Here’s the entire text of the prepared remarks from Linear Technology's (ticker: LLTC) Q3 2005 conference call. The Q&A is in a separate article. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Paul Coghlan, Linear Technology – CFO
Hello, good morning. Welcome to the Linear Technology Conference Call. I'm here today with Lothar Maier, our CEO, and with Dave Bell, our President. I will give you a brief overview of our recently completed first quarter and then address the current business climate. We will then open up the conference call for questions to be directed at Lothar, Dave or myself. I trust you've all seen copies of our press release, which was published last night.
[Standard disclaimer omitted]
The financial statements for the just completed September quarter contain the effects of FAS 123 R., stock based compensation. This long discussed and anticipated accounting pronouncement is a requirement for companies beginning with those whose new fiscal year commences after June 30, 2005. Linear is one of these companies and consequently is one of the first public companies required to report its financial results employing FAS 123 R under Generally Accepted Accounting Principals, or GAAP. The majority of companies and most of Linear's competitors will not be required to report under FAS 123 R until later in the year. Because of this discrepancy in timing and because the effects of FAS 123 R are not yet well understood most investors have requested that we report pro forma as well as GAAP financial results. Indeed most of the earnings estimates published on Linear estimate proforma and not GAAP earnings.
In our press release, we have attempted to demonstrate the differences between our results with stock based compensation included and with it excluded. Essentially the impact on Linear's earnings was $9,270,000 after tax, or 9%, or $0.04 at the EPS level, $0.35 on a proforma basis versus $0.31 on a GAAP basis. As you are aware FAS 123 R requires companies to estimate the value of stock options using the Black-Scholes or other option valuation techniques. These require estimates to be made of stock price volatility, option longevity and employee termination rates. During the past five years the market price of Linear stock options at the Data Grant has varied from a low of $23 to a high of $55. The Black-Scholes valuation of these options granted has range from a low of $10 to a high of $25. These estimated values have been used in determining the charge to our income statement for this quarter.
FAS 123 R has also impacted the number of shares used in the determination of diluted shares outstanding. On a GAAP or FAS 123 R basis, we have 2,511,000 more diluted shares included in the calculation of diluted shares outstanding than would have been calculated under prior accounting regulations. In addition FAS 123 R has an impact on our balance sheet and will have an impact on our cash flow statement. The most obvious impact on the balance sheet is an increase in inventory value. To the extent stock based compensation is granted to employees in manufacturing, i.e. cost of goods sold, these costs are required to be first capitalized in inventory and subsequently passed through the income statement when the products are sold. Other balance sheet accounts affected are the deferred tax asset and equity accounts. Each of these accounts will increase as stock based compensation is amortized. Subsequently these amounts will be impacted when estimated deferred tax assets are compared with actual if any realized benefits.
This is all great stuff if you are an accounting theoretician. However on a broad scale stock compensation accounting however flawed, does give investor in general since of comparable value between and among companies for the stock distributed to employees. We continue to strongly believe employee ownership is essential to motivate outstanding performance. Managing it to the benefit of both shareholders and employees is our job. As I said earlier, the percentage impact on earnings for the quarter was roughly 9%. Our return on sales with this estimated charge was 39%. Whereas, before the charge our return on sales was 42%. Both are very respectable returns neither of which we believe we would have reached without employee ownership.
Aside from stock option accounting, I would now like to focus on how the business performed in the September quarter. For the September quarter sales were essentially flat with the June quarter. GAAP EPS of $0.31 was down $0.03 from the $0.34 reported in June largely due to stock based compensation as I discussed above. The business trends that influence future financial results particularly bookings improved from the previous quarter. For the first time in several quarters we had positive book-to-bill ratio. Gross profit and operating margins decreased modestly. Again, largely due to the effects of stock based compensation. And also due to increases in engineering and sales head counts. These increases were partially offset by an increase in interest income. Finally the tax rate increase from 30% last year to 30.5% for this year.
