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OmniVision Technologies (NASDAQ:OVTI)

F2Q10 Earnings Call

November 30, 2009 5:00 pm ET

Executives

Brian Dunn – Investor Relations

Shaw Hong – President, Chief Executive Officer

Ray Cisneros – Vice President Sales

Bruce Wyer – Vice President Marketing

Anson Chan – Chief Financial Officer

Analysts

Quinn Bolton – Needham & Company

Betsy Van Hees – Wedbush Morgan Securities

Harsh Kumar – Morgan Keegan

Analyst for Yair Reiner – Oppenheimer

Analyst for Tristan Gerra – Robert W. Baird

Operator

Welcome to the OmniVision Technologies earnings conference call for the fiscal second quarter of 2010. (Operator Instructions) I would now like to turn the presentation over to your host, Mr. Brian Dunn. Please proceed Sir.

Brian Dunn

Thank you. Good afternoon everyone and welcome to our fiscal 2010 second quarter earnings conference call. Just after the close of market today, OmniVision issued an earnings release reporting our financial results for our second fiscal quarter. You can access this release from the investor relations section of our website at ovt.com.

Please be advised that this call is being webcast live and is also being recorded for playback purposes. Both the live webcast and the replay can also be accessed from the investor relations section of our website.

Before we begin, we wish to remind you that certain information discussed in this call, in particular our revenues, earnings targets and our forward-looking product plans is based on information as of today November 30, 2009 and contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those set forth in such statements. During the presentation today, we will present important factors related to our business which may potentially affect those forward-looking statements. As a result, we caution you against placing undue reliance on those forward-looking which reflect our opinion only as of today’s date. For a discussion of these risks and uncertainties, you should review the forward-looking statements disclosure in the earnings release we issued to today as well as OmniVision’s SEC filings including our annual report on Form 10-K for fiscal 2009 and our quarterly reports on Form 10-Q and other reports filed with the SEC from time to time. As a reminder, we disclaim any obligation to update information contained in any forward-looking statement.

During this call we will discuss GAAP and non-GAAP financial measures, the latter of which excludes stock based compensation expenses and other charges that are driven primarily by discrete events that management does not consider to be directly related to our core operating performance such as a goodwill impairment charge in fiscal 2009. A reconciliation between the two is available in our earnings release posted on our website. With that, I will now turn the call over to OmniVision’s President and Chief Executive Officer, Mr. Shaw Hong.

Shaw Hong

Thank you Brian. I would like to welcome everyone who is participating in our call today. Joining me today are Anson Chan, our CFO; Ray Cisneros, our VP of Sales and Bruce Wyer, our VP of Marketing.

I will begin the call with an overview of our results for the quarter and then provide our thoughts on the overall status and trends we see in the image sensor market as well as our recent accomplishments and how we will continue to execute our strategic objectives. I will ask Ray to present an overview of sales activity and outlook followed by Bruce who will comment on our worldwide market opportunity and our project strategies. Finally, Anson will discuss in detail our financial results for the second fiscal quarter. Anson will also provide our outlook for the third quarter of fiscal 2010. We will conclude as usual by answering as many of your questions as time permits.

We are pleased to report fiscal 2010 second quarter revenues of $183 million representing sequential growth of 74% over last quarter. Gross margin also improved sequentially to 24% for the current quarter from 22.4% in the first quarter. We recorded GAAP net income of $8.1 million or $0.16 per diluted share while our non-GAAP net income totaled $14.3 million or $0.27 per diluted share. Our cash and short term investments at quarter end remained strong, increasing to $354 million.

In August we provided guidance that reflected our sense of cautious optimism we had in the emerging economic turnaround. Today we are [relieved] the quarter results that lend further support to our prior comments regarding our strategic direction and the market trends that we have observed.

The 74% increase in revenue we reported reflects both a recovery in our customer demand and our ability to rapidly scale our entire supply chain. This is underscored by our record second quarter $145 million unit sales. We continue to drive value growth across all our markets reflecting both the results of our design wins and the improvement in [inaudible] demand.

In particular, we are continuing to see an increase in [inaudible] and mobile phone and low cost manufacturers as they build inventory for the holidays. We remain focused on the development of key additional markets while aggressively pursuing attractive opportunities in our emerging product segments which offer the potential of above average returns. We continue to see a push for increased megapixel count in the higher end of the mobile format. This is particularly true in the Smart Phone category. In fact, strong sales activity in the Smart Phone market in particular in the 3 megapixel category, added to our revenue growth as we also recorded strong growth in the 2 megapixel market and in the entry level handset markets.

Both Ray and Bruce will provide further color on those current market developments in a few minutes.

