Fairchild Semiconductor Q2 2006 Earnings Call Transcript

Jul.20.06 | About: Fairchild Semiconductor (FCS)

Fairchild Semiconductor International, Inc. (NASDAQ:FCS)

Q2 2006 Earnings Call

July 20, 2006 9:00 am ET

Executives

Mark Thompson - President and CEO

Mark Frey - EVP and CFO

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

Dan Janson - Senior Director of IR

Analysts

Craig Ellis - Citigroup Smith Barney

Romit Shah - Lehman Brothers

Bill Lewis - JP Morgan

Ross Seymore - Deutsche Bank

Michael Masdea - Credit Suisse

Steve Smigie - Raymond James

Tore Svanberg - Piper Jaffray

Tristan Gerra - Robert W. Baird

Michael McConnell - Pacific Crest

Eric Gomberg - Thomas Weisel Partners

Quinn Bolton - Needham and Company

Ambrish Srivastava - BMO Capital Markets

Craig Berger - Wedbush Morgan

Operator

Good morning and welcome, ladies and gentlemen, to the Fairchild Semiconductor Second Quarter 2006 Earnings Call. At this time, I like to inform you 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 question-and-answers after the presentation.

I would now like to turn conference over to Dan Janson. Please go ahead, sir.

Dan Janson

Thank you and good morning and thank you for dialing into Fairchild Semiconductor's second quarter 2006 financial results conference call. With me today is Mark Thompson, President and CEO; Mark Frey, our Executive Vice President and CFO; and Bob Conrad, our Executive Vice President and General Manager for the Analog Product Group. We will be attending a couple of investor conferences this quarter, including the Pacific Crest Securities Tech Forum in Vail on August 8. We are also attending Citigroup's Global Tech Conference on September 6, in New York.

This call is being simultaneously webcast from the Investor Relations section of our website at fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days. I also wanted to note that we plan to publish a mid-quarter press release to update our business outlook on September 6, before the market opens.

Now, I'll start today's call with a review of our quarterly results. Mark Thompson will discuss the results in more detail, and then Bob will update us on design wins and the end markets. Mark Frey will wrap up with financial highlights and discuss our forward guidance for the third quarter of 2006. Finally, we will reserve time for questions-and-answers. This call is scheduled to last approximately 60 minutes.

Fairchild Semiconductor today announced results for the second quarter ended July 2, 2006. Fairchild reported second quarter sales of $406.3 million, a 1% decrease from the prior quarter and 17% more than the second quarter of 2005. Fairchild's second quarter returned to the normal 13 week duration, compared to the first quarter of 2006 that included 14 weeks.

Fairchild reported second quarter net income of $23 million, or $0.18 per diluted share, compared to a net income of $26.6 million, or $0.21 per diluted share in the prior quarter, and net loss of $205.3 million, or $1.71 per share in the second quarter of 2005.

Gross margin was 30.8%, 90 basis points higher sequentially, and 10.9 percentage points higher than in the second quarter of 2005. Included in the second quarter of 2006 results is $7.6 million in total equity-based compensation. Fairchild reported second quarter adjusted net income of $28.8 million, or $0.23 per diluted share, compared to adjusted net income of $25.6 million, or $0.21 per diluted share in the prior quarter, and an adjusted net loss of $2.2 million, or $0.02 per share in the second quarter of 2005.

Adjusted net income or loss excludes amortization of acquisition-related intangibles, restructuring and impairments, net gain on the sale of the LED lamps and displays product line, associated net tax benefits of these items and other acquisition-related intangibles, the impact of reserving the deferred tax asset and other items. Adjusted results include equity-based compensation expense in 2006.

Now, 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 and 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 adjusted 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 the 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. The website also contains 2006 Q2 fact sheet and updated financial section with updated unaudited financial highlights, including detailed breakups of segment and regional revenues, gross margins, EBIT and EBITDA.

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

Mark Thompson

Thank you, Dan. Good morning and thanks for joining us. It has been about three weeks since our Analyst Day event, where we presented a detailed plan and target business model for our ongoing transition to higher value analog and functional power products.

Our second quarter results provide more evidence to the effectiveness of this plan and the progress we made in the last year. Our second quarter sales were down less than 1% sequentially, even though we had one less week than in the first quarter. We increased our average daily sales rate by more than 6% sequentially, as we selectively add capacity to keep up with our higher distribution retail and maintain lead times at more stable level.

On a year-on-year basis -- year-over-year basis, second quarter sales were up more than 17% due to continued growth in distributor resale, which were up about 9%, and higher sales into OEM up nearly 14% year-on-year. Our bookings during the quarter continued to be healthy. We’re being vigilant in addressing any signs of excessive order rates. We've developed a process to identify and address a typical order pattern, and we continue to closely monitor our booking activities. In fact, we work closely with our customers to push out or cancel more than $15 million in more speculative orders during the second quarter. Even with these actions, we still built backlog during the quarter and believe we're well positioned with high quality backlog entering the third quarter.

