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Freescale Semiconductor (FSL)

Q3 2006 Earnings Call

October 19, 2006 5:00 pm ET

Executives:

Mitch Haws, Vice President, Investor Relations

Michel Mayer, Chief Executive Officer

Alan Campbell, Chief Financial Officer

Analysts:

James Faucette – Pacific Crest Securities

Glen Yeung, Citigroup

Ron Lee, UBS

Jake Kaminny(?) - Morgan Stanley

Mickey(?) Lee - Goldman Sachs

Presentation

Operator

Good afternoon and welcome to the Freescale Semiconductor Q3 2006 financial results conference call. Operator instructions. I would now like to turn the conference over to Mr. Mitch Haws, Vice President, Investor Relations. Sir, you may begin when ready.

Mitch Haws, Vice President, Investor Relations

Thank you and welcome everyone to our Q3 2006 conference call. With me today as usual are Michel Mayer, our CEO, and Alan Campbell, our Chief Financial Officer. The earnings release and financial statements discussed today are available at the investor relations section of our website at Freescale.com. This call is also being webcast live at our site. We will today make certain forward-looking statements. These forward-looking statements, including statements about the proposed merger, and statements about our expected financial performance for Q4 2006. These statements are based upon our current expectations and assumptions, and we cannot assure you that these expectations will be correct due to inherent risks and uncertainties. Our actual results could differ materially from these statements.

Please review our filings with the SEC for a more detailed discussion of the factors that could cause such results to differ, as well as other factors that could affect our future results. With that, I will turn the call over to Michel Mayer.

Michel Mayer, Chief Executive Officer

Thanks, Mitch. Good afternoon, welcome to this earnings call. Joining me as always is Alan Campbell, our CFO. I am going to give you an overview of the quarter and then I will turn the call over to Alan to cover the financials. Before I review the quarter, as you are I’m sure most likely aware, we announced on September 15 that the company signed a definitive agreement with a consortium of private equity funds led by the Blackstone Group to be acquired in a merger transaction for a price of $40 per share in cash. The Board of Directors of Freescale has unanimously approved the merger agreement and resolved to recommend that Freescale stockholders adopt the agreement. A special meeting of stockholders to approve the merger has been scheduled for November 13, 2006. Stockholders of record on October 18 2006 are entitled to vote at the special meeting. We filed this morning with the SEC the definitive proxy statement in which further information concerning this merger is contained.

As I’m sure you understand, the purpose of this call is to discuss our Q3 results and so we do not plan – and I mean it, we do not plan – to comment any further on the transaction during today’s call. We will not take any questions related to the transaction.

Moving on to the results in the quarter, sales for the quarter grew 12% over last year to $1.62 billion. Excluding divested businesses, Apple and so on, sales really grew 17% YoverY. All three segments contributed to the growth. We increased our gross margin to 46.1% for this quarter including our options expense. The revenue growth, gross margin improvement and continued operating expense controls drove an operating margin of 16.4%. I think those results again, as we’ve underscored every quarter, show the value of our diversified revenue model.

Let me now discuss our three major businesses, starting with TSPG transportation and standard products. The Q3 revenue was $682 million and operating margin was 21%, which is nine points ahead of last year. Automotive revenues were impacted in Q3 by a steeper than expected decline in North American vehicle production. US automotive revenue sales during the quarter were frankly lower as we exited than when we entered the quarter. North American big three production was down 13% YoverY and down 23% sequentially.

Despite this weakness, we were still able to grow our automotive business versus last year. This was driven by more than 50% growth in Japan and more than 20% growth in Asia. This highlights the progress on one of our key growth initiatives, broadening the base of our automotive business is important as market share shifts continue to occur among the other makers around the world. We also continue to see very strong growth in analog and sensors, primarily driven by demand for advanced safety systems.

