STMicroelectronics Q3 2007 Earnings Call Transcript

STMicroelectronics NV (STM)

Q3 2007 Earnings Call

October 24, 2007 9:00 am ET

Executives

Stan March - VP, IR

Carlo Bozotti - President, CEO

Carlo Ferro - CFO, EVP

Tommi Uhari - EVP

Carmelo Papa - EVP of Micro, Power, Analog

Alain Dutheil - COO

Analysts

Cody Acree - Stifel Nicolaus

Sandeep Deshpande - JP Morgan

Nicholas Gudva - UBS

Tristan Gerra - Robert W Baird

Simon Schafer - Goldman Sachs

Jonathan Crossfield - Merrill Lynch

Otto de la Parque - Cheuvreux

Didier Scemama - ABN Amro

Robert Sanders - Dresdner Kleinwort

Francois Meunier - Cazenove

Jerome Ramel - Exane BNP Paribas

John Dryden - Charter Equity Research

Presentation

Operator

Hello, and welcome to the STMicroelectronics' third quarter 2007 conference call. (Operator Instructions) For your information, this conference is being recorded. I would like now to turn the conference over to Mr. Stan March, Vice President, and Investor Relations for STMicroelectronics. Mr. March, please go ahead.

Stan March

Thank you, Vicky. Good day, and thanks to all of you for joining us for STMicroelectronics' third quarter 2007 Earnings Call.

Hosting the call today is Carlo Bozotti, ST's President and Chief Executive Officer. Joining Carlo on the call today are Alain Dutheil, our Chief Operating Officer; Carlo Ferro, our Chief Financial Officer; Tommi Uhari, our Executive Vice President. Representing the Application-Specific Product groups is Carmelo Papa, our Executive Vice President for our Industrial and Multi-segment Sector, IMS.

This call will include forward-looking statements that involve risks, and you can find our list of risk factors describing these in the Press Release issued yesterday, as well as in our 20-F.

At the conclusion of Carlo's introductory comments, we'll open the call to your questions. To allow for as many of you as possible to ask questions, please limit yourself to a single question and one follow up. It's in the interest of all participants.

With that housekeeping concluded, I'd now like to turn the call over to Carlo Bozotti. Carlo?

Carlo Bozotti

Hello and thank you for joining us on this call today to discuss our financial performance, business highlights and outlook, and I appreciate your interest in ST.

To summarize, let me share some key highlights of the quarter. First, we came in at the high end of our revenue range due to better than anticipated wireless volumes and strength in computer peripherals.

Second, gross margin, excluding the one time charge, came in at the middle of our range. We could have done better in capturing the higher revenue performance if not limited by the weak industry conditions in Flash memories. Third, ASG posted very strong sequential growth in revenues, and improvement in operating margin, lifting it over 10%.

Fourth, we are strengthening our position in wireless, and believe we are very well positioned in this market in comparison to other competitors.

Fifth, the cash flow from operations continues to grow, and is up significantly from the year-ago three and nine-month periods. And finally, RONA, return on net asset, in total was 10.4% and excluding Flash, RONA was approximately 14% in the third quarter.

Now, I would like to begin with a discussion of the results for the Flash Memory Group, and an update on key steps to completing the divestiture of our FMG Group. FMG sales increased 6% sequentially, a good performance. The operating margin loss increased to 9.9% from 7.6% in the second quarter, reflecting some underutilization of capacity.

Also the third quarter FMG financial results do not reflect a significant impact of suspended depreciation, as most of it is currently in inventory within the assets held for sale category. Obviously, this suspended depreciation policy only impacts FMG.

Turning to the divestiture of FMG, we have cleared some of the most important gating factors. Last week, regulatory clearance was received in US adding to the European Union regulatory approval which was received earlier. We are working now with our partners to stand up Numonyx and bring the transaction to completion. As Intel indicated last week at the time of their earnings call, we expect to conclude by year end.

Now, let's shift our focus to what ST will look like after January 1, and how our ongoing businesses are doing.

Turning first to our Application-Specific Groups. This segment will account for about 63% of our total sales compared to 54% today. Looking at the performance in the third quarter, ASG's revenues increased 7% on a sequential basis, and on double-digit wireless and computer peripherals growth.

More specifically, we had a very strong demand in our wireless segment. Wireless sales increased double digits sequentially on strength in several areas, including radio frequency, power management and connectivity.

In addition, we have started to ramp-up a 3G digital baseband business at Ericsson Mobile Platform licensees. This product ramp-up is basically progressing in line with the plan that we have articulated at our analyst day in May. In fact, current volume estimates for 2008 are looking more robust than what we saw back then.

For the medium and long term, as you know, we have entered into a strategic 3G digital baseband sourcing agreement with Nokia on August 8. In connection with this transaction, a talented team of design engineers, about 200 in total, will join ST from Nokia.

Turning to Computer Peripherals, sales were up double digits sequentially on strong unit growth led by data storage, with sequential growth of our hard disk drive business as the key factor.

Sequential strength also benefited from the second quarter comparison where, if you recall, we were impacted by quarter-end shipment shifts.

But comparables aside, it was a very solid quarter for Computer Peripherals. And as we look to the fourth quarter, we will begin volume shipments of our proprietary system on a chip for the data storage market, a significant accomplishment for us, and a revenue driver in this segment for 2008. And on top of that, we were recently awarded a design win for our next generation 65 nanometer System-on-Chip, again, based exclusively on our own intellectual properties.

