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Semtech Corporation (NASDAQ:SMTC)

F3Q10 Earnings Call

November 18, 2009; 05:00 pm ET

Executives

Emeka Chukwu - Vice President, Chief Financial Officer

Mohan Maheswaran - President, Chief Executive Officer

Chris Rogers - Director FD&A, Investor Relations

Analysts

Harsh Kumar - Morgan Keegan

Rick Schafer - Oppenheimer

Li-Wen Zhang - Pacific Crest

Steven Smigie - Raymond James

Ian Ing - Broadpoint Amtech

James Snyder - Goldman Sachs

Craig Ellis - Caris & Company

David Wu - GC Research

Harsh Kumar - Morgan Keegan

Operator

Good afternoon, my name is Courtney and I will be your conference operator today. At this time I would like to welcome everyone to the Q3 FY10 Sematech Corporation earnings release conference call. (Operator Instructions)

Thank you Mr. Chris Rogers, you may begin your conference.

Chris Rogers

Thank you Courtney and welcome to our fiscal year 2010 third quarter conference call. We have just issued our press releases announcing our unaudited results for our third quarter ending October 25, 2009, and the acquisition of Sierra Monolithics Inc. A copy of our press release is available on our website, www.semtech.com as well as national news and financial market wires. A replay of this call will also be available on the investor relations section of our website through December 18.

During this call, Mohan Maheswaran, Semtech’s President and Chief Executive Officer and Emeka Chukwu, our Chief Financial Officer will be discussing our news and answering your questions. Our call today will include forward-looking statements that include risks and uncertainties that could cause actual results to differ materially from those made during this call.

We encourage you to review the Safe Harbor statements included in today’s press releases as well as other risk factors noted in Semtech’s most recent periodic reporting documents on Forms 10-Q and 10-K filed with the SEC for more detailed discussions.

Also during this call we may refer to pro forma or other financial measures that are not prepared according to generally accepted accounting principles. In conjunction, we have provided supplemental information in our third quarter results press release to help readers understand the company’s comparable financial performance between periods.

Thanks for your attention to this important preliminary information. I will now turn the call over to Emeka Chukwu, Semtech’s CFO.

Emeka Chukwu

Thank you Chris and good afternoon everyone. In my prepared remarks I would discuss our Q3 financial performance, our Q4 outlook and we conclude with more details on this Sierra Monolithics or SMI acquisition that was announced this afternoon.

Revenues for the third quarter of fiscal 2010 were $75.1 million, a 13% sequential increase and down 6% from the same quarter last year. In the third quarter, 61% of our revenues were derived from customers in Asia, 23% from North America and 16% from Europe.

Direct service represented approximately 51% of total revenues while distribution led up to 49% of total revenues. Our GAAP net loss for the quarter was $20.9 million or $0.34 per share down from net income of $11.5 million or $0.19 per share for the same quarter last year and net income of $7.4 million or $0.12 per share for the second quarter of 2010.

It is important to note that our GAAP net loss for the quarter incorporates a one time tax expense of approximately $33 million related to the decision to repurchase foreign based for funding the SMI transaction. Although the SMI transaction is being announced now in our Q4, the transaction does result in a one time tax expense that we retroactively incurred in Q3. Excluding this one time tax expense, our GAAP net income would have been $11.9 million or $0.19 per share.

Bookings were up sequentially in Q3 driving a positive book to bill for the quarter. We saw increases in all end markets. Net trans orders accounted for 41% of shipments during the quarter. In the third quarter, especially related to equity based compensation were $4.1 million or 5% of revenue. This is a decrease of approximately $900,000 from the second quarter of fiscal 2010.

This sequential decrease was due to a revaluation of our WARs accounted for liabilities and a through up for future assumptions. In Q3, due to an increase in activity related to our ongoing stock option matters we incurred approximately $1.1 million of legal expenses compared to a net benefit of $327,000 in Q2.

GAAP gross margin for the third quarter of fiscal 2010 was sequentially up by 60 basis points to 55.1% driven by increased revenue for higher gross margin products from our advanced communication on sensing and power management product groups. GAAP SG&A expenses were $18.5 million for the quarter or 25% of revenue, an increase of $1.8 million from the second quarter of fiscal 2010.

This increase was driven by the termination of the company’s mandatory time off, higher litigation expenses and higher selling cost partially offset by lower equity compensation. GAAP research and development expenses were $10.5 million for the quarter or 14% of revenue down $100,000 from $10.6 million in Q2 due to lower equity compensation expense.

