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National Semiconductor Corporation (NSM) F1Q08 Earnings Call September 6, 2007 4:30 PM ET

Executives

Long Ly - Investor Relations Manager

Brian Halla - Chairman, Chief Executive Officer

Lewis Chew - Chief Financial Officer

Don Macleod - President, Chief Operating Officer

Analysts

Chris Danely – JP Morgan

Ross Seymour - Deutsche Bank

Louis Gerhardy - Morgan Stanley

John Pitzer - Credit Suisse

Simona Jakowski - Goldman Sachs

Krishna Shankar - JMP Securities

Craig Hettenbach - Wachovia Securities

Romit Shah - Lehman Brothers

Sumit Dhanda - Banc of America

Steve Smigie - Raymond James

Presentation

Operator

I would like to welcome everyone to the first quarter fiscal year 2008 earnings conference call. (Operator Instructions) At this time it is my pleasure to turn our conference over to Mr. Long Ly, Investor Relations Manager. Sir, you may begin.

Long Ly

Thank you. I would like to again welcome everyone to National Semiconductor’s call today. Joining me are Brian Halla, Chairman and Chief Executive Officer; Lewis Chew, Chief Financial Officer; and Don Macleod, President and Chief Operating Officer.

The purpose of today’s call is to discuss National Semiconductor’s first quarter fiscal 2008 results which ended on August 26, 2007. As a reminder, today’s call will contain forward-looking statements and projections that involve risks and uncertainties that could cause actual results to differ materially. You should review the Safe Harbor statement contained in the press release published today as well as our most recent SEC filing for a complete description of those risks and uncertainties.

Also in compliance with SEC Regulation FD, this call is open to all and is being broadcast live over our investor relations website. For those of you who have missed the press release or would like a replay of the call you can find it on National’s IR website at www.national.com.

I would like to inform everyone of two upcoming events. National’s shareholders’ meeting will be held in Santa Clara on Friday, September 28 at 10 am Pacific time. We will have the formal annual meeting of stockholders followed by a brief presentation to review the company’s progress and financial results. We will also have an analyst meeting at the American Conference Center in New York on Wednesday, October 3 at 10 am Eastern time. The focus of the New York analyst meeting will be on National’s product portfolio and business strategy. Please visit National’s IR website for more information on these events.

In today’s call, I will provide a recap of the first quarter financial results; Brian Halla will give an overview of the business environment and an update on the company’s focus and priorities going forward; Lewis Chew will expand on the first quarter results and provide and outlook for the second quarter of fiscal year 2008; Don Macleod will then discuss our products and business in more detail. We will then take questions until approximately 2:30 pm Pacific time.

The first quarter results were as follows: sales were $471.5 million, up 3.4% from $455.9 million in Q4 fiscal year 2007 and down 13% from $541.4 million in last year’s first quarter. Gross margins were a record 63% in Q1, up from 62.5% in the prior quarter and 61.7% in last year’s first quarter. Operating expenses in the first quarter were $169.3 million. Net interest expense was $8.4 million and the effective tax rate for the quarter was 30%. As a result, National posted GAAP net earnings of $85.6 million, or $0.30 per fully diluted share in Q1 fiscal year 2008. The fully diluted share count for the first quarter was 283.9 million shares.

I would now turn it over to Brian Halla for an overview of the business environment and the company’s focus and priorities.

Brian Halla

Thank you, Long. In my commentary this afternoon, I’ll try to give an overview of the market and business environment and how National is performing in that environment. I’ll touch on the company’s priorities and focus, and wrap up with a few words about our outlook in the company’s direction.

While it looks like people that can’t pay their mortgages are still buying handsets. Demand in the quarter held up reasonably well considering it was summer, which is traditionally down for us. Stability rules the day, as there was no major snapback and the distributors are still running with low levels of stock on their shelves, which went down slightly in the quarter. As I indicated, demand for wireless held up nicely, with the high-end phones being where the action is, at least for us.

All in all, the company did pretty well as we grew our revenues for the second straight quarter. We ended up with $471 million in change, which was up 3.5 points, and we booked enough orders to expect to grow revenues again. Our internal inventories and, as I said, distributor inventories came down in the quarter, but we were still able to improve our gross margins to 63% and a new record. Our fabrication plants, meanwhile, again spent the quarter relatively underutilized. We continued to control our operating expenses, which allowed us to achieve $0.30 per share on our current base of 284 million shares. Our book-to-bill exceeded 1 for the third quarter in a row, which allows us to guide to revenue growth in the current quarter.

We continue to focus on getting our new, richer mix of higher-value analog products into the marketplace. We generated quite a few of these products during the 60:30:30 march and we’ve been seeing the benefit of the gross margin line up. We’re also continuing to work with potential winners driving demand in the new mega trends with products that, for the most part, were not inspired by the early PC-driven mega trends. We’ve already seen the benefit of our products’ enabling capabilities, driven by the mega trend of fully featured personal mobile devices.

Our new target partners will hopefully emerge as leaders in energy, video transmission, security and healthcare. The products you’ll see will be analog systems and subsystems, which by the way, may not exactly fit into the traditional standard linear market segments tracked dutifully by the WSTS since the early 1800s. Perhaps we’ll see innovation in the areas of analog signal processing or analog-to-information processors or even analog computing engines, designed to reverse the inconsequential power efficiencies of processing systems -- that is CPUs and DSPs -- invented during an era when energy wasn’t an issue; kind of like when no one worried about oil shortages or dependence on the Middle East when gasoline was only $0.75 a gallon. Power efficiency is our overarching theme and we find ourselves, as a company, in the sweet spot of a world going green and a consumer base which is demanding more and more features but longer and longer battery life.

