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OmniVision Technologies, Inc. (NASDAQ:OVTI)

F1Q08 Earnings Call

August 30, 2007 5:00 pm ET

Executives

Steven Horwitz - Director, Investor Relations

Shaw Hong - President, Chief Executive Officer

Peter Leigh - Chief Financial Officer

Ray Cisneros - Vice President, Sales

Analysts

Paul Coster - JP Morgan

Satya Chillara - Pacific Growth Equities

Tayyib Shah - Longbow Research

Tristan Gerra - Robert W. Baird

Aaron Husock – Morgan Stanley

Kevin Cassidy - Thomas Weisel

Harsh Kumar - Morgan Keegan

Quinn Bolton - Needham & Co.

Adam Benjamin - Jefferies & Co.

Catherine Bogart - AG Edwards

Amit Kapur - Piper Jaffray

TRANSCRIPT SPONSOR
Wall Street Breakfast

Operator

Welcome to the first quarter 2008 OmniVision Technologies earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's conference, Mr. Steven Horwitz, Director of Investor Relations. Please proceed.

Steven Horwitz

Good afternoon, everyone and welcome to our first earnings conference call of fiscal 2008. After the market closed today, OmniVision issued an earnings release reporting our financial results for our first fiscal quarter. You can access this release from the investor relations section of our website at www.ovt.com or on the financial newswires.

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

We have also arranged to record this call. The taped replay will be available approximately one hour after the call's conclusion and will be available for 48 hours. The dial-in access number for this replay is 617-801-6888. The replay passcode is 32561547.

This conference call will include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include statements about our financial projections for the second quarter of fiscal 2008 and beyond; our expectations for continued gross margin improvement in Q2; our expectations for growth in the market for image sensors; our expectations regarding our ability to continue to compete effectively in the market; statements regarding our position to meet increased demand for higher-resolution sensors; our expectations for growth in the market for PC cameras; the anticipated introduction, acceptance and benefits of our new products; our expectations regarding our ability to take advantage of future opportunities, anticipated product and market developments.

All these forward-looking statements involve known and unknown risks, uncertainties and important factors that may cause actual company or industry results, levels of activity, performance or achievements to differ from those expressed or implied by the statements. In evaluating these forward-looking statements, you should specifically consider various risk factors, including the risk factors detailed from time to time in OmniVision's Securities and Exchange Commission filings and reports, including but not limited to the company's annual reports on Form 10-K filed for the fiscal year ended April 30, 2007, and quarterly reports on Form 10-Q that we file from time to time. These factors may cause the company's results to differ materially from the forward-looking statements made in the conference call.

Although the company believes that the expectations reflected in its forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievements. These forward-looking statements are made only as of today's date, and OmniVision expressly disclaims any obligation to update or revise the information contained in the forward-looking statements. This concludes the Safe Harbor statement.

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

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

Shaw Hong

Thank you, Steven and good afternoon, ladies and gentlemen. Thank you for joining us on today's call. With me today are Peter Leigh, our CFO; and Ray Cisneros, our VP of Sales. On today's call, I will begin with an overview of our results and then I will provide a general business update. Peter will provide you with the financial details of our fiscal first quarter and outlook for the second quarter. Afterwards, we will take your questions. Ray is with us to provide additional insight.

I am very happy to be here today to talk to you about surging demand for OmniVision products. This is a direct result of our effective execution across multiple markets and multiple geographies. In particular, revenue for the first quarter was $173 million. GAAP earnings were $0.23 per diluted share, which included a one-time tax benefit of $0.08, as Peter will explain in more detail. Excluding stock-based compensation expenses, non-GAAP earnings were $0.35 per diluted share. Our cash and short-term investments remain strong, totaling about $295 million.

In the first quarter, we sold about 86 million sensors compared to approximately 62 million in the fourth quarter and 58 million in last year's first quarter. Throughout the first quarter, we continued to experience a very strong demand for our products that we reported during our last earnings conference call. As a result of this strong demand, we were able to significantly exceed the upper end of our revenue and earnings guidance.

Our strong revenue performance came primarily from three sources: first, with the increasing popularity of handsets with 2 megapixel sensors; second, strong demand for high-quality VGA sensors, as image sensor penetration into handsets continues to increase; third, we saw a significant increase in revenue from the PC mobile market. In this market also, the attach rate is accelerating and we are seeing a meaningful migration to high-resolution sensors.

Our ability to meet this surging demand is a testament to the strength of our supply chain partnerships. As a fabless company, we rely on our operational leadership and the responsiveness and efficiency of our manufacturing partners. This collaboration is essential to provide us with the capacity to meet the needs of our customers. When the demand environment significantly improved a few months ago, all of our partners quickly ramped their production. TSMC has been very helpful in providing us with all of the wafers that we required. This illustrates the strength of the relationship that our combined efforts have forged over past decades. VisEra, our joint venture with TSMC, has quickly ramped the production for our color filter and micro-lens processors.

For chip-scale packaging, you may recall that we began working closely with XinTec about one year ago to ensure that they increased their capacity. XinTec has been successful in expanding its production and improving its yield. We have also begun receiving chip-scale packaging from our new CSP partner, WLCSP. Last but not least, we are successfully increasing our final test capacity to handle the increased volume. We are very pleased to have such strong relationships in our supply chain, which enable us to deliver such strong results.