Consumer revenue was up mid-single digits sequentially on continued strength of our set-top box offerings, and deployment of our high-definition enabling solution. Historically, the third quarter was the highest quarter for our consumer segment sales but, just as we experienced last year, we anticipate growth to continue in the fourth quarter of 2007.

Our recent announcement with Korea Telecom for high definition IP set-top box products is an example of our continued success in this competitive global market.

In Automotive we saw the normal seasonal weakness on a sequential basis, but year-over-year Automotive revenues were up 4.5%, and we expect the growth to restart in the fourth quarter. Two recent design wins, a next generation worldwide airbag platform, and our penetration of the portable navigation device at Garmin, point out ST’s significant capabilities to not only serve existing global customers, but expand into new markets as well.

From an operating margin perspective, the sequential swing was quite dramatic, with operating profit growing about $90 million. We benefited from a more favorable product mix and manufacturing cost improvement.

Manufacturing delivered a significant improvement in the second quarter, the quarter when the products sold in Q3 have been primarily fabricated with improved logic technology enhancement and improved efficiency.

Product mix in the third quarter was favorably impacted by our MMC Group, which grew faster than our other groups in ASG. And within this group, Application-Specific products increased much faster than the camera modules. In the fourth quarter, we anticipate higher unit sales of camera modules which should have a moderating influence on ASG's product mix.

So overall, looking to the fourth quarter, we expect to see good sequential top-line growth in our ASG segment.

Turning now to our IMS segment, sales increased both sequentially, and year over year, with MEMS products in wireless and gaming applications posting the largest growth.

Our product design wins in MEMS are continuing with these applications, as ST accelerometer products offer customers enhanced functionality and flexibility.

We also benefited from good growth in industrial, power conversion and advanced analogue products, where we continue to add design resources for these important product categories.

IMS accounted for 31% of net revenues in the quarter and will represent about 37% of the Company, post the completion of the FMG transaction.

Finally, in the third quarter this year IMS was able to demonstrate good leverage translating the sales performance into operating profit.

In the Press Release we discussed that, following a comprehensive review of employee benefit programs within ST, we have revisited the accounting for a seniority recognition programs at one of our large affiliates. And this had been in place since 1986.

Historically, we have expensed the costs when incurred, and they are now accrued over the service period of the employee.

In connection with the revision, we incurred a one-time, non-cash charge for the past periods of about $21 million pretax.

More than $7 million were charged to cost of goods, more than $8 million to R&D and nearly $5 million in SG&A expenses.

Our gross margin for the quarter came in at 35.5% without the impact of that one-time charge. Excluding FMG, our gross margin was 39.1%, posting a very significant progression from the prior quarters. However, entering Q4 this performance will be challenged by the negative effect of the currency. Operating expense control allowed us to reach our target of expenses being less than 28% of net revenues.

In Q3, SG&A and R&D combined, represented 27.8% of sales, and 27.3% excluding the one-time charge.

Inventory, excluding FMG, increased by $33 million in total, and included a currency transaction adjustment of $29 million.

Indeed, levels remain substantially flat with a 6.1% sales expansion, which accelerated inventory turns to four times, excluding Flash. I cannot say I am happy about that performance, but want to note the move into the right direction.

Now, let’s move to a discussion of our outlook. At the end of the second quarter we indicated that we expected to see sequential growth in both the third and fourth quarters. We also indicated that we expect to see about 20% growth in ASG net revenues from Q1 to Q4 of this year.

In the third quarter, we came in at the high end of our 2% to 7% range. For the fourth quarter, based upon our backlog and order visibility, we are anticipating a higher sequential growth opportunity in the range between 4% to 9%. And we are also confirming the ASG growth objective.

For the gross margin we are targeting 36.5%. The factors influencing this outlook are mix and currency. The significant negative move in the dollar since the end of the second quarter will be fully visible in Q4. Currency is the largest single reason for the limited leverage. While manufacturing improvements have been realized, they will not completely offset currency impact.

To address this most recent move in the dollar, we are now focusing additional efforts on aggressive product portfolio management within our division , identifying for action those product families that are underperforming and are more vulnerable in this current scenario. We will continue to implement these and other actions to offset currency effects.

Looking ahead to 2008, industry analysts are forecasting semiconductor industry growth in the mid to high single digits. While it is too early for us to comment precisely on this, as we are completing our budgeting for 2008, we are ready to share our capital expenditure plan. We believe that following the separation of FMG, we can grow faster than the industry while targeting to keep our CapEx to sales ratio below 10% for next year.

At the outset of 2007, we set a CapEx budget of about $1.2 billion and anticipate coming in at or below that figure. Our guidance for 2007 and 2008 CapEx also assumes that we will purchase tools from Crolles 2 as they are needed for expansion of our own capacity for 300 millimeter logic.

Net operating cash flow reached $255 million in the third quarter, and $652m for the first nine months of 2007. For the 2007 year to date, net operating cash flow was 9% of sales, and clearly shows the implementation of our lighter asset policy and the figures demonstrate that we are well in line with our goals. And with our planned further reduction in capital spending, we will further boost cash flow in 2008.

Overall, this was a very solid quarter for ST. We have made significant progress since the start of the year in strengthening and improving the performance of our largest business segment, ASG. In particular, our core Wireless business remains strong and recent developments will further improve our positioning.

Recall, that ST is home to Europe's largest and, we believe, best positioned wireless semiconductor supplier. And as we look to 2008 we see continuing wireless sales growth.

