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ON Semiconductor Corp. (NASDAQ:ONNN)

Q3 2007 Earnings Call

October 30, 2007, 8:00 AM ET

Executives

Ken Rizvi - Director, IR

Donald Colvin - EVP, CFO and Treasurer

Keith Jackson - President and CEO

Analysts

Romit Shah - Lehman Brothers

Chris Danely - J.P. Morgan

Craig Ellis - Citigroup

Tristan Gerra - Robert W. Baird

Steve Smigie - Raymond James

Amit Chopra - Credit Suisse

Michael McConnell - Pacific-Crest Securities

Mark Lipacis - Morgan Stanley

Ramesh Misra - Collins Stewart

Craig Berger - FBR

Kevin Cassidy - Thomas Weisel Partners

Presentation

Operator

Good day, ladies and gentlemen and welcome to the ON Semiconductor Third Quarter Earnings Release Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's release call Mr. Ken Rizvi. Sir, you may begin.

Ken Rizvi - Director, Investor Relations

Thank you Howard. Good morning and thank you for joining ON Semiconductor's third quarter 2007 conference call. I am joined today by Keith Jackson, our CEO, and Donald Colvin, our CFO. This call is being webcast on the Investor Relations section of our website at www.onsemi.com and will be available for approximately 30 days along with our earnings release for the third quarter of 2007.

Our earnings release in this presentation includes certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most direct comparable under GAAP are in our earnings release and posted on our website in the Investor Relations section.

In the upcoming quarter we will present at the Credit Suisse Technology Conference on November 28th, and the Lehman Brothers Global Technology Conference on December 6. We will also open up the NASDAQ tock market on November 9th.

During the course of this conference call we will make projections or other forward-looking statements regarding future events or the future financial performance of the company. The words estimate, intend, expect, plan or similar expressions are intended to identify forward-looking statements. We wish to caution that such statements are subject risks and uncertainties that could cause actual results or event to differ materially. Important factors relating to our business including factors that could cause actual results to differ from our forward-looking statements are described in our Form 10-K and other filings with the SEC. The company assumes no obligation to update forward-looking statements to reflect actual results, changed assumptions or other factors.

Now let's hear from Donald Colvin, our CFO, who will provide an overview of the third quarter of 2007.

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Thank you Ken and thanks to everyone who is joining us today. ON Semiconductor Corporation today announced that total revenues in the third quarter of 2007 were $402.9 million. As anticipated, an increase of approximately 6% from the second quarter of 2007. Total revenues during the quarter included approximately $381.1 million of product revenues and approximately $21.8 million of manufacturing services revenue. During the third quarter of 2007, the company reported net income of $63.8 million or $0.20 per share on a fully diluted basis, which included approximately $2 million or $0.01 per share fully diluted associated with restructuring, asset impairments and other.

During the second quarter of 2007, the company reported net income of $63.3 million or $0.21 per share on a fully diluted basis. The company's total gross margin in the third quarter was 38.6%, an increase of approximately 30 basis points as compared to the second quarter of 2007, primarily due to higher revenue, which was partially offset by a $5 million reduction of internal inventories.

At the end of the third quarter, days sales outstanding were approximately 44 days. Internal inventories decreased on a days basis by approximately 60 to 80 days as we completed internal inventories during the quarter.

Distribution inventories in dollar terms were approximately 11 weeks. Cash capital expenditures during the quarter were approximately $34 million. The company exited the third quarter with cash and cash equivalents of $327.1 million, up over $71 million from the second quarter.

Now I would like to turn it over to Keith Jackson for additional comments on the business environment. Keith.

Keith Jackson - President and Chief Executive Officer

Thanks Don. Now for an overview of our end markets. During the third quarter of 2007, we saw a sequential revenue growth in our consumer-driven end markets of consumer electronics, computing and wireless.

The consumer electronics end market grew by over 38% sequentially, primarily driven by game console builds as well as growth in LCD TV and MP3 platform builds. The consumer electronics end market represented approximately 24% of our third quarter product sales.

The computing end market grew by approximately 11% sequentially on a dollar basis and represented approximately 25% of third quarter product sales. In the third quarter, we saw continued computing platform ramps associated with back-to-school builds as well as the penetration of our new products targeted towards the computing end market.