Close relationships in our supply chain are only one part of the story. We are also working on improving the other factors that drive our results. These factors are: first, improving our operating efficiencies; second, addressing the major trends that affect our mainstream product business; third, developing our advanced product business; and fourth, advancing new technologies.

Last quarter, I reported on several key initiatives that we are working on to improve gross margins and operating margins. We have made some progress on this front and we expect to make further progress in future quarters. Let me update you on these initiatives. We are working very aggressively with all our vendors to reduce input costs and improve output yields. We are making progress with PFC in developing new processes and new products using their 300mm DRAM capacity. We expect to begin production on the larger wafers in the second half of calendar 2008. VisEra made further progress in their program to expand their capacity and to prepare their facilities to handle 300mm wafers.

We began to realize better yields at XinTec. This is a direct result of the close collaboration among TSMC, XinTec and ourselves. We are also achieving better yield at our new CSP partner, WLCSP. We have made substantial progress in our program to upgrade and automate our final test facility. This should increase capacity, lower costs and make our testing process more efficient.

On the operating expense side, we are continuing to be very prudent in our spending. In particular, we are taking a disciplined approach to controlling the growth in our headcount. By controlling the growth in the headcount, we can obtain greater leverage from our business model as we benefit from a significant surge in revenue.

Let me now turn to our mainstream product business, which addresses principally the mobile handset market. Mobile handsets accounted for just over 70% of our revenues in the first quarter. First and foremost, we benefited from strong demand for sensors in all of our main resolutions and across all geographies. We believe that this trend is a reflection of both better market conditions and the competitive advantages of our products.

Demand for our 2-megapixel sensor is both strong and accelerating. This quarter, the share of 2-megapixel and higher resolution sensors exceeded 10% of total units and we believe this share will continue to increase. In fact, the faster transition to 2-megapixel sensors has led to increased activity on all higher-resolution sensors. As we move past the stage of cameras being included in the handsets simply as required features, consumers are differentiating their full purchases based on image capture performance. This acceleration in demand for improved image capture is driving greater interest in higher resolutions, and we believe that our product roadmap matches well with this trend. In June, we announced our first 0.25-inch 3-megapixel sensor, and we are in the early stage of competing for next-generation design sockets. We have received very positive initial feedback from our customers and believe that we are well-positioned to meet demand at this resolution.

Meanwhile, demand for our VGA products remains very strong. Adoption of VGA sensors into entry-level phones is growing in all markets. The penetration rates of cameras onto handsets is increasing, a trend that we believe will continue in 2008. Supporting this demand were the first volume shipments during the quarter of our 1/10-inch VGA CameraChip.

Along with these very strong penetration rates, the addition of a second sensor to handsets for use in video conferencing is gaining momentum. In the first quarter, we began volume shipments to several customers of our SGA CameraChip sensor designed for 3G handsets. This sensor utilizes a 3.6-micron pixel with OmniPixel2 technology and combines superior low-light performance and image quality with a compact module designed to provide a reliable, cost-effective camera solution. Low-light performance is critical to videoconferencing applications. LCD sensors rarely emit enough light to compensate for the low-light conditions found in most indoor environments.

Complementing the meaningful increase in demand that we are seeing from the Tier 1 OEMs serving the U.S., Europe, Korea and Japan, market conditions in China are also very strong. We are working on many projects with all resolutions, including 2 and 3-megapixel sensors. A significant amount of production in China is exported out of the country. Chinese OEMs are the principal supplier for markets in South America, Russia, India and other geographies. At the same time, the economy in China is growing strongly, leading to significant demand within the country, much of which is being met by Chinese suppliers. We have always maintained a strong presence in China. We believe that our product portfolio positions us well to maintain and extend our market leadership.

We continue to work with our customers on our TrueFocus product, utilizing wafer encoding. As you know, we have already secured design wins with TrueFocus and anticipate meaningful revenue in calendar 2008. What we have learned from the handset maker, who continues to be very excited by these technologies, is that having the sensor and DSP functionality on a single chip is a critical requirement. We are already being announced on multiple projects to develop single-chip wafer encoding products.

I'd like to turn now to our advanced product business and talk about some very positive developments. As I mentioned in my introductory comments, we are seeing a dramatic increase in image sensor attach rates in the PC notebook market. We believe that the total market will be about 20 million to 25 million units in 2007 out of a total of 100 million laptops. This is a much faster attach rate than we originally anticipated. With design wins at four of the five leading manufacturers, we have a dominant market share.

It is important to note that our customers have adopted our sensors at all resolutions. This illustrates how the videoconferencing application is gaining momentum and demanding higher resolutions as PC notebook manufacturers around the world look to differentiate their products in a highly competitive marketplace.

In the security market, we are continuing to make progress on our goal to ship more sensors into the commercial segment of the market. For example, we are working on new projects to equip IP security cameras that will be used for property and the building surveillance.

In the automotive market, we unveiled significant a new product developed for vehicles. This new sensor provides near-infrared sensitivity and can be operated in dual-mode, allowing it to function both in day and night vision applications. This eliminates the need for a separate display system. The new night vision capability expands the sensor's light sensitivity up to 1050 nanometers. This is a near-infrared sensitivity. This allows automatic switching of the sensor between modes and allows for object detection in complete darkness and outside and beyond the range of a vehicle's headlights. Potential applications for this near-infrared sensor include driver assistance and safety applications to detect pedestrians, objects and signs; rear-view or backup camera applications; and motion detection vehicle security applications.

