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Analog Devices, Inc. (NASDAQ:ADI)

F2Q10 Earnings Call

May 18, 2010 5:00 pm ET

Executives

Mindy Kohl – Director Investor Relations

Dave Zinsner – VP, Finance & CFO

Jerry Fishman – President & CEO

Analysts

Doug Freedman – Broadpoint AmTech

Steve Smige – Raymond James & Associates

Shawn Webster – Macquarie Securities

Christopher Danely – JP Morgan

Ross Seymore – Deutsche Bank

Terence Whalen – Citigroup

Jim Covello – Goldman Sachs

John Pitzer – Credit Suisse

Craig Ellis – Caris & Company

David Wong – Wells Fargo

Stacy Rasgon – Bernstein Research

Operator

Welcome everyone to the Analog Devices fiscal second quarter 2010 earnings conference call. (Operator instructions) Thank you. Ms. Kohl, you may begin your conference.

Mindy Kohl

Thank you and good afternoon everyone. This is Mindy Kohl, Director of Investor Relations. We appreciate you joining us for today’s call. If you haven’t yet seen our second quarter fiscal 2010 release, you can access it by visiting our website at analog.com and clicking on the headlines on the homepage.

This conference call is also being webcast live. From analog.com select Investor Relations and follow the instructions shown next to the microphone icon. A recording of this conference call will be available today within about two hours of this call’s completion and will remain available via telephone playback for one week. This webcast will also be archived on our IR website.

Participating on today’s call is Jerry Fishman, President and CEO. During the first part of the call, Jerry and Dave will present our second quarter results as well as our short-term outlook. The remainder of the time will be devoted to answering questions from our analyst participants. During today’s call we will refer to several non-GAAP financial measures that have been adjusted for certain nonrecurring items in order to provide investors with useful information regarding our results of operations and business trends. We have included reconciliations of these non-GAAP measures to their most directly comparable GAAP measures in today’s earnings release which is posted on the IR website.

We have also updated the schedules on our IR website which include the historical quarterly and annual summary P&Ls for continuing operations as well as historical quarterly and annual information for [product] revenue from continuing operations by end market and product type.

Next I would ask you to please note that the information we are about to discuss includes forward-looking statements, which include risks and uncertainties. The Company’s actual results could differ materially from those we will be discussing. Factors that can contribute to such differences include, but are not limited to, those described in the Company’s SEC filings including our most recent quarterly report on Form 10-Q.

The forward-looking information that is provided by the Company in this call represents the Company’s outlook as of today and we do not undertake any obligation to update the forward-looking statements made by us. Subsequent events and developments may cause the Company’s outlook to change. Therefore, this conference call will include time-sensitive information that may be accurate only as of the date of the live broadcast, which is May 18, 2010.

With that, let’s begin with the opening remarks from our CEO, Jerry Fishman.

Jerry Fishman

Good afternoon and thanks for joining us today on today’s second quarter earnings call. As you can tell from the press release we put out earlier the second quarter was just a great quarter for ADI. Our revenues grew about 11% sequentially, 41% year-over-year to $668 million which is above our recent peak we achieved in 2008.

Our earnings per share grew at a rate more than three times the rate of revenue growth for a record $0.55 per share for the quarter. As we described to many of our investors at the beginning of last year, we set a goal to fundamentally improve ADI’s operating model and obviously we have made significant progress towards achieving that goal. In the second quarter our gross margins reached record levels increasing 390 basis points sequentially to 65% and our operating margins ran up to 32% which is over 700 basis points higher than our recent peak.

Because of our strong financial performance and our very strong cash flow our board has approved a 10% increase to our quarterly dividend to now $0.22 per share. Our industrial revenues were particularly strong and increased by over 20% sequentially as industrial activity picked up worldwide. Automotive revenues also increased substantially. Consumer and communications revenues were approximately flat sequentially. Revenues increased overall in the United States, Europe and Asia and declined slightly in Japan. I will elaborate a little bit more on the end markets and some of the trends in each of the markets after Dave discusses the financial results in a bit more detail.

I think very importantly we continue to be recognized in the industry as the premier analog supplier. In January Huawei, one of China’s top telcom companies and one of our largest customers awarded ADI their Golden Core Supplier Award to ADI for delivering superior performance, technology, quality, responsiveness and in delivery. In March one of the industrial automation leaders, Rockwell, named ADI the Electronics Supplier of the Year for 2009. It is very noteworthy that ADI was the only semiconductor company to be recognized with this award from Rockwell.

