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National Semiconductor Corporation (NSM)

F1Q07 Earnings Conference Call

September 7, 2006 4:30 pm ET

Executives

Brian Halla - Chief Executive Officer

Don Macleod - President and Chief Operating Officer

Lewis Chew - Chief Financial Officer

Long Ly - Investor Relations Manager

Analysts

Michael Masdea - Credit Suisse

Adam Parker - Bernstein & Co., Inc.

Mark Edelstone - Morgan Stanley

Chris Caso - Friedman, Billings, Ramsey & Co

Ross Seymore - Deutsche Banc

Joseph Osha - Merrill Lynch

Simona Jankowski - Goldman Sachs & Co

Presentation

Operator

Good afternoon. My name is Christian and I will be your conference operator today. At this time, I would like to welcome everyone to the National Semiconductor Corporation Q1 fiscal year 2007 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer period.

(Operator Instructions)

Thank you. It is now my pleasure to turn the call over to your host, Mr. Long Ly, Investor Relations Manager. Sir, you may begin your conference.

Long Ly

Thank you. I would like to again welcome everyone to our call today. Joining me are: Brian Halla, Chairman and Chief Executive Officer; Lewis Chew, Chief Financial Officer; and Don Macleod, President and Chief Operating Officer.

The purpose of today’s call is to discuss National Semiconductor’s first quarter fiscal 2007 results, which ended on August 27, 2006. As a reminder, today’s call will contain forward-looking statements and projections that involve risks and uncertainties that could cause actual results to differ materially. You should review the Safe Harbor statement contained in the press release published today, as well as our most recent SEC filing for a complete description of those risks and uncertainties.

Also, in compliance with SEC Regulation FD, this call is open to all and is being broadcast live over our investor relations website.

For those of you who may have missed the press release, or would like a replay of the call, you can find it on National’s IR website at www.national.com.

I would like to inform everyone that National’s annual shareholders meeting will be held in Santa Clara on Friday, October 6th, at 10:00 am Pacific time. We will also have a separate analysts meeting at the American Conference Center in New York on Wednesday, October 11th at 10:00 am Eastern time. Please visit National’s IR website for more information on these events.

In today’s call, I will provide a recap of the first quarter financial results. Brian Halla will provide an overview of the company’s progress. Lewis Chew will expand on the first quarter results and provide an outlook for the second quarter, and Don Macleod will discuss our analog standard linear product progress. We will then take questions until 2:30 pm Pacific time.

The first quarter results were as follows:

  • Sales were $541.4 million, down from $572.6 million in Q2 Fiscal year 2006, and up from $493.8 million in last year’s first quarter;
  • Gross margins were 61.7%, up from 61.4% in the prior quarter and up from 56.2% in last year’s first quarter;
  • Operating expenses were $167.4 million;
  • Interest income was $10.5 million; and
  • The effective tax rate for the quarter was 31.7%.

As a result, National posted net earnings of $120.1 million, or $0.35 per fully diluted share. The fully diluted share count for the quarter was 343.7 million shares.

I will now turn it over to Brian Halla for an overview of the company’s progress. Brian.

Brian Halla

Thank you, Long. Just to refresh everyone’s memory, on August 22nd, National sent out a press release guiding to 6% down versus the original guidance of 2% to 3% down. We highlighted three areas responsible for the decline.

First, we saw lower-than-expected revenues due to adjustments in demand from some handset customers.

Second, as we expected and desired lower revenues from our transition foundry support of businesses previously sold off.

Finally, some general seasonal slowness.

Though the press release did not elaborate, or attempt to elaborate on specific areas of handset weakness, this item was clearly received as the man-bites-dog part of the story that got all the attention. However, we believe it is inappropriate to try to extrapolate to the overall health of the handset market, just because of our own experiences.

In our case, the demand adjustment in handsets was attributed to a combination of handset model changes, company-specific adjustments to build rates, and some corresponding inventory adjustments.

As we have said many times before, our strategy in the handset arena is to add more value to our customers and their products. With corresponding higher gross margins and more proprietary products, we are staying the course with that strategy, as we have across the board in our other market segments.

Having said all of this, it is important to highlight that this release also reported that we were keeping our gross margin guidance intact.

I think the gross margin story might be better than we have been able to articulate. I guess I will intentionally try to stay inarticulate here and see if the rest of the numbers in the call might be able to speak for themselves.

It is our company’s goal and our goal for our distributors, as you might expect, to continue to keep downward pressure on our inventories. As a result, we see in factory utilization obviously a major factor in gross margin calculations, drop below the 80% level.

We will reduce utilization to the below 70% kind of level in Q2 in order to bring down our in-house inventories. We believe we can do this and yet keep our gross margin above the 60% level through a continuing richer mix of higher value, higher ASP, and more proprietary products, and at the same time by keeping our expenses under control.

Also, I am sure everyone understands that the quicker we can replace the transitional foundry support revenues with higher margin standard linear revenue, the better.

So what do we see happening with our products in the market place? Again, we will continue to shy away from trying to be a spokesperson for our customers’ markets and focus instead on the activity in the market place around our own products. To that end, we turned in some decent numbers. Overall, power management revenues were up 10% year on year. Data converters, the star, up 40% year on year, and interface was up 10% year on year. We will continue to focus our investments on standard linear analog and that business makes up 76% of our revenue, up from 74% last quarter.

Those too we will provide additional details, particularly about our distribution channel, in a minute.

Going forward, we will continue to drive our product portfolio to the higher margin, higher ASPs to provide more value to our customers. Our R&D investments reflect this goal, along with rigorous and ongoing reviews of products and their expected pricing before and during product development, and before product launch and during the initial quote activity.

All of our employees know that our current gross margin short-term target is 65%.

As we head into our second fiscal quarter, we do so with a backlog lower than that with which we entered Q1. At this time, our distributors are taking a cautious outlook. With respect to resales going into Q2, we anticipate that with our lead times, even with our reduced utilization levels being kept under control, our distributors will take this opportunity to reduce their inventories heading toward the end of the calendar year.