For the medical market, we have been working closely with our partners to bring image sensors to the many potential applications. For intubation, our partners have now received FDA approval and will be moving into the mass production phase. Another partner of ours is very close to receiving FDA approval for women's health applications. We continue to be excited by the long-term prospect of this market.

Now I would like to update you on our technology development. OmniVision has always worked hard to be at the forefront of technologies in the image sensor space. Today, as our customers are examining our quarter-inch 3-megapixel products, the success of our OmniPixel3 architecture is becoming more apparent. The OmniPixel3 platform features a 1.75-micron pixel size that is necessary to fit over 3 million pixels into the key quarter-inch form factor. When you shrink the pixel, you reduce the amount of light that reaches each pixel. It is precisely the ability to improve the efficiency of the pixel that enables OmniVision to remain a technology leader by producing a superior image.

One of the many aspects of our latest pixel that enhances picture quality is the use of very low stack height. The low stack height improves the ability of the sensor to deliver a good image in low light conditions. We have received a very positive initial feedback from our customers on the OmniPixel3 architecture.

We are very encouraged by the opportunities for our high-resolution sensors. In fact, we are already well underway in developing next-generation pixel technologies. We are currently working on 1.4-micron pixel size and beyond. Along with other technology developments, we believe that our ability to deliver small pixels will keep us at the forefront of technologies for the image sensor market.

Before I turn the call over to Peter, I want to make you aware of another important development. I am pleased to report to you that this past Monday, Bruce Weyer joined OmniVision as VP of Marketing. Bruce comes to us with over 20 years of high technology marketing and business management experience with Xilinx, PacTel, AMD and Lockheed. We are delighted to add Bruce to our already strong management team. I will now turn the call over to Peter.

Peter Leigh

Thank you, Sean and good afternoon, everyone. For the first quarter of fiscal 2008, which ended July 31, 2007, OmniVision is reporting revenue of $173.1 million, up 45.2% sequentially and 26.5% on a year-over-year basis. Just over 70% of our revenue in the first quarter came from mobile handsets, while about 30% came from our advanced products group and DSCs. The advanced products group includes notebook PCs and webcams, security and surveillance, toy and video game consoles, automotive and medical products. The principal contributor to the change in mix was the strength in notebook PCs.

Direct sales to original equipment manufacturers and value-added resellers accounted for approximately 65% of revenue in the first quarter of fiscal 2008, while about 35% came from sales through distributors. We use distributors to assist us with finished goods supply chain management and to minimize credit risks with less well-established customers.

We shipped approximately 86 million image sensors in the fiscal first quarter. Our weighted average selling price was $2 as compared to $1.92 last quarter. The principal contributor to the increase in ASP this quarter was the change in product mix towards 2-megapixel products.

Gross margin for the first quarter was 23.4% compared to 22.3% last quarter. Excluding stock-based compensation expense of $953,000 gross margin was 24%. The principal contributor to the increase in gross margin in the July quarter was again, increase in sales of 2-megapixel products. We are, as you know, constantly under pressure from our customers to deliver better products at lower prices, and as Shaw discussed earlier in the call, we are working with all of our manufacturing and supplier partners throughout the supply chain to improve efficiencies in every stage of production. We expect to see further improvement in gross margin in the second quarter.

R&D expense in the first quarter was $17.4 million, up from the $15.6 million we reported in the prior quarter. Our R&D expense includes approximately $2.3 million of stock-based compensation expense. Excluding stock-based compensation expense, R&D in the quarter was $15.1 million compared to $12.7 million in the prior quarter. The main contributor to the increase was higher NRE costs, the cost of the mask we buy when we release designs for new products to the foundry. NRE expense does tend to fluctuate quarter to quarter, and in fact, we anticipate a further increase in NRE expense for the current quarter.

SGA expenses in the quarter totaled $15.2 million, up from $13.8 million in the prior quarter. Our SG&A expense includes approximately $2.9 million of stock-based compensation expense. Excluding stock-based compensation expense, SG&A in the quarter was $12.3 million compared to $10.7 million in the prior quarter. The increase in spending is principally due to a small increase in headcount and an increase in sales commission payments due to higher revenues.

Our operating profit in the quarter was $8 million; excluding stock-based compensation, operating income was $14.2 million. Our pretax earnings in the first quarter were $11.6 million. Our net income in the first quarter was $13 million or $0.23 per diluted share compared to a net loss of $1.5 million or $0.03 per diluted share in the previous quarter. Net income in the first quarter of last year was $15.9 million or $0.28 per diluted share.

Our results for the first quarter of fiscal 2008 included $6.8 million of non-cash stock-based compensation expense under SFAS 123 R. Excluding this non-cash stock-based compensation expense, our non-GAAP net income was $19.8 million or $0.35 per diluted share. This compares to non-GAAP net income in the first quarter of fiscal 2007, excluding $6.2 million of stock-based compensation expense and related tax effects of $22.1 million or $0.39 per diluted share.

As Shaw mentioned, EPS in the current quarter includes a one-time tax benefit of $0.08 per share. The benefit arises from a tax law change in one of the foreign jurisdictions in which we do business, and in accordance with GAAP, we treat the effect of such changes as a discrete item in the quarter in which the change occurs.

Overall, I can say that we are pleased with the progress that we have made in the first quarter and look forward to continuing this progress in the current quarter.

