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Conexant Systems Inc. (NASDAQ:CNXT-RETIRED)

F2Q10 Earnings Call

April 27, 2010 05:00 a.m. ET

Executives

Scott Allen - SVP, Communications, and IR

Scott Mercer - Chairman and CEO

Christian Scherp - Co-President

Jean Hu - CFO and SVP, Business Development

Analysts

Dan Morris - Oppenheimer

Blayne Curtis - Jefferies

Operator

I would like to introduce Scott Allen, Senior Vice President of Communications and Investor Relations for Conexant Systems Inc., who will chair this afternoon's conference call.

Scott Allen

Thank you, operator. Good afternoon everyone, and welcome to Conexant's second quarter fiscal 2010 earnings conference call. Joining me today are Scott Mercer, our Chairman and Chief Executive Officer; Christian Scherp, Co-President; Sailesh Chittipeddi, Co-President; and Jean Hu, Chief Financial Officer.

Scott will begin today's call with introductory remarks. Jean will review our second quarter financial highlights, and Christian will provide business highlights. Scott will then return with our outlook for the third fiscal quarter, and we'll open the call for questions.

Please note that our comments today will include statements relating to future results that are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results may differ substantially from those projected as a result of certain risks and uncertainties, including but not limited to those noted in our earnings release and those detailed from time-to-time in our SEC filings.

The financial information we will discuss today is based in part on non-GAAP financial measures. The company believes that these financial measures, which we term core financial measures, provide an enhanced understanding of our underlying operating performance. A reconciliation of core to GAAP measures is included in our earnings release, a copy of which is available on our website at www.conexant.com.

I will now turn the call over to Scott.

Scott Mercer

Thank you, Scott. I'm pleased to report that the Conexant team once again delivered outstanding performance, meeting our exceeding the guidance we provided on every core financial metric, including gross margin, operating expenses, and operating income. We also exceeded expectations on revenue, and for the second consecutive quarter we delivered core operating margins in excess of 20% of revenues.

During the quarter, we completed the financial restructuring of our company, which was one of our highest priorities, by successfully executing new debt and equity transactions designed to raise the capital required to retire our convertible debt, "puttable" in March 2011, replaced $175 million of senior secured notes due 2015, and we completed a secondary offering of common stock that included the exercise of the over-allotment options, raising $50 million.

With the proceeds from our debt and equity offerings and available cash, we made a tender offer for the balance of our $232 million of convertible debt and retired $105 million of the notes. The remaining note-holders elected to maintain their position, leaving us with the option of calling the rest of the convertible notes in March of next year.

Prior to the completion of our successful effort to strengthen our capital structure, several of our most important customers have excluded us from competing for certain new designs because of our financial situation. I'm pleased to report that with our capital structure issues behind us, we are once again competing for designs at these accounts, and we expect to win our fair share of the business.

We remain focused on capturing market share for the existing products and delivering new solutions for imaging, audio, embedded modem, and video surveillance applications. Our company is addressing a total available market with more than $1 billion today. We have an outstanding IP portfolio and a motivated workforce, and our customer list includes worldwide leaders.

We also plan to apply our core capabilities in analog and mixed-signal design and firmware and software development to capitalize on new opportunities in adjacent markets.

Before I turn the call over to Jean for overview of our second quarter results, I'd like to note that our imaging and audio businesses, where we have focused the majority of our investment dollars, once again accounted for well over half of quarterly revenues. Jean.

Jean Hu

Thank you, Scott. Before I discuss our financial results in detail, I'd like to note that reconciliation of core to GAAP measures is included in our earnings release. Second quarter revenues of $61.9 million were above our high end guidance of 6k to %61 million, and approximately flat sequentially.

Second quarter core gross margins were $38 million, 61.5% of revenues, 50 basis points better than our guidance of 61%, because of product mix and our team's ongoing effort to improve manufacturing cost.

Core operating expenses were $25 million and in line with our expectations. R&D expenses were $13.6 million, and SG&A expenses totaled $11.4 million.

Second quarter core operating income was $13 million, or 21% of revenue compared to expectations, entering the quarter of a range of $11.6 million to $12.5 million. Net interest expense of $4.1 million was $1.3 million higher than our guidance implied, because of additional interest expense associated with our new senior secured debt.

Other expenses were $365,000, (due primarily) to foreign exchange, and the taxes were $332,000. Our net income was $8.3 million, or $0.12 per share based on average yield for 70.5 million shares outstanding during the quarter.

