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Executives

Terri Donnelly

John W. Hohener - Chief Financial Officer, Executive Vice President and Secretary

James J. Peterson - Chief Executive Officer, President, Director and Chairman of Executive Committee

Steven G. Litchfield - Chief Strategy Officer and Executive Vice President

Paul Pickle - Executive Vice President of Integrated Circuits Group

Analysts

Erik Rasmussen - Stifel, Nicolaus & Co., Inc., Research Division

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Richard E. Schafer - Oppenheimer & Co. Inc., Research Division

Mark Delaney - Goldman Sachs Group Inc., Research Division

Andrew Huang - Sterne Agee & Leach Inc., Research Division

David M. Wong - Wells Fargo Securities, LLC, Research Division

Microsemi Corporation (MSCC) Q3 2013 Earnings Call July 25, 2013 4:45 PM ET

Operator

Good afternoon. My name is Hope, and I will be your conference operator today. At this time, I would like to welcome everyone to the Microsemi's Third Quarter Earnings Conference Call. [Operator Instructions] Thank you. Ms. Terri Donnelly, call coordinator, you may begin your conference.

Terri Donnelly

Good afternoon, and welcome to Microsemi's Earnings Conference Call for Microsemi's Third Quarter of Fiscal 2013. I am Terri Donnelly, coordinator of this call.

In a few moments, you will hear from, and have an opportunity to ask questions of, Jim Peterson, our President and Chief Executive Officer; of John Hohener, our Executive Vice President and Chief Financial Officer; of Steve Litchfield, our Executive Vice President and Chief Strategy Officer; and Paul Pickle, our Executive Vice President, Integrated Circuits Group.

A recording of this conference call will be available on the Microsemi website under the Investors section. Our website is located at www.microsemi.com.

Microsemi issues guidance in the form of a limited business outlook on our expectations for the next quarter. This business outlook reflects our expectations as of July 25, 2013, and is continually subject to reassessment due to changing market conditions and other factors and therefore must be considered only as management's present opinion.

Actual results may be materially different. However, management undertakes no obligation to update these or any forward-looking statements, whether as a result of new information, future events or otherwise. If an event -- if an update to our business outlook is provided, the information will be in the form of a news release.

We wish to caution you that all of our statements, except the company's past financial results, are just our current opinions, predictions and expectations. Actual future events or results may be -- differ materially.

For a review of Risk Factors, please refer to Microsemi's report on Form 10-K for the fiscal year ended September 30, 2012, which was filed with the SEC on November 21, 2012, and our latest Form 10-Q, which was filed with the SEC on April 30, 2013.

With that said, I'm going to turn the call over to John to discuss our financial results. And then Jim will address our end markets and overall business strategy. Here's John Hohener.

John W. Hohener

Thank you, Terri.

Net sales for the quarter ended June 30, 2013, were $242.6 million, up 3.1% sequentially. Booking strength and resulting in a book-to-bill ratio greater than 1:1. And as such, Microsemi expects that net sales in the fourth quarter of fiscal year 2013 will increase 2% to 4% sequentially.

Our GAAP gross margin was 57%, improving 30 basis points sequentially and 120 basis points over the prior year quarter. This improvement over the prior year quarter, where sales were higher, demonstrates that the efficiency of our operations has improved significantly. We currently expect fourth quarter gross margin to approximate the third quarter, based on the mix of product in our near-term backlog.

Our non-GAAP selling, general and administrative expenses were $41.3 million or 17% of sales, compared to 17.7% of sales in the prior quarter. This improvement reflected targeted programs aimed at reducing selling expenses. For the fourth quarter, we forecast that SG&A expenses will decrease as a percentage of sales by 30 to 70 basis points.

Research and development costs were $42.4 million -- excuse me, $42.2 million or 17.4% of sales compared to $42 million or 17.8% of sales in the prior quarter. We remain committed to new product development and will invest R&D dollars in our core strategic initiatives. That said, for the fourth quarter, we forecast R&D expense to decrease as a percentage of sales by 30 to 70 basis points.

