International Rectifier's CEO Discusses F3Q 2014 Results - Earnings Call Transcript

May. 2.14 | About: International Rectifier (IRF)

International Rectifier Corporation (NYSE:IRF)

F3Q 2014 Earnings Conference Call

April 30, 2014 5:00 AM ET

Executives

Christopher Toth – Executive Director-Investor Relations

Oleg Khaykin – President, Chief Executive Officer & Director

Ilan Daskal – Chief Financial Officer & Executive Vice President

Analysts

Steven Smigie – Raymond James & Associates, Inc.

Gabriela Borges – Goldman Sachs & Co.

Alex D. Gauna – JMP Securities LLC

Dean Grumlose – Stifel, Nicolaus & Co., Inc.

David M. Wong – Wells Fargo Securities LLC

Atif Malik – Citigroup Global Markets Inc.

Christopher AJ Rolland – FBR Capital Markets

Operator

Good afternoon. My name is Kelly and I will be your conference operator today. At this time, I would like to welcome everyone to the International Rectifier's Third-Quarter Fiscal Year 2014 Earnings Conference Call. All lines will be placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question answer session. (Operator Instructions) thank you.

I will now turn the call over to Chris Toth, Investor Relations for International Rectifier. Mr. Toth, you may begin your conference.

Christopher Toth

Thank you, Kelly. Hello and good afternoon. We all welcome you to the International Rectifier third-quarter fiscal year 2014 earnings conference call. On the call today are Chief Executive Officer, Oleg Khaykin and Chief Financial Officer, Ilan Daskal.

I trust you’ve all seen copies of our press release, which was published about an hour ago. If not, the press release can be found on our website at investor.irf.com, in the Investor Relations section.

Before we begin, I would like to remind you that except for historical information, the matters we’ll be describing this afternoon will be forward-looking statements that are dependent upon certain risks and uncertainties, including factors such as orders shipped and received during the quarter, level of bookings, the timing and introduction of new technologies and products, general semiconductor industry conditions, and the overall economy and financial markets. In addition to these risks, we refer you to the risk factors included in our press release, and in our most recent SEC filings.

I would also like to mention that in addition to reporting our GAAP financial results, we present supplemental non-GAAP financial data. A reconciliation of the non-GAAP to GAAP measures set out in our press release and in discussion today can be found in our press release and on our website. We believe providing our non-GAAP measures, combined with our GAAP results, provides a more meaningful representation regarding the Company’s operational performance.

Our non-GAAP presentation and EPS calculation exclude certain items such as accelerated depreciation, restructuring charges, amortization of acquisition-related intangibles, and certain discrete tax items, among others. Lastly I would like to highlight the following upcoming investor relations event. On Tuesday, May 6, we'll be attending the 2014 Jefferies Technology Media and Telecom Conference in Miami, Florida.

Now, Ilan will discuss our most recent financials. Ilan.

Ilan Daskal

Thank you, Chris. Good afternoon and thank you all for joining us. For the third quarter of fiscal 2014 IR reported a revenue of $269.3 million, which was flat compared to the prior quarter and a 20% increase from the third quarter of fiscal year of 2013. GAAP gross margin increased to 37.2% in the quarter.

GAAP gross margin in the quarter included a one-time benefit of $2.8 million related to a release of a legacy product claim reserve. Non-GAAP gross margin for the quarter was 36.3% and excluded a $2.8 million to release of reserve and $507,000 of accelerated depreciation associated with the resizing of our Newport, Wales hub.

Overall, GAAP net income was $19.1 million or $0.26 per share for the quarter. This compares with GAAP net income of $17.9 million or $0.25 per share in the prior quarter and GAAP net loss of $21.2 million of $0.31 per share in the prior year quarter. Non-GAAP net income was $19.7 million or $0.27 per share for the quarter.

Non-GAAP net income excluded the release of the $2.8 million reserve, accelerated deprecation of $507,000, asset impairment restructuring and other charges of $1.6 million, amortization of intangibles of $1.6 million, and a net tax benefit of $400,000. These compared with a non-GAAP net income of $13.4 million or $0.19 per share in the December quarter and non-GAAP net loss of $19.8 million or $0.29 per share in the March quarter of last year.