Interest and other income was $1.1 million in the third quarter compared to $300,000 in the second quarter of fiscal 2010 reflecting the receipt of $827,000 in settlement of our property insurance claim for the relevance of fire incident. Our business interruption claim related to the relevance of fire remains our spending.

Our GAAP tax rate in the third quarter was 258% compared to 15.7% in Q2 reflecting the tax impact on the use of our foreign cash to fund the acquisition of SMI. Excluding this one time tax expense our tax rate in the third quarter would have been 9.6% because of a favorable regional mix of income. The diluted share count for Q3 was 61 million shares.

Moving on to the balance sheet. In Q3, we generated approximately $23.3 million in cash from operations which is 31% of revenue and ended the quarter with approximately $316 million of cash and investments. In Q3, more repurchases were made on the 2008 stock repurchase program. We have $15 million left on the 2008 stock repurchase program.

The company spent approximately $3.8 million on property plant and equipment in Q3. Depreciation and amortization for the third quarter was approximately $1.7 million including $302,000 of intangibles amortization.

Accounts receivable was flat from Q2 and days sales outstanding decreased to 31 days from 34 last quarter. Net inventory decreased by $1.2 million or 5% in the third quarter as compared to Q2, and the days of inventory decreased to 70 days from 80 days in Q2. We expect inventories to be approximately flat in Q4.

Inventory at our distribution partners declined approximately $900,000 or 3% from Q2. Channels days of inventory declined to 72 days from 79 days in Q2. We are pleased with both our internal and channel inventory positions.

Now to our Q4 outlook. A quick reminder that our fourth quarter of fiscal 2010 will be a 14-week quarter. Also, this outlook excludes any financial results associated with the SMI acquisition.

Typically, our Q4 demand is softer than Q3 demand. Due to the strong bookings that we saw in Q3, which has continued into the fourth quarter and also due to the impact of the extra week, we expect our fourth quarter revenue to be sequentially flat to up 4%. To achieve the mid point of this guidance of up 2% we needed net sales orders of approximately 39% at the beginning of the quarter.

In the fourth quarter of fiscal 2010 we expect the GAAP net income of $0.15 to $0.17 per diluted share. GAAP gross margin is expected to be sequentially flat to up 40 basis points due to projected favorable mix of higher communications revenue and lower computing revenue. We expect GAAP SG&A expenses of $20 million, an increase of $1.5 million because of the extra week and legal and accounting expenses associated with the SMI acquisition.

GAAP R&D expenses of $11.2 million are expected in the fourth quarter. These sequential increase of $700,000 is due primarily due to the impact of the extra week and new product expenses.

Equity compensation expense is expected to be approximately $4.7 million broken down as follows. $250,000 in manufacturing, $3.2 million in SG&A and $1.2 million in R&D. The sequential increase of $600,000 is primarily due to the impact of the extra week. We expect stock option with related legal expenses of approximately $800,000 in the fourth quarter of fiscal 2010, a decrease of $200,000 from Q3.

We expect interest and other income of approximately $300,000 in Q4. Our GAAP tax rate is expected to be approximately 14% for the fourth quarter. As a reminder these rates can be affected by several factors including the original mix of income, fluctuations in foreign exchange rates and ability to utilize past credits.

We expect diluted weighted average share outstanding of 62.2 million shares in the fourth quarter of fiscal 2010. In the fourth quarter of fiscal 2010 we expect capital spending to be approximately $3 million to support a ramp up of new products and various new process and package developments. Depreciation should be approximately $1.8 million and amortization of intangibles would be $302,000 in the fourth quarter of fiscal 2010.

Now, turning to the details of the SMI acquisition. On the terms of the agreements Semtech will pay the stockholders of SMI $180 million in cash. Semtech will also assume the existing uninvested options of SMI employees valued at approximately $8 million and grant additional equity incentives of up to $12 million to employees at closing.

In order to meet any indemnifiable claims are specified in the definitive agreements $18 million would be placed in escrow for 12 months. We expect to incur an additional $2.5 million in transaction fees upon close of the acquisition. We expect to fund the acquisition with our existing cash and investment reserves in association with bringing back a portion of our overseas cash to fund the transaction, we took a one time tax provision of approximately $33 million in Q3.

In connection with this transaction we explored broad range of financing alternatives and concluded that even with this one time tax expires utilizing our existing cash represented the most attractive financial outcome for Semtech. After the transaction closing Semtech would return approximately $130 million of cash and investments. Given the profitability and load capital intensity of our business we are constant that this amount is sufficient to run our business going forward.

