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OmniVision Technologies (OVTI)

Q1 2007 Earnings Conference Call

August 31, 2006, 5:00 pm EST

Executives:

Jason Gold, Financial Dynamics, Investor Relations

Shaw Hong, President, CEO

Peter Leigh, VP Finance, CFO

Jess Lee, VP, Mainstream Products

Hasan Gadjali, VP, Advanced Products

Analysts:

Satya Chillara, Pacific Growth Equities

Evan Wang (Tore Svanberg), Piper Jaffray

Jason Pflaum, Thomas Weisel Partners

Harsh Kumar, Morgan Keegan

David Wu, Global Grown Capital

Douglas Wage, First Investors

Tristan Gerra, Robert W. Baird

Quinn Bolton, Needham & Company

Tayyib Shah, Longbow Securities

Doug Freedman, AmTech Research

Adam Benjamin, Jefferies & Co

Operator

Good day, ladies and gentlemen and welcome to the OmniVision Technologies 2007 First Quarter Earnings Conference Call. My name is Camie and it will be my pleasure to be your operator today. At this time, all participants are in a listen-only mode. We’ll conduct a question and answer session towards the end of this conference. If at any during the call you require assistance, please press * and 0 and an operator will be happy to assist you. As a reminder this conference is being recorded for replay purposes. I would now like to turn the call over to Jason Gold with Financial Dynamics; please proceed sir.

Jason Gold, Financial Dynamics, Investor Relations

Thank you, Camie, and good afternoon everyone. Earlier this afternoon, OmniVision issued a release reporting its financial results for the first fiscal quarter of 2007. This release can be accessed from the investor relations section of our website at www.ovt.com or on the financial news letters.

Before we begin, here are a few items for everyone to reference. This call is being webcast live and a web replay will be available for 12 months. We have also arranged to record this call. A taped replay will available approximately one hour after the call’s conclusion and will be available for 48 hours. The dial-in access number for this replay is 617-801-6888 and the replay pass code is 21097328. Both the call and the webcast replay can be accessed from the investor relations section of our website at www.ovt.com.

This conference call contains forward-looking statements within the meaning of Section 27-A of the Securities Act of 1933 as amended and Section 21-E of the Securities Exchange Act of 1934 as amended. These forward-looking statements include statements about our financial projections for the second quarter of fiscal 2007, our expectations for growth in image sensor markets, the ability of our management to successfully lead the company and grow the company, our ability to achieve superior performance, our expectations regarding the use of certain recently purchased packaging equipment, our expectations regarding the camera phone market and the products sold in such markets, the anticipated introduction, acceptance, and benefits for our new products including products that incorporate our wafer encoding technology, the release of products by third parties, our expectations regarding the automobile market, our expectations regarding future investments in Tessera or joint venture with TSMC, our ability to create value for our stockholders, our ability to grow the business throughout calendar 2007, and our ability to introduce new and advanced products ahead of our competition. All involve known and unknown risks, uncertainties and other important factors that may cause results, levels of activity, performance or achievements to differ from those expressed or implied by these forward-looking statements.

In evaluating these forward-looking statements, you should specifically consider various risk factors, including risk factors detailed from time to time in OmniVision's Securities and Exchange Commission filings and reports including but not limited to the Company's annual report in Form 10-K filed for the fiscal year ended April 30, 2006, and its most recent quarterly report filed on Form 10-Q. These factors may cause the company's results to differ materially from the forward-looking statements made in the conference call.

Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee further results, levels of activity, performance or achievements. These forward-looking statements are made only as of today's date and OmniVision expressly disclaims any obligation to update or revise the information contained in the forward-looking statements. This concludes the Safe Harbor statement.

Please also note that this conference call will provide listeners with certain financial metrics determined on a non-GAAP basis for comparison to previous quarters and our outlook for future quarters. These financial metrics together with the corresponding GAAP numbers and reconciliation to the comparable GAAP financial measures are contained in today’s financial results press release, which we have posted on our website at Investors on www.ovt.com under the press releases and have furnished to the SEC on Form 8-K. We encourage listeners to review these items.

I would now like to turn the call over to OmniVision's President and Chief Executive Officer, Mr. Shaw Hong. Shaw…

Shaw Hong, President, CEO

Thank you, Jason, and good afternoon ladies and gentlemen. Thank you for joining us on today's call. With me today are Peter Leigh, our CFO; Jess Lee, VP of Mainstream Products; and Hasan Gadjali, VP of Advanced Products.

On today's call, I will begin with an overview of our results and I will discuss the current status of the business, followed by a highlight summary, Peter will provide you with the financial details, and then I will address the broader strategic outlook. We will then take your questions and for that Jess and Hasan are here to provide additional insight.

Before we begin the regular agenda, I do want to say a word about our cofounder, Raymond Wu. As you probably know by now, in early August Raymond decided to resign his position with the company in order to pursue other interests. Raymond has made significant contributions to all of our successes. Both he and his many contributions will be missed.

In order to further strengthen our team, James He was promoted to the position of Chief Operating Officer. James has been with OmniVision since the very beginning days of the company in 1995. During his tenure he has been invaluable in leading the company’s engineering, the operation teams, and has directly contributed to growing the company’s revenue to over $500 million. With his help, we have established ourselves at the forefront of the image sensor industry with leadership position in many markets including mobile handsets, digital still cameras, security, notebooks and PCs, toys, automotive, and most recently medical.

In this new role, James will ensure that engineering, training, sales, marketing, and production all work together seamlessly. James’ dedication and the proven track record have better positioned the company to execute on its long-term goal strategies. Additionally, Jess Lee, Hasan Gadjali, and Ray Cisneros will be increasing their responsibility with respect to marketing and sales. Let me take a moment to ensure that you are more familiar with the strong team that is already in place that will allow OmniVision to continue to grow and prosper.

