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OmniVision Technologies, Inc. (NASDAQ:OVTI)

F2Q08 Earnings Call

November 29, 2007 5:00 pm ET

Executives

Steven Horwitz - IR

Shaw Hong - President and CEO

Peter Leigh - CFO

Ray Cisneros – VP, Sales

Bruce Weyer – VP, Marketing

Analysts

Aaron Husock - Morgan Stanley

Tayyib Shah - Longbow Research

Kevin Cassidy - Thomas Weisel Partners

Paul Coster – JP Morgan

Tristan Gerra - Robert W. Baird

Quinn Bolton - Needham & Co

Daniel Gelbtuch - CIBC

Amit Kapur - Piper Jaffray

Doug Freedman - American Technology Research

Adam Benjamin - Jefferies

Hans Mosesmann - Raymond James

Operator

Welcome to the second quarter 2008 OmniVision Technologies earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today, Mr. Steven Horwitz. Please proceed, sir.

Steven Horwitz

Thank you, Audria. Good afternoon, everyone and welcome to our fiscal 2008 second quarter earnings conference call. After the market closed today, OmniVision issued an earnings release reporting our financial results for our second quarter. You can access this release from the Investor Relations section of our website at www.OVT.com, or on the financial news wires.

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

We have also arranged to record this call. The taped replay will be available approximately one hour after the call's conclusion and will be available for 48 hours. The dial-in access number for this replay is 617.801.6888. The replay passcode is 41536514.

This conference call will include forward-looking statements within the meaning of Section 27(a) of the Securities Act of 1933, as amended, and section 21(e) of the Securities Exchange Act of 1934, as amended.

These forward-looking statements include: statements about our financial projections for the third quarter of fiscal 2008 and beyond; our expectations for continued gross margin improvement; our expectations for growth in the markets for image sensors; our expectations regarding the long-term revenue contribution of the markets in which we compete; the anticipated introduction, acceptance, benefits and success of our new products; and our expectations regarding our future tax rate.

All these forward-looking statements involve known and unknown risks, uncertainties, and important factors that may cause actual company or industry results, level of activity, performance or achievements to differ from those expressed or implied by the statements we make.

In evaluating these forward-looking statements, you should specifically consider various risk factors, including the risk factors detailed from time to time in OmniVision's Securities and Exchange Commission filings and reports including, but not limited to, the company's annual report on Form 10-K filed for the fiscal year ended April 30, 2007; and quarterly reports on Form 10-Q that we file from time to time.

These factors may cause the company's results to differ materially from the forward-looking statements we make in this conference call. Although the company believes that the expectations reflected in its forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievements.

These forward-looking statements are made only as of today's date and OmniVision expressly disclaims any obligation to update or revise the information contained in the forward-looking statements. This concludes the Safe Harbor statement.

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

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

Shaw Hong

Thank you, Steven. Good afternoon, ladies and gentlemen. Thank you for joining us on today's call. With me today are Peter Leigh, our CFO; Ray Cisneros, our VP of Sales; and joining us for the first time, Bruce Weyer, our VP of Marketing. Bruce joined us in late August and has 20 years of technology experience, most recently with Xilinx.

On today's call, I will begin with an overview of our results. Then I will provide a general business update. Peter will provide you with the financial details of our fiscal second quarter and outlook for the third quarter. Afterwards, we will take your questions; and for that, Ray and Bruce are with us to provide additional insights.

First of all, I'm happy to talk about the very strong results we posted this quarter. In particular, revenue this quarter reached a record $233 million. GAAP earnings were $0.36 per diluted share. Excluding stock-based compensation expenses, non-GAAP earnings were $0.51 per diluted share. Our cash and short-term investments remain strong, totaling about $324 million at quarter end.

In the second quarter, we sold a record 120 million sensors compared to approximately 86 million in the first quarter and 65 million in last year's second quarter. Throughout the quarter, we continued to see record strong demand for our products across all geographies.

Our success today and in the future depends on our ability to execute on the three key elements of our company strategy. These three key elements are:

  1. Technology and leadership.
  2. The efficient and timely delivery of our products to customers.
  3. Providing our customers with the highest level of service and support.

Technology is at the heart of everything we do at OmniVision, and technology leadership is the most important factor in our continued success and market share growth. As we look to build on our market leadership position, we have several technology advantages.

Our 1.75 micron pixel that is the basis of our OmniVision Pixel3 architecture is proving itself a market leader. With this architecture, we were able to shrink the size of the pixel to fit into smaller camera modules and achieve lower costs. We also have been able to achieve image quality substantially better than the prior 2.2 micron pixel generation. We believe that we are ahead of the competition in the development of our next-generation technology for a high performance 1.4 micron pixel. This pixel size will enable the next generation of higher resolutions in even smaller form factors.