We expect SMI to positively contribute to Semtech’s financial profile in terms of revenue growth, gross margin and earnings per share. SMI who has given out a compounded rate of over 40% in the past five years especially generates revenue of approximately $15 million in calendar year 2009 we expect the SMI business to grow 20% to 30% in calendar year 2010 largely driven by growth in demand for 4G and 100G technology. The gross margin is currently in the needs to the high end of Sensex gross margin target of 55% to 60%.

Factoring in SMI’s current quarterly operating expense run rate of have $6 to $7 million and our expectations of 22% to 25% non-GAAP tax rate we expect the transaction to be immediately accretive to Semtech’s non-GAAP earnings per share. Based on an expected GAAP tax rate of 18% to 21% we expect the transaction to be accretive to a GAAP earnings per share within 12 months.

In summary, we had an excellent Q3. We grew revenue 13% sequentially, we expanded GAAP gross margin 60 basis point sequentially and a 160 basis points on a year over year basis. We continue to demonstrate the leverage in our model by agreeing operative income 42% sequentially. We generated $19.5 million or 26% of revenue in free cash flow with our demonstrated ability to grow organically we are excited about this future with the acquisition of Sierra Monolithics.

I will now hand the call over to Mohan.

Mohan Maheswaran

Thank you, Emeka. Good afternoon everyone. I will discuss our Q3 fiscal 2010 performance by end market and by product group and then discuss our acquisition of Sierra Monolithics which we announce today shortly before our Q3 earnings results.

Q3 of fiscal year 2010 is another really strong quarter for Semtech. We achieved net revenues of $75.1 million this is above the high end of our revenue guidance and represents a 13% sequential increase versus Q2 of fiscal year 2010. We also increased our GAAP gross margins to 55.1%.

In Q3, revenues from communications increased and represented approximately 21% of revenues. High end consumer revenues increased and represented 43% of revenues industrial revenues were down and represented approximately 20% of revenues while computing revenues increased and represented approximately 16% of revenues.

As we anticipated, we saw seasonal increases in our consumer and computing businesses and there was relative strength from the communications segment. The industrial segment was softer in Q3 due mostly to softness from the military and aerospace segments within our power discreet business in North America.

Now, let me discuss the performance of each of our product groups in Q3. In Q3 our power management revenues increased sequentially by 20%. Strength in our power management business was driven by all end markets with computing and high end consumer segments exhibiting the strongest growth. We continue to make very good progress in reinventing our power management business to become a more diverse business with the revenue contributions from all major market segments and with higher overall gross margins.

We are very encouraged by the quality of some of our new product platforms and attraction of these new platforms and customers in all geographies. For example, we recently announced a new tiny LED backlighting driver platform for handheld backlighting systems and we already have good design win traction from this new platform.

We also announced a new synchronous buck regulated platform targeted at the high efficiency low EMI applications. This new platform is also doing quite well from a design win standpoint in the computer peripheral and communication segments. We expect our power management revenues to be approximately flat in Q4.

In Q3 our protection revenues increased sequentially by 16%. Demand for our protection products remained strong in the quarter driven mostly by the high end consumer, communications infrastructure and computing segments. The increase in demand by our protection devices is being driven by the increase in the number of ports requiring protection, increasing performance requirements of these ports and the increase in system returns our customers are facing due to unprotected systems.

Our protection business unit continues to execute quite superbly and we are really encouraged by the design win momentum of our protection products across all our target end markets in all regions. In Q3, we extended our high performance protection platform targeted at 2.50 systems. These new proprietary protection devices are designed for high end smart phones using 65 nanometer base chip sets.

In Q3, we also released our next generation proprietary high end protection process technology. This new process enables us to design and build ultra small home factor protection devices with extremely low capacitance and extremely low leakage. We will begin volume shipments of products based on this advanced process in Q4. In Q4 we expect our protection revenues to increase modestly.

Our power discrete revenues were down approximately 31% sequentially in Q3 as the military and aerospace segment continues to remain very soft. This result was disappointing as we had anticipated some modest recovery in these markets. In Q3 while revenues were disappointing we started to see a modest improvement in orders.

Our high reliability power discrete business is driven by demand from the aerospace military, industrial and high end medical markets. Our main focus areas in the power discrete business are accelerating the release of new products that expand SAN and be improving on the supply throughput of our Janus space products as we improve our fab yields. Our fab yields are improving nicely and should be back to optimum levels by the end of this quarter.