As we approach the last quarter of the year, ST is much stronger than at this same time in 2006. While on the surface net sales and earnings look similar, we have engineered a significant rebound since the start of this year. After a difficult first half, we are positioned to end the year growing in 2007 in line with the industry estimates and to see further market share progress in 2008.

Now, let me stop to take your questions. Thank you.

Stan March

Hello, Vicky?

Question-and-Answer Session

Operator

(Operator Instructions). We have our first question from Mr. Cody Acree, Stifel Nicolaus. Please go ahead sir.

Cody Acree - Stifel Nicolaus

Thanks, and congrats guys on a good quarter and a good outlook. Can you talk about the Wireless growth? Obviously, we have the Ericsson baseband that is starting to contribute. How significant is that into your fourth quarter guidance? What can we expect? Maybe any details you can give for 2008.

And then outside of the Nokia announcement that sounds like it's maybe more of a 2010 event, what's the bridge between here and there that continues to add to Wireless growth between those two major OEMs?

Carlo Bozotti

Well, I think that Tommi will comment on that, Tommi

Tommi Uhari

Right. This is Tommi Uhari. So overall, on Wireless we are seeing a continued growth into Q4 and into next year. It's true what we are seeing in our Nomadik family. It's true what we are seeing also at the digital baseband. And I think those together with the, let's say, high volume that our customers are able to get for their products, those all contribute to the continued growth in 2008.

Cody Acree - Stifel Nicolaus

Maybe you have handicap Nomadik versus digital baseband growth for 2008?

Tommi Uhari

I think that we see strong growth in both areas. I think that when we are further into next year, we can comment more on the -- we can see whether it's possible to comment more on the detailed performance of each product line. But overall in the digital area, this comprises the two of these. We see a very strong growth into next year.

Cody Acree - Stifel Nicolaus

Okay, very good. And then lastly, on the storage side, you talked about a significant design win with an OEM. When can we begin to expect to see revenue from that design win? And then any color on future projects, and what you expect for 2008 for that storage business?

Stan March

Cody, it's Stan. On that, we'll see sales from the proprietary SoCs beginning in Q4. This is for the first 90 nanometer solution. The 65 nanometer, obviously, just a recent award, and obviously we've got some work to do in some period of time before that. But when we talked about growth drivers for 2008, we were specifically talking about this proprietary SoC, that's the 90 nanometer version, that'll begin shipping in the fourth quarter.

Cody Acree - Stifel Nicolaus

And Stan, is that 65 nanometer, is that an '08 revenue driver or is it ?

Stan March

No, the 65 nanometer will not be. The 90 nanometer will be.

Cody Acree - Stifel Nicolaus

Okay, great. Thank you.

Stan March

Vicky, next question, please.

Operator

The next question is from Mr. Sandeep Deshpande, JPMorgan. Please go ahead, sir.

Sandeep Deshpande - JPMorgan

Yes, hello. Good afternoon. A couple of questions. Firstly on your ASG, I mean you had a very strong performance on your ASG. But what was very surprising was the flow-through of the margin. Your revenues in ASG sequentially grew by about $98 million, -- sorry, the margin flow-through was about 98%. And we possibly can't be looking to see this kind of flow-through going forward. Was this due, to some extent, due to some highly under-utilized Fabs which caused this flow-through to be so great? Or was there a major mix shift within the revenue base in ASG itself?

And you said, Carlo that we're going to see more shipments of camera modules into the next quarter. So how should we be looking at this margin flow-through going forward? And I have a follow on.

Yes. I think Carlo Ferro will comment on the financial performance of ASG.

Carlo Ferro

Good morning, good afternoon everybody. Yeah, Sandeep thanks for having captured this performance. I'll say it's really a significant leverage in our numbers overall and those of ASG especially this quarter. There are various factors. The most relevant are two.

One is the efficiency of our Fab. Through the inventory cycle we are taking in the cost of goods sold of Q3, the advantage of significant manufacturing improvement incurred from Q1 to the second quarter. This is very important. Manufacturing continues to improve. I would not expect, sequentially, a similar kind of progression.

The mix in Q3 has been very favorable for ASG, with some important growth in various areas, especially in the area of the multimedia and communication. I would say that also we see in the portfolio in multimedia and communication some higher growth in the application-specific product and the [ASIC], in respect to the camera module has positively contributed to the gross margin dynamics. So those are the positive factors.

And you may have also noticed from our report about the effective exchange rate that, thanks to hedging activity, the current environment has started to deteriorate in early July this year has not affected yet the third quarter result. Since the change from the 1.33 of Q2 to the 1.36 of Q3 is, is I would say, negative, but somehow minor in respect to what is, unfortunately, awaiting for us now when moving from 1.36 in Q3 to 1.41 for Q4.

So on this basis, frankly, we cannot at this stage anticipate a similar progression or ability of completely keeping very short term the current level. While the key ingredients on the product portfolio and on the mix improvement, manufacturing improvement will continue to be a significant boost through 2008.

Sandeep Deshpande - JPMorgan

Okay, thank you. And in the follow up, I want to talk a little bit about the strategy in your Wireless business. You're now clearly ramping up with EMP. Longer term, Nokia comes through. And now you seem to becoming a major player in the baseband market. But there are still too many players in the baseband market. Do you intend to be a consolidator in that market, or do you intend to continue in this organic strategy?

And secondly, in relation to that, there is a lot of cash generation in your business. Is that going to be used for some of these acquisitions, or is some of it going to be returned to the shareholder base? Thank you.

