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Executives

Mark Veeh – Investor Relations Manager

Brian Halla – Executive Chairman of the Board

Don Macleod – President, Chief Executive Operator, Chief Operating Officer

Lewis Chew – Chief Financial Officer

Analysts

Terence Whalen - Citi

James Schneider - Goldman Sachs

Craig Ellis - Caris & Co.

John Pitzer - Credit Suisse

Mark Lipacis - Morgan Stanley

Douglas Freedman - Broadpoint Amtech

Stacy Rasgon - Sanford C. Bernstein

Chris Danely - JP Morgan

Romit Shah- Barclays Capital

Ross Seymore - Deutsche Bank

National Semiconductor Corp. (NSM) F2Q10 Earnings Call December 10, 2009 4:30 PM ET

Operator

Good afternoon. My name is Marcello and I will be your conference operator today. At this time, I would like to welcome everyone to the National Semiconductor second quarter fiscal year 2010 conference call. (Operator Instructions) I will now turn the call over to Mr. Mark Veeh, Investor Relations Manager. Sir, you may begin your conference.

Mark Veeh

Thank you and welcome, everyone to National Semiconductor’s second quarter fiscal year 2010 earnings conference call. Joining me on the call today is our Executive Chairman, Brian Halla; our President and Chief Executive Officer, Don MacLeod; and our Chief Financial Officer, Lewis Chew.

During our prepared section of this call, we will be providing details around our Q2 results, background to our Q3 outlook, and providing some commentary around recent market trends and business environment. At the end of our prepared comments, we will then take questions until approximately 2:30 p.m. Pacific Time.

As we begin our call, I would like to remind everyone that today's discussions will contain forward-looking statements that involve risk factors that could cause National Semiconductor’s results to differ materially from management’s current expectations. Please review the Safe Harbor statement contained in the press release published today, as well as our most recent SEC filing for a complete description of those risks.

Also, in compliance with SEC Regulation FD, this call is being broadcast live over our Investor Relations website. For those of you who have missed the press release or would like a replay of the call, you can find it by going to National’s IR Web site at www.national.com.

So with that, I will now turn it over to Brian for opening remarks.

Brian Halla

Thank you, Mark and good afternoon, everyone. As this is my 54th and final earnings call with National Semiconductor, it’s gratifying to report that the vectors appear to be pointing in the right direction. I am talking, of course, about growth and growth with increasing profitability. I believe that as a company, we have put in place the infrastructure to keep these vectors pointed in the right direction.

So in this commentary, I will talk about how the quarter shaped up and then introduce our new CEO who will talk specifically about how we maintain our momentum.

The revenue in the quarter showed better growth than we had originally expected. If you’ll recall, our guidance was based on an assumption that turns would be pretty much the same as in the prior quarter. The actual turns are much higher than we had projected -- now hold on, I know what you are thinking -- anytime there is an unexpected up-tick in turns, a flag goes up that asks is this panic, is there stockpiling or double ordering. In a few minutes, we’ll try to go over the indicators we look at when we ask ourselves these questions and then you can make up your own minds.

Bookings, led by healthy turns activity, grew nicely by 17% in the quarter. As a positive, the better-than-expected bookings came from the industrial or broad markets and may well represent a picture of wider spread health. Our gross margins came in better than expected and grew by a whopping 420 basis points to reach 65.3%. With a little help from early savings from Texas, along with continuing improvement in product mix, our utilization stayed roughly flat in the quarter at 46%.

We were able to bring down our internal inventories, both in dollars and days as we had planned, although the demand in the back-end of the quarter did have our packaging group scrambling. Even with higher spending in the quarter, which Lewis will discuss in a moment, the net GAAP earnings were better than expected at $0.20, up $0.07 from last quarter.

Of course, these days the outlook is the most interesting news. We are traditionally down in the post Christmas build quarter due to the wireless and consumer slow-down post holidays. However, we expect this consumer slow-down to be offset by the higher backlog already in place for the industrial or broader markets, which as you know are less impacted by typical seasonality.

Having said all of this, even if turns are less robust than they were in the prior quarter, we are still comfortable guiding to a roughly flattish outlook. We expect that distributor inventories, which are already at the low-end of the scale, will remain under control.

As promised, we’ll review our conclusions about whether or not there is double ordering. First of all, our lead times have remained pretty stable. Yes, I know there were reports of shortages from competitors but for the most part, these seemed to be relatively isolated occurrences with rational non-panicked explanations.

We closely monitor the distributor resales to compare with our shipments to them and those quantities have stayed pretty much in line, so no, we don’t see a build-up on the disti shelves. In fact, inventory levels throughout the supply chain seem pretty much under control right now. Once the holidays are behind us, we’ll be in a position to assess the OEM inventory levels, which will give us the best indication of the variable we don’t control, end demand.

Looking forward, the priorities of the management team and the new CEO are the same as they have been at National. We intend to continue to execute on the revenue growth opportunities. We will do this by continuing to leverage our industry leading position in power management and by leveraging our strengths in design, manufacturing, and channel management.

We believe that this industry is far from mature and the traction we are seeing in the emerging markets, as well as the established industrial market, is confirmation.

As you can see, revenue growth for this company drives a very high fall-through to gross margins and operating income. Continuing the focus on growth and the corresponding investments in growth is key to securing what we believe can be a very bright future for National.

Now it’s my privilege and pleasure to introduce the CEO of National Semiconductor to talk about those growth areas and initiatives and their performance so far. Congratulations, Donnie -- it’s your show.

Don Macleod

Thank you, Brian and we will certainly miss you here. So let me talk in more detail about the business we saw in the quarter, where we saw revenue growth and also where we saw progress leading to the potential for more revenue growth out in the future.

