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Fairchild Semiconductor International, Inc. (FCS)

Q1 2006 Earnings Call

April 20, 2006 9:00 am ET

Executives

Dan Janson - Senior Director of IR

Mark Thompson - President and CEO

Mark Frey - EVP and CFO

Bob Conrad - SVP and General Manager of the Analog Products Group

Analysts

Ross Seymore - Deutsche Bank

Craig Ellis - Citigroup

Romit Shah - Lehman Brothers

Bill Lewis - JP Morgan

Michael Masdea - Credit Suisse

Steve Smigie - Raymond James

Tristan Gerra - Robert Baird

Michael McConnell - Pacific Crest Securities

Quinn Bolton - Needham and Company

Jim Schneider - Wedbush Morgan Securities

Presentation

Operator

Good morning and welcome ladies and gentlemen to the First Quarter 2006 Earnings Call. At this time, I would like to inform that this conference is being recorded and that all participants are in a listen-only mode. At the request of the company, we will open the conference up for questions and answers after the presentation.

I would now like to turn the conference over to Mr. Dan Janson. Please go ahead, Sir.

Dan Janson

Thank you. Good morning and thank you for dialing into Fairchild Semiconductor's first quarter 2006 financial results conference call. With me today is Mark Thompson, President and CEO; Mark Frey, our new Executive Vice President and CFO; Bob Conrad, our Senior Vice President and General Manager of the Analog Products Group; and Izak Bencuya, our Executive Vice President and General Manager of the Functional Power Group.

First I would like to highlight some upcoming investor conferences that we will be attending. On May 2, we will be attending the CSFB Semiconductor and Semiconductor Capital Equipment Conference in New York. We'll attend the Piper Jaffray Hardware & Communication Conference on May 10 in New York, and then the Robert W. Baird Growth Stock Conference in Chicago on May 11. We'll also address the JP Morgan Technology Conference in San Francisco on May 23, and the Citigroup Semiconductor Conference in Boston on June 1. Finally, we'll present that the Bear Stearns Technology Conference in New York on June 13.

We will be calling our Annual Analyst Day on June 28 at the Computer History Museum in Mountain View, California. And this is the first time we held the event on the West Coast and we look forward to seeing our large shareholders in the West in that area as well as all the sell-side analysts that cover us. So please mark the calendar for June 28 to join our executive management team for a morning of presentations and discussions about the future of Fairchild.

This call is being simultaneously webcast from the Investor Relations session of our website at fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days.

I also want to note that we plan to publish our mid-quarter press release to update our business outlook on June 7 before the market opens.

Now I will start today's call with a review of our quarterly and annual -- quarterly results. Mark Thompson will discuss the results in more detail and then Bob will provide some additional color on our strong analog performance as well as update us on design wins and end markets. Mark Frey will wrap up with financial highlights and discuss our full guidance for the second quarter of 2006.

Finally, we will reserve time for questions and answers. We schedule this call to last approximately 60 minutes.

Fairchild Semiconductor today announced results for the first quarter ended April 2, 2006. Fairchild reported first quarter sales of $409.5 million, 10% increase from the prior quarter and 13% more than the first quarter of 2005.

Fairchild's first quarter of 2006 included 14 weeks instead of the normal 13 weeks fiscal quarter. Fairchild reported first quarter net income of $26.6 million or $0.21 per diluted share compared to a net loss of $4.7 million or $0.04 per share in the prior quarter and a net loss of $10.4 million or $0.09 per share in the first quarter of 2005. Gross margin was 29.9%, 570 basis points higher sequentially and 680 basis points higher than in the first quarter of 2005. Included in the first quarter results are $5.3 million in total stock-based compensation in accordance with Statement of Financial Accounting Standards Number 123R, $3.2 million net gain on the sale of LED lamps and displays product line and a $3.5 million in net tax benefits related to certain finalized tax filings and audit outcomes.

Fairchild reported first quarter pro forma net income of $25.6 million or $0.21 per diluted share, significantly better than the pro forma net income of $13.6 million or $0.11 per diluted share in the prior quarter and the pro forma net income of $12.5 million or $0.10 per diluted share in the first quarter of 2005. Pro forma net income excludes amortization of acquisition related intangibles, restructuring and impairments, gains from the sale of the LED lamps and displays product line, certain net tax benefits, litigation settlement proceeds, charges for potential settlement losses, impact of tax repatriation and other items. Pro forma results include stock-based compensation expense.

Fairchild management will be making forward-looking statements in this conference call. These statements including all statements about future results and performance are made based on assumptions, estimates that involve risk and uncertainty. Many factors could cause actual results to differ materially from those expressed in forward-looking statements.

A discussion of these risk factors is provided in the quarterly and annual reports we file with the SEC. In addition, during this call we may refer to pro forma or other financial measures that are not prepared according to generally accepted accounting principles. We use non-GAAP measures because we believe they provide useful information about operating performance of our businesses that should be considered by investors in conjunction with GAAP measures that we also provide.