Our foundry support of previously divested businesses should decline another $20 million to $25 million. We do, however, expect an increase in OEM sales in Q2, but not enough to offset the decline from the above two factors.

Given these expectations, we are guiding revenue for the quarter to be down in the 2% to 5% range to $515 million to $530 million revenue levels. Our margin guidance for the quarter will remain above the 60% level.

We continue to find the success of the standard linear markets is based on excellent circuit design combined with outstanding packaging and process technology, delivered through a flawless manufacturing service, supply and logistics network. National continues to drive the highest standards in all of these areas.

We focus on and continue to launch new products in the precision and general purpose but low-power consuming amplifier area. Our highest speed at the highest power efficiency levels see us gaining significant design win momentum in the data conversion area and we now have moved into the three to six gig sample levels of performance at, of course, the lowest power consume of any competing products.

We continue to drive standards in the innovative new small format packaging technology such as our micro-array packaging capability. We continue to focus our central technology resources on developing proprietary process technologies that take advantage of the line density improvements driven by the digital CMOS leads but is biased by specific characteristics required by the highest value-added analog circuits.

Our manufacturing service, supply and logistics continue to receive accolades and awards from our key customers.

The course we have chosen for National is a good one and the right one. Our employees have turned in an outstanding level of performance and execution which has in turn generated increased levels of gross margins and profits and overall gains in market share.

Let me now turn it over to Lewis.

Lewis Chew

Thanks, Brian. Well, as you have heard by now, we are projecting Q2 revenue to be down by anywhere from 2% to 5% sequentially from the Q1 that we just finished. In a typical year, we would normally expect our second quarter revenues to increase sequentially heading into the holiday season, but not this year, so I would like to spend a couple of minutes going over some of the key factors that are driving this outlook.

I will start by discussing the trends in foundry revenue that comes from providing manufacturing support for the two businesses, cordless and super IO, that we divested a little over a year ago.

In the quarter that we just finished, Q1, our foundry revenues for cordless and super IO were in the lower $30 million range combined, down about $11 million from the preceding Q4. Looking forward into the second quarter, we are anticipating that this same category of foundry revenue will decline again by around $20 million to $25 million, as the two new owners of these businesses continue to transfer their manufacturing needs to other sources outside of National, which is consistent with what we wanted when we sold the businesses. This means that the Q2 foundry revenue should end up roughly at around the $10 million level.

So now, I will turn my comments towards the rest of National’s ongoing business.

In Q1 that we just finished, the total new orders for the quarter were less than what they were in Q4. Average weekly bookings in August did not increase from July’s weekly bookings, like they would normally in a typical year, and as a result, our opening 13-week backlog for Q2 is below what it was at the beginning of Q1.

All of this decrease was driven by lower backlog for the foundry support and lower backlog from distributors. Opening backlog from OEM customers is actually up slightly compared to what it was at the beginning of Q1.

With respect to the distribution channel, the key things to look at are the resale rates and the distributor inventory level. During Q1, distributor weeks of inventory for us increased by about a week, to end at around 11 weeks. During Q2, we are not planning on much of a change in distributor resales, but we are expecting to bring distributor weeks of inventory down by a half to one full week as we continue to maintain tighter limits on this metric than in previous years.

For example, in the fall of calendar 2004, when the industry last went through a big inventory correction, distributor weeks of inventory at that time were two or three weeks higher than they are now.

So between the large drop-off in foundry revenues, combined with a planned reduction in distributor inventory, which is then only partially offset by some seasonal growth in OEM customer revenue, we currently see total company revenues dropping 2% to 5% sequentially in the second quarter.

So let’s move on to a more positive topic like gross margin.

As you saw in our press release, Q1 gross margin percentage was 61.7%. This was slightly higher than what we had in Q4, and Q1 also included a first-time impact of $2.5 million from stock compensation expense under FASB-123R, which went into effect for us in the first quarter.

Our Q1 ending inventory was about $6 million higher than Q4, of which about $3 million of that increase came from stock compensation costs under FASB-123R.

Our average fab utilization in Q1 based on wafer starts was around 77%, which was down about 10 points from Q4, so the fact that our gross margin percentage went up in Q1 while revenues were down and fab utilization was down 10 points, I think speak volumes about the progress we continue to make in the high value portion of our standard linear product portfolio. That is not to mention the excellent cost efficiencies from our manufacturing organization.

So in Q2, we are planning at this point to reduce our manufacturing volume to reflect the revenue outlook and also to bring our own in-house inventories down. At this time, we are expecting fab utilization in Q2 to average below 70%, and although this will have a negative impact on our gross margin percentage, we are expecting that we will keep gross margin percentage above 60%.

This gross margin percentage guidance includes an estimated $6 million to $7 million of stock compensation that will be in costs of goods sold in Q2.

Now, before I go over the guidance on the rest of the P&L, and since this was the first quarter for FASB-123R for us, let me recap the actual stock compensation expenses that we recorded in Q1 by various line items and then, when I go over the Q2 operating expense outlook, I will specify what we are including as an estimate for stock compensation expense for each of those line items.

Total stock compensation expense including in Q1 results were $23.9 million pre-tax, of which, as I mentioned a second ago, $2.5 million was in cost of goods sold, $7.5 million was in R&D expense, and $13.9 million was in SG&A expense.

In Q2, R&D expense in total is expected to range from $92 million to $94 million. This would include approximately $9 million of stock compensation expense.

SG&A expense in Q2 should range from $84 million to $86 million, and this includes approximately $18 million of stock compensation expense.

So if you combine those two with what I mentioned about cost of goods sold, the total stock compensation expense in Q2 would be approximately $33 million to $34 million pre-tax, and that number is higher than Q1 because it includes an incremental impact -- in other words, a sort of spike in expense -- from having to accelerate the amortization of stock option expense for option recipients who at the time of grant are already eligible for retirement, or will become eligible within the vesting period. Now, this issue affects only the timing of when the stock compensation expense is recorded and is not a unique issue to National.