Carlo Bozotti

Well, I think I will take this. It's Carlo Bozotti. I believe that we are focusing on organic growth in the Wireless domain. And I think, of course, the opportunities here are products. The move to digital for us is significant. We were not digital. So we had a lot of products with other frequencies, or power management, other, let's say, complementary functions. But today connectivity is growing very rapidly. I think that connectivity will continue to grow.

And in addition, there is the core, the digital core of the phone, the digital baseband, and the application processor. So, this is from a product point of view. But I think also from a customer point of view we have more opportunities. So, of course, it's clear that next year the growth of Ericsson Mobile Platform licensees will be very significant, and very material. We'll see. But in parallel, we are working with other customers to expand our customer base in the Wireless domain.

Now, concerning the acquisition, I think that we will be more aggressive on product portfolio in two ways. I think that we will be less tolerant with those families, and I'm talking about, of course, now product divisions, not major groups. They are not yet performing properly. And they are more impacted by the very unfavorable dollar rate. There are some families who are paying but is more significant [and that] we will be less tolerant on this respect with these families.

But at the same time, growth in activity is getting -- [some] activity taking strategic initiatives. But, at the same time, I think we'll be also looking at opportunities to add flavor to our products -- to our product portfolio and complementing it with properly in terms of application, application products, looking at the [radio]. So this is going to be more important for us in the future after the very intense nine months that we had in 2007.

Tommi Uhari

Alright, if you'll allow me to expand a little bit. So basically, overall, our strategy in Wireless is really based on working with industry leaders in the area of the modem technology, so both with Nokia and Ericsson. And I would characterize the deal that we have with Nokia as much more than organic. So, it is really a step forward in our capability to provide overall system solutions. And I think it positions us extremely well for the mid and long term.

Sandeep Deshpande - JPMorgan

Thank you.

Stan March

Okay, Vicky, next question please.

Operator

Next question from [Mr. Nicholas Gudva], UBS. Please go ahead, sir.

Nicholas Gudva - UBS

Yes. Hi, very good afternoon gentlemen. Just the first question on Flash; we obviously haven't seen the flow-through yet of the depreciation reduction in Q3. So should we expect that to accrue in Q4? And would this be enough in your view to turn FMG breakeven or plus going forward? And I’ve got a follow up after that. Thank you.

Carlo Ferro

Let me take the question. Hi Gudva; first of all congratulations and good luck on your new position, and it’s the first time, I guess you are asking the questions from this new firm. The answers to your two questions are yes and yes. Indeed the effects of assets held for sale accounting is not evident yet in the performance of our Flash business, given a heavy start of accounting for assets held for sale in early June, and approx four month inventory cycle for this category of products.

These are will be very evident and much more evident in the fourth quarter, and also as a result of that, in addition to leveraging on a higher sales and also some expected other manufacturing cost improvement, we do expect our Flash business could be a positive contributor to the operating profit of the Company in Q4.

Nicholas Gudva - UBS

Okay, great. And as a follow up, if I understand you correctly in the opening remarks, you said that your view in '08 of your EMP-related business will be higher than what you thought in May. Now, in May, if I remember well, you said that you'll ship into about 30 million units basically in '08 versus 10 million units in '07. So are you suggesting that you think you will ship more than 30 million units of basebands for Ericsson Mobile Platform next year? And, if so, what kind of underlying market share assumption are you taking for EMP for the overall 3G baseband business?

Carlo Bozotti

Tommi?

Tommi Uhari

I think that we are very well in line with our earlier estimates of strong growth into next year. I think that it is difficult to give the exact number due to all the confidentiality that we want to respect here. But I think that the ballpark that you mentioned is correct.

Nicholas Gudva - UBS

Okay, fair enough. And that assumes market share for EMP broadly flat into next year? Is that your best-case scenario, just as a working assumption, obviously?

Tommi Uhari

I wouldn't like to comment on our customers' markets here.

Nicholas Gudva - UBS

Right. Okay. Well, I'll try to figure it out myself then. Thank you very much.

Stan March

Thank you. Vicky, next question please.

Operator

The next question is from Mr. Tristan Gerra, Robert W. Baird. Please go ahead, sir.

Tristan Gerra - Robert W. Baird

Hello, good afternoon. Previously, you said that 45 nanometer would be on track for a ramp in the first half of '08. If you could elaborate on that, if you mean sampling, what type of products we're likely to see at 45 nanometer first, and when?

Carlo Bozotti

We did not mention previously, and (inaudible) 45, but maybe it was some earlier media conference call. Maybe, Tommi, you can describe what we are doing on 45 nanometer on the digital baseband.

Tommi Uhari

So, basically, on the process development, we are firmly on track to have the capability to manufacture already, let's say, during next year. We have already sampled a number of devices.

The exact ramp-up of when we start, of course, it depends on the designing cycle of our customers. The key products that will go to volume will be in Wireless, but they are later than 2008.

Tristan Gerra - Robert W. Baird

Okay. And then any idea of the timing of when you could have a single chip 3G baseband Nomadik?

Tommi Uhari

Basically, from the Nokia licensed modem technology, we have the capability to create chips like that for the market in 2010. And it's product road-mapping decision, or product road–mapping question which we are currently working on. So, technically the capability is there for 2010, but we haven't yet communicated a firm plan in that area.

Tristan Gerra - Robert W. Baird

Okay. And then, finally, if you could just give us utilization rates for the quarter.

