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Freescale Semiconductor (NYSE:FSL)

Q3 2011 Results

October 20, 2011 5:00 p.m. ET

Executives

Mitch Haws – Investor Relations

Rich Beyer – Chairman and Chief Executive Officer

Alan Campbell – Chief Financial Officer

Analysts

John Pitzer – Credit Suisse

Ross Seymore – Deutsche Bank

Glen Yeung – Citi

Harlan Sur – JPMorgan

C.J. Muse – Barclays

Stacy Rasgon - Sanford Bernstein

Ambrish Srivastava - BMO

Michael McConnell - Pacific Crest Securities

Jeff Harlib – Barclays Capital

Auguste Richard - Piper Jaffray

Operator

Welcome to Freescale’s 2011 Third Quarter Results Conference Call. [Operator instructions.] Now I will turn the meeting over to Mitch Haws. Sir, you may begin.

Mitch Haws

Thank you operator, and thanks to all of you and welcome to our third quarter 2011 conference call. With me today are Rich Beyer, our chairman and CEO, and Alan Campbell, our chief financial officer.

Before we begin today’s prepared remarks, let me remind everyone that today’s discussion does contain forward-looking statements that are based on our current outlook and as such do include certain risks and uncertainties.

Please refer to our press release, our Form 10-K, and other filings with the SEC for a more detailed discussion of the specific risk factors that could cause our actual results to differ materially. Also today, we will reference non-GAAP financial measures and we will post the appropriate GAAP financial reconciliation to our website at freescale.com.

With that, I’ll turn the call to Rich.

Rich Beyer

Good afternoon and welcome to our third quarter conference call. Q3 marked a challenging period for Freescale and the rest of the semiconductor industry. Macroeconomic conditions and demand softened more than we initially expected during the quarter, which negatively impacted our financial results as they have impacted our industry.

Despite the pressure on the top line, we continued to improve gross margins. Let’s look at some of the key points. Revenues were $1.142 billion and that represented a decrease of 6.6% sequentially and were in line with the third quarter of 2010. Adjusted gross margins increased sequentially to 46.1%, a 50 basis point increase over Q2.

This performance generated adjusted net income of $72 million compared to $70 million in Q2. Adjusted earnings per share were $0.29 compared to $0.33 in Q2, reflecting a higher share count in Q3.

Now Alan will provide additional insights into our financial performance in Q3. I will then provide an update on some business highlights and our Q4 outlook, after which Alan and I will be happy to entertain your questions.

Alan Campbell

Good afternoon and thank you again for joining today’s call. As Rich said, Q3 was challenging, but we continued executing well on gross margins and cash. As I review the financials in more detail, please note that I will be focusing on the results excluding the impact of purchase price accounting and certain other items. We believe this to be a more meaningful representation of our ongoing financial performance.

Let me now look at the third quarter in more detail. Revenues were $1.142 billion, representing a sequential decrease of 6.6%, which is in line with our preannouncement on September 26. Sales declined by half a point, or $6 million compared to Q3 last year.

Microcontroller product sales were $395 million, 8% below the second quarter and 6% below the third quarter of last year. Automotive sales were down only modestly from the second quarter as expected, due to normal seasonality, [and did] increase over the same period last year.

Sales of our MCUs into the industrial markets were considerably weaker than we forecast on both a sequential and a year over year basis due to weaker end demands. Networking and multimedia revenues were $292 million in the quarter, down 6% from Q2 and down 14% from last year.

Our networking revenues were negatively impacted by lower demand and pockets of elevated inventory in enterprise and wireless infrastructure markets. Our revenues in our consumer focused business grew from Q2 in line with normal seasonality.

RF, analog, and sensor product net sales were $306 million, 3% below Q2 but 12% ahead of Q3 last year. Sequentially, our RF business was consistent with Q2 and above the same quarter last year. We continued to benefit from our strong position with all major carriers in the U.S., Europe, and Asia.

Our sensor business was in line with Q2, and improved on a year over year basis, benefiting from our growing presence in consumer devices. Analog revenues declined from Q2 due to typical automotive seasonality. Our analog revenues increased over the same period last year.

Cellular product sales were $97 million, down over 20% compared to the second quarter, and other products, which consist of primarily foundry sales and IP revenue, resulted in net sales of $52 million compared to $44 million in the second quarter and $30 million last year.

Finally, sales to distribution decreased 13% sequentially and 7% compared to the same period last year, [unintelligible] the weakening trends, particularly in the industrial end market.

Sequentially, distribution inventory was down slightly in dollar terms. Measured in units, inventories were at 11.5 weeks compared to 10.7 in Q2 and 8.8 last year. Our book-to-bill ratio in the third quarter was 0.9, compared to 1 in the second quarter.

Looking at gross margins and operating expenses, we continued to make sequential and year over year improvements in gross margins. On a sequential basis, adjusted gross margin improved by 50 basis points.

The higher utilization associated with our 150 mm fab transition was offset by much lower utilization of our assembly and test factories as we reacted to the weaker revenues that we saw in the latter part of the third quarter. Operational efficiencies including product yields, procurement savings, and lower depreciation more than offset the impact of lower sales.

On an annual basis, adjusted gross margin improved by approximately 400 basis points. Our internal front-end factory utilization was approximately 83% in the third quarter. This compares to 78% in Q2 and 76% in Q3 of last year.

Let me now turn to operating expenses. SG&A was $129 million, or 11.3% of sales, in line with the second quarter on a percentage basis and consistent with our target operating model. The SG&A dollars declined sequentially as we managed discretionary spend.

