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International Rectifier (NYSE:IRF)

Q4 2011 Results

August 17, 2011 5:00 p.m. ET

Executives

Chris Toth – Investor Relations

Ilan Daskal – CFO, EVP

Oleg Khaykin – President, CEO, Director

Analysts

Ramesh Misra – Brigantine Advisors

James Schneider – Goldman Sachs

Alex Gauna - JMP Securities

Kevin Cassidy - Stifel Nicolaus

Stephen Chin – UBS

Brian Piccioni – BMO Capital Markets

Steve Smigie – Raymond James

Craig Berger – FBR Capital Markets

Operator

Good afternoon. At this time I would like to welcome everyone to the International Rectifier fourth quarter and full year fiscal 2011 conference call. [Operator instructions.] I would now like to turn the conference over to Chris Toth, Investor Relations. Thank you. Mr. Toth, you may begin your conference.

Chris Toth

Thank you operator, and good afternoon. If you have not already read through our press release issued earlier today, it can be found on our website at investor.irf.com in the Investor Relations section. This call is being broadcast over the internet and can also be found through the IR’s web address. A conference call replay will be available following this call through August 24, 2011. After our prepared comments, we will open the line for questions.

Our discussion today will include some forward-looking statements made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. We caution that such statements are subject to a number of uncertainties and actual results may differ materially. Risk factors that could affect the company's actual results are included in our press release issued today and the company's filings with the SEC, including the most recent forms 10-K and 10-Q.

Before we begin, I would also like to mention the following upcoming events. On Wednesday, August 24, we will be attending to Morgan Stanley Semiconductor Corporate Access Day in Chicago, and on Wednesday, September 7, we’ll be attending the Citi Technology Conference in New York City.

Now, Ilan will discuss our most recent financials. Ilan?

Ilan Daskal

Thank you Chris. Good afternoon, and thank you all for joining us. For the fourth quarter of fiscal 2011, IR reported a revenue of $317.2 million, which was a 6.9% increase from the prior quarter and a 20.3% increase from the fourth quarter of fiscal 2010.

Revenue growth accelerated as we saw strength in the appliance, industrial, and consumer end markets. Gross margin was 37.2%, resulting from a shift of product mix as our PMD revenue increased sharply from higher demand and our higher-margin HiRel business decreased to timing of shipments.

We reported a net income of $39.6 million or $0.55 per fully diluted share, compared with $49.5 million, or $0.69 per fully diluted share in the March quarter. The June quarter results included a $12.4 million gross tax benefit that benefitted fully diluted earnings per share by $0.18.

The March quarter included a $6.5 million gross tax benefit and a $3.5 million reversal of restructuring charges. In March these two items benefitted fully diluted earnings per share by $0.14.

In the earnings per share calculation please note that even though the company does not pay dividends, accounting rules require us to allocate a portion of net income to any unvested restricted stock units on which we could pay dividend equivalents.

In the June and March quarters, the amount of net income excluded from the earnings per share calculation was $573,000 and $733,000 respectively. If you do not make these adjustments, you will calculate the diluted earnings per share to be $0.01 higher than what we have reported.

For the June quarter, R&D expenses were $32.5 million, which represented 10.2% of revenue. The increase in R&D was primarily from the inclusion of the CHiL acquisition. SG&A expenses were $52.1 million, which represented 16.4% of revenue. The increase from the March quarter was primarily from higher ERP implementation expenses, legal fees, audit expenses, and the addition of CHiL.

Operating income for the quarter was $30.6 million and represented 9.7% of sales for the quarter. Other income net was $1 million in the June quarter and interest income net was $1.9 million, primarily from the sale of our Level 3 investments.

Income tax for the June quarter was a $6.2 million benefit due primarily to a net release of tax reserves on deferred assets and other discrete items totaling $12.4 million. This was partially offset by about $6.2 million in tax accruals in our foreign jurisdictions.

The total cash, cash equivalents, and investments at the end of the fourth quarter was $499.7 million, which included $2.1 million of restricted cash. We have successfully liquidated our Level 3 mortgage and asset-backed securities. We are now down to less than $1 million for these securities at end of the June quarter from about $98 million at the end of the September quarter of 2008.

During the quarter we increased inventory by $9.5 million to $250.2 million. Weeks of inventory decreased about 1 week to 16.3 weeks. Cash from operating activities in the quarter was $62.3 million and free cash flow was $9.6 million.

