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OmniVision Technologies (NASDAQ:OVTI)

F2Q07 Earnings Call

November 30, 2006 5:00 pm ET

Executives

Jason Golz - Investor Relations

Shaw Hong - President, Chief Executive Officer, Director

Peter V. Leigh - Chief Financial Officer, Vice President-Finance

Jess Lee - Vice President of Mainstream Products

Hasan Gadjali - Vice President of Advanced Products

Analysts

Jennifer West - Merriman Curhan Ford & Co.

Harsh Kumar - Morgan Keegan

Jason Pflaum - Thomas Weisel Partners

Paul Coster - JP Morgan

Adam Benjamin - Jefferies & Company

Satya Chillara - Pacific Growth Equities

Kent Shaw - Market Capital

Quinn Bolton - Needham & Company

David Wu - Global Crown Capital

Tore Svanberg - Piper Jaffray

Bill Baldwin

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the Q2 2007 OmniVision Technologies earnings conference call. My name is Rob and I will be your operator today.

(Operator Instructions)

At this time, I would like to turn the conference over to your host for today’s call, Mr. Jason Golz.

Jason Golz

Thank you, Rob, and good afternoon, everyone. Earlier this afternoon, OmniVision issued a release reporting its financial results for its fiscal second quarter of 2007. This release can be accessed from the investor relations section of our website at www.ovt.com, or on the financial newswire.

Before we begin, here are a few items for everyone to reference.

This call is being webcast live and a web replay will be available for 12 months. We have also arranged to record this call. The tape replay will be available approximately one hour after the call’s conclusion and will be available for 48 hours. The dial-in access number for this replay is 617-801-6888. The replay passcode is 65561189.

Both the webcast and the replay can be accessed in the investor relations section of OmniVision’s website at ovt.com.

This conference call contains forward-looking statements within the meaning of Section 27(NYSE:A) of the Securities Act of 1933 as amended and Section 21(NYSE:E) of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve known and unknown risks, uncertainties and other important factors that may cause actual company or industry results, level of activity, performance or achievements to differ from those expressed or implied by these forward-looking statements.

In evaluating these forward-looking statements, you should specifically consider the various risk factors detailed from time to time in OmniVision’s Securities and Exchange Commission filings, including but not limited to the company’s annual report on Form 10-K filed for the fiscal year ended April 30, 2006, and its most recent quarterly report filed on Form 10-Q.

These factors could cause the company’s results to differ materially from the forward-looking statements made in this conference call. Although the company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, level of activity, performance or achievement. These forward-looking statements are made only as of today’s date, and OmniVision expressly disclaims any obligation to update or revise the information contained in the forward-looking statements.

This concludes the safe harbor statement.

Please also note that on this conference call, we will provide listeners with certain financial metrics determined on a non-GAAP basis, both for comparisons to previous quarters and for our outlook for future quarters. These financial metrics, together with the corresponding GAAP numbers and reconciliation to the comparable GAAP financial measures, are contained in today’s financial results press release, which we have posted on our website at investors on ovt.com, under press releases, and have furnished to the SEC on Form 8-K. We encourage listeners to review these items.

I would now like to turn the call over to OmniVision’s President and Chief Executive Officer, Mr. Shaw Hong. Shaw.

Shaw Hong

Thank you, Jason, and good afternoon, ladies and gentlemen. Thank you for joining us on today’s call. With me today are: Peter Leigh, our CFO; Jess Lee, VP of Mainstream Products; and Hasan Gadjali, VP of Advanced Products.

On today’s call, I will begin with an overview of our results, and then I will provide a general business update, followed by a highlight summary. Peter will provide you with the financial details, and then I will address our broader strategic outlook. We will then take your questions and for that, Jess and Hasan are here to provide additional insight.

Before I talk about the current quarter, I first wanted to mention that the Board of Directors has appointed James He, our Chief Operating Officer, to the Board. As I mentioned last quarter, James has been with OmniVision since the very first day of the company in 1995. He has been an extremely important contributor to the success of OmniVision, leading the company’s research and engineering efforts for many years.

As we move forward, James will continue to be a key contributor to the strategic development and business operations of OmniVision.

Revenue during the second quarter was about $138 million. Earnings were $0.10 per share. Excluding stock-option expenses, the litigation settlement accrual and related tax effect, non-GAAP earnings were $0.28 per share.

Our balance sheet at the end of the quarter remains strong. Our cash and short-term investments totaled about $350 million, and we have no debt.

In the second quarter, we sold about 65 million sensors. The volume of OmniVision’s imaging sensor shipped in the quarter increased 12% sequentially, due primarily to increased demand for handsets.

With units at an all-time high, we remain focused on our strategy of capturing, converting and processing images, and we are continuing to develop new technologies for all of our markets and to deliver higher quality solutions to our customers.

During the quarter, we introduced our sixth generation 1.3-megapixel image sensor in a 1/5-inch optical format, the world’s smallest. This new 1.3-megapixel sensor has been well-received by tier-one customers, and we already have multiple design wins in both handsets and notebooks.

Additionally, we continue to achieve success with our advanced business products with the introduction of OmniVision CameraChips, targeted at high-end commercial security applications, including smart systems.

As we enter the holiday season, you can see the success of OmniVision first-hand by looking at how many products using our image sensor technologies are now available on [inaudible].

In addition to the latest mobile handset device and digital still cameras, you will see inventive new toys, like the Spy Video Card, and the very high-profile, recently launched entertainment game console as well as notebook computers with embedded webcams.

