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Spansion (NYSE:CODE)

Q2 2014 Earnings Conference Call

July 30, 2014 4:30 p.m. ET

Executives

Rahul Mathur – Vice President of Finance and Investor Relations

John H. Kispert – Chief Executive Officer, Member of Spansion's Board of Directors

Randy Furr – Executive Vice President and Chief Financial Officer

Analysts

Craig Hettenbach – Morgan Stanley

Christopher Hemmelgarn - Barclays Capital, Research Division

Suji De Silva – Topeka Capital Markets

Rajvindra S. Gill - Needham & Company

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Vijay Rakesh – Sterne Agee

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2014 Spansion Earnings Conference Call. My name is Kim, and I will be your operator for today. At this time all participants are in a listen-only mode, later we will conduct the question-and-answer session. (Operator Instructions) As a reminder this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Mr. Rahul Mathur, please proceed.

Rahul Mathur

Thank you, Kim. Good afternoon and thank you for joining us on today’s call to discuss Spansion's second quarter 2014 financial results. With me today from Spansion are John Kispert, Chief Executive Officer; and Randy Furr, Executive Vice President and Chief Financial Officer.

We hope you saw our earnings release issued today and posted to our website. Also on our website is a brief slide presentation that we will refer to during our call today.

Before we move on, please note the Safe Harbor statement on Slide 2 of today's earnings presentation. During the course of this meeting, we will make forward-looking statements regarding future events for the financial performance of the company. Such statements are based on assumptions as of the current date, and these forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those statements. We urge you to review in detail the risks and uncertainties discussed in our filings with the Securities and Exchange Commission. We disclaim any duty to update forward-looking statements.

Our agenda for the call today is as follows: John will discuss key highlights from the quarter; then Randy will review these from a financial perspective and provide the forward-looking guidance. A Q&A session will follow.

With that, I will now turn the call over to John Kispert, CEO.

John H. Kispert

Thanks Rahul. Good afternoon and welcome to our second quarter earnings call. My comments today will address our second quarter results what we’re seeing in the market we participate in, the latest developments across our various businesses and our design win progress.

During the second quarter demand was strong, we continued to execute in the steady progress with our new microcontroller and analog business groups and our Flash products including NAND and our 45 nanometer family of base products continue to grow quarter-on-quarter.

However, we face supply constraints with our microcontroller foundry partners and they were not able to keep up with our increasing customer demand. Out team has done a great job addressing these issues over last months and we’re currently seeing steady improvement through the entire supply chain.

Most importantly our suppliers and customers are working closely with us. We’re drawing the MCU business which we expect will continue at a healthy rate. In addition, we had a shortfall in licensing revenue, which is variable and thus difficult to predict. As we have communicated in the past, we’re a strong licensing pipeline and expect growth in this area. These factors resulted in revenue and gross margins at the lower end of our estimated range.

Turning to our financial results, we achieved revenue of $315 million, a sequential increase of 1% over Q1 and an increase of 61% over Q2 of one year ago. Non-GAAP gross margin was 33.2%, non-GAAP operating income was $22 million. Despite the revenue and margin shortfall diluted non-GAAP EPS was approximately $0.24 at the midpoint of our estimated range of $0.21 to $0.27.

So, we had good execution factoring in the absence of approximately $15 million to $20 million in revenue that we had anticipated in product and licensing. On another positive note our cash position is in line with our cash levels prior to last year’s acquisition with cash, cash equivalents and short term investments at approximately $305 million.

Our strategy to grow our business, expand our addressable market, improve our profitability and generate cash remains consistent in the following four key areas. First, growing our microcontroller business worldwide including all the proprietary technology and our arm based microcontrollers, as well as integrated solutions that combine critical technologies such as our embedded Flash technology, software, application specific middleware security and human machine interfaces as a means to offer differentiated solutions for our customers.

Second, expanding our analog business across all markets and regions; third, growing our Flash memory leadership position in the embedded market; and lastly, commercializing and protecting our intellectual property.

I will now provide an update on each of these areas.

In our microcontroller business, demand continues to be strong. We made significant progress in new product development and introduced a number of new products. For the automotive market we announced (inaudible) family of products based on Cortex-R5 ARM cores. This family of products delivers advanced human machine interfaces, advanced security features and networking for a broad range of applications such as hybrid and electric vehicles, body electronic, battery management, cluster displays, age factor, heating, ventilation and air-conditioning as well ADAS or advanced driver assistance systems.

