Molex F2Q07 (Qtr End 12/31/06) Earnings Call Transcript

TRANSCRIPT SPONSOR

Molex (MOLX)
F2Q07 Earnings Call
January 18, 2007 5:00 pm ET

Executives

Neil Lefort - Vice President of Investor Relations
Martin Slark - President and Chief Executive Officer
David Johnson - Vice President and Chief Financial Officer
Liam McCarthy - President and Chief Operating Officer

Analysts

Errol Redman - Redman Capital
Matthew Sheerin - Thomas Weisel Partners
Bernie Mahon - Morgan Stanley
[Bhupen Bohar] - Bull Securities
Michael Walker - Credit Suisse
Tom Deng - JP Morgan
Carter Shoop - Deutsche Bank
Jim Suva - Citigroup
Steven Fox - Merrill Lynch
Yuri Krapivin - Lehman Brothers
Kevin Sarsany - Next Generation Research
Shawn Harrison - Longbow Research
Jeff Rosenberg - William Blair & Company
Alexander Paris - Barrington Research
Alan Mitrani - Sylvan Lake Asset Management
Michael Hamilton - RBC Dain
Scott Craig - Banc of America

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the Molex Incorporated 2007 Second Quarter Earnings Conference Call. My name is Camie and it will be my pleasure to be your coordinator today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session toward the end of this conference. [Operator Instructions].

As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to the Senior Vice President of Molex, Mr. Neil Lefort. Please proceed, sir.

Neil Lefort

Thank you very much, Camie and thanks to everybody for participating with us today. So with me on the call are Martin Slark, our CEO; Dave Johnson, our CFO, and Liam McCarthy, our President and COO.

As Camie said, this call is being recorded and is available in telephone replay by dialing the numbers supplied in the press release. The call is also available live and in replay by accessing our website. Please note that we have added slides to our presentation, and those wishing to view the slides, can do so on our website under the Investors section.

As usual, we would like to limit the call to one hour, and in the Q&A mode, we would like to ask for one question per participant and one follow-up question. Thank you.

And now I'm going to turn to page two on our slide which is our forward-looking statement. I'm just going to read an abbreviated version of that on the call to save time but the forward-looking statement is also contained in the press release.

Statements in this conference call that are not historical are forward-looking, and are subject to various risks and uncertainties that could cause actual results to vary materially from those stated. This call speaks only to the date and Molex disclaims any obligation to revise these forward-looking statements or provide any updates regarding information contained in this call resulting from new information, future events or otherwise.

Now I'd like to briefly look at page three and have you look at page three which is our summary of the quarter. It covers year-over-year growth in organic and the definition of organic for the call is the Molex results without the inclusion of the acquisition of Woodhead.

I'm now going to turn to page four where I'm going to go through some of these summary items in more detail. Sales increased 20% for the quarter to 200 -- sorry -- $837.5 million. Organic sales excluding Woodhead grew 12%. Sales were within the range of our initial outlook; however the mix by industry shifted during the quarter with an unfavorable impact on margins. As a result, gross margin was disappointing and declined to 30.9%. Dave will have more to say on this later.

SG&A was 20% of sales, flat with September and down 90 basis points from last year. The effective tax rate was increased for the quarter to 30% compared to 28.5% in September. This was the result of adjusting the full year rate of fiscal 2007 to an estimated tax rate of 29.2% and is primarily due to the mix of earnings on a global basis. Earnings per share were $0.36, up 16% from last year but disappointing when compared to our outlook at the beginning of the quarter. All EPS comparisons during this call are to last year's GAAP reported results.

Now looking at page five, which is an analysis of the backlog. The backlog at the end of the December quarter was $375.9 million. That backlog represents an increase of 26.3% over the prior year. The backlog did decline from $425.3 million at the end of September so there was a sequential decrease in the backlog of 11%. As I said, the backlog was 26.3 above last year and would be up close to 20%, excluding the $19.8 million that is added for Woodhead.

Now, I'm going to look at the stock -- briefly look at the stock buyback. During the quarter, we bought 260,000 shares of MOLXA. We spent $7.5 million to do that. Just a reminder to everyone, the Board extended the authorization of the buyback which was the $250 million buyback to September 30, 2007; therefore, we have about $37.5 million left under that authorization.

Now I'm going to turn the call over to Martin.

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Martin Slark

Thank you, Neil and good afternoon, everybody. Looking now at slide seven which shows our revenue trend over the last five quarters, that's $838 million, actually those revenues were all-time record for Molex and as Neil said, were up about 20% from the prior year and well within the guidance that we have previously given.

If you now turn to slide eight, I'll talk briefly about where that revenue growth came from by industry sector. Our strongest growth this quarter was in the diversified industrial market which really supports the acquisition we have made of Woodhead to strengthen our position in that market. This, as you know, includes digital industrial applications but there's very good growth in the medical electronics and the non-automotive transportation sectors.

We had good growth in Consumer, driven by digital consumer electronics and the games market where we have strong plan with all of the three major manufacturers there. Automotive was surprisingly strong but reflects continued increase in electronic content in vehicles and increased penetration of Asian suppliers which we think will be an increase in the important factor moving forward.

Growth rates in the Telecom and Data markets were weaker this quarter. Weaker growth in Telecom was due to the cell phone sector. In the Data market, weaker areas were primarily in the mainframe and desktop sectors. Desktop data storage and the notebook sectors remained strong.