In the showroom, you will see new automobiles with the latest rear-view cameras and van departing warning systems.

Assisting in the security of malls, parking lots and stores, commercial video monitoring systems will be featuring our security and surveillance CameraChips.

Consumers are also able to install their own home-based security systems using OmniVision sensors.

Innovating and collaborating with our customers to help them bring their idea to market has been very rewarding for us, and we are able to continue our efforts to enable their success.

As we mentioned during our last earnings call, we began taking the necessary steps to relieve our chip scale packaging constraints during the fiscal second quarter. Our goal is to have the first line of equipment in place before the end of the calendar year, and to have the second line of equipment in place by July of calendar 2007. I am glad to report that we are on track to accomplish this goal, with the first line in the early stages of ramping up.

Unit volume in our mainstream products business, which addresses our large volume customers in mobile handset and digital still cameras, grew significantly in the second quarter. Our goal is to drive our technologies and products to lead the market in the fast-growth mobile wireless arena.

During the quarter, we shipped our first sample of our sensor based on the WaveFront coding technology. We have received the feedback from our customers that they have a high level of interest in WaveFront coding, and we are working internally to optimize the technology.

Optimizing the technology will push out the realization of first quarter revenues, but we remain committed to fully exploiting the potential of this revolutionary approach to focusing lens systems.

Also during the quarter, we launched our sixth generation 1.3-megapixel camera chip sensor called the OV9660. The sensor is a 1/5-inch optical format and enables a 25% single camera module, meeting the requirements of [inaudible] mobile handset designs.

Additionally, the smaller module size is especially attractive to handset makers, because it allows drop-in upgrade from VGA to 1.3-megapixel, thereby extending the life of existing VGA camera phone designs.

As the mobile handset market continues to expand, we have discovered that for each of their products, our customers tend to seek one of three unique solutions. We have adopted a strategy to address these different solutions, which balances the demand of customers who require the highest resolutions, those that want functionality, and the customers that have cost as the leading decision factor.

Addressing the higher resolution requirements, OmniVision is leading the industry transition to 2-megapixel products within a 1/4-inch solution, and it is developing 3-megapixel solutions to follow.

Addressing the needs of functionality, we have introduced a 1.3-megapixel solution on our OmniPixel 2 architecture. This provides improved performance in a more compact sensor.

Lastly, the company offers an interesting VGA sensor to meet the increasing demand in the handset market for lower-priced sensors with superior image quality.

Let me now turn to our advanced product business, where we continued to reach new milestones in the second quarter.

We are now in four of the top five notebook manufacturers. We have been successful in this market because of our expertise in the mobile handset space. Similar to handsets, notebooks also require small form factor and a low [hide] product. For example, our OV9660, which I touched on earlier, is generating interest from ultra-portable laptop manufacturers because of its small form factor.

Due to size constraints, these manufacturers have been limited to using only VGA resolution cameras. The introduction of this sensor now allows these ultra-portable laptop makers to upgrade to 1.3-megapixel cameras without the need for a costly system redesign.

Additionally, we introduced the OV7720, a high performance VGA sensor designed on our OmniPixel 2 platform. In addition to addressing the notebook market, this very small sensor is also ideal for use in webcams, both IP and 3G handsets, and security and surveillance applications.

The OV7720 is a high performance VGA sensor capable of running at 60 frames per second that also delivers exceptional low-light sensitivities and performance, without sacrificing the speed required for advanced security applications.

For the evolving security and surveillance market, we introduced the new OV7949, a sensor designed specifically for commercial CC TV and video monitoring security systems. We also announced that OV7949 has been selected by a major U.S.-based tier-one customer of commercial grade security cameras. This highly integrated, single-chip video camera chip sensor packs a high level of functionality and operates extremely well in low-light conditions, a feature especially critical to indoor and night security monitoring systems.

Besides excellent performance in near-dark environments, the new OV7949 also shows significant reduction in [roaming] and smearing effects, and operates well in extreme temperatures.

For the toys and games market, we are excited to be working with two of the three largest video game console manufacturers. For both platforms, we are selling our sensors for separate stand-alone image capture systems that works in conjunction with each system. We expect that a test rate for these accessories will be higher than for previous versions.

An increased test rate should occur, because we are launching our product at the same time as the game console, and there are a greater number of games being introduced that can take advantage of the systems separately.

While we have mentioned our excitement surrounding our role in the video spy card, we are also participating in the success of several additional toys with embedded cameras.

The automotive market is another area in which we have high expectations for the future. As you know, we are already in mass production of sensors for both domestic and European auto manufacturers. During the October quarter, we began working with two new OEM customers. Both current and new customers are recognizing that there is significant demand for multiple sensors in automobiles, such as rear-view cameras, and van departure warning systems.

Lastly, for the medical market, our new OVCD920 is being designed into many applications. The lead time in this market, however, can be lengthy. This is due to several reasons, most of which are related to the safety and the regulatory issues. Our current expectation is that we will see revenue from this market in 2007, with more significant volumes in 2008.

Over the long run, we believe that in the medical market, there are a tremendous number of opportunities for our sensors.

Before I turn the call over to Peter, I would like to talk about what we are doing to improve profitability. There are three areas in particular which we are emphasizing to improve our profitability.

First, we are working very diligently with our supply chain in order to ensure that we are operating under the most cost-effective model.

Secondly, we will continue to introduce new technologies, such as bringing out our 1.3-megapixel on the latest architectures, and bringing to market further innovative technologies already in our research and development pipeline.