Our system on a chip solutions with high dynamic range, HDR, anti-shake and near infrared capabilities, serving the handset, digital camera, PC camera, auto, security, medical, and gaming markets are also industry leaders; and, we also have wafer encoding technology for extended depth of field applications.

By itself, leading technology does not make a business. OmniVision also has demonstrated the ability to deliver its market-leading technology to its customers. Amongst the important ways in which we consistently deliver products are:

We have established key partnerships to ensure that we have an efficient manufacturing process. We have a very strong strategic alliance with TSMC, including being one of their top customers. We work closely with TSMC to maintain the highest quality in our color filter and microlens joint venture, et cetera.

We also work closely with TSMC to optimize production at XinTec, our primary chip scale packaging (NYSE:CSP) provider. Early this year, to add further CSP capacity, we added a new supplier, WL CSP. We have designed, installed, and now are in production with our own automatic testers to make our final testing process more efficient and effective.

These actions contributed to our shipment of well over 300 million units of more than 50 types of products in the last four quarters. This represents a greater than 50% unit increase over the previous four quarters.

The combination of our technology leadership and our ability to efficiently deliver our products enables us to secure design wins. Then, with our service and support, we help our customers maximize their ability to ship high production volumes. Our business and our employees are exclusively focused on the image sensor market. No other company has OmniVision's level of dedication to image sensors. From one end of the organization to the other, our business is essentially providing solutions to meet the needs of our customers.

To do so, we work hard to support the customer before, during and after we win the design, receive orders, and deliver the products. We have been able to meet our customer needs by having offices around the world. Throughout North America, Europe and Asia we have salespeople, field application, quality and design engineers, as well as production and logistics centers. This worldwide presence has given our customers the confidence that we can meet their needs efficiently and effectively.

Let me now turn to our mainstream product business, which addresses principally the mobile handset market. Mobile handsets accounted for approximately 65% of our revenues in the second quarter. This quarter, we again benefited from strong demand for sensors across multiple resolutions.

During the quarter, we continued to see strong demand for our 1/4-inch 2 megapixel sensor product. The mix of 2 megapixel and higher resolution sensors approached 15% of total units this quarter. This sensor continues to win socket designs, which is a key to increasing our market share.

The adoption of 2 megapixel is a promising sign for our higher-resolution sensors. Our new 1/5-inch 2 megapixel sensor has already achieved early socket design wins from customers looking to upgrade from VGA and 1 megapixel sensors. These customers informed us our product is significantly ahead of those of our competitors. This feedback provides us with early indications that our OmniPixel3 and our expanded system on a chip platform with HDR, anti-shake and MIPI should be successful.

As the market continues to move to higher-resolution sensors, we are very encouraged with the level of interest and early design wins with our 1/4-inch 3 megapixel sensor. We are winning sockets at a very fast pace, including multiple tier 1 design wins.

Our 1/4-inch 3 megapixel sensor, based on the 1.75 micron pixel, is the most advanced in the marketplace today. We believe that our sensor produces the highest-quality images and has the best low light sensitivity. The performance of our pixel is a direct contributor to our design win success. We expect to see initial revenues from our 3-megapixel sensor in the coming quarter.

Our new 1/5 inch, 1.3 megapixel camera chip has also won major design socket wins in tier 1 OEM accounts, and we have begun a steep production ramp this fiscal quarter and we expect to continue. The 1/5-inch form factor represents a new standard for the market, offering a low cost upgrade for the traditional VGA market. Our current VGA sensor is considered the most robust product of its type currently available, and it provides best in class image performance in the market.

VGA demand continues to be very strong, and we are now shipping in volume with our 1/10-inch VGA camera chip. We continue to see the increased expansion of the entry-level handset market with cameras, which is directly benefiting VGA. We believe that our strong position in the entry level VGA market gives us an important headstart as customers in developing markets demand better quality images from their camera cell phone.

A significant amount of expansion still remains in these developing markets. Although China already buys nearly double the handsets that are purchased in the U.S., only about one-quarter of the Chinese population has phones today. In India, the penetration rate is only 4% today. Clearly, the size of the mobile handset market should continue to expand in these markets. In addition, the demand for secondary cameras for video conferencing in the 3G mobile handset market is also helping to expand the total market demand for VGA sensors.

In wafer encoding, we continue to work with our customers to begin shipping our two-chip TrueFocus solution. We anticipate that we will see our first revenue from this product in the first quarter of calendar 2008.

Throughout this process, our customers have provided us with very positive feedback regarding wafer encoding technology. Based on their feedback, we feel confident that both our first TrueFocus product and our next-generation product will be successful in the marketplace.