You can find a reconciliation of non-GAAP to comparable GAAP measures at the Investor Relations section of our website at fairchildsemi.com. Website also contains 2006 first quarter fact sheet and updated financial sections with updated unaudited financial highlights including detailed breakout of segment and retail revenues, gross margins, EBIT and EBITDA.

Now I will turn the discussion over to Mark Thompson, who will review the quarter in more detail.

Mark Thompson

Thanks, Dan. Good morning and thank you for joining us. As many of you know, we set some aggressive operational and financial performance goals in the middle of last year and I am pleased to report that Fairchild delivered impressive first quarter results ahead of our expectations. In the next few minutes I will update you on progress including my thoughts about our sales and gross margin growth, analog performance, channel management and inventory control.

Let's start with top-line performance. We grew first quarter sales by more than 10% sequentially above our initial expectations. Keep in mind we had an extra week in the first quarter that explains 7% to 8% of sequential sales increase which was partially offset by 2% reduction in sales related to the divestiture of our LED lamps and displays product line at the beginning of the quarter. Netting this out results in a 4% to 5% apples-to-apples sales increase compared to Q4 2005, well above our typical first quarter results of down 2% to 3%.

After spending most of last year reducing inventories and improving our channel management processes we were able to resume shipping in line with end market consumption in the first quarter which drove most of our above seasonal sales growth. We also believe that we have gained market share in both our analog and high value power discrete businesses, based on the latest WSTS data.

Our goal has been to grow our analog and power discrete business at/above the market rate while becoming increasingly selective in our lower margins standard products business and this is exactly the profile performance we delivered in Q1. We grew our analog sales a strong 18%, power discrete nearly 13%, while reducing standard products revenue by 1% from the previous quarter. The increase in sales helped to improve our utilization rates to our target levels, typically in the low to mid 90s which coupled with a modest improvement in product mix enabled us to significantly increase gross margins 570 basis points sequentially, to effectively achieve our immediate goal of 30% in 2006.

Clearly we have made faster progress improving our gross margins than anticipated. We expect to make steady progress toward our next objective of mid 30% gross margins by delivering more new products, while mixing out lower value products to better optimize the margin mix running in our factories. In this way, we believe we can show continued gross margin leverage even as we maintain our target utilization.

I am particularly pleased with our improvement in the analog gross margin, now above 40%, which is the highest level we have recorded since the year 2000. This is also beginning to reflect the investments we made in product development and field application support to build a higher value product portfolio. We are making solid progress toward our goals to build our analog business to the $500 million sales level at 45% to 50% gross margins in the next three years. Bob will discuss our analog progress in more detail a little later in this call.

Our bookings were even greater than sales allowing us to build backlog during the quarter and position us very well for Q2. We are monitoring our backlogs very closely for signs of excess order rate. We are managing lead times more effectively on analog and high power discrete which we believe reduces the potential for excessive order rates. We have actually reduced blended lead times during the second half of the first quarter to about 10 weeks with lead times for our analog and power discrete products generally below this level are roughly half of what they were during the last up cycle of 2004. We are also working closely with our small distributors in Asia to ensure that their order rates are in line with the end market demand, using paper performance incentives to drive better management, which leads me to the distribution channel. We are keenly focused on managing our distribution channel to closely map our shipments for the channel sell-through.

In the first quarter channel resales were seasonably lower in Asia due to the lunar New Year holiday but sequentially higher in other regions resulted in worldwide resales being about 3% lower than the prior quarter. We responded by adjusting our shipments into our distributors to achieve about 1% reduction of inventory dollar, while we held weeks in supply roughly flat to the prior quarter. We are of to a great start in 2006 and look forward to building on this momentum during the rest of the year.

We are still early in the process of mixing out lower margin business to improve our gross margins. Our new product pipeline continues to improve, as we build our technical capabilities to better sell and support high value products in the field. We are managing lead times more effectively on analog and high power discrete products to better meet our customer requirements and to minimize the potential for excessive order rate, and we are watching inventories like a hawk to stay in our target range.

I believe the impressive results we delivered in the first quarter offer just a glimpse of the improvement possible for Fairchild as we continue our transition to higher product value portfolio in the fast growing analog and power management market.

I would like to take a minute to welcome Mark Frey, our new CFO, who will discuss our financials in just a few minutes. I have known Mark for years, worked closely with him in [tasked roles] and delighted to have him on the team. You will find Mark to be a great person to be work with, articulate, credible and with highest level of integrity.

Now, Bob will review the analog results for more details as well as our progress in new products, design wins and end-market dynamics.

Bob Conrad

Thanks Mark. We delivered impressive analog financial performance in the first quarter which is more indicative of the results possible with our higher value product mix and stable inventories. With sales of $82.1 million, up 18% sequentially and gross margins of slightly more than 40%, our analog business reached an important turning point in Q1. I want to take a few minutes to explain some of the reasons for this turnaround followed by a review of our end-market.

