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Jabil Circuit Inc. (NYSE:JBL)

F2Q07 Earnings Call

May 24, 2007 1:00 pm ET

Executives

Beth Walters - VP, Communications and IR

Forbes Alexander - CFO

Tim Main - President and CEO

Analysts

Shawn Harrison - Longbow Research

Yuri Krapivin - Lehman Brothers

Steven Fox - Merrill Lynch

Louis Miscioscia - Cowen

Kevin Kessel - Bear Stearns

Paras Bhargava - BMO Capital Markets

Amit Daryanani - RBC Capital Markets

Will Stein - Credit Suisse

Jim Suva - Citigroup

Presentation

Operator

Good afternoon. My name is Tasha, and I will be your conference operator today. At this time, I would like to welcome everyone to the Jabil Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. Ms. Walters, you may begin your conference.

Beth Walters

Thank you. Welcome to our earnings conference call. Joining me today on the call are President and Chief Executive Officer, Tim Main, and our Chief Financial Officer, Forbes Alexander. This call is being recorded and will be posted for audio playback on the Jabil website in the investor section along with all of today's press releases.

During this conference call, we will be making forward-looking statements, including those regarding our currently-expected third quarter fiscal 2007 net revenues, core operating margins and core earnings per share, as well as the integration and anticipated operation of our recent Taiwan Green Point acquisition, the anticipated outlook for certain aspects of our business and our long-term outlook for the company, our industry, our business sectors, and our realignment of our manufacturing capacity and the related costs and timing. These statements are based on current expectations, forecasts, and assumptions involving risks and uncertainties that could cause actual outcomes and results to differ materially.

These risks and uncertainties include but are not limited to, the Securities and Exchange Commission having views different from ours on the results of the review of our past stock option grants being conducted by a special committee of our Board and governmental authorities. And the review of our historical recognition of our revenue by our audit committee; the impact of the restatement of our financial statements and in any other actions that may be taken or required as a result of any such reviews.

Risks and costs inherent in litigation, including any pending or future litigation relating to our stock option grants; the restatement of our financial statements as a result for the evaluation of our historical stock option practices and our revenue recognition and associated financial statements or any declines on the price of our stock. Whether or when we will realign our capacity and whether any such activity will adversely affect our cost structure, ability to service customers and labor relations.

And our ability to successfully address the challenges associated with integrating our acquisition of Green Point. Our ability to take advantage of perceived benefits of offering customers vertically integrated services. Our ability to effectively address certain operational issues that have adversely affected certain of our operations. Changes in technology, competition, anticipated growth for us in our industry that may not occur, managing rapid growth, managing any rapid declines in customer demand that may occur, our ability to successfully consummate acquisitions, managing the integration of businesses we acquire, risks associated with international sales and operations, retaining key personnel, our dependence on a limited number of large customers, business and competitive factors generally affecting the electronic manufacturing services industry, our customers and our business, other factors that we may not have currently identified or quantity, and other risks, relevant factors, and uncertainties identified in our annual report on Form 10-K for the fiscal year-ended August 31, 2006, subsequent reports on Form 10-Q and Form 8-K and our other securities filing.

Jabil disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events, or otherwise. We are pleased to be providing you with our GAAP and core operating financial results for the fourth quarter and for the full-year of fiscal 2006 and for the first and second fiscal quarters of 2007.

I do refer you to Form 10-K filed on May 15, 2007, and Form 10-Q filed this morning, May 24th. Today we will be providing you with details surrounding the key events and impacts on our operations and full financial performance during the last three quarters.

During our prepared remarks, we will review the income statement and balance sheet items for each period and discuss sequential impacts and changes, beginning with the income statement and revenues.

Forbes?

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Forbes Alexander

Thank you, Beth. Good afternoon. As Beth said, I'd like to start with the revenue situation. Revenue for the fourth quarter fiscal 2006 grew sequentially by 14% to $2.955 billion. On a year-over-year basis, the quarter represents a 45% growth in revenue. Revenues for the full fiscal year of 2006 were $10.267 billion, representing a 36% growth over fiscal 2005.

Revenue for the first fiscal quarter of 2007 expanded by 9% sequentially to $3.224 billion, representing a 34% growth in revenue on a year-over-year basis. Revenue for the second fiscal quarter of 2007 was $2.935 billion. This includes revenue from our Green Point acquisition for the period 15th of January to 28th of February 2007 of approximately $59 million. The quarter represents 27% growth in revenue on a year-over-year basis and 9% of $290 million decline on a same sequential basis, reflecting its traditional seasonal nature of our consumer sector. Excluding the Green Point revenues, revenue overall declined 11% or $350 million sequentially.

