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Cypress Semiconductor Corporation (NASDAQ:CY)

Q1 2006 Earnings Call

April 20, 2006 11:30 am ET

Executives

T.J. Rodgers - President and CEO

Brad Buss - CFO

Chris Seams - VP Marketing, Sales and Manufacturing

Ahmad Chatila - VP Memory and Imaging Division

Norm Taffe - VP Consumer and Computation Division

Dinesh Ramanathan - VP Data Communications Division

Analysts

Michael Masdea - Credit Suisse First Boston

Chris Danley - JP Morgan

Alex Guana - UBS

Craig Hettenbach - Wachovia Securities

Tim Luke - Lehman Brothers

Louis Gerhardy - Morgan Stanley

Doug Freedman - Amtech Research

Sandy Harrison - Pacific Growth Equities

John Quarles - Citigroup

Srini Pajjuri - Merrill Lynch

Adam Benjamin - Jefferies & Co.

Presentation

Operator

Good morning and welcome to Cypress Semiconductor's First Quarter Conference Call. Your line is on a listen-only mode until the question-and-answer segment of today's call. This call is being recorded. If you have any objections, you may disconnect at this time.

I would now like to turn the call over to Mr. T.J. Rodgers, President and CEO of Cypress Semiconductor. Thank you, sir. You may begin.

T.J. Rodgers

Good morning. We're here to report the first quarter results. We'll do finances from CFO, Brad Buss first, then markets from Chris Seams. Then I'll make a few comments, brief ones, and we'll get on to questions. Brad?

Brad Buss

Thanks, T.J. Good morning and thanks for attending our call. I just want to start off with the usual safe harbor that we will be making forward-looking statements. They do entail certain risks and we please refer you to our SEC documents.

So Q1 got off to a good start. We had $249.1 million, which exceeded our prior guidance. We grew 4.5% sequentially and a strong 24.4% on a year-over-year basis.

On an adjusted GAAP basis, which excludes stock-based comp charges, intangibles and other acquisition-related and restructuring charges, we achieved a net profit of $10 million, which resulted in diluted earnings per share of $0.07. This compares with our profit of $5.8 million in the prior quarter, which was a $0.04 earnings per share and a significant improvement from a loss of $0.19 in the prior quarter of -- or the first quarter of 2005.

On a GAAP basis, we achieved a net profit of $7.1 million, which resulted in diluted earnings per share of $0.05. There's a few notables in the quarter for GAAP. As you all know, the stock-based comp charges came into effect that was $10.7 million. We also had a $10 million gain on the sale of investments. We had a one-time gain of $6 million related to the NSE sale and we had our usual charges related to the amortization of intangibles and other acquisition charges from the past.

On a comparative basis, the loss per share in the prior quarter was $0.02 and the year-over-year quarter it was $0.53. Our adjusted GAAP gross margin increased almost a percent up to 41.9% and our semiconductor margin was 46.9%, up nicely from 44.1% in Q4 and it was mainly driven by improvements in our CCD and MID divisions and we're continually focused on achieving our 50% target.

Adjusted GAAP operating expenses on a dollar basis, which includes R&D and SG&A grew modestly by only $1.9 million from the fourth quarter and R&D as a percentage of revenue is at its lowest level since the first quarter of 2001 and SG&A as a percentage of revenue is at its lowest level since the second quarter of 2004. We continue to be intensely focused on driving OpEx towards our business model.

Net inventory was $84.3 million, up from the prior quarter as we continue to strategically build inventories that have been too low over the last few quarters. Days of inventory were at 52, up slightly from 48 and are still south of our model of 65. CapEx was $37.5 million for the quarter and included approximately $20 million for SunPower manufacturing build-out. Depreciation for the quarter was $26.9 million.

Our cash balances continued to grow and totaled $414 million, an increase of $20.7 million from the fourth quarter. And, just as a reminder, that balance does not include approximately $59 million in proceeds from the sale of our investment in NetLogic, which did not settle until April.

Now I'm going to move on to guidance for Q2. Our consolidated revenue is expected to be up in the range of $257 to $262 million. Consolidated gross margins of 42% to 44% and semiconductor margins of 47% to 48%, both of obviously, which are subject to vary with product mix.

Adjusted GAAP EPS of $0.08 to $0.10 and, in summary, I just want to thank the entire worldwide Cypress team for a solid execution during Q1 and a great start to 2006.

I'll turn the call over to Chris for a discussion of our markets.

Chris Seams

Thanks, Brad. Let me cover some of the usual market indices for the first quarter and then I'll turn the call over to T.J. for the details. In terms of revenue split by geography, Asia remained our largest market. It was 43%, which was down from 48% prior quarter. North America was 27%, which was up 24% in the prior quarter. Both of those changes were really driven by the growth in SunPower. Europe and Japan remained relatively flat 20% and 10% of sales.

No one customer was greater than 10% of our sales. Our units were slightly down, 182 million units, which was down from the record prior quarter of 188 million. Our ASPs rose modestly to $1.04, up from $1.02 in the prior quarter. Our demand remains very healthy.

Our book-to-bill rose to 1.07, up from 1.03 in the prior quarter and our six month backlog grew to $312 million. That's up from $288 million in the prior quarter. Both of those were driven by strength in memories where the lead times were stretching out into the next quarter, driving the backlog up. We entered this quarter 82% booked, which is relatively flat from the last quarter.

Now let me turn the call over to T.J.

T.J. Rodgers

First, to break down the finances a little bit by business units or by divisions, the revenue of $249.1, the leading division was CCD with $89.2 million, 36% of sales, followed by MID, Memory and Imaging, $76.2 million, 31% of sales.

SunPower was third. They moved from fourth to third place among our divisions, $42 million in revenue, 17% of sales, and Data Com, $32 million, 13% of sales. In terms of gross margins, Data Com posted a 63% gross margin, followed by CCD with a 51% gross margin and MID with a 34.2% gross margin.