R&D in the quarter was $200 million or 17.5% of sales, also in line with the prior quarter on a percentage basis and with our target operating model. Total R&D dollars declined from Q2 due to lower compensation incentives and other discretionary expense.

Core investments in new products and technology were not impacted. The level of investment in R&D continues to support the growth initiatives we have targeted in our core markets and product areas.

Adjusted operating earnings excluding the impact of purchase price accounting and other items were $200 million, or 17.5% of sales. This compares to $216 million, 17.7% of sales, in the second quarter, and $115 million in the third quarter of last year.

Our adjusted net earnings in the quarter were $72 million, exclusive of purchase accounting, reorganization charges, stock based compensation, and other adjustments in today’s earnings release.

This compares to adjusted net earnings of $70 million in the second quarter and $12 million in the same period last year. Sequentially, adjusted net earnings benefited from lower operating expenses and lower interest expense. Earnings per share, exclusive of the above adjustments, were $0.29, compared to $0.33 in the second quarter and $0.06 in Q3 last year.

Sequentially, earnings per share were negatively impacted by approximately $0.04 due to the higher share count, reflecting the full impact of the IPO that was completed in the second quarter.

EBITDA in the third quarter was $271 million, or 24% of sales, compared to $292 million, or 24% of sales in the second quarter and $253 million for the third quarter of last year. Our adjusted EBITDA was $1.31 billion on a trailing 12-month basis.

Working capital was 20% of sales, and represented a usage of cash on both a sequential and annual basis. This was the result of increased inventory and increased receivable days. Our A/R days sales outstanding were 40 in the quarter. This compares to 35 in Q2 and 36 in the same period last year. This increase was driven by the linearity of sales this quarter, which was more concentrated in September than in prior quarters.

Payable days were at 59 compared to 55 in the second quarter and 63 days in the same period last year. Our inventory dollars were ahead of Q2 by about $51 million and total inventory days were at 117 compared to 101 in the second quarter and 95 in the third quarter of last year.

Excluding the impact of the build-ahead inventory associated with the factory closures, inventory days were at 109. The inventory growth in the quarter was primarily due to lower order rates as the quarter progressed.

Cash and cash equivalents were $744 million. In addition to cash, recall that we also have an undrawn revolving credit facility of $400 million. We used $27 million of cash to retire $27 million of bonds in the quarter which will reduce our annual interest expense by approximately $2.5 million.

Our capital expenditures for the quarter were $48 million or 4% of sales. During the third quarter we also received our first cash payment related to an insurance claim we filed following the earthquake in Japan for the impact on our Sendai facility. Included in the cash balance is $20 million of the initial insurance proceeds. Following the quarter end, we have received an additional $16 million on top of that.

Given our consistent execution in managing cash, we continue to have solid liquidity. Our cash and cash equivalents, coupled with our undrawn revolver, affords us the opportunity to continue to invest in the business, fund our capital expenditures, and continue to delever.

As noted in the income statement, we incurred approximately $55 million in charges during the quarter which were largely due to the call premiums associated with the related debt reduction efforts completed in early June. Recall that this transaction was initiated in June but closed during July, so the $55 million charge was incurred in the third quarter. Net debt inclusive of the transactions is approximately $5.8 billion.

Finally, I’d like to provide an update on the progress we’ve made to date on the closures of our two remaining 150 mm wafer fab facilities in Sendai, Japan and Toulouse, France. If you’ll recall, we plan to generate $120 million in annualized savings when we complete the closure of the facilities and the transition to our 200 mm fabs. The process of completing the transition from our Sendai facility is on track, with the accelerated schedule we started in March following the earthquake.

The Sendai facility was not reopened for production after this tragedy in March of 2011. At this time, many product qualifications and transitions have already been completed. We expect to complete the remaining transitions in the coming few months, but given the early closure of the Sendai factory caused by the earthquake, we saw some accelerated benefits begin in the third quarter of this year.

With respect to the facility in Toulouse, France, we have been working for some time with our customers to transition production to our 200 mm facilities in the U.S. We have now received the final orders for products for this factory.

Due to our desire to ensure a smooth transition for our auto customers we have elected to move the final closing date to the second quarter of 2012. This will slightly delay the savings from the closure of the Toulouse facility. The delay, however, will be offset in part by the accelerated savings from Sendai.

So at this point, I’d like to turn the call back to Rich.

Rich Beyer

Thanks. I’d like to touch on some recent highlights that underscore Freescale’s momentum in the marketplace. But first let me make a few comments about our Freescale technology forums that were held in Asia in the third quarter.

We completed our Freescale technology forums in India, China, and Japan with record attendance at all of our venues. During those events, we continued to receive solid feedback on our product roadmaps and alignment with our customers’ needs. I’ll touch on some of the announcements in the individual sections about the market.

So let’s talk about the automotive market. At the FTF India, Freescale announced a partnership with Bosch Electronics to introduce a cost-effective and ready to use airbag reference platform for the automotive safety segment in developing markets. This will leverage our two companies’ systems expertise and global leadership positions.

Through our collaboration, we will enable local suppliers in developing markets to adopt an affordable airbag safety solution that reduces design risk, is easy to implement, and represents the highest automotive quality standards.

As automotive systems rely more and more on sophisticated electronics and software, functional safety depends on those systems operating correctly to their inputs. New global automotive standards on functional safety will be published by the end of 2011, and Freescale has launched our Safe Assure initiative that simplifies the system certification process for our customers by providing the solutions and support to address the requirements of these functional safety standards.

Freescale supports the highest safety integration levels and our extensive experience in system implementation, back-end support, and commitment to zero-defect quality make Freescale an ideal partner for functional safety certification.