Thirdly, we will continue to work with our customers to provide them with higher resolution, higher integration, and smaller form factor products.

We believe that by focusing on these three areas, we should be able to return to an improving operating model.

I will now turn the call over to Peter, who will discuss our second quarter financial results in detail. Peter.

Peter V. Leigh

Thank you, Shaw, and good afternoon, everyone. For the second quarter of fiscal 2007, which ended October 31, 2006, OmniVision had revenue of $137.7 million, up slightly from last quarter and up 9% on a year-over-year basis.

Approximately 85% of our revenue in the second quarter came from mobile handsets, compared to 80% in the prior quarter. Just under 5% came from digital still camera OEMs, compared to approximately 10% during the prior quarter. About 10% of our business, both this quarter and last quarter, came from our advanced products, which includes security and surveillance, toy and video game consoles, webcam and notebook PCs, and automotive products.

The numbers for end user market revenue are necessarily imprecise because we sell to module makers and through distributors and we have updated the prior quarter data to reflect new information.

Direct sales to original equipment manufacturers and value-added resellers accounted for about 63% of revenue in the second quarter of fiscal ’07, with a balance of 37% coming from sales through distributors.

We shipped approximately 65 million image sensors in the second fiscal quarter, an increase of about 12% from the approximately 58 million units we shipped in the July quarter. Our blended average selling price was $2.12, down $0.23 from the $2.35 we reported in the prior quarter. While pricing pressure is a constant in our universe, by far the largest contributing factor to the decrease was the change in our overall volume and revenue mix, in particular the larger share of VGA sensors in our unit and dollar volume.

Gross margin for the second quarter was 33.1% compared to 36.3% last quarter. Our gross profit reflects approximately $1 million of stock-based compensation expense compared to $0.9 million last quarter.

Gross profit in the quarter includes $1.6 million of compensation from a supplier whose product quality in previous periods did not meet the company’s quality standards. In the prior period, gross profit included $2.2 million for similar issues.

The decline in gross margin in the October period was primarily the result of a shift in product mix together with pricing pressure.

R&D expense in the second quarter was $18.7 million, up from the $16.8 million we reported in the prior quarter. Our R&D expense includes approximately $3.6 million of stock-based compensation. Excluding stock-based compensation expense, R&D in the quarter was $15 million compared to $13.8 million in the prior quarter.

SG&A expenses in the quarter totaled $15.8 million. Our SG&A expense includes approximately $4.2 million of stock-based compensation expense. Excluding stock-based compensation expense, SG&A in the quarter was $11.6 million, compared to $10 million in the prior quarter.

We have also accrued $3.3 million this quarter for the company’s share of a probable settlement of a class action securities litigation originally filed in mid-2004. Both the Board and management believe that it is in the best interest of the company to put this matter behind us.

Operating income in the quarter was $7.8 million. Operating income reflects total stock-based compensation expense of $8.8 million and the $3.3 million litigation accrual.

Our tax rate for the quarter is approximately 33%. The increase from Q1 reflects the fact that we now expect that our tax rate for the current fiscal year will be about 28.5%, slightly higher than the 26% we were expecting at the end of Q1. The change in the rate is due to a change in the expected geographic mix of our income this year, offset by the fact that we now expect that, in accordance with FIN-46, we may be required to deconsolidate VisEra during fiscal Q3. This change may be required because during fiscal Q3, we expect to take over from VisEra the back-end supply chain management functions that they have been performing for us. This change would have virtually no impact either on reported revenue or on reported net income.

Net income in the second quarter was $5.4 million, or $0.10 per diluted share, compared to net income of $15.9 million or $0.28 per diluted share in the previous quarter. Excluding total non-cash stock-based compensation expenses of $8.8 million, and the litigation settlement expense of $3.3 million and the related tax effects, non-GAAP net income in the second quarter of fiscal 2007 was $15.7 million, and non-GAAP earnings were $0.28 per diluted share. Net income in the prior year quarter was $22.6 million, or $0.41 per diluted share.

Let me turn now to the balance sheet, which remains overall in good shape. We ended the quarter with cash and short-term investments totaling about $350 million. Inventories at quarter end net of reserves were $103.7 million, up $35.2 million from last quarter, and were somewhat higher than they needed to be. Our goal is to maintain annualized inventory turns of between 4 and 5 times. At the end of October, our inventory turn rate was 3.6 times.

$23.9 million of increase in inventory reflects the increase in the company’s work in process inventory late in the quarter. Part of this increase reflects planning for higher unit volumes in the third quarter and in preparation for the start-up of the additional packaging capacity that the company owns at its CSP supplier, XinTec. The new capacity is now in the early stages of ramping and we expect to achieve full capacity by the end of December.

Part of the increase reflects a shift in demand towards VGA and the fact that the change came too late in the quarter to change our wafer production schedules.

The increase in inventories was in current high volume products and as a consequence, we do not believe that the increase significantly raises our risk of obsolescence or of excess inventory.

As I said a moment ago, our inventory turns goal remains 4 to 5 times, and we plan to be back on track no later than the end of the fiscal year. As many of you know, our production lead time is 12 to 14 weeks. Our order lead times, by contrast, are sometimes shorter. Consequently, we believe that we can enhance our competitive position by maintaining higher inventory in order to achieve greater flexibility in meeting shorter lead time orders.

Accounts receivable at the end of the quarter were $75.3 million, up $3.3 million from $72 million at the end of the first quarter. Our days sales outstanding were 50 days, up from 48 at the end of July, and overall our receivables are in very good shape.