Over the past few years Jess Lee has been instrumental in establishing strategic relationships with tier one mobile headset makers and in growing OmniVision’s mainstream business. Hasan Gadjali has been one of the main drivers for identifying and developing many of the company’s new market avenues. His in-depth understanding of the market covered by the advanced product growth, will have the company continue to expand its position in the image sensor market. Ray Cisneros, who has been promoted to VP of Sales, brings over 20 years of experience in semiconductor companies. During this time, he has gained valuable experience in building and managing a global sales infrastructure and acting as a liaison between the different operating functions within the company. Among them, they have provided more than 15 years of combined service to OmniVision. We are very confident that we have assembled the best possible team with James, Jess, Hasan, and Ray to take OmniVision to the next step.

With the experience that James brings in all aspects of the business, the marketing expertise of Jess and Hasan, and the sales experience of Ray, we are very confident of our ability to succeed.

Now, I’d like to take a moment to summarize the results of the quarter. Revenue during the July quarter was about $137 million, and earnings were $0.28 per share. Non-GAAP earnings, i.e. earnings excluding stock-based compensation expense, were $0.39 per share.

Our balance sheet at the end of the quarter remains very strong. Our cash and short-term investments totaled over $377 million. Just over 70% of our revenue in the first quarter came from mobile handsets, just under 10% from the digital still camera OEMs, and about 20% of our business came from our advanced product growth, which includes security and surveillance, toy and video game consoles, webcam and notebook PCs, and automotive products. Year-over-year revenues were up by over 40% during the quarter.

During the quarter we began shipping the world’s first quarter-inch 2 megapixel sensors in volume into the mobile handset market. Additionally, we achieved security and surveillance as we continued expand our presence into the higher end of commercial security systems and in toys and games, as our customers began ramping production for the holiday season.

Our goal as a company has always been to be the image sensor of choice in the market that we serve over the years. We have accomplished this by focusing on our key objectives, which are to grow our customer base and a number of design wins, to continue to demonstrate technology leadership, to identify and to extend our reach into new emerging markets, to serve our customers as strategic partners, to focus continuous attention on product cost, and to intelligently invest in the right parts of our business at the right time.

Executing on these objectives translating into superior business performance; for example, with respect to investing in the right parts of our business, we are currently putting more emphasis on spending the backend production capacity available to us. Specifically, we have begun to purchase new packaging equipment that is being installed and will be operated for us by our CSP packaging partner, Wintech. To date, we have spent over $70 million on new equipment. This should be up and running by the end of calendar year.

Unit volumes in our mainstream product business which serves our customers in mobile handsets and digital still cameras continued to gross in the first quarter. In addition to our strong shipment of VGA and 1.3 megapixel products, we began volume shipment of the world’s first quarter-inch 2 megapixel sensors with our OV2640 camera chip. The OV2640 based on our OmniPixel 2 architecture takes brilliant pictures. This is why handset makers who are migrating to digital still camera quality have chosen our solution. Our product leadership here has led to a solid ramp of sensor shipments. Once again, we have driven a new even higher resolution camera phone into the mainstream.

Our global presence in the camera phone market continues to grow. The European handset makers are introducing higher resolution products into the mainstream, while at the same time they are penetrating the new market with very low end products. With these efforts they have increasing market share.

In Asia, we see the focus of handset makers just starting to ship from very low resolution products to mid and higher resolutions. As you know, earlier this year, LG Electronics chose OmniVision to be their strategic supplier, and we continue to strengthen our relationship with them. LG’s strong position in the CDMA market combined with our partnership in cameras has driven very healthy adoption of camera phones, especially in the U.S. market.

In addition, other strategic partners of ours such as Lenovo have been steadily increasing market share. As you may already know, we are providing Lenovo with a majority of their image sensors.

Finally, our effort with our strategic customer in the U.S. has been yielding positive results. We are happy to report that our multiple design wins with U.S. handset makers have been ramping successfully. Overall, we believe that adoption of the cameras into handsets will continue to grow. What is considered high end today we will be gradually driving into the mainstream. This is our core strength. What is mid range today will be at the low end tomorrow. This is where many new camera phone users will initially come from. What handset makers want is more resolution and more quality in cost and the mechanical format that allows them to address mass markets. To meet this demand we have a strong product pipeline at the low, the mid, and the high end.

The VGA resolution will continue to be strong, especially in emerging market phones. With the push for the digital still camera level image quality, we see our 2 megapixel products as seeing a strong demand. In the mid range of the market we believe new innovation at 1.3 megapixels could score a new demand. Along with these lines we will be announcing a new product very soon.

At the very high end, another important change is taking place in the mobile handset market. As camera phones move to higher resolutions, they have a greater need for focusing technology to address this trend. We are on track to deliver the first sample of our first product incorporating wafer encoding technology in September. We are currently taking the final steps in bringing this innovative product to the market. This will provide our customer with many advantages over the standard auto focus system in use today. These advantages include a smaller, more reliable, and much more easier mass produce.

For the end-user customers, the photographers, the entire picture is always in focus, significantly improving the picture taking experience. While we believe that the mobile handset market is the most attractive initial market for the technology, wafer encoding has applications across all of our markets and any market which involves image capture. Our goal is to make wafer encoding synonymous with high-quality imaging.

Several of OmniVision’s advanced products continue to make notable progress in the first quarter. We achieved solid growth in the security and surveillance market as our OV7949 and OV7950 sensors continue to gain acceptance in higher end security systems. Our transition from the “do it yourself” market into the core circuit television market and the introduction of new chips to our current line of security products have progressed well with continued design wins that should helps us grow the business throughout calendar 2007.

We also achieved strong growth with our toys and games products. Our design wins with two of the three major entertainment game console players began ramping as they prepare for the upcoming holiday season. People in the gaming community have come to expect most online gaming should also include video collaboration, other uses of camera including game control, user interaction, and video animation.