Throughout our product lines, our focus continues to be on defining products, often at a system or signal path level, that represent breakthrough product technologies which provide differentiation to our customers’ products. We have done this consistently in the high-end personal mobile devices.

The combination of a higher opening backlog and lower distributor inventories should lead to improved turns orders in the current quarter. Based on that expectation we feel reasonably comfortable guiding to a 4% to 7% revenue growth in the quarter. As I indicated earlier, we would expect to see further improvement in our gross margin.

This company’s ability to reshape itself was proven during the 60/30/30 march. Instead of following the cycles and going in and out of red ink during the last five years, the company became more and more profitable with higher and higher gross margins, and we are beginning our fifth straight fiscal year in a row of ROIC, or return on invested capital, of over 20%. In those prior four years, the strong cash generation, along with our leverage, has allowed us to buy back about $4 billion of our company’s stock, pay out a dividend, and plow back into R&D the funding for what has now become a much richer mix of higher value analog product. We’ll continue this behavior while moving onto the development of analog systems and subsystems that will be used to differentiate the products of our partners at the front end of the new mega trends.

We have a rich heritage of consistently improving manufacturing, service and logistics that our customers revere as heads and shoulders above our peer group. It’s a manufacturing machine that can continue to reduce costs while just over half-loaded and yet continue to turn in record gross margins. Our supply chain excellence, combined with rock-solid financial fundamentals represent, I believe, an outstanding platform from which to leverage our power efficient, high performance, high value analog product portfolio; a portfolio more and more including analog systems and subsystems targeting the frontier of new mega trends and redefining the traditional analog space.

Lewis, over to you.

Lewis Chew

Thank you, Brian. During my segment of the call today, I’ll go over what we saw in some of our various business indicators during Q1, such as bookings patterns from our customers and the resale activity in the distribution channel, and even the level of distributor inventory. These indicators set the foundation for the Q2 outlook, so as I discuss the revenue projections, I will highlight key assumptions we’ve made and how those assumptions relate to the recent trends that we’ve been seeing.

Let me talk about bookings first. For the company as a whole, bookings were up about 6% sequentially in Q1. A larger portion of this growth came from our OEM customer base. This OEM uptick was driven mainly by some new product cycles that saw increased orders during the quarter. And Don Macleod will talk in more detail about our products and markets during his segment of the call.

Regarding summer seasonality during Q1, we started out with June actually not that bad, with total company bookings on a weekly run rate basis being fairly comparable to what we saw in May. Then, order rates in July and August were higher compared to June, leading to the overall increase for the quarter.

Within the overall bookings, turns orders were also a little higher in Q1 compared to Q4. Although this is not always the case during a summer quarter, this year it was consistent with the low levels of distributor inventory that were in the channel coming into Q1. It was also consistent with our low manufacturing lead times which have remained pretty steady for the last several quarters.

Over the summer, distributor resales were down slightly, which is not unusual for the season, and distributor inventory dollars of our product were also down slightly and so we ended the quarter at a little over nine weeks of just the inventory which is definitely at the low end of operating levels for our distributors, based on history.

The higher bookings in Q1 also drove an increase in our opening 13-week backlog heading into Q2 and that’s predominately with, again, our OEM customer base. So during Q2, we expect to see improved turns orders from our distributors given the low levels of inventory that they are currently carrying. Based on the backlog and the other factors that I’ve gone over, we are projecting, as Brian said, that revenue will increase sequentially by 4% to 7% in Q2.

Let me turn now to the rest of the income statement outlook for Q2. I’ll start with gross margin, which hit 63% in Q1 for the first time in our history. If you look at the increase in gross margin in Q1 relative to the increase in our sales, the incremental gross margin fall through percentage was in the high 70s. At the same time, we were able to bring down inventory on hand by about $10 million. Our actual fab volume in terms of wafer starts was very comparable to what it was in Q4; however our capacity utilization percentage in Q1 at around 64% was higher than last quarter mostly because we decommissioned and eliminated some unused equipment capacity in Q1. This was partly in connection with the 8-inch upgrade project in the Texas fab that we’ve been working on for several quarters now. The equipment that we decommissioned and the corresponding recalibration of our available capacity figure didn’t have any significant net impact on margin for the quarter.

In Q2 we are anticipating that gross margin will increase again and range somewhere between 63% and 64%. Within that projection we are planning to increase the level of wafer starts slightly compared to Q1 with fab utilization during Q2 currently projected to be in the middle 60s percentage range. We are also modeling our internal inventory to drop again in Q2.

I haven’t mentioned my favorite topic, stock compensation expenses, yet so let’s cover that now. In Q1 total stock compensation expenses were about $20 million of which $5 million was in cost of sales, $7 million was in R&D expense and $8 million was in SG&A expense. In Q2, total stock compensation expense is expected to be around $27 million of which about $6 million will be cost of sales, about $8 million will be in R&D and about $13 million will be in SG&A. Now the increase in Q2 over Q1 is mainly due to what we refer to as the retirement eligible, which means that for all employees who at the time of grant are technically eligible for retirement or will become eligible in the next four years, their options expense is amortized over an accelerated time period, which is about six months. This causes a spike in our expense in Q2 and is a timing issue only and is not unique to National. This is similar issue that we had last year when Q2 stock comp expense was $33.2 million in that quarter.

Moving on to the other line items on the income statement, total R&D expense is projected to range from $95 million to $96 million as we continue to invest roughly 18% to 20% of our sales into R&D. Total SG&A expense is expected to run between $83 million and $85 million and the increase in both of these line items from Q1 to Q2 is driven mostly by two factors: (a) the quarter on quarter increase in the stock comp expense; and (b) our annual focal salary adjustments, which go into effect right near the beginning of our second quarter. The other incoming expense line in Q2 should continue to be relatively minor, around $1 million of expense. Gross interest income is expected to range from $9 million to $10 million, as short-term rates have come down very recently and gross interest expense is projected to be about $23.5 million, as we now incur a full quarter’s worth of interest on our debt. This compares to about $19.5 million of gross interest expense in Q1.