We have been joined Fairchild more than two year ago, we have been focusing our analog team on opportunities where we can provide leadership products offering unique value to our customers. When Mark took over as CEO, he challenged us to accelerate the transition of our analog business to become a clear leader in our chosen market. To meet this goal, we've increased our design effort by adding more design teams and design centers while building a stronger field applications team.

While these investments are for our long-term goals, we are already seeing the impact on our product portfolio. One metric that we track to measure our new product success is a percent of total backlog that is comprised of new products, which we define as those released within the last three years. This metric has been rising steadily over the last two years and has been in the range of 55% to 60% of the backlog for analog business during the last three quarters up from the mid 40% range a year ago. Margins on our new products are higher than our average indicating the potential for continued gross margin expansion.

Looking at some examples with the types of new products that are driving these improvements. We won designs with a variety of our leading power conversion products, including our highly energy efficient FPS power switches and power factor correction solutions that help to drive significant sequential increase in the first quarter of power conversion sales at record margins. These products serve a wide variety of end markets including consumer electronics and all supportable to lighting and high power industrial motors.

Our analog switch products continue to win important designs in handset and computing applications enabling us to us achieve record sales again this quarter while building a very strong backlog position. We are expanding our strength in audio switches to new USB switch solution targeting high growth handset and computing application.

We recorded strong sales and bookings growth of our signal path analog business led by a high margin µSerDes interface products and our highly integrated analog video filters, drivers and amplifiers. We continue to expand our design win base and expect to steadily ramp revenue in this line across 2006, as more of these designs go into production. And our system power business we believe we have gained share with our VRD 10-compliant system regulators and expect to continue this momentum with our new generation of VRD 11 compliant solutions. We are also winning new designs with system regulators for the memory graphics and other sub systems in the computing and storage end market.

In our functional power products we won a number of new designs with a highly integrated SPM line of power module in a variety of air conditioner and industrial motor applications enabling us to achieve record sales for these products in the first quarter.

We are also winning designs and gaining market share with our advanced low power MOSFET products targeted for LCD television and we expect this market to continue growing at well above average rate. Our new product execution continues to improve making the foundation for higher sales at better margins in the future.

Turning now to our end markets, sales continued to be solid in all of the end markets with particular strengths in product supporting industrial, handset and computing applications. Bookings grew steadily during the quarter resulting in continued backlog growth even as we maintained stable lead times. Order rates were at or about fourth quarter 2005 levels in virtually all end markets while demand was strong as power products servicing the power supply, battery charger and desktop PC segments.

Let me turn it over to Mark Frey for more on our financial results and our forward-looking guidance.

Mark Frey

Thanks Bob. Let me start with financial highlights. We delivered excellent financial performance in virtually all aspects of our business led by our significant improvement in margins. Our strong sales growth improved product mix coupled with better utilization and operational performance enabled us to increase gross margins to 29.9%. We effectively managed total pro forma operating expense to remain within our guidance increasing $90 million sequentially due to bonus accruals, stock-based compensation expense, and the greater number of days in the quarter.

Our stock-based compensation expense was higher than our regional guidance because our better than expected financial performance resulted in higher performance share expense. In addition, the expense amortization of these performance shares is front end loaded. Our underlying effective pro forma tax rate was 15.8% in the first quarter and reflects the benefits of generating profits in low tax jurisdictions, as well as the usage of a portion of the US deferred tax assets that were reserved in 2005. These combined factors enabled us to record more than an 88% sequential increase in our pro forma earnings and EPS in the first quarter.

During the first quarter, we generated 3 million in cash flow from operation resulting in cash and marketable investments of $535.6 million. Internal inventories remained lean and well within our target range given our higher sales level.

My past experiences have made it clear to me the importance of maintaining tight controls of inventory and spending in general, and I plan to focus intensely of staying within our target ranges. Our $23 million in capital spending for the quarter keeps us within our annual budget of 6% to 8% of sales. Cash flow was negatively impacted by the payment of nearly $20 million of accrued liabilities for our fourth quarter tax repatriation and the settlement of certain liability claims.

Turning now to our forward guidance, we expect second quarter revenues to be flat to down 3% sequentially as we return to a 13-week second quarter from the 14-week first quarter of 2006. We entered the second quarter with a stronger backlog position than a quarter ago, which coupled with continuing capacity additions should allow us to sequentially increase our daily ship rates from less than 4.2 million per day in the first quarter to more than 4.4 million per day in the second quarter of 2006. This represents about 6% sequential increase in our daily ship rates. We forecast gross margins to increase about 50 to 100 basis points sequentially, due to expected improvements in our product mix and slightly better utilization. Looking forward to the rest of 2006 and 2007, we expect to continue growing sales for our analog and power discrete products at/above the market rate while maintaining our tight control of general and internal inventories. We believe the combination of profitable sale growth and improved product mix through more new products and less low margin commodity business will allow us to make continued steady progress toward our next goal of mid 30% gross margins.