These are just two examples of the recognition we are receiving across our customer base for our innovative signal processing solutions that give our customers a very significant competitive advantage coupled with our superior customer service and responsiveness to our customer’s needs.

Now I am going to turn the call over to Dave Zinsner who will provide a little more detail about our financial results.

Dave Zinsner

Thanks Jerry. As Jerry mentioned revenues in the second quarter grew 11% sequentially and 41% from the same quarter last year to $668 million. We responded to the significant increases in demand over the past few quarters while keeping our lead times short.

During the second quarter we shipped nearly 100% of our orders from direct customers within 4-8 weeks and nearly 90% of our orders from distributors within 4-8 weeks. This is similar to our lead times during the first quarter for OEM customers and only slightly longer for distributors where our ordering patterns tend to be more volatile.

In our view our ability to deliver quickly and reliably has three significant benefits. First, we believe in the current environment our lead times are winning us cross over business from competitors. Second, we believe over the long term ADI will continue to gain share since customers are confident in ADI’s ability to meet its commitments to them in a volatile environment. Lastly, we believe that ADI’s short and steady lead times should reduce the likelihood of double ordering that typically results from extended lead times providing us a somewhat more accurate picture of end demand.

Gross margins for the second quarter increased to 65%, up 390 basis points sequentially and also up 390 basis points from the last time our revenues were in the $660 million range which was during the fourth quarter of 2008. This margin increase is primarily the result of lower manufacturing costs derived from the manufacturing consolidations we completed last year, higher manufacturing utilization and to a lesser degree our richer mix of higher margin products used in industrial applications.

Our inventory levels remain within our stated range of 90-100 days at 97 days cost of sales, up only $4 million sequentially. Our distributor days of inventory declined slightly. At approximately 8 weeks it continues to be healthy and at historically low levels. Our deferred income on shipments to distributors is up approximately 17% sequentially reflecting much higher sales in distribution combined with significantly higher gross margins which further increased our deferred income.

Internal fab utilization rose about 10 percentage points to approximately the low 70’s of production rated capacity. In line with better than expected revenue growth we have raised our capital spending plans slightly to approximately $95 million for the year. Longer term we can add substantial capacity to existing clean rooms if needed with a relatively low level of additional capital equipment.

Operating expenses were $220 million with the most significant increases in variable compensation driven by significantly higher operating margins and also higher sales commissions. Operating expense as a percentage of sales have declined from 36.3% at the end of fiscal 2008 to 33% of sales in the second quarter as we are now operating the business with 7% less non-manufacturing personnel. In addition, our strategy has been to increase the percentage of our operating expenses that are variable so we can more effectively modulate these expenses in response to future business cycles.

Operating margins increased to 32% of revenues. The last time our revenues were at current levels operating margins were less than 25% of sales. 720 basis points lower than in our recently completed quarter. This quarter’s substantially higher operating margins are partly due to an improving business environment but equally important our results reflect the actions we have taken over the past few years to better focus our investments and improve our execution and our cost structure.

Our tax rate was 21.9% which was up from 20.3% last quarter as we now estimate our annual tax rate to be 21.3% excluding the effect of restructuring expenses. We have also carefully managed our working capital. In addition to keeping our inventory within our stated range, day sales outstanding has remained in check at 45 days despite a tighter credit environment worldwide.

Cash flow from operations totaled $278 million or 42% of revenues and free cash flow was $261 million or 39% of revenues. Our cash balance now totals approximately $2.4 billion or $2 billion net of debt which is more than $200 million higher than the previous quarter and more than $700 million higher than the previous year.

In summary, by every financial and business metric this was a very successful quarter for ADI. I will now turn the call back over to Jerry who will discuss the results from each of the end markets.

Jerry Fishman

For the third consecutive quarter now we see strong sequential growth from the industrial market. For this quarter industrial revenues grew about 20% sequentially to about $316 million which is a very positive sign for recovery in this broad and diversified industry group.

The growth in the second quarter was primarily driven by growth in the industrial automation and instrumentation markets but every application area within the industrial category also showed sequential improvement. All regions had good growth in industrial products with particular strength in industrial products in Europe and in North America.

Our revenues from our automotive customers were approximately $84 million for the quarter which was up 14% quarter-over-quarter. Although certainly the growth of the automotive industry has been helped to some degree by the stimulus programs, feedback from many of our automotive customers indicating their belief that improving overall demand has also been the result of the gradual and steady improvement in consumer confidence.

Further ADI technology is most relevant to higher end cars which have not been the primary beneficiary of most government stimulus programs. Finally, we continue to see very favorable macro trends for ADI within the automotive space including safety, fuel efficiency and convenience, all of which drive higher dollar content for ADI.

