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Tessera Technologies Inc. (NASDAQ:TSRA)

Q2 2007 Earnings Call

August 02, 2007, 4:30 PM ET

Executives

Moriah Shilton - IR

Bruce M. McWilliams - Chairman, President and CEO

Charles A. Webster - EVP and CFO

Analysts

Mehdi Hosseini - FBR

CJ Muse - Lehman Brothers

Brett Hodess - Merrill Lynch

Arnab Chanda - Deutsche Bank

Raj Seth - Cowen and Company

Jesse Pichel - Piper Jaffray

Raymond Rund - Shaker Investments

Daniel Myers - Crosslink Capital

Presentation

Operator

Welcome to the Tessera Second Quarter Conference Call. At this time all participants are in a listen-only mode. Following management's prepared remarks, we will hold a Q&A session. [Operator Instructions]

As a reminder this conference is being recorded August 2, 2007.

I would now like to turn the conference over to Moriah Shilton. Please go ahead, Ma'am.

Moriah Shilton - Investor Relations

Thank you, Laney, and good afternoon, everyone. Thank you for joining us for the Tessera Technologies second quarter 2007 results conference call. By now you should have received a copy of the press release. If you have not please contact Lippert Heilshorn and Associates at 415-433-3777 and we will forward a copy to you.

This call is being broadcast live over the Internet. A webcast replay will be available at www.Tessera.com for 90 days after the call. In addition, a telephone replay of this call will be made available for 48 hours, beginning approximately two hours after the conclusion of this call. To listen to the replay in the US please dial 800-642-1687 and internationally dial 706-645-9291. The access code is 614-2082.

I will now read a short Safe Harbor statement.

During the course of this conference call management may make projections of other forward-looking statements which are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause actual results to differ significantly from those projected.

Material factors that may cause results to differ from the statements made include delays, setbacks or losses relating to our intellectual property, litigations or any invalidation or limitation of our key patents; fluctuations in our operating results due to the timing of new royalties or due to legal costs; changes in patent laws, regulation or enforcement that might affect our ability to protect our intellectual property; the risk of a decline in demand for semiconductor products; value by the industry to adopt our technologies; competing technologies; the future expiration of our patents and our license agreements and the cessation of related royalty income; the failure or refusal of licensees to pay royalties; and failure to achieve the gross prospects and synergies expected from acquisition transactions.

You are cautioned not to place undue reliance on the forward-looking statements which speak only as of the date of this release. Tessera's filings with the Securities and Exchange Commission including its annual report on Form-10K for the year ended December 31, 2006, and its quarterly report on Form-10Q for the quarter ended March 31, 2007, include more information about factors that could affect the Company's financial results.

On the call today from management are Bruce McWilliams, Tessera's Chairman, President and Chief Executive Officer and Charlie Webster, Chief Financial Officer.

During this call today management will discuss certain non-GAAP financial measures for comparison purposes only and they will be using non-GAAP numbers in their prepared remarks. The non-GAAP amounts of cost of revenues, research and development, selling, general and administrative expenses, net income and earnings per share do not include three items... stock-based compensation, deal amortization charges and uncashed tax expense.

Tessera includes only actual cash taxes in its non-GAAP results because the Company does not currently pay federal or state income taxes and does not expect to until sometime in 2008.

Management believes the non-GAAP amounts provide a more meaningful comparison measure of quarter-over-quarter and year-over-year financial performance. Please refer to the Company's second quarter 2007 earnings press release and to the Company's web site for reconciliation of non-GAAP measures to GAAP.

After management's opening remarks, we will open the call to your questions. So that management is able to respond to as many of you as possible please restrict yourselves to an opening and a follow-on question. Please re-enter the queue if you have additional questions.

And with that, I would like to turn the call over to Bruce.

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Thank you, Moriah.

Financial results in new technology were on track in the second quarter and in line with our guidance. Total revenue for the second quarter were $46.7 million, up 92% over the second quarter of 2006. Royalties and license fees were $36.3 million up 86% year-over-year and 2% quarter-over-quarter. We are pleased with these results.

As many of you know we recognize royalties one quarter in arrears. As such our 2Q results were in large part a reflection of our customers' seasonally soft first quarter. Regardless we are able to post solid numbers and to sequentially grow our royalties revenue which speaks to the diversity and strength of our business.

In addition to our solid financial performance, in the second quarter we announced new technologies in both our packaging and interconnect and consumer optics groups. We are seeing significant interest in these new technologies and in July, we signed our first consumer optics license for wafer level camera optics.

Now I will discuss these developments in greater detail starting with a review of our packaging and interconnect business.

Although the memory industry experienced further price declines due to oversupply, unit volumes continued to climb in line with our expectations. The transition to DDR2 which is packaged in our CSP technology continues. DDR2 units now account for greater than 60% of the DRAM unit shipped in the second quarter. In the third and fourth quarters we expect moderation of DDR2 unit growth but strong year-over-year growth, driven by an ever greater memory requirements of the consumer electronic devices.

Long-term we believe Tessera CSP technology provides both higher performance and increasingly lower costs and will remain the industry's leading package solution for DDR3 and beyond.