First let me talk about trends in our major end market segments. The industrial market, which includes medical, automotive, aerospace, military and the general industrial segment, our sales here were up 17% on the prior quarter. The automotive portion of that market saw the most significant percentage sales growth, as design wins for our automotive entertainment and power management products went into production and, as our customers in the automotive industry who have been running the factories on short work weeks, restored shifts. The overall industrial market actually accounted for 40% of our sales in the quarter.

The mobile device market, at about 30% of our sales, saw flat sales over the previous quarter. Shipments to customers in Korea were down in the quarter, but this was offset by increased shipments to a European and Americas based handset suppliers.

Our third largest segment, which is communications and networking, had about 11% or 12% of our sales in the quarter. Sales here also grew 11% over the prior quarter and here we saw growth in our business with both European and China-based customers for our signal processing and power management products.

These three categories I just covered cover 80% of the company’s sales in the quarter.

So now let me look at the revenue growth drivers from an analog product perspective.

Our power management business, at now 50% of our sales in the quarter, saw sales growth of 12%. Within our power management area, our simple switcher family of easy-to-use power supply solutions saw sales growth of 14% following 38% growth in the previous quarter. Here we introduced a November further significant improvements to our web bench, online design tool for power supply designers. We released a new visualizer tool that allows the designer to trade off efficiency, footprint, and cost in various power supply choices -- in fact, the tool allows you to select from 48 billion combinations in its database of 21,000 components from 110 different manufacturers.

Another growth driver going forward in this simple switcher area will be our new simple switcher integrated power modules. Here we already have over 100 design-ins for this first family of modules in medical, smart grid, avionics, broadcast video, and other applications. By the way, our simply switcher sales in the quarter accounted for about 10% of our overall company sales.

Another power management growth area for us in the quarter was our new LED lighting power thrust. Sales again here nearly doubled sequentially from a small but fast-growing base, and 70% of these sales were to customers in China, in diverse applications such as street lighting, automotive lighting, to in-home applications.

I see this LED lighting area as a potential $100 million per year revenue opportunity for National Semiconductor in about three years if we continue to execute here.

The [powering] and driving LED applications for us goes beyond the general lighting illumination space. We are also enjoying revenue growth from LED backlighting applications in high-end notebook PCs and smartphones. In the quarter, our power management sales into these LED backlighting opportunities grew, led by production ramps from recently launched Android smartphones to offset weaker sales of other mobile device power management products to Korean handset manufacturers.

Another power management growth area for us is in renewable energy and in particular in the solar area. We aim to be the power electronics leader in this completely new power efficiency communications and monitoring capability, and we do this by improving the efficiency of solar installations and also electric vehicle batteries.

In the solar area, we continue to make initial shipments of a reference design solar magic power optimizer to distributors and large installers in quantities of a few thousand units in the quarter. We continue to get great endorsement for this innovative solar magic power management application. Just two weeks ago, we received the renewable energy electra award in London.

Our new term objective in this solar area is to work with solar panel manufacturers directly to enable them to introduce more energy efficient or smarter panels with our solar magic power management chips integrated into these panels. We are currently expecting the first panel manufacturers to introduce these smart panels in the second half of calendar year 2010.

So moving on from a power management product area to cover some other analog areas where we saw sales growth in the quarter, our audio products for mobile devices grew sales 10% in the quarter, and this was driven by pre-holiday production ramps for MP3 and other miniature mobile devices using our ceramic speaker drivers. Our new automotive infotainment business where we supply our FPD link technology for in-car communications management achieved sales growth of about 20% in the quarter, and here we are on track to grow this business significantly. At our shareholder meeting 2.5 months ago, I said that we could generate about $10 million in revenue from this automotive infotainment business this fiscal year. In fact, we are already at a run-rate that suggests that the current year of fiscal year sales number will be about $15 million, and maybe three times that per year of revenue three years out, as more and more vehicles add cameras, flat panel dashboards, and more sophisticated entertainment and navigation systems, we at National have the opportunity to capture multiple dollars of silicon per car.

A very good example of this is the new Audi A8 that was launched at the end of November. It has 25 National Semiconductor integrated circuits per car, and these cover not only the display and camera communications but also LED headlights, LED turn indicators, the instrument cluster, electrical steering, and gear box sensing applications.

So moving on from our product areas to a regional view of our business, our sales to the European region grew fastest in the quarter -- they were actually up 30% and here we were very broad industrial business space and we believe that we are gaining share in distribution in the European region, where we recently implemented new programs to incentivize our distributors.

And by the way, our European distributors resales -- in other words, their sales out of our products, were also off about 30% in U.S. dollar terms this quarter over Q1. Our sales in Japan also grew about 13% sequential, and this was led by customers in the industrial, printer, copier, and gaming areas.

And finally, a few comments about our business model -- as we indicated earlier, we did clearly much better than we expected going into the quarter in our gross margin at 65.3% in the quarter, and Lewis will give you more details on that later.

We are now becoming increasingly more comfortable with achieving gross margins in the upper 60% range, and the manufacturing actions to enable that are nearly complete. And at the same time, our product portfolio mix continues to get richer.

We now intend to put a lot more emphasis on revenue growth and we have a lot of market, product and channel new initiatives in place now to drive this growth. And if you add this to what looks like a recovering growth environment for our industry, we have the prospect of significant earning leverage for National Semiconductor in front of us as we go into calendar year 2010.

So with that, now let me hand over to our CFO, Lewis Chew. Lewis.

Lewis Chew

Thank you, Don. In my segment today, I will begin by providing more detail on the bookings and the turns activity that we saw in Q2 and how that affected backlog heading into Q3 and what we are modeling for turns in Q3. And just as a quick reminder, turns orders are those orders that are placed with delivery requested in the same quarter.

As part of the bookings and turns discussion, I will discuss the distribution channel, including their resale rates and their inventory levels, and address how all that fits into the revenue guidance.

Once I cover the basis for the Q3 revenue outlook, I will continue with a discussion of our gross margin percentage and topics related to that, such as product mix, factory utilization, and cost improvements from the Texas fab closure project. I will then review the operating expense outlook for Q3 and highlight any notables in that area. And then I will finish up with some comments on balance sheet items and also on key operating and performance metrics.