Cash capital expenditures for the quarter were $52.6 million. For the 2011 fiscal year, cash capital expands were $146.3 million, which represented about 12% of revenue. Of the $146.3 million, about $31 million was related to our ERP implementation.

Depreciation and amortization expense was $19.6 million and stock based compensation was $4.2 million. We did not repurchase any shares of our stock during the June quarter and had 69.9 million shares outstanding at the end of the quarter. We continue to balance the components of our capital allocation model between operational cash needs, strategic growth initiatives, and share repurchases.

Moving on to our outlook, we currently expect our revenue for the September quarter to be between $290 million and $310 million. For this projected revenue range, we currently estimate gross margin in the September quarter to increase to about 39%, primarily due to better factory utilization within the June quarter and product mix.

We expect R&D expenses to be about $35 million. The increase is driven by increased engineering builds to support the launch of new products and technologies. SG&A expenses are expected to be about flat compared with the June quarter.

For the September quarter, amortization of acquisition-related intangibles is expected to be about $2.6 million. For the remainder of the 2012 fiscal year, we expect this quarterly amount to be about $2 million.

Other expense net is expected to be about $500,000 and interest income net is expected to be about $200,000 due to low interest rates. Our tax rate for the September quarter is expected to be about 10%. For fiscal year 2012, we expect a tax rate of approximately 10% as we will continue to utilize reserves and tax credits to offset most of our taxable income.

And finally, for the September quarter we expect our cash capital expenditures to be between $55 million and $60 million, of which about $10 million is for ERP implementation. For the 2012 fiscal year we expect capex to be approximately 12% of revenue depending on end market demand. The majority of our capex will be driven by investments in internal manufacturing upgrades and new process technology.

Our ERP implementation is nearly complete, and we expect less than $20 million in additional capex, most of which will be in the first half of our 2012 fiscal year.

Now Oleg will give you the latest update on our business. Oleg?

Oleg Khaykin

Thanks Ilan. Fiscal 2011 was a good year for International Rectifier. Let me begin by recapping our achievements. We grew year over year revenue by 31.4%, exiting the fiscal year on a run rate of about $1.25 billion annualized.

Our June quarter revenue is now about 50% above the ongoing September 2008 revenue peak. Gross margin for the year was 39.5%, significantly above the 32.7% achieved in fiscal 2010. Our operating income increased significantly year over year and we ended the fiscal year with over $7 in cash and investments per share.

Next, let me discuss several highlights from the past year worth noting. First, we have rebuilt IR back to about comparable 2007 pre-divestiture revenue levels. Much of our success was driven by R&D investment and growth acceleration as a result of revamping and productizing IR’s technologies and recapturing market share with Tier 1 customers.

Our strategy has led to record design win activities in our business units and continues to position IR for future growth above the industry range. Second, we completed the CHiL acquisition that strengthens and expands IR’s competitive position in emerging digital power management applications.

And finally, we continued to improve our operational efficiencies over the past year. We contained to add external capacity and reached our goal of about a 70-30 split between internal and external manufacturing. And we are able to offset increased material costs through higher productivity.

For the June quarter, we saw strong growth momentum in Europe in both automotive and industrial end markets. Asia was particularly robust, and we continued to see strong growth driven by appliance, automotive, consumer computing and industrial customers. The Americas were about flat, and the industrial market slowed. And Japan exhibited weakness, particularly towards the second half of the quarter.

Moving on to our business units, the enterprise power business unit revenue increased 4.8% from the last quarter, driven by computing and graphics shipments to Tier 1 customers. Our communications business showed modest growth and our server business was about flat compared to the prior quarter. We continued to see a nice ramp in our digital products in performance desktops and graphics cards.

The increase in enterprise power gross margin to 37.5% was largely due to a change in product mix in the June quarter towards computing and graphics as well as startup costs of digital power products acquired since the CHiL acquisition.

We continue to see strong design win traction in next generation servers as well as in the high-performance computing and graphics segments. Our power management devices business unit revenue increased 19.6% from the prior quarter. This increase was driven by strength in high-volume consumer industrial markets.

We entered the June quarter with a strong outlook. However, the outlook dipped toward the end of the quarter as customers began pushing out orders in an effort to reduce their inventories. Overall, we continue to see strong design win activity across a broad range of customers as we expanded our discrete product portfolio and end markets.

Our energy saving product business unit revenue grew 4.4% over the last quarter, driven by continued demand for our motion control and high-voltage products, mainly in Asia. The strength in Asia, however, was tempered by relative weakness in the North American markets and overall weakness in consumer products, particularly flat panel TVs.