We also announced a new development platform for our automotive sensors that delivers scalable tools to help speed design of sensor-based applications like airbag systems, electronic stability control, electronic parking brake, and engine control. As the leading independent supplier of automotive MEMS sensors, we are committed to delivering advanced and affordable development platforms that drive automotive [unintelligible] innovation.

Let’s look at our networking business. In networking the analyst group Gartner released their market share report for wired and wireless networking processors, and Freescale was ranked number one with 53% market share in 2010. The report cited the rapid adoption of Freescale’s QorIQ multicore processor family for our market share gains, placing Freescale ahead of our nearest competitor by more than 40%.

To continue this momentum, Freescale announced the sampling of our first QorIQ Converge products at our Freescale technology forum in China. Designed for femto and picocell base stations, these products offer the most highly integrated solution in the market with RFIC communication and antennae interfaces, a perfect complement to our industry-leading multimode RF power amplifier solutions.

With a multicore architecture that balances DSP and communications processing cores for optimal performance efficiency, QorIQ Converge offers a scalable portfolio that leverages the same software, from femtocells to macrocells, providing ultimate flexibility for this highly evolving market.

Given the complexities of multicore design, software libraries and advanced development tools are critical for customer design implementation. We have partnered with Mentor Graphics to develop a software library to optimize the performance of our AltiVec engine, which delivers DSP-level floating point computations for our new QorIQ AMP series of multicore processors.

This embedded software foundation will help speed and simplify the development of advanced applications like navigation systems, medical diagnostic imaging, and video surveillance systems.

Let’s talk about our industrial business. In the industrial market, we continue to reinforce our microcontroller portfolio. We introduced our next-generation 8-bit microcontrollers, which are designed to provide outstanding durability and reliability for harsh industrial and automotive applications. Built on our S08 core, these devices deliver exceptional EFT and ESD performance to withstand the harsh and noisy environments of smart meters and building controls, uninterruptable power supplies, HVAC systems, and appliances.

We expanded our award-winning Kinetis 32-bit microcontroller portfolio with 60 new entry-level devices based upon the ARM Cortex-M4 processor. These new additions are the lowest-power Kinetis microcontrollers to date, and offer an extensive suite of on-chip peripheral integration. Our innovative flex memory and capacitive touch-sensing controller peripheral make Kinetis well-suited for metering, factory automation, remote controls, and portable medical devices.

We also expanded our Tower System development platform with 15 new modules featuring our Kinetis and ColdFire Plus microcontrollers as well as new modules to support our power architecture processors and microcontrollers. The Freescale Tower System provides engineers with a customizable design environment that offers mix and match tool selections that help speed time to market and reduce overall development tool costs.

Now our consumer business. We continue to gain momentum with our i.MX multicore apps processors. Just a few months after demonstrating our first silicant, we have begun shipping samples to our alpha customers. First International Computer, FIC, one of the world’s leading ODMs of electronic devices, announced they have adopted our i.MX multicore processors for their next-generation media tablet designs.

With world sales growing at 32% per year, e-readers continue to be one of the fastest-growing consumer devices. Freescale is the number-one supplier of processors for e-readers and many of our customer designs also utilize our power-management ICs for extended battery life and MEMS sensors for gaming and display-orientation.

Now let me take a few minutes to discuss our Q4 outlook. We expect Q4 revenues to be in the range of $1 billion to $1.06 billion in Q4. On a sequential basis, we expect our automotive revenues to be flat with Q3, our networking revenues to be down modestly, our consumer revenues to be flat, and our industrial revenue to decline in the low teens on a percentage basis from Q3. And our cellular revenues will decline significantly, estimated to drop in the 50% range from Q3 levels. Finally, we expect gross margins to decline from Q3 in the range of 200 basis points due to lower utilization in our fabs and back-end facilities as we focus on managing inventory levels.

So let me summarize. Despite a difficult macroeconomic environment, the company continued to generate solid gross margins. The flexibility of our asset-light model, our efficient cost structure, and our diversified revenue base are helping us to mitigate the impact of the challenging environment. And we continue to generate solid design wins that position us well for future revenue and profit growth. We continue to strengthen our position as the premier provider of embedded processing solutions and I’m confident that we have the strategy, the team, the products, and the technologies to continue to win in the marketplace.

With that, Alan and I are happy to address your questions. Operator, ready for questions.

Operator

Thank you. [Operator instructions.] Our final question comes from John Pitzer with Credit Suisse. Your line is open.

John Pitzer – Credit Suisse

Rich and Alan, can you talk a little bit, on the cellular business, what the profitability of that business looks like? And given the rapid decline there in the calendar fourth quarter is this sort of the new level from which you would expect it to be flat? And then I have a follow up question.

Alan Campbell

First of all, we don’t disclose the profitability for the segments, but what we have said in the past and remain consistent, this is a business that has declined quite rapidly and significantly over the past couple of years and despite that revenue decline we have shown that we continue to improve the overall gross margins as well as the profitability. Most of the manufacturing associated with this business also is outsourced, so it does not impact our internal factory utilization.

John Pitzer – Credit Suisse

And then on the opex decline this quarter, how much of it was you guys just being sort of diligent as business didn’t materialize versus any kind of one-time gains you might have gotten from Sendai closures?

Alan Campbell

From an operating expense, it didn’t impact. Let me talk about Sendai in a second. Operating expense, what happened is in the month of June, as we said, we started to see a little bit of weakening and Rich and I at that point immediately put our foot on the pedal, on the break, and started reducing some of the discretionary costs. And that obviously paid dividends in the third quarter. We were able to reduce operating expenses by about $15 million. On the Sendai impact, that impacted our gross margins and the impact was a slight favorable as we’ve communicated in the past, as we’ve moved products out of Sendai and we started ramping them in our own internal facilities. So we saw a small gain there. We’ll also see a small gain coming into the fourth quarter associated with the Sendai transition.