Our communications revenues at about $133 million for the quarter were down very slightly from Q1. Networking applications, optical, microwave and satellite increases were offset by a decline in wireless revenues primarily as a result of delays in base station programs in China. For Q3 based on current ordering patterns and the backlog we have in place we expect growth from our Chinese base station customers. European and U.S. base station sales increased during the second quarter.

The wire line market had its fourth consecutive quarter of sequential improvement delivering good return on the very significant investments that we have made over the past few years in applications such as optical communications and also cable. This quarter revenues from wired communication applications were up approximately 20% sequentially. Revenues from the consumer market were about $120 million which was up a couple of percent from the previous quarter but up about 45% from last year.

We saw a particular strength in the digital camera and portable media markets and our customers today are indicating consumers are once again buying these types of products. In the computing sector our revenues increased 15% sequentially which still represents only a modest 2% of our total revenues.

The new orders for the quarter were again very strong in the second quarter. As a result of backlog for shipment in the third quarter increased from both OEM customers and distribution end customers and the book to bill ratio for the quarter was well above 1. Looking ahead to the third quarter given a higher backlog we are expecting continued revenue growth.

We are currently planning for our revenues to be in the range of $695-715 million for the third quarter. We expect this growth to be fairly broad based and that is based on our customer forecasts and the opening backlog we had starting this quarter. We are planning for our gross margins to be in a range of 65-66%. We are expecting operating expenses to grow as a result of higher variable comp as the operating margins continue to expand. The quarter OpEx growth is planned to be well below our anticipated revenue growth in the third quarter giving us additional leverage in the third quarter.

As a result we anticipate our operating margins will expand to the 33-34% range and earnings per share should be in a range of $0.59 to $0.61. Obviously we are very pleased with our operating performance both in terms of our growth and our profitability in the second quarter. We have fundamentally and significantly improved our operating margin structure at ADI without sacrificing sales growth opportunities which has been our goal for the past few years as we sharpened our strategic focus and we reduced costs company-wide.

We believe we still have additional leverage ahead of us as we fully recognize the benefits of lower unit costs, continue to experience good price stability in most of our products and we limit expense growth to a fraction of sales growth and continue to develop very innovative products that help our customers gain share in the markets they serve and command good margins. While the external world of course remains uncertain we are today a fundamentally better and a fundamentally stronger company than a few years ago. We believe as we continue to demonstrate world-class financial returns and above market growth our shareholders will be the beneficiary ultimately of this success.

Mindy Kohl

Thank you Jerry. During today’s Q&A period please limit yourself to one primary question and no more than one follow-on question. We will give you another opportunity to ask additional questions if we have time remaining. Operator, we are now ready for questions from our analyst participants.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Doug Freedman – Broadpoint AmTech.

Doug Freedman – Broadpoint AmTech

As much as I hate to ask the hypothetical question, you mentioned in your commentary the company has increased its flexibility to the spending the company does in regards to the cycle. With these stocks not really able to get moving here it is clear that people recognize business is strong but my question really is hypothetically if you were to see revenues decline by 10% what impact would that have to the earnings potential for the company?

Dave Zinsner

I don’t think I want to go right into the measuring because it depends on mix and things like that. I can tell you what we have done is changed the balance of the OpEx between what is variable and what is fixed. So as revenues if they were to decline we have an ability to maintain a lot more of the profits to the P&L and hopefully keep the margin relatively balanced.

Doug Freedman – Broadpoint AmTech

If you could focus on one segment you think you are seeing much better than expected demand from, not really customers trying to do an inventory rebuild. Where is it that the demand is surprising you to the upside?

Jerry Fishman

I would say probably the place it has been the strongest are in the industrial and automotive side. At least for this part of the seasonal lift. Typically our second quarter is a strong industrial quarter but I think the industrial part of the business has recovered quicker than we would have expected. It is above where it was at the peak of the last cycle but not by that much and it is spread out amongst so many customers, in that space probably 10,000 plus customers, so I don’t think there is a broad inventory accumulation cycle going on.

That business was down very substantially last year, well over 30%, and I think what has happened is when we talk to the large customers; the Rockwells in the U.S. and their counterparts in Europe and China, I think they are seeing the fact their factories are running higher than they did and their inventory levels have been very low. I think they are predicting this is not really a bubble. You never know, as you well know, about what your customers are really doing but we don’t get a lot of sense from the large customers that they are stockpiling inventory here.

