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Fairchild Semiconductor International Inc. (NASDAQ:FCS)

Q4 2006 Earnings Call

January 25, 2007 9:00 am ET

Executives

Dan Janson - VP of IR

Mark Frey - EVP and CFO

Mark Thompson - President and CEO

Bob Conrad - EVP and General Manager of Analog Products Group

Analysts

Ross Seymore - Deutsche Bank

Craig Ellis - Citigroup

Romit Shah - Lehman Brothers

Bill Lewis - JP Morgan

Michael Masdea - Credit Suisse

Steve Smigie - Raymond James

Eric Gomberg - Thomas Weisel Partners

Tristan Gerra - Robert W. Baird

Quinn Bolton - Needham & Company

Craig Berger - Wedbush

Presentation

Operator

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

I will now turn conference over to Mr. Dan Janson. Please go ahead, sir.

Dan Janson

Good morning, and thank you for dialing into Fairchild Semiconductor's fourth quarter and full year 2006 financial results conference call. With me today is Mark Thompson, Fairchild's President and CEO, and Mark Frey, our Executive Vice President and CFO.

We will be attending a number of investor conferences this quarter, including the Piper Jaffray Analog Conference in Boston, the Thomas Weisel Tech Conference in San Francisco, Deutsche Bank Small Cap Conference and the Raymond James Institutional Investor Conference both in Florida and finally Citigroup's Small and Mid-Cap Conference in Las Vegas. We are planning to host a Functional Power Group technology review for investors and analysts at our San Jose offices on the morning of February 22nd. This will be a great opportunity for investors to learn more about the technology and products that are driving our strong growth in FPG. We will also webcast this event and details of how you can listen in are posted on our website. I also want to note that we plan to publish a mid-quarter press release to update our business outlook on March 7, before the market opens. Mark Frey will start today's call with a review of our fourth quarter financial results and discuss our forward guidance for the first quarter of 2007. Mark Thompson, will then address in more detail our operational performance and new product plans. Finally, we will reserve time for questions and answers. This call is scheduled to last approximately 60 minutes and is being simultaneously webcast from the Investor Relations section of our website at fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days.

Fairchild management will be making forward-looking statements in this conference call. These statements, including all statements about future results and performance, are made based on assumptions and estimates that involve risk and uncertainty. Many factors could cause the actual results to differ materially from those expressed in forward-looking statements. A discussion of these risk factors is provided in the quarterly and annual reports we filed with the SEC. In addition, during this call, we may refer to adjusted or other financial measures that are not prepared according to Generally Accepted Accounting Principles. We use non-GAAP measures, because we believe they provide useful information about the operating performance of our businesses and should be considered by investors in conjunction with GAAP measures that we also provide. You can find a reconciliation of non-GAAP to comparable GAAP measures at the Investor Relations section of our website at investor.fairchildsemi.com. The website also contains 2006 Q4 fact sheet and updated financial section with updated unaudited financial highlights, including detailed breakouts of segment and regional revenues, gross margins, EBIT and EBITDA.

Now, I'll turn the discussion over to Mark Frey.

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Mark Frey

Thanks, Dan. Fairchild today announced results for the fourth quarter and full year ended December 31, 2006. We reported fourth quarter sales of $418.3 million flat from the prior quarter and 13% higher than in the fourth quarter of 2005. Fairchild reported fourth quarter net income of $8.7 million or $0.07 per diluted share compared to net income of $25.1 million or $0.20 per diluted share in the prior quarter and a net loss of $4.7 million or $0.04 per share in the fourth quarter of 2005. Gross margin was 29%, a 170 basis points lower sequentially and 480 basis points higher than in the fourth quarter of 2005.

Included in the fourth quarter 2006 results were $6.7 million in total equity-based compensation in accordance with statement of Financial Accounting Standards number 123 R. Also included in fourth quarter of 2006 results was the restructuring charge of $3.2 million for cost related to the consolidation and simplification of certain supply chain planning processes and the streamlining and transfer of certain information system support activities as well as a reserve for potential losses of $8.2 million related to the previously announced unfavorable judgment in a legal proceeding with ZTE, which Fairchild intends to appeal.

Fairchild reported fourth quarter adjusted net income of $26.7 million or $0.21 per diluted share compared to adjusted net income of $30.6 million or $0.25 per diluted share in the prior quarter and adjusted net income of $13.6 million or $0.11 per diluted share in the fourth quarter of 2005. Adjusted net income excludes amortization of acquisition-related intangibles, restructuring and impairments, lawsuit settlement gains or reserves for potential losses, net gains on the sale of the LED lamps and displays product line and associated net tax benefits of these items and other acquisition-related intangibles. Adjusted results include equity-based compensation expense in 2006.