We calculate contributions to earnings per share of the various divisions. So our $0.07, if you look at the profit of the divisions, with all of the OIE and other in it. So we take the divisions to a full reportable-- publicly reportable P&L. If you look at the contribution to earnings and earnings per share, MID lost $0.01 per share and that was a combination of making $0.02 per share on the memory business, the static RAM business, and losing $0.03 per share on the imaging sensing business, where we had $7.4 million in revenue but very large R&D expenses and a net loss of $0.03 per share. Data Com contributed $0.02 per share. CCD, Consumer and Computation, contributed $0.05 a share, SunPower $0.02 a share.

The two biggest changes from the prior quarter, Memory and Imaging went from minus $0.05 to minus $0.01, so that was a gain of $0.04. And SunPower increased from $0.01 to $0.02, so that was an increase of a $0.01. We expect both of those two groups to contribute more next quarter.

A few product notes. I cut them down a little bit this time. First of all on CCD. They had a success at Pentax. They're in the Pentax digital still camera, which is always a good design win for us. PSoC showing its versatility in the Shake Reduction system where it takes the input of two gyroscopes and creates the electrical signals to drive the voice coils to keep the camera moving in the -- the lenses of the camera moving in the opposite of the jitter in your hand.

Our Lucky Goldstar put us into a consumer air purifier. That's important because we're in a bunch of Lucky Goldstar cell phones, but it demonstrates one dynamic we're learning about PSoC and that is that with programmable analog technology, the first design win is a big one. It takes a while to get in and once you get a few zealots in a corporation, then the design wins start coming more for free. And at Lucky Goldstar, we've started to penetrate and get a bunch of consumer wins.

In the USB world, we worked with a company called AuthenTec and we created a USB-based fingerprint security device, which will allow fingerprint security to go into a USB device for $7.

In Data Com, as you heard, we sold the NSE business. We actually turned it into cash. The nominal value of the sale was $50 million, but the benefit to the party, to NetLogic apparently pleased their shareholders and we ended up netting $59 million from the sale and we actually are holding some stock in escrow, which will net us $5 or $6 more million down the line when that escrow closes out.

I'd also like to remind everybody that although we are no longer developing network search engines or CAM, we kept the entire CAM line, which is the bulk of our sales to Cisco, and we are in the process of cutting down that division to a legacy group that should be able to make decent money when they're not investing the huge amounts that are required to do CAM development.

In Memory and Imaging, we have two image sensor points of notice. First of all, we have a product called the LUPA-3000 [sic LUPA-300]. The reason I'm talking about it is because we won product of the year from a group called analogZONE. The reason is that this product has a very high frame rate which something called a snapshot shutter. It's a very specialized device and it is pretty unique in its space.

We also -- I talked about it in the annual report, put the night vision sensor in the Mercedes, which, although it's not a huge dollar win for us, obviously gives us some premium position in the automotive imaging space, which is one of the three biggest spaces in imaging.

And finally, we introduced a RAM that's called a 72 megabit Quad Data Rate II+ RAM. That long acronym is important. Quad Data Rate is the RAM which is -- has separate inputs and outputs and has double data rate, meaning it's a data transaction on both the upswing and the downswing of the clock. Two ports times two transitions per cycle, four times the data rate -- Quad Data Rate. That RAM, which we co-invented with two other companies, has become the industry standard ultrahigh performance RAM in routers and in very high performance computers. And we've created -- there was a first generation and a second generation. We've now created a II+ generation, which we're the first one to market, in response to requests from our customers to tweak that last little bit of performance. It'll give us a temporary advantage for two or three quarters where we'll be able to get for products like I said, in excess of 50% gross margins.

And finally, SunPower two points, as noted. One is the Board of Directors of SunPower approved its second plant through SunPower, a 200-megawatt plant that will sit next to the 100-megawatt plant that is currently being built out in Manila, taking SunPower's nameplate capacity from 100 to 300 megawatts.

And then finally, a bullet that is not in the press release, but sort of late-breaking news, SunPower's next generation cell beyond the one we make is 20% efficiency. It will be 22% and they actually did product their first working 22% cell in the quarter.

Those are the only ones I wanted to highlight. We're ready for questions. Michelle?

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). Michael Masdea, you may ask your question.

Michael Masdea - Credit Suisse First Boston

Yeah. Thanks a lot. Let's see, I guess the first question is we've had a lot of noise about lead times moving out and coming back in and concerns about inventory and then a lack of concern. What's your take on everything and what's, more importantly, the customer mentality out there? Is it moving around as much as the sentiment is?

T.J. Rodgers

Let me take a high-level swag at that one. Actually, Chris, you go ahead. You're more in the war than I am.

Chris Seams

Yeah. We're seeing the lead times stretch out, as I mentioned within memories and obviously, that some market has a heritage of some ups and downs and maybe some bookings that aren't quite real. We are stretched well out. We are running our factories just like we like to, which is giving proprietary products everything that they can take and then filling the rest of the factory with memories. So, memories are tight now. Everything else seems to be in control.

Michael Masdea - Credit Suisse First Boston

Do your customers feel okay kind of with the response times you guys have now and it's more comfortable out there?

Chris Seams

No, they could be happier and we're working with them to keep them happy and lined up. They'd like a little bit more inventory than we're giving them.

Michael Masdea - Credit Suisse First Boston

Great. And then you guys have done a good job of recently looking at your business and making decisions on whether to have capacity internal and what businesses to keep and get rid of, etcetera. Any updates there? Or is it kind of as is for now and you're feeling pretty comfortable on the business review front?

T.J. Rodgers

Sure. I'll make a couple of comments. One of the things that's hurt us in the past is that as we take swings like the Grand Canyon 2000-2001 and then the other peaks and bumps is that if you make every wafer that produces revenue close to it, you end up hiring and laying off people at a rate that is faster than you can assimilate and train people. And you end up always being ramp-rate limited on the way up and always having too many people on the way down. So, we have decided to go outside to alleviate the problem so that we can go into a foundry and have the swings in capacity not jack our internal fabs around so much. That's point one.