GAAP return on sales was 38.7%. Pro forma return on sales was 42.4%. GAAP earnings per share of $0.31 decreased from the prior quarter and $0.02 from the similar quarter last year. Pro forma EPS of $0.35 increased $0.01 from the prior quarter and $0.02 from the similar quarter last year. Diluted shares outstanding increased 1.86 million. FAS 123 R had an effect of 2,511,000, which means had stock compensation accounting not been implemented, diluted shares actually would have decreased by 651,000. During the quarter the company's cash and short term investments increased by $43.6 million, net of spending $64.5 million to purchase 1,656,000 shares of common stock. The company also declared a cash dividend of $0.10 per share for the quarter. In conclusion business sales and profits were essentially unchanged from the prior quarter. On the other hand, bookings were strong our highest level in a long time. Most in markets improved with particular strength in high-end consumer. Our ending on hand inventory at distributors is lean. Cancellations are still small. And lead times have remained unchanged at four to six weeks. We continue to have an excellent business model and are therefore able to remain both highly profitable and cash flow positive. Accordingly we achieved strong financial performance in various generally regarded financial indices.
I have already discussed our return on sales. Our return on equity was 20% and our return on assets was 17%. When you take cash and short-term investments out of these two calculations, our net return on equity was 189% and our return on operating assets was 80%. We have no debt and our current ratio was 9.2 to one. Cash and short-term investments now total 1,835,000,000, an increase of $43.6 million over the previous quarter. Cash and short-term investments represent 90% of stockholders equity. Looking ahead to the December quarter, customers generally continue to be cautious and order to supply the true end demand and not build inventory. However in this environment we are pleased with our bookings momentum. Consequently, we expect sales to increase and to grow in a range more in line with our historical December quarter patterns, roughly 3% to 4% this current quarter.
Now I would like to address the quarter’s results on a line-by-line basis. First I would like to start with bookings. As I stated earlier our bookings increased over the previous quarter, cancellations were minor and we had a positive book-to-bill ratio. Geographically bookings increased both domestically and internationally. However, more of the increase was due to business created in the USA. Internationally, bookings were up in Japan and the rest of Asia and down slightly in Europe, which is typical for a summer quarter. At this time every quarter we give you a break down of our bookings percentages by end markets to give you insight into those markets that drive our business. Since this is the first quarter of our new fiscal year, we have taken the opportunity to update our end market categories. We have added certain hand-held electronics devices to our high-end consumer area that were previously reported in computer.
As I stated in my opening comments, most end markets improved with particular strength in high-end consumer. Communications continues to be our largest area and represents approximately 32% of our business, down from 33% estimated last quarter but up in absolute dollars. For us the three significant areas within communications are cell phone handsets, cell phone and telecom infrastructure and networking. Cell phone handsets decreased from 9% of sales to 8% of sales. However, it did not change much in absolute dollars. Cell phone and telecom infrastructure at 11% of our business is unchanged from last quarter but up in absolute dollars. Networking remained at roughly 13% of our business, again up in absolute dollars.
Our second largest business area is industrial, which was 31% of our business, down from 32% last quarter but again up in absolute dollars. Industrial has a cross section of many customers in many markets. For the September quarter, computer represented 14% of our business, down from 17% last quarter, although two of the three-percentage point decline was due to a re class to high-end consumer. High-end consumer was the strongest area within the quarter growing from a revised 10% last quarter to 14% this quarter. MP3 player activity, satellite radio and hand-held GPS receivers, among other consumer products contributed to the gain in this area. Automotive at 6% of our business and space level products at 3% of our business were similar percentages but up in absolute dollars from last quarter.
In summary many products and functions migrate within computer, high-end consumer and cell phones. These three categories encompass 36% of our business, up from 34% in the prior quarter. Moving from bookings to sales, as I said earlier, sales sequentially were similar from quarter to quarter while growing 1% from the similar quarter in the prior year. Geographically sales were basically unchanged between domestic and international in total. Within international, Europe was down, which is typical for a summer quarter and Asia was up due to increased consumer products. In the USA, OEM and distribution were also mostly unchanged quarter to quarter. In summary, the USA was 28% of sales, Europe 16%, down from 18% last quarter, Japan remained at 14%, and rest of world, primarily Asia Pacific, was 42%, up from 39% last quarter. Note that 51% of our sales were created in the USA of which 23% were shipped overseas.