So let me start with bookings and turns. Total bookings for the company in Q2 were better than we originally expected as they increased 17% sequentially. We started out with September bookings being noticeably higher than August, and then we saw a continuation as October and November orders also increased sequentially.

Turns orders, which are a subset of the total bookings, saw a similar theme. The turns that we got in Q2 were much higher than Q1 and also above original projections as they were stronger than expected in each of the three months of the quarter we just finished.

The improvement we saw in total orders as well as turns orders were across the board from a regional perspective, as we saw increases in all of our major geographies. Europe’s order increase was notably strong, as they tend to benefit more from the industrial markets. And industrial was the biggest driver of the recent improvements in our business levels.

We served the industrial markets mainly through the distribution channel and during Q2, we saw distribution resales increase significantly. The percentage increase in total distributor resales was even higher than the 10% sequential revenue increase that we had in our revenues for Q2, and as a result, the weeks of distributor inventory went down in the quarter to end at a little over eight weeks, even though distributor inventory in dollars did increase a little bit.

The Asia-Pacific region for us saw their weeks of distributor inventory dip down to around a six week level, which is very low for National by historical standards.

It is clear to us that the increase in orders from distributors in Q2 was driven mainly by higher resales and less so from pure restocking.

The increased order activity which allowed us to achieve higher-than-expected revenue in Q2 also gave us higher opening 13-week backlog for Q3. As a result, we are guiding Q3 revenues to be approximately flat, even though a more typical seasonal pattern for us in Q3 would for revenue to be sequentially down.

The higher opening backlog is predominantly in our industrial businesses and that will offset the seasonally down activity post holidays that we do anticipate in the wireless market and other consumer oriented areas.

The turns orders that we require for the Q3 revenue outlook is well below the turns that we had in Q2, which factors in seasonality.

I would now like to move on to gross margins. Gross margin of 65.3% in Q2 benefited from better mix and higher sales volume, as well as cost savings, which included a full quarter of the China plant being closed and some Texas savings achieved ahead of schedule.

We had been targeting roughly $12 million per quarter or about four points of total margin improvement from the closure of the Texas fab after the end of Q4 fiscal 10 and some of that improvement was achieved in Q2 that we just finished.

Our fab capacity utilization was about 46% in Q2 as we lowered our internal inventories by about $7 million. In Q3, based on our flattish revenue outlook, we anticipate the gross margin percentage will be about the same as it was in Q2.

We will continue transferring our manufacturing processes from the Texas plant to our remaining plants in Q3, and we estimate that these activities will cost approximately $5 million to $6 million of restructuring expenses during the quarter, which we will break out separately on our income statement.

We continue to target Q4 as the last quarter of production for Texas. Then, in the first part of fiscal 2011, which is not that far off for us, we should see the remaining gross margin benefit from the Texas plant closure, which we estimate at roughly three points of incremental margin at current revenue levels.

Now let me cover operating expenses, which in total are also expected to remain fairly comparable to what they were in Q2 as we are now back to normal operating mode and not really deploying temporary savings measures.

R&D expenses are expected to range from $68 million to $70 million. SG&A expenses are expected to range from $78 million to $80 million. And stock compensation is running a little higher than typical in Q3, from some accelerated expense items, mostly affecting SG&A, and it should come down somewhat in Q4.

Total stock comp is projected to be around $19 million in Q3, broken down approximately as follows -- $3 million in cost of sales, $4 million in R&D, and $12 million in SG&A. Other income and expense is estimated to be about $1 million of expense.

Interest expense net is expected to hold steady at about $14.5 million, as interest rates have levelled out and are running very low these days. The effective income tax rate in Q3 is projected to range from 28% to 30%. The lower than expected tax rate in Q2 was helped by a positive impact from certain foreign income related tax issues, as well as discrete benefits from resolution of tax items.

Moving on to the balance sheet and operating metrics, our capital expenditures in Q2 were about $13 million and we estimate that Q3 capital expenditures will range from $12 million to $18 million. Our ending inventory on hand for Q2 was $116 million, down about $7 million from Q1. Days of inventory on hand ended at around 89 days, which is down about three days from the 92 we had at the end of Q1.

Our days of receivables at the end of Q2 was about 24 days, similar to what we had at the end of Q1 as we continued to run our revenues with very good linearity through the quarter, combined with timely cash collections.

And the company’s cash reserves ended Q2 at $822 million, up from $734 million in the prior quarter. During Q2, we paid down about $16 million of our debt principal, in line with the original schedule.

Operating margin in Q2 was about 22%, and return on invested capital was about 16% for the quarter. Both of these include stock expense but not restructuring charges.

From a business model perspective, revenue growth is the top priority right now, combined with high follow-through to the operating income line. Our gross margin progress puts us in a nice position to support the growth initiatives going forward, and also we have ample fab capacity to support additional revenue and this enables us to run a low capital intensity, even in a strong growth scenario.

So now I’d like to turn it back over to Mark Veeh to moderate the Q&A session, and by the way, Mark, congratulations on becoming a new father just in this last week. You almost made it through my comments without dozing off, and that’s a good job. So Mark, you can do the Q&A now.

Mark Veeh

Thanks, Lewis. At this time, I will ask the Operator to open up the lines to begin the Q&A session. Operator, can we please have our first question?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Terence Whalen with Citi.

Terence Whalen - Citi

The first question relates to Lewis, I think you said the outlook for flat revenues assumes a lower level of turns level. With the 17% order growth that we saw, how much lower a level of turns, if you can help us understand that? Thank you.

Lewis Chew

Sure. The 17% bookings growth that we had in Q2 really got distributed into three buckets -- part of that helped us make our numbers in Q2 be better, because remember that 17% includes the up-tick in turns that we got, so some of that’s already been booked and shipped and recorded.