Point two, that's related to it, that move has been facilitated by the fact that for the first time in history Cypress was able to buy wafer outside for some technologies, underline that point, for some technologies, as cheaply as we can make it inside. Now that, of course, total cash cost outside versus fully loaded cost inside and, therefore the cash cost outside is higher than inside. But the dynamic that's produced there is that the first generation of high-tech fabs in China is now five years old, is now obsolete for making the dynamic RAMs for memory that they were put together to make and, therefore, all of a sudden, they've got a one acre fab that's really nicely done, that's capable of making 130-nanometer products with very high yields and quality, but there's no memory business any more and they're going, holy shit, we better get ourselves some product. And, therefore, they're dropping prices to attract guys like us and we are putting our N-minus-2 node, 130-nanometer node technology, into them for prices that are as good as inside.

So that's one thing that's happening. It's extremely important to me. We are a semiconductor company, we make those. I just came back from Shanghai and I just did an operations review in Shanghai for the fab, went over right down to the minutiae of detailed densities and cycle times and line yields and stuff like that and I found a one acre, and I'm not exaggerating, a one acre clean room full of state-of-the-art equipment for 130 nanometers. So, it's a big opportunity. They're very happy to have us as customers and we will build on that partnership going forward and also, I think, unless there's some sort of huge downturn I don't see, I'll be able to keep our fabs loaded, which is always a profitable situation for us going forward.

On the divestiture front, we continue to evaluate the businesses that either aren't strategically aligned or are chronic financial underperformers and we are prepared to focus ourselves and depend on some of those businesses. I'll mention only one of them because we are active on it right now and that is the dynamic RAM business.

Ahmad Chatila runs Memory and Imaging and, therefore, this dynamic RAM business, which is a pseudo-static RAM with a dynamic RAM core, reports to him. Can you talk about DRAM please?

Ahmad Chatila

Yes. So this business right now is profitable for us, but it's not aligned with our manufacturing and sales and research and development infrastructure. So, we are at this time in discussion with many groups, including investors and other companies to divest this business. And we expect this to have a very positive impact on Cypress in the long run.

T.J. Rodgers

So, we will do one of two things. The business is actually being quite well run and it has actually made money for the last two quarters. Now it's kind of money we aspire to make, but nonetheless it's not detracting from our bottom line. So we think it's a good time to sell it. We've got some good new product. If not, we will simply go into the harvest mode in that business, completely remove R&D and other expenses from it and take the products we've got and run them. We can do that because these DRAMs, unlike personal computer DRAMs, which have a short life cycle and are always going to the next generation, these DRAMs for cell phones are pretty specialized. Cell phones don't really have Moore's Law kind of needs for more and more bits of memory. So, these DRAMs have a lifetime of two to three years. So, we'll either sell it or we'll go into a harvest period, a two to three year harvest period. That's the one that's on, the next on the radar screen.

Michael Masdea - Credit Suisse First Boston

It was very helpful. And maybe a quick product one, just to follow that up, before I go away. The CMOS image sensors, a lot of people look out there and they see a big DRAM company making those and you're still in ramp mode, but longer term, help us understand what your true differentiation is going to be and if you have any kind of concerns about competing against the kind of the big fab-heavy companies out there or at least one of them making that product?

T.J. Rodgers

Well, I wish I'd have enforced the one or two question rule before you asked that one. The fact is, we bought ourselves a couple of image sensor companies, one in Boston and one in Belgium, at the time when our fabs were empty. They're no longer empty. They're full in order to use trailing edge capacity to keep them always focused on making image sensors. So the fact is, the small companies we bought were not capable in the first year after we bought them of getting us into the cell phone image sensor business, which, as you point out, absolutely correctly, is -- has been turned into the DRAM business by that big DRAM company in Boise, Idaho, that I admire very much. Therefore, if you look at taking capacity that you don't have and making a product that's difficult to make for prices that are difficult to achieve in a market that's dominated by a competitor that lives in a low-cost area, you start to ask yourself, why am I doing this to myself? At that time, you start asking what are my core competencies in this area and how can I make money doing things that are better and more inventive?

That is the reason I made that sort of arcane point this morning about the LUPA-300 being the product of the year. So, the high-level answer to your question is, we're exploring value-added areas of the image sensing business where we have core competencies that are different from mass market chips for cell phones.

So, a cell phone chip, just to give you a little technology flavor, is four transistors. A cheaper chip with less image quality is three transistors. Cypress makes chips with five and six transistors per pixel. Six transistors per pixel allows you, in effect, to shoot motion pictures. Five transistors per pixel allows you to shoot a picture with a moving camera in which the squares, as you move along, don't get blurred into rhombuses, crooked squares, because of the motion of the camera and the shutter that moves across the pixel. We're capable of making cameras with very high frame rates, not 30 frames per second like the cell phone aspires to but 1000 frames per second. So, we are currently looking at a bunch of markets, security, automotive. We have particular competence in automotive. Our group in Cambridge spun out of MID. Our three professors from MID are on the Board of technical advisors. One of them runs the intelligent transportation laboratory at MID.

So, for example, we see -- the guys at -- in our small camera facility in Cambridge, they have -- they have the ability to make hardware in a camera that can look at the drivers, sense motion, detect areas of the frame that are moving and make decisions based on that and then have those decisions feed into an automotive system. That's very much more highly value-added than a cell phone camera where the image quality is such that you typically click it and never even print it once in its life. So we're working on a business plan which we will announce over the next six months to try to position our imaging capability, which is significant, technically, in an area where we can make some money. But you called it right. The cell phone camera market does not look like a place where we want to go in and try to make a bunch of money.

Michael Masdea - Credit Suisse First Boston

For what it's worth, I like that answer. Thanks a lot.

Operator

Thank you. Chris Danley, you may ask your question. Please state your company name.

Chris Danley - JP Morgan

Sure. It's JP Morgan. Hey, guys, it's nice to see the SRAM market finally going back. Can you just give us a sense of what you think is driving it and what you're seeing as far as pricing goes? And it sounds like there's some allocation out there? When do you think that's going to get fixed?

Ahmad Chatila

Okay. This is Ahmad Chatila. I run the Memory and Imaging Division where SRAM is a business unit in my organization. What's driving it is two fold. One, there's an explosion a little bit in the wireless space where the low-end phones are growing and that still uses SRAM. But, more importantly, there is continuous consolidation in the market where the number one and number four guy are end-of-lifing certain lines of business that they have. So, we view the SRAM business as a nice, less cyclical, profitable business in the long run and that's what's going on.

