Spansion Q3 2007 Earnings Call Transcript

| About: Spansion Inc. (SPSN)

Spansion Inc. (SPSN) Q3 2007 Earnings Call October 16, 2007 4:30 PM ET

Executives

Bob Okunski - Director of Investor Relations

Bertrand F. Cambou - President, Chief Executive Officer,Director

Dario Sacomani - Chief Financial Officer, Executive VicePresident

Analysts

Glen Yeung - Citigroup

Ahmed Seraf - Credit Suisse

Aaron Husock - Morgan Stanley

Daniel Amir - Lazard Capital

JoAnne Feeney - FTN MidWest

Betsy Van Hees - Cowen & Company

Bobby Gujavrty - Deutsche Bank

Operator

Good day everyone and welcome to the Spansion third quarter2007 earnings results conference call. Today’s call is being recorded. At thistime, for opening remarks and introductions, I would like to turn the call overto the Director of Investor Relations, Mr. Bob Okunski. Please go ahead, sir.

Bob Okunski

Thanks, Dustin. Good afternoon, everyone and welcome toSpansion's third quarter 2007 earnings conference call. This is Bob Okunski,Director of Investor Relations here at Spansion. Joining me are Bertrand Cambou,President and CEO; and Dario Sacomani, Executive Vice President and ChiefFinancial Officer. As for procedure on this call, Bertrand will start out witha high level view, followed by Dario who will give some additional color on ourperformance and then turn it back to Bertrand for guidance. We will then openup the call for questions.

Before beginning today’s discussion, I need to spend a fewminutes remind you of the Safe Harbor limitations of our discussion. Duringthis call, we will make forward-looking statements that are made pursuant tothe Safe Harbor provisions of the Private Securities Litigation Reform Act of1995, including but not limited to statements regarding the expected productionat SP1, expectations that Spansion will complete the Saifun acquisition and itsassociated future impacts, expected fourth quarter sales, gross margins, ASPs,and expected fourth quarter costs in research and development, sales, generaland administrative expenses, net interest expense, taxes and capitalexpenditures.

Investors are cautioned that these forward-lookingstatements in this conference call involve risks and uncertainties that couldcause actual results to differ materially from the company’s currentexpectations.

For risks that the company considers to be important factorsthat could cause actual results to differ materially from those set forth inthese forward-looking statements, the company urges investors to view in detailthe risks and uncertainties in the company’s Securities and Exchange Commissionfilings, including but not limited to Spansion Inc.’s annual report on Form10-K for the fiscal year ended December 31, 2006, and quarterly report on Form10-Q for the quarter ended July 1, 2007.

Also, a copy of this press release is available on ourwebsite and this live call is being recorded for replay purposes and can beaccess on our investor relations website at www.spansion.com.

Now, let me turn the call over to Bertrand Cambou, Spansion'sPresident and CEO. Bertrand.

Bertrand F. Cambou

Good afternoon. Thank you, Bob and thank you for joining us.I will focus my comments on the state of the business. Dario will go throughthe financials.

The two most significant highlights for the quarter were thestabilization of ASPs and improvement in the book-to-bill ratio. First, let ustalk about ASPs. In the third quarter, we saw a return to a more stable pricingenvironment, reversing the difficult business conditions that we experienced inthe first six months of the year.

For the first time in more than one year, price per bit rosesequentially, reflecting stability across product line, leveraging the strongdemand for MirrorBit solutions. This is in contrast from previous quarterswhere price per bit declined sequentially 18% in Q2 and 12% in Q1. We are veryencouraged by this recent trend as we enter now the seasonally strong fourthquarter.

Let us talk about the book-to-bill. In Q3, book-to-billratio was at 1.3. This is the highest level we experienced in more than oneyear and is giving us confidence that the overall demand for our product isrobust as we enter Q4.

Booking strength was across product lines and regions,except in wireless Japan, where we experienced an inventory correction due tothe prior build-up of inventory in the early part of the year.

Demand for 90-nanometer MirrorBit was particularly strongand we intend to take advantage of this momentum with Fab 25 now fully ready at90-nanometer and 300-millimeter 90-nanometer wafers available out of TSMC.

From an operational standpoint, revenue and gross marginincreased in the quarter while total operating expenses, which include R&Dand SG&A, declined, despite the accelerated start-up of Spansion 1. Dariowill provide further detail on this.

I am now going to comment on our results by division. Theconsumer set-top box and industrial division business, CSID, had another recordquarter, with revenue up 8% to $294 million. Strength was general and ASP perbit stabilized. In fact, in this division, blended ASP increased. We againleveraged the transition to high density MirrorBit solutions, gainingparticular traction with the one-gigabit NOR offering.

We further penetrated the serial, peripheral and interfacesegment with backlog almost doubling compared to last quarter.

Q3 was another good quarter for CSID, with continuingtraction in market share. Book-to-bill in Q3 was again greater than 1 for CSID,reflecting a strong backlog to finish the year.