The effective income tax rate for Q2 is expected to be in the 32% range. The Q1 tax rate was a little lower, as it benefited from some specific tax items that we are not projecting to repeat in Q2.

With regards to the balance sheet, our capital expenditures in Q1 were about $24 million and we are currently expecting capital spending to be $30 million to $35 million in Q2. We ended the quarter with approximately 86 days of inventory, which was down from about 93 days last quarter and we had about 34 days sales outstanding in our receivables, which is higher than last quarter but still very good on an absolute basis.

We launched our accelerated stock buyback at the beginning of Q1, right after our June earnings call. As a result of that program, our weighted average share count was down from 327 million shares in Q4 to about 284 million shares in Q1. In Q2, there will be a further incremental impact of several million shares from the ASB, as the shares that were delivered to us in early Q1 get weighted in for all of Q2. Beyond the ASB, as of the beginning of Q2, we have about $880 million available in approved stock buyback programs for future repurchases and our ending cash reserves were about $960 million; and no, we won’t try to spend that all in one quarter. Operating margin in Q1 was about 27% and return on invested capital for the quarter was about 21%, both including stock compensation expenses.

Now let me turn it over to Don Macleod.

Don Macleod

Thank you, Lewis. So let me now expand on the business trends as we saw them in the quarter. In doing this, I’d like to highlight how business is more and more being driven by markets and applications where analog is increasingly becoming the differentiator. This is becoming much more of a system or subsystem level discussion, and especially where power conversion and system energy management are the key enablers. National Semiconductor has been recognized for a long time as a leader in providing customers with power management techniques and methodologies, especially in the rapidly growing portable application space. Now we can also demonstrate where these power management capabilities are both complementary and additive to our other analog intellectual property in enabling us to address other fast-growing market opportunities.

A well understood portable application is in the wireless handset space. In this quarter, sales of our products into the wireless handset space grew by about 10% sequentially, while earning a mid-teens percent sales growth in the previous quarter. This market represented about a third of our total sales in the quarter. There are many drivers behind this growth in sales to mobile phone customers. We continue to enjoy growing business opportunities with the market leader across our product portfolio of power management, audio amplifier, lighting and display management products. We’re also increasing our share of business with other Top 5 handset suppliers. I can point to middle and high-end models, in CDMA, GSM Edge and 3G standards where National now has increased overall semiconductor content from $1 and above per handset, and some high end or feature phones where the total dollar content is in the $2 to $4 range per handset.

We at National understand the analog system needs of portable devices better than any other semiconductor company. As evidence of this, you can see our analog silicon on reference designs from a number of wireless silicon chip set suppliers and a number of emerging Asian competitors. As an indication of the breadth of our position in mobile phone handsets, you can see National Semiconductor silicon in, for example, handsets supporting the new 450 Megahertz CDMA standard launched in the six southwestern provinces in China, and in the largest local brand shipping in China over the summer; and in addition, the new TDS CDMA handsets for that same China market. We are also suppliers to the leading North American enterprise handset provider, and the most visible new high-end consumer handset launched over the summer. Our power management solutions are usually the foundation of a relationship with handset customers and their subsystem providers.

However, often the component level decisions are often still being made by the OEM, or the reference design provider, who challenges us to optimize the analog portions of their system. The human interface requirements of better audio; brighter and multiple displays; data-enabled higher power; and more color lighting, all result in greater demand, or the need for more precision from the energy supply, which is the battery -- and we’re good at this.

An example of this challenge occurred in the quarter, when we won sockets from Top 5 handset providers with a Flash lighting solution that complements high definition 3 to 5 megapixel camera phones. Here, both factory usage and also fast and high output Flash response is required, another solution won by stacking multiple LEDs. Our opportunity in mobile phone handsets is increasing, as multimedia features and differentiation are demanded by more customers worldwide. Multimedia handsets were 80 million units of last year’s market, according to Nokia’s press conference of last week, and we project 50% growth for that portion of the mobile phone market this year, to 120 million units.

In other markets, beyond mobile phone handsets, our large panel display business had flat sales over Q4. Our networking products, that is covering both cellular bay stations and other networking, was also flat over the fourth quarter. Our sales in the quarter to automotive, industrial, medical, military and aerospace, and other broad market customers which are mainly serviced through our distributors, were in aggregate slightly down in the quarter and as Lewis earlier indicated, our distributors decreased their inventories slightly also in the quarter. Sales to PC customers grew in the quarter, and finally, sales to consumer customers grew more significantly. These increased sales to consumer customers in the quarter were driven by the same system level needs, i.e., energy efficiency in handheld devices, as consumers demand more video performance, for example, in new versions of MP3 type players, and new handheld navigational GPS type devices.

Features that are first evidenced in these handheld consumer devices tend to migrate to larger systems. For example, LED drivers, which have been popular in mobile devices – and National Semiconductor, by the way, being the first to provide these – are now emerging in flat panel displays. We have design wins where white LED drivers are replacing CCFL drivers and for even larger LCD TV panels, we have designed wins for new RGB-based backlighting, all providing better displays with energy savings.

Richer video playback on the handheld or larger device is also enabled by another analog skill set that National Semiconductor possesses. Our single path focus on high definition and full HD 1080P video infrastructure addresses customers in studio broadcast, professional writing and switching applications. Here our interface amplifier and audio capabilities all come together to surround the FPGAs with the very best analog signals. And by the way, as these FPGAs shrink in geometry, they need more and more to be complemented by higher performance analog. We’ll talk more about this at our New York analysts meeting on October 3rd.