The second thing is, which is most relevant to your question, we did have some backlog build for Q3, which I will talk about in a second, and then third, we actually also built a little more backlog in Q4 compared to that same point last quarter. So in Q3, if you compare to Q2, we had our turns running as a percent of revenue in the high-end of our range and in past, I told people on this call that a typical number to think about for National is in the sort of 20% of revenue range. But in certain bad times, it can dip down to the 10s and in good times, it can move up to the high 20s, so if you think about Q2, our turns ratio was at the high end of the range and for the quarter we are heading into, which is post holidays, we cannot anticipate that that same high level of turns will continue, so let’s just say our flat outlook assumes a more normal level of turns, which means it’s down quite a bit from what we saw in Q2.

Terence Whalen - Citi

Okay, thanks, Lewis and then maybe if I could ask my follow-up as a question to Donnie -- Donnie, in terms of some of the imperatives that you have now that you are CEO, it sounds like you are taking a more aggressive stance on revenue growth overall -- can you talk about how you balance that out in between looking at specific vertical applications like maybe LED lighting or renewable energy or automotive versus focusing energy on really improving your traction in the distribution channel? Thank you.

Don Macleod

Just to put that in perspective, I made the comment, we have the luxury now of being within sight of getting to our high 60s type gross margin goal as a company. Lewis showed you the progression from today’s 65% to 300 basis points more coming from our Texas plant closure, which is only less than six months, I guess, from now. So we are now focused a lot more intensely on revenue growth and I think we can be a lot more aggressive in some markets, given our margin richness at this point in time. The markets that really excite us are those that thrive on our power management competencies. You mentioned some of the initiatives in, for example, in LED lighting, which really are attractive for us, not just for the general illumination space but also for the portable device backlighting and notebook PC backlighting. That’s extremely attractive.

Solar energy is a particularly attractive opportunity for us. We clearly want to be the power electronics leader in providing more efficiency in this fast-growing solar space.

Electric vehicle batteries -- we want to be the leader in terms of smart management systems for charging and managing those batteries going forward. These are things we’ve talked about a lot and more recently, you’ve heard us talk about some of our very broad industrial business, for example our simple switcher business which, as I referred to, we are running at about 10% of the company’s revenues. This business is hugely through our distribution channel and we are in the last six months we’ve been actively putting in place not just new incentives but the new infrastructure to support our distributors, infrastructure of people and training and tools, web bench tool. As I mentioned, we are extending that for use to the general market for people who design power supplies so that they come to us as the go-to place to learn about how to do that.

We have a lot of initiatives in place in that space. In the consumer market, the audio opportunities we have in many of these small consumer devices, a lot of that is already visible to you and we can put more emphasis on it and be more aggressive, frankly, in capturing business in that space, given our margin situation.

Terence Whalen - Citi

Okay, appreciate the follow-up. Thanks, Donnie.

Operator

Your next question comes from the line of James Schneider with Goldman Sachs.

James Schneider - Goldman Sachs

I guess first of all on the gross margin, with respect to mix at this point, the industrial business, as you mentioned, is accelerating pretty hard coming into the next quarter so do you think that overall the mix of business that you have exiting the next quarter is going to be about in line with where you think equilibrium is going forward? Or do you think there is still more to go on the industrial side?

Lewis Chew

You know, going into Q3, it’s likely that the industrial will be a relatively stronger part of our business from a behavioural standpoint but it is hard for us to project forward the impact on mix per se because even within those businesses, there’s a range. So this is not about mix moving two points of margin but I do think your instincts are correct that mix can improve from a business standpoint but from a pure margin standpoint in any given quarter, I’ve told you guys before that it’s hard to be that precise in terms of half a point there or half a point here.

James Schneider - Goldman Sachs

I understand but you think -- you know, getting back to closer equilibrium with the consumer business at this point?

Don Macleod

Maybe just let me pick up on that one -- when we go through, looking back at the quarter we just finished, one of the surprisingly strong areas in our business was in fact our distributor resales through the quarter. And as Lewis mentioned, that’s really where we deploy the vast majority of our industrial business. And if you kind of examine our distributor resales, as I mentioned to you, they were up 30% in Europe for our quarter just completed versus the August quarter. They were up about 10% in the Americas and in Asia for the same relative comps. And if you look at the business base in each of these regions, the drivers aren’t the same. The industrial drivers aren’t any particular one. They are very broad. Okay, in Europe we had a fairly significant up-tick from automotive related business that we would classify under that general industrial category so our distributors are telling us that the resale activity should hold up and if that assumption continues, we should be seeing more of our sales going into this industrial space -- frankly when you look at the December, January, February quarter, which is our third quarter, and you look at the 30% of our business that is driven by mobile phones and other related consumer portable devices, we would expect that business to shrink a little bit in that window of time, given consumer behaviour. It’s very normal. Every year we see that so by definition, if these distributor resales and industrial broad strength continues, we should see more of our sales in the third quarter coming from that industrial space.

James Schneider - Goldman Sachs

I understand. That’s very helpful color. And then Donnie, maybe a follow-up for you -- if you look at the growth initiatives which you are trying to drive, you mentioned a number of them, do you expect that longer term, we’ll have anymore R&D intensity associated with driving those initiatives or do you think we are at a pretty comfortable level right here?

Don Macleod

Well, as you see from the P&L, we are spending about 20% of sales on R&D today and we think that’s about the right ratio. We took some very strong actions earlier in the calendar year to take our ratios in line and we are now in a place where we should be. I think our R&D is pretty well balanced and 20% is about the right number. Maybe it’s a little bit high but it’s in the right perspective.

James Schneider - Goldman Sachs

Great, thanks very much.

Operator

Your next question comes from the line of Craig Ellis with Caris & Co.

Craig Ellis - Caris & Co.

Lewis, just a clarification on gross margins -- could you give us the relative contribution to the gross margin increase in the second quarter for mix, volume, and cost?