Looking at our fourth quarter results in more detail, sales were flat compared to the prior quarter and gross margins decreased to 170 basis points due to lower factory utilization as we reduced inventories $3.8 million, or one day, during the quarter. Remember that we built about $12 million of internal inventories in Q3. So this is effectively $16 million swing in output during the fourth quarter.

Reviewing gross margins by product line, the Analog Products Group posted 50 basis points sequential improvement to 30.1%. This was due to the favorable impact of not having the one-time Q3 negative reserve allowance adjustment, which was partially offset by the negative impact of lower factory utilization, as we reduced analog inventory by nearly five days. Gross margins were 350 basis points lower than the prior quarter for the Functional Power Group due primarily to lower utilization rates and the reserve allowance adjustment that added 120 basis points to the Q3 results.

The Standard Products Group grew gross margins to 27.7% in spite of $9.6 million sequential decrease in sales as disciplined pricing and a variable cost structure offset reduce sales volumes. R&D and SG&A expenses were at the low end of our forecast range, as a result of previously announced streamlining actions, spending controls and adjustments to the bonus accrual. Our other income and expense line on the P&L, which is primarily net interest expense, was down $1.6 million sequentially and benefited from a shift to investments with higher interest rates and overall higher cash balances invested.

Finally, we increased cash and marketable securities by $30.4 million to $586.4 million in the fourth quarter. Our cash flow from operations was $57.3 million and benefited from strong management of accounts receivable and inventories as DSO remained at 35 days and inventory declines to 74 days.

Full year revenues for 2006 were $1.65 billion, an increase of 16% compared to $1.43 billion in 2005. Fairchild reported net income of $83.4 million or $0.67 per diluted share in 2006 compared to a net loss of $241.2 million or $2.01 per share in 2005. On an adjusted basis, the company reported 2006 net income of $111.7 million or $0.90 per diluted share compared to 20.9 million or $0.17 per diluted share in 2005.

Turning now to our forward guidance. Excluding the impact from the expected System General acquisition, we anticipate that first quarter revenues will be 3% to 6% lower and gross margins will be 50 to 100 basis points lower sequentially due to lower sales volume during our typically soft first quarter. At the start of the quarter we had nearly 90% of first quarter sales guidance booked and scheduled to ship. We expect R&D and SG&A spending including equity-based compensation to be approximately $87 to $90 million in the first quarter. Equity-based compensation expense is forecast to be between $6.5 million and $7.5 million in the first quarter. We expect to successfully complete the tender offer for System General in the first quarter and consolidate their financial results with ours with a deduction for the minority interest subtracted from net income. Given that 71% of System General shares have been tendered, we would expect to report at least this percentage ownership for most of February and all of March and possibly more as additional shares are tendered in the next week. This accounting treatment will continue to be used until the expected share swap which is completed this summer with exact timing dependent on regulatory approval.

I also want to update some general guidance for the full year 2007. Assuming that first quarter is the trough in sales and gross margins and normal seasonality for the rest of 2007, we expect gross margins to exit the year at 32.5% to 33.5%. This target incorporates expectations for new product revenues at higher margins, certain manufacturing cost reductions and the impact of operating leverage from second half sales growth. We expect to forecast -- we forecast operating expenses to be in the range of $87 to $91 million per quarter, which should drive solid net income improvement as sales growth resumes in 2007. We estimate the 2007 GAAP effective tax rate to be approximately 17% plus or minus 3%. Now I’ll turn the call over to Mark Thompson.

Mark Thompson

Thanks Mark. Fairchild delivered excellent 2006 results while taking a number of important steps toward our goal of building a high-value company. At the last two analyst days we made clear our goal is delivering higher and more stable earnings through a combination of better supply chain management and higher value products. Our progress towards these goals became evident as we delivered 434% increase in adjusted net income and 16% increase in sales for 2006 versus 2005. We grew our Analog Products Group sales 20% in 2006 compared to the prior year on the strength of a greater than 55% annual increase in analog switches and a 26% increase in video filter sales.

Our Functional Power Group also grew about 20% year-over-year paced by 27% increase in low voltage MOSFET sales. Our Standard Products Group reported less than 5% increase in annual sales and substantially higher margins during 2006 as we managed this building business to maximize cash flow and earnings contribution. Operationally, we managed our internal and channel inventories with the interim target range during what's proven to be dynamic year for the industry. We also tightly controlled 2006 capital spending to be approximately 7% of sales for the year as for our business model. We made good progress in 2006 and have set stage for further improvement in 2007.