Moving onto operating expenses; R&D expenses were $32.7 million and represented 12.1% of revenue. SG&A expenses were $45 million and represented 16.7% of revenue. Amortization of acquisition related intangibles was $1.6 million. During the quarter, we reported $1.6 million in asset impairments restructuring and other charges. Excluding the one-time non-GAAP operating income was $20.1 million, or 7.5% of revenue.

Other expense net for the quarter was $451,000 and was primarily the result of unfavorable foreign exchange rates. GAAP tax for the quarter was $449,000 benefit. Non-GAAP tax expense for the quarter was a de minimis amount and excluded net tax effects on a one-time items totaling $400,000. We ended the quarter $543 million of total cash, cash equivalents and investments, including restrictive cash of $1.4 million.

Total cash for the quarter increased $38 million. During the quarter, inventory decreased about $6 million to $242 million, which is about 18.5 weeks. In the March quarter, we generated $51.6 million in cash from operating activities. Cash capital expenditures for the quarter was $13.2 million or about 5% of revenue. Free cash flow was $38.4 million.

Depreciation and amortization expense was $21.9 million, and stock-based compensation expense was $6.5 million. During the quarter, we purchased about 100,000 shares of our stock at a total cost of $2.6 million. We had 71.3 million shares outstanding at the end of the quarter.

Now moving onto our outlook. We currently expect revenue for the June quarter to be between $280 million and $295 million. For this projected revenue range, we currently estimate non-GAAP gross margin to be between 36% and 36.5%. We plan to lower utilization in the June quarter to reduce our level of inventory and offset any gross margin impact with improved operational efficiencies.

We expect R&D expenses to be about $33 million and SG&A to be between $45 million and $46 million. Amortization of acquisition related intangibles is expected to be about $1.6 million. For the June quarter, we expect approximately $1 million to $1.5 million in restructuring charges, resulting from the resizing of our manufacturing facilities.

Other expense net is expected to be about $1 million. Non-GAAP tax expense for the quarter is expected to be about $4 million, mainly due to foreign tax accruals. And finally, for the June quarter we expect our cash capital expenditures to be about $12 million. CapEx for the 2014 fiscal year would be about 4.5% of revenue.

Now, Oleg will give you the latest update on our business. Oleg?

Oleg Khaykin

Thank you, Ilan. We had a solid start in 2014. We are executing well and benefiting from a nice market recovery. We are also seeing strong momentum behind our specific growth drivers such as digital power management, automotive applications, and high power industrial and appliance module business.

Same as last quarter, demand remains steady across all of our business units. Order push outs and cancellations remain low, and end market demand was significantly stronger versus a year ago.

For the remainder of the calendar year, we remain optimistic that business conditions will continue to improve as economic recovery continues. Geographically, for the March quarter, Europe exhibited the greatest strength due to both industrial and automotive end markets.

North America increased nicely, driven by automotive and industrial markets. And as expected, Asia was modestly down as we saw seasonally weakness in the computing and consumer end markets that was somewhat offset by increases across the automotive and industrial end markets.

Moving on to our individual business units. The enterprise power business unit revenue decreased about 3% to $32.1 million the decrease was mainly due to PC market seasonality. That said, server, communications, infrastructure and gaming demand remained relatively healthy.

For the June quarter, we expect enterprise power to grow significantly due to the ramp of several computing platforms and strengthen in gaming. We are also starting to see the initial production orders for the Grantley server platform, which is expected to launch in the second half of the year.

Design win activity for our Digital Power Management solutions was strong and we remain confident in significant share gains when Grantley ramps in the second half of the year. Power management devices revenue decreased about 6% to $97 million in the quarter. Strong pick up in industrial business in Europe and North America was offset by seasonal weakness in the power supply and consumer and computing end markets. Overall, lead times for MOSFETs continue to remain about normal and pricing was relatively flat compared with the previous quarter.

For the June quarter, we expect PMD to pick up significantly, driven by stronger demand and seasonal strength in consumer and computing. Our energy saving products business unit revenue rebounded about 16% to $54 million during the quarter, driven by seasonality, share gain and new product ramps.