It would be very surprising on a customer base as broad as this both by product, customer and geography that all of these customers would be acting in unison to build inventory. I think they are recovering some of the inventory that they depressed but I think they are ordering commensurate with what they think their outlook is at least for the next six months. As we look at the third quarter we are predicting that industrial revenues will grow again.

We have looked at this from the large customers, small customers, distributors and at least the sense we get fairly broadly across the board is that business has recovered quicker than we would have thought but not to levels we would have predicted they would recover to. The automotive stuff is the part that there is obviously some of that stimulus stuff which could [have] more people buying cars but I don’t think at least what we hear from our guys that run that business that a huge amount of the increases we have seen are due to that. Most of our products as I mentioned in my opening comments are in the higher end cars. That is not going to benefit too much from the stimulus stuff. But our content for each car and safety stuff and sensors, and all the products we have been working on for a couple of years is just much higher than it was a couple of years ago.

We don’t have a sense of automotive companies stockpiling inventory either. First of all, I don’t think they want to. Secondly, I don’t think they have the cash to. Those are the two segments probably that have surprised us most on the upside.

Operator

The next question comes from the line of Steve Smige – Raymond James & Associates.

Steve Smige – Raymond James & Associates

I was hoping you could talk a little bit about the com business in more detail. As I look back over the past number of years it seems sort of flattish dollar wise. Maybe some classification changes there or something. You obviously said there was some 20% growth there in the wire line business but overall it still is sort of flattish. Can you talk about how that might roll out over the coming year? Do you think we can see better growth going forward out of that?

Jerry Fishman

This is in communications?

Steve Smige – Raymond James & Associates

Overall communications.

Jerry Fishman

I think you know that business is obviously a very large customer business and when one customer does well often you see that customer flatten it out for awhile. Clearly the part we were really disappointed in this quarter was a few of our large customers in China we actually saw a decline this quarter which was anomalous to that business mainly because there was some well publicized push outs in China capital spending in the communications business. I think as we go forward we have looked at the order book pretty carefully particularly over the last month or so. Based on the orders we have on the books from our customers in China we expect we are going to have third quarter be a good growth quarter in the business in China.

Even during all of the ups and downs in the wireless market over the last couple of quarters the non-[China] business has continued to grow. So I mean we have a very solid position. We are the largest market share holder in Asia, Europe and the United States. If anything I think our share is better than it was 2-3 years ago. So I think as that business ebbs and flows with capital spending and inventory cycles with those customers I think the wireless communications part of the business is going to continue to be a good growth driver for us in the coming years.

It tends to be a little lumpy for sure but what I tend to pay attention to the most is the feedback we are getting from the customers about our position, how we are doing. The award we got from Huawei was a great substantiation of the fact we have an enormously strong position and one of the strongest players in the base station business in the world. We also have very strong positions in other very significant players; Ericsson and [inaudible]. So I think we have a very good balance and we have a very strong position which is going to continue to have that business be a good business for us a long time in the future if we keep executing.

Steve Smige – Raymond James & Associates

You took the dividend up. Obviously feeling a lot better about cash flow. I think you had raised some debt to maybe ensure that back when things were pretty ugly. I am curious now that cash flow is obviously better and you are taking up the dividend, will you also choose to pay down the debt or do you keep that for awhile? Can you talk to that?

Dave Zinsner

We have a few years yet before we have to decide on the debt. At this point we have plenty of cash in the U.S. and we have plenty of cash worldwide and so we are certainly not in need of any cash. The focus of the dividend was really to represent what we think is a very strong cash flow model for the company going forward and we seek to provide some of that back to the shareholders in the form of a dividend.

Jerry Fishman

I think also the debt is very low cost. We swapped it to floating rates which turned out to be at least for now a good thing to do. So the net cost for that debt is extremely low. We haven’t decided but it is not a high priority for us right now.

Operator

The next question comes from the line of Shawn Webster – Macquarie Securities.

Shawn Webster – Macquarie Securities

On the gross margin in terms of Q2 do you expect your utilization rate to increase as well? In terms of the long-term operating model you highlighted at your analyst day it looks going into Q2 you will be above the high end of the range. Is there any change in your mind in terms of the longer-term operating model? How should we think about that evolving over the next year or so?

Jerry Fishman

I think as far as utilization, utilization will bump up slightly in the quarter. As far as long-term models let’s get to where we said we were going to get to first and then we will talk about that some more. We are obviously very optimistic about our prospects going forward but I would like to see another quarter before we get into that conversation.

