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National Semiconductor Corporation (NSM)

F2Q07 Earnings Call

December 7, 2006 4:30 pm ET

Executives

Long Ly - IR Manager

Brian Halla - Chairman and CEO

Lewis Chew - CFO

Don Macleod - President and COO

Analysts

Mark Edelstone - Morgan Stanley

Adam Parker - Sanford Bernstein

Simona Jankowski - Goldman Sachs

Ross Seymore - Deutsche Bank

Michael Masdea - Credit Suisse

Uche Orji - UBS New York

Sumit Dhanda - Banc of America Securities

Craig Hettenbach - Wachovia

Tore Svanberg - Piper Jaffray

Presentation

Operator

Good afternoon. My name is Takia and I will be your conference operator today. At this time, I would like to welcome everyone to the Q2 Fiscal Year 2007 Earnings Call hosted by National Semiconductor Corporation. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator Instructions). Thank you. It is now my pleasure to turn the floor over to your host, Mr. Long Ly, Investor Relations Manager. Sir, you may begin your conference.

Long Ly

Thank you. Good afternoon and I would like to again welcome everyone to our call today. Joining me are Brian Halla, Chairman and Chief Executive Officer; Lewis Chew, Chief Financial Officer; and Don Macleod, President and Chief Operating Officer.

The purpose of today’s call is to discuss National Semiconductor’s second quarter fiscal 2007 results, which ended on November 26, 2006. As a reminder, today's call will contain forward-looking statements and projections that involve risks and uncertainties that could cause actual results to differ materially. You should review the Safe Harbor statement contained in the press release published today, as well as our most recent SEC filing for a complete description of those risks and uncertainties.

Also, in compliance with SEC Regulation FD, this call is open to all and is being broadcast live over our Investor Relations website. For those of you who may have missed the press release, or would like a replay of the call, you can find it on National's IR website at www.national.com.

In today's call, I will provide a recap of the second quarter financial results. Brian Halla will provide an overview of the company's progress, Lewis Chew will expand on the second quarter results and provide an outlook for the third quarter, and Don Macleod will discuss our analog standard linear product progress. We will then take questions until 2:30 pm Pacific Time.

The second quarter results were as follows. Sales were $501.6 million, down 7.4% from $541.4 million in Q1 fiscal year 2007, and down 7.8% from $544 million in last year's second quarter. Gross margins were 58.9%, down from 61.7% in the prior quarter and up from 57.2% in last year's second quarter.

Operating expenses were $170.4 million. Interest income was $9.5 million and the effective tax rate for the quarter was 32.3%. As a result, National posted net earnings of $91.4 million or $0.27 per fully diluted share. The fully diluted share count for the quarter was 335.6 million shares.

I will now turn it over to Brian Halla for an overview of the company's progress. Brian?

Brian Halla

Thank you, Long. For the next couple of minutes, I'll try to hit some of the key points that may be picking your interest about how our quarter transpired and hopefully explain the key drivers and our outlook.

Revenues were down in the quarter by 7.4% from the prior quarter. This is little more than we thought when we began the quarter with 2% to 5% kind of an opening guidance -- 2% to 5% down kind of an opening guidance. Somewhere decline was intentional and desired, although a portion of the decline was unexpected. Having just returned from an investor conference, we've seen every other question was about inventory, I will cover that issue as well in my comments today.

Covering a positive, I'll highlight that our gross margins have held up much better than ever before, through this type of cycle.

Next, I'll cover some general market trends and outlook, set the stage for Donnie's product and market commentary. I'll conclude with the statement about our business model strategy and direction.

Let's talk about the revenue. We'd pick up part of the pieces of the revenue decline. The foundry revenue declined about $20 million or about four of the percentage points. As you recall, the quicker we can rid ourselves of the revenues associated with previously disposed businesses, the better for our overall margins.

Our shipments into distribution were down a little, over 20 million quarter-on-quarter, as we brought the inventories down by about half a week; even though the distributor resale were roughly flat with Q1.

The wireless handset area was essentially flat for the quarter, although we originally thought we would see a bit of an uptick over the prior quarter. Overall and consistent with some of the previous information, the turns business in the quarter came in lower than we expected.

This quarter was the inventory quarter. Let's look at the inventories by channel. During the quarter, we brought down our internal inventories by 18 million or about 7 days to 79 days. Our distributors for the most part tell us that their inventories are now about where they should be. As I mentioned earlier, we took our distribution channel down a half a week. The only other area to highlight is the EMSs or contract manufacturers. Here we still see some further inventory reductions.

Gross margins continue to be a bright spot. The gross margins for the quarter came in at around 59% even with factory utilizations dipping below 60%. Beyond the obvious indication here of our strong factory execution and efficiencies, the more compelling story is that we continue to see the impact of the higher margin contribution of a much richer mix of value-added standard linear analog product, where ASPs continued to grow.

Margin improvement has been a focus we have discussed for a few years at these calls, and now given this current trough where less than 60% of our factories are utilized, the portfolio impact on our margins is starting to speak for itself. And by the way, our short-term goal of hitting 65% gross margin is still on the table.

If you recall in the last inventory correction trough in calendar '04, our margins bottomed out closer to 50%, which at the time was the best the company had ever performed in such a correction. Prior to the trough in '04, the res of primarily resulted in a flood or red ink. Beyond the obvious healthier margin portfolio and testimony through our manufacturing efficiencies, the thought of where our margins and profits can go when we get back to closer to 85% utilization brings a smile. So, now I will expect you to ask, how do you National get back on a growth path towards that 85% kind of utilization. What are the growth engines?

Let me first talk about the wireless handset market. Here, our strategy has been to deemphasize the commodity low-end circuits made available by many suppliers in favor of investing our R&D dollars in the higher value-added higher margin contributions and capabilities such as advanced power management like PowerWise or advanced audio subsystems or display technologies, such as Mobile Pixel Link or Ceramic Speaker Drivers, all of which are currently enjoying design wins at leading handset makers. But handsets are just a limited segment when it comes to almost everything going mobile or if it still plugs into the wall it want's to be as green as possible or use the least amount of energy.