We expect operating expenses to remain flat with the first quarter as we selectively fund new product development opportunities while rigorously controlling infrastructure costs. Our underlying effective tax rate for 2006 is expected to remain at approximately the same level as the first quarter of 2006. It is important to note that effective tax rates can vary as the regional distribution of income shifts during the year. We are forecasting our stock-based compensation expense to be in the $6 million to $7 million per quarter range for the rest of 2006.

Our strong first quarter results and guidance for sequentially higher daily shipments and gross margin for the second quarter provide more evidence of the progress Fairchild is making at improving the quality of our business.

I am personally excited to be part of this great team and to help lead the powerful transformation that’s underway at Fairchild. Thank you. I will turn the call now back over to Dan.

Dan Janson

Great, thanks Mark. We will now open the call to questions. I would ask that in order to allow more of you to ask questions, we would limit each person to one question and one follow-up. Thanks and let's take the first question please.

Question-and-Answer Session

Operator

Thank you. Our first question will come from Ross Seymore, Deutsche Bank

Ross Seymore - Deutsche Bank

Thanks and congratulations on a strong quarter. Just wanted to look in to your guidance on both the top line and the gross margin, if you could break that down a little bit by the three basic segments that you have the power analog, the discrete and the standard products, that would be helpful?

Dan Janson

Sure, while we have guided the sales flat to down 3% and as you could see in the profile for Q1 our analog sales grew the most and I think that's going to be a scene that we should be seeing playing out for '06 that our analog business should be growing the fastest, our discrete business is going to be growing at a very healthy clip, both either at/above market and then on the standard product side, like you saw, we are going continue to run that in a very selective mode and I would expect to see the least growth there.

Mark Frey

As for the gross margins, we would get some leverage out of the increased daily shipped rates, plus we continue to have a positive mix out of reduced low margin commodity products and additional higher margin analog products.

Ross Seymore - Deutsche Bank

Okay. And I guess is the follow-up, given your new target as the mid thirties and the gross margin. Can you just explain a couple of the leverage that you get there and then any general timeframe that we could expect that goal to be achieved?

Mark Thompson

Well, Mark here, let me answer you question backwards. First is we are in the middle of re-running our financial models and we are not done with that yet. So, one our plans come analyst day is to provide a refresh of our improvement schedule at that time and so I would like to differed the answer to that for the analysts day discussion and in terms of the mechanisms to improve margin are heavily increasingly orient toward new product development, new application development and making space in the factories for those product by reducing the commodity end of the business and that will be a consistent team most aggressively worked in analog but will be managed across the business that way.

Ross Seymore - Deutsche Bank

Great thank you.

Operator

And we will now hear from Craig Ellis, Citigroup.

Craig Ellis - Citigroup

Thank you. Good morning everybody and congratulations on the strong quarter. Just to clarify the strength in the quarter versus the mid quarter update, how much of the basic 1.4% incremental revenue growth came from either a better end-market performance, maybe better execution on the part of field application engineers through your internal supply chain or alternatively just new product expenses that you haven quite picked in?

Mark Thompson

Well it's very difficult to partition those because they are really part of the machine that we have been working very hard on and so, certainly they all contributed, we commented during, if you recall during Q4 that we fell that our revamp supply chain organization had done a very good job of delivering on short lead opportunities and that continued to trend into Q1 and the performance of that team continues to improve. We continue to see a very good residence between the new products that the analog and the high power MOSFETs teams are launching. So really it's a -- there is no single element that's driving the performances of the business. It's -- the system is working bit better each quarter and I think that what's driving the results.

Craig Ellis - Citigroup

Okay. And then may be a strategy question for you, Mark, you have that LED divestiture in the first quarter. You are getting great momentum on the analog types of business, can you talk about how you look at organic growth within the analog segment versus the potential for some selective acquisitions that augment the core that you have there?

Mark Thompson

Bob, do you want to handle the analog product question?

Bob Conrad

Yeah. Obviously, even with -- taken out the 14 week of this quarter, we grew quite strongly and so we are doing clearly double-digit well above market rate for this year, and in Mark's commentary he described they are trying to get into the $450 million to $500 million analog business size out in 2008, we have been at that run rate some point through the year. And we feel like we are on pace to that and can do that without acquisitions. So we are always looking at acquisitions to both -- obviously refine our own strategic view as well as look for opportunities to accelerate that. But we are working at that same on track to get to that range of business in 2008. And this year we are at or ahead of that pace that we had actually kind of outlined last fall.

Mark Thompson

Well, let me add a quick comment in addition to Bob's about acquisition, so one of the structural changes that we made last year was we took one of our officers, Pete Groth and had him worked full time on acquisition analysis and really developing a framework for both deal flow and also getting very disciplined about things that we buy and sell. And so Pete managed the process for the LED divestiture, for example, that went very smoothly. We are looking very hard at lots of things that we could acquire that would accelerate the trajectory of our strategy, but we will be very disciplined about what we buy and in the event that we do acquire, it will clearly line up with one of our key strategic goals and will quantify deliverables at that time.

Craig Ellis - Citigroup

Great. And then lastly for Mark Frey. Mark first welcome on board, and secondly, how should we think about where you'd like internal inventories to be as exit second quarter?

