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Here’s the entire text of the Q&A from AU Optronics’ (ticker: AUO) Q3 2005 conference call. The prepared remarks are here. 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.

Q&A

Operator

Operator Instructions And your first questions comes from CJ Muse from Lehman Brothers. You may go ahead.

Q - CJ Muse

Yes, good evening. I was hoping you could comment on what your expectations are for undersupply/oversupply in the first half of 2006?

A - Hui Hsiung3

Yes, this Hui Hsiung answering your question. For the first half, we believe there is an about 5% over-capacity. For the second half, it's almost balanced at the end. However, I must caution that I think the 5% over-capacity actually is very manageable, and also it did not take into account a possibility of a material shortage or a slower ramp-up for the new capacity.

Q - CJ Muse

Okay, and what kind of oversupply do you think is healthy?

A - Hui Hsiung

I think generally speaking we say if it's within 3% it's, we call it, balanced. So, this is slightly above that level, but I don't say though it's, I mean, 5%, a single digit, a mid-single digit, our business is usually quite management. If it's double digit, then it's harder to manage. Usually 5%, there's various actions we can take such as slightly reduce the capacity loading or shift the product mix. And also, I think this amount of over capacity actually is, on the average, industrial-wide. But I think individual companies may see somewhat different capacities on the demand and supply. For example, I believe for next year, because of the expected high growth, LCD TV demand, I think the company who are, for example, are top five companies who are pretty much occupying about 95% of the LCD market today, I think will see less a problem than the second tier of companies. So, this, I think, will see some parity among different panel suppliers.

Q - CJ Muse

Okay, if I could just follow-up with one last question. Can you comment on what the average LCD TV size was in the third quarter, and what your expectations are for the fourth quarter and then into 2006? Thank you.

A - Hui Hsiung

I don't have that number on hand, but I can tell you we're seeing a pretty dramatic shift, up-shift, of panel sizes for LCD TV. For the fourth quarter, what we call large size LCD TVs, 30 inch or larger, and this will be over 40% of the total LCD TV market, and I think this trend will continue into next year.

By the end of next year, we think this large size percentage will be over 60%. So, in terms of panel sizes, this year we are seeing 32 inch become mainstream. May be that will become the largest contribution for the TV demand. And next year, 32 continue to dominate, and together with 37 Gen 6 lines coming up. So, I think some 40/42 inch are emerging, but really the '07 40 inch above, maybe a larger amount. But I think next year predominantly still 32 to 37 inch.

Operator

And your next question comes from Mr. Hash, from Peterman. You may go ahead.

Q - Mr. Hash

Thank you. Congratulations on a very strong number. My first question was, I think clearly you continue this Company's like yours continue to add to your capacity. At the same time, your demand peaks in the current month for maybe 15 days from now, because the end product has to be in the game channel by the last month of the year. In this scenario where demand is going to peak very soon, supply continues to build, when, if any, will management consider lowering utilization rates at their fabs and reducing supply?

A - Hui Hsiung

Okay, this is Hui Hsiung trying to answer your question. Yes, what you're saying is the results to holiday seasons, transition of PC products, yes, usually it peaks at November and the second half of December is start to reduce. But however, for the past two years actually it has been up. It happened for some products, such as LCD monitor. So, although LCD monitors growth start slowing down given the saturation of this segment of the market, but we think this will be picked up by LCD TV. We do expect a high growth of LCD TV. So, from Q4 to Q1 we actually do not expect a big drop in LCD TV demand. Some area, such as in Asia market, even in U.S. market we are likely to see the momentum continue into Q1.

Usually PC products does see some change, a downward change in the beginning of the year. But, again, that we have already taken into account by saying that next year, the first half, with some slight over-capacity. I think it's still too early to say whether PC will see a big drop. We probably see now notebook still continue have pretty strong momentum, and this is driven by low cost notebook desk top computer, I think that another interesting thing is with the upward shift of the LCD TV size. This is not only LCD TV actually, Monitor also shift up in size, together with Notebook. So, we actually do not expect a very big drop in Q1 demand in terms of total area.

