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Executives

Chuck Ives - Director of IR

Wayne Fortun - CEO

Kathleen Skarvan - President of Disk Drive Components Division

Steve Polacek - CFO

Dave Radloff - Corporate Controller

Analysts

Rich Kugele - Needham & Company

Christian Schwab - Craig-Hallum Capital Group

Eric Reubel - MTR Securities

Edward Lee - Pacific Madrone Capital

Jim Brilliant - Century Management

Tom Lewis - High Road Value Research

Hutchinson Technology Inc. (HTCH) F2Q10 (Qtr End 03/28/10) Earnings Call April 27, 2010 5:00 PM ET

Operator

Welcome to the Hutchinson Technology's second quarter results conference call. (Operator Instructions)

I would now like to turn the conference over to Mr. Chuck Ives, Director of Investor Relations.

Chuck Ives

Good afternoon, everyone. Welcome to our second quarter results conference call. On the call with me today are Wayne Fortun, our CEO; Kathleen Skarvan, President of our Disk Drive Components Division; Steve Polacek, our CFO; and Dave Radloff, our Corporate Controller.

Rick Penn, President of our BioMeasurement Division, he is out of the country on business. In Rick's absence, I will be providing an update on the BioMeasurement Division later in this call.

As a reminder, we will be providing forward-looking information on demand for and shipments of the company's products, production capabilities and capacity; capital spending; worldwide disk drive and suspension assembly demand and shipments; pricing; product cost; our plans to establish an assembly operation in Thailand; our BioMeasurement Division's revenue; product commercialization and adoption; customer education; company's results of operations and operating performance.

These forward-looking statements involve risks and uncertainties as they are based on our current expectations. Our actual results could differ materially as a result of several factors that are described in our periodic reports on file with the SEC. In connection with the adoption of SEC rules governing fair disclosure, the company provides financial information and projections only through means that are designed to provide broad distribution of the information to the public. The company will not make projections or provide material nonpublic information through any other means.

We issued our second quarter results announcement just after the market closed this afternoon, and it is now posted on our website at www.htch.com.

I'll turn the call over to Wayne now for his opening remarks.

Wayne Fortun

Thanks, Chuck. Good afternoon, everyone, and thank you for joining us today. As you saw in our second quarter results announcement, we reported a net loss in the quarter primarily because of a 16% decline in suspension assembly shipments compared with the preceding quarter.

While we expected demand in the second quarter to decline sequentially, our second quarter shipments declined more on a percentage basis than the estimated total available market for suspension assemblies did. Our reduced volume was primarily the result of a temporary market share loss that we believe is limited to the fiscal 2010 second quarter.

In short, the combination of share shifts among our drive makers and problems we encountered as we broadly implemented certain TSA+ process improvements results in a short-term market share loss.

We have corrected the process problems that constrained our capacity and hampered our yield improvements and prevented us from meeting demand in the last quarter. Based on volume commitments on customers' programs, we're confident we will regain market share in the third quarter.

Despite the difficulties in our second quarter, we've continued to strengthen our balance sheet. We retired the remaining $41 million balance on our 2.25% convertible subordinated notes that was due on March 15, 2010. And we sold a portion of our auction rate securities portfolio for $19.3 million in cash.

I'll turn it over now to Kathleen who will give you an update on the Disk Drive Components Division.

Kathleen Skarvan

Thanks, Wayne. During our fiscal 2010 second quarter, we shipped 130 million assemblies, down 16% from 155 million in the preceding quarter and up 22% from 107 million in last year's second quarter.

For the quarter, our mix of products shipped was as follows: Suspensions for 3.5-inch ATA applications accounted for 46% of our shipment compared to 42% in the preceding quarter. Mobile applications accounted for 32% of our shipment compared with 38% in the preceding quarter. And enterprise applications accounted for 22% of our shipment compared with 20% in the preceding quarter.

Compared with the preceding quarter, our shipments of suspension for 3.5-inch ATA and enterprise applications decreased 7% and 5% respectively. The shipments for mobile applications were down 31% sequentially. Share shifts among the disk drive makers contributed to our lower second quarter demand in the mobile and enterprise segments.

Our share was also impacted as certain TSA+ process improvements were broadly implemented and new TSA+ products were brought into production, causing yield declines and capacity constraints that temporarily prevented us from meeting demand. These issues have since then resolved. TSA+ yields have improved in the past four weeks of our third quarter or the first four weeks.

Average selling price in the fiscal 2010 second quarter was $0.66, down from $0.68 in the preceding quarter and $0.71 in last year's second quarter. The price decline reflects the continuation of a competitive pricing environment.

Our second quarter suspension assembly shipments included 20 million TSA+ suspension assemblies or about 15% of our volume, down from 25 million or 16% of volume in the preceding quarter.

Due to the short-term decline in the open capacity constraints that I mentioned, the TSA+ cost burden increased in the second quarter to $7.9 million from $7.4 million in the preceding quarter. We do remain confident in our TSA+ production ramp and yield improvement efforts. With the combination of higher TSA+ volume and yield, we believe that we can eliminate the TSA+ cost burden by the end of the current fiscal year.