You will recall that earlier this year we announced a joint design program with ST Microelectronics, centered around the power architecture for automotive. Since the announcement, we’ve had staff join design facilities, we have already designed a new generation micro controller core, we have defined product roadmaps and we have aligned poster technologies. The joint design centers that we have opened, we anticipate to reach a headcount of 120 engineers by the end of this year. As we move from design to production, customers will benefit from the dual source availability of our jointly designed automotive MPUs.

In consumer and industrial, we continue to make good progress in strengthening our presence in distribution. TSPG’s distribution revenue in Q3 was nearly 30% above last year. Our 32-bit ColdFire product contributed significantly to the growth in consumer and industrial, demonstrating over 25% growth both sequentially and year over year. We are seeing increased penetration in a number of applications such as industrial controls and networking applications. At the Freescale Technology Forum, we continued to build momentum for our controller continuum roadmap with the launch of our ColdFire V1 core. This will provide the engine for the industry’s first 32-bit devices that are comfortable with 8-bit micro controllers. At the lower end of the continuum, we introduced a new 8-bit micro controller, that combines an analog to digital converter with five volt operation, but reduces board space, system costs and power consumption for a variety of consumer markets.

Looking ahead for TSPG, we expect the production cuts in both Q3 and Q4 may temper the typical Q4 strength that we see in automotive. The traction that we’re gaining in Japan and Europe automotive, along with continued strength in consumer, industrial and distribution should help to mitigate this impact.

Let me now switch to networking. That business generated revenue of $369 million with operating margins of 27%. We have been very successful in covering the loss of the Apple business each quarter this year and that was an important goal for us. If you adjust for the discontinued businesses in networking, Q3 revenue increased 26% YoverY, driven by continued strength in our infrastructure market – both wireless and wireline and increasing traction in small office and home networking applications including set top boxes.

We have a strong track record this year on design wins in the networking space across our communications processors and DSP product families. Our RF business also remains strong as we expand into new markets including industrial, scientific and medical applications. We still see ongoing demand for GSM build out and one of our major customers in Europe, soon to be a European American company, told us that they expect GSM to remain strong well into the future.

Also during the quarter, we adopted a new model for developing our StarCore technology. You I am sure remember that this was part of a joint venture with Infineon and Agere. This joint venture helped us to develop technology which is the basis of some of the most advanced and powerful processors in the industry. We believe that moving the StarCore technology development internally will allow us to increase flexibility and speed to better serve our customers.

During the quarter we introduced several new power (click free?) devices, including one processor that provides intelligent traffic management with security that converged networks need while ensuring top of the line performance; one order that is security optimized that plays to the increasing need for confidentiality in the hardcopy printing and imaging market. Those types of products are essential to winning high end printing sockets which are important growth drivers for the business today and into 2007.

Together with IBM and Power.org, we are continuing to transform the power architectural technology. We recently announced a new merged instruction set architecture Power ISA version 2.03, which merges many of the capabilities of previous power PC ISA versions into one unified documentation set. We also introduced the first openly collaborative platform specification. The power architecture remains a key underpinning to both our networking and automotive product portfolios. It is by the way used by the FT Freescale Alliance that we discussed a little bit earlier.

Finally, we partnered with Wavesat to deliver WiMAX enabled customer premise equipment – CPE – reference platform with designs to enable a converged wireless business and essential gateway solution. With WiMAX gaining some momentum around the world, some key platform solutions like ours are what the market needs to drive rapid deployment of broadband wireless technology in cost effective CPE products. This reference platform is based on the power of (quick 2?) processor, it supports 802.16d certification and it can be integrated to support new industry standards for mobility, for those of you who are experts here, like 802.16e.

Looking ahead to Q4 for the networking segments, we would expect revenue to be in line with Q3. This would represent double digit growth again of the prior year, while seasonally slower capex trends for the rest of the year may modestly pressure the RF business. The linearity is much improved versus 2004 or 2005 and helping to mitigate this impact is continued growth in our new family of processors.