Now, I would like to turn to the outlook for the third quarter of fiscal 2007, which will end on January 31st.

Based on current trends, the company expects fiscal third quarter 2007 revenue will be in the range of $135 million to $145 million, and earnings will be between $0.05 and $0.12 per share on a diluted basis.

Excluding the estimated expense and related tax effects associated with stock-based compensation in accordance with FAS-123R, the company expects non-GAAP earnings will be in the range of $0.16 to $0.23 per share on a diluted basis.

I would now like to turn the proceedings back to Shaw for some strategic commentary.

Shaw Hong

Thank you, Peter. OmniVision’s core competency is centered on the image sensor. Our goal is to expand our influence on all the key elements of the image pipeline. By that, we mean live capture, the conversion of light into images, and the processing of these images.

Our team is the best and the brightest at what they do. In order to achieve this goal, our entire team is committed to executing the following objectives:

  1. To grow our customer base and the number of design wins;
  2. To continue to demonstrate technology leadership;
  3. To identify and extend our reach into new emerging applications;
  4. To serve our customers as strategic partners; and
  5. To intelligently invest in the right parts of our business at the right time.

We believe that by executing on these objectives, we will achieve strong business performance.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Sir, I have your first question today coming to you from Ms. Jennifer West.

Jennifer West - Merriman Curhan Ford & Co.

Good afternoon. I was wondering if we could dig into the pricing a little bit more. Is it possible for you to break out, pricing was down around 10% in the quarter. How much of that was mix related versus how much was pricing pressure related?

Peter V. Leigh

Jennifer, we do not generally disaggregate that quantitatively because it is, as you are probably aware, information that we do not get from our competitors. I am afraid you will simply have to rest with the statement that I made. The majority of the decline this quarter is due to product mix.

Jennifer West - Merriman Curhan Ford & Co.

Okay, maybe I can ask it a different way. Do you still view average annual pricing pressure as being 20% to 25% annually?

Peter V. Leigh

We do.

Jennifer West - Merriman Curhan Ford & Co.

Okay, and so you would expect with some mix change next quarter looking like that is going to skew more into VGA, you would expect an additional quarter of pricing to come down because of mix?

Peter V. Leigh

Well, no, I do not think that joining two points and declaring a trend is necessarily the right way of looking at this. Maybe I could turn this one over to Jess to talk a little bit about what we are looking for in terms of mix during the current quarter.

Jess Lee

I think what we are seeing qualitatively that our megapixel products will be trending up next quarter, and this is for a variety of different reasons. In general though, I just want to point out one thing. Product mix for us is really determined by our successes and our customers at specific phone design wins, so if one phone or if a set of phones happen to be more popular and another set happens to be less popular, then that determines the popularity of that sensor.

What has been happening recently is that the VGA low-end phones are a lot more popular than a lot of the megapixel phones. What is happening in the future is we feel we have some visibility that our 1.3-meg products will be becoming more popular based on the forecast that we see in the short-term, and in the longer term, we are pretty excited about our upcoming 1.3-meg product, the one that we just announced, the 9660. That is seeing tremendous positive feedback from a variety of different customers, and actually that has been designed in a couple of tier-ones already.

Jennifer West - Merriman Curhan Ford & Co.

Just to clarify, in the third quarter, you do expect the mix, you are expecting the mix to shift to megapixel, and maybe the percentage of total units in VGA to be down sequentially?

Jess Lee

Correct.

Peter V. Leigh

Well, not necessarily down in absolute terms, but in terms of share, yes.

Jennifer West - Merriman Curhan Ford & Co.

Okay. Thank you.

Operator

Thank you. We will go to Mr. Harsh Kumar from Morgan Keegan.

Harsh Kumar - Morgan Keegan

Hey, guys, kind of a question along similar lines. Your long-term structure, from what I understand, financial structure is 35% gross margin. We are looking at numbers that are coming in below that. Just on a pro forma basis, if we ex out all the payments that you guys are getting and previously sold off stuff, is that still the case? Should we be looking at your company and thinking of this as a 35% gross margin model, or a 30% gross margin model longer term?

Peter V. Leigh

The goal remains to achieve the 35% gross margin, but the current environment simply does not permit that and I do not want to encourage you to believe that we will return to 35%-plus anytime in the immediate future.

Harsh Kumar - Morgan Keegan

Okay, and again, the question that I guess I have been asking now for some time, $350 million in cash, can we expect a buy-back anytime? If so, maybe you could give us some logic of why there is no buy-back at this point in time?

Peter V. Leigh

We keep that whole question of buy-back, and you and I have talked about this a number of times, you are quite right, we keep that whole issue of a buy-back under continual consideration, but with the capital investments we are currently making, we think that this is not the time to indicate these kinds of -- to use cash in this particular way. We got to make some major efforts that were indicated to build an improving operating model, including changing the way we manage our supply chain, introducing new technologies and new products, and pushing our products up the resolution curve. All of those things do take money.

Harsh Kumar - Morgan Keegan

Fair enough. Could I ask one more, Peter, and then I will get out of the queue and come back later, if there is time?

Peter V. Leigh

Please do.

Harsh Kumar - Morgan Keegan

Okay, your R&D and SG&A took off over the last two or three quarters pretty heavily, I guess. Sales have been somewhat flattish, maybe up a little bit. Could you tell us what has gone on there, even on a pro forma basis?

Peter V. Leigh

Well, the biggest single driver of increased expenses, of course, is headcount, and we have a very rigorous process by which we evaluate headcount adds, and we will be even more rigorous in this regard going forward.

