sunnyvale fab, these savings will plan to increase to $11 million to $12 million per quarter during the second-half of 2007.

We also continue to look for opportunities to trim product lines that are unlikely to meet our operating objectives.

Lastly, we have, over the last six months, and actually over the last year, we have been aggressive buyers of our stock, which in the near-term has been slightly accretive and could be even more so as our earnings increase in the future.

Overall, we remain focused on achieving our financial model of 60% gross margins, 30% operating margins, on a GAAP basis in the future. We believe that our technology portfolio, our brand reputation, our cash generation capability are the key levers to achieving those objectives.

Maria Tagliaferro

Thank you, Jerry. During today’s Q&A period, if you would please limit yourself to one primary question, and then a follow-on question. We will give you an opportunity to ask additional questions if we have more time.

With that, Operator, could you just please remind our analyst participants how to submit questions, and then we will take the first one.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Michael Masdea.

Michael Masdea - Credit Suisse First Boston Corporation

Thank you. As you walk through a number of the dynamics going on, it sounds like there is a lot going on. If you go back to the beginning of the quarter, you were pretty optimistic, and then certainly in the fourth quarter, given the power management kicking in, maybe on the notebook side or for other reasons, seasonality, probably thought it was going to be a little better.

Just walk us through each quarter what you think was the biggest surprise, and then really, if you take those out of the picture, how you think underlying demand is really playing out, even when you factor in some of the lead-time issues.

Jerald G. Fishman

I think overall, end demand seems okay in most of the market segments. The general weakness in the computer segment I think was widely commented on by many people during the quarter, including some of the guys making the processors.

I think the handset thing, which was the other part of the surprise, sort of flattened out last quarter, and I think also it has been pretty widely reported that, at least in many countries in Asia, China, and Korea, there was some build-up of handset inventories during the previous quarter, which people started to adjust last quarter.

I think the most generic way to think about demand is what is happening on our industrial business, because that really aggregates just a lot of different customers in a lot of different markets. That business remained pretty strong.

The consumer business was pleasantly strong. There has been a lot of commentary about how the consumer business was going to weaken. We had a pretty good, strong consumer quarter, and we think next quarter will be good too, seasonally.

Typically, the third quarter for us is not a strong consumer quarter, but that turned out to be okay as we thought it would, given the forecast we had from our customers.

The only real surprises were the computer sector was weaker, and that was really a combination of the fact that the market was weaker and also, we deliberately walked away from a bunch of business that just simply did not meet our margin objectives in that sector. That is part of what we have been doing to restructure that business over the last couple of quarters. The management of that business has really taken a very strong position, and I think an appropriate one, that there is no reason for us to sell products at some of the gross margins we were achieving in that business.

Some of them we have actually managed to raise the gross margin and other ones, we basically are just not going to do.

As we look at the overall landscape, that is the pluses and minuses as we saw them.

Michael Masdea - Credit Suisse First Boston Corporation

Just real quick, with the restructuring, you have generally moved away from some of the less profitable vertical markets, but a couple of your acquisitions look to be a little more vertical-market focused. Can you walk us through your recent acquisitions and just help us understand why they look to be a little bit more vertical market, but it seems the opposite direction of where you have been moving your restructuring.

Jerald G. Fishman

I think on the largest one, which was the Integrant acquisition, I think the way you would think about Integrant is they are one of the better low power CMOS tuner companies in the world. You know, tuners are going to go into a lot of different products, and they have a widely dispersed customer base and a very strong capability to proliferate very low-powered CMOS technology into many, many markets.

One of the early markets will be mobile TV, but I think there are many, many other markets in the future. Basically, we have a cracker-jack team of people that know how to build those products and know how to take it to market, and are very well-respected by the customer base that they serve.

I think in the longer-term, every market is a vertical, to some degree. Every market where there are a lot of customers and there is increasing concentration, there is a vertical. I think at ADI, our business is going to be made up by serving vertical customers and serving the customers, the markets where have 10,000 customers in a particular market segment.

I think in order to -- with a company our size, in order to grow the company, you have to really do both. You have to serve some of the larger customers, and I think at the same time you really have to continue to build that franchise of the 60,000 or 80,000 customers around the world in every market segment.

I really think you need a combination of both, and that is what the Integrant acquisition was geared to.

As far as acquiring the software stacks on the handset [side of things], I think increasingly, our customer base believes you cannot be in that business at any level unless you control more of the software. We had a relationship with TTP for many years, and we thought that was the right thing to do to preserve and expand that market as well.

Fortunately, we actually did that right before TTP was acquired by Motorola and I think that gives us a path forward for those products with our customers.