In the wireless market, the industry experienced softening in the fourth quarter of 2006, which continued into the first quarter of 2007, driven by a combination of seasonality and a reduction in high-end sales. The industry's second quarter shipments improved somewhat and are expected to continue to grow modestly through the remainder of the year driven mainly by strength in emerging markets and replacement sales in mature markets.

For the full year 2007 over 1.1 billion handsets are expected to ship. We anticipate growing our position in this market in the future. On the technology development front in the second quarter we introduced the MicroPILR platform, a suite of next-generation packaging and interconnect technology. We believe the profile, pitch, performance and reliability attributes of this platform will enable us to extend our technology and market leadership position in the wireless and DRAM markets for years to come.

Several major IDMs and others are currently evaluating the package on package implementation of our MicroPILR platform. Specifically, the packaging of multiple high-density DRAM devices, as well as the stacking of logic plus memory devices within the same footprint. DRAM manufacturers are actively searching for high frequency DDR2 and DDR3 stacking solutions to meet industry's demand for greater memory capacity in computing devices.

A leading semiconductor manufacturer and its preferred high-volume subcontractor assembler are currently evaluating our technologies in the preproduction environment. Results from this evaluation are expected later this year.

In addition, major IDMs are evaluating our MicroPILR technology for stacked, mixed functionality types, specifically a baseband applications processor with memory. Using Tessera's MicroPILR technology, IDMs reduce the overall profile of the stacked assembly to less than 1.2 mm, which is an increasingly common profile requirement for mobile phone manufacturers.

We believe the valuations underway position us extremely well to capitalize on the integration of highly advanced, low-profile, mixed device packaged solutions. We believe this could enter production as early as the second half of 2008.

We continue to make progress on our enforcement action. In the Amkor arbitration we have completed fact discovery and have begun expert discovery. The arbitration panel recently adopted Judge Wilkins' prior rulings regarding claims construction from the TI and Samsung lawsuits. As you know both of these lawsuits resulted in favorable settlements for Tessera.

The arbitration hearing is now scheduled for March of 2008. In pace of the ITC action accelerated in July when it was reassigned to Judge Chernisky after the prior Judge retired. On July 11th Judge Cherinisky said the target date for the completion of our ITC action and issued the ground rules that cleared the path for discovery to start in earnest. Which it has.

Based on the target date set by Judge Chernisky we believe the trial is likely to take place in March of 2008, which is sooner than we could have expected a trial in the related California lawsuit. The ITC previously found our patents to be a paradigm shift in packaging technology.

While the US Patent Office agreed earlier this year to the defendant's requests for reexamination of the patents and litigation the Patent Office grants such request over 90% of the time. Again these patents are battle-tested. The ITC found Tessera's patents to be valid and infringed over some of the same arguments under consideration in the reexamination.

In June the defendants asked for a five-month stay of the ITC action while the re-exams proceed and we are still waiting for a ruling on this motion. However, historically, the ITC has very rarely ever granted a stay in view of the re-exam.

As we progress toward successful resolution of these legal matters, any licensing terms we might offer will become progressively less favorable to the licensee. And it is not clear that a license will be made available to every infringing company.

Now let's review the consumer optics business. In Q2, we announced OptiML wafer level camera technology. This technology makes it possible for cameras to be manufactured at the wafer level and significantly reduces the size and total cost of camera modules in mobile phone application.

Our wafer level camera technology has generated strong interest from the industry. In July, we signed our first license. This license is with Alps Electric, a $6 billion high-volume manufacturer based in Japan. Alps will manufacture lens modules from bonded wafers or sheets of lenses using the OptiML technology for customers ranging from camera module makers to image sensor manufacturers.

Potential customers can now package image sensors in our CSP or chip onboard wafer level packages. Next year they will be able to procure wafer level lens modules from Alps for direct bonding to image sensors, thereby achieving the key elements of a low-cost, low-profile camera module. We expect volume shipments of the OptiML wafer level camera using this technology to occur in the second half of 2008.

These events suggest we are in the advanced stage of development of a wafer level camera and have demonstrated functional VGA prototypes that have met the optical performance specifications of a Tier 1 camera module supplier. We are working with our manufacturing partners to finalize the manufacturing process to transfer by year end, after which we expect additional manufacturers of OptiML to come online.

This will enable us to penetrate and begin to capitalize on the growth of our initial target market, camera phones, which according to TSR is expected to grow to over one billion units by 2010.

OptiML Focus is our new technology which enables the whole image to be in focus at the same time with no moving parts. This replaces the need for autofocus. We have several leading companies in the supply chain interested in this technology. One of whom is a camera module manufacturer with whom we are in an advanced development stage of a 3 megapixel product, which should be integrated into a Tier 1 manufactured handset in the first half of 2008.

In addition, in the next year we plan to offer new features such as zoom and antishake in this platform.

In summary, our consumer optics business created in large part through the acquisitions of SHELLCASE, Digital Optics and Eyesquad has created a new product platform for Tessera that addresses the large and rapidly growing camera phone market. We are now generating great interest from leading OEMs and camera module manufacturers for this technology, and are in the process of actively building out the supply chain.

Overall we remain confident in our consumer optics business and that it will grow to be a substantial part of our revenue by 2010.

I would now like to turn the call over to Charlie for a review of the financials.