In the toy market, we began supplying Wild Planet Toys with sensors for their new Spy Video Cars. The toy is a remote control car equipped with a video camera and infrared night vision. It received a significant amount of attention at the recent international toy fest. Needless to say, we expect the Spy Video Car will be a hot product during the coming holiday season. It will be available online at major retailers such as Target and Toys “R” Us beginning this quarter.

In the notebook space, we continue to win designs, and we mentioned last quarter we are already supplying sensors to three of the top five notebook OEMs. Now, we are expanding our presence into the Asia market as well, firmly establishing OmniVision as the market leader for sensors in notebooks. OmniVision shipments to notebooks and standalone PC camera manufacturers continues to grow as services such Skype, Google, AOL, and Yahoo are adding video capability to their conferencing software. Very soon Microsoft will release a new operating system that will support a camera device in the same manner as a mouse device. We are already working with USB/DSP partners to support the new release.

The full size automotive market continues to show steady progress for OmniVision. Most of the products shipped into automotives today are CCDs. However, more design requirements using CMOS are becoming more prolific. Although this market does not have a steep on the growth curve as the consumer electronic market, we believe that over time it will become one of our largest markets.

As we look into the future, we expect that automotive will have multiple sensors to enhance vehicle safety and improve the driver’s experience. In addition to the rear view cameras and lane departure systems, our CMOS cameras are already gaining acceptance. There are many more opportunities for sensors in the vehicles. For example, as I mentioned last quarter, beginning in 2007 the EU is mandating that all new trucks and buses have 360-degree visibility, which for vehicles requires as many as 16 sensors. Also, smart airbags can use a sensor to determine if there is a young child or elderly person in the passenger seat, which will tell the system to use less force when the airbag is deployed.

Sensors may also be used for applications such as rain sensors, head light dimming systems, and much more. For near term applications, during the quarter, we launched our OV7949 which features low light sensitivity with significantly reduced blooming. We used the blooming capability, which is particular important for rear view cameras with need to be able to record a clear image even when faced with a bright headlight of trailing vehicles. Blooming capabilities also is very important for blackbox cameras, which are intended to visually document accidents for liability or insurance purposes; where the brightness of the brake lights of a vehicle directly in front of sensor can blur or disturb the image and prevent clear documentation of events.

For the medical market we have designed an innovative ventilation tool developed by ETView. We have discussed this opportunity before and I like to take a moment to elaborate on why we are excited about it. Intubation is a procedure by which medical personnel insert a tube into a patient’s windpipe in order to deliver oxygen to the lungs. For doctors, during the point of insertion for intubation, it greatly enhances their ability to successfully place the tube in the patient’s windpipe rather than, for example, in the throat. This product has already received FDA approval. There are approximately 15 million intubations performed annually worldwide.

Errors in traditional intubation can lead to brain injuries and permanent disabilities, or even be fateful. Also, hospitals are required to take mobile x-ray for each intubation performed outside of the operating room to verify the position of the tube. By providing a real time image the need for x-ray is eliminated. So for reasons they include both increased safety and lower cost, we believe that the image sensor based solution is ideal.

As you can see, we are doing many interesting and innovative things with our sensors. While we continue to focus on improving the technology and features, reducing the power requirements and the size, we are really proud of the innovation part. We are improving image quality for the end-users, we are improving safety, and we are adding useful features to many consumer products. Additionally, one of our main focuses will be on pushing our technology development so that we can truly be at the leading edge. As always, our goal is to be the market leader in CMOS image sensors.

I will now turn the call over to Peter who will discuss our first quarter financial results in detail. Peter…

Peter Leigh, VP Finance, CFO

Thank you, Shaw, and good afternoon everyone. For the first quarter of fiscal 2007, which ended July 31, 2006, OmniVision’s revenues were $136.9 million, up 4% sequentially and up 43% on a year-over-year basis. Direct sales to original equipment manufacturers and value-added resellers accounted for about 68% of revenue in the first quarter of fiscal 2007, with the balance of 32% coming from sales through distributors.

We shipped approximately 58 million image sensors in the first fiscal quarter, an increase of about 10 million from the approximately 48 million units shipped in the April quarter. Our blended average selling price was $2.35. The reduction was mainly due to price erosions during the quarter, offset to some extent by the first volume shipments of 2 megapixel sensors.

Gross margin for the first quarter was 36.3% compared to 36.8% last quarter. Our gross profit in the first quarter reflects approximately $0.9 million of stock-based compensation expense. Excluding stock-based compensation expense, gross margin in the quarter was 37%.

During the quarter, the company booked additional provisions for excess and obsolete inventory of approximately $0.9 million. Revenue from the sale of previously reserved inventory was $2.9 million. In addition, during the quarter, we recognized credits of $2.2 million of compensation from suppliers whose product quality in previous periods did not meet our standards.

As we continue to see strong growth opportunities for the company, we believe that investing in our business, primarily in the R&D and sales and marketing functions, is very important. R&D expense in the first quarter was $16.8 million, up from the $11.7 million we reported in the prior quarter. Keep in mind once again that this was the first quarter in which the company recognized stock compensation expense under FAS 123R. Of the $5.1 million increase $3 million was due to stock compensation and most of the remainder came from an increase in the numbers of masked sets for new products that we released to our foundry partners. Excluding stock-based compensation R&D expense was approximately $13.8 million.

SG&A expenses in the quarter totaled $12.5 million, up from $10.2 million in the previous quarter. Here again the largest contributor to the increase was stock-based compensation totaling $2.5 million. Excluding stock-based compensation, SG&A expense was approximately $10 million.

Our GAAP operating income in the quarter was $20.4 million and our operating margin was 15%. Excluding stock-based compensation expense, operating income was $26.9 million and operating margin was 19.7%. This compares to last quarter when we reported operating income of $26.6 million and an operating margin of 20.2%.

Our interest income in the quarter was $3.4 million, up $0.8 million from last quarter, reflecting both higher interest rates and higher cash balances.