Harsh Kumar - Morgan Keegan

Thank you.

Operator

Thank you. We will go to Jason Pflaum from Thomas Weisel Partners.

Jason Pflaum - Thomas Weisel Partners

Yes, good afternoon. Just to follow on that last question, as far as op-ex, looking forward to the next couple of quarters, maybe you could be a little bit more specific as far as expectations.

Peter V. Leigh

What we tend to see, Jason, is that other things being equal, op-ex goes up between $2 million and $2.5 million a quarter. I think the way to look at this, and I think I have said this on previous calls, is to go back and look at it over a period of time, take out the changes that arise, for example, out of the consolidation of VisEra, and just look at it on that sort of average basis.

We do have to invest in the future of this business. This business is based on technology and that requires constant investment, as you know.

Jason Pflaum - Thomas Weisel Partners

Okay, and just to follow-up on the gross margin outlook. It would appear on a pro-forma basis based on the guidance that maybe it is down a couple hundred basis points again in the context of an improving mix towards megapixel and above. Maybe you could just help us understand that, and give us --

Peter V. Leigh

I think your calculation is in the right area and I think the thing you have to always take into account is the pricing pressure. That is something that we have very limited control over.

Jason Pflaum - Thomas Weisel Partners

Okay, and then just lastly on the inventory, maybe you could give us an idea of what the composition of inventories look like today, with respect to megapixel, VGA, and maybe 2-megapixel, or just a general sense there.

Peter V. Leigh

We do not typically break out the inventories by individual resolutions. Suffice it to say that we are very comfortable that these inventory levels present no risk of obsolescence and, as I indicated in my prepared remarks, we think that actually there is an advantage in having slightly higher inventories, so that we can respond more rapidly to changes in the demand picture in the market place.

Jason Pflaum - Thomas Weisel Partners

Okay. Very good. Thank you, guys.

Operator

Thank you, sir. We will go to Mr. Paul Coster from JP Morgan.

Paul Coster - JP Morgan

Thank you. Peter, could you give us some sense of what percentage of your overall revenues related to VGA versus megapixel, and how that compares to the industry?

Peter V. Leigh

I will take the first-half of that. The VGA in the quarter was close to two-thirds in terms of units versus the typical 50% plus that we have seen over the last several quarters. As far as the industry is concerned --

Jess Lee

We do not have any specific numbers from our competitors, so I do not know if we can comment on how we compare to our competitors.

Paul Coster - JP Morgan

I am sorry, I didn’t quite catch that.

Jess Lee

Actually, I was just saying we have very little data, as you may be in a similar position, on our competitors. They do not break out revenues --

Paul Coster - JP Morgan

You seem to be going sort of in the opposite direction that the industry would at least intuitively be heading. Is that a true statement or do you think that there is just a --

Jess Lee

Actually, I think that is not necessarily true. I think the popularity of low-end phones have been driving the growth of the overall handset market. I think every year, everyone is surprised by how much the handset market grows, and a lot of that growth does come from the low-end.

We have been focused on different parts of the market. One of them is the low-end, and I guess we have had more success there than we have had in other areas.

Paul Coster - JP Morgan

When you say, in the prepared remarks, you said that you had a surprise order for VGA, which has caused you to build up your work-in-progress inventory accordingly, yet you are also saying that the market is shifting to megapixel. Are you just looking at two different metrics to make those two apparently inconsistent statements?

Peter V. Leigh

I do not think it is inconsistent, Paul. I think we are looking at two different time periods. In Q2, what we saw was a late period surge in VGA which required that we pull in certain wafers in order to meet that demand, and the megapixel wafers were on the line, and we could not prevent them from being delivered. That is what caused the immediate shift in the inventory.

Longer term, I think your statement, again I defer to Jess on this, but I think your general statement about the market moving toward megapixel is correct, and indeed part of our strategy of course is to encourage our customers, drive our customers to move up the resolution curve, because we believe that is where our technology has the best advantage over the competition.

In the meantime, what you also have going on is a fairly dramatic adoption of first-time cameras in the low-end of the market, in the what I believe are now commonly referred to as the bricks countries, Brazil, Russia, India, and China. There, traditionally cell phones did not have cameras. Now what is happening is you are seeing an increasing adoption of initially VGA cameras in those phones, and part of our strategy, of course, is to capture those slots and indeed then migrate those slots to megapixel as soon as we can. We are already seeing some of that migration.

Paul Coster - JP Morgan

What was cap-ex spend in the quarter and when we will see meaningful revenues from WaveFront encoding?

Peter V. Leigh

Cap-ex in the quarter, I think the capital expenditure during the quarter was about $43 million, or thereabouts. That is a combination of the investment in the chip scale packaging at XinTec and the initial investment in the expansion of this era. Sorry, what was your second question?

Paul Coster - JP Morgan

WaveFront encoding, when will it contribute to revenues? It sounds like it is pushed out again.

Peter V. Leigh

It is pushed out, and I think it may be too early for us to set a firm timeframe at this point. We do have some work to do to optimize this technology.

Paul Coster - JP Morgan

Okay. Thank you.

Operator

Thank you, sir. We will go to Mr. Adam Benjamin from Jefferies and Company.

Adam Benjamin - Jefferies & Company

Thanks, good afternoon. First, Jess, you talked a little bit about what you thought the mix would be in the January quarter. You had previously talked about 2-megapixel getting up to 10% by the end of the year here as a target. You did not mention 2-megapixel, so I am just curious where you see that coming out in the January quarter.