In this family we also introduced a multi-core product with 2 megabytes of R embedded Flash that operates at 200 megahertz. This is an example of integrating our technologies intellectual property. We will be in production with this product with our first customer for hybrid electric cables this quarter.

In addition, we introduced and started sampling another single core ARM based product with high performance CAN FD Interface. This enhances the performance of in-vehicle networking from various applications in automotive body electronics. With the ray of product family we now also offer application tailored system solutions to ease both hardware and software design as well as integration across automotive applications.

As reported last quarter, the Internet of Things will be a significant area of opportunity for us overtime. In standalone microcontroller and also an integration solutions with our Flash and analog products.

Through active participation in a number of partnerships, we will continue to contribute to open standards and technology collaboration to accelerate the adoption of the Internet of Things. We’ve a number of new products in development for the automotive, industrial and mass markets as well as certain consumer markets and these products will launch by the end of this year.

At the same time we expanded our software ecosystem and enabling solution toolkits. Customers continue to reward us with new designs across all of our markets based on our differentiated microcontroller offerings and support.

In our analog business, we saw demand in automotive and consumer applications. Last month we introduced our energy harvesting solution which eliminates the need for batteries or extend the life of batteries in a multitude of devices from individual wearable electronics to nodes in a wireless sensor network.

This product family includes ultra low power management integrated circuits or PMIC with dual input that enables efficient harvesting from both solar and vibration energy. We also announced an Ultra Low Voltage PMIC for solar and thermal. These devices work seamlessly with expansion of ultra low power microcontrollers for industrial and consumer applications with low power requirements.

Last week we started sampling our series of multichannel DC-to-DC power management integrated circuits that supply three channels of power out of single chip. These are designed for cutting edge system on chip products, all forms of memory and peripheral products that make up the core of office automation equipment and network devices with advanced image and voice processing functions. All these new product offerings along with our LED lighting solutions will enable us to grow our analog in the coming quarters.

Moving to our Flash business, revenue increased 9% sequentially, we’re strategically selecting high growth and high value add embedded platforms or embedded market segments. These are applications where we can deliver sustained differentiated value. We actively turn away from business where we’re not differentiated and/or our customers do not see a differentiated value in technology, application support or engineering service.

Our NAND business continues to ramp and expand and our latest 45 nanometer products also showed increased demand over the last quarter. We’re pleased with our continued chipset acceptance and customer interest in our breakthrough HyperBus interface and this interface couple with our industry leading Flash is gaining wider acceptance with our chipset partners. As they integrate the interface and our Flash with their controller or in some case system on-chip product.

In the area of commercializing and protecting our intellectual property, we’re relentless in protecting our IP as evidenced by our ongoing litigation with one of our competitors. We continue to proactively explore opportunities to license our technology and to sell non-core patents to interested parties. The number of opportunities we have has grown. In the June ending quarter we had a number of negotiations ongoing at the beginning of the quarter, none of which materialized by the end of the quarter.

These opportunities have not gone away and we will continue to work on closing them to enhance the return of our investment in our technology. However, we expect incremental licensing will remain variable and the timing difficult to predict.

I’ll now cover our design win progress. As a reminder, these wins are across all of our markets and/or segments, and all of our products including, microcontrollers, flash, analog and mixed signal.

In our consumer segment, we secured approximately 315 design wins. MCUs, analog and flash will so on increase across a number of applications. High density serial Flash showed the biggest increase as we see the need for fast, high density and more reliable Flash increased across applications.

We also continued our leadership position with set-top boxes, consistent with previous quarters we also secured wins across some gateways, digital TVs, digital cameras, printers or office equipment, home entertainment and gaming controllers.

In Transportation & Industrial, there were over 400 design wins across multiple applications including security surveillance, aerospace, factory automation, energy, medical, wearables, point-of-sale, vending machine controls, motor control for home appliance as well as automotive, infotainment, auto safety, auto telematics, auto clusters and of course, powertrain and body electronics.

We’re continuing to see interest in gaining traction from multiple expansion products for key applications in these segments. For example, for advanced driver assistance systems, we had a key design win with our latest analog technology coupled with our Flash with the leader in the auto industry.

Finally, in Communications & Gaming, we secured approximately 100 design wins. Data centers dominated the majority of the communication wins with a broad mix of switch and routers as well as data storage products driving Flash memory growth in this segment.

Looking forward, our growth drivers remain intact, we’re partnering with customers to design innovative system solutions for connected and intelligent embedded devices across all of our markets. With the design wins we’re getting to expect to make steady progress expanding sales outside of Japan for our microcontrollers and our analog products. And we will continue to move more and more production in-house for these products. This will lower our cost, improve our time to market and improve the predictability of supply.