I watched with interest and amazement a recent Churchill Club, Guy Kawasaki panel of a bunch of high school and college teenagers on how they use technology. None of them used e-mail, except out of respect to respond to an elder. Instead, they send up to 4000 text messages a month. None of them used the landline anymore to make phone call, and the average amount of TV watch was on average less than an hour a week. Instead that same mobile device that lets them text message friends, allows them to access user or peer generated content on such venues as YouTube and MySpace. These highly mobile self-entertaining consumers of tomorrow's semiconductors will of course continue to demand more and more functionality on their mobile information center, and yet they will continue to expect longer and longer battery life or at least the same each time a feature is added.

So you can continue to expect growth for National in the applications where portability, and the lowest power consumption are the differentiating characteristics of those applications. And in this space where we believe we can continue to add unique value, we believe that we can continue to get paid for it.

Beyond that, we also have many growth opportunities, what we call the broad market. And these initiatives again where the lowest power, higher speed, and precision are the differentiators, we are already bearing fruit. Our investments in the highest performance, the lowest power consuming Giga-Sample data conversion products gives us a unique offering in the converter market where we've already doubled our market share in the last three years. And we continue to invest in this portfolio with comprehensive and complete offerings and general purpose data conversion.

Likewise, we have seen tremendous reception to our new offerings in precision amplifiers where combined with our award-winning VIP50 process technology, we have enabled families of recently announced products to be getting designed in the succession products of ultrasound machines, where there is a need to eliminate any noise over the entire temperature range of the chips. These are just a couple of examples of broad market applications. And I might add that the broad market margins and ASPs continue to be a strong driver for the corporate goals in these metrics.

So what are some of the other markets trends driving our numbers? Bookings in generals seem to hit their low point in September and have been steadily improving month-by-month thereafter. This steady pickup, however, was starting from point lower than the quarter before. As a result we begin this quarter with a 13-week backlog, which is down significantly. The broader markets just discussed continue to grow design win momentum but not yet offsetting for us the decelerating growth in the wireless business.

And as I said before, the EMSs or contract manufacturers are continuing their inventory reductions, which we will discuss in our outlook.

So, what is the outlook going forward? With the 13-week opening backlog down combined with our intention of further reducing foundry support and assuming that shipments to the contract manufacturers will decline further, as they clean up inventories, and also assuming that the wireless handset guys will be down seasonally, we expect revenues will likely decline about 8% to 11% in the quarter.

Setting aside the near-term trough in our revenues, nothing happened this quarter or in the collection of the last few quarters to have us rethink our current direction. We've seen this before and we remain nothing but encouraged by our performance during this trough. Our intention is to stay the course and offering higher value-added products in the standard linear analog space where the uniqueness of our solutions will continue to earn a higher gross margin, higher ASP. This we believe will happen concurrent with the company's return to growth and at the same time allow us to maintain our ROIC above the 20% level. This next quarter or so should see the end of inventory corrections and industry supply demand stabilization and we look forward to the upside leverage of increased utilizations going forward.

Over to you, Lewis.

Lewis Chew

Thanks Brian. I want to start off my comments with some back ground data on the business trends that we saw in Q2 and this will hopefully allow you to put our Q3 revenue guidance in context and understand the various drivers as well as the market environment that we are operating in right now. So, first let me comment on bookings in general. As we've said in the press release, our total bookings for all of Q2 were down about 16% in Q1. The quarter started out very slowly with September order rates being substantially less than they were in August. But September did prove to be the low point for the quarter as it relates to new orders because the weekly average bookings increased in October and then again in November. Nevertheless, the decrease in bookings for Q2 was accompanied by lower turns orders as well which of course impacted our Q2 revenues, and as Brian mentioned, it also caused our opening 13-week backlog to be lower heading into Q3.

If I look at bookings in a little more detail, it is worth noting that even though our business is usually split about 50-50 between distributors and OEMs, a larger portion of the bookings decline in Q2 was from our OEM customers, and by the way, included in this would be the EMSs that we sell to that really support a variety of OEM customers. The booking patterns we saw in Q2 indicated us that OEMs and EMSs had plenty of component inventories.

Our distributors were a slightly different story because distributor bookings were down by less than 10% from Q1. Distributor re-sales in our three primary geographical regions Asia, Americas, and Europe were about the same in aggregate as they were in Q1 and distributor inventories went down during Q2, both in absolute dollars and also in terms of week supply.

You may remember that in our September earnings call, I'd said at that time that we did plan to bring down the level of distributor inventory during Q2. And so we ended this quarter, meaning Q2, with our distributors at around ten and a half weeks of inventory in our sales, or as Brian said, about a half week less than the previous quarter.

So, at this point, we are projecting Q3 revenues to be down 8% to 11% sequentially from Q2. About 2 percentage points of this drop off in Q3 will come from a decline in the foundry revenue supporting the Cordless and Super I/O businesses that we disposed of last year. The revenue that we have from this foundry support in Q2 was about $13 million, but it will only be a couple of million dollars in Q3. The rest, and I should say most, of the Q3 sequential revenue decline for the company is being driven by a combination of factors. First, we are anticipating seasonally lower build activity by customers in vertical markets such as wireless and displays and computing. Secondly, we have much lower backlog from the collective group of contract manufacturers that we sell to. Now some of this overlaps with the comment I just made about lower activity in the vertical markets but some of it is also because they are looking to reduce their inventory level.

And finally, we will see a little lower shipments to distributors as we expect their re-sales to be down a little bit in the quarter. However, distributor inventories during the quarter are not expected to change significantly from Q2 to Q3.