Chris Danley - JP Morgan

And can you guys comment on pricing?

Ahmad Chatila

Pricing, I would say, is flat to up. It's very healthy these days.

T.J. Rodgers

One comment. The reason I talked about the II+, the Quad Data Rate II+ RAM was to mention what I told you about gross margins. Our RAM business is now divided into two divisions -- our RAM division, excuse me, is divided into two business units. The traditional static RAMs, which are high-end low-speed asynchronous static RAMs, the RAM Cypress has been making since our founding in 1982, typically have lower prices and lower margins and we are going into a legacy mode on them. We've actually moved the center of the business unit, that is, marketing and the business unit manager to Bangalore. So, we're going to get a cost structure that will allow us to participate in those markets forever and make money. The other kind of static RAM, synchronous static RAM, typically are big, expensive and high performance. The 72 meg synch sells for?

Ahmad Chatila

$80.

T.J. Rodgers

$80. And the gross margin in that business unit was?

Ahmad Chatila

That business unit is in the 45% to 50% range.

T.J. Rodgers

So on its way towards 50% and will exceed 50% as we go forward. So those RAMs are big and high tech and they're still centered in San Jose. So we're starting to sell in to the SRAM business, especially with the announcement of end of life of a couple of important competitors, in a way that I think we can start to make money in the long haul on SRAMs.

Chris Danley - JP Morgan

Great. And with the business getting better, I assume this will have a positive effect on gross margins for the rest of the year?

T.J. Rodgers

Brad?

Brad Buss

Yeah. That's definitely our expectation. I think as we showed you, we popped up to 47% on our semiconductor margins in total and the MID group contributed pretty heavy and we're on our way to 50% as we exit the year.

Chris Danley - JP Morgan

Great. And then last question, any end market commentary would be appreciated.

Chris Seams

I guess what you're asking is in the segments that we swim in, how do we see the business? In wireless, I think you heard Ahmad's comment that bodes well on the low end for handsets for memories and in the high end we've got some new products coming in that hopefully we'll be able to talk about significant revenue. And then across the board we're seeing PSoC penetration into that marketplace. So, we see wireless as strong as an end market and good market for us. Com, where we serve it, continues to be solid for us both in Q1 and in Q2. And in Consumer, we're seeing the usual first half not being as strong as second half but the forecasts we're getting for second half are strong.

Chris Danley - JP Morgan

Great. Thanks, guys.

Operator

Thank you. Alex Guana, you may ask your question and please state your company name.

Alex Guana - UBS

Yes. UBS. And I was wondering, with regard to this PSoC specifically, how are ASPs trending in that product category? And could we get an update on your targets for PSoC for the year?

Norm Taffe

Hi. This is Norm Taffe. I'm the Vice President of the Consumer and Computation Division. PSoC is one of the businesses in my division. To answer your first question with regard to ASP, ASPs were up last quarter and as our customer base broadens on that product, we expect that trend to continue and to continue to be firm ASPs and good margins going forward. Relative to expectations for the year, we continue to expect strong growth this year, consistent with the guidance we gave previously of roughly doubling in 2006 versus our sales in 2005.

Alex Guana - UBS

Okay. And with regard to SRAM, I understand the strength you're seeing in cell phones now. How is SRAM trending within networking? And is there a potential further margin lift from your networking side of revenues within the SRAM product line?

Ahmad Chatila

We see some. This is Ahmad Chatila that runs the Memory and Imaging Division. We see some. It's not as strong as wireless, but it's there. Overall, we're unable to say what is a competitive situation where some competitors have end of lifed some of their lines and what is a real market upswing and we will figure that out in the next few quarters.

Alex Guana - UBS

And with regard to the capacity situation, the tightness that has existed, does some of that take away from gross margin leverage in the back half of the year from SRAM or with the cost cutting that's going on or the lack of reinvestment? Does that really overwhelm any factors in terms of catching up on the supply side?

T.J. Rodgers

We -- the lack of reinvestment means really not building another -- a third fab or another wing in one of our existing fabs, but we're going to get the capacity we need by virtue of this foundry play that I talked about earlier. That will free up our internal capacity for making static RAMs. Second point is there is a tremendous amount of capacity still left in the Moore's Law curve for us. Our static RAMs were only 27%, I guess I should really be bragging. We've got a 27% reduction in 90 nanometers in static RAMs. So as we convert our 130, 150, 180, 250 nanometer static RAMs to 90 nanometers and we will convert across the board, we will derive a lot more high-tech, high-margin capacity out of our internal plants. And then the N-minus-2 generation stuff where we're cost sensitive, that'll be made in China and sold out of India and we'll still be able to bring in gross margin and profit on that.

Alex Guana - UBS

Speaking of China, you mentioned that you've now got your first PSoC coming out of Grace and congratulations on that. Is that coming in at an accretive gross margin to you at present or does that still need more room to ramp to get to an accretive?

T.J. Rodgers

Accretive gross margin meaning that the manufacturing cost in China equals the manufacturing cost here?

Alex Guana - UBS

Exactly.

T.J. Rodgers

Talk about wafer costs at Grace relative to internal wafer costs, please.

Ahmad Chatila

The wafer cost (inaudible) that we are manufacturing, the wafer cost at Grace is equivalent to a little bit lower in terms of cash versus full loaded on PSoC this year as we load it up. So, we expect capacity healthy gross margin compared to the wafers we build in our internal fabs.

T.J. Rodgers

And with regard to yield, PSoC is a chip that lives in one of two states. You get no die per wafer or 90% of the dies on a wafer work. So it's a small enough die that once you get the recipe to a first order, the number of chips on a wafer is pretty much what you sell. So, we expect the wafer cost to dominate in the cost equation and it will be slightly better.

Alex Guana - UBS

Okay. Thank you very much.

Brad Buss

Hey, Alex, this is Brad. Just to clarify. We have first silicon coming out of Grace. We're not actually shipping product that's driving revenue and margin out of Grace yet.