The wireless end market grew by approximately 3% sequentially and represented approximately 18% of the third quarter 2007 product sales.

The automotive, industrial and networking end markets were seasonally down with automotive representing approximately 16%, industrial representing approximately 11%, and networking representing approximately 6% of the third quarter product sales respectively.

During the third quarter, on a direct billing basis, no product OEM customer was more than 5% of product sales and our top five product OEM customers were Continental, Delta, Motorola, Sony Ericsson, and Samsung. Our top manufacturing services customer was LSI, as anticipated.

On a geographic basis, our contribution this quarter from product sales in Asia, excluding Japan, were up 400 basis points and represented approximately 64% of product sales. Our product sales in the Americas decreased by approximately 100 basis points and represented approximately 19% of product sales. Sales in Europe decreased by 100 basis points and represented approximately 15% of product sales during the quarter and sales in Japan were down 200 basis points to 2% of product sales.

Looking across the channels, sales to the distribution channel were down by 400 basis points to approximately 48% of product sales. Direct sales to OEMs increased by approximately 300 basis points to approximately 41% of product sales, and the EMS channel increased by approximately 100 basis points to 11% of product sales.

During the third quarter, product revenues broken out by our divisions were as follow -- The Standard Products Group represented approximately 33% of product sales, the Automotive and Power Regulation Group represented approximately 30% of product sales, the Computing Products Group represented approximately 25% of product sales, and the Digital and Consumer Products Group represented approximately 12% of sales. We will publish the quarterly revenue, gross margin, and operating margin breakout of these divisions in our 10-Q filing.

Now I would like to provide you with some details on the progress we have made. In the computing end market, we continue to see strong growth of our power regulators, pulse width modulators, power factor controllers, and multiphase controllers for desktop, notebook and power supply markets. In the third quarter, we continued our design penetration in global OEM desktop platforms, and increased our share of analog controllers to over 10% from approximately 3% in the previous year. We expect to see continued growth in the computing end market for the upcoming fourth quarter.

Our GreenPoint energy efficient power supply solutions continue to meet and exceed emerging global standards for power efficiency. We recently released two more GreenPoint reference design solutions for the consumer electronics end market. Our 5-watt power adapter reference design and our 16-watt DSL modem adapter design help our customers around the world develop products that reduce energy consumption in both active and standby modes. We have already released nine GreenPoint reference design solutions to-date.

Recently, two major computing manufacturers have included our products in their new 80 PLUS efficient power supplies for desktop power supply. These 80 PLUS efficient power supplies contain up to $3.50 of our content per unit and position ON for continued growth in the high efficiency power supply market.

Our products and solutions continue to win awards with our customers and within the industry. We have recently won Celestica's Total Cost of Ownership Supplier Award presented to suppliers who demonstrate excellence in quality, delivery, technology, service, and flexibility. We also received Best Power Solution Supplier Awards from two major consumer products manufacturers -- Hisense and Samsung. Additionally, we were awarded Green Partner Certificates from three major OEMs -- Sony, Samsung and Canon. These partnerships along with our work with ENERGY STAR, China CECP, and other regulatory agencies enabled us to continue our leadership position in efficient power management solutions for a variety of end market applications.

In the consumers end market, our power efficient products and solutions continue to win designs in the LCD TV end market. iSuppli expects this market to see a compound annual growth rate of approximately 20% over the next four years. We anticipate our SAM for the LCD TV market will increase from approximately $4.50 in 2007 to more than $6 in 2008 based on new product introductions. We have had initial success in this end market with two major LCD TV manufacturers beginning production ramps in anticipation of holiday demand.

Now I would like to turn it back over to Donald for our other forward-looking guidance. Donald?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Thank you Keith. Fourth quarter 2007 outlook. Based upon product booking trends, backlog levels, anticipated manufacturing services revenue, and estimated turns levels, we anticipate that total revenues will be approximately flat to up 2% sequentially in the fourth quarter of 2007. We also anticipate that approximately 22 million of our total revenue will come from manufacturing services. Backlog levels at the beginning of the fourth quarter in 2007 were up from backlog levels at the beginning of the third quarter of 2007 and represent over 90% of our anticipated fourth quarter 2007 revenues.