The March quarter was particularly robust in Europe and North America as both regions saw strong rebound in the business demand. Asia, however, remained relatively soft. We continue to remain optimistic for growth in ESP as we have expanded our product offering to include new lines of high power modules for appliance and industrial applications.

In the June quarter, we expect ESP revenue to continue the momentum. An economic recovery in China later this year would be a further catalyst for continued recovery of our ESP business. Our automotive products business unit revenue increased 4% to about $38 million. The automotive end market continues to remain strong for us, and our design win activity is robust in new electric, hybrid and conventional vehicles.

In conventional vehicles we continue to see steady growth of high semiconductor content electrical systems replacing the traditional mechanical and hydraulic systems in the under-the-hood applications such as air conditioning, motors, power steering and braking systems. We expect momentum in automotive to continue in the June quarter.

Lastly, our HiRel business unit revenue decreased about 5% to $48 million. Satellite and commercial aviation remain the predominant end markets for this business unit. Military business is relatively small and we do not see any impact associated with U.S. government funding. Overall, our bookings and backlog remain stable and we continue to see steady long-term growth in our business. We expect demand to remain stable in the June quarter.

Now, an update on inventories. During the March quarter, sell through increased about 6% where our sell in decreased about 2% compared with December. Channel inventory dollars were up slightly to about 12 weeks. We continue to monitor closely distributer inventory relative to the end-market demand. We lowered factory utilization to about 80%, and were able to reduce our internal inventory levels by about $6 million. We continue to see a greater level of turn’s business than we have historically and with greater level of die banks and less finished goods inventory, we continued to keep lead times normal.

Now, I would like to provide an update on our ongoing activities. Our Newport fab resizing is on track and is about a year away from completion. This is expected to contribute about 1% to 1.5% of gross margin improvement. Our new ultra-thin wafer processing facility in Singapore is now operational and ramping. the June quarter will mark its first full quarter of production.

Our gallium nitride on silicon program continues to progress nicely. We are continuing to sample and qualify our 600-volt products with customers as we prepare for commercial production. We are in discussions with customers in a broad range of applications in the industrial, appliance, consumer and power-supply markets. In May at the PCIM Trade Show in Germany, we will demonstrate the latest in our innovative GaN technology and product and their superior performance, efficiency and power density.

In summary we continue to execute well and we remain well positioned as demand trends improve and our company’s specific growth drivers come into play. We have strong design win visibility in digital power management, automotive applications and high power industrial and appliance module which we expect to the principle drivers of our near-term growth.

We continue to make good progress in gaining share and improving our profitability. We remain well positioned in markets that are expected to outgrow the semiconductor industry as a whole. And our team is aligned and focused to drive results.

This concludes our prepared remarks and I would like now to open it to Q&A. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Steve Smigie of Raymond James. Your line is open.

Steven Smigie – Raymond James & Associates, Inc.

Great, thanks a lot, guys, congratulations on the nice report and guide here. Oleg, you talked a little bit about enterprise power being pretty strong in June, I think as Grantley ramps here. Can you talk about the magnitude of what we might see sequentially in growth? Would we expect, again, see sequential growth on top of a big number as we go into September as all that ramps?

Oleg Khaykin

Sure, I mean, I think you know I’ve mentioned the significance, so we expect to be at least, I mean June quarter is kind of the beginning of the ramp in this business unit, and a lot of the uptick is just seasonality stronger computing markets, so we expect to be in north of 10% growth in this business unit.

It could be higher, I mean some of its driven by the churns business, but also what we are seeing starting to contribute a little bit this quarter is some of the advanced Grantley orders. So its kind of the first phase is just purely computing recovery, that’s driving it. Plus some of the new platforms in the personal computing space. The next revenue uptick will come in the September quarter.

We're already getting early orders for the Grantley, and that will be another meaningful uptick for this business unit, so if I were to kind of characterize where we're going to see the biggest swing in terms of the revenue from last quarter to, say, end of September, clearly enterprise power business unit is the biggest one.

Steven Smigie – Raymond James & Associates, Inc.

Great, that’s very helpful.

Oleg Khaykin

Yes, obviously also as the server business ramps, the – a product margin mix is obviously a better one than personal computing.