Jess Lee

Thanks for bringing that up. We actually have exceeded our target for 2-meg already. We are now past the 10% mark in terms of units for our 2-meg, so we are quite happy with that.

Adam Benjamin - Jefferies & Company

Could you quantify just the ASP differential you are getting on a percentage basis versus say a 1.3 or VGA?

Peter V. Leigh

What we have said, Adam, in the past, and it is really as far as we are comfortable going, is that roughly speaking, 1-megapixel is twice the VGA, and 2-megapixel is an increment of maybe 50% to 75% over the 1-megapixel.

Adam Benjamin - Jefferies & Company

Okay, so with the shift of going over 50% to almost two-thirds VGA in the current quarter, I am just trying to reconcile that with you hitting that 10% target, Jess.

Jess Lee

Right, so the combination obviously has been weighted more heavily than we expected this quarter with the VGA. Obviously with an increase from a half to almost two-thirds, that is pretty sizable. Our 2-meg did help, but the VGA has been much more popular than we thought it would be.

Adam Benjamin - Jefferies & Company

And that means the 1.3 kind of got squeezed a little bit less than you thought as well?

Jess Lee

Exactly. I think what we are seeing is a popularity rise of the VGA and of the 2-meg. Now, going forward, we think that trend will be reversed. As we said short-term, in the coming quarter, our 1.3-meg product will become more popular, just because of the phones that they are. Longer term, our 9660 is looking to be even more popular than that, just because of the way we can upgrade our existing VGA customers to that 1.3.

The whole goal behind that product is that it is the same mechanical footprint as our current VGA products, so with the huge volume that is behind the current VGA, we are looking to aggressively migrate those customers to the new 1.3.

Adam Benjamin - Jefferies & Company

Could you talk at all about the 2-megapixel business? Is it shipping? Is it tier-one, tier-two, tier-three customers and geographies?

Jess Lee

Actually, it is a mix of tier-one and tier-twos. Beyond that, I am not sure that I could really comment. It is predominantly tier-one, I would say.

Adam Benjamin - Jefferies & Company

All right, just two quick follow-ups. Peter, you mentioned the tax rate. Are you referring to 28% we should be modeling going forward?

Peter V. Leigh

Correct.

Adam Benjamin - Jefferies & Company

Then, just to clarify on VisEra, could you just talk a little bit about what is going on there? I think there is some confusion as to the deconsolidation there and what exactly your strategy is going forward. Thank you.

Peter V. Leigh

The deconsolidation, if it happens, is mandated by FIN-46, and is a function of the business decisions that we make. In particular in this case, it has to do with the evolving agreement with VisEra and in particular the fact that we are, as part of this whole business of managing the supply chain, we are taking back from VisEra the management of the back-end supply chain, which VisEra has been handling for us for several quarters now. Actually, more than a couple, two or three years. That is what drives the deconsolidation.

In terms of the strategy, VisEra remains our primary and indeed our sole source for color filter and micro lens, and we have no intention of changing that. That is where they fit into our production pipeline.

Operator

Thank you. We will go to Satya Chillara from Pacific Growth Equities.

Satya Chillara - Pacific Growth Equities

This question is maybe for Shaw. Shaw, I wanted to understand the macro picture here. With the amount of money that you are putting in, in terms of capacity at XinTec, with camera phone penetration close to 70% to 75%, now you are increasing the capacity with Samsung, Micron, all of these guys really fighting the battle here. Do you think it is a prudent strategy to increase the capacity at this point? I wanted to get your thoughts, please.

Shaw Hong

I think it is very important for us, this investment for us to increase our capacity. Currently, sometimes we have some shortage here and there. We want to solve this issue.

Also, in the near future, once the demands for --

Jess Lee

I think the market is growing, as you pointed out, and the penetration continues to be growing, so we see that in terms of raw units, the demand will grow significantly. We are planning for that in terms of our back-end capacity.

Satya Chillara - Pacific Growth Equities

Right. Just a clarification there, with the pricing I think getting aggressive, you guys also increasing capacity, that means your margins get squeezed, and with the way you are telling us 2-megapixel may not be picking up, VGA and 1.3-megapixel pricing on those somewhat brutal compared to 2-megapixel. That is where I am coming from.

Jess Lee

I understand what you are saying, but fundamentally we aim to capture as much of the market as this market grows. We are not going to be stepping back from the market just because pricing is getting tougher. We have many strategies underway to build the foundation for our future growth, and one of those is managing our supply chain to be more efficient and to drive down costs. That is a long-term goal. It is a short-term goal, obviously, too, and long-term, with increased capacity and more aggressive cost structures, we believe we can be back on a growth path again.

Satya Chillara - Pacific Growth Equities

Okay, one last question from my side, on the VGA two-thirds of the mix. Is that mainly coming from the top-tier accounts, or the Chinese accounts?

Jess Lee

Actually, it is a pretty good mix of everybody right now.

Satya Chillara - Pacific Growth Equities

Okay, great. Thank you.

Operator

Thank you, sir. We will go to Kent Shaw from [Market] Capital.

Kent Shaw - Market Capital

Thanks, gentlemen. Could you just give us a little bit of a progress report, I suppose, on the WaveFront coding products, as far as sampling and time for introduction and those types of things? Thank you.

Jess Lee

As we said before on this call, we are taking more time to productize this technology. This is new technology, and we are needing to further optimize this new technology to fully exploit its potential.