We also continue to win customer acceptance on new programs with our TSA+ product. As a result, we expect TSA+ shipments to grow significantly as a percent of our volume over the next two quarters.

In the next couple of years, our additive TSA+ suspensions will become the vast majority of our product mix as they continue to replace their subtractive TSA suspensions.

To respond to the growth in TSA+ demand, we are expanding our TSA+ capacity and increasing our planned fiscal 2010 capital spending from $35 million to about $50 million.

Regarding our future assembly operation in Thailand, construction of the facility and hiring and training of employees are all proceeding on schedule. We currently expect to ship products for customer qualifications from our Thai operation early in fiscal 2011.

As I mentioned in our first quarter conference call, we have been actively involved in the design of dual stage actuated suspensions for several customers. That work has further progressed, and our dual-stage products are now plan of record on three programs with two customers. We also have dual stage coding and sampling activity in progress with all other disk drive OEMs.

With respect to our outlook, we expect our third quarter share gains to offset a projected seasonal decline in disk drive shipments, resulting in relatively flat suspension assembly shipments compared with our second quarter.

Full year projections of disk drive shipments for calendar 2010 have been strengthening, and we are well positioned to gain market share on customer programs that are expected ramp to higher volume as the year progresses.

I'll turn the call over to Chuck now for a review of BioMeasurement Division and health.

Chuck Ives

Thanks, Kathleen. Net sales for the BioMeasurement Division in the fiscal 2010 second quarter totaled $687,000, up from $508,000 in the preceding quarter and $458,000 in last year's second quarter, short of our expectations.

In light of the Division's current pace of sales through the first half of the fiscal year and spending constraints in the healthcare markets worldwide, we now expect net sales for fiscal 2010 to be approximately $3 million, down from our earlier projection of $4 million to $6 million.

While sales were short of our goal, we are pleased with the continued growth in sensor sales and repeat business. The number of InSpectra StO2 sensors sold in our second quarter more than doubled compared with the preceding quarter as system usage among our expanding customer base increases. We now have 120 customers and the worldwide base of installed monitors has nearly doubled year-over-year to 280.

We're also pleased with continued high interest in our Advanced StO2 Education Programs or ASEP. This program for physicians and nurses focuses on the use of InSpectra StO2 monitoring in specific clinical situations. We continue to use a strong linkage between clinician participation in this program and increased sensor usage.

Our efforts to expand the use of InSpectra StO2 monitoring to applications beyond trauma medicine are also beginning to gain momentum. For example, the high patient volumes in emergency rooms are providing quick and compelling opportunities to demonstrate the value of InSpectra StO2 in identifying problems that other measures of patient status do not detect.

In addition, some customers are starting to adopt InSpectra StO2 as an alternative to central catheters for monitoring patient status. This is another opportunity to help hospitals reduce their treatment costs, possibly avoid infection-related complications which further increases costs for the hospital.

I'll turn the call over to Steve now for a discussion of our financial results.

Steve Polacek

Thanks, Chuck. Net sales for the fiscal 2010 second quarter totaled $87.6 million, down 19% from $108.3 million in the preceding quarter, but up 11% from $79 million in last year's second quarter.

Revenue percentages for our top customers in the quarter were as follows: Western Digital, 44%; SAE/TDK, 24%; Seagate, 11%; Hitachi, 9%.

Gross profit in the second quarter was $7.3 million or 8.3% of net sales compared with $20.8 million or an 18.2% of net sales in the preceding quarter. The declining volumes in ASP were the primary reasons for the sequential decline. Compared with last year's second quarter, gross profit improved by $19.1 million, an $8.6 million increase in net sales, reflecting the benefits of our fiscal 2009 restructuring actions.

Depreciation and amortization expense was $13.3 million in the fiscal 2010 second quarter, down from $14.8 million in the preceding quarter and $21.1 million in last year's second quarter.

R&D expenses were $5.4 million, up about $300,000 from the preceding quarter, but down $2.1 million from last year's second quarter. Sequential quarter increase in R&D spending is primarily the result of increased development activity in the dual-stage suspension assembly program.

SG&A expenses totaled $13.2 million, up $700,000 from the preceding quarter, but down $1.7 million from last year's second quarter. Sequential quarter increase resulted from higher levels of spending in the BioMeasurement Division for clinician education, sales and marketing activities and additional startup expenses for assembly operation in Thailand.

These startup expenses totaled about $700,000 in our second quarter, incurring an operating loss of $11.3 million in the second quarter compared with an operating profit of $3.1 million in the preceding quarter and operating loss of $57.6 million in last year's second quarter. The operating loss in the BioMeasurement Division was $5.3 million compared with $4.9 million in preceding quarter and $6.2 million in last year's second quarter.

Interest expense in fiscal 2010 second quarter was $4.2 million, flat with preceding quarter and down from $5.2 million last year's second quarter. As noted in our results announcement, second quarter interest expense includes $2.1 million of non-cash interest expense resulting from our adoption of FASB guidance for accounting for convertible debt instruments.

During the quarter, we sold $22.6 million in principle amount of auction rate securities for $19.3 million in cash. There is second quarter loss of our auction rate securities portfolio of $2.8 million, and the second quarter sales resulted in an additional net loss of $420,000.