Now lets a take minute to review the fourth quarter in more detail. Sales by end market were basically inline with seasonal expectations. We saw lighter than seasonal demand for our product servicing the computing end markets which we have had anticipated prior Microsoft Vista launch. We also saw a slowdown in our Asian distribution resale late in the quarter, which pushed our channel inventories to the upper end of our target range of 11 plus or minus 1 week. We decreased utilization rates as planned in the fourth quarter specially, in the analog fab in Maine as we successfully reduced internal inventories during the quarter. Lead times also decreased during the quarter and are now 9 to 10 week range on average with the longest lead times for our analog power conversations and leading-edge functional power products that continues to generate strong demand.

Let me summarize the current demand environment from our perspective. We saw some late quarter weakness in demand, especially in Asia distribution sell-through. Distribution sell-through rebounded in the first weeks of Q1 and we're watching the channel very closely. We believe that continuing our disciplined supply chain management by maintaining inventories within our target range and reducing lead times during the seasonally soft times of year or reduce sales and gross margin variability while enabling us to quickly translate improved demand into strong financial performance.

Let's turn now to new products. Our primary focus for 2007 is shifting Fairchild's new product development engine into high gear. We made a significant investment in design resources in FAEs over the last two years and we are expecting a steady stream of new design wins, as many important new products are released across the year. For example, our micro-SerDes product family that manages the signal flow across the hinge of the clamshell and slider handset, posted record quarter in Q4 and now has enough backlog to ship $7 million to $8 million in the first quarter of 2007. We're in production with 16 handset models now and expect this number to steadily grow across 2007.

Our analog switch business posted another record sale year in 2006 and we expect this trend to continue as we combine audio and USB switching capabilities on a single chip. We've been investing heavily in high frequency DC/DC regulation capability, offering improved power efficiency, reduced passive content for our portable applications and we expect the first product should be offered for sale in mid-2007.

Our Smart Power Modules, or SPM business had a break-out quarter in Q4 posting record sales of nearly $8 million. These highly integrated multi-chip modules provide complete power management solutions for a range of consumer and industrial applications. We're also developing some important fab process and advancements that will enable to deliver optimized low voltage and high voltage MOSFET and IGBT solutions for specific applications. A good example of this is our next generation PowerTrench technology that enables us to produce low voltage MOSFETs specifically tailored to high-side and low-side switching in computing applications.

In the high-voltage product line, our latest MOSFET fab process is expected to reduce our die size more than 30% which will drive better margins in the same socket. We'll share more of this new product story at the upcoming FPG technology review that Dan mentioned earlier.

Let me wrap up with a summary of where we are in our tender offer for System General. As of January 24, approximately 71% of System General shares have been tendered, therefore, subject to regulatory approvals which we expect to obtain, we anticipate successfully completing the tender offer in early February, and then begin the steps toward completing the share swap and final merger transactions. We expect to complete this acquisition during the third quarter of 2007. This is a big deal for Fairchild and will help us firmly establish ourselves as a leading technology provider in a fast growing offline AC to DC conversion market.

Thanks. Now I'll turn the call back over to Dan.

Dan Janson

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

Question-and-Answer Session

Operator

Thank you, sir. The question-and-answer session will begin at this time. (Operator Instructions). And we'll hear first from Ross Seymore with Deutsche Bank.

Ross Seymore - Deutsche Bank

Thanks. Good morning, guys. Just a question on the guidance is down on the revenue side. It doesn't seem that are compared to what we are hearing from other people. Can you give us a little bit of color on what sort of inventory adjustments both in the channel and internally is assumed in that revenue guidance? And maybe any color by the three sub-segments within revenue as to how they might behave within that general guidance?

Mark Thompson

Ross, let me try to comment on that. All of our inventory parameters are inside of our goal and so our intent is to keep them inside the goal. We'll be seeing of course depending on ship out, we expect to keep inventories approximately flat during Q1.

Ross Seymore - Deutsche Bank

Both internally and in the channel?

Mark Thompson

Correct.

Ross Seymore - Deutsche Bank

Okay. And then what about by the APG, FPG, Standard Products etcetera within that down three to six that you talked about, any big deltas, one segment doing better than the others, etcetera?

Mark Thompson

No. I would say that within the arrow bar of any prediction, they are all performing approximately the same in projecting Q1 from Q4.