Our sector information for the quarters in percentage terms is as we've previously disclosed. However, I will review that. First of all, dealing with the fourth quarter of 2006, automotive was 5%; computing and storage, 12%; consumer, 31%; instrumentation and medical, 17%; networking, 18%; peripherals, 6%; telecom, 6%; and other was 5%.

Turning to the first quarter of fiscal '07, automotive was 4%; computing and storage, 11%; consumer, 36%; instrumentation and medical, 15%; networking, 18%; peripherals, 6%; telecom was 5%; and other 5%.

Finally, second fiscal quarter of 2007, automotive, 5%; computing and storage, 12%; consumer, 29%; instrumentation and medical, 17%; networking, 20%; peripherals, 7%; telecom, 5%; and other, also 5%.

I now would like to turn to address operating income. For the fourth quarter of fiscal 2006, there was a GAAP operating loss of $7.6 million. And for the 2006 fiscal year, GAAP operating income was $241.8 million. Core operating income, excluding the amortization of intangibles, stock-based compensation, restructuring and impairment charges was $90.2 million or 3% for the quarter and $391.6 million or 3.8% for the full fiscal year.

Legal and accounting expenses related to the option and independent counsel reviews in the quarter, was approximately $3 million. Core earnings per diluted share were $0.36 for the fourth fiscal year and $1.53 for the full fiscal year.

On a year-over-year basis, this represented 20% growth in core operating income.

Now turning my attention to fiscal year 2007. The first fiscal quarter's GAAP operating income was $52.7 million as compared to $88.8 million for the same period in the prior year. Core operating income, excluding the amortization of intangibles, stock-based compensation, restructuring and impairment charges, was $85 million or 2.6% of revenue as compared to $111.8 million or 4.7% of revenue for the same period in the prior year.

Net interest expense in the quarter was $12.6 million, reflecting lower levels of cash on hand during the quarter and increased borrowings under our revolving credit facility to fund our seasonal working capital needs. Core earnings per diluted share were $0.20.

As we disclosed to you on our December call, revenue for the quarter was roughly flat. However, product mix was not in our favor during the quarter and our revenue stream was more material intensive than expected by a negative 50 basis points.

During that quarter, we launched a new product in the consumer sector, which was developed by Jabil. Due to technical delays and production ramp issues with the product, we experienced significant cost overruns and lowered our forward-looking demand expectations from our customers.

Accordingly, we elected to withdraw the product from our business plan and recorded charges and other expenses of approximately $12 million or 40 negative basis points in the first fiscal quarter. We also continued to experience losses in the electrical and mechanical tooling operation and suffered from certain underperforming sites in the Americas and Europe.

Legal and accounting expenses related to the option and independent counsel reviews in that quarter were approximately $4.6 million or 15 negative basis points.

Turning to the second fiscal quarter of 2007, our February quarter. GAAP operating income was $36.7 million as compared to $83.3 for the same period in fiscal 2006. Core operating income, excluding the amortization of intangibles, stock-based compensation, restructuring and impairment charges, was $55.6 million or 1.9% of revenue as compared to $96.1 million or 4.2% of revenue for the same period in the prior year.

During the quarter, our net interest expense was $21.3 million, reflecting borrowings of approximately $871 million to fund the tender offer on Green Point during the quarter and borrowings under our revolving credit facility to fund working capital needs. As a result, core earnings per diluted share were $0.14.

Sequentially, second fiscal quarter was characterized by a decline in revenues in core operating income in our largest business sector due to the seasonal nature of our consumer business.

As we have previously discussed, the consumer sector revenue fell by 31%, excluding the Green Point revenues that were consolidated for approximately $360 million. This decline and the associated under absorption of our cost base had in excess of 100 negative basis points on the quarter.

Also in the quarter, the electro-mechanical tooling capability had a smaller impact on our second fiscal quarter results and is expected to continue to decline in importance in future quarters.

Legal and accounting expenses related to the option and independent counsel reviews in the quarter were approximately $3.6 million or roughly 12 negative basis points.

Now, turning our attention to the balance sheet and ratio trends. We previously provided key balance sheet information during our last three quarters. And with that in mind, I'd like to provide you a quick recap of our balance sheet and ratio trends for the end of February 2007, our second fiscal quarter.

Excluding the consolidation of Green Point, the Company's sales cycle at the end of February expanded by 2 days to 25 days. An improvement in the level of days sales outstanding was offset by two additional days in inventory and a reduction in accounts payable days outstanding.

Excluding Green Point, inventory fell by $87 million and was at 48 days for the quarter, 7.4 turns.

With the addition of Green Point inventories, the overall net reduction in inventory was $12 million and inventories overall represented 50 days.