Turning now to page nine, and looking at our bookings, they obviously dropped significantly from September quarter; however at $779 million, they were close to the quarterly average of $780 million over the last five quarters. When compared to the high-end September quarter, it helps them to note that firstly, the year-over-year growth rates were strong in July and August and as we previously mentioned, moderated in September.

This moderation accelerated during the December quarter and was further negatively impacted by supply chain inventory corrections primarily in the month of December. For example, our highest sequential decline in bookings occurred in the EMS contract manufacturing sector and most likely this is a result of adjustments to the year-end inventory levels.

Bookings also declined sequentially in the distribution channel. As we mentioned on last call, the September quarter was very strong in this channel. Effective September 1st, we put through increased prices to our distributors. Some of the strengthen in the September quarter and the corresponding drop in September maybe due to distributors booking early in July and August ahead of the price increase. Some of the current decline was also due to inventory adjustments that distributed, mostly we believe of their larger accounts.

So the benefit of hindsight, the exceptionally strong 20% bookings growth and the 1.05 book-to-bill ratio in September, clearly ended up impacting us in December and reduced our overall bookings for the quarter.

Now let me pass the call to Dave Johnson.

David Johnson

Thank you, Martin. The reconciliation on page ten shows the elements making up EBITDA for the current quarter compared to the last quarter. Starting with net income of $66.4 million and subtracting net interest income of $2 million, that is comprised of interest income of $3.7 million, offset by interest expense of $1.7 million, and add back income taxes of $28.5 million and the effective tax rate for the quarter was 30% which was an increase from our effective tax rate last quarter of 28.5%.

We've gone through the process to estimate our full year rate and is now 29.2% and we made that adjustment this quarter. The increase in the effective rate simply reflects the mix of profit between countries with varying tax rates. Then after adding back depreciation and amortization of $59.6 million, we arrive at EBITDA of $152.5 million or 18.2% of revenue.

The key balance sheet metrics are shown on page 11. Cash decreased slightly to $343.5 million and that's after repaying a $44 million 5.5% line of credit with the US Bank.

Next accounts receivable decreased in absolute dollars but increased slightly by one day to 75 days and that's primarily as a result of higher days from some key customers in Japan. Inventory increased by $15 million of which $5 million is an increase related to our VMI inventory at customer service hubs. Inventory days increased by one day to 73 days, but the VMI hub days increased by about seven days to a level that is well above our historic norm.

During the quarter there was a movement of additional inventory to hubs as directed by our customers and at the end of the quarter there was also a slowdown in pulls from hubs, particularly in the mobile phone customers.

Total debt dropped to $132.8 million, just during the quarter and that's due to the repayment of debt that I mentioned previously. The balance of our debt is primarily a three year yen denominated financing for 15 billion yen or approximately $130 million at current exchange rate, and that carries a fixed interest rate of just under 1.3%.

Capital expenditures for the quarter were $80.2 million and R&D was $40.4 million, reflecting the continued investments that we're making in new products and capacity for the growth of our business.

Our gross margin trend, as shown on page 12, gross margin for the current quarter was 30.9%. That's 160 basis points below Q1 and 180 basis points below the prior year quarter.

The primary drivers for the sequential reduction in gross margin are first, the impact of unusually high price erosion from our mobile phone customers which is related to contract price negotiations. The sequential impact of the price erosion from just our mobile phone customers was $11 million.

Next, based on our policy with the increased -- we increased our reserves for slow and excess inventory by approximately $3 million during the quarter and that's as a result primarily of our declining order backlog from customers. We called it orders decline by about 10% sequentially from Q1 to Q2.

And finally, we incurred start-up costs in the new product technology area that is currently ramping up for a single customer but will be expanded to additional customers in fiscal year 2008. Our gross margin losses for the initial program in this quarter were about $2 million.

Our SG&A trend as a percent of revenue is shown on page 13. A year ago, in Q2, we were at 20.9% of revenue, Q3 last year, 21.8%, Q4 came down to 19.6% and then in the first quarter of this year, and now, again, in the second quarter, we're at 20% of net revenue. This quarter's SG&A reflects sequentially higher selling expenses and lower admin expenses and then higher foreign exchange losses but in total, as a percent of sales, as I said, is at 20%.

The trend of return on invested capital is shown on page 14, a year ago in the second quarter we were at 9.3%. That increased to 9.8 in Q3 last year, up to 10.3 at the end of last year. Q1 was up again sharply to 12.1% and then, now, back down to 11%, a decline but not back down yet to the Q4 level of last year. The decline in the ROIC is primarily a result of our decline in gross margin and therefore net income during the quarter.

On page 15, we reiterate our long-term model. Our long-term model to remind you is to have gross margin in the range of 33 to 35%, SG&A in the range of 19 to 21%, resulting in a net income percentage of 10%.

It's easy to see that our biggest challenge today is getting gross margin back to the lower end of our model range of 33%. To get back to this level, we will continue to work on our product printing activities which most recently have been focused on the industrial market.

We're making good progress on the Woodhead acquisition integration which we expect to further improve our gross margins, and we are moving rapidly toward our new global division structure which we expect to allow us to deploy assets more effectively, across the Company, and to improve our new product selection and development processes as we go forward.

Now, I'll turn the call over to Liam for some comments.