Charles A. Webster - Executive Vice President and Chief Financial Officer

Thank you, Bruce.

Before I go through detailed Q2 '07 results I'd like to advise you that starting next quarter, in line with the practices of many other public companies currently, Tessera will begin using the term non-GAAP instead of pro forma to discuss our operating expenses and profitability. And to remind you Tessera's non-GAAP results do not include stock-based compensation, deal amortization charges and non-cash tax expense. We include only actual cash taxes in our non-GAAP results because we do not currently pay Federal or state income taxes and do not expect to until sometime in 2008.

To help you better understand our results we have included a detail reconciliation between our GAAP and non-GAAP numbers in our earnings release and on our website.

As Bruce mentioned we're very pleased with our results in the second quarter of 2007. Revenues... in particular, our royalties and licenses... were right in line with our expectations. Operating expenses and profitability was slightly better than anticipated and cash flow was very strong during the period, all while making continued progress and expanding the business into new large volume end markets.

Let me now take you through the details. Total revenues were $46.7 million up 92% year-over-year, roughly flat sequentially and just above the midpoint of our guidance. Revenue included royalties and licenses of $36.3 million which increased 86% year-over-year and 2% quarter-over-quarter, again in line with guidance. And products and services revenue which was $10.4 million up approximately $1 million from the previous quarter.

Overall, growth in royalties and licenses this quarter met our expectations despite slower growth in the wireless industry and some softness in our funded R&D revenue, due to project timing. Offsetting this was continued strong unit growth in DRAM and very strong demand for our Micro optics lithography products.

Now let me briefly review our expenses during the second quarter. Total GAAP operating expenses were $32.2 million including stock-based compensation expense of $5.1 million and non-cash deal amortization of approximately $1.9 million. Subtracting these non-cash items, total non-GAAP expenses were $25.2 million in line with our guidance of between $25 million and $25.5 million.

On a non-GAAP basis, cost of revenue was $4.4 million, up approximately $700,000 from the first quarter on higher product revenues and slightly higher period costs on several government-funded R&D programs. Internal R&D was $7.0 million, down slightly from the first quarter.

I would like to highlight, however, that our R&D has more than doubled from the second quarter of 2006 and now represents roughly 15% of revenues. I would also like to point out that our total technical effort which is a combination of internal R&D plus cost of revenues attributable to government-funded R&D represents just above 20% of quarterly revenues and, again, illustrates our significant and increasing commitment to new technology development.

Non-GAAP SG&A was $9.3 million up just over $600,000 due partly to non-recurring marketing and advertising expenses. Litigation expense was $4.5 million which was lower than our guidance range of $5 million to $5.5 million as the Northern California action was stayed or paused temporarily in favor of the more recent ITC action.

Stock-based compensation was above guidance due to a change in variable accounting for certain stock option grants. The impact of this modification in accounting is to increase our stock compensation, starting in Q2 and continuing through year-end by a modest amount. There is no cash impact.

Interest income was $2.8 million, reflecting our strong cash balance during the period. Cash taxes were $2.5 million, in line with our guidance from last quarter, and higher that our ongoing cash tax rate of approximately $800,000 to $900,000 due to a onetime shift from Q1 to Q2 of international cash tax payments. GAAP taxes were $7.4 million or approximately 43%, also in line with our guidance. GAAP EPS was $0.20 and non-GAAP EPS was $0.45, both on a fully diluted weighted average share count of 49.0 million shares.

Cash flow from operations was $27 million or approximately 57% of revenue. Total cash flow was $32 million and at the end of the quarter we held $236 million in cash and short-term investments and no debt.

Now let me offer a few comments on our business outlook and provide guidance for the third quarter of 2007. The overall business environment remains favorable for Tessera; and we are optimistic about the key drivers of our longer-term growth. Near-term we expect DRAM unit growth to remain strong and believe that 2007 is likely to be another great year, with an approximate 40% increase in total DRAM units over 2006. The wireless industry's December '06 quarter and March '07 quarter, however, were softer due to a broader industry slowdown. We see modest signs of improvement for the remainder of this year.

So a much smaller portion of our revenues, lithography has slowed after a very strong period and the third quarter outlook is somewhat muted. In addition due principally to project funding cycles the third quarter outlook for funded R&D is slightly softer than earlier this year. We believe both of these dynamics are short-term in nature.

As a result Q3 '07 royalties and license fees should be in line with our expectations, up 7 to 10% quarter-over-quarter or between $39 million and $40 million. Products and services, however, are expected to be $8 million below our $9 million to $10 million quarterly run rate due to the conditions I just discussed. And as a result total revenue is targeted to be $47 million to $48 million for the quarter.

Please note that per Company policy these estimates do not include any revenues from licenses, settlements or royalties from the parties currently involved in our legal actions. We expect to see significant results from these efforts; but we do not feel it advisable to predict their timing or magnitude.

On a non-GAAP basis total expenses are targeted at $27 million to $27.5 million up roughly $2 million quarter-over-quarter due principally to higher litigation expense. Litigation expense is forecasted to be between $6 million and $6.5 million in the third quarter up from Q2 reflecting increased activity in both our ITC action and the Amkor arbitration. Both actions are moving at a faster pace than earlier in the year in anticipation of trials in the end of the first quarter of 2008. As you know, however, litigation expense is very difficult to predict and depends in large part on the other parties in our legal actions.