Based on all the expectations entering the quarter and prior to the issuance of new debt and equity, which resulted in a increased expense and higher share count, our earnings per share for the quarter would have been $0.15, better than the $0.13 to $0.14 we anticipated.

On a GAAP basis, revenue was essentially equivalent to our core results. Gross margins were $37.8 million, or 51.1% of revenue. GAAP operating expense of $26.9 million included a $1.76 million stock compensation charge, $284,000 in intangible amortization, and $210,000 of credit from reversal of restructuring reserves.

GAAP net interest expense of $7.7 million included $3.6 million in non-cash interest expense associated with adoption of ATB14-1 and the write-off of that insurance cost. Offsetting that interest expenses, we had a gain of $7.7 million from other income, primarily associated with a gain on the sale of an equity investment and a change in the valuation of our Mindspeed warrant. GAAP net income, including discontinued operations was $10.9 million, or $0.15 per diluted share, based on 70.5 million shares.

Turning now to the balance sheet. At close of the second fiscal quarter, our cash and cash equivalents totaled $187.5 million, compared to $59.1 million in the previous quarter. During the quarter, the company reached $175 million in new senior secured debt and $50 million through the issuance of new shares of common stock and we retired approximately $105 million of the convertible notes due in 2026.

At end of the quarter, we had $127.7 million of 4% face value convertible. Until we retired the remaining convertible notes, our interest expense associated with those notes will be approximately $1.5 million per quarter. In addition, we will have approximately $5.3 million in quarterly interest expense associated with our new senior secured note.

From the operation perspective, inventories in the second quarter were $9.6 million, compared to $9.2 million in the prior quarter. As anticipated, our operations team delivered another industry-leading 10 inventory returns.

I would now like to turn the call over to Christian for a review of our businesses.

Christian Scherp

Thank you very much, Jean. We are focused on delivering innovative solutions that contributes to our customers' success in imaging, audio, embedded modem, and video surveillance applications. In imaging, our product portfolio includes System-on-Chip solutions for multi-function and photo printing applications. These products also go into fax machines, connected frames, and interactive display devices.

Today's multi-function printer market is divided into merchant and captive segments, with the merchant piece accounting for approximately 25% of the total market. We hold the leading position in the segment, and we are focused on expanding our presence. And the captive segment, which accounts for approximately 75% of the total market, leading printing OEMs, currently designing solutions in-house continue to weight the benefits of outsourcing designs to merchant suppliers.

With our product portfolio, and years of experience with imaging technologies, we're in a good position to benefit when decisions are made to outsource (NYSE:MSP) designs. During the quarter, shipments to our leading North American based (MSP) customer increased significantly as they gained market share.

We also continue to win new and refreshed product platforms with our (MSP) and sec solutions at manufacturers worldwide. In addition, our recently announced photo printer SoC controller was chosen by a large Japanese manufacturer for an inkless portable printing platform, and by a brand name global manufacturer for a digital camera with integrated ink-free photo printing capabilities.

Consumer demand for portable printing products is increased, and our team is committed to gaining share in this market segment. In connected frames, we teamed with AnyDATA, a global wireless device manufacturer, to deliver a reference design that allows consumers to transmit and share videos, photos, and other data over 3G broadband cellular networks.

We recently demonstrated our new solution at the Mobile World Congress in Europe and the CTIA Tradeshow in the United States where we saw a high level of entrants in our platforms.

In audio, we provide products for the PC market, as well as integrated speakers-on-a-chip solutions for the rapidly growing embedded audio markets, which includes headsets, multimedia phones and other applications that require audio and voice functionality. In embedded audio, we have developed unique capabilities over the years, and our expertise in mixed-signal technologies as well as audio and voice algorithms provides us with a significant competitive advantage in terms of integration, performance, and cost.

In embedded audio, we continue to see strong design win momentum. During the quarter, new wins included a USB headset with a worldwide provider of digital entertainment products for PC and internet applications and an IP phone developed by a leading Asian electronics manufacturer.

We are ramping to volume production now with numerous customers. From the small base, embedded audio revenues will essentially double on a sequential basis, and we expect this trend to continue.

We also offer high definition audio solutions for Netbooks, Notebooks and Smartbooks. The superior audio quality and low-power consumption at competitive price points are important. During the quarter, we won new audio business with major PC manufacturers worldwide.