Let me now turn to the balance sheet, which remains in excellent shape. The company ended the first quarter with cash, cash equivalents and short-term investments totaling $294.8 million. The decrease in cash from the end of the last fiscal year was mostly due to our share repurchases during the first quarter. During the quarter, we repurchased about 566,000 shares at an average purchase price of $17 per share.

Accounts receivable at quarter end, net of allowances, was $71.8 million, up $6.1 million from last quarter. Our days sales outstanding was 38 days compared to 49 days last quarter. Our accounts receivable remain in excellent shape, although I do not think we can necessarily assume that we can keep receivables as low as 38 days. At July 31, 2007, inventory was $138.3 million compared to $119.7 million on April 30, 2007. Quarter-end inventory represented 96 days of sales. The majority of the increase is in WIP and reflects our need to put in orders to match the pickup in demand. Our goal remains for inventory to be in the range of 75 to 90 days, equivalent to annual turns of four to five times. Again this quarter, we found ourselves in the enviable situation of needing to increase inventory in order to meet very strong future demand.

Now I'd like to turn to the outlook for the second quarter of fiscal 2008, which will end on October 31, 2007. We are continuing to see additional strength in demand for our image sensors, which leads us to expect further strong growth in the second quarter, building on the record first quarter revenues that we reported today. We currently expect second quarter revenue will be in the range of $210 million to $230 million, representing a 21% to 33% increase over the first quarter. This should translate to earnings of between $0.19 and $0.31 per diluted share. Excluding the estimated expense and related tax effects associated with stock-based compensation, in accordance with FAS 123(NYSE:R), we expect non-GAAP earnings will be in the range of $0.34 to $0.46 per diluted share.

I also want to provide you with an update to our projected tax rate. On a GAAP basis, the rate may fluctuate significantly from quarter to quarter. However, as a result of tax planning measures we have now fully implemented, we believe that our sustainable average annual effective tax rate, excluding the effect of stock-based compensation, will be between 10% and 12% as compared to 22% previously. This reduction is principally the result of changes in the way we do business outside the United States.

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

Shaw Hong

Thank you, Peter. OmniVision's core competency is centered on image sensor technology. Our employees have worked hard to improve the performance of the company over the last two quarters. I am encouraged by our progress in the following areas: improving business efficiencies, maintaining mainstream product leadership, developing advanced markets for image sensors and advancing our technology leadership position to deliver industry-leading products.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

Your first question comes from Paul Coster - JP Morgan.

Paul Coster - JP Morgan

Thanks and good afternoon, Peter and Shaw. Peter, good to see the gross margins recovering, but they're still way short of where they were this time last year when we were in the mid-30s. Can you give us some sense of where you think this trajectory will take you now? I think it's something to do with the FIFO recognition of inventory costs, but why the margins didn't respond a little bit faster, given the ASP numbers and the product shift mix and the volumes involved.

Peter Leigh

Let me try and answer your first question first. On the question of where do margins go, the difficulty, as you know, Paul, with that question is that it will depend crucially on where prices go, and that is something over which we have very little control. I think the important point for me is that at the low end of the guidance range we have now given, $210 million, you've got to reckon that $700,000 of pretax income now is about $0.01 a share. So 1% on that low-end guidance range is worth $0.03 a share. I think that what our task here is is to continue to increase margins steadily quarter by quarter.

The question of whether or not you could really get margins back to the mid-30s I think is much more complicated. My short answer is that you really are going to have to develop some truly innovative products that provide you with a significant advantage over the competition. We do a lot of work in R&D, but as you know, our policy is not to talk about that in advance of having products. So I think I am just going to have to leave it at that.

On the question you raised about why didn't it happen sooner, I think you've really got the answer right, and that is that we do account for inventory on a FIFO basis, and so any reduction in costs that come today do take a while to work through the inventory and into the P&L.

Paul Coster - JP Morgan

But just taking the guidance that you've issued, assuming that your operating expenses remain more or less constant as a percentage of overall revenues, then we should see a fairly significant improvement in gross margins in the next quarter, maybe 300 or 400 basis points. Is that a fair assessment?

Peter Leigh

I think that may be a little bit optimistic, Paul. I did mention that we expect to see NRE expenses take a further jump this quarter, and as you know, we prefer to give conservative guidance. So I think that it is not realistic to expect 300 to 400 basis points in a single quarter.

Paul Coster - JP Morgan

A lot of speculation has occurred this quarter regarding competition. Samsung and Micron have been described in various ways as being a little less aggressive in pricing. Can you confirm that? Can you say anything at all about the competitive landscape and why it may have changed at all?

Ray Cisneros

In terms of the competitive nature in the landscape, it is still very strong; it's still very normal. We don't see any significant changes just yet. However, I think we have to give it some time to see how these things play out. But at the moment, it is still a very robust market, although I would say very competitive still.

Paul Coster - JP Morgan

Obviously, people will be concerned that we are sort of in the midpoint of a very strong seasonal period and you are benefiting from a product cycle. Of course the stock has, in the past, reflected the sort of downside of that seasonality and the downside of the product cycles. Can you say anything, Peter, that will reassure people that we are not headed for another precipitous disappointment, I suppose, in the second half of this fiscal year? Is there anything that you can see further out that would give us reasons to be a bit more comfortable about the outlook?

Peter Leigh

Well, as you know, our policy is to give quantitative guidance only for the current quarter. But I will say that subject to normal seasonal influences, at this point we think the outlook for the balance of the fiscal year remains very positive.