Our pre-tax loss in the quarter totaled $15.1 million compared with a pre-tax loss of $30,000 in the preceding quarter. We had an income tax expense of $500,000 related to income tax (rule) in Japan. That compares to an income tax benefit of $2.3 million in the preceding quarter and $200,000 in last year's second quarter.

Our net loss for the fiscal 2010 second quarter totaled $15.6 million or $0.67 per share. This includes a previously mentioned non-cash interest expense of $2.1 million or $0.09 per share.

During the fiscal 2010 second quarter, we generated $7.4 million in cash from operations and spent $7.7 million on capital expenditures, resulting in a negative free cash flow of $300,000.

During the quarter, we retired the remaining $21.1 million balance of our June quarter convertible subordinated notes, which were due on March 15, 2010. The principle amount of our total debt balance is now $254 million and $296 million at end of the preceding quarter.

Our cash and investments now at quarter-end totaled $197 million, down from $242 million at the end of the preceding quarter, primarily due to the debt retirements I just discussed.

Our share count at the end of fiscal 2010 second quarter was approximately $23.4 million, resulting in book value per share of $13.20. Our book value includes approximately $1.25 per share primarily related to the portion of our convertible debt that we're required to reclassify shareholders' equity for the accounting gains for convertible debt instruments.

Turning now to our outlook, and both Wayne and Kathleen noted we are confident that during the third quarter, we will regain market shares that we temporarily lost during the second quarter.

Return on expected share gains, we expect our third quarter shipments to be relatively flat compared to the preceding quarter despite a projected seasonal decline in (dispatched) shipment for the quarter. We expect pricing will continue to be competitive.

Our R&D expenses should remain relatively flat. Our SG&A expenses are expected to increase primarily due to increased startup expenses for its high assembly facility. We estimate a $10 million in startup expenses for the fiscal 2010. $1.2 million have been incurred through our first two quarters. The estimate of these startup expenses will total $3.5 million in our third quarter and $5 million in our fourth quarter.

Effective tax rate is expected to be about 0% for the remainder of the fiscal year. Depreciation and amortization expense in fiscal 2010 is expected to be between $50 million and $55 million.

As we noted in our results announcement, we are increasing our planned capital spending for fiscal 2010, approximately $50 million from the $35 million, The incremental $50 million is for the support of expanding TSA+ production capacity in response to customer demand.

As stated previously, our fiscal 2010 capital spending also includes $50 million for the construction of our assembly facility in Thailand.

I'll turn the call over to Wayne now for his closing comments.

Wayne Fortun

Thanks, Steve. We are disappointed to be reporting a sizeable loss from the second quarter. The impact of the weaker volume we were expecting in the quarter was made worse by the production inefficiencies and temporary share losses we encountered in the quarter.

In the first fours weeks of the third quarter, all indications are that we have resolved the TSA+ production problems, and we are confident we are regaining market share that was lost during our second quarter.

The contrast between our 2010 first quarter and our second quarter results shows the high degree of leverage in our business model both on the downside and on the upside.

Our path to consistent profitability continues to include growing our suspension assembly revenue, improving our TSA+ production efficiency, expanding TSA+ adoption, establishing operations in Thailand and growing revenue in our BioMeasurement Division.

We're sharply focused on all of these initiatives.

That concludes our prepared remarks.

Question-and-Answer session

Operator

(Operator instructions) Our first question is from the line of Rich Kugele with Needham & Company.

Rich Kugele - Needham & Company

Just a couple of questions. I guess first, your original guidance for the quarter that had suggested something in the mid-teens type unit decline was predicated on the idea that there was a shift in programs you were on that had lower suspension counts, right? But what you're stating here is that there were yield issues that prevented you from shipping. And so if you could just explain, again, what really happened and what is the issue on the TSA+ side or that regular TSA, that would help as well.

Kathleen Skarvan

Good question, and really there are a combination of factors, but we believe that our inability to ship TSA+ probably was one of the larger contributors. But it is accurate that one of our customers we believe had a lower hedge curve. We also believe that there was some share loss. So again, trying to put that in order of priority, I would say there are a number of inhibiting factors that I would somewhat label in the way I just described.

Wayne Fortun

Just to be emphatic about being clear, it was the TSA+ that was the problem and not TSA on the yield and therefore our output.

Kathleen Skarvan

And I think it's important to comment additionally on the process improvement that exclusive to TSA+, although we aren't going to talk specifically about what that improvement was for competitive reasons.

It's important to note that we felt the timing was right to make this change, which guarantees that we continue to have a competitive product long term with requirements changing and continuing to be more stringent and requirements shifting and becoming more complex. So felt the timing was right now.

And as we said, we are through it and on to improved TSA rates.

Operator

Our next question is from the line of Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Wayne, how bad the results have to be to pre-release?

Wayne Fortun

I'm going to give that question to Steve. And we've thought about that, of course, Christian, and I'll let Steve respond.

Steve Polacek

Christian, as you know, we do not give specific revenue or EPS guidance. The only time we typically will go ahead and do a pre-release is if we cannot do, for example, a lot of quarter results and industry conference, then we go ahead and do that in advance of that.