Alex Guana - UBS

Okay. Thank you.

T.J. Rodgers

That's right. When is our plan to ship first revenue out of Grace?

Ahmad Chatila

End of Q3, beginning of Q4.

T.J. Rodgers

So, we're ahead of the schedule and the nominal schedule is a little bit of revenue in Q3 and the ability to start cranking in Q4.

Operator

Thank you. And our next question comes from Mr. Craig Hettenbach. You may ask your question and please state your company name.

Craig Hettenbach - Wachovia Securities

Yes, thank you. Wachovia Securities. With a lot of the investor focus still on the PSoC for MP3 players, T.J., can you talk about some of the design win momentum that you're seeing in more of a broader industrial end market?

T.J. Rodgers

Sure. Let me give you one number, because I just reviewed it and it's in my head and then I'll have Norm give you some color on it. First of all, we talked about the ASP going up on PSoC earlier. The dynamic behind that, when you first launch PSoC, you obviously search around to get the biggest wins you can get. So that gives you a nice ramp and takes you off. The downside of a big win is you're always dealing with a big consumer company, Lucky Goldstar, for example, in cell phones and the negotiation for price is a pretty tough one. To make the real money in PSoC, you have to have a model that's more like microchip where you have a lot of customers and they're buying hundreds or a few thousand units and they're less price sensitive and all of a sudden the product that you might sell for under $1 to Sharp goes for $2.25 in medium volumes. The downside of medium volume is it's medium and, therefore, you have to have a lot of customers.

This last quarter, we crossed the 1,000 customer mark, 1,022 for PSoC and that's the name of the game. We got off the ground with two big wins and we loved them, of course, because they allowed us to get our deals and get the size of this division up so we can start spending more on R&D and proliferate it, but we're in a process, a selling process, to really ensure the way we sell. Norm?

Norm Taffe

Yeah. Just to follow up on that, certainly a big focus for us is the expansion of the customer base. We have penetrated a lot of the industrial application space more recently, although those are slower to ramp. But typical things like microwave ovens, the air purifier we mentioned in -- from LG, etcetera, are all using PSoC either for motor control or even the CapSense application that is common in MP3 players is something that can be done by PSoC in taking buttons away from all kinds of equipment. So, we are certainly expanding our customer base significantly. That's one of the reasons, also the ASP is getting stronger and we expect that trend to continue.

Craig Hettenbach - Wachovia Securities

Great. And then a second question. In the area of PCs, can you talk about some order trends you're seeing there? Obviously with some weakness in the processor market, particularly Intel, but what are you guys seeing for your PC clock business compared to typical seasonality?

Norm Taffe

Again this is Norm Taffe. PC clock is another part of the CCD business. Frankly for us, we had a lot of strength in Q1 on the PC clock business, in many cases it's driven by the fact that we're well positioned in the notebook space and the notebooks were much stronger than desktops. So, we've seen strength there. Going out, things don't look as bad as what we've heard as far as in the marketplace. Things seem pretty strong for PC clocks for us.

T.J. Rodgers

Let me -- in the PC space, this is a differentiation that may not matter to your analysis, but we see it. We have very little on the mother board. The PC clocks being one of the few things. Our PC clock business is currently about $7.5 million a quarter. What's our total clock business?

Norm Taffe

Total clock business is about $35 million a quarter.

T.J. Rodgers

So, it's one-fifth, 20%, of our total clock business. So, when we look at the PC market, we're more in to the PC peripherals, human interface devices, mouse, keyboard, joystick and printers, etcetera. And that market we don't see the kind of malaise that we read about in the newspapers with regard to the microprocessor wars.

Craig Hettenbach - Wachovia Securities

Thanks. Thanks for the clarification.

Operator

Thank you. Tim Luke, you may ask your question and please state your company name.

Tim Luke - Lehman Brothers

Thanks. Just a quick question with respect to the DCD area. How should we think about that now for the sort of second half of the year in terms of the shape of revenue and what your focus will be with this arena following the disposal? Thanks.

Dinesh Ramanathan

Hi. This is Dinesh Ramanathan. I'm the Vice President for the Data Communication Division. So, we're expecting actually revenues to go up for us in -- for quarter-over-quarter. So that's Q1 to Q2 and there is bunch of new products that we're working on which you'll see coming from us in the Q3 and Q4 timeframe. And I'm expecting revenue from there to grow and it to be a healthy division inside the company at good gross margin.

T.J. Rodgers

Let me put a little color on that. Data Com traditionally has been our most high profit division. It was sort of where we put our bets and aligned our other divisions during 2000 and obviously, that balloon got burst at that time. Currently Data Com does $32 million a quarter, 63% gross margins. Okay. So, if you compare that to the Memory and Imaging Division at 34% gross margin, it's more like $50 million or $60 million division in terms of generation of gross margin. So, we really love the margins. The problem is after the dot com bubble burst, we ended up with the network search engine and the network search engines, which we were hoping would be like our other specialty memories dual-port RAMs and five-ports, typified by 60%-70% gross margin. And what happened was the network search engine business basically was a custom business for Cisco. Cisco solicited it's four suppliers in a space where there was enough business for about two and managed to have a bunch of companies spending huge amounts on R&D to support businesses at 40% gross margin with negotiating leverage in the wrong direction. That's when I pulled the plug on NSE.

We're now left with the old core of Data Com, 63% gross margins on $30 million is not bad. You could easily take the company public on those numbers alone if you were a startup. So, our objective there, Dinesh is the new VP. He's not a silicon guy like I am in the sense of having worked in the fab once in his life. He's a system guy and we're -- our goal there is to build up a bunch of nuggets. We want the basket of nuggets to be big and they'll build up over time and we will be announcing them, but we announced -- we have-- we won't. We've got some interesting products that have nice gross margins. And so, it's not going to be fast-growing revenue, but over the years, it's going to -- our goal is to keep that revenue especially the gross margin at 60%-plus and add to the basket of products. And the systems level guy is the one that's going to do that.

Tim Luke - Lehman Brothers

Thank you. Brad, I was also just wondering if you'd give some color on how you see OpEx trending into the second quarter and maybe for the second half?