Ross Seymore - Deutsche Bank

Okay. And then I guess the one follow-up question would be, you talked about assuming the first quarter, the trough and normal seasonality after that. Can you give us a little bit of an idea why you would assume the first quarter is the trough? Is there any sort of demand that you are seeing? I guess you mentioned that bookings or sell through in the channel start picking up early this quarter. Is that one of the reasons you think the first quarter is the trough?

Mark Thompson

Well, I said there's two things. From a historical pattern point of view, if you look over 5 year period, Q1 is typically below either Q4 or Q2. So, there's a historical pattern. The other thing of course is that we look at how the subsequent quarter is filling and by comparison, Q2 is filling approximately -- we are only three weeks in. So its early day but its filling approximately equal to Q4. So, if that trend continued, then that would result in a Q2 being roughly equal to our -- what our Q4 was. So those are reasons, the two basic reasons why at this point in time, we feel it's a reasonable assumption although of course we are still early in the quarter.

Mark Frey

And Ross, the other thing that I would add is, remember that we run about two-thirds of our business through distribution and nearly three quarters of our business goes through Asia. And so, we typically see a reduction or a step down in sell through from the Asian distributors in Q1, because most of their customers are on holiday for at least one week, their on the Lunar New Year holiday. So, we don't have that phenomenon in Q2. So that's assuming a tail win for us in Q2 typically.

Ross Seymore - Deutsche Bank

Perfect. Thank you.

Operator

And next, we will hear from Craig Ellis with Citigroup.

Craig Ellis - Citigroup

Thanks, and good morning, guys. Mark, you commented in the release and in the comments about segment margins or corporate margins averaging between 32.5% and 33.5% exiting the year. How would we expect the segments to perform around that and is that inclusive of the System General deal?

Mark Thompson

First, it is not inclusive of the System General deal. So, we haven't refined our models on that. So that would of course raise the corporate performance and would come back as we've committed after the tender is closed with some updated information for your financial models. In terms of how we would expect the individual segments to perform, we would anticipate that analog will improve the most across the year. We would anticipate that FPG would be next, and then SPG the least.

Craig Ellis - Citigroup

Okay. And following up on that, how much opportunity is there to mix out SPG this year?

Mark Thompson

Well, there is less than it was last year. We've got rid off fair bid of very little margin business, but there is -- between FPG and SPG, we anticipate and then baked into our numbers is some number between $20 million and $40 million of eliminated low margin business.

Craig Ellis - Citigroup

Okay. And then, there was a comment on investments in last two years on field engineering and product designed. Where is the organization right now in it's capabilities in those two areas and how much further investment do you think is needed?

Mark Thompson

So, we brought on three significant teams in a combination of power conversion in DC/DC. And so the thing that we're seeing now is that a number of these programs are getting commercial traction and a lot of them are going out in chip-scale packages. So, a lot of the incremental investment that we see in 2007 won't be as much on the front-end design piece, which is what we are investing in quite heavily in late '05 and through '06. But in more of the manufacturing engineering capability associated with bringing on a completely different package and back-end handling capability plus product extensions as those products ramp and inevitably gain acceptance across both broader application sets, but also beyond the original targeted customers.

Craig Ellis - Citigroup

Very helpful and then lastly, can you just highlight what you think some of the better growth drivers will be within the analog? I hope, you mentioned micro-SerDes is getting some good design wins across a number of OEMs. But in terms of growth, how would you prioritize the primary segments within analog?

Bob Conrad

Yeah. So, Bob Conrad here. For '07 as in '06 our strongest growth area is the signal path business, which is the heart of that is the analog switch business and also interface, which is becoming material as Mark mentioned will be $70 million in the first quarter and hopefully up from there for the rest of the year. Secondarily, it's our offline power conversion business, which grew about 25% last year total and won't be that strong this year because of general market conditions, but it too will grow strongly. But at least for us in 2007 will be our DC-to-DC, our power management business because most of the efforts that Mark just referred to are just starting at the very initials stages in the market in '07 and we're expecting to be drivers in '08.

Craig Ellis - Citigroup

Thanks guys.

Operator

And the next question comes from Romit Shah, with Lehman Brothers.

Romit Shah - Lehman Brothers

Okay, thanks a lot. Mark, given that you think inventory all of the inventory parameters are within the target range why are you guys choosing to under ship consumption -- the guidance of 4% to 5%, I am guessing with the well below what normal resale would be -- which would be I would think at least flat.