We expect that average selling prices for the fourth quarter of 2007 will be down approximately 2% sequentially. We expect our product gross margin and total gross margin in the fourth quarter to be approximately flat with the third quarter of 2007. For the fourth quarter we expect cash capital expenditures of approximately $20 million. For the fourth quarter, we also expect total operating expenses of approximately 20% with SG&A expenses at between 11% to 12 % of sales and R&D expenses between 8% to 9% of sales.

We anticipate that net interest expense will be around $6.5 million for the fourth quarter and taxes to be approximately $2.5 million. We currently expect stock-based compensation expense in a pre and post-tax basis to be approximately $5 million in the fourth quarter of 2007 and this expense is included in our guidance. Based on the stock price at the end of the third quarter, our fully diluted share count would be approximately 319 million shares in the fourth quarter of 2007. The fully diluted share count can change based upon a change in our stock price. Further details on share count and EPS calculations are provided regularly in our 10-Qs and Ks. We will also post a table outlining potential fully diluted share count changes on our website in the Investor Relations section based upon various stock price assumption.

With that, I would like to start the Q&A session.

Question And Answer

Operator

[Operator Instructions] Our first question or comment comes from the line of Mr. Romit Shah of Lehman Brothers. Your line is open.

Romit Shah - Lehman Brothers

Yes, thanks a lot. Did you guys buy back any stock in the quarter?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

No.

Romit Shah - Lehman Brothers

Don, could you just elaborate on that? I noticed the cash balance jumped up to $327 million. Why didn't you guys buy back any stock and if you could just prioritize what are the future uses of cash going forward?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Sure. I think as a company, we have stated with cash, we have three uses of our cash. One, we can pay down debt, which we've done in the past; buy back stock, which we've also done; or invest in the business. And I think what we have been stating when we attended various conferences is that our priority has been to kick the tires on some strategic opportunities where cash would help us facilitate some acquisitions. So that's why we are not currently prioritizing stock buybacks or debt pay-downs. This activity is very much a hit or miss activity and we have announced nothing because we have completed nothing. So, our optionality still remains, but we have been saying that we were extrapolating [ph] examination of strategic opportunities rather than pursuing stock buy backs or debt payoffs at the end of the third quarter.

Romit Shah - Lehman Brothers

Okay. And as a follow-up, could you just elaborate on the product booking trends you have seen in the last four weeks and why you guys are guiding to, I guess, accelerating growth here in Q4?

Keith Jackson - President and Chief Executive Officer

Okay. This is Keith Jackson. I'll cover that one. We tend to remain on the conservative side when we go into fourth quarter's relative returns. The December quarter typically shows us a customer base that wants to have lean inventories going out of their calendar years. And so what we normally do is just be conservative on the turn side for December, Romit. So I think that's what you're seeing reflected in the guidance.

Romit Shah - Lehman Brothers

Okay, great thank you.

Operator

Our next or comment comes from the line of Chris Danely from J.P Morgan. Your line is open.

Chris Danely - J.P. Morgan

Thanks guys. Hey, Keith. Like the PC end market you think is going to be strongest for Q4, can you just give us your thoughts on your other large end markets, wireless networking etc.?

Keith Jackson - President and Chief Executive Officer

Okay. Certainly again we should see some continued strength in consumer and PCs. I believe that automotive will not see much change quarter-on-quarter. Our stronger quarters there tend to be in the first half for the year, and the same with industrial. The networking side actually again should be relatively flat going into the fourth quarter. So, I think you're looking at industrial, automotive, and networking being relatively flat quarter-on-quarter. r.

Chris Danely - J.P. Morgan

How about wireless?

Keith Jackson - President and Chief Executive Officer

Wireless may be up slightly.

Chris Danely - J.P. Morgan

Okay. And then Donald, can you talk about gross margin trends after Q4 going into next year?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Sure. Well, obviously we don't give guidance for next year, but we are very happy to come in just under 39% gross margin combined in the third quarter, an increase... slight increase over the second quarter. As we go through next year, the mix of our will change. We will have more product revenues and less manufacturing services revenues. So I think it's kind of fair to say that seasonally the first half of the year is not as strong. The gross margin will be around the exit velocity depending on the mix, and we would expect to grow our gross margin in the second half of next year. I think that's the kind of best big picture view we have now. But we have been encouraged by the fact that we saw a sequential growth in gross margin in the third quarter even although we took some proactive measures to reduce our internal inventories by $5 million. So we feel pretty happy that we have a strong stable gross margin on which to build a growth in gross margin next year.