Liam McCarthy

Thanks, Dave. I would now like to give an update on Woodhead, which was if you're looking at the slides, is on pages 16 and 17. So if you turn to page 16, firstly, I'd like to say that we are making good progress on our integration planning with trends develop to leverage economy to scale, eliminate duplicate activities and implement best practices.

From the planning phase of the integration process, we've identified synergies across many functional areas and we are working now on those very seriously. Part of which is the consolidation of manufacturing in the Woodhead Americas operation into our wireless Mexico, which -- and this part of the process is already in progress.

The total planned synergies is tied to the functional operation areas, tied to (inaudible) target of approximately $15 million to $20 million over the next two and a half years, which less than half of this will be realized in fiscal '08 and the full amount will be realized by fiscal '09.

If you turn to page 17, the other area of dimension of synergy associated with the Woodhead acquisition would be synergies on the sales and the marketing channels. These include the opportunity to sell existing products in Asia, opportunities to sell Nordics products through the Woodhead channel, etcetera.

So there's many synergies in the sales and marketing area. Our integration planning team has projected that this synergy can increase the annual Woodhead revenue by up to 10 to 15% over the next three years.

And finally, we see the second half sales of our Woodhead industrial line that it should be significantly stronger than the first half, significantly in the range of 15 to 20% higher than the first half, which would be in line with the historic trend or pattern. Consequently, we would expect operating margins should be stronger in the second half for our Woodhead business.

We're very positive on the acquisition of Woodhead. It has significantly increased our knowledge, our capabilities, and strength to build industrial as a much more significant part of our total business.

Now I'd like to pass you over to Martin.

Martin Slark

Thank you, Liam.

If you'd now like to turn to page 18, I'd like to talk briefly about the outlook for the next quarter. The Company estimates that revenues in the third fiscal quarter ending March 31st 2007 will be in the range of $800 million to $830 million, and earnings per share will be in the range of $0.32 to $0.36. The Company anticipates providing an outlook for the 2007 Fourth Quarter ending June 30th 2007 in its next earnings release on April 19th 2007.

I would like to emphasize that we are not seeing abnormal rates of order cancellations or delays in customers' new projects. Rather, we believe that the industry demand is in the process of returning to more normal growth rates. And this moderation process is being augmented by above normal seasonal inventory adjustments within the supply chain.

To put things into perspective, our total sales during calendar year 2006 grew by 21.3%, and organically it grew by 17.9%. These results compare to an estimated industry growth rate of approximately 12.6%. We believe for the growth of 1.7 times the market is a reasonable achievement for the second-largest company in any industry.

Forecasts we have seen for global GDP indicate a reduction in growth from 3.6 to 2.7% in 2007. Industry forecasts the connector industry reflect this moderation with a projected growth rate for the connector market of approximately 7.9%. While a significant reduction from 2006 growth, this still represents strong industry performance at the higher end of historical levels.

We're working on very positive long-term initiatives, such as our global reorganization, and we are confident that the integration of Woodhead is proceeding as planned. And as mentioned earlier, we will see synergies that will result in higher sales growth and cost reductions.

We'll also continue to review our overall cost structure and adjust where we think it is prudent. We also have a very strong balance sheet, which should help us manage without external constraints, no matter how the global conditions may change. In total, we believe the Company continues to be very well positioned in an industry that will continue to grow.

Thank you very much. We'll now like to turn the call open for questions.

Question-and-Answer-Session

Operator

And ladies and gentlemen, as a reminder, we ask that you limit yourself to one question and one follow-up only. [Operator Instructions].

And your first question, gentlemen, comes from the line of Daniel Lopez with Redman Capital. Please proceed.

Errol Redman - Redman Capital

Hello. My name is Errol Redman. And my first question is your forecasts imply on a net income basis that the margins will contract. You don't provide the gross margins. And by "contract," I mean, in comparison to those that were reported in the second quarter of fiscal '07. Could you amplify the reasons why this contraction is taking place and when do you expect it to change?

Martin Slark

Thanks, Errol. That's a good question. And Dave is going to -- Johnson is going to give you some additional detail on our projections for margins. And then I'll probably add some additional comments afterwards.

David Johnson

As Martin pointed out, the guidance that we have is for revenue of $800 million to $830 million and EPS of $0.32 to $0.36. In terms of the margins, certainly, that will depend somewhat on where the revenue level is. But at the midpoint of that guidance, I would expect margins to be up slightly.

I don't think that guidance implies they're coming down. We would have a slight improvement, I think, in margins, though slight. And there's some factors to lead to that. But there will be a sequential increase also in SG&A probably. And then as a percent of revenue, it would be increasing, because our revenue would be or is forecast to be coming down from the second quarter.

Some of the factors that would lead to an improvement in the margins are some of the costs that we incurred during this quarter that we believe will not repeat. But you know, we're being cautious, now.

The margins that we showed and we reported in the second quarter, 30.9%, is certainly well below our target level and we're working hard to move that back in the upward direction. But I think we'll be cautious in giving guidance and move it up too quickly in the third quarter.

Martin Slark

I think, Errol, one other comment we would add to that is that one of the significant headwinds our industry has had during calendar year '06, as you know, has been very dramatic increases in the cost of the key raw materials we buy, particularly copper.

And as you know, in the last quarter, there has been a fairly significant reduction in the cost of copper. The stock price of that since the end of Q1 versus the end of Q2 has dropped 18%. And so far, this quarter, it's dropped another 10%. So one of the things we're trying to factor in as well is at what point in time does that impact the buy prices of the key raw materials we buy and when we might benefit from that.