These are the most important take-away’s in the quarter. In other words, while it is too early to assess just how these developments will transfer into long-term revenue trends order [this]. Our new order ability and design wins were very encouraging and generally in line with our cautious optimism regarding the continued general economic recovery. Throughout this entire time we have continued to invest in our technology and in our product portfolio of total image sensor technologies as well as in our supply chain while maintaining a strong and fiscally conservative financial position.

This financial position and the substantial operating cash flow have supported our ongoing commitment to advance every asset of these technologies. Our commitment to technology innovation has been guided by our understanding of the key trends shaping the image sensor market. We noted the last quarter several key trends including the increasing sophistication of consumer expectations. Coupled with this dynamic is the rapidly expanding number of mainframe applications which employ image sensor technologies to meet end customer demand in increasingly novel and unexpected directions.

The extension of [inaudible] products like netbooks and the mobile internet devices is [inaudible]. Recognizing the need for more complicated image solutions we have consistently directed our resources and efforts towards development of progressively more complex image sensor technologies and I believe we have well positioned ourselves in the market and are now recognized as a technology leader in our selected target markets.

Third, our automated [inaudible] technology continues to gain broad market acceptance due to its leading low light sensitivity. We are pleased to be able to say today that the CMOS technology now rivals the quality and the performance of [CCD]. Further we are the first company to commercialize the use of the BSI technology. Our continuous efforts to invest the very best in quality based on our BSI technology has led to ongoing investment in our key sensor sensitivity.

We are very excited about our recently announced 1.75 micron Omni BSI architecture that delivers the industry’s prime capture solution for high performance, streaming video applications. [inaudible] our assembly of Omni BSI was used on our first assembly of low [inaudible] architecture and offer the industry’s best low light image capture with excellent color reproduction and [inaudible]. Additionally, we are actively designing our second generation Omni BSI 2 pixel technologies while our competitors are still trying to deliver their first generation technology.

Finally, our introduction of the [inaudible] technology is a remarkable step forward in image processing. The CameraCube presented a complete camera structure which layers the image sensor, filter, lens cap and the packaging in one [large] grade

As such, it is the industry’s smallest camera solution and provides the [unit costs] through the elimination of components and commits a single supply chain that speeds time to market. Since we introduced our CameraCube six months ago we have gained substantial manufacturing experience that places us well ahead of our competition in understanding and in meeting our customer’s needs. However, we cannot stop with new technology advancement. We continue to [transmit] advanced new technologies into credible product solutions to meet the needs of our customers.

Our introduction and developing new products across the spectrum of solutions and end product markets support this strategic direction. I am confident that our broad range of products provides us a well balanced product portfolio. We are well positioned and we are prepared to take advantage of the many growth market opportunities. We do not develop our new products or technologies in a vacuum. Each of our efforts is delivered by our long-term market value strategy and that is to be the clear leader in each of our target markets with strong acceptation of revenue trends.

As [Roy] will discuss, this market strategy based on the defense of our historical area of strength and the pursuit of high growth market opportunities. It is the cornerstone to our product development efforts. Recently we have begun to develop and entire new class of products to address the needs of the emerging entertainment device market. Our products enable global media players with integrated high definition radio applications with audio and data [handsets]. This represents one of our fastest growing market segments, representing our marketing and sales efforts to further provide the markets that we serve with strong growth from the [circulating] digital still and video camera, medical and automotive segments as well as the emerging entertainment segment.

Before I turn the discussion over to Ray, I must emphasize that we will never rest on our past success. I am pleased to say that OmniVision has never been more recognized in the marketplace due in part to our increasing penetration of the Tier One consumer product first, the penetration of the emerging markets we serve and due to our broad portfolio of product offerings. I have personally never been more excited by the prospects for our company as we continue to pursue the opportunities of our own creation.

With that I will turn the call over to Ray who will provide an update on the quarter sales activity. Ray?

Ray Cisneros

Thank you Shaw. As Shaw mentioned, we are pleased with our second quarter results. All customers, regions and markets showed strength. Product splits are driving to a more balanced level. We have seen not only steady revenue growth this quarter and last in our major segments of handset and notebooks but we have seen exceptionally strong relative growth in our digital still camera, security and in new segment we will categorize as the entertainment market.

We are aiming to drive at balanced coverage and sales from the regional perspective. We are very pleased with our North American sales taking a prominent role in our revenue mix and we are very pleased with early inroads into the Japan market. Going forward our outlook is positive with continual gains and new design wins with key customers, products and applications.