Our overall blended utilization rates remained roughly at our target levels during the second quarter. We're selectively adding capacity to support our continued growth and to maintain more stable lead times for higher margin analog and functional power products.

In a similar pattern as the first quarter, lead times increased somewhat during the middle of the quarter, but we're able to manage them back into the 10 to 12 week range by the end of Q2.

We raised gross margins another 90 basis points from the prior quarter, due primarily to better product mix and higher daily sales rate, partially offset by higher equity-based compensation expense and price increases for certain raw materials. This is the fourth quarter in a row that we've increased gross margins, which are now nearly 11 percentage points higher than a year ago.

Our efforts to improve product mix and aggressively address the low-end of our margin distribution are producing good results. This is especially evident in 410 basis points and sequential increase in gross margins that we've recorded for our Standard Products Group in the second quarter.

In addition to improving product mix to deliver better margins and earnings, another important element of our strategy is to increase our distribution resale, while tightly managing inventory levels. Our distributors recorded more than 3% sequential increase in the resale in the second quarter, resulting in the highest level of distribution resale since the year 2000. We effectively managed our sales into the channel to maintain inventory levels roughly flat to the prior quarter at 11 weeks of supply.

At our recent Analyst Day, we presented what we believe is a compelling vision for Fairchild. We received great feedback from analysts and investors, especially on the target business models, which highlights potential for strong earnings growth over the next three years. I believe the results we delivered in the second quarter and our expectations for continued progress in the second half will provide more evidence that we're on track to achieve our goals.

Now, I will ask Bob to review our progress in new products, design wins and overall end market dynamics.

Bob Conrad

Thanks Mark. We had another strong quarter of new product developments and design win activity in our Analog and Functional Power groups. On the analog side, we saw robust bookings and numerous design wins for highly efficient FPS power conversion products in a variety of DVD and TV applications, especially in China. We are leveraging our power resource centers and joint development labs with key Chinese customers to expand our market share in this fast growing region. Our low cost filter drivers are also gaining market share in the LCD TV market as our products provide more cost effective highly integrated solution to our customers than previously available.

In the computing end market, we continue to expand our penetration beyond the CPU board with innovative DC solutions. We won a number of designs in PC and server memory subsystems, as well as in many storage applications with our latest low voltage regulation product.

We had another record quarter for sales in our analog switch product with revenues up 2% sequentially even with a week less in the quarter. During Q2, we won new designs in a variety of handsets, ultra portable and computer applications with these innovative products. Our micro-SerDes product line continues to gain important design wins, and we are now in production on eight different handsets. Our continued strength in these types of products, introduction and design wins will be a big part of our future success in the analog business.

Reviewing our functional power products, we had a strong quarter for design wins for our new low voltage MOSFETs and IntelliMAX integrated load switches. We continue to win designs with our latest low voltage switches in a variety of computing and ultra portal applications for our performance, efficiency and extremely small form factors are crucial to our customer success. Our advanced PowerTrench IV and V processes are a leading edge of low voltage MOSFET technology, allowing Fairchild to meet the most demanding customer requirements.

Our high voltage switches and integrated Smart Power Modules, or SPMs, are also gaining penetration in a variety of consumer and industrial applications. We won a number of designs with these products in advanced high-definition LCD plasma TVs during the second quarter, which will help drive our growth in the second half 2006 and into 2007.

Turning now to our end markets. Sales and order rates were solid in the most end markets with particular strength in product supporting industrial applications. As expected, we saw the normal Q2 seasonal slowdown in orders for our product support in computing end market. Overall, demand continues to be healthy and we ended the second half of 2006 with an excellent backlog position.

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

Mark Frey

Thanks Bob. Let me start with some of our financial highlights. We continued our steady improvement in margins in the second quarter. Looking at gross margins by product line, our Functional Power Group increased their gross margins 120 basis points due to new products, ongoing product mix action and manufacturing cost improvements. Our Analog Group recorded a240 basis point decrease in gross margins, due to a shift in product mix, inventory adjustment charges and the impact of reducing our factory run rate to adjust analog inventory.

We recorded strong sales and bookings for our power conversion products, currently running in about at the mid 30% gross margin range, which impacts our overall analog margin mix. We recorded the largest gain in standard products, up 410 basis points sequentially due to a combination of better product mix and pricing improvement.

R&D and SG&A spending were roughly flat with the prior quarter, as increased equity compensation and salary expense offset the impact of fewer days in the quarter. The combination of higher margins and disciplined spending enabled us to deliver a very healthy 13% sequential increase in second quarter adjusted net income.

Turning to the balance sheet. Internal inventories increased to $231 million to support our higher shipping rate, while weeks of supply remained roughly flat with the prior quarter at about 10 weeks. We generated $63 million in cash from operations, resulting in 523 million in cash and marketable securities at the end of the second quarter, down only $13 million even after we paid off 50 million in bank debt during the quarter. Our total debt minus cash and marketable securities, or net debt, decreased to $72 million at the end of Q2, the lowest level in our history.