Ilan Daskal

Steve, I would also add that the Grantley usually in each platform takes about three to four quarters until it fully kind of replaces the power generation.

Steven Smigie – Raymond James & Associates, Inc.

Yes.

Ilan Daskal

So, it will take normally to be replaced you know between September until the March quarter or the first half of 2015.

Oleg Khaykin

Yes, typically the roll off time is about 25% substitution against the previous platform for every quarter. So it takes about three quarters to really drive most of the substitution.

Steven Smigie – Raymond James & Associates, Inc.

Okay. Thanks. Since you mentioned a better gross margin, it seems like you have a number of drivers here. You've got mix. Ultimately, we've got Wales coming down in about a year as you said. Can you talk about the benefit you would get from just overall depreciation here being greater than CapEx? However, will that be a meaningful addition? It seems like you could get several hundred points of improvement from that, too?

Ilan Daskal

So Steve, it's about $400 basis. It's about $10 million to $12 million a quarter, but generally, when you look at the drivers to get to our target model, definitely continued scale in higher utilization coupled, with a mix that Oleg just mentioned and then, you know, we continue to monitor kind of the inventory and the internal versus external utilization that with a fab light model that we started already a few years back and the closure of the 6-inch hub in Newport will give us the 1 to 1.5 points in the next 12 months.

Oleg Khaykin

Yes. And if I look at next 12 months, there's a number of factors, so clearly shutting down 6-inch fab in U.K. will be a big impact in the margin. Over the next couple of quarters, as our Singapore facility fully ramps, the absorption will improve and it will be further improved and also one of the things that you might have noticed in my notes, we're actually lowering slightly our utilization this quarter by keeping our margins fairly high.

And what we're doing here is over the last couple of years we made significant improvements in our operational effectiveness, and having several quarters of stated demand enabled us to really dial-in the supply chain in such a way that we can now reduce further work in process and still maintain our quality of service.

So we are basically trying to see how much more we can squeeze out of our whip inventory so by doing that, we actually starting fewer wafers than we are shipping, and as we approach to the new effective equilibrium, we'll start ramping the utilization to put it more in line with the ins and outs and that will further give us better utilization and obviously better absorption.

Steven Smigie – Raymond James & Associates, Inc.

Okay. Great. And if I could sneak one more in here. As I look at your PMD business, on a fiscal basis that looks like it's going to go from roughly $80 million in FY 2013 and depending on exactly how June finishes, maybe $125 million here in FY 2014. So, like a 50%, 55% year-over-year growth, which is pretty impressive. I know you guys have been investing there and obviously that's probably not a sustainable rate, but can you talk about maybe the growth opportunity in that business over the next fiscal year given that's your largest segment?

Oleg Khaykin

Yes. I think you're kind of getting ahead of me here. I mean out of 125 you probably just gave my general manager for the business a heart attack. I mean, really, I think $80 million last year Q2, it was in the 80s, remember it was Q2, Q3 were kind of the bottom of the whole thing and there was a lot of inventory adjustment, so there were some artificial under absorption I think for those kind of products, right?

I think June quarter we really going to be, between, I would say $100 million to $110 million probably on the higher side of that, but I don't think it's going to be $125 million, but that said, we do have a very good traction in that business unit. I mean, we believe, discrete business unit is a good business. It's not a 50% margin business unit, but you can make money if you segment the market the right way.

You deliver the right cost performance products, and I mean, judging from what I see, I think, and given to some degree a defocussing on some of the players in the market on that market segment, we feel this is one area we can continue to gain share and maintain above average growth for the semiconductor industry.

Steven Smigie – Raymond James & Associates, Inc.

Okay, great. Thank you.

Oleg Khaykin

Thank you.

Ilan Daskal

Thanks, Steve.

Operator

Your next question comes from the line of Gabriela Borges of Goldman Sachs. Your line is open.

Gabriela Borges – Goldman Sachs & Co.

Congrats on the strong quarter. I want to follow up on your commentary on seeing a higher level of turn’s business. I think it was both this quarter and the quarter before as well. Maybe you can talk about what's been driving that and whether it's broad based or in a couple of particular end markets of products? Then, with lead times still being normal, are there any signs of customers being more willing to restock inventory? Thank you.