The progress that we have made with our full array of image sensor products for the cell phone market positions us well to capitalize on the world's largest selling consumer electronic device. In 2007, worldwide cell phone volumes will be about 1.1 billion units, and more than 70% of these cell phones will have at least one camera onboard. Next year the number will climb to 1.25 billion, with a camera attach rate closer to 80%. The year after that, units will climb to 1.35 billion and it is likely that attach rates will go even higher. The opportunity is already huge and it's only getting larger.

Also, within our mainstream products business, we saw some seasonal strength for the digital still camera market during the quarter. These sales were mainly 3 and 5 megapixel sensors.

Let me turn now to what we have decided to call our emerging products. On past calls, this is the area we referred to as Advanced Products. The biggest driver for increased revenue in our emerging products is the PC camera business. We are well positioned to take advantage of the surging demand for sensors in the PC notebook market. In fact, during the quarter we secured several new design wins with multiple notebook OEMs. We believe the total market for sensors in the PC notebook business will exceed 25 million units in 2007, representing more than 25% share of all notebooks.

We are also seeing increased adoption of sensors in standalone webcams, as well as cameras embedded in PC monitors. Our significant share in the PC market is attributable to our technology leadership and the wide range of products we offer, including sensors designed specifically for this market that have a larger pixel size than our competitors' products, which provides much better low light sensitivities. It is also very encouraging to see the PC market adopting in production higher resolution, including 2 megapixels.

In the security market, we continued to gain traction. During the quarter, we announced that a new customer, Fitivision, is using our sensor in multiple models of wired and wireless IP security cameras. These cameras are designed to serve the needs of the small office/home office SOHO market for low cost digital surveillance solutions.

In the automotive market, we have been steadily adding design wins for systems that will be incorporated into cars in Europe, cars in the USA, and more recently, cars built in China. We are continuing to build our presence in this market by providing our customers with new and innovative products.

This quarter, we announced a significant new product developed specifically for vehicles. This new sensor provides near infrared capabilities and can be operated in dual mode, allowing it to function both in day and night vision applications. We continue to win programs in the automotive segment for 360-degree viewing, forward and rearview applications and occupant sensing. We believe that the longer-term revenue contribution of this market will be significant.

In the medical market, we announced that our customer Avantis is using our smallest image sensor at 1/18 of an inch in their Third Eye endoscope accessory to serve the colonoscopy market. The Avantis disposable product has already been cleared by the FDA. Avantis is building out a dedicated salesforce to introduce this new device to colonoscopy specialists nationwide.

As there are many potential applications for the image sensors in the medical market, we are constantly being engaged by customers who want to develop new products to address their markets. This high level of interest from customers around the world is further indication that the medical market has the potential to be one of OmniVision's largest markets in the future.

I will now turn the call over to Peter.

Peter Leigh

Thank you, Shaw and good afternoon, everyone. For the second quarter of fiscal 2008 which ended October 31, 2007, OmniVision is reporting revenue of $232.6 million, up 34.4% sequentially and 69% on a year-over-year basis. Just over 65% of our revenue in the second quarter came from mobile handsets, while about 35% came from what we are now calling our emerging products group and from DSCs. The emerging products group includes notebook PCs, webcams, security and surveillance, toy and videogame consoles, automotive and medical products. The principal contributor to the change in mix was the strength in notebook PCs.

Direct sales to original equipment manufacturers and value-added resellers accounted for approximately 70% of revenue in the second quarter of fiscal 2008, while about 30% came from sales through distributors. We use distributors to assist us with finished goods supply chain management, and to minimize credit risks with less well-established customers. We shipped approximately 120 million image sensors in the second fiscal quarter. Our weighted average selling price was $1.92 as compared to $2.00 last quarter.

Gross margin for the second quarter was 25.2% compared to 23.4% last quarter. Excluding stock-based compensation expense of $969,000 included in cost of goods sold, gross margin was 25.6% compared to 24%. The principal contributors to the increase in gross margin in the October quarter were lower production costs and improved yields.

I should also mention that during the second quarter, we recorded additional excess and obsolete inventory reserves of $7.7 million compared to $4.7 million in the first quarter. So inventory reserves reduced gross margin by 330 basis points in Q2, versus 270 basis points in Q1. Revenue from the sale of previously reserved products was $1.5 million, versus $1.9 million in Q1.

As you know, we are constantly under pressure from our customers to deliver better products at lower prices. As Shaw discussed earlier in the call, we are working with all of our manufacturing and packaging supplier partners throughout our supply chain to improve efficiencies at every stage of production. We expect to see further improvement in gross margin in the third quarter, although it is unlikely that the increase will be as large as it was this quarter.

R&D expense in the second quarter was $20.2 million, up from the $17.4 million we reported in the prior quarter. Our R&D expense includes approximately $3.4 million of stock-based compensation expense. Excluding stock-based compensation expense, R&D in the quarter was $16.8 million, compared to $15.1 million in the prior quarter.