In the third quarter we expect stock-based compensation to be approximately $5 million and deal amortization charges to be roughly $1.9 million. Other income is projected to be $2.7 million and the Company's book tax rate is projected to be 43% of pretax profit. Cash taxes for our non-GAAP results are expected to be approximately $900,000 in the third quarter. Fully diluted shares are projected to be $49.5 million.

I would now like to turn the call back to Bruce.

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Thank you, Charlie.

In summary, we continue to be very optimistic about our future and the value we can bring to our customers and shareholders. In the next two years, we anticipate continued strong growth in our CSP business, driven by increased market penetration.

In addition, new product offerings such as MicroPILR enable us to maintain our leadership position in our core semiconductor markets while opening up new revenue-bearing opportunities for the Company long-term. Through the acquisitions of SHELLCASE, Digital Optics and Eyesquad, we have laid the foundation for our consumer optics business and created OptiML... a new product platform that addresses a large and rapidly growing camera market.

As discussed earlier, we are now actively building a supply chain required to support volume production in cameras utilizing our technology and are very pleased with our progress to date. We are confident that this will grow into a substantial business for the Company long-term. Furthermore, we believe we will be able to continue to scale and grow our business through our R&D efforts and acquisitions because our business model offers a compelling value proposition to the industry.

By funding the development of key infrastructure technologies that enable OEMs to deliver innovative products, Tessera improves our customers time-to-market, reduces our customers' development risks, lowers the industry's overall R&D expense and facilitates broad adoption by helping create the necessary infrastructure and lowering overall materials cost. We anticipate this value proposition will only continue grow and drive future growth for our company. I look forward to sharing with you our continued progress and success.

Thank you. I would now like to open the call for questions.

Question and Answer

Operator

[Operator Instructions]

Your first question comes from Mehdi Hosseini with FBR.

Mehdi Hosseini - FBR

Yes. Thanks for taking my questions. Two questions, first, for Bruce. You talked about a lot of the investments that you have made finally materializing and you talked about opportunities in different fronts, help us understand the kind of magnitude of these opportunities that you're working on? And I'm not asking for exact dollar amount of revenue contribution, but help us understand the size of the opportunities that could turn out to be pan out?

And number two question has to do with -- it seems like your business model has changed slightly especially given your exposure to litho market. And I see you're actually building up some inventories over the past couple of quarters. Is that trend going to continue going forward, and to that extent, how are you going to manage that compared to a year ago where inventory was non-existing?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Okay. Well, let me talk about the size of the opportunity for cameras. The camera -- most phones already have cameras in them, and as I've mentioned, this is going to be a big unit market just in mobile handsets. There are other markets that we think are technology applies to like automotive and security. But right now we're focusing on design wins in the mobile phone market.

Now, here we add much more value than just a package. We add complete solution for the optics, the assembly as well as the package for the image sensor. So because of that we believe we'll be able to get a much higher royalty per unit. So even though we're in a market with CST with 10 billion units, because this is a much higher royalty, it can contribute substantially to our business.

Now, in addition to just that we also started to introduce our technologies that enable effectively autofocus with this new technology we're calling optimal focus. And again, that commands a good royalty per handset.

Now, there we're entering in the market where you have higher resolution in initially 3 megapixel, because that's where people need autofocus and zoom-type solutions. But overtime, those will become the dominant types of cameras you'll find in phones. Together those two plays we believe will end up being a substantial part of our business. And more important, our long-term vision is to provide more and more technologies in the handset; and we really think we're just in the beginning of being able to do that with cameras and chip packages. And we see this as a great opportunity and, historically, what gets adopted in the handsets then propagates to the whole consumer electronics industry.

Mehdi Hosseini - FBR

That's great. And I kind of understand the total size of the market but as you have the largest agreement with Alps and as you move forward to penetrate these markets, how should we think about the steps taken to penetrate these markets?

Obviously from our end we are trying to determine the incremental revenue that would come in over the next one or two years. So help us understand the kind of step that is going to be taken to penetrate these new markets?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Well, we're not giving near-term guidance but we have said that we think this will add $100 million of revenue to the company by 2010 time frame. We still believe that to be the case. Generally large OEMs don't suddenly risk their whole product line with a new product plus the infrastructure is not all in place. So at best you could get some kind of a linear ramp.

We in our Optimal Focus technology as I mentioned at Tier 1 OEM has said that they are going to put this technology into a handset. We can't disclose who that is. We are... we've been engaged for several months now with one of their key suppliers of cameras.

So we are pretty confident that is going to happen. VGA is how we are initially entering the mobile phone market there. They want a very low-cost camera for emerging markets. But once that is proven out in the supply chain, we think this will ramp to 2 megapixel and other cameras; and we are very pleased that we now have parts that meet the full spec required to get into those.

Mehdi Hosseini - FBR

So should we expect the next announcement to be actually a type of paying customer that by some time in '08 we would begin to see a material impact? Is that how we should think about it? The next licensing agreement will actually be the beginning of many agreements?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Generally all of our licensing agreements are agreements that they will pay us a royalty.

