OmniVision F3Q07 (Qtr End 01/31/07) Earnings Call Transcript

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OmniVision Technologies (NASDAQ:OVTI)

F3Q07 Earnings Call

March 1, 2007 5:00 pm ET

Executives:

Jason Golz - Investor Relations

Shaw Hong - President, Chief Executive Officer, Director

Peter V. Leigh - Chief Financial Officer, Vice President-Finance

Jess Lee - Vice President of Mainstream Products

Hasan Gadjali - Vice President of Advanced Products

Analysts:

Tayyib Shah – Longbow Research

Jennifer West - Merriman Curhan Ford

Tore Svanberg - Piper Jaffray

Aaron Hussett - Morgan-Stanley

Adam Benjamin - Jefferies

Tristan Gerra – Robert W. Baird & Co.

Betsy Hees - WR Hambrecht

Presentation:

Operator

Welcome to the third fiscal quarter 2007 OmniVision Technologies earnings conference call. My name is Eric and I will be your coordinator for today. At this time all participants are in a listen only mode. We will be facilitating a question and answer session towards the end of the conference. If at any time during the call you require assistance, press * followed by 0 and a coordinator will be there to assist you. As a reminder this conference is being recorded.

I will now like to turn our presentation over to our host, Mr. Jason Golz. Please proceed Sir.

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Jason Golz

Thank you Eric and good afternoon everyone. Earlier this afternoon, OmniVision issued a release reporting its financial results for the third quarter of fiscal 2007. This release can be accessed from the investor relations section of our website at www.ovt.com, or on the financial newswire.

Before we begin, here are a few items for everyone to reference. This call is being webcast live and a web replay will be available for 12 months. We have also arranged to record this call. The tape replay will be available approximately one hour after the call’s conclusion and will be available for 7 days. The dial-in access number for this replay is 617-801-6888. The replay passcode is 14768867. Both the webcast and the replay can be accessed in the investor relations section of OmniVision’s website at ovt.com.

This conference call contains forward-looking statements within the meaning of Section 27(NYSE:A) of the Securities Act of 1933 as amended and Section 21(NYSE:E) of the Securities Exchange Act of 1934, as amended. These forward-looking statements include statements about our financial projections for the fourth quarter of fiscal 2007 and beyond, our expectations for growth in the market for image sensors, our expectations regarding our ability to continue to compete effectively in the market, anticipated introduction, acceptance benefits of our new products, our expectations regarding our ability to take advantage of future opportunities, and anticipated product and market development beginning in the fourth quarter of fiscal 2007.

All these forward-looking statements involve known and unknown risks and uncertainties and important factors that may cause actual company or industry results, level of activity, performance, or achievements to differ from those expressed or implied by these statements.

In evaluating these forward-looking statements, you should specifically consider various risk factors including the risk factors detailed from time to time in OmniVision’s Securities and Exchange Commission filings, and reports including but not limited to the company’s annual report on Form 10-K filed for the fiscal year ended April 30, 2006, and its most recent quarterly report filed on Form 10-Q.

These factors may cause the company’s results to differ materially from the forward-looking statements made in this conference call. Although the company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievement. These forward-looking statements are made only as of today’s date, and OmniVision expressly disclaims any obligation to update or revise the information contained in the forward-looking statements. This concludes the safe harbor statement.

Please also note that this conference call, we will provide listeners with certain financial metrics determined on a non-GAAP basis for comparisons to previous quarters and our outlook for the current quarter. These financial metrics, together with the corresponding GAAP number and reconciliation to comparable GAAP financial measures, are contained in today’s financial results press release, which we have posted on our website at investors on ovt.com, under press releases, and have furnished to the SEC on Form 8-K. We encourage listeners to review these items.

Now I would now like to turn the call over to OmniVision’s President and Chief Executive Officer, Mr. Shaw Hong. Shaw?

Shaw Hong

Thank you Jason and good afternoon ladies and gentlemen. Thank you for joining us on today’s call. With me today are Peter Leigh, our CFO, Jess Lee, VP of Mainstream Products, and Hasan Gadjali, VP of advanced products. On today’s call I will begin with an overview of our results and then I will provide a general business update. Peter will provide you with the financial details of our fiscal third quarter of 2007 and outlook for the current period. Afterwards we will take your questions, and for that Jess and Hasan are here to provide additional insight.

Our revenue during the third quarter was about $134 million. Earnings were $0.07 per diluted share. Excluding stock-option expenses, non-GAAP earnings were $0.20 per diluted share.