Finally, let’s take a look at WM wireless and mobile solutions. Revenues of $540 million, that’s a 5% sequential growth and 19% YoverY. Operating margin in the quarter was 7%. The revenue growth in this quarter has been driven by strength across our top customers, as evidence of our continued penetration across the chipsets within Motorola, our power management and power amplifier revenue has tripled in the past year. New devices introduced this quarter with Freescale content includes the Motorola quasar(?) and RAZR. Both include our RF (inaudible) power management and PA products. In addition, Motorola’s new 3G line up including the RAZRxx, the RAZR max HDSPA phones are all based on complete Freescale chipsets. In fact, their entire 3G lineup is based on chipsets.

We are also seeing results in our efforts to expand into the merchant markets with components such as H-RF(?), a number of announced and unannounced phones are utilizing our RF solution.

In Q3, we also began volume shipments of our i.MX products for portable music players such as Toshiba’s Gigabit. We continue to make progress with other customers as well. Some of you have seen probably from your comments on Nokia earlier this month, it was public so I can talk about this – it mentions our chipset design begin produced by Elektrobit. We are working diligently to support this program for delivery during 2007. Building on the success of another application process and solution, the i.MX21, we introduced the i.MX27 which moves us another step closer to delivering full HD quality video solutions for mobile and handheld applications, such as V2IP, mobile phones and portable media players.

Video continues to be a key driver in the mobile space, from applications such as video conferencing to highest resolutions required to deliver the optimal user experience.

Our wireless business has grown 20% in each of the first three quarters, which is solid progress for the wireless team. The performance has been less cyclical than in the prior years. Looking to Q4, we would expect modest revenue growth sequentially, representing another quarter of double digit deliveries again.

As you look at our overall performance this year, so far, you can see that the diversity of our revenue base continues to provide us with the ability, in that uncertain economic environment and with some of our segments having a little bit of difficulty. I’m starting to be pleased with the progress in our execution. We are not there yet. But we are continuing to transform Freescale into an industry leader. With that, I would like to turn the call to Alan Campbell, our CFO.

Alan Campbell, Chief Financial Officer

Thank you, Michel. Our financial results show we continue to make solid progress in driving financial improvement. As Michel stated, our Q3 revenues were over $1.6 billion, representing a 12% increase from the same period last year and a 1% sequential increase in a quarter that is typically down. All three segments improved on a year on year basis. Our orders in Q3 were $1.7 billion, representing a 1.05 book to bill with our wireless group above one and networking and transportation slightly below one. Our gross margins were 46.1%, up 320bps from the same period last year and up 10bps from the last quarter.

While our margins remained essentially flat versus last quarter, they were negatively impacted by product mix, offset by stronger IP revenues. Our distribution revenue is a key focus area which as you know historically has experienced a higher margin, where 15% of our total sales flat from last quarter but up from 13% a year ago. Our net income was $257 million or 15.9% of sales. This performance compares very favorably to the $164 million or 11% of sales in the same period last year and the Q2 level of $260 million. Keep in mind that this quarter does include a bond redemption fee of $15 million as I communicated last quarter.

Our operating expenses in total were $479 million and stock option expense in Q3 was $14 million spilt across the SG&A, R&D and the cost of goods. Our SG&A as a percentage of revenue was 11.2%, essentially flat with last year and slightly down from last quarter. R&D was 18.4% of revenues, which on a percentage basis is down from last year and also down from last quarter. I will say it’s also down on a dollar basis, driven primarily by timing of grants we received in the quarter. Our operating margins for Q3 were 16.4%. Net interest income in Q3 was $7 million compared to income of $1 million a year ago and $8 million last quarter. Interest income was favorably impacted by higher returns and interest expense was reduced due to the redemption of the $400 million floating rate notes early in the quarter.