In the wireless solution division, WSD, revenue was down 7%to $317 million, due to the inventory correction in Japan that reduced revenueby approximately $40 million of high ASP, high density product. Note that wehad anticipated this correction and reprioritized manufacturing to otherbusinesses to minimize the financial impact.

We were glad to see our business outside Japan growingquarter on quarter by $20 million, as a result of successful penetration of topfive handset OEMs and success in China.

ASP per bit outside Japan stabilized and worldwide unitshipments went from 82 million units in Q2 to 96 million in Q3, indicating thatwe are making good progress in unit share.

Book-to-bill in WSD was extremely robust, higher than 1.5,driven by the acceptance of our 90-nanometer MirrorBit technology solutions,positioning us for an upside during the holiday season.

Other significant events during the quarter include theannouncement of the official opening full production of Spansion 1, a factory fully dedicated to 65-nanometerMirrorBit technology. We will use Spansion 1 to produce MirrorBit at65-nanometer this year. And then we will qualify our entire NOR product familyproductions as early as early ’08, including the new Eclipse architecture.

We are glad to say that this facility is the only300-millimeter 65-nanometer NOR factory in the world that has been designed totake advantage of MirrorBit technology. Our intention is to migrate quicklySpansion 1 to 45-nanometer toward the end of ’08.

This path will accelerate our cost leadership and leveragefor high density NOR device architectures.

Before closing, I want to reiterate how excited I am aboutthe announcement last week on the pending acquisition of Saifun. Thistransaction will have three impacts on our company. First, to securecomprehensive intellectual property around our successful MirrorBit technology;second, it will enable us to enter into the technology licensing business,expanding our margin and accelerating our path to profitability; and third, expandour engineering by increasing the size of our design team by 50%.

The Saifun team brings a lot of experience, depth ofexpertise in areas like four bit per cell, SPI, data storage, and specificdesign expertise around MirrorBit. We expect the transaction to be closed inabout three months and are looking forward to working together as a combinedcompany.

With that, I would like to turn the call over to Dario Sacomani,our CFO, to discuss our financial performance in greater detail. Dario.

Dario Sacomani

Thanks, Bertrand and good afternoon, everyone. Thanks forjoining us. Just a few specifics of our financial performance for the quarter;net sales for the quarter were $611 million, up from $609 million last quarter.And as Bertrand mentioned earlier, our revenue performance was impacted by theinventory correction in certain parts of the Japanese handset market, which isprimarily high ASP, high density 90-nanometer products.

The third quarter gross margin was up 50 basis pointssequentially to 18% as our improvement in manufacturing efficiency was affectedby our lower density product mix. I would say it’s probably in the range of 50to 70 basis point impact associated with the lower density product mix.

In addition to that, we had some factory output issuesassociated with the earthquake in Japan, which was in the range of 30 to 50 basispoints. So actually, although we improved in gross margin, I think that therewas an opportunity to do better than we did.

For Q4, we expect gross margin to be approximately flatsequentially as the better manufacturing execution and the more stable pricingenvironment is most likely going to be offset by costs associated withaccelerating the production ramp of SP1.

We are going to continue to focus on reducing our manufacturingexpenses through further implementation of our wafer level test initiatives,which we’ve talked about before, increased 90-nanometer output, and betterrationalization of our back-end test costs. All of those three initiativeswe’ve talked about before as being our key cost reduction efforts.

Research and development expenses were flat at about $111million, or 18% of revenues, as the increase in the SP1 ramp-up costs wereoffset by benefits related to our cost control initiatives.

Based on the current SP1 production timing, the majority ofthe start-up costs for Q4 are going to remain in R&D. With that, weanticipate R&D expenses to increase about 3% from Q3 to Q4. Now, anychanges in these, the timing of these production qualifications are merelygoing to result in a reclassification of expenses from R&D to cost of goodssold.

Q3 sales marketing, general and administrative expenses were$58 million, which represented 9.5% of revenue, which is down from 10% ofrevenue in Q2 of ‘07. We expect the SG&A expenses to be approximately 9% oftotal revenue in Q4.

Operating loss for the quarter was $59 million, down 9%versus last quarter, as we saw a slight improvement in our gross margin andbenefited from our continued focus on our cost control initiatives.

Net interest expense for the quarter was $17 million andreflects the elimination of certain one-time benefits that we talked about inQ2 of ’07, primarily related to real estate gains in Asia.

We anticipate that net interest expense will be approximately$18 million in Q4. We also recorded a tax benefit of $4.3 million for thequarter related to adjustment of allowances in our Japanese operations. Weexpect taxes to be nil in Q4.

Q3 net loss was $72 million, compared to a $67 million lossin the second quarter of ’07, and Q307 net loss per share for the quarter was$0.53.

