LTX-Credence Corporation F3Q10 (Qtr End 04/30/2010) Earnings Call Transcript

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LTX-Credence Corporation (LTXC) F3Q10 Earnings Call May 26, 2010 10:00 AM ET

Executives

Mark Gallenberger – VP, CFO and Treasurer

David Tacelli – CEO and President

Analysts

Vernon Essi – Needham & Company

Christopher Muse – Barclays Capital

Dave Duley – Steelhead Securities

Patrick Ho – Stifel Nicolaus

Christian Schwab – Craig-Hallum Capital

John [Melspin] – Inaudible Company

Michael Bertz – Kennedy Capital

Operator

Welcome to the LTX-Credence Corporation’s third quarter earnings conference call. (Operator Instructions) At the request of LTX-Credence, this conference call is being recorded. Speakers for today’s call will be David Tacelli, Chief Executive Officer and President; and Mark Gallenberger, Vice President and Chief Financial Officer.

At this time, I would like to turn the conference over to Mr. Mark Gallenberger. Sir, you may begin.

Mark Gallenberger

Thank you and welcome to LTX-Credence Corporation’s third quarter fiscal year 2010 conference call for the period ended April 30, 2010. Joining me on today’s call is Dave Tacelli, CEO and President.

After my introductory comments, Dave will discuss the company’s performance for the third quarter and discuss the business outlook. Then I will provide further detail on the company’s financial performance during the third quarter as well as provide guidance for the fourth quarter of fiscal year 2010. We will take your questions after our prepared remarks.

A replay of this call will be made available through June 25th by dialing 888-286-8010, and the pass code is 60016672, or you can visit our website at www.ltxc.com. As a reminder, the only authorized spokespeople for the company are Dave Tacelli, Rich Yerganian and myself.

Now, for our Safe-Harbor statement. During the course of this conference call we may make projections or other forward-looking statements regarding LTX-Credence’s business outlook or the future financial performance of the company. We wish to caution you that these statements such as projected revenues, net income, earnings per share, operating expenses, gross margin, cash flow, non-GAAP measures and break-even targets are only predictions and that actual events or results may differ materially.

The guidance provided during this call represents the company’s estimates as of this day and the company assumes no obligation to update this guidance. Please refer to our Safe Harbor statement in our earnings release for more information on important factors that could cause actual results to differ.

Now onto the call. Dave?

David Tacelli

Thank you, Mark. Good afternoon, everyone. I will start today’s call with a high level review of the current business environment for the AT industry followed by a detailed review of the key components driving our top line growth.

The three components contributing to our revenue expansion include the current general business environment, share gains we have made in our existing markets and share gains in our new marketing initiatives. Our results for the third quarter and guidance for the fourth indicate that our business continues to gain momentum. Our financial results during this period represent well over 100% revenue growth year-over-year. While visibility in our industry is typically limited to a 3-month window, customers are indicating to us that strong conditions should continue into the second half of the calendar year.

With sales just beginning to approach our normalized quarterly run rate, this clearly indicates to us that we are still in the early stages of a growth cycle for the AT industry. While every business cycle is different, most independent market research firms that forecast for our industry expect a multi-year growth cycle. While not every quarter during that period will be a growth quarter the trend during this period is expected to be headed in a positive direction.

Over the past 90 days we started to see many of our larger, more established customers begin to order equipment for capacity expansion. Our business has recovered nicely as the cycle turned positive. Compared to our third fiscal quarter last year our revenues were up over 100%. Even with this revenue growth we believe the tester buy rate is still below the trend line. While we see a portion of our growth driven by the overall cycle recovery, a significant piece has come from share gains in our new marketing initiatives.

The one remaining component of the cyclical recovery for us was the broadening of capacity demand to all our target markets and customers. Several core market segments including RF, power management, automotive and digital consumer grew 35% quarter-over-quarter and are forecast to grow another 40% in our fiscal Q4. We have commented on previous calls we expected customers who had not purchased capacity in 2009 to begin adding capacity in early 2010. This has proved to be the case.