Our automotive products business unit revenue grew 3.3% from the prior quarter to a new high of $31.9 million, driven by strong demand in Europe. Design win activity remains robust as we continue to see solid traction for our automotive switches and ICs.

The growth in our overall revenue were partially offset by a decrease in our HiRel business unit, down 10.8% in revenue compared to the March quarter. The decline was due to timing of shipments related to several programs that shipped in the September quarter. That said, we continue to see strength in booking in our high-reliability power management products in many of the areas we serve, such as space and commercial aviation. Overall, our position in HiRel markets remains strong.

Now, an update on channel inventories. During the June quarter, sell-in sales outpaced sell-through sales due to a slowdown in POS. As a result, channel inventory dollars increased and we ended the quarter with about 9.5 weeks of inventory. Lead times have continued to come down, and we are back to normal for the majority of our products.

Overall, factory utilization remained about 90% during the June quarter. Over the next quarter or two, we expect to slightly lower our utilization levels to align with lower end market demand and additional capacity coming online to support our high-voltage power products.

In the September quarter, we expect our HiRel business to return to about $50 million quarterly run rate and expect enterprise power to be slightly up as well. Energy saving products is expected to be flat to slightly down, and in automotive, we expect a seasonal decline in the middle single digits as a result of European summer vacations and push-outs from Japanese auto customers to the December quarter.

Lastly, we expect our PMD business unit to significantly decline as OEMs and distis burn off inventories. As I’m sure you’re aware, the market situation has weakened. Over the past 2 months, we have seen our market segments impacted to one degree or another and visibility has quickly become clouded.

We have observed increasing trends of customer order push-outs in the end of June and that have accelerated through our July and continues into August. These trends are a response to customers drastically taking down their inventories in view of increased market uncertainty. As a result, we expect our September quarter revenue to be in the $290 million to $310 million range.

That said, we view this period of uncertainty as an opportunity to position IR for the future by focusing on 3 areas. First, the revenue growth. Over the past 11 quarters, we have managed to grow revenue organically by about 50% above the ongoing levels from the September 2008 peak.

Irrespective of the market slowdown, we remain focused on our growth drivers: The R&D investment, design wins, and market share gains. There is nothing that fundamentally changes how we continue to drive our business growth and we intend to continue to outgrow the industry in the coming years.

Second is gross margin. By improving our operational efficiency and building scale, we have been able to lift our gross margins to the high 30% range. We have come a long way in improving the stability of our margins and we have put in place a more flexible manufacturing model in order to maintain our margins at the current levels.

In the near future, despite weakened end market demand, uncertain market conditions, and expanded manufacturing capacity coming online, we expect to continue to run our margins in about the 37% to 39% range.

And finally, managing our opex. During our fiscal 2012, if end market demand is stable, we expect SG&A to peak out in the mid-$50 million quarterly level range and then go down to about $50 million quarterly level by the end of fiscal 2012 or the beginning of fiscal 2013.

The elevated SG&A will be a result of 2 main drivers. First, higher ERP costs as we go live with our SAP system. We expect this to last several quarters as depreciation and training costs are incurred and legacy costs are wound down. The second is higher legal expenses as we protect and enforce our intellectual property rights.

For the 2012 fiscal year, we expect R&D spending to be in the $33 million to $35 million range. Similar to the last downturn, we expect to accelerate our strategic investments in R&D. This includes increased engineering bills, support new technology development, introduction of new technology power platforms and products and expansion of our digital power management product portfolio.

In conclusion, we are well-positioned in high growth end markets, with the right technologies. The focus on energy efficiency is only expected to accelerate. We continue to invest in our future, renew our product portfolio, transform our operations, and prudently manage our capital.

This concludes our prepared remarks. We will now open the lines for your questions. Operator?

Question-and-Answer Session

Operator

[Operator instructions.] And your first question comes from Ramesh Misra with Brigantine Advisors.

Ramesh Misra – Brigantine Advisors

In regards to the slowdown that you’re seeing, would you use this opportunity to go forward with your factory consolidation plans?

Oleg Khaykin

What we see in this slowdown, it’s really driven, I think, more by the inventory rebalancing. If I would look at the June quarter, it started out very enthusiastic from our customers with a very high expectation for the September into December quarter. As the quarter progressed, there’s been, as you know, a lot of uncertainties and concerns over some of the slowdown potentially in China and of course further compounded by the U.S. debt situation. So what we are seeing today is really much more of a rebalancing of inventories in anticipation of maybe a weaker December quarter. But that said, at the same time, when I look at what our customers are actually shipping through, those shipments are actually down only slightly, so really what we are seeing is that our channel partners and OEMs are trying to get their inventories down to 6 weeks, and potentially lower. And at this point in time, I believe this is a temporary condition and it would be imprudent to rush to extreme things like shutting down factories.