Mehdi Hosseini - FBR

Yes I'm talking about a sizable royalty that actually would get you to $100 million.

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes. We think we're on the path to do that with the sorts of contracts we are in the process or we are negotiating our half.

Charles A. Webster - Executive Vice President and Chief Financial Officer

I think we'll see more licensees. There will be actual dollars that are not going to be as significant as the royalties. As we've said I think quite consistently we see those royalties starting to ramp in the second half of '08 and become really material in '09. So I think the developments with Alps is very encouraging. It's validating the path that we're on.

But beyond that we can't give you specifics on dollars.

Now if I could I would like to comment quickly on your other question about inventories and the litho business. The Digital Optics acquisition has been just wonderfully successful for us. That business, the people we've acquired and made part of the Tessera team are just doing great things.

And the business has continued to grow even though it's not our core focus. The core focus is to take the core technology and efficient into technology licensing away for level camera. But the litho business in Q2 hit all-time highs and has been very strong.

Now on the inventory... inventory today is about 1.6 million. That's roughly flat with the prior quarter. Remember, we are selling very, very sophisticated defractive optical elements in the center of this business and the actual cost of goods sold in the inventory there are really quite modest. So I don't think that's a major concern as we progress.

Mehdi Hosseini - FBR

Are you keeping your year-end guidance intact? Has that changed or has that remained the same?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Yes. Thanks for that question. Let me just first refresh. What we got for 2007 was total revenues of $193 million to $198 million and royalties and license fees up 55%. Now as we speak to you today, we feel comfortable with our range of $193 million to $198 million and confident that our royalties and license fees will achieve a very impressive 55% '07 over '06 growth.

As I mentioned with respect to Q3, products and services particularly in litho will be a little bit lighter in the third quarter. Again we are optimistic that that picks up in the fourth and, again, all of these numbers contain no upsides for settlements. And obviously we are active on a variety of fronts there.

Mehdi Hosseini - FBR

Great. Thank you.

Operator

Our next question comes from CJ Muse with Lehman Brothers.

CJ Muse - Lehman Brothers

Couple of questions here. First off on the gross margin it looks like it gets around 200 bips and clearly I guess maybe the litho set grew a little bit. But I wouldn't imagine that would explain the whole difference. So could you help me out with that?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Sure. Cost of revenues was up slightly period over period. And the reasons were, first, we had slightly different mix in the litho business with slightly higher cost of goods sold; and second we had slightly higher cost of revenues associated... I mentioned in my script... with several of our government funded R&D projects. Those I would describe as from quarter to quarter fluctuations and no particular long-term impact.

CJ Muse - Lehman Brothers

And then I guess I can squeeze in two quick follow-ups. First off on service revenue that's dipping in September. What is your outlook for December and then beyond in 2008 as to whether the run rate in the first half of '07 is sustainable? And then second question, in terms of other income I know there was an FX uplift in Q1. Did that happen in Q2 and is that number sustainable?

Charles A. Webster - Executive Vice President and Chief Financial Officer

So on the first question I think we're not prepared to guide for Q4 in 2008. As we have said in the past, the products and services business is a nice complement both to R&D and to the core activities of our wafer optics program. And there's no particular change to that. So I think broadly we would expect over time to see the run rate return.

On other income there was an FX benefit in Q1. There was a very small FX benefit again in Q2. And the key issue for us is our cash balance continues to grow. As I mentioned in my comments we are up $32 million in cash. Our operating cash flow 58% of revenues which is obviously a great result. And we're getting good returns on the cash balance.

CJ Muse - Lehman Brothers

Excellent. Thank you.

Charles A. Webster - Executive Vice President and Chief Financial Officer

Thanks.

Operator

Your next question comes from Brett Hodess with Merrill Lynch.

Brett Hodess - Merrill Lynch

Hi. Good afternoon. Bruce, I was wondering if you could talk a little bit about timing of when a cellphone maker would actually announce a license to put in a full optical camera solution from you guys, given that you can now buy all the parts.

You can get the image center and the SHELLCASE packaging with Alps coming up over time you can get the lenses. If you could hazard a guess on when we might see something like that from a handset maker?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes our discussions with the supply chains... actually the licenses will probably be with the camera makers, the image sensor makers, and the infrastructure guys... not directly with the OEMs. But we are in position and we are getting indications that the optimal focus that will be in the first half of the year and we are busy working on the infrastructure; and we believe late second quarter really third quarter is when you'll start to see this stuff in the handsets.

And even though technology is now working and in spec, it's just simply things like equipment lead times of six months and you know you have to qualify this stuff. But people very much want these kind of products in their handsets; and it's just a question of how quickly we can ramp it and our estimate is, realistically, it's a second half '08 event.

Brett Hodess - Merrill Lynch

And what steps does... now that a customer could buy the lens and get the image sensor in a package and whatnot, what steps do they have to go through to set up a production line to make these things together and get ready to put them on a circuit board? Is it... how long does that take for a new assembler, let's say, to put into place?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes, well, there are three elements to the technology. One is the packaging of the image center. That infrastructure does exist. We need more capacity of it but that's essentially the SHELLCASE technology.