We completed the refinancing of our Term B loan and revolving line of credit during the second quarter. And I was pleased that we were able to not only reduce our interest rate to LIBOR plus 1.5%, but also eliminate some restrictions on future potential strategic option, such as acquisitions or bond repurchases. We expect to save about $2.5 million per year in interest expense at current rates due to this refinancing.

Turning now to our forward guidance. We expect third quarter revenues to be roughly flat and gross margins to be flat to up 50 basis points sequentially. We have more than 90% of our guided sales booked and scheduled to ship in the quarter, and we’re comfortable with our guidance for what is typically a seasonally slower quarter. We expect R&D and SG&A spending, including equity-based compensation, to remain at about 21% to 21.5% of sales in the third quarter. Equity-based compensation expense is expected to be between $6 and $7 million, and we expect the effective tax rate to be approximately 15% in the third quarter.

Fairchild has a clear plan to transition our business to higher value analog and integrated power products, and we've presented straight forward business model targets for investors to judge our performance. We’re committed to making steady, sustainable progress towards these goals, and we look forward to building on our success over the last year, as we enter the second half of 2006.

Thank you. I’ll turn the call over to Dan now.

Dan Janson

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question will come from Craig Ellis.

Craig Ellis - Citigroup Smith Barney

Thanks and good morning, guys. The first question is on the segment gross margin performance. As I look at analog and functional power and standard product, it's counterintuitive given the industry on communication's revenue strength for the quarter. Was there something that was surprising on the analog business that developed intra-quarter, and can you quantify the inventory adjustment that impacted gross margins?

Mark Frey

I can't quantify the inventory adjustment. I will say that in the March quarter, Craig, we had very high operating leverage and growing to 40%, it was pretty much most of the stars aligned together. In Q2, our power conversion business became a much bigger part of the total mix and it has a lower than average gross margin profile and that -- [for that] watered down the total.

Craig Ellis - Citigroup Smith Barney

And did you see anything on the pricing side in Q2 in that business, or was pricing essentially flat quarter-to-quarter?

Mark Frey

I believe pricing --

Bob Conrad

There was not really a pricing driven impact there.

Craig Ellis - Citigroup Smith Barney

Okay. And then as a follow-up. Inventories were up on-hand about 8% in the quarter. How should we look at what you want to do with on-hand inventories over the course of the third quarter, Mark?

Mark Thompson

We're targeting inventories to be roughly flat in terms of weeks. So, we're targeting that for both, internal inventories and channel inventories.

Craig Ellis - Citigroup Smith Barney

Okay, thanks guys.

Operator

Thanks very much, sir. We'll now take our next question from Romit Shah. Please go ahead, sir, with Lehman Brothers.

Romit Shah - Lehman Brothers

Thanks. Guys, there is a lot of evidence recently that demand in the marketplace has slowed and historically Fairchild has been one of the first companies to see the weakness. Can you help us understand why Fairchild's business has proven to be more resilient this year, is it attributable largely to better lead times, content gains, and larger [SAM]? Thanks.

Mark Thompson

Well, I think it’s a piece of all of the above and, of course, you never really get to conduct a controlled experiment to know. But I think lead times is very key. We have managed to keep lead times in good control throughout this. And so, I think that creates better integrity in terms of what your backlog is. I think our dialog with all of our customers is much more active than I believe it's probably been in the past, so we have been able to see early when customers were making adjustments in demand levels and we are able to react in a timely way. So, when a certain piece of business got rescheduled, we have been able to go find somebody else who could use it. A lot of this tie to the supply chain changes that we have made in really having kind of cradle-to-grave view of the supply chain now. And so, I think all of those things have contributed to our improved stability of performance at this point in the cycle.

Romit Shah - Lehman Brothers

Okay. Mark, can you quantify the impact from the increased raw material cost on gross margins, please?

Mark Frey

Yeah, roughly -- first of all, the equity compensation is about 40 basis points, you could probably calculate that because we disclosed it. The combination of gold-polymer and actually Korean won currency impact is about a 100 basis points, if you compare back to say Q4, because these have been moving through Q1 and Q2. And so, there was an impact in Q1, but by Q2 it had accumulated to about a 100 basis points.

Romit Shah - Lehman Brothers

Thank you.

Operator

Thanks very much. And we will now move to Bill Lewis with JP Morgan.

Bill Lewis - JP Morgan

Hi, great, thank you. I guess my question is about the outlook, particularly on the revenue side, maybe somewhat related to some of the prior questions. I think typically is a kind of flat, slightly down quarter for you. You are getting flat, and you have kind of good guidance given the environment and given seasonality. So, could you maybe talk about what might be kind of doing a little bit better this quarter and if there is any kind of guidance you could provide on where the growth is going to come either by the product group or by end market that would be helpful? Thanks.