Moving from market drivers and trains to a few more specifics of our product categories in the quarter. Analog products accounted for 91% of our sales in the quarter, up from 89% last quarter. Our interface products grew 10% in the quarter to represent 8% of our sales, which is up from 7% last quarter. This was driven mainly by increased sales of our MPL or mobile pixel linked products which drives streams of video to small form factor displays at very low power.

Our applications-specific analog products also grew significantly in the quarter to now represent 8% of our sales, and this was driven by growth in integrated display drivers for consumer and handheld applications. Power management sales increased slightly by 1% sequentially and account for 45% of our sales. Amplifier products were flat in the quarter at 25% of our sales and finally, data converters grew by 6% in the quarter to now represent 5% of our sales.

As we indicated in our earnings press release, this quarter’s gross margin at 63% of our sales is a new record for National Semiconductor. Our last quarter was also a previous record. In our call last quarter, I said that half of the increase in our overall sales that quarter was attributed to new product revenues. This quarter I can say that new product sales growth was the equivalent of all our sequential sales growth. Here again, new products are those released in the last 3 years.

Our company ASP for the quarter also grew 2% over last year’s Q1. But in addition to growing higher value new products, the other contributor to a record gross margin result was our in-house manufacturing capability. In the quarter, as Lewis said, we took our inventory down by about $10 million and this increase was mainly in our die bank. However, our follow through to gross profit from incremental revenues in the quarter were still above 75%.

Going forward to our second quarter, as we said earlier, we have a higher opening order backlog, with that growth in backlog coming from our large OEM customer base. Assuming normal consumer spending behavior and a typical seasonal distributor resale pattern, we are in a position to keep up our recent trend of top line revenue growth and margin improvements.

So back to you Long now for Q&A.

Long Ly

All right with that operator, please open the lines for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Chris Danely – JP Morgan.

Chris Danely – JP Morgan

Thanks guys. Nice quarter and good outlook. Can you just talk about what you are seeing out there in terms of end demand trends, and which end markets do you expect to be the strongest for the rest of the year? And, where you are maybe a little bit more concerned?

Don Macleod

Obviously the tone of the call suggests that we're seeing strong market conditions in the mobile handset market, the mobile phone and other devices of that similar nature. This isn't a new topic; we said basically the same thing 13 weeks ago in our last quarter call. If you look at this point in time, we have some visibility into what our customers in that marketplace are looking for the rest of this calendar year, which really is the peak build season before the holiday selling pattern.

I think another observation that we make is that there are many new devices coming into those markets, particularly at the middle and higher end which appear to be selling quite well. So we see good strength in that market. It isn't any one particular customer. It seems to be pretty broad and it's broadly spread across the world, it's not focused on any one individual market. I've referenced discussion about Europe, U.S., and Asian markets.

Beyond the mobile phone and related devices, the other element we talked about is the consumer-like products that we saw grow significantly in the quarter, also focused on the holiday selling season. We are looking forward to that continuing through the end of the calendar year. Beyond that, the observations that we made where we saw a slight increase in our PC-based business, which isn't a big deal for National. We look at 5% to 7% of our sales coming from that space. The position in more broad markets, including industrial is a little bit clouded because we're obviously affected by the fact that our distributors continue to reduce their carrying inventory level even though they're seeing pretty normal resale. I guess the outlook on that one is somewhat, I would say normal or typical of the season.

Brian, do you want to add to that?

Brian Halla

Chris, there's a couple types of demand. There’s obviously demand that turns into revenue and there's also demand for products early in the stages of customer design wins. We're seeing strong demand for our power efficient circuits from a lot of -- I think I've probably over-used the term mega trend. We're seeing strong demand for power efficient circuits from areas like healthcare, instrumentation, ultrasound, security and surveillance, anything where energy is an issue. Of course, video transmission is very strong for us right now from a design standpoint as all the broadcasters get ready to start broadcasting in 1080P.

Chris Danely – JP Morgan

Are you a little bit surprised that given the fact that it seems like demand is okay, are you a little surprised that just the inventory continues to go down and do you think we're at risk for seeing some lead time stretch out this quarter as they try to take down inventory again?

Don Macleod

Surprised isn't the word. For us, low levels of distribution inventory are actually okay. At the end of the day, the real issue is the end consumer or the distributor and can the distributor service those? I say that for us low levels of distribution, assuming we manage that, are okay because there's really only upside in terms of our business from these low levels of inventory. I would say that over the past few weeks, we have seen a number of expedites from customers who are looking for product through distributors and the distributors don't have the inventory. Not a big deal yet, but I think we're at that point in the calendar year where distributor inventories are going to get tested and our lead times at this point are very low and we're able to address all the opportunities as much as we can off the shelf with these short lead times. But we are at the point when I think the next step in this is for distributors to put more inventory on the shelves assuming they get confident about the outlook for the rest of this calendar year. We'll take next year when we get there.

Operator

Your next question comes from Ross Seymour - Deutsche Bank.

Ross Seymour - Deutsche Bank

A question on seasonality; now that your business model has changed and is a lot more profitable and arguably more stable, how should we think about seasonality versus historical levels as we go into the November and then if you would into the February quarter?

Lewis Chew

Hey, Ross, this is Lewis, looks like you made it back from your maternity leave okay. I think right now as Don pointed out, quite a bit of our revenue is still driven off consumer driven devices. So for the time being, we still see a seasonal pattern that's relatively similar to what we've had in the past, meaning a strong so-called Christmas quarter and maybe a weaker after Christmas quarter. I think it'll take some time to see the portfolio move to where you don't see that seasonality or don't expect it.