Brad Buss

Sure. I mean, I think, like as I mentioned, I mean as a percentage of revenue it keeps trending down. We're working really hard towards our target. I think you can kind of look at kind of total OpEx kind of growing 1% to 1.5% kind of on average. We're actually making money and able to put the money away for bonus plans, but we're also managing a lot of the other business units as T.J. and the rest of the VPs have mentioned to ensure that we're taking our costs out. So, you'll see a continual focus in that area.

Tim Luke - Lehman Brothers

And lastly, if you could just give the clarification on the PSoC revenue last year, if you have it doubling this year?

Norm Taffe

This is Norm Taffe. We finished last year around $47 million.

Tim Luke - Lehman Brothers

That's right. Great. Thanks a lot, guys.

Operator

Thank you. Louis Gerhardy, you may ask your question and please state your company name.

Louis Gerhardy - Morgan Stanley

Good morning. Louis Gerhardy, Morgan Stanley. I just wanted to understand the indirect channels, distributors and CM. How did they perform in Q1 versus the direct channels? And what's your outlook here for Q2? And then just a follow-up. Brad, I think indirect channels are maybe 50% of your business. Approximately how much of that does Cypress defer income on?

T.J. Rodgers

Okay. Want to do that one?

Brad Buss

Well, why don't I take that one. Yeah, you're right. About 50% of revenue goes through some level of distributor and about 20% to 25% of that would go -- would be deferred, i.e., we take revenue on a sell-through basis.

Louis Gerhardy - Morgan Stanley

So, 10% to 12%, then, of the total company?

Brad Buss

Yeah.

Louis Gerhardy - Morgan Stanley

Okay.

Chris Seams

This is Chris Seams. In terms of demand in both the first quarter and then in the second quarter outlook in the distribution channel, it was strong in Q1. We actually stocked a little bit of inventory on PSoC. That's the only place where we grew inventory. So, we sold through well everywhere else. In PSoC, we were putting product on the shelves where it should have been all along. So, inventory levels there are healthy and we're predicting another strong quarter for distribution in the second quarter.

Louis Gerhardy - Morgan Stanley

So, one thing I was after. Did the indirect channels outperform direct in Q1? And then for Q2, same question?

Chris Seams

No. For Q2 it's flat, as well. We're predicting strength in both direct and indirect, about equal.

Louis Gerhardy - Morgan Stanley

Thank you.

Operator

Thank you. Doug Freedman, you may ask your question. Please state your company name.

Doug Freedman - Amtech Research

Amtech Research. A lot of my questions have been asked and answered, but I guess one area I don't think we've touched on is the USB segment. If we could get some color on what you're seeing the outlook for that is.

Norm Taffe

Hi. Again, this is Norm Taffe. USB was quite strong in Q1 as we caught up through a lot of delinquent orders and we had strong -- continued strong strength, particularly in high-speed USB, which continues to get designed into more and more applications. The strength of USBs continues to surprise us. We remain very, very strong there. We do see some pullback in Q2 as we have some extended seasonality in the spaces, but expect it to continue to be strong through the back half of the year, which is the normal high peak for USB.

Doug Freedman - Amtech Research

And then, Brad, if you could, are there any one-timers that we should be aware of for Q2 to get us closer on a pro forma number?

Brad Buss

I sure hope not. And you're -- on adjusted GAAP, you mean?

Doug Freedman - Amtech Research

Yeah.

Brad Buss

Yeah. No, really nothing outside the ordinary.

Doug Freedman - Amtech Research

So the impact of the closing of the sale that you said occurred in April --?

Brad Buss

Well, that's a cash, that's a balance.

Doug Freedman - Amtech Research

It's strictly cash balance sheet, nothing coming through on the --?

Brad Buss

Yeah, any gain related to some of the shares that T.J. mentioned that we still had, I would put them through GAAP only.

Doug Freedman - Amtech Research

All right. Terrific. Thanks so much.

Operator

Thank you. Sandy Harrison, you may ask your question and please state your company name.

Sandy Harrison - Pacific Growth Equities

Thanks. Pacific Growth Equities. When you guys talked in some of your prepared remarks about the inventory in the channel and where you guys stand on that with some of the businesses, how do you expect to fill that channel out? Is it -- do you expect to get it in Q2? Is it going to be built out through the year? How do you kind of see layering in that along with your fab capacity?

Chris Seams

This is Chris Seams. Maybe you can clarify your question for me?

Sandy Harrison - Pacific Growth Equities

Yeah. How happy are you with the amount of product in distribution? You said you built some in PSoC, but it sounds like that was it and what are some of the areas that you want to add into distribution as well as maybe in your own inventories?

Chris Seams

We're relatively happy with the inventory levels overall. I would say we're weak in memories and that's just a condition of the overall market right now. We'd like more memories and we're managing that.

Sandy Harrison - Pacific Growth Equities

Got you. And when do you expect to try to catch up with that? Is that something, mid-year, end of year?

Chris Seams

I don't have a crystal ball for that. I hope never, but the answer we predict is probably toward the end of Q3.

Sandy Harrison - Pacific Growth Equities

Got you. And on the PSoC, you had talked about you crossed over the 1,000 customer mark. What are some of the customers that if you would -- had a category of where most of your interest or a lot of your interest is coming from? What are the most or some of the more recent wins? What kind of products are they in and where are you having some really -- some bigger wins, as far as being able to walk in and take the designs?

Norm Taffe

All right. This is Norm Taffe again. The first thing I'd say is like I'd repeat the statement that it is very broad based, literally wins in (inaudible) and industrial space. I'd say that there's certain applications that have driven that across a broad area. I mentioned the CapSense. We're in all kinds of things that replace buttons and buttons are on everything from washing machines to microwaves and we've got wins in all those areas. So, that's where a lot of the excitement of those over 1,000 unique customers in Q4 come from, albeit, as T.J. mentioned, in many cases they're small volume individually but then the designs seem to just replicate inside the customer. So there's sort of no end to designs there.