I do not think those are examples of either a vertical or horizontal focus. I think they are just examples of acquiring the technology we think we need to do the job that we set out to do.

Operator

Your next question comes from the line of Sumit Dhanda.

Sumit Dhanda - Banc of America Securities

A couple of questions. First, you noted that orders weakened through the course of the third quarter. Can you tell us exactly when the weakness started to manifest itself? Then, has there been any pick-up here through the month of July?

Jerald G. Fishman

I would say generically, we reported last quarter that in a single quarter, our reported backlog went up $75 million, and we also talked during the last conference call, I believe, about how we did not really believe that was realistic in one quarter for the order rates to improve that greatly, and it indicated to us that some people were trying to get in line, particularly as the foundries were reported full, and the back-end subcontractors were reported not to be sufficiently capitalized to meet a lot of the demand that was going on out there.

I think what basically happened in Q3 is that customers began to believe that they were not at risk for deliveries, whereas three months before, when they loaded us up with $75 million of improved backlog, they believed that they were at risk for deliveries. I think as a result, the world got a little more uncertain. There was a lot of stuff going on out there in the world in the last quarter, and I think a lot of customers across many applications began to pull back a little on the amount of inventory they wanted to hold. I think that is what happened generically across the board. Some market segments react more quickly to that, but I think we saw that really across the board with many of our customers.

I think the trends through the quarter, month-to-month were not really definable. The order rates in May were below what we thought they would be and they also were in June and July. I do not think there was any definable trend, downward or upward, during the quarter.

I think what really happened is the market basically adjusted to the fact that the lead times come in a little bit and customers weren’t as concerned about growing their inventories as much as they were three months ago.

I think if you listen to the commentary, or at least the reported commentary of many of our competitors, who we listen to a little bit, I think most of them are a little bit more cautious at the margin than they were three months ago, and certainly we are as well, at least for the coming quarter.

I do not think that has much to do with what will happen in 2007, which I think most people believe is going to be a good year, but I do sense that there is a lot more caution around than there was three months ago. Certainly our competitors have reacted to that, the stock market has reacted to that, and that is not surprising.

Sumit Dhanda - Banc of America Securities

Let me just get this clear, then. Do you require significantly higher turns, orders and shipments through August, September and October, or the remainder of the quarter, for that matter, to hit this flat guidance that you have put out there?

Joseph E. McDonough

We have about 65% of that guidance in backlog now. If you look back a year ago in the third quarter, there was 55% of the next quarter’s sales in backlog. As Jerry mentioned, the backlog, and as we discussed in the last conference call, the backlog had gotten up to levels that were very high on any kind of a trend basis. 65% is still a pretty healthy backlog, so we require something in the 40% to 45% range for turns for next quarter, if you assume -- the calculation this quarter were 10% or 11%, which is not an unusual number.

Sumit Dhanda - Banc of America Securities

Just a quick follow-up or two here, you talked about the cost savings starting to help starting in the second-half of fiscal ’07, if I heard you correctly.

Jerald G. Fishman

I am sorry. I missed your comment.

Sumit Dhanda - Banc of America Securities

I thought you said that the cost-savings would start to help you in the second-half of the…

Jerald G. Fishman

No, what I said specifically is that during the first two quarters, it will be somewhere around $6 million to $8 million a quarter during the first two quarters, and about $11 million or $12 million a quarter in the second two quarters. We expect it ought to begin to help us in our Q1. Does that clear it up?

Sumit Dhanda - Banc of America Securities

Yes, that does clear it up. The final question I have for you is you are talking about a 15% to 20% growth model. I do not want to belabor this fact, but ADI has really underperformed the rest of the analog peer group here recently. 2006, your revenues are basically going to be flat with 2004, and even just the broader market has grown faster than you have over the last two years.

Help me understand exactly what it is that you are doing so differently which will help you to get back to the promised land.

Jerald G. Fishman

First of all, we are getting out of some product areas that we do not think are strategically relevant. We had a very, very strong 2004, so those comparisons are a little bit challenging for us.

I think generically, the fastest-growing part of the analog business over the last two years specifically has been in power management, where we have been on under [inaudible]. We have significantly upped our investment level in that business because in order to grow with the kinds of rates we want to, we have to be a larger factor in that business. I think if you look at what the market enabled in the converter and amplifier business, our share, the share that is reported by the external market people, have been in fact growing in some cases, and flat in other cases, so I do not think it is a question of our products not doing well over the last year. It is a question that the power management part of the analog business has been not a large part of our sales, and will become a larger part of our sales in the future.