Ramesh Misra – Brigantine Advisors

In regard to some of your more price-sensitive products, are you seeing any pricing pressure there?

Oleg Khaykin

Well, I think what you’re seeing is you poll all your distributors, right? And they all say their demand from their customers has dropped, and they’re trying to burn off inventories. But at the same time, some of them are trying to use this as an opportunity to buy some products at a discount and they do come back and say hey, I don’t really need it. I’m pushing out the products into the next quarter, but tell you what, I could potentially take it and move it if I could get X% discount on rebate. We have taken a very strict and very tough position that if they push out the product we’re not doing any deals. Because it’s just, in my view, at this point in time, a foolish errand, which will further destroy your pricing longer term. So I wouldn’t say there is pressure to reduce prices, but there’s plenty people looking to exploit the situation for their gain, and our firm position in the industry has been we are going to maintain the pricing discipline, at this time at least.

Operator

Your next question comes from James Schneider with Goldman Sachs.

James Schneider – Goldman Sachs

I was wondering if you could give us a little bit more color on the order patterns you saw in terms of linearity. You talked about the push-outs going from June into the current quarter. Could you talk a little bit more specifically about did things continue to get worse in June and July? Have things stabilized at all in terms of orders in August? Or do things continue to deteriorate from here?

Oleg Khaykin

Well, that’s a very good question. When we started the June quarter, we actually expected our September quarter to be up significantly from the June quarter, and I would say probably all the way up until the end of May that was kind of the picture. Towards the end of May, the last week, you started seeing some products getting pushed out, and then, like clockwork, throughout June we started seeing a weekly push-out. And it accelerated further in July.

And it’s continued at the same pace the past July into August, and I would say it’s continuing as we speak. So if you had for example asked me the question, let’s say 3-4 weeks ago, I would have said we think our September quarter is probably now going to be flat rather than up. But given where things stand and the continuous push-outs that are going on, we felt it’s prudent to provide a broader guidance range.

And you know, some of it is really driven, because we’re approaching a 30-day window beyond which the customers cannot push the products out. So just kind of understanding their situation you cannot blame them. They are very concerned about the December demand and their view on it is hey, if I delay pushing out my order as much as possible, I know these guys are going to have product already well in the pipeline, so it doesn’t hurt for me to push it out. There is no penalty, but if I really actually need it in September they will have the product available, which unfortunately they’re probably right, at least in the short term. But it obviously is not a good long term strategy.

See, from where I sit today, we actually are looking at 2 potential scenarios for the September quarter. If the trend continues through August and there is no snap-back or is no orders appearing to our customers and their customers for December, and September comes in weak, anemic, then we will be probably closer to the lower end of the range.

However, if people have been overreacting and as usually happens in this industry, the herd mentality, they go too far and all of a sudden in September they realize that the world is not going to come to an end in the December quarter, we may have pull-ins and expedites coming from the customers and we may find ourselves at the higher end of the range.

So if I were to say, where I sit today, I think the situation continues to be very volatile as everybody’s continuously, I would say in many ways neurotically, reexamining their inventories and order books.

Operator

Your next question comes from Alex Gauna with JMP Securities.

Alex Gauna - JMP Securities

I was wondering if you could give some color. You just answered how the variance could be on the September quarter, but are you fully booked now for the low end of your guidance range? And can you talk to what you would typically see in the month of September. I would think Europe in particular coming back from vacation you might see some order activity.

Oleg Khaykin

It’s a good point on Europe. That obviously has the potential for that. But I think at least for our automotive we think the numbers are fully baked in. Because they typically pre-build inventory before they go on vacation. And the same thing is in industrial segments. In terms of fully booking, heck, I would say one or two weeks ago I thought I was fully booked. The reality is we still have two more weeks where customers can push the product out. So yes, we are booked. We are actually more than booked. But the reality is you have still two more weeks where there is no penalty to push the product into the December quarter.

Alex Gauna - JMP Securities

Okay, and with regard to that December quarter, you mentioned nine and a half weeks of channel inventory. Where do you think it should be in this environment? And given uncertainty right now and typical seasonality, would it be safe to assume at this juncture that December is looking like a down sequential quarter? Or is it premature to say that?