Shawn Webster – Macquarie Securities

In the supply chain inventory it sounds like things are still a little bit on the lean side. Are there any end markets or areas where you are seeing inventories at a normal level?

Jerry Fishman

At a normal or abnormal?

Shawn Webster – Macquarie Securities

At a normal level just because it seems like a lot of areas are a little bit on the lean side.

Jerry Fishman

I really don’t know that enough to be definitive in a comment on that. Most of the comments we get about inventory from our customers are anecdotal. The inventories we really understand the best are what is in distribution but beyond distribution we don’t know where it is going. So it is very hard to answer that question accurately and definitively.

Operator

The next question comes from the line of Christopher Danely – JP Morgan.

Christopher Danely – JP Morgan

A different way to ask that question, can you give us a sense of what utilization rates are and maybe what the incremental gross margin is as the utilization rates go higher?

Dave Zinsner

The current utilization for the second quarter was in the low 70’s. I think I even mentioned that. It likely will be going into the mid 70’s so not a significant increase in utilization but that is going to be a benefit to our gross margins. Really the bigger driver for gross margins I think in the next quarter is going to be additional cost reductions associated with the fab consolidations.

Christopher Danely – JP Morgan

In terms of the strength in the industrial and auto in particular what would you describe would be the major factors of the strength? Do you think there is still some inventory replenishment out there? Is it share gains? Is it increasing content? Is it a mix of all three? Is there something else in there? Maybe highlight one or two of the biggest factors you think are driving that.

Jerry Fishman

I think it is all of those things probably in some ratio we don’t really know definitively. One of the interesting things and we talked about this a little at the analyst meeting we had a couple of months ago is there are some new segments in the industrial area that are growing pretty rapidly that we are very well penetrated in. I think I also mentioned that or the [guy] who runs our industrial business mentioned that his goal is he really believes the industrial market could provide as much or more growth than any other market segment we are in given the growth rates in some of these segments.

I think the old story that the industrial market was a [sweet deal] market and it is going to grow 2% a year, the real excitement is in cell phones and consumer products is the only place with any growth I think it is going to turn out to be fallacious.

I think there is significant opportunities in the industrial business and I think also the automotive business where just the electronics changing and just more and more signal processing content in automotive products and industrial products and there is great opportunities for growth there just like there are in every other market segment. I think when history is written, at least for ADI, we are making our investments in the industrial or the automotive business, I am not speaking broadly for all semiconductor companies but just for ADI I think it will turn out the industrial business does hold its own relative to anything else we are doing on the growth side.

Operator

The next question comes from the line of Ross Seymore – Deutsche Bank.

Ross Seymore – Deutsche Bank

A question on the gross margin side. You mentioned some of the lower costs from the fab closures was in the quarter. Can you talk a little bit about how much that added in the April quarter and how much is left as we go forward?

Dave Zinsner

It was meaningful. It has been meaningful now for the last few quarters. It is a combination of the consolidation of the 6 inch line in Limerick into the 8 inch which we completed midway through last year. At the end of the year we closed down Cambridge and we are already starting to see some benefit. We saw some benefit in the second quarter. We will see more benefit in the third quarter. Those are the things that are really the big drivers of our gross margin leverage right now.

Ross Seymore – Deutsche Bank

I believe in the past you talked about the Cambridge side was about $40 million in savings. Do you have any kind of rough ballpark how much of that you have already seen and how much is left to be benefited from?

Dave Zinsner

Rough order of magnitude I think we have got roughly about 1/3 of it. There is probably 2/3 left.

Ross Seymore – Deutsche Bank

On the revenue side of the equation everybody is clearly nervous about too much inventory and things have been good for awhile to come. Can you talk about the turns you did in the April quarter and any sort of turns assumption you have whether it is increasing or decreasing in conservatism for your July quarter guidance?

Dave Zinsner

One thing you have to remember is when we are looking at backlog we are looking at backlog placed on us. So the distributor backlog tends to not be a great measure. So we have to kind of, we do a lot of different analysis to come up with a number that we predict for revenue. We hardly ever look at this number I would tell you. But it ran a little less than 40% in the second quarter. It is probably going to be a little bit even lower than that. We are getting a fair amount of visibility obviously from our distributors.

Jerry Fishman

The opening backlog is up quite a bit. I think as Dave said the backlog distributors place on here is not indicative of anything. So we don’t really, I mean look at that very carefully. We look at what distributors are actually selling through and we look at what the large OEM customers are telling us and that is how we come up with the guidance.

Operator

The next question comes from the line of Terence Whalen – Citigroup.