Our balance sheet at the end of the quarter remains strong. Our cash and short-term investments totaled about $341 million. We have virtually no debt.

In the third quarter we sold about 66 million sensors. The number of OmniVision’s sensors shipped in the quarter was about 60% higher than the third quarter last year and increased 3% sequentially. In this condition in the quarter we’re less robust than we anticipated when we spoke to you in early December, and the consequential revenue came in the shade under the low end of our guidance, and as Peter will explain in more detail our outlook for the balance of 2007 remains subdued.

Since its beginning in 1995, OmniVision has been a leader in imaging sensors. Over that time we have had many hurdles to clear and many successes. Our financial strength is clear evidence of our past successes. Currently, our financial performance is not satisfactory and we are determined to improve it. Improving our financial performance will not be easy, but to demonstrate its confidence in OmniVision’s future, the board of directors has authorized the company to repurchase up to $100 million of our common stock.

In order to get back to the kind of successful performance that we have achieved in the past, we must focus even more aggressively to develop market leading products. We were the first to introduce an image sensor for the mobile handset. We were the first to market with 2, 3, and 5 megapixels imagery sensors. And we were the first to introduce 1 and 2 megapixels imagery sensors on the popular quality inch form section.

Our initial successes attracted many competitors and more recently, some of our competitors have caught up with us. Our number one goal is to re-establish ourselves as the market leader and we believe that we can accomplish this. Recently we launched our first sensor with wavefront coded technology. We caused this product true focus and we believe that it revolutionizes camera technology by offering for the first time true point and shoot capability where the entire mix is always being focused and always available for instant, one click capture. What this means is that there is no longer any waiting for the lens to focus and as a result there will be no more picture opportunities lost waiting for the image to come into focus.

With this product we are targeting the mobile handset market with a small, durable, easy to manufacture, and a cost competitive module. The camera module consists of a wavefront coded lens, a 3 megapixel imagery sensor, and a true focus signal processing. Our patent in wavefront coding technology is a proprietary method of creating a picture that’s in focus across virtually the entire image. A special wavefront coded lens element optically changes the direction of the light to form an intermediate image on the sensor, a process known as encoding. And our true focus digital signal process reworks this intermediate image to transform it into a process known as decoding. What is especially striking about this development is that now, for the first time, consumers can take sharp, crystal clear photos, with a virtually unlimited depth of field.

Last month at the 3GSM congress in Barcelona, we demonstrated the first of what we intend to be a whole series of revolutionary true focus products based on our patented wavefront encoding technology, and we are now shipping samples of this product to interested customers.

As we move forward, we have several other important R&D programs on the way which we believe will lead to exciting developments in the future.

We have recently begun shipping samples of a 5.17 megapixel autofocus camera module for mobile handsets. This new module provides a high resolution, high quality solution, with auto-focus capability, a function previously associated with digital still cameras and expensive camera phones.

We expect 5 megapixel cameras to become the norm for high performance mobile handsets as consumer’s expectations of quality and functionality continue to evolve. The module has been developed and pre-tested with consumers, and is already in production.

We also started shipping samples of our new 1/10 inch VGA camera chip sensors, the OV7680. The OV7680 is a cost effective, efficient, contrasting camera module solution designed for use as the primary camera in entry level camera phones and for use as the secondary camera in video conferencing applications.

The OV7680 employs a unique, nonlinear, micro-lens chip technology to reduce the distance between the sensor and the lens, and enables us to significantly reduce the height of the module without compromising image quality or camera performance.

Minimizing module height is the critical requirement for slim camera phones where the module can be no thicker than the handset housing. Because it combines an ultra slim module height with outstanding image performance, the OV7680 is also well suited for use in PC notebooks, where the module height is limited by the thickness of the LCD housing.

PC notebooks are one of the fasted growing markets served by our advanced product. The OV7680 enables high quality video conferencing because it operates at a full 30 frames per second, the scan for motion video speed consumers are used to seeing in movie theaters.

Our mainstream products business, which address our large volume customers for mobile handsets and digital still cameras, continues to grow in the third quarter, while our (inaudible) continue to advance, average steady price again declined at a rate that exceeded our ability to reduce cost.

With this trend to reverse, we must work even more diligently with our manufacturing partners and try to find the common ground on cost and develop new technologies to enable more cost effective solutions in the future.