In the second quarter we shipped approximately 145 million units at an average selling price of $1.27. This compares with approximately 75 million units shipped in the first quarter at an average selling price of $1.40. Sequential revenue growth was driven by our strong position in the Smart Phone handset market, mainstream handset market and notebook market. The sequential decline in ASP is the result of an exceptionally strong demand in the mainstream handset market that drove a revenue mix shift towards lower resolution products.

In the second quarter the 145 million units shipped was a historical high. This level of volume exemplifies OmniVision’s supply chain strength and its ability to react in the marketplace. In quarter-over-quarter trending, all product categories experienced significant growth. There were no exceptions.

In the second quarter unit sales of sensors 2 megapixel and higher was comparable to our first quarter, exceeding 20% of total shipments. Unit sales of 1.3 megapixel sensors were 10% of total shipments in the second quarter as compared to 15% in the prior quarter. Finally, unit sales of sensors that were VGA below increased to approximately 70% in the second quarter.

In terms of product markets, our mobile phone sales were up 75% quarter-over-quarter and represented slightly less than 60% of our revenues in the second quarter. Notebook and PC sales were also up approximately 30% quarter-over-quarter and totaled slightly over 20% of revenues in the quarter. Sales of our other emerging market products accounted for just under 20%, a significant growth due to the emergence of multimedia devices in the entertainment segment, strong seasonal activity in the DCS market and steady sales in the security market.

Within the mobile phone market we experienced a strong growth anticipated in the Smart Phone category plus an added boost in an exceptionally strong demand in the entry level mainframe segment. Several high profile customer Smart Phone devices carry the gamut of our ¼ inch three megapixel product line. The Smart Phone segment is proving to be a high growth category with consumers demanding the total value that features in Smart Phone devices provide.

Going forward, no 3 megapixel node holds steady in this category but our lineup of 5 megapixel products will ramp up quickly. We currently deliver our ¼ inch 5 megapixel to this market but our 1/3 inch 5 megapixel sensor has gained significant design win traction and significant shipments will ramp within the next two quarters.

In addition, 8 megapixel sensors which also serve the Smart Phone category have begun to ramp in the third quarter. The 5 megapixel and the 8 megapixel products mark a watershed point in that our Omni BSI technology will migrate into the handset market in significant volumes, a testament to our strategy of adding value to the end customer through exceptional imaging quality in small form factors.

In the mainstream, entry level category, exceptionally strong demand was driven by a continuation of the market expansion we believe began several quarters ago. The large manufacturing and engineering base in Asia is driving a change in the product and services landscape of this region. In addition to designing and manufacturing products for its own internal consumption it is now serving the larger OEM business model for global Tier One brands as well as exporting higher volumes of its own design and billed handset brands to the emerging countries such as India, Indonesia, Viet Nam and Brazil.

Not only did we ship record unit volumes of VGA products to China, but in fact we also shipped record volume levels of our 2 megapixel product line during the second quarter. Additionally, 3 megapixel and 5 megapixel sensors sold in increasingly higher volumes as products from this region are rapidly moving up the consumer value chain. Finally, this region also drove our camera chief start up sales into several Tier One brands for secondary camera applications and our demand is progressively increasingly.

Our next largest market is the PC notebook segment. We shipped a historical record high into this category in Q2 from our specialized VGA 1.3 megapixel, 2 megapixel and even 3 megapixel products. We continue to hold the largest market share in this area by continuously introducing higher value solutions. This market is quickly migrating to the multimedia needs of high definition formats and we are securing significant socket design wins with our new lineup of HD products for 720P or 1080P formats combined with leveraging our high sensitivity Omni and [Asis 3] and Omni BSI pixel architecture.

Revenues from all Tier One brands in North America, Taiwan and Japan contributed to our notebook business. In our emerging categories, several exciting trends are occurring. As mentioned last quarter we secured significant inroads into the Japanese market for digital video camera application using our 8 megapixel BSI product. This product is now on the market and has been well received. It has opened a door not only to the application category but also to the high value region of Japan. Our 5 megapixel BSI products have also secured multiple design wins in the digital still camera market and shipments began in the third quarter.

In the relatively new segment of multimedia devices under our entertainment market category we shipped significant volumes of the specialized VGA sensor. This segment is evolving rapidly and additional design wins have already been secured. Security drove a tangible portion of our revenue with shipments from our high sensitivity analog and digital VGA products. Going forward we are well positioned with new, specialized HD products for the emerging IP camera segment and the next generation analog products for penetration into the large CCTV segment. Several key design wins have been secured in this space.

In summary, we have executed in winning key customers and markets. We believe we are in a strong position with the right products and the right channels. We are confident in our outlook.

Shaw Hong

Thank you Ray. I would now like to turn the call over to Bruce who will discuss our technology and marketing efforts in more detail. Bruce?

