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OmniVision Technologies, Inc. (NASDAQ:OVTI)

F4Q07 Earnings Call

May 31, 2007 5:00 pm ET

Executives

Steven Horwitz - Director, Investor Relations

Shaw Hong - President, Chief Executive Officer

Peter Leigh - Chief Financial Officer

Ray Cisneros - Vice President, Sales

Analysts

Aaron Husock - Morgan Stanley

Doug Freedman - American Technology Research

Tayib Shah - Longbow Research

Adam Benjamin - Jefferies & Company

Satya Chillara - Pacific Growth Equities

Paul Coster - J.P. Morgan

Jason Pflaum - Thomas Weisel Partners

Harsh Kumar - Morgan Keegan

Quinn Bolton - Needham & Company

Daniel Gelbtuch - CIBC World Markets

TRANSCRIPT SPONSOR
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Operator

Good day, ladies and gentlemen and welcome to the OmniVision Technologies fiscal 2007 fourth quarter and full year earnings conference call. (Operator Instructions) I would now like to turn our presentation over to your host, Mr. Steven Horwitz, Director of Investor Relations for OmniVision. Please proceed, sir.

Steven Horwitz

Thank you. Good afternoon, everyone. Earlier this afternoon, OmniVision issued a release reporting our financial results for the fourth quarter and full year fiscal 2007. You can access this release from the investor relations section of our website at www.ovt.com, or on the financial newswire.

Before we begin, here are a few items for everyone’s reference. This call is being webcast live and a web replay will be available for 12 months. Both the live webcast and replay can also be accessed from the investor relations section of OmniVision's website at www.ovt.com.

We have also arranged to record this call. The taped replay will be available approximately one hour after the call’s conclusion and will be available for 48 hours. The dial-in access number for this replay is 617-801-6888. The replay passcode is 34233128.

This conference call will include forward-looking statements within the meaning of Section 27(NYSE:A) of the Securities Act of 1933 as amended and Section 21(NYSE:E) of the Securities Exchange Act of 1934 as amended. These forward-looking statements include statements about our financial projections for the first quarter of fiscal 2008 and beyond. Our expectations for growth in the market for image sensors, our expectations regarding our ability to continue to compete effectively in the market, anticipated introduction, acceptance and benefits of our new products, our expectations regarding our ability to take advantage of future opportunities and anticipated product and market developments beginning in the first quarter of 2008.

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

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

These factors may cause company results to differ materially from the forward-looking statements made in this conference call. Although the company believes that the expectations reflected in its forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievement.

These forward-looking statements are made only as of today’s date and OmniVision expressly disclaims any obligation to update or revise the information contained in the forward-looking statements. This concludes the Safe Harbor statement.

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

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

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Shaw Hong

Thank you, Steven and good afternoon, ladies and gentlemen. Thank you for joining us on today’s call. With me today are Peter Leigh, our CFO; Ray Cisneros, our VP of Sales; and Hasan Gadjali, VP of Advanced Products.

On today’s call, I will begin with an overview of our results and then I will provide a general business update. Peter will provide you with the financial details of our fiscal fourth quarter and outlook for the first quarter. Afterwards, we will take your questions, and for that Ray and Hasan are here to provide additional insight.

Our revenue for the fourth quarter was $119.2 million. Our GAAP loss was $0.03 per diluted share. Excluding stock option expenses, non-GAAP earnings were $0.06 per diluted share. Our balance sheet at the end of the year remains strong. Our cash and short-term investments totaled about $305 million.

Revenue for fiscal 2007 was $528 million, with GAAP earnings of $0.43 per diluted share. Excluding stock option expenses and litigation settlement expenses, net of tax effects, non-GAAP earnings were $0.93 per diluted share.

In the fourth quarter, we sold about 62 million sensors, compared to approximately 66 million in the third quarter and 48 million in last year’s fourth quarter.

At the time of our third quarter conference call, we were cautious in our guidance for the fourth quarter, in part due to the relatively high inventory of handsets in the channel. We indicated then that going to fourth quarter, business conditions were challenging and visibility was limited.

As things turned out, soon after the call we began to see demand strengthen and it continued to strengthen as the quarter progressed. As a result, we were able to significantly exceed the upper end of our revenue guidance for the fourth quarter and have provided guidance for the first quarter that is significantly higher than the street was expecting.

Revenues were better than expected, particularly in 2-megapixel and VGA. More importantly, we saw acceleration in 2-megapixel orders for future quarters, demonstrating what we believe to be a fundamental shift in the mobile handset market to higher resolution sensors.

At the same time, demand for higher quality VGA sensors continues to show significant strength as the penetration of cameras into handsets continues to increase.

Lastly, we saw increased demand in the PC notebook market. We are very encouraged with what we are seeing in this market and we will cover this in more detail a little later.

Now, I would like to update you on three key areas of focus in our business. The three areas that I will cover are first, our initiatives to improve our operating results; second, an overview of the major trends that we see in our mainstream products business; and third, the improvement in our advanced products business.

Let me begin with an update on our initiatives to improve our operating results. Our goal is to deliver cost-effective solutions to our customers and deliver superior long-term returns to our shareholders.

The key driver of our operating results is gross margin. As you will have noticed from our press release, gross margin continued to be under pressure in the quarter. To address this, we have numerous initiatives underway to return gross margin to a higher level.