Errol Redman - Redman Capital

Could you -- on that very last point, I was hoping that you could quantify it or give us some metrics that we can understand, the effects of copper decline on your gross margin percentages.

And then the other question I had was you mentioned mobile phones as a cause -- as one of the causes for the margin compression in the second quarter. Could you amplify that and discuss when and if or how you hope to reduce these problems? Because it was only a very small shortfall in revenue caused an unusually large margin impact. So I was hoping you would go into more detail on that issue.

Martin Slark

Let me tackle the mobile phone question. And then I'll let Dave or Liam talk a little bit about the extent to which we think at this point we can quantify the potential impact of raw material changes on our operating numbers.

What happened in the quarter in terms of the profit impact on for us in the mobile phones is really a combination of two things. First of all, if you look at the cell phone industry, which I'm sure you've been studying, the actual unit growth in the cell phone market was about as predicted. There were close to 1 billion cell phones sold last year.

But what's happened is the mix of those phones, which at the beginning of the year were predicted to be approximately 50/50 in terms of higher-end, high-functionality phones versus low-end, voice-only phones that are sold in the developing world shifted pretty significantly towards the lower-end phones, where frankly there are also lower margin components used.

And I think you've seen the impact of that a tad on Nokia and Motorola. So in total, it's still a very profitable area for Molex, but there was a significant shift in the market. We also renegotiated some prices to lock in our business volume for the next couple of years because we believe that that market is still attractive in the long run.

But I think the combination of price negotiations with some of those key customers and the mix change is what impacted the overall margin. I'll let Dave talk about the impact of copper.

David Johnson

Okay. The -- Martin gave you some of the spot price changes. The way I look at it is really the average price of copper in the second quarter was up about -- I'm sorry, was down about 8%. The average price in gold was actually pretty flat Q1 to Q2. And as you know, we've got some of that hedged. And so really no change on gold.

Trying to predict what the actual dollar impact of copper is in the quarter is a bit difficult. We've tried to estimate that. My view is it's probably, at this point, no major change between Q1 and Q2. Some evidence that we have is we still have $1 million purchase price variance positive PPV which indicates the -- that in our -- still in our inventory, we have higher costs from prior periods negative purchase price variances which we had to capitalize again this quarter.

So I think looking to the future though, if the prices stay where they are or continue to come down, more importantly, if the price of copper continues to come down, kind of the cycle that it would hit our income statement, I think that somewhere toward the end of this third quarter, we might be seeing impact of that. We have not factored that into our guidance that we have assumed no impact positive or negative on the change of copper for this third quarter.

Operator

Your next question comes from the line of Matt Sheerin with Thomas Weisel Partners. Please go ahead, sir.

Matthew Sheerin - Thomas Weisel Partners

Yes, thank you. I just wanted to ask a question regarding your comments on pricing to handset customers. It sounds like it was a little bit worse than you expected. Could you elaborate a little bit on that? And are you in the position to walk away from certain deals with customers in order to focus on more profitable business, or do you have the sort of the capacity in place where you need to continue to focus on that area?

Martin Slark

Thanks for that question. We have annual price negotiations, obviously with a lot of our major customers, and some of the cell phone ones come up in this quarter. And obviously, when you're a major supplier to those customers, you look at the overall mix of business. And I think the overall business with the cell phone market is still a very good one for us.

And we think that market is going to continue to grow and also we look at that. We look at the overall handheld device market and what we can potentially sell into that with existing products and future products. And so, I don't think we've been in a position yet where we want to walk away from any business because, frankly, where the margins erode sometimes that's on all of the products as well and we want to maintain our share with all of those accounts.

And we have a very large market share with those significant clients, which enables us to continue to work with them today and participate on new designs. But I think you've seen that this was a tough quarter for the industry and the fact that we are a major player there was reflected in our results.

Matthew Sheerin - Thomas Weisel Partners

Okay, great. And just as a follow-up question, you've talked about automotive being relatively strong. Could you just talk about your opportunities going forward in automotive and how you're positioned there?

Martin Slark

Yes. We're getting to the point now where roughly 20% of our sales are in the automotive market. And as you know, we started from a very low base in the automotive, not that many years ago. So we are very pleased with the position that we have built.

And as we've said in the past, our position historically has been strongest in North America, next strongest in Europe, and perhaps weakest in Asia, but we've been working very hard the last few years to strengthen that position in Asia. I think a number of trends are happening which we think are positive for Molex because I think most people would be surprised to see ongoing growth in automotive revenues given what's happened to the big three in North America.

The two big trends are there's increasing electronic content in the car and that's not the old electrical content that was dominated by previous suppliers of the industry. It tends to be comfort and convenience, safety type applications, which are electronic in nature, using products that Molex is very strong in. And then a very strong position in Japan and China is helping us build a stronger position with those players.

In total, the automotive market represents about $9 billion of the overall worldwide connector market. It's the largest single segment that is out there. So I think continuing to build our segment there, our strength there globally and our market share globally is a good long-term trend for us.

Operator

Your next question comes from the line of Bernie Mahon with Morgan Stanley. Please proceed.