Bruce Wyer

Thank you Shaw. There are three main topics I will be discussing today. First, our strong leadership position in providing CMOS sensors optimized for high definition video applications. Second, our continued focus on growing our baseline high line business. I will finish with recent successes we have seen within the emerging automotive and medical markets.

During the second quarter OmniVision introduced the OV2715, the 1080P high definition sensor optimized for the security market. This followed the September announcement of the OV2710, the 1080P sensor optimized for the notebook webcam market. OmniVision now offers our industry leading fourth native HD sensor, optimized for 720P and 1080P video applications. During the quarter we also announced that Microsoft had selected the OV9712, the native 27P sensor for their flagship Live Cam Cinema webcam product. Microsoft chose the sensor due to its best in class whole life performance and image quality.

Additionally, OmniVision’s recently announced 5 megapixel and 8 megapixel Omni BSI sensors are designed to support 720P and 1080P high definition video applications. OmniVision has established clear leadership in streaming video based markets including the notebook, netbook, webcam, automotive and security markets. We are now ideally positioned for a major transition to high definition sensors in the notebook, webcam, security, entertainment and next generation mobile phone markets.

Whereas, in high definition video represents the next big trend in the market, many mobile phone consumers are still without a camera. This is particularly true in China, India and in developing countries. In October OmniVision announced the OV7675 VGA sensor, designed to deliver optimized performance at a competitive price. The price and performance of this sensor makes it an ideal choice for the high growth Indian and Chinese markets. OmniVision is dedicated to retaining our volume leadership in the CMOS image sensor market. Maintaining a strong position in the VGA for 2 megapixel resolutions is a key part of our leadership strategy.

Another key strategy for the company is to establish strong leadership position in the emerging automotive and medical markets. In September OmniVision announced our image sensors had been selected by Altech Corporation, a leading Taiwanese imaging systems provider, for two emerging drivers for this application; 360 degree surround view and land departure warning systems. Their Eagle View vision system provides true 360 degree coverage of the area around the vehicle. Multiple OmniVision CMOS sensors provide real time imaging of the vehicle’s surroundings. The system also allows drivers to switch to rear view camera mode while reversing the vehicle.

Additionally, OmniVision automotive grade sensors mounted behind the windshield or rear view mirror continuously track rear view lane marking to monitor and warn the driver if they are drifting into adjacent lanes. Another exciting development for OmniVision is the participation in the advancement of medical procedures. In September announced that our ultra small OV6920 medical sensor was selected for ETView’s next generation medical intubation system. These tracheoscopic ventilation tubes provide oxygen to a patient’s lungs during medical procedures. The small diameter of the sensor and tubes provides patient comfort while offering real-time monitoring of the upper airways. With the emergence of disposable endoscopic procedures, the industry is reducing the transmission of infectious disease while reducing overall medical costs.

In summary, OmniVision is ideally positioned for the major transition to high definition sensors in the high line consumer markets. We continue to invest in the leadership solutions for the high volume China and India markets and anticipate strong growth in emerging applications for the security, automotive and medical markets.

Shaw Hong

Thank you Bruce. I will now turn the call over to Anson who will discuss our second quarter financial performance and provide guidance for our third fiscal quarter.

Anson Chan

Thank you Shaw and good afternoon everyone. As Shaw mentioned at the beginning of the call, revenues for the second quarter of fiscal 2010 were $183.3 million up 74% sequentially. Direct sales to OEMs and VARs accounted for 53% of revenues in the second quarter of fiscal 2010 and the remainder came from sales through our distributor channels.

Our second quarter gross margin was 24% which marked a further improvement from the 22% we reported in our first quarter fiscal 2010. Excluding stock based compensation expense of $624,000 included in cost of revenues, gross margin was 24.3%, up from 23.2% in the first quarter. The improvement in gross margin during the second quarter was a result of several factors. The primary driver was the further improvement in the production yield in some of our newer generation products. As this trend continues we expect to see a modest improvement in gross margin in our third quarter.

Increased production capacity utilization also contributed to the gross margin improvement. With respect to our allowance for excess and obsolete inventories, we reported approximately $6.4 million during the second quarter which represents approximately 3.5% of our revenues for the quarter. R&D expenses in the second quarter totaled $18.9 million representing a limited 2% increase from the $18.4 million we reported for our first fiscal quarter.

One of the main components of our R&D expenses is NRE expense. As we have noted in previous calls, our NRE expense can fluctuate from quarter-to-quarter depending on the number of new designs we release to the public. We expect to release additional mass designs to TSMC in the third quarter and our total R&D and NRE expenses will be slightly higher than our second quarter spend rate. R&D expense in the second quarter included approximately $2.7 million of stock based compensation expense. Excluding stock based compensation expense, R&D expense was $16.1 million as compared to the $16 million in the first quarter.