Moving on to the balance sheet, we remained focused on cashmanagement. DSOs declined to 52 days from 58 days last quarter. Days payableincreased to 85 days from 72 days, reflecting the continued impact of our largeCapEx spend for SP1 in Q2.

Inventory days were 97 days, up from 87 days in Q207 andreflects our increased build of 90-nanometer parts for anticipated seasonalstrength in Q4 of ’07.

CapEx for the quarter came in at approximately $195 million,down from $595 million last quarter, as we continued to spend on our SP1facility. Approximately 75% of the CapEx spend in the quarter was for65-nanometer and 45-nanometer development, primarily at 300-millimeter wafer diameter,as well as our improved testing initiatives. We still anticipate CapEx to bearound $1 billion for the year, depending on the timing of deliveries. Anddepreciation for the quarter was $130 million.

At the end of Q3 2007, our cash and short-term investmentbalances were $529 million, down $189 million as we paid for the SP1 equipmentthat we purchased last quarter. Net debt was up $387 million due to the declinein cash and the partial draw-down of our GE equipment loan related to our SP1investment.

Revolver capacity at the end of the quarter wasapproximately $180 million, as well as approximately $200 million to beavailable under our GE term facility.

EBITDA for the quarter was approximately $71 million, whichis actually up $8 million from Q2 if you exclude the benefits of the Asia landsale. And cash flow from operations adjusted for the accounts payablefluctuation related to SP1 in Q2 was approximately $70 million. If you’llrecall, we had a big increase in cash flow from operations last quarter and adecrease in cash flow from operations this quarter, but if you adjust the twoquarters for the anomaly associated with the CapEx spending in Q2, it’s about$70 million worth of cash flow per quarter.

And with that, I will turn it back to Bertrand to discussour expectations for Q4. Bertrand.

Bertrand F. Cambou

Thank you, Dario. Looking forward, Q4 is a seasonally strongquarter in this industry and all indicators point toward a typical pattern thisyear. ASPs are stabilized and we anticipate ASP erosion to be back to a moretypical level, with ASP per bit down 6% to 7% sequentially.

Given these trends, we estimate that Spansion revenue in Q4will be in the $640 million to $700 million range; gross margin will beapproximately flat sequentially, as the benefit from the revenue increase willbe offset by the extra burden of starting Spansion 1 in volume production.

Our cost control programs are still in motion and we expectall the cost parameters to be rather good.

In conclusion, the stabilization of ASPs in Q3 wasencouraging for us, as the very difficult environment that we observed in thefirst half of the year seems to have improved. We are also very encouraged tosee that our booking rate points toward growth and continued acceptance of MirrorBittechnology, in particular at the very cost effective 90-nanometer node.

Finally, with both the successful acceleration of our new300-millimeter factory Spansion 1 at 65-nanometer and the agreement with Saifunare significant events that are going to position us well for success in 2008and beyond.

With that, I would like to open up the call for questions.Thank you.

Question-and-AnswerSession

Operator

(Operator Instructions) We’ll go first to Glen Yeung with Citigroup.

Glen Yeung -Citigroup

Thanks. Dario, questions for you to start with; I’m not sureI understood what you were saying about R&D. Your suggestion that R&Din the fourth quarter will be up 3% to 4% because of some of the expendituresfor starting up SP1 will still be R&D expenditures at that point?

Dario Sacomani

Correct. The timing of when we turn it on, it could be earlyin the fourth quarter, it could be the beginning of December, it could betowards the back of December, so what I did is I guided you guys as though itwas all going to be for the quarter in R&D. If in fact we get earlierqualification than that, than some of that is going to just shift from R&Dto COGS, but I tried to guide you with a flat gross margin and a 3% increase inR&D. If that switches a little bit due to qualification timing, you willstill be okay on your bottom line.

Glen Yeung -Citigroup

I guess the question is why wouldn’t gross margins be higherthan in higher revenues if you are not putting the expenses of SP1 into COGS?

Dario Sacomani

I anticipated that we would turn on depreciation tosomething in the range of $7 million to $10 million, and how much of theR&D material actually gets reclassed up into COGS. Like I said, I didn’tknow yet so I tried to guide you so that you would get the right bottom line.

Glen Yeung -Citigroup

I’m sorry, I’m still a little confused here. So are yousuggesting that gross margins could in fact be higher than flat and dependingon what happens to R&D, or is there a reason that gross margins would havebeen lower in the fourth quarter if not for the issue of SP1?

Dario Sacomani

No, absolutely not. I think given the ASP environment, Ithink that they would have been up but I am assuming in that number I gave youaround $7 million to $10 million of incremental depreciation and I’ve assumedthat all the engineering material continues to be in R&D. If in fact someof it transfers up to COGS, I’m expecting a lower gross margin. But no, I thinkexcluding SP1, I think it would have improved.