I think as Brian mentioned, when he first said that I thought two kinds of demand, what does that mean? But what he is talking about, there's a lot of activity going on for us that is the pipeline for what will eventually become revenue and a lot of that stuff is broader than maybe the stuff that we're shipping today. But for right now, like Don said, you add it up we've got a third of our business going to hand sets, 5% to 7% going into PCs, another chunk going into displays. You're almost up to half of our revenue in markets that do tend to be fairly seasonal in the traditional sense.

Ross Seymour - Deutsche Bank

That makes sense. You mentioned about the wireless a lot, with the revenues up 10%, clearly that is a nice growth driver for you. Can you give us a little more color on the sources of demand there? Is it specifically one customer launching a new high-end phone? Or, is it a little more broad-based? Any color would be helpful?

Don Macleod

Ross, I probably should just refer you back to some of the comments I made about the spectrum of demand we are seeing in the mobile phone. I think I made a number of comments saying that our business with the market leader was continuing to grow. We were seeing our business with other top 5 handset providers grow and improve in terms of value per phone. I specifically mentioned a number of different opportunities growing in China, and we are again seeing more of our business come from our position on reference designs from some of the well-known providers of reference designs to the mobile phone market place, and in fact some new providers of what you might call wireless chipsets who are complementing their chipsets with analog products from us.

The spectrum there is pretty broad. I also mentioned that we were involved with some visible consumer phones on one end, and enterprise-like phones that you probably carry yourself on the other.

So it is not that there is one particular trend here. The only trend that we would allude to is that we are seeing our value per handset moving up, at this point, in that multimedia or mid to high end handset space which is now, again according to Nokia, an 80 million unit market last year growing to 120 million this year. It is a sizeable market now with a wide diversity of companies selling products from that marketplace.

Ross Seymour - Deutsche Bank

The last question really quick, a little bit more of an accounting one for Lewis. The receivables were up, so any color on that? Any guidance, more specifically, on what you think the share count will do in the second quarter, and then I will go away.

Lewis Chew

Sure. As you guys all know on the call, we have always had, probably what I would call the best in class DSO. So first of all, DSO for the quarter at 34 days is very normal for us considering that our invoice terms are typically net 30. it just so happened that last quarter, because of some of the timing of payments received, probably from bigger distributors, our DSOs were down a little bit at what I would call an unusually low point at 30 days. So nothing unusual there.

If your thinly veiled question is, were revenues pretty linear? Yes they were. What was the second half of the question, Ross?

Ross Seymour - Deutsche Bank

Share count in the second quarter?

Lewis Chew

Basically, if you look at our numbers, because we have actually published the actual shares outstanding, the share count weighted went down about 43 million from Q4 to Q1 and you can see from our filings that we had about 50 million shares delivered to us in the ASB, so you can pretty much assume that now that incremental chunk gets weighted in for all of Q2. It is hard for me to give specific guidance on the actual share count because there are other variables that I can’t control like the level of option exercises during the quarter and also the movement in the share price. But you can pretty much project that there will be a several million share movement downward, if nothing else, for the weighting of the remainder of that ASB coming into Q2.

Operator

Your next question comes from Louis Gerhardy - Morgan Stanley.

Louis Gerhardy - Morgan Stanley

Can you just talk about what percent of revenue DISTI was in the quarter, and then for the expectations on the next quarter, what do you think DISTI inventory in dollars will do sequentially, and what type of growth should we expect from DISTI resale in the November quarter?

Lewis Chew

But DISTI revenue for us has been running in the mid-50s percent range, kind of 55%, 57% type-range. In the quarter that we’re in right now, meaning Q2, we’re currently modeling that DISTI resales will be relatively stable. Part of that is because with our short lead time, the amount of visibility that they need to give us is somewhat limited, so our guidance does not bake in any substantial increase in DISTI resales, although I would say that historically, you might expect to see some activity pick up during this quarter.

Now part of this is bridging off of what we saw in Q1 and even in Q4, where the industrial markets have been relatively steady. They haven’t been down, but they also haven’t been up and so we’re not willing to necessarily bake in to our numbers, as Brian would put it, some snapback. The So DISTI inventories we’re also modeling to remain relatively stable, but as Don pointed out, if in fact the DISTIs start to see customers expediting them, they may need to respond likewise. Hopefully, we’ll be ready to supply them with extra inventory.

Louis Gerhardy - Morgan Stanley

Can you comment on how far complete you are with the 8-inch transition in the Texas fab and how much more capacity might be taken offline there?

Lewis Chew

Sure. At this point, we are internally modeling to turn on that 8-inch conversion, if you will, at the end of our Q2 and we don’t anticipate any, at least not right now, any more significant decommissioning. We tried to do that fresh in Q1 and start off the year fresh. Also when we bring that online, our capacity will tweak up a little, but not a lot.

Operator

Your next question comes from John Pitzer - Credit Suisse.

John Pitzer - Credit Suisse

Don, last quarter you gave us blended ASPs, both year over year and sequential. I only heard the year over year in the prepared comments. Do you have sequential change in blended average selling price?

Don Macleod

Yes; one of the points you might notice, I refer to the company’s ASP, because we’re finding that in past quarters I referred to our standard linear ASP as the number. I think, as I mentioned to you, this quarter we saw a significant increase in our application-specific analog sales in the quarter, so the number I gave you was the overall company’s ASP, which grew 2%. The ASPs did not grow sequentially.

John Pitzer - Credit Suisse

As you guys start thinking about the gross margin targets longer term and maybe approaching a mid-60s number, Lewis, can you help me out? Is it expectation that ASP does the heavy lifting from here or is it really the 8-inch capacity coming online and utilization rates ticking up?