In embedded modems, we continue to see strong demand for our solutions in point-of-sales terminals where we have built a market-leading position. Our customers include the top three manufacturers globally, as well as nearly every point of sale OEM in China. We also continue to gain traction with our embedded modem solutions for the satellite set top box application space.

During the quarter, we displaced a key competitor to secure our first design win with a European based set top box provider. In video surveillance, we strengthened our product portfolio with a new family of highly integrated multi-channel decoder for video surveillance systems with digital video recording capabilities.

These second generation solution features the industry-lowest power consumption, and are shipping to customers worldwide now. Last quarter, we introduced an ultra-low power encoder for "smart home" and commercial security systems targeted at applications that include motion sensors, intercoms, and IP network cameras, to just name a few.

The solution supports passive infrared technology, which is becoming increasingly popular because it dramatically reduces incidents of costly false alarms. We have already secured multiple wins with our new solution, and are positioned to win designs with the world's leading security alarm manufacturers. Shipments in support of these orders will commence this quarter.

I would now like to turn the call back over to Scott for our first fiscal quarter outlook. Scott.

Scott Mercer

Thanks, Christian. For the past several years, we have focused our investments in the areas of imaging, audio, and video surveillance. The design cycles range from nine to 24 months.

For the June quarter, the modest sequentially growth we expect in these businesses will not offset the significant declines we anticipate in our legacy businesses, which include wireless networking and modems for digital television platforms in Japan. In addition, our core earnings per share will be impacted by increased interest expense associated with our new senior secured notes, and our remaining convertible debt as well as by higher number of shares outstanding.

Considering these factors, we expect revenues for the third fiscal quarter of 2010 to be 60 to $61 million. We anticipate the third quarter core gross margin will be about 61% of revenues, and the core operating expenses will again be at approximately $25 million. As a result, we anticipate that our third quarter core operating income will be between $11.6 million and $12.2 million with core net income of $0.05 to $0.06 per share based on approximately 83 million shares outstanding. Scott.

Scott Allen

Thank you, Scott. That concludes our prepared comments today. Operator, we're now ready to open the lines for the questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Dan Morris from Oppenheimer.

Dan Morris - Oppenheimer

First off, could you provide us a breakout of how your major segments did during this last quarter?

Christian Scherp

As you know, we don't necessarily breakout revenues by segments quantitatively, but qualitatively our imaging business was essentially flat quarter-over-quarter. And as Scott mentioned in his remarks, we saw a decline essentially in our legacy businesses, which includes our modem business going into digital TV platforms in Japan as well as some weakness in our wireless business now moving forward.

This was offset with continued strengthening of our imagining business and also in our video business.

Dan Morris - Oppenheimer

Just to look at the legacy business and how that might track going forward, how much is the wireless LAN and the legacy modem business right now, and how quickly is that going to fall off over the next year or so?

Scott Mercer

Interestingly enough, we had a very strong first quarter in legacy businesses. And one of the businesses we didn't talk about in there, we actually had some business we were shipping to IKONOS, installed from the DSL business, they opted to not take over manufacturing for.

We're going to see a much more rapid decline than we have seen in the last two quarters starting in the next quarter, and even more of a decline percentage wise once we're in the fourth quarter.

So as we've kind of been saying in the meetings over the last quarter or two, it'll be about two to three quarters in our belief. And then the change in the legacy businesses really won't start masking the growth we're having in the underlying businesses. But it's still almost 20% of our revenue base this last quarter, so it'll start decreasing pretty significantly.

Dan Morris - Oppenheimer

So if you took out the legacy then, when you look at the guidance for 60 to 61, are you expecting your other major segments to grow?

Scott Mercer

Yes, as I said in the prepared remarks, we're going to see a modest sequential growth in our other businesses. There'll be lag of a very small base once again by embedded audio, but we will see certainly a sequential growth in our core businesses. I am not going to quantify it that much, but pretty significant declines sequentially in the legacy businesses. And we expect those trends to continue over the balance of the year.

Dan Morris - Oppenheimer

And just looking at your guidance, how does backlog compare to last quarter? Is it the type of turns requirements that you are looking for?

Christian Scherp

Entering the quarter, the backlog, it's just a tad below where we used to be at the same time, the previous quarter. Still, overall, strength in the market, and there are some customers that seem to order with a little less lead time, but overall going pretty much with the same backlog into the quarter.