Included in the interest line item that is $15 million of fees associated with the bond redemption. Depreciation and amortization was $157 million or 9.7% of sales and this compares to the $166 million or 0.4%(?) of sales a year ago. EBITDA in Q3 was $417 million, 25.8% of sales compared to $343 million a year ago and $405 million in Q2. Our GAAP EPS was $0.61 per share which does include $0.03 of options expense. This level compares favorably to last year and last quarter, where EPS was $0.38 and $0.61 per share respectively. Our effective tax rate expectation for the year is approximately 6% with a cash tax rate of approximately half of that. I will add that during Q3 2006, we did record $11 million of one-time non-cash benefits, primarily associated with reducing the valuation allowance in one of our foreign entities. Fully diluted share count is 424 million which is flat with last quarter.

I will now summarize a little on the segments, so our transportation and standard products reported Q3 revenues of $682 million down 2% sequentially and up 10% on a YoverY basis. As Michel mentioned, our operating margins in Q3 were 21%. This compares very favorably with the 12% reported in the same period last year and I will add it’s flat with the last quarter. Our networking revenues were $369 million and were essentially flat on a sequential basis and were up 3% versus the same period last year. Again, excluding the impact of discontinued businesses, revenues would have grown a very strong 26% YoverY. Q3 revenues in this business were 27% compared to the 19% last year or 28% in the last quarter. Again, driven by favorable product mix within the networking portfolio.

Our wireless revenues in Q3 were $540 million, up 19% versus a year ago and up 5% sequentially. Operating margins were 7%, with margins benefiting from the higher sales level as well as product mix. That concludes the little discussion on the segment performance. Now I can take a quick look at the balance sheet.

Our cash for short-term investments and marketable securities at the end of Q3 was $3 billion, which represented a decline of $246 million from the end of last quarter. However, this included the $400 million bond redemption. As we have indicated over the past several quarters, it was also impacted by a slightly higher level of capex of $193 million or 11.9% of sales. Our DSOs and payable days in the quarter were 40 days and 59 days respectively, and this compares to the 34 and 62 in Q2. Our receivable days did increase due to the normal linearity of Q3 revenues.

Inventories increased by $63 million and inventory days increased to 78 compared to 72 days last quarter and 71 days in the same period last year. This level of days is within the range of historical values and most of the increase was in TSPG, due to the weakness in automotive revenues that Michel touched on. Our distribution revenues increased 27% YoverY and weeks of inventory were relatively flat and remained below the nine weeks of sales. Looking ahead to Q4 2006, we expect revenues to be in the range of $1.535 billion to $1.635 billion. We also expect gross margins to be essentially in line with our experience in Q3. That concludes our remarks, now what I’d like to do is pass it over to the operator for some questions and answers.

Question-and-Answer Session

Operator

Operator instructions. Our first question is from James Faucette – Pacific Crest Securities.

Q - James Faucette – Pacific Crest Securities

I had a quick couple of questions in terms of your margin development in Q3, progressing pretty nicely overall and I just wanted to know if you still look and feel like you will be able to achieve the 200-300bps improvement by the end of next year versus Q1 this year and what the primary drivers of that would be.

A - Alan Campbell

Very clearly, we do expect continued expansion from gross margins. There are a number of elements that will drive that. One is procurement – we have aggressively been after reduction in supplier pricing. Two is portfolio, you’ve heard us talk hopefully in the past about some opportunities within our portfolio. We have great opportunities in some of our businesses like analog to significantly enhance our margins. Three is pricing, we’re looking at, sophistication in our pricing and have actions in place. Four is our operational efficiencies. Obviously when we’re running a size of business with the diversification of products, markets, there are many, many things that can enhance our margins but you can have the assurance that there is a commitment from the full 24,000?plus employees that we will continue to expand our margins.

A - Michel Mayer

So yes, we are comfortable with the 200-300bps by the end of next year.

Operator

Our next question comes from Glen Yeung, Citigroup.

Q - Glen Yeung, Citigroup

Once you get your sense of the overall two end markets, and forgive me if these have been asked, I just got on the call. Both the handset but also the infrastructure business and recognizing that, I’m sure you’ve always had a good view on that – there seems to be some mixed messages and I would point out that one of your – I don’t know if they’re a competitor or another chip company, actually said it may not be that bad in Q4. I wondered what you thought about the infrastructure side of the house?