Chris Danely - J.P. Morgan

You know, that leads me to my last question. Do you guys feel comfortable with your inventory right now, so the utilization rate should stay kind of flattish and then trend up in the second half of next year?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

I think that's a very fair observation. If you listened to the detailed comments, our distribution inventory was around 11 weeks, which is pretty near its all-time low, which I think was just about 10.5 or so. It was flat quarter-over-quarter, so no growth in distribution inventory. Internal inventories on a dollar basis were down by about $5 million and about 8 days, I believe, on a days basis. So we are very comfortable that our inventories are in very good shape and that we don't have any inventory overhang going into next year.

Chris Danely - J.P. Morgan

Great. Thanks guys.

Operator

Our next question or comment comes from the line of Mr. Craig Ellis from Citigroup. Your line is open.

Craig Ellis - Citigroup

Thanks and good morning guys. Don or Keith, could you just follow-up a little bit more on the handset business? I know you try to diversify your OEM exposure there. Would you expect broad-based growth in the fourth quarter or are you seeing particular strength out of certain OEMs?

Keith Jackson - President and Chief Executive Officer

No, I'd say it's more broad based in Q4 and again it's not a very strong growth over Q3. I think Q3, the numbers certainly build a good base for Q4, but there is not going to an acceleration in that marketplace in Q4.

Craig Ellis - Citigroup

Okay. And then switching over to the pricing commentary, down about 2% in the third quarter, expected the same in the fourth. Is that across the portfolio or are you seeing pricing being more intense in certain part of the business?

Keith Jackson - President and Chief Executive Officer

Pricing is usually more intense in our discrete lines versus our analog lines. It's a pretty normal thing. Q3 was a little stronger pressure than we had been experiencing and I think Q4 will be less pressure than Q3. But nonetheless there have been some fairly steady ASP declines throughout the year quarter by quarter and slightly more discrete versus analog.

Craig Ellis - Citigroup

Okay. And then looking a little bit further out on the CapEx side, any color on what the CapEx spend will look like in 2008?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

I think we showed guidance for the fourth quarter. We received about $20 million of capital expenditure in the fourth quarter, I think. So, if you look at that on a run rate basis, it's about $80 million. I think that's roughly the number we are seeing from our bottom-up forecast for next year, something under $100 million, in the $80 million $90 million range for capital expenditures.

Craig Ellis - Citigroup

Okay. And then just lastly for me, Keith or Don, could you just frame some of the key milestones as we look at the Gresham facility and your ability to port you own analog products into that facility as we go through next year?

Keith Jackson - President and Chief Executive Officer

Yes, certainly. We are actually qualifying our first analog products now and so we are pretty excited about that. There will be some ramp in Q1, but really the end of Q2 will mark some significant volumes moving into Gresham. Our second major analog process should be coming online toward the third quarter and then that will get basically the bulk of the rest of the company's analog products. So what we're looking forward is a very strong second half next year with our analog products in Gresham.

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

We did meet a milestone also I think in the fourth quarter, we will have more starts of wafers than of LSI wafers in the fourth quarter of this year. Right now we're running trench and some other parts in there. And so that's what we said we would do and we met that milestone. And thanks to Gresham, we are able to cut back the capital expenditures in the other fabs and then we've started restructuring of our manufacturing base, which is the primary reason you have the $2 million restructuring cost as the... more products are run in Gresham, we don't require the same size of platform elsewhere. So that's the activities we started in the third quarter.

Craig Ellis - Citigroup

And Don, would those activities be expected just to continue through next year as you continue to ramp up Gresham then?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

We will continue to rationalize our manufacturing footprint as we ramp up Gresham, exactly.

Craig Ellis - Citigroup

Okay. And then just the follow-up on this particular topic, any indication from LSI in terms of how intensively they would expect to use the manufacturing services beyond the end of agreement mid next year?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Well, I think the... although that's a take-or-pay contract, we do anticipate that we will continue to supply LSI after the end of that contract. Right now the contract... officially the take-or-pay part expires from the middle of next year. When we... if and when we get any changes to that we will announce it. But we do anticipate that we will continue to service them with manufacturing services after the expiration of the take-or-pay contract and if I get any more color we will officially announce that once we have any contract in place.