Mark Frey

What we -- as you said, Bill, we are guiding for basically seasonal, maybe a little better, and the reason for that is that we come in with what we think is a fairly good quality backlog. We've done a lot of work to scrub the backlog, and so, we are coming in as we said over 90% booked and scheduled to ship. The strength, well, we noted specifically that the industrial end markets we've seen not only strong sales in Q2, but also good booking trends there, so that’s going to we think perform pretty well. And then, as far as the other end markets, we expect a normal seasonality to play a role. As we noted, computing market has been a little softer, but that’s not unusual, that’s kind of seasonal. There have been some commentaries about LCD panels out there being a little softer. Again, that’s fairly seasonal. We would expect that to start coming back more as we go through the summer. So, our booking profile, our backlog positions gives us the confidence to schedule -- to guide what we have. And as we have said, we've been scrubbing that backlog pretty hard. So, we think we're in pretty good shape.

Bill Lewis - JP Morgan

Okay. And on pricing, could you quantify what pricing was in the quarter and what you're assuming pricing to be in the third quarter in your guidance?

Mark Frey

Well, pricing has been pretty moderate for the last couple of quarters, and we usually expect pricing to be down, say, 2% to 4% quarter-on-quarter, and it's been more flattish the last couple of quarters. And it looks like it's probably still kind of in that noise range right now, maybe being flat to down 1%. So, it continues the trend that we've seen in the last couple of quarters being pretty moderate.

Bill Lewis - JP Morgan

Okay, thank you.

Operator

Thank you very much. We'll now take our next question from Ross Seymore with Deutsche Bank.

Ross Seymore - Deutsche Bank

Thanks guys. Just a question on the gross margin, specifically in the standard products area, nice popup there, you told us why it happened. Just wondered how sustainable that is in kind of related gross margin question, the decrease on the power analog side of things, how do you expect that to play out going forward?

Mark Thompson

So the -- I think the short simple answer on how sustainable will that be for a downturn on standard products is, we don't know. And, I mean, certainly all of our businesses have been looking very aggressively at their product portfolios and have been pushing on higher quality business. Those products are all multiply sourced, and so, we do expect that they will have more pricing erosion during a downturn than the others. But we've changed enough fundamentals about the company that we don’t really have the data to trend the way we used to. So, I think we are just going to have to go through whenever a softening occurs and see how it does. We expect it to be better than historical, but we have no data to trend and to make estimates based on.

Ross Seymore - Deutsche Bank

Okay. And then a follow-up question, more on the demand side of things. Mark, at the Analyst Day you commented that, somewhat tongue in cheek, that the main reason you thought there might be a correction in semis is because of the stock prices rather than what your customers were saying. In the last three to four weeks, have you seen anything that brings the view of customers more in line with what the stock market is saying or has there been no change to that statement?

Mark Thompson

No, I would still keep the tongue in the cheek, but I would still make the same statement. We haven’t seen particular increase in cancellation rates. The -- normally Q3 backlog is fairly strong, people put orders on the books, since its quieter season, there is a lot of vacation in various parts of the industry and so forth. But, guiding flat as was noted in an earlier question is actually stronger than historical performance. A lot of things can happen, but based on what we see today, we feel quite comfortable with that guidance. So, while there are a variety of data points that have already been mentioned by folks in terms of LCD panels, handsets, and so forth, being a tad softer, we have not seen that materialize in terms of negative effect on order rates and overall health of our backlog at this point.

Ross Seymore - Deutsche Bank

Great, thank you.

Operator

Thank you very much. And now from Credit Suisse we have Michael Masdea.

Michael Masdea - Credit Suisse

Thanks a lot. I guess the first question is on the lead times. Given kind of the visibility that a lot of companies out there are dealing with, little bit shorter possibly, given some of the risks. Why not try to drive those lead times down even further, under 10 to 12 weeks, to reduce some of the risk out there?

Mark Thompson

We are driving them as low as they can go. I mean, we -- I think everyone would agree that lower is better. The boundary conditions for that are, how much do you want to spend on your capital. So again, we're trying to target, sort of, the center of probabilities. We think in the current environment that 10 to 12 is competitive stand. Certainly, if demand slackens, those will naturally go down. As we've, I think, consistently addressed in our past conversations with financial community, we are erring on the side of being conservative with our capital expenditures. And so, that is the one boundary condition. So, we are constantly readjusting those things. We do a re-crank on -- we essentially re-plan the company once a week, as we go through this. So, we'll continue to manage it, but we believe that our current state is competitive and strikes a healthy balance between being cautious on capital and maintaining a good visibility with our customers.

Michael Masdea - Credit Suisse

Thanks. And then on the 15 million of push out and cancellations that you, sort of, said you dealt it. Can you talk about the timing of when that happened and was that related to the adjustments in lead time that you guys talked about?

Mark Thompson

That was -- that's a project that we run now couple of times a quarter, where essentially what we do is, we track at what we regard is abnormal order rate, which are higher than somebody ramps their rate more than a certain amount above historical demand. It causes a little system alarm bell to go off, and then we dispatch a team of customer, service and our sales folks to go talk to them and say, why are you putting these orders on the books, what are your end programs. If there is not substantial evidence of end program, then we negotiate with them to not take those orders or de-book them or push them off into the future some place where we can deal with them at another time. So, that’s an established part of our backlog management process now. We do it at least twice a quarter. We just in fact did a very aggressive one at the opening of Q3 to make sure that our backlog -- we had as much visibility in the backlog with this high quality as it could possibly be.