Mark Thompson

So, if this we -- we are making sure that we don’t over ship the low end of possible resale in the channel and so we want to make sure that I think everyone is seeing it's a difficult time of year to build demand models there was weak resale at the end of December as we commented, and so we simply want to make sure that we don't go outside of our boundary conditions and if you want to make sure that we are very well positioned to rebound our financial performance very strongly in Q2. So we think on balance, we ought to be cautious on the inventory side and position ourselves to emerge into a very strong Q2 performance.

Bob Conrad

Hey, Romit, let me just, add to that. If we were a primarily North American and European centric company, then our POS -- our resales from distribution in Q1 probably would be flat at best if not a little better than that. But since we are very much an Asian centric company with a very predominantly Asian customer base, POS is typically down for us in Q1, because again these guys are taking week off, and so while they'll try to make some of that up before and after, it's still -- when you take one week out of 13, you’re going to impact the resale level.

Romit Shah - Lehman Brothers

Yeah, I guess that's what the message from you guys is that resales generally doesn't change on a quarterly basis and the fact that you're guiding down mid-single digits and also saying that you think inventories are within target range, it just surprises me a little bit.

Mark Frey

I think Romit, this is Mark Frey that our message in the past is we've tended to have increases and decreases that exceeded the normal pattern of sell-through because of the way we made these channels. Going forward, we will more closely match our shipments with sale through in the channel, but it's not to say the channel doesn’t have seasonality to it, for our business, Q1 is typically down followed by Q2 being up, reasonable amount, and then 2% to 4% in Q3 and Q4.

Mark Thompson

I can quantify that the average POS for us over a five-year period, Q1 versus Q4 is actually down approximately 4%, so that's a very normal seasonal number for the pure distribution point of sale piece. So really all we're doing is taking a historical -- our inventories are good, we're taking a historical knocks in POS that we see to Dan’s point every single Q1 and we're simply making sure that we don’t go outside of balance as we go through Q1 and not be positioned for a great Q2.

Romit Shah - Lehman Brothers

And I guess given what you saw at the end of December you guys are just deciding to play it a little bit conservative?

Mark Thompson

Just a little bit more. That's correct.

Romit Shah - Lehman Brothers

Okay.

Bob Conrad

Ultimately Romit, our major successes that we keep the distribution channel inventories within our target range. That's our objective. We don't want to grow inventories. We want to match what the sell-through is? What we're shipping in?

Romit Shah - Lehman Brothers

My follow-up question is with the expectations that orders should start to improve in Q1. I mean historically when orders do come back we tend to see pricing get more competitive particularly in your standard products business, so you guys factoring that into your margin guidance either for Q1 or for the full year?

Mark Thompson

Yes. We are. So if you look at the -- to reflect on a comment I made earlier, which is we anticipate shading $20 to $40 million in revenue in '07 versus the equivalent product base in '06. A chunk of that is stuff that we just think will be sufficiently competitive that we want to bid on it and so we're and just anticipating executing those businesses rather than going to pricing places we don't want to go, and so that is absolutely baked into the forward guidance.

Romit Shah - Lehman Brothers

Okay. Thank you.

Operator

And next we will hear from Bill Lewis with JP Morgan.

Bill Lewis - JP Morgan

Great. Thanks. Just maybe a clarification first on pricing. Could you talk about pricing was in the quarter and your expectations for Q1?

Mark Frey

Well, we've been expecting what we typically expect pricing to be down to as much as 4% quarter-on-quarter. For over a year now we've seen more moderate pricing than that, so as I said earlier as we said earlier Bill, we came into this quarter with about 90% of our guided revenues on the books, so we kind of know, what the pricing looks like for majority of what we have guided and that pricing continues to be very much in the same vain as its been in the last couple of quarters, what I characterize it's still quite moderate.

Bill Lewis - JP Morgan

Okay, thanks Dan, and then I guess question from Mark. Just looking at the analog business, the gross margins in the quarter did improve but would you anticipating more substantial improvement in the December quarter and then I guess going forward, should this begin to improve in Q1 and sort of talk about if you would the trends through out the year because I believe you are anticipating those to really return may be by the end of the year back to close to their target levels at least close to 40% margins.

Mark Frey

Yes, Bill we did expect the analog margins to improve small amount because again you eliminated this tailwind of this reclassification we did in Q3, but we saw the plans down significantly as we took 5 days of inventory out of analog and I would expect that will stay in that mode in Q1, where I will continue to take down the analog inventories and then we will see progression after that into the remainder of the year approaching the target mid 30, high 30% range for analog as it access in the year.