Q - Mr. Hash

Thank you. And just in case demand turns out to be a bit weaker than you anticipated, it's a hypothetical question, but if that happens, would you look to reduce utilization rate as one of the leaders from protecting the profitability? And if you, go ahead

A - Hui Hsiung

Yes, definitely. I think our policy, our strategy, has always been minimizing our inventory and that turned out to be quite successful in past few years by keeping the inventory lower. And I think in the past we did have some problem convincing our competitors doing the same thing. But in recent months, especially this year, actually, it did start to happen. I think that the industry understand the benefit of keeping the capacity low. Again, even if the scenario does happen that we have a 5% over capacity this is not the drastic action to reduce about 5% of the loading. And this, coupled with the fact that many of the product cost structure is some 80% are actually material costs. So, fixed costs at 20% if you reduced the 5%, even 10%, loading, that impact on cost is actually, not very big. So, we think the industry become more mature. That is precisely what our competitors would do.

Q - Mr. Hash

Okay, and one just last question. Is it correct that the TFT panel industry currently is offering price protection clauses on their contracts with their customers? That is, the price ha decline going into the month of December, then the lowered prices will be effective with a retrospective effect?

A - Hui Hsiung

Not a common practice among the industry. I think usually some of the second tier may offer individually this kind of policy. But, in general, we don't do that, and it's actually not necessary. Again, I think the best practice is to reduce loading and minimize the inventory, because even you produce inventory and you keep the inventory at a customer's house and providing price attaching. It's the same thing. The inventory loss is occurring nonetheless. So, we don't do that and I know many of our competitors don't do that.

Operator

And your next question comes from Matthew Smith from CIBC. You may go ahead.

Q - Matthew Smith

Good evening, gentlemen. Some of your competitors, LG Phillips and Samsung specifically, seem to be pointing to some pockets of excess inventory in monitor panels in the channel during the September quarter. I wondered what you were seeing and what your expectations were for monitor panel ASPs and profitability on those applications through the fourth quarter and into the first quarter of next year? Thank you.

A - Hui Hsiung

Yes, I think I did hear individual cases of where there are some inventory. But I don't think it's widespread. I think before this conference actually we had a check in the channels of some of the customers and we found actually the inventory level is by and large healthy. And actually this is no surprise. Since last year, Q3 was a very bad situation when at the demand suddenly dropped and the inventory was very high. So many customers actually get hurt by that period. So actually since then, the whole supply chain become much more conservative in terms of keeping the inventory, and that practice has been carried out throughout this year. So far, we saw quite reasonable inventory throughout the pipeline. So, the evaluation is a quite isolated case we found. Also, perhaps, to mention that this Q3/Q4, it seems to me that some areas, relatively consumer segments still pretty strong and some still developing markets, China, Russia, that area, I think that monitor demand is pretty strong. Even some channels, even in Europe they saw pretty strong demand in monitor. I think U.S. somewhat lower, but still the description we get is this is expected within the expectations. Or they don't see a very weak monitor demand actually.

Q - Matthew Smith

Thank you. And your expectations for gross margin from here. Do you anticipate sequential improvement in 4Q, and do you think that is sustainable through the first half of next year, given your expectations for this supply and demand balance? Thanks.

A - Max Cheng

Okay, this is Max Cheng answering your question. Yes, we do see enough. There's some possibility to see the gross margin improvement in Q4 due to we have chance to move some products to our premium segment. So, there's some chance. And also because the Gen 6 also which could lower our cost across TV and other PC satisfied application. Going to next year, I would say, at this moment, it would be very difficult to give you any forecast at this moment. Thank you.

Operator

And your next question comes from Ivan Gull. You may go ahead.

Q - Ivan Gull

Hi, good evening, thank you very much for taking my questions. I have a number of them. The first one is, earlier you talked about market being in oversupply by 5% in the first half of next year, and you talked about the potential for shortage of materials. Can you perhaps share and give your assessment of what materials you think could be in shortage by first half of 2006?

A - Hui Hsiung

Actually, I didn't say 5 to 10%. I actually say 5% for first half. That's pretty precise. Second half is balanced, okay. The material shortage is CPS lamps are especially long lamp that for large size TV. And also even some notebook, white form notebook, such as 15.4 inch require longer lamp that we are seeing some shortage. Also some pre-omperization film and material. We found the capacity extension from supply side may not catch up with the growth in panel capacity. So that we may see some gap for the first half as well as second half of next year.