Craig Ellis - Citigroup

Okay. Thanks gentlemen.

Operator

Our next question or comment comes from the line of Mr. Tristan Gerra from Robert Baird. Your line is open.

Tristan Gerra - Robert W. Baird

Good morning. Could you guys elaborate on the internal inventory reduction, what products or end market and by how much did this impact gross margin in the quarter?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

This was not product-related. It's just that we took actions to make sure that we weren't building too much internal inventory and I think 86 days we had, we adjusted it to 80, as I stated. So, we believe that you got to run that... we can't really build up too much inventory, especially when you go into the year-end. So, this would be basically work-in-process inventory across all product lines. And so, we always proactively measure and control our... both our internal inventories and the distribution inventories to make sure that we don't have this inventory overhang. So I don't think it's fair to say it was product-specific, it was just in general, Tristan.

Tristan Gerra - Robert W. Baird

And was there any particular reason that led you to do that? Obviously your production plans were decent entering the quarter, so was this based on this, the feedback or anything else that would have led you to do that? And also I guess the follow-up will be why wouldn't we see a rebound in gross margin sequentially in Q4 on that basis of this inventory adjustment?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Well, I think the... it wasn't based upon distribution activities in the... and the feedback from distribution no [ph]. And as a matter of fact, our distribution business actually finished off stronger towards the end of the quarter, but as a prudent husbandry, as I said, we didn't want to continue to increase. So we reduced our manufacturing plant and we had a slight adjustment. We don't anticipate that these inventories will go down in the fourth quarter and that's why we gave approximately flat gross margins for the fourth quarter.

Tristan Gerra - Robert W. Baird

Okay. And then a quick last one, when is the designing phase for the Montevina platform and where do you stand in terms of power management wins there?

Keith Jackson - President and Chief Executive Officer

So, the answer to that is again we are seeing various customers ramping at various times on that and of course we have a range of wins in that platform. So I mean, I don't know that I can give you a more specific break-out right now, Tristan.

Tristan Gerra - Robert W. Baird

Very good, than you.

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

I think just one point on that, Tristan, I think when you look at our power management that goes in cycles and controllers. Right now we've got some good design wins in the areas we weren't too present in [ph] before and this is based on what Keith was saying that this stuff is going to ramp in Gresham in the second half of next year.

Tristan Gerra - Robert W. Baird

Okay, thanks.

Operator

Our next question or comment comes from the line of Steve Smigie from Raymond James. Your line is open.

Steve Smigie - Raymond James

Great. Thank you. I was wondering if you could comment on what... an I apologize if this was asked. But can you comment on what you think the seasonality should be in... typically in Q1?

Keith Jackson - President and Chief Executive Officer

Typically it is down slightly. We see our automotive, industrial and networking portions of the business actually grow in Q1 versus Q4 and the consumer businesses tend to be softer as the major ramps that they have are for the Christmas and Chinese New Year seasons. So, overall it tends to be kind of flat to slightly down as opposed to up sequentially.

Steve Smigie - Raymond James

But it's closer to sort of a 1% drop, it sounds like you are saying, versus may be a 4% drop?

Keith Jackson - President and Chief Executive Officer

Yes, I think this year our drop was a bit larger than the normal trend and we are expecting to not have that larger the drop going forward, but again we can't provide your guidance on that yet.

Steve Smigie - Raymond James

Okay. And the pricing was about 2% to 3% in Q3 from what you said. Why you think that the pricing is going to start to get a little bit better here in Q4?

Keith Jackson - President and Chief Executive Officer

We just base our ASPs, we kind of look at the backlog, which as you can see is about 90% on the books. And so we have a fairly good picture of what it's going to look like, minus the turns. And just basically feedback from that basis plus our sales channel tells us that the pressure is just slightly less than it was in Q3.

Steve Smigie - Raymond James

Okay. And the last question was just on the manufacturing, which locations did you rationalize during the quarter?