Glen Yeung -Citigroup

Okay, I understand. I think I got it. Thanks. The otherquestion I had was just thinking about the mix of consumer versus wireless andmaybe Bertrand, for you; as we look into the fourth quarter, what do you expectthat mix to look like? How much more business are we seeing in consumer? Andmaybe if you could just answer that also in terms of revenue mix but also,what’s the relative profitability there? It sounds like the pricing in consumeris a little bit better and as we shift towards consumer, does that help or hurtyou?

Bertrand F. Cambou

Let me try to give you -- of course, we are looking at theguidance right now here, but what we are looking at is the CSID has been kindof every quarter going up, I would say like a clock in the sense of gaining marketshare. Obviously as we are gaining a lot of market share, we start to get to apoint where now market share is going to be -- I don’t have the number here butit is not going to be very far from 40%. And compared with essentially 25% 18months ago, which means we are getting to a point of keep increasing is notgoing to be as easy as it was.

I anticipate CSID to increase a little bit in Q4 but thebulk of the growth is going to be coming from the wireless outside Japan intothe big OEM, where actually if you look at my margin compared with CSID, thisis similar. This is actually a good business that we have lined up. This is90-nanometer MirrorBit. That’s the bulk of the growth in wireless.

I feel that this growth is going to be good quality businessfor us.

Glen Yeung -Citigroup

And you are confident that it’s really what’s in yourbacklog right now?

Bertrand F. Cambou

Yes.

Glen Yeung -Citigroup

You’re confident why Japan will come back, it’s because thebacklog is so --

Bertrand F. Cambou

But Japan is not going to come back.

Glen Yeung -Citigroup

Sorry, not going to come back.

Bertrand F. Cambou

Japan is not going to come back. Japan is going to be as-is.We are actually modeling it flat. It could be a bit up, yes, but we are notgoing to count on it. All the growth is essentially the big top OEM, a littlebit in China, but it is really solid, you know, big account, you know -- andthis is using our most cost-effective technology.

Glen Yeung -Citigroup

I just have one quick last question for Dario, which is whendo you think gross margins can start to actually go up? I guess that dependssomewhat on start-up charges for SP1 go away?

Dario Sacomani

I think as we get to -- you know, we are trying to getourselves to about 2,000 wafer starts a week, which I think we should probablyget to by the end of Q1 of ’08. I think at that point in time, I think we’llprobably see some start-up, some pressure on gross margin in Q1 but I wouldsuggest that perhaps once we get into Q2, we start seeing an improvement ingross margin again.

Bertrand F. Cambou

To echo what Dario said, 2,000 wafers a week is what we havelined up in the plan and right now, we are looking at the end of Q1. At thatpoint, of course, in SP1 is going to be competitive with what we are currentlyachieving and getting the kind of break-even at that point. After that, ofcourse we are going to keep ramping up Spansion 1 and that is going to be ahelp rather than a drag.

Glen Yeung -Citigroup

So flat gross margins again in Q1, you think?

Bertrand F. Cambou

Well, in Q1 obviously it is too early for us to guide youbecause we want to better understand the seasonality pattern, which means thatit is too premature, Glen. Ask us the question next quarter.

Glen Yeung - Citigroup

Okay, thanks.

Operator

We’ll go next to John Pitzer with Credit Suisse.

Ahmed Seraf - CreditSuisse

Thank you. This is Ahmed Seraf calling in for John. I waswondering, could you elaborate a little more on your market share comments andgive us a competitive landscape update? Specifically, could you address -- oneof your Asian competitors last week said they were taking market share as well.Have you seen any impact from that?

Bertrand F. Cambou

If we look at the market share, the CSID business has been kindof very steady, stable gain and if you look at the last 18 months, we had ahuge gain. It has been quarter after quarter of going up a significant numberevery quarter, to a point now that we are almost 300 million a quarter on CSID.

On this particular one, the company in Asiathat you are referring, are not being very effective so far. We know that theyare trying to penetrate some big account. Within the consumer space, they arekind of a pretty much of a niche.

Now, in the wireless space, if I look at some of the majorwins that we have in our backlog that has been created, this 1.5 book-to-billthat we reported, some of that has been a direct hit taking market share awayfrom them.

We think that in the near future, we are going to take somebusiness away from them in wireless with our 90-nanometer family that has beenvery well accepted into the top OEM company.

With that being said, obviously the competition is intenseand I don’t know who is gaining market share on whom here, but my sense is as acompany, we are very focused, like we say, on the CSID and into the majoraccount in wireless and in those accounts, we are kind of [inaudible] in our approachto market here and we think that we are gaining traction on that space.

Ahmed Seraf - CreditSuisse

Okay, and a quick follow-up for your Q4 guidance, whatpricing assumptions do you have going into that or for that guidance? Also,what have you seen quarter to date for pricing?

Bertrand F. Cambou

Like I was alludingduring my prepared remarks, we are anticipating a typical level of ASP erosionsof 6% to 7% per bit per quarter. That is kind of the hypothesis we took andthat is in line with the -- this is in line with what we are looking at in theindustry.