Lewis Chew

We do think that in the market we operate in, John, that ASP and margin are correlated. Broadly across semi-conductors, you couldn’t say that because you start factoring things in like memory. We do view that, for us, ASP going up is a good thing but as you can imagine it’s not a completely 100%, one-to-one correlation. So, we do have initiatives underway in the company to focus on higher value products and then we think, quite naturally, what that drives is a higher ASP. So I don’t want to imply that we’re focusing on ASP purely from a numbers standpoint. The reality is, if you release products that have a lot more value, things like the display drivers or whatever, it’s just going to have more dollars attached to that.

John Pitzer - Credit Suisse

Given the strength of the new products here, do you guys have the luxury of walking away from some competitive situations where pricing doesn’t necessarily fit into your view of the margin profiles?

Brian Halla

No, I wouldn’t call it a luxury; I would call it an edict. We do walk away where we can’t add unique value.

John Pitzer - Credit Suisse

Brian, has the number of walkaways increased over time? Help me understand; again, it’s sort of this idea of margins over utilization and what’s the right ROI over time? I know that you have been asked this question in the past. I’m curious, are you getting more aggressive walking away from business or is it about the same as it has been trend line?

Brian Halla

No, it’s actually something that was part of the 60/30/30 march and it’s well behind us. WE don’t tend to bid on the commodities on the yearly contracts and, for the most part, we don’t ask to bid on those. We’re not asked to second-source product any more, which is very refreshing and we put a lot of emphasis on starts control, the new designs, new products that we start to make sure that they’ll add unique value in the marketplace and we can get paid for what we do.

Don Macleod

I just don’t like the word walking away. We have plenty of opportunities. It’s a question of choosing the opportunities rather than walking away from the business once we’ve designed the product. As you saw from the numbers this quarter, you could account for the whole revenue growth this quarter over last with new product revenue growth, which is clearly based on decisions taken to address opportunities that were successful rather than us coming to the market and then deciding whether or not to take the business. So it’s a style of business.

I want to pick back up on an observation about the mid 60s gross margins. Our goal to get those kind of gross margins is entirely driven by our portfolio. Any bonuses that we get through capacity utilization or cost reductions in the wafer fabs are incremental to that. So the whole premise here is not that we will get to mid 60s gross margin filling up the fab. We have a fab size at this point where cost is optimal. If we run these fabs at better capacity, of course we’ll get a benefit but that’s not the premise of our margin opportunities. It’s entirely based on focusing our efforts on higher value, analog new products that give us those margins and you’ve seen the trend in terms of recent quarter margin improvements and those trends have all come from that higher value portion. Obviously our factories are doing their job but it’s not coming from them increasing their capacity utilization.

John Pitzer - Credit Suisse

Don, not to be too myopic but if you look at the current quarter’s expectations on gross margins that’s again going to be heavy lifting done by better mix?

Don Macleod

Absolutely and the observation Lewis made I think we’re very mildly taking our wafer starts up in the quarter; not enough to make any huge difference to the margin in itself.

Operator

Your next question comes from the line of Simona Jakowski - Goldman Sachs.

Simona Jakowski - Goldman Sachs

Just wanted to follow up on the ASP question. It sounds like ASP has maybe declined slightly quarter-on-quarter although I would have thought they’d be up a little bit considering that pretty much your entire growth was from new products. I think you’ve said in the past that the new product ASP is quite a bit higher on average than the existing product.

Maybe related to that, it sounds like you had a pretty nice increase in analog ASP which I would have assumed have higher ASPs so maybe if you can just comment on the mix impact on your ASP as well.

Don Macleod

Simona, I’ll take that at a very high level. One of the observations you might draw from the discussion we’ve had about this quarter is that more of our business is coming from the OEM customer base and less of the relative business is coming from business generated through our distributors. Frankly we do have better ASPs that come from the very broad market business that goes through the distribution channel and that was obviously the channel that was weakest in terms of selling into in the quarter.

As you recall, the inventories came down a little and we did have a slight drop in our resales over the summer primarily driven by activity in Europe. I would say that that is a clear seasonal trend that we would think would adjust itself going forward for the rest of this calendar year. That’s a very macro high level answer to the question that you posed.

Simona Jakowski - Goldman Sachs

I’m curious why you guys are reducing your inventories right now? You know we are getting into the stronger part of the year, we’re in a reasonably healthy part of the cycle and you mentioned you have started to see some anecdote on distributors receiving some expedites. So can you just walk us through the thinking behind that?

Lewis Chew

The reality is that last quarter we were days of inventory in the 90s and I don’t think I had ever said that that was our model. As you know right now, the DISTI channel is being relatively conservative about their inventories and we actually have quite a bit of inventory in our die bank. The reality is that our manufacturing machine is very good and we can take advantage of that to be able to lower inventory during a time where that doesn’t cost our gross margin to go down.

I think right now one of the question people are likely to ask is what is your inventory model, Lewis, and you haven’t talked about that in a while? In the old days, it used to be 65 to 75 days and when we started going to pure play analog, we said that that model was likely to rise; but I don’t think that we necessarily want the model to be in the 90s.

So we got down to the 80s and again, coming into this quarter we are still anticipating the margins will go up. We don’t feel like we need to grow inventory at this point so at this point, we are anticipating that it will go down a little bit. Do you want to add something to that, Don?

Don Macleod

Well, at the most tactical level, we are trying to smooth out the fab loadings between quarters so we don’t jerk them around, and then another practical point is that we made the observation that we had stronger bookings in the last quarter from an OEM customer base, particularly a larger OEM customer base. Logistically, many of these customers give us forecasts, so from a die bank planning perspective, we are a lot easier able to plan our die bank requirements for the second quarter when we have those forecasts, not that they are 100% accurate but they are a much better indication of our needs to build and that’s why we took our die bank down slightly in the first quarter and it is really a practical, day-to-day running the factories issue and planning for the builds.