So for modeling purposes, looking beyond Q2, I would expect the stock compensation to drop back down to around $30 million in Q3, and then $25 million or $26 million in Q4.

The other income and expense line in Q2 should be relatively minor, around $1 million in expense, and interest income for Q2 is expected to be around $10 million. The effective tax rate for Q2 is currently projected to range from 31% to 32%.

Now by the way, with regard to tax related matters, you may recall that in the fourth quarter, we had a one-time repatriation of accumulated foreign earnings under the American Jobs Creation Act, which is commonly referred to as the JCA. I would like to confirm that in Q4, we adopted a domestic reinvestment plan in accordance with the requirements of that JCA. Under our domestic reinvestment plan, we are planning to focus our spending on two areas over the next several years. One, analog research and development activities at various design centers throughout the U.S., and two, capital improvements and additions in our U.S. wafer fabs in Texas and Maine.

For example, in the first quarter that we just completed, we invested around $21 million on capital in our domestic fabs.

Now, our total company capital expenditures in Q1 were $41 million, and we are projecting Q2 cap-ex to be around the same level. We are continuing to convert some of our capacity in the Texas fabs from 6-inch wafers to 8-inch wafers, and the rest of the capital is mainly being invested throughout the rest of our existing manufacturing plants.

As a side note, the closure of the former Singapore assembly plant is now done, with all equipment transfers completed as of the end of Q1.

A couple of final comments on the balance sheet and operating metrics. We ended the quarter with approximately 86 days of inventory and about 33 days sales outstanding in our receivables. During the first quarter, we bought back $285 million of our stock, or about 12 million shares, and we ended the quarter with $840 million of cash reserves. Heading into Q2, we still have about $370 million remaining under approved stock buy-back program. The operating margin in Q1 was about 31% and return on invested capital for the quarter was nearly 27%, both of which include the impact of stock compensation expenses that I reviewed earlier.

Now, I would like to turn it over to Don Macleod who can talk more about some of our products and our markets. Don.

Don Macleod

Thank you, Lewis. Let me now cover in more detail the revenue trends we saw in the quarter. I will talk about our progress in transitioning our product portfolio to the higher-margin standard linear product areas, and I will talk about conditions we saw in various end markets.

Looking first at the end user market trends we saw in the quarter, as Lewis already indicated, about $11 million of our revenue decline in the quarter was attributed to our foundry sales. Of the remaining $20 million to $21 million revenue decline, most can be attributed to the mobile phone handset market, and most of the rest to the flat panel display market.

In the quarter, our sales for the mobile phone market were impacted by customer demand rate adjustments, which occurred mostly at the beginning of the quarter. Our sales to the mobile phone market were also impacted as, for example, we de-emphasized lower ASP and margined power management building blocks, commoditized audio amplifiers, and some older RF circuits that are now integrated.

Regarding the large format display market, here we were impacted by the excess inventory of LCD TV flat panels of our customers which, by the way, we feel is now largely worked off. Given recent reductions in flat panel pricing, the TV enabled portion of this market will now provide much greater opportunities for us going forward.

Our ongoing business into other markets beyond mobile phone handsets and flat panel displays was in aggregate essentially flat with the preceding fourth quarter.

Let me now talk about our business from a product line perspective, focusing in our analog standard linear product areas, and again I will use the SIAWSTS product definitions as a reference.

First, our higher margin, industry-defined standard linear products made up 76% of our sales in the quarter, and this was up from 74% in Q4, and by the way, ended up 82% of our bookings in this first quarter.

The star performer in this area, as Brian already mentioned, was our data converter product line, where revenues were up 6% in Q4 and about 40% over last year’s Q1. Here we saw increased revenues from our expanding portfolio of general purpose A-to-D and D-to-A converters, especially with our customers in Europe and Japan, with our digital temperature sensors and with our application-specific analog front-ends for copiers, printers, and scanners.

In this quarter, we also significantly expanded our DAC, our digital to analog converter portfolio, with the launch of new ultra low-power 8-, 10-, and 12-bit DACs for portable battery powered applications in industrial, medical and consumer markets.

Our data converter products made up 6% of our revenues in the quarter. As a reference point, they accounted for 4% of our sales in Q1 of last year, and the product line achieved record high gross margins this quarter.

Revenues from our power management products, which in aggregate made up 41% of our sales in the quarter, were about flat with Q4 and up about 10% from last year’s Q1.

Looking at trends that impacted our power management product areas beyond the mobile phone market that I discussed earlier, our high-voltage power management product line saw about 5% revenue growth over Q4, and about 20% revenue growth over last year’s Q1.

Here, our value proposition is based on the fact that many of today’s new consumer and industrial products are powered by sources which are either higher voltage or can experience higher voltage transients or spikes during the normal course of their operation.

In this high voltage power management area, we saw revenues grow for our simple switchers which, as the name implies, provide ease of use in designing power supplies, and our new LM5000 family of high voltage products.

Examples of the very broad market applications for these products are in automotive, industrial, consumer, and security markets.

We also launched our first application-specific high voltage and high brightness LED driver product in this quarter, to address the fast-growing LED lighting space.

In another large, broader market power management area, our low-voltage products, we also saw flat revenues over the fourth quarter and about 15% revenue growth over last year’s Q1.

For our overall business in the mobile phone handset was impacted this quarter. Looking forward, I feel good about our opportunities for high performance power management in handsets.

Here are a few examples of products released in this quarter, some of which have already achieved revenue:

  • A new DC to DC converter that powers applications, processors and mobile phones, such as DVBH, or mobile handheld TV, wi-fi and wireless land processors, camera and video processors, and MP3 music players and mobile phones. A mobile phone market leader is already using this device instead of an integrated power management unit to increase the run time for MP3 played from 12 to 20 plus hours;
  • For RF and signal pass power in the mobile phone handset, another of our new products which sits between the battery and the RF power amplifier enables the power supplied to the RF power amplifier to be optimized as needed to control and minimize transmit power;
  • We also released in the quarter a new flash LED driver for driving high-powered LED camera flashes in handheld mobile devices. This product is new circuitry that draws current from the battery using a graduated and controlled regime, resulting in significantly lower noise spikes and therefore less dropped calls. This product is also designed into several new models at a market leader.