Michael Masdea - Credit Suisse

And I guess, probably I am trying to understand is, why you think that’s occurring? Is there a certain end market or is there -- there was a lead time pop out in that area or do you think its just aggressive customers or what?

Mark Thompson

I think there is a mix of cause for why peoples order rates, in some case they think they may be able to get some business in the future, but they don’t know where it is. Some cases, frankly it's been on the stake on their part, and so just a little bit of all of the above.

Michael Masdea - Credit Suisse

Great. Thanks a lot.

Operator

Thank you very much. And now we'll take question from Steve Smigie with Raymond James.

Steve Smigie - Raymond James

Great, thank you. Giving the high level of backlog you have in the quarter, and I guess the weakness you are seeing in the equity markets, are you being a little bit cautious in terms of your guidance? I know, it's little better than seasonally, but is there some potential upside there as well?

Mark Thompson

Well, certainly there is upside potential in it. It's always our goal to emerge on the high side of guidance or beyond. But our guidance is chosen carefully, so that we believe that barring some unforeseen circumstance, we can deliver the guidance that we commit to the financial community. So, yes, there is upside and we will update, of course, as Dan pointed out in September, if we feel more confident that we can deliver the upside. Then at that time we will adjust our guidance.

Mark Frey

As you know, Steve, the summer months are usually the slower months. So, it's prudent that in this quarter not to get too aggressive until you get through those couple of summer months. And so, we have got a good backlog coming in the quarter and we will see how the summer months play out.

Steve Smigie - Raymond James

Okay. Turning back to the gross margin on the standard products. Could you give us some sort of sense in normalized environment where you guys might be able to get that to, say, over the next 18 months or so or two years.

Mark Frey

I believe at our Analyst Day conference we presented to you a model that had a range between 23% and 27% for the current Standard Product Group. There are strategies of making the group smaller through a more aggressive mix out and getting that gross margin target closer to 30%, but we really haven’t finished the process of deciding which course would be most advantageous to us.

Steve Smigie - Raymond James

Okay. I think one of your comments on the improvement there was some mixed improvement. Was that more a decision of customer coming in and taking specific parts of higher margin or again more of your efforts to mix out some of the other parts?

Mark Frey

I think it was both. We certainly had some active mix out activities during the quarter and we had some within the product lines a shift to some favorable products for us.

Steve Smigie - Raymond James

Okay. Our last question was just on the lead times. Was there -- could you comment on the lead times in the particular categories over lead times much longer in standard products versus the analog, for example?

Mark Thompson

It’s the mix. Certainly we've tried to give the slots in production to analog at the expense of standard products. So, certainly I think our single highest lead times are in -- actually that’s not correct, the mean for standard products is higher than analog. So it does tend to be higher, which has also pushed us up, pushed the team towards mixing some of those out.

Mark Frey

I mean, we addressed kind of the spot spikes in lead times on an ongoing basis. We've had a couple of examples in the analog world. Bob mentioned, for example, power conversion. You've seen some lead times jump out there on power conversion, because the demand has been so strong. So, we are actively working that. We work it both, in the back end, as well as selectively adding capacity in the fab. So, it's an ongoing process. I think we've been pretty vocal about our desire to keep analog lead times down around 10 weeks or so, and we are probably a little above that now, but we've got the actions in place to get them back where we want them to be.

Steve Smigie - Raymond James

Great, thank you very much.

Operator

Thank you. We'll now move to Tore Svanberg with Piper Jaffray.

Tore Svanberg - Piper Jaffray

Could you talk a little bit about the linearity of your bookings last quarter? Are you there?

Dan Janson

Sorry, we're -- we're just thinking.

Mark Thompson

We are trying to --

Dan Janson

I think we are trying to think was there anything that was really unusual.

Mark Thompson

Yeah.

Bob Conrad

Dan, I guess, at least for analog, it was quite linear with the only perturbations being what Mark talked about in trying to go work areas of backlog where were concerned it was too high. And, we are working to manage it down, but it was pretty linear for analog.

Tore Svanberg - Piper Jaffray

Very good, and it looks like you're assuming about 10% turns this quarter. Just looking back in history, is that usually the level of turns you would get in the September quarter?

Mark Frey

Did you say the September quarter?

Tore Svanberg - Piper Jaffray

Yes, 10% turns, yes.

Mark Frey

I think traditionally we would get more turns than 10%.

Mark Thompson

Yes. I mean the way I would look at turns story, it’s a function of where our lead times are. Obviously, if we’ve got 6 week lead times, we can do more turns in the quarter, because we have more opportunity to book and sell. We’re sitting at, as we said, between 10 to 12 week lead times right now. So, having more than 90% of what we have scheduled to ship on the books is probably a good number. That makes sense given where our lead times are at.

Tore Svanberg - Piper Jaffray

Great. And then just finally, looks like you're going to maintain your utilization rates where they are next quarter. Could you remind us where they are in certain parts of manufacturing?