Terence Whalen – Citigroup

On the device revenue performance it seems like you had very strong performances from amplifiers and RF as well as from power management and some of the other analog signal processing circuits. It seems like data converters grew a little bit less, about 5% sequentially. I was wondering what contributed to that? Was it end market mix? Do you have any observations in general about the data converter market competition?

Dave Zinsner

One thing you might not want to misread is just one quarter’s performance in data converter. Data converters has been up every quarter since the second quarter of last year sequentially. So where some of these other product areas have kind of been up and down a little bit through the year, data converters had very, very steady improvement since Q2 of last year. So I think on a peak to trough or peak to peak analysis or what have you, you will see that data converters is actually doing really well.

Jerry Fishman

On the question on the competition, I think there is a lot of competition out there. It is a great market and we have 40 plus percent of it and everybody wants it. There are a lot of people that have been investing a lot in the converter market and so on. I think when you look at all the statistics and you listen to the customers which are the ultimate statistic I think that is a great business and it is probably one of the best market segments in the analog space. It is one of the very few that the shares are concentrated as it is in the converter market. There is every bit of evidence our share over the last couple of years has gone up despite all of the competitive noise out there and it is certainly the highest priority we have is to keep that high or even increase it in future quarters. I think based on what I have seen we are doing in that business I think we have a good chance of doing that.

Terence Whalen – Citigroup

Regarding your commentary about distributor inventory I think the past three quarters you have said it is about 8 weeks. You said it went down actually fractionally but not enough to be a half week or so. Can you kind of help me understand that comment in light of the deferred income to distribution at 17%? I know if I normalize for gross margin that comes out to only about a 10% growth. Am I to understand that distributor revenues grew over 10% sequentially to drive distributor days down?

Dave Zinsner

Distributor revenues were higher than the corporate average and OEM was lower than the corporate average. You are correct. That is what drove it.

Terence Whalen – Citigroup

In general, the level of distribution inventory, do you expect that to have to go up at some point or is this the new normal?

Dave Zinsner

I think they are trying to keep it within that kind of 8 week range. It slipped a little bit and that is based on just the fact they have been ramping and so there is a little bit of a lag to keep pace with that.

Jerry Fishman

I think we are also trying to keep it in that range. We have an interest in not putting too much inventory in the channel. When we get orders placed on us which are not things we look at very closely we have a lot of dialogue with those distributors about, what is the sell through, why do you want it, so on and so forth. I think we have a very significant stake in keeping our inventories at reasonable levels. We don’t get any revenue credit for it but we would confuse everybody if we don’t do that. By the way, capacity is more scarce [inaudible] so the last thing we want to do is use capacity to just put inventory on distributor shelves beyond what their sell through is. We just don’t do that.

Operator

The next question comes from the line of Jim Covello – Goldman Sachs.

Jim Covello – Goldman Sachs

I want to drill down even a bit further on the gross margin thing that I know has been probed on a little bit. I know Dave you talked about utilization and you made the comments of where it is and where it is going. Then you said about 1/3 of the last fab closure is baked into the numbers and 2/3 is still to come. Can you give us a sense of how much maybe on a basis point impact that 2/3 left is having on the margins? Then I think Jerry mentioned pricing is the other margin leverage in his closing comments. Do you need prices to go up to have margin leverage or are your costs coming down enough so if prices stay flat or only go down a little bit there is incremental margin leverage there as well?

Dave Zinsner

There is still about 100 basis points of benefit still coming from fab closures.

Jim Covello – Goldman Sachs

Is that all coming in the next quarter or is that to be spread out over the next couple of quarters?

Dave Zinsner

Spread out probably over a couple of quarters.

Jim Covello – Goldman Sachs

The pricing leverage?

Jerry Fishman

We always watch pricing. We have very high value added products and we are always in the mode of making sure we get paid for the product commensurate with the value they create. We are not anticipating wholesale price increases to maintain or improve our margins across the board. We always have opportunities on older products and so on to think about that because we are one of the very few or only company that supports semiconductor products for 20 years or more after we introduce them, which is a great value to our customers.

I think the direct answer to your question is we are not anticipating any significant price increases to either maintain or raise our margins.

Jim Covello – Goldman Sachs

Relative to the power management business that is something that got discussed quite a bit maybe 9-12 months ago. Obviously with the business being so robust now maybe there is not as much urgency for kind of new growth opportunities. But where is your head on that potential avenue for growth looking forward?

Jerry Fishman

I think it is still good. The whole challenge for ADI in the power business has been to focus on areas where we really have unique stuff. We have gone through a metamorphosis a year or two ago to better focus it towards particularly applications where we already have a very significant control of the billed materials.