Bill Lewis - JP Morgan

All right great, thanks, Mark.

Operator

And next we will hear from Michael Masdea with Credit Suisse.

Michael Masdea - Credit Suisse

Yes, thanks a lot. On the Systems General front, I know you are going to give us more guidance once you use the tender offer but is there any major reason we can get first order from just taking their model on combining 71% with yours or is there other GAAP piece looking to be bigger than that?

Mark Frey

Well, first of all, when you take their model you -- and you're modeling our revenue, you bring in all the revenue and all the margin, and then you subtract out below the net profit line. They are minority interest in it. And that's the way the accounting is done. Obviously, they are still a public company and we can't comment on what we know about them. They do have public disclosures in the run rate of sales in their Q4 that would imply that you would think that a quarterly sales run rate would be in the $10 million to $11 million range margins in the mid to high 40 range.

Michael Masdea - Credit Suisse

Okay. Thank you. And then on the trend side, similar to what you went into last quarter, 90% booked. Where these trends come from last quarter and maybe where did they fall short? And then this coming quarter where are you looking for the trends to really be generated?

Mark Frey

I don't see a pattern. First of all, there's churn. So, at this point in the cycle, you both lose backlog and you add backlog. That certainly was the case in Q4. But the turns that we require are primarily in the SPG and the APG area. FPG is probably slightly better loaded.

Michael Masdea - Credit Suisse

And I guess, one last follow-up on that one, just really is lead time front. Do you feel like you still should have lead time shorter if possible or do you think we are going to stabilize here?

Mark Thompson

Well, we would certainly like to have our lead time shorter than they are. Ideally, we knocked them down in another week or two and lead time management is one of our number one goals as a company for 2007. We did -- made a lot of changes in the supply chain in 2006 and saw a lot of improvements as a result. But one thing we weren't completely satisfied was with our lead time management. So that's one of the top-level goal for our supply chain team for 2007.

Michael Masdea - Credit Suisse

Thank you.

Operator

And the next question comes from Steve Smigie with Raymond James.

Steve Smigie - Raymond James

Great. Thank you. I just want to follow up on the lead time question. Lead times just seem to come in a little bit. Is that more a reflection of demand dropping off or is that again sort of better management of the supply chain?

Dan Janson

Well, this is Dan. I think it is a combination of things. I think we continued to scrub backlog pretty hard. So, wherever we see situations where it appears that especially some of the Asian distributions may be have got ahead of themselves in ordering. We start questioning that demand. That helps us to get lead times down. We've done I think a better job at managing from the package constraints in particular that we had in the back end. That's helped as well. So, you put all that together and I think that's certainly what's driving the line share of the change. And again just for perspective, we're down slightly. We're down about a week, week and a half of where we were a quarter ago.

Steve Smigie - Raymond James

Okay. And then in terms of the guidance, it seems that you are saying you are pretty much -- you have very high distribution and sales out of distribution. Your guidance have been in line with that, and [how you traditionally work] and some of the other companies out there are seeing maybe even a more substantial declining Q1 than seasonal. What is it that's maybe keeping you in line seasonally where other people are doing somewhat worse than that? Is there some sort of differentiation you can point to?

Dan Janson

Well, I can't comment on what they are seeing. We are telling what we are seeing. We do have a very broad set of applications in customer base. So, we're not impacted by any individual segment as much as other companies who might be more wireless or computing exposed.

Mark Frey

Steve, it also -- it seems that from our -- my analysis certainly that the folks that would have had the biggest corrections are the ones that typically had a little bit of an inventory build on top of the normal seasonality and as we said, our inventories are still within our target range. So that's helped us.

Steve Smigie - Raymond James

Okay. Great, thank you.

Operator

And next, we will hear from Eric Gomberg with Thomas Weisel Partners.

Eric Gomberg - Thomas Weisel Partners

Hey, guy. Great, thanks. I am hoping you can may be give a little bit more granularity regarding where utilization exited the year? And when you would anticipate actually increasing plant loadings?

Mark Frey

So, yeah, utilization rate as we guided last quarter were down in Q4 especially in our analog fab in Maine. As we said in the call earlier, we took 5 days of analog inventory out. And as Mark said, we are going to work on some analog inventory in this quarter as well. So, we will still continue to see some of that impact on utilization rates, especially in our analog fab in Maine. So I mean utilization rates, we haven't provided that kind of granularity specifically in this quarter. We are looking forward but I would expect them to be somewhat comparable of what they were in Q4. As Mark said, we are not looking to build inventory or necessarily drain inventory but basically it's going to hold where we are.