Moving to the other two standard linear product areas, first, our interface products that made up 9% of our sales in the quarter, here we saw revenue down about 10% sequentially and up about 10% year on year. Most of our sales to the flat panel display market fell into this category and, as I said earlier, we saw slower business in that marketplace in the quarter due to excess inventory conditions at our customers.

The broader market product burst of our high-speed interface product line, which is focused on analog signal conditioning, position timing, communications infrastructure, and video markets, continues. Here, going forward, we expect to see growth opportunities for our new serial digital interface, or SDI products, that enable the high-definition broadcast studio and professional infrastructure as it ramps up to meet growing consumer HD TV needs.

Our amplifier products, which were 20% of our sales in the quarter, saw revenues decrease by about 4% in the quarter. All of this could be attributed to the mobile phone marketplace.

In amplifiers, our focus is to continue to build a differentiated broader market portfolio of products that earn us the highest margins and ASP. We do this by focusing our new product resources on high-speed and precision operational amplifiers.

In audio amplifiers, we are also now focused on precision and performance products, and value-added audio subsystems. For example, in the audio area in the quarter, we obtained our first production orders for new broad market performance audio products where ASPs are $5 to $10 plus each. Next week, we will be launching new, very high-performance audio operational amplifiers, and we are now also seeing orders for our ceramic speaker drivers and mobile phone handset applications, where we enable the very thin form factor of ceramic speakers.

Now, let me talk about other indicators of our progress to a higher performance, higher margin analog standard linear product portfolio.

Our standard linear portfolio ASP, or average selling price, in the quarter was up 18% on last year’s Q1. This is a reflection of the increasing proprietary content and broader market nature of our new product offerings.

Our power management ASP was up about 15% year on year. Amplifier ASPs were up 18% year on year, and interface, where we already have a higher ASP, were also up 7%.

The best performer in terms of ASP improvement year on year, however, was our emerging data converter product line, where ASPs were up over 30% year on year. By the way, as I said earlier, revenues here were up 40% year on year.

How does all this fit together? Our goal is to grow our gross margins to 65% of sales and beyond, and translate this into earnings per share growth without compromising on our long-term 20% or better ROIC objective.

Looking forward, you can see how rich our ASP standard linear business areas will enable us to drive gross margins up further. In the just completed quarter, standard linear products made up 76% of our revenues, but 82% of our bookings, and our book-to-bill ratio in the quarter for our standard linear products was slightly above 1.

Going forward, we will soon be at a point where 80% or better of our revenues should come from these higher margin and higher ASP standard linear products. This will further increment our gross margins, especially when we ramp back up our factory utilization following this current adjustment.

I would like to hand it now back to Long to moderate the Q-and-A. Long.

Long Ly

Thanks, Don. At this time, I will ask the operator to open up the lines to begin the Q-and-A session. Please limit yourself to one question and one follow-up so that we can accommodate as many people as possible. Operator.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from Michael Masdea of Credit Suisse. Please go ahead.

Michael Masdea - Credit Suisse

Thank you very much. Maybe just a quick, making sure I have the numbers right, Lewis. So you are talking about down $20 million to $25 million in the foundry business, and you talked about 515 to 530 for revenue, it seems like almost all that decline coming from the foundry piece. This piece is obviously a much lower piece then, and then you could see that more than offset potentially by the ongoing business? Is that the way to think about it?

Lewis Chew

Well, in terms of -- I am sorry, that last bit of your question, I missed on, Michael, but you are correct. We obviously a year ago, a lot of people were asking us when will this revenue go away, and a year later we can now answer that. The 20 to 25, that is the piece we feel pretty comfortable about, because obviously you are supplying foundry to somebody who you just sold the business to, and then kind of everything else nets out to about flat.

What was the other half of your question?

Michael Masdea - Credit Suisse

Just trying to get a magnitude of the Disti piece. It seems pretty small in terms of the decline that you are expecting. Is that fair?

Lewis Chew

Yes, the Disti dynamic is kind of interesting, Michael, so let me expand a little bit on what we saw going on there. Heading into Q2, I would say in a normal year, you would expect to see Disties with an attitude that the resales would ramp. Right now, we do not see a lot of aggressive ramp in those resales, but we do know that they are intending to bring the resales -- I am sorry, bring the Disti weeks of inventory down, so we are actually assuming at this point the Disti sales this quarter for us will actually be down because of the dynamic with the inventory.

Then, on the OEM side, we actually have a little higher OEM backlog going into this quarter, so that piece is likely to grow, so it is kind of like those three factors all net together for the down 2 to 5.

Brian Halla

Michael, your first statement was correct that most of the decline is going to be due to the $25 million decline of foundry business.

Michael Masdea - Credit Suisse

Is there anything more we can read into the difference between the OEM and Disti dynamic? Anything else, any risk of some share loss or anything between the end markets that is driving that, that separate dynamic?

Lewis Chew

Let me start that one, and then I will hand it over to Brian or Don. The one dynamic, Michael, that we have seen throughout this last year-and-a-half, judging even from the question that you guys have been asking is, are Disties operating at lower inventory level? I think the answer is turning out to be yes, because you compare where we are now to where we were back in ’04, only two years ago, the weeks of Disti inventory are probably two to three weeks less, and there does not seem to be any inclination for them to ever bring it back to those kind of 12, 14 week levels, so the dynamic that is different right now is that even though we all feel there will be a holiday season, the Disties want to bring inventories down, we think, before the holiday period and that is what is causing them to be a little bit more cautious, where I think the OEMs are just working through their normal end demand pattern, which is typically up before Christmas.

Michael Masdea - Credit Suisse

Last quick one for me, if I can, just the wireless piece -- is there any segmentation between tier-1s and tier-2s, or emerging markets develop? Anything on that front that the wireless broke out weaker in some areas?