Mark Frey

Well, we are targeting to be flat as we exit second quarter. As a general comment, as you know I have come from Lam Research where we kept setting the bar lower and lower below even theoretical models of what was achievable and the results are very impressive. So I am a hawk on inventories and I have only just gotten started here, but I will be looking and challenging all aspects of the channel of inventories including external inventories to make sure that we can optimize the [mark] because I think it is one of those underlying things that drives other benefits offer to the company whether it's cycle time whether it's more leverage over pricing et cetera.

Craig Ellis - Citigroup

Great. Thanks guys.

Operator

And we will now hear from Romit Shah with Lehman Brothers.

Romit Shah - Lehman Brothers

Great. Thanks for taking my question. How should we think about the 18% sales growth in analog? I mean, even if I strip out the 7% to 8% contribution from the extra week it seems a lot faster than consumption, and you guys are not building inventories, help us think about the contribution from market share gains?

Mark Thompson

Bob, that sounds like a market share question for you.

Bob Conrad

Well, obviously. Yes, we are out growing the market. Yes we do not achieve that by building inventory in the distribution channels, consistent with the overall company performance on that front as well. The computing segment was up strongly for us this quarter in both CPU power management VRD 10 as well as system regulators. The signal path business, which is our switches, our µSerDes was in our first full quarter of production, it was up well into the double digits quarter-on-quarter as well. And then over in our AC-DC, where our Green FPS or sub-1-W standby power product family was up again nearly 20% quarter-on-quarter. So we are seeing just a lot of growth from each of the product strategies in actually widely varied market. So overall market share in the analog segment were still a relatively small player, but we probably gained couple of sensible points quarter-on-quarter overall. And we are doing it in segments that we are already in, so it has obviously increased share as opposed to trying to be broader than we were a year ago.

Romit Shah - Lehman Brothers

Okay. And could you just clarify the comment that lead times contracted in the second half of the quarter, was that that you guys just actively trying to be more responsive on orders or did you start to see customers make some cuts on some of the longer lead time products, in standard products for example?

Mark Thompson

Well a couple of things, first is that the longest lead times in general are in standard products, so consistent with the best -- the most important strategic business gets the first shot at capacity, the lead times I believe are longest in logic for example. So, its part of the continued process and in fact the only -- the order rate is very, very strong. The only orders that were taken of the books were taken off as a result of our collaboration with end customers in concluding together that there was no demonstrated end market for what they -- particularly in case of distribution, what people wanted to put on the book and we took multiple tens of millions of dollars off the books as a results of that and it was always a collaborative discussion with the distributor. So, there is -- that’s a bit of the process and so Robin Goodwin and the supply chain team continued to improve their process and active dialog with the end customers for what's the key timings for things are and managing a process that allows us to move the mean lead times down by moving something's in and something's out.

Mark Frey

The only other thing I would add to that Romit, as you know, we take lead time units very seriously here. We think that’s a big element in preventing excessive order rates which has marked the cycles in the past. In the analog area in particular, we have also circled the added capacity, because we know on the analog side in particular having our lead times to be less than 10 weeks is really crucial to that market and we are really trying to manage that way.

Romit Shah - Lehman Brothers

Well Mark, I mean what's your view, just in general on distributor inventories, I mean at 10 weeks do you think they should be carrying more, I mean just given the bookings strength and the better than seasonal growth you guys are saying?

Mark Thompson

Well that's one of the debates we are having right now and I tend to -- at the end of the day come out pretty lined with Mark Frey on this one which is I don't see any evidence that we need to raise our inventory levels. We will continue to look at our end service levels carefully, our share levels and continue to align the inventory with high resale velocities, so we will continue to be thoughtful about it but we have seen no evidence that suggest we should be increasing our weeks of inventory in the channel.

Romit Shah - Lehman Brothers

Great congratulations.

Operator

Moving on, we will now hear from Bill Lewis, JP Morgan.

Bill Lewis - JP Morgan

Thanks and could you -- I don't know if you have said what the book-to-bill was because you did talk about backlog, was that above one this quarter and what's your turns requirement for the coming quarter guidance?

Mark Thompson

It is above one, we don't normally talk about book-to-bill, but we did comment that bookings were greater than sales, so you could infer from that the book-to-bill was favorable. And our stole requirement is very small -- somewhere in the order of less than 10%.

Bill Lewis - JP Morgan

Okay and based on that discussion around lead times, are you expecting that lead times will hold set in the coming quarter, can you try to expand just some thoughts on where it's going to come out?

Mark Thompson

Well if you look, I think that in Q1 they were banded by 10 and 12 weeks approximately, if you looked at how they moved around through the quarter. Certainly we would be happy if we could get it underneath the ten week band, given the strength of demand, I think that is unlikely but we will continue to make sure it doesn’t go above the upper control limit of 12.

Bill Lewis - JP Morgan

Okay and lastly, could you comment on the pricing environment in the quarter? Thanks.