John Pitzer – Credit Suisse

And then my last question, Rich on the networking business being down modestly, that’s better than we’ve heard from some other guys that have announced here. What do you think the market’s doing versus new programs where you’re ramping? And then I’d love to get sort of your two cents on the Broadcom NetLogic acquisition and how you think that might change the comparative landscape over time, if at all.

Rich Beyer

As Alan said in our remarks, our networking business was down, and our consumer business was up as we expected. So we saw pretty significant erosion in the third quarter and we think for us that has stabilized. Not stabilized enough to be flat, but stabilized that the erosion in Q4 is going to be muted. We may have simply seen the erosion a little bit sooner. So we don’t think there’s anything dramatic. We think that market is going through some slowdown, just because of the macroeconomic environment. These are very capital intensive markets and I think our customers are being cautious and being careful about inventory. So I think that’s what’s happening in the market. Broadcom and NetLogic, Broadcom is more of partner of ours than a competitor of ours in many respects. We announced in the quarter some things we’re doing with Ethernet in vehicles together and so forth. So we will continue to have a collaborative effort. NetLogic has been a competitor in a portion of their business. They also have other parts of their business that we don’t compete with. We think that was something that Broadcom obviously thought was strategically important to them, but we continue to be the major player. I just told you we have 53% of the market. The next two guys had 40% less and neither one of them was NetLogic. So NetLogic is a small player. I don’t want to downplay. They’re an important force in the marketplace, but I don’t think that’s going to dramatically change the landscape. But obviously we stay cognizant of what changes like that could do for us, to make sure that we’re in a position to succeed ourselves.

Operator

Our next question comes from Ross Seymore with Deutsche Bank.

Ross Seymore – Deutsche Bank

Just wondered, between the OEM side of the business and disty, clearly in this last quarter disty was very weak. How would you describe the demand environment from those two general buckets as we look going forward into the fourth quarter?

Rich Beyer

I think the disty part of our business is the area that is showing continued signs of weakness. There is no question about the fact that the demand signals through disty are weak and the insight we have into Q4 suggests they’re going to continue to be weak. I did indicate in the guidance that our industrial business will be down low teens this quarter. Obviously the industrial stuff almost exclusively goes through disty. So the disty channel is a weak part of the equation. But we did indicate that the networking business will continue to be down, and that’s mostly OEM. So I’d say for us the disty is the one that’s contracting the most at the moment.

Ross Seymore – Deutsche Bank

And on that topic, on both sides, the linearity of the bookings as this quarter progressed and then any update for the first month of the fourth quarter?

Alan Campbell

The linearity in the third quarter, first of all, was very back end loaded. We said before that Q3 historically is a difficult quarter with July and August being a very late month with vacations, particularly in Europe, where 40% of our revenues are. Saying all that, with the current micro conditions, we did see even heavier linearity toward the end of September. I think it’s a little bit early, Ross, going into the fourth quarter, to really comment on the fourth quarter since we’re only a couple of weeks in here. And obviously we’ll continue to monitor that.

Ross Seymore – Deutsche Bank

I guess one final one housekeepingwise. Maybe I missed it. Opex in the fourth quarter itself, I know you talked about taking out $15 million of expense, but for the fourth quarter specifically how should we think about R&D and SG&A?

Alan Campbell

Yeah, we did take out, as you said, $50 million in the third quarter. We expect to continue to reduce our R&D and SG&A. Probably more SG&A. We are trying to hold tight with the investment in R&D, although we are cutting back on all discretionary expense, even within R&D. So we would expect to continue to reduce the opex going into the fourth quarter.

Ross Seymore – Deutsche Bank

And is that $15 million number the bogey that you get the full credit of in the fourth quarter?

Alan Campbell

Well, I think $15 million may be a little bit high, Ross, relative to what we’ve just done. But we will continue to reduce. I don’t think it’s appropriate to be that specific about the gains on opex at this point.

Operator

And our next question comes from Glen Yeung with Citi.

Glen Yeung – Citi

Can I first ask about what you’re seeing from your distribution customers? Obviously they’re working down inventory, but do you have a sense as to whether or not they believe that they are nearing the levels they’d like to be at exiting the fourth quarter? I know we’ll have to make an assumption about demand in that statement, but any thought you have there would be helpful.

Rich Beyer

You know, because demand has dropped for the industry pretty significantly since the July timeframe, lead times are naturally pulling in for us and we want our lead times to be at target. And so because the lead times have pulled in, the disty customers do not see any compelling reason to be ordering significantly far into the future. So our perception and our discussions with our distys say their insights into when the demand is going to pick up are not very clear, and so our insights into what to expect are also not so clear.

Glen Yeung – Citi

But is it safe to say that you are shipping below consumption rates at this point?

Rich Beyer

On a personal level, I believe we are now shipping below consumption rates, yes.

Glen Yeung – Citi

Second question is around gross margin, going to be down as you guided to in the fourth quarter. When I look back at your history of gross margins at least as far back as I can see in my model, we’ve not seen more than three quarters of gross margin decline, and then it was only once. So I wonder if you have a sense of that now. Obviously there’s a lot of moving parts, with fab closures. Do you think this could be an extended period of margin decline? Or are there things that you can do beyond the fourth quarter to help stabilize the margin?