The fabrication of the stacks of glass with the lenses on it that in the wafer form, that's what we are busy ramping with Alps and we believe also there will be another such supplier coming along in a bit here.

Then the third element is actually an attachment of that and that's relatively standard equipment, and doesn't require too much different infrastructure than people already have in place.

The big step is the optics and generally getting more capacity so that you can truly support the hundreds of millions of units that you need to really service this market.

Brett Hodess - Merrill Lynch

And the second question I had has to do with litigation Bruce. And Charlie? If you look at these two suits essentially going to court next March, in the past typically once you get to trial it's a couple of weeks and then there's a waiting period after that for decisions.

But would you think that litigation expense might decline in the few quarters after that, assuming that you don't launch another suit against another infringer? Or how should we think about litigation once we get past that March period?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

I would... historically it's always declined dramatically after we conclude a litigation and then if we had another one and it takes a while to ramp. So I think that's a relatively good assumption.

Brett Hodess - Merrill Lynch

Great. Thank you.

Operator

Your next question comes from Arnab Chanda with Deutsche Bank.

Arnab Chanda - Deutsche Bank

Thank you. A question for Charlie and maybe another one for Bruce. Charlie, if you look at the expense increase which is about a couple of million. You decide $1 million is litigation. What's the other side? And can you tell me that qualitatively it would be ongoing?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Sure. Just to clarify. So from Q2 to Q3 '07, if you take the midpoint of guidance we are going from $25.2 million total expenses in Q2 to $27.2 million in Q3. $2 million of that delta is litigation which is going from $4.5 million to $6.25 million at the midpoint.

So the principal increase as in 85% is litigation. Again, associated with the faster pace of activities today. A small additional increment is associated with R&D and, specifically, more activity on the wafer level camera program.

Arnab Chanda - Deutsche Bank

Question for Bruce. Couple of sort of high level questions. First of all if you look at your unexplored opportunity in semiconductor packaging and principally, seems to me, it's sort of high pin count and then low pin count. I think you have taken care of the medium pin count. Can you talk a little bit about whether MicroPILR helps you address any of those two opportunities and if so, in what time frame?

Then last question about the wafer level camera. What time frame should we start to see royalty revenues? Would it be 2008 or a little bit beyond that point?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes, let me answer the second one first. So wafer level camera again we think you'll see royalty to start to become... to start to contribute in some significant way in the second half of next year and then ramp from there on out as we think it is the technology that the industry will change to because of its cost and size advantage. So the second half of next year.

And the other question we actually believe there is a good chance that a variant of MicroPILR technology can address the high pin count market where... we're investigating that making prototypes. But we won't really know until we get some customer products qualified and work those issues, but we are optimistic that it moves us into new markets that we are not in today and can increase our overall opportunity.

Arnab Chanda - Deutsche Bank

Bruce, just one follow-up to that. What time frame should we know that one way or the other? Would that be this year or next year or what's your anticipation on that?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes. I think midpoint next year we should know that... the amount of the high pin count market that that can address. I think early next year we should know the size of its affect and things like mobile handsets for package on package.

Arnab Chanda - Deutsche Bank

Thank you, Charlie. Thanks, Bruce.

Operator

Your next question comes from Raj Seth with Cowen and Company.

Raj Seth - Cowen and Company

Hi. Thanks. Just a couple. Bruce, just to follow on Brett's Q&A as the supply chain around this optics business is building from now forward, what role do you play? And is there any implication for the service business?

Is there increased service content helping these guys get the infrastructure up or do you just show the product and its third parties that do this all?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

You know our initial partnerships are very close partnerships with our people working in their facility and vice versa. As we flesh out all the issues for high-volume, high yield manufacturing process, in a lot of sense it's a partnership. Then what this enables us to do this as we bring on the rest of the industry, I think there'll be a much greater opportunity for actually service contracts as you are saying to generate revenue.

And this increase is our value proposition to our customers since we can really help accelerate their getting into production. So I think you're going to see more service-related revenue in '08 of the type you are talking about. But it's really too early for us to guide on that.

Raj Seth - Cowen and Company

But you'll get paid for the service associated with getting the infrastructure up. It's not something you... that's a prerequisite for the industry that you effectively have to give it away?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

We believe we will get paid for a portion of that starting next year.

Raj Seth - Cowen and Company

Charlie, can you tell me are there any high-volume breakpoints in any of the DRAM contracts which are coming up? I know there were some breakpoints at lower volumes. Are there any at very high volumes that are approaching?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Well, if I understand the question right it points in a pretty specific direction. And we are bound by some customer confidentiality contracts in all of these engagements not to provide and then it's Company policy not to provide specific details.

But broadly, I can say that some of our customers have received preferential pricing that takes into account a whole number of different factors that include volumes. I will also tell you that preferential pricing has been provided very rarely in our history and, in general, only to customers who are first movers. As we have signaled consistently, customers who take us to the considerable expense and trouble of litigation as we defend our IP will definitely continue to get worse deals.

I hope that helps you if it did get all the way there.

Raj Seth - Cowen and Company

Last one. Forgive me if you mentioned this. Any update on when you might hope to hear back from the ITC about whether or not they are going to stay that case for the patent review?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

We don't have a window on that. We expect it in the near future, but can't say any more than that.