Ahmed Seraf - CreditSuisse

Okay, and if I could just ask one last quick one, for your Saifunacquisition, looking at the external customers, have you got a chance to go tothem and get a sense of are they renewing their contracts, even though theymight be sourcing from what they perceive as a competitor now? Do you have anyconfidence around those external customers?

Bertrand F. Cambou

I actually received several -- I’m going to meet some ofthem later on here but I received a few contacts from some of them and they arepretty happy because obviously one of the most pressing issues they had is theknow-how with Spansion property, and for them to fully enjoy the Saifun IP,they were kind of constrained by not infringing Spansion IP, which is right nowwe have an opportunity to increase the satisfaction of some of those Saifuncustomers going forward.

And of course, we are going to work on a case-by-case, butby and large, we received some relief from those accounts which are looking atthe merge as an opportunity for them to freely win in that space.

Ahmed Seraf - CreditSuisse

Sounds great. Thank you.

Operator

We’ll go next to Aaron Husock with Morgan Stanley.

Aaron Husock - MorganStanley

Great. Thanks for taking my questions. I guess first, I waswondering can you give us a sense for how much the unit impact was from Japanwireless? Because you still put up a very good handset unit number.

Bertrand F. Cambou

The unit in Japan is always very low and ASP very, veryhigh, which means that you have to look at these units as being kind of a smallnumber. If I was to say a couple of million units, that would be kind of aclose call. Over the 96 that we shipped, as you can see, this is not a big, bignumber.

Of course, on the revenue standpoint, that’s a $40 millionimpact, which is given you the idea of the type of ASP that we are talkingabout.

Aaron Husock - MorganStanley

I guess looking at the total content per handset that yousold in the quarter, it was down about 20% sequentially, so even if I add backthe Japanimpact, it looks like it was probably still down meaningfully.

Bertrand F. Cambou

No, if you actually take the $40 million away, we grew by$20 million and units shipment too were 40 million up, which means that the mixwas slightly less but I would say this is 5% to 10% type of number. But the bitwas also less, which means that the ASP was, like we say, per bit was prettystable.

Like I was indicating to the caller previously, what we haveon the backlog is all 90-nanometer and that we have in the wireless space, 1.5book-to-bill, and this is high density that we are going to essentially sellduring the holiday season, which means that you can look at the little [pause]on the content for us in Q3. However, on the backlog is going to be quicklyreversed as we are going forward.

Aaron Husock - MorganStanley

Okay, good, good. Can you give us what your ORNAND saleswere in the quarter?

Bertrand F. Cambou

The ORNAND sales went down by essentially $40 million,because everything we were doing in Japan was ORNAND. However, a couple of veryencouraging news on the ORNAND.

We currently receiving Q3 a backlog of $10 million of ORNANDQuad and we are very encouraged. You know, $10 million in a quarter is not anymore negligible and for us, the plan is to go very, very had at 65-nanometerdirectly out of Spansion 1 for the first essentially three to six months. Thebulk of Spansion 1 is all going to be ORNAND 65-nanometer, which means thataltogether, we see the ORNAND revenue decreasing a bit in the second half of ’07to essentially rebound quite well in 2008 with the combination of the quad thatis now getting more and more acceptance and the 65-nanometer 300-millimeterwafers.

Aaron Husock - MorganStanley

Okay. That makes sense. I guess for Dario, roughly how much inR&D dollars a quarter is related to the SP1 start-up costs at this point?

Dario Sacomani

It was up $1 million in Q3. It was about $13 millioncompared to $12 million in the prior quarter.

Aaron Husock - MorganStanley

Okay, and is that -- okay, got it. And just one last one,what was options expense in the quarter?

Dario Sacomani

It was about $4.5 million.

Aaron Husock - MorganStanley

Okay, great. Thanks, guys.

Operator

We’ll go next to Daniel Amir with Lazard Capital.

Daniel Amir - LazardCapital

Thanks a lot. Thank you for taking my call. A couple ofquestions; first of all, a follow-up on the ORNAND -- I mean, considering theEclipse coming out next year, I guess what, end of Q108, what type of momentumdo you expect in the ORNAND for next year in terms of year-over-year growth?

Bertrand F. Cambou

Obviously ORNAND is a new architecture right now. It isreceiving some fantastic customer receptions. One of the opportunities is goingto actually set it into a NOR socket and that will be potentially major for us,as a significant piece of NOR could switch to Eclipse.

Now, in the ORNAND space, the 65-nanometer is going to bepotentially bigger than the 90 because this is -- the cost structure is muchmore competitive. The 90-nanometer, we had the 200-millimeter wafers versus 300for 65 and all density are very price competitive, which means that what weexpect is a way -- I don’t know what, if we can give you a number here but itis going to be significant -- twice as much or more, I don’t know yet but thisis in this order of magnitude.