For example, four of our largest customers from the past cycle generated over 35% of revenue growth in Q3 compared to Q2. These same four customers are expected to grow again in the fourth quarter and we expect continued increases in our revenue from these accounts through the balance of the year. Like all companies in our industry we tie a portion of our revenue growth to market share gain so it is important to clarify how we look at share gains because not everyone defines them the same way.

Our definition for market share gain is simple; it only happens when we have taken a specific piece of business away from a competitor. For example, our success in the microcontroller market is directly tied to winning customers that had previously used a competitor’s product. We don’t consider it a market share gain when an existing customer wins business for their new sockets and that drives incremental sales for us. In that situation we are already the installed supplier.

As I said earlier there are three components fueling growth. The first is the recovery in our business as the new growth cycle unfolds. The last peak for SOC test systems was in 2006 followed by three down years with 2009 representing the worst year for our industry since 1992. Most independent research firms are forecasting growth the next three years with 2010 expected to be anywhere from a 60-100% increase over 2009. Following such an unusually low level of business last year we see no reason to discount these expectations.

The second component of our growth profile relates to winning new customers in key market segments. The revenue contributions from these successes will play out later this calendar year as share gains directly from a competitor begin to contribute to the top line. Our most notable successes are with two significant new customers. Both are IDMs with broad portfolios of RF, automotive, power management and other analog mixed signal products. The combination of these two customers has the potential to contribute incremental revenues of $20-25 million annually.

A question you may ask is how is LTX-Credence able to effectively compete for this business? Ultimately it comes down to delivering technical innovation that lowers our customer’s overall cost of test. Over the next six months you will see a series of new product introductions that in one case further enhance our position as the leading RFPA test system provider for the communications market segment and in another expand the capabilities of the largest installed base of test systems in the world, the ASL1K.

The third component of our growth profile is the most exciting because it represents share gains that are happening in our new marketing initiatives which are driving top line growth today. Our penetration into the microcontroller, general purpose wafer probe and precision analog markets continues to meet success. We have received orders from two new customers and have made significant progress at two others. In particular the wafer probe market was particularly strong in Q3. We now have well over 100 Diamonds installed at various OSATs performing general purpose wafer probe testing.

Some of these new customers will start contributing to our revenue this quarter with other customers moving into production later this calendar year. These three initiatives contributed 30% of product revenues in Q3 and are expected to drive about the same level of revenue dollars in Q4. The success we are experiencing in the microcontroller and wafer probe markets is due in part to our newly introduced Integrated Multi-system Architecture (IMA) technology. There are now four customers that have either adopted or are in the process of adopting IMA for applications ranging from general purpose wafer probe to strip testing of microcontrollers.

Our success in these markets has led to the Diamond seeing very strong growth over the past year. With this added momentum we expect to ship a record number of Diamonds during the fourth fiscal quarter. As we continue to increase revenue our business model is performing ahead of expectations generating industry-leading gross margin and EBITDA equal to 23% of revenues in the third quarter, climbing to approximately 28% in the fourth fiscal quarter.

Our balance sheet is very strong and our cash position will continue to grow each quarter with positive EBITDA performance. In addition to the cash generation from operations we completed a very successful equity offering during the third fiscal quarter raising approximately $48 million. We put the proceeds from that secondary offering to work immediately by buying back almost all of the outstanding convertible debt at a discount. This resulted in a savings of over $5 million for the company.

This morning we also announced that LTX-Credence’s board of directors has authorized the company to submit a proposal to the shareholders seeking authorization to affect a reverse split of the company’s common stock. We believe this transaction will broaden LTX-Credence’s appeal to institutional investors and reduce transactional costs and certain administrative expenses.

Moreover the reverse split comes at a time when LTX-Credence’s strategic execution and focus on fundamentals are strengthening the company’s financial and competitive position, thereby enhancing long-term shareholder value. With our desired business model firmly in place and a balance sheet free of any significant debt our focus has been and will continue to be on expanding our top line revenue.