We have not yet --

Kent Shaw - Market Capital

Excuse me, is that a result of feedback from the customers that have seen it or sampled it, or is it just a matter of testing internally that you decided --

Jess Lee

We internally, and the customers themselves are fairly happy with this technology. The feedback has all been positive but internally, we have realized that there is more for us to do and we will be taking more time to optimize this product.

Operator

Thank you. We will go to Quinn Bolton from Needham and Company.

Quinn Bolton - Needham & Company

First question, I just wanted to see if you could make any comments about the forward pricing environment. It sounds like pricing has been pretty aggressive for the last six months. Now that we are kind of near the peak of the holiday season, have you seen any let up in pricing pressure, or do you think it is going to be a fairly constant per quarter price decline for the next few quarters? Then I have a follow-up.

Jess Lee

I think the general trend, as Peter has said before, is yearly, we are seeing a price erosion of 20% to 25%, or a cost expectation erosion of 20% to 25% for our customers. That has not changed, but as you can see, quarter to quarter, there can be fluctuations in that. But on average, we believe it to be fairly positive.

Quinn Bolton - Needham & Company

So you have not seen any acceleration or pause in pricing pressure here in the last quarter or so, or expect it in the next quarter?

Jess Lee

Right, not in terms of the big picture.

Quinn Bolton - Needham & Company

Okay. The second question for Peter, Peter, in the past three quarters, you have given us the benefit of previously written down inventory and then also the amount of newly written down inventory in the quarter. I was just wondering if you had those figures.

Peter V. Leigh

I do, if you will give me one second. I think that the sales of previously reversed inventory in the quarter was $4.1 million, and we booked about $1.5 million of new reserves.

Quinn Bolton - Needham & Company

Great. Lastly, I guess for Jess, perhaps, you talked a lot about the 9660, the 1/5-inch optical format kind of being drop-in compatible with a lot of the VGA modules out there. Do you think a lot of the lower-end business that you do now in VGA, is there the opportunity with the new 1/5-inch to replace a lot of that VGA business with a new 9660, or do you think because of pricing differences that the low-end of that market really stays VGA because of the price delta?

Jess Lee

I think there are a couple of different trends that we expect will happen in the VGA market, simply because there are so many designs there and so many units behind there.

A lot of our customers are looking to differentiate. Some are looking to differentiate with lower pricing and some are looking to differentiate in other ways with better features. Fundamentally, when you have a camera phone these days, whether it is VGA or even low-resolution VGA, a camera phone can only be marketed as a camera phone. But when you have the capability to say it is megapixel, that is a big differentiator.

We are looking for two trends in the future. One is a downgrade to our SGA product, which we also recently introduced, the 6680, and an upgrade to the 9660. For the folks who want to differentiate, they will upgrade.

Quinn Bolton - Needham & Company

Okay, so you might see the existing low-end business bifurcate, some going to the 9660, some going to even lower resolution, lower cost solutions?

Jess Lee

Right, and some actually staying at VGA simply because they do not need to make the change.

Quinn Bolton - Needham & Company

Great. Thank you.

Operator

Thank you. We will go to David Wu from Global Crown Capital.

David Wu - Global Crown Capital

Good afternoon. I have a couple of questions. Could you help me with the first one, which is if your mix is going to more megapixel in the third fiscal quarter, how come we are looking at declining gross margin at the same time? I thought the product mix was the number one driver for margin profitability. Am I missing the start-up costs on 2-megapixels are still on increasing tag, or something like that, to cause the margin trend to be down quarter on quarter on a richer mix? That was the first question.

The second one is really looking at the business. I was surprised that your VGA percentage went up, because your primary competitor had declining VGA business in the quarter that ended in August. Not exactly in October, but the heart of the business appears to have gone over to 1-megapixel, with 2 being the sweet spot. How do you compare yourself, your product shipment versus theirs?

Peter V. Leigh

Let me take your first question, and then maybe Jess can answer your second question. You were asking, how do I reconcile the decline in margin in Q3 with the shift towards megapixel?

David Wu - Global Crown Capital

That is right.

Peter V. Leigh

I think the thing that you may be overlooking is the overall price trend. It is true that as you move toward megapixel, you have in general higher prices and better margins, but then you have a secular decline in the pricing overall, so the two things that we are talking, the two things that you are talking about are not mutually exclusive or contradictory.

David Wu - Global Crown Capital

You are talking about pricing pressure, I assume that it is happening at 1.3-megapixel as well.

Peter V. Leigh

Yes. Believe me, I do not think we get a single call from any customer offering to pay us higher prices.

David Wu - Global Crown Capital

That’s true. Would that change as you transition to the newer OmniPixel 2 architecture?

Peter V. Leigh

I’m sorry, could you say that one more time?

David Wu - Global Crown Capital

Would that statement be true if you today were shipping OmniPixel 2 architecture as opposed to the older architecture, which presumably had higher costs?

Peter V. Leigh

The pricing pressure is across the board. It is going to vary from product to product, obviously, but it does not, unfortunately, the customers do not give us a buy just because we tell them that the technology is new.

Jess Lee

I think the point though is, as we -- I think you were talking about a technology, and if we look at the bigger picture, the newer technology is being rolled into higher resolution products. As we drive into higher resolutions, we do have more and more differentiation from a lot of our competitors than just price, so yes, that does help, in the end. But as Peter said, pricing pressure does exist across the board for all products.

David Wu - Global Crown Capital

Can you explain why your trend in business is different from -- your portfolio business appears to be different from Micron’s.