Moving to margins. Gross margin. Gross margin was 78.1%. This impressive number validates our strategy of selling unique, high performance analog semi-conductors into a broad customer base. Gross margin decreased eight-tenths of a point from last quarter. Stock option accounting contributed to this change as did slight changes in product mix and factory efficiencies. ASPs increased slightly during the quarter to $1.55 from $1.54 in the previous quarter.
R&D. R&D increased as a percent of sales from 12.6% last quarter to 14.8% this quarter, while increasing $5.4 million in absolute dollars. Stock option accounting constituted 4 million of this increase. The remaining 1.4 million increase was largely due to labor increases particularly for headcount additions in the circuit design area. This was a particularly productive quarter for us in hiring in a circuit design area, as the hiring of talented engineers ultimately determines our sales growth. SG&A. Selling, general and administrative costs also increased, going from 10.9% last quarter to 12.2% this quarter, an increase of 3.3 million. Stock option accounting was 3.1 million of this increase. Other increases in labor were largely offset by a decrease in legal costs as certain legal cases settled prior to trial on terms favorable to the Company.
Operating income decreased by 8.652 million, of which 7.1 million is due to stock option accounting as discussed above. Nevertheless, operating income is still a very impressive 51.2% f sale. Interest income increased by 1.8 million, largely due to the increase in the average rate of interest earned from 2.16% last quarter to 2.41% this quarter, due to the continuing increases in the Fed funds rate. Our effective income tax rate increased to 30.5% for this fiscal year from 30% last fiscal year. This increase is due to a minor decrease in our offshore tax benefits. Nevertheless major tax savings items continue to be the benefits from our tax holidays overseas, our tax-exempt interest income, our foreign sales tax benefits and our R&D credit. The resulting net income of 99.181 million is a decrease of 6.866 million from the previous quarter.
An earnings per share of $0.31 is a decrease of $0.03. The average shares outstanding used in the calculation of EPS increased 1,86 million during the quarter. All of these changes in net income, EPS and shares outstanding were largely due to the accounting for stock based compensation. On a pro forma basis before stock based compensation net income would have been 108.451 million EPS $0.35 per share, and diluted shares outstanding would have decreased by 651,000 shares. Moving to the balance sheet. Cash and short-term investments increased by 43.6 million, net of 64.5 million spent to purchase 1.656 million shares of common stock this quarter. Our cash and short term invest balance is 1.835 billion and represents 79% of total assets and 90% of stockholders equity. Accounts receivable of $120.9 million is a decrease of $5 million from the previous quarter. Our day’s sales in accounts receivable were basically unchanged at 44 days versus 45 days that we reported last quarter. This decrease in receivables is due largely to the increase in sales in Asia and the decrease in sales in Europe that I referred to earlier. Asia generally has shorter payment terms and therefore our accounts receivable balance would be lower.
Inventory at $37.181 million increased 2.9 million from $34.328 million reported last quarter. $1.2 million of this increase is due to the implementation of stock option accounting that I referred to above. The other $1.5 million increase is in anticipation of improving sales in the December quarter, particularly in the consumer based products area. Our inventory turns of 6.3 X compares with 6.4 X last quarter.
Deferred taxes and other current assets increased 6 million from the June quarter. 4 million of the increase relates to deferred taxes on stock option accounting. The remaining 2 million is primarily an increase in interest receivable on our investments. Our property, plant and equipment increased by 5.504 million. As we had additions of $15.867 million, and depreciation of $10.363 million. Our additions were primarily for our expansion projects at both our fabrication plants and also for tests and assembly equipment to increase back end capacity for growing sales. Other assets totaled $52.1 million, and decreased by $5.8 million. They consist primarily of intangible assets relating to technology agreements, which are amortized over their contractual period primarily ten years using a straight-line method of amortization. There was also a reduction in long-term deferred taxes resulting from the exercise of restricted stock.