Christian Schwab - Craig-Hallum Capital Group

Okay. And then on ASPs, given the increase in TSA+, when do you expect ASPs to bottom or stop going down?

Kathleen Skarvan

Well, Christian, it would be great if that was the type of inventory we're in. I believe though we're going to still continue to see pressure from our customers who continue to see regular price declines. And so we're not anticipating that there is necessarily a flattening out. And we continue to look at rates to reduce costs, so that we continue to do (technical difficulty).

Christian Schwab - Craig-Hallum Capital Group

One to two years out, where do you think suspension pricing is?

Wayne Fortun

Two years out, allow me to go two years Christian, you'll see a larger volume of DSA in the mix. And to that, we'll force up the average sell price somewhat. And so it probably bottoms. And because of DSA, it moves back up somewhat out by that time.

But I think the other thing quite honestly, Christian, is that in the supply chain within drives, there has been some compression in terms of availability or capacity. But in the case of suspensions, there was plenty of excess capacity. So it's been a competitive pricing market and probably will remain so, because that capacity hasn't been utilized yet. But we may actually be seeing, I guess, in the next year or so that the capacity has started to look like it's more on the order being fully used. Therefore, we may see not quite as an aggressive pricing environment out a year or so, but we'll have to see.

Kathleen is right. It's still driving this a little bit. We really have had an overcapacity situation by all of the players for the last 18 months.

Christian Schwab - Craig-Hallum Capital

And you talked about the dual-stage suspension, three programs, two customers. Is one of those two customers a previous significant customer who said they were going to stop buying suspensions from you?

Wayne Fortun

We won't talk about the customers. But we'll wait before we start naming anybody, because once all of them are involved, then we might speak more about who we're moving with.

Christian Schwab - Craig-Hallum Capital

And I think heard that the BioMeasurement Division lost $5.3 million this quarter. Is that correct?

Wayne Fortun

Yes, that's correct.

Christian Schwab - Craig-Hallum Capital

Given your reduction in sales from $4 million to $6 million down to $3 million, can you give us an idea of what type of unit level of suspension and flash mix of that is now needed to improve gross margins to get back to a level of breakeven?

Steve Polacek

I think you had two different kind of questions in there. You were talking a little about Bio and you also were talking about the disk drive side of it. I think what we've said before is our total revenues for the company-wide (inaudible) $115 million in a quarter, so that we can come to a breakeven result on the bottom-line.

Christian Schwab - Craig-Hallum Capital

So at $115 million a quarter, you're going to need a substantial recovery in suspension units with continued ASP pressure to get just back to breakeven. Is that fair?

Wayne Fortun

Yes. As we said in our comments that for our fiscal third quarter we expect volumes to be flat with the second quarter. So that's kind of where we're going to be. That's where we see kind of the suspension side of the business. And as you said, (inaudible) continued pressure on ASPs.

Christian Schwab - Craig-Hallum Capital

So even if it is back in the envelope, we did some match over here, even if you gain five points this year at a market that's growing 15%, unless you have a tremendous mix up or significant yield recovery on the TSA+, it's going to be pretty hard to make money. Is that fair?

Wayne Fortun

Short term, we'd say that's accurate. But as we look at where the general industry is viewed, if we look at the full second half of the calendar year and we move into our fourth quarter, end of quarter of the coming year, those numbers are anticipated to be up substantially. And I think at that point, there may be the possibility then to see that larger swing you're describing, Christian.

Christian Schwab - Craig-Hallum Capital

Right. But what's your dig on optimistic format? You talked about Q3 units for the disk drive industry being up, call it, 12% to 14% and then maybe up 3% to 5% in the December quarter. I don't think that gives you guys enough units to get there unless I'm looking at it wrongly.

Wayne Fortun

That's probably not wrong and one in which we will have to see how it all plays. We think that we can improve our position from this perspective, but we won't be able to see it fully healthy without overall demand rising with it.

Operator

Our next question is from the line of Eric Reubel with MTR Securities.

Eric Reubel - MTR Securities

With the ramp up in CapEx, can you discuss kind of a target for free cash flow for the year and what level are you comfortable at sort of burning cash if you were to go that way in fiscal 2010?

Steve Polacek

Actually there was about $20 million of breakeven for the second quarter and maybe about $200 million for the first quarter. When we look forward into the third and fourth quarter, we're going to have significant CapEx in the latter half of the fiscal year. So we're projecting about $50 million of the expenses out (inaudible). So we have about $35 million. So that's going to absorb a significant amount of our cash during the year.

Eric Reubel - MTR Securities

When I think about gross margin and where we're at now with somewhere in the 8% range, how should I think about the incremental gross margin as you do ramp in calendar Q3 and calendar Q4? And what kind of drop through rate should I be thinking about model gross margin for the back half of the calendar year?

Wayne Fortun

Now, I'd say we'd start with that the cost of goods sold is about 50-50, fixed versus variable. So that helps a lot in getting a feel for as the volume grows how much of the cost rises with what is constant.

Operator

Our next question is from the line of Edward Lee with Pacific Madrone Capital.