Mark Thompson

And I guess to add the other piece to your question, the -- because of the way how we have managed inventory through this. If the Q2 up occurs as the current models suggest it will. We will need to begin to ramp the plants during Q1 in order to meet that demand. So that's -- you would see that change starting during Q1 but really affecting the earn significantly in Q2.

Eric Gomberg - Thomas Weisel Partners

Okay, that's helpful. Can I ask -- as far as the comment regarding exiting the year, say 32.5% to 33.5%, how much of the delta from 1Q to 4Q is based on going to normalized utilization versus higher overall sales versus a richer mix towards more higher margin analog products?

Mark Frey

About half of the delta is basically what we call standard margin progression based on new product shipments at higher margins and mix improvements within product lines. And the other half would be the combination of higher, simple leverage on running the factories more full, plus the cost reductions that we have targeted for the year.

Eric Gomberg - Thomas Weisel Partners

And just one last thing. The channel inventory, I think in the prepared remarks or press release, you said it moved to the high end of the targeted range and I was wondering specifically in terms of weeks where that stands?

Mark Frey

Well, our target range is 11 weeks, plus or minus one and we are on the high end of that.

Eric Gomberg - Thomas Weisel Partners

So, it moved up just a week?

Mark Frey

Yeah, but not quite too much. Yeah.

Mark Thompson

But, yeah. It was in the bottom half of the range and now it's in the top half.

Eric Gomberg - Thomas Weisel Partners

Okay. Thanks.

Operator

And the next question comes from Tristan Gerra with Robert Baird.

Tristan Gerra - Robert W. Baird

Good morning. With your expectation that Q2 revenues could potentially go back to the Q4 level, is that assuming that distribution inventory levels go back to the lower end of the range which is where it was in the second half of last year or is that assuming that it's still around the 12-week level?

Mark Thompson

Tristan, I'm not sure we've modeled it to that degree of granularity, but if we are seeing a reemergence of demand, we will try to get the channel inventories back to the lower end of the range, but early on we would probably focus on having service levels available to be able to meet the demand increases.

Mark Frey

Maybe one comment on top of that is -- one of the things that we commented at last here at analyst day is that our approach to distribution management was to exit at an up cycle at the bottom half of the range and to exit at a down cycle at the top half of the range. And so to allow the range to smooth both our service levels and our factory outputs and so far the trajectory that we're showing is exactly the one that we targeted to achieve.

Tristan Gerra - Robert W. Baird

Okay. And then just a quick follow-up. My understanding was that most at lead times in the industry increased in Q4. Are you do you see trends there or is that coming down rapidly on the basis of cancellations?

Mark Frey

Well I think we talked about this at the last call, Tristan, and maybe in between calls. Our lead time trend has been fairly stable for our Functional Power Business. The lead times there has tended to be a little bit higher than the liked generally because as we've said in the call we've continued to see pretty strong demand on the leading edge functional power products. So I don't know that I would characterize them as having gone up, but I would say they're still a little higher than we would like.

Tristan Gerra - Robert W. Baird

Great. Thanks guys.

Operator

And next we'll hear from Quinn Bolton with Needham & Company.

Quinn Bolton - Needham & Company

Thanks. Just wanted to clarify Mark your comments about keeping inventories sort of flat in the first quarter, wasn’t sure if you are referring to inventories on a weeks basis or absolute dollar inventories.

Mark Frey

Dollar inventory.

Quinn Bolton - Needham & Company

So dollar inventory stay flat in the channels so because sales come down, you might actually see further increase in weeks of inventory, you're comfortable with that because you are coming into a second -- a stronger second quarter or you want to have the inventory in place for service levels and ability to meet turns is that kind of a fair?

Mark Frey

That’s correct.

Quinn Bolton - Needham & Company

Okay. So, do you keep inventories roughly flat in the gross margin guidance for the first quarter, [roughly] no inventory effect in the Q1 margin guidance. So that’s a ability to flat so really the gross margin guidance probably just primarily function of the lower absorption and lower sales quarter-to-quarter.

Mark Frey

That’s correct. We -- that’s exactly right.

Quinn Bolton - Needham & Company

Okay, great. Thank you.

Operator

And the next question comes from Craig Berger with Wedbush.

Craig Berger - Wedbush

Good morning. I am hoping you can provide a little commentary around the wireless end market, outside of your ramps of some of your product [offerings]?