I think in the overall sense, a large part of the growth for some of our competitors in the last year has been in the handset business, where we have not had a lot of growth for all the reasons that we talked about. On the other hand now, the handset business is a much smaller percentage of our business than it has been in the past, and we see a lot of opportunities to grow that business, particularly on the analog side in the future.

I would say there are a lot of reasons for optimism about the future. None of it is a certainty, but I think a model for analog of about 15% a year, which is what we have been saying, is about the right model…[Technical Difficulties]…we can grow our earnings a lot faster than our sales by some of the things that we have done and some things that we will do in the future.

Sumit Dhanda - Banc of America Securities

Just one more question, I am sorry. The cancellation last quarter, you said 10% to 11%. When was that, in the April quarter? Can you tell me?

Jerald G. Fishman

It was something like that, which is similar to recent quarters.

Operator

Your next question comes from the line of Joseph Osha.

Joseph Osha - Merrill Lynch

Two questions. First, on the power management side, I hear you in terms of that being a big market, but is the market now, especially on the PC side, it seems to be intensely competitive with declining ASPs and some cases, declining margins. Why at this juncture do you want a piece of this?

Jerald G. Fishman

I think we want a piece of it where the margins are reasonably high. There are some very good competitors out there that reliably make good margins in that business, albeit they might not be 75 anymore, but they are up there in the 60’s in terms of the gross margin level.

The other part is that we have a lot of pull into that market by virtue of a much more product portfolio, and we have a lot of customers that are basically after us to get competitive products on the market. They really want to buy it from us.

Our belief is if you can build power management product margins in the low 60’s in that business, that is a pretty good business for us. I think that would be very welcomed when we look at our profit margins over the next couple of years.

It is an important market. I think at the bottom of the market, I think you are quite right -- that is not a place we want to be, where we want to invest or where in fact we even want to support existing products.

There are a lot of products where we are already showing a lot of content where we can package power management with them, and I think we can do very well relative to companies that really are just selling pinpoint power solutions. That is certainly our goal. We want to stay up-market in that. We think we can -- it might not be as profitable on a gross margin line as some of the horizontal products in the analog business, but again, when we get to be $2.5 billion, you have to have some drivers that can add a lot of sales. I think power management sales at those kinds of gross margins are one of the ways to get there. That is the way I think about it.

Joseph Osha - Merrill Lynch

Thank you. Then, on the second issue, you acquired some intellectual property from TTP Comm. TTP Comm is now owned by Motorola. What is the nature of that relationship now? Do you have an ongoing relationship with them, or you kind of felt out what you need and you are going to paddle your own canoe from now on? If you could give me some color on that.

Jerald G. Fishman

There are a lot of things possible, but we are expecting that what we had with TTP is what we are going to get, and that in the future, we will have other relationships. If there is a possibility with TTP, maybe we will do some more stuff with them, but we do not exactly know how that is going to come out and we are not counting on that for the future.

Joseph Osha - Merrill Lynch

So it is in a state of flux at this point. You have intellectual properties resulting…

Jerald G. Fishman

Yes, and we have taken a bunch of people from them that will be able to support and enhance that intellectual property.

Joseph Osha - Merrill Lynch

Okay, understood. Thank you.

Operator

Your next question comes from the line of Steve Smigi.

Steve Smigi - Raymond James & Associates

If I could ask just a little bit on the power business, what activity you have in terms of design wins, or what stage we are in terms of getting new products into customers?

Jerald G. Fishman

We have a lot of design wins, but we do not have a lot of revenue on the new stuff yet since these products are just making it into the market place. You know, we have been in the last quarter to two, where the new ones are doing well and the old ones we are getting out of, so you do not see a lot of that on the top-line, but I think over the next couple of quarters, our guys -- we just went through a pretty detailed review of that just a couple of days ago. There is a lot of good stuff out there. There is no reason why we should not have that be a larger business.

We have good technology. We have hundreds of people in that organization now that have been cranking to get good products out, and they have a pretty good sense of where they want to be, so I think that is going to be upside for us going forward.

Talking about any particular customer I think is a little premature. I would rather report high revenues than make pronouncements about customer wins, and that is certainly what I am going to plan to be looking at.

Steve Smigi - Raymond James & Associates

Do you expect to have a significant number of new, more products coming out? Or do you feel like you got a lot of the product out already and you have the design wins?

Jerald G. Fishman

Like I said, we have very large engineering group focused on this thing in many locations around the world, from California to Europe, and in Asia as well. They have a very aggressive product line. We have financed that over the last six months in particular, the last year. We are going to finance it next year. We have to play to win in that business, and we believe this is a category we can win in.

Operator

Your next question comes from the line of Adam Parker.