Mark Frey

The low to mid 90% level. That will adjust because we are selectively adding capacity in certain areas where we have higher demand.

Tore Svanberg - Piper Jaffray

Great. Thank you very much.

Operator

Thank you. We’ll now move to Tristan Gerra with Robert W. Baird.

Tristan Gerra - Robert W. Baird

Good morning. Could you single out the impact of the raw material increase on your gross margin for the second half? And then you mentioned 100 basis point impact in Q2. Could you tell us again what this included?

Mark Frey

The 100 basis point included the changes in raw material prices, primarily polymers and gold, both directly and as those prices filtered through our subcontractors. It also included an estimate of the effect of the strengthening won on the conversion of our cost in Korea where, as you know, we have a very substantial operation. And what was the first question? Again the raw material --

Tristan Gerra - Robert W. Baird

To get a sense of the raw material impact on gross margin in the second half?

Mark Frey

We think the price resettlement has run most of its course. There are a couple of subcontractors that we had longer contracts with, and we don’t know what the renegotiation with those subcontractors will be. But by and large, we've seen the won stabilize. Gold has actually come-off of its peak, and we're still watching them carefully. So, there will be a much smaller ongoing impact and they are already baked into the historic numbers.

Tristan Gerra - Robert W. Baird

Okay. And then what about stock compensation specifically?

Mark Frey

That actually will -- it was 7.6 million in second quarter and 1.7 million above the line, which is about 40 basis points. That will come down slightly. We had some special items in the second quarter and the nuances of forfeiture patterns and vesting patterns effect that and we would expect that, as I say, to moderate slightly in the third and fourth quarter

Tristan Gerra - Robert W. Baird

Okay. And then the last one, could you remind us what is the benefit of your new depreciation policy and gross margin versus Q1 on last year?

Dan Janson

So, year-over-year change, it was 2 to 3 percentage points, yes.

Tristan Gerra - Robert W. Baird

Great. Thank you.

Operator

And moving on, we'll now take a question from Michael McConnell with Pacific Crest.

Michael McConnell - Pacific Crest

Thank you. I was wondering if you could quantify the increase in backlog sequentially in Q2.

Mark Thompson

Mike, we don’t normally give out specifics on backlog. What we will say and what we have said last couple of quarters that we have continued to build backlog and Q2 was no exception to that. We did build backlog during the quarter.

Michael McConnell - Pacific Crest

Okay. So I guess, looking at this year, building backlog you are seeing some over ordering from customers. Do you think that the overall ordering from end customers is occurring because you are trying to raise price right now? And so they are trying to get the products earlier before the price hikes take effect or anticipating future price hikes?

Mark Thompson

I don’t think that’s the dominant element. I think if we were to [ferredo] the root cause of some of the over orderings, I don’t think there is any one specific thing. Certainly, there always is some speculative buying in the distribution community. They buy and resell, so it that’s a natural thing. But I don’t -- I certainly don’t -- we don’t see, for example, it's not correlated necessarily with places where the biggest price moves have made. So, I don’t really think that’s a primary driver of it.

Michael Masdea - Credit Suisse

Okay. And then the -- is it primarily occurring in that standard product segment where you've seen the lead times little bit longer?

Mark Thompson

No, not at all. In fact, it's been primarily concentrated in the analog and in FPG.

Michael Masdea - Credit Suisse

Analog, okay, and FPG. Okay, great.

Bob Conrad

Yeah, I mean, and specifically in analog, Mark Frey mentioned a little bit of a mix shift. Our power conversion or offline power business grew strongly quarter-on-quarter about 7%, and that’s also where the backlog has been the strongest and where we've worked the backlog the most and where our lead times have long estimates. Centered around, obviously, we're actually gaining share, especially in China. But in addition, we've had some very specific package constraints, and as Dan alluded to, we've taken action on those. They get all results through the back half of the year.

Michael Masdea - Credit Suisse

Okay. And then, could you just remind us, what type of cancellation window your customers have with you, the backlog? Is it 30 days?

Mark Thompson

Yes, that’s most of it, would be 30 days.

Michael Masdea - Credit Suisse

Okay. Thank you very much.

Operator

Thank you. And we will now hear from Eric Gomberg with Thomas Weisel Partners.

Eric Gomberg - Thomas Weisel Partners

Hi, thank you. You commented earlier that PC was weak in the second quarter, which is pretty well known. I didn’t quite understand if you expect PC to be up sequentially in the third quarter, and maybe you could give a sense of on flat guidance, which end markets should be higher sequentially and which would you expect to be lower?

Mark Frey

Well, we are not counting on computer, changing its patterns in Q3. I think we're seeing the continuation of strong demand in industrial areas. Those are probably the two extremes on the more cautious and on the more aggressive side for us.

Dan Janson

Yes, that’s a good way to characterize it. I mean, as we said, we noted that demand on the PC side was little softer in Q2, and so clearly the bookings in Q2 are going to impact what we'll ship in Q3. So, I think you can read that one. We also mentioned that industrial was stronger. So we would expect industrial to continue to be strong in Q3. And then, the other end market is pretty much in line with normal seasonality.