Edward Lee - Pacific Madrone Capital

If shipments are going to be flat sequentially, maybe up a little bit in the fourth quarter, ASP is going down and R&D going up, I mean just to confirm, it doesn't look like you're going to be breakeven here for the next few quarters? And free cash, will it going to be negative because of increased CapEx? Is that right?

Wayne Fortun

Just a couple of clarifying comments. I think you said fourth quarter will be flat. We're really talking second and third being flat. We think that in the fourth quarter, total demand will be up in our share and we'll have recovered our share position. And therefore, we think we will grow with the market in that fourth quarter and that will be up. Well, it's a guess, but we're generally talking 12% within the quarter is likely. So I think that it's not right to think of the fourth quarter as flat.

As far as the R&D, I think it's flat from this and don't anticipate that it can be continuing to rise. And then the CapEx, we've already spoken to that is that with the free cash flow that we've had this year, we'll probably, as we look at the balance of the year, end up real close to a breakeven on free cash flow for the year. It will be close to that as we look at the spending at the balance of the year.

Edward Lee - Pacific Madrone Capital

Now going into the next fiscal year with the new CapEx in place, presumably lower-cost structure in Thailand and assuming you'll have a normal industry ramp, how much can profitability improve or the free cash flow picture improve? I assume that CapEx is kind of a one-time thing.

Wayne Fortun

Let me answer the last question first. The CapEx will really be dependent upon just how much the industry grows. And if we se it growing a lot, then we may actually be having to consider CapEx for our TSA+, not for any of the rest of the assembly businesses or the like. But that we'll see and there will be a relatively good news if the market is growing that much.

As Kathleen talked about we had on the TSA+, we believe we're carrying a burden right now, roughly $7.5 million a quarter on TSA+, as we're ramping this new process and carrying the overhead that is not being utilized fully as it should be.

We remain of the view that that $7.5 million a quarter burden, we'll be able to get rid of that burden by the end of the fiscal year or the start of the new year. So that shifts fairly substantially what our profitability potential is on an ongoing business that we can get that kind of hope out of our TSA+.

Edward Lee - Pacific Madrone Capital

Can you just clarify what that means exactly, what a burden is? I mean assuming that you'd need a lot more volume in your TSA+ to absorb a cost that you already encourage, not as if it's a cost that's going to go away. Is that correct?

Wayne Fortun

Some of it will be actually going away, because it's variable cost that runs high at this juncture because of yields and not being where we expect them to be. And when you look at the learning curves that we're on and what we think we can do to improve as we proceed, those yields will also improve the overall output of those lines so that we get more use out of the line and improve our labor costs and so forth.

So the variable side cost will be coming down, as well as then just more output per the overhead dollar that is there. So some of it is cost actually being removed. Some of it is just better utilization of the overhead dollars.

So that's one of the things we look at, and that's really relative to our other product lines that we're shipping in the mix. And so as we are increasing that TSA+ as part of our mix and we're comparing it to our older TSA product line, it really is a burden. And we think we can get it so that it runs as well or as economically sound as the TSA product that we're shipping.

And better, as we then roll into 2011 and we've talked about that literally, because we are the only vertically supplied manufacturer of this flexure that we will have several pennies advantage over our competition by making it ourselves.

So that's what we think in terms of removing of that cost burden and where we stand as we look to 2011. And then we've talked about that we believe where we can get into with the total volume increase, we can get into something in the neighborhood of the mid-20s target gross profit as Thailand starts up and we get the volumes where we want and TSA+ is running where it should be.

And we think that those things are achievable as we roll into the latter part of 2011.

Edward Lee - Pacific Madrone Capital

Okay. One last question and I'll give up the line here. In terms of the BioMesurement business, it's been growing, but below expectations for some time and continue to lose money in that operation. At what point is the pain threshold saying that this doesn't make sense, investment in this business doesn't make sense?

Wayne Fortun

Well, for the time being, we're still handling the pain pretty well. And the reason is that while the dollars for the sales are not ruling in as rapidly as we would like, the momentum on this is continuing to give us indications to say it is worth sticking up for some while yet and to ride through this. And so I think we will stay on this course for some while and want to see this through, particularly as we have gotten some of the evidence here that Chuck talked about earlier in the emergency medicine as we're seeing it doubling from quarter-to-quarter on repeat sales for our sensors.

We are not getting this large install base of both monitors and hospitals actually starting to use the sensors, but we think it should be expected. And with our education and so forth, we've estimated that a reasonable size, medium-size hospital and the bulk of which we've sold in that 120 hospitals that we have right now is customers nicely represent $1 million a year on revenue. And so we have a lot of the hard work done in terms of a solid installed base it's now, educating them and getting them to the point where they start using to really cover the patients well it should be utilized on. So for the time being, we're going to stay the course.

Operator

(Operator Instructions) Our next question is a follow-up question from the line of Rich Kugele with Needham & Company.

Rich Kugele - Needham & Company

I did want to ask, Kathleen, in terms of the TSA+, did you need to re-qualify or do you need to re-qualify after making those changes that you implemented?

Kathleen Skarvan

There was a small expedited re-qualification, and that's behind us already. That just was again an opportune time as the volumes are at a lower level than they are originally. We're expecting to significantly improve those volumes. We believe it was the right timing to do that now. So all subsequent products moving forward will already be using (inaudible).