Adam Parker - Sanford C. Bernstein & Co., Inc.

Two questions, just so I can understand the guidance, maybe you can put the relevance of the guidance in some broader context. Why did you guys prerelease the results you are given, revenue is so far outside the range, and how far below that range would the revenue have to be for you to prerelease negatively?

Jerald G. Fishman

First of all, I do not think it is that far below the range. It is a couple percent below the range. Everyone’s perception about that, but it is certainly not a quarter we are happy with, not satisfied with, but I do not think this was the kind of quarter that a massive change of where we were going to be.

We are one of the few companies that actually reports their results seven working days after the end of the quarter, so by the time you really know what is going to happen, it is a couple of days. We are trying to understand it so we can sound and be intelligent of what happened and what the future is out there, and that is the judgment we made.

I think if there was a very significant miss, much larger than that, I think we would maybe think about it.

Adam Parker - Sanford C. Bernstein & Co., Inc.

So it would be more like $20 million, $30 million revenue, or something bigger?

Jerald G. Fishman

Yes, I would say. The discussion that the handset market in China was weak is not news to anybody, nor is the fact that there was weakness in the computer sector.

Like I said, it is not a quarter that I am happy with and satisfied with, but on the other hand, I think there are some things going in the marketplace that are very well understood.

Adam Parker - Sanford C. Bernstein & Co., Inc.

That could just be that…

Joseph E. McDonough

Adam, I think as Maria said at the outset of the call, we are not accepting the obligation to update the guidance that we are giving.

Adam Parker - Sanford C. Bernstein & Co., Inc.

Yes, I get that, Joe. Thank you. The second question is about DSP, which is clearly you evolved your strategy there and switched to being more optimistic revenue opportunities of DSP than maybe you were a year ago, in some of the vertical markets. Again, we are looking at another quarter where analog outgrows DSP, and I think it is something like 10 or 11 of the last 13 quarters where that has happened.

Maybe you could help us understand, what do you expect from DSP in the October quarter or the next year? On a fully [inaudible] basis here, the DSP, was it profitable this quarter? How many more quarters can you go before you have to be more aggressive with the DSP strategy? What gives you confidence we are on the cusp of something much better than we have seen the past several years with DSP?

Jerald G. Fishman

We continue to record where we are getting traction, with both small customers and larger customers and, as you can well understand, this business has been under intense review each quarter and we look at each of the things and we make a judgment of whether that is the best thing for us to do.

Our DSP business last quarter approximately broke even, even though the revenues were lower than we had thought they were going to be. Our goal is to keep improving that towards being a contributor to our profitability rather than a detractor.

So we look at that each quarter. We look at what the customers are saying. We look at what the organization is saying. We look at what the financials are, and we decide where we want to be and where we do not want to be, and that is the best I could tell you.

Adam Parker - Sanford C. Bernstein & Co., Inc.

But it does not have to, in your mind, grow much faster than analog to be a good business or remain it?

Jerald G. Fishman

I do not think it has to grow a lot faster than the analog business to be a good business to be in. I think if it grew at the kind of rates the analog business does and we wind up being able to amortize that big engineering nut over a large amount of sales, I think the incremental profit opportunity there is still very good for us, relative to the base we are at.

Adam Parker - Sanford C. Bernstein & Co., Inc.

I am trying to understand what you guys put out as your long-term margin goal of 30%, and I just think your guidance is something like 19% operating margins for the next quarter, so you need a lot of revenue growth to get that done.

Jerald G. Fishman

I do not know where you got that number.

Adam Parker - Sanford C. Bernstein & Co., Inc.

You guided for higher operating expenses and flat gross profit, it is on flat revenue, right? So you have to have lower operating margins than you just reported, on a GAAP basis. Whatever the number is, it is just lower than what you just did, and it is several hundred basis points away from the target goal, which implies you need a lot of revenue, right?

Jerald G. Fishman

It implies that we expect this is a growth business, Adam, and the fact that we have had very good sequential revenue growth the last couple of quarters, and we expect that will continue. If we did not expect it will continue, we would have a different conversation.

Adam Parker - Sanford C. Bernstein & Co., Inc.

I guess the very good part is subjective, right? If your long-term model is 15%, you just did 3%, it is below the long-term model, so it is not, by that long-term context, it is not that good. I think that is -- then you are guiding flat, so you are basically well below the long-term model this last quarter and this next quarter, right?

Jerald G. Fishman

Yes, well -- look, we have made a judgment that says that there are a lot of parts moving around quarter to quarter, and there are a lot of things going on with acquisitions that we made that we are trying to get the growth rate up as a result of, and a lot of other things we are doing. Quarter to quarter, those things are going to move along, but I think that over a very long period of time, including last quarter, we have a history of growing the top-line a lot faster than -- growing the bottom line a lot faster than the top line. I do not think there is any reason to think that we will not do that again in 2007.