In Q4 we expect our power discrete revenues to be approximately flat. Revenue for the advance communication and sensing business increased 27% sequentially. Strength in this business was driven by both the communication segment and the industrial segment. Specifically, revenues from our new top sync timing synchronization platform reached a new record and revenues from new industrial wireless platforms and existing medical platforms, resulted in a very strong quarter for our advanced comp and sensing business.

Our advanced communication and sensing business continues to do very well from a new platform execution, design win and booking standpoint. In Q3, bookings of our advanced communication infrastructure products reached another record high driven by momentum in the 3G, 4G LTE and WiMax infrastructure segments. We are seeing very good momentum at all major infrastructure OEMs as they deploy new IP back hole and multi standard access base station solutions.

Also in Q3 we continue to see very good design win traction of our new RF platforms in the energy harvesting, security and home automation sub segments as well as some new emerging applications in consumer segments. We also recently announced our first consumer analog touch screen sensing platform targeted at consumer and industrial resisted touch controller applications.

Semtech’s new touch screen platform is an ultra low power small formed factor high EST platform that leverages several of the competences we have in the company. We believe the addition of touch screen platforms to our portfolio will enhance that portfolio sell at both our consumer computing and our industrial customers. We already had design wins from our new touch screen platform that should generate revenues early in fiscal year 2011.

In Q4, we expect revenues from our advanced communications and sensing business to increase modestly. From a distribution POS standpoint in Q3 we saw total POS increased by approximately 6% driven mostly by Asia. Distributor inventory was down again in Q2 from 79 days to 72 days. We believe that our channel inventory is at the levels necessary to appropriately support our customers as we entered Q4 with a positive book to bill and a positive demand outlook.

Moving on to new products and design wins. In Q2, we released nine new products and recorded over 668 new design wins and we were pleased with both these results. We believe that we are uniquely positioned to benefit from many fast growing segments and we do expect to see a continuation of the strong design win momentum within these segments as we bring out new leadership platforms in Q4.

Now, let me comment on our acquisition of Sierra Monolithics. Today we entered into a definitive agreement to acquire Sierra Monolithics. I call my colleagues on Semtech’s board and Semtech senior management team I am extremely pleased be entering into this important and exciting transaction for many reasons some of which I would discuss on this call.

Sierra Monolithics or SMI as I shall refer to for the rest of this call, is leader in 40 gigabit per second and 100 gigabit per second devices sold into the communications infrastructure market and is a recognized leader in the design and development of RF, microwave and millimeter wave communications technologies for multiple emerging applications.

Headquartered in Irvine, Southern California with design centers in Irvine and Redondo Beach, California we believe that SMI is an extremely good pitch strategically, culturally and geographically and financially with Semtech. We are very excited by both the short term and long term opportunities that the acquisition brings to Semtech.

SMI’s 40 gigabit per second service product portfolio includes multiple chip sets which address all the major 40 gigabit per second modulation schemes currently being deployed worldwide. These leadership products have enabled Sierra Monolithics to become a key supplier to almost all of the major telecom OEMs and optical module customers offering 40 gigabit per second solutions.

Following up on a success in the 40 gigabits per second SiGe’s arena SMI was also the first semiconductor company to provide both client side as well as line side a 100 gigabit per second SiGe’s chipsets for the emerging 100 gigabit per second telecom and datacom markets.

In addition, SMI leverages its expertise in high frequency wireless technologies and protocols to deliver wireless solutions for high performance, high performance military and wireless networking applications. We believe that the market for 40 gigabit per second and 100 gigabit per second devices will continue to grow at a very rapid rate as both public and private networks look to increase their bandwidths to accommodate more voice, video and data traffic in both long haul and short reach applications.

SMI has experienced significant growth over the past few years fueled by rapid growth in traffic of the both wireline and wireless telecom networks. Future market growth drivers include growing video traffic over the internet, competition between cable operators and telecom carriers, emergence of data centers cloud computing and wireless data services.

Semtech will become one of the few semiconductor companies that operate portfolio technologies and platform that span sub one gigahertz ultra low power industrial wireless segment through the 1 gigahertz to 20 gigahertz RF and microwave communication segments and through the 20 gigahertz to 110 gigahertz millimeter wave communication segments.

The acquisition of Sierra Monolithics also brings to Semtech a treasure chest of intellectual property for microwave products targeted at the industrial segment and the communication segment. Most specifically the military commutation segment, industrial segment and the communications infrastructure segment, all these markets are attractive markets and fit well with Semtech’s current strategy.