In summary, we are benefiting from an industry growth cycle. We have a very strong pipeline of new customers and products and our business model is delivering results among the best in the industry and our balance sheet is essentially debt free. Our focus of growing the top line is starting to show results while further establishing us as a significant player in the three market segments I have just reviewed. We continue to explore new markets where we can leverage our engineering innovation and low cost of test solutions, turning those into additional business opportunities for the company.

With that I would now like to turn the call over to Mark for detailed comments on the quarter. Mark?

Mark Gallenberger

Thanks Dave. Revenue for the quarter was $56.1 million, up 17% from the prior quarter. Gross margin expanded to 57.3%, up from 54.1% last quarter due to higher revenue absorption of fixed costs and continued strong variable margin on our product mix.

R&D spending was $12.3 million which was essentially flat from last quarter. SG&A was $11.4 million up from last quarter primarily due to variable expenses that are tied to revenue and profit such as sales commissions and employee profit sharing. Amortization of purchased intangible assets related to the Credence merger was $2.7 million. The restructuring charge in the quarter of $788,000 was due to excess space we plan to vacate in our Milpitas location.

Net income for the quarter was $6.8 million or $0.05 per share on a GAAP basis. Excluding one-time items our non-GAAP net income for the quarter was $7.2 million or $0.05 per share or $0.06 per share when excluding the additional shares that were issued from the secondary offering which was $0.01 better when compared to our original guidance of $0.04 to $0.05 per share. The one-time items excluded from the non-GAAP calculation are the $788,000 restructuring charge related to excess space in Milpitas, a one-time benefit of $1 million related to the recovery of a previously written off receivable, amortization of $2.7 million and a $2.1 million gain on the extinguishment of convertible debt that was repurchased during the quarter.

EBITDA for the quarter was $12.8 million or 23% of revenue which excludes stock based compensation expense of $1.1 million. During the quarter we issued 17.8 million shares of common stock at $2.85 per share resulting in net proceeds to the company of approximately $48 million. We used the proceeds to retire debt during the quarter. $31 million of the proceeds was used to retire $36.2 million in convertible debt obligations and future interest payments yielding approximately 15% annualized return on this transaction.

The remaining amount from the secondary offering plus existing cash was used to pay down the $40 million revolver with Silicon Valley Bank. Subsequent to quarter end on May 15th we also paid off the remaining amount due on the May 2010 convertible note totaling $1.5 million. Therefore, as of today the only remaining debt is approximately $900,000 in convertible notes which are due in May of 2011.

Next I will provide a breakdown of revenue for the quarter. 60% of revenue came from IDMs while 40% came from sub-contract test and fabless companies. 80% of revenue was product while 20% was for service. For the quarter we had three customers represent greater than 10% of revenue.

Now on to the balance sheet. We ended the quarter with gross cash of approximately $76 million and net cash of approximately $74 million. For the quarter, net cash increased approximately $63 million of which $48 million came from the secondary offering and $15 million came from operations. We finished the quarter with trade accounts receivable of $38.2 million. DSOs decreased to 61 days from 62 days in the prior quarter as we were successful in tightly managing the collections process.

Inventory was $26.8 million which is down $3 million from the prior quarter driven by consumption of existing inventory that was used for revenue shipment. Net capital expenditures during the quarter was $1 million and depreciation expense was $3.4 million. We ended the quarter with accounts payable of $15.4 million and stock holder’s equity of $162 million.

Guidance for Q4 is as follows; we expect revenue to be in a range of $71-73 million which is a sequential increase of 27-30%. Non-GAAP earnings per share is projected to be $0.10 assuming 147 million shares outstanding. The non-GAAP earnings guidance excludes amortization of purchased intangible assets of $2.7 million. Also factored into this guidance is the restoration of the pay cuts the company instituted 12 months ago which adds approximately $1 million of operating expense per quarter.

We also expect gross margin of approximately 58%. EBITDA excluding stock based compensation should be approximately 28% and we expect to generate approximately 20% of operating cash.