Daniel Amir - LazardCapital

Okay. The second one, you are currently -- I guess there’scurrently the negotiations going on a bit for next year on the NOR pricingside. Can you comment a bit where does this stand right now, what’s kind ofyour impression maybe compared to last year?

Bertrand F. Cambou

Obviously we have a case right now where some customer needus more than they need last year. In particular, with the merge between our twomajor competitors where suddenly some companies find they have only one sourceand they are talking to us right now, and that’s good timing for us, as theyare essentially either new customer or new as a desire to go much higher.

Across the board, I would say that the situation we haveright now is normal, which means that we have to give some price concessions,no more than we usually do but this year, we have a lot of cost reduction inthe pipe between the next generation technology. The 65-nanometer is comingvery hard and the large wafer diameters we have a lot to offer here, which meanactually we can, on a negotiation standpoint, we think that we have -- I don’twant to say the upper hand, but we have an opportunity to do rather well wethink this year.

Daniel Amir - LazardCapital

Okay. And then my final question, what do you think CapExwill be for ’08? I guess around $1 billion here in ’07 -- what’s the --obviously it’s coming down in ’08 but any ballpark figure, Dario?

Bertrand F. Cambou

I’m going to let Dario answer but before he answers, all hecan say is it is going to be a function of how we want to or fast we want to goto Spansion 1.

Dario Sacomani

I was just going to add, it is; it’s a function of demand,which we are working through right now, demand and affordability and that’swhat’s the pacing item for SP1 and we’ll hope to give you a lot better guidanceon that during next quarter’s call.

Bertrand F. Cambou

To give you some information here, if I can, a document,right now we essentially have baked a plan to go to 2,000 wafers a week, likeDario said. With an extra $400 million or so, we can go to 4K per week. Now,the question here -- in Spansion 1.

Now the question here is do we need that much, and we arelooking at scenarios right now maybe doing only 3K per week or, you know, andso on and so forth, which means -- there is a $400 million incremental spendingin Spansion 1 and we have not decided anything right now.

Daniel Amir - LazardCapital

Okay. Thanks a lot.

Operator

We’ll go next to JoAnne Feeney with FTN MidWest.

JoAnne Feeney - FTNMidWest

Thanks. Good afternoon, folks. Just a further question aboutthe manufacturing side of things, just trying to understand the timing of thetransition from 65 to 45, but perhaps before we get to that, maybe you couldsummarize for us where you are doing your manufacturing, how much you are usingin house, Fab 25, how much you are still using foundry capacity, the old JVfabs, and how much TSMC? Just so we can get a feel of where your capacity is comingfrom and what kind of process technology you are emphasizing at this point.

Bertrand F. Cambou

Let me quickly say here, I’ll start, JV1 and JV2 that wesold to Fujitsu, we are keeping the facility at constant. It is loading rightnow, essentially full. The demand is there. JV3 is all converted right nowessentially to 110-nanometer and it’s full, and there is no changes at 110. Weare still using TSMC as well and that one next year may go down. As we aretransitioning to 90-nanometer, we are not going to need as much foundry at 110.

At 90-nanometer right now, Fab 25 is full. We are using TSMCfoundry at 90-nanometer and as we are going to migrated to 65-nanometer nextyear, we have several options here and we are going to study that. But oneoption here would be to reduce our foundry, convert Fab 25 to 65, and of coursegoing to 65 on foundry as well. Of course, this is a work in process right nowthat we are going to essentially -- we have built the company right now withquite a bit of flexibility and we are spending our money into the leading edgetechnology node, and obviously this is where we wanted to be because then wecan respond to ups and downs of the business and to maximize our response tothe customer in an appropriate way.

Dario Sacomani

JoAnne, just to quantify a little bit about what Bertrandsaid, about 35% of our starts in the quarter were 90-nanometer and of that,TSMC was about a third of it. So overall, TSMC is getting close to about 15% ofthe wafer starts. So we’ve got flexibility.

JoAnne Feeney - FTNMidWest

If I could follow-up, it sounds like then you are not in asmuch of a hurry to decrease use of the old JV fabs and switch them over, switchthat capacity over to SP1. Is that correct?

Bertrand F. Cambou

The old JV, this is all the small densities, commodityparts, 16, 32-meg, 64-meg -- this is all the legacy parts. Eventually, we aregoing to migrate that to 110-nanometer, which is JV3. We are not going totransfer that to Spansion 1.

Spansion 1 is essentially either cost reductions of mid- tohigh-density, I would say starting at the 256 megabit and above, as well asaligning us to participate into the emerging high-density part of the industry.

JoAnne Feeney - FTNMidWest

And then, it seemed like the move to 45-nanometer has beenslowed a little bit. It seemed like that was originally planned for early ormiddle of ’08 and now you are talking about the end of ’08. Is that because youare just not seeing quite the uptake in terms of aggregate demand or there’s alot of capacity in the industry at this point, so you don’t see any reason torush that? How do we understand that?