We expect that our effective tax rate for the fiscal year including the effect of stock-based compensation expense under FAS 123R will be approximately 26%. Excluding stock-based compensation our effective tax rate should be closer to 21%.

Net income in the first quarter was $15.9 million or $0.28 per diluted share, compared to net income of $22.5 million or $0.39 per diluted share in the fourth quarter of 2006, and net income of $14.4 million or $0.25 per diluted share in the prior year period. Included in OmniVision’s results for the first quarter of fiscal 2007 are $6.5 million of non-cash stock-based compensation expenses, which is a result of our adoption of FAS 123R on May 1, 2006.

Net income reported in prior periods did not include stock-based compensation expense under FAS 123R. Of course, as you all know, stock-based compensation is a rather unusual sort of expense because it has no impact on cash flow and unlike every other expense it does not reduce the company’s net worth. Instead, under FAS 123R we make the assumption that our stockholders have paid in additional capital equal to the expense we record, and this is why we think it’s useful to present our results excluding stock-based compensation expense and the related tax effect. Our non-GAAP net income in the first quarter of fiscal 2007 was $22.1 million and non-GAAP earnings per diluted share were $0.39.

Let me now turn to the balance sheet, which remains in excellent shape. We ended the quarter with cash, cash equivalents, and short-term investments totaling about $377.5 million. Accounts receivable at quarter end, net of reserves, were $72 million. Our day sales outstanding were 48 days, up slightly from 45 days at the end of April. Inventory was $68.5 million on July 31, 2006, up from $55 million at end of April. Most of the increase is in the form of width representing product that is not yet available for sale. Inventory turns were 5.1 times, slightly above our target range of 4-5 times.

As we look at capital requirements over the next several quarters and as Shaw has already mentioned, we’re working to expand our backend chip scale packaging capacity by purchasing equipment that will be operated by our CSP partner Wintech. This month we’ve disposed over $17 million towards this project. In total our plan calls for us to process approximately $50 million worth of equipment over the next three quarters. We anticipate that the first of the equipment should be installed and providing the company with products by the end of this calendar year.

In addition, between now and the end of calendar 2007, we anticipate making additional investments with a similar amount in Tessera, our joint venture with CSMC to expand the color filter capacity that’s available to us.

Before I turn to the outlook for the current quarter, I do want to say a few words about gross margin. As all of you know, intense price competition and the consequent price erosion is a fact of life in the semiconductor business and thus one of our constant objectives is to drive costs as fast or faster than prices decline. There are two elements to meeting this objective. For our current products we work closely and continuously with all of our vendors to lower cost and to improve productivity by increasing yields at every stage of the production process. Typically newer products tend to have the most room for yield improvement, and the present time we are focusing particularly on the recently launched 2 megapixel sensors, which we expect will represent an increasingly large portion of our revenues going forward. For future products we have several programs underway to design lower cost sensors. In the meantime, as we’ve made clear on previous occasions, we intend to be competitive.

And now I would like to turn to the outlook for the second quarter of fiscal 2007 which will end on October 31, 2006. Although the demand environment didn’t change much from the April quarter to the July quarter, we believe that of late the pricing environment has become more difficult. Based on current trends, the company expects fiscal second quarter 2007 revenue will be in the range of $135 million to $145 million. Including the estimated expense of $9.1 million associated with stock-based compensation calculated in accordance with FAS 123R, the company expects earnings to be in the range of $0.12 to $0.20 per diluted share. Excluding FAS 123R expenses and the related net tax effects, the company expects non-GAAP earnings will be in the range of $0.26 to $0.34 per share.

With that, I’d now like to turn the proceedings back to Shaw for some strategic commentary.

Shaw Hong, President, CEO

Thank you, Peter. OmniVision’s core competition is centered on the image sensor. As we have said before, our goal is to run all the key elements of the image pipeline. By that it means light capture, the conversion of light into images, and the processing of these images. This emphasis allows us to concentrate on what we do better than anyone else in the world.

As I said earlier, our entire team is committed to achieving the following objectives, which are: to grow our customer base and a number of design wins, to continue to demonstrate technology leadership, to identify and extend our reach into new emerging markets, to serve our customers as strategic partners, to focus continuous attention on product cost, and to intelligently invest in the right part of our business at the right time. We believe that if we deliver on these objectives we will create value for our stockholders.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, if you’d like to place a question, pleas press * and 1 on your touchtone telephone. If your question has been answered or you wish to withdraw your question, press * and 2. Questions will be taken in the order received. Please limit you questions to one question and one followup. Press * and 1 to begin. Your first question comes from the line of Satya Chillara with Pacific Growth Equities; please proceed.

Satya Chillara, Pacific Growth Equities

Good afternoon. Peter, can you guys talk about what the forecast is at this point for the entire fiscal year in terms of pricing? It seems pricing is much difficult here, so what are you forecasting for the entire year, and if I look at your previous years on a blended basis it’s 25% down, so what’s the new forecast at this point?

Peter Leigh, VP Finance, CFO

Generally, Satya, we think that the 20% to 25% on an annual basis is right. There is going to be variation from quarter to quarter as you understand, but I think 20% to 25% is a good place to be.

Satya Chillara, Pacific Growth Equities

One followup question for Jess, in terms of VGA, which is 1.3 and 2 megapixels, where is it more aggressive in terms of pricing, which density is that?

Jess Lee, VP, Mainstream Products

Yeah, I think we see strong demand across the board for VGA 1.3 and 2. As you can suspect in the lower end such as VGA there is a little bit more intense price pressure. That’s kind of driven form two different directions: one is from obviously some competitors and another is something that we probably have to explain in more detail but driven from the handset vendor side. Everyone is trying to upgrade. So, this means you’re upgrading non-camera phones to camera phones. To do that you’re targeting phones and to do penetrate that market you need to have an aggressive cost structure.