Now speaking of inventories, during Q2 we did also bring down our own in-house inventories by about $18 million, and we did this by lowering our fab utilization to slightly below 60% for the quarter. And although our gross margin also dipped down to about 59% in Q2, which includes by the way, $6.6 million of stock compensation expense, it is worth noting that this gross margin performance is nearly nine points better than it was the last time our fab utilization dropped 63% back in the fall quarter of calendar 2004.

In Q3, we will continue to run our fabs below 60% utilization in light of the near-term demand environment. We are planning to reduce on-hand inventories again, but not as much as the $18 million reduction that we did in Q2. We expect our Q3 gross margin percentage to range from 58% to 59%, which includes about $7 million of stock compensation expense impact.

At this point, I would like to summarize the actual stock compensation expenses that we recorded in Q2 by the various line items on the income statement, and then when I go over the Q3 operating expense outlook, I will specify what we are including as an estimate for stock compensation expense for each line item.

Total stock compensation expense included in the Q2 results was $33.2 million pre-tax, which includes sort of a spike that I will discuss in a minute. Of that total 33.2, $6.6 million was in cost of good sold, $8.8 million was in R&D expense, and $17.8 million was in SG&A expense.

In Q3, total R&D expense is projected to range from $89 million to $91 million and this includes approximately $9 million of stock compensation expense. SG&A expense in Q3 is expected to range from $76 million to $78 million and this includes approximately $15 million of stock compensation expense.

So, to reiterate an explanation I provided at the last conference call, stock compensation expense went up in our Q2 just ended, because it included an incremental impact, in other words, the spike that I referred to a second ago, from having to accelerate the amortization of stock option expense, to those option recipients, who at the time of grant, are already eligible for retirement, or will become eligible within the vesting period. And I should note that our annual grant to employees is typically made in July. This issue affects only the timing of when the stock compensation expense is recorded and is not a unique issue to National.

The sum total of estimated stock compensation expense for Q3 is about $31 million and for modeling purposes, I would expect that total to drop back down to about $25 million or $26 million in Q4.

The other income and expense line in Q3 should be relatively minor, around $1 million of expense, and miraculously there was not stock compensation in this line item. Interest income is expected to range from $8 million to $9 million, and the effective tax rate for Q3 is projected to be around 33%.

So, let me wrap up with a few comments on the balance sheet and return on capital.

In Q2, capital expenditures were about $30 million. We are projecting Q3 capital spending to range from $40 million to $45 million, and one of the key projects we are continuing to work on, is converting some of our capacity into Texas fab from 6-inch wafer equipment to 8-inch wafer capacity. We ended the quarter with approximately 79 days of inventory and about 34 day sales outstanding in our receivables.

During the second quarter, we bought back a $178 million of our stock, which was a little over 7 million shares, and ended the quarter with $780 million of cash reserves, and heading into Q3, we still have about a $190 million remaining under approved stock buy-back program. Operating margin in Q2 was 25% and return on invested capital for the quarter was about 21%, both of these metrics include the impact of the stock compensation expenses that I reviewed earlier.

So now, I would like to turn it over to Don Macleod, who will talk more about our products and our markets. Don.

Don Macleod

Yes. Thank you, Lewis. So, let me now cover our product and market trends as we saw them through the quarter in more detail. And first let me talk about end market trends. Sales for the mobile phone market in the quarter were flat, with the preceding first quarter. Within this mobile phone market, our sales increased quarter-on-quarter to the top three market leaders, but declined due other participants in that market particularly those located in Japan. Order rates, from customers in the mobile phone markets were also down over the first quarter, our customer's suggested orders for the slower post holiday season.

Sales for the communications networking market, were down over Q1. Here we also saw slower sales into the wireless base station infrastructure market, as our customer sales of 2 and 2.5G wireless base stations did not appear grow over our first quarter. The impact of this was mostly seen through slower sales to contract manufacturers, as they also reduced inventory levels in the quarter. Our business in the 3G Base Stations saw more positive trends in the quarter but as yet is less significant in volume for us.

Sales into the display market were also down slightly over first quarter. Here all of the reduction occurred through our distributor channel in Asia Pacific and in the most part; this was also driven by inventory reductions rather than weaknesses in the end market. The other major end market contributor to our quarterly sales decline was already covered by Brain and Lewis, which the reduction in foundry sales for our previously sold cordless and PC chipset businesses.

Looking at our revenue trends from a product portfolio perspective; using the analog standard linear definitions from the SIAWSTS industry data; our analog standard linear product sales were down 4% quarter-on-quarter. In this quarter, they accounted for 78% of our overall sales, up from 76% last quarter and 74% in the fourth quarter of last fiscal year.

Bookings in the quarter for these analog standard linear products, accounted for 82% of overall quarterly booking. This however is not an indicator that bookings in the quarter were necessarily strong. It's more an indication of our forward portfolio rotation as bookings relating to the foundry business fell as planed to now negligible numbers.

Looking at the four product areas in the analog standard linear category, the largest contributor for us continues to be the power management area. Here revenues were flat over the immediately proceeding first quarter. In power management, our sales into the mobile phone market in the quarter grew sequentially. Our sales of higher performance applications specific circuits out grew reductions in sales of lower margin more commoditized power management products to these mobile phone customers.

In addition, similar to what transpired last quarter, sales of our high voltage power management products again grew sequentially over the first quarter. Here, more-and-more of the design wins for our new LM5000 series of high voltage power products are going into production. Mostly in very broad market applications, but also in consumer portable products that require high voltage transient protection. For example, in consumer devices that can be powered or charged in a car.

On the other hand, our broad market low and medium voltage power management products saw sales decline sequentially as distributors reduced inventories through the quarter. Overall, power management products accounted for about 44% of our company sales in the quarter and this was up from 41% in the last quarter.

Turning now to the next largest analog standard linear product area is amplifiers, which accounted for 21% of our sales in the quarter. Here sales were down by about 5% sequentially in the quarter. Sales of high-speed amplifiers, precision amplifiers and audio amplifiers were up sequentially. On the other hand, sales of general purpose amplifiers and low-voltage amplifiers were down. These last two more matured amplifier product areas saw slower sales growth into both the distribution channel, as our distributors reduced inventory and the mobile phone handset market.