Our principle goal for our mainstream business is to align OmniVision’s image sensors with fast growth wireless products that ultimately become dominant in their respective markets. For this to occur, we must recapture product leadership in this market.

Given our fabulous business, we believe it is very important to be at the leading edge of the technology curve, especially when it comes to focusing on modules and sensors for mobile handsets, which represents over 80% of our business.

The proper introductions that I mentioned earlier, such as our True Focus camera with wavefront encoding technology, our 5 megapixel sensor, as well as our 1/10 inch VGA sensor, all addresses the mobile handset market.

These new products represent the first of many important product advancement that we plan to make in this market sector. We’ll continue to invest in R&D to ensure that we are in a position to deliver technology leading products in a timely manner, and that we meet our product roadmap schedule.

Let me turn now to activity in our advanced products business.

The notebook market is where we are seeing the strongest growth. We are pleased to report that our products are now in use by four of the top five notebook manufacturers of last calendar year.

In addition to VGA sensors, we shipped several 1.3 megapixel products to this market, and this calendar year we have begun to see an aggression to 2 megapixel cameras. In addition, there is a new breed of notebooks that are videoconferencing capable. As such, these notebooks will benefit from our OV7720, which is one of the best VGA chips in the market today for low light environments.

Similar to the mobile handset market, PC notebook LCD panels are getting thinner and thinner, requiring that the embedded camera also have a small form factor with a low height module. We believe that our new 1/10 inch OV7680, with its ultra compact low profile, is a strong contender in this market.

For sometime cameras for security applications have faced challenges when it comes to delivering clear images across a variety of conditions. This is especially true in environments that are high in contrast, in other words, environments that include both very bright and very dim areas.

Examples of such high contrast environments include bank lobbies, exterior ATM machines, parking structures, and offices. These conditions are challenging to conventional CCTV cameras because their CCD sensors don’t have enough dynamic range to show clear images from both bright and dark position opposites.

In bank lobbies for example, most security measures require detailed images, both inside the lobby as well as outside the door. Now suppose you come to a particular secluded camera that can show you the bright or dark areas, but not both. Until now, the security industry could only address this issue by using expensive, multiple sensor chip solution, combined with a special DSP.

Next week we will be officially announcing our new view sensor, a cost effective, high dynamic range camera chip that can provide a single chip solution for all lighting conditions. We’re very excited about the new capabilities of this addition to our family of sensors.

In the security and surveillance sector, we are maintaining our market share in consumer products. Separately, we are recently penetrating to conventional commercial CCTV accounts. Our OV7950 and OV7949 sensors have been accepted by the top five Taiwanese CCTV camera makers for dormitory security cameras.

Our OV7720 is also being designed into new products as part of the Korean development of IP secluded cam.

We have also won the designing for socket, 3G mobile phone that incorporates a new interface secluded camera as a feature. In the Torikan games market, we are delighted to report that at 2007 New York toy sales, of all of the toys that feature cameras, all three that received the toys of the year award, use OmniVision sensor.

In the automotive markets, our sensors are already on the road in cars and SUV’s, built by U.S., Japanese, and European automakers. We are designing applications that include the rear view and side view cameras, land departure warning systems, and smart airbags.

We will also be raising the bar in advanced digital color sensing applications. With our high dynamic range sensor, there will be 10-620 that I mentioned a moment ago.

In the medical market, which we believe hosts free commerce for the future, our new OV6920 is being designed into several instruments that meet the strict requirements and specifications for medical devices.

Our customers continue to make head waves with the necessary safety studies and derogatory approvals. In addition to our OV6920, one of our medical customers has also adopted the OV2640 when instrument is designed for the women’s health market.

Looking ahead, our Kenya leadership position in innovation and in product performance will always be a key factor in our success. This will take continued investment in R&D and provide the right facilities over the long-term for our R&D and headquarter staff here in California. We announced today that we have agreed to purchase a complex of the buildings in Santa Clara to house all our existing headquarters personal and to provide room for expansion.

In the same way, earlier this week we signed a new foundry manufacturing agreement with Power Semiconductor. In time this new agreement will give us access to alternative process for certain web providers of ours with additional flexibility in managing our product supply channel.

By listening to and working with our key customers in all the end market research, our number one strategic goal is to advance our image technology and create high quality cost effectives solutions for our customers.

In the months ahead, we will continue to focus on our key objectives which are to develop on a timely basis the products and the solutions our customers want. To grow both our customer base and a number of our design leads, to extend our reach into new and emerging markets, to serve our customers as a strategic partners and to intelligently invest in the right area of our business at the right time.