This acquisition would be the largest in Semtech’s history and will significantly expand our competencies, our portfolio, our engineering talent and our SAN. The acquisition of Sierra Monolithics will create a uniquely differentiated company that has leadership position in several product categories with the opportunity to develop leadership positions in several more categories.

Once the transaction is closed Semtech will be a technology leader in high end protection platforms, in timing synchronization platforms and 40 gigabits and 100 gigabits per second SiGe’s platforms, in handheld vitality backlighting power management platforms, in ultra low power small form factor medical platforms, in ultra lower power industrial wireless platforms, in high bound with wireless solutions for the defense industry, and in high reliability power discrete devices to military, space, industrial and medical markets.

I believe that these leadership technology platforms in addition to Semtech’s overall broad portfolio high performance annual products position us well to outperform the market in the future.

The acquisition will also help us to achieve the following objectives price for the top line revenue growth with another high performance growth engine and accelerate that journey to $500 million and beyond. At a product line which will be immediately accretive to Semtech’s non-GAAP gross margins and accretive to Semtech’s non-GAAP earnings per share and that fits well with that current financial model.

As the product line targeted the communications core infrastructure high end routers, datacom and microwave communications for commercial and military applications increasing our overall communications and industrial content. Strengthen Semtech’s strategic value proposition to major OEMs in the communication infrastructure and industrial markets by offering our customers a broader range of products and a broader array of competencies we believe that cross technology selling opportunities will exist in addition to cross marketing opportunities.

And finally, brings into Semtech a team of highly talented engineers and executives. In total Sierra Monolithics will add approximately 60 engineers to the company, the Chairman of Sierra Monolithics, Charles Harper and the President and CEO Javed Patel will both join the Semtech leadership team reporting to me. Both executives are very strong additions to our management team and I’m personally delighted to have them both join us as well as the rest of their team.

As I have stated on previous conference calls, it is my belief that Semtech is executing very well as a company. And so, I believe the timing of this acquisition is very good for us. I also believe that due to the location, strategic fit and the cultural fit between the two companies that integration should be manageable and relatively fast and that we would drive solid execution of the combined companies in a relatively short time frame.

Finally, the combined company will have an even better end market balance than we have had previously with 27% of revenues coming from communications, 27% from industrial, 13% from computing and 33% from high end consumer. We believe this mix will allows us to continue to grow faster than our peers while continuing to expand gross and operating margins.

I will now hand the call back to the operator, and Chris and Emeka and I would be happy to answer questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Harsh Kumar - Morgan Keegan.

Harsh Kumar - Morgan Keegan

I have got two questions here; first of all, Mohan, from what I understand about your company, I think your OpEx structure is geared for I will call it $95 million to $110 million in revenues, what does this deal do for you from a leverage standpoint outside of the margin structure that Sierra Monolithic brings?

Mohan Maheswaran

It adds up about $50 million of top line revenue Harsh and I think the main thing that it does for us is it gives us access to our whole new set of spaces that we haven’t participated before. So it’s really a SAN expansion strategy and then obviously with the leadership position they have in 40 gig and 100 gig which are both very fast growing markets enables us really to drive further top line growth.

With that said I think there are opportunities to continue to expand gross margins. I think there is a fit both companies is very good as I mentioned on the call and I think with the balance of common industrial increasing I think that will help us from a portfolio standpoint as well. So, all of those should give us a little bit more opportunity to grow our earnings.

Harsh Kumar - Morgan Keegan

Just one more follow-up; your guidance Mohan at the mid point of up 2%, you’ve got an extra week which roughly is about call it 7% to 7.5% something like that. If I back out the extra week you are somewhat cautious or worse than seasonal this time around down about 5% to 6% call it. Is it just, when I look at your call, I mean business seems to be very good, what’s the reason for some sort of hold back calling on guidance.

Mohan Maheswaran

Well, let’s say Q4 is seasonally down for us Harsh, I mean consumer and computing are seasonally down. We do have the extra week but from a standpoint of seasonality I think the fact that we are guiding up tells you that actually our businesses are holding up quite well. We expect consumer probably to be flat or slightly up, computing to be probably slightly down, communications to be up and industrial to be up. So depending on how those play out I think our guidance is still very positive.

Operator

Your next question comes from Rick Schafer – Oppenheimer.

Rick Schafer - Oppenheimer

Just a quick follow-up on the SMI deal; just can you give an idea of expected timing when the deal ought to close and maybe back to our question a little bit, how accretive can you give us any kind of order of magnitude or just an idea I guess of how accretive the deal ought to be and how much of it depends on sort of cost reductions and efficiencies.