Don Macleod

In general, in the wireless handset market, if you look at our broad customer behavior in that marketplace, I think early in the first-half of this calendar year, based on what we saw with customer orders and the pool of shipments out of these orders, I think we probably would view that the early part of the first-half of our customer base looked like it was stronger than they expected.

As we went in towards the second-half of the year, I think there was still early in the summer some behaviors in our customers where their focus was ensuring supply in a situation where there might be tight component availability in the second-half of the year.

What we really saw over the summer was our customer base, broadly in the mobile phone marketplace, adjusting their second-half demand to a more realistic level, and a level that was in line with our factory builds rather than perhaps their marketing assumptions on forecasts, and an order level that was more in line with normal availability of products. When we go into this point of the year, we really have the backlog in place with our customer base for the rest of this calendar year in the mobile phone space, so it is pretty visible to us.

We think that marketplace is behaving pretty normally, but I think at this point, we are not looking for the same kind of upsides and pull-ins for the wireless customer base that we saw last year in September and October, so that is kind of behind the guidance that we gave you.

Operator

Your next question comes from Adam Parker of Sanford Bernstein. Please go ahead.

Adam Parker - Bernstein & Co., Inc.

Lewis, I think I heard you say that Disti inventory was up a week to 11 weeks. Is that what you said?

Lewis Chew

Yes.

Adam Parker - Bernstein & Co., Inc.

What was the low it has been in the past several quarters, just for context? Can you talk about what is the low it has been, and if you kind of think forward beyond this quarter, you know, when can you envision it getting back to that low? Clearly it is going to come down here, which I think would probably be a longer-term positive, so just walk me through how much lower it could get, where that is in historical context kind of thing.

Lewis Chew

Over the last four quarters, we have had a couple of quarters that are what I would call the low point, which is kind of in the mid- to high-nine week range, so call it somewhere between nine-and-a-half and 10 weeks, we had a couple for quarters, but not consecutively, where it got down to that level. This week, it moved up to 11 from a combination of the actual inventory growing and then resales dropping over the summer, which is not uncommon.

Right now, based on the data, I would say that looks like the range with which our Disties are operating with. I know the last couple of quarters you heard Brian mention Goldilocks many times, and that is probably the result of Goldilocks is keeping inventory in a tighter range like that, and at a lower level than we had back in ’04. In ’04, the range was probably more like a 10- to 14-week range.

If you are asking right now where would be the low point, I know that when it got down to the nine-and-a-half week level, because of the shape of the cycles right now, that ends up creating some tightness on the Disties in terms of them meeting their obligations in terms of shipments on time and all that.

Adam Parker - Bernstein & Co., Inc.

So we are only talking about a week, week-and-a-half above what you consider starting to make them worried about being able to meet demand?

Lewis Chew

Yes.

Adam Parker - Bernstein & Co., Inc.

Versus two to three weeks below when it was sort of terrible in ’04?

Lewis Chew

That is right.

Adam Parker - Bernstein & Co., Inc.

So it is getting very sensitive to a few days here.

Lewis Chew

Yes, in fact, interestingly enough, internally, we probably start looking at it more in days as well, but the whole industry is used to talking about weeks, which is interesting because on our own inventory, we talk about days, not weeks, so maybe we will eventually migrate more towards days, but right now, everybody talks in terms of weeks. That actually gives us some latitude to do some rounding as well.

Adam Parker - Bernstein & Co., Inc.

Last thing, did you get any unusual levels of cancellations during the quarter? What was the percentage there versus normal?

Lewis Chew

We do not really track the percentage of cancellations, but I would say that during the quarter, part of the issue we faced was that we had opening backlog and some of it did get pushed out, but that is all netted into our numbers. I would say when we talk about less demand, less shipment to the handset market, that is not another factor on top of that. That is part of what we faced, right, was that maybe if it was a super strong period, you would see all the backlog hold plus maybe some pull-in, whereas this quarter, we did not see any pull-ins. We probably saw a little bit of push-outs.

Adam Parker - Bernstein & Co., Inc.

So is it fair to say that that magnitude there is just the difference between your original guidance and your reported number?

Lewis Chew

Yes, I would say that is probably part of what caused it, yes.

Adam Parker - Bernstein & Co., Inc.

That difference above what would be a normal level of cancellation?

Lewis Chew

Well, like I said, it is hard to quantify what would be a normal level of cancellation because typically, it is related more to where you are in the cycle than a normal seasonality. I would not normally come into a summer saying we expect a lot of cancellations. What we would normally expect is just slower activity, but this year and this quarter, because we came off a strong first-half calendar ’06, I think that is what caused some of the push-out. Also, there was some rumbling about a little bit of extra inventory out there. That probably caused it as well.

Adam Parker - Bernstein & Co., Inc.

Do you -- you made me think of one other thing, sorry -- do you guys track the backlog from 14 to 26 weeks versus one to 13? Is there something about push-outs that makes you uncomfortable with that ratio, or is that ratio not even relevant for the way you guys run things?

Lewis Chew

Well, from a process standpoint, we absolutely do that same cut-off. We looked at one to 13 weeks, and 14 to 26 weeks backlog, and actually the out-quarter backlog, if you will, has held pretty good. It was more the near-term backlog that we saw some movement, but we do track that.

Adam Parker - Bernstein & Co., Inc.

All right, and there is nothing here that is making you above your threshold on comfort-ability, or whatever?

Lewis Chew

Well, if it is based on the out-quarter backlog, no, there are no flags out there right now.

Adam Parker - Bernstein & Co., Inc.

Thank you.

Brian Halla

Adam, I just want to clarify the difference between unusual cancellations and push-outs and unexpected, because we use the term unexpected in the release in August. There are just examples of -- let’s say a large handset manufacturer is committed to a certain protocol, and during the quarter decided to back out of that, whatever content we had on those phones, it certainly would not be unusual that we would see that content, or that we would see the demand for those phones go down. It was unexpected but certainly not unusual.

Operator

Your next question comes from Mark Edelstone of Morgan Stanley. Please go ahead.

Mark Edelstone - Morgan Stanley

Good afternoon, guys. First question is what was the actual decline in wireless revenues in the quarter, sequentially?