Combining our technologies across Flash, microcontrollers, analog, software, middleware, security and human machine interfaces into integrated solutions will be a key development focus, which we expect to see the benefit starting in the first half of next year. At the same time we will strive to achieve higher level to profitability and continue to tightly manage expenses. With the new mix of products coming to market across all of our businesses, we’re optimistic about the future growth.

And with that I’ll turn the call over to Randy to discuss more specifics on the financials.

Randy Furr

Thanks, John. As I discuss the Q2 financial results in more detail, I’ll be referring to the Q2 financial results, presentation we posted in the investor relations section of our website.

On slide 3, let me start with the summary of our fiscal Q2 2014 operating results. Again, revenue were $315 million, non-GAAP gross margin 33.2%, and non-GAAP diluted EPS come in at $0.24.

On slide 4 of that presentation, you will see a breakdown of our sales by end market and geography. For your reference this is based on “ship to” location and as mentioned total revenue was $315 million with the $174 million from Flash memory, $134 million from our microcontroller and analog mixed signal businesses and $7 million from licensing.

From an end market perspective with the exception of royalty licensing revenue being less than anticipated, revenue distribution was generally in line with expectations. On a regional basis, our results were again in line with our expectations, we did see nice growth in Japan from our Flash pachinko gaming business as it rebounded from the previous quarter.

From a business perspective, our embedded Flash business driven by strong demand for NAND Flash was up over 9% quarter-over-Quarter, a number in line with normal seasonality for Q2. Our microcontroller and analog mixed signal businesses actually posted a quarter-over-quarter decline of approximately 5%. What drove this decline and as we previously mentioned, we continue to be challenged by having insufficient supply to meet demand in this business.

As our major foundry partner in our analog and microcontroller business was not able to meet our total demand. With that said, we continue to make up for it and improving these supply chain challenges. This impacted us again and I think John mentioned this, in the neighborhood of $10 million to $15 million in revenue in Q2.

Turning to slide 5, we will review the income statement. We will start with the far left column, GAAP earnings. This column includes the effect of purchase accounting as a result of the Fujitsu microcontroller and analog mixed signal acquisition. As many of you know, purchase accounting requires inventory to be written up to essentially market value.

In column 2 of slide 5, we’ve listed the acquisition related charges. There in Q2 and in line with comments I just made, we incurred approximately $1 million and lost non-GAAP profit due to amortization of the fair value markup on the acquired inventory. Also during Q2 we incurred approximately $2.6 million in cost related to the acquisition and integration. This was offset by a net $2.4 million gain related to pension assets acquired in the business. Q3 will be the last quarter we expect to have material acquisition and integration charges related to the Fujitsu acquisition.

Column 3 or 4 are standard non-cash, non-GAAP adjustments and column 5 is our defensive litigation charges. Reserve, reversal on final settlement of all bankruptcy related claims plus charges related to our financing transactions.

A brief comment on litigation charge for Q2: In August of last year we filed two separate lawsuits against a competitor for infringing upon our IP and is generally considered normal in such situations that same competitor filed two complaints against expansion. We then filed two additional complaints in 2014 against them and they in turn and more recently filed two additional complaints against us, so now a total of 8 lawsuits.

We took charges in connection with these complaints against us in Q3 and Q4 last year and Q1 of this year, per our policy we accrue for the next four quarters of expected legal cost related to defensive lawsuits such as these.

The $12 million represents a change to the accrual as a result of truing up the next three quarters of expected litigation expenses, but not only the two existing defensive complaints but also adding the two new complaints along with adding one additional quarter to get four quarters total. And again, this is all per our policy.

Column 6 nets the non-GAAP and as you can see non-GAAP gross margin was 33.2% in Q2. Even though this gross margin was in line with our estimates, we were a bit disappointed, so little more color here. First, in favorably benefitting gross margin our internal fab equipment utilization rate did increase from approximately 55% in Q1 to approximately 69% in Q2. However, negatively impacting gross margin in Q2 was our royalty and licensing revenue, this was down about $5 million from Q1 or about 100 basis points of gross margin.

Excluding the impact of licensing, our gross margin and EPS would have been close to the top end of our estimates. As we previously mentioned, incremental licensing revenue can be lumpy, with that said we do expect to see additional incremental licensing revenue in the second half of 2014.