I will also tell you that we continue to be very successful in that consumer space. We have multiple wins now in handsets. We've only announced the LG wins. I'm not ready to announce more, but I can tell you there absolutely is a lot of activity in multiple handset vendors in taking advantage of the flexibility of PSoC. So it's a great device. It's a lot of -- it's not just to penetrate the traditional microcontroller space, because of programmable analog, but also very, very high volume applications in both the PC and the consumer handset space.

Sandy Harrison - Pacific Growth Equities

Great. Thanks for the clarification.

Operator

Thank you. Glen Yeung, you may ask your question and please state your company name.

John Quarles - Citigroup

This is John Quarles for Glen Yeung at Citigroup. Guys, if I can just return to SRAM for a couple of quick questions, I know this business has performed pretty well this year and what I'm wondering is if maybe the -- where people were thinking or we were thinking revenue or SRAM revenues as a percentage of sales might settle out, it might actually be a little bit higher, especially considering just three weeks ago you guys announced a technology agreement with Semtech? Can you give me an idea of how I should think about this business in terms of what its kind of revenue trajectory might be and if within here there are opportunities, whether it's through Semtech or other areas that maybe change the gross margin profile within this business?

Ahmad Chatila

Hi, Glen. This is Ahmad Chatila. So, our objective in the Memory and Imaging Division is to do two things; one, the pure commodity is to reduce the cyclicality and the market is helping us because competitors are, as I said are exiting and we're converting to very high end, like T.J. said, synchronous SRAM. So that's one and because of that, the gross margin will move up. From a Semtech situation, that is a very high value-added product where we're collaborating with other divisions within the company to make system-on-a-chip. So, it is our objective and we have made some good gains, is to be non-cyclical and improve gross margins through value-added products.

John Quarles - Citigroup

Is the fruits of this Semtech agreement something we might actually see harvested this year or is it going to require a little more engineering effort to get something out?

Ahmad Chatila

You will see a slight impact in second half of this year and you will see, potentially, some good impact in 2007 and 2008. I will leave it at that.

John Quarles - Citigroup

Got you. And then if I can just ask one quick question in Data Com. Can you guys give us any kind of update on opportunities you might be pursuing there with regards to handsets? I think you guys have talked about working on a 3G opportunity. I'm just wondering if there's anything there you can tell us?

Dinesh Ramanathan

Yes. This is Dinesh Ramanathan. So, one of the things we are doing inside Data Com is basically utilizing all the intellectual property that we have inside the company and building the value-added devices for the markets that you talked about. In addition to that, we have announced equalizers -- video equalizers that are, again good gross margin products for us. These are devices that primarily go into the professional video market. We're going to be announcing cable drivers again to fulfill our portfolio in the professional video space. There's also other devices that we are working on that scale into the HDTV market, as well.

So, there's a bunch of R&D that's going on inside Data Com at this point and it's focused, some in the handset space, some in the HDTV space and we continue to have our traditional businesses in the wireless infrastructure space, as well. And my expectation is that all those businesses will grow and add to Data Com's bottom line.

T.J. Rodgers

Let me give a little bit higher level view of what he said. So, HDTV is digital. You get a lot of pixels with a lot of variation in color in each pixel. It requires a lot of data. HDTV is 1.6 gigabits per second. So all of a sudden a consumer device crosses over where data communication skills are required. The high end of that, going back to the focus of building a small business bigger, $30 million a quarter, build it up to $50 over time with very high gross margins. The high end of the HDTV business is the studio.

In the studio, basically you have a bunch of sources of input for video. They run on a cable. As they go on a cable, the video signal turns into crap within a few hundred feet and then at the end of the cable you have to have, in effect, a physical layer, which is called an equalizer, which takes the signal back out of the cable. Then it goes into a switcher. So you have 20 channels coming in, 10 channels going out and you have to switch 1.6 gigabit stuff and then on the output, you have to drive it into another cable and driving into a cable with 1.6 gigabit signal is another high-end thing. So, you have maybe 10 or 20 channels of input, 10 or 20 channels of output requiring equalizers and cable drivers and a switcher in the middle.

We either have or will have all of those products and that is what Data Com has been working on in the last year. It currently is not a huge part and they're clocks and they're high-precision clocks, which we've made for years. That's actually how we got into the business, finding our clock in virtually every studio, HDTV studio, in the world, and starting to look at the boards. We now have the ability to put $1,000 of [bomb] into studio switching and we're now looking to extend it to the consumer side, which still has to handle 1.6 gigabits. So that's what the thrust of all last year and it's starting to yield. What was the revenue last quarter in that time?

Dinesh Ramanathan

$7.5 million.

T.J. Rodgers

So, we've built it up to $7.5 million a quarter business and that's growing and then we have a step beyond that, which we've been working on for the last year but we haven't announced yet. So that's sort of how we think and work in Data Com. We have the skill set to move data around and to handle it and have high precision on it. And then we're asking ourselves what markets can that skill set be applied to.

John Quarles - Citigroup

Got it. Thanks for the answers, guys.

Operator

Thank you. (Operator Instructions). Srini Pajjuri, you may ask your question and please state your company name.

Srini Pajjuri - Merrill Lynch

Thank you. Merrill Lynch. Just a few quick questions. The first one, you mentioned you're going to exit the DRAM business. Could you give us what's the size of that business today and also if it's included in your June guidance or excluded from it and also what kind of impact it'll have on the margins and EPS, if any?

T.J. Rodgers

First, size, Ahmad.

Ahmad Chatila

Srini, this is Ahmad. The revenue is $10 million a quarter.

T.J. Rodgers

So with regard to the revenue, you have to think about what happens when it goes away. Right now with SunPower growing better than $10 million per quarter, per quarter, right now is a real great time for us to get rid of some of the businesses which we don't want to be in the long haul and not impact our growth rate. With regard to the revenue being in the third quarter estimate, it is.

Brad Buss

Second quarter.

T.J. Rodgers

Excuse me, second quarter. It is.

Brad Buss

It currently still is.

T.J. Rodgers

And I don't think we can get a deal done this quarter, anyway. So it would be a third quarter impact if we get a deal done. If not, the revenue will stay and it will simply drift on over the next eight quarters.