Keith Jackson - President and Chief Executive Officer

We have announced we're closing down one of our factories in Phoenix. And so there's actions actively underway there. And we've actually shrunk the activities is our Japan factory as well.

Steve Smigie - Raymond James

Okay, great. Thank you.

Operator

Our next question or comment comes from the line of Mr. John Pitzer from Credit Suisse. Your line is open

Amit Chopra - Credit Suisse

Thanks. This is actually Amit. I was wondering could you comment did you see any changes to lead times in the quarter?

Keith Jackson - President and Chief Executive Officer

Not significantly, we're still running kind of the 8 to 10 range for lead times on our high volume runners. So, really no significant change.

Amit Chopra - Credit Suisse

Okay. And your book-to-bill, could you give us was it above one or was that just below one?

Keith Jackson - President and Chief Executive Officer

Should have been just right at one. I mean, couldn't have been much different.

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

We don't normally give --

Keith Jackson - President and Chief Executive Officer

We don't normally give that, but --

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Give any book-to-bill stuff because what is important is to look at the aging because you can enter a lot borders like four or five months and by the time you come to ship them, they get rescheduled. So what is encouraging, as we said [ph], is revenues would be flat to up and our opening backlog for Q4 was up. So the key point we've always pointed to investors has been the backlog coverage for the next quarter. So that's slightly improved, so that's the key point we'd like to look at.

Amit Chopra - Credit Suisse

Okay. And then just one last question, I know it's always hard to predict, but can you give us your view on the micro environment and I guess tax within micro, if you guys are so broad based?

Keith Jackson - President and Chief Executive Officer

We do see broad based things here. I guess we've seen I guess what I would consider some surprising resilience in the consumer markets. Despite all of the macro wins in the credit markets and the housing markets in the U.S., we actually have seen that hold up pretty well. So, overall I guess the sentiment here is a cautious one from the company because there are a lot of things out there predominantly driven by credit issues that could soften the demand picture going forward, but frankly we have not yet seen that happen. So we're I guess cautiously optimistic that electronics sector will not see significant impact.

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

I think one thing I would state that we clearly see has less volatility, and that the... those last thwart quarters when lead times, delinquency bookings levels than we've seen in previous cycles. But normally what happens is feast or famine in the semiconductors and so we've seen a lot better supply chain management from our customers, from our distributors and associated with that last thwart in bookings and lead times and things like that. So we're seeing more of a more stable, less volatile environment and coupled with observations Keith mentioned about customer resilience.

Amit Chopra - Credit Suisse

Okay, sounds great, thank you.

Operator

Our next question or comment comes from the line of Mr. Michael McConnell from Pacific-Crest Securities, your line is open.

Michael McConnell - Pacific-Crest Securities

Thank you. Regarding the guidance for Q4, is this just a function of customers keeping their forecasts to you a little bit more closer to their vest, so visibility is a little more muted with respect to maybe the month of December or are you actually... have you seen some cancellations? Could you just go a little bit more into what's kind of driving the element of conservatism with respect to Q4?

Keith Jackson - President and Chief Executive Officer

We have not seen any cancellations. Again, on a seasonal basis, you typically have a broad range of customers who want to have minimal inventories leaving their calendar fiscal years. And so typically the amount of turns that you get in the third month of the quarter is much less than what you would expect to see, for example, in the third quarter or second quarter. So it's not about cancellations, it's really just about anticipating what I would call normal customer behavior in... at the end of the calendar year

Michael McConnell - Pacific-Crest Securities

And then with respect to the OpEx in Q3, can you talk about a little bit why that came at least based on my expectations higher than I think most people were expecting in terms of --?

Keith Jackson - President and Chief Executive Officer

I think mostly what you saw was increases in R&D and there we're very purposely increasing the rate of development in Gresham in order to fill up that facility as fast as we possibly can. And I think that's the major change you may have from what you are expecting.

Michael McConnell - Pacific-Crest Securities

And if we look at next year, should we still expect a more something --?

Keith Jackson - President and Chief Executive Officer

No, I think from an increase perspective, you've pretty much seen what we are going to do there and by the second half of next year it actually should start easing as we get all of our processes up and running.

Michael McConnell - Pacific-Crest Securities

Okay. And then with respect to the driving, I understand that you are expecting pricing to moderate in Q4, but could you talk about why you saw the more pressure maybe you were expecting in Q3?