Satya Chillara, Pacific Growth Equities

Okay, great, thank you.

Operator

Your next question comes from the line of Tore Svanberg with Piper Jaffray; please proceed.

Evan Wang, Piper Jaffray

Hi, this is actually Evan Wang calling for Tore. We were wondering if you have seen any new competitors entering the market more recently, if you can comment on that.

Jess Lee, VP, Mainstream Products

Hi, this is Jess. In terms of new competitors, not really. Most of what we see in the market place is really similar to what we’ve seen in previous quarters.

Evan Wang, Piper Jaffray

Along the same line of question as before, how is the pricing in the non-cellphone market, mainly the automotive, gaming, and security?

Hasan Gadjali, VP, Advanced Products

In the non-automotive market I think the market has continued to grow and I think we are more focused in getting more sockets rather than pricing erosions. So, we are seeing new business opportunity and growth in volume.

Evan Wang, Piper Jaffray

The last question is, what do you expect the mix to be like exiting 2006 between VGA 1.3 and 2?

Hasan Gadjali, VP, Advanced Products

I think VGA will remain strong, 1.3, as we introduce newer products that have newer innovations they will come back, and 2 mega continues on a strong growth back. We’re happy to already see that our 2 megapixel product line is contributing significant revenue even in this quarter.

Evan Wang, Piper Jaffray

Can you give us an idea of what the mix is for this past quarter?

Hasan Gadjali, VP, Advanced Products

We typically don’t give out specific mixes, but we said before that our VGA is north of 50% and the remainder is shared between 1.3 and 2 on a more upward trend than 1.3.

Evan Wang, Piper Jaffray

Okay, thank you very much.

Operator

Your next question comes from the line of Jason Pflaum with Thomas Weisel Partners; please proceed.

Jason Pflaum, Thomas Weisel Partners

Good afternoon guys, a couple of quick questions. First, looking at the guidance and I guess what it implies for the gross margin, I was running some quick numbers and it seemed to suggest another step down in the 33% range or somewhere give or take. Can you talk about what the primary drivers are there, is it the ASP erosion or is there an ongoing mix consideration that’s weighing there?

Peter Leigh, VP Finance, CFO

The principle imprint is the one that you identified, Jason, which is ASP erosion. In the meantime, as we said in our prepared remarks, we’re working very diligently with all participants in our supply chain to continue to drive down cost, but that is of course a longer term proposition and we won’t necessarily see the results of all of those initiatives for a couple of quarters at least.

Jess Lee, VP, Mainstream Products

Jason, I’d like to add in more detail that there are three initiatives that we have. One is this constant review of our cost structure and working with our partners to improve our supply chain to get cost down. But there are two other initiatives and this is what we’ve been doing for a long and we will continue. The first is to aggressively adopt newer technologies and newer products. As we upgrade people to newer resolutions they will adopt higher quality product at a lower price with hopefully better margins for us. The second thing is we see this ongoing trend of people upgrading. So, people are upgrading from non-camera phones to camera phones, people are upgrading from 1.3 to 2 meg. So, there is a constant path wall to help our mix.

Jason Pflaum, Thomas Weisel Partners

Okay. The last question here, on the last call you indicated that you would like to be growing sequentially into the calendar first quarter time period, which will be against what normal seasonality would suggest, and looking at your guidance this quarter, what really has changed in that if anything? And then if you can just talk generally about some visibility into the next couple of quarters.

Jess Lee, VP, Mainstream Products

Well, I think we’ve been somewhat constrained on the backend as Peter has alluded to. The CSP packaging technology has been very successful for us. More and more customers continue to find that a package sensor is more friendly to work with than a raw dye. So, overall the popularity of CSP has exceeded our expectations recently. So, we’re working to remove this limitation with the investment that Peter already talked about.

Jason Pflaum, Thomas Weisel Partners

Any sense of how much that perhaps has gated your revenue?

Peter Leigh, VP Finance, CFO

To quantify it is always a hard thing to do, but I will say that with the addition of new capacity by the end of this new calendar year we think that our third quarter revenues should be up nicely from where we’re guiding for the second quarter.

Jason Pflaum, Thomas Weisel Partners

Finally, what are the margin implications of some of these new backend investments, can you talk about that generally?

Peter Leigh, VP Finance, CFO

Well, as with every other element of our cost, we’re going to make those costs as competitive as we possibly can, and the important point I think about making the investment in the equipment directly is that this is the way in which we get dedicated capacity. This capacity obviously, since we are in the equipment, is used for our products and our products alone.

Jason Pflaum, Thomas Weisel Partners

Okay, thanks guys.

Operator

And your next question comes from the line of Harsh Kumar with Morgan Keegan; please proceed.

Harsh Kumar, Morgan Keegan

I’m thinking of your business long term. The way I’m computing a gross margin outside of all these kind of one-time things hat you had was bout 34%, is that how we should think about this business as a 34% margin business longer term, can you help me with that?

Peter Leigh, VP Finance, CFO

Our goal remains the mid-to-upper mid 30’s target that we talked about I think over at least a year, and that remains the goal. In the short run we will be competitive and I think that it’s prudent to anticipate that margins will be under pressure for the next one or two quarters, but longer term the goal remains this mid-to-upper mid 30 band that we talked about.

Harsh Kumar, Morgan Keegan

So, I guess what you’re saying is once you get the new capacity back in place, early part of next year calendar, you do expect margins to go up a little bit, is that what I’m hearing?

Peter Leigh, VP Finance, CFO

Subject always to the underlying overlying consideration of what happens to ASPs, and sadly we don’t have as much control over ASPs as we would like.

Harsh Kumar, Morgan Keegan

And that was actually my next question, Peter. You mentioned that we should think about 20% to 25% ASP erosion per year. Your ASPs I think just dropped greater than 10% in the sequential quarter; I mean that will imply a much more significant increase in ASP decline, can you help us collaborate those statements?