Raj Seth - Cowen and Company

But weeks, months?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

We think it's week time frame.

Raj Seth - Cowen and Company

Weeks?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Sure.

Raj Seth - Cowen and Company

Thanks.

Operator

Your next question comes from Jesse Pichel with Piper Jaffray.

Jesse Pichel - Piper Jaffray

Hi. Given your comments on... and answers to Brett's questions should we assume that legal expense increases again in Q4 and then again in Q1 '08?

Charles A. Webster - Executive Vice President and Chief Financial Officer

You know what we said when we started the year was that we expected litigation in the range of $22 million to $25 million. Obviously as we are ticking through the year, we are under that spend rate with the midpoint of the guidance in Q3 we are around 15 1/2. So we feel pretty comfortable about our litigation guidance range; and I'm not in a position now to guide Q4.

Certainly as activities increase spend can increase, but again overall against our guidance range, we feel very comfortable.

Jesse Pichel - Piper Jaffray

Then what about the other items of OpEx? You backed your revenue guidance for the year on your legal line. What about the other items?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Is the question how --.

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Are you updating any of your full year guidance for OpEx?

Charles A. Webster - Executive Vice President and Chief Financial Officer

I just would say in aggregate we feel comfortable with the range. If litigation came in a little bit lighter we might be a little bit lighter on the range for the full year, but again it's a little early to say.

Jesse Pichel - Piper Jaffray

The funded R&D line has always been lumpy and I guess we haven't seen the lithography business through Digital Optics yet. Can these businesses come back in Q4?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Yes.

Jesse Pichel - Piper Jaffray

Million dollar range?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Yes, they definitely can and you're right. These are not as predictable businesses but they are relatively low margin and we do them for strategic purposes. But, yes, it is their nature and particularly in that we don't aggressively try to develop this business. We in fact do the reversed. We are very strategic about what types of businesses we take to make sure they are not diversions.

I think it will remain a lumpy element of our business, but small and not have profound effects on our current…

Jesse Pichel - Piper Jaffray

On an $8 million service business per quarter, can you just give us some color on what the breakout is for funded R&D versus lithography versus rough estimates…

Charles A. Webster - Executive Vice President and Chief Financial Officer

What we have said is it is roughly 50-50. A touch 60-40 over the last couple of quarters since Digital Optics has been so strong in the litho side.

Jesse Pichel - Piper Jaffray

And I would like to just probe on some more color on the legal front. Bruce are you in mandatory mediation there with Amkor? And under the ITC case as well?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

We are not really in a position to discuss specifics. I can say that we have ongoing discussions with a number of the players. Actually I feel good about where things are at, but we don't really discuss ever anything specific about negotiations.

Jesse Pichel - Piper Jaffray

And I must have missed it. When was the Markman's hearing under Wilkins?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Well, Judge Wilkins --.

Jesse Pichel - Piper Jaffray

Under the arbitration case.

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes, Judge Wilkins was the Judge in both the TI and the Samsung case and --.

Jesse Pichel - Piper Jaffray

When did that become the same Markman result as under the arbitration case?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

In the Samsung... I mean in the Amkor case? I don't remember the exact date. Do you, Charlie?

Charles A. Webster - Executive Vice President and Chief Financial Officer

It was two quarters ago or more. I can't --.

Jesse Pichel - Piper Jaffray

Okay. I guess that's it for me. Thanks very much.

Operator

Your next question comes from Ray Rund with Shaker Investments.

Raymond Rund - Shaker Investments

Thank you. I was just looking for some more understanding or clarification, I guess, on the litigation expenses that you guided for the year and I got a little bit lost when you're talking about them coming down following the close of litigation. Was that scheduled for probably second quarter of next year?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes, Charlie, why don't you discuss that?

Charles A. Webster - Executive Vice President and Chief Financial Officer

I think what Bruce mentioned was that historically and certainly in 2006 we had seen an increase in litigations in the periods leading up to the trial and a somewhat large decrease in litigation immediately after. For the simple reason that the activity slows down.

What we can't say today and certainly don't mean to be guiding for 2008 litigation is what exactly the timing will be and the proceedings and whether or not there are appeals. There are a variety of different factors that obviously we will take into account when we guide for 2008 but that's a few months off.

Raymond Rund - Shaker Investments

Is it prudent do you think to expect that Q4 and Q1 of 2008... I mean Q4 of 2007 and Q1 of 2008 will probably see sequential increases in your litigation expenses?

Charles A. Webster - Executive Vice President and Chief Financial Officer

Not necessarily. Again, I guess we would reiterate that our annual guidance for '07 still feels good. $22 million to $25 million in total litigation expenses for the year. It could be at the lower end of that that obviously we are going to do everything that we can and need to do to defend our IT.

And we have been extremely successful in the past and expect to be again. Going into '08 again we are just not prepared to comment right now.

Raymond Rund - Shaker Investments

Thank you very much.

Operator

Your next question comes from Mehdi Hosseini with FBR.

Mehdi Hosseini - FBR

Thank you. Bruce, I want to go back to my earlier question and ask the same question a different way. I see your technology offering especially in the integrated camera module as disruptive in nature. You are basically coming in and providing a solution that would say if the customer end customer 50% of the total cost.