Our non-GAAP operating income was $54.8 million or 22.6% of sales compared to $50 million or 21.2% of sales in the prior quarter. We recorded $7.2 million in non-GAAP interest and other expense compared to $8.2 million last quarter, reflecting the effect of the credit facility refinancing we completed in the second quarter. Subsequent to the end of the quarter, we completed 23 -- we completed a $23 million optional term loan principal payment that brought the principal balance outstanding on our credit facilities to $676 million, down from a high of $849.6 million. As a result of the principal payment, we expect interest and other expense to decline approximately $200 million -- $200,000 next quarter.

Non-GAAP net income was $44.8 million or $0.49 per diluted share. We expect fourth quarter non-GAAP earnings per diluted share of between $0.51 and $0.55.

Our non-GAAP effective tax rate for the quarter was 6%, which we expect to remain the same next quarter.

For the third quarter, we recorded GAAP operating income of $25.2 million compared to $11.8 million last quarter and $21.3 million reported a year ago. We recorded GAAP net income of $18.3 million compared to a net loss of $2.8 million last quarter and net income of $8.1 million reported a year ago.

For the third quarter, our GAAP results included noncash expenses of $21 million in amortization; $7.1 million in stock-based compensation; and $200,000 in amortization of refinancing costs, which was offset by $300,000 in income related to the change in fair value of our interest rate swaps. We recorded $1.5 million in restructuring charges and other expenses.

During the third quarter, we adjusted the estimated payout of our performance share grants, which decreased third quarter's stock-based compensation expense. We estimate that fourth quarter stock-based compensation expense will be approximately $10 million.

Capital spending was $13.6 million, slightly higher than forecast, compared to $9 million in the prior quarter. Next quarter, we expect capital spending to be between $11 million and $12 million.

Depreciation and amortization expense was $28 million compared to $28.3 million in the prior quarter.

Accounts receivable was $151.2 million compared to $158.4 million at the end of the prior quarter.

Inventories were $166.6 million compared to $162.7 million at the end of the prior quarter.

DSO decreased to 58 days from 62 days, a result of improved collections and improved linearity during the quarter. Days of inventory remain consistent at 144 days.

As I mentioned earlier, subsequent to the end of the quarter, we prepaid $23 million in principal on our term loan. With this payment, we achieved our goal of paying down our term loan by $100 million during the fiscal year, and we accomplished this ahead of plan. We plan to continue paying approximately $100 million in our next fiscal year, with a goal of retiring our loan within its terms.

We ended the quarter with a cash balance of $220.9 million, and our operating cash flow was $52.6 million. Our best estimates of the end market percentage breakout of net sales for the third quarter was approximately: communications, 28%; defense and security, 31%; aerospace, 19%; and industrial, 22%.

With that, I will turn the call over to Jim Peterson.

James J. Peterson

Okay. Thanks, John. With that, let's go to the end markets.

Our communications end market grew nicely in the June quarter, with revenues up over 5% sequentially and accounting for 28% of total revenues. In the quarter, we saw upside to our initial expectations for PoE, timing and sync and voice circuit products. As we look into the September quarter in the second half of the calendar, we expect a continuation of the growth trends in communications.

Timing and sync continues to benefit from increased infrastructure spending. PoE continues to expand new market opportunities and will begin shipping into smaller cell applications, and our RF devices are poised for an uptick in the second half of the calendar year.

Our defense and security shipments, after growing over 5% sequentially in the March quarter, modulated in June. Revenue declined about 4% sequentially and accounted for 31% of the revenues.

Looking past the lumpiness of any 1 quarter period, we remain confident in our growth prospects in the defense, security markets. We grew backlog during the quarter, driven by stronger bookings for C4ISR, military avionics and cybersecurity applications. Design engagements within the nickel customers are on the rise and we are seeking content -- seeing content growth on a number of approval for our high-profile programs.

Aerospace grew 2% sequentially in the June quarter and accounted for 19% of total revenues. Satellite revenues just started to benefit from strong satellite booking levels over the prior 3 quarters, and we look forward to continued revenue strength as long as these long-cycle projects continue to make their way through the fabs. We expect this growth trend to continue, driven by strong satellite and commercial aerospace fundamentals and in Microsemi's growing dollar content within.