Oleg Khaykin

Thank you, Gabriela. So I think I would say as you can imagine it's a fairly neurotic environment in the market. I mean just look at the stock market going up and down. In many cases a lot our customers have very dynamic view of what their end market needs, and respectively their customer needs are, so the result, nobody really wants to hold any inventory.

Especially coming out of the winter quarters you got, people just holding whatever they have on their books, and that's what they want to hold. So as a result, I mean, used to be, you get your orders and 90% of what your ship is what's been pre-ordered or quarter before.

What we're seeing is actually, especially in the second half of the quarter, there's always a lot of spot market opportunities come up and having die bank and having some finished goods on hand, enables you to grab some opportunistic business. Now that’s said, I think as markets and the demand continues to recover, with every quarter and I'll probably venture to say that probably after the summer we are going to seeing less of it, because I think we have seen at least anecdotal and in some cases actual evidence of spot market shortages in various products that are starting to pop up, and you know, it's not so much a shortage, it's just all of a sudden you cannot get a two-week delivery window. You have to place a full week time order.

And I think more customers are starting to recognize it and starting to plan for longer term orders and maybe a little bit higher inventories. I wouldn't say it's already massively swinging the pendulum in that direction, but I think the level of awareness has gone up significantly in the market space in that respect.

Gabriela Borges – Goldman Sachs & Co.

Okay helpful.

Oleg Khaykin

I would also add to that, you know lead time is still normal. As you can see, we are reducing slightly our utilization, and the supply chain that we have right now can accommodate a higher turn business once, now that we are implemented on the manufacturing efficiencies. So we can accommodate a higher turn business.

Ilan Daskal

Yes, with the shorter cycle time, we're able to respond quicker to the market demand.

Gabriela Borges – Goldman Sachs & Co.

Makes a lot of sense. And then maybe just as a follow-up, can you give us an update with the traction you're seeing with the new families of IGBT modules and where that opportunity is materializing inline with your original expectations. Thanks very much.

Oleg Khaykin

Well sure, I mean I think, we have a double advantage with out new family of IGBTs. On one hand we have a truly high performance silicon which is among the best in the industry. In some categories it's truly the best. And as you probably know, if you look at the segmentation of the market the larger part of the market for IGBTs is the modules and fairly small part of the market is discrete.

So if you want to play in the bigger part of the market, you’ll either have to sell in discrete die, which is what we do, or you can even get more aggressive and enter the market with some of the standard type footprint and power modules. We are doing both as we launched the new IGBT , we are selling it to companies that make big industrial modules, and we also introducing a family of modules targeting the high volume kind of standard power model – parts of the market, you know, for distribution, electrical distribution, electrical machinery kind of the power supplies and things like that.

And I mean it’s a significant market, its you win there by having a standard product with superior performance and I think we have both in that respect , both our packaging and silicon is more efficient than what a lot of the incumbent products in the market.

Gabriela Borges – Goldman Sachs & Co.

Appreciate the color. Thank you.

Ilan Daskal

Sure.

Oleg Khaykin

Thank you.

Operator

Your next question comes from the line of Alex Gauna of JMP Securities. Your line is open.

Alex D. Gauna – JMP Securities LLC

Thanks for taking my question and nice quarter, guys. Oleg, I know you touched on this, that you have not necessarily seen lead times extend, but you've seen some spot shortages. I think you've been articulating for, at least a couple of quarters now, that this is somewhat of an untenable situation for the market that at some point lead times have to extend. What would it take to get some lead times extending out for you? What do you make of the fact that it hasn't started to happen already?

Oleg Khaykin

Well, I think the – there is two things, right, I mean, when we talk about lead time there is a true kind of lead time where you place in order and they have to start wafers and run them through the fab and I package them and so on right. What we have done is we have adjusted the mix. We're using kind of statistics of the caustic, statistic of forecasting to build more die and have die bank and that allows us to do kind of three week response time to a package it and being able to – and we are able to get the packaging capacity on the short notice.

The things that really will start squeezing it is the die banks are getting leaner, including us, and I think a lot of our competitors are seeing their die banks also becoming leaner, but also I think the first area of pinch the industry may see is the packaging capacity filling up, and we are seeing all of our assembly and test providers getting very tight on capacity.