SG&A expenses in the second quarter totaled $16.2 million or $2 million increase over the $14.2 million we reported in our first quarter. The change was driven by an increase in commissions resulting from the 74% advance in revenues during the second quarter. Our second quarter SG&A expenses included approximately $2.8 million of stock based compensation expense. Excluding stock based compensation expense, SG&A expenses in the second quarter was $13.4 million as compared to $11.3 million we reported in the first fiscal quarter.

Our GAAP operating income totaled $8.9 million which represents a dramatic improvement from the $8.9 million operating loss that we reported in the first quarter. Excluding stock based compensation our operating income was $15 million. Our GAAP pre-tax income totaled $8.9 million again a dramatic improvement from the $8.6 million GAAP pre-tax loss that we reported in the first quarter. Excluding stock based compensation our pre-tax income was $15 million.

Our GAAP tax rate for the second quarter was 10.8% resulting in a GAAP income tax provision of $1 million. Excluding the effects of stock based compensation, our non-GAAP tax provision was fairly comparable at $0.8 million. As was the case for the first quarter our tax provision was driven primarily by our taxpaying entities in foreign jurisdictions. For the third quarter we expect these entities to remain the dominant factor in our income tax expense computation. As a result, we expect the tax provision amount for our third quarter to be comparable to our second fiscal quarter.

In the second quarter our GAAP net income attributable to OmniVision was $8.1 million or $0.16 per diluted share as compared to a net loss of $9.9 million or $0.19 per share in the first quarter. Excluding non-cash stock based compensation expense our non-GAAP net income attributable to OmniVision for the second quarter was $14.3 million or $0.27 per diluted share. This compares to a non-GAAP net loss of $3.9 million or $0.08 per share in the first quarter.

Let me now turn to the balance sheet which is in even better shape than our first quarter. We ended the second quarter with cash, cash equivalents and short-term investments totaling $354 million. This compares to $309 million at the end of the first quarter. The improvement in our cash balance was driven primarily by further gains in working capital efficiencies which generated positive cash flows from operations.

Accounts receivable at the end of our second quarter net of allowances was $67.7 million, up from $48.4 million at the end of our first quarter. This increase in accounts receivable is the result of increased product shipments in the second quarter. However, even on the higher revenues our day sales outstanding were just 34 days, eight days lower than the first quarter. Maintaining day sales in the lower 30’s may not be sustainable although we are certainly proud of what we have accomplished.

As of October 31, 2009, inventory was $92.2 million, a decline of 7% from $99.2 million balance at the close of our first quarter. Our October inventory represented 61 day sales or annual inventory turns of six times. This is slower than our stated goal of 75-90 day sales or annual turns of 4-5 turns but we are comfortable with our current level of inventory.

Before I go into our guidance for the third quarter which will end on January 31, 2010, I would like to talk about a slight change to the seasonality that we are experiencing in our business. Before last year’s downturn for a few consecutive years our fiscal second and third quarters were typically comparable in terms of gross revenues. This time around, as Ray has indicated, our regional sales coverage has shifted and the North America and Japan regions are more prominent.

This, in turn, has shifted some of the business from the holiday season inventory sales into our second quarter. Consequently, we expect the third quarter to come in with less revenue. With that said, we now expect our third quarter revenues to be in a range of $145 million to $160 million. Our GAAP earnings are expected to range from $0.02 to $0.12 per diluted share. Excluding the estimated expense and related tax effect associated with stock based compensation expense, we expect our non-GAAP earnings will be in a range of $0.14 to $0.24 per diluted share.

Please note this guidance does not take into consideration any possible accounting effects from our recently announced employee stock option exchange program. The program is designed to have minimal stock compensation charge. However, the ultimate compensation charge and associated tax effect will be determined by our employee’s participation rate, our stock price and other valuation assumptions at the expiration of the program, currently expected to be December 16, 2009. With that I will now turn the presentation to Shaw.

Shaw Hong

In summary, we are very pleased with our second quarter results as we believe they are indicative of the encouraging signs we are seeing in the consumer products market and the overall global economy. We also view our results as a testament to the competitive depreciation and customer demand we are seeing for our flagship, Omni BSI and CameraCube product which are both shipping into marketable Tier One globally.

We believe we are uniquely positioned to capitalize on the growth and expansion of the image sensor market, with our technology, the financial strength and long history of delivering on our goals. We look forward to continuing to share our success with you in the quarters to come. Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Quinn Bolton – Needham & Company.