Rich Kugele - Needham & Company

And then lastly on TSA+ in general, do you see when you are in full volume on TSA + that your share has an opportunity to be different than it is today overall? Any advantages relative to your competition who are also obviously using additive. But is the performance better? Is there an opportunity for you to gain share just solely based on the availability of a higher-performance device.

Kathleen Skarvan

I have optimism in that regard, Rich, and it's for a number of reasons. We found that our vertical integration has provided us faster lead times. We know that if you get your product to the customer first and they are using that, then that's what they tune their process to.

We also believe that we have a competitive offering right now with our (inaudible). It is possible over time that again due to our vertical integration and enough understanding suspension design from the components through the finished assembly that we are going to find other competitive advantages in regard to that product.

And then finally, you've got what we think is going to be the very best economics in the industry. Our business model we think with Thailand and TSA+ will prove to be the very best. But again, there's reason to be optimistic.

Operator

Our next question is from the line of (Mark Miller) with Global Financial. Please go ahead.

Unidentified Analyst

There has been a lot of talk about component constraints. Now, suspensions are not mentioned. It's more heads and substrates, but that's been a recurring theme if you listened to it at Western Digital. But we are also hearing that TDK and Japanese are being very slow to commit to added capacity. I wonder if that could be an opportunity for you if we do get into this regime of constraint components. And one of your major competitors or more, they're not going to expand to put the money in the capacity. I'm just wondering what your feelings are on that.

And also, if you could talk a little about the dual stage actuator, the future of that, in terms of where it's going and in terms of volumes and acceptance.

Kathleen Skarvan

Relative to your first question on TDK, our understanding is it that you're talking about their expansion relative to their head capacity. I know just recently I read an announcement that they actually are making some additional investments in their Japan facility, their head operations. But I'm not sure that that will have a positive or negative effect on the suspension requirements. But it is certainly something we keep an eye on to understand (inaudible) may shift, for example.

Wayne Fortun

The only thing I'd add to that is that generally what we've seen that there is a constraint somewhere in the supply chain for the drive makers, and the drive makers are making more money that generally more of that from an economic standpoint will trickle down to the supply base. But we haven't witnessed that in the current situation because of the competitive nature on suspensions, but perhaps that might be the case, but I wouldn't comment on that a great deal, Mark.

On the DSA side, I look at this as that it appears that DSA has more applicability than we would have thought two or three years ago as we were doing our long-term technology analysis. Some of the newer approaches and requirements on the drives, as they're trying to improve their area density, our finding that dual stage or a secondary actuator on the suspension is probably the most economical way to try to advance area density for the drive makers.

And that looks to us like it probably has multi-year application and on a broader use within the drive families than we had originally thought. So while we made these in large volume and then put it on the shelf and thought that it might only be a very slim portion of the industry, it now looks like it could be significantly more. And we're very carefully watching over this and then working with customers appropriately.

And so that will be an interesting adder to the pricing. And some new challenges in terms of the manufacturer which we think would re-incur knowledge on, because we shipped 100 million of these parts in volume in the past.

Unidentified Analyst

So we'd be sticking our next step too far to (inaudible) within next year, it could be 15%, 20% or were you still two years away on that?

Wayne Fortun

I think it's more like two years, Mark. I think you are too fast. We'd probably be seeing enough in a way of some percentage actually shipping to be notable and then a lot of sampling which in our world that's thousands of parts. But to get to the 15% range, I'd say two years, you ought to be thinking that way.

Operator

Our next question is from the line of Jim Brilliant with Century Management.

Jim Brilliant - Century Management

On the question of breakeven, I think you've got the revenues of $115 million or so as breakeven. Is that right?

Wayne Fortun

Yes.

Jim Brilliant - Century Management

Does that include the $7.5 million burden from TSA+?

Wayne Fortun

Yes.

Jim Brilliant - Century Management

So what's breakeven by the September quarter when the burden should be zero?

Wayne Fortun

The run rate on the TSA burden, we'll be approximating zero when we get to the end of the fiscal year. So during the fourth quarter, we will have a TSA burden.

Steve Polacek

Yes, I think, Jim, as I mentioned, some of it's variable expense that will come down, but some of it is covering the overhead expense. So some of it is revenue that has to rise to help us fully utilize that unused and poorly used overhead we're carrying there. So I don't think it's quite right to say it's an exclusion of, because somehow $115 million is going to be added TSA+ volume that we'll be utilizing better and therefore lowering that burden.

Jim Brilliant - Century Management

So how do I look at it then? I understand that part. You need some volume to cover that unabsorbed overhead. But the other part is just in efficiencies and waste, et cetera. So how do I look at it? Part of it is volume. So how do I look at these? In other words, the December quarter is breakeven, still $115 million, or should it be lower than that, given that part of it is just some better processes as you go forward?

Wayne Fortun

First off, the total burden on TSA+ is not unlike the rest of our cost of making a product. And so that burden is about 50-50 of variable cost versus fixed. So now you can figure that we've got $3 million and $3.25 million or something like that variable that should be improving as we move on. So that would probably help that model somewhat.