The movement you cannot automatically, find a spot market capacity to package your die, you start planning finish goods inventory, and that alone will kick up your lead times – spot market lead times but several quarters – several weeks. And the movement you are not out of your die, then you will really start to looking at 10 week to 12 week full lead time.

So I think this probably maybe 1 to 1.5 quarters of flexibility last and I think probably by some time this summer we may see people having to place real forecast rather than hoping for being able to 5%, 10% upside to their demand.

Alex D. Gauna – JMP Securities LLC

Okay. I got you. Thank you. I missed a portion of the call, so I apologize if you've already addressed this topic. You've done a great job growing your automotive business, continues to climb as a percentage of the mix. I couldn't help but notice that the gross margins dropped sequentially there. It was the only segment that did. Is there anything in particular behind that drop? If we think about automotive bigger picture, what do you think it should be as a percentage of your business? What do you think the gross margins can get to there?

Oleg Khaykin

Well, so I think I would not really pay any attention to the gross margins on automotive business, at least as you see them reported. As a reality there is you know we look at it two ways. We look at the pricing and we look at the standard margin, right.

And both the revenue and the standard margins in that business continue to increase, but automotive business remember it is, it has the greatest exposure to our U.K. fab, so as we reduce the loadings in the U.K. fab as we wind down the production, disproportion amount of under absorption is being allocated to the automotive business because they are kind of the last customer remaining in that facility.

Also to the extent we idling back some of the fab utilization to further squeeze out work in process inventory to optimize it for our new cycle times, some of that under absorption is also being allocated to automotive. So since they have a dubious distinction to be, have majority of their product sourced in all internal operations, anytime our utilization goes down or in case of U.K. facility, as we work to phase it out they, they're carry disproportionately higher allocation.

Once that thing goes away, that's the business unit you're going to see the biggest swing in the margins when we talked about for whole company 1 to 1.5 percentage benefit that will be disproportionately found in the automotive business unit. Overall, our long-term goal for automotive business unit is to be in the 35%t to 45% gross margin business.

Ilan Daskal

Alex, if you look at the absorption and utilization effort of these specific lines that you run the automotive parts, you'll see that the margins on all the automotive business unit, the entire business unit is stable and growing. So, and that's the way we benchmark it. Right now, the gross margin is representative to the current, you know, lines that you run the parts in the different locations.

Alex D. Gauna – JMP Securities LLC

Okay, I got it. Thank you very much.

Ilan Daskal

So, it's a little bit deleveraging of the whole allocation methodology here.

Oleg Khaykin

Thanks, Alex.

Operator

Your next question comes from the line of Kevin Cassidy of Stifel Nicolaus. Your line is open.

Dean Grumlose – Stifel, Nicolaus & Co., Inc.

Hello, this is Dean Grumlose calling in for Kevin. Thank you, very much for taking my call. In the Grantley ramp, do you notice any difference from your expectation of how this production ramp may have happened? And If so, what may have changed?

Oleg Khaykin

Well, I think the, it looks like the ramp is going to be in the second half. And we already have orders on books and it keeps coming in every week. Really kind of starting towards the end of June and really ramping throughout September quarter, and just kind of looking at the history.

I think that ramp will be closer to the Nehalem ramp which was s a generation prior to, Romley, right, so if we look to that, I mean, there you had a very strong ramp for about two, three quarters where the generation of service substituted to previous generation and then it kind of flattens out and get, and more or less gets into the kind of these the steady state business. So I expect the ramp to be very strong in the first two quarters, and then kind of starting to he's by the third quarter.

Dean Grumlose – Stifel, Nicolaus & Co., Inc.

Okay. And there is follow-up in your automotive business, are you experiencing similar gross margins whether vehicles are luxury or mid range or economy or is it fairly consistent across consistent across the range of vehicle?

Oleg Khaykin

Well, I mean, it's really, we don't its kind, I guess, the same products get sold into the high end cars and low end cars. I mean, the difference may be low end cars may not have as many bells and whistles so the product may be available to the lesser degree in a lower end cars and higher degrees in the newer customers.