We have redoubled our efforts to ensure that our supply chain is operating as efficiently and as cost-effectively as possible. To accomplish this, we have taken several steps.

One, as a fab-less company, virtually all of our product costs are brought in and we are working very aggressively with all our vendors to reduce input costs and improve output yields;

Two, we are collaborating very closely with TSMC to develop new and lower cost technologies;

Three, as you may remember from last quarter, we entered into a foundry manufacturing agreement with PFC to develop new processes and new products using their 300-millimeter DRAM capacity;

Four, along with TSMC, we have continued to fund our joint venture with VisEra to expand their capacity and help prepare their facilities to handle 300-millimeter wafers;

Five, earlier this month, we also made an investment in the WLCSP, a chip scale packaging partner. This provides us with a second source of chip scale packaging capacity;

Six, we believe that TSMC’s acquisition of a controlling interest in XinTec, our original CSP provider, will bring a higher level of efficiency to XinTec’s production processes and lead to increased yields;

Seven, we are in the process of automating and upgrading our final testing facility by installing new test equipment, making our testing process more efficient.

All of these initiatives will take time to bear fruit, but we believe that gross margin in the current quarter will show a modest improvement from the margin we reported for the fourth quarter and we are determined to pursue continuous margin improvement in the quarters ahead.

On the operating expense side, we are continuing to be very prudent in our spending. In particular, we are looking to counter the growth in our headcount. We have a process in place to ensure that we fill only the most critical positions and hire the highest caliber of people.

With respect to research and development, it is very important for us to continue to invest in our business. By concentrating on the key areas of technology and product development, we can fuel our growth for the future.

The surge in revenue we now expect in the current quarter is tangible evidence of how previous research and development dollars have positioned us well to be a leader in the image sensors space.

Let me now provide an overview of the trend that we see developing in our mainstream products business. We are pleased to report that demand for our 2-megapixel sensors is picking up. Based on what we see today, we expect this trend to continue throughout the rest of the year. We believe that the success of the 2-megapixel resolution demonstrates to both the handset makers and the service providers that the end consumer is willing to pay more for a better handset camera with a higher resolution sensor. This should lead the handset makers to push more aggressively for even higher resolution sensors for higher-end phones. We believe that our product roadmap matches well with this trend.

We are also seeing an increase in the number of dual sensor phones. The second sensor, which is typically low resolution, gives access to cell phone videoconferencing capabilities, based on the increased bandwidth provided by 3G networks. Some of the more robust market predictions forecast that dual sensor phones could represent as many as 8% of all phones shipped at the end of calendar 2007.

The initial markets for these phones are Europe, Japan and Korea where 3G networks are most widely deployed. But 3G is expanding in other areas of the world, including the United States, and we expect the dual sensor phones to follow.

As I mentioned earlier, we continue to see significant strength in demand for our VGA sensors. In particular, sensors we produced in the compact chip scale package, which is easier for our customers to incorporate into their products. This strength in demand, which I expect to continue through 2007, is driven by the increasing adoption of cameras into handsets. Some observers now expect that camera penetration in 2007 will be as high as 80%.

Importantly, the consumer typically purchases their first camera phone with a VGA sensor and then, when the time comes for a replacement, looks to upgrade to a phone with a higher resolution camera.

In the area of technology, we announced last week the availability of our new OmniPixel3 architecture. This third generation pixel design architecture features our new 1.75 micron pixel, which is among the smallest current available, and offers higher resolution in a smaller form factor, while providing better performance and image quality.

The OmniPixel3 architecture incorporates several significant technology developments that enable increased pixel density and maximizes the performance of the new 1.75 micron pixel. The new architecture uses leading edge design rules on a dedicated and proprietary 0.11 micron CMOS process, a 20% improvement in form factor, plus increased sensitivity means the sensors based on the OmniPixel3 architecture provide a more vibrant color reduction which is more true to life.

Pixel size is critical for the optical sensor markets, especially in mobile handsets and notebooks. As the industry mix continues to upgrade to higher resolutions in small form factors, our continued ability to reduce pixel size and deliver improved performance will continue to play an important role in our success in future design cycles.

In addition to the OmniPixel3 architecture, we are already working on future technology improvements that will position us well to take advantage of the need for smaller and smaller pixel sizes.

We are also very close to launching the OV3640, the first product based on the new architecture, a higher performance, 3.2-megapixel image sensor for high-end slim phones, which is capable of fitting into the all-important quarter-inch form factor.

We are demonstrating technology leadership with our first True Focus product, a 3-megapixel camera for mobile handsets, which utilizes our patented wafer encoding technology. Wafer encoding technology is a proprietary method of creating a picture that is in focus across a virtually unlimited depth of field. By creating an image that is always in focus, the technology allows for instant image capture that is true point-and-shoot, with no focusing delay.

We demonstrated this product at 3GSM this year and mentioned it briefly on our last conference call. We are pleased to report today that this product has already secured design wins in the marketplace and we expect it to be a differentiator for us going forward.

I would like to turn now to our advanced product business and talk about some very positive developments.