Moving on to operating expenses, R&D was $39 million or 12.3% of revenue. This was down approximately $1 million from Q1 and reflects just normal quarter-to-quarter variability in our discretionary R&D spending. In Q2 we released four new products from our analog and microcontroller businesses including analog mixed, energy harvesting and microcontroller for a range of automotive applications.

SG&A was flat quarter-over-quarter at $44 million or 13.9% of revenue included in Q2’s SG&A expense is approximately $4 million related to our offensive portion of our litigation activities equating to approximately $0.06 of earnings. We expect to incur roughly $6 million of offensive litigation charges in Q3, as this $6 million equates to roughly $0.10 of earnings obviously our earnings will be significantly better without these litigation charges.

This translated to non-GAAP operating income of $22.1 million compared to last quarter's $19 million. The non-GAAP operating margin was 7% in Q2, in line with our estimates, we incurred approximately $4.5 million in interest and other non-operating items. And going forward, we are anticipating approximately $4.3 million to $5.3 million a quarter and other non-operating expenses.

Our income tax expense in Q2 was $2million, coming at about $1 million below our estimated range due to reductions in tax accruals and certain foreign and local jurisdictions and the non-GAAP tax treatment of the gain on the pension assets that we acquired. As a reminder we have significant U.S. and California NOLs and the $2 million in tax expense in Q2 primarily represents foreign taxes. Going forward, we should see taxes in the $3 million to $3.5 million range each quarter. Adjusted EBITDA was $36.1 million or 11.5% of sales. Our non-GAAP diluted EPS as I mentioned was $0.24 in Q2.

The Q2 non-GAAP results listed in Column 6 of Slide 5 relate to the financials depicted on Slide 6, which we have included here to show kind of an apples-to-apples quarterly comparison going back to Q2 of 2013.

Now I would like to turn the conversation to the balance sheet. So please refer to Slide 7. And I will start with cash. We ended the quarter with cash, cash equivalents and short-term investments of $305 million. This was up from Q1’s $289 million and came from $28 million of cash flow from operations netted against $12 million of capital payments. We are pleased with this result, as you can see by comparing our cash and debt for the period of Q2 2013 to Q2 2014 that despite completing a significant and transformative acquisition over the past 12 months, our cash is the same as a year ago before the transaction and our balance sheet debt is approximately $6 million yield less, so again, a great outcome for us over the last year in terms of cash.

With respect to working capital, trade accounts receivable was up $1 million to $178 million at the end of Q2. DSO or day sales outstanding ended at 51 days which is slightly lower as compared to last quarter. Inventory for Q2 was $252 million which equated to a decrease of 2 days to 103 days of inventory and accounts payable was $148 million at the end of Q2 which equated to 48 days. As net cash cycle days saw a nice decrease from 115 days in Q1 to 106 days in Q2.

So, in summary, the quarter we experienced some lumpiness with respect to our royalty and licensing revenue, but given the challenge with a supply in our analog and microcontroller business, a quarter that was otherwise solidly executed.

And now I’ll turn the discussion to the outlook for Q3, so please refer to Slide 9.

Let me start with a high-level discussion. As we show in our earnings release, the estimated range for Q3 net sales is $305 million to $345 million. We estimate non-GAAP gross margin to be in the 33.5 to 36.5 range, and this would translate to non-GAAP diluted EPS in the range of $0.22 to $0.30. At the midpoint, revenue was up a little north of 3%. And again, and as I mentioned previously included in these estimates is approximately $6 million of litigation expenses and this equates to approximately $0.10 of EPS.

Excluded from these non-GAAP estimates are approximately $1 million to $2 million related to the amortization of inventory markup to fair value in our microcontroller and analog acquisition; another $1 million to $2 million of expenses related to integration of the microcontroller and analog business and approximately $1 million to $2 million related to restructuring. Our normal IP, amortization, accretion of noncash interest associated with the convertible notes and equity compensation expenses; and approximately $3 million to $4 million in defensive litigation charges.

Slide 10 list our third quarter 2014 focus areas, and these include again driving top line growth; accelerate development and introduction of new products across all of our businesses. Expand worldwide adoption of Flash memory, microcontrollers and analog; drive design win momentum for all products across all segments; again to continue to focus on operational efficiencies. We’ve included Slide 13 to help and reconciliation this historical GAAP to non-GAAP.

So with that again, I'd like to again thank you for your time today and turn the call back over to Kim for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Craig Hettenbach from Morgan Stanley. Please proceed.

Craig Hettenbach – Morgan Stanley

Yes, thank you. On the supply issues with the foundry, can you quantify if there’s an impact to Q3 sales baked in and then also with the supply issues, do you think there’s any issue in terms of lost business where you lose share and you expect to be able to kind of get this business back?