Mark Thompson

Well, so two things as demand is strong, pricing pressure tends to be less and we are certainly observing that. I would comment however that our margin goals don’t assume favorable pricing interjectory. So, that cushion is built into the view.

Bill Lewis - JP Morgan

Thank you.

Operator

And we will now hear from Michael Masdea, Credit Suisse.

Michael Masdea - Credit Suisse

Thanks a lot. The analog, Bob, the gross margin is phenomena, I don’t think I have ever seen in my life I guess 1860 basis points expansion in the quarter. Can you help us just with the pieces of that? It seems like, is that all product driven, mix driven, how much was just the revenue piece and help us with that?

Bob Conrad

Well I can explain a couple of the biggest chunks, Indiana market jumped in as well, roughly a third of that was driven by mix flash pricing, and I wouldn’t really drive that pricing is being the major factor there. One of the things as we said, we are focused on mixing out lower margin business. So, that obviously generates an ASP improvement as well. And then other two-thirds was the combination obviously of factory utilization benefits, but that was the smaller piece of it. As we had talked about last year, we had spend a lot of time cleaning up a number of things in terms of end of the life processes and programs, which mostly came to fruition in fourth quarter as well as the supporting reducing distribution inventory. And a lot of that weighed heavily on fourth quarter and basically was at a normal low level in Q1, which was one of the big -- was one of the big improvements in margins quarter-on-quarter.

Michael Masdea - Credit Suisse

Okay. Great. Thanks. And I guess, as we are listening to all this commentary about the store earlier, but it seems interesting that your commentary about lead times coming in, in just the tad, which is partially it sounds like something they are trying to do. OEM is seeing more than distributors, and distributors not allowing to build inventory. It seems a little different than what we are hearing out there, is there any reason why you think your seeing something a little different in aggregate than what we've been hearing somewhat from the other companies with the caveat that is still early in earnings?

Mark Frey

Well, it always difficult to analyze competitive commentary. So I think in this case we'll leave that to the expert switch with you guys, and stick to the commentary on our business side. I mean, we've hit the key themes that we believe in which is to really focus to supply chain on getting the most important and valuable products to our customers and creating a process and a mechanism that put those first in line. And so I think we are seeing that starting to work pretty well for us. So that may be a source of some differences versus some others, but I'll not speculate for you.

Mark Thompson

I mean, the only comment that I was really on -- Mike is that, if you look at higher value companies you'll find that generally their lead times don't vary as much.

Michael Masdea - Credit Suisse

Sure.

Mark Thompson

I think that's part of the transition that you are hearing and we recognize that and hence how we are tying to manage the business.

Michael Masdea - Credit Suisse

Fair enough. Thanks a lot guys.

Operator

Steve Smigie, Raymond James has our next question.

Steve Smigie - Raymond James

Okay. Thank you. I was hoping if you could comment a little bit on the tax rate, you mentioned in your guidance that would be similar to Q1. So is that -- by that you mean the 15.8% throughout '06?

Mark Frey

Yes. Plus or minus let's say three points. As you know, we reserved 195 million last year for our NOLs in the US, and so as we book income in the US until we recapture those reserves, the effective tax rate is zero. And then we have income in Korea, which if you read our 10-K, we have a partial tax holiday that still has several years to go there. And so that profile will support that level of ETR going forward.

Steve Smigie - Raymond James

Okay. This is a follow-up, if you could -- does that then continue into 2007 and just if I could, your [strict] comment on how much of sales will drop off relative to the LED sale going forward and how much going in sort of [foundry tax]?

Mark Frey

I'll do the first half of that question, we are not commenting on 2007, but the underlying profiles, I don’t expect to change a great deal, and obviously the calculation in terms of the US and how much income is generated between now and 2007.

Dan Janson

Steve, if you go and look at the 10-K and you figure out how big the NOL was you will realize that if we burn through that in 2006 we are going to have huge year. So I think it will last several years out there.

Mark Frey

It is going to be there for a while. The LED revenue has gone, we didn’t -- we virtually reported no LED revenue in first quarter. And then one thing to keep in mind, in Korea, we have a partial tax holiday and that will begin to phase out over the next four years. So next year's tax rate will be slightly higher than this year's tax rate in a location like that.

Steve Smigie - Raymond James

Okay. Thank you.

Operator

And we will now hear from Tristan Gerra, Robert Baird.

Tristan Gerra - Robert Baird

Good morning. Looking at your disty sales or sale in which was about in line with -- and resale that could assume a double-digit increase in sales to OEMs, is that a correct assumption and could you may be explain what was driving that? Is it new products specifically?

Mark Thompson

Certainly, I don’t have the breakout in front of me of our growth in the OEM segment. I don’t think we break that out. But certainly one of these strong areas of focus has been with our alignment with our tier one OEM. We have made a lot of progress on that recently and see that continuing to accelerate, and that is heavily concentrated on new leadership products.

Dan Janson

Yeah. I will give you a little bit more color on that Tristan. Our sales into disty were up because remember we were under shipping the channel's consumption levels last quarter. So we were up strong both in OEM and disty, but the key in the disty side was that we ultimately match which we shipped into, what shipments sold through.