Lewis Chew

I could but then I’d have to kill you. Sorry.

Craig Ellis - Caris & Co.

Tough way to end the year.

Lewis Chew

You guys have to watch out because when business gets better, all my wacky humor comes flowing back. Let’s just say that all three of those had a nice contribution, although it is fair to say that from the manufacturing side, once again I have to give them kudos because we were -- remember, we were already expecting to get some benefit this quarter from a full quarter of having closed down China, and we did get that but we also got another -- you want to think about zip code, roughly in the neighbourhood of a point of benefit from accelerating some savings in Texas. And then the rest of the margin improvement would come from a combination of better mix, as well as the higher sales volume, which means that our manufacturing variances are being spread over a bigger number.

Craig Ellis - Caris & Co.

Okay. Related to gross margin, how long can we cruise at 46% utilization before it starts to go up?

Lewis Chew

Well, the quarter that we are going into, we actually do anticipate our internal inventories shrinking a little. Some of that is mix related. Our manufacturing organization does have a fairly detailed model they like to run on the composition of inventory, raw materials, die banks, finished goods. And so the utilization will probably remain relatively steady here for another quarter but going on down the road, if the bookings were to continue the kind of momentum we see at today, then it is likely we will have to start raising the utilization going forward. But at this time, Craig, it’s very early for me to say by how much -- I can’t say well in Q4, we’re going to take the utilization up five or 10 points but that’s not inconceivable.

The other thing that I would like to highlight too, Craig, is that we actually had been, from a strategic planning standpoint, had planned all along to have some of our U.K. capacity convert from six to eight inch eventually and I think in this near-term here, sometime in the next two quarters, we will actually go ahead and do that because we can do that within the same fab structure, but we get some cost and capacity benefits from that as well.

So the utilization we’ll just have to keep track of but for the quarter we are going into, we think it will remain relatively stable.

Craig Ellis - Caris & Co.

Okay, thanks for that, Lewis. And then on channel inventory, eight weeks I think is a pretty low level for you guys. Do you think the channel will stay there or should we expect channel inventory weeks to move up a little bit in calendar 10?

Lewis Chew

I think you should expect them to move back up, quite frankly, because we did not come into this quarter anticipating that the weeks would start with an [8] handle, and the reason it has an [8] handle on it is because the resales were stronger than we expected and even though our billings were also stronger, the weeks went down. So I think in the near term here, it wouldn’t be unreasonable to think about those weeks getting back into the 9-ish range as opposed to the 8 range.

Craig Ellis - Caris & Co.

Okay. Lastly for me, Brian, not much off the hook but I’ll give you a soft ball -- is the cork still in the bottle?

Brian Halla

I think it’s coming out tonight. I don’t know anything about how it relates to the business, but --

Craig Ellis - Caris & Co.

Congratulations.

Operator

Your next question comes from the line of John Pitzer with Credit Suisse.

John Pitzer - Credit Suisse

Don, I guess my first question is I know it’s kind of dangerous to look at market share trends at inflection points but if you look at your revenue sort of the peak quarter to the trough versus your peers, you guys seem to be down a lot more than everyone else. Kind of curious how I should view that -- if not market share loss, what’s another way of thinking about that dynamic?

Don Macleod

Well, I would rather you look at this from a perspective of the last few quarters. We’ve just grown our business 10% this most recent quarter. 13 weeks ago we were on this same conference call talking about having grown our business 12% in terms of the quarter to quarter sequentials, so I am looking forward here with a view that we continue that and I think our perspective on the business for what really is the holiday quarter of December, January, February is that our business is projected to be flat in that quarter versus the usual kind of down cycle, and just compare the last couple of quarters of our results and compare that with the guidance our competitors are giving for this fourth quarter, I think we are holding our own pretty well.

John Pitzer - Credit Suisse

And then Don, just a clarification so that I understand -- when you talk about these new growth initiatives and your ability to go after them now because you are back up to sort of a high 60% corporate gross margin, are these growth initiatives consistent with that high 60s or are these areas where you are willing to give up gross margin to go after growth?

Don Macleod

Well, you can really take these growth initiatives into kind of two categories -- there are that that fit into the broad industrial category, if we chose to use these loose words. For example, our initiatives in LED lighting, our initiatives in solar energy, our initiatives in electric vehicle battery management, our initiatives in the automotive space -- all of these are if you want to call it non-consumer related activities in the classical sense and these are businesses that today we enjoy very nice margins in. We can just be a little bit more aggressive in helping to drive these businesses as we go forward. And I think the LED lighting example is a good one, where I would say at this point from a power supply point of view, we are the -- we are the leaders in that space and I think we can do a lot more to create the market by enabling price points that enable growth in that market.

One of the particularly exciting things I see about this LED lighting space, I read a quote this week from Phillips saying that 80%, in their view 80% of all home lighting installations by the year 2020 will be covered by LED lighting and we want to be part of that growth and we can do that with a little bit more luxury from a margin and a cost point of view. And if you put growth as the hood ornament in the front of the vehicle here, we can drive the organization to look for these opportunities, rather than just saying everything is focused on some gross margin hurdle.

So I think we have a little bit of a refocusing in terms of this growth message and we have the -- frankly we have the opportunities in the portfolio to drive that.

John Pitzer - Credit Suisse

Great, and then guys, last question for me -- Lewis, you talked about front-end utilization. It clearly sounds like there’s no constraints there. I’m kind of curious when you look at your back-end test in packaging, we’ve heard about some tightness there. What are you guys seeing and is that limiting your ability to ship to demand?

Lewis Chew

You know, we are seeing some of that as well, John. We did see our utilization in the back-end climb this quarter and we certainly had people working some longer hours than maybe we expected at the beginning of the quarter -- right now we don’t necessarily see that per se as a constraint but it certainly is nice to be talking about them being busy as opposed to them being under-utilized. And currently our lead times, our published lead times have remained stable. Our execution against the lead times maybe have slipped by a couple of points but not dramatically, but our manufacturing organization is watching that very closely because one of the things we do want to maintain is the very strong reputation we have with customers of being able to deliver on time. But yeah, our utilization in back-end did go up in Q2.