Carlo Bozotti

Yes, sure. In fact, utilization rate for the quarter was about 86%, both on 8 inch and on the 6 inch. Now, when we were impacted by a low utilization rate of these two Fabs which are producing memory, R2 on one side because we are decreasing the production there. And the other one -- R2 is in Italy in Agrate, and [Amucure 8], without these two plants, because now I think we need to start speaking of a company without memory, we'll be 88%.

Tristan Gerra - Robert W. Baird

Great.

Carlo Bozotti

And for Q4 we are expecting about the same, probably a little bit lower, about 87%.

Tristan Gerra - Robert W. Baird

And that be ex-memory?

Carlo Bozotti

Yes, without memory.

Tristan Gerra - Robert W. Baird

Okay, great. Thank you.

Stan March

Okay. Vicky, next question, please.

Operator

The next question is from Mr. Simon Schafer, Goldman Sachs. Please go ahead, sir.

Simon Schafer - Goldman Sachs

Hi there. Thanks very much. I wanted to ask a question on Crolles 2. I think you have the option to buy out that equipment, and the deadline, to my knowledge, is at the end of this calendar year. I was wondering whether you could update us as to what the plan is.

Tommi Uhari

Yeah, absolutely, we have the option to buy the equipment. In fact, as Carlo was mentioning in his opening remarks, in the budget we are talking about the -- the first input that we are giving to you, which is less than 10% CapEx to sales for next year, we are including this possibility.

And by the way, the buyout of the equipment will be shared between this year. And this year we are mentioning $1.2 billion of CapEx. This includes part of buying back the equipment from one of our partners, and the rest will be next year. And, again, the 10% CapEx to sales includes the buyback of this equipment.

Simon Schafer - Goldman Sachs

Okay. Thank you. And my follow-up question would be looking at your gross margin guidance, does that presume much of an increase in gross margin in the Flash Memory Group, or is that roughly the same as it was this time?

Carlo Ferro

No, Simon, this is Carlo Ferro. Gross margin in Flash Memory Group will improve in Q4 as earlier anticipated, also boosted by the effect of accounting of assets held for sale.

Simon Schafer - Goldman Sachs

Thanks, Carlo.

Stan March

Vicky, ready for the next question, please.

Operator

Next question from Mr. Jonathan Crossfield, Merrill Lynch. Please go ahead, sir.

Jonathan Crossfield - Merrill Lynch

Thanks for taking the questions. Given the strong core cash generation, and the expected nearly $500 million you're going to get from the disposal of Flash, are you planning to accelerate cash returns to shareholders, or are you looking to focus more on the acquisition side?

Carlo Bozotti

No, I think that's what we want to do to maintain flexibility, to push the two opportunities. It is clear that ST will stay systematically below 10% CapEx to sales ratio. This is the decision that we have taken. We believe can grow faster than the market, operating with capital investment program of this dimension, including the ramp in Crolles 2 which is, of course, good news. And I believe that the opportunity of the free cash flow generation will remain. And we do not see any risk in the capital intensity moving on for ST in the future.

So, it is obvious that we want to maintain the two opportunities, the one of remunerating the shareholders on one side, but on the other side also working more aggressive on the product portfolio. And as I said already, a couple of times, yes, in terms of acquisition, but also in terms of doing those things that we believe do not perform at the level they should perform. And, of course, in this we need to take into consideration the aggravation of the exchange rate that sometimes has an impact stronger on certain product lines rather than other product lines.

So I think we will maintain the flexibility. And it is for sure that for us it's a way of no return, the one of much more mitigated capital intensity in running our business. And we will maintain the flexibility to both remunerate our shareholders, but also to move on with additional value to the product line.

Jonathan Crossfield - Merrill Lynch

Thanks, Carlo. And then just as a follow up, how do you expect operating expenses to develop in the next couple of quarters as you bring in the 200 Nokia engineers through the deal that you've done there?

Carlo Ferro

Do you want me to take this?

Carlo Bozotti

Yes, Carlo Ferro will take it. We are going to integrate 200 engineers but, at the end, their overall cost as you can imagine, is a relevant ingredient when discussing the sequential dynamic of our overall expenses, but when looking at overall the next quarter we can, I would say, easily digest these additional costs. Having said that, very short term in Q4, we see various incremental factors for R&D and SG&A expenses to increase in absolute dollar.

In addition to the integration of the Nokia R&D team, there are a couple of other technical ingredients. One is, unfortunately, the exchange rate whose impact is estimated on expenses sequentially in a range between $15 million to $20 million. And another one is the number of work days, which is a combination of a couple of more days of calendar given our cutoff on December 31 in Q4, as opposed to the usual four, four, five calendar. And the other one is that normally vacations are very high in Q3, and low in the fourth quarter.

Having said that, referring to absolute dollar I remain absolutely comfortable that leveraging on sales growth, the [OpEx] to sales ratio will decrease sequentially, and will remain definitely below our 28% target threshold.

Jonathan Crossfield - Merrill Lynch

Great, thank you very much, Carlo.

Carlo Ferro

Sure.

Stan March

Vicky, next question, please.

Operator

The next question from Mr. Odon De Laporte, Cheuvreux. Please go ahead, sir.

Odon De Laporte - Cheuvreux

Yes, good afternoon, everyone. I was wondering, how do you think the Joint Venture in Memory will fund its investment in 300mm, given that they will have $500 million in the opening balance sheet? And then I have a follow up.

Carlo Ferro

Well, it's Carlo Ferro again taking the question. At the end, the new company will be an independent entity, motivated and measured on two major parameters. Number one, a time to go to IPO and, number two, value that they can create for their shareholders.