And the next analog standard linear category, interface, which accounted for about 8% of our sales in the quarter, here revenues were down about 15% sequentially in Q1. Two main contributors to this, were slower business from communications networking customers mainly in the mobile phone base station market for our LVDS and SerDes products and reductions in distribution inventory. To some extent, the slower interface business from communications and networking customers was also driven by inventory reductions at contract manufacturers.

Now to the fourth analog standard linear category, data converters, which accounted for about 5% of overall sales in the quarter. Here after a number of quarters of nice sequential growth, sales were down over Q1 by about 15%. As in the interface product area, the factors contributing to the sequential sales reduction were wireless base station customers, contract manufacturers and distribution inventory reduction. But also in this data converter area, slower sales of older digital temperature sensor products to the consumer games marketplace.

So, what does this tell you about our progress and our strategy? With the overall semiconductor marketplace going through a slow phase, how do the elements of our analog high-value product positioning holding up? First, as I said earlier, more and more of our sales are coming from analog standard linear products. These are now up to 78% of our sales and likely to exceed 80% in the very near short term.

Within each of four analog standard linear categories, our emphasis on the higher performance product areas is reflected in our higher ASPs or average selling prices. Our overall analog standard linear ASP for this quarter was up by about 10% over last year's Q2. Again, remember this covers 78% of the company's overall sales in the quarter.

These higher ASPs reflect our progress in bringing higher performance new products to the market and the de-emphasis in each standard linear product segment and commodity products. The improving quarterly ASP data clearly shows that our new products are gaining momentum. For example in this quarter, nearly 40% of our sales of both power management and data converter products came from new products introduced in the last three years and there is more to come. For example, this fiscal year-to-date for power management, we introduced 149 new products, and this is up from just over 100 for the same first six months of last fiscal year. Higher ASPs from new product is a key value driver towards our gross margin improvement objective.

Our manufacturing organization is also a key strategic asset for us, not just in delivery and service flexibility for our customers, but also in cost flexibility. For example, in the second quarter, we actually reduced our back-end test and assembly unit costs over the immediately preceding first quarter despite a significant reduction in units built and shipped as we finally enjoy the full benefits of our Singapore test and assembly plant shutdown, which was completed last quarter.

So to wrap up, in aggregate number terms, this was not an onwards and upwards quarter. And, the outlook for the third quarter is not any better. However, if you look at the ongoing indicators of our execution on the strategy, which is to go and reposition our analog products in higher value areas, I think that in that area, we have continued our progress in this quarter. I'd like to now hand it back over to Long to moderate the Q&A. Long?

Long Ly

Thanks, Don. At this time, I'll ask the operator to open up the lines to begin the Q&A session. Please limit yourself to one question and one follow-up as necessary so that we can accommodate as many people as possible. Operator, please open up the line.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is coming from Adam Parker with Sanford Bernstein, please go ahead. Adam Parker, you may now ask your question.

Long Ly

Operator, let's skip Adam, we will come back on it if we can contact him.

Operator

Your next question is coming from Mark Edelstone with Morgan Stanley, please go ahead.

Mark Edelstone - Morgan Stanley

Good afternoon guys. One, just question on how you think about business going forward. Obviously, your inventories are so higher than you would like them, so what is the current target level? And then I have got a strategic question after that.

Don Macleod

This is Don Macleod. I will take your question about the inventory levels. I am not sure I would make that statement that they are higher than we would like them. We took inventories down this quarter and obviously we have a position that we want to take with die bank with our inventories so that we are position when business does pick up. And I think our finished goods are within our normal range of finished goods at the high end of the 2- to 4-week range which we normally carry on the shelf. So, I think the inventories are pretty much in line with where we want them to be and we are able to keep our lead times in reasonable shape given those inventories. Brian, do you want to take the second part?

Brian Halla

Yeah. With the one exception we mentioned in the commentary, Mark, about we still see the contract manufacturers reconciling and reducing their inventories pretty much attributed to the generation 2 and 2.5G base stations, but other than that I agree with Donnie, that the inventories are about where we want them. Our goal has always kind of been in the 70 to 80 days of internal inventory, more and more of that die bank and 10.5 weeks for distribution seems pretty good. So, I think we are pretty much there and if we are not, we should be there by the end of the quarter or just slightly into it or after that.

Mark Edelstone - Morgan Stanley

Okay, fair enough. The other question then was you guys have obviously done a great job of pruning products and basically delivering more value-added high margin products for the company. As business recovers sometimes say in 2007, can you just give us some thoughts based on the discipline that you guys have in terms of the markets you are going after in that high margin opportunity you are looking for, what type of increased in the served market you are going after do you think is out there given those sort of margin objectives that you now have?

Brian Halla

I'll start with kind of the 30,000 foot statement and say that it sure feels good to be number one in power management, standard linear analog segment because more and more things are going mobile and more and more mobile devices are adding features; and I would say that some of our growth engines are still in that -- well in the middle of that that mobile space. So, and as I've said in the commentary, when you are sitting at under 60% utilization with 59 points of gross margin, one can only -- can't help it, but feel anything but good. I mean, but nothing but good when you look at what happens when you get back to about 85% utilization.

Having said that, we have several growth engines within the broad market area that still haven't even scratched the surface; one of those of courses is in data conversion where we've doubled our market share in the last three years, and if we can double our market share every three years, I'll be happy camper. And we are launching a lot of new precision amplifier products because of our VIP10 process technology capability. We are going ahead with our reconciliation of our own capacity to make sure that Texas has the 8-inch capability when we need it, but I think it bodes pretty well for a bright future. Donnie.