As I briefly mentioned earlier, we are seeing a very good ramp in the PC notebook market, with design wins at four of the five leading notebook manufacturers. Our market share is very strong. We believe that we are well-positioned to take advantage of the acceleration in the attach rate for cameras in this market. Our OV7725 sensor offers superior image quality in all lighting conditions and we are winning designs at resolutions up to and including 2-megapixels.

From some of the market estimates we have seen, the number of notebooks shipping with a camera this year could exceed 20 million, which equates to an attach rate of about 25%. Adoption rates appear to be accelerating and PC notebook units could increase to over 30 million next year.

We also continued to make inroads into the PC webcam peripherals market and believe our share in this market will continue to grow this year and next.

Before I update you on our security and automotive business, I want to say a little about our new high dynamic range, or HDR sensors, that addresses a very specific need in these two markets.

Dynamic range refers to the capacity of a sensor to capture widely deferring light levels in a single image and to rapidly adjust to changes in light levels. The higher the dynamic range, the faster the sensor can adapt to these changes and the more closely it can function like the human eye under quickly changing lighting conditions.

In early March, we announced our high-speed OV10620 sensor, the first HDR CMOS sensor using our proprietary color HDR technology. The OV10620 rapidly switches to HDR mode to handle extreme variations of bright and dark conditions within the same scene, and automatically switches back to non-HDR mode when conditions return to normal. In addition, its 6-by-6 micron pixel size enables it to simultaneously capture and process image data ranging from bright sunlight to dark shadowed regions.

The two markets embracing this new technology first are the security and automotive markets. Although interestingly, we are now seeing increased interest in HDR in the handset market, which demonstrates how technology advances cross over from one market to another.

The new single chip OV10620 sensor can provide security camera manufacturers with a more cost-effective solution compared to existing multiple chip CCD camera solutions with HDR capabilities.

The OV10620 also has superior performance to competing CMOS color HDR systems. These advantages are allowing us to gain more and more traction in the commercial CCTV market.

We continue to see good prospects for image sensors in the automotive markets. There continues to be increasing design activity on multiple applications as we work with both automotive component suppliers and the major OEMs.

Most of the new projects that we are working on are utilizing our HDR technology and we continue to secure design wins across the U.S., Europe and Japan. One of the applications in which design activity continues to grow is for fleet monitoring for use in cargo trucks and for 360 degree views for cars. We continue to believe that the automotive market is very promising, with steady growth that should become more meaningful over the next few years.

In the gaming and toy market, we continue to maintain a strong presence with the tier one entertainment console makers, including the PlayStation 3 and the PlayStation portable device. Our image sensors also continue to enable new toys, such as [Microscore], wireless robots, and toy ATM machines. We believe that the adoption rate of add-on cameras in toys will continue to increase as we approach this holiday season with the introduction of new games that utilize this functionality.

In the medical market, we were pleased to learn just this month that our colonoscopy partner has received FDA approval for their device using our 1/18th of an inch sensor. Colonoscopy is generally regarded as the preferred method for the detection and prevention of colon cancer, which is the third most common cancer in the United States.

The product using our sensor allows the physician to see more of the colon during a routine colonoscopy and thus detect and remove more of the abnormalities that can lead to colon cancer. There are 23 million colonoscopy procedures performed annually in the U.S. and approximately twice that many worldwide. As we have mentioned in the past, this sensor is a single-use product.

I will now turn the call over to Peter, who will discuss our fourth quarter financial results in detail. Peter.

Peter Leigh

Thank you, Shaw and good afternoon, everyone. For the fourth quarter of fiscal 2007, which ended April 30th, OmniVision had revenue of $119.2 million, down 11.3% sequentially and 9.6% on a year-over-year basis. Approximately 80% of our revenue in the fourth quarter came from mobile handsets; about 5% came from digital still camera OEMs; and about 15% of our revenues came from our advanced products group, which includes notebook PCs and webcams, security and surveillance, toy and videogame consoles, automotive and medical products.

Direct sales to original equipment manufacturers and value-added resellers accounted for slightly over half of revenue in the fourth quarter of fiscal 2007, and just under half came from sales through distributors, which was very similar to the third quarter mix.

We used distributors to assist us with the finished goods supply chain management and to minimize credit risks with less well-established customers.

We shipped approximately 62 million image sensors in the fiscal fourth quarter. Our weighted average selling price was $1.92 as compared to $2.02 last quarter. The principal contributor to the reduction in ASP this quarter was the small change in product mix towards VGA products.

Gross margin for the fourth quarter was 22.3% compared to 24.9% last quarter, including the effect of $800,000 of stock-based compensation expense. The principal contributor to the decline in gross margin in the April quarter was the small change in product mix.

We continue to be under significant pressure from our customers to deliver better products at lower prices, and as Shaw discussed earlier in the call, we are working diligently with every one of our manufacturing and packaging supplier partners to improve efficiencies at every stage of the supply chain. We expect to see a modest improvement in gross margin in the current quarter and our goal is to achieve incremental improvements through the entire fiscal year and beyond.

R&D expense in the fourth quarter was $15.6 million, down from the $16.5 million we reported in the prior quarter. Our R&D expense includes approximately $2.8 million of stock-based compensation expense. Excluding stock-based compensation expense, R&D in the quarter was $12.7 million compared to $13.5 million in the prior quarter.