A - Michel Mayer

You mean networking, right, Glen?

Q - Glen Yeung, Citigroup

Networking, I actually mean specifically wireless base stations.

A - Michel Mayer

We think it’s not that bad, you’re right. Seasonally, the capex tends to go down a little bit in Q4 for the wireless infrastructure as we see it so we tend to experience the seasonal pressure on our RF business, but that being said, this year all the indications seem to be that it’s going to be much more muted. The year seems to be much more linear, if you want, on the capex profile of our large customers. I don’t know what they’ve done better – planning? As you know, those things tend to be large rollouts. I think part of the emphasis this year has been a lot of add on, on this relatively healthy wave of GSM add on, on existing networks. That is probably more linear than a new rollout. I can tell you that what we observe is that Q4 is not going to be as depressed as it is usually in our infrastructure business. Does that answer your question?

Q - Glen Yeung, Citigroup

It does, Michel – are there any anomalies geographically there or does it look pretty smooth across the board?

A - Michel Mayer

I think it’s weaker in the US from what I can tell.

Q - Glen Yeung, Citigroup

Okay, that’s interesting. You probably did address this, but the other question was on handsets. My sense is you had a pretty good handset number. It sounds like you may have taken some market share there, particularly given what your largest customer reported. I just wanted to get your sense of market share versus end market?

A - Michel Mayer

I think we might have had – let me just remind everybody that we are, because of the lag in the supply chain, we are not necessarily tracking Motorola exactly quarter to quarter, okay? So people always need to keep that in mind, because they have to buy our kit before they build their phones. That being said, yes we are gaining market share in general, market share off Motorola, but we clearly have power management, our business, our people year over year, so we know we’re getting share. We’ve displaced some of our competitors in Motorola phones, we know that, and we’re starting to gain traction in the RF business outside where we were not playing. All of our gain is probably outside also getting ready with market share, but I think it’s minimal at this point. I have more ambitions for next year in terms of starting to gain more share. You’re right, we’re probably gaining a little bit.

Operator

Our next question comes from Ron Lee, UBS.

Q – Ron Lee, UBS

Congratulations on a good quarter. Just a question on 3G, if you were launching a new 3G platform at Motorola for this quarter, what is your expectation for the ramp and can you comment in general on your outlook for the 3G market in 2007?

A - Michel Mayer

Thanks, it’s a good question. I will not comment on the ramp because I would be guiding too closely to a customer, which I never do as you know. But on my expectation side of the 3G market, I think it is finally going to happen in 2007. I am starting to push that more to mid second half of 2007, frankly, than a very, very strong Christmas here, just because I am uncertain on the state of the earth’s economy in the first part of 2007 but also the impact on consumers. The second thing is I observed that the operators seem to be a little bit more cautious and linear in their view of how they’re going to growth their 3G share there. I think they are gradually becoming more realistic and have stopped thinking it’s going to be a hockey stick. It’s just a matter of when the hockey stick is going to happen. They seem to have gradually accepted that it’s going to be more linear. It’s going to happen definitively in 2007. The high products are there, the high price point is there now, but I think it’s going to be more linear than everybody would like it to, probably from a revenue point of view. That’s my view.

Q – Ron Lee, UBS

How about from a margins point of view, how is the mix in 3G increase going to improve your margins in the wireless division?

A - Michel Mayer

Significantly. Clearly, one of the things that we need is that product mix. That being said, because it is going to be more linear and more in time, there will be a market expectation that high will gradually reduce, so it’s going to help. The product mix is going to help us improve the margins, but it’s not going to be as much as it would have been if we had been able to…

Operator

Our next question comes from Jake Kaminny(?) - Morgan Stanley.