Don Macleod

Brian, you've kind of said it, but I would view, Mark, two indicators of objectives going forward, I mentioned and I want to make the point again, our ASPs improved 10% this second quarter over last year's and this really is portfolio rotation. We are now at a point; for example, in this quarter we just completed our commodity products for analog, as we define them. It went down. Sales of those commodity products declined quarter-on-quarter by about $12 million. Now obviously that affects the top-line of the company, but we replaced all those products with these newer higher ASP new products that give us that extra value. Brian mentioned our data converters. Even if I look at our data converters this quarter, our ASP and data converters for that whole portfolio is up over 40% on last year's second quarter, and we have new products coming along that is going to further that.

So it's kind of painful going through the, if you want the running down of the commodity businesses, the running down of the foundry business that's going away, but we are building momentum with new products with much higher value that are replacing these products and kind of the slate is almost clean of commodities and the slate is almost clean of those foundry products and we are ready to move forward with the new stuff. So this is kind of a turning point, I think, for the company. It's only a question of how long we will be at this low level before we move forward. And you'll see more evidence of these higher ASP products coming into the market. But obviously, they drive the margin and growth.

Long Ly

Alright, operator -- Thanks, Mark. Next question.

Operator

Your next question is coming from Adam Parker with Sanford Bernstein. Please go ahead.

Adam Parker - Sanford Bernstein

Yeah. Hi. Sorry about that before, what percentage of your revenue is through contract manufacturing -- (inaudible) basis a couple of quarters ago?

Lewis Chew

Yeah. If I look at the collection of contract manufacturers that will lump all the obvious names into -- we're getting some serious cross talk in the background there, but anyway, it probably ranges anywhere from 11%, 12% of our revenue. It's typically the range of that. And again the reason why we have generally not talked about this category in the past is because we tend to view those guys not necessarily as a separate group of customers but a lot of flow-through for guys like the large cell phone people and of course for PC. But, we mentioned it this quarter because if we collectively look at them as a group, there is no doubt that we saw significantly lower bookings from them as a group and significantly lower backlog from them as a group. But again, it's kind of, like I said, 11%, 12% of our business is [costly] and actually that number has been very steady over the last five quarters.

Long Ly

Adam, do you have a follow-up. All right, operator, next question.

Operator

Your next question comes from Simona Jankowski with Goldman Sachs. Please go ahead.

Simona Jankowski - Goldman Sachs

Hi. Thank you for taking my question. I was actually a little surprised by how low your utilization ended up in the quarter. I think initially, you had expected something that was may be more in the mid-60% range and coupled with your comments previously that back in the '04 timeframe, utilization had come down a little bit too much, and inventories internally had come down too much. This is now even before you guys were two years ago. So, I just kind of wanted to get an understanding of what the thinking was behind that and then I have a follow up as well.

Lewis Chew

Sure. The first thing I will point out Simona is you are correct. Last cycle; lets say we bottomed out at 63% utilization, and this quarter we will call it 58. So, remember when we did, and again, I don’t want to make this sound like a commercial, but when we hit the bottom of the trough in that last cycle in '04, we had 5 or 6 consecutive quarters of pretty strong growth and during that period we did add a little capacity. So, at this point right now, it makes me feel good as we added our capacity but that has not unhinged on our ability to deliver the margins. I think the delta that you are seeing there incrementally is that we took the utilization down but we have got a little extra capacity now than we did back in '04. Now, the reason why we brought it lower than kind of maybe what I intimated when we made the call last quarter as we came into the quarter obviously thinking revenues would be higher than we ended up doing because we had to re-guide; and two, we also mentioned that the bookings pattern weren’t all that encouraging. So, we decided to take somewhat of a preemptive strike and bring those inventories down, metric wise, I think one of the manufacturing group's objectives was get it below 80 days and I would commend them for doing that without really screwing up the margins. But those -- that's really the reason. We didn’t see great bookings during the quarter and we knew the revenue at some point was going to not hit the mark, I thought obviously why we are re-guided, so we took inventory down to go with it.

Simona Jankowski - Goldman Sachs

Okay, that makes sense. And just as a follow-up looking at it on the flipside through next year; you guys probably have done this analysis internally, but how should we think about the sensitivity of your gross margin to your utilization. So, in other words, is there anyway you can quantify for us, for every 10 points of utilization increase, how should that fall through to your gross margins?

Lewis Chew

Yeah. I think going forward, I'll be glad when we get back on the growth track, but historically Simona, we have had a model where our incremental fall through has been in the 70's and often times getting up into the high 70's, and I would tie it more to that. Because, obviously we don’t see ourselves increasing utilization, unless it was accompanied with an increase in business, so, you can almost make those two highly correlated. So, I would still be comfortable with the fall through margin from the point we are at now going forward, up there in the 70's and sometimes slightly higher.

Simona Jankowski - Goldman Sachs

Okay. Thank you very much.

Operator

Thank you. Your next question comes from Ross Seymore with Deutsche Bank. Please go ahead.

Ross Seymore - Deutsche Bank

Thanks guys. Just a question on the ASP side of the equation, I think we kind of talked about it last time. Don, you mentioned that the ASP's were up 10% year-over-year and that's clearly a commendable increase. But it also means the units drop pretty precipitously. Now that trade-off if you have low end units is always a wise one; but, has there come a point where trading the margins for the revenues or trading ASP’s for units starts to be our deliver revenue growth that is below you peers, and how should I think about that especially with your goal of getting the utilization some day back up again and just having a little bit of trouble reconciling those data points.

Don Macleod

I don’t think there is any difficulty. If you look at what we've been saying for, or listen to what we've been saying for the past 17 years; we have been deemphasizing a lot of those volume products that puts our manufacturing capabilities, volume products being the commodity products and having got these products to a really low point now in our portfolio, we are still running capacity utilizations in the high 50’s percent, and again looking to these numbers, we took our inventory down in the quarter, so the real sales rate of production would imply a capacity utilization something better than we actually achieved in the quarter. So, the whole emphasis in our manufacturing organization is not on running volume for the sake of volume its on the sake of focusing on the value products, the new products, the higher ASP products that quite often involve very different and more manufacturing steps in the older commodity products we had; more complex packages, more masked step processors and smaller lots. And our manufacturing capabilities, as Lewis, said, really turned on a dime this last quarter, but they also turned on a dime in supporting our new product introductions with shorter lead times and all the things that get these new products into production, and get them earning higher ASP’s. There are some big, big concession taking place in our manufacturing capabilities of the company and they are certainly not just focused on filling the fabs with more volume, quite the reversing in fact.