John H. Kispert

Hey Craig, it’s John. A key question that we’ve been very focused on, I’ll take the last part of the question which is, we went into the quarter with very, very tight supply and more demand and as the quarter went on that gap widened. I can tell you right now, we’ve absolutely closed the gap between the two, we’re comfortable with where we are going forward and of course our supply chain is longer. So, we saw that completely caught up with our customers and so lot of time with customers our design win activity is improved quarter-on-quarter, we don’t think we’ve lost anything I think you know this business, it’s not when you get designed out very quickly.

So, I think we are absolutely through the hard part of it. Now as far as what’s baked into the next quarter, there’s not lot of supply improvement baked into next quarter, we chose to and continue to be a consistent, to take almost pragmatic approach as we could. I think it’s important to remember that when we acquired this business that, we were dependant on one supplier and that supplier was a captive supplier and they are making changes to become a foundry and as they go through those changes we’ve got very involved with them and helping those changes to take place. So, we don’t have these kind of issues, but we’re caught up and going forward here.

Craig Hettenbach – Morgan Stanley

Okay, so if I could just follow up on that. You are saying uptick and any improvement but do you expect any impact in other words, do you think in Q3 would have been able to ship more or not?

John H. Kispert

Yes, we absolutely, I mean we had nice momentum going in until the really golden, we came along in the fabs cut got power down if you will and cold starts did not go well. And we are caught up now. We think Q3 could improve certainly the demand there. It's really a matter of us increasing the supply week in and week out.

Craig Hettenbach – Morgan Stanley

Okay. If I could follow-up the focus you guys place on the balance sheet right back to where you were before the acquisition, how are you thinking about that in terms of other potential deals, tuck ins or any cash return, how should we think about the balance sheet improvement?

Randy Furr

Yes Craig, good question. I get that a lot. We are going to continue to focus on generating cash and I think an ideal world we get to kind of net cash position which would be ideal. With that said, we do have a rather active corporate development effort to look at areas where we think as you mentioned a tuck in acquisition here or there might benefit us, but there is nothing at this point that’s we can talk about. I think if we get to a point to where, we get to net cash position then I think we then reevaluate what we do with the cash and potentially return some of that to shareholders, but we are not to that point yet.

Operator

Your next question comes from the line of Chris Hemmelgarn from Barclays. Please proceed.

Christopher Hemmelgarn - Barclays Capital, Research Division

Thanks very much for taking my question. Congrats on the good margin guidance. It’s very exciting to see the progress there. I guess first of all, I mean do you kind of following up on the supply issues. I mean once you are able to bring production in-house, does that really ease that materially, do you think you could do materially more business once you bring all that production or some of the production out of Fujitsu’s fabs?

John H. Kispert

Hey Chris, we are very confident that we will have lower cost and far more predictable supply and the ability to make longer term commitments to our customers. We are very comfortable with that. I think it's important for everybody to understand also, the first couple weeks of this quarter have been very solid as far as the supply coming out of our fabs in Japan. They are very good. So, we are up to a good start in fact Q2 would last for couple of days longer, we wouldn't be having this conversation. We were really, thought we were going to have a chance to make it in Q2. So right now we are seeing steady progress in Japan, but that doesn’t detours us from the plan we stated before which is to bring more and more of the production in-house and those plans are proceeding.

Randy Furr

I will add though that you mentioned Fujitsu, there are going to be a long term partner for us in certain areas for a long time and for certain technologies we will not bring in and we will continue to work together and improve the challenges that we have experienced in the supply side. We work together and know get better and these kinds of issues we experienced in Q2, we will improve that. We hope that we won't see those in the future. I do want to stress that we are married to Fujitsu for a long time here and we want to work together and continue to get better together.

Christopher Hemmelgarn - Barclays Capital, Research Division

That's helpful, thanks. Then is my follow-up, could you just discuss little bit what assumptions you have for your sub segments that you baked into get to your Q3 guidance and then beyond that I mean now that you have had, I guess, you are coming up in a year that you had Fujitsu integrated, what are you seasonality expectations for Q4?

John H. Kispert

Hey Chris, this is John, just the way I think about things, I think about them regionally, sonly just walk through region by region as far as how second half is kind of line up and which, I think your questions which application or platforms are stronger. I think Asia, across flash, microcontroller and analog fundamentally China we are going to see nice solid growth there. It seemed to have done very good job as far as demand creation and they already own six applications like set-top box and home gateway and we talked about securities and surveillance before actually game consoles also is now out of force there. We are in – our performance of your MCUs and the density continues to increase in flash in Asia. So Asia what we call Asia Pac which is essentially China and so we see nice opportunities to the second half of the year.