I think the group out there has responded well to that and I think we have begun already to see the benefits of better focus in that business. It improved significantly last quarter. One quarter does not make a business one way or the other but I think there are a lot of indicators in there that if we focus, I mean we are not taking on the broad power business trying to compete across a $7 billion with entrenched competitors. We are looking for opportunities where we can do something unique and where we have a large control over the billed materials. I think if we do that and we stay true to that strategy I think we will do very well in that business.

Operator

The next question comes from the line of John Pitzer – Credit Suisse.

John Pitzer – Credit Suisse

I guess I am going to go back to a comment I think Jerry made in the opening comments about your short lead times allowing you to gain some market share. I was hoping you could quantify that a little bit. Is that the main driver why some of the other businesses outside of converters grew more quickly sequentially? Are those share gains you think sustainable?

Jerry Fishman

I would say quarter-to-quarter it is very hard to make that judgment. I think the [crossover] business is not significant relative to our total sales but it is significant I think relative to our reputation. So I think the more important victory here, if there is one, is customers come to us and we can supply the stuff. Certainly the conversations we have had with our sales force is we wouldn’t expect to be losing that business when other competitors start to deliver again. There is no reason for that. I think a lot of that business is going to stick and I think it is going to increase in future quarters.

It is not meaningful relative to $650-700 million of sales but it is very relevant to the perception of Analog as a supplier. I think that is the more important take away from this.

John Pitzer – Credit Suisse

Going back to the deferred shipment line, understanding you need to adjust that sequential growth number for gross margins but even when I do that you are still kind of back to peak revenue levels but deferred shipments are above that level. Just help me understand why I shouldn’t be worried that is some sort of yellow flag that there might be some inventory building. Is there a change in the business where you are just going to be running with higher deferred shipments going forward? How would you expect that to trend over the next few quarters?

Dave Zinsner

One thing you have to remember is that the cost of the inventory being held at distribution is not necessarily the same. In other words, the gross margins aren’t exactly the same change for the total company as they are for that. So, the gross margin has actually improved a bit more at the disti level than they did for the total company over the peak to peak period of time. So that is driving a lot of it. I think you will find, and I am pretty sure when I did the analysis that the days of inventory are actually lower than they were by a good 10 days or so from the Q4 2008 period. We have pretty good accurate assessments of that.

John Pitzer – Credit Suisse

So it is all being driven just by better profitability on your part?

Dave Zinsner

That, plus I think that disti is now back to levels where they are shipping at a fairly decent rate.

Jerry Fishman

It turns out companies like Analog the distribution margins are usually higher because the volumes we ship out are much lower and the customer base is much more fragmented. That is the more profitable part of our business. It is also the part that services the industrial market mostly. All those things add up to the fact that business tends to be higher margins than anything else we do.

Operator

The next question comes from the line of Craig Ellis – Caris & Company.

Craig Ellis – Caris & Company

Cycling back to gross margin, nice tailwinds in utilization and in factory shutdown and consolidation activity. Are there any headwinds at play? For example, last year consumer grew at well above average rate in the second half of the year. Anything like that going on?

Dave Zinsner

Our anticipation is that mix will impact the third quarter by a little bit but mix in either direction quarter-to-quarter tends to be well below a point and we have enough things going the other direction in terms of utilization and cost reductions that we are able to offset those and more. We are not very concerned about gross margins and our ability to get leverage.

Craig Ellis – Caris & Company

A utilization related question, I think we would typically expect analog companies to run at utilization levels in the low to mid 80’s and the company is moving back towards the mid 70’s but how do you look at utilization here? Do you view it as something that can move up and be run in the mid 80’s percent range or is there a reason we should expect ADI’s utilization level to really hover in the mid 70’s range?

Jerry Fishman

I think it has the opportunity to move up a little bit. As Dave said we have increased capital spending slightly to make sure we are right about this. I think the important take away on that is for relatively small amounts of incremental capital we can add capacity both cheaply and quickly. So the capacity additions we are putting on are really incremental in nature. Our goal is to keep our lead times low and that is what we are going to do in the absence of something cataclysmic happening on the top line on the upside, that is where we are going to be.

Craig Ellis – Caris & Company

Is the incremental spending on the capital side, the uptick in guidance for the year on the front end or the back end or both?