With the consolidation of Green Point, sales cycle, at the end of the second quarter were 29 days, an expansion of 14 days from the end of fiscal year 2006.

Cash flow used in operations for fiscal year 2007 to-date is $253 million, this cash all being consumed in the first fiscal quarter of 2007, our seasonally high quarter in consumer sector.

Cash and cash equivalents were $555 million as compared to $651 million at the end of the first quarter and $774 million for the end of the fourth fiscal quarter.

Our returns on invested capital remained above our weighted average cost of capital since in the fourth fiscal quarter of '06 and the first fiscal quarter of 2007, while it fell to 7% at the end of the second financial quarter.

Current debt outstanding at the end of the second quarter approximated $1 billion as a result of drawing $870 million to fund the tender of Taiwan Green Point shares and draws on the combined companys' revolving credit facility to fund operational activities.

I'd now like to turn to the third fiscal quarter of 2007. Our guidance provided to you in March for the third fiscal quarter remains, with the revenue estimated to be in the range of $2.9 billion to $3 billion, consistent at the midpoint of this range with our second fiscal quarter. Our revenue expectations are based upon a steady view of the overall end market growth and the timing of transition of certain consumer products.

Core operating income excluding any costs associated with the ongoing reviews, are expected to be in the range of 2.5% to 3%. Core earnings per diluted share is expected to be in the range of $0.17 to $0.23, reflecting higher levels of interest expense associated with the acquisition of Green Point and the utilization of our revolvers to fund working capital needs during the quarter.

I would like to remind you that our short-term revenue guidance continues to reflect a muted view of end-market growth along with our deliberate and disciplined action in pricing, allowing us to move towards our targeted operating income levels over the course of the next few quarters.

I would now like to hand the call over to Tim Main.

Tim Main

Thanks, Forbes. First of all, I'd like to say that we are pleased to be back on schedule with our filings and have full financial details to share with investors. It's been almost one year, since we last discussed our financial performance with the benefit of complete financial information and I am relieved to have this period behind us.

Second, I will be the first to acknowledge that our financial performance over the past three quarters has been uncharacteristic for Jabil and significantly below our long-term objectives. There have been many changes to the conditions we are operating in over the past year. The industry environment and the overall economic environment have changed significantly.

However, in terms of issues specific to Jabil, there are three principal factors appearing in core margins over the past three quarter.

One is the inquiry process and the direct expenses associated with it. Second is the electro-mechanical tooling operation?

And third, our certain Jabil designed products that we have withdrawn from our business plan. The total of these three factors is approximately $60 million to $65 million over that three-quarter period.

From fiscal Q4 of '06 through fiscal Q2 of '07, we generated revenue of approximately $9.1 billion, meaning that these three factors alone diluted core margins by about 70 basis points. We expect these three factors to be substantially reduced or eliminated from our results over the next few quarters.

As mentioned in our previous conference call and during our analyst meeting earlier this month. We are also proactively changing the mix of our business in the consumer segment. This will be healthy for our business long-term, but in the short-term will mean lower revenues than originally expected. This reduced demand level is expected to have a negative impact of 20 to 30 basis points on core operating margins.

Other factors affecting margins are more material-intensive revenue stream as we add additional CTO supply chain services, and the ramp of new customers and programs with existing customers. But this is about where we have been and I think it's much more important to be focused on where we are going.

First of all, our operational performance is in excellent shape. Although our financial performance has been less than desired, our execution of the day-to-day business and support of our customers is actually very high.

Second, we are winning in virtually all sectors in customer relationships. Excluding our consumer segment and Green Point, our business will grow 29% in fiscal 2007 over 2006. This growth gives us high confidence regarding our forward-looking prospects.

Lastly, we believe our consumer sector is well-positioned for long-term growth. The addition of Green Point and our strong position in product categories, such as displays, set-top boxes, and mobility we think can deliver sustained growth at acceptable returns. Our diversification will be a key strength going forward.

In summary, I would like to express my thanks to shareholders that have believed in our Company through a difficult and tumultuous period. We are working diligently to return Jabil to a robust engine of growth in returns. And we are confident, we are on that path.

Beth Walters

Operator, we're ready to begin our question-and-answer period.

Question-and-Answer Session

Operator

Okay. And your first question comes from Shawn Harrison.

Shawn Harrison - Longbow Research

Hi, good afternoon. First question just has to deal with any update to the fourth quarter guidance that you provided about a month ago?

Tim Main

Really, in the middle of an internal Jabil business planning cycle, so that really makes it inappropriate for us to comment on Q4. I'd ask people not to read anything gloomy or positive into that. We are about three weeks away from our Q3 conference call and on that conference call. We'll update our Q4 guidance.