Rich Beyer

I don’t think this is a period of steady gross margin decline. We just showed that in the third quarter, despite the revenue dropping 6.6%, we actually moved up the gross margin. Now it’s going to drop on the order of 9.5-10% and we’ve guided that it is going to drop. But as we have spoken with investors quite consistently, we have a number of levers. We work them diligently every day. Some of the levers are affected by revenue volumes and some are not. I think we continue to do a very good job of driving the other things, making sure that our capital intensity is lower than it was in the past, allowing depreciation to drop, continuing to do as best we can to utilize the facilities, moving some of our external production internally, constant focus on operational execution and yields and quality improvements and so forth. So we don’t think this is the beginning of a long trend. We hope that we’re able to stabilize around the level that we’ve guided for Q4 in the quarters beyond that.

Glen Yeung – Citi

Can I just sneak one more in, which is as you say we don’t have a lot of visibility on demand levels here. Can you talk about kind of contingency plans for lack of a better term, with respect to opex in 2012? Were demand to be noticeably lower than 2011, what would be the kind of things that you would do to reduce costs?

Rich Beyer

Well, this is, as they say, not our first rodeo. The downturn in 2009 was cataclysmic. There the industry had to take what might be argued draconian actions, reductions in force. Clearly we know that we need to continue to generate gross margin and operating margins and EBITDA and we need to keep generating cash. So we’re taking a series of what I would consider to be quite substantive efforts to reduce opex and clearly we have contingency plans that are much more severe. We don’t see at the moment, because of the lack of visibility, that we need to do something draconian. What we do not want to do is to cut major development programs or marketing programs that are going to lead this company to continue to grow in the future. And so we’re trying everything we can to protect those, and we’ll do everything we can in all other areas that are non-revenue-growth future generating activities. That’s where we’ll take the actions if things get considerably worse.

Operator

And our next question comes from Harlan Sur with JPMorgan.

Harlan Sur – JPMorgan

The weakness that the team saw in wireless infrastructure, and I guess more here in the fourth quarter, was that more inventory workdowns based on a slower capex spending environment for current generation deployments? Or were there some pushouts for 4G LTE based deployments as well?

Rich Beyer

It was definitely both. There was an expectation that there would be more deployments, for example TD-SCMA in China, that seems to be happening more slowly than we anticipated, and therefore some of our customers had inventory. They were able to bleed out more slowly and lower the demand. Also, LTE is happening slowly, although we are getting the indications that 2012 is going to be more robust for LTE. And then there’s no question that in the communications infrastructure space there were some building of inventories in the second quarter associated with the concerns about supply with Sendai. And when those concerns were mitigated or alleviated in Q3 that people bled off their inventory. So some lowering of demand because some of the future products are happening more slowly and some because of inventory burn.

Harlan Sur – JPMorgan

On some of the 4G LTE stuff, we’ve heard the same thing about pushouts. Are those being kind of rescheduled for first half of next year as the operators work through some of their technical issues and then begin to start ramping?

Rich Beyer

Yeah, that’s what we’re seeing. That’s what’s happening for the demand for us. It’s not being cancelled, it’s being pushed out to the early part of next year.

Harlan Sur – JPMorgan

And then utilizations were 83% in Q3, so where does the team expect them to be in Q4? And I guess given a flattish to down seasonal Q1, would you expect utilizations to decline further in the March quarter?

Alan Campbell

Utilization did increase in the third quarter, first of all. Part of that was a function of the Sendai closure and transferring products into our existing facilities. We made the conscious decision also to build a bit of inventory and keep it in [die]. We do expect the utilization to drop as we go into the fourth quarter and we can wait to see and get better indications for the first and second quarters as to how it’s going to look. I will add that on the back end, on the assembly and test, we did quite significantly ratchet back our production run rates and so utilization did fall, did decline Q2 to Q3. But from a front end standpoint, I think it’s fair that we will reduce in the fourth quarter.

Operator

Our next question comes from C.J. Muse with Barclays.

C.J. Muse – Barclays

I guess first question on the gross margin side, trying to dig a little bit deeper there, if we were to assume revenues would hold at these levels, so really trying to capture nonutilization levers, and with Toulouse moving to Q2 ’12, how should we think about the trajectory from Q4 through 2012?

Alan Campbell

As we’ve said before, the factory footprint utilization is one of the five building blocks that we’ve identified to continue to improve gross margins. On top of that, we have the operational efficiencies, which is a lot of the back to basics, the product yields, the test times. We have procurement, we have depreciation, and we have portfolio. So yes, we will be impacted and were impacted a little bit on the utilization, both on the front end and back end, but we do expect with our business model to continue to sequentially improve in gross margins.

C.J. Muse – Barclays

So down 200 bps December. You think you’ll continue to take it up starting in March, even if we hold revenues flat?

Alan Campbell

Well, we’ll have to wait to see. I don’t want to give guidance for the first quarter. But as we’ve said, we have given a commitment to continue to improve our gross margins 50-75 basis points. That was halted in some respect because of the utilization as a result of the macroeconomics. But as Rich said earlier, we do have a heavy focus on gross margin, and there’s three or four other elements at work. We continue to focus and obviously show improvement.

C.J. Muse – Barclays

I guess are there any of those, non-utilization based, that you can kind of point to and guide us to to help us understand the trajectory in ’12?

Alan Campbell

If you look at the operational efficiency, we’ve given target models which take us up into the 53-55%, and when we quantify the elements that would take us from where we are today to that level, we’ve said before factory utilization was 300 basis points. We said operational efficiencies were 200 basis points. We said that procurement was just over 200 basis points. So all these elements will help continue to drive, and these operational efficiencies - procurement, depreciation - are not predicated on our revenue growth.