Peter Leigh, VP Finance, CFO

Of course, that’s the right arithmetic Harsh, but bear in mind for example in the January quarter our ASPs actually went up, the January ’06 quarter. So, I think the point is that you have a general pricing trend of 20% to 25% erosion but you’re going to see fluctuations around that trend.

Harsh Kumar, Morgan Keegan

Is it because of the mix, Peter, is that what’s happening?

Peter Leigh, VP Finance, CFO

Part of it. Obviously, as 2 megapixels becomes a larger and larger portion of our total volume, that would have an upward effect on our overall blended weighted ASP.

Harsh Kumar, Morgan Keegan

Got it, last question, and I’ll come back later. How about a stock buyback at this price given you have so much cash and no debt, wouldn’t be the right and the intuitive thing to do, can you help me understand why there’s no buyback in place?

Peter Leigh, VP Finance, CFO

Well that’s a question that we do review from time to time and we will continue to keep under review, but I think the important point to recognize is that we are engaged in a number of a important capital investments at the present time, and I long believe that you’re better off ending a war with one bullet left over rather than being one bullet short.

Harsh Kumar, Morgan Keegan

Okay, that’s fair enough, thank you.

Operator

And your next question comes from the line of David Wu with Global Crown Capital; please proceed.

David Wu, Global Grown Capital

Good afternoon. Can you talk a little bit that when you start shipping to megapixel in the first fiscal quarter, I guess that’s a small quarter, we looking at less than 5% of our revenues in that category, and until you get to the end of the year how big a cap should we think about 2 megapixels, would it ever become more than 10% of revenue until your install capacities start coming on or those chips go packaging?

Jess Lee, VP, Mainstream Products

Hi David, I think the quick answer for you is, as our current plan goes by the end of the year, the 2 meg product should be significantly more than 10% of our revenues.

David Wu, Global Grown Capital

By the end of your calendar year or your fiscal year?

Jess Lee, VP, Mainstream Products

By the end of the calendar year.

David Wu, Global Grown Capital

The difference between what you’re telling us and prior I guess is the mix of bare dye versus CSP, which originally you were thinking 50/50 and is now 80/20, that kind of thing that’s part of your revenue limitation looking out to your seasonally stronger second quarter, is that the problem?

Jess Lee, VP, Mainstream Products

In a way that we said this, the limiter for us has been on the backend and that’s specifically CSP. We’ve never really thought of CSP and QV as 50/50, we’ve always expected more on CSP, but recently due to the popularity and this upswing in demand, it’s exceeded our expectations.

David Wu, Global Grown Capital

Okay. Maybe if you can add just a little bit of clarification, on 1.3 meg part of your market which I guess your mainstream, what can you do to make it more attractive, is it a cost reduction or is it a quality enhancement?

Jess Lee, VP, Mainstream Products

Again, everyone is on this upgrade path, non-camera phones to camera phones using VGA. The obvious thing would be to look at current VGA phones to adopt 1.3. So, we’re looking at multiple things, one is the optical format which affects the size and one is cost, but there are various factors that we’re looking at in the next innovative product.

David Wu, Global Grown Capital

Okay, thank you.

Operator

And your next question comes from the line of Douglas Wage with First Investors; please proceed.

Douglas Wage, First Investors

Good evening, real quick. So, we are going to see wafer encoding in September, correct?

Peter Leigh, VP Finance, CFO

That is correct, we intent to deliver the first samples to the customers we’re working with in September.

Douglas Wage, First Investors

When will investors be able to look at this, you guys are having an analyst day where we can come and see this technology, probably ground breaking if you think what it’s going to do?

Peter Leigh, VP Finance, CFO

That is part of the program and believe me you will be getting an invitation.

Douglas Wage, First Investors

All right, fabulous. Next question is on options, I guess this current quarter about half of EPS, when should we expect a fall in option granting and option expense going forward?

Peter Leigh, VP Finance, CFO

We have scaled back the level of our option grants some, but as a company we believe that the incentive effect of stock options remains intact, and to be perfectly frank with you we don’t think that that incentive should be changed because of the way that the accountants have decided we should reflect that in our financial statement. After all as I did say in my prepared remarks, this is a rather unusual sort of expense, it doesn’t reduce your network and it has no effect on cash flow as I’m sure you understand.

Douglas Wage, First Investors

Lastly, Shelton was selling 4 million shares in the last 12 months, when will these sales end and at these prices, what’s the status on that?

Peter Leigh, VP Finance, CFO

These are shares as you know as subject to a trend beside program, and all of our stockholders the decisions they make about their shares are personal to them.

Douglas Wage, First Investors

Fair enough, thanks a lot.

Operator

Your next question comes from the line of Tristan Gerra with Robert Baird; please proceed.

Tristan Gerra, Robert W. Baird

Good afternoon. Looking at he gross margin decline for the October quarter, you said that you expect to pick up in a couple of quarters, what will be really driving this particularly since you will be at seasonal peak from unit standpoint and what will be driving gross margin back to the 35% level?

Peter Leigh, VP Finance, CFO

Well, one of the things Jason you have to bear in mind is by then we expect wafer encoding well established in the revenue stream and that will have a positive impact. And our programs to reduce cost go on day and night regardless of how they impact a particular quarter.

Jess Lee, VP, Mainstream Products

Right, we just wanted to highlight again our three-part strategy here. As Peter talked about, first is really aggressively working with our partners to reduce cost in our supply chain, and second is to adopt newer technologies in terms of our sensors. What customers want is more features and more form factorance at lower cost. We’ve seen this successful execute with the OmniPixel 2 and I guess what we’re alluding to is you’ll see something from us fairly soon on newer technologies for newer products.

Tristan Gerra, Robert W. Baird

Now, assuming that the wafer encoding product launches successfully, my assumption is that it has to remain a very small percentage of total revenues for a long time given that even today VGA is still over 50% of your mix and that technology is really targeting 3 megapixels. So, can you tell us a little bit about the margin differential for that product and how much you think it can contribute to the topline a year from now?