Shawn Harrison - Longbow Research

Okay. My second question -- or second set of questions, just has to deal with more financial aspects. If we look at the increase in operational expenses, in the second quarter was that principally due to Taiwan Green Point or was there anything else in there that we should be aware of?

Forbes Alexander

Shawn, when you say increase in operational expenses?

Shawn Harrison - Longbow Research

The $10 million sequential increase from the November quarter to the February quarter, was that all Taiwan Green Point?

Forbes Alexander

Yes.

Shawn Harrison - Longbow Research

Okay. And then, if we look to the bridge loan, I guess converting that in the long-term debt, when do you think that will occur and what would be the potential interest rate on the long-term debt? Because I think it's about 6.5% right now in the bridge loan, if I'm correct.

Forbes Alexander

Yes, that's correct. In terms of Taiwan, now we're current, that's the first stage and we will certainly be looking to make that a more permanent form of capital over the summer month here.

So, I would certainly expect that to be in its permanent form by the end of the summer. In terms of interest rates, anywhere in that 6.25% to 6.5% I think is probably appropriate. Maybe a small percentage trend that a little bit, but more than purpose it's that what I'd use.

Shawn Harrison - Longbow Research

Okay, so no substantial savings other than maybe a reduction in the revolver usage for working capital needs?

Forbes Alexander

Yes, that's correct.

Shawn Harrison - Longbow Research

Okay. Finally, just a tax rate guidance, going forward? It's bounded about here a bit.

Forbes Alexander

I'd use 16%.

Shawn Harrison - Longbow Research

Okay, thank you.

Operator

Your next question comes from Yuri Krapivin of Lehman Brothers.

Yuri Krapivin - Lehman Brothers

Good afternoon, everybody. First of all, the question on the growth rates by end markets, the guidance that you provided on your previous earnings calls for individual end markets, does this outlook still stand? In particular, you're looking for the consumer segment to be down 10% but for the peripheral segment to be up around 15%?

Tim Main

Go ahead.

Forbes Alexander

Yuri. Yes, that's the same. In terms of the overall sequential movement in our sectors, there's no change from the previous guidance we gave.

Yuri Krapivin - Lehman Brothers

Okay. And then, another question, with respect to your consumer market, particularly in the handset area, are you sort of winning new programs at this point, which can give you sufficient confidence that your consumer segment will return to growth in the next several quarters?

Tim Main

I think the most fundamental change in, let's call it mobility segment, because there are a number of products in that area -- the most significant change in that segment is moving from EMS model focused at least somewhat on printed circuit board assembly and fundamental EMS assembly of products in that space to one of a vertically-integrated model that includes decorative plastic, housings in a vertical model.

As we go through that process, we think the vertical model will deliver more sustainable growth at more attractive returns to us long-term, but in the short-term again we'll have this revenue depression over a two, three-quarter period.

We are winning new programs to answer, to be direct to your question, we are winning programs on that vertical model and that give us a very good confidence level that this strategy that we embarked on with the acquisition of Green Point and the tuning of our consumer segment overall will yield positive results that will start to show up sometime in fiscal '08.

Yuri Krapivin - Lehman Brothers

Okay. Thank you.

Operator

Your next question comes from Steven Fox of Merrill Lynch.

Steven Fox - Merrill Lynch

Hi, good afternoon. Forbes, I was wondering, you mentioned the $60 million to $65 million hit from the three items. If I look at year-over-year decline in core profits it went from $89 million to $44 million. So I was wondering if we could just round out that discussion. How much did volume help and what other offsets were in that decline?

Forbes Alexander

$80 million to $44 million?

Steven Fox - Merrill Lynch

Yes, year over year. A year ago February you had $89 million in core profits.

Forbes Alexander

Steve, where are you coming up with $44 million?

Steven Fox - Merrill Lynch

I thought I was just looking at your core earnings for the quarter, February --?

Forbes Alexander

Our fiscal second quarter core earnings were $56 million.

Steven Fox - Merrill Lynch

I'm excluding option expense, sorry. So, either way you cut it. It's roughly about a $50 million, $55 million decline in your core earnings.

Forbes Alexander

Right.

Steven Fox - Merrill Lynch

Can you just decompose that a little bit?

Forbes Alexander

That's actually principally associated with the under absorption in terms of our overall manufacturing cost base. If you look at the drop in terms of consumer sector, Q1 and Q2, both of those quarters. In fiscal '06, revenues declined by $90 million. In fiscal '07, it was about $290 million, $300 million, and that was including Taiwan Green Point, $350 million I think excluding that. So what you're actually seeing is there is somewhere in the region about 17% in each fiscal years of operating margin decline in that revenue dollar. So it's really focused around the under absorption of that cost base.