The main contributor to the increase in R&D expense was higher NRE costs, the cost of the masks we buy when we release designs for new products to the foundry. NRE expense does tend to fluctuate quarter to quarter.

SG&A expenses in the quarter totaled $15.8 million, up from $15.2 million in the prior quarter. Our SG&A expense includes approximately $3.5 million of stock-based compensation expense. Excluding stock-based compensation expense, SG&A in the quarter was $12.3 million, essentially flat quarter over quarter.

Our GAAP operating profit in the quarter was $22.7 million. Excluding stock-based compensation expense, operating income was $30.5 million.

Our GAAP pre-tax earnings in the second quarter were $25.6 million. Excluding stock-based compensation, pre-tax earnings were $33.5 million. Our GAAP tax rate in the quarter was 20%. When we exclude stock-based compensation expense, our non-GAAP tax rate falls to 13% and we think that going forward, our non-GAAP tax rate will remain in the low double-digits.

Our GAAP net income in the second quarter was $20.5 million or $0.36 per diluted share, compared to net income of $13 million, or $0.23 per diluted share in the previous quarter. Net income in the second quarter of last year was $5.4 million, or $0.10 per diluted share.

Our results for the second quarter of fiscal 2008 include $8.6 million of non-cash stock-based compensation expense under SFAS 123 R. Excluding this non-cash stock-based compensation expense, non-GAAP net income was $29.1 million, or $0.51 per diluted share. This compares to non-GAAP net income in the second quarter of fiscal 2007, excluding $8.1 million of stock-based compensation expense and the related tax effects of $15.7 million, or $0.28 per diluted share.

Overall, I can say that we are very pleased with the progress that we've made this quarter and we look forward to continuing this progress in the third quarter and beyond.

Let me turn now to the balance sheet, which remains in excellent shape. The company ended the second quarter with cash, cash equivalents and short-term investments totaling $323.9 million. The increase in cash from the previous quarter was mostly due to free cash flow generated from operations, which in part reflects good management of working capital.

Accounts receivable at quarter end, net of allowances, were $87.7 million, up $15.9 million from last quarter. However on higher revenue, our days sales outstanding were just 35 days, three days lower than last quarter. Overall, our accounts receivable remain in excellent shape, although I do not think that we can necessarily assume that we can keep receivables as low as 35 days.

At October 31, 2007 inventory was $133.4 million compared to $138.3 million on July 31. Quarter end inventory represented 71 days sales, which is the equivalent of annual turns of 5.2 times. The majority of the inventory is in WIP to meet ongoing demand. Our goal remains for inventory to be in the range of 75 to 90 days, equivalent to annual turns of four to five times.

Now I would like to turn to the outlook for the third quarter of fiscal 2008, which will end on January 31st next year. We are continuing to see strength in the demand for our image sensors, which leads us to expect strong revenue in the third quarter, continuing to levels similar to the record second quarter revenues that we reported today.

We currently expect third quarter revenue will be in the range of $220 million to $240 million. This should translate to GAAP earnings of between $0.26 and $0.39 per diluted share. Excluding the estimated expense and related tax effects associated with stock-based compensation, we expect non-GAAP earnings will be in the range of $0.41 to $0.54 per diluted share. As I mentioned, we think that going forward our non-GAAP tax rate will remain in the low double-digits.

With that, I would like to turn the proceedings back to Shaw for some strategic commentary.

Shaw Hong

Thank you, Peter. OmniVision's core competency is centered on image sensor technology. It is through the combination of technology leadership, unmatched delivery, and commitment to service that will allow us to continue posting the types of financial results we did this quarter.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

Your first question comes from Aaron Husock - Morgan Stanley.

Aaron Husock - Morgan Stanley

On the inventory reserves, looking back historically, these haven't always been a net negative for you, looking at the charge-offs versus the sale of previously reserved inventory. It's been about neutral over time but the past few quarters it's been a significant drag on the gross margin.

Should we see that come back towards neutral some time relatively soon? Also, why haven't you been buying back the stock, given the excessive cash balance and the buyback that you put in place?

Peter Leigh

Let me deal first with your question about inventory. As you understand very well, unlike fine wine and certain cheeses, our inventory doesn't get better with age. We have to look very carefully at our inventory on a quarterly basis. The relationship between the reserves we take at any quarter end and the sales of the previously reserved products, there is no real relationship between those two numbers. They just happen to be numbers that do affect the gross margin, which is why we report them together.

But there's no real relationship between the two of them, because the sales of previously reserved inventory is just that; it's sales of material that you had on the books that you previously reserved for which you find a market, albeit most likely at a price significantly lower than the price at which the product was originally sold.