Oleg Khaykin

What’s interesting is if you look at your order books, people are not cancelling orders. They are pushing them into the December quarter. So if you take all of the volumes in the December quarter, you could make a hypothesis that the December quarter should be strong, but I think it’s too premature to believe in it, because come the December quarter if the order books for our customers continue to be weak, then we push it out into the March quarter. So I think at this point in time, it’s too vague to make any kind of definitive observation. Now, that said, if you have been following retail sales, they all seem to be doing pretty well, so the product is selling fairly well on the retail side, which just purely through the restocking, at least my hypothesis is the December quarter should not be catastrophic or anything like that. But it’s still too early to tell.

Alex Gauna - JMP Securities

Is nine and a half weeks the right amount of channel inventory then? Or does it have to come down a bit.

Oleg Khaykin

No, the reality is I’m trying not to put more product in the channel, because I don’t want to create more on my books. Clearly if revenues drop, nine and a half weeks inventory today could quickly become 12 or 14 weeks, right? It’s all a matter of your exit velocity. So from our perspective, because we still have quite a bit of product in the [inaudible] that is being pushed out or customers want to delay it, we’re going to see our total inventory increase in the September quarter, because you still have this pipeline of product moving. But in the absolute dollars, I’m trying to keep it out of the channel and mainly keep it where I can have control over it, where I can divert it as various people start scrambling potentially for expedites of products as they find themselves in a very short position. Because I think from the point of view of the business, distributor holding six or less weeks of inventory is not sustainable, so to the extent the demand into the December quarter remains even reasonably good, they will very quickly run out of inventory.

Ilan Daskal

Oleg, I will add to that, probably a normalized inventory level that we proceed is 9-10 weeks. With the volatility that we see, we may see the channel inventory going down, but our internal inventory may go up.

Oleg Khaykin

And in fact it’s better to hold the product internally when you have such big volatility, because you may have some people come in urgently looking for much more product, and others may not. But once you ship it in the channel, you cannot really redirect it.

Operator

Your next question comes from Kevin Cassidy with Stifel Nicolaus.

Kevin Cassidy - Stifel Nicolaus

You mentioned the next-generation servers and there’s been a lot of discussion this quarter on whether the [inaudible] is later than expected. How is it from your perspective.

Oleg Khaykin

Well, I think since it hasn’t been made public, I prefer not to comment on the rumors. So we’ll just leave it as rumors. But I would say things from IR’s perspective, we are in a pretty good position in VR12 generation. We believe we’ll have even stronger position in VR12.5, which will be kind of the speedbump or the refresh. So obviously if VR12 gets delayed, it may actually become even better for us, because the next generation would come in sooner. But that said, we have a very strong position in the current generation, VR11.1, so to the extent anything gets delayed, it benefits us tremendously.

Kevin Cassidy - Stifel Nicolaus

Okay, so you think you’re gaining market share. Do you have an idea of what percentage you’d have?

Oleg Khaykin

I think I probably don’t know the percentage, because there’s a lot of different OEMs. We lost share at some customers, we’ve gained share at others. So I think ultimately I’ll wait to see what share of respective customers captured before I calculate my share. But I think we ended up in a somewhat weaker position in VR12, but we are actually in a much stronger position for VR12.5.

Kevin Cassidy - Stifel Nicolaus

And on the Japanese auto, you said there was push-outs. Do you think that was because there was not a full bill of material, or was it any other reason?

Oleg Khaykin

I think some of it is material, but I also heard some explanations that in trying to conserve power, they are trying to delay heavy manufacturing or energy hungry manufacturing more into the December quarter when there’s a less need for air conditioning.

Operator

Your next question comes from Steven Chin with UBS.

Stephen Chin – UBS

First question I had was on the enterprise power division. I just want to drill down a little bit more on the server related exposure there. Can you talk a little about what your expectations are for that part of the business for the September quarter? Is that holding flat? Or is there some [inaudible] growth there because of new buying going to the year end?

Oleg Khaykin

Well, you know, it’s kind of tricky this time around, because the server sales have been fairly flat, and I would say not exciting, because the platform is now 2 years old and a number of customers may be waiting for the next generation of products. So it’s kind of like with a lot of older car models the OEMs have to give significant discounts to stimulate sales of the older generation before the new one is released. So I don’t expect server sales to be anything to write home about for the remainder of the current platform. It will continue go at a steady pace, but just as in the previous cycles, we see generally the server revenue go flat or actually start to decline as people wait for the next-generation platform.