Bernie Mahon - Morgan Stanley

Hey, good evening. Question for you, and as it relates to demand, seems like you're a little bit weaker in revenues in the December quarter and I think you just -- that's mostly attributable to the handsets. Is there any other segment that was maybe a little bit below plan?

And then when you look out to March, it seems like your guidance is kind of in line with normal seasonality. I mean is there any segment that you think is a little bit weaker or a little bit where you're seeing a little bit more strength than you would have previously anticipated?

David Johnson

Yes, thanks for the question. Let me give you some initial thoughts on that and Liam may have additional comments. I'd say the other segment that was weaker in the December quarter compared to our expectations in September were certain parts of the data market. The mainframe computer part of that and desktop computing was weaker than we had anticipated. But data storage continues to be strong and we think that will continue as we go into this quarter.

I think the segments that we were pleased with were the ongoing growth in industrial, which we think Woodhead is helping us there get into new customers and new applications, and particularly the medical part of that market, and again, we think the ongoing penetration of the electronics in automotive.

The things -- the other ongoing trend we believe there it is if you think of seasonality these days, what will happen in consumer related markets, which is consumer electronics and we think the cell phones, is you're going to see a lot of new models to be launched after Chinese New Year. So typically, you would see a seasonal drop now, and then, hopefully, a pickup would start in March.

Bernie Mahon - Morgan Stanley

Okay. So just to maybe summarize, for the March quarter, where you are seeing probably more -- broader strength? Or from an end market perspective, are you still expecting kind of weakness in the servers and mainframe and in the phone segment?

David Johnson

I would say the places where we think we're going to see the strength would be -- strongest would be industrial market.

Bernie Mahon - Morgan Stanley

Okay, thanks.

Operator

Your next question comes from the line of [Bhupen Bohar] with Bull Securities. Please go ahead.

Bhupen Bohar - Bull Securities

Hi, how are you? Hello?

Martin Slark

Good. Yes, thanks. Go ahead.

Bhupen Bohar - Bull Securities

Yes. Just have a small question actually on your sequential booking decline. Could you just give me a flavor on that like what particular end markets actually saw the decline?

Martin Slark

Sure. If you look at the declines in bookings sequentially, the biggest declines would have been in the data consumer and in the cell phone portion of the telecom market.

Bhupen Bohar - Bull Securities

Okay. And the other question actually was about the pricing erosion. Could you give us a flavor like in terms of percentage, like what kind of pricing decline was -- that you see actually in this particular quarter?

Martin Slark

I'll let Dave Johnson answer that question for you.

David Johnson

Yes. I -- during my session, I talked about the 11 -- the impact of $11 million that's -- ironically, it comes out to be about 11% also. So if you look at the mobile business itself the way we calculate our price erosion, the sequential impact was $11 million and the sequential impact was 11%.

Martin Slark

And cell phone if you look at -- the cell phone sector, if you look at price erosion in the overall connector market, we have said many times that historically that has been in the range of 3 to 5%. We've had a number of quarters with the high price of raw materials where price erosion has dropped below the 3% level. In total, it crept up above that minimum level and is back in a more normal range now over the last quarter.

Bhupen Bohar - Bull Securities

Thanks a lot.

Operator

Your next question comes from the line of Michael Walker with Credit Suisse. Please proceed.

Michael Walker - Credit Suisse

Thanks. Dave, you talked about inventories adjustments being part of the problem and distribution and EMS. Are you seeing those corrections and adjustments continue here in the March quarter?

David Johnson

We -- it's obviously difficult for us, Michael, to see the end inventory at the EMS companies. I mean, on a day-to-day basis. We do see them at distribution. Our view is that the distribution situation will correct relatively quickly. And what I can tell you is that I think the biggest reflection of ours would be from a bookings perspective.

And bookings seem to be returning to more normal levels after the significant slowdown we saw in the back half of last quarter. Particularly from those, particularly from the distribution channel, so I think that's the indicator we have. It's obviously very early in the quarter and it's hard to predict any trends from that, but that would be our feeling at this point.

Michael Walker - Credit Suisse

Okay. And my follow-up is I hate to re-ask a question, but I didn't really understand the answer. It does look like you're embedding flattish at best margins in the March quarter. And I know your top line base is going to be down so that hurts a little bit.

But I need to understand what's going on with gross margins. Why are they not going to improve or are they going to improve and exactly what's driving that and why is your SG&A going to be up in dollar terms when your topline is down sequentially?

David Johnson

Okay. Well, let's start with the gross margins. As I said, I do believe that it will be a sequential increase in gross margins, albeit slight. I think that we are, as I said before being cautious to overstate what that growth could be. Certainly, we are trying to make many improvements in furthering our printing activities and I mentioned there was some one-time items that should not recur and there for, we should see an improvement for that.

So how I would look at it is a slight improvement in gross margins and you know, the SG&A activities we've got programs in place. We are moving out on a worldwide Six Sigma program. We are moving out still on a global reorganization. There's a lot of activities that have extremely positive long-term potential, which we are continuing to work on.

Not a significant increase in SG&A on a $1.01 but it's a marginal increase in SG&A. And the way I model that would come to the midpoint of the range that we've given.

Operator

Your next question comes from the line of Tom Deng with JP Morgan. Please proceed.

Tom Deng - JP Morgan

Hi, good evening, guys. A quick one for you, Martin, again, back on the inventory, you talked a little bit like the situation especially with distributors might correct itself a little faster, maybe this quarter. Some of the other ones take a little bit longer but in your prepared commentary you guys has talked overall hubs were up about seven days.