We believe that if we can successfully execute on this objective, we will return to robust business performance.

Before I turn the call over to Peter, I wanted to mention that this will be the last conference call that Jess Lee will be participating in as VP of Mainstream Products here at OmniVision. Jess has accepted a CEO position at a very early stage starter. On behalf of all of us, I want to just take this opportunity to thank him for all of his contribution here and to wish him in the very best of luck in his new endeavors while we search for a replacement for Jess. Jess would you like to say a couple of words?

Jess Lee

Thank you Shaw. I am very grateful for the opportunity Shaw has given me and the management team at OmniVision here has given me. I would also like to thank all my staff for all their hard work over the years. I believe in the work that we’ve been doing here at OmniVision and remain confident that with continued hard work, many programs currently underway will bring the company much success in the future.

The reason I have chosen to leave OmniVision is because I have been offered what I believe to be a rare opportunity I couldn’t refuse, an opportunity to lead and build a new company.

Shaw Hong

Thank you Jess. I will now turn over the call to Peter who will discuss our sales quarter financial results in detail.

Peter?

Peter V. Leigh

Thank you Shaw and good afternoon everyone. For the third quarter of fiscal 2007 which ended January 31st, 2007, OmniVision had revenue of $134.4 million down 2% both sequentially and on a year over year basis. Approximately 80% of our revenue in the third quarter came from mobile handsets, about 5% came from digital still camera and OEM’s, and about 15% of our revenues came from our advanced products groups which includes security and surveillance, toy and video game and consuls, webcam and notebook PCs, and automotive products.

Red sales to original equipment manufacturer’s and value added resellers accounted for slightly over half of revenue in the third quarter of fiscal 2007, and just under half came through sales through distributors.

Changes of sales through distributors was significantly higher than in recent quarters. In the year ago quarter, sales through distributors accounted for approximately 24% of revenues and last quarter they contributed about 37%.

It is important to add that unlike some other industries, the gross margins on our distributor sales are very similar to the gross margins on sales to OEM’s and value added resellers. We use distributors to assist us with finished goods supply chain management and to minimize credit risks with less well established customers.

We shipped approximately 66 million image sensors in the third fiscal quarter, an increase of 3% from approximately 65 million units shipped in the previous quarter. Our weekly average selling price was $2.02. Gross margin for the third quarter was 24.9% compared to 33.1% last quarter.

The principle contributor to the decline in gross margin in the January period will continue pricing pressure during the quarter, coupled with the fact that we’re selling higher cost inventory that was built in previous quarters. There is no question that we continue to be under extreme pressure from our customers to deliver better products at lower prices and our operating people are working diligently with our manufacturing partners to improve efficiencies at every stage of the supply chain.

R&D expense in the third quarter was $16.5 million, down from the $18.7 million we reported in the prior quarter. Our R&D expense includes approximately $3 million of stock based compensation expense, excluding stock based compensation expense R&D in the quarter which was $13.5 million compared to $15 million in the prior quarter.

There were two main contributors to the reduction. First, a portion of our quarterly employee compensation is variable. When operating profit disappears, our profit sharing pool disappears along with it.

Second, our NRE costs, the costs of the masks we buy for new products and the cost of our electronic design software were both lower in the quarter. NRE expense does tend to fluctuate quarter to quarter, but because we remain committed to the development of new technologies, the longer term trend is up. ST&A expenses in the quarter totaled $16.6 million up from $15.8 million in the prior quarter. Our ST&A expense includes approximately $3.6 million of stock based compensation expense. Excluding stock based compensation expense, ST&A was $13 million compared to $11.6 million in the prior quarter. Part of the increase is attributable to the higher distributor commission expense we incurred, because as I mentioned a moment ago, a higher portion of our revenues this quarter came through operating income, which in the quarter was $0.3 million. Excluding sub-based compensation, operating income was $7.9 million. Other income is negative for the quarter as a result of the deconsolidation of this era.

A pretax income in the quarter was $3.8 million and rather unusually, we recorded a tax benefit against this income. There were two principal reasons for this. First, in December, Congress passed and the President signed a provision renewing the R&D tax credit retroactive to January 1st, 2006. The second, the expiring of the statute of limitations in one of the jurisdictions where we do business allowed us to release a tax reserve which is no longer required. We now expect our defective tax rate from this fiscal year will be between 22-25%.