In summary, our success in driving top line growth continues to show up in the P&L. The business model we have built continues to perform extremely well and our balance sheet has been significantly improved through the cash raised from the secondary offering as well as strong positive cash flow from operations along with the pay down of most of our debt. Over the next several quarters we will continue to drive new customers we have won from the engineering phase of development into full volume production.

This concludes our prepared remarks and at this time we will take your questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Vernon Essi – Needham & Company.

Vernon Essi – Needham & Company

I want to ask first of all your other income line, just walk through sort of the different pieces in there and how we should expect that on a go-forward basis. It looks like you got that one-time gain on the convert in there if I am not mistaken. Is that correct?

Mark Gallenberger

That’s correct. You will see the one-time gain there and so obviously that will not repeat. So really the only thing that will be hitting the other income line now is interest expense and interest income. Interest expense is going to be very, very minimal. It is only $900,000 approximately at a 3.5% coupon. So then the balance will be what level of interest income we can earn on the cash on hand. As you know, it is pretty low interest rates these days so you are not going to have a huge number but we expect that to be a net interest positive number versus an expense.

Vernon Essi – Needham & Company

On your gross margin you described obviously seeing some benefits on your fixed costs as well as getting some better variable cost gains sequentially. Asking an obvious question here but you guide your revenue up pretty solidly. Why not a better leverage on your gross margin? You guide to 58%. Is this conservative or is there a reason why there might be a mix issue behind the scenes that causes that not to expand more?

Mark Gallenberger

I think if you actually do the math you will see actual drop through on the incremental revenue dropping through at a pretty healthy rate. Actually above what we typically model which is a 60% drop through. So I think what you are seeing is the sheer fact the incremental drop through rate we typically model at 60% the gross margin is approaching that umber. So when you look at it mathematically you are kind of starting to see the leveling off of gross margin percentage of the company but the drop through rates are still very solid and there has been no change with respect to that. It is just that your overall company gross margin is approaching your overall business model drop through rates.

Vernon Essi – Needham & Company

Generally on the industry itself I think one of the concerns a lot of people have on the device side of course is extended lead times and order cancellations out on the horizon. Can you discuss I guess your overview of your backlog and how comfortable you are going into the back half of calendar 2010 with regard to capacity needs and how solid you feel about the durability of your shipment levels?

David Tacelli

For the last few years this industry has turned into more of a turns business. I don’t see that changing. If you look at what we have booked over the last quarter the majority of what we have booked is leaving the manufacturing facility over the next 90-120 days. So I feel pretty good about it.

The second part of that is how do we look at the back half of the year and get comfort that it is going to continue to grow and all of that comes from where our customers are telling us they are taking their production cycle. We don’t see and they don’t see any significant increase in their inventory levels for IC demand. We also from our production side like everyone we occasionally run into component issues and component delays but I think the manufacturing group and our outsource suppliers have done a really good job of being able to manage that so we haven’t seen significant delays in shipments to our customers.

So overall backlog is solid. Customers are expressing strength in the back half. Really no inventory being built. I give a lot of kudos to the manufacturing and outsource suppliers who have been able to help us manage that for cycle time to our customers.

Vernon Essi – Needham & Company

For reference purposes, prior super hot cycles the dreaded allocation situation starts to kick in. Are we even anywhere close to that with where you folks are on your manufacturing or will it still take several large quarters to get there?

David Tacelli

I think from time to time and across a variety of different components I think all of us in this space are seeing that today. I do believe we have done a better job mainly because we have been outsourced for an extended period of time. So we have anticipated some of this and therefore had a better planning process going in with long lead items. I do see certain IC manufacturers putting people on allocation. I just feel the team here has done a little bit better job than I have seen in the industry.

Operator

The next question comes from the line of Christopher Muse – Barclays Capital.

Christopher Muse – Barclays Capital

On the receivable reverse where does that show up on the income statement?

David Tacelli

I believe it is in the other income and expense. You are talking about the pickup of the written off receivables?

Christopher Muse – Barclays Capital

Yes, the $1 million.