The main contributor to the reduction was lower NRE costs, the costs of the mask we buy when we release designs for new products to the foundry. NRE expense does tend to fluctuate quarter to quarter, but because we remain committed to the development of new technologies, the longer term trend is up.

SG&A expenses in the quarter totaled $13.8 million, down from $16.6 million in the prior quarter. Our SG&A expense includes approximately $3.1 million of stock-based compensation expense. Excluding stock-based compensation expense, SG&A in the quarter was $10.7 million compared to $13 million in the prior quarter.

The decrease in spending is principally due to a reduction in sales commission payments, which are the result both of adjustments to certain of our commission rates and of lower total distributor revenues in the quarter.

Our operating loss in the quarter was $2.8 million. Excluding stock-based compensation, operating income was $4 million.

Our pretax loss in the fourth quarter was $1.3 million, and our effective tax rate for the fiscal year 2007 was 24%.

Our net loss in the fourth quarter was $1.5 million, or $0.03 per diluted shares, compared to net income of $4.1 million, or $0.07 per diluted share in the previous quarter. Net income in the fourth quarter of last year was $22.5 million, or $0.39 per diluted share.

Included in our results for the fourth quarter of fiscal 2007 was a total of $6.8 million of non-cash stock-based compensation expense under SFAS-123R. Net income reported in the year-ago period did not include stock-based compensation expense, and excluding this non-cash stock-based compensation expense and the related tax effect, non-GAAP net income in the fourth quarter of fiscal 2007 was $3.1 million, and non-GAAP earnings were $0.06 per diluted share.

Although the results this quarter came in above our guidance, we know that we have much more work to do to improve both sales and margin performance to a level we believe is satisfactory.

Let me turn now to the balance sheet, which remains in excellent shape. The company ended the fiscal year with cash, cash equivalents and short-term investments totaling $305.3 million. The decrease in cash from our fiscal third quarter was largely due to the investment of an additional $27 million in VisEra, our joint venture with TSMC. We also completed the purchase of the complex of buildings in Santa Clara for R&D and headquarters, which we mentioned during our last call. The building purchase was largely financed by $27.6 million of long-term debt.

Accounts receivable at quarter end, net of reserves, were $65.7 million, down $7.5 million from last quarter. Our day sales outstanding were 49 days compared to 50 days last quarter. Overall, our accounts receivable remain in excellent shape.

At April 30, 2007, inventory was $119.7 million compared to $105.5 million on January 31, 2007. The majority of the increase is in [WIP] and reflects our need to pull in orders to match up with the pick-up in demand, which began in early March. Our goal remains for inventory to be in the range of 75 to 90 days, equivalent to annual turns of four to five times, and we believe that we will be within that range by the end of the current quarter.

Now, I would like to turn to the outlook for the first quarter of fiscal 2008, which will end on July 31, 2007.

As we have frequently indicated in the past, the markets we serve are very dynamic and conditions can change quickly. Sometimes things go against us. Sometimes, such as now they go in our favor. We also stated on our third quarter call that we started to see early signs of improvement in business for the first quarter of fiscal 2008. This pick-up in business did in fact materialize for us, not just in stronger revenue in the fourth quarter, allowing us to outperform our guidance, but leads us to provide very robust guidance for the first quarter.

We now expect first quarter revenue to be in the range of $155 million to $165 million, representing a 30% to 38% increase over the fourth quarter. This should translate to a profit of between $0.03 and $0.11 per diluted share.

Excluding the estimated expense and related tax effects associated with stock-based compensation in accordance with FAS-123R, we expect non-GAAP earnings will be in the range of $0.13 to $0.21 per diluted share.

Now, as regular listeners to OmniVision's earnings conference calls know, our policy is to limit quantitative guidance to the current quarter, but we will say that we remain positive on the outlook for the remainder of the calendar year.

I would now like to turn the proceedings back to Shaw for some strategic commentary.

Shaw Hong

Thank you, Peter. OmniVision’s core competency is centered on image sensor technology. I’m encouraged by the progress that we are making on the three focus areas we talked about today, which are: paying relentless attention to reducing costs -- we intend to deliver cost-effective solutions to our customers and deliver superior long-term returns to our shareholders;

Pursuing mainstream product technology leadership -- by continuing to invest and deliver industry-leading products, we believe we can continue to grow;

Expanding our progress in our advanced products market -- by working with our customer partners to migrate their solutions to more advanced products, offering consumers better quality and more features in existing markets and innovative products in new applications.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Aaron Husock representing Morgan Stanley. Please proceed.

Aaron Husock - Morgan Stanley

Thanks for taking my call. I guess to start, could you give us a little more detail on the mix in the quarter and where that’s going? I guess last quarter, you were around two-third VGA, 10% 2-megapixel and the rest 1.3. Where did that come out in the April quarter and where can that go in July?

Peter Leigh

As I indicated in my prepared remarks, VGA was up a little bit in the quarter, around 70% and the 1-megapixel and 2-megapixel shares were virtually unchanged. We do believe that 2-megapixel should increase as a percentage of revenues in the upcoming quarters.

Aaron Husock - Morgan Stanley

How high could 2-megapixel be as a percentage of sales in the July quarter?

Peter Leigh

We don’t break out the guidance to that level of detail. Let’s just say that directionally the trend is very positive.