Last but not least, industrial was our star performer in the June quarter. Here, revenues grew 13% sequentially to account for 22% of revenues, benefiting from the improving booking levels we have seen since January. Our industrial markets were broadly stronger. Highlights include the ongoing ramp of our ultra-low power radios into ICD and Medtronic, medical contributions from MRI applications and a resurgence in solar-driven revenues.

With that, let's look at our end market activity. I would like to move now to the press release, which we launched alongside our earnings release today.

In case you didn't see it, today, Microsemi announced the largest contract design win in the company's history, a contract with the U.S. government to develop a complex SoC solution. We expect this contract will derive $75 million of revenue over the next 2 years. More importantly, this design win validates Microsemi's total solution approach to the marketplace. It was our unique technology platform and capabilities that propelled us past the competition, comprised of many of the semiconductor industry's leading blue chip suppliers.

As I spoke about at our Analyst Day in September, we've really transformed Microsemi. We had built upon the strengths in technology, security and reliability. While at the same time, the markets we serve have turned to us in demanding these features.

With that, let me sum up the June quarter. We reported solid results, with increased revenue and improving operating metrics. Profitability benefited from our continued diligence in executing cost-control measures. Our operating cash flow for the quarter exceeded $52 million. And we saw a number of significant design win successes, as customers increasingly rely on Microsemi as their total solution provider. We remain confident that our overall strategy continues to bring benefit to our shareholders.

With that, I thank you for your interest and support, and we'll take questions from our analysts.

[Operator Instructions]

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Tore Svanberg with Stifel.

Erik Rasmussen - Stifel, Nicolaus & Co., Inc., Research Division

This is Erik calling in for Torri. Congrats on the award, seems like a really nice validation for you guys. Can you talk about the ramp, how you see that ramp over those 2 years? And can you comment on what process technology this contract will be on?

James J. Peterson

Sure. I -- well, I appreciate you saying it does validate, it validates what we've been talking about. It validates our technology, the total solution to leverage our technologies. Litch, you want to speak a little bit here on the technologies?

Steven G. Litchfield

Well, I mean -- so this road, it is over 2 years, and so we don't really expect a material increase in the next quarter. So it really starts to ramp kind of in the second half of 2013. As far as the process, I mean, we don't process on -- we don't talk about process on any of our products today, and we're not going to talk about it on this one. I mean, we essentially use more or less all of the major foundries out there today, and so it would obviously be on a foundry solution.

Erik Rasmussen - Stifel, Nicolaus & Co., Inc., Research Division

Okay. It seems like defense, security took a little bit of a breather this quarter, down 4%. Can you just kind of talk about next quarter what you're seeing? And maybe put some commentary around sequestration and any sort of impact you're seeing? Do you think this is kind of bottoming out in terms of spending cuts?

James J. Peterson

Yes. Spending cuts, let's talk about the spending cuts and sequestration. I think the major thing for that to understand is the uncertainty is subsiding in the word sequestration. It was down. We use the word lumpy -- lumpiness in defense and security, and at times in aerospace. The interesting part, the backlog grew and it's up 6% year-over-year. There's a tremendous amount of programs that are being issued. There's a lot of foreign military sales. There's bigger programs and there's strength to the orders, I think just the lumpiness.

Operator

Your next question is from the line of Steve Smigie with Raymond James.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Just a follow-up on the award. I know you said it's spread out over 2 years. Is it something that would start to ramp this quarter? Or was it more subsequent to that?

James J. Peterson

Remember, it's a development order. It's-- there was [ph] last year is the development component. That's over 2 years. So just expect a nonlinear kind of a ramp. It's a major core technology. It's extremely dense digital chip, complex features and using our SoC.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Okay, great. And then for gross margin, I think you guys guided for roughly flat for September quarter. How should we be thinking about the ramp up to 60%, that's something we should continue to expect directionally?

James J. Peterson

Well yes. Well, yes, let me be clear on this, right? $280 million, we're 60-30 on that. John, you want to talk...

John W. Hohener

Yes. No, but to Jim's point, $280 million, 60-30, we've said in the past, its not going to be a linear progression necessarily to get there. Some quarters, we'll be up materially like we have been -- like we were last quarter and this quarter. This next quarter, though, we are guiding it to be flattish, primarily due to mix. One thing to remember is that our GAAP and our non-GAAP gross margin are the same. And quite frankly, we were quite proud of the gross margin that we had this quarter. We had better absorption, cost controls and our revenue was up. And so from that standpoint, the other thing to point out is that we're having higher gross margin, lesser revenues than what we saw a year ago. So the efficiency that we built in the organization is starting to pay off nicely.