David Tacelli

Yes, that is in other income expense.

Christopher Muse – Barclays Capital

Looking at your guidance for July you just talked about gross margin guidance and it looks good there. In terms of OpEx is looks like to get to that $0.10 at the midpoint of your guidance OpEx has to grow by about $2.5 million plus. Is that what you are thinking or is that EPS guidance potentially conservative?

Mark Gallenberger

As I mentioned in the prepared remarks about $1 million of that is coming back in permanently because of the restoration of the pay cuts. So that is going to be SG&A plus the R&D line but in terms of total OpEx that is going to be the extra $1 million. The other piece is variable expenses. When we pay our distributors their sales commissions those all hit down on the SG&A line as a selling expense. So that will simply expand and contract with the revenue growth or contraction at some point when the industry starts to roll over. So that is not a permanent cost. That is just something that simply gets factored into our drop through rates for the net income line.

David Tacelli

One of the things and Mark talked about the restoration of the pay cuts, when we went through the entire merger integration process we were very focused on making long-term permanent reductions to the cost structure of the company. This reinstitution of the pay reduction of $1 million is really the only expense that comes back in that was temporary of the $112 million of cost reduction.

Christopher Muse – Barclays Capital

I guess though at the low 70 revenue run rate around $26.5 million is what we should think about for OpEx?

David Tacelli

That sounds about right. Yes.

Christopher Muse – Barclays Capital

Also I wanted to follow-up on a sustainability question. In terms of where your backlog is today what kind of visibility does that provide for the October quarter? Are you seeing extended lead times for certain products beyond that three months? So you are starting to feel more comfortable there from backlog or your comfort in the second half is just more from your dialogue with customers?

David Tacelli

A combination of both. We are seeing certain customers I will call “try and get into the queue” to make sure their volume is protected and their cycle is protected. In general it is comments they are feeling still very strong about the back half.

Christopher Muse – Barclays Capital

We have heard kind of conflicting data points on the size of the SOC test market this year. You have Teradyne. If you back out memory they are around $2.7 billion. If you listen to [inaudible] they are talking kind of $2-2.2 billion. What does your model say on that from the crystal ball?

David Tacelli

Let me take you back to 2009. If I look at the SOC space not counting memory, the SOC space depending on who you talked to was somewhere between $1.1-1.3 billion. Now the data we see is probably more in line with what [inaudible] talks about more in line with $2-2.2 billion.

Christopher Muse – Barclays Capital

Within that number do you include service?

David Tacelli

Yes.

Operator

The next question comes from the line of Dave Duley – Steelhead Securities.

Dave Duley – Steelhead Securities

You talked about the ASL 1000 I think having the largest installed base of testers. Can you give us an idea of what that installed base was and maybe give us an idea of what kind of shipment rates you are seeing from that sector at this point?

David Tacelli

What I can tell you is the ASL installed base at the end of the next quarter will be approaching over 4,000 units in the field. As far as shipment rates, without trying to get specific on quantities of testers let’s just say it is in the triple digits on a quarterly run rate.

Dave Duley – Steelhead Securities

The applications that are driving that kind of large shipment volumes is it similar to the J750? Or maybe just give us a few of the top applications that are driving that growth.

David Tacelli

It is not the 750 type applications. It is more focused on analog type applications. So it would be more comparable to different products that our competitors produce mainly from some of their acquisitions. More like what I would call the Teradyne Eagle product or low-end Teradyne flex product.

Dave Duley – Steelhead Securities

The percentages of the OSAT business I think you mentioned it was 40% last quarter. Do you see that percentage going higher with the substantial growth you are seeing in the upcoming quarter?

David Tacelli

I don’t think it is going to go much higher. I think what you are going to see and what Mark talked about was not only the OSAT but also the kind of fabless people that are driving it that actually have equipment that is going into some of these fabless or engineering environments. I don’t think you are going to see it go much higher. I think the dollars potentially will rise but the percentage will probably stay the same because you have some of the major IDMs we had not seen business with turning on now so we are shipping into them as well.