Bob Conrad

Bob Conrad here, quite a bit of our signal path business goes into the wireless segment and we are highly penetrated in switches your comparative may be how hot things were going earlier in the year it has soften a little bit. The other part of our business in signal path that is handsets centric, micro-SerDes doesn’t really reflect any kind of end market conditions because diffusion of a new technology. So and I think the general comment as we have seen some slight softening but we expect the outlook to be pretty good for the products that we are participating in for 2007.

Craig Berger - Wedbush

Great. And then just one follow-up, I know on the segment gross margins you commented analog likely to increase the most, but these gross margins are all pretty close together here, what you see is the structural kind of long-term gross margin potential for these businesses?

Mark Thompson

So the -- at the May or June Analyst Day we set out some models for our three segments, and it was all of them having three-year goals to be at contributing between 15% and 20% operating income as a percent of the sales. And, so at the top it was analog which we've modeled at number in the $500 million range at approximately 50% margins, 20% below the line or 30% below the line contributing 20% to the company. Next in that sequence what is -- was FPG where our long-term -- our three-year goals for that were 40% gross margin, 20% below the line and 20% contribution and -- did I miss?

Mark Frey

Actually the FPG, we have a target band of 35 to 37.

Mark Thompson

37, okay. And then the FPG is --

Mark Frey

23 to 27. So we're actually in the FPG band right now and we're reassessing what the complexion of that business would look like.

Craig Berger - Wedbush

In the analog business, what do you have to do to close the gap there it seems pretty far off?

Mark Thompson

Develop new products at high margins.

Craig Berger - Wedbush

Sounds easier said than done but --

Mark Frey

No, I don't think there is anything easy about it but if you look at the -- and I don't think anybody would, but, if you look there've been a couple of categories where we've shown the ability to do it and micro-SerDes is a completely new product definition that was essentially zero revenue in 2005 and we have $8 million roughly in Q1 and we expect that to grow across the year. In our analog switch we've gone from a bit player to having 1/3 of that market that. In the DC/DC space we have some very unique solutions and some very excited end-market customers and some very high efficiency, high frequency applications that allow them to get rid of passive networks and those are in a variety of customers' laboratories as we speak. So there is a pretty significant set of things that are coming out that really, we believe, very strongly will move the needle. The SG acquisition, as we articulated has the potential to really transform what is now $200 million power conversion business. And so there is -- the blocks are there, we need to execute obviously, but there are a number of places where I think it's easy to show that we've done that and are actually quite confident that exiting '07 we'll see a very, very different kind of analog business in Fairchild has ever had.

Mark Thompson

As I said Craig, one thing I would comment on to -- I think it's useful to think of those goals as different time constants for each one. The standard products objective that we laid out, it was probably the one that was closest that had been and the fact as Mark Frey just indicated. We, basically for the last couple of quarters, have been at our target model at the gross margin level. We still have a little bit work to do at the operating margin level but obviously made a lot of progress. Because it was a lot of a mixed out story, which we tended to have more direct control over and has a shorter time constant to effect.

Functional Power is kind of in the middle, because it's a combination. There is some new products obviously, part of that story, but there's a fair amount of mix out and in fact if you look at half the Functional Power business of that model today, the low voltage business and the high voltage business is basically following that same blueprint to success and we are going to talk a lot about that at the February technology review of the FPG.

Finally analog because it's primarily a new product story because if you remember, in 2005, Bob's group did a lot of its mix out. So in 2007 and beyond, this is primarily a new product story and as you know, Craig, new products take a little bit longer. So that has the longest time constant for us.

Bob Conrad

Yeah, Bob Conrad. With the risk of being a little redundant, I would just like to reiterate on the Systems General side and the short term of the margin expansion is simply the addition of the revenue. But the strategic rational, there about two to three horizon is the skills and relationships those people have, we believe it's going to expand the margin, the value proposition, what is today $160 million internal power conversion business. So, that's one of the reasons why -- that's a fundamental strategic reason why the SG acquisition is a high-leverage point for us.

Craig Berger - Wedbush

Thanks a lot for the detail and good luck tracking into the goals in 2007.

Mark Frey

Thanks, Craig.

Operator

And with no further questions, I will now turn the conference back to Mr. Dan Janson. Please go ahead.

Dan Janson

Great. Well, thank you very much and thanks to all of you for joining us today. That will conclude our call.

Operator

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 1-888-203-1112 or 1-719-457-0820 with the pass code of 6815446. This concludes our conference for today. Thank you for your participation and have a great day. All parties may now disconnect.

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