Bertrand F. Cambou

The way you have to understand that is we don’t want toessentially confuse our manufacturing organizations. Right now, we are loadingfactory Spansion 1 at 65-nanometer 300-millimeter, and we want to have thattransition to be flawless. And the 45 is going to follow right after that.

Now are we about the schedule where we are planning to be?Yes, I think as an industry, if you look at the business we are in, the 40,45-nanometer migrations, these are late ’08 and I believe we are going to beconsistent with the best-in-class memory company.

Don’t forget that at that point, we need immersionlithography. Those too are not cheap and there is some kind of maturity that wehave to master before we go to high volumes. We are very pleased with theshrink ability of MirrorBit at 45-nanometer. We are very, very active on theprogram as we speak and are planning that to happen in the ’08 timeframe.

JoAnne Feeney - FTNMidWest

Okay, so it sounds like then you feel like at 65-nanometer,your costs will be very competitive and so you don’t see the reason to rush to45 at this point?

Bertrand F. Cambou

At 65-nanometer using 300 millimeter wafers andMirrorBit, we believe that we are going to have a best-in-class cost structurein our industry and that is obviously going to be the case for the 2008timeframe.

Dario Sacomani

And as we’ve talked about before, I don’t know if you’veheard us talk about it before, JoAnne, but we get a real significant benefit incosts as we go to 65-nanometer because we’ve got a microcontroller on boardevery chip and it allows us to do built-in self-test, so to your point and tojust echo what Bertrand said, 65-nanometer is a great cost reduction node forus.

JoAnne Feeney - FTNMidWest

Okay, terrific. Thanks very much.

Operator

We’ll go next to Betsy Van Hees with Cowen & Company.

Betsy Van Hees -Cowen & Company

Thank you very much for taking my call. I just had a coupleof questions. First, can you give us a breakout by technology, floating gate,MirrorBit, ORNAND, your revenue in Q3?

Dario Sacomani

MirrorBit percent?

Betsy Van Hees -Cowen & Company

Yeah, the percent of revenue.

Dario Sacomani

Seventy-one percent, Betsy, was MirrorBit.

Betsy Van Hees -Cowen & Company

Okay, and ORNAND and floating gate?

Bertrand F. Cambou

I think ORNAND we did what, $55 million?

Dario Sacomani

Close to 50.

Bertrand F. Cambou

A little bit less than 10% on ORNAND.

Dario Sacomani

That’s in the MirrorBit number, Betsy. So it’s 71 --

Bertrand F. Cambou

And then 30 or 29% would be floating gate.

Betsy Van Hees -Cowen & Company

Okay, great. Thank you. And then I also had a question inregard to wireless. What percent of wireless business is multi-chip packaging?

Bertrand F. Cambou

Seventy-five percent.

Dario Sacomani

At least.

Betsy Van Hees -Cowen & Company

At least 75%? All right, and then on the memory, on theaddition memory that is being packaged in that, that’s essentially apass-through to the customer, to the end customer, correct?

Bertrand F. Cambou

Essentially.

Betsy Van Hees -Cowen & Company

Okay, great. Thanks. When looking at the balance sheet, canyou give us a little color as to it went up quite a bit sequentially, up over10%. Can you give us a little bit of an idea; is that largely due to the Japanproduct being pushed out and is that in there and when we can expect that toship?

Bertrand F. Cambou

You are talking about the inventory right now?

Betsy Van Hees -Cowen & Company

Right, inventory.

Bertrand F. Cambou

Okay, no, inventory actually -- no, we did not buildinventory in Japan because we anticipated -- what we had in Japan -- let meexplain it.

The customer, which is the telephone operators in Japan, isnot selling their phone and that stuff has been rippling through the channelbut we saw it coming. Already last quarter we switched capacity into what weneed to do, which is currently because the business is going up with thebook-to-bill of 1.3 on average, 1.5 inquarter, we have to build ahead, if I can say, to be able to increase revenuein Q4. We should have the revenue, the inventory that we essentially created inQ3 is to be successful in serving our market in Q4. Nothing to do with Japan.

Betsy Van Hees -Cowen & Company

Okay, great. And then if I understood you correctly, yousaid that Fab 25 was full, meaning that you are at capacity?

Bertrand F. Cambou

Totally at capacity, yes.

Betsy Van Hees -Cowen & Company

Okay, totally at capacity. Given that you are at yourcapacity basically constrained at Fab 25, is there any jeopardy to the guidancethat you’ve given us or can we expect there could be some potential --

Bertrand F. Cambou

No, because the guidance that we are giving you incorporateswhat we can deliver and by the way, there is a lot of improvement right now atFab 25. We are essentially investing a bit in Fab 25. We want to increase therun-rate in Fab 25. We have TSMC as a buffer that is going to be much biggergoing forward. We have Spansion 1 that is going to start to contribute prettysoon. And then of course, we have the inventory prepared to meet the number.