Steven Fox - Merrill Lynch

Okay. Then looking ahead, I understand you don't want to talk about two quarters out, but in terms of operationally, Tim, do you still feel good about the operation improvements you expect over the next two to three quarters, putting aside the end markets for a second?

Tim Main

Yes. I think we'll take this step by step. We're at a point now where it's very difficult to reconcile where we are today with where we were a year ago when we actually had full financial statements to talk about. I'm not being evasive, but a whole lot of things have changed since that point in time. And I think what we have to do at this point is accept it as where we are today. We still have a growing business that is fundamentally in good shape in terms of our operational day-to-day execution of the business, customer relationships, growth and the rest of it, and we're going to have to take it quarter-by-quarter to rebuild our margin profile, rebuild our profitability, and rebuild investor confidence in our ability to do that. So, yes, we are looking to sequentially improve the business as we go forward.

Steven Fox - Merrill Lynch

Thank you.

Operator

Your next question comes from Louis Miscioscia of Cowen.

Louis Miscioscia - Cowen

Yes, thank you. Tim, at the analyst meeting, you talked about some of the core EMS business growing from $3 billion of revs to $4.5 billion. I don't know, if you've had any wins that you could highlight that'd be helpful? And also, generally this business, obviously, is higher margin than the consumer business. But is it above your normal target for the company as a corporate average?

Tim Main

In terms of the legacy EMS segments or the core EMS segments of computing and storage, networking, telecommunications, automotive, medical instrumentation, defense and aerospace, yes, we're seeing significant 29% year-over-year growth. And actually in the second half of '07, 17% growth over the second half of '06. So continuing growth in those areas, Lou and I can't give you specific wins, because I would have to mention customer names. But we've had significant wins in the instrumentation and medical segments, both in medical products and the instrumentation area. We've had a significant win in automotive. We're expanding in terms of CTO and other services in our computing and storage segment.

Our networking segment is growing. And there's a pipeline of opportunity in telecommunications as well, and defense and aerospace. So we feel really good about those segments and we feel good enough about those segments that we don't have any desperation whatsoever in terms of going after business in the consumer segment, which does not meet our return objectives.

So we can patiently drill our way out of the situation that we're in and we regard that as an attractive option to the corporation and we'll continue to do that. In terms of new business being booked and the incremental margins associated with it, yes, everything is being booked at margins and returns that are accretive to our current average.

Louis Miscioscia - Cowen

And then, restructuring was supposed to help margins in the August quarter. Is that still all on track and just maybe any comment on restructuring? Thank you.

Forbes Alexander

Lou, yes, that is on track. In terms of our overall restructuring plan that we laid out, I think, three or four quarters ago now, we're about halfway through that. And it's very much on track to where we started to go around that timeframe. In terms of the benefit to us in the fourth quarter, as we talked about, I think, on the previous earnings call, that looks surrounded by that 30-basis point improvement, just depending on the timing of when employees leave the Company.

Louis Miscioscia - Cowen

How about long term? Does it go up to about 50 once you're all done?

Forbes Alexander

Yes, it should certainly be in the 40 to 50 basis point range. We talked about it three or four quarters ago. It should be in that range, again depending on the timing in the second half of the program through our fiscal 2008.

Louis Miscioscia - Cowen

Okay, thank you.

Forbes Alexander

You're welcome.

Operator

Your next question comes from Kevin Kessel of Bear Stearns.

Kevin Kessel - Bear Stearns

Hi, there. Can you talk a little bit about the SG&A dollars today in terms of what component do you feel is relatively fixed going forward? Where would you target it to be going forward?

Forbes Alexander

Yes, Kevin. So, in these numbers that we've also given you today, there's approximately, I think on average about $3.5 million a quarter in terms of expenses associated with the reviews we've undergone. There will be some in fiscal Q3. That's based on the guidance that we've provided to you. I would expect some of that to linger through Q4, given there's some assets being [plaited] up and some lawsuits out there. I think in terms of SG&A overall, as we move through the balance of this fiscal year, I think the core numbers are probably in the $115 million a quarter, type range.

Kevin Kessel - Bear Stearns

$115 million, you said?

Forbes Alexander

Yes, something of that nature, $115 million, $116 million. The numbers for fiscal '07. We'll give you some better guidance in '08 at the end of the August quarter.

Kevin Kessel - Bear Stearns

Okay. And then just so I'm clear, in your core numbers are you backing out these accounting and legal expenses?

Forbes Alexander

We have not. In the data we've provided you today and in our releases, we have not done that. The guidance that we've given you for Q3 does exclude those costs.

Kevin Kessel - Bear Stearns

1.5 million to 3 million?

Forbes Alexander

That is correct.