As to how this plays out going forward, that's always very hard to predict. I don't think, as a first approximation, it's wrong to assume that over time these things will be about neutral.

On the question of the stock buyback, as we say in all our public filings, the stock buyback is something that we look at carefully on a quarterly basis. We make a decision on a quarterly basis. It's a little bit like the Federal Open Markets Committee, you understand. We take a vote here. The only difference is that in our case, we don't report the vote and we don't publish the minutes.

Operator

Your next question comes from Tayyib Shah - Longbow Research.

Tayyib Shah - Longbow Research

Peter, if I could get a clarification on the margins, you had a 300 basis point headwind from the sale of reserved inventory. When you say that margin improvement going forward will be less than what we saw in this quarter, have you built a similar amount of inventory reserves in your forecast?

Peter Leigh

No, Tayyib. I thank you for the question. What I was referring to was simply the difference between the reported margin for Q1 versus Q2. As I just said a moment ago to Aaron, it simply isn't practical for us to forecast reserves because in a dynamic market like the one we're in, we have to look every quarter end at the prospects for each of the products that we have in inventory and make an educated judgment about how much of the product that we have on the books we will be able to sell. Any inventory we have in excess of 12 months' demand, we will reserve.

Tayyib Shah - Longbow Research

So, in that case, why wouldn't we see at least a 300 basis point jump in margins, just because you are not forecasting any reserved inventory?

Peter Leigh

No, wait a minute. You've got to remember that there are reserves, that you take reserves every quarter. The effect of the inventory reserves this quarter is 330 basis points. The effect of the reserves last quarter was 270 basis points. So quarter over quarter, you're talking about a net change of 60 basis points. It would be wonderful if we could have a quarter where we had no inventory reserves at all but that's not altogether realistic in the business we're in.

Tayyib Shah - Longbow Research

I was wondering about your guidance. When you say that margin improvement will be modest going forward, what sort of forecast is implicit in that guidance?

Peter Leigh

Well as you know, we don't give quantitative guidance on each line in the income statement, Tayyib. I think I'm going to have to leave it to your not inconsiderable talents to fill in the gap between the top line and the bottom line.

Tayyib Shah - Longbow Research

Just finally, your EPS guidance, the midpoint is below this quarter, but revenue is kind of flattish. So, just wondering what's going on that's causing you to be cautious.

Peter Leigh

We do expect to see some increase in our NRE expense during the current quarter. As we've said, I think on a number of conference calls, the most variable operating expense we have is the NRE expense, which is a direct reflection of the number of designs that we release to the foundries in a given quarter. On balance, you want to see us releasing more designs, not fewer, because it's the new designs which of course provide the foundation for the future revenue growth.

Operator

Your next question comes from Kevin Cassidy - Thomas Weisel Partners.

Kevin Cassidy - Thomas Weisel Partners

As you're looking out to next quarter, do you expect your mix between the mobile and emerging products to be about the same? Or do you expect emerging products to continue to grow?

Peter Leigh

Again, we don't generally give guidance to that level of granularity, Kevin. But I think that you can take it that the mix is going to be approximately similar to what you're seeing here now.

Kevin Cassidy - Thomas Weisel Partners

As a gross number, the growth in mobile was pretty significant quarter over quarter. Can you give some more granularity of where you saw that growth?

Ray Cisneros

We saw pretty strong growth across the board from different regions in our handset customer base, both from North America, Europe and Asia. So it's pretty well balanced in terms of the handset business. Obviously, that's our biggest driver in terms of revenue so we're very pleased with regard to the balance of that.

Operator

Your next question comes from Paul Coster – JP Morgan.

Paul Coster - JP Morgan

The investor base for OmniVision is quick to price in the next sort of cyclical downturn or seasonal downturn in the business, but it seems to be very difficult to predict if and when that's going to happen. Looking a little bit further out, is there any reason to anticipate seasonality or cyclicality at this point?

Ray Cisneros

Obviously, the cyclical nature of our business is always there. Year-over-year we've seen it transpire. The way we like to look at is the big picture. If you look at our situation a year ago versus this year and then how we're staging ourselves for the next coming calendar year, I think the real story about OmniVision is our growth in terms of our business as well as our product position.

So, when you take it into that context, we're very pleased with the current situation we're in. Basically, that leads us into the preparation of the next following 12 months to back into our new products that as we mentioned, are gaining pretty good traction in the marketplace.

Although there might be cyclical trends to our business, we seem to see it as a launching platform on our progress year over year, and how we're going. So we're looking forward to the next 12 months.

Paul Coster - JP Morgan

I get that; I'm just trying to figure out what is the cycle length? Because if you look at your historical results, it's not obvious that there is an easy pattern here.