Q - Ivan Gull

And my second question is can you talk a bit about what kind of cost down assets on the material side you might be able to achieve in Q4? I know you talked a bit about Gen 6 ramp up having an impact on your margins in Q4, but what about cost down efforts from the materials point of view?

A - HB Chen

This is HB speaking. Generally, from the TV segment, we can see more room for this cost reduction. But for this monitor segment and the notebook segments, actually the room has become bad. But overall, for TV here, because of some new design models, plus some new material in production and so on, we can see more room. But overall, in Q4 we still can have some indicative improvement on this bits of material of maybe 1-2%. And on the other hand, very important here is our Gen 6 ramping up getting even larger. More input with a higher addition ready in Gen 6, and plus our new Gen fab. So, it's actually, I believe the contribution from there even more than is purely material reduction.

Q - Ivan Gull

Thank you, and I have a final question. Can you comment on the margin differential between the notebook, monitor and TV segment for you in the third quarter, and maybe talk a bit about how you expect those margin differentials to change one or two quarters in the future?

A - Max Cheng

Okay, this is Max Cheng. I’m very sorry, because we do not provide our segment report at this moment. So, we do not have this kind of information. Overall, actually, by end of Q3, all the products we have actually provided very good margins in general. So, we don't see any deficiency in our files by any specific part at this moment.

Operator

And your next question comes from Frank Yuan from Morgan Stanley. You may go ahead, sir.

Q - Frank Yuan

Good evening. Okay, my first question was along with the, can you talk about maybe your income, your possibility whether LCD monitor notebook in small business size?

A - Max Cheng

Frank, could you say it again, your question?

Q - Frank Yuan

Sure. Yes, the first question is talking your rank, your profitability by product group, LCD TV, monitor, notebook in small medium size.

A - Julie Chen

Frank, I think we just answered that question earlier. We cannot provide segment information. So, unfortunately we do not have that kind of data. However, Mr. Chen just commented that at end of third quarter, August product group, seemed to have pretty good performance the day of, you know that.

Q - Frank Yuan

Okay, a follow-up. Yes, a follow-up to that, I guess, on the Gen 6 fab, in terms of cost, can you tell me when on a per area basis, that the LCD TV cost will be very comparable or lower than the LCD monitor in the Gen 6 fab?

A - Max Cheng

Frank, this is within that particularly in our classified area sizes. So, I'm sorry I couldn't provide you that kind of information. But, again, TV has big room to improve size and HP and Dr. Hui Hsiung just mentioned several times. Because you know TV edges first, and we just try to ramp out Gen 6 with bigger scales. So, I believe in our 32 and 37 will be very competitive in the coming quarter and in next year. I believe we won't see any big problem to achieve a bigger room of cost up for TV panel.

Q - Frank Yuan

And because currently there's a shortage of 33 inch and 37 inch. When do you expect to meet the demand fully in the next couple of months?

A - Max Cheng

I would say, it's still maybe hard to say, because even there's a lot of new capacity is coming on line fast. A spike in production as you mentioned. Maybe there's just a few company who could support the market with good quality products. So, it's hard to say at this moment. Even the new competitors however, it may not be easy. It's a tight situation in short period of time.

A - Hui Hsiung

Maybe I'd like comment this. The TV, especially the large size TV, if you're talking about the branded customers, top 10 brands are actually, and their qualification process is actually quite long. So, I think beyond top five players I think you're talking about now they qualify for next year, I think the contribution won't be very large. Also, I think now there is already a technology gap amongst first tier and the second tier. So, pretty much, this is a market I mean, this year it’s 35% occupied by these five players, and I think next year I do also believe very high I mean around 90% still. I'm talking of branded customers. So, as a result, new capacity even there, maybe second tier, the new capacity that is still difficult to compete into the TV market. Also, responding to your earlier comment, you worried about the profitability of TV product. I think and even new generation, Gen 6, we achieved sufficient yield to render it profitable. So, that's actually not only 32 inch. 37 inch we already start to mass produce a lot much. So, we do expect this will contribute to profitability throughout next year.

Q - Frank Yuan

My last question, may I please, a minimum packing implementation next year of 10%, what do you expect AU Optronics effective tax rate to change in 2006?

A - Hui Hsiung

For the text Frank I do believe the little bit maybe, limit amount in year ‘06 due to which we enjoyed the tax incentive in Taiwan. So, I don't think that will become a major portion in our income statement for next year.