Mohan Maheswaran

The deal should close by the end of the year, certainly before the end of the calendar year is our expectation.

Emeka Chukwu

And Rick, so with regards to the accretion I think what we have stated is that on a non-GAAP basis excluding stock based compensation and cost of our intangibles that we expect the deal to be immediately accretive. We don’t have an exact number yet but it should be really accretive with regards to any sort of cost synergies at this point we have not really bagged in any synergies. SMI is an organization that runs pretty lean.

Any cost synergies that we would expect to see from an integration probably would be offset by spending to pursue additional revenue opportunities. So at this point we are expected to be accretive immediately on the non-GAAP basis without a lot of cost synergies.

Rick Schafer - Oppenheimer

Then second question just on sort of the military, defense side of the business. It seems to be again weighing on the industrial segment. I guess you gave some colors that orders had started to pickup there. Can you give any more color exactly what’s happened there, maybe describe sort of what you see in the channel there. I know that Channel seems also lean everywhere except maybe in the defense piece.

Mohan Maheswaran

I think that is most of it, Rick, channel is still pretty heavy with the military. I think with the change of administration there is a little bit, its not clear which programs are getting funded and which ones are not and some of the maybe the legacy programs are not being funded the same way as they were.

So a little bit of uncertainty there, but I think the good news is that we still see opportunity to expand our SAM, so, regardless of what goes in the market place I think that once we start to get the Janus space products out and start to get some of the new products out we should start to get back on a growth curve independent of the market.

Operator

Your next question comes from Li-Wen Zhang - Pacific Crest.

Li-Wen Zhang - Pacific Crest

My question is how about the lead times, currency lead time compared to historical, do you get any changes there?

Mohan Maheswaran

The orderly times are similar nothing really unusual there, supply lead times I would say are pretty consistent as well Li-Wen, I don’t think there is anything very different.

Li-Wen Zhang - Pacific Crest

And also, are there any changes in foundry outsourcing strategies?

Mohan Maheswaran

No, that strategy is still the same. We continue to use multiple foundry partners we don’t have our own manufacturing fab outside our power discrete business as you know and that continues to be the strategy. So we work very closely with our foundry partners and then develop leadership process technologies and continue to rely on them to support us through the ups and downs of the semiconductor industry.

Operator

Your next question comes from Steve Smigie - Raymond James.

Steven Smigie - Raymond James

Mohan when you put up on several nice quarters in the power management business how sustainable is that kind of growth, can you talk a little bit about a new platform that you might be having coming out in that area?

Mohan Maheswaran

Yes, power management business is doing quite well. The strategy has been come out with what’s more new product platforms, try to balance the business from being historically more computing centric to little bit more diverse, and we are seeing good traction there.

So I am pleased with the progress in the handheld space, I am pleased with the progress in the computer peripheral space I think consumer is doing quite well. So we have more and more platforms coming out and I think we will continue to see that as you watch the releases come out and we’ll see more and more products that are really differentiated power products for us I think we will continue to do quite well.

Steven Smigie - Raymond James

Great and then also in terms of overall communications and how you go to market, obviously, you had top sync product and some other comps products. How does that fit in with the selling of the new comps products, how does the sales force work together, can you talk a little bit about how that?

Mohan Maheswaran

Yes, that’s one of the beauties of this deal really is that, it really strengthens our portfolio to the type of customers that we have been seeing quite good traction on with that timing synchronization platform.

Also even the power and protection when we go into some of the major OEMs and we are protecting 10 gigabit Ethernet ports and providing the power solutions for some of these OEMs to be able to also provide 40 gig and 100 gig studies devices I think is a real win for us and then the other opportunity as we see it, as we start to talk with these OEM direct customers in terms of their strategies and where are the biggest integration opportunities I think the wireless plate for us, the very high end microwave wireless integration becomes a real key strategy for us.

Operator

Your next question comes from Douglas Freedman - Broadpoint Amtech.

Ian Ing - Broadpoint Amtech

Can you talk a little bit more about the customers that they are attracting now and also the potential customers they could gain once they become part of Semtech and perhaps more like a tier one supplier.

Mohan Maheswaran

Well, SMI has actually done a very good job in the communications infrastructure space, they really have very good penetration of a lot of the leading players there and also the module providers into that space. I think that actually they are going to benefit Semtech from that standpoint, the penetration of those customers.