Ray Cisneros

You know what? Some of this is partly related to the expansion of the marketplace. Another big factor is probably the component of emerging markets like the PC laptop business. So I think these major trends start putting a little bit of a complex mix in terms of equations one might think you could back yourself into. So I think you might be seeing some of those factors as part of your analysis.

Peter Leigh

Paul, let me just add to that. Ever since I've been with this company, I've looked to try and figure out what the impact is of seasonal influences. What you find is that yes, there probably is some seasonal influence but it seems to get offset, sometimes completely offset, by other more specific things that are going on in the marketplace.

Paul Coster - JP Morgan

I think the stock anticipated four of the last three down cycles, et cetera. The other point I wanted to make was on the competitive landscape front. Can you just talk about that at the moment?

Bruce Weyer

Over the last few years we've seen a number of companies that have come into the market and quite a few have actually left the market as well. We really feel that our strength is our technology and our ability to deliver the significant volumes of sensors that customers need and support those customers to the best of our ability. Because of these factors we believe we've got a compelling story to our customers and we should enable and continue to have a forefront in the industry.

Operator

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

Tristan Gerra - Robert W. Baird

Could you talk about current trends in the China handset market? Changing order patterns, and perhaps tie this to your guidance?

Ray Cisneros

Obviously, like I mentioned, the key thing I want to reinforce here is I'm very pleased with our balance in all geographies worldwide; as I mentioned, North America, Europe, and as well as Asia. Of course, China is a very strong market for us and most of you who are aware of this marketplace, or the market information, China drives a very large number or volume of manufacturing of handsets, as well as the camera modules as they back into that.

Obviously, we're keeping close track on the trends there in China. The volume, however, is such critical mass volume and OmniVision doing so well in it, it seems like any fluctuations, we'll be able to absorb those small fluctuations in the context of our overall revenue.

Tristan Gerra - Robert W. Baird

More specifically, have you seen any cancellations or any offset that leads you to be more conservative in terms of your guidance as a result?

Ray Cisneros

Right now we're watching it very closely. I can't say we're seeing anything in particular. But certainly, we're keeping an eye on it.

Operator

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

Quinn Bolton - Needham & Co.

I just wanted to follow up on Tristan's question about China. MediaTek, I guess overnight, took down their guidance to be down 15% to 20% citing weakness in handsets and some supply shortages. You guys haven't seen some of those same issues?

Ray Cisneros

We are aware of the MediaTek situation, although MediaTek might play into a larger marketplace than we do simply because we're a subset of perhaps what they serve. Obviously, it's tough to cut, slice and dice what they're looking at, but we are aware of that. Right now, so far, we're pretty secure with what we see in China for our business.

Quinn Bolton - Needham & Co.

Peter, on the gross margin guidance you said that you do expect some continued growth or expansion in gross margin, but not to the same level as the fiscal second quarter. I just wanted to make sure that's coming from cost-reduction efforts, improved yields, product mix, rather than any explicit assumption about lower inventory reserves.

Peter Leigh

That is correct. You're right. It's real cost improvement. It's not the effect of changing in reserves. That is correct.

Quinn Bolton - Needham & Co.

So, you have some real cost-reduction efforts that kick in and then to the extent you had no reserves -- and I understand that you take reserves every quarter -- but if you had no reserves, that's where that extra 300-plus basis point number could factor in?

Peter Leigh

That is correct. Let me just, if I may, take the opportunity to say to all of you what a terrific job the operating people in this company have done and do every single day on the cost front. I think it is truly remarkable what they've done to drive down the costs in this period.

Operator

Your next question comes from Daniel Gelbtuch - CIBC.

Daniel Gelbtuch - CIBC

A question about the competitive landscape. Obviously with Micron publicly stating that they're looking to get out of the business and with MagnaChip having their sights set on going into the public market and probably are looking to be more profitable, how would you characterize the competitive landscape right now? Would you care to comment on Hynix's move by investing in SiliconFile? And what do you think that is going to bring?

Bruce Weyer

I'll talk a little bit about the competitive landscape. Certainly we're very aware of the discussions in the market about some of the moves at the corporate level for some of our competitors. I think what we really want to always look at is you really want to reflect on your own position, your own technology, and your own execution.

We think we're executing quite well as a company. We think our technology is well-positioned for the future. Certainly, if you look at the last two quarters there's been good market growth overall but with sequential growth for us of 45% and 35% back-to-back, we think that we're very well-positioned and continuing to gain market share relative to our competitors.

Daniel Gelbtuch - CIBC

Would you characterize this as being an order of magnitude, let's say a year-and-a-half ago, MagnaChip being back in the market aggressively would you say this is probably a more benign market, competitive market, right now, relatively speaking?