Brian Halla

Hello, Ross, this is Brian. The history of the semiconductor industry has kind of been driven by the mantra of sell the fabs -- sell fabs. I think this quarter we've kind of proven that, we don't have to sell a fab to turn in respectable numbers. And, the way we have been driving the organization is in the area of product definition, selling the fab should be a byproduct of a product well-defined and not a driving force for the definition of the product. And, I think that in not so distant future we will start to show exactly what we mean by that.

Lewis Chew

Yes, and I think, the capitalization model within, we have often talked about our capital spending to sales ratio; this is not leading edge DRAM stuff, or whatever you might call it. Even our most expensive fab our newest fab, how the precision runs it about 25% of total spending. So, we have a lot of room here to flex the volume and have practice of doing that very well.

Ross Seymore - Deutsche Bank

Okay. Then I guess the one follow-up would be, I think Don you have said that the core analog business was down about 4% this quarter; that seems to be pretty much in line with what your competitor are talking about, so no real surprise there. We look forward into February, the down six to nine looks to be a little bit more volatile to the downside than most of us would have expected. You went through the reasons why and we have yet to hear from your peer group, but it does that first flush look a little more volatile than the traditional high performance analog guys. Is there any reason in the market that you are seeing that your business would be more volatile than your peers?

Brian Halla

Actually, Ross, I will pass it back to Lewis to repeat the explanations for where the business is going to be done next quarter. Just add to add to your point, the 4% decline in analog standard linear business ties very well to the -- not so well at all, but ties closely to the $20 million reduction and shipments to our distributors that we had in the period versus what they sold out, so --

Lewis Chew

Ross, you are already highlighting in your question one of the roles, we take reluctantly which is being somewhat of leading indicator. The reality is that we don’t really know whatever everyone else, including your competitors, use for their March quarter, which would equate to our February. So, let's take your question at face value, which is that we are showing a pretty sharp drop-off in revenue next quarter versus this when maybe what you didn’t say was, hey, our normal seasonality might be down three points, just call it that, right? And the thing that we don’t normally talk a lot about, but that Adam asked question that was, this collective group of contract manufacturers, which has been operating in a very steady range for the last five quarters including even the last quarter when we missed. And this next quarter, it's very clear to us that that collective group of people has a drop-off in backlog that makes up a good chunk of our revenue decline next quarter.

And although we think we've done enough digging to know that some of that is handset and some of that is other vertical stuff, the way I would rationalize it is kind of like this, if we are going to drop-off 8 to 11 points, two points of that is pretty much done, so we know we are going to drop-off in foundry. And then if you think of our vertical business being let's call it 26%, 28% is wireless, another 6 to 7 display, another 6 to 7 PC, that's 40% to 43% of our business that I wouldn't be surprised when the data emerges that unit drop-off in those markets could 10% to 15% in the March quarter. And that's what we were dealing with right now is that obviously these contracts manufacturers are right in those markets I just mentioned and on top of that since they don’t really report inventories to people like us, we tend to use industry data on inventory and it does appear like they are a little heavy on inventory because I just saw a recent report that showed that this inventory compared to the '04 cycle is down this cycle versus last, but the EMSs, their inventory is up this cycle versus the last and we never really talk a lot about that, it doesn’t make a big enough part of our business.

So, the one piece I can answer is us against competitors. Because nobody is out there with March numbers yet, but we have got to call the numbers like we see them, and right now the backlog is down that drives the number like we are guiding today.

Ross Seymore - Deutsche Bank

Okay. Thank you.

Operator

Thank you. Your next question comes from Michael Masdea with Credit Suisse. Please go ahead.

Michael Masdea - Credit Suisse

Yes, maybe the first question is just the word trough has been turned out there a lot, and it sounds like there is still not lot of visibility. Is that mainly --, I mean obviously you have had a number difficult quarters, is that mainly due to the fact that you are coming off these difficult quarters and that you feel that this is probably as bad as it gets given seasonality or is there anything else that kind of gives you the confidence to [guess] or maybe troughing here?

Lewis Chew

Well, let me start with that one Mike, and then I will let my colleagues finish up the answer. One of the things we have had throughout this whole cycle as you know is pretty stable lead times. And so, unlike the last cycle where lead times got high and then shrink, and you could more accurately predict the trough based on when your lead times turned, we have maintained pretty stable lead times. So, I think what we are doing is looking back at that life last cycle, and in fact in the last cycle we did seem to experience a trough in revenues, if you will, in our kind of post holiday quarter of that cycle, that February quarter. And right now, we have got a drop-off in backlog, the bookings dropped this quarter. Obviously, we watch things throughout quarter to look for indicators. But normally for us following this post holiday quarter, things will pick back up and if were in an environment where people have been dropping inventories, that’s kind of what we are intimating, but you are right, we don’t really know right now. Visibility is going to be dictated by your lead times and our lead times have consistently been about six weeks for the last nine months. So, we haven’t done anything to stimulate more visibility in other words.

Michael Masdea - Credit Suisse

Got it. Yes, that makes sense. And just a follow-up question, Donnie, earlier you said a comment about the slate is largely clean of the commodity business or it's getting to the end of that process. If you just look at that on the surface that would suggest that your growth multiple to the industry would start to be actually improve. Is that an expectation that we should have or is it the wrong way to think about it?