Net income in the third quarter was $4.1 million or $0.07 per diluted share compared to net income of $5.4 million or $0.10 per diluted share in the previous quarter. Net income in the third quarter of last year was $29.6 million or $0.53 per diluted share. Included in our results for the third quarter of fiscal 2007 is a total of $7.6 million in non-cash stock based compensation expense under FAS123R.

Net income reported in the year ago period did not include stock based compensation expense and excluding this non stack based compensation expense in the related tax effect. Non-GAAP net income in the third quarter of fiscal 2007 was $11.1 million and earnings were $0.20 per diluted share.

As we already stated, these results are clearly unsatisfactory and we are determined to improve them. Because expense walks on the backs of people, we are looking carefully at all requests for increased headcount. At the same time, it's important to say again that technology is the lifeboat of this company and we do not intend to eat our own seacorn.

Let me turn now to the balance sheet which remains in excellence shape. The company ended the period with cash, cash equivalents, and short term investments totaling $340.8 million. It is this strong cash position which enables us to confidently go through with the stock repurchase program that we announced today.

Accounts receivable at quarter end net or reserve is $73.2 million, down $2.1 million from last quarter. Our day sales outstanding were steady at 50 days and overall our accounts receivable remained in excellent shape.

At January 31st, 2007, inventory was $105.5 million, compared to $103.7 million on October 31st, 2006. As we mentioned last quarter, our goal is to maintain inventory at a level somewhere between 75 to 90 days, i.e. to achieve annualized inventory terms of between four and five times. With the production plan that we've been following for the last several months and despite the weak revenues that we now expect in the current quarter, we entirely expect that inventories will be lower at the end of April.

Before I get to the article for the current quarter I should say a word about the deconsolidation for this era. Rules regarding consolidation and deconsolidation are very complex. The key point that I wanted to make is that deconsolidation has had no material impact on our reported revenues or reported net income and it will also have no material impact on our P&L going forward.

Now I'd like to turn to the article for the fourth quarter of fiscal 2007 which will end on April 30th. My presentation to the need in our conference in January, I said that we expect that the calendar of 2007 will be a difficult year. Our expectations for the current quarter show just how difficult it is proving to be.

Based on current trends, we expect fiscal fourth quarter 2007 revenue will be in the range of $100-110 million and that we will post a loss of between $0.08 and $0.16 per share. Excluding the estimated expense in related tax effects associated with stock based compensation in accordance with FAS123R, we expect non-GAAP earnings will be in the range of a loss of $0.06 to a profit $0.02 per share.

The reduction in revenue in the April quarter is due principally to two factors. First, we're experiencing a more pronounced seasonal down-turn than usual as a result of the lunar New Year. And second, we're seeing higher levels of inventory in the channel which we believe should be worked through during the current quarter.

Now as regular listeners to OmniVision's earnings conference calls know, our policy is to limit guidance to the current quarter. This is because the markets we serve are very dynamic and consequently our future visibility is very limited.

However, what we do already know about first quarter of fiscal 2008, that is May, June, and July, leads us to believe that revenues will show a substantial recovery from the level we are projecting for the current quarter and that the current quarter marks the bottom of a narrow trough.

Now I'd like to turn the proceedings back to Shaw for some strategic commentary.

Shaw Hong

Thank you, Peter. OmniVision's whole concept is centered on image sensor technology. Our goal is to expand our sphere of inference and market penetration into all the key elements of the image pipeline. By that, we mean live capture the converging of lighting to images and the processing of these images.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

Ladies and gentleman, if you would like to ask a question, please press "star" followed by "one" on your touch tone telephone. If your question has been asked and you wish to withdraw your question press "star two". Please limit your questions to one question at a time and a follow up. Stand by for your first question.

First question comes from the line of Tayyib Shah with Longbow Research. Please proceed.

Tayyib Shah – Longbow Research

Hi guys. Can you talk about the Omnipixel two based 1.3 mega pixels and where is it in terms of the promotion ramp and is it a significant portion of revenue now?

Jess Lee

I'd say, this is Jess, I think you're referring to the 9660 we still have this product in its happening stages. It hasn't ramped production yet. When we do, you will hear it from us. But it's actually doing very well in the market place with a very high number of design widths we have.

Tayyib Shah – Longbow Research

And how quickly to you expect it to ramp? Should we think of it as in basing your current prototype by the end of the year? Your current 1.3 modem?