Quinn Bolton – Needham & Company

I was wondering if you could talk a little bit more about the guidance for the third quarter and some of the effects you are seeing. I guess I am a little surprised at the magnitude of the drop off in the third quarter. Then, since you talked in the prepared script about changes to your seasonal patterns, can you give us your current expectations about what you expect seasonality to do now in the April quarter given a seasonally slower period in Q3. Is the fourth quarter now likely to be flat from Q3 levels? What would you see normal seasonality being out in the fiscal fourth quarter?

Ray Cisneros

I think what we mentioned was that North America now is a good portion of our revenue mix which meant the traditional Christmas season and material and products being built up for that drove our Q2 numbers to where we are at and therefore a little bit of a step down in Q3. Going forward the same type of customer mix now dictates perhaps in the spring time season there is another seasonality as people look forward to the summer season of building up material for things like Graduation, Father’s Day, Mother’s Day and these kinds of holidays. So, we might start seeing some kind of trending like that but we will have to wait and see how that materializes.

Quinn Bolton – Needham & Company

Q4 has historically been seasonally down. Would you currently expect it to still be seasonally down? Do you think it is…just to give some sense because there does seem to be a pretty meaningful shift in the seasonal patterns.

Ray Cisneros

What Q4 does is it basically straddles the spring calendar year. My expectation is now with our customer mix the way it is we start building up for some improved sales in that quarter.

Anson Chan

This is not going to be another step down from Q3 looking at Q4.

Quinn Bolton – Needham & Company

A second question I think Shaw in your closing remarks you said that the CameraCube and Omni BSI were now shipping to multiple Tier One’s. Can you give us a sense of when you think those revenues will become material contributors to revenue?

Ray Cisneros

We are extremely excited about the traction we have in design wins with customers buying our CameraCube. It is tangible. It is material, albeit a very small percentage right now. The way it is working out to be, most of these cameras are backing into the secondary camera application and handsets so therefore the actual mass or volume of this particular camera is not as large as the primary camera. Going forward we expect to transition this technology into primary camera applications but that has yet to be plans laid out or openly discussed yet so we are still very excited about this whole trend.

Quinn Bolton – Needham & Company

I was surprised with the VGA strength in the quarter and you mentioned strength in China and India. Could you just talk a little bit about your positioning in the China markets? It looks like you have regained some share there. Can you talk a little bit about how you see that competitive landscape and things like customer service and support? It looks like it has allowed you to reclaim some share in that market.

Ray Cisneros

Absolutely. The whole thing about the China market is an evolution, if you will, on where it has been and where it is going. I think where it has been has been predominately historically sort of a self-serving type of market. Vertically sort of driven. Then now evolving into more of a global service and solution provider to the marketplace in terms of ODM business as well as exporting. So the whole dynamics of China is changing and it is a good point. It means all the more importance of customer service, product and technology solutions need to be provided in this market.

We are up for the challenge. Of course there is a lot of competition but we have some strategies in place that will start addressing some of these new challenges.

Operator

The next question comes from the line of Betsy Van Hees – Wedbush Morgan Securities.

Betsy Van Hees – Wedbush Morgan Securities

Can we circle back to the previous question? I wanted to get a little bit of understanding about the new seasonality. So we are going to see a down tick because of the improvement we are seeing in your market share in North America and penetration I believe in Japan. Then when we look at your fiscal Q4 where is that going to be in terms of up/down and what is going to be driving that?

Ray Cisneros

I think it is too early to make commitments on Q4 numbers obviously but I think what Anson and I are trying to make as clear as possible is we don’t expect another down tick from Q3. In other words, Q4 will not be down from Q3.

Betsy Van Hees – Wedbush Morgan Securities

In terms of mix, VGA was obviously exceptionally strong and that is largely due to the fact you are gaining share in China and then we are also seeing new markets in the emerging market segment in the portable media players. How are you looking at mix as you move forward in this fiscal quarter?

Ray Cisneros

It is looking quite well. In fact, in the prepared script we mentioned the product mix is not just talking about VGA we are extremely happy in our traction and gain in the 3 megapixel node. Then coming forward in the upcoming quarters will be an exceptionally strong 5 megapixel demand from our Tier One customer base globally, not just North America but even in Asia picking up our quarter inch 5 meg and our third inch 5 meg. Overall from a unit mix there is one set of numbers. From a revenue mix there is a separate set of numbers. In both cases both are driving exceptionally strong demand.

When we talk about the VGA, you made some comments about in Asia VGA being the dominant product sold there, China has also been a great marketplace for our higher resolution products. We have had a historical high of 2 megapixel shipments into China and then 3 megapixel and 5 megapixel are increasingly shipping in higher volumes.