Stephen Chin – UBS

And how about the notebook part of the business? How’s the ramp status of that? Or potentially [inaudible] demand that you might be seeing on the notebook power management side?

Oleg Khaykin

I think for us it’s been going actually pretty good. On the notebook and graphics cards we’ve gained more customers. But it obviously comes in at the lower margin, so in the June quarter notebook and graphics were very strong, but it pulled the average margin for the business unit and it was further compounded by the startup costs of the CHiL products that we bought as they were starting to ramp. So there was additional cost to get things going, which further dragged down the margins.

Stephen Chin – UBS

And then last question I had was on gross margins. Can you help me better understand the commentary regarding the guidance on gross margins relative to capacity utilization. I think Ilan mentioned that margins will go back up to about 3.5% based on utilization rates and also mix, but I think I also heard you mention that you’ll be bringing your internal factory utilization down from the 90% in the June quarter. So if you could clarify that it would be helpful.

Oleg Khaykin

Right. So I’ll answer and then I’ll let Ilan chime in. The gross margins are driven by 2 things. One, it’s driven by the cost-effectiveness of the factory. If they’re running full, you get lower costs. So that’s self-explanatory. But also there is a mix, so because some of our biggest slowdown this quarter is in automotive and the PMD business units, which have margins below our company average, so that actually gives you a mixed benefit. Also, on top of it, our June quarter was a very busy quarter, and our factories are running high utilizations, so the products that we are selling through are coming out at a lower cost. So overall that helps to push gross margin in the September quarter up quite a bit as you can see. To the extent that we slow down some of our factories to rebalance the mix between different products, and also to match supply to demand, we’re going to reduce the utilization so that would put some downward trend on margins in the other quarters, and that’s why we gave the range between 37% and 39%.

Ilan Daskal

So basically Steve, based on what Oleg said, there are two factors, the utilization and the mix. In June, we had a very high utilization. The mix was impacted mainly by the HiRel business unit and therefore the actual was lower gross margin a bit in June but for September we’ll enjoy, from the high utilization rate in June - there’s always 1 quarter lag there - and right now we already operate with a low utilization rate, so that will have probably an impact of about 1-2 points headwind into the December gross margin. And again, the mix in September is being impacted positively by the lower revenue of the PMD products.

Operator

Your next question comes from Brian Piccioni with BMO Capital Markets

Brian Piccioni – BMO Capital Markets

With respect to the SG&A ramp through the year, once the ERP implementation is done, and you should have savings and that sort of thing, when we look beyond 2012, how would we model SG&A?

Oleg Khaykin

As we indicated in the prepared remarks, we plan to get it down to about 50 and obviously from there it probably will scale lower than the revenue growth, assuming we are back to a kind of normalized growth and we’ll continue to outgrow the peers and gain more market share. The incremental SG&A relatively to the gross revenue is going to be much lower. So we will start to gain all those efficiencies from the new system.

Brian Piccioni – BMO Capital Markets

If I understood correctly, based on what you said earlier in the call, and there was a lot of information there, so I apologize if I got it wrong. You’re going to go up in 2012, come down back to about 50, and then it sounds like in 2013 and beyond you’ll probably grow from 50 but obviously at a lower rate an average price of revenue.

Oleg Khaykin

Correct.

Brian Piccioni – BMO Capital Markets

Okay. And I’ve got to ask, because I ask [inaudible]. We’re seeing a lot of activity on the GaN over silicon announcements out of startups and this sort of stuff. Of course I don’t know if that has any relevance to your comments vis-à-vis intellectual property issues, or legal expenses and so on, but if you could give us an update there and with respect to design win activity if any at all.

Oleg Khaykin

Well, I think you hit the nail on the head. GaN on silicon technology is not free. We have made a significant number of breakthroughs in this technology, and obviously it’s much more difficult to get it done first time around, and it’s much easier to be the follower. One of the things we do is we aggressively patent intellectual property in and around our products, both at the process level as well as the device level, and the short phrase on it is GaN on silicon ain’t free. So I’ll just kind of leave it at that and the people can make the corresponding conclusions from that.

Operator

Your next question comes from Steve Smigie with Raymond James.

Steve Smigie – Raymond James

You talked about the push-out of the revenue you’ve been seeing in terms of the ramp. Is that business that can potentially come back at some point, or is this just business loss at this point?