Japan, I would say it's very relatively flat. We are very, very focused on, it's hard to get an uptick in what the demand signal really is. But we are getting more and more penetration across auto, industrial, many of the consumer markets, but a really lot of it tied to the Japan economy and purchasing. So right now, we are probably taking more conservative approach there and thinking about it.

In Europe, the seasonality to your question is, is the June quarter always the difficult quarter and that's not behind us, I mean, I think we did very well there. We definitely think it's up going into Q3 and its driven by industrial and auto for us and the team is doing a great job there and across flash, across microcontrollers and of course the analog piece.

We were really bit focused on Korea, primarily in the consumer, high end consumer devices as well as auto and that’s going well. You will see very nice growth for us in the second half of the year in Korea.

And Americas steady improvement, we don’t see a big huge uptick where we are going to be a very strong second half of the year, we will be in the communications networking and routers really as probably the outlier growth for us. I think if you would have to summarize how we look at this, in the flash business we are going to focus on where we can create more and more value and we are not going to focus on areas where there is just revenue growth, we are really going focus more on and where we can bring more engineering support and more of our value add and of course create higher margins.

And the AM business, right now the more we can supply, the more we can grow and that’s a big focus for us and the design wins are there, it’s just a matter of us reacting to it.

Randy Furr

And Chris you had a second question, what was it?

Christopher Hemmelgarn - Barclays Capital, Research Division

Just beyond regional, I mean any comment on how you break out industrial transport com gaming and consumer in terms of your expectations for Q3?

John H. Kispert

Yes as I said kind of by region, I gave you that where we were I think that stronger, I mean in today’s world the platforms by region can get very much different just where the key suppliers are.

Christopher Hemmelgarn - Barclays Capital, Research Division

That’s very helpful. Thanks guys.

John H. Kispert

Thanks Chris.

Operator

Your next question comes from the line of Suji De Silva from Topeka. Please proceed.

Suji De Silva – Topeka Capital Markets

Hi guys. So, on the guidance, it’s a little wider than typical I understand, bunch of puts and takes here. But what can go kind of in the quarter than can help you towards the higher end versus lower end from the supply side versus where you are now?

John H. Kispert

Yes, Suji, I think number one thing is supply microcontrollers and analog business, we are supply constrained, demand keeps improving and we were kind of all hands on deck we have been now for two months right from sales folks, right on back to everybody in the operations team to get high quality parts to our customers so that hands down is the best opportunity. We see very good opportunities on the flash side, the density keep improving, I think the pricing is better than it has been in the last two years, three years we see steady improvement there. So I wouldn’t expect as much growth there where we are going to have growth on the flash side, it’s going to be in the higher densities, we think it will be up in 10% to 15% in higher densities year-on-year and that’s of course where we focused the most. So I think steady on the flash side.

Randy Furr

Yes, I will add that we are trying to somewhat change our orbit and focus on higher value opportunities especially in the flash side of our business and I think that might cause you some top line, but if you look at the midpoint of the guidance for Q3 and gross margin, its 35% up from 33.2% went roughly $10 million increase at the midpoint. If you do the math most of that increase is really falling through, so the point of that is that look if we really want to focus on top line growth we could possibly do that at the expense of gross margin, but what we are really focusing on here today is higher value added opportunities which will favorably impact our gross margin as we kind of reflected in our guidance there.

Suji De Silva – Topeka Capital Markets

Okay and then a little bit longer term question on supply, Fujitsu is only foundry customer and when you do transition products over well certain families be done in-house versus Fujitsu or will the entire family be fungible across the two in terms of flexibility?

John H. Kispert

Suji its John. The first part of the question, we are not the only, we are certainly the largest, we are not the only. And the second part of our question as we move, the way you do it Suji is, you move processes, certainly we have identified processes and we are working with Fujitsu on that. We are also working with a foundry, you will see announcements coming out of Japan whether foundry will start working more and more with Fujitsu and we think that would be very positive for us because obviously it’s a different business model, different set of processes that they can bring to the Fujitsu team. But to answer your question both on the analog side and MCU side, we have identified processes and we are going to transition over the time and we have bunch of folks working on it.

Suji De Silva – Topeka Capital Markets

Okay, great. Thanks guys.

Operator

Your next question comes from the line of Rajvindra Gill from Needham & Company. Please proceed.