Aaron Husock - Morgan Stanley

Okay, and I was a little surprised to see that you weren’t active with the buy-back in the quarter. Can you give us an update there? Do you think you will be buying back some stock this quarter?

Peter Leigh

Well, Aaron, as you know there are a large number of factors that we take into account in deciding whether and when to buy back stock. The fact is we don’t comment on reasons for or engage in speculation about our share of repurchase actions.

Aaron Husock - Morgan Stanley

One final question -- there’s been some talk in the market about a shortage of image sensors for the PC and notebook market in China. Can you just comment on that, what you are seeing there? Is there a shortage and do you guys have adequate supply?

Ray Cisneros

That’s an interesting comment but no, we don’t see that. Right now, we feel very strong about our position in the PC cam and laptop market, and so we can’t really confirm that and we don’t see it.

Aaron Husock - Morgan Stanley

Thank you.

Operator

As a reminder, please limit yourself to one question and one follow-up. From the line of American Technology Research, the next question comes from Doug Freedman. Please proceed.

Doug Freedman - American Technology Research

First of all, congratulations on sort of seeing the bottom and the turnaround here. If you could go into a little bit of detail on how quickly we can expect to see the gross margin improvement start to flow through. Clearly there’s a bunch of inventory there and if you could let us know what you are seeing as far as the value of that inventory.

Peter Leigh

It is harder usually to climb a hill than it is to fall down one, so I think I will limit myself to simply saying that we see incremental improvement in the first quarter and as I said earlier and Shaw made it very clear in his remarks, that we are committed to improving margin throughout the current fiscal year and beyond.

Exactly how quickly we can do that of course depends critically on what happens to selling prices in the market, and that is always difficult for us to predict.

Doug Freedman - American Technology Research

Is there a way that you can help us understand what the guiding factors are, how much we should look at ASPs being a contributing factor versus your ability to reduce cost?

Peter Leigh

I think the way you have to look at it is that historically in this market, prices have gone down at roughly 20% to 25% per year, and if you look at the last two quarters for OmniVision, actually we are at about a 20% decline. Historically, the company has been able to drive down its costs at about that rate. Our task now, of course, is to drive our costs down faster than that so that we can begin to see some margin expansion. We think we are on the right track to doing that and we hope to be able to deliver steady improvement over the next several quarters.

Doug Freedman - American Technology Research

Is it safe to say that your unit cost presently in inventory is -- we need to work through that inventory before we can see really any material change in gross margin?

Peter Leigh

I think the way to think about it is rather that anything that happens because of our 12- to 14-week lead time, we obviously have a delay. Any action that we take today that reduces cost does not actually affect gross margin for a quarter, but the fact that we’re telling you that we expect gross margin to improve in the current quarter should I think give you some confidence that the product costs in the pipeline are lower than they have been.

Doug Freedman - American Technology Research

And then, if we look at ASPs by marketplace, could you help us understand where you are seeing the price pressure and how the different marketplaces are developing from an ASP standpoint?

Ray Cisneros

You know, the ASP pressures as Peter mentioned are always present and obviously in the handset market, we probably see the strongest pressures there. On the other hand, as Peter has mentioned, our cost reduction efforts are going to be something we try to mitigate that issue, as well as the product mix because our product mix has migrated to a higher resolution. We have a favorable situation that garners a higher ASP.

On the other hand, the advanced business unit also bolsters up our position for total ASPs as a corporation goes, so overall I think it is a broad answer to your question, but it is also mixed conditions that answer your question.

Doug Freedman - American Technology Research

Lastly, the previous caller had a question regarding shortages in the marketplace. More specifically, are you seeing any shortages of component or back-end assembly capability that might be limiting supply in the market?

Peter Leigh

I don’t think so. We have been working very hard with our various suppliers for a number of quarters to make sure we have adequate capacity. We mentioned, for example, the investment in WLCSP in order to add a second source of CSP packaging. At this point, we believe that our back-end capacity will keep pace with the increase in demand.

Doug Freedman - American Technology Research

Terrific. Thank you and congratulations on seeing the turnaround.

Operator

As a reminder, please limit yourself to one question and one follow-up. Representing Longbow Research, the next question comes from Tayib Shah. Please proceed.

Tayib Shah - Longbow Research

Congratulations on the guidance. The guidance is impressive. If you can help us understand the $155 million to $165 million revenue guidance, how much of that is your underlying natural revenue run-rate and how much do you think is customers replenishing some of their inventories?

Ray Cisneros

I’m not sure I understand your question, but suffice it to say that the guidance is driven by a broad surge in our core customer base in the VGA handset market for entry level phones and that’s been very strong for us most recently.

Of course, the adder to that is the 2-megapixel position in OmniVision, how we were able to execute on our plan to release next-generation resolution sensors, and that’s backing into some very good position in the marketplace. These are the drivers for the guidance. I’m not sure if I touched upon answering your question specifically.

Tayib Shah - Longbow Research

I wanted to ask if a lot of the revenue strength is coming from customers replenishing their inventories.

Ray Cisneros

I would say it is a customer base that is a little bit of a mix of a current customer base that expands, and I would say it is a customer base that as we’ve executed on our business plan to win more design sockets that added to the revenue.