Oleg Khaykin

Well, we think this is obviously business that did not disappear. I think as you know September quarter is generally the strongest quarter in the industry, so as we started out June quarter a lot of the customers were having certain expectations on September and then December and some of their expectations came down. They effectively pushed out the orders.

So now that the industry consensus is that the September quarter is not going to be strong and there’s a lot of concerns how all these debt discussions and all the uncertainties that have transpired will play out into the December demand. So what customers just did is you’re still building those products you’re still building those systems. You’re still going to need this product. The question is at what run rate.

So at least right now it’s the industry assumption that it’s going to go down quite significantly. And as a result the orders have been pushed out. What we are doing on our part is we’re trying to now rebalance our velocity of our supply chain to adjust it for the slower demand in the September and December quarter. Now to the extent the market has overshot by being doom and gloom, and in the end the demand is stronger, there’s going to be the opposite reaction probably in the next one or two quarters.

Steve Smigie – Raymond James

What quarter do you expect the SG&A to peak given the ERP ramp and around where do you think that would peak out dollarwise?

Ilan Daskal

We plan probably to go live with the new ERP system by the end of the calendar year. So around this timeframe I believe is when the SG&A will peak.

Steve Smigie – Raymond James

And the dollar amount?

Ilan Daskal

We said the mid-50s is kind of the peak level that we see right now.

Steve Smigie – Raymond James

And so turning to gross margin, you’re going to be pulling utilization down a little bit. Where would you see - and I know you gave a range - sort of your trough gross margin going forward?

Ilan Daskal

Probably it’s going to fluctuate. It depends on, obviously, as I mentioned, the utilization and the mix. And as we said in the prepared remarks, it’s going to be in the range of between 37% and 39% and it all depends on those two factors.

Oleg Khaykin

And I think clearly right now our assumption in terms of the one-, two-, three-quarter visibility is more an inventory correction with some slowdown, no drastic fall off in the business. Obviously if we have a repeat of 2009 with a significant downturn, all bets are off. But I think in the case of looking at 10-15% correction we’re in pretty good shape.

Operator

Your next question comes from Craig Berger with FBR.

Craig Berger – FBR Capital Markets

Can you just comment on commodity pressures and also bigger picture? You’ve set a target for your gross margins above 40%, and now you’re talking about 37-39%. So I guess what’s changed and what’s the action plan to get you at or above 40%?

Ilan Daskal

Maybe I’ll start with the commodities and then Oleg can chime in on the overall target model. The impact of the commodities on the overall cost of sales was not a large amount. And some of the commodities went down even. And anyway in the last few quarters the manufacturing efficiencies that we managed to have were much higher than any impact of the material and commodity cost. And we saw a spike kind of a few quarter back, and now some of the commodities are even down.

Oleg Khaykin

So I think it takes a couple quarters for the change in commodity prices to trickle down to us. So the big uptick in the second half of last year, calendar year, has showed up and put a lot of pressure on our margins to the tune of 1-2% in the earlier part of the year. Now we’re actually seeing some commodities, as part of this slowdown, are dropping. So we’re obviously taking advantage of that and we hope to see the benefits of it later. In terms of the question on the margin, I think it’s fair to say that our model has not changed. Growth is an instrumental, a key element, in us achieving our target model and as we scale our operation - a lot of the cost elements that are fixed become a smaller and smaller percentage and it helps with the margin expansion and the manufacturing efficiencies. But also, more importantly, the new products that we’ve been launching in the last 2-3 years become more and more pronounced in our mix and some of the legacy products will ride off into the sunset. Mix will play an important element in expanding the margins.

Craig Berger – FBR Capital Markets

Okay, so basically expect better news in coming quarters and years as your new products and mix contribute more.

Oleg Khaykin

Well, and obviously a key element here is the market returns to more a bullish outlook and the growth resumes.

Craig Berger – FBR Capital Markets

And then as a followup, I think we’ve covered SG&A rising up to 55ish by mid to late fiscal ’12 and then falling back towards 50. I think you said on R&D it’s going to be 35 in the September quarter and then it holds steady from there for the year? Is that the right way to think about that?

Oleg Khaykin

Well, I think what’s driving our growth in R&D is, as they say, never let a good crisis go unexploited. As the business slows down, it provides us with an opportunity to significantly increase the number of learning cycles on new technologies. So we put the products through the fab and back-end assembly. So this way it allows you to reduce your [inaudible] time for the new product testing and development. So we intend to take full advantage of this slowdown. So that’s going to drive our R&D op. Also, the new R&D includes some of the costs that we acquired with that CHiL semiconductor, and we have a very broad portfolio of new products that we plan to launch in the next 6-9 months. And that’s probably going to [inaudible] engineering bills and obviously that costs a higher amount of money. So I think if some of these launches are more successful and happen faster it may pare back somewhat. But I think for the safe assumption I would take about $35 million of the run rate.