Don Macleod

It's easy to draw that conclusion, but the fact is that things that are going away in our portfolio are coming to a point when they’ve almost all gone away. It's not just the commodities it's the foundry business and some of the other old, mature kind of ASSP analog type business we've talked about. And I think we're positioned to grow the other stuff pretty well from now, but as Lewis said, we don’t really have indicators, no demand or backlog if that's ready to happen next week or next quarter.

Michael Masdea - Credit Suisse

Got it. Thanks a lot guys.

Operator

Thank you. Your next question is coming from Uche Orji with UBS New York, please go ahead. Uche, it is your time to ask the question.

Uche Orji - UBS New York

Yes. Thank you very much. Thank you very much. Just very quickly on the contract manufacturers, you've mentioned this has probably been the one area where we've been hit by something unexpected. But do you have any confidence that with this guidance given, I know you've talked about utilization troughing, should we read this to mean that with this level of guidance probably into the February quarter we should expect that -- excess inventory from this segment should also be correct. Is that fair conclusion to draw at this point?

Lewis Chew

Well let me try to frame my answer the right way here. The level of drop off and backlog in contract manufacturers this quarter, it would be hard for me to imagine that same scale of drop off next quarter, let's look at that way. So I think that the scale of drop off in the backlog would tell me that they took a big step in reducing their bookings on us this quarter to presumably deal with a combination of the seasonality in these vertical markets and whatever excess inventory they have. But at some point you can't go below zero. I am not implying it was zero, but the drop off was so significant that it's hard to say over the next quarter we get another one of those because it would basically be close to zero.

Uche Orji - UBS New York

Alright. Thank you. Fair enough.

Lewis Chew

That doesn’t mean that we know for a fact that they will have their inventories all, as Brian put it, cleaned up this quarter, but the signal was clear that they wanted to take some inventories down this quarter.

Uche Orji - UBS New York

That’s helpful. If I look at what you were seeing in Japan, the question of Japan excess handset inventory has been talked about for the last few months. What is your sense as to where we are in sense of the correction of handset inventory in Japan and get a [customer view] of the markets that you was talking about has been where you saw a decline?

Brian Halla

Well, Uche, as you know or as you might may or may not know, you just started covering us, our Japan sales are very traditional in a sense that all of our Japan sales go through the [Diary 10], and so even though they are viewed as distributors, we view that as kind of a pass-through and it is true that we did see a decline in their resale rates during the quarter that we are in or that we just finished, but right now our Japan region is telling us that they see a fairly flat environment in their [Diary 10] resales from Q2 to Q3. Now that is as much as we know and we are only obviously 8 days into this quarter. But that’s our view, and that doesn’t mean that all of the inventories are done with, but that’s the indicator right now. We had a drop-off in Q2 and it doesn’t look like that drop off will repeat in Q3, at least not in Japan.

Uche Orji - UBS New York

That’s helpful. Thank you very much.

Operator

Thank you. Your next question is coming from Sumit Dhanda with Banc of America Securities. Please go ahead.

Sumit Dhanda - Banc of America Securities

Yes. Hi, guys. A couple of questions. First, I guess, Brian this one is for you. If I look at your business ex-foundry and the run rate that you will be at in the February quarter and then I compare it back to the trough level that your hit late '04, they're very similar numbers. So that is suggesting to me that if I am comparing to equivalent trough hypothetically, there hasn't been much growth in the base business. Is there something I am missing or what has been occurring in the business, which is preventing growth from showing up, which should be in accordance what the end market has done at this point?

Brian Halla

Sumit, I'll let Lewis take a first stab at that and I'll grab it back if you need me too.

Lewis Chew

Hey, Sumit I just want to clarify the way you are asking this question, which I think is fair by the way. You are saying that if you look at our cumulative drop off from peak to trough in '04 cycle versus '06 cycle, you see the same number, is that the way you are phrasing the question.

Sumit Dhanda - Banc of America Securities

Well, you can look at that way or you could just say, well, base business should be about $450 million in the February quarter and if you think back to August of '04 that was about the same number and so I --

Lewis Chew

Yeah. Okay. I've got it. So what you have to remember is back in '04 you can't call that's 450 number base business because at that time we had not divested either the super I/O or cordless. So the way I would look at it is that in back in '04, '05 cycle, we cumulatively dropped off -- pick a number, let's call it 24% from peak to trough. And now let's call that's the whole company. And this time around even if our drop off is the same, seven point to that give or take, is being driven by our disposal of these two businesses. Because two quarters ago when we did our 571 in revenue, with our peak in this cycles as it is turning out, about 44 million of that revenue was from this -- the cordless super I/O, whether it's sounds or whatever, that is going away this time that was in the trough numbers last time around.

So, I would actually say that right now, we feel pretty good that if in fact we are seeing the trough which might just ask about it would in fact be a notch higher than it was the last time around. And we -- that bears itself out because in the period after the trough in '04, we clearly grew share in standard linear for some period of time, and that base business is resident in our numbers today.

Sumit Dhanda - Banc of America Securities

May be I'll discuss this offline with you. Let me just ask a separate question. The distribution inventory you said down about half a week, my recollection was that your target was to get it down to between 9 and 10 weeks from the 11-week level that you are at currently or last quarter. So, is this a new level that you now feel comfortable with or are you suggesting that we are not quite done with the distribution inventory perhaps?

Brian Halla

Yeah, when I gave guidance last quarter, you are right Sumit that I have said we were about a 11 weeks at the end of last quarter and I believe, you can check beyond this but I believe what I said in my guidance was, we were looking to bring inventories down by a half to a week. So, that would range me from 10 to 11 right? Or 10 to 10.5, we ended up this quarter at about 10.5. And I would say that, the reason why it didn’t drop any lower is more due to the same kind of relative soft environment, that didn’t drive their volume any higher than may be, what we would have anticipated beginning the quarter. But I did not commit to dropping it below 10 because we are starting at 11 and I said we would drop it by half to one week. That means the floor would have been 10. Now, your other question, where are we comfortable operating; even right now, we've probably got some spots around the world, where that regional -- just the inventory looks pretty low or collectively from a global standpoint, this kind of 10 to 10.5 week, we are comfortable with. That’s still probably two weeks lower than where it was operating on average back in '04.