John Pitzer - Credit Suisse

Great, thanks, guys, very helpful.

Don Macleod

A follow-up on that -- this is a great time to be in the position where you own your own manufacturing facilities, particularly the back-end test and assembly. Clearly there are constraints out there in the sub-contract world in that space but we are pretty much fully self-supported from our own internal factories in that space, so we get a lot of flexibility and priority out of that, so we don’t really have products that are extended lead times or issues of supply constraints at this point.

Operator

Your next question comes from the line of Mark Lipacis with Morgan Stanley.

Mark Lipacis - Morgan Stanley

Lewis, did you say that you still expect more benefit on the gross margin line this quarter from fab closings?

Lewis Chew

No, this quarter I am expecting gross margins to remain relatively stable because the accelerated benefit that we got this quarter I just finished will continue but I am not anticipating another layer of that. The remaining benefit I continue to model to happen in sort of the first half of 2011, fiscal 2011.

Mark Lipacis - Morgan Stanley

Okay, I understand. Thank you. And looking into this year, into this upcoming calendar year, which products do you guys believe have the best opportunity to drive upside surprises? Thank you.

Don Macleod

Do you want me to take that one, Lewis?

Lewis Chew

Yeah.

Don Macleod

Yeah, I’ll take that. Upside surprises -- I’m not quite sure of that word but what are we planning to see growth as we go into calendar year 2010, I will do no more than repeat the initiatives that we talked about before -- LED lighting, solar energy, electric vehicle battery management, automotive opportunities, particularly for in-car communication and infotainment, wireless base stations, and audio opportunities in consumer devices. And then on top of that as the broad industrial markets recover around the world, our portfolio of simple switcher products and now as we just launched the new simple switcher power modules that enable even more ease of use in design, we have a lot of things that we are driving as unique initiatives but it is also things that are driven by the recovering economies around the world. So it’s very broadly spread. I think you can understand the opportunity from each of these. We’ve talked about them consistently -- they are not new for today.

Mark Lipacis - Morgan Stanley

Thank you, Donnie.

Operator

Your next question comes from the line of Douglas Freedman with Broadpoint Amtech.

Douglas Freedman - Broadpoint Amtech

Lewis, if I could start with you on the expenses this quarter, they came in a little bit higher than expected. What was attributing to that higher than expected expense line?

Lewis Chew

You know, on the OpEx side, it was sort of a sprinkling across a number of different things that at a general level I would say is attributable to us starting to see the business coming back. I think the bookings strength that we saw this quarter, combined with what Don and I both said about the reseller rates, tell us that there’s a good portion of what we are seeing right now that is not a head fake. So in terms of delineating the types of things that happened, there was sort of higher business activity across the board, including projects that we had been putting on hold in R&D, customer visits, sales and marketing, getting back to normal compensation levels. It’s the first time in a while that the company actually had headcount go up, not down, which I think is good news just for the broad economy in general. And I think that’s good. We understand that there is quite a ways to go to get back to where we were before and we are not going to take that lightly. I think our operating expense ratios are still higher than what I would like them to be but you can't fix that overnight and we’ve got to run a business that is certainly growing right now. The objective longer term is to get OpEx percentages starting with a 3 handle, not a 4, and I think with some reasonable amount of growth and with us holding expenses relatively steady, we can do that.

So like I said, for Q2, I don’t want to point my finger at any one thing. It was sort of a number of different things. I know I had even given guidance for expenses to go up. It was a little higher than I expected coming into the quarter but we are looking at trying to hold that flat in Q3.

Douglas Freedman - Broadpoint Amtech

And then looking at Q3, is it not a quarter in which you guys traditionally see sort of expenses come in due to the holidays and the fact that you have shut downs? What is the shut down schedule this year? And then just sort of longer term, looking at the -- you know, since you are mentioning ratios, the SG&A ratio has sort of flipped on us. That used to be lower than the R&D percentage -- now it’s actually higher. Can you explain why the investment in the business is going in that direction?

Lewis Chew

Sure. In terms of the savings in Q3, yes, there are more holidays in Q3 versus Q2, I think you could argue that within my guidance, I am allowing for some decline but it’s not like we save $5 million next quarter from holiday savings. That’s typically a million or two, so I think that’s fair. But like I said, the additional activity that we started in Q2, that’s going to continue in Q3. I mean, we actually have lots and lots of customers right now more worried about not getting their product than worried about getting too much product, so we have to make sure we take care of that.

In terms of the SG&A versus R&D, I don’t -- this is not an excuse. It’s just a factual statement but a disproportionate amount of some of our non-cash stock comp goes into there and I’d say from a longer term perspective, Doug, you will see that coming back down. We’ve got some things that are being accelerated but a year from now we’ll see that number come down and we do expect longer term to bring those ratios more in parity, as you’ve pointed out, so we are not ignoring that either.

Douglas Freedman - Broadpoint Amtech

All right, great. Thank you.

Operator

Your next question comes from the line of Stacy Rasgon with Sanford C. Bernstein.

Stacy Rasgon - Sanford C. Bernstein

Just one question on the timing of the remaining Texas benefit -- I think you had said on this call that you were still expecting that within the first half. I thought your original guidance on that a quarter or two ago was we probably see it as like a step change in Q1 2011. Has that kind of moved out a little bit or at what point should we be modeling sort of the full benefit, the remaining three points or whatever it is from that?