C.J. Muse – Barclays

Okay, so I guess big picture if we stay here you still think you can get close to 50% over time. And would that be a 2012 event, or 2013?

Alan Campbell

We’ve said before that the expectation is the first building block is to get into the 49-50%, and that’s very much within our sights. We did communicate that the delay of the closure of our Toulouse facility, that would have a slight negative impact on our margins. But it will delay it by a quarter, so the delay is a quarter. It’s not a significant delay. And against that backdrop, we’ve also said that we are accelerating savings associated with Sendai. So we still have confidence with the opportunity to continue to improve gross margin.

C.J. Muse – Barclays

And I guess on the opex side, I know that you guys were targeting 28% overall, but clearly things have gotten worse. So curious, given the state of where we are today, what are your targets now?

Alan Campbell

The targets remain 28%. When we set our model, we have expectations across the company, within the business groups, within the divisions, that we operate to that model. That is our target model. There will be some deviations as business fluctuates between that. Again, if you look at it on a positive note, if you think about, despite a decline in revenues in the third quarter, we’re still holding SG&A at just over 11%. So we were able to take quite significant actions, more on the G&A side, to get that percentage at the target model. On the R&D side, we’ll still operate to the 17%. We are focused on a lot of the discretionary expense, and we don’t intend at this point to cut any of the programs that could impact future revenue and gross margin.

C.J. Muse – Barclays

And I guess last question is for Rich. Curious on the industrial side if you could I guess dig a little bit deeper in terms of the trends you’re seeing for Q4 in terms of guiding low-teens. And particularly interested in what you’re seeing within China specifically.

Rich Beyer

Well, what we saw is the industrial market and distribution reacted to the problems of Sendai by building inventory. All of you and we know that’s exactly what happens as we move into a sudden supply-demand imbalance. I actually talked to a customer of ours, partner, and he said oh yeah, as soon as I heard about the earthquake I told my purchasing people to double up everything that we’re buying just so we don’t get caught short. And then two months later I told them to stop buying until we bleed it off. So there was a lot of buying in the second quarter and then in the third quarter they started to bleed that off. However, we can’t deny that our industrial business is strong in U.S., Europe, and China. And U.S. and Europe over the last three months have shown pretty serious deterioration in GDP, and so the industrial business is being affected now by demand. In China we saw a similar pattern of ordering of parts and now bleeding off of the parts. The Chinese economy is still strong, but a little bit less so, and I think our customers there too are just a little bit wary. So we’re seeing similar perturbations in China in the demand profile as we are in North America and Europe.

Operator

And our next question comes from Stacy Rasgon with Sanford Bernstein.

Stacy Rasgon - Sanford Bernstein

First question. You said that you have felt the need to build some inventory internally to build die inventory. Why was that? And what would your gross margins have been this quarter if you hadn’t actually built that inventory? Because it was inflating utilization a bit I would assume.

Rich Beyer

Yeah, we made the determination that our businesses continue to be strong. We don’t see anything that leads to - in our core businesses. I’ll exclude the cellular business, which we knew was going to continue to drift away when we discontinued, effectively, investing in that business. But in the other businesses, we feel very strongly about these businesses. We do believe, as I said to Glenn’s question earlier, that we think in a bunch of different areas the industry is operating where order patterns are below consumption rates. And when that happens, there will be a snap back. We want to be sure that we are in a position to respond to that. It was a very painful experience for the industry in late 2009, 2010 when things started to snap back. So we made a conscious decision to slow down the back end, to keep the inventory in die bank form, but to build a little bit of inventory to help get our lead times down to an acceptable point. So of course it had a little bit of effect on utilization. I don’t want to speculate. Some of it had to do with products that we bought from our partners like TSMC and Global Foundries internally. So yes, no question it had a little bit of a beneficial effect, but it was to get our lead times to where they need to be and to get ourselves in a position where we can respond very quickly when the inevitable change in trajectory takes place for the company.

Stacy Rasgon - Sanford Bernstein

I’m just trying to determine, do you think your gross margins this quarter would have still been up?

Alan Campbell

Actually I would say yes to that, Stacy. And another thing I would add is that when you look at the inventory build, two-thirds of it was planned. One third was due to the end of life associated with the closure of Sendai and Toulouse. So we’ve been trying hard to build inventory there to respond to the customers. One third was in the consumer side, which we know we needed inventory to respond into the fourth quarter to service that. And it’s fair that probably one third of that inventory was a result of the linearity and slowdown in the macroeconomic.

Stacy Rasgon - Sanford Bernstein

I know you don’t want to give a trajectory of margins going forward the next couple quarters, but given that the fab closures are both moving around - you’re accelerating Sendai, you’re pushing out Toulouse - can you give us some feeling for the trajectory of how the cost savings from those fab closures are going to hit over the next, say, three or four quarters? Until Toulouse is closed?

Alan Campbell

I think the cost savings associated are pretty consistent with how we’ve communicated them in the past. If you take the total savings, first of all, we said that of the $120 million identified, there would be $50 million associated with Sendai and there would be approximately $70 million associated with the Toulouse closure. This is predicated on taking those volumes and then taking them and loading them into [unintelligible] facilities. The Sendai has initiated, so $50 million on annualized. You can work out the quarterly impact there, roughly $12-13 million a quarter. We’re starting to ramp up on those savings. We saw a little bit in Q3, and we’ll see some more in Q4 and Q1. The Toulouse savings, we had initially scheduled to be in the second half of 2012, pre- the pushout into the second quarter and the closure. We’re now saying that those $70 million savings will kick in in the third quarter into the fourth and we’ll get the full annualized savings now by Q1 2013.