And then I think that as we look at that December quarter and where we see the volume, we will have to make sure and add in that what might happen to pricing at the same time. And so that can be a moving target as we see wherever pricing isn't constant for us, and so we need to speed revenue.

And then finally, we will be really turning on Thailand by then, but it'll be running at higher cost and not as efficient as it will be only months later when we've had a chance to run it for three to six months. And so that's why I'm so much hesitant to give you an exact calculation in that December quarter.

There's a lot of things going on, and particularly both pricing as a part of when we're talking revenue versus volume, and then second would be the Thailand operation which will be ramping up in cost between now and then and we'll just have really started shipping out of it.

Jim Brilliant - Century Management

The December quarter only because it was the first quarter in which you suggest you won't have the TSA+ burden, but what's your say kind of on an ongoing state, assuming TSA+ ramps as you expect and the burden is gone and you have Thailand that's up, you're spending another $50 million in capital with the possibility of continuing to spend even more based on the success of TSA+.

But that can be running in place here, so I'm trying to get a sense of, with all that you're doing and all that you've done, how does this lower your cost structure so that in the tech world where ASPs continue to decline, you get ahead of the game as opposed to following it?

So not necessarily on a quarterly basis; I used December as I said, only because that was when that burden goes away. But how do we get ahead of the game as opposed to not like we've been, in the face of another $50 million being spent in capital.

Steve Polacek

I think that when we talk about our gross margin target that we think is achievable, that would include the depreciation for an ongoing maintenance expense at the very least which we probably put in the neighborhood of $30 to $40 million in CapEx that we've put in place.

And then as we talked about, with the Thai operation, it is helping us to lower our cost. And then TSA+ is not just that the burden goes away, but as we then continue to ramp that volume, we think that it's giving us several pennies per (part) of a cost advantage over our competitors who have to buy the product from our competitor, Nitto Denko. So we think that we will have the lowest cost in the industry, and be able to very competitive.

And at that point to such an extent that the volume will rise for us, both in share and total market volume, and then that our competitors won't be able to price in the same place that we can, and we can more money out of them. All of those taken into account, our estimate is that we can achieve that in the mid 20s gross margin. And with the kind of SG&A that we have, it's typical that we would be returning in the 30s in terms of our operating margin and where we can go.

Jim Brilliant - Century Management

And when is it that you'll have that several cents cost advantage.

Steve Polacek

Once we hit it where the burden is no longer there, then it starts to trip the other way, and every quarter that goes by, is giving us more and more of an advantage as we see that volumes rise, and our efficiencies continue. And so it literally is the kind of key is that when you resize that December quarter that would finally get to the point where this thing now is doing exactly what we had intended it to do and to bring us advantage, every month that goes by is lending to the advantage for us, not just holding steady.

Jim Brilliant - Century Management

And when is the Thai facility up running and operating at its expected cost levels?

Kathleen Skarvan

We'll be qualifying that site with the customer at the beginning of our fiscal year or so in that October/November timeframe. And we have shown when we start returning on that investment, and it will be towards the second-half to the end of 2011. And again, it depends on how fast we can ramp that facility up. So again, as Wayne was saying, you're going to have that TSA+ burden come off and then actually start enhancing our cost model, business model.

And it is same with the Thailand as we progress through 2011.

Jim Brilliant - Century Management

To clarify for me anyways, does the TSA+ burden going away, does that give you the couple cents of cost advantage, or do you require the Thailand to be up as well?

Kathleen Skarvan

So we'll start seeing a cost advantage already with TSA+, and then on top of it is the bonus I believe at Thailand. And then you have an additional bonus of the way the Drive industry continues to strengthen its units and volumes. So as Wayne was saying, you combine all those three, and the model becomes legally the best in the industry.

Operator

Our next question is from the line of Tom Lewis with High Road Value Research.

Tom Lewis - High Road Value Research

It looks like about 15% of your volume in this past quarter was TSA+. Can you hazard a guess up to the timeframe when it's the other way around, say 85% of your volume?

Kathleen Skarvan

We believe that it would be over 50% of our volume as we move into the next fiscal year. And right now we have a philosophy that we want to continue buying a small portion of our flexure requirements from Nitto Denko, and that maybe anywhere from 15% to 20% overall is where we think that makes sense to balance our own internal capital needs versus --

Tom Lewis - High Road Value Research

-- more or less indefinitely?

Kathleen Skarvan

Right now that would be the plan, yes.

Tom Lewis - High Road Value Research

So greater than 50% you said next year.

Kathleen Skarvan

As we enter the next fiscal year, and I would say by the end of 2011 we'll be almost phased out of TSA.

Tom Lewis - High Road Value Research

What I'm wondering about that is, we've just gone through yet another painful volume step change around TSA, and when I think about what your volumes would be, we can hope and expect those volumes to be a year or two from now; would seem like you've got a few more volume step changes like that to go through. Is there anything in particular about this one that you just went through that you could share with us that would give us a sense as to the likelihood of those step changes being any more or less painful than that?