Operator

And your next question comes from Nick Teal from Macquarie Security. You may go ahead.

Q - Nick Teal

Hi, good evening everybody, a couple of questions. The first one is maybe for Dr. Hsiung. Regarding the transition from 17 inch monitors to 19 inch monitors, I think that was one of the expectations for this year. And, from my impression, is that it doesn't seem to be very strong, and I was wondering if you can comment on maybe for monitor demand for next year, if you do expect more 19 inch and perhaps even 20 and 21 inch LCD monitors to become more popular? And my second question is perhaps for Max, it's regarding operating expenses. It looks like the SG&A expenses in the third quarter almost doubled for the second quarter. I was wondering what the factors are for that one, as well as maybe some guidance for the operating expenses into the fourth quarter? Thanks a lot.

A - Hui Hsiung

Thank you. I’ll answer the first question. Indeed, in terms of monitor, I think we're still seeing gradual shifting up of the percentage from 17 inch to 19 inch. That is ongoing. But I think, as you mentioned, next year the overall monitor market, the growth will reduce from past around 40% annual growth to some 20 some per cent annually. But, however, have a stronger presence in the 20 top inch wide format monitor. This is a kind of new driver and it's occupied both a high end as well as a transition from for example, 20 inch wide, this is actually transition from 19 inch, 4 by 3. So, it's almost the same category. And this we believe will have some volume next year. So, we try to be early mover in the wide format monitor market. Automatically, this 20 plus inch market and usually it's a higher FT a well. It takes for example, it's very efficient in Gen 6. So, we actually have some percentage of Gen 6 capacity dedicated to large size monitors, especially wide monitor.

A - Max Cheng

Okay, this is Max. I'm trying to answer your second question. Well, there's a couple of reason. Was the higher operating expenses in Q3. The first reason was our Gen 5 ramp up in Q3, which we put into in SG&A under our accounting policy. So, that will be one of the reasons. The other one will be there's a lot of expenses just top line related. For this reason, you will see the amount is probably higher than in terms of absolute amounts.

Going to Q4 I believe that the expenses will be, in terms of percentage, it could be around 5 to 6%. Okay, it could be across to 5.0 to 5.5%, if I'm not mistaken, going to Q4. I guess they’ll still be in this kind of range.

Q - Nick Teal

That's great. Thank you Dr. Hsiung and Max.

Operator

And your next question comes from Chung Ho Ong from SG Asset Management. You may go ahead.

Q - Chung Ho Ong

Hi, just got a short question. Can you give us an update on your 7.5 G plans, and how do you plan to fund it?

A - Hui Hsiung

That's my understanding. Well, the schedule for Gen 7.5 will be scheduled to move in those equipment in Q2 of '06, and then test one in Q3, and then hopefully start to ramp up our mass production in Q4, year 2006. The funding, actually it's been pretty much fully funded already because at this moment we still have a long term bank facility, about NT$85b. So actually we still have room to withdraw those syndication loans under current covenants of our terms with those banks. So, I guess for those CapEx, we do not have any problems for next year.

Q - Chung Ho Ong

Right, so there's actually no change in the ramping up schedules for 7.5. Is it possible to actually bring it forward one or two quarters?

A - Hui Hsiung

You mean, push pull or go ahead?

Q - Chung Ho Ong

Bring it forward, yes. Is it possible?

A - Max Cheng

Bring it forward?

A - Hui Hsiung

This is impossible because of the equipment lead time.

Q - Chung Ho Ong

Right, right. So, the earliest is 4Q for ramp up.

A - Hui Hsiung

Yes.

Q - Chung Ho Ong

Alright, thanks. Thank you.

Operator

Operator Instructions And your next question comes from Ash Fish from Tigermann. You may go ahead.

Q - Ash Fish

Thank you. It seems that clearly from hearing all of you that you do believe in a relative sense monitor demand growth eventually, it will slowdown, because penetration already is quite high. But you believe a world supply will be quite limited because even demand will be quite strong. Now, could you throw some color on your expectations for ASP TV demand for 2005 and in 2006?