So having that as a background has the customer already decided to implement the new way of building this module infrastructure in place and it's just a matter of determining when the ramp is going to happen? Or are they still evaluating the benefits of these destructive technologies?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Well, different OEMs are different places. Some of these OEMs have showed this type of technology is on their roadmap. But again they must be conservative in that they have to see product qualified in sufficient multiple sources. Well we are confident all this stuff is going to come online, but they're not going to firmly commit to issue purchase orders and whatnot until all the little steps have gone through.

We feel very good about where we are and in this and we get lots of assurances and --

Charles A. Webster - Executive Vice President and Chief Financial Officer

And I think the fact that a company like Alps... a relatively conservative company, a $6 billion company... making the capital investments and doing this speaks volumes to the industry's desire for this sort of thing. We can't comment specifically on the people we are working with, but probably your best way to approach it is to talk directly with the OEMs and the other people out there in the supply chain and get firsthand their opinions.

Mehdi Hosseini - FBR

So what happens to the vendors or technology suppliers that are currently have exposure to the way things have been built?

Charles A. Webster - Executive Vice President and Chief Financial Officer

That's the beauty of our model. If we were a manufacturing company, we would be a competitor, but we are really a friend in the channel here in that, now the first movers are going to do better, but we license to all people in the channel.

So we will be there to enable them with the new technology and the nice thing about it is those guys already have a lot to the capital needed already in terms of testing equipment and dealing with [inaudible] centers and so forth. So they can move into it relatively quickly. And we feel we will be in a good position to support everybody in the channel next year.

Mehdi Hosseini - FBR

Thanks.

Operator

Your next question comes from Dan Myers with Crosslink Capital.

Daniel Myers - Crosslink Capital

Bruce, I think in your prepared remarks you talked about MicroPILR being a technology that would be applicable in baseband and maybe combining baseband and memory together. First of all, a question... did I hear that correct?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes.

Daniel Myers - Crosslink Capital

Could you just elaborate on that a little bit?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes people really like stacked chips. 3-D packaging, because you know allow smaller footprint and actually in a lot of ways reduces the overall cost because you don't need as complicated of a printed wiring board underneath it to interconnect everything and shaves off additional cost. But these big packages have their problems in particular, things like drop test and so forth.

And our tests with device makers show our technology is superior in that respect, but the other more important thing is in the connections going up and down vertically, MicroPILR enables a much finer pitch. So we can route more signals vertically than the other technologies and that's very attractive proposition for a high pin count card like the baseband processor that needs to interface with a memory.

So we are getting very strong interest and again a lot like wafer level camera. This stuff can't happen immediately because we have to work to build out the supply chain. But we are in sort of preproduction stages and demonstrating the technology and, then, it will be the stage of getting the infrastructure put in place. And we are optimistic that you will start to see these kinds of products in the second half of next year.

Daniel Myers - Crosslink Capital

And could you just talk about the impact to royalty... if someone switches from using existing technology to MicroPILR. Is it neutral, is it negative, is it positive?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

I'm sorry. The question is... ?

Daniel Myers - Crosslink Capital

The impact to royalty, the impact to revenue. If we look at them say that they are using your baseband currently... .

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Yes, there are two things. One is that we have an additional channel for royalty through the materials segment that we license people that make the substrate. So that's incremental.

However it's really a replacement on the packaging side of the existing stuff, but that is also important that we get the industry to move over to newer technology. So we are in a very good position to renew our licenses in the next decade as they come up for expiration sort of started in 2012 and beyond.

Daniel Myers - Crosslink Capital

So overall is it incremental?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

It's incremental overall.

Daniel Myers - Crosslink Capital

And could you give us just, roughly, figure of merit if existing technology is 1, would this be 1.05, is it 1.2? Is it 1.5 --?

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

You know, I don't have it.

Charles A. Webster - Executive Vice President and Chief Financial Officer

Are you asking of the aggregate market or are you asking about the cents per chip?

Daniel Myers - Crosslink Capital

Either way that you want to look at it.

Charles A. Webster - Executive Vice President and Chief Financial Officer

There are really two things here. If we are successful penetrating other markets with it... which we have some reason to believe we may be... then it's very substantial. It opens up a new market. If it is just the incremental revenue from the substrate, the material side... yes I think that's more a 1.2 or 1.4 of that.

But I actually have a... it really depends a lot on the chip type and I would have to look across the product mix to a different number for stack DRAM and for baseband. And I guess I am just not prepared to give you a number. I hadn't thought of it that way.

Daniel Myers - Crosslink Capital

Thank you very much and thank you for the clarification on that.

Operator

Our next question comes from Kathryn Burdorik [ph] with AG Edwards. Kathryn, you may go ahead.

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Moriah, I think we have time for one more question. Hello?

Operator

That is all the time we have today for questions. Please proceed with your presentation or any closing remarks.

Bruce M. McWilliams - Chairman, President and Chief Executive Officer

Well, thank you very much for attending our call and I will look forward to updating you guys next quarter. Thanks.

Operator

Ladies and gentlemen, that concludes our conference call for today. We thank you for your participation and ask that you please disconnect your lines.

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