I think where Semtech are going to bring more value to Sierra Monolithics is really on the broader wireless plate and also in the defense area. So, specifically the wireless area, we have a pretty good traction there with our tops and timing synchronization product for example and the ability to parlay some of the CRO technology into those customers I think is a good opportunity. Obviously I can’t mention any customers at this point.

Ian Ing - Broadpoint Amtech

Great and moving on to gross margin expansion opportunities I see that SMI is fabulous in using the SiGe process so should I assume there is like fairly limited manufacturing leverage there but these are going to remains of the tracks.

Mohan Maheswaran

Well, they have similar operations to us and they are a fabulous company. I think the opportunity is to bring some of the know-how and knowledge of building complex analog high volume products to Sierra Monolithics and to try to minimize costs. From that standpoint there is opportunity I think but their gross margins are actually better than ours. So I think at this point in time, I would say that the margin profile is probably the right profile for us going forward.

Operator

Your next question comes from James Snyder - Goldman Sachs.

James Snyder - Goldman Sachs

Mohan, maybe you could talk a little bit about what you are seeing in the industrial end market ex-military and aerospace section of that. Are you seeing that being strong again in Q4 and would you expect your distributors to again deplete inventory in the quarter?

Mohan Maheswaran

So Jim the industrial is strengthening outside the military space is definitely getting stronger and we do expect it to increase in Q4 also. And then the other part of the question was?

James Snyder - Goldman Sachs

Whether you expect to see to deplete inventory again in the quarter.

Mohan Maheswaran

Yes, I think POS was strong in Q3, I think POS is going to continue to be quite strong in Q4. So, but the days are kind of in line it was 72 days I think days of inventory is about right. If POS continues to increase then obviously they will probably have to start replenishing.

James Snyder - Goldman Sachs

Then maybe just a follow-up; just a detail on the OpEx for SMI. The $6 million of OpEx, would you expect that to - how does that split between SG&A and R&D and would you expect any efficiencies there?

Emeka Chukwu

Jim, this is Emeka, I think I’m not quite sure of the split between SG&A and R&D. But like I said before we do expect that obviously as we do the integration that there will be some efficiencies.

However, SMI really offers us a lot of revenue opportunities and we would be looking to have some discretionary spending in areas that will allow us to pursue higher revenue. So, what we are looking at, at this point is that we are not really expecting that much cost synergies from this transaction.

Operator

Your next question comes from Craig Ellis - Caris & Company.

Craig Ellis - Caris & Company

Mohan can you just provide some context how long have you guys known SMI or you are looking at other potential candidates in addition to SMI, fill out the picture a little bit for us.

Mohan Maheswaran

Yes. For some time I think I have been talking about how Semtech has gradually being improving its execution organically and I was comfortable that as an organic engine we have been doing very well. Focused now on the scale side, how do we grow the business and try to expand SAM, and that was really kind of the beginning of the process probably about 12-18 months ago.

We have set a very rigid very tough framework and you know has to be company that has unique competences and fast growing markets, extremely difficult products to develop, differentiate on process and analog design and packaging has to be a cultural fit, customer oriented, fast moving, value of the people assets, has to be able to fit our gross margin model and our operating margin model, has to be accretive on a non-GAAP basis fairly quickly, and on a GAAP basis within a reasonable timeframe 6 to 12 months, has to be able to strengthen our portfolio, location was important, and then really just end market balance bringing us a little bit more industrial consumer, sorry industrial and communication.

So I have been talking to SMI all over a year. We knew that they had been looking at potentially going IPO but I think they got very comfortable with us as a partnership, obviously they had to look at other alternatives. But when we started to really talk about the opportunities I think they felt and we felt that it was a very good fit for both companies.

Craig Ellis - Caris & Company

It seems like there is quite a few tail wind sequentially with gross margin at least a number on the mix side. So are there any headwinds given that the low end of the gross margin guidance is flat what could cause gross margins to be flat sequentially since mix should get better.

Emeka Chukwu

So, the conserve would have is although we expect mix to get better but you just never will know. You could see continued strength in the consumer business and maybe you even in the computing business. So, taking all of that into account obviously the gist of your question is that if the mix gets better as we would expect, our expectation is that we should come out at the higher end of the gross margin guidance.

Craig Ellis - Caris & Company

Okay that’s clear and then one last detail. On the cash balance, how much of that now is in the US versus outside the US?

Emeka Chukwu

Towards the end of our Q3 probably 25% to 30% was in the US and the balance is obviously what we’ve reported is that after transaction we expect to have about $130 million left and my estimation will be at that 40% of that will probably in the US.

Operator

Your next question comes from David Wu - GC Research.