Betsy Van Hees – Wedbush Morgan Securities

In regard to gross margin you said it was going to tick up slightly in fiscal Q3. Can we continue that trend as we move forward into fiscal Q4 and next year?

Anson Chan

That is what management is working towards. Obviously our policy only gives us the ability to give you one quarter outlook at this time but we do expect margins to continue to expand, at least through Q3.

Betsy Van Hees – Wedbush Morgan Securities

You have a tremendous amount of cash on the balance sheet. Congratulations. What are your plans with that cash moving forward?

Shaw Hong

We are always looking for possible activities that can expand on the product portfolio be it through M&A or even through developing new technologies. It wasn’t easy to deploy cash in terms of CapEx because we do need new testing equipment and sometimes when new products come on line we also need capacity expansion. So that is pretty much how we plan to use the cash in the short term.

Operator

The next question comes from the line of Harsh Kumar – Morgan Keegan.

Harsh Kumar – Morgan Keegan

Just quickly going back to your guidance. Could you tell us how much US and Japan was as a percentage of revenue was in the latest quarter?

Anson Chan

We don’t really break that out. Needless to say the supply chain hasn’t really changed so in terms of actual physical shipments the vast majority is still going to Asia.

Harsh Kumar – Morgan Keegan

But the end demand you are saying has shifted more towards North American products. Is that correct?

Ray Cisneros

Obviously we don’t break out the details in the revenue mix but suffice it to say our growth and strength now in North America has driven quite a bit of our execution and planning and technology and selling our products to the right customers, we are extremely happy with our traction there and North America, as you well know, it is filled with a lot of good opportunities and great customers. Then in Japan with our BSI technology is another great in-road we made with the digital camcorder. What it brought to us is exposure into the Japan market for our BSI technology that is now being embraced quite aggressively by good companies out there as well.

Harsh Kumar – Morgan Keegan

Can you talk about the visibility? Is it the case where you simply don’t have an adequate amount of visibility going out into the holiday build that you are being perhaps a little bit cautious? Also could you give us a sense of what the backlog was like or any kind of input into the order trends we could wrap our arms around the guidance?

Ray Cisneros

No, the Q3 guidance is no lack of visibility built in there. It is what it is. We are fairly comfortable with the guidance. You may be reading more than really is there in terms of the number. It is primarily driven or has been driven to a good extent now by the customer mix as we keep talking about. It is tracking now with that seasonality for that customer mix.

Anson Chan

We have talked about that before. We do have a 10 to almost 12 week lead time so we only put that inventory essentially before our fiscal Q3. Even with a six times turn at the end of the quarter we are still comfortable with what we have because we believe that is sufficient to give the guidance that we provide now.

Operator

The next question comes from the line of Analyst for Yair Reiner – Oppenheimer.

Analyst for Yair Reiner – Oppenheimer

I just wanted to get a little more detail on the notebooks. It seemed the sequential growth was pretty strong there. I am guessing it has to do with the favorable mix. Can you talk a little more about how the resolution is trending there and how it will trend?

Ray Cisneros

Let me see if I got your question. I think you may have a two-part question. The notebook, all segments of our business actually increased because of such a high step in both revenue and unit shipment. Every single category in our business mix quarter-over-quarter was a dramatic step up in Q2. The notebook business was not by any means devoid of this trend. It actually achieved a very significant step up in units and in revenue. It was just overshadowed by extremely strong growth in the handset demand in Q2. Quarter-over-quarter absolute numbers a very strong trend in all markets and resolutions.

Analyst for Yair Reiner – Oppenheimer

Was there a shift in resolution mix for notebooks?

Ray Cisneros

No. There wasn’t really any shift in resolution mix for notebooks. There was a good blend of specialized VGA’s, mainstream VGA and 1 megapixel and very strong 2 megapixel. In addition a small portion of 3 megapixel. They pretty much tracked in mix. It just got overshadowed by the very strong entry level handset business.

Analyst for Yair Reiner – Oppenheimer

Shifting over to China, you mentioned some strategy for dealing with more competition in China before. Can you talk a little bit about what some of those strategies might be?

Ray Cisneros

As Bruce mentioned in his script there is the launch of our new VGA 7675. It is I would say the best, bar none, balance between cost and performance. The other strategy we have been talking about here is the CameraCube for secondary camera applications. Going forward there are other strategies we need to take into action as we go forward because the China market as we mentioned we feel has expanded because of its infrastructure and readiness to basically change business models globally.

Analyst for Yair Reiner – Oppenheimer

Given what you said about customer mix should we expect VGA revenue out of China to be pretty much flat?

Ray Cisneros

Revenues out of China to be flat? I would say the revenues out of China from Q1 to Q2 obviously increased and going from Q2 to Q3 are very similar.