Peter Leigh

Let me just add, if I understand your question, I don’t think that in the evidence that we can see that the customers who are coming to us now with increased demand intend to put the sensors on the shelf. They are coming to us with increased demand because they have in turn increased demand for their products. They will ship them just as soon as they can incorporate them into their products.

Tayib Shah - Longbow Research

Can you guys help us understand our 2-megapixel traction? Maybe if you can give us the number of design wins you have in that space, that would help us understand your competitive position?

Peter Leigh

As I think you know, we do not talk about specific numbers of design wins and to be honest with you, I’m not sure that would help even if we were willing to talk about it because remember, in the end what drives the demand for our products is not only the number of design wins but how successful the individual products and particular manufacturers are with the products that have our sensors in them.

Tayib Shah - Longbow Research

Fair enough. Thank you.

Operator

With Jefferies, you have a question from the line of Adam Benjamin. Please proceed.

Adam Benjamin - Jefferies & Company

Thanks for taking my question. Just to follow up on the guidance here, can you quantify or give us a rough gauge as to how much of that is being driven by a unit increase or a mix shift?

Peter Leigh

It’s a combination of the two, Adam. We are seeing an increase in total volume, but as we said, it also reflects a very strong upsurge in the 2-megapixel component.

Adam Benjamin - Jefferies & Company

So on a blended ASP basis, Peter, could you see ASPs flattish on the quarter in July?

Peter Leigh

I think that’s within the realm of possibility, although I don’t want to go further than that because we don’t typically give guidance, forward-looking guidance on ASPs but directionally, the answer is yes.

Adam Benjamin - Jefferies & Company

And then, could you just give us a rough sense as to your margin profile for VGA, 1.3 and 2-megapixel without giving the specific numbers? Can you quantify roughly where those fit on a comparative basis?

Peter Leigh

Only directionally to say that in general, we get better margins the higher the resolution in the product, in part because I think it is more apparent to the customer that we have a superior product and secondly because there are fewer competitors in the higher resolution spaces.

Adam Benjamin - Jefferies & Company

Obviously it is higher -- is there a 2X multiple or is it -- can you put some gauge on that?

Peter Leigh

I’m sorry but I just can’t go beyond that and for the obvious reason that anything we see about margins on products will just cause Ray’s phone to light up from customers who think that they are paying too much for their products.

Adam Benjamin - Jefferies & Company

Last question on the op-ex side, op-ex came down significantly due to some commissions, I guess. I assume given the guidance you have given for July, that op-ex grows a fair amount on a sequential basis. I’m assuming we should -- should we be looking at that number as a number higher than the January quarter, given the fact that the April quarter was sort of an artificial base?

Peter Leigh

I’m not sure that’s necessarily the right way to look at it. Will it be higher in the first quarter? I think the answer is yes but I think that the point I made about selectively lowering commission rates, that’s a permanent change and so we will have the benefits of that on an ongoing basis. I think you will see SG&A growing sequentially from Q4 but clearly not growing anything like revenue is growing. The name of the game here, after all, long-term is to grow revenues and grow your gross profit faster than your operating expenses go up.

Adam Benjamin - Jefferies & Company

But all the efforts you are making on some of the R&D fronts, that does not cause an increase in the R&D side?

Peter Leigh

I think R&D could conceivably go back to closer to the third quarter level in the first quarter, but as I indicated the key variable in R&D is this line we call NRE -- non-recurring engineering costs for the masks for the designs that we release to the foundry and by its nature, R&D is uncertain. You can’t necessarily know precisely which week you are going to release the design. After all, the key in this is to release designs which are as fault-free as you can possibly make them and that is something that you cannot tie to a calendar.

Adam Benjamin - Jefferies & Company

Thanks a lot, guys.

Operator

Your next question comes from the line of Satya Chillara representing Pacific Growth Equities. Please proceed.

Satya Chillara - Pacific Growth Equities

Good afternoon, gentlemen. First question; can you guys talk about the demand if you look at the top five OEMs versus others, where is the demand coming from? Is that coming from China or from the top five, if you can give us some qualitative assessment there, please.

Ray Cisneros

I think overall, OmniVision has a pretty broad base now of customer mix that is driving our business. Overall, it is well-balanced and obviously with the higher resolution, without getting into specifics, you could gather who might be driving that and obviously it is probably the largest players.

On the other hand, the overall base of our VGA mix has been something of a legacy good business for OmniVision and that continues to grow.

Satya Chillara - Pacific Growth Equities

Second question; in terms of 3-megapixel and above, particularly for handsets, what kind of design activity is happening, or when do you expect design wins in this category, whether it is 3- or 5-megapixel design chips?

Ray Cisneros

Obviously in the script, as you heard from Mr. Hong, that our 1.75 pixel is now in full swing of activity. With this, we are looking at probably in 2008 as probably being the more material return on that investment in terms of revenue, and we are looking forward to that.

Satya Chillara - Pacific Growth Equities

Last question, for Shaw, wafer encoding: I don’t remember listening to wafer encoding commentary. Anything you can say, Shaw, in terms of where you are, what is the status there and design wins or anything?

Shaw Hong

In my script, I put it very clear. Wafer encoding, we have made some big progress and some solid potential customers to use this technology. That is something in my script I already iterated.

Peter Leigh

We do have design wins. We did say also that we have design wins for the True Focus products, so I’m sorry you missed it but it was right there.