Jess Lee

I think by the end of the year you'll see a significant switch over of not just the current 1.3 customers to the 9660 but also a lot of upgrades. So by the end of the year is a safe assumption.

Tayyib Shah – Longbow Research

OK and question for Peter. What is the timeline for this year repurchase program? How quickly to you plan to implement $100 million that's been sent?

Peter V. Leigh

Well you know Tayyib, I think if you'd ask any of your clients what their specific plans were in the stock market they wouldn't answer and I have to take the same view.

Tayyib Shah – Longbow Research

OK fair enough. And finally you've seen a fair amount of ESPN margin pressure and you're competing from only these other IBMs. Have you looked at other possible business combination with other IBMs that would help you protect your margin?

Peter V. Leigh

I'm sorry to be so unresponsive but I don't think that's a question that would be appropriate for us to comment on. The longer term strategy of the company is always of course a question, but management is concerned about when we have something to talk about, we'll talk about it, but until then I think it's more appropriate for us not to comment.

Tayyib Shah – Longbow Research

OK, and maybe if you could just comment on where do you expect the five megapixel project to start and about when should we expect that to ramp and to become a significant good driver for the company?

Jess Lee

I believe the project we recently announced…it's been seeing some recent activity in the higher sphere global cost. We don't have any projections yet as to how big of a contributor it will be but it's pretty safe to say that that will also rack the next few quarters.

Tayyib Shah – Longbow Research

Thank you guys.

Operator

As a reminder, ladies and gentleman, please limit to one question and a follow up.

Your next question comes from the line of Jennifer West with Merriman. Please proceed.

Jennifer West - Merriman Curhan Ford

Good afternoon. I was wondering if you could qualitatively maybe talk to the gross margin impact that you saw in the third quarter between the pricing pressure and the higher cost inventory and maybe as mix as a factor as well?

Peter V. Leigh

Mix was a factor, Jennifer, but not majorly this quarter. The biggest impact came from pricing and the higher cost inventory was also a big factor in the equation. We had some negative manufacturing experience over the previous quarter which had declined with inventory, and then on a first in first out basis, we have to charge them through with the revenue in the current quarter.

Jennifer West - Merriman Curhan Ford

Ok, and then should we assume that the pricing pressure is continuing, or are you seeing any kind of let up at all? Should we assume that you’re 5% again next quarter? The units are going down more than the revenue guidance that you provide?

Peter V. Leigh

We have yet to get the first telephone from a customer volunteering to pay a higher price for a product, so I’m not confident that we’re going to see significant let up in pricing pressure. We are however, making some progress on the cost front, and how it all pays out, I’m afraid only time will tell.

Jennifer West - Merriman Curhan Ford

Ok, and then can you just maybe…what gives you the visibility and the confidence that you’re going to see improvement in the July quarter? I mean is it just that you think inventories are going to work through the channel? Or are you seeing design winds that should start to kick in?

Peter V. Leigh

Well no, thank you for that question. The guidance we give… the specific guidance of the current quarter, and the quantitative guidance for the out quarter is based on actual sale opportunities, it’s built from the ground up. So when we talk quantitatively about the out quarter it’s based on an obviously still incomplete, but nevertheless an order book for the months of May, June and July.

Jennifer West - Merriman Curhan Ford

Ok, and then I guess the last question for me is just that I’m assuming you’re expecting gross margins to bottom out in the April quarter, can you maybe (inaudible) bottoming out above 21%?

Peter V. Leigh

Well again, we don’t give specific guidance about on goes margin, but certainly there is a tremendous amount of work going on here to get this gross margin erosion to stop, it has to stop. I think it’s very clear both to us and to all of the people in our manufacturing supply chain, we’re all in this together, and we need to figure out a way of matching our costs with the revenues that the market provides.

Operator

You’re next question comes from Tore Svanberg with Piper Jaffray, please proceed.

Tore Svanberg - Piper Jaffray

Yes good afternoon, first of all, could you just take us back and explain a little bit what happened with your high cost inventory? Was this mismanaging? I’m just trying to understand why you had such a steep decrease in inventories the previous quarters, and now you’re paying for it.

Peter V. Leigh

Well if you recall Tore, what happened was at the end of Q1 we saw a sudden surge in demand for VGA, and by the time we were in a position to respond to that shift, the wavefronts we had previously committed to the higher megapixel products we’re already in production, and we had no way of stopping them. Once these trains leave the station, there is no way of stopping them.