But in aggregate your inventory was only up about a day so a little more clarification here on maybe how many customers you've got on hub systems. Was there a big pick up this quarter and you had both hub fill and then, also you didn't have the pull out of the hubs. It would help just kind of explain the difference there and then I have a quick follow-up for you.

Martin Slark

Thanks. So let me just address the hub question. We have today I think about 350 VMI locations around the world, which in some of those are multiple locations for an end customer. So I would factor that down to the number to get the actual number of customers involved and what typically happens with those VMI hubs is the customer pulls from that inventory, we end up invoicing the same day.

Now, we have contractual relationships with those customers whereby even though we manage the inventory for them, ultimately we're able to ship that to them and obviously what they can do and I think where the flexibility is if they see a slowdown and demand, they just don't pull at the end of the period and that's clearly what happened here which is why I think you would see a bigger spike there.

And of course, as we said before, generally speaking, we think moving inventory to hubs is a good thing on two fronts. One is even though the days went up, the number of days is still less than the overall inventory. And secondly, you've got computer linkages with the end customers and that's another way of locking you in with the end customer but obviously you'll take greater volatility at the end of the period.

Tom Deng - JP Morgan

Okay. And then a quick one. It sounds like if some of the inventory pulls this quarter that you were stuck with last quarter, you should have another pretty strong quarter of cash generation. I'm assuming the debt stays in place just given where the cost of that debt is and really, it's only a little less than $40 left on the buyback.

What's the expectation for a reup of the buyback if you use that this quarter and then, for incremental cash flow, just talk about what the priorities are for the cash flow over the next couple of quarters. It looks like you should probably generate some good cash.

Martin Slark

Yeah. Probably as you know, I mean if you look back at the whole of last calendar year and for many years, Molex generates a lot of cash and we don't think that's going to change. We consciously made the decision this quarter to pay down the US debt which had a higher interest rate.

We are not in any great hurry to obviously pay down the Japanese debt, given the very low rate of interest there and in fact the expectation if we do pay that down is we pay that down out of the Japanese operating profit. We had our Board meeting actually the end of next week and our intention then would be to review the buyback then and determine where we would go from this point forward with the balance of the buyback that has been authorized.

And I think the other potential use for cash other than reinvestment in the business, which we can clearly fund, would be to look for other tuck-in type acquisitions in selected end markets that would strengthen our position.

Tom Deng - JP Morgan

Okay.

Martin Slark

If I could just initiate a bit here. We have quite a few people on the queue and just to be fair so that everyone does get to ask a question we would like to retract our offer of a follow-up question. So if the people in the queue could kindly condense it to one question, we can try to handle everyone. Thanks.

Operator

Your next question, gentlemen, comes from the line of Carter Shoop with Deutsche Bank. Please go ahead.

Carter Shoop - Deutsche Bank

Great. Thanks. Can you talk a little bit about potential restructuring options here for the Company and also as part of that, maybe discuss some of the investment, that is undergoing rate now in regards to the transformation to more of a global operation and if assuming that would be one-time in nature, when do you anticipate that to cease?

Martin Slark

So we have announced that we are moving to five part focused global divisions July 1st away from the four geographic regions that we have in place today. We believe that we're on track to get that done. And we think that that structure will enable us firstly to service our customers more effectively.

And secondly, to put out production around the world in the most cost effective locations and eliminate some of the duplication of tooling, and things that we've had in place in the past. We have not announced at this point in time any kind of restructuring associated with that realignment of our resources and obviously once we get the new structure in place we'll look at where we have resources around the world and how we can best use them going forward. And if any excess resources need to be addressed in the context of that restructure.

Operator

Your next question comes from the line of Jim Suva with Citigroup. Go ahead, sir.

Jim Suva - Citigroup

Great. Thank you. Can you explain to us why one wouldn't think that the mixed items in the handset area are not permanent especially since I assumed that the 3 million of inventory reserve was for inventory kind of as a reserved mathematical function not obsolete inventory and in essence you should get a boost of 3 million flow through next quarter that you kind of have written down in reserve today. Why are we expecting or why shouldn't one believe a permanent gross margin pressure from this?

Martin Slark

I think a couple of things. If you look at the gross margin pressure we had the last quarter, we did make a point that not all of it was related to the cell phone market. But if you look at the key cell phone companies we are dealing with, towards the end of last quarter, they've all announced that they saw a significantly larger number of low end phones.

But they are also as we have been working within some time designing and developing a large number of higher end phones with greater functionality, including phones that are going to have the capability for streaming video, four go capability, etc, And as those new models are launched, we think that mix will shift.

So talking to those end companies, even though I think the sheer volume of lower end phones that are sold is going to continue to increase because of the growing market in places like India and China. We think there will be going forward this year increased opportunity to sell into higher end phones as well as those companies launch new models.

Operator

The following question comes from the line of Steven Fox with Merrill Lynch.

Steven Fox - Merrill Lynch

Hi. Good afternoon. Just one more question on the gross margins. Martin, your commentary seems to suggest that gross margin should bounce back into historical range fairly quickly. So I guess I got to ask one more time, why wouldn't that happen given that you see new models rolling out after Chinese New Year. You see this as a shorter inventory correction. Is it just you're trying to be conservative or what else am I missing in putting this together?