Srini Pajjuri - Merrill Lynch

Okay and then the next question is on the image sensor business. T.J., it looks like your capacity utilization is pretty close to 90% and if you indeed have success in this market, would you be manufacturing these products in-house and, if so, do you anticipate any more CapEx in the second half of the year?

T.J. Rodgers

Great question. We originally bought the image sensors to fill half-empty fabs, which are no longer half-empty. We no longer have space for image sensors. Hence, the shift from high-volume cell phone-type image sensors, which currently sell for $2.50. I was reviewing an image sensor yesterday for a two-dimensional barcode reader. It has special properties to it and sells for $750. Right? Ahmad, is that? $750. So, if you go into the value-added image sensing business and look for high performance, high speed, high resolution, etcetera that very good night vision which we have got, you can make the image sensors without burning a lot of fab capacity. So that strategy is also consistent with the fact we're out of capacity.

The last point, the technology we're transferring to Grace is our so-called [CA] technology, which is 130-nanometer technology. And the image sensors don't need, actually don't benefit from, 90 or 65 nanometer technology. They need transistors that are good enough to switch a pixel and then the cheapest possible wafer you can get once you've done that. The chip is filled with pixels, which necessarily take up area, and therefore, there's sort of a certain number of square millimeters that have to get consumed just for diodes sitting there sensing it. And therefore, the cheapest cost per square millimeter of silicon is the best technology for an image sensor, not necessarily the most advanced technology.

The upshot of what I'm saying is that we, in effect, are transferring our image sensor capability to Grace right now in the form a precursor process that is a very first close cousin. So, if we do enter into some medium volume image sensing businesses in the future, such as image sensors in personal computers, then we will have that capacity offshore in N-minus-2 node foundries.

Srini Pajjuri - Merrill Lynch

Okay, fair enough. And finally, T.J., it's been almost two or three quarters since SunPower went public and that stock has done well. On the other hand, the -- I don't think the Cypress shareholders are seeing much benefit from that. I'm just wondering if there's any change in your thinking regarding how much you want to own SunPower?

T.J. Rodgers

You're right. We're not getting all the value in Cypress shares that you could impute from the value of SunPower and you can solve that problem by buying a lot of our stock in the rest of the trading day today. I tend not to think about SunPower in the first few quarters after they go public. I tend to think about -- the incorporation date of Cypress is December 1, 1982. So this is 2006. I've been around for 24 years. I don't think about SunPower and what happens over the last three quarters. I think about the last 58 -- the last 10 years of my career in which the price of oil is $70. I can bring in energy from the sun. I can turn energy into data. I can control buses, run machines and what sort of intellectual property parts do I want under our corporate umbrella to be able to make things that I don't even know what they are yet? And I can tell you for a fact, I know that harnessing energy and making very low-cost wafers is something we do well and something that's going to be important in the future. So I'm frustrated with the value creation so far, but I've got to have a longer view than how did you trade in the first three quarters after the IPO.

Srini Pajjuri - Merrill Lynch

So, the short answer is you're going to maintain the 87% share?

T.J. Rodgers

You got it.

Srini Pajjuri - Merrill Lynch

Thanks.

Operator

Thank you. Adam Benjamin, you may ask your question and please state your company name.

Adam Benjamin - Jefferies & Co.

Thanks. Jefferies. With respect to the questions you've answered on the SRAM business, it's been on a decline and now it appears as if it's sort of bottomed. Is that a business you expect to kind of grow sequentially throughout the rest of this year and could it, in fact, be up year-over-year for the full year in '06?

Ahmad Chatila

Hi, Adam. This is Ahmad. I expect it to grow sequentially and I would expect it to grow versus last year for the simple reason that some of our competitors are end-of-lifing some of their lines and that's the only reason. And I agree with your assessment that has bottomed out to a large extent.

Adam Benjamin - Jefferies & Co.

Okay. And then, T.J., on the sensor business that you talked about, going after some of the higher speed, higher performance opportunities, what are the design cycles there? And, obviously in automotive they're much longer. Should we be looking at this as really an '07 revenue opportunity as opposed to '06?

T.J. Rodgers

When you say sensors, you were talking about--

Adam Benjamin - Jefferies & Co.

Sensors.

T.J. Rodgers

Image sensors?

Adam Benjamin - Jefferies & Co.

Yes.

T.J. Rodgers

No, we expect to grow our business in image sensors sequentially. Some of the opportunities, like automobiles, you're absolutely right. There's a long latency from the time you start working on it until you get money and that latency was absorbed by small camera prior to our acquisition of them and we started getting some money out of that shortly after we acquired them. Other of the opportunities, if someone wants, for example, an image sensor that has extraordinary dynamic range and still does 1,000 frames per second, the thing you first start talking about is, okay, we'll do that for you and there's a $1 million payment having to do with doing the development and taping it out and a $500,000 payment for having delivered the first sample. So, it's a custom-like business, which is a pay-as-you-go for the customer who can't get it anywhere else.

So, even though we're making some sort of high-tech image sensors, it doesn't mean we're in the mode of waiting three or four years for revenue.

Adam Benjamin - Jefferies & Co.

Okay. And then I apologize if this was already asked. With respect to NSE, you had typically been running $9, $10, $11 million per quarter in that business. With the divestiture, you will still continue to get some revenue there. How should we think about that revenue stream into the back half of this year and into '07?

Dinesh Ramanathan

This is Dinesh Ramanathan. We're expecting to do anywhere between $7 and $8 million a quarter on that stream of revenue.

Adam Benjamin - Jefferies & Co.

And that can continue out for the foreseeable future?

Dinesh Ramanathan

Yeah. And we're projecting that into 2007, as well.

Adam Benjamin - Jefferies & Co.

Thanks.

Operator

Thank you. At this time, we are showing no further questions. Sir, I'll turn the call back over to you for any closing comments.

T.J. Rodgers

Thank you very much for attending our conference call. We've reported a first quarter in which we exceeded guidance for both revenue and EPS and we've guided for an improved quarter in the second quarter. Thank you very much.

Operator

Thank you. You may disconnect at this time. This does conclude today's conference call.

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