Simona Jakowski - Goldman Sachs

But your own lead times didn’t really go down, so aren’t you at all nervous that now you have lower inventory, maybe only the second lowest days of inventory among all of your peers and sold to distributors, so you guys seem pretty confident that you can meet any kind of demand fluctuations.

Don Macleod

We don’t think we’re confident but we do think we can meet the demand that is in front of us, yes.

Simona Jakowski - Goldman Sachs

Okay. Thank you.

Long Ly

Operator, let’s move on to the next caller, please.

Operator

Your next question comes from the line of Krishna Shankar with JMP. Your line is open.

Krishna Shankar - JMP Securities

Yes, if you look at the handset market, it sounds like you have a pretty good seasonal [inaudible] going on now across the range of handset manufacturers and regions. Can you give us some sense -- you know, it sounds like everybody is angling for a piece of this mid to high end market and what do you see in terms of end demand and [inaudible] some of these high end handsets?

Don Macleod

Krishna, I’ll take that. I mean, obviously we’re not at the end of the day the party selling the handsets to the consumers. We can only give you a flavor for the way they place demands on us. I think as we mentioned to you, we saw a significant growth in that demand from the handset base.

But to make the point, where we see that demand coming from is that slice of the mobile phone space that is middle to high end multimedia feature phones, and I think at the end of the day the point is that that is becoming a bigger business and that’s becoming a space where we can get dollar or multi-dollar content in these phones. And again, what differentiates those phones, it’s the better video or the better audio or the longer battery life or the better lighting.

Frankly, these are the things that cell phones, if they are priced at the right price point, then these are the things that drive our analog business and so far, at this point, so good.

Krishna Shankar - JMP Securities

And you still see room for [data content] [inaudible] opportunities going forward there?

Don Macleod

Absolutely and I think if we’ve been having this discussion, we would be sort of prefacing that question with what about integration, et cetera. Well, you know, integration is not a feature when you try and diversify and distinctively modify your brand to produce different phones with different features.

And that’s really where we play, and particularly in driving displays and audio into mobile phones, this is where we do a really good job and these are the areas where all these new MP3-enabled phones and fully featured video phones are driving demand for us today.

Krishna Shankar - JMP Securities

And my final question I guess is now that you are sort of approaching the mid 60s, would you care to comment on your longer term gross and operating margin targets over the next 12 to 18 months?

Lewis Chew

Sure, I’ll comment on that, Krishna. Ask me again when we get to 65.

Krishna Shankar - JMP Securities

Okay. Thank you.

Long Ly

Operator, next question, please.

Operator

Your next question comes from the line of Craig Hettenbach with Wachovia.

Craig Hettenbach - Wachovia Securities

Just to stay on the handset theme, a lot of solid growth was in the high end. Could you just comment on the mid range, what type of functionality of phones that you would say are in the mid range are actually participating in today and that you see as attractive?

Don Macleod

No, I’m not going to make comments on specific phones. Frankly, our business is not dependent on any one or two particular models. I think for me to comment on individual phones would be an issue of customer confidence.

Craig Hettenbach - Wachovia Securities

It was more of a broader, not individual phones but just the type of functionality of phones that you would characterize as mid range.

Don Macleod

Well, to repeat the point, the question Krishna asked before you, where we are seeing the value in the phones and where we’re seeing customers coming for support from National Semiconductor, it is in phones that have larger displays, color displays, phones that have more audio features, audio subsystems, headphone drivers, and phones that have neat lighting, neat backlighting, et cetera, on all of these, with the macro kind of trend that all of that is done at the expense of the battery, so the more efficiently we can convert that power, the more the system energy is capable of supporting all the functionality.

I think in my call I made an observation as mobile phones with camera features go to higher and higher pixel count, if you want to take pictures at night so you need flash lighting to light up the scenario you are taking the pictures on. We are winning designs with those LEDs that do the boost for flash lighting. It is just another example of one of the many features that differentiate individual phones.

Craig Hettenbach - Wachovia Securities

Okay, thank you, and if I can ask another one, on the consumer electronics business, this time of year, are you seeing the typical build you would historically see or is the inventory management within the channel impacting that build rate, if you will, August into September here?

Don Macleod

Well, the consumer devices that made the most difference in terms of our recent results are devices that were launched quite recently, so I think it is too early to say what the inventories are or will be going forward. I think that’s a question we can talk about in December.

Craig Hettenbach - Wachovia Securities

Okay. Thank you.

Long Ly

Thanks, Craig. Let’s move on to the next caller, please.

Operator

Your next question comes from the line of Romit Shah with Lehman Brothers. Sir, your line is open.

Romit Shah - Lehman Brothers

Great. Thanks for taking my question. Lewis, on the ramp-up of the Texas fab, just balancing presumably higher depreciation and some cost efficiencies as well, is there a meaningful impact to gross margin today from this ramp up?

Lewis Chew

No, not really. Part of what we’ve been absorbing in the gross margin already is some of our conversion costs. We’ve just been absorbing without crying about it, so that’s already been in our numbers. So you could almost say that we’ve already been incurring expense in our gross margin that as a proxy would be expense that we incur when we bring it online.

But no, we don’t see any significant impact from bringing that online.

Don Macleod

Just to make the point that when we do bring it online, you have 8-inch capacity that replaces prior 6-inch capacity, so we get the cost reduction at the die level that results from that conversion. And you know, many of the 6-inch, or part of that 6-inch capacity, as Lewis said, we eliminate that older capacity. We don’t need to support it with energy and all the other things that you need to keep a fab clean, so we get cost reductions in the existing 6-inch fab at the same time.

Romit Shah - Lehman Brothers

Okay, and if I could just go back to the outlook for the November period. You baked into your guidance -- you guys are basically assuming that the channel remains in the nine to ten week range, and if some of these [exits] that your distributors are seeing does translate into some restocking, that could be potential upside for the forecast for November?