Dave Duley – Steelhead Securities

Along those lines you mentioned you had three 10% customers. I can’t remember if you would disclose who those are or what the percentages are. Any information there would be helpful.

Mark Gallenberger

We only disclose the actual names on an annual basis for that. We are going to hold off on that until the end of the year.

Dave Duley – Steelhead Securities

Could you give us percentages?

Mark Gallenberger

I can give you percentages. They range from 10% to 29%.

Dave Duley – Steelhead Securities

It does sound based on your prepared remarks though talking about how a lot of your historical customers are back at the table that maybe one of these three customers is new at being a 10% customer in this cycle.

David Tacelli

This cycle yes. That is correct.

Operator

The next question comes from the line of Patrick Ho – Stifel Nicolaus.

Patrick Ho – Stifel Nicolaus

What was the turns level during April? I know you mentioned you expect it to remain at a relatively high level on a going forward basis. Does that create any difficulties managing hat with your contract manufacturing partner? Or do they even give you some additional visibility given the current environment remained relatively robust?

Mark Gallenberger

I think right now given the current environment we are actually seeing our turns business actually go down quarter-over-quarter. Because of that and because lead times across the industry is getting extended to some extent that is driving our customers to understand they do need to give us more visibility in their business. To answer your question on April turns I don’t have the specific month but clearly the quarter-over-quarter trend was lower turns business and I expect that trend to continue for our July quarter as well and that trend I think might even continue through the second half of the calendar year.

I think with that it is all good news in terms of seeing a pickup in business but it also puts pressure on the supply chain and it puts pressure on our outsource manufacturing partners. They need to get some more visibility as well and we have been able to give them that.

Patrick Ho – Stifel Nicolaus

You talked about some of the market share gains both in your core markets as well as in some of the new market forays that you have. Can you comment in terms of market segment where you are seeing the most gains in your core markets?

David Tacelli

Directly attributable to analog or complex mixed signal. So areas where we have introduced an instrument for the data converter test module and that has opened a lot of doors and it has opened a lot of opportunity for us to go after not only the converter market but customers that do a wide range of devices in high performance mixed signal. We have seen applications in the automotive space which has been several accounts and I will call just general purpose analog. They are directly from or directly attributable to share gains that will happen where customers were not using our product over the past 5-7 years.

Patrick Ho – Stifel Nicolaus

Can I correctly characterize this as both with existing customers and new customers?

David Tacelli

You can correctly characterize it as both.

Patrick Ho – Stifel Nicolaus

You mentioned some new products coming out over the next few months. Are these products within your current platforms you have or is this something that is going to be “new”?

David Tacelli

One is inside the current platform and one will be an extension of an existing platform. The PA product we are coming out with is inside the current platform and the things we are doing with ASL and actually not only extending the life but giving it more capability is another example of how we have taken the two companies, analog from one and digital from another and combined it and extended that product out to give that almost 4,000 units in the field additional life and additional revenue opportunity for us.

Operator

The next question comes from the line of Christian Schwab – Craig-Hallum Capital.

Christian Schwab – Craig-Hallum Capital

On the taxes, what should we be assuming as far as a tax rate going forward?

Mark Gallenberger

Right now we still have enough NOLs that have been created even post-merger that you should still be planning just the minimum 2% AMT for tax provision. Post-merger we probably have created about $100 million of NOLs and pre-merger the taxes are limited because the ownership change in both companies. That limitation is about $10 million of NOLs per year on the pre-merger NOLs. We are still in pretty good shape for awhile.

Christian Schwab – Craig-Hallum Capital

Given your positive commentary regarding market share gains, new customer initiatives and a couple of guys being $20-25 million incremental revenue a year, have you officially changed your market share objective going forward? I know before you said you were kind of in the 12% give or take area and hoped to reach 15%. Given those type of changes is there any update on that?

David Tacelli

Internally we have far more aggressive targets than what we have stated.

Christian Schwab – Craig-Hallum Capital

Can you give us an update on what given the huge restructuring you did we are obviously seeing tremendous operating leverage with operating margins up to 15% here. Do you have an internal operating margin goal?