And as a shareholder we do expect the new company would make the most appropriate decision for his strategy, and the timing of its strategy, to move to the 300 millimeter based on the obvious combinations of various decision factors, including demand, including technology, including comparison to the direct competitors and, of course, including the ability to self-sustain his own investment, and their financial standpoint.

Odon De Laporte - Cheuvreux

Thank you. I have a follow up. Do you think it would make sense to set up a Joint Venture in the area of camera sensors or camera modules in order to get the critical size?

Carlo Bozotti

Well, as I said, we will become more aggressive. Also, under the pressure of the exchange rate on our dollar portfolio but, frankly, I have to say that we have some opportunities, but I do not want and I cannot comment on any of these opportunities. I think that, in general, the principle must be that any of the product divisions has to deliver the expected financial performance. And for us, the minimum run-up for any of our product division is 12%.

And I believe that there are some that are under scrutiny and there are, of course, for these divisions a number of options. We can close the activity. We can sell the activity, or we can venture with somebody else. And I think this is, of course, an area where we'll be more aggressive in the future, but I do not like to comment on the specific divisions at this point.

Odon De Laporte - Cheuvreux

I understand.

Tommi Uhari

If you allow me a comment on the camera. So basically, what we are seeing is that the technology position that we have is our new manufacturing process that is being ramped up, and the next ones that are in the pipe, we believe that we have a very good image sensor quality.

Also the know-how that we have built in the area of miniaturization and being able to create the modules becomes extremely valuable, even more so than before when we are moving to wafer level camera solutions. And we believe that all our traditional semiconductor know-how will be accrued, so a value-adding element in moving forward in the Camera business.

Odon De Laporte - Cheuvreux

Thank you very much.

Stan March

Next question, please, Vicky.

Operator

Next question from Mr. Didier Scemama, ABN Amro. Please go ahead, sir.

Didier Scemama - ABN Amro

Good afternoon, gentlemen, and thanks very much for taking my question. I'd like to come back to the gross margin that you reported, and I'd just like to clarify a number of things. First of all, on your gross margins ex-Flash at 39.1%, we basically see on the dollar about $76 million sequentially, an increase. And that's precisely about -- probably due to about $70 million decline in depreciation, sequentially. So, it feels like, basically the ramp-up of your new products in Logic did not generate really a significant improvement in underlying margins, but rather that your gross margins were basically supported by a fall in depreciation? Associated to that question is basically the significant decline in gross margins in FMG where they went from 19% in Q1 to about 10% in Q3. I appreciate that you still have the depreciation to fall in that business, to improve the margins in Q4. But can you just maybe help us reconcile this very sharp decline in gross margin and very strong increase in the Logic business? That would be very interesting?

Carlo Ferro

Yes, Didier, this is Carlo Ferro. We need to set the page on the appropriate number, and I am sorry, we do not normally report on the press release depreciation for Flash for the non-Flash business, but given your question, maybe that's okay that I show the number, for second quarter 2007 depreciation excluding Flash have been $266 million. And for the third quarter 2007 they are $263 million. So you have [well captured], there is a reduction, but this reduction is as little as $3 million. I guess, this answers the question.

Didier Scemama - ABN Amro

So the 70 million is going into FMG, but at the same time the gross margin go down by 4 points sequentially?

Carmelo Papa

There reason of why Flash depreciation goes down, basically, because of holding -- depreciating the assets held for sale. And we have started in June, and the cycle of inventory for Flash is approximately four months. So, this reduction in depreciation is substantially recaptured reducing the inventory value for Flash. You have also -- you cannot [knock it]. But looking at the asset held for sale balance, these overall included in the inventory of Flash, also includes inventory of Flash that went down.

So what happened is that depreciation overall for the Company was down. This is because of Flash -- the Flash portion is not yet in the gross margin, and is in the value of the inventory. For the non-Flash portion, the change depreciation is substantially immaterial to the gross margin dynamic being a $3 million gap.

Didier Scemama - ABN Amro

Okay, and just a quick follow up then. One of your U.S. competitors is sharply down this morning in the U.S. on the back of a substantial increase in R&D in the fourth quarter, and going forward, I think, to basically accelerate the ramp of their growth market. I'm just wondering what we should expect for ST's R&D budget, let's say, in 2008 for the Company, obviously, ex-Flash, at least in the percentage of sales? That would be very interesting, thank you.

Carlo Bozotti

Yes, I want to make an overall comment on our own R&D effort. I think that the trend in ST is to accelerate on the [front] of solutions, solutions to be provided, of course, to all our customers, and in many of the areas where we operate, from the simpler industrial solutions to very complex platforms in the area of digital consumer and wireless, multimedia.

On the other hand, I think we have the opportunity to decrease relative terms. The effort in technology development. And as you know, we have communicated the effort will be very much on what we define as derivative technologies, also primary technologies. Both in the area of CMOS, but also in the area of Smart Power products.

So I think there will be a shift. I think that the shift is happening, and will happen, of course, and there will be an increasing effort in the company on application software products and more focusing of the technology R&D effort on dedicated technologies, proprietary technologies.

Today, the Company is still developing two platforms in terms of technology; the full Flash platform and the full CMOS platform.

In the new configuration the company will not work on a pool technology platform development. In fact, on the Flash we are separating, and on the CMOS we have decided to join the IBM consortia to share this with many more partners. So, overall, we expect a shift, but we have not changed our objectives in terms of expense to sales, both to R&D and SG&A.

Didier Scemama - ABN Amro

Okay, thanks.