Scott Mercer

And yes, Dan, I'd say that the customers are acting say more normally for the first time in a couple of quarters. We're not getting quite as long a lead time order flow as we have been. We had a couple of quarters where it was pretty extraordinary, and was well beyond what we'd ever experienced before. I don't know what you're hearing from some of your other companies you follow, but in my speaking with other folks, I think there is kind of a consensus; a lot of normalcy is returning I think into the marketplace.

Dan Morris - Oppenheimer

And just a follow up Scott on one of your comments about the capital structure; and you had mentioned that there had been prior customers that sort of shied away from you as you were going through all this restructuring and that they are coming back. Can you help us understand qualitatively I guess where are those customers, what type of applications are we looking at, and what kind of an opportunity I guess might you have if you win them back.

Scott Mercer

Sure. I'm not going to give the answer, but everybody can figure them out I suppose. As you know, the very, very top tier PC manufacturers are very robust purchasing organizations and include extensive reviews of supplier stability. And it's been with the very, very top tier North American based PC organizations that we had our most challenges during our trek through the financial wilderness. We're now back on track, and back and available there.

So, it was really in the PC aspects of those businesses more than anything else. So, PC audio, is where we are again really back to back so to speak, and those would be the major areas at this point.

Operator

(Operator Instructions) Our next question will come from Blayne Curtis from Jefferies.

Blayne Curtis - Jefferies

Scott, sorry to go back to raise the question; the wireless business was going to fall off and then it was going to stay around a bit longer and now it seems like it's going to fall back off. It's my understanding it's 4% or 5% of revenue. So I thought there is some kind of industrial products at a longer tail. Obviously the kind of stuff I guess falls off more dramatically. So am I getting this right that we're back to falling off in a couple of quarters?

Scott Mercer

Yes, so to speak. We think all of the legacy businesses, the sequential declines will start to accelerate over the back half of the year. And so, we certainly expect.

Blayne Curtis - Jefferies

And how long is the tail on this business?

Scott Mercer

Some of them have gone away very quickly, for example, the digital television business in Japan. As you may know, they made a architectural or a standard body change that's no longer required, back channel modems in digital TV in Japan, and that kind of went off like a light switch. So that's gone away. Wireless, Lord knows how many quarters we're still going to ship some wireless. We just don't think it will be at these levels.

There is also some real old legacy product that we had over the last past. We've had some one-time buy activity in, and this goes (inaudible) spend our days. So those will not reoccur. So if you look at the wireless, the DTV drop off, and there's still, believe it or not a tail of PC modems, we think we'll really start to accelerate that sequential reductions in the second half to where by next fiscal year, the effect you'll see in the growth of the underlying businesses should really be driving the results.

Blayne Curtis - Jefferies

I got you. And then to your point that about 20% revenue was legacy, your modem business is (well) on a 30% total revenue, so I mean that's assuming I guess half of that modem business still is yet to go away?

Scott Mercer

No, no, keep in mind, when I talk modem business's legacy I'm only talking about PC modem. And (data) modem was just fine, thank you very much.

Blayne Curtis - Jefferies

Okay, so how do you get to the 20% total revenue with legacy?

Scott Mercer

Well, that includes digital television that includes wireless that includes everything we've been doing with IKONOS, that includes all the legacy products from pre-spin out even with Rockwell. There's a lot of cats and dogs in there, and it obviously includes PC modems.

Blayne Curtis - Jefferies

I'm just trying to figure out, I mean you basically have 5 buckets of revenue; modem, imaging, audio, video, and wireless. Well, actually six.

Scott Mercer

And others.

Blayne Curtis - Jefferies

Okay. So where is all this revenue falling into that metric?

Scott Mercer

If you want to understand the mix of it, this last quarter, the biggest chunk was in the other category, which would include wireless, include one-time buy things from pre-spin out. And the next biggest would have been PC modem.

Christian Scherp

And then this is a very deep business.

Scott Mercer

Right, actually the next lots in the digital TV and then there you are. Hello? Blayne? Think operator we go on to the next call perhaps. I think we lost Blayne.

Operator

Mr. Allen, there are no more questions at this time.

Scott Allen

Thank you, operator. That concludes our conference call today. On behalf of the entire Conexant management team, thank you for your participation this afternoon. We look forward to updating you on our performance again next quarter.

Operator

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation. You may now disconnect.

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Source: Conexant Systems, Inc. F2Q10 Earnings Call Transcript

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