Sumit Dhanda - Banc of America Securities

Okay. And then one final question. You have done a commendable job of keeping operating expenses under control, even as revenues have dropped here. I mean is there much more headroom hypothetically, if Q3 is not the trough, do you see more ability to cut costs here with declines in revenue or are we at sort of a limit here?

Lewis Chew

Well Brian has asked me to start working for -- I get a free lunch in the cafeteria everyday and -- sorry. Remember everybody out there, you got to maintain your sense of humor in all circumstances. Yeah. That’s right. And then next, Don has going to have to do that too.

No, I think it is a sort of question, I mean we have through the cycle, even when revenues were growing up, I would argue that we were very judicious with even how we grew or didn’t grow our OpEx. So, the one thing we are not going to do is we are not going to start the R&D. If you could get a window into some of the projects we have going on here, it's very encouraging. On the structural side, I think we saw what happened in the last trough of the cycle and sales picked back up again. So yeah, we are flexing the variable tools that you can imagine we have at our disposal. We have days-off and we cut back on the discretionary spending. But at this point, we don’t have anything dramatic; we are going to put on the table like cutting off an arm or something like that. But I think right now, I am comfortable with you guys, modeling the operating expenses within a range of dollars and not worry so much about the percent and then we will have to go back to the growth question and hopefully let the top-line take care of that.

Sumit Dhanda - Banc of America Securities

Okay. Thank you very much.

Operator

Thank you. Your next question is coming from Craig Hettenbach with Wachovia. Please go ahead.

Craig Hettenbach - Wachovia

Yes thank you. If we can go back to data converter piece, you guys have had some good traction there in the last two years. In addition to new product introductions, just give a sense of anything else you're doing on the sales side or FAE efforts to help boost that business?

Don Macleod

That's a good question. Just to reflect again on the point I made, this is Don Macleod, on data converters. About 40% of our sales from data converter products this quarter was in products that we introduced in the last three years. And Craig, I think you've, referred to nice launching products but it's more appropriate that you actually get them designed into the customers and that's the step we're working on. We've actually increased the headcount in the field that we have in field applications engineers over the past three years by about 40%. And if you look at the numbers that we need to kind of get this broad market penetration, this is kind of what we think we need to do, and these investments have now been made. So, I think we we're on the threshold of seeing these general purpose data converters and these very high-speed -- ultra high speed data converters become even more significant for the company. And as I would say data converters and interface of the two areas, where we get the best value, the best ASPs and the more we grow these, this is proportional effect it has over the company as a whole.

Craig Hettenbach - Wachovia

Great. And if I could just follow-up with an end market question, the flat panel market, lot of volatility on the component side and demand looks reasonable out there. What's your sense in the next couple of quarters of trends in the flat panel space?

Don Macleod

Craig, this is Don Macleod. I'll take that. And just from our point of view, the part of the flat panel marketplace that we address is really the LCD TV space. We don’t view that supplying components to notebooks displays or monitors is an attractive business proposition. If you think about our ASP and margin objectives, these are not markets where you can typically secure and hold these kind of margins. So, we are a lot more selective about where we take business in that panel space. But we feel, we are pretty excited about what’s happening in the LCD TV space. And the last time I talked to one of the leading players in that market, which was recently, the input I got was that the factories were full producing LCD TVs and they were all in the process of adding capacity for what’s call the Next-Gen 8 glass facility. So is an attractive market, you just have to be very selective as a semiconductor supplier where you play to ensure that you get the margins that you want. I think that dismisses a very difficult, we have being selective and we kind of like the top end of it.

Long Ly

Okay, operator, we have time for one more question.

Operator

Okay. Your next question is coming from Tore Svanberg with Piper Jaffray. Please go ahead.

Tore Svanberg - Piper Jaffray

Yes, good afternoon, thanks. I hope you still serve us coffee at your next analyst day. Just a couple of question, first of all just to clarify, you said bookings seemed to have troughed in September, so does that mean bookings were up month-to-month both in October and November?

Brian Halla

They were, but remember I also followed that up with a statement saying, we started at a little lower point than the prior quarter.

Tore Svanberg - Piper Jaffray

Okay, fair enough. And also you seem to suggest that utilization is going to trough this quarter. Am I reading into that too much, and if so, when would you start to ramp up the fabs again?

Lewis Chew

Well, I am comfortable saying that we currently would expect utilization to trough in Q3 because we are only going to go down slightly from where we averaged in Q2. And remember, Tore, even with the revenue dropping off, we do plan to burn off more inventory in Q3, but not as much as we did in Q2. So, if we see some positive signs in bookings that then lead to the normal kind of whatever seasonality we get in our Q4, then that would be the catalyst for us not to need to push utilization down any further because obviously like the last cycle, once things pick back up, there is no need to keep burning inventory. And you'll notice that one of the things we are not going to do this time around is bring inventory down as low in terms of dollars as we did in last cycle because we do feel that they got too low and then we weren’t able to respond to the snap back, if you will.

Tore Svanberg - Piper Jaffray

Understood, and the final question for Donnie; Donnie you mentioned 40% of power management and data conversion now coming from new products. What would that percentage be, let's say, in 2004?

Don Macleod

I can't give the specifics for power and data conversion but for the company that number would be more in the high 20s and it's obviously now better than that probably for the analog part of the company, so--

Tore Svanberg - Piper Jaffray

Great, thank you very much.

Don Macleod

We feel good about that.

Long Ly

Alright. So, operator with that we are going to end our call today. Let me remind everyone that the replay is available on our website. Thank you for joining us.

Operator

This concludes today's National Semiconductor Corporation conference call. You may now disconnect your lines and have a wonderful day.

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Source: National Semiconductor F2Q07 (Qtr End 11/26/06) Earnings Call Transcript
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