Jess Lee, VP, Mainstream Products

Let me answer your question in a couple of different ways here. So between Peter and I we talked newer technologies being adopted in newer products. So wafer encoding is just one of those, that is as you said for the higher end, and as you can probably guess those have not been huge volumes compared to VGA 1.2 and 2. So, the other part of what I said was…maybe I should be more clear…is there will be newer technologies adopted into the lower end, mid range, and even 2 megapixel products. So, we’re looking forward some of these newer technologies coming out fairly soon.

Tristan Gerra, Robert W. Baird

Last question, could you tell us what China was as a percentage of revenues in the July quarter?

Peter Leigh, VP Finance, CFO

China was 19% of revenues, Tristan, but I do think it’s important to recognize that roughly three quarters of our business comes from the combination of China, Taiwan, and Hong Kong, and since we are selling either to distributors or to module makers, the geographic distribution of our sales really doesn’t say anything about where those products end up. So, I think it’s important not to draw too definite conclusions from the geographic conclusion of our revenues.

Jess Lee, VP, Mainstream Products

And Peter gave the breakup of China, but if you look at our overall China and Greater China, which includes Taiwan and Hong Kong, that has remained roughly stable at 75% to 80%. As far as the geographically distributed business in terms of end customers that does remain fairly well distributed over the U.S., EU, and Asia regions, driven by the top tiers as well as some of the second tiers.

Tristan Gerra, Robert W. Baird

Great, thank you.

Operator

And your next question comes from the line of Quinn Bolton with Needham and Company.

Quinn Bolton, Needham & Company

Thanks, just a couple of clarifications and then I’ve got a technology question. First on the mix, when you talk about VGA being over 15% of the mix, I’m assuming you’re still talking units there or are you talking revenue?

Jess Lee, VP, Mainstream Products

We’re talking units.

Quinn Bolton, Needham & Company

Okay. Also, on the mix between bare dye and CSP, it sounds like CSP may be roughly one-thirds, is that sort of in the ballpark?

Jess Lee, VP, Mainstream Products

Well, we haven’t given out specific numbers for competitive reasons, but I guess we can say it’s currently a large majority of our products.

Quinn Bolton, Needham & Company

Okay, on the technology, you talked about a number of cost reduction efforts, I was wondering if you might be able to give us an update on sort of just where you are with the pixel size, and most of your products are 2.2 micronpixels or even 1.8 and smaller to the extent that you’ve got it on the roadmap, how you think that changes the manufacturing cost of the image sensors?

Jess Lee, VP, Mainstream Products

Absolutely that does have a direct relationship with how we bring cost down between these newer technologies. Currently, we’re shaping in volume of 2.2 micronpixels, our 2 meg sensor, and our 3 megapixel sensors, and we have demonstrate that we’re actually first to market with this technology. Again, when you compare us, and I’m sure you will compare us with other companies, you’ve got to keep in mind what we actually ship. A lot of companies tend to introduce newer technologies really, really early on and not actually ship to a year and a half to two years later. So, when we have a 1.75 or 1.8 micronpixel technologies ready, you’ll know about it and when you know about it we’ll actually be shipping it.

Quinn Bolton, Needham & Company

Okay, then any update on 300-mm wafers, is that something you remain on track for, any update there?

Jess Lee, VP, Mainstream Products

Yeah, we’re right on track and as we said before we will introduce products based on that technology when it’s economically the right thing to do, but rest assured that’s something we are spending resources on already.

Quinn Bolton, Needham & Company

Thank you very much.

Operator

And your next question comes from the line of Tayyib Shah with Longbow Research; please proceed.

Tayyib Shah, Longbow Securities

Can you give us an idea of what the breadth of your 2 megapixel design wins is, and do most of your new design wins go into production in the current quarter or does that take until the end of calendar ’06?

Jess Lee, VP, Mainstream Products

Actually, every week we see more designing activity on that, so it’s hard to give you a very specific number, but right now we’re looking at dozens of design wins and many of those are in the midst of ramping, but the spread does reach into next year as far as we can see in terms of new design ramping.

Tayyib Shah, Longbow Securities

And what is ramping this are most of those designs going to go into production in this quarter, meaning that you don’t see that big a delta on 2 megapixels when you get closer to January quarter?

Jess Lee, VP, Mainstream Products

Well, again, I think we’ll have to look carefully, but roughly the split kind of comes in bumps, so there’s been a big kind of a steep ramp that we’re on now. In fact, some of the phones are already shipping and on store shelves. Things will dip a little bit and pick up a little bit in the early part of next year in terms of 2 megs. So, there’s no smooth ramp of dozens of phones, I would say a big chunk of the phones are in the midst of ramping now, and another big chunk will start next year.

Tayyib Shah, Longbow Securities

And then, can you give us an idea of how your market share at 2 megapixel is different from what you have on 1.3 and VGA, are you guys significantly in a better position competition wise in the 2 megapixel space?

Jess Lee, VP, Mainstream Products

I think its’ safe to say that we’ve seen continually in our 2 meg product a strong set of differentiating features, which I guess I don’t have time to go through this call, but it does have pretty strong differentiators, both in terms of size and in terms of certain functions.

Tayyib Shah, Longbow Securities

And then on the cost side, are you guys making most of your products on 300 mm right now?

Jess Lee, VP, Mainstream Products

We’re not making any of our products on 300 right now. We’ve only said that we will be transitioning 200 to 300 when the time is right economically.

Tayyib Shah, Longbow Securities

All right, thank you guys.

Operator

And your next question comes from the line of Doug Freedman with AmTech Research; please proceed.

Doug Freedman, AmTech Research

Hi, thank you. Peter, I just want to make sure I understand the capital spending plan properly, because you mentioned the investment and assembly equipment and then a separate investment at TSMC to Tessera, the total of those two is what for the year?