For example if you take air conditioning, probably in the higher end cars, you may have invertized air conditioner for the backseat, so you may have two products for the front and for the back. Whereas in the small vehicle you may only have one or no air conditioning at all. So it's less so of the type of vehicle. It's really more of the features and, capabilities available in the vehicle.

Dean Grumlose – Stifel, Nicolaus & Co., Inc.

Okay. That's pretty helpful. Thank you.

Oleg Khaykin

Sure.

Operator

Your next question comes from the line of David Wong of Wells Fargo. Your line is open.

David M. Wong – Wells Fargo Securities LLC

Thanks very much. You been keeping your operating expenses at about the same level, I guess around $78 million for several quarters. At what revenue level will you begin to let your operating expenses rise to scale with the business?

Oleg Khaykin

Well, David, that's a good question. It's not an easy thing to do because if our revenue has scaled up so have the commissions and the, shipping costs. What we have been able to do is reduce internal costs to do some of this offset. I believe up to about, $300 million we have enough things that we can offset against the internal cost and do more squeezing here and there. Beyond $300 million, you're going to see some increases coming.

Mainly due to the percentage of commissions, in form of commissions or additional shipping costs for any revenue beyond that. And for the R&D we try to target and keep the R&D in the same range.

Oleg Khaykin

So overall, but David you know the target model is still intact to take both operating expenses overall to the $75 million per quarter.

David M. Wong – Wells Fargo Securities LLC

Okay, great. And you have a number of products that sell into variety of our devices used in China as an end market. What is the demand scenario within China look like for your 10 markets?

Oleg Khaykin

So I mean, China has at least for our energy saving products is a significant market, its air conditioners, its fans, its compressors a lot of industrial machinery, motor controls and clearly a lot of that demand is driven by just kind of Chinese specific spending GDP and so on and as we’ve all seen the China economy has been relatively – they haven’t been really able to get the growth, I mean reenergize beyond the nominal growth. So to the extent the government does succeed I know they are trying to get consumption growing again that would be a positive for us. and it’s purely a lot of consumer and business consumption electrical machinery and equipment by the businesses.

David M. Wong – Wells Fargo Securities LLC

Great and my final question. Great. My final question, you talked a lot about the growth drivers for your products into the servers, so that's the enterprise power division. With all of this and with Grantley ramping, what do you expect this segment will be as a percent of revenues by say 4Q this year? Given, I guess it's closer to 12% now?

Oleg Khaykin

Well I don’t know if I’m going to give percentage of total, but I think we do expect the enterprise power business unit to exit this year north of $40 million a quarter.

David M. Wong – Wells Fargo Securities LLC

Great. Thanks.

Ilan Daskal

Thank you David.

Oleg Khaykin

Thanks.

Operator

Your next question comes from the line of Atif Malik of Citi. Your line is open.

Atif Malik – Citigroup Global Markets Inc.

Hi, thanks for taking my question and good job on the results and guide. This question on the gross margins, you talked about lowering the utilization to adjust for the inventory. Can you give us some color on where you're seeing higher inventory levels? Is it across the board or is it some particular end market?

Oleg Khaykin

Sorry, let me make sure I understand your question. Are you asking inventory within IR or in particular channels?

Atif Malik – Citigroup Global Markets Inc.

No, just trying to understand the areas where you want to lower your inventories because you want to lower your utilization?

Oleg Khaykin

Oh okay. so this is really we are trying to optimize our working capital. Traditionally you have to carry certain amount of internal inventory, big chuck of it is in working process. So to the extent you are – your cycle time is longer through your fabs in assembly, you need to carry more material in the pipeline.

As you optimize your production and you are able to deliver better fab and assembly and test cycle times, which is exactly where we are now finding ourself to be we are trying to see, well lets artificially reduce the number of wafer starts below that what we see a wafer shipments. And see how much whip can we bleed out of system and still maintain our service level.

So what we are trying to do is really leverage improvements in our operational efficiency and try to see what is the minimum amount of working capital we can operate our fabs and assembly and test facilities. So that is really what we are doing this quarter, I mean, because reality is if you look at our revenue growth and output you could easily make an argument that if we all things are the same we can increase utilization and as our gross margin would even do better.