Rajvindra S. Gill - Needham & Company

Thanks for taking my questions. Can you talk a little bit about the lead times in the microcontroller business, now factory in the production issues?

John H. Kispert

It’s a great question. It’s changing mildly, Raj are you a customer is that a way are you asking?

Rajvindra S. Gill - Needham & Company

Yes.

John H. Kispert

We are, there is a difference when you have environment like this, we are not really stating leading time, it’s a very sticky businesses we are in. We are literally living on what we produce gets direct to customers. Now the question earlier nobody has got lines down on us and I’ve been very proud of both the Fujitsu folks and our team to keep that from happening. But, we’re not even in a position where we are saying that this is a lead time, we are in a position right now where we just want to make sure that we are not screwing up any of our customers’ production schedules and that’s really the focus right now.

Randy Furr

In fairness to the business, our customers’ demand in that business and the microcontroller and analog is up, I mean, we are having to deal with it, the challenge is that some of their businesses are doing pretty well and it does mean incremental demand capacity that we need to do go deal with and that’s what we are doing with today.

Rajvindra S. Gill - Needham & Company

And so, you have talked about kind of a 40% growth margin hopefully by mid next year and you talked about OpEx being around 25% of sales, so you gain 15% operating margin, given that you have got a pretty well for the gross margin, again update on your thinking along those lines?

John H. Kispert

I’ll allow Randy go first on the modeling type and I can go –

Randy Furr

Rajiv, I appreciate the question. I think I do remember the question and the question was along the lines, given everything you are seeing in the business, the combination of the headwinds and the tailwinds, could your business get to a 40% gross margin by midyear next year and to answer that because we don’t provide guidance, but to answer that question would have obviously been at least in my mind, would have been yes. And we could get there and I think what would drive that would continue to be the things that we have mentioned in the past which is continuing to grow our licensing revenue and to continue to increase capacity utilization in our internal fab here going forward. And moving some of the analog, microcontroller production internal and those three things alone will help contribute nice increase to the gross margin. We will get the 40% by midyear and I am not going to on this call predict that but it is something that certainly could happen by then.

Rajvindra S. Gill - Needham & Company

And, last question just on the licensing, I am trying to reconcile the OpEx, which you’re showing is $10 million offensive litigation which is strip out, you don’t strip out, you said it has $0.10 EPS impact. But at the same time you are not sure about the royalty stream when you are going to be able to monetize that. I just want little more color on what's going on with licensing and when you think that could pick back up again and what are the factors in your mind? Because I think previously at the start of the year you said that the ongoing licensing royalty would kind of increase from $10 million a quarter to $15 million to $20 million kind of excluding any one time settlement. So, I am just wondering what the progress is there? Thank you.

John H. Kispert

Raj it’s John. Over the last six to nine months we have said it about incrementally about $18 million, so I don't think anything has changed, we went into the June ending quarter, our Q2 with probably about half to dozen opportunities where we were in negotiation. The quarter ended before we could close on them and frankly it had more to do with us trying to get the right transactions in place for all of our constituencies, our employees our customers and our shareholders. Not these opportunities have gone away, they are all still there. We still believe we have plenty of opportunities this year. I can tell you from my perspective patience is probably the right way to go on this, we think that more value created as time goes on with the technology that we have. So, I hope that gives you a little bit of flavor, a little bit of context of what we are looking at.

Rajvindra S. Gill - Needham & Company

Thanks.

Operator

Your next question comes from the line of Krishna Shankar from Roth Capital. Please proceed.

John H. Kispert

Krishna, are you on?

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Yes, can you hear me now?

John H. Kispert

There you go. We can hear you.

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Yes. I was just wondering if you could perhaps have more strength in Q3 at some of your foundry constraints disappear and you move more off the capacity internally, do you anticipate some sort of catch-up upside in Q3 in the analog and microcontroller product revenues?

John H. Kispert

Yes, I think that's the big question Krishna. We are trying not to predict exactly when that's going to happen, but certainly our focus, lot of people working on it. There is still – demand is still out stripping the supply even though team has done a great job. We have had at the first three weeks of this quarter have been very good from the supply side, I am very happy with the improvement. And as you said, longer term when I say longer term, it’s into next year and the following year, we will be moving production to our fab in Austin, specific products where we can do that relatively sooner and that will give us lower cost base and obviously more control in predictability and production levels going forward.

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Okay. And Randy in your guidance for Q3 again what kind of licensing and royalty revenues are you assuming?