Bruce Weyer

If you look at the last couple of years, I think, you could characterize the market as being pretty competitive. You certainly have seen some aggressive behaviors competitively. Two years later, you look at our position in the market, we think we're as strong -- if not a stronger position -- than we had been a couple years ago. You can't fully estimate what the attempt or a goal would be for MagnaChip. But again, if you look at history, I think we've done quite well in this market and it has been a competitive market.

Daniel Gelbtuch - CIBC

What would you attribute your success to? Is it a function of a combination of being, let's say a CSP leader, being the first to execute on higher megapixels? Is it quality? On costs, how do you guys stack up?

Bruce Weyer

Well, if you look at the full history of the company, of course, we founded this business. We entered very early into the CMOS sensor business. If you look at the last year, the position of the company relative to the competition, I think most people would contend that our quality of our sensor relative to the competition has continued to improve over time.

We've always been a high-volume supplier in the market. I think the areas in respect of our technology and the quality of our product in the market continues to improve. Again, people can leave the market and reenter the market. But it's not just about what price point they might put into the marketplace, but also the quality of their product. We've seen low-cost plays in the past and I think the customers really do a very good job of balancing quality versus price.

So I cannot forecast in any way shape or form what competitors will do in the future, but we've seen aggressive tactics in the past and we've done fine.

Daniel Gelbtuch - CIBC

Finally, just on the supply/demand balance in the market, it sounds like there is certainly new vectors of demand that are starting to take off here. Would it be safe to characterize the market in terms of supply and demand is very much in balance, and you're seeing maybe less supply-driven pressure on the competitive front?

Ray Cisneros

There's a very, very strong demand, obviously, you've seen in the past 12 months and it's continuing going forward, as far as we can tell. Obviously from the supply side, our position in this marketplace is to provide the delivery of product and volume. As Mr. Shaw Hong has described, our dedication and our focus is to continue to build this capacity so we deliver product to the marketplace. But obviously, we're feeding to a very strong demand marketplace both in handset, laptop and then going forward, obviously, emerging markets such as security, automotive and medical.

Operator

Your next question comes from Amit Kapur - Piper Jaffray.

Amit Kapur - Piper Jaffray

In terms of the demand that you've been seeing in emerging markets from mobile handsets applications, are you seeing any evidence of consumers in those markets skipping over resolution levels? Say going from no camera phone to 2 plus megapixel resolutions? Or is the adoption curve you are seeing following similar to what happened in more mature markets?

Ray Cisneros

I would say there's a pretty good pattern I think most people that follow the handset market have seen. There is a continued expansion of the entry level handset market. That, obviously, picks up the VGA. The next step up we've been seeing as a trend is going to 2-megapixel, and that's why you might have followed our reports in the past, how the megapixel is not the front runner. It goes from 2 megapixel and then VGA as being the two strongest-selling products. Those are the trends so far.

Now going forward, however, most of you are aware the ¼ inch 3 megapixel will be the big winner in calendar year 2008. Obviously, we're positioning our company to take advantage of that.

Operator

Your next question comes from Doug Freedman - American Technology Research.

Doug Freedman - American Technology Research

Could you spend a little time talking about what you see happening with the wafer level packaging and what impact that may have on the VGA market and the ASPs there?

Ray Cisneros

Obviously there's a lot of technology that goes into our business, everything from packaging to optics to sensors, as well as even some of the chipset strategies. We're definitely keeping a close watch on that. That's our mode right now.

Obviously we have to investigate, do our own investigation. But at the moment, we're on the sidelines doing our due diligence. So far, that's pretty much the posture we're taking.

Doug Freedman - American Technology Research

If you could spend a little time talking about the power chip ramp that you plan. I know it's for mid-2008. If you could talk a little bit about what percentage of product you would like to see coming from power chip and how we should think of that ramp.

Peter Leigh

I think, Doug, it's a little bit early to talk about what the ramp would be. This is a development program which was originally intended and still is planned to deliver product in the second half of 2008. As we get closer to that date, we will update you on our progress. But it's too early to speculate.

I think the important point to remember that is that TSMC is by far and away our biggest supplier and we don't expect that to change at any time in the future.

Doug Freedman - American Technology Research

I'm just trying to put in perspective power chip and whether we should think that maybe 10% of revenues could come from them by the end of the year next year? Is it a material number? Is it something that we really shouldn't focus on how development there is going to happen?

Peter Leigh

I wouldn't focus on it a great deal at this point, because I think it's too early to tell for sure how this will work.

Doug Freedman - American Technology Research

Are there any actions, Peter or Ray, that you guys can take outside of cost reductions to the existing product portfolio to improve the gross margins? Is the market maturing to the point where we're ready to pay for image quality?