Mark Gallenberger

It is a very, very interesting question. We have put together business models where we look at, and I think you can probably do this as well, what the market will do and what percentage share we will gain by customer and how that will translate based on the given mix in products. So internally yes we do have operating margin targets. But the way I think about it is pretty simple.

If you take whatever the revenue growth is and this is the way to model it, and if you use kind of what I call a 60/50 formula that every revenue dollar will go to the gross margin at 60% and every dollar that goes to gross margin drops to the bottom line at about 50%. You can then take it all the way through so you can see that as you start to get up into $80-90 million revenue rate you are going to be in a mid 20’s on an operating margin. It is just a formula that follows all the way up.

David Tacelli

I think to add a little bit more color we have worked pretty hard to get the company to this type of business model. Now it is really about focusing on the top line to grow the share. I think we accomplished our mission in getting to break-even in the leverage model to the point where it is at today and I wouldn’t expect any material changes from this point forward and now we are focused really on the top line.

Christian Schwab – Craig-Hallum Capital

The share gains in the microcontroller side I know in the past you though you would have roughly 8% share in 2009. Do you still hope to at least double that in 2010 with the market share goal in that market approaching 30%?

David Tacelli

We are on track to be on that plan.

Operator

The next question comes from the line of John [Melspin] – Inaudible Company.

John [Melspin] – Inaudible Company

My question is related to just what you have gone into not that long ago you entered successfully the microcontroller market and wafer probe market. Is it superior product? What do you attribute your success in entering these new areas?

David Tacelli

The easiest way for me to describe it and I don’t want to downplay the technology but the technology we have in some of the products we have has allowed us to drive down the cost of test for our customers. The Diamond product specifically when we related it to microcontrollers or wafer probe the size, scale, operating cost, capital cost and throughput gives customers the ability to downscale from higher priced platforms or migrate from platforms that are a little bit long in the tooth. Really it gives them the ability to cost down.

Mark Gallenberger

I think also what that does is it is not trying to discount an existing product. It is the technology and the innovation of the engineering team that has enabled a new level of cost of test which is very attractive for our customers that are constantly under pressure to reduce their costs. So that is what has really enabled them to dramatically change their cost profile as it relates to test.

David Tacelli

Another way to validate what we are saying is just look at the P&L profile. We are entering these markets. They are very competitive markets. Our competitors, at least one of our competitors produces a very good product for a couple of these markets and although we have an aggressive approach on how to gain share, it is showing up as positive in the gross margin. So we are doing it in the structure o the product technology still being able to offer a lower cost test to our customer.

John [Melspin] – Inaudible Company

Are you hiring in any particular, and I am curious about this as far as the question geared towards hiring in any particular areas at this time as far as expansion of either the sales force, the R&D department? Any areas again of the company you are expanding either steadily or rapidly that you can talk about?

David Tacelli

We have a lot of the engineering projects we have decided to go after from our marketing strategy already funded to the point where we think it is properly funded. So if we do make a strategic change in any way as it relates to that product roadmap or the markets we want to serve then clearly we have to revisit that. Right now we do believe the core team is funded properly.

The piece when you have more success with new customers and new applications you are winning you tend to have to move up the applications engineering expense in the form of additional hires there. So that area we are constantly looking at to see if we need to properly fund that area of the business. In terms of the other aspects of the business, the administrative functions as well as sales and marketing I think we have got things properly funded for the mission we have in front of us.

Operator

The next question comes from the line of Michael Bertz – Kennedy Capital.

Michael Bertz – Kennedy Capital

I wanted to follow-up on that a little bit in terms of what investments you think you need to make and if you have any granularity you can share with us in terms of what directions you want to take the products. You say it is fully funded to R&D. Does that imply then we should think about the OpEx structure is it is going to bump up here in the next quarter as being something that could be fairly consistent at least on a fixed basis over the course of fiscal 2011?