Operator

Your next question comes from Satya Chillara - Pacific Growth Equities.

Satya Chillara - Pacific Growth Equities

Good afternoon, gentlemen. I wanted to start off for the October quarter at this point, in terms of units as well as ASP trends, Peter, can you comment on how those things are shaping up? You commented on the gross margins, but can you talk about units and ASPs, please?

Peter Leigh

We think that there will be a further increase in the share of 2-megapixel products, Satya. But you know, even at this point in the quarter, it is very hard for us to predict exactly what the mix will be. Consequently, we prefer not to talk specifically about our ASP expectations. Directionally, I think that the 2-megapixel trend is positive for ASPs. Whether that actually translates into an absolute increase, I think we will simply have to wait and see.

Satya Chillara - Pacific Growth Equities

In terms of PCs, it sounds like PCs, you've got a pretty good growth going on. Do you care to comment on the market share right now? In terms of the top five OEMs, where are you? What kind of products are you selling, VGAs to 1-megapixel to 2-megapixel? If you can maybe break it down a little bit about the PC market that would be great.

Ray Cisneros

We are very pleased with the whole laptop PC market. It is an emerging growth market for us and I think it has taken a lot of people by surprise in terms of how fast the adoption rate of cameras are in this item.

In regards to the resolutions they are adopting, we are seeing across the board all resolutions are being adopted. What was a very pleasant surprise for us was the adoption also of a 2-megapixel resolution up to that point as well. So from that standpoint, this particular market represents another great opportunity for OmniVision.

Satya Chillara - Pacific Growth Equities

The October quarter guidance, Peter, does it include 80% of the sales going into cell phones, or is that the same kind of breakdown you have just given for the July quarter? How is that mix shaking out?

Peter Leigh

Again, we deliberately limited our guidance to the things we are comfortable talking about. But I think that you can assume that order of magnitude, the proportions will be similar.

Operator

Your next question comes from Tayyib Shah - Longbow Research.

Tayyib Shah - Longbow Research

Congratulations on a great quarter. My question is on OmniPixel3. When should we expect those products to come into the market, and will it be introduced for 3-megapixel first and the rest of the product line later down the road, or should we expect to see this across the product line fairly quickly?

Ray Cisneros

As you are well aware, we have already introduced the OmniPixel3 in our 3-megapixel product line, and we expect that to be contributing to revenues sometime by mid-2008. As you mentioned, of course, the idea is always to share this next-pixel generation across the gamut of resolutions, and obviously to give the benefit to the customer for technology as well as next-generation product benefits.

Tayyib Shah - Longbow Research

So should we expect that to be across the product line by the end of this year?

Ray Cisneros

Well, we will leave it at basically a general statement to say how we pick and choose this OmniPixel3 technology, how we release it to which products is right now within the limit of what we can say today, and that's all we can say for now.

Tayyib Shah - Longbow Research

I guess a question for Peter. We have seen this in the past where you've had a period of very strong revenues but then your competitors moved into high-resolution 2-megapixel sensors ahead of you. Now we are seeing once again a period of strength, but we are hearing noises out of Micron that they are already transitioning to 1.75-micron ahead of you. So maybe if you could just address when you think that your 2-megapixel and 3-megapixel will start to show up as a meaningful portion of revenues. Any color on that would be helpful.

Peter Leigh

Let me see if I can parse your question. The 3-megapixel sensor that we introduced in June on OmniPixel3 technology has a 1.75-micron pixel. We believe that that 1.75-micron pixel is at least as good as and possibly even better than any of the competitors' products. We are very comfortable showing that pixel off to any and all of our customers against any and all of the competitive products. So we think that we are right up there as a market leader in that particular important product characteristic.

As Ray mentioned, the 1.75-micron pixel will eventually find its way into other products as we develop and introduce new products on OmniPixel3.Does that answer your question?

Tayyib Shah - Longbow Research

It does, in a way. Just one final question, if I may. Is there any chance we might be getting more 300mm equipment available at your main foundry supplier for image sensors at some point in the near future, or do we have to wait until next year for you to start producing on 300mm?

Peter Leigh

It's something that we keep under continuous review, but there are no immediate plans for migrating to 300mm at TSMC.

Operator

Your next question comes from Tristan Gerra - Robert W. Baird.

Tristan Gerra - Robert W. Baird

What percentage of revenues are you targeting for your 2-megapixel products by the end of this calendar year, given the ramp that you're currently seeing?

Peter Leigh

We don't talk about the mix in terms of revenues. We talk only in terms of units. 2-megapixel and above is above 10% this quarter. We think we will see a further increase in the current quarter, but as I said in answer to an earlier question, I don't want to necessarily quantify that because even at this point in the quarter, it is not easy for us to know exactly how the entire mix will turn out.

Tristan Gerra - Robert W. Baird

For the quarter, given the guidance, is it fair to say that the units are primarily responsible for this trend you are seeing, rather than mix?

Peter Leigh

It's a combination.

Operator

Your next question comes from Aaron Husock – Morgan Stanley.

Aaron Husock – Morgan Stanley

Just to start, can you be a little bit more specific about what your mix was in the quarter, 2 megapixel, 1.3 and VGA?

Ray Cisneros

As Peter mentioned in his description, our mix was roughly slightly above 70% for VGA, 15% for megapixel and above 10% for 2-megapixel.

Aaron Husock – Morgan Stanley

As you're looking at what you expect for the mix in the October quarter, and I do believe there have been some changes to the competitive pricing environment, is it realistic for us to think that your blended average price can increase again, or do you see things out there that could change that?