Peter Leigh

Is the market ready to pay? Let me attempt to answer, if I understand the question. I think the answer is yes, because that really is what lies behind the whole 3-megapixel initiative, and then the higher megapixels that come later. I think there is clear evidence now that a portion at least of the consumer base is willing to pay to have a better camera on their cell phone. My guess is that that will only accelerate over time.

It's reported that 90% of the people who have a camera on their cellphone have never printed a picture and never sent it by email, which represents a huge opportunity because most of us who have ever owned a camera at least have the pictures printed. We may not necessarily send them by email, but we certainly have them printed.

Ray Cisneros

I'll just say one more comment about this subject. I think it's back to the roots of our business which is technology. I think as Peter alluded to, the migration up the resolution ladder just doesn't mean you're adding more pixels; it actually means you're developing deeper technology. So, going from 1.75 and then jumping into 1.4 micron pixels is not something every competitor can do. I would say it would start whittling down the competition quite dramatically.

So, it's a way to back into your question, what's a higher value the customer can place on a sensor? I think it's there. I think it's going to happen. That's just from the sensor side. There are other complications like optics as well as packaging.

Doug Freedman - American Technology Research

Do you think that your average ASP going forward can decline at a slower pace than you think the marketplace?

Peter Leigh

Is that a logical possibility? I would say definitely yes.

Operator

Your next question comes from Adam Benjamin - Jefferies.

Adam Benjamin - Jefferies

Typically, your ASP increase or decrease in your total business is a good proxy for your camera phone ASP movement, whether up or down for the quarter. Was that the case for this quarter as well?

Peter Leigh

As you know, Adam, we don't break out the ASP by individual product segment. But as is always the case, when you have 65% of your revenue coming from essentially a single category, the two are going to track.

Adam Benjamin - Jefferies

With respect to the other emerging businesses, were there any changes in the quarter there on ASP that were worth noting?

Peter Leigh

I'm sorry; I didn't quite understand the question.

Adam Benjamin - Jefferies

With respect to the emerging business that was 35% of the revenue this quarter, was there any fluctuations both up or down that are worth pointing out for the ASPs within that segment?

Peter Leigh

None that I think are really noteworthy.

Adam Benjamin - Jefferies

You've talked in the past about camera phone ASPs that we should be thinking about that at about a 20% ASP decline on a year-over-year basis. Is that where we should continue thinking about that?

Peter Leigh

Obviously we would prefer to see that decline slow down. In fact, if you look back over the last three quarters, the decline probably has been somewhat less than that annual rate. That 20% is an average over a period of five years or six years or however long this product category has been in existence.

So for the moment, as I think we mentioned in an answer to an earlier question, the pricing environment is relatively benign.

Adam Benjamin - Jefferies

I know it's still hard to tell because you still have the January quarter ahead, but if that's the case, do you think if things hold decently well for you, you can come in for the calendar year '07 for camera phone ASPs being less than a 20% decline?

Peter Leigh

I think that's a distinct possibility.

Operator

Your final question comes from Hans Mosesmann - Raymond James.

Hans Mosesmann - Raymond James

I have a strategic question, or a positioning question and I'm under the assumption that as we go from VGA to 1, 2, 3 to 4 megapixels, that the advantages that you bring to the market are getting better and better and better.

Now, a way to look at this could be if you observe the graphics market, 3-D graphics where eight or nine years ago there was 30 guys and now there's only two. Is it reasonable for us to assume that as we go into these higher resolutions that the incremental player will bow out or get kicked out of the market? Is that one way to look at this? Is it getting harder and harder for people to keep up with you guys?

Bruce Weyer

As you move up, and if you look at the mix of our products over the last couple of years, certainly there's more emphasis and contributions technically on the ISP portion of our chips. If you look at the number of feature sets we put into the marketplace and the differentiation that's brought, I think that those are the areas where I think a company is going to have a harder time competing longer term, because it's becoming a more complex business in that respect.

Additionally, the Advanced Technologies we're putting in place now as you move from 1.75 micron pixels down to 1.4 and in the future down to 1.1, that complexity also is getting deeper and broader. You can't take a simplistic process technology approach and really compete in those sectors either.

So yes; certainly the technology is getting broader and deeper and it's going to be harder for some of the competitors to stay in the market.

Operator

At this time there are no further questions. I would now like to turn the presentation back over to Mr. Shaw Hong for closing remarks.

Shaw Hong

Thank you. In closing, I want to reiterate our confidence in the ability of OmniVision to continue to be a market leader in advancing image sensing technology. Our recent performance has been very strong, and we are well-positioned to introduce new products and existing product enhancements that meet the needs of our customers ahead of the competition.

We thank our team for its hard work, and you for participating in our call. We look forward to speaking with you next quarter.

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Source: OmniVision F2Q08 (Qtr End 10/31/07) Earnings Call Transcript
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