David Wu - GC Research

Can you tell us who the top competitors are in the market, and also I am little curious about once the accounting thing is over in terms of, when do you think we could get accretive contribution from SMI? And the last thing I have was I am little bit confused, because Mohan you talked about the mix of the end markets after the SMI would come in, I assume SMI is all in communications and the 27, 27, 13, 33 show that SMI is only in comp, in some other businesses maybe you could me on that?

Mohan Maheswaran

Let me start with that David. So, SMI is both industrial and communications. So they have both communications products but also products that go into the military, we categorize those as industrial products. So the end market balance will be communications will be approximately 27%, industrial will be approximately 27% high-end consumable will be approximately 33% and computing will be approximately 13%.

So, then on from a competition standpoint on the optical side, its mostly internal basics, Mostly, the OEMs who choose to have their own internal developments is really the competition. Some module manufacturers also have their own chipsets. So that’s mostly the competition in the 40 gig and 100 gig space. In the wireless RS space its Maxim and Hittite and in the microwave space I would says its Hittite.

Emeka Chukwu

And so David with your questions to when we expect to get our accretive, I think I can lay it out this way. On a non-GAAP basis we expect the deal to be accretive upon closing. If you exclude the cost of intangibles our expectation is that the deal should be accretive within three to six months. Now on a full GAAP basis the expectation is that it should be accretive within 6 to 12 months.

David Wu - GC Research

Full GAAP.

Emeka Chukwu

Full GAAP within 6 to 12 months

David Wu - GC Research

Okay, I was wondering whether there is other than not going public were there other competing bidders for SMI. It looks like the numbers ought to be pretty attractive from a financial standpoint and they seem to be serving hot growing markets. So I was curious whether there were other competing bids in this spot?

Mohan Maheswaran

Yes, I’m sure they had `to weigh up the transaction with other versus Semtech. We know we want involved in a broad formal option, they did tell us that, but I have been in dialogue with SMI for quite some time and from the outset we kind of built a good understanding of where the opportunities were with each other and I think that was really important. But to answer your question I’m pretty sure they had to weigh up some opportunities without the company as part of the process that they would use, but we want part of a formal broader auction.

David Wu - GC Research

Okay, now I was curious because they are down in Orange County and around there, there is one big company with billions of dollars and they make a lot of acquisitions. I was curious how they - how did $180 million came about?

Mohan Maheswaran

Essentially you know it’s we have bankers and they have bankers and bankers token, that’s how we came up with the value.

Operator

(Operator Instructions) Your next question comes from Harsh Kumar - Morgan Keegan.

Harsh Kumar - Morgan Keegan

Guys, can you just give us some idea about the tax rate for the out year particularly with the two companies combining.

Emeka Chukwu

During my prepared remarks I did indicate that on a non-GAAP basis we do expect the tax rate to be somewhere between 22% and 25% and on a GAAP basis we expect it to be somewhere between 18% and 21%.

Operator

Your next question comes from David Wu - GC Research

David Wu - GC Research

On the GAAP basis do you assume the R&D tax credit in the US continues or do you assume that it expires.

Emeka Chukwu

We assume that it continues and there is no reason to assume otherwise at this point. Obviously that is an issue that is taken up every year, but at this point we assume that it continues.

David Wu - GC Research

Okay and SMI would not change the tax rate for the company right?

Emeka Chukwu

I don’t think SMI would change that significantly. One of the benefits that SMI business is going to have from the integration with us too is that they will be able to enjoy the benefits of our tax planning and structure. So, it’s more just the mix of the Arabian yield might be a little bit more on the domestic side, but we don’t expect the Arabian is to really impact our tax rate that much.

Operator

You have no further questions at this time.

Mohan Maheswaran

Let me summarize by saying that Q3 of FY10 was a very good quarter for Semtech. Revenues increased sequentially by 13% we were able to generate approximately 26% of revenues in free cash flow and increase that cash balance by $25 million to $316 million.

Our end market balance and traction from our new product platforms in all end markets are enabling us to continue to outperform that peer group and maintain the very resilient profit and cash generation model we have. We are very excited with this Sierra Monolithics acquisition and strongly believe that the additional product breadth and technology capability that this acquisition brings will enable us to continue on our growth journey to $500 million and beyond.

With that I would like to thank everyone for participating in our third quarter conference call and look forward to updating you all next quarter, thank you.

Operator

This concludes today’s conference call you may now disconnect.

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Source: Semtech Corporation F3Q10 (Qtr End 25/10/09) Earnings Call Transcript
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