Randy Furr

Yes. So, good question. So, we are expecting a small increase in the licensing and royalties. It's in $2 million to $4 million range and again that’s based upon what’s transpired thus far in the quarter and what we expect to happen by the end of the quarter. That could prove to be conservative, but obviously after last quarter if we got anything in the estimates we feel pretty good about it.

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Okay. Thank you.

Operator

Your next question comes from the line of Vijay Rakesh from Sterne Agee, please proceed.

Vijay Rakesh – Sterne Agee

Hi John and Randy. I still look at 3Q, you mentioned long cycles down and you are not baked in any supply chain improvement, but I should look at Q4 do you expect the supply chain to be in full swing by then and are you looking at fixing the Fujitsu side of the business or accelerating the pull ends?

John H. Kispert

Say the last part of the question Rakesh, I didn’t catch the last part of the question.

Vijay Rakesh – Sterne Agee

Yes, I was wondering if you look at fixing the supply chain, are you more looking at fixing Fujitsu or accelerating the pull end of products into your own fab? Thanks.

John H. Kispert

I would say that we are working very closely with Fujitsu in adding capacity and it took longer than we had anticipated and we are going to continue to work on that. At the same time, we are working, I would say just as hard, it's a different group of people which is ramping the new processes in your fab. So, in parallel levels and I wouldn't be able to say one is getting more focus then the other, I can tell you both are very, very important. I think one question earlier to the first part of your question Rakesh is that in our microcontroller analog business and even in our flash business, Q4 is typically the best quarter. With the supply constraints we only get one quarter guidance, but we are certainly reluctant to sit there and say good – I do feel very confident that we are not losing market share where times like this actually bring you closer and closer to your major customers because you are talking to them constantly and working on kind of solve some of these issues. So, we feel good about moving into the second half of the year with what we have gone through in Q2.

Vijay Rakesh – Sterne Agee

Got it and if you look, you mentioned strong design wing here, can you give some color on the number of design wins as you look at 2Q and how the pipeline looks as the customers are still sticking around, I mean, how the response has been obviously just a little bit to that and a little bit here? Thanks.

John H. Kispert

Unfortunately, the call broke up there little bit Vijay, I just want to make sure we understood the question and it has to do with the pipeline going forward of demand?

Vijay Rakesh – Sterne Agee

Of your 2Q design wins and your pipeline of design wins going forward and if the customers are still sticking around and how the customer response has been with this? Thanks.

John H. Kispert

Vijay it’s John again. I think the customers have stuck with us and we haven’t lost anybody. Everything as I said earlier, it’s human nature when things are tough, you spend more time to get work on issues together. So, I would say in Japan, stronger and stronger relationships certainly in Europe in the auto industry stronger and stronger relationships. I think you guys can see that in our design win improvements. It’s unlikely you are going to get new business if you are not delivering to folks where it's kind of a 24/7 operation where we are just standing on top of each customer and there is many of them and making sure that we are not letting them down and on the delivering. They, of course, would like more and more inventory also. We have depleted their inventory so there is – that’s why once the supply can get up to where the demand is, we think there is some more opportunity for the company because folks would like more inventory in the channel and in in-house next to their product.

Vijay Rakesh – Sterne Agee

Okay and just last question, how much is design wins up sequentially in 2Q if you could give us a number on that just to get some more color? Thanks. That's it.

John H. Kispert

Yes Vijay, it was in my prepared remarks. I just off the top of my head, auto actually was more flattish maybe slightly down and primarily because things don't go as fast in Germany, we are obviously big part of our auto businesses in the months of June. Frankly going into July and August, but still is very healthy bigger than almost double when it was last year when we got into the business. Industrial was up. We are very excited about that. Consumer was up and the key for us in consumer is focusing on the right platforms. So once we are – we talked about carrying more value in where we can use our expertise more so, we like to call high value add design wins in the consumer market. And in communications and gaming, I would say it was relatively flat. There are some, I think we are also good start there though for Q3 just the timing and some of the engineering programs particularly in communication. So, I think we are in a very good position there and things are, well that will be strong for us in the second half.

Operator

And ladies and gentlemen that concludes our question-and-answer session. I will now turn the conference back to John for closing remarks.

John H. Kispert

Thanks very much Kim and thank you to everybody for joining us today. We appreciate your interest in Spansion. We will be presenting numerous investor conferences throughout the quarter and look forward to seeing you and have a good evening.

Operator

This concludes today's conference. Thank you for your participation. You may now disconnect. And have a great day.

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Source: Spansion's (CODE) CEO John Kispert on Q2 2014 Results - Earnings Call Transcript
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