The guidance is actually totally supported by ourmanufacturing plan right now.

Betsy Van Hees -Cowen & Company

Okay, great. And then Dario, just a question for you on theincome statement for next year. Can you give us an idea of how we should belooking at taxes for you guys next year?

Dario Sacomani

I think you are probably safe to say -- it depends on themix from a jurisdiction perspective but I would say just to model anywherebetween 25% and 30%.

Betsy Van Hees -Cowen & Company

Okay. All right. Thank you so much for taking my call.

Operator

We have time for one final question and that will come fromBobby Gujavrty with Deutsche Bank.

Bobby Gujavrty -Deutsche Bank

Thanks, guys, for squeezing me in. Last quarter youmentioned that the DRAM pass through had some impact on revenues and margins.Did that have any impact this quarter or negligible?

Dario Sacomani

It was negligible. That’s why we didn’t mention it. It waspretty much flat.

Bertrand F. Cambou

Yes, exactly because we had the exact same DRAM contentquarter on quarter.

Bobby Gujavrty -Deutsche Bank

Okay, fair enough and back to inventories; do you expectthem to be down next quarter?

Bertrand F. Cambou

We are going to watch Q1 very carefully and as you know, Q1we have the Chinese New Year, which is a very exciting time. The problem withthe Chinese New Year -- this is not a problem but this is a reality that is --we need to have product in January because the Chinese are going to takevacations on February and we need to be sure that everything is done beforethat vacation, which means that we need to have inventory in place for thefirst part of the quarter to respond to Chinese New Year, which means that weare currently asking our sales team to place all the backlog for Q1 to be surethat we are ready to sell to market. And that is going to essentially dictateour inventory at the end of the quarter.

Bobby Gujavrty -Deutsche Bank

So flat, maybe something like that?

Dario Sacomani

Even flat would be down to like 87 days from 97, so from adays perspective, even if it is flat, the volume increase in Q4 is going toreduce the days by about 10 days. But like Bertrand said, it is going to bedependent on the need we see for January.

Bertrand F. Cambou

On the inventory standpoint, I have to add that as we arewatching inventory in the channel to our distributor right now, we are at thelow end of where they want us to be, which means that there is definitely -- Idon’t want to say a shortage in the channel but we are in an environment rightnow where we need parts. Of course, we need the right parts and the right mixand -- but so far, it is a pretty good business environment right now for us.

Bobby Gujavrty -Deutsche Bank

Okay, fair enough. And just on the margins, it sounds like-- I mean, it sounds like you guys are doing pretty well on cost reduction. Depreciationseems to be robbing you a little bit from the margin improvement on an incomestatement but your cash margin is clearly improving.

Do you expect that maybe depreciation will be a bit of aheadwind in the first half of next year as well, in terms of gross marginimprovement? I understand your cash margin will continue to improve but just onan income statement basis.

Dario Sacomani

Like we just were talking about earlier from one of theother questions, just to -- you’re right. I mean, it’s going to -- we areprobably going to have some SP1 start-up costs in Q1 putting pressure on grossmargin but like we talked about, from a P&L perspective, once we get thatthing running at a clip of 2,000 aweek, hopefully towards the end of Q1, we should kind of get over the seriousincremental margin pressure.

But you are right; it’s going to be a headwind, particularlyas we get the start-up of SP1, which is the driver of the incrementaldepreciation.

Bobby Gujavrty -Deutsche Bank

Okay, and just a last question, more of a market kid ofcommentary; do you see any impact -- DRAM prices are obviously quite low and itlooks like NAND prices are following them. Do you see that that has any impacton kind of the DRAM/NAND combination indirectly becoming more cost competitive?Does that put any impact on NOR or they are just very different market segmentsand there are very few where there is overlap between the two solutions?

Bertrand F. Cambou

It seems to be that on the NOR market, we received a beatingso far this year. How much lower do you want us to go as an industry? We kindof were the leading -- I don’t want to say dog here, but we kind of took a lotof beating on that one which -- we think we are at a point right now with theNOR, the NOR is right-priced and the customer knows that the balance,supply/demand and the cost environment is such that we are -- I don’t want tosay we have reached a plateau here because who knows, right? Things can changebut there is an overall understanding here that room for cost reductions thathave been out of control at the beginning of the year is most like over. Butagain, sometimes you have double-dip. What you say may happen but so far,that’s not what we are observing and that’s definitely not what we observed inQ3.

Bobby Gujavrty -Deutsche Bank

Okay. Thanks, guys.

Operator

At this time, I would like to turn things back to ourspeakers for any additional or closing comments.

Bertrand F. Cambou

We would like to thank everybody for spending time with usand listening to the Spansion story. Thank you. Bye-bye.

Operator

Again, that does conclude today’s conference call. Thank youfor your participation. You may disconnect at this time.

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