So we ended the October quarter with inventory higher than we wanted it to be, and higher than it should’ve been. But at the same time, we also had by that time released orders to the foundries, which again it was simply not feasible to stop them. And what we said then, and I repeated it again in my prepared today, was that we expected inventory to be back where you think it out to be by the end of the fiscal year. I said that on our last conference call and I said it again today.

Tore Svanberg - Piper Jaffray

So this misalignment if you will should be pretty much over by the April quarter?

Peter V. Leigh

That is the intention.

Tore Svanberg - Piper Jaffray

Ok, and then just final question, you mentioned there is a lot of work going on for the gross margin decline to stop, other than the inventory misalignment, what are two other things that you’re doing right now specifically in order to stop that gross margin decline?

Peter V. Leigh

Well, the key to the control of gross margins as you know in the semi-conductor industry, in the short run, the number one thing is yield. We’re buying wavefronts at a set price, and our cost per unit depends directly on the number of good die you get out of each wavefront, and that in the particular case of image sensors is a very complicated process because the wavefronts go through a whole series of separate production steps that at each step there is a yield loss. And you can’t get the yield loss to zero, but you obviously want to reduce it to the maximum possible extent that you can, and for example if you take the recent announcement over the investment by TSMC and Zintex, to our set it’s a very positive sign because what it means is now Zintex will have access to all of the engineering talent and resource that TSMC has and that should enable us to make significant progress on our CSP packaging which we consider to be a major competitive advantage.

Operator

Your next question comes from the line of Aaron Hussett with Morgan-Stanley, please proceed.

Aaron Hussett - Morgan-Stanley

Great, thank you for taking my question.

I guess to start; can you just tell us what percentage of your unit for VGA for the January quarter?

Peter V. Leigh

The forces of VGA units were roughly in the plus 60% range, not so dissimilar from what they have been in the prior quarter Aaron.

Aaron Hussett - Morgan-Stanley

I could say we were about two-thirds last quarter so did it actually fall to 60% or was it right in that two-thirds area?

Peter V. Leigh

Two-thirds…two-thirds of what find?

Aaron Hussett - Morgan-Stanley

Okay and then on the two megapixels side. That ran pretty well for you in the October quarter. Did that actually get above ten percent of units in the January quarter?

Shaw Hong

It was above ten in the second quarter and slightly below ten in the third quarter. It went down just a little bit.

Aaron Hussett - Morgan-Stanley

OK. What happened there to cause the decline in the two mega pixels percentage? It seems like that was ramping up pretty well.

Shaw Hong

I think it was mainly just adjustments of inventory. I don’t think there is any long term significance in that.

Aaron Hussett - Morgan-Stanley

Okay. Are you expecting any kind of significant or changes in your mix in either direction in the April quarter?

Shaw Hong

We don’t talk specifically about mix in a perspective basis but I think qualitative we can say the mix is not likely to be a major (stumbling) not likely to see major shift in the current quarter.

Operator

Your next question comes from the line of Adam Benjamin with Jeffries.

Please proceed.

Adam Benjamin - Jefferies

Thanks guys. Just want to talk a little bit about the gross margin this quarter. We dropped below the 30% threshold which has been I know a target for you for some time as to a number you don’t want to drop below. Now that you’re down in the mid twenties, I guess I have a question. It looks like it’s going to continue into the April quarter. How should we be thinking about the long term targets for this company? Is now kind of the high end of 30% level as an achievable target at some point again or are you still starting to think about this business more in the mid 20% range going forward?

Shaw Hong

Well Adam, as you and I have discussed, all the once financed people are not paid to be optimistic. So, we have to run the business on the basis of what we can see now. I think the question of whether you would actually put a limit on your own goal for margin, no, you would never do that. And certainly part of the effort to develop new technology is to achieve the kind of product differentiation that enables us to get the higher margins that we got, what six, eight quarters ago. So we’re not going to give up on that goal but in the meantime, what you have to do is learn to run the business with a different gross margin level and you have enjoyed historically.

Adam Benjamin – Jefferies

Okay and I guess you’re guidelines doesn’t seem to necessary reconcile with what the trends have been a little bit in the market as there seems to be more and more phones being introduced with two mega pixels sensors that are being introduced and enter in the market and being higher volume here throughout the year. I guess I am trying to reconcile that with your mix which continues to be heavily slanted toward the VGA and actually came down from last quarter where you had over 10% mix at two mega pixels. Can you reconcile that a little bit?