Eric Gomberg - Thomas Weisel Partners

And, which would you expect to be stronger, standard products or analog in the third quarter?

Mark Frey

From a revenue standpoint?

Eric Gomberg - Thomas Weisel Partners

Yes. I mean, either -- would you expect them in terms of sequentially flat down which -- if any difference, which --

Mark Thompson

The analog is definitely stronger than standard products in terms of quarter-on-quarter growth.

Eric Gomberg - Thomas Weisel Partners

Okay. And just one other question. It sounds like maybe demand is leveling off somewhat. Should we assume that it might limit near term margin expansion? Should we model the out quarters with more of a flattish gross margin versus additional near-term expansion?

Mark Thompson

So, I mean, we would certainly -- there is the couple of pieces to this. I guess if I started with the conclusion and work back. Yes, we are being cautious about the opportunities for gross margin expansion during the back half of this year and feel much more confident in the timing for some key programs that are going to improve the slope of that rate coming in, in the first half of 2007. So, that’s our current expectation. Again, if you look at the way this has played out versus some of our earlier communications, we made earlier gains faster than we thought we would, and I think that’s inevitably causing the back half of this year to have a lower slope and we have a number of key programs that we believe will really accelerate that again in the first half of next year.

Eric Gomberg - Thomas Weisel Partners

Is there no chance to say the mid 30s gross margin target for next year?

Mark Thompson

No, our strategic targets remain as we have articulated them. But, of course, as we update and the plans become more specific and the programs more concrete, inevitably it moves from a straight line to having a little bit more of a saw tooth character.

Eric Gomberg - Thomas Weisel Partners

Okay. Thank you.

Operator

And, Quinn Bolton from Needham and Company has our next question.

Quinn Bolton - Needham and Company

Hi, just wanted a follow-up on two points. One, just the revenue guidance being sort of flattish sequentially, probably you're not going to get a big boost from increased utilization rate. So, was sort of curious as to where the potential 50 basis points, high end of the range is coming from in terms of gross margin improvement. Is that your sort of better mix recovery in analog, or could you just sort of discuss what might lead to gross margin improvement on kind of a flattish revenue outlook?

Mark Thompson

Yeah, it would be primarily mix driven.

Quinn Bolton - Needham and Company

Okay. To some of-- again, recovering in analog or just within each of the product families?

Mark Frey

No, I would say it would be quite distributed across the product families.

Quinn Bolton - Needham and Company

Okay. And then the second question is, with your lead times 10 to 12 weeks, I'm assuming most of your turns business has to be done in the month of July to, sort of, get that on the books to be able to ship by quarter end. Is it sort of the risk in the quarter that you actually see debookings through August and September, or do you end up seeing just because of the backend load in the quarter that you can actually book and ship, a fair amount of business in the month of September?

Mark Thompson

The primary risk to the quarter, and I'll call risk here in terms of risk the guidance, would be in -- an excel -- increase in the rate of de-bookings and rescheduling versus our current trends.

Quinn Bolton - Needham and Company

Okay, great. Thank you.

Operator

And we'll now hear from Ambrish Srivastava with BMO Capital Markets.

Ambrish Srivastava - BMO Capital Markets

Hi, good morning. Two questions, Mark, about the scrubbing process. Is this something that you have initiated since you had been there, because I’m going back to two years ago and just to the press release you guys had about the volatility in the backlog? The second question, where are you adding capacity and what specific design wins or end markets are supporting your conviction that you need to add capacity? Thanks.

Mark Thompson

Well, actually a couple of things. First is the process that we're using to scrub backlog is new, and in fact we really piloted it maybe two quarters ago and have been as with all of our processes doing an active check, update, improve process on it. And, Fairchild employees are no longer permitted to say the word volatile. So, in application or anything at all, so it has to come up -- go to their thesaurus if they want to describe uncertainty.

Ambrish Srivastava - BMO Capital Markets

Where are we adding capacity?

Mark Thompson

Well, capacity is being driven by our strategic programs with our key accounts. So, we've talked, for example, in places like micro-SerDes where we have a number of design wins, we have new phones going into production, and that's one example of where we've put quite a lot of new capacity in place in order to meet the demand of those customers. Other examples are in some of our power MOSFETs, like the PT VI and PT V technologies that Mark referenced earlier. Those are getting very good acceptance in a broad set of markets and those are places where those are strategic businesses important to our customers, quite profitable to us and are the places where we are strategically adding. So, in general the capacity additions are being driven directly by key focused programs that are Tier 1 OEMs.

Ambrish Srivastava - BMO Capital Markets

Okay. Thank you.

Operator

And we will now hear from Craig Berger with Wedbush Morgan.

Craig Berger - Wedbush Morgan

Good morning. Thanks for taking my question. Real quickly, just a couple of tactical things here. On OpEx, you guys basically guided to flat, as we move into out of Q3 and into Q4 and beyond, should we would be thinking about that 21% to 21.5% range being pretty standard or what's your spending growth plan? Thank you.