Lewis Chew

It’s a small subtlety, Stacy, but I am glad you asked it because it is a fair question. I would still say that we expect a large portion of that in Q1. The one small complexity that I always have to allow for is any time you have a transition where an entire fab goes away, there could be some interim step where you roll it through the inventory first. But nevertheless, that benefit that we are targeting, we will get and I am very confident that by the end of the first half, we will get it all -- how much of that comes in Q1 versus Q2, certainly it would be our objective to try to get the bulk of that in Q1. But I’m just giving myself a little bit of wiggle room. But I think longer term, the objectives [are different] -- it shouldn’t really change the picture at all.

Stacy Rasgon - Sanford C. Bernstein

Got it, and was there anymore bridge inventory built up for that transition in this quarter, even with the total inventories down?

Lewis Chew

Yes, so now we’ve built several million worth of bridge inventory but it’s not even worth highlighting that when we have a quarter where inventory went down. But we did in fact build a little bit more bridge inventory this quarter but just like last quarter, those are single digit millions of dollars.

Stacy Rasgon - Sanford C. Bernstein

Got it. Okay, and I guess for my follow-up, I just want to clarify -- you said the disti weeks of inventory now is low at right around 8 weeks. Is there no amount -- and you said that we should probably expect that to come up over time. Is there any amount of that I guess restock or that coming up off of that 8 week number in your guidance for next quarter?

Lewis Chew

If you look at the base model for the flat outlook, Stacy, I am incorporating an assumption that the disti weeks gets back to somewhere more in the 9 range, which would imply that the inventories go up. What we don’t know right now is exactly what will happen with resales. I’d say we are taking a fairly modest stance on resales but if resales are stronger, that might cause the weeks to stay down in that 8 range, which I personally think is too low, and that we’ll have to deal with that during the course of quarter. But embedded in the base model for this quarter is that the weeks will come up and we are not assuming any significant increase in resales obviously that’s a pure guess at this point.

Stacy Rasgon - Sanford C. Bernstein

Got it, great -- and Mark, congratulations on the new addition.

Operator

Your next question comes from the line of Chris Danely with JP Morgan.

Chris Danely - JP Morgan

Yeah, Mark, congrats on the IPO by the way -- I’m right behind you by a couple of months. I just have a couple of quick questions. By the way, Lewis, what percentage of your revenue is disti these days?

Lewis Chew

Say that again?

Chris Danely - JP Morgan

What percentage of your total revenue is through distribution these days?

Lewis Chew

Roughly 60%.

Chris Danely - JP Morgan

Okay, and then why would you guys [inaudible] take up the inventory now in a seasonally weak quarter versus later when things are a little bit stronger?

Lewis Chew

You know, the number one reason, Chris, is that I don’t think that they necessarily intended it to end this low for our quarter end, right, because on November 30th is sort of a meaningless thing to a disti. The reality is that the inventories in some regions are probably too low to support the business that they are getting. Like I mentioned Asia-Pacific at around six weeks, you know, our manufacturing time is six weeks, so do you really want to run a channel with only six weeks of inventory when National’s replenishment cycle is at least six weeks?

So it’s probably not that they are trying to build inventory but probably getting it back to a more appropriate level because we’ve been running on a model where even 10 weeks of inventory was considered more on the light side. It just happened to push down into the 9s during these last couple of quarters.

So I think for us, what we normally see is as you work your way through the weak part of December and January, as you get into February they stop thinking about the holidays and start thinking about the strength that comes in the May quarter, and that may be what provides some back-up for me to say that they would increase their inventories, just from a gross dollar standpoint, to get ready for that May quarter.

Chris Danely - JP Morgan

Okay, and this is what they are telling you guys as well?

Lewis Chew

Yes.

Chris Danely - JP Morgan

Okay, and the other was beyond the Texas closing, benefit to gross margins, as your utilization rates increase, whenever that happens, those should also benefit gross margins, correct?

Lewis Chew

Yes, we continue to try to run the company with a model of roughly 80% follow-through on incremental sales dollars.

Chris Danely - JP Morgan

Okay, great. And then in terms of your own inventory plans, I think there are 88 or 89 days, do you guys have some sort of goal for inventory days at the company?

Lewis Chew

Yeah, we probably have a range, Chris, of a model. I would say if you allow me some latitude, it would probably be in the neighbourhood of 80 to 90 days, if you will, and you know, for a while there, we are -- it tipped over 100 days, so if you assume that that is the range, then we are at the very high end of that, so the decline in inventory that we are targeting this quarter will get us closer to being in the middle of that range and then from that point forward, it will be driven by the business conditions.

Chris Danely - JP Morgan

Okay, and then on the OpEx targets, do you guys have a -- I guess a target percentage for your SG&A?

Lewis Chew

Lower than it is today.

Chris Danely - JP Morgan

I’ll take that, and then last question for Donnie -- you guys talked about the increasing focus on revenue growth and moving away from margins. Do you guys think that perhaps in the past you might have lost some share as a result of maybe some very stringent pricing practices and so now that you guys have the opportunity to maybe get a little more aggressive on pricing, that can be a very effective way to gain back the market share?

Don Macleod

Well, I’ll qualify that statement -- I didn’t say we are moving away from margins. I said that our focus is to try and focus more on revenue growth and I think the issue on the table for us is there’s really two levels to that -- the new product initiatives we talked about, we certainly can push for revenue growth in those space. On the other side, yes, we can be more aggressive where it suits us to go for business in some of these high volume consumer related businesses where we can take business we might have walked away from in the past.

It’s possible that we can do that now because we’ve got the disciplines in place, we have the margin structure in place and our factories are lined up to do that. And when you have a situation as Lewis just mentioned where 80% to 85% of every extra revenue dollar falls through to margin, it makes sense for us to go after those revenue dollars and capture that incremental fall through and show you the accelerated earnings per share growth at the bottom line. That’s the objective and we will certainly push these buttons as we go through calendar year 2010.