Peter Leigh, VP Finance, CFO

What we said was that the Wintech project is $50 million in total over the next three quarters and the Tessera investment would be of a similar amount. We’re still developing so I don’t want to put a precise number on it, but I want to give you the indication that we intend to invest in that part of our supply chain also.

Doug Freedman, AmTech Research

Do you have cash on hand estimate for the end of the year?

Peter Leigh, VP Finance, CFO

We do, but it’s not one that we make public.

Doug Freedman, AmTech Research

Could you help me understand what we should be thinking about as far as the investment in R&D? If I look at your spending rate and growth in spending on the R&D line, it’s been almost 15% per quarter over the last several quarters with only one quarter where there wasn’t that large an increase, how should I think about that going forward, and I’m trying to get an idea of how much spending is required in all of these efforts that are ongoing to try to reduce cost?

Peter Leigh, VP Finance, CFO

Well what I said consistently, Doug, and I think you’re new to this story, is to think about it in dollar terms rather than in terms of percentage growth, and I think if you estimate that R& expense is going to increase between $3.25 million and $1.5 million per quarter that will get you in the right ballpark. I think the important point to emphasize is that technology is the heart of our business and we are gong to invest in this business with all the money that we believe it takes to maintain our technology leadership position.

Doug Freedman, AmTech Research

Thank you very much.

Operator

And gentlemen, your last question comes from the line of Adam Benjamin with Jefferies & Company; please proceed.

Adam Benjamin, Jefferies & Co

Thanks guys. You had been talking for several quarters now about 2 megapixels and some wins with tier ones that you had, and I think people were anxiously looking forward to the ramp of the 2 megapixels and the impact it would have on ASPs and gross margins. And based on your guidance, I’m just trying to reconcile finishing the year at say 10% of your mix at 2 megapixels and how you get to the gross margin levels that you’re talking about. That’s the first question.

Peter Leigh, VP Finance, CFO

When we talk about 10%, Adam, we’re talking about volumes, unit volumes, and obviously have a higher percentage impact on revenues because the price of 2 megapixels is substantially higher than either 1 megapixel or VGA. So, I want to make sure that we’re on the same page in that respect.

Adam Benjamin, Jefferies & Co

Right, you’re talking about volume?

Peter Leigh, VP Finance, CFO

Sure, we’re talking about volume and I think 10% maybe on the low side for exiting 2006. What we said and what we still believe is that volume will be in the 10% to 15% when we exit 2006.

Adam Benjamin, Jefferies & Co

Right, so you’ve seen ASPs decline as a total business 17% sequentially last quarter, this quarter is 14%, and you talked about 20% to 25% year-over-year decline, I’m just trying to reconcile that those declines are pretty large and it would be hard pressed to see you do 20% to 25% for year, and based on your guidance it wouldn’t reconcile with that. So, I’m just trying to figure all that out given the fact that you do have 2 megapixels coming on and you would think the gross margin will be higher there.

Peter Leigh, VP Finance, CFO

Well, the piece you maybe missing is that 2 megapixels is a relatively new product and as is generally the case with new products that’s where you have the most scope for yield improvement, and yield improvement of course translates directly into improved gross margins.

Adam Benjamin, Jefferies & Co

Okay, so can you talk about your current yields on the 2 megapixels versus your more established products then?

Peter Leigh, VP Finance, CFO

We don’t talk about yields, Adam, I’m sorry that’s not something we want to get into a public forum. So, I would say that people here are working day and night to improve the yield on these products, and as I said a moment ago, the scope for improving yield is for obvious reasons the largest with the newer products.

Adam Benjamin, Jefferies & Co

But your answer would imply that there is significant room for improvement, so the yields aren’t particularly strong compared to your existing products, so I was just trying to get some range, obviously they are lower, is it 20% to 30% lower, some kind of qualitative answer there?

Jess Lee, VP, Mainstream Products

I think Peter has talked about our constant yield improvements just as a general effort that we have across the board for all our products. New products tend to have more room for yield improvement as Peter says. I think you’re trying to reconcile some things that are related to that but also ASPs, and I think if you’ll look at the split that we gave at the beginning of the discussion, DSC did go down slightly, so that did contribute to the ASP decline even though 2 meg was coming out strong. So that may go part of the way in answering your question.

Adam Benjamin, Jefferies & Co

Actually while you’re on the topic, I know you cannot break out revenue this way anymore, but as you look at camera phone and then DSC as a separate group, security and surveillance, toys and games, and then PC cameras, can you just talk about whether each one of those businesses were up or down sequentially in the quarter, that will be helpful as it relates to ASPs?

Peter Leigh, VP Finance, CFO

Well, you’re right, we don’t break it out. What we said was that DSCs this quarter represented about 7% of revenues and that is down from the prior quarter and obviously DSCs tend to be concentrated in the higher resolution arena.

Adam Benjamin, Jefferies & Co

And PC cameras directionally up or down as well as toys and game and security and surveillance?

Peter Leigh, VP Finance, CFO

Up.

Adam Benjamin, Jefferies & Co

All those were up?

Peter Leigh, VP Finance, CFO

Up.

Adam Benjamin, Jefferies & Co

Thanks a lot guys.

Operator

Ladies and gentlemen, I would now like to turn the call over to Mr. Hong for closing remarks; please proceed sir.

Shaw Hong, President, CEO

In closing I want to reiterate our confidence in the ability of OmniVision to continue to advance image sensing technology. We are well positioned to introduce new and advanced products ahead of the competition. We appreciate all the work our team continues to contribute to our success. We thank you for participating in our call. We look forward to speaking with you next quarter. Good bye.

Operator

Thank you for attending today’s conference. This concludes the presentation. You may now disconnect.

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Source: OmniVision Technologies F1Q07 (Qtr End 7/31/06) Earnings Call Transcript (OVTI)
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