Lewis Chew

Yeah, that’s right. I mean, that’s why we try to be pretty transparent with you guys about what we’ve assumed in our guidance because obviously the guidance is a whole set of those assumptions, and it is true that we are assuming that there is no restocking that happens in the quarter. We’ll be perfectly glad to deal with it if it occurs.

Romit Shah - Lehman Brothers

Okay, and if I could just lastly on SG&A, Lewis, did you say that in the February quarter, we should get back to a more normal run-rate, or as a percentage of sales SG&A would maybe drop back down to the 16% range, where we saw it in the August period?

Lewis Chew

I’m not sure I actually made any comments about SG&A in February, but I think if what you are referring to is this spike in stock compensation expense, then it is true that similar to the pattern you saw last year, we would expect that to recede in the February quarter but I haven’t given any specifics out there but yes, you could look at that pattern and expect that to come down a little.

Romit Shah - Lehman Brothers

Okay. Thank you.

Long Ly

Next caller, please, Operator.

Operator

Your next question comes from the line of Sumit Dhanda with Banc of America. Sir, your line is open.

Sumit Dhanda - Banc of America

Just a question for you guys, Donnie or Brian, on the power management business, which was up about 1% sequentially. And your handsets, on the other hand, as a category were up 10%. Any reason why the power business didn’t grow a little faster, given how fast handsets grew for you in the quarter?

Don Macleod

Well, the power business is 45% of our sales. We have a lot more business probably in the power marketplace than we have that just focus -- than that that just focuses on the handset.

You know, a couple of underlying factors; our handset business covers virtually the whole spectrum of National Semiconductor products. Power management amplifiers, audio amplifiers, interface, display drivers, and the features that we see at the high end phones that drive most of the functionality.

You know, some of it’s in power but a lot of it is in these other spaces but the underlying performance feature that we always try to address in all those areas is to have the most efficient use of power or the lowest power in all of these applications, whether it’s audio or whether it’s display or whether it’s interface.

And I think if you go back and look at the power management business, it did grow slightly sequentially. We would not expect to see that in the summer quarter because so much of our power business is very broad and through the distribution base, and as Lewis mentioned to you, we did see a slight reduction in resales and inventory in the distribution base over the summer.

So seeing growth at all over the summer obviously alludes to the fact that that growth did come from the handset space.

Lewis Chew

And it is true, Sumit, that without giving out specific numbers, the piece of power that we would call the piece going into wireless did grow more than that average number. And for the total company what Don is alluding to is that normally in the summer, we would be down in the summer seasonality wise, which goes back to Ross’ question.

So you have to start first with the assumption that our normal business pattern is to be down a couple of points in the summer and that would be across all product lines. It just so happens that all these questions are popping up in the context of us growing 3.4%, which we were quite happy to see.

Sumit Dhanda - Banc of America

Yes, I understand. And then, could you possibly share with us what percentage of your power business is focused on handsets?

Lewis Chew

We don’t break that out separately, no.

Sumit Dhanda - Banc of America

Okay. All right. Thank you so much.

Long Ly

All right. Thanks, Sumit. Operator, we have time for one more caller.

Operator

Yes, sir, and we have one final question from the line of Steve Smigie with Raymond James. Sir, your line is open.

Steve Smigie - Raymond James

Great. Thank you. I just wanted to follow up a little bit on some of the comments about utilization and gross margin. You stated that you were hoping to really drive gross margin by product mix but if I look back to past cycle, I think you got about 500 basis points of gross margin expansion as you did ramp up utilization levels from around here up towards your higher levels where you sort of top out at. Would I not expect to see that 500 basis points of expansion this time as you ramp back up?

Lewis Chew

Hey, Steve, this is Lewis, although I’m not sure she got your last name pronounced.

Steve Smigie - Raymond James

It happens.

Lewis Chew

Yes, it happens all the time. That’s what you get for having a complicated last name. No, absolutely. What Don was saying was our gross margin focus is organic in the sense that it is aimed at the portfolio but we also do absolutely get a benefit from ramping up the fab and I’m sure that our factory workers would like nothing better than to see more volume coming to their fab.

I don’t want to commit to a specific number like 500 basis points but I applaud you for looking at past history and saying yes. We look at past history as well and would like to try to repeat performance along those lines, but yes, there would be a significant increase in our margin purely from volume if we were, for example, to take utilization from 65 to 85, yeah, we would definitely see a very positive impact from that, in addition to whatever we also got organically from the portfolio, which is independent than the statement about utilization.

Steve Smigie - Raymond James

Okay, and just sort of as a follow-up on that, where are we in terms of cleaning up the inventory level such that going forward, you are not working on bringing that down? I mean, I guess you talked a little bit about your model but is it maybe next quarter where you just start to ramp utilization as the revenue comes in?

Lewis Chew

Yeah, you know, this is amazing. We’ve gone through this whole call and not one question or comment had been made about EMSs, so let me throw that into the mix as well. We did actually see our orders from the EMSs go up this quarter. They are not back to where they were three quarters ago, so that to me would be in indication that they’ve been “cleaning up” their inventories and maybe close to being done.

Clearly the DISTIs are at the low end of their range and we are moving well into maybe what you could call the lower end of our range, so at this point the stage is set hopefully for not a lot, if any, of what you would call cleaning up of inventory. I think hopefully we’ve kind of left that behind us on this call.

Steve Smigie - Raymond James

Okay, great. Thanks very much.

Long Ly

All right. With that, we’re going to end the call today. Let me remind you that the replay is available on our website. Thank you for joining us.

Operator

This concludes today’s Q1 fiscal year 2008 conference call. You may now disconnect.

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Source: National Semiconductor F1Q08 (Qtr End 8/26/07) Earnings Call Transcript
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