Keith Jackson - President and Chief Executive Officer

I think just generic expectations from customers, it's always a very competitive marketplace, but as the volume buys go down in the consumer industry, you see some of the customer power come to play, and they are able to get very aggressive on the bigger builds. So, again I think it's going to be a little bit seasonal. As the consumer piece of that equation softens in the first half, I think you will see less pressure and then you will more pressures again in the third quarter next year.

Michael McConnell - Pacific-Crest Securities

Okay. Thank you very much.

Operator

Our next question or comment comes from the line of Mr. Mark Lipacis from Morgan Stanley. Your line is open.

Mark Lipacis - Morgan Stanley

Thank you. Thanks for taking my call. On the SG&A, I guess last quarter you were guiding for 10% to 11% of sales. This quarter you are guiding for 11% to 12% of sales. Could you just run through why you're kind of taking up the outlook there and how we should think about the long-term operating model? Thank you.

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Well, I think... this is Donald. Just to elaborate on a couple of points, we present our results on a GAAP basis and one can dispute whether the... our competition that does on a non-GAAP cash basis is correct. But one of the key points is we do have a lot of stock based compensation, the non-cash based stock compensation, which was around $4 million in the quarter, and a lot of that goes into the operating expense, particularly the SG&A line item. So, we had $4.1 million of non-cash stock based compensation in the third quarter. So that has been trending up as the stock option expenses trends up because we had benefited in the past from a accelerated vesting for certain options which no longer take place. So, that and other reasons to keep competitive offers has resulted in an increase in non-cash based stock expense and that is in the numbers for the third quarter, plus the R&D expense that Keith mentioned associated with ramping of Gresham facility. So these are the two major reasons on... plus a bit of a bonus as well. These are the two major reasons for... three major reasons for operating expense.

The guidance we gave for the fourth quarter with operating expense are approximately 20% of revenue, is pretty much in line with what we have been saying for the last few quarters, and we don't really see that changing above that 20% next year. But you've got approval that PCs, in particular temporarily we jack up the R&D and we don't see that increasing from its current basis, and you've got to look at the impact of the non-cash stock-based expense.

Mark Lipacis - Morgan Stanley

Okay. So, I am sorry, OpEx, we should be thinking about in 20% range R&D --?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Once again, that's... our model are between depending on the top line 19.5% to 20%. That's the kind of range we look at.

Mark Lipacis - Morgan Stanley

And you guys like R&D in this 8% to 9% of sales range also?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

Well, 11% to 12% for SG&A and 8% to 9% for R&D and these are models that we look at or we announced when we had our analyst day. We gave our long term strategic model, which was $450 million, on a top line 45% gross margin and 19.5% to 20% operating expense. So that's a model we still maintain and that's the one we are operating towards.

Mark Lipacis - Morgan Stanley

Okay. Thank you very much.

Operator

Our next question or comment comes from the line of Mr. Ramesh Misra from Collins Stewart, your line is open.

Ramesh Misra - Collins Stewart

Thanks, good morning guys. First question was in regard to the notebook arena. Keith, you've mentioned in the past that this is an area of significant pursuit for ON Semi. Can you give us an idea of how you anticipate that to ramp over the next few quarters, where that portion of that business is out of your overall PC business in the near term and how that trends further out?

Keith Jackson - President and Chief Executive Officer

Yes, so, notebooks have been the smallest portion of our PC business. We've been dominantly desktops and servers. In our content, if you go back to '06, inside of a notebook computer, the opportunity for content there was less than about $0.50. Over the next eight to 10 quarters, we expect that $0.50 to be ramping up above $8 of content on a fairly regular basis. So, we're expecting significant growth from a content perspective on a quarter-by-quarter basis. And I would expect notebooks would be a larger percentage of our total, again on a quarter-by-quarter basis. There's a number of design wins we've already gotten with our new products, taking that number well over $1.5 for the first quarter of 2008. And again, there's a fairly steep ramp in our content capability from there over the next eight quarters.

Ramesh Misra - Collins Stewart

Okay. So, in the early part of '08 you are still under the $2 mark?