Stacy Rasgon - Sanford Bernstein

So you still think you can be at 50% gross margins by the end of 2012, which is what you were saying prior to everything?

Alan Campbell

Well, I think it would probably be going into the first quarter, end of first quarter 2013, basically because of the delay in the closure of the Toulouse facility. It’s also a function, needless to say, of volume in the macro as to what revenues will do.

Stacy Rasgon - Sanford Bernstein

And one more, just quick housekeeping, if I could. I know you got a little bit more insurance in from Sendai. Are all the costs associated with the unexpected closure of Sendai finished? Or do you have more cost to come?

Alan Campbell

The costs are being offset, in the reorg line in the income statement that you’ll see in the tables with the release. But most of the costs have been incurred. At the end of the fourth quarter we will have a severance cash outlay and that should be the kind of closure of the Sendai facility. There will always be moving parts as we have to terminate contracts but I would say most of the costs will be behind us by the end of the year.

Operator

And our next question comes from Ambrish Srivastava with BMO. Your line is open.

Ambrish Srivastava - BMO

Alan, question on cash and free cash flow. I think you had mentioned on the last call that $750 [million] was the cash balance and you were a little below. And free cash flow was also negative. Do you expect to generate free cash flow in the fourth quarter and what should we expect the cash balance to be?

Alan Campbell

Obviously I will say we continue to be very comfortable on managing cash and where we are. Despite the challenging environment, we did end up just below $750 [million]. We did spend $27 million in the third quarter on some bond buyback and the operating cash flow, free cash flow, was positive. It was impacted negatively by some of the working capital associated with the linearity of sales. So I do feel very comfortable with our cash position, and as we look into the fourth quarter, we would expect to keep our cash balance around the same range as we had in the third quarter.

Ambrish Srivastava - BMO

Okay, and then I had a follow up, just getting back to margins. You articulated the levers. So in the fourth quarter what are the levers that are really not working and what are the kind of offsetting factors that are working against those factors that help you keep the margins to the 50-75 bp target that you laid out?

Alan Campbell

I would say all the levers are working for gross margin as we’ve communicated, with the exception of utilization. Utilization is the only item that’s having a negative impact and that had a negative impact also in the third quarter. So as we’ve said, the operational efficiencies are making progress. The procurement progress, depreciation progress. So it really is a function, at the moment, of the macroeconomic and utilization of our internal factories.

Ambrish Srivastava - BMO

And product mix has nothing to do with it? [unintelligible] business is not disproportionately higher?

Alan Campbell

We’ve always got product mix. We’ve got a very rich and diversified portfolio, but I wouldn’t say product mix is having any benefit or negative impact on gross margin.

Operator

Our next question comes from Michael McConnell with Pacific Crest Securities.

Michael McConnell - Pacific Crest Securities

I was curious, with the automotive outlook for flat for Q4, it seems to be one of the better performing segments. What’s the confidence level of the sustainability for growth as we look into the first half of next year? And what’s driving the relative outperformance, do you feel, in Q4, with auto?

Rich Beyer

The automotive industry is supposed to grow a little bit in Q4. Producing is supposed to grow modestly. I will say, however, as it relates to Freescale, a disproportionate amount of it is going to be the Japanese car manufacturers coming back on stream. So they’re going to get more of the growth than the North American or European suppliers. And we have more content, as we’ve said many times before, much more content in places outside Japan. And also there was some inventory that the automotive industry try to acquire parts when they were concerned about Sendai because you’re all aware of how much of a difficulty there was for one of our Japanese competitors over there. So they’re bleeding off some of the inventories, which is why we think automotive will be flat, flattish. Going into 2012, all the projections indicate that there’s going to be modest growth, modest as in mid-single digit growth, in vehicle production, and the continued increase in semiconductor content in vehicles will continue at the previous pace. So the automotive industry is, we think, geared to continue to grow. The semiconductor content will continue to grow at very high single digits, if not low single digits. So we continue to be bullish about what 2012 is going to do for Freescale’s automotive business.

Michael McConnell - Pacific Crest Securities

And I was just wondering, on that followup, just what’s the general tone when you talk to customers right now, looking beyond Q4. We’ve had a couple of other broad-based companies comment that with some optimism regarding industrial, some optimism regarding communications, which were seasonally stronger on the first half of the year. Could you share with us maybe some of the feedback you’re getting in terms of potential growth, reacceleration, in Q1?

Rich Beyer

You know, the customers I talk to are as concerned about the macroeconomic environment in North America and Europe as we are. And many of us feel that we need clarity on what is going to happen in both of those huge, huge markets. And if the situations don’t get better, then we may be in for a rough first half of the year. On the other hand, we’re all praying that we do see those settle down and consumer confidence comes back in both of those markets. So I would say the customers I talk to have a similar view, that it really depends. Do we fix the problems of Europe and North America to at least begin to create consumer confidence that will lead to business confidence and the beginning of an uptick in the marketplace. It’s just too early to call because of those two issues.

Michael McConnell - Pacific Crest Securities

And then just the final question I had, on AMP, when should we - these are very long design cycles. You’ve talked about the press release introducing it. When should we expect, at the earliest, some type of inflection that would be material to the model from some of the design wins you’re going after? Are we looking at two years? Is it three years? What’s the timeframe for AMP to really start to compete against some of the smaller companies?