Kevin Kessel - Bear Stearns

You mentioned in terms of the losses in electromechanical tooling. Where does that stand right now in terms of dollars, and what is implied in May?

Tim Main

I don't have a May number for you. We'll consider discussing on that in a few weeks, but I'd expect it to be virtually immaterial to our numbers from Q4 onwards.

Kevin Kessel - Bear Stearns

All right. Thank you very much.

Operator

Your next question comes from Paras Bhargava of BMO Capital Markets.

Paras Bhargava - BMO Capital Markets

Good afternoon, gentleman. If you look at the OpEx, just digging a little deeper into the OpEx number, I think the gentleman earlier asked how much of it's fixed and how much of it's variable. As your revenue growth starts to come back, how should we expect the OpEx line to behave?

Tim Main

It definitely does not scale as a percentage to revenue. A significant amount of it is fixed in terms of IT infrastructure and stewardship and some other areas that are in SG&A. We're also focusing, since most of our growth is in low cost locations, that has less than ratable effect on SG&A expenses as we grow revenue. I think you need to remember that we acquired Green Point. We also have a services business, the services business is growing, both of which have naturally higher SG&A structures than the corporation does overall.

I would be expecting, talking about our long-term expectation, that over the next two years, so fiscal '08, fiscal '09. That we will resume a process of leveraging down operating expenses as a percent of revenue. We successfully did that from fiscal 2002 through fiscal 2005, reducing SG&A as a percentage of revenue from somewhere in the mid five's to the mid three's. And I think we'll see that process resume in our operating expense line in fiscal '08 and fiscal '09.

Paras Bhargava - BMO Capital Markets

All right. In terms of the near-term items that you were talking about, Tim, how long do you expect those to remain? Is it a three or four quarter item or the change in consumer and then some of the other [edicurrents] that you're working your way through, or is it a longer term is that lighter than that?

Tim Main

We talked about this on our last conference call and I believe at the analyst meeting that in terms of under absorption of our manufacturing and operating infrastructure today. We need another $200 million to $400 million in revenue, depending on the mix of revenue or the mix of the segments within that revenue increase.

So, if we get a near-term balance from consumer, near term being in Q1 '08, higher than expected, then we might be able to recover faster than normal. We're not going to do that just in order to book revenue. The breadth of the business is growing at a very good rate. So, if we continue to see lateral growth or no growth in consumer, we could rely on the rest of our business to grow and that could extend that process in the next three or four quarters.

Paras Bhargava - BMO Capital Markets

All right. And then finally, in terms of the opportunity environment, and I know you're saying the end market expectations are tepid, but what are you seeing in terms of the opportunity environment and what kind of pricing behavior are you seeing from some of the people that are relatively desperate now?

Tim Main

I think we've talked quite a bit about pricing environment in the consumer segment and the need for us to move from our EMS-based model into a vertically integrated model in displays and other areas, a more product development focused orientation, so that's under way. The pricing environment in that area has been severe, and that's one of the reasons that we pushed away from some of the opportunities there.

The balance of our business, we're seeing a very good pipeline of opportunity. They tend to be end-to-end supply chain solutions, which feed right into Jabil's strengths. And while the pricing environment program to program might seem a little crazy from time to time, we're not seeing anything irresponsible in that area. In fact, as the customer base moves more and more to a globally-based end-to-end solution, the number of potential competitors narrows significantly down to a few.

And so, I feel pretty good about our ability to earn targeted returns in that area, and the pipeline of opportunity is actually pretty good.

Paras Bhargava - BMO Capital Markets

Thank you.

Operator

Your next question comes from the line of Amit Daryanani of RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Thanks a lot. I guess, just a question on -- you guys have been spending about $3 million, $4 million of incremental audit expenses for the last few quarters. What sort of headwind did you have built into the margin expectations you provided for the May and August quarter?

Tim Main

Amit, could you come again with that, please?

Amit Daryanani - RBC Capital Markets

Yeah. I mean, you've been spending about $3.5 million to $4 million of these incremental audit expenses for the last few quarters. And back in March when you provided guidance for May and August quarters, what sort of audit expense was built into those margin expectations?

Forbes Alexander

We excluded those expenses from our guidance.

Amit Daryanani - RBC Capital Markets

For both quarters. So, in May quarter, you're essentially going to have $3 million of incremental expense then?

Forbes Alexander

No, no. What [our reoccurrence] did, the guidance that we gave you in March stands, okay. So, that range of guidance in terms of $2.25 million to $2.75 million of core operating income excludes any legal expenses.

Amit Daryanani - RBC Capital Markets

All right. And then--

Forbes Alexander

For Q4.