Satya Chillara - Pacific Growth Equities

Okay, understood and in terms of average ASPs and when the production, any other tidbits there in terms of when the production would start on this chip?

Peter Leigh

Only to say that we expect this to produce revenues in 2008.

Satya Chillara - Pacific Growth Equities

Got it. Thank you, Peter.

Operator

Your next question comes from the line of Paul Coster representing JP Morgan. Please proceed.

Paul Coster - J.P. Morgan

Thanks. Peter, that’s fiscal year ’08, is that correct? Regarding wafer encoding?

Peter Leigh

No actually, it’s calendar. Thank you, Paul. It’s actually calendar. Just for the record, starts on January 1st and finishes on December 31st.

Paul Coster - J.P. Morgan

Got it. The guidance that you have issued suggest that your market share in the next quarter, just on the back of the envelope here, in the handset market is potentially north of 25%. Do you agree and how do you think the competitive dynamics are shaping up in the space at the moment?

Ray Cisneros

Historically, we’ve mentioned that our market share is anywhere between 25% to 30%. Obviously it depends on which third party reference report you are going to look at, but yes, given our guidance obviously there should be some juggling of the numbers. It is only until the numbers are set and done do we ever get a good feel of the total market share as that, the overall number, the total available market continues to grow as well.

But yes, we expect some favorable results.

Paul Coster - J.P. Morgan

How is the competitive landscape changing?

Ray Cisneros

The competitive landscape is -- I think what Peter indicated is a good point. At the higher resolutions, there’s less competitors therefore that’s definitely the prime target for OmniVision in all its strategies. The competitive environment for the lower end resolutions is somewhat populated. On the other hand, going forward this business is tough so -- but near-term, there is no change.

Paul Coster - J.P. Morgan

Last question -- should we be concerned at all that in order to drive profitability, the cutbacks at the op-ex level could do some lasting damage? I’m really sort of looking on a year-on-year basis, revenues are going to be up very significantly in this fiscal first quarter and yet your operating expenses as a percentage of revenues are down quite significantly. R&D in particular, is that something I should be worried about?

Peter Leigh

I honestly don’t think so, Paul. I think it is really a coincidence, albeit a happy coincidence that R&D happened to be down in this trough quarter but the two are really unrelated. I think I can speak confidently for all my colleagues here in saying that we are focused on the long-term success of this business and we will not sacrifice the long-term prospects for short-term financial performance.

Paul Coster - J.P. Morgan

Thank you.

Operator

From the line of Thomas Weisel Partners, with the next question we have Jason Pflaum. Please proceed.

Jason Pflaum - Thomas Weisel Partners

Good afternoon, guys. Most of my questions were answered but a couple of quick ones maybe for Peter. This past quarter, did you guys sell any of the high-cost inventory or was that mostly sold through in the January quarter?

Peter Leigh

We did still have some of the higher cost inventory to sell in the fourth quarter, Jason, and so that’s helpful. I think this is really part of the same question that I think Adam was asking earlier, which is of course that over time -- let me put it this way, that it takes time for lower costs to feed through into cost of sales because of the roughly one quarter it takes us to produce our products.

Jason Pflaum - Thomas Weisel Partners

Okay, but by and large that’s pretty much out of the mix at this point?

Peter Leigh

That is correct.

Jason Pflaum - Thomas Weisel Partners

As far as the guidance, maybe give a little more flavor as far as your backlog coverage relative to your guidance and how that may compare to prior quarters. I’m just trying to get a gauge on how strong the bookings trends have been.

Peter Leigh

We don’t typically talk a lot about backlog for the simple reason that backlog is not necessarily a very good indicator of the future of the business. Ray and his team produced this guidance based on specific customer orders and customer prospects and so it is a very robust process, in my view, and I think the fact that we have generally been able to deliver results very consistent with guidance is evidence of that.

Jason Pflaum - Thomas Weisel Partners

Okay, so you would characterize it as consistent with prior quarters as far as your level of visibility at this point?

Peter Leigh

Yes, generally speaking. Yes.

Jason Pflaum - Thomas Weisel Partners

Okay, last question just on the tax rate; what’s the best go-forward tax rate at this point? Is it still 22% to 25%?

Peter Leigh

I think the way to do this is that if you are looking at the non-GAAP earnings, the earnings excluding FAS-123R expense, I think you use a similar tax rate to the one we used in ’07. You can calculate that looking at the press release or you can call me afterwards.

Jason Pflaum - Thomas Weisel Partners

Okay, very well. Thanks, guys.

Operator

Representing Morgan Keegan, the next question comes from Harsh Kumar. Please proceed.

Harsh Kumar - Morgan Keegan

First of all, congratulations Shaw, Peter and Ray. A couple of questions; first of all, I’m trying to understand your guidance of 34%, roughly at the midpoint sequentially. I know the markets are not going that fast so I’m trying to figure out if you are taking share or what’s going on, if some killer applications you’ve gone into or some new handset models -- any light that you can shed, I would appreciate very much.

Ray Cisneros

Obviously we are very enthusiastic about our situation with the 2-megapixel. It sort of reflects our preparation and our execution in terms of product and technology, as we stress in our script. I think the results in our guidance reflect that.