Q - Jake Kaminny(?) - Morgan Stanley

I just wanted to talk about capex and your plans for 2007 and what we should be thinking about in terms of the level versus what you’ve been spending so far in 2006. If you talk a little bit about what you’re seeing, in terms of is it more front end, is it more back end, are you guys advancing the process technology, just a little bit of color on that please?

A - Alan Campbell

I’ll take that one, Jake. Our capex was a little bit higher in Q3, as we had previously communicated, actually representing over 11% of sales. Going forward, I think it’s fair to say that we will continue with our stated model which is 10% of sales over the cycle. The reason it was a little bit higher in Q3 is as we said before there were some specific areas that we had opportunity to invest and improve margins going forward. Most of the capex I should say is a combination of front end for technology expansion. It also includes some process technology as well as assembling tests. It covers a combination of all, as one would expect from running both assembly tests and manufacturing facilities.

Q - Jake Kaminny(?) - Morgan Stanley

Do you use outside partners to help you with any of your manufacturing?

A - Alan Campbell

Yes, we currently outsource approximately 20% of our silicon today. That can significantly increase, and actually on the assembly and test, depending on the package, it’s probably in the range of 50-60% that is outsourced. This is a key element, because as part of that strategy it really gives us a lot of flexibility to ride the markets and it gives us opportunity to collect capacity back in to keep our internal factories loaded.

Q - Jake Kaminny(?) - Morgan Stanley

Any plans to try to increase the amount of the front end outsourcing? Or is that the level you want to keep it at?

A - Alan Campbell

It is going to be a function, yes there is, there could be plans to increase the outsourcing. It could be a function of the market and our success to market with the technology. It’s reasonable to say that could increase and has increased beyond 20% in the past.

Operator

Thank you. Our next question comes from Mickey Lee(?) of Goldman Sachs.

Q – Mickey Lee(?) - Goldman Sachs

In terms of a question on the micro controller side of things, you had introduced a controller continuum strategy and I was just wondering if you could talk about the traction of that program and also what you’re seeing from a competitive response on that side of things, if there’s been any sort of tactical response?

A - Michel Mayer

I am not aware of a strong, visible response from our competition due to the concept of continuum. Let me say I am not away, things might be happening out there but they haven’t leveled to my level and I think that in part it is because in order to have a continuum strategy which says you want to have 8, 16 and 32-bit controllers that have some level of compatibility and help the customers for their software from low end to high end, to do that you need to have a complete range of 8, 16 and 32-bit processors and so for example, people who might be very strong in 8-bit and trying to grow in 16 but are not present in 32-bit cannot really have a continuum strategy. Do we see traction? Yes, frankly. The ColdFire V-1, which is the first 32-bit device that we have that’s compatible with 8-bit controllers, we are seeing a lot of interest and some early traction. I don’t want to portray that it’s a tidal wave but it’s strong and for sure, I’m getting very positive feedback from customers on the concept and how attractive it is. I don’t know if that gives you a feel.

Q – Mickey Lee(?) - Goldman Sachs

Definitely. One follow-up question, on area that you had focused on in terms of Freescale’s objective was increasing the distribution business. You’ve done a very good job of that in particular. I’m just wondering what you’re seeing there in terms of the dynamics at the distributors in terms of inventories and lead times in general. That would be very helpful thank you.

A - Michel Mayer

Our own inventory in distribution is flat, trending slightly down, so it’s nothing particular to report there. If you look at the details of the micro segment, you might find that the automotive related inventory might be a little bit on the rise. All in all, it’s flat, trending down, so nothing to report here specifically on the inventory side. I hear sometimes a little bit of caution when I talk to them about their overall inventory positions from an industry point of view when I talk to the distributors, but my observation is that they are managing that pretty well. I don’t think there is a looming inventory problem during distribution. That is my observation. Thank you very much, I think we are going to close now. Thank you very much for your attention. Good bye.

Operator

Thank you, participants. This does conclude today’s conference call. You may disconnect at this time. Everyone, have a great day.

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