Peter Leigh

Is it realistic? It's realistic. Is it going to happen? I think we'll just all have to wait until November when we report and see. Believe me, we are not unwilling to share with you the things that we know, but we don't really want to be in a position of giving you information on which we can't be sure.

Aaron Husock – Morgan Stanley

As you were talking about earlier with the way your inventory works and your costs work, as you make progress on your cost initiatives, it sounds like you've already managed to execute on the back-end yield improvement and some of the move to more automated tests. When do those benefits really flow through the income statement? Is it the October quarter, or are we going to be waiting for the January quarter?

Peter Leigh

I think you want to think of this more in terms of a continuous improvement. What you're going to see is if we continue to execute the way we are executing now, you are going to see continuous improvement next quarter and the quarter after that because this is a hedge row by hedge row battle that we fight to improve yields and to lower costs. It is not a single moment where we can declare victory. It just doesn't work like that, I'm afraid.

Aaron Husock – Morgan Stanley

One more, just on wafer encoding, you were talking about how some of your customers want a single-chip solution and you are now developing that. Do you think that desire for a single-chip solution in any way impedes the initial ramp-up of the two-chip wafer encoded solution you have wins for already?

Peter Leigh

Not directly, but I do think that it is very clear now that what we have to do is to integrate wafer encoding into the single-chip solution in order to make this a mass-market product.

Operator

Your next question comes from Kevin Cassidy - Thomas Weisel.

Kevin Cassidy - Thomas Weisel

On your new source for 300mm DRAM capacity, you said second half '08. Can you say a little more about that, more details?

Peter Leigh

I'm not quite sure what more detail you're looking for. I mean, the point is that we have to develop new processes with PFC. We have a long relationship with PFC, but this is a new initiative for us and for them, and it is going to take a little bit of time to develop processes on the DRAM manufacturing process. Remember, our existing sensors are made on a logic process, so there is a lot of work to be done and we think that it is realistic to expect that we will get production in the second half of 2008, and that the economics of this will be very favorable.

Kevin Cassidy - Thomas Weisel

Will it be 2-megapixel and above? Or what kind of products?

Peter Leigh

We haven't specifically announced what products it will be. I think the answer is that depending on how successful we are, that will in turn determine just how many products we migrate to PFC.

Operator

Your next question comes from Harsh Kumar - Morgan Keegan.

Harsh Kumar - Morgan Keegan

First of all, congratulations. These are tremendous numbers, obviously, and great guidance as well. A couple of questions. Let's just strip out the PC side of the business for a second, and thinking about just the handset side, Shaw or Peter, is it pretty fair to assume that you are taking market share in handsets? Is that how we should think about this?

Ray Cisneros

If you look at the quarter-ending numbers and then our guidance, obviously, that means higher numbers. And you look at the overall market share obviously there is a trend for us that that goes up. Eventually, the data analysts will have to give us some feedback on where we stand, but it looks favorable to OmniVision.

Harsh Kumar - Morgan Keegan

All right, because I know you guys are doing well in PCs, but I was just curious. Was there any previously written-off inventory in the numbers?

Peter Leigh

There was a small amount. If I remember rightly, it is under $2 million for the quarter.

Harsh Kumar - Morgan Keegan

Okay, that's very helpful, Peter. Then, of course, with your numbers going up on the top line pretty high, Peter, your OpEx as a percentage is going to drop off. How should we think about your model at this point? Are we to assume that your OpEx as a percentage of sales will go back to what it was, or are you going to try to manage it on an absolute dollar basis from here? Any color you can provide would be very helpful.

Peter Leigh

As I think we have discussed in the past, I think it is better really to think about this in terms of absolute dollars, look at the growth rate. As Shaw indicated, we are trying to be very prudent about our spending. But at the same time, we recognize that we have to invest in the future of the business. That means that on a case-by-case basis, we will add people and we will spend money when we think that it's in our long-term interest to do so.

Harsh Kumar - Morgan Keegan

That’s helpful. So basically, on an absolute basis. Last question, your tax rate. I am a little confused. Is that a GAAP guidance on the tax rate of 10% to 12% or pro forma?

Peter Leigh

No, the problem with the GAAP tax rate, to put it simplest, remember that now that we have the stock-based compensation expense in our GAAP numbers, our effective tax rate in any quarter depends to a very large extent on the number of stock option exercises and the prices at which those options were issued and so forth. So the GAAP tax rate is going to fluctuate a great deal from quarter to quarter. And in addition, because of a recent revenue ruling having to do with how you allocate stock-based comp between U.S. operations and foreign operations, our effective GAAP rate is likely to go up. Meanwhile, the underlying tax rate as a result of the way we organize our business is going down, so when you strip out the stock-based comp, the effective rate goes down to somewhere between 10% and 12%.

Operator

Your next question comes from Quinn Bolton - Needham & Co.

Quinn Bolton - Needham & Co.

Let me offer my congratulations on the strong results. A number of clarifications, and then just one question. First, on the inventory that was previously written off, I'm assuming that you guys probably had to write down some other inventory, and wondering if that just sort of balanced out? I know you tend to have both components in any given quarter.

Peter Leigh

Actually Quinn, the amount of new reserves we took this quarter was a little higher than last quarter. Again, the number was around $4.8 million, somewhere in that region. So it was actually up from the previous quarter. The reality of this business is that there are going to be some products, even with the best production in the world, that you have to write off, and unfortunately, unlike fine wines and some cheeses, our inventory just doesn't get better with age.