Adam Parker - Sanford C. Bernstein & Co., Inc.

Thank you.

Operator

Your next question comes from the line of Tore Svanberg.

Tore Svanberg - US Bancorp Piper Jaffray

Good afternoon. Two questions. First of all, in power management, that business seems to be growing less than the industry now for a while. Are you pretty comfortable that you have all the internal resources to make that a big successful business, or are you also considering maybe some potential M&A?

Jerald G. Fishman

That is certainly a possibility in the future, I would not want to rule it out. Right now, we are working hard. We have built a tremendous confidence in that business over the last year in terms of size and experience. Our goal is to use that confidence. We are absorbing all the costs of that build up in our operating costs. Our goal is to have that be a real contributor for us in the future. That is why we are making very sizable investments in that business, and that is what we are going to try to keep doing.

I have reviewed personally the plan for that business and what they are trying to do, and I think they have a good shot at achieving their objectives.

Tore Svanberg - US Bancorp Piper Jaffray

My second question is on internal versus external capacity. Once you are done with your consolidation plans, how would that look as far as internally versus externally?

Joseph E. McDonough

Let me just look at this quarter, how that turned out. This quarter, our percentage of sales from internal fabs was about 57%. We have been down 52%, 53% in quarters past about a year ago, so I think it is reasonable to expect that the ratio of sales from internal fabs to external fabs will probably migrate downward toward the 50%, 55% range as we go forward.

We certainly have plenty of capacity in the fabs that we have. We are just consolidating the manufacturing into our existing fabs. There is plenty of footprint opportunity there, modest capital expenditures to expand out the capacity of those fabs. So there is no concern that we have about not having enough headroom on the internal fabs.

We also have very strong relationships with external foundries, principally TSMC and we are not concerned about our access to capacity from the external fabs.

Operator

Your next question comes from the line of David Wu.

David Wu - Global Crown Capital

Good afternoon. I was curious about two things. Number one is on the spending on the DSP side, I guess Blackfin continues to be funded pretty richly. I was wondering whether you actually can hold those on these dollars flat into 2007 fiscal year.

The other one has to do with your bookings. We have inventory correction in both the low-end cell phone business in Asian markets, plus the PC situation. It does not feel like 2004 mid-year all over again, but on the other hand, could it just be as simple as a one-quarter problem, that by the end of your Q4, we will clean up and onward and upward from there?

Jerald G. Fishman

Let me answer the first question. We have really flattened out the expenses relative to Blackfin. We have the core done. We are doing many, many different spins of that core right now to make it more widely applicable to a wider range of customers, so I think that we have every bit the ability to keep that spending flat or perhaps even a little bit lower in 2007.

Is this a one-quarter phenomenon or not? I guess time will tell. We certainly did not ship any huge amounts of inventory above the consumption rates from any quarters like happened in 2004, so I think that is sort of a leading indicator that there should not be all that much inventory out there, but we will have to wait and see what happens. It could turn out that we get a big bounce, a strong bounce back in Q4, and it turns out to be a one-quarter phenomenon. We will have to wait and see how that goes.

David Wu - Global Crown Capital

What is the lead time currently?

Jerald G. Fishman

It varies tremendously from product to product, but it is probably a little bit lower than it was last quarter.

Joseph E. McDonough

About eight weeks of…

Jerald G. Fishman

Yes, it is a little less than that now.

Maria Tagliaferro

We can take the next question now, Operator.

Operator

Your next question comes from the line of Ross C. Seymore.

Ross C. Seymore - Deutsche Banc Securities

Thank you. A lot of questions have been asked and answered, but Jerry, just your look on the inventory and the computing and then the handset side specifically, what is your view on when you can start to ship closer to end consumption?

Jerald G. Fishman

It is very hard to say, because you do not know the details of any of the customers’ inventories specifically but certainly we would hope that would be the case by the end of the fourth quarter.

Ross C. Seymore - Deutsche Banc Securities

So once we head into first quarter, you would expect to have an easier comp there and be shipping in line?

Jerald G. Fishman

That is my opinion right now.

Ross C. Seymore - Deutsche Banc Securities

Fair enough. The Integrant acquisition, is that still about one point to percentage growth in the October quarter?

Jerald G. Fishman

Yes, roughly in that range.