Jerry Fishman

It is both. We are incrementally making more investments to get more internal wafers out. We are also making investments in back end equipment to make sure we get the [wafers] out we can test them and go on. So it is really across the board. Again, for a company that is running $2.7 or $2.8 billion still our capital plan is below $100 million this year. I think we have become a lot less capital intensive and we can make given the footprint we have in our fabs we can make incremental investments and get a lot more unit growth out of there.

Operator

The next question comes from the line of David Wong – Wells Fargo.

David Wong – Wells Fargo

I know you don’t want to give explicit guidance beyond the June quarter but can you help us understand the seasonality in the September quarter? If we look back several years in some years September is a decline sequentially and in other years it grows. Specifically can you give us a feel for what proportion of your revenues today come from end markets that seasonally decline in the September quarter?

Jerry Fishman

I think your comment earlier is probably one of [inaudible]. It is very challenging to figure out precise seasonality when the markets are so volatile. I don’t think we have any better read on seasonally what happens in Q4 compared to the rest of the year. So we just don’t know enough. Some years, as you say, go up and in some years they go down. Six months out we just don’t have a good sense of what is going to drive that. The only thing we typically know is that our second quarter is usually our seasonally strongest quarter because it is more days in distribution than our first quarter which has holidays.

But beyond that it bounces around year to year based on mix, based on seasonality, based on inventory levels, based on so many things it is just very, very hard to predict and I think that is why we don’t predict it.

David Wong – Wells Fargo

To try another question with the elephant in the room, any signs of any weakening in demand from European end markets at this point?

Jerry Fishman

No.

Operator

The next question comes from the line of Stacy Rasgon – Bernstein Research.

Stacy Rasgon – Bernstein Research

On OpEx, now that you are at basically back or exceeding previous peak revenue levels would it be fair to say at this point that all of the temporary OpEx cuts you were discussing before have now returned and all of the permanent cuts at this point have actually been completed? Are you basically at the right OpEx model you have been targeting? Are there any more I guess further, is there any more further fat I guess to take out?

Jerry Fishman

We are at the model we put out at about 33% of sales. As I think Dave or I mentioned in the coming quarters we are planning to grow OpEx a lot less than our record assuming the revenues come through that we expect. So I think we will get some more OpEx leverage in future quarters. I think the thing that is noteworthy on the OpEx line is we have long had a plan at Analog that incented all of our employees to get our operating margins up quite a bit. What you have seen is the rise in OpEx over the last couple of quarters is primarily the result of that success.

It is not a trivial exercise to put on 700 points of operating leverage from last time we were at these kinds of levels. I think the pressure continues to keep moving the margins up at the company. The payback for employees doing that has been quite high. Of course the margin has been on a very steep incline. Even though we expect the margins to improve in future quarters we don’t expect or at least we are not anticipating to add another 700 basis points on the margins in the short-term.

I think certainly the rate of acceleration of that is going to go down quite a bit. We are going to try and control the OpEx to a fraction of revenue growth rate. So the answer to your question is we still think we have more OpEx leverage coming up in the future.

Stacy Rasgon – Bernstein Research

A quick follow-up on the RF business. I know the amplifier and RF business looks like it was up quite considerably, about 16% quarter-over-quarter. My understanding was a fair amount of the RF piece of this was actually the communication infrastructure. It looks like it was down a little bit. I know this was a big, key strategic focus of yours that you talked about on the analyst day. Could you just give us a little bit of color on what you are seeing in the RF business in particular I guess in light of where it was in this quarter and also maybe outlook for the year?

Jerry Fishman

I think it is a great business for us. In the case of the analyst meeting we heard more in detail of the applications. It turns out it is a fair amount of RF in the wire line side of the business as well as the wireless side of the business and in other segments as well. I think we have a very broad product base in RF. We have great technology. The feedback we are getting from the customers in terms of growth and roadmaps to the future is very strong. I think that is going to be a very important business for us and we are doing extremely well at it right now.

Operator

The next question comes from the line of Doug Freedman – Broadpoint AmTech.

Doug Freedman – Broadpoint AmTech

If you look at the R&D tax credit getting extended what impact would that have on the tax rate going forward?

Dave Zinsner

You mean if it was approved?

Doug Freedman – Broadpoint AmTech

Yes.

Dave Zinsner

It is a percentage or two.

Mindy Kohl

That concludes our Q&A session. Thank you all for your participation. We look forward to talking with you again during our third quarter 2010 conference call which is scheduled for August 17, 2010 beginning at 5 p.m. ET. Thanks very much.

Operator

This concludes today’s Analog Devices conference call. You may now disconnect.

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Source: Analog Devices, Inc. F2Q10 (Qtr End 05/01/2010) Earnings Call Transcript
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