James J. Peterson

This is great because also figure the $75 million we're speaking of, right? It's a development order. And naturally, development orders are using a lesser margin. But that having been said, blended, we're saying $57 million and flattish. And $280 million is the model, 60-30, that's still intact, I assure you.

Operator

Your next question is from the line of Rick Schafer with Oppenheimer.

Richard E. Schafer - Oppenheimer & Co. Inc., Research Division

I got a -- just a follow-up question on what you just said, Jim. I think I'd heard you correctly. But are you saying that the base, the incremental gross margin related to this new contract is going to be above corporate average?

James J. Peterson

No, no. Developments are normally less than product averages. But the point here is that we're at $57 million now and we're stronger than we're a year ago, right, at a lesser revenues, fortunately or unfortunately. So we're putting the right efficiencies. But I just want to reinforce the 60-30 model, that this is built into that model.

Richard E. Schafer - Oppenheimer & Co. Inc., Research Division

Okay, okay. And then the second question is just -- I'll keep it on defense here. Is there any metric you guys have that can show us sort of -- we all know your content is increasing in defense and how it's been trending up over the last few years. I mean, I guess, Jim, is there a way to look at it and say how much -- like, I don't know if it's on an average contract basis or how you guys would break that out, but jut kind of give us a feel for is your average content in defense going up 5% a year, 10% a year, I mean, kind of a metric we can use.

James J. Peterson

Yes. The main thing is of course that we're up 6% year-over-year, right? The older programs that are going on in defense, we're actually getting new dollar content in older programs. There's a crying demand for next-generation homeland security and cybersecurity products, which the incumbents who are the most certain to come to Microsemi for their solutions, Rick. And look at the launching of foreign military sales. And last but not least, right, we have $100 million lots of sand with our high-end SSD product line. So it's hard to break out because we're in that almost every platform. But I'm telling you, it's lesser and lesser, the older 2 thing, the old Microsemi discrete things, and the focus is on all next-generation of more complex, broader technologies. So it's a great mix going on. And you got to look at, in the end, in our total numbers.

Richard E. Schafer - Oppenheimer & Co. Inc., Research Division

Right. No, no, I see. I was just trying to find a way to quantify that, what's going on there. But anyway, it sounds like the general trend -- I mean I know defense has been sort of one of your laggers in terms of gross margin over the years. But it sounds like maybe as you move more to SoCs, more to the module kind of level, maybe those gross margins kind of catch up to corporate average?

James J. Peterson

Here's what we look at, right? This quarter is down 4% sequentially, and my gross margins are up 30 basis points and up 120 year-over-year.

John W. Hohener

Yes.

James J. Peterson

So if defense is modulating, that's fine. It's not this great high margin, if you don't get it, what happens to you Microsemi? It might be the best point to that answer.

Operator

Your next question comes from the line of Mark Delaney with Goldman Sachs.

Mark Delaney - Goldman Sachs Group Inc., Research Division

I was hoping you could clarify and provide an update on the PLD products and some of the new market opportunities that you're trying to enter with those?

James J. Peterson

Paul, you want to?

Paul Pickle

Sure. Jim's kind of alluded to it a little bit. When you look at some of our defense and security applications, our end markets that we've traditionally sold into, big part of the draw has been new SmartFusion 2 offering. But it's been much more a bigger draw in some of the other end markets that we've had. We're finding penetration in communications. And even aerospace, we're seeing those controller contents, PLD contents go up on new airframes. And so right now, we feel pretty good about where that strategy is sitting. It's doing rather well for us.

Mark Delaney - Goldman Sachs Group Inc., Research Division

For my follow-up, I wanted to just talk about the distribution channel. What was your sell-in to distributors relative to sellout? Just trying to get a sense of what your inventory levels are at your distributors.