Martin Slark

I think, Steve, unfortunately, we are looking at the business from our standpoint about what do we do year to year. And how do we grow our market share and how do we grow our margins. I think the difference is you're all very, very focused on what happens in the next quarter and particularly in the next quarter we've got Chinese New Year in the middle of that.

We've just had which everybody has seen I think a significant inventory correction across the market and I think we're not sure of a couple of factors. One, across the industry, how quickly does that correct. How quickly does the new, do these new models get launched which give us the chance to sell hopefully higher margin and also potentially when does the flow through of some of these raw material costs impact us?

There's a number of factors that we don't believe will necessarily benefit us in the next quarter. They could potentially but I think it will be wrong at this point to commit having that happen but I'm sure you can appreciate we are very dissatisfied with the gross margin down to the level that it is today and we worked very hard last year to get it back up again and we'll work equally hard to get it back up again this year.

Operator

Your next question comes from the line of Yuri Krapivin with Lehman Brothers.

Yuri Krapivin - Lehman Brothers

Good afternoon. In the past, you talked about exiting some low margin assembly-type business. I'm just wondering, is this process complete at this point or is it still ongoing?

Martin Slark

Yuri, we believe at this point that that process is completed. At one point in time, our value-added sales, the integrated product sales we talked about, was close to 20% of our revenue. That has now dropped to about 16% of our revenue. And that is a result of us eliminating some of that low margin business.

Now, we believe we'll continue to grow that business. And it has grown in the last year where we will be more selective about taking projects that have either higher Molex content or higher engineering content where we can protect the margin.

Operator

Your next question comes from the line of Kevin Sarsany with Next Generation Research.

Kevin Sarsany - Next Generation Research

Hi. I was just -- wanted a little clarification on the pricing in the handset you mentioned it was about $11 million impact. And I was wondering if I recall correctly, your percentage of business in handsets -- and just do the math in the quarter -- it looks like it reduced gross profitability by about 7%.

Now, are these prices expected to continue so unless you get a mix change in the handset high and low-end? Does that 11 million kind of keep going and how? If it does, how do you plan on offsetting it besides through volume and I hope that mixed changes?

David Johnson

You already -- the mathematics that you were doing, if you look there, our cell phone revenues are of roughly 100 million-plus a quarter. And that 11 million erosion that we saw in the quarter, as you correctly pointed out, that therefore is approximately in that 11% range.

None of those prices based on the products we sold this quarter would change. So improving the margin in that segment would be a function of; one, as a change in mix; and two, a reduction in our own costs through either production cost reductions or raw material costs coming down and then obviously getting the volume up again in the next couple of quarters.

Operator

Your next question comes from the line of Shawn Harrison with Longbow Research. Go ahead, sir.

Shawn Harrison - Longbow Research

Hi, just following up on kind of the pricing discussion, but not particularly in handsets. If raw material costs, you know, do come down in the June quarter in terms of a full run rate, how quickly do you give that back to customers in terms of price decreases through distribution, since you raised pricing at distribution multiple times over the past 18 months?

Martin Slark

You know, it's very hard to answer that question. I mean some of the end customers that we deal with are impacted by the same raw materials we are, and they can see the same indexes that we could all see. They obviously have to be negotiated day-to-day.

I think, however, there is -- the same way, there was a time lag between when the commodities went up and then the actual raw materials that we buy went up in price and then when we would do something about it. I think there is going to be an equal lag going the other way.

One of the things we're trying to look at now is we've seen the commodities come down. We need to see that reflected in the raw materials that we buy. And then we need to benefit from that before we would have discussions with customers about price reductions.

David Johnson

And the other part -- the other point is we didn't get 100% of the material cost increase as it went up that we are comfortable with. The numbers are very -- you know, we played a very fair range to our customers in trying to negotiate. So we shouldn't assume that because costs were going down, it was an equal impact in terms of price. And as Martin said, that would require a delayed process of negotiation and review.

Martin Slark

I think the other thing too is the total pricing environment in context, during the period in the middle of last year when raw material prices were at their highest, our price erosion dropped down way below the 3% level.

It's now back into that normal range, but it's at the low end of that range. So total price erosion in the total market outside of cell phone market, which is obviously under a lot of pressure itself, is still at pay fairly reasonable level.

Operator

Your next question comes from the line of Jeff Rosenberg with William Blair & Company.

Jeff Rosenberg - William Blair & Company

Hi. Martin, I just wanted to ask when we look at your revenue guidance for next quarter, you're guiding for revenue that's comfortably above the bookings you just saw in the second quarter. Does that mean that you are already seeing a meaningful improvement in bookings this quarter or, you know, what gives you the comfort level to say that you'll ship revenues well above what you have been booking at?

Martin Slark

Good question, Jeff. You obviously had the benefit of being at the end of the call and doing the mathematics to look at that. We've assumed a couple of things. One, that the bookings are going to improve during this quarter and so above and fall to 775 level that we saw last quarter.

Secondly, we had some remaining backlog that can be shipped this quarter. So we took last quarter's bookings rate, assumed some marginal increase in that, plus some shipment of some backlog that we've got. And we've obviously got some orders that are orders that are scheduled over the time due to be shipped in this quarter. And that's where we came up with that range.

Operator

Your next question comes from the line of Alexander Paris with Barrington Research. Please go ahead.

Alexander Paris - Barrington Research

Thank you. I think I got most of the questions answered. But just on the cell phones, roughly what percentage of your total sales are cell phones?