Quinn Bolton - Needham & Co.

No, I just wanted to make sure that both sides of the equation were being presented. The second clarification is on the tax rate change. Does that take effect here in this fiscal second quarter?

Peter Leigh

No, that is from the beginning of the fiscal year.

Quinn Bolton - Needham & Co.

I mean, you had a tax benefit on a pro forma basis in Q1?

Peter Leigh

That was both pro forma and GAAP, because we have, remember, that $0.08 that we talked about the tax change, that appears in both the GAAP and the non-GAAP numbers.

Quinn Bolton - Needham & Co.

So you think it's 10% to 12% for the year. Does that mean it's higher than 10% to 12% in the last three quarters of the year because you had a net benefit in Q1, or should we just model 10% to 12%?

Peter Leigh

Just ignore the net benefit. That's a discrete item. I'm talking about the steady-state tax rate.

Quinn Bolton - Needham & Co.

Lastly on the clarifications, the R&D or NRE costs going up again in the current quarter. Any sense you can give us, is that another $1 million, $2 million, just kind of rough ballpark?

Peter Leigh

We don't typically give guidance to that level of granularity. I wanted to make sure that I told people that the costs would go up this quarter, so that we didn't leave you with the wrong impression that somehow the increase in Q1 was an aberration. Above all, I think I have to make the point that these NRE costs, they are the lifeblood of this company. The more new, good designs we release to the foundry, the better foundation we are building for the future of the business.

Quinn Bolton - Needham & Co.

No, I understand, I know it's a lumpy business. I'm just trying to get a sense of, it seems like in fiscal Q1 and fiscal Q2, you may have higher than average NRE costs in the quarter. Is that a fair statement?

Peter Leigh

Yes, I think that's fair.

Quinn Bolton - Needham & Co.

Lastly, it sounds like, from speaking to some of the folks in the supply chain, that supply was pretty tight for your sensors in the July quarter. Do you think that there was any demand left on the table, any sort of catch-up demand taking place in October, or did you guys feel that you could pretty much meet all the customer requests through the July quarter?

Ray Cisneros

Definitely demand is strong, but as Mr. Hong mentioned in his statements, we are driving our supply chain to deliver the product on time, and based on everything we've seen, it seems to be well-balanced from our standpoint.

Quinn Bolton - Needham & Co.

So you felt you met most customer requests through the July quarter?

Ray Cisneros

Correct.

Peter Leigh

Let me just add, if I may, that the operating side of this company and the production people under James and Eugene don't appear on this conference call. They really play a critical role in this whole process of making sure we do get the supply we need, and have done an outstanding job.

Operator

Your next question comes from Adam Benjamin - Jefferies & Co.

Adam Benjamin - Jefferies & Co.

It looks like on a blended basis, ASPs were up about 5% for the overall company. Should we be thinking that the handset segment was roughly in line with that as well?

Peter Leigh

Handsets are such a big part of our business that basically the two go, excuse me, hand in hand.

Adam Benjamin - Jefferies & Co.

So roughly in line with that 5% increase is what you're saying?

Peter Leigh

Yes.

Adam Benjamin - Jefferies & Co.

You mentioned 2-megapixel being about a little over 10% of the unit mix in the quarter. I think in the last couple quarters, you have mentioned those numbers, too. Where were those, roughly?

Peter Leigh

In the quarter, just over 10%. I think actually, if you go back to Q2 of '07, we did get above 10% then we went down a little bit below 10% because VGA was very, very strong, stayed a little below 10%. We're back over 10% now, and we expect that number to go further higher this quarter.

Adam Benjamin - Jefferies & Co.

Right. That's what I thought. So give or take, it has been a little bit below, a little bit above for probably three or four quarters now?

Peter Leigh

Agreed, although bear in mind on an ever-increasing mix.

Adam Benjamin - Jefferies & Co.

Right. I am just trying to reconcile where that ASP bump came from, because it does not appear like there was that big a mix shift to 2-megapixel from VGA.

Peter Leigh

In terms of the percentages, it may not be that much, but bear in mind that the price of a 2-megapixel sensor is significantly higher than VGA. So the unit mix moves the needle quite quickly.

Adam Benjamin - Jefferies & Co.

On the PC camera front, you are seeing some strength there. Can you give us some kind of magnitude in terms of the unit growth sequentially that you saw? Was it significantly higher than the overall unit growth for the company on a quarter-over-quarter basis?

Ray Cisneros

Yes, we did see a significant increase in unit growth, and we still see that trend continuing. So definitely this is an emerging high-growth market for OmniVision; it certainly looks that way.

Adam Benjamin - Jefferies & Co.

Was it as high as triple digits sequential growth, or lower than that?

Peter Leigh

We don’t typically break the numbers down that finely, Adam. Most of our competitors are probably listening to this call, and we would rather make them work a bit harder to figure these answers out.

Adam Benjamin - Jefferies & Co.

Moving to the gross margin front, in terms of your implied gross margin guidance, given what you talked about on OpEx, Peter, and the 10% to 12% tax rate, it looks like you are right around the 24%, 25% level. Is that the level that we should be thinking about? You made some comments earlier in the call about not returning back to the 30%-plus level. Should we be thinking about the long-term level steady-state for this company more in the mid- to high-20% range?