Ross C. Seymore - Deutsche Banc Securities

Then, finally, we have talked a lot about the power management side and acquisitions to get into it, or organic growth. Switching over a little bit to the bigger part of your business, in converters and amplifiers, a lot of your competition is talking about making in-roads in there, albeit slow, there are many of them making small in-roads and slow in-roads. Are you seeing any evidence of losing shares, even at the margin? Or is the simple reason that your analog business has underperformed is because you are underrepresented in power management?

Jerald G. Fishman

I think it is 99% the latter and 1% the former.

Ross C. Seymore - Deutsche Banc Securities

When do you think what you are exposed to, amplifiers and converters, will start to grow at a rate that exceeds power management?

Jerald G. Fishman

Are you asking when that will happen?

Ross C. Seymore - Deutsche Banc Securities

Either what end markets have to cooperate, when do you see those end markets cooperate -- any color you can give on that would be great.

Jerald G. Fishman

I think the converter market and the amplifier market have a long-term growth rate that is pretty good. I would expect that any normal year, or any normal quarter, we get good growth in those businesses. Certainly there is not any absence of applications for converter technology in a world that is mostly analog but yet does a lot of digital processing, and amplifiers are a staple that are always going to be used.

I think there is in the whole market, there is more competition. I do not think there is any doubt about that. The guys in the converter business are trying to power, the guys in the power business are trying to do converters because everybody is concerned about top-line growth in the next five years.

I think that when you look out in time, there has been a run-up on the power side, which is heavily influenced by the portable equipment growing faster than the plugged in equipment.

I think if you look out over time, there is absolutely no reason why any of those products should grow any slower or faster than any other products. I expect that is probably what is going to happen.

The converter and amplifier business is a great business. It is probably the highest ASP business in the analog business. It is the business that has the largest franchise value because it is so entwined in so many applications with so many different customers that even if you have a competitor that gets good product out, it takes five years to get any traction.

The power management business historically has been a little bit more of a hot product business, with larger customers and faster product cycles than we experience in the converter business.

I think the general characteristics of the amplifier and converter business I think are, and they remain today to be terrific characteristics. It is very obvious why many competitors want to be in that business. Like any franchise business, we have 2000 converter products and we sell them to 56,000 customers, as of last count, and that is hard to make a lot of in-roads on. No one customer being a very large percentage of the sales. That is the whole thing about the franchise nature of the amplifier and converter business. The fragmentation, the long life cycles, the high margins, the entrenched customer base on it that have bought from us for so many years.

I think it turns out it will be a lot harder to displace those kinds of products in our customer base than we believe it will be to displace power management competitors in that business, because of the franchise nature of the amplifier and converter business.

Having said that, it is always hard to get the other guys business. I think we have seen that in power management. I think many of our competitors have seen that in the converter and amplifier business.

It is easy to hire people and get people working on it, but it is hard to get real products out when the other guy has 20 years more experience getting those products out than you do. In some ways, that protects to some degree our converter and amplifier franchise, and makes the power stuff harder. That is why it has taken us as long as it has to get any real traction in that business.

Ross C. Seymore - Deutsche Banc Securities

One quick one, I hope, as a follow-up. With 6% of your sales right now in power management, for you to say that business is a success in your mind, roughly what percentage of sales would that have to be a year or two years from now?

Jerald G. Fishman

That depends on the denominator as well as the numerator. I would say that we have 65% or so of our business in the corporations, in amplifier, converters, and 6% in power management, and the power management market is bigger than the amplifier and converter market. I would say if that was not a meaningfully high number, we will not be doing very well in that either. I do not have a firm number in mind, but there is a lot of room to grow there for us, and we are certainly making the investments to be able to do that.

Operator

Your next question comes from the line of William C. Conroy.

William C. Conroy - Sanders Morris Harris

Good afternoon, thanks for taking my call. Jerry, maybe this one is for Joe, can you give us a little bit of detail on the inventory situation in the distribution channel?

Joseph E. McDonough

The inventory in the distribution channel rose a bit this past quarter. I think they might have another day or so of inventory over and above what they have had. That is not an unusual level of turns. They are still at a normal turns level.

William C. Conroy - Sanders Morris Harris

As a follow-up, do you guys anticipate or see any impact from the dissolution of Star Corp?

Jerald G. Fishman

That is always hard to tell. Certainly that improves the remaining companies in that business opportunity. We always believe that there was a broad opportunity for DSP and I think Star Corp has basically said that it is real hard to do. It takes a lot of stamina to stay at it.

I think at the margin, we did not see them very often, but certainly it is a margin that makes us even a more viable competitor because there are not many DSP suppliers left out there.

William C. Conroy - Sanders Morris Harris

Thank you.

Operator

Your next question comes from the line of Bill Lewis.