Stan March

Okay, Vicky, I think we're ready for the next question, please.

Operator

The next question is from Mr. Robert Sanders, Dresdner Kleinwort. Please go ahead, sir.

Robert Sanders - Dresdner Kleinwort

Yes, hi. Good afternoon, everyone. Just a quick question for Tommi, actually, just on the Nomadik processor. I was just wondering if you could just give us a bit more color on how you expect the ramp to pan out from Q2 next year at your biggest customer. Should we just sort of expect it to be a few models and then accelerating from there and getting quite significant in Q4? Is that the sort of thing that you are expecting at the moment?

Tommi Uhari

Nice try, but I won't comment, say more widely. So I will just say that on the business, what we are seeing is that the ramp continues very strongly next year. Of course, that will be supported by more models, but a customer-wise comment is not possible for us to make.

Robert Sanders - Dresdner Kleinwort

Okay, and then just a follow up for Carlo, if you could just give us the outsourcing percentage in the quarter for STM, excluding Flash, that would be great, thanks.

Alain Dutheil

Yes, this is Alain Dutheil. Excluding Flash, what we have today is a little bit more than 7%. The total of the Company is close to 14%, but the non-Flash is 7.5%, and in Q4 it will be about the same, about 7%.

Robert Sanders - Dresdner Kleinwort

Okay, thanks a lot.

Stan March

Vicky, next question, please.

Operator

The next question is from Mr. Francois Meunier, Cazenove. Please go ahead, sir.

Francois Meunier - Cazenove

Hello, and congratulations on your very good results, despite the weakening dollar. In terms of the positive mix impact we have seen in Q3, and which is probably likely to continue in Q4, is it a structural strength, or is it something which is going to be seasonal some more, basically a better mix in H2 than in H1, and that would continue into 2008?

Carlo Bozotti

No. I think that probably with business point of view it's something that we are trying to drive very strongly. I think that we are trying to drive this very strong in all the groups where we operate. For instance, we did not mention the IMS, and I want to comment on IMS also because Carmelo Papa is here with us, and he is very -- he's [bright]!

I think in IMS, we want to drive this mix improvement very, very strongly, and we have tried to do that. And I think, of course, it takes time, but we will get there. So we want to sell much more advance on our products. We want to sell much more high-end microcontrollers. We want to sell much more in our MEMS products rather than simple [discreet].

So this is an effort that we are continually doing. We want to accelerate when at the same time there is a reluctance here but, trust me, it is a very, very strong drive to improve the mix in all the products where we operate.

Now, if we look at a more short-term view, I think that Q3 was very good, a very good mix because the Wireless was -- excuse me, ASG was strong, and within MMG, MMC was strong. And as I said, Camera was not that strong in Q3, and so we may have variations in the short term, quarter after quarter, but there is a very strong drive in the Company for anything we do to improve the mix, moving from lower-end products to higher-end products and this drive will accelerate.

Francois Meunier - Cazenove

Okay, now a question for Carlo Ferro. In terms of acquisitions, if I remember in the past, then the, something which was basically the main criteria for acquisitions was that the acquisition couldn't be dilutive to earnings. Is it still valid? And also, do you have a limit in terms of size? So basically, you don't want to buy anything more than $2 billion or more than $3 billion?

Carlo Ferro

I would say that the real metric is the value that the acquisition overall provides, and the ability for the Company to increase shareholders' value generation. Then, whether it requires a given size or another, I would not expect to be a limitation, also considering the financial plans of the Company, currently exiting, and based on that, and based on our track record performance, of course, a significant ability to tap that capital market is required.

So in this respect, I'm not among those CFOs putting to our management team or suggesting limitation in value for acquisition -- in amount for acquisition. I see a lot of attention and convergence of all our team on the fact that an acquisition has to be well balanced in terms of investment and future return in order to be shortly accretive to our EPS.

Francois Meunier - Cazenove

But you would still need to be accretive to earnings, say not the first year but, say the second year?

Carlo Ferro

That makes a lot of sense.

Carlo Bozotti

Yes, absolutely. I think that the criteria -- we always had three criteria's, and maybe we should add a fourth criteria in these days. I think the three criteria, number one, of course from a broader point of view need to make sense. And this is obvious, and I believe that the complementarity, completing what we have, creating value to -- creating more value to our offer is an important criteria.

The second criteria is in all, majority. The -- for instance, in Japan, we are not present and this could make sense, but everything, as you know -- there is law in Japan in terms of M&As activities. And the third criteria is the return, and absolutely -- what we have is the objective that any acquisition needs to be accretive the second year.

Now, for us, the dollar is also important. The exchange rate is important, and the dependence on the Euro. We are taking a lot of steps. We are reducing our manufacturing costs, and moving more and more activity from the western world to Asia. Last year we closed two Fabs in Europe. This year we are restructuring to separate FMG with additional closing. We have decided to close one Fab in Morocco. We have decided to close two Fabs in U.S., and all of this, more or less, is moving to Asia, so this is going to help. But if, on the product line, there is a way to have some better, natural hedging, of course, this is also an important criteria.

Francois Meunier - Cazenove

Okay, thank you very much.

Carlo Ferro

Thank you.

Stan March

Okay, Vicky, next question, please.

Operator

Next question from Mr. Jerome Ramel, Exane BNP Paribas. Please go ahead, sir.

Jerome Ramel - Exane BNP Paribas

Yes, good afternoon. Just want to make sure I understood correctly. What should be the level of depreciation for 2008, excluding the Flash? Should be around $1 billion?