Keith Jackson - President and Chief Executive Officer

Still under $2 in the early part of '08, correct. It doesn't get over $2 until the second half of '08. We do... we expect to see some ramps there using our controllers and that would almost double that number.

Ramesh Misra - Collins Stewart

Got it. In regards to Gresham, you've talked in the past about pursuing other foundry customers in addition to LSI. Can you provide us an update on where that stands?

Keith Jackson - President and Chief Executive Officer

Our... we are expecting to see more of a ramp for our high frequency copper processes as we enter next year. We had hoped that would ramp earlier, but as it turns out, the customer quals have taken longer than we expected. So we do expect to see some ramps from that sector, but no other significant foundry customers coming on line other than those products.

Ramesh Misra - Collins Stewart

Okay. And then finally in regards to the portion of your test and assembly business that you outsource, can you provide an update in terms of pulling that in into your China facility and do you expect the proportion that you are outsourcing to actually decline on your test and assembly side?

Keith Jackson - President and Chief Executive Officer

Yes, we do. We continue to pull things in and I would expect that that would continue into 2008 and our plan there would be to pull out approximately 100 basis points of outsourcing in that sector year-on-year.

Ramesh Misra - Collins Stewart

Okay, thanks very much.

Operator

Our next question or comment comes from the line of Craig Berger from FBR. Your line is open.

Craig Berger - FBR

Good morning, thanks for taking the question. We've kind of addressed this, but just to be clear on the foundry business. I think you used to say your breakeven gross margin was around... would be around $30 million in quarterly revenues and looks like you are about breakeven or a little positive this quarter. So is the new breakeven level kind of in the $21 million range?

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

This is Donald here. That's probably under $25 million.

Craig Berger - FBR

Under 25.

Donald Colvin - Executive Vice President, Chief Financial Officer and Treasurer

And the reason being we have taken reduced cost basis, so under $25 million.

Craig Berger - FBR

Okay. Next question is can you just help us understand do you have any insight into what your customers component inventory levels look like? You grew 6% sequential, I am trying to understand how much of that is a restocking effect that maybe will not be repeated in Q4 or Q1?

Keith Jackson - President and Chief Executive Officer

Generally speaking, customer inventories are in pretty good shape. We talked about the distribution channel, we can measure that very directly with the systems we have. On the OEM side, again what we have observed is they are trying to push more and more inventory back to the component suppliers and that is a very noticeable approach that they are taking there. And so again in our checks with the customers, they are very lean in that OEM channel as well. So I would not expect to see any impact on sales based on changes in inventory above and beyond what I've described earlier as the normal seasonality for the fourth quarter.

Craig Berger - FBR

And on lead times, you guys said there was no change there. What's kind of the range that you guys are operating at?

Keith Jackson - President and Chief Executive Officer

Again, the volume products are 8 to 10 weeks.

Craig Berger - FBR

8 to 10 weeks. Thanks.

Operator

Our final question and comment comes from the line of Mr. Kevin Cassidy from Thomas Weisel Partners. Your line is open.

Kevin Cassidy - Thomas Weisel Partners

Thank you. Just a couple more questions about the ASP decline, can you say which of your competitors were putting the pressure on, was it Asian manufacturers, European manufacturers, US based?

Keith Jackson - President and Chief Executive Officer

The ASPs have been very broad based this year. There is not one misbehaved competitor as it were, nor is it really acceleration of any Asian based influence. It is in my estimation nothing more complex than there is enough supply to meet all the demand and you've got some very large consumer manufacturers that have very large buying power, that end up driving that process. So, the simple answer is it's really not a competitive landscape reaction, I think it's a broad market reaction, and I believe those ASP declines are fairly consistent across the rest of our markets.

Kevin Cassidy - Thomas Weisel Partners

Okay. So how about within your product groups, which one does it affect the most, is it digital consumer products --?

Keith Jackson - President and Chief Executive Officer

It typically affects the Standard Products Group the most. It is again more... felt more in the discrete lines than it is in the analog lines.

Kevin Cassidy - Thomas Weisel Partners

Okay, thank you very much.

Operator

Ladies and gentlemen, this concludes the ON Semiconductor third quarter earnings release conference call. Thank you for your participation. You may now disconnect.

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Source: ON Semiconductor Corp. Q3 2007 Earnings Call Transcript
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