Bill Lewis - J.P. Morgan

Thank you. I guess just again on the 30% operating margin target. I know you have been asked on it, but I think you expected to hit it or get close to it in this fourth quarter. You are not going to now. Are there any specific actions you are taking to account for the downturn, or are you just hoping to ride it out? I guess related to that, what has to happen for you to get to that target? Is it purely revenue growth from here, or talk about anything else you are doing.

Jerald G. Fishman

As I mentioned a little earlier, we are expecting to get some lift on the gross margins as a result of some of the actions we have already taken. I think as we think about the world, you do not change your plan based on what happened in one quarter because you missed the revenue by a couple percent.

I think if it turns out that is the beginning of some economic issues that start going on, that will force the industry into retrenchment, we will have to decide what to do. But I think we try hard to look at this over many quarters, and we act as appropriately with that in mind.

I cannot say we will, I cannot say we will not. We are certainly, at the margin, putting more scrutiny on businesses because of what happened last quarter, and we will have to wait and see how that all comes out.

Bill Lewis - J.P. Morgan

Related to that, do you have a new target when you think you might achieve it, or what it takes to get there?

Jerald G. Fishman

I think as we finish up Q4 and we put together our plan for 2007, we will have a better look at the revenue targets and the expense targets and the margin targets, and we will try to give you a little more color on that at the end of next quarter.

Joseph E. McDonough

That 30% objective was at revenues of 715 or 725, so we are obviously a ways away on the revenue front.

Bill Lewis - J.P. Morgan

The second question, kind of related, if I could, I know you are not going to want to try for the first fiscal quarter, your January quarter, but historically, or at least in the last few years, it has been a tough quarter for you. I do not think you have grown in the January quarter since 2003. Could you maybe talk about what you think the dynamics might look like, given the weaker results you saw this quarter and looking into the fourth quarter, what that might start to look like for you?

Jerald G. Fishman

I think we will have to wait and see how we end up in Q4. The typical seasonal patterns are a little bit more complicated now. There are so many different variables pulling at the revenue line, both up and down. I think we will take a look at where we go in Q4, we will take a look at the order patterns, we will take a look at the backlogs, and then we will give you some sense of that at the end of Q4.

Operator

Your next question comes from the line of Mona Eraiba.

Mona Eraiba - Rosetta Group Research

Could you elaborate more on the handset area with the Asian supplier? I know it has declined to be less significant for you, but do you see that just as a short-term issue or do you think it is going to continue to shrink?

Jerald G. Fishman

If you go over to Asia and you see what is going on with some of those Asian customers, they are pretty fierce competitors. We have the probability of TDS CDMA beginning to deploy next year. It might be three months, it might be nine months, but it is going to happen over there. I think it has been widely reported we have a very strong position in that business in China, particularly for the local market, which TDS CDMA would supply.

I think it is very premature to marginalize the Chinese or the Asian suppliers in the phone business.

Mona Eraiba - Rosetta Group Research

Also, I wanted further clarification of the infrastructure area, which appears to be pretty strong for you. Could you just elaborate how it looks going forward?

Jerald G. Fishman

We will have to see what happens going forward, but that is a large business for us. It is 11% or so of our sales. It is a business where we would typically show certainly dozens and maybe even as much as 100 different products into a bay station, converters and amplifiers and many other analog functions, and at some bay stations, some DSP’s.

It really in many ways represents the ideal type of market for analog because it is very product fragmented. It is very performance-oriented and it is a market that pays if you can build the best converters and other types of products. There is a large build-out going on on the infrastructure side, both in Asia and in other places, and I think that is what that business has been so strong.

Mona Eraiba - Rosetta Group Research

Do you have any specific customer who is big in that area, or are you broadly based with various equipment suppliers?

Jerald G. Fishman

One of our slides that we show our investors said that if somebody makes a phone call, it is going through a bay station that has our parts in it. We have a very broad participation of our products with virtually every bay station manufacturer in the world.

Mona Eraiba - Rosetta Group Research

Final question on the computer area, do you see any sign of potential recovery as a result of the new product introduction from Intel, the price cuts, et cetera?

Jerald G. Fishman

Yes, we are expecting that our computer business will do a little bit better in the fourth quarter. That is typically what happens anyhow, seasonally. On the audio side, we have some good products. On the power management side, we have some good products. We are hopeful we will get some growth in that sector in Q4.

Mona Eraiba - Rosetta Group Research

But you do not see a sharp turnaround in the business, since Q2 was unusually weak?

Jerald G. Fishman

I do not know. We will see how that goes. I am always slow to make a prediction based on seven days of data this quarter.