Don Macleod

Can I come back to that? What is the second question, Mark?

Mark Edelstone - Morgan Stanley

Don, you talked earlier about some of the weakness in wireless. It sounds like it was premeditated by you guys backing away from some of the lower margin businesses in power management, for example.

So when you look at your product portfolio and the targets that you have for wireless going forward, is the content per phone that you have looking out 12 to 24 months from now, increasing or decreasing from where it has been?

Don Macleod

Let me just go and answer -- I have the data on the first part of your question, which is what was the decline to the wireless segment. Of the very visible identified customer base, our sales declined about $14 million or $15 million to the wireless base. You know, part of that is this obsolescence of the products. For example, one component of that was these old RFPLLs that we shipped to the CDMA handsets based on those going the way of the handsets going away.

You know, another $2 million or $3 million of that was older audio amplifiers that are also end of life in customer base. Some also on top of that was older LDOs that we had been shipping in to some of our customers since the late 90s, and they are still doing for some of the older handsets but we obviously do not emphasize these.

Our position on the handset is really one of identifying the high performance analog spaces. Our goal is not just to do anything any customer in the mobile phone wants us to do. It is to try and continue to move upscale in terms of the value of the product.

I gave you three good examples of products that are actually shipping into current handsets from market leaders, and you see the features. You know, we help to drive displays. We help to improve the efficiency of the RF segments in the phones. We drive peripherals, whether it is MP3 or flash camera devices, or any of the audio features. We feel good about our place in those phones, which tend frankly to be in more of the higher ASP handsets. Our place is not in the huge volume, low-end entry-level phones. That is where most of the integration takes place.

Going forward, these higher-end value phones, we have a good place in. We tend not to have a place in the broad market lower-cost phones, and that is not a new situation.

Mark Edelstone - Morgan Stanley

But when you look at the business going forward, would the expectation be that longer term, you can continue to have wireless be 30% to 35% of revenues, or when you look at the dynamics of the higher growth at the lower end, in terms of just volume, is it more likely that wireless will decline as a percentage of revenues?

Don Macleod

I would say our place is in those 3G phones where all of these added features are in, and by its nature, our goal as a company actually is to grow the broader market portion of our portfolio and power management amplifiers interface and data conversion. As we do that, that should offset the position that we have in the mobile phone over time, and it is not unreasonable in a few years to look at the mobile phone being more like 25% of our revenues in that time, but that is driven as much by the growth in the broader market catalog products than it is by any planned decline in our position in the mobile phone.

Mark Edelstone - Morgan Stanley

Just one last question -- the weakness in the point of sale going forward for distribution in November is somewhat unusual. Can you speculate as to why you think that is happening? Is that EMS inventories that are too high that is going to pressure the sell-out in distribution? What do you think is causing that weakness, or the weaker-than-normal outlook in what should be a pretty good distribution quarter?

Lewis Chew

Mark, let me try to add some color using Q1 data points. In Q1, I think what we saw was a relatively healthy environment in the Europe region, for example, and a relatively weaker environment in Asia and North America. You mentioned EMS, and we suspect that EMS was a contributing factor for the North America relative weakness, because as you know, we do not ship a lot directly to EMS’, but our North American distributors do.

At this point, what we are kind of blaming it on is that distributors are being pretty cautious about their inventories, and because there has not been enough time gone by to show any surge in resale, there could be things like EMS, but generically speaking, it is hard to pin it down to any one item. We do know that in Q1, Asia and North America Disti regions were relatively more cautious than Europe was.

Operator

Your next question comes from Chris Caso of Friedman, Billings. Please go ahead.

Chris Caso - Friedman, Billings, Ramsey & Co.

Thank you. I wonder if you could follow up on some of the comments you had with regard to the end-markets. You made some comments, for example, on the LCD market where you thought that the inventory that was in there was burning off, I suppose. Maybe it is independent of some of the distribution issues, kind of what you are seeing for end-markets for the year relative to typical seasonality.

Brian Halla

I will let Donnie put the parentheses on it, but just to start out, the flat panel display comment that Donnie made, of course, if they have inventory that they are trying to flush out on one hand, we will see a dip in their demand on us for these parts. On the other hand, the way they flush that inventory is to reduce prices, and the more they reduce the prices for flat panels, as long as we can take a brave pill and hold ours, that is obviously very good for us going forward. We are pretty happy about that.

In terms of some of the other products, obviously it is not just cell phones that are portable and handheld. We have seen a lot of new announcements and we are happy to be a part of a lot of those new announcements. I will turn it over to Donnie.

Don Macleod

The two markets that we are closest to, mobile phones and displays, I think we have covered but the key I think is the way we look at the markets from a product perspective. In other words, what we are shipping. If we look at our broad, standard linear business in the quarter, it held up over the fourth quarter and we did, as I said earlier, we did have a slightly positive book-to-bill ratio in that broad, analog business. That includes, by the way, our distributor activities, which do go to these very dissipated customers around the world.

I would say frankly that we see good conditions in those markets in general. What we are talking about in this call is more or less two specific issues. One, the mobile phone activity and the other being the distribution channel from a, if you want, from a channel management point of view rather than the end demand. Our distributors did turn a little bit cautious at the end of the quarter in the Americas and Asia, as Lewis mentioned. But for example, our distributors in Europe had a good summer, a better summer than they planned and they are looking forward to good conditions going forward.

I do not think we are looking at markets from a half-empty perspective here at all. It is really specifics that have topics that relate to our sales decline over the second quarter.

Chris Caso - Friedman, Billings, Ramsey & Co.

Okay, just as a follow-up, I know you guys are aware of the history in the last cycle back in ’04, where things did wind up worse than you expected at about this time in the calendar. Can you compare what you are seeing now, perhaps what some of the differences may be to 2004, which may give you a little more confidence in the visibility? Or maybe the answer is it is about the same.

Lewis Chew

At least I will give you credit for being diplomatic about that.