What we are choosing to do it see a given our better performance of our factories, let’s try and see how much more – with how much less working capital we can operate our supply chain and then once we determine the equilibrium from there on increase the wafer start. So it’s still working progress optimization exercise.

Atif Malik – Citigroup Global Markets Inc.

Got it. In terms of long-term overall gross margins, you guys talked about 1 to 1.5 points of gross margin expansion in next year. Should we still be thinking about in 38% gross margins that $300 million revenue levels?

Oleg Khaykin

So if the – 1% to 1.5% gross margin will be purely from the closer of the 6-inch far been in the U.K., however you know if when revenue continues to scale and the economy will continue to recover, so obviously to higher utilization will get us a better gross margin and then our target is still to get with 40%. So other kind of areas that will contribute additional you now gross margin expansion to the 1% to 1.5%.

Ilan Daskal

I would say today we have – if you look at the – what we have in terms of the dry powder. So first you get 1% to 1.5% on the fab 10 we still have about 2% reserve that we can get by better utilization – getting high utilization of the fabs. And then of course, the mix which further gives you an additional gross margin leverage. So I think between all of these and you can see if you get to the 300 million north of high utilization and recovery in the higher margin mix. We see 40% as a very realistic goal.

Atif Malik – Citigroup Global Markets Inc.

Very helpful, thanks.

Operator

(Operator Instructions) Your next question comes from the line of Christopher Rolland of FBR Capital. Your line is open.

Christopher AJ Rolland – FBR Capital Markets

Hey guys, thanks for allowing me ask a question. And please forgive me if this was already asked. Can you guys perhaps give us some idea about segments next quarter, or force rank them and tell us if there's any deviations that you see from typical seasonality? Thanks.

Oleg Khaykin

Sure, I think I wouldn’t say – I'll probably say one of the things that are deviating, slightly from the seasonality is I think enterprise power clearly has a recovery but it's going to be some – we are going to see some of the upsides from the early Grantley orders.

So in that respect, we expect slightly stronger than seasonal uptick in that business unit. We expect a significant uptick in the power management devices. I think we continue to see strength in North American and European markets, and June quarter also is generally strong in Asia, so in that respect, we expect a very strong uptick in the revenues.

Automotive, I think it's a steady continuous increase, energy saving products is also a steady continuous increase, and HiRel is relatively flat with its market. So if I were to say in terms of where we're going to see more meaningful strength, it will be in the enterprise power and power management devices business units.

Christopher AJ Rolland – FBR Capital Markets

Great. Thank you. Also, seems like we had a stronger seasonal lift off of Q1 into Q2, and I thought this would maybe have meant a little higher gross margins than guidance would imply here. So sounds like some of that inventory burn, but perhaps maybe a little bit low there. Is it just a one-quarter lag or how should we eventually think about this playing out? Thanks.

Oleg Khaykin

So, I mean some of that you’re right I mean, if we were running our fabs kind of in line with the, what we are shipping, starting the same number wafers as we are shipping out, we would run high utilization, you would have higher gross margin, right, so we're trading off some gross margin versus a continuous inventory reduction, right?

But also there is a mix, because in the June quarter, higher – a lot of some of the higher revenue ramp is computing and consumer, and that's generally somewhat lower margin than the industrial and automotive, right, so in that respect, within the two, that's the guidance we have and also remember we did say we are now ramping our Singapore facility, and it will take us about 1.5 quarter to ramp it up to four production and there is still some under absorption being taken from there, and as we continue to take down U.K. facility, it provides for a greater level of drag on the, overall margins for the next couple of quarters.

Ilan Daskal

Chris, but the number builder Is the lower inventory plan to lower utilization that does offset the much higher revenue.

Oleg Khaykin

Yes.

Christopher AJ Rolland – FBR Capital Markets

Okay. Great. Thanks, great detail. Thanks, guys.

Ilan Daskal

Thank you.

Operator

At this time there are no further questions. I will now turn the call back over to management for closing remarks.

Oleg Khaykin

Thank you. Thank you all for joining us today. And we look forward to speaking with you in person over the next several weeks. Have a good day.

Operator

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

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