Operator

Your next question comes from the line of Craig Ellis.

Terence Whalen - Citigroup

Hi, it is Terence Whalen for Craig Ellis. Thanks for taking my question. Jerry, could you help us understand -- I know you are reluctant to give forecasts, specifically given seven days of data, but given the backlog too, can you help us understand directionally across some of the markets, which markets you might think would be up and which would be down, given the flat guidance? Thank you.

Jerald G. Fishman

I think it is very hard to do that with the product portfolio we have. I think we will just have to wait and see what is going to happen in Q4. I think it is very premature to try to do that.

Terence Whalen - Citigroup

Then, related to the handset business, it seems like handset sales were flat but vertical DSP was down. Is that to say that your analog and RF in handsets is maybe performing better than base [nands]?

Jerald G. Fishman

Yes.

Terence Whalen - Citigroup

Do you expect that trend to recover, or…

Jerald G. Fishman

Well, I hope both would perform well, but we will have to wait and see. Certainly in the handset business, we have tremendous value added on the analog side. We are working as hard as we can to commercialize on that.

Terence Whalen - Citigroup

Last one and I will let you go, on the guidance for the improvement in costs, the $6 million for the first two quarters and $11 million for the second, if we kind of roll that up, it looks like it would be 160 basis point improvement in gross margins. Is that a number that we might actually see fall to the gross margin line, or would that be offset by taking more fab revenue? Thank you.

Jerald G. Fishman

Again, we will have to try to give you some guidance on that when we finish up the quarter and we see where we are headed in the early part of the year. A lot of that is based on the product mix. There were so many variables that it is very hard to predict in advance. Certainly our goals have been to get to gross margin up above the 60% level where we are now on the basis that we said, and certainly this is one of the areas that could help us do that, if everything else holds constant.

Operator

(Operator Instructions)

Your next question comes from the line of Louis Gerhardy.

Louis Gerhardy - Morgan Stanley Dean Witter

Good afternoon. I just wanted to understand. You mention that you haircutted your customers’ forecasts a little bit. Can you just give us a sense of how much you did that? Was this a significant cut, or a slight cut?

Jerald G. Fishman

It all depends on your perspective on that, but I would say it is probably $5 million, $7 million, it is sort of 1% of sales, maybe a little bit more, not a lot more than that, at least in the quarter.

Louis Gerhardy - Morgan Stanley Dean Witter

Then, just on the fab closure, if we can just think about the benefit in the January quarter in dollars of the fab closure, can you just give us a sense of what the dollar savings would be in the January quarter?

Jerald G. Fishman

I think we said earlier that it was a savings of $6 million to $8 million in the first quarter and the second quarter…

Louis Gerhardy - Morgan Stanley Dean Witter

In the first-half of the year, in each quarter…

Jerald G. Fishman

In each quarter, in the first-half of the year…

Joseph E. McDonough

It is probably toward the lower end in the first-half, the upper end in the second-half. The way it works is we have been manufacturing wafers and inventory out of the old fab, and so that has to work its way through inventory, carrying its old cost and the cost of goods sold before we can sell the new product that we manufacture in the new fab. So there is just a little bit of a snake that we have to get through there.

Jerald G. Fishman

We had forecast that was a $45 million annual running rate number and everything we see still says that is the case.

Joseph E. McDonough

We should see that in the second-half of the year, the full benefit.

Jerald G. Fishman

We will see the full benefit of that in the second-half of the year.

Joseph E. McDonough

How we get there along the way remains to be seen.

Louis Gerhardy - Morgan Stanley Dean Witter

Right. Then, Jerry, you had mentioned, you are still considering, you have it on the table, of maybe divesting some businesses or getting out of certain areas. Can you just give us a sense of how many areas have you identified? Is there a timeframe that you have established for coming to a conclusion here on anything?

Jerald G. Fishman

I think the way I think about it is that as we do those -- clearly every time you have a setback in a particular quarter, we have a very aggressive objective to get the operating margins up. We know the impact of that on our valuation, so we are not insensitive to that.

I think we continuously view each business once a quarter. We have taken some actions. I expect we will take others in the future. I think as we take them, we will let you know. That is the best I can say.

Maria Tagliaferro

Okay, great. We cannot exactly see the queue here during our call today, but I believe we are cleared of all questions remaining, so we would like to thank everyone for joining us today. For your calendars, you can schedule the fourth quarter conference call, which is planned for Tuesday, November 14th at 4:30. Thank you very much.

Operator

This concludes today’s Analog Devices conference call. You may now disconnect.

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Source: Analog Devices Q3 2006 Earnings Conference Call Transcript (ADI)
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