John W. Hohener

Well, as you know, we recognize revenue on a sell-in basis. And our distributors right now base versus OEMs, around 50-50. And what we've seen is a shift to a more efficient model, basically because the disti is accreting, doing a demand creation for us.

James J. Peterson

Yes. Paul, let me touch on it a little bit, too, about just the last quarter. Actually, quite honestly, in absolute dollars, we shipped less the disti last quarter than the previous quarter. And to John's point, the real change for Microsemi and the benefit to our relation with our distributors, which by the way is growing because customers want us to strengthen the relationship with the distributors, is we're focusing probably 95% of our effort on demand creation. The older Microsemi was fulfillment. And today, it's demand creation at our distribution channel.

Operator

Your next question is from the line of Andrew Huang, Sterne Agee.

Andrew Huang - Sterne Agee & Leach Inc., Research Division

Just wanted to focus a little bit more on the free cash flow or operating cash flow. I'm just kind of curious why the CapEx was a lot higher than you guided to? And then I have a follow-up.

John W. Hohener

Yes, well, we had some additional purchases in terms of testers and we're also going through some consolidation, where we had to facilitize some expenses. We do see that as kind of a onetime blip and our cash flow will back down to the $10 million to $11 million range by next quarter, as we guided.

James J. Peterson

Let me give you a little color. We just announced a $75 million development contract. You might expect us needing a little capital on that.

Andrew Huang - Sterne Agee & Leach Inc., Research Division

Great. And then the follow-up question was actually on the contract. So Jim, you talked about the fact that it's a development contract. So I guess, my question is after the 2 years is up, what happens after that? Is there going to be like a mass production that comes along after that?

James J. Peterson

We offer [ph] in all the contract and turn it to revenues. So let's just leave it at that.

Operator

Your next question is from the line of David Wong, Wells Fargo.

David M. Wong - Wells Fargo Securities, LLC, Research Division

Jim, I'm a bit curtailed by your new rule that you need well-thought-out questions, but I'll do my best. What segments or product groups are your highest priorities for R&D spending?

James J. Peterson

For -- right now the one that's on top of my mind is the $75 million complex SoC development. I'm excited with what we're doing in communications. Microsemi, if it's not known today, it should be known as a communications company going forward. Gosh, I've got a lot of good things going on in the defense and security market space. I'm not shy on opportunities and concepts in aerospace. And I don't want to leave the last but not the least, the star performer, industrial, especially in the medical business and the communications, the radio control there. We've got -- it's across the board. There's a lot of tremendous opportunities. I think we spoke, too, in that at the Analyst Day and going forward, right? We -- now, it's a different Microsemi. We have probably -- I would -- I hope to put up against anybody for a broad technology portfolio company. And we're focusing on major platforms, and we're winning.

David M. Wong - Wells Fargo Securities, LLC, Research Division

Great. And what's your thinking about acquisitions now? You've got sequential growth resuming and you've had a few quarters of digestion of your balance.

James J. Peterson

Not so different than we've been taking the last 2 years. If I find something that is strategic in nature and technical that can help me take market share from competitors and grow my business, at this point, no different than the last couple quarters. We see something that makes sense, we'll do it and thus, probably to lead to the smaller dollar.

Operator

Your next question is from the line of Quinn Bolton, Needham & Company.

Unknown Analyst

Joe [ph] calling in on behalf of Quinn. Was hoping you could provide a little bit of color around timing and sync business, where the demand is coming from? Is it carrier or network spending? Any color there would be helpful.

James J. Peterson

Paul, you want to jump on that?

Paul Pickle

Sure. Our timing and sync business was up this past quarter. We're absolutely benefiting from some of the infrastructure spend that's out there. The China Mobile spend has been beneficial for us. As we look to the LTE-A rollouts, we expect to benefit from that as well. So it should be a good trend going forward.

Unknown Analyst

So is that predominantly all Asian based? I mean, anything going on in North America? Or...

Paul Pickle

We've seen some movement in North America. And surprisingly enough, I think Europe is starting to uptick as well.

James J. Peterson

Well, the infrastructure spending is up, and that's good news for us.

Operator

[Operator Instructions] And there are no further questions at this time.

James J. Peterson

Thanks for joining, and have a great day.

Operator

Thank you. This does conclude today's conference call. You may now disconnect.

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