David Johnson

We've said that -- and just off the top of my head that our total revenue from the telecommunications market is around the 27% level and we think about 17% to 18% of that is in cell phones and the balance is in infrastructure. So, say about 18% of our revenue.

Alexander Paris - Barrington Research

And just looking at that mix, is that just a matter of the demand is rising very rapidly from emerging countries with growing disposal income and therefore, they're kind of first time buyers of cell phones?

David Johnson

Yes. If you go, it's particularly in China and India. I think you've seen a number of factors there. First of all, Motorola and Nokia are both increasing their presence domestically, in both China and in India. They have designed and developed low-end, voice only phones specifically, for those end markets, where local consumers are able to buy them.

They're available at extremely low cost. And then you can also appreciate in those developing countries, they've made the decision basically, not to put in copper, hardwire infrastructure. The whole telecommunications market is driven around cellular. So you got a huge number of consumers in both of those countries, getting to a disposable income level where they can afford both to buy and use cell phones.

Martin Slark

It's a good question and you know, it's probably better answered by our customers in that area where they think, the demand for cell phones is going. But one would hope that, that you have a wave of the emerging markets where many people are being introduced to cell phones, they become affordable, but over time, you would think that they would be on the same code.

But people of the United States and the people and Europe are on, that eventually they will start to migrate up and then we would see phones with higher content. But it's a good question. It's probably one that the forecast we've seen I think are, in the short-term are continuation of greater part of the cell phone market moving towards the lower end-type phones and you know -- but I think eventually those will migrate into higher phones.

Operator

Your next question comes from the line of Alan Mitrani with Sylvan Lake Asset Management. Please, go ahead.

Alan Mitrani - Sylvan Lake Asset Management

Hi. I'm along with everybody else. I don't understand the gross margin issue. Maybe try to approach in different way. Woodhead last I checked had margins somewhere between 37% and 38% gross margins. Is that still true?

David Johnson

No, that's not true. I think that margins prior to acquisition of Woodhead declined somewhat and at an end were lower when we took over the Company in its early stages.

Alan Mitrani - Sylvan Lake Asset Management

Okay. Are they above Molex's corporate gross margins?

David Johnson

Yes. They are above Molex's corporate gross margins, certainly, and I'd say slightly below what you stated a minute ago at the time of the acquisition.

Operator

Your next question comes from the line of Michael Hamilton with RBC Dain. Please go ahead.

Michael Hamilton - RBC Dain

Good evening. Could you just take a couple minutes looking at some of the key contractual lock-ins that you've made in here and give a picture, as to whether those lock-ins will play out a little differently than what we've seen in the past? In other words, if you achieved some objectives in these contracts, that are different from what we've had in the past?

David Johnson

Are you talking about failed contracts as a result of the price negotiations we've had with customers over the last quarter?

Michael Hamilton - RBC Dain

Exactly.

David Johnson

Yes. I don't think they are significantly different in terms of these are generally annual negotiations and as a result of that, you effectively lock in your position for the following year. So I would say they are substantially the same.

Michael Hamilton - RBC Dain

I just wanted to go back a little bit on the question that Alan raised. You know, I don't think, Alan, anywhere in the call we've really ascribed Woodhead to an issue with the gross profit margins. Dave analyzed the sequential changes of gross profit margin and some of it we said, we have $11 million sequential increase in price erosion in the mobile area.

That certainly was a big area for us. We also saw a shift, where we're supplying into lower content and those do not have the gross margin potential that we would have in higher content. And I think that's information that I think has been probably relayed to the market earlier by some of our customers in that area.

And the third thing is that, we did have to pickup some additional reserves because we talked about the hub inventory when the customers don't open the hub inventory at the end of the quarter, they have a higher inventory to put our slow and excess reserves on. And then Dave also mentioned a new product technology that we're in the startup phase and I think, Dave said that cost us $2 million on the quarter.

So all of those together, really do reconcile fairly closely to the sequential gap in gross margin.

Martin Slark

And I wanted to say too that, I think to answer that last question also fully, it is not the Woodhead margins that are driving our margins down in the Second Quarter. If that wasn't made clear before, I want to make that very clear.

Operator

Your last question, gentlemen, comes from the line of Scott Craig with Banc of America. Please go ahead.

Scott Craig - Banc of America

Hey, good afternoon. Can you just give us a quick update as to what percentage of your sales are to the EMS industry? And then also what are your expectations for that segment of your sales as we work into the first quarter? Thanks, calendar first quarter. Thanks.

David Johnson

As you look at actually Q2 results, approximately 23% or 25% of our revenues were in the EMS sector and about 22% were in distribution. That 23% actually is marginally lower than the number that we have seen in the previous few quarters which I think again reflects the fact that we saw a slowdown in the CM sector.

And I think as you've seen before, when we see these quarter end corrections and inventory adjustments, that filters back through the supply chain, impacts the CM's and then impact us. And so I think that's why that share of our business was down. So I think we would expect that to probably remain at the same level in Q3 and then start to pickup again in Q4.

Operator

At this time, gentlemen, there are no more questions in queue.

Martin Slark

Thank you. We would like to thank everybody for their attention this afternoon and we look forward to talking to you at a later date. Thank you.

Operator

Thank you for attending today's conference. This concludes the presentation. You may now disconnect. Good day.

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