A - Hui Hsiung

Yes, the 2005, the TV set demand now looks like is around 20m sets. And 2006, the TV set demand, we believe, is quite likely is in the 70%, 80% range. So, 75%. So, I think mainly people grew versus in the neighborhood of 35m sets. That's for next year TV set demand. However, that is not equivalent to panel demand. Usually, TV still, from the past experience, TV still have a roughly quarter pipeline inventory like, in other words, 2005, the set demand is 20m, but panel demand around 25m. Accordingly, 2006 the set demand is 35m, and panel demand is around 44m. And this has usually caused some confusion, but systematically we check. We found empirically it does happen and it's longer, also the majority of the shipment is by sea shipment. So, the majority in transit a long lead time. As well, a longer channel lead time. And I think another point I'd like to make is not only the volume growth, but the size growth. For example, Q4 this year and our large size above 40%, and this is pretty much the industrial large size, around 40% some this larger than like 30 inch, and this trend was going up to, by the end of Q4 next year, we believe will be over 60%. So that is, by itself, it's a very significant growth in capacity requirement.

Q - Ash Fish

Yes, and how much do you think is the monitor inventory in the channel? You know, when you speak with your customers and they're having some discussion particularly on the 19 inch? So, could you comment?

A - Hui Hsiung

Yes, it's a good question. The 15 inch, we think, is shorter. Is probably 2, 3 weeks. And the 19 inch is probably four weeks, some six weeks. And this is still considered as normal for what we talk to. So, anywhere between two weeks to six weeks.

Operator

And at this time, your next question comes from Jenny Sash from OU Optix. You may go ahead. Hello Jenny, your line is open.

Q - Helen Hope

Hello, hi. This is Helen Hope from Goldman Sachs. You mentioned in the afternoon that there is no change to the 6G, 7.5G ramp up plan, and the CapEx project increase is simply change of timing on payments, your equipment suppliers. Can you help me understand, why you want to pay your equipment suppliers earlier? I would assume you have pretty good negotiation power, and would still really like to pay later rather than earlier? And then, the second question I have is that how much flexibility do you have in terms of the '06 CapEx? Any chance you could still adjust or postpone your spending for second half '06?

A - Max Cheng

Helen, this is Max. I'll try to answer your first question. Actually, you know, because all the time we do not exactly understand what kind of a schedule for those equipments from our equipment vendor side. So, it's very difficult for us, for financial department, to forecast a very precise number at the beginning of this year. So, all the time we will give you a range of our CapEx in a year. Also, you know, for 2006 we are saying NT$70b to NT$80b. That is the range. At the minute we pay our vendor earlier for that purpose. So, that is the reason, not because we pay them very early, which is not the case.

Q - Helen Hope

And then for '06 CapEx, do you still have some flexibility in terms of adjustments? For instance, can you adjust your, say, second half '06 spending without incurring any penalty by your suppliers?

A - Max Cheng

You mean flexibility to change our schedule?

Q - Helen Hope

Yes, linked, assuming at some point, the first half next year, you decide to spend less in the second half of '06. Is that possible to make that adjustment?

A - HB Chen

Yes. This is HB speaking. I think as I mentioned very clearly this afternoon, we are looking for this long term, more long term plan, and not make any decision change just because one quarter, or two quarters over supply or whatever, okay. We just keep our plan, keep on going, okay. There's not any reason to have some adjustments.

A - Max Cheng

That's the first part. I'd just like to add some comment. Again, the over capacity is over all industry, but for AUO actually, just based on our current customers, both TV and Monitor, actually considering the normal growth of customer demand, we are already very tight for first half. So, at least at this point we don't see any reason we should slowdown our capacity ramp up for the Gen 6.

Operator

Operator Instructions You have a question from Helen Wong from Goldman Sachs. You may go ahead. Helen your line is open.

Julie Chen, Senior Manager of Finance

Operator, I think we can close our session for today. Thank you.

Operator

Okay, ladies and gentlemen, this closes the question and answer session. Now, I'll turn it back over to the management for closing comments.

Hui Hsiung, Executive VP

Yes, I think today's conference I think is quite clear. But we hope you understand all the papers in Q3 and the Q4 outlook, and we try to manage very well in next coming years. Thank you very much.

Julie Chen, Senior Manager of Finance

Thank you for participating tonight, and I hope we talk to you in our next quarter results conference. Thank you. Good night and good day.

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