In terms of market share, like in the previous question, it was similar to that, obviously there might be some good end results. We anticipate that in particular with the higher resolution segment. How does that pan out overall for OmniVision? Obviously we’ll have to wait and see when the final market shares are divided up, but we feel very good about this.

Harsh Kumar - Morgan Keegan

So are you suggesting that you might be doing market share in the higher end space, perhaps? That’s the only real explanation that I can think of why you would be outperforming the market significantly.

Ray Cisneros

It’s interesting. I should mention as well in the VGA space, as Peter has indicated, there was a slight increase in the VGA percent mix in Q4 and we see the same strong VGA position in Q1 as well. So we have a bi-fold surge here of 2-megapixel and VGA.

Harsh Kumar - Morgan Keegan

Okay, got it. That’s helpful. Another question on the same kind of line -- is there an additional cost because 2-megapixel is so new? Is there sort of frictional cost as you ramp 2-megapixel, or are you pretty much in a position where you can make them mass at corporate average or better?

Peter Leigh

2-megapixel sensors by definition cost more than VGA because you get fewer wafers but if your question is, is the production process mature and therefore is the cost under good control, the answer is yes.

Harsh Kumar - Morgan Keegan

Fair enough. That’s helpful. What I meant is gross margin as a percentage. And then -- I guess most of the other ones have been answered and I’ll just get back to you, Peter, after the call.

Operator

From the line of Needham & Company, your next question comes from Quinn Bolton. Please proceed.

Quinn Bolton - Needham & Company

Peter, I was just wondering if you could give a little bit more clarity. You gave quantitative guidance for July and then you said you felt optimistic about the remainder of the year. Does that mean you expect to see normal seasonality, or July and October are your stronger quarters? I’m just trying to get a sense how you are thinking about that October quarter, whether we would see typical seasonality, which I think implies growth October versus July, in a typical year.

Peter Leigh

As you know, we don’t give quantitative guidance beyond the first quarter, not because we are shy but because we don’t know. I think the best I can tell you is that from what we can see today, the remaining quarter in calendar ’07 will continue some of the trends we’ll seeing in Q1.

Quinn Bolton - Needham & Company

Okay, great and then just lastly, on the True Focus, now that you’ve got some design wins, have you set pricing in those designs and is there any more guidance you can give? I think you’ve said that the True Focus allows you to capture anywhere between $2.50 and $4 per module. Do you still feel comfortable with that range, that you are going to get that kind of a premium with the True Focus product?

Peter Leigh

We can’t discuss the specifics of the pricing beyond what we’ve already said but equally, as a benchmark, we still think that that’s a useful way of thinking about the issue.

Quinn Bolton - Needham & Company

Great. Thank you.

Operator

Our final question will come from the line of Daniel Gelbtuch representing CIBC. Please proceed.

Daniel Gelbtuch - CIBC World Markets

Congratulations on an excellent quarter and excellent guidance. I just wanted to ask about drilling a little deeper into the VGA business. What would you characterize the end market for that? Was that mostly China? Within that, what does the competitive environment look like and how critical is the fact that you guys are pretty much one of the only ones with CSP in that market? Where do you see your competitors on that front?

Ray Cisneros

No, I would not characterize it as only China business. Quite frankly, the VGA camera that is used in handsets is -- we’re talking about entry level handset cameras, so from that standpoint, where the handset ends up getting sold at the end of the day can vary. I could say that to bolster this kind of comment, obviously some of our business is in China but there’s quite a majority in ODM type, entry-level handset cameras that is becoming a growing trend in the handset business to channel the manufacturing and designs in that area.

Daniel Gelbtuch - CIBC World Markets

I would actually rephrase it -- is it mostly tier two as opposed to tier one, the top five?

Ray Cisneros

I can’t break it down that specifically, but I could tell you this; that it’s across the board with the growth in the handset using a VGA camera.

Daniel Gelbtuch - CIBC World Markets

As far as competition on the VGA front, are you seeing competitors with the CSP product? Is that something that we should be worried about going forward?

Ray Cisneros

I think OmniVision's investment in CSP, it’s pretty clear. Not only have we done it in the past but we continue to do our investment for CSP going forward in the future and it represents a very critical advantage OmniVision has. So far our competition is not there.

Daniel Gelbtuch - CIBC World Markets

As far as the 2-megapixel, is it safe to assume that that’s mostly tier one or is it mixed with let’s say, for example, tier two in China and some tier one as well?

Ray Cisneros

I can’t break it down in detail, but I can tell you that it’s all of the above.

Daniel Gelbtuch - CIBC World Markets

Thank you very much.

Operator

Ladies and gentlemen, this now concludes the question-and-answer session. At this time, I will turn the call over to Mr. Hong for closing remarks.

Shaw Hong

In closing, I want to reiterate our confidence in the ability of OmniVision to continue to be a market leader in advancing image sensing technology. We are well-positioned to introduce new and advanced products that meet the needs of our customers ahead of the competition.

We appreciate all of the work that every member of our team has done to contribute to our success and we thank you for participating in our call. We look forward to speaking with you next quarter. Goodbye.

Operator

Thank you for your participation in today’s conference. Ladies and gentlemen, this concludes the presentation. You may all disconnect and have a good day.

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Source: OmniVision F4Q07 (Qtr End 4/30/07) Earnings Call Transcript

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