First of all, the thing I would point out there is we try to learn from our history, not hide from it, so to remind everyone on the call in ’04, we came into that quarter and we ended up down 18%.

This time around, what is different? The first thing that is different is what I mentioned about the Disti inventories. Disti inventories are two to three weeks less than they were back then, and that is a combination from both the actual inventory being lower and the ongoing rate of resales, not just this quarter because this quarter was actually a down quarter, being higher because the market has grown. So that is one big factor.

Two, lead times -- our lead times, which we did not mention on this call because it is no longer a topic of any relevance, has hung in the six-week range based on an 85% performance, which is very consistent with the last couple of quarters.

In the ’04 cycle we, as well as many of the other chip companies out there, had lead times stretching out well into the double-digits, which then have the propensity to cause more so-called double-ordering or whatever, which ends up in some of these abnormal backlog adjustments that Adam asked about earlier.

Those are three factual data points I will give you that is different. It does not mean it will not happen but we have looked at all those numbers. I hope we feel like we have not ignored what happened in ’04, and we have done a lot leading up to this quarter to try to manage that, even though there is going to be cyclicality.

Like Don said, the broad market that we serve, which makes up now probably more than half of the company, was pretty stable from Q4 to Q1, and we do not see a lot of signs that there will be a huge drop-off on that market area in Q2.

Right now, what we are dealing with is some of the softness that we have in our handset demand and also these distributor adjustments. That is how I would hopefully not sound defensive in addressing now versus ’04.

Chris Caso - Friedman, Billings, Ramsey & Co.

Just one final one, related to what you said with regard to the OEM inventories. We talked a lot about the distributor inventory. Give us some color on what you think your OEM customers may be doing. Is it maybe taking some of the same actions as the distributors, or perhaps just keeping the inventory more flat?

Lewis Chew

I will start it and let Don finish it. As you guys all probably know, the OEMs do not report their inventories to us like distributors do. However, I would say that part of what impacted us in the Q1 we just finished were actually some inventory adjustments, but certainly they were not as severe as what we saw back in ’04. Heading into the Q2 timeframe, we certainly are not getting any indications from our OEM customers that they need to burn inventory. The one area that always seems to pop up is the flat panel display, but I think Brian already put that one to bed.

Chris Caso - Friedman, Billings, Ramsey & Co.

Great. Thank you.

Operator

Your next question comes from Ross Seymore of Deutsche Banc. Please go ahead.

Ross Seymore - Deutsche Banc

A question on the utilization and the impact on the gross margin. If I look at going from May to August, your utilization is dropping by about 10 points. You said your foundry revenue has dropped by about $10 million. If I look August to November, both the foundry revenues are going to drop more and the utilization is going to drop less. I would have thought the negative impact on gross margin would have been greater in the May to August timeframe, given those two metrics and how they were shifting. Can you explain to me why that gross margin change is occurring at the time it is?

Lewis Chew

I think what is embedded in all of that, Ross, that we try to allude to is we feel as a company, we are continuing to make very good strides on the underlying core portfolio of the company. You have two factors going on. Our utilization is dropping and our revenue is dropping, which of course has less cost coverage, but the portfolio continues to advance. Don already in his prepared comments made several indications of where ASP was climbing.

I think what we have going on right now is the natural question that is going to follow is, okay, you guys are going to be down below 70% utilization. Going forward, should we still expect fall-through gross margin in the 70s? I would say absolutely. At below 70% utilization, if we can keep margins above 60%, that is a real big achievement for this company. Then we will have clear space to sell this high-performance analog stuff. You know we are trying to clear this foundry revenue out anyway. That is low margin stuff.

I cannot specifically reconcile for you the decline metrics from May until now, but suffice it to say that embedded in all that is all the portfolio goodness that we have going on.

Ross Seymore - Deutsche Banc

I guess as a follow-up on that, the goodness should have been occurring in both times, and the badness, from a mix point of view, is actually going away, because the foundry is going down. If the only metric that really changes from one quarter to the next is the utilization rate, then the fact that your utilization is dropping less going into November than it did heading into August, I am still kind of confused. I guess there is no good answer to that.

Lewis Chew

The other thing too is that you are probably using my GAAP numbers, and if you did not notice, I do not want to hide behind this, but we also have a bigger impact this quarter from stock-comp expense than we had last quarter. So the stock-comp expense in the Q1 number was only $2.5 million, and the number that is going to hit us in cost of goods sold in Q2 is more like $6 million to $7 million. That is costing us a point right there. We are not hiding behind that. The 60% margin includes that.

Ross Seymore - Deutsche Banc

Okay, fair enough. The one follow-up, Donnie talked about the ASPs getting better in your business, and that is clearly a nice positive for your overall gross margin. The two-part question to that would be how long do you think you can continue to get the ASPs to improve before you really need to get the unit growth to start? I guess the math would be if your ASPs were up 18% year over year in standard analog, that would mean somewhere around a 7% drop in the units that you shipped. When do you think that unit side actually starts to grow as well?

Don Macleod

You have the numbers exactly right. The units, this year’s first quarter versus last year’s were actually down 7%, and ASPs were up 18%.

The question you are asking also alludes to the fact that you are suggesting our ASP increase will start slowing down over time. The ASP increase is a portfolio exercise. What we are doing over time is substituting older products with newer products with newer, higher ASPs.

Clearly at the end of the day, we are looking to improve the complexity of those products to help us reach our higher ASPs, so the dynamic in our manufacturing processes is actually the way we move to more and more differentiated proprietary analog wafer fab processes that allow us to get this higher performance and higher ASP.

The dialog we are having in our wafer fabs is one that I talk often about, which is focusing the factories on value, not volume. That value comes from complex processing. For example, as we move into precision amplifiers, our back-end needs to focus on tri-temp testing, whereas before we just did single temp-testing, and obviously we moved more units through the testing process.

The complexity factor is the one we are addressing. Obviously at the same time, Lewis mentioned our Texas upgrade to 8 inches, which adds the cost improvement factors, which is a continuous fact of life in our equation.

Our units are down and we want those units to be down and we want to earn more higher ASP for each unit that we sell.