Craig Berger – FBR Capital Markets

And so basically you’re telling us 35 and 55 is $90 million and so you’re saying essentially you’re not going to exceed $90 million in opex this year on a quarterly basis? And I ask because last quarter you did $77 million in opex on essentially the same revenue you’re guiding us to in September. And so that’s a big, healthy step up in opex given the revenue situation.

Oleg Khaykin

I think that’s a very good observation Craig. If you added it up, that’s kind of the numbers we say, not to exceed, that’s our intention. Obviously also we have expectations that the world is not coming to an end, the market will return to growth and so on. Obviously if that does not happen we are going to explore all ways of reducing both elements in opex down quite significantly.

Craig Berger – FBR Capital Markets

Last question, and thank you for answering. Obviously you’ve got these revenue adjustments happening in September. How do we think about fiscal ’12 revenues given your design win funnel and whatever visibility you do have now?

Oleg Khaykin

Well, I think as I mentioned in March, if you take the basic underlying conditions, that the market continues to be healthy, we expect very nice growth. And in fact as I said in the March quarter, our visibility at that time into September was to set an all-time IR record with or without the divestiture in 2007. So we had a very strong outlook, and those design wins are still there. They’re going into production, so obviously if the market strength returns we expect to see a significant recovery in our growth.

Operator

[Operator instructions.] You do have a followup from James Schneider with Goldman Sachs.

James Schneider – Goldman Sachs

Thanks. Just one quick followup. On the gross margins, you talked about elevated channel inventories and the internal inventories are I think a record dollar high. Just given the outlook, what’s the confidence level on 37% gross margin being the floor? Does that assume that things in terms of the overall demand environment don’t get any worse from here? Or is there some additional [inaudible] allowing for demand to still get worse in the December quarter?

Ilan Daskal

There is some element of additional deterioration in the forecast, but definitely we do not plan right now, based on our forecast, we did not plan [inaudible] another W on the macro level, right? So it’s not a repetition of 2009. That’s not what we had in our scenario at this point in time. Obviously if that occurs, we will have to adjust it and see what would be the outcome. But taking into account the volatility in the orders that we see and the pattern that we see right now and potential continuation of that pattern for a while, we took that into account with the rate we provided. Definitely with the flexibility that we built in the last few years. You remember a few years back, we were almost completely internal manufacturing. We were 100% internal manufacturing based. Now we have the mix of about 70-30 and that positions us for a much better situation and for those fluctuations in the marketplace.

Operator

You do have a followup from Alex Gauna with JMP Securities.

Alex Gauna - JMP Securities

You gave some very granular answers to your outlook on the server side. I was wondering can you do the same thing on the HiRel side? Can you talk to were they push-outs or was it a surprise? And then with regard to the timing of future HiRel projects, how does that pipeline look? And I ask this because it seems to have such a pronounced effect on the gross margin side of things?

Oleg Khaykin

Sure, just to give you a little background on the difference in HiRel and the commercial business, in the commercial business building the product takes a long time and testing is fairly short. In the HiRel space, testing and [burning] takes a significant amount of cycle time and what we had, because our June quarter kind of ended a little bit earlier, 25th, 26th of June, we had a rather large chunk of the order did not complete all the testing that we thought would be done by then. And we slipped by literally several days. So as a result the September quarter will come in higher by the same amount. So if you kind of take $50 million as your run rate, what we see today at least in that business, to the extent we missed the June quarter by a couple million dollars we expect September quarter to come in up by several million dollars. So since this particular lot that was being built is a fairly high margin product, it makes a meaningful impact from the overall gross margin.

Now in terms of the HiRel business, we have very little military business, almost the bulk of our business is in space and commercial aviation with some medical and heavy duty industrial. And all these segments seem to be pretty good at least for the visibility for the next couple years. I know there’s a lot of nervousness on the military sales given all the budget cuts. I think at least in our case we are very well positioned not to be impacted by that budgetary hit.

Operator

At this time there are no further questions. Gentlemen, are there any closing remarks?

Oleg Khaykin

Yes. Thank you very much for joining us today, and we look forward to speaking with all of you in the coming months. Take care.

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