Moving to the liability side of the balance sheet, accounts payable increased 4.8 million due to payables for capital equipment purchases. Accrued income taxes, payroll and other accrued liabilities increased by 12.3 million. The largest items here are our profit sharing accrual and our income taxes payable. We pay out profit sharing twice a year, so our accrual increases in the second and fourth quarters and decreases in the first and third quarters when payments are made. The decrease in the profit sharing accrual was offset by an increase in income taxes payable since we had no estimated income tax payments due in Q1 and we will have two due in Q2. Deferred income on shipments into distribution decreased by 812,000. We shipped less to distribution this quarter than they shipped out to their end customers and this resulted in the modest decrease in deferred income. Our accounting on shipments to U.S. distribution is conservative. We do not record a sale nor income in our results of operations until the distributor ships the product out to its end customer. We continue to closely control our inventory distribution to properly position the inventory without any un-needed build up.
Deferred tax and other long-term liabilities remain largely unchanged. Changes in stockholder equity accounts were primarily the result of the usual quarterly transactions for net income, dividends paid and employee stock activity. In addition this quarter there was an increase in common stock for the quarterly calculation of stock based compensation under FAS 123 R. Looking forward, historically the December quarter shows an improvement over the September quarter, and we expect this trend to repeat this year. There are general macro economic concerns in the marketplace. Continuing high levels of oil pricing and rising interest rates have raised some concerns on the impact these will have on consumer spending. Customers in many end markets are generally cautious and therefore tend to order just the current demand.
Nevertheless, our bookings improved last quarter and we had a positive book-to-bill ratio for the first time in several quarters. Our turns requirements, i.e. business that needs to book and ship within the quarter has improved a bit, but at 60% it's still at the high-end of our historical patterns. Our lead times are four to six weeks, which can easily support this level of turns as we have often done in the past. We are well positioned in certain high-end consumer based customers that are leaders in their field and that have positive business opportunities in their December quarter. Consequently we are forecasting the December quarter to be representative of our historical pattern and for sales to grow in the 3 to 5, in the 3 to 4% range. With respect to profits. The impact of stock option accounting will be relatively similar to this quarter. Consequently profits should roughly track sales, and therefore we are also forecasting an increase for profits in the three to 4% range similar to sales. We have told that you we have been adding to our infrastructure. We have basically completed the new building at our Singapore test location and also completing our projects to add capacity to our wafer fabrication plans in Camas, Washington and Milpitas, California. These projects are important as we expect to need the capacity.
We sell into many diverse in markets that are rich in analog circuit tree, either to manage power in portable products or to sense real world electronic signals and then convert them from analog to a digital format for easy storage and transmission. We supply high performance analog solutions that are key to the functioning of most electronic systems. Our linear or analog parts have a symbiotic relationship with digital circuits in a world that is becoming more electronic. Our circuits reside in a broad cross section of end products whether they are in industrial applications, communications applications or consumer electronics. In each of these areas we often have circumstances in the latest generation ends products such as computing and communicating devices, cell phones capable of multi-media access and transmission, security monitoring devices, power over ethernet industrial applications, the latest GPS systems in new model cars and high-end consumer products such as digital still cameras and MP3 players.
Earlier this week we announced a new family of module projects. These new micro modules represent a significant business opportunity and are expected to bring considerable revenues in the next several years. In summary we are in a strong segment of the electronics marketplace, namely high performance [INAUDIBLE]. We met our projection for the September quarter and our projecting to grow in the September quarter to be in line with our historical patterns. Finally for all of you that are stockholders please read the annual report and proxies prior to our November 2 annual meeting. A key proposal is to add shares to our employee stock option plan that is Proposal Number Two. In light of our performance on the stock option reporting, I believe this proposal needs your support. Please vote accordingly or call us if you have any concerns.
I would now like to open up the conference call for questions to be addressed to either Lothar, Dave or myself.