Tristan Gerra - Robert Baird

Okay. And then as follow up, could you quantify the pricing trends in Q1 and your expectation for Q2?

Mark Thompson

Well, I hope I am consistent with when we answered that a few minutes ago. What we have seen is a moderation of price reductions. We saw that in Q4, we see that continue into Q1, however, our forward guidance does not assume that. We assume a fully competitive market when we make our gross margin analysis.

Tristan Gerra - Robert Baird

Okay, so I guess it is fair to assume, maybe lowest single digit very slightly down, if you can get to that level of detail?

Mark Frey

We say, Tristan, that we typically run in the down 2% to 4% per quarter, quarter-per-quarter range and we have been saying the last quarter, so that we have been on the low end of that and I think given what Mark had stated that, we are clearly in the low end of that range probably even a little bit below that range right now, going into Q2 where our backlog positions are very similar, the margin on the backlog, we are kind of still in that very favorable range of pricing. But as Mark said, we don't really count on big pricing swings to help us in the gross margin side. If its there, it's great but it's not a big part of the calculation for us.

Tristan Gerra - Robert Baird

Great, that helped a lot. Thank you.

Operator

And we will take a question from Michael McConnell, Pacific Crest Securities.

Michael McConnell - Pacific Crest Securities

Thank you. Looking at the strength in desktop PCs, we have obviously heard some what different trends coming from some much larger companies. Can you tell about your comfort level with that trend that seems to be obviously a little bit different and then secondly looking at the tax rate for a clarification of that, that would be a pro forma tax rate, is that the assumption?

Mark Thompson

Okay well, Mark A will take the market share one and Mark B will take the tax rate piece of that. So, we commented that we believe we took share in a couple of key places, we have said that overall in computing and Bob commented on some of the VRD10 compliant regulators and such. So, we do believe that we have taken share in those spaces and so I think that's the tie-off to our analysis and yours, and we clearly grew faster than the market in those spaces.

Mark Frey

As to the tax rate, there is really only about a one point difference between our GAAP underlying tax rate and our pro forma and that's because there is very little tax expense associated with the intangible depreciation that we add back in for our pro forma purposes. But the guidance we gave you was pro forma.

Michael McConnell - Pacific Crest Securities

Okay, so that is helpful. And then looking at the overall company utilization rate, what was that in the quarter?

Mark Frey

It's overall in the low to mid-nineties right now.

Michael McConnell - Pacific Crest Securities

Would it be fair to say then that the next lever then to been more mixed driven for the gross margin lines I suppose, are we kind of done with utilizations being the incremental driver of the gross margins?

Mark Thompson

Absolutely.

Michael McConnell - Pacific Crest Securities

So that is -- so we can just -- so mix is what we have looking forward then to drive that gross margin line?

Mark Thompson

I am sorry. Could you repeat the second part of that question?

Michael McConnell - Pacific Crest Securities

What I am trying to get, we had two levers for your gross margins going forward, we had obviously higher utilization rate and we had improving product mix. So, can we take the utilization rate now out of that equation looking forward to your gross margin lines?

Mark Thompson

Well I wouldn't say you take it out, I think it’s a very small component. Certainly we don't plan to increase loadings beyond their current state. And so what we will continue to do is as we will be expanding capacity in places where we have very good margin, so that will improve that margin profile and we are targeting our product development at obviously at a high margin component and as that comes online it will squeeze out the low margin component where we are constraining capacity, and so it's a complex mix process, but those are basically the two component drivers.

Michael McConnell - Pacific Crest Securities

Okay and if can speak one last one and I will be quick, just a remark, the company is obviously running right now in kind of sell-through mode operationally in terms of how you are handling your distributors now. When are we going start to see revenue recognition now move from sell-in to sell-through is that on the table now that we have (inaudible)?

Mark Frey

It's always on the table to analyze but if I am comfortable that we are managing the company on a sell-through basis I don’t see any reason why I would go to all of the confusion that would result from doing an accounting change. Number of very high quality companies that we compete with, recognize revenue on a sell-in basis and there is no problem understanding what the results are. So, well we keep looking at that carefully and is very essential to our operational management of the company but unless that profile changes I don’t necessarily see the need to make the accounting change.

Michael McConnell - Pacific Crest Securities

Thank you.

Operator

And we will now hear from Quinn Bolton, Needham and Company.

Quinn Bolton - Needham and Company

Hi just wanted to follow up on sort of the capacity editions, it's sound like the plan is to sort of moderately, or modestly add capacity in strategic areas and also to grab some incremental capacities just through the ramp down of older standard product. So sort of mix shift gives you some sort of capacity in your new products, and then you also have limited capacity additions. So we are not going to see your wafer starts or sort of data run rate on the [fabless inside] jump significantly in '06.

Mark Thompson

That's correct.