Mark Frey

Well, it will vary obviously with how we are performing, because our bonus and our equity compensation will vary with delivering results to shareholders. As you know, at our Analyst Day, we presented a three year target to get combined operating expenses, including equity compensation, to around the 20% range. And so we look for opportunities to make progress towards that, and that will not be linear either. But, we on an ongoing basis will try to grow our OpEx slower than our revenue.

Craig Berger - Wedbush Morgan

Great. And then with respect to taxes, I apologize if you guys addressed this, 15% for Q3, is that your new standard tax rate or what's going on there?

Mark Frey

Well, I hesitate to ever articulate around standard tax rate. Let me remind you that the tax rate derives from where we make our income. As you know, we wrote-off our deferred tax asset last year that was $195 million. And so, as we make income in the US, we have a zero tax rate until we claim those assets. We have a tax holiday in Korea, which is disclosed in our 10-K and we pay about 6% income tax there. So, that creates a weighted tax of -- and it can vary, it depends on where we make our income of about 15%. And there is fairly large, it's not a narrow band, it's just a variability band, because it’s a result of combination of special items which almost always occur across quarters and where we jurisdictionally make our income. Is that what you are looking for?

Craig Berger - Wedbush Morgan

Yes. One -- just one brief follow-up on that. Mark, what number should we be using for '07?

Mark Frey

I am not guiding past '06. But if you look at the underlying contributions to tax rate, we would have to make a lot of income in the US, as you can imagine, to work all the way through those tax write-offs. And in Korea, our holiday will notch-up in expenses to about 15% next year. So, you could factor something in for that.

Craig Berger - Wedbush Morgan

Great. Thanks and nice job.

Operator

And we will now take our first follow-up question from Craig Ellis with Citigroup.

Craig Ellis - Citigroup Smith Barney

Thank you, just wanted to cycle back on inventory. For the build in the quarter, can you just identify how much of that would have been either finished or raw? And then secondly, how should we think about to build across the three product segments, functional power, analog and standard products?

Mark Frey

On the breakdown it was primarily WIP and finished goods. There was some amount of raw materials across product lines. It was weighted towards analog, I believe, with number two being the functional power.

Craig Ellis - Citigroup Smith Barney

All right. Thanks, Mark.

Operator

And we have another follow-up question from Tristan Gerra with Robert W. Baird

Tristan Gerra - Robert W. Baird

Hi, again. You mentioned that gross margin expansion will slow down a little bit into second half versus the first half before picking up again early '07. Could you expand on why that will be? I mean, if we look at the pricing environment, it looks to be pretty stable. So, we are not going to really see an impact -- or incremental impact here in the second half. And also in terms of your new products, included in cell phones, it looks like you're still pretty at early stage of the ramp. And so, I'm just wondering what will have really helped the first half potentially at the expense of the second half in terms of gross margin expansion.

Mark Thompson

Okay. So, let me try to comment on some of the elements that went into what we just described. So, it’s the case first that the thing we have tried consistently to do is to deliver -- to offer guidance to the finance community that we feel very confident that we know how to do. And so, we aren’t -- we tend -- we'll naturally tend to be a little bit conservative in terms of thinking about the events that will occur. The mix out process that was, if you look at the two components that drive margin. One, our strategic programs where the overall quality of the product, the importance for the customer, and therefore the opportunity to make margins tend to be slow to occur, their new product development, their design-in on new platforms and they tend to be slower. The mix out piece where you are simply taking your current business and optimizing the better business against the poor margin business, it tends to be faster. So, when we put our models out for people about how to think about Fairchild, there were a lot of very key programs that were beginning to hit during this year. But we are really going to hit in 2007 in volume in a sort that can really move the mix of 1.6 plus billion dollar business.

What occurred was that the mix process got acculturated within the company more rapidly than we anticipated, and so we made -- what was going to be a kind of straight line across the year, wound up getting pulled in and front-end loaded. So what that means is that the natural process of the low hanging fruit on the margin distribution piece has largely been harvested, and so that piece will naturally slow down, and while it gets caught up by the key strategic product platform piece, which is slower. So, it's really a timing thing. It's not at all a statement that, everybody has one with this in the sense of we have the dollars of income earlier than we thought, but that just means that the rate of improvement will slow down for a little while potentially over the next -- over the back half of this year.

Tristan Gerra - Robert W. Baird

Great, that helps a lot. Thank you.

Dan Janson

We have time for one more question please.

Operator

(Operator Instructions). And Dan, it appears to be the last one. I'll go ahead and turn the call back over to you.

Dan Janson

Excellent. Well, thank you very much for all of you for joining us. We appreciate your attendance.

Operator

Ladies and gentlemen, if you wish to access the replay of this conference, you may do so by dialing 888-203-1112 or 719-457-0820 with the pass code of 8634884. This concludes our conference for today. Thank you all for your participation and have a great day. All parties may now disconnect.

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