Amit Daryanani - RBC Capital Markets

Got it. And then just one other thing. In your K you've talked about $4 million expense you're anticipating taking in the May quarter to compensate employees that essentially exercise the Section 490 affected options. Was that built into the margin expectation or was that excluded as well?

Forbes Alexander

The guidance that we gave you was core, which excludes all compensation costs associated with stock options or restricted stock.

Amit Daryanani - RBC Capital Markets

All right.

Forbes Alexander

There is no impact in terms of the overall guidance we've given you. And that was baked into the GAAP guidance we provided also.

Amit Daryanani - RBC Capital Markets

Perfect, that's it. Thanks a lot.

Forbes Alexander

Okay.

Operator

Your next question comes from Will Stein of Credit Suisse.

Will Stein - Credit Suisse

Great, thanks for taking my call. I'd like to hear you guys talk a bit about the R&D expense and how customers are responding to the range of design services you're offering. We're seeing R&D having declined fairly materially, at least on a dollars basis, over the last two quarters. How should we expect that going forward? I understand there was an ODM project that was essentially canceled, but I understand you guys are doing a lot in way of both ODM and joint design with customers. Any thing you could talk about that and how we should think about the R&D expense going forward would be very helpful.

Tim Main

Sure. I don't want people to expect that the R&D line is going to go away or expand significantly from where it is today. I think it's a process of being more focused in specific product categories that are connected to major brand OEMs and mainstream products. It's also an area that, in terms of product development capabilities that there's a very large underlying infrastructure that builds significant NRE dollars to our customer base and is actually a very significant muscle, particularly in collaborative products.

So, our spend in that area in terms of product development resources in a purely design engineering spaces on the order of $70 million to $80 million a year. And what you see in our -- most of that's obviously compensated by our customers in collaborative design projects as NRE. So, what you're seeing is pure R&D dollars associated with advanced manufacturing technology development, which is a part of our R&D for our manufacturing infrastructure, as well as what you'd call reference designs and pure ODM types of product development.

Will Stein - Credit Suisse

So--

Tim Main

Does that answer your question?

Will Stein - Credit Suisse

I think that helps. So there's actually $70 million, $80 million per year in NRE that you're receiving that doesn't show up in that line. Where would that be? In SG&A?

Forbes Alexander

Well, no. That's effectively netted -- basically, the costs that we incur, to Tim's point, we've got infrastructure in place of design engineers and capabilities that costs us in $70 million, $80 million a year, and we recover effectively, in Q2 our published number's $8 million of R&D, so we effectively recover the balance of that $70 million bar the $8 million, if you follow me, so that's a net number that you're seeing there.

Will Stein - Credit Suisse

Yeah, okay. So--

Forbes Alexander

So, I would expect it to be at similar-type levels, $8 million a quarter, something in that nature.

Will Stein - Credit Suisse

Okay. That's it. I think that's it for me. Thank you very much.

Operator

Your next question comes from the line of Jim Suva of Citigroup.

Jim Suva - Citigroup

Great. Thank you very much. Just a quick housekeeping question for Forbes and a follow up to Tim; Again, your core numbers include the legal and accounting fees while your guidance excludes it, so we've kind of got apples-to-oranges comparison, is that correct?

Forbes Alexander

That's correct.

Jim Suva - Citigroup

Okay. And then the follow-up for Tim. Tim, I believe it was back in November when you first talked about a more subdued demand environment. Can you tell us if that environment has gotten even more subdued, been stable? What direction have we gone? Because I see today that one of your -- I believe one of your customers, Network Application, lowered guidance pretty significantly. It seems like wireline, wireless infrastructure in Europe and North America is still a little soft. Can you update us on your subduedness and this meeting that you have internally, was it planned normally, or this a need-based need to have a meeting?

Tim Main

No, it was not an emergency meeting of people here. It's part of our normal planning cycle and it'd be cheating a little bit for people to get a look at Q4 at this point. It's way out of a normal communications cycle with the investment community to be talking to you in the last week of a quarter. So, to provide any color or additional information on forward-looking guidance, it's not fruitful for us. And I think we're only three weeks away from our Q3 conference call.

So, we'll do a better job of talking about Q4 and our forward-looking expectations then. In terms of the overall demand environment, it certainly hasn't gotten any better. I think that significantly, materially more subdued, no, but kind of a continued sideways motion without much optimism regarding a recovery of demand. I think that would be an appropriate way to look at it.

Jim Suva - Citigroup

Great. And thank you for clarifying about that meeting coming up that isn't the emergency. I've been getting a lot of e-mails on that. And as a quick follow-up, I know you spent great lengths of time talking about your improvement in operating margins, yet investors still have trouble getting to where you're talking about going forward. Can you just maybe help us understand a little bit, how much of it is under Jabil control versus end-market growth? You said $200 million to $400 million in revenues. Can you maybe give investors one more shot at that?