Quinn Bolton - Needham and Company

Okay. And then so on the incremental, usually what you guys are going from, say, the mid 70s to where you are now in capacity utilization, you get fairly high incremental gross margin on each dollar of revenue, each higher dollar of revenue. Now that you are kind of at your fairly loaded utilization rate, where do you think margin would be on an incremental basis on a go forward, is that still in the 50% range? Do you think it's lower or is it really just a function of mix shift so kind of hard to call?

Dan Janson

Well. It's interesting, if you think about it because if it's something where we are adding capacity right, just like if we were just using more subcon, obviously, we'd have a lot less incremental fall through. If it's a mix shift there is a lot of fall through because you are basically, you haven't seen cost structure but you are just getting a lot more for the product that you are making. So you've got this range there and as we've just said, we are going to be, as you characterized, very actively Quinn, we are going to be modestly adding capacity, because remember we are only going to spend 6% to 8% of our sales on capital, roughly half what we've spent the last up cycle year that we had in 2004. So we are going to have constraints about how much we can add, and then on the other side, we are going to have strong product mix enhancements going forward, which have great fall through. So that's one of the central element, I think, that is different about the story now, and I hope that people will comprehend us as we go forward in future quarters results that they did in the past. When we started to cap out on utilization, people would say, utilization leverage is over, the gross margin improvement may be much less now. The story we think going forward is with the modest increases in capacity coupled with the product mixes, we can keep extending the gross margin leverage for some time to come.

Quinn Bolton - Needham and Company

Great. Just wanted to make sure you guys had that point address. Thanks.

Operator

And we will now hear from Craig Berger, Wedbush Morgan Securities.

Jim Schneider - Wedbush Morgan Securities

Good morning. This is actually Jim Schneider for Craig. I think most of my questions have been answered, but if you could comment on overall OpEx guidance for the year that will be helpful?

Mark Frey

We expect OpEx to remain roughly flat with Q1. The current run rate of our bonus accrual is expected to stand about where it is now because it's sort of in the max range for the program that we have defined. Equity comp will increase to an area between 6 and 7 million, and that's for two reasons. One is, one of our performance programs was actually granted half way through the first quarter, and we only have one half of a quarter's worth of run rate. In future quarters we will get full quarter run rate, which will add about $600,000. The other is in the adoption of the new accounting. We have about $1.5 million that are expensed above the line in gross margins for our equity comp. We capitalized about 800,000 of that into inventory that sort of a one-time thing. And so going forward, we would be incurring about $1.5 million per period above the line. And so that sign, sort of, was a headwind but we are going to focus on finding other areas where we can continuously decrease the cost of our infrastructure activities to keep that in check.

Jim Schneider - Wedbush Morgan Securities

Okay.

Mark Thompson

Let me just add one more embellishment to Mark's comment, so while our goal is to maintain our OpEx flat, we are continuing to focus on shifting its mix toward R&D and away from G&A. We have picked up two first class design teams in the last quarter on the analog side, Bob continues to scrub the world for high quality teams as we find those, we are picking them up and adding them in product capability areas, we think represent growth opportunities and we are finding the budget out of G&A. So you will -- we have talked before about shifting the mix on that, our OpEx and we will continue to drive that process.

Jim Schneider - Wedbush Morgan Securities

Okay, thanks. And one follow-up, can you comment on the backend and suddenly some of your competitors have noted tightness there. What do you see, and is it rolling over?

Mark Frey

Certainly there are some constraints in the backend, I think probably, if I were to look at some of the commentary I have seen in other parts of the industry, it's probably less of an issue for us than it is for some others. I think, we have probably more in-house capability and some control over that, so again we are just like at the front-end at the backend we are able to compromise the low value business and shift the capacity toward the high-end business. And so we have worked that process effectively for us and so I think that’s been less of an issue for us.

Dan Janson

Jim, the other thing I would notice, if you look at what we have given you guys for guidance, we are taking our daily ship rates up about 6%. So clearly we are going to find more capacity in the backend, either some just bear utilization as well as some selective capacity ads that we have been doing. The tightness is clearly more of the chip-scale package type product that is where we have been adding capacity and that is where we will probably continue to invest.

Jim Schneider - Wedbush Morgan Securities

And thanks, and can you just quickly remind me of the amount you have out sourced on the backend?

Mark Thompson

I am not -- I don't think we have commented on that previously.

Dan Janson

We have given ranges in the past. It really varies depending on the products. Our analog products for the most part are in sourced, some of our discrete products we have got lot of outsourcing, so it is a mix. So, we can range anywhere from very little to maybe 60%, 70%.

Jim Schneider - Wedbush Morgan Securities

Okay, thanks so much.

Operator

And there are no further questions. Mr. Janson, I'll turn it back over to you for closing remarks.

Dan Janson

Okay, well thank you all for joining us. We look forward to seeing you all on June 28th, at our analyst day in Mountain View. Thanks a lot for joining us today.

Operator

And that concludes today's conference. We do appreciate your participation today, have a great afternoon.

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Source: Fairchild Semiconductor Q1 2006 Earnings Call Transcript
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