Shaw Hong

Adam, I think there are a couple of points here. I think as Peter as mentioned, the current slight dip in the two meg is not indicative of the future trend. I think it’s the inventory issues at the customer end that’s working itself out. Initially, we had a pretty aggressive ramp, we backed off of it and the plan is for them to obviously continue and grow in the two meg arena. You and I have both seen a lot of new two meg phones being introduced recently and bear in mind that those are models, those aren’t necessarily numbers of units shipped. I think we’re pretty much in line with what makes this a difficult handset. There is a very large component of hand devices with VGA and cameras, but large numbers are still out there

Operator

Your next question goes to the line of Tristan Gerra with Robert Baird. Please proceed.

Tristan Gerra – Robert W. Baird & Co.

Hi Guys. Could you talk about the $13 million insurance proceeds in the balance sheet and whether this had an impact on the P&L?

Shaw Hong

Hi Tristan. No it doesn’t. The accounting rules, bless them, require that when you have a settlement like this we have to show the settlement broad. That is we have to record as an asset the $13 million the insurance companies have in principle agreed to contribute to the settlement, and then we record as a liability on the balance sheet $13.75 million which represents what we have to pay gross. So you really have to net those two out. It has no P&L impact on the current quarter. We booked last quarter $3.3 million which was the total amount of our costs and that was the end of it.

Tristan Gerra – Robert W. Baird & Co.

OK. And then, given that sales were up about 30% sequentially, what assumption should we make in terms of gross margin trans, I understand that you’re not going to guide beyond the current quarter but nevertheless given that it looks as if there’s now a significant increase of inventories in the channel, what does that mean in terms of you being able to increase your factory load in the quarter?

Shaw Hong

Well, let me be sure we’re on the same page. When we spoke of inventory in the channel what we were referring to was the (inaudible) that I think you would have seen from others also having to do with inventory of handsets in the channel, not inventory as a census. Inventory as a census as far as we can tell in the channel are fine. It’s further down the food chain where there’s been a certain amount of inventory billed that a lot of this will be clarified when people come back from their extended lunar new year holiday.

Tristan Gerra – Robert W. Baird & Co.

Do you have a particular geographic exposure in terms of your distribution? Is it mostly China or is it pretty much irrelevant to the actual end market?

Shaw Hong

We do use distributors in China. That is a sensible way of handling the supply chain in China and as I indicated in my prepared remarks, this has to do with the supply chain management and managing the credit risks. The sales through distributors, broadly speaking have very similar margins to the margins we achieve on our sales to OEM’s and to value added re-salers.

Operator

Your final question comes from the line of Betsy Hees with WR Hambrecht. Please proceed.

Betsy Hees - WR Hambrecht

Hi. Thanks for taking my call. I had a question in regard to the inventory in the handset channel. You mentioned that you believe that we’re at the bottom of the trough, and I was wondering what confidence in what you’re seeing in the market to indicate that that’s truly where we are?

Shaw Hong

Well, first of all Betsy. The comment about the bottom of the trough was more related to the pattern of our revenues. It wasn’t a comment directly addressing the handset inventory. Nevertheless, I think my colleague, Jess may wish to say a word about this. The sense is that we expect that handset inventory to work itself off during the current quarter and things to get back more or less to normal.

Betsy Hees - WR Hambrecht

OK. I was wondering if you could give us just a little bit more color on that. What signs are you seeing for that if you’re waiting for your customers to come back from their extended lunar new year? Where are these indications that this is improving?

Shaw Hong

Well, I think that a normal part of our process is fairly long term forecasting of the demand of the customers and this goes out quite a few months, and what we’ve been seeing short term, and what we’ve been seeing longer term has given us confidence in what Peter stated earlier.

Betsy Hees - WR Hambrecht

OK. Great. Thank you.

Operator

Ladies and gentlemen, this concludes our Q&A session. I would like to hand the call over to management for closing remarks.

Shaw Hong

In closing I want to reiterate our confidence in the ability of OmniVision’s to continue to be a market leader in advanced image sensor technology. We are well positioned to introduce new and advanced products that meet the needs of our customers ahead of the competition. We appreciate all of the work that every member of our team has done to contribute to our success. And we thank you for participating in our call. We look forward to speaking with you next quarter. Good bye.

Operator

Thank you for your participation in today’s conference. This concludes our presentation. You may now disconnect. Have a good day.

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