Unidentified Company Representative

No, more than that.

Carlo Ferro

It is, frankly, not a matter of having a (inaudible). I did not say it yet, please. For next year, we expect between $1.050 billion and $1.1 billion. We talk after the time of the Flash separation about $1.050 billion, and the only difference today is the exchange rate impact. So, please take a reference of $1.050 billion to $1.1 billion.

Jerome Ramel - Exane BNP Paribas

Okay, and second question, what was the level of outsourcing in Q3, and are you still targeting to reach the 15% by the end of this year?

Alain Dutheil

No, in fact, I gave the number; this is Alain Dutheil speaking, just a while ago. The level of outsourcing with Memory is close to 14%, and -- but without Memory, is between 7% and 7.5%. And of course, during 2008, this number, 7.5%, because at that time the Company will be without FMG, we will move progressively to 15% and 20%. So at the end of -- probably at the end of the year or the beginning of 2009, we'll be at about 20%, from 7.5%.

Jerome Ramel - Exane BNP Paribas

Okay, thank you.

Stan March

Vicky, next question, please. Hello, Vicky.

Operator

We have a follow-up question from Mr. Cody Acree, Stifel & Nicolaus. Please go ahead, sir.

Stan March

Okay, thank you.

Cody Acree - Stifel Nicolaus

Thanks, you guys for fitting me in. Just one quick follow up. We've had lots of earnings here from a lot of your peers, and quite different views as far as the health of the inventory channel, and what the level of orders have meant for stocking of inventories throughout the third quarter and into Q4. Do you have an opinion on, maybe, some of your different end markets, what the health of the channel is, and what you are shipping to consumption levels?

Carlo Bozotti

Well, I think I have reason to -- we have recently gone through, for instance, the dollar is a good indicator of the inventory status of all our distributors in the world. And I believe that there is a big effort that is in place at all our distributors, and they are reducing inventory. I have to say that I saw inventory reductions at many of our distributors already happen and this is a good indication. It is, of course, is important for the industrial, for the multi-segment market.

While, as we see a strong demand, we do not believe there is any accommodation on inventory, not on Wireless, and I believe that consumer is a similar trend. Well, of course, such strength of the Euro, this may give some concern about the European economy, and we see that this, of course, is a general concern because the Euro is so strong, and this may limit exports from the European companies. We are monitoring that. We are very attentive to look at that.

But, in general, I think what we need to do is to wait for the Christmas season, and understand how sales for Christmas will go through, and this is particularly important for the Wireless business, because the demand today is very, very solid in Wireless, very strong in Wireless.

Cody Acree - Stifel Nicolaus

All right, perfect. Thanks for the comments.

Carlo Bozotti

Thank you.

Stan March

And Vicky, we have time for one more question.

Operator

The next question is from Mr. John Dryden, Charter Equity Research. Please go ahead, sir.

John Dryden - Charter Equity Research

Yes, Carlo, could you comment, ex-FMG, on progress with your growth initiatives? I'm really looking for strengths and weaknesses versus your expectations trading off China, Japan, the key accounts, and the up-selling to the outside of the top 23?

Carlo Bozotti

Yes. Yes, absolutely. I think we are doing good progress. This year, there is a major problem. And I think everybody knows, is very much related to one Wireless customer that had an impact, particularly on our -- in the first half on our Memory business, on the FMG business. For the rest, it's going through nicely. I think that Japan is solidly growing. China today is almost 30% of the Company revenues which is very, very strong performance.

I think that, as you know, we are targeting, in fact, there is a form of deployment to target 16 new customers, and they are from all the geographies, and I believe we are doing good progresses there. So I think we are also progressing with our mass marketing initiatives. So I think in all of these items, in all of these categories, initiatives, we have good progresses. It is more some of our strategic -- traditional strategic accounts where there is some limitations of the growth this year.

So, apart this very specific case on Flash Memory in the first half, I would say that the rest is performing very well, and Japan is solid. We are growing and we would expect to continue to grow next year.

China is, as I said, is now almost 30% of the Company in terms of revenues, and there is a very strong focus on these 16 accounts. Some of them are fantastic, of course, but some of them less but, overall, I think is very good. So, apart this glitch in the first half that was specific to one customer and very much on Memories, I believe is progressing very -- is progressing very well.

John Dryden - Charter Equity Research

Thanks for that. Just a follow up, moving to -- back to OpEx. You discussed Nokia. Could you also discuss, ex-Flash, how the roll-off there will be, going into the first quarter? Can we still expect to be within your range on lower revenue in March?

Alain Dutheil

The question is about OpEx trends at post-Flash from January 1?

Carlo Ferro

No, on the -- I would say that we may need a couple of quarters after the closing of the deal to somehow digest this portion of resources that, as you can imagine, when carving out the business could not be fully transferred for retaining the functionality of the operation.

As we said, the combination of continuing to grow revenues and productivity, we are solving and managing some of these possible effects of cost that put us, very comparable to be back in our target of OpEx below 28% for the second half of next year.

John Dryden - Charter Equity Research

Thanks for taking my questions, and good afternoon.

Stan March

Thank you very much, John. Thank you. Ladies and gentlemen, at this time, this will conclude the conference call. Thank you very much for your participation. If you have any follow-up questions, please don't hesitate to call myself or any member of the Investor Relations team for ST. Thank you very much, and have a nice day.

Operator

Ladies and gentlemen, the conference call is now over, and you may disconnect your telephones. Thank you very much for joining. Good bye.

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