Rich Beyer

AMP, we’ll be sampling in the early part of 2012, and just as you pointed out, the design cycles are, before you start to see appreciable revenue it’s typically 12 months. So that’s a phenomenon that will benefit us in 2013. Having said that, the QorIQ products that we released two years ago are definitely helping us now and growing nicely. The QorIQ Converge products, which we launched in February at Barcelona, and I talked about them on the script, about the first members of that family for pico and femto, those will start to provide revenue for us - obviously we’re sampling them - but they’ll start to provide revenue in the first half of 2012. So we’ve had these waves of products, with the QorIQ and the DSP family of products, that are helping us today. And the Converge will help us in ’12 and the AMP will help us beginning in ’13.

Operator

Our next question comes from Jeff Harlib with Barclays Capital.

Jeff Harlib – Barclays Capital

Alan, just on the lower utilization and the planned inventory reduction, can you just talk what’s your target to bring down inventory in terms of days? And is the 200 basis point expected reduction mainly due to that underabsorption?

Alan Campbell

Let me say a couple of things on the inventory. First of all, despite the fact of building inventory in the third quarter, as we’ve said two third of that was really planned, and part of the overall plan, with end of life as well as consumer for the fourth quarter. So our inventory position isn’t overly concerning at this point. In saying that, we are bringing down run rates in the fourth quarter to manage the inventory relative to the outlook that’s out there. We will see utilizations drop off, which is having a negative impact on our gross margins. So there’s a lot of specific issues. But it’s fair to say that on the front end, on the increased or decreased utilization, every one point of utilization could have a 30% impact on gross margins. So for modeling purposes that may be able to help. But overall, from an inventory standpoint, the days are high. It’s not at the model, but it’s not causing significant concern relative to the businesses we’re in at the moment.

Jeff Harlib – Barclays Capital

Okay, and you didn’t say what you expect with utilization in Q4, right?

Alan Campbell

We haven’t. We just said we think it will drop by two or three points, and that was a large part of the reason for the reduction in gross margin guidance that we’ve given.

Jeff Harlib – Barclays Capital

And if customers ordered end of life programs, has there been some building relative to the Toulouse closure?

Alan Campbell

There’s a lot of work and effort required as we close down facilities. With the Sendai as well as with Toulouse, we are required to build quite significant inventory to respond to the customer demands and the qualification time it takes to go into a new factory. In the third quarter, as we’ve said, one third of the inventory build was along with that end of life alone. We said overall we’re at 117 days. If we take out the end of life inventory build, which is not our normal basis, that inventory days is at 109.

Jeff Harlib – Barclays Capital

And just on capex, can you just talk about in the current environment if you’re going to bring that down to a lower percentage of sales? What’s your near term plan there?

Alan Campbell

Yeah, we are. For this year, I think, we’ve given a target model of 4-5%. I think it’s fair that this year we’ll be in the 3% range. Through the third quarter capital was a little bit higher than normal, primarily because of the need to put some equipment at our existing [8-inch] facilities associated with the closure of Toulouse and Sendai. We’ve communicated that in the past, that we probably will end up spending $25 million of capital and most of that actually came in in the third quarter. So we will see capital being reduced as we go forth.

Operator

Our next question comes from Auguste Richard with Piper Jaffray.

Auguste Richard - Piper Jaffray

I was just hoping you’d give just a little bit more color on the networking side of the business, as to the relative strength of enterprise wireless and the telco side.

Rich Beyer

We saw both sides of the equation, the service provider as well as the enterprise, show signs of weakening in the quarter. I’d say wireless was a little bit worse as we saw both inventory corrections, conservatism, as well as things like push out of the China buildout and some of the LTE stuff. But the enterprise business was also down as it was impacted particularly here in North America and in Europe by virtue of the slower GDP, which caused those customers to be more cautious in their build plans.

Auguste Richard - Piper Jaffray

And then just one followup. Xilinx and Altera have introduced ARM-based FPGAs, like Xilinx’s [unintelligible] product that looks like it’s going to be competitive with the IMX6, and I was just wondering if you could sort of take a minute and just give us an idea of what the competitive advantages and disadvantages are of the two solutions in the embedded space.

Rich Beyer

You’re right. We’re obviously aware of the ARM processor being embedded into FPGAs. They operate in many respects, I don’t want to define their business. You know them really well. But the places we see them are in industrial and communications markets. Our i.MX goes into other markets. Our i.MX is in the center stack of vehicles. Our i.MX is in smart mobile devices. Those are the two major areas where our i.MX is targeted. It’s not targeted at the industrial market, nor is it targeted at the communications market. So if by virtue of their embedding the ARM in those processors, in their FPGAs, will enable them to penetrate markets it will be markets that we don’t compete with them in with our i.MX family. So of course we watch what any player in our industry does with anything that could be associated with our stuff, but at the moment it doesn’t seem to us that it represents a threat to our i.MX family.

Rich Beyer

Operator, I think we better stop at that. Let me just summarize. We’re in a semiconductor downturn that is a demand softening downturn. The fact of the matter is Freescale seems to be weathering this thing well. We’re very pleased that we have a very strong production model, an asset-light model, and we believe we’re going to manage through this particular downturn with only modest erosion in our gross margins before we get back on the inevitable track that we’ve committed to investors, so 50-75 basis points per quarter improvement. And we think our core businesses are continuing to perform very well. Our cellular business, as we’ve indicated, has come down faster than the other parts of the business, but the other core parts of the business are performing quite well relative to the overall market, and we think that’s the strength of the balance that we have with an automotive business, a networking business, an industrial business, and a consumer business. So we think we’re on the right trajectory. We think we’re managing through this downturn effectively, and we certainly appreciate all of your support on this call. Thanks very much, and we’ll see you in 90 days.

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