Analyst for Yair Reiner – Oppenheimer

Very similar as in they will increase again or they will be flat?

Ray Cisneros

They will be very similar in mix as well as probably on the flat side.

Operator

The next question comes from the line of Analyst for Tristan Gerra – Robert W. Baird.

Analyst for Tristan Gerra – Robert W. Baird

We have kind of danced around it a bit but I was wondering if you could talk about do you expect your VGA mix in the next quarter and in the next year to be similar as to percentage of units? You said that the North America and Japan business, which I assume is a higher megapixel mix, is actually going to be falling off in the next quarter. So should we actually see VGA approaching maybe 75% of total units in this next quarter?

Ray Cisneros

It is hard to predict right now. I see it pretty much trending equivalent to the Q2 numbers.

Analyst for Tristan Gerra – Robert W. Baird

For next quarter? What about for calendar 2010?

Ray Cisneros

Calendar 2010 I see a growth in higher resolution products. Something I think we touched upon, we talked certainly a lot about the 3 megapixel. We talked a lot about the 5 meg but we also are going to start ramping up our 8 megapixel in handset categories as well as DSC applications. The other thing that will be driving the 5 meg is not just that Smart Phone category but also the DSC applications. I have a feeling VGA will stay strong but on the other hand the higher resolutions are picking up for us.

Analyst for Tristan Gerra – Robert W. Baird

That is as a percentage of units as well a percentage of revenue?

Ray Cisneros

Correct.

Analyst for Tristan Gerra – Robert W. Baird

You talked a little bit about you have enough inventory for what you have guided to but would you say that inventory or any capacity type mix has impacted negatively your fiscal third quarter guidance?

Anson Chan

Not at all. In fact, our fiscal Q2 we demonstrated how flexible our supply chain is. We exceeded our guidance by $13 million and we have no problem making that kind of shipment.

Analyst for Tristan Gerra – Robert W. Baird

You talked a little bit about the changes in seasonality going forward. Are you looking specifically for any changes in the seasonality of your feature phone business or is that just more Smart Phone business is what is going to impact your seasonality and your feature phone business is going to be pretty much the same?

Ray Cisneros

Honestly it is quite a mix here because we are picking up traction in digital still camera design wins. We have accomplished that. We have accomplished quite a bit of Smart Phone design win activity as well. Then we expect the security driven by our HD products to start picking up and notebooks is always something that continuously is evolving. That is migrating into 3 megapixel quite rapidly as well. So it is a big mix there quite frankly.

Analyst for Tristan Gerra – Robert W. Baird

You said you have lots more wins in this entertainment segment. Can you say whether that is with new customers or whether that is with the same customer? Also can you give any kind of a bogey for what that was as a percentage of revenue? Did that hit 5-10% of revenue yet or is that a goal for some time over the next 12 months?

Ray Cisneros

We won’t break out the revenue mix. I think we need to put some quarters in our experience here in what it starts evolving or looking like. I can tell you the multimedia device, we are allocating that to something we are calling the “entertainment market.” What that means is there is a bunch of stuff in there for us. Not just mobile type devices but also perhaps even things that you find in your home entertainment area. So it is going to be a mix of customers, a mix of products, and we need to see how this trending starts looking out for us.

Operator

The next question comes from the line of Quinn Bolton – Needham & Company.

Quinn Bolton – Needham & Company

I wanted to follow up on that comment about the fiscal fourth quarter and you expect you will not take another step down. Is that where you are saying your typically seasonality is or is this really being driven by specific design win programs or perhaps market share gains that you see for OmniVision? I am just trying to separate what would a typical seasonal pattern be versus perhaps whether or not you are gaining share in that quarter?

Ray Cisneros

That is a good question and a fair question. Honestly it is a mix of both. We have gained market share and then seasonality, if you track the western hemisphere type companies, their seasonality backs into Christmas and the end of the calendar year holidays. Then they drive it back up during the summer period for a bunch of events that typically drive sales such as Graduation day, Father’s Day, Mother’s Day and these sorts of events. It is sort of a double-hump seasonality traditionally for a western hemisphere based type mix.

That being said, it doesn’t mean it is going to be the only thing driving our revenue. I kind of like the balance now. We have that going. Then we also have our large market share in Asia. So we got I think the better part of two worlds here.

Operator

That does conclude the time we have for questions. I would like to turn the call back over to management for any closing remarks. Please proceed.

Shaw Hong

Thank you all for participating in this quarter’s call. We will talk to you again in about three months. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. That does conclude the presentation. You may disconnect. Have a wonderful day.

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Source: OmniVision Technologies F2Q10 (Qtr End 10/31/09) Earnings Call Transcript
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