Wayne Fortun

I think that the volume increase in the number of added part numbers that we had to deal within this quarter are that expectancies. We would not want you to mislead anyone and have him think that that was the reason for the difficulties. It really was a process change that we were making; it was a fundamental process change to the overall TSA+ line and not tied to the part numbers or the volume increase.

And as Kathleen said earlier, part of the reason we did it was, if we're going to have to make this change, we decided that it would be better to make this change now when the volumes are where they are than to wait when you're about running $50 million a quarter and then try to make that change, that would have been a lot more difficult and a lot more trying.

And so I think that you should think about it as, we look to the future, and the price we paid in this last quarter making this fundamental change is behind us. And then, it really will be, while there is always some modest issues as you add part numbers and start up new products, it is nothing like what we just went through in terms of a major process improvement that was a fundamental shift. It's behind us, and I think that you shouldn't think of those added volumes as the same kind of problems that you witnessed in this quarter.

Tom Lewis - High Road Value Research

So would it be fair to say that there is at least a bit of that old, tiny, brute force, get this done, before the seasonal ramp that made this as bad as it was?

Wayne Fortun

That is correct. And we can't conclude it. We didn't have the potential to manage the mix so carefully that we could actually ramp a few small volume products with the process changes. We were trying to do some others, that would have been wonderful.

On the other hand, if we weren't looking at that now, it was really gaining momentum in the direction of where the flexures needed to go. We just decided, we better jump in with this and make the change completely now, before we get in too, and there's already going to be just the seasonality move.

We fully expect that when we go into the March quarter of 2011, our TSA+ volumes will be substantially higher than we are today, and we couldn't afford to make this kind of change then either.

Operator

(Operator Instructions) Our next question is a follow-up question from the line of Edward Lee with Pacific Madrone Capital.

Edward Lee - Pacific Madrone Capital

Just a question in terms of the company's capital structure. Right now, you have a lot of cash still on the balance sheet. Now that you've dealt with the near term convert maturity, you have the one outstanding convert that's (portable) on a few years.

The question is how do you guys think about it terms of what's the appropriate longer term capital structure. Do you need that much cash followed by that much debt, or why have such a large cash balance, and what do you think the right mix is, and what potential future investments would require having a significant cash balance on the business?

Particularly, if this CapEx cycle that you're going through right now, this year it's probably going to be free cash flow neutral.

Steve Polacek

Our total cash investment balance at the end of the quarter was about $197 million, but what you need to take into consideration is that we have a loan against our ARS portfolio. The ARS portfolio is about $67 million as of the end of the quarter, and against that we have an outstanding loan of about $55 million. So you really need to take that 196 and take off the 56.

Edward Lee - Pacific Madrone Capital

So I'm looking at something in the order of $140 million in cash and $170 in debt. Let's just say that. Does that seem like an appropriate capital structure for the company going forward or?

Steve Polacek

Well, a couple of things; one is, we believe we need to maintain at least about $75 million to $100 million of liquid cash and investments for our particular business models and take care of the seasonality and the working capital changes in the CapEx. But the dip downs are actually a little bit higher from a principle perspective because of $200 million in total.

So our debt maturity is out there (inaudible), but we want to make sure that we are positioned to go ahead and deal with that on a timely basis. So we're kind of balancing out our cash needs with our financing needs to make sure that we're being able to deal with that appropriately.

Edward Lee - Pacific Madrone Capital

Okay. And just a follow question to the TSA+ and the Nitto Denko stuff and the cost advantages. Just so I understand this, right now your competitors in the TSA+ buy the flexures from Nitto Denko, and you think that, that causes a cost disadvantage relative to your process not today, but over time. Yet, the pricing on the TSA+ still continues to go down.

How do the competitors, even though they have this cost burden of having to buy the flexures from Nitto Denko keep the pricing umbrella so low that it still becomes such a cost burden on the company?

Steve Polacek

No, it makes sense in that is exactly why Kathleen was saying that we think that our business model is the lowest cost model there is, and we have --

Edward Lee - Pacific Madrone Capital

I guess the question is, are your competitors losing a similar amount of money, or even more by having to supply TSA with purchase substrate today?

Steve Polacek

Well, not at the current time, and that’s because we are just cranking this line up and trying to get it to be as efficient as it needs to be. But as we look to the future and we get the TSA+ running so that it's no longer new and we work through the yield issues and leverage the overhead, then at that point, we think we probably start that line in December, so that we think that every month that goes by, we will actually be gaining advantage on them and then in fact our profits will be improving.

And if the pricing continues to be driving downward, we have a better and better advantage over them and therefore we'll be making money at some point where we would estimate they're not.

And so I wouldn't say they're losing money right at this moment in time, partly because of the cost that we're carrying right now on the TSA+ as a startup.

Operator

Mr. Fortun, I show there are no further questions at this time. Please continue with any closing remarks.

Wayne Fortun

Well, thank you, everyone, for joining us on the call today and we sure appreciate the questions and the level of interest. And we'll talk to you next quarter.

Operator

Ladies and gentlemen, this concludes the Hutchinson Technology second quarter results conference call. Thank you for using ACT conferencing. You may now disconnect.

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Source: Hutchinson Technology Inc. F2Q10 (Qtr End 03/28/10) Earnings Call
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