Ross Seymore - Deutsche Banc

Overall, I think that is a great trade-off. I am just kind of wondering that mix equation, where you are improving it in your overall portfolio, now that heading into November, it looks like your standard analog business should be up well north of 80% of your total sales, or somewhere in that range. Is it just that remaining 20% that is the opportunity to improve the mix, or is there within that 80%, a mix shift up potential as well?

Don Macleod

You made the point about our standard analog business being -- standard linear business being up over 80%. As I said, it was 82% were bookings in the quarter. Mathematically, if you just look at the foundry business that we are getting out of, that has gone from 6% of our revenues to potentially 2% or so of our revenues as we move into the next quarter, so that alone gets us to a point where 80% of our business is the good stuff, the standard linear portion.

Within the rest of our portfolio, we have a very clear-cut set of direction. It is get the ASPs and the margins up or kill the products. In those areas, we are obviously working also on improving the value of those, but the focus is on the 80% of goodness and getting that number up to 80% and 90% over time.

Lewis Chew

Although I usually cannot improve at all on anything that Don says, one thing I would point out is that in the last couple of years, we have been very open about increasing the number of new products released each year, and everyone out there who studies this area knows that there is a bit of a longer tail in standard linear, but we absolutely think strategically over the next couple of years, that as we work through this part of the transition that you are focused on, we will see and should see unit growth, even at the higher ASP, because that usually follows these new product releases.

We do know that, for example, in fiscal ‘06, our new product releases, which was heavily focused on standard linear, was up significantly over FY05. That is the kind of longer term comment.

Operator

Your next question comes from Joseph Osha of Merrill Lynch. Please go ahead.

Joseph Osha - Merrill Lynch

Two questions. First, I am trying to figure out, pretty clearly you were over-producing, if you will, coming into this quarter, and now you are under-producing. What is the normalized gross margin that this business is operating at right now? Is 60.5% to 61% a reasonable number, if we leave out all -- just sort of forecasting utilization?

Lewis Chew

You want that number inclusive of stock-option expenses?

Joseph Osha - Merrill Lynch

Yes, I am a GAAP guy.

Lewis Chew

I thought you were going to say that. Okay, yes, I think right now, our utilization, if you want to think of normal utilization being 75 to 80, than I think our margins are somewhere in the low- to mid-60s.

I think right now, the quarter that we are in, we are going to drop utilization to below 70 and burn inventory, so again, that has a dampening effect on margins, as Ross was so kind to point out.

You know that we have this -- let’s call it near-term goal, Joe, to get our margins to 65%, and we know for a fact that our standard linear portfolio drives a margin of at least that number, and it is our job to get more revenue from standard linear as we move up in this old stuff, so I think we would want to stick to this goal of 65. If you want to view a normalized number right now, it is slightly below that because of options, and I am fine with that.

Joseph Osha - Merrill Lynch

I was just trying to get a sense as to how you normalized your leaving out this supply chain investment, or this inventory adjustment, more properly.

Second question then, sorry, I would’ve thought we would have touched on this -- how have bookings so far this quarter compared with what you saw through August?

Lewis Chew

First of all, let me tell you what we did see in August, is we expected more of a pick-up in bookings than we got. Right now, I would say that the bookings rate for the first seven days of this quarter is probably running about the same. That does not surprise us, because there is nothing particularly notable about this week versus last week, except that this is the week we had to release earnings.

I think right now, Joe, with lead times being relatively short, and with distributors being cautious on inventory, that we are probably going to have to work our way through September to get a better view on what is really going to happen for the so-called Christmas season.

Long Ly

Operator, at this time, we will take one more question.

Operator

Your last question comes from Simona Jankowski of Goldman Sachs. Please go ahead.

Simona Jankowski - Goldman Sachs & Co

Thank you. I was just wondering, as far as your production goes, how low would you be comfortable with having your inventory go, in terms of days before you think that it is prudent to ramp it up again, and at what utilization do you think that low point would be?

Lewis Chew

Let me again use history as a metric. In this last cycle, which was only over this last two years leading up to a couple of quarters ago, our days of inventory got as low as 63, and we will clearly say that that was substantially too low. We had significant delinquencies at that level and we had a very difficult time meeting our delivery metrics that are more of an internal problem.

I would say right now as a company, that even though I used to say that we ran in the 65 to 75 day range, it would seem to me that it is not a stretch to think that we should operate more in a 70 to 80 day type of range. We are still working that number because our product portfolio is expanding, so we want to make sure we have the right mix of dye and all those kinds of things that you know affect linear companies.

I do not think that we are going to try to burn inventory down to 63 days this time around. Even in that last cycle, we never had any write-offs of inventory that we had to throw away. It just caused a big [protivation] in the manufacturing organizations, which they absolutely hate.

I think what we are going to do is try to bring inventory down a little bit this quarter and maybe bring it down a little more after that, but we are not going to try to burn off $30 million a quarter.

Simona Jankowski - Goldman Sachs & Co

Thank you. Then, just one other question. On the gross margin impact and then benefit from the shut-down of the Singapore assembly and tech facility, is the full run-rate of that benefit going to be now starting in the second quarter? How did that play out for the first fiscal quarter? Was the ramp-up cost smaller than the benefit?

Lewis Chew

Actually, I would say that beginning the start of Q2, whatever benefit that we yield from Singapore, which we do believe was the benefit we originally set out to get, is in our numbers. As part of an offset to that, this project that we have going on to convert some capacity in Texas is costing us some dollars as well. We have not broken that out specifically, but it is soaking up a portion of those savings we would get from Singapore. Once that activity is done, which is not for another several quarters, we might get anywhere from a half to three-quarters of a point benefit based on today’s sales from that activity going away, because obviously those are not forever costs.

Long Ly

With that, we are going to end our call. Let me remind you that the replay is available on our website. Thank you.

Operator

This concludes today’s National Semiconductor conference call. You may now disconnect.

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Source: National Semiconductor F1Q07 (Qtr End 08/27/06) Earnings Call Transcript (NSM)
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