Peter Leigh

I don't want to take that position. What I wanted to do and what I was trying to do in the earlier answer was just to indicate that giving longer-term guidance on margin is simply not possible, given what we know about this market and how dynamic the marketplace is.

I think that the goal here is to continue to see incremental improvement quarter by quarter. As I mentioned earlier, I think what's really important, seems to me, from an investor's point of view is that at the current run rate of revenues, even 100 basis point improvement in margin has a meaningful impact on EPS. In other words, you don't have to get back to 30% or 35% to have some real leverage in this business model.

Adam Benjamin - Jefferies & Co.

Understood. Just one last question. Shaw laid out the three drivers for the growth in the quarter, which sound like they'll continue into the October quarter. Can you give a little bit more granularity without naming specific customers, was it any specific geographies, any specific new Tier 1 design wins, anything that could give us a little bit more granularity in terms of where this strength, both for the July quarter and October quarter, is coming from?

Ray Cisneros

I think we mentioned in our statements there's a couple things going on here. One is across the board, we did see some socket design wins with Tier 1 companies as well as with ODM companies and even Tier 2 companies. On top of that, geographically, the overall business mix is very healthy across the board in all geographies. By that, I mean even to our end customers' geography locations. So it is a twofold mix of good strength in geographies as well as in the business models.

Adam Benjamin - Jefferies & Co.

What about in terms of share?

Ray Cisneros

In terms of market share?

Adam Benjamin - Jefferies & Co.

Sure.

Ray Cisneros

In terms of market share, as I mentioned, obviously with the unit growth in this quarter we just closed as well as the quarter we're in, it definitely speaks for some upward trend. Obviously, we anticipate good feedback on our overall market share position. That's basically speculation for now, but definitely the trend is that way.

Operator

Your next question comes from Catherine Bogart - AG Edwards.

Catherine Bogart - AG Edwards

Just following on that last question, in your dealings with customers, are you dealing with a broader customer base and increasingly diversified units there, or is it strength at existing relationships that you're seeing?

Ray Cisneros

No, it is both. There's definitely an increase in a broader customer base. Obviously, with the emergence of the laptop market, that exposes us to new customers in that space as well as our handset space. It is a broadening of our customer base in all tiers, Tier 1s and below.

Catherine Bogart - AG Edwards

On the handset business, the strength in VGA, is that stemming from low-end handsets versus a secondary camera in handsets? Could you give some color on that?

Ray Cisneros

That's a good question. We've made a couple of comments about the strength of VGA as well as the XGA we have, which is the secondary camera sensor. So in regards to the VGA there is a trend, in my opinion, for an emerging or I should say a broadening of the entry-level handset market, where that keeps expanding into emerging markets and different geographies. In regards to the secondary camera, we mentioned our XGA sensor fits that niche nicely with its high performance for that particular application.

Catherine Bogart - AG Edwards

At what point would you see perhaps in the future a need to go to a sub-$1 VGA to continue penetrating the emerging market? Is that something that you would really have to focus on near term?

Ray Cisneros

Well, obviously, that is always something that is on the table for discussion, both from the customer side as well as the supplier side. But at the moment, we are just happy to supply what we have right now. How the trend goes, we will have to see how that pans out with regards to ASPs.

Catherine Bogart - AG Edwards

On the availability of chip-scale packaging, could you discuss that a little bit? Do you see that as a competitive advantage for OmniVision?

Ray Cisneros

Obviously, OmniVision has a long history with chip-scale packaging, and it does serve us well with our customer base, as well as what our technology strategy is. So overall, it is a strength of OmniVision.

Catherine Bogart - AG Edwards

And in terms of availability, overall market-wise?

Ray Cisneros

In terms of availability, as we refer back to our statements, that's back to our supply chain. That's where we drive our supply technologies, as well as our partners. Expanding that capacity is always part of our plan, as you can see, based on our statements. So we are definitely on top of it and making sure this scales with what we need.

Catherine Bogart - AG Edwards

Great. Congratulations on the quarter.

Operator

Your next question comes from Amit Kapur - Piper Jaffray.

Amit Kapur - Piper Jaffray

Obviously in the handset market there is a lot more buzz out there with the launch of the iPhone and some new carrier pricing plans. Are you seeing any evidence in the discussions you're having with customers that they are starting to move upstream in terms of the levels of resolution, if the initial discussion was around designing into VGA, and then come back to you in response to what they are seeing from some of their competitors, they are moving upstream to, say, 2-megapixel and beyond? Are you seeing any signs of that?

Ray Cisneros

Across the board, there is a general trend definitely to look forward to higher resolutions. Our customers' strategies and marketing strategies are very complex. They cover across the gamut of everything from entry-level phones to high end phones, but in general, yes. The movement is to higher resolutions, but on the other hand, the market is so large and there is still continual expansion in the market, so in my opinion there is strength going both ways in all resolutions. So you will see a good mix going forward.

Operator

You have no further questions. I would now like to turn the call back over to Mr. Shaw Hong for closing remarks.

Shaw Hong

In closing, I want to reiterate our confidence in the ability of OmniVision to continue to be a market leader in advancing image-sensing technology. We are well-positioned to introduce new and advanced products that meet the needs of our customers ahead of the competition. We thank our team for its hard work and your participation in our call. We look forward to speaking with you next quarter. Good bye.

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Source: OmniVision F1Q08 (Qtr End 7/31/07) Earnings Call Transcript

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