David Tacelli

I will answer that last piece first. I do think it is going to be pretty consistent. You are not going to see any significant bump up. As Mark talked about, as we approach these new wins and they come along with requirements to do specific applications so that customers can rollout the testers into production we will look to add the appropriate applications engineering talent into the field to be able to do that. But you are not talking significant quantities of hires to go after any new technology.

It is really supporting the new wins. I don’t see any significant hire on the engineering side as Mark talked about because we are staffed for the progress we want. I think where there would be a change is if we decided there was a market segment we are not going after today and we needed to develop an instrument or we needed to do something specific with software that was additional to the projects we undertook, then we would add that based on the business justification and communicate that to everyone accordingly and let them know this is what we are doing. But that doesn’t exist today outside of supporting new wins by getting more applications into production.

Michael Bertz – Kennedy Capital

That is an interesting question you bring there. If we were to look at let’s say an adjacent segment or something you are not really dealing with right now, what kind of internal hurdle rate would you put out there that you would need to hit to make that worthwhile for the investment you need to have? I don’t want to say jeopardize the business you have built now but where would that need to be to make that attractive to you?

David Tacelli

Significantly higher than the hurdle rates or the internal rate of return for the company right now. We place a significant burden because the risks associated with going into a new market is very high. So the rate of return has to be commensurate with that risk.

Michael Bertz – Kennedy Capital

Can I pin you down on a number that would have to be significantly higher?

David Tacelli

I don’t think we are ready to give you a specific number. Our philosophy is given the company’s current market share in the SOC space we think there is much opportunity for us to continue to grow our share by focusing in the areas we know and we know pretty well.

Michael Bertz – Kennedy Capital

I am not asking you to make some big massive investment [charge]. So on the balance sheet, inventory came down quarter-over-quarter. How should I expect that to trend here? Do you think you can support and ramp the business, again being very trends related, at that kind of inventory level or you are still at 100 days or so or do you see that grow some?

Mark Gallenberger

You have to keep in mind we are fully outsourced. So a lot of the inventory we did burn off was excess that was created in the prior cycle. We are still burning that off. But as we ramp our business it is ironic how most companies, more traditional companies that are not outsourced you see inventories actually ramp up. It is the opposite for us where you actually see inventory levels actually decline because our outsource providers are the ones that are seeing increases in their inventory levels.

On the flip side, when the industry rolls over you would actually start to see our inventory levels actually grow unlike in-source companies that would see inventory levels decline. So that is kind of how the outsource model works. It is kind of the opposite effect as opposed to doing in-house manufacturing. So right now, this is a long winded answer and I apologize for that but I would expect inventory levels to still decline a little bit further but not that much more.

Michael Bertz – Kennedy Capital

So a little further in dollars but maybe more in days?

Mark Gallenberger

Yes, a little bit further in dollars. That is correct.

Operator

The next question comes from the line of Dave Duley – Steelhead Securities.

Dave Duley – Steelhead Securities

Does the $2.2 billion market size change your thinking about what your mid cycle target model should be? Could you remind us what your mid cycle target model is?

David Tacelli

What we have been talking to everybody about is at about this 12.5-13% market share number for the space we look at. We thought that was about a $65-70 million cross cycle revenue goal. If the market increases and our share goals increase yes it does increase the cross cycle revenue goals of the company.

Mark Gallenberger

I think the cross cycle assumption was like $2.1 billion market size. Clearly that was a cross cycle number. The third party forecast for 2010 was below that number. So I think it is a little too early to say whether the cross cycle industry size has grown from the $2.1 billion assumption but clearly the up cycle is off to a very, very good start.

Operator

There are no further questions. I would like to turn the call back over to Mark Gallenberger for closing remarks.

Mark Gallenberger

I want to thank everybody for joining us today. Richard Yerganian is actually presenting today at the B. Riley conference in California. Next week we will be in Minneapolis presenting at the Craig Hallum conference. So thank you very much for joining us and we hope to see you on the road. Thank you.

Operator

Thank you for your participation in today’s conference. That concludes the presentation. You may now disconnect. Have a great day.

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