Brian Halla

I just want to make sure that everybody heard what Donnie said clearly -- we are not giving up margins to grow revenue. And in fact, I’ll repeat what I said in the opening paragraph of my commentary -- we are talking about growth with increasing profitability, so we are -- what Donnie was saying is we are in the range of our margin goals now and we don’t plan to leave that range with these new initiatives and he also said after he listed all those new initiatives that we enjoy very comfortable margins in each of those areas, especially the ones that go through distribution.

Chris Danely - JP Morgan

Great, thanks, guys.

Operator

Your next question comes from the line of Romit Shah with Barclays Capital.

Romit Shah - Barclays Capital

Donnie, you mentioned that with respect to the handset business, that Korea was down in the quarter. Is there still some inventory lingering out there or are we getting back to more normal seasonal growth patterns?

Don Macleod

I can only give you a bit of flavour -- clearly we look at the mobile phone market place in the context of seven major customers that we have. These are basically the five -- top five and the two Smartphone guys. A few of those customers are in Korea and as we said, we did not see revenue growth in this most recent quarter from these two customers.

It’s kind of dangerous to say this but if I look at the backlog that we have from both these two customers in aggregate today, and if we ship that backlog, we would not reduce our billings any further to these two guys over the quarter we just finished. However, we haven’t reached the end of the holiday selling season so I am not sure that these backlogs will either hold, be reduced, or even incremented going forward. But the indications we have are that that inventory adjustment at least as far as we see it, is complete. There may be another one after the holiday season is over but at this point, that’s where we see it.

Brian Halla

And you can bias what Donnie said by the fact that many of our large OEMs deal with us through vendor managed inventory, so we have a pretty good feel for what their real demand is because they take the product out, they need it and we replenish it.

Romit Shah - Barclays Capital

Okay, that’s very helpful. Lewis, the business is throwing off a lot of cash -- can you help us think through stock buy-back versus bringing down the debt further?

Lewis Chew

There’s actually three pieces, Romit, so you brought up two -- stock buy-back, bringing down the debt, but also dividends. I’ll talk about dividends first -- the way we’ve been trying to manage dividends as a company through this downturn is looking at the dividend pay-out ratio relative to our earnings and we are now back to a much more healthy relationship because this quarter the dividend declaration was $0.08 and we earned $0.20 and that’s better than back when we were paying $0.08 on $0.13.

So in the future, it’s likely that we will have some movement there. In the near-term here in about six months, we do have a small tranche of debt coming due so certainly we want to have the flexibility to be able to deal with that as we will, and obviously I can't talk about that until the day it get here.

And in terms of stock buy-back going forward, we have consistently said in the past that we are a business that when things are going well, we will generate cash in excess of what we need for reinvestment in the business and we will return that to the shareholders, either through the form of buy-backs or dividends.

So it’s going to be a combination of the three.

Romit Shah - Barclays Capital

All right, that’s great. I also want to pass along my congratulations to Mark. I’m sorry these other guys don’t believe in paternity leave.

Lewis Chew

We gave him one day off.

Mark Veeh

Operator, we have time for one more question.

Operator

Your next question and final question will be from the line of Ross Seymore with Deutsche Bank.

Ross Seymore - Deutsche Bank

One question on the revenue side of things first -- kind of a different spin on an earlier question -- if I look at the peak revenues from last year quarter to what you guys are doing and guiding for in this next quarter, I think you are down about 25%. A lot of your peers are closer to 15. I guess the first part of it -- why do you think that delta has widened to that? And then more probably important, going forward, what do you expect that delta to do -- shrink, expand, stay the same, et cetera?

Lewis Chew

Yeah, Ross, this is one that has received no shortage of attention over time and I don’t know how many times I can go back and look at all of the different things that occurred but during that window of time, we were probably impacted by taking inventory out of disti channel, which causes our revenues to go down faster. There probably was some movement of share due to pricing or whatever but going forward, I think the most important thing for us to focus on as a company is how we grow coming out of this, because I can't unwind something that happened last June. I mean, the reality is right now when I look at these last two quarters that have gone by, we are definitely holding our own against the competition and I am very encouraged by what I see with the revenue opportunities we have in front of us and that’s probably about all that we can do.

Don, can you add some more color to that?

Don Macleod

No, I think that’s the key -- if you look at the last two quarters, look at the revenue growth we’ve been able to show, look at the bookings growth, two quarters where our bookings have grown 17% each sequentially, look at the activity in our distributor resales -- actually our distributor resales grew faster than the sales we reported this quarter as a company. I don’t see any reason unless there’s an economic collapse here why that couldn’t continue certainly in the first quarter of next calendar year, so let’s look forward and see how we can evidence this focus on revenue growth and I just want to close by saying my three important priorities for the company are revenue growth, revenue growth, and revenue growth and let’s leave it at that.

Ross Seymore - Deutsche Bank

That sounds like a good answer to that one, and then one real quick one on gross margin -- if mix is going to improve in this next quarter, as you said seasonally, is there something offsetting that improvement that is keeping your gross margin guidance flat?

Lewis Chew

Yeah, a little bit comes on the side that I mentioned with the inventory, Ross, because we are not planning to increase our utilization over this holiday. I think earlier there was a question about -- I think it was from Doug Friedman about us saving expenses in the quarter because of days off for holidays but at the same time, we also have less days to manufacture inventory and absorb those costs, so I think the flat guidance is a relatively consistent message with the revenue, if there’s ways that we can improve margin, fine but I certainly wouldn’t want to portray a picture where margins are going to go up a lot just because of mix. As I said earlier, mix can move around a little bit each quarter but it’s not going to be points worth of margin, right -- you’re talking about basis points.

Ross Seymore - Deutsche Bank

Okay, great. And congrats to Mark as well.

Mark Veeh

Thanks. So at this time, we are now going to end the call. Let me remind you that the replay is available on our website and thank you for joining our call today.

Operator

Ladies and gentlemen, this does conclude today’s conference call. We’d like to thank you for your participation. You may now disconnect.

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Source: National Semiconductor F2Q10 (Qtr End 11/30/09) Earnings Call Transcript
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