Tim Main

Sure. And I know there are investors that are going to base their decisions on five, six years of previous experience and understanding our margin performance and the way we run our business and are looking past the last few quarters and we really appreciate their support. In terms of the more skeptical investors that can't see how we'll get from where we are today to where we'll be, I really think we have to take it step-by-step and go quarter-by-quarter and show better performance as we go.

We've talked about, to be more specific and granular answer to your question, we've talked about a number of issues, three primary issues, three primary factors that had about a 70 basis point impact to our operating margins. Those will essentially be reduced to completely eliminate it over the next couple of quarters.

So, that's step number one. Step number two is making sure that we're making the right decisions in the consumer segment and continuing to press the process of outsourcing from the vertically integrated model of OEMs into a virtualization process in outsourcing with Jabil. That secular trend outsourcing is still strong, it's still there even in a week end-market demand environment.

As I said before, the second half of our year in '07, we'll grow 17% over the second half of '06, excluding the consumer segment and excluding Green Point. And in terms of year-over-year, those traditional EMS segments will grow at about a 29% year-over-year growth rate. So, yes, we need about $200 million to $400 million in additional loading of our infrastructure because the costs and footprint and infrastructure was put in place for a higher revenue level than we have today.

And when we get that $200 million to $400 million of additional loading, that will have a very significant impact on our operating margin performance. So, in kind of quick form, how we get from point A to point B is, one, eliminate the Jabil-induced errors, or the factors that have been specific to Jabil, the three we've talked about, and continuing to grow the business in a responsible way. And I think if we continue to do those things in terms of growing the business responsibly, we'll get there.

Jim Suva - Citigroup

Great. Thank you so much for all the details.

Tim Main

Okay.

Operator

(Operator Instructions). And we have a follow-up question from Amit Daryanani of RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Thanks. Just a quick question on the restructuring benefits. In the K, you guys talked about $8.4 million in savings in fiscal '07. Is that all going to get realized in Q4, essentially, and nothing in Q3?

Forbes Alexander

There's a little bit in Q3, but the primary piece of that's Q4.

Amit Daryanani - RBC Capital Markets

All right, perfect. Thanks a lot.

Operator

We have a follow-up question from Will Stein of Credit Suisse.

Will Stein - Credit Suisse

Thanks. Forbes, can you just help us, a quick question on the interest expense line going forward. Obviously, we saw a big ramp up going to the term loan related to the Taiwan Green Point. Where should we think about that going in the current quarter, the May quarter? Is that relatively consistent, or are there more months that's outstanding?

Forbes Alexander

There's more months, Will. So, if you remember, in the first quarter, it was half way through that quarter. So, you're going to have a full quarter's affect of the term loan. So, you probably want to add somewhere in the region of $8 million to $8.5 million. So basically, take 1/24th of $900 million or 6.5%.

Will Stein - Credit Suisse

Great. Thanks very much.

Operator

(Operator Instructions). You have a follow-up question from Jim Suva of Citigroup.

Jim Suva - Citigroup

Thank you. Quickly, can you talk about working capital inventory and cash flow management? It seems like a lot of the shortness in revenues and profitability consumed it. Can we look forward to cash flow positive going forward and your inventory levels? You see a lot of room there for improvement?

Forbes Alexander

Sure, Jim, yes. In terms of cash flows, yes, you should expect to see positive cash flow from operations, particularly as our revenue stream in terms of the guidance we provided you is substantially flat through the balance of this fiscal year.

And as we turn our operating income levels in the northward to where we've previously seen, that's obviously going to generate cash flow.

In terms of our inventory levels clearly some opportunity to improve those. If you look at inventory on an overall basis, excluding the Taiwan Green Point last quarter, which I think added somewhere in the region of $80 million in two to three days, our inventory levels have been substantially in days outstanding flat over the last three or four quarters, round about 46 days. So, yeah there's still opportunity for improvement there and I think as we move through the balance of the year, there's opportunity there.

Again, as we exit the fiscal year, first fiscal quarter is typically a seasonally up quarter, so a little bit guided there. But clearly there's opportunity to take $50 million to $150 million out of that number over the course of the next few quarters, so I think there's some real opportunity there.

Jim Suva - Citigroup

Thank you very much.

Operator

(Operator Instructions).

Beth Walters

Okay. Thank you, everyone, for joining us today for the conference call. We will, as mentioned several times, look forward to reporting our fiscal third quarter on June 21st, which we'll be hosting a conference call then. So, thank you very much.

Operator

This concludes today's conference, and you may now disconnect.

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Source: Jabil Circuit F2Q07 (Qtr End 2/28/07) Earnings Call Transcript
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