Jess Lee

Well, I think there are two factors at play there. First, I will go back to my point about design wins in phones. Depending on which particular phones or handsets you are in, that can dictate a lot of your growth. It just so happens that the handsets that we are in cross from VGA to 1.3 to 2-meg. The VGAs have ended up being extremely popular. That is one part of the story.

I think the second part of the story is our competitor, the one that you mentioned, if I can guess correctly here, they have publicly said that they are declining VGA business, not intending to compete there. That is somewhat -- I do not know if you want to call it artificial, but that is structure that way.

We believe we are following the market in terms of how popular VGA is, but we are also doing fairly well in the 1.3 in the coming quarters, and the 2-meg, as we have said before, has met and exceeded our expectations.

David Wu - Global Crown Capital

What in the present -- let’s assume pricing never gets any better. What is the key to reverse the declining gross margin trend?

Peter V. Leigh

Clearly the key is to drive down your costs as fast or faster than your price has been declining. There are two ways you do that. One is in the short run, you work with all of the parts of your supply chain to get them to sharpen their pencils and improve their yields in order to drive down costs, but really as important is developing new technologies, new approaches to sensor manufacturing so that you can have lower product prices going forward.

We have a number of technologies in the pipeline which we are not at liberty to talk about publicly, which are designed with that goal in mind.

Jess Lee

We really will go back to the three elements of our foundation. One is managing our supply chain to be more efficient, more streamlined at driving down costs. Developing and introducing new technologies and new products, and driving and pushing the resolution curve.

I think all three combined will bring us back to our anticipated goals.

David Wu - Global Crown Capital

Okay. Thank you.

Operator

Thank you. We will go to Tore Svanberg from Piper Jaffray.

Tore Svanberg - Piper Jaffray

Good afternoon. A couple of questions. First of all, did the so-called 1.3 squeeze have anything to do with your lack of capacity in chip scale packaging?

Jess Lee

No. I believe the answer to that is no.

Tore Svanberg - Piper Jaffray

Okay, very good. Second of all, just to get a little bit more clarity on inventories, I do realize how you were explaining it, but I think now inventory days are running above 100 days. Longer term, steady state, where do you think the inventory days should be?

Peter V. Leigh

I think inventory days should not be greater than 90 days, which is why I said in my prepared remarks that the inventories at the end of the quarter were higher than they needed to be. I hope I articulated to you why that happened.

We have a firm plan in place to bring inventories back to within that 90 to 75 days, 4 to 5 times turns, by the end of the current fiscal year.

Tore Svanberg - Piper Jaffray

Okay. So you expect to be in the 90-day range for this coming quarter?

Peter V. Leigh

No, I said by the end of the fiscal year. It does take longer to change direction in a big ship.

Tore Svanberg - Piper Jaffray

Okay, fair enough. Final question, advanced products, hovering around 10% of revenues. When can we possibly expect a breakout there to about 20%? Is that going to be a calendar ’07 event? Or will we have to wait until ’08?

Hasan Gadjali

We start to see quite a big growth in certain market segments. The advanced product business actually comprises of a couple of business segments, and they are in this particular order. We see a big growth in the embedded notebook market, security, toys, games, and the automotive.

From these, since most of the chips that are sold in the embedded notebook are similar to the mobile phone, and the integrators that are used are the same, we found actually it is difficult for us to actually count the percentage of what growth in advanced products is right now for the notebooks, because they are using the same kind of roadmaps that we are seeing in the notebooks.

For the last quarter, we start to see a ramp in the notebook volume for shipment to those customers. I think the reason why you see a huge ramp on those mobile handset numbers, they might be part of the numbers of the notebook ramp, actually. I think we will be able to clarify that later. Peter.

Peter V. Leigh

I think the point, I think your question was going from 10% to 20%. I think the only point I would make to you is remember that when you have such an overwhelming and large portion of your business in handsets, it does not take a very large percentage increase in handsets to offset what would be a much more dramatic percentage increase off the smaller base in advanced products.

After all, at the end of the day, the goal here is to grow all of these markets. That is why we have been increasing capacity, so that we do not have to make those kinds of allocation decisions between our customers.

Tore Svanberg - Piper Jaffray

Okay, fair enough. Thank you very much.

Operator

Thank you, sir. Sir, your last question today will be from Mr. Bill [Baldwin] of [inaudible] Capital.

Bill Baldwin

Most of my questions have been answered, but going back to the VGA and the roadmap, do you think there is going to be a time, say two years out, when this thing starts to fall away for you guys, or is this going to be a product that you are going to keep? I guess I am referring more into the handset space.

Jess Lee

We do have internal estimates of what each product category is going to do over the longer term, so one to two years out. VGA looks to be the foundation for a lot of different handset makers, because as I mentioned before, low-end handsets are going to be very popular. So a combination. We think in the future VGA, SGA, as well as even our upcoming 9660 will be fairly popular in the future for these low-end handsets.

Operator

Thank you, sir. As there are no further questions, I would like to turn the call back to management for any closing remarks.

Shaw Hong

In closing, I want to reiterate our confidence in the ability of OmniVision to continue to advance image sensing technology. We are well-positioned to introduce new and advanced products ahead of the competition. We appreciate all the work our team continues to contribute to our success, and we thank you for participating in our call. We look forward to speaking with you next quarter. Goodbye.

Operator

Thank you, sir. Thank you again, ladies and gentlemen. This brings our conference call to a close. Please feel free to disconnect your lines now at any time.

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Source: OmniVision F2Q07 (Qtr End 10/31/06) Earnings Call Transcript
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