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

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 Technologiesearnings conference call. (Operator Instructions) I would now like to turn thepresentation 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 earningsconference call. After the market closed today, OmniVision issued an earningsrelease reporting our financial results for our second quarter. You can accessthis 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'sreference. This call is being webcast live and a web replay will be availablefor 12 months. Both the live webcast and replay can also be accessed from theInvestor Relations section of the OmniVision website at www.OVT.com.

We have also arranged to record this call. The taped replaywill be available approximately one hour after the call's conclusion and willbe 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 statementswithin 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 aboutour financial projections for the third quarter of fiscal 2008 and beyond; ourexpectations for continued gross margin improvement; our expectations forgrowth in the markets for image sensors; our expectations regarding thelong-term revenue contribution of the markets in which we compete; theanticipated introduction, acceptance, benefits and success of our new products;and our expectations regarding our future tax rate.

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

In evaluating these forward-looking statements, you shouldspecifically consider various risk factors, including the risk factors detailedfrom time to time in OmniVision's Securities and Exchange Commission filingsand reports including, but not limited to, the company's annual report on Form10-K filed for the fiscal year ended April 30, 2007; and quarterly reports onForm 10-Q that we file from time to time.

These factors may cause the company's results to differmaterially from the forward-looking statements we make in this conference call.Although the company believes that the expectations reflected in itsforward-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'sdate and OmniVision expressly disclaims any obligation to update or revise theinformation contained in the forward-looking statements. This concludes the Safe Harbor statement.

Please also note that this conference call will providelisteners with certain financial metrics determined on a non-GAAP basis, bothfor a comparison to previous quarters and for our outlook for the currentquarter. These financial metrics, together with a reconciliation to comparableGAAP financial measures, are contained in today's financial results pressrelease, which we have posted on our website at investors on OVT.com underpress releases, and furnished to the SEC on Form 8-K. We encourage listeners toreview these items.

Now I'd like to turn the call over to OmniVision's Presidentand 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, ourCFO; Ray Cisneros, our VP of Sales; and joining us for the first time, BruceWeyer, our VP of Marketing. Bruce joined us in late August and has 20 years oftechnology 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 thefinancial details of our fiscal second quarter and outlook for the thirdquarter. Afterwards, we will take your questions; and for that, Ray and Bruceare with us to provide additional insights.

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

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

Our success today and in the future depends on our abilityto execute on the three key elements of our company strategy. These three keyelements 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 atOmniVision, and technology leadership is the most important factor in ourcontinued success and market share growth. As we look to build on our marketleadership position, we have several technology advantages.

Our 1.75 micron pixel that is the basis of our OmniVisionPixel3 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 modulesand achieve lower costs. We also have been able to achieve image qualitysubstantially better than the prior 2.2 micron pixel generation. We believethat we are ahead of the competition in the development of our next-generationtechnology for a high performance 1.4 micron pixel. This pixel size will enablethe 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 industryleaders; and, we also have wafer encoding technology for extended depth of fieldapplications.

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

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

We also work closely with TSMC to optimize production atXinTec, our primary chip scale packaging (NYSE:CSP) provider. Early this year, toadd 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 ourfinal testing process more efficient and effective.

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

The combination of our technology leadership and our abilityto efficiently deliver our products enables us to secure design wins. Then,with our service and support, we help our customers maximize their ability toship high production volumes. Our business and our employees are exclusivelyfocused on the image sensor market. No other company has OmniVision's level ofdedication to image sensors. From one end of the organization to the other, ourbusiness 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 theworld. Throughout North America, Europeand Asia we have salespeople, field application, qualityand design engineers, as well as production and logistics centers. Thisworldwide presence has given our customers the confidence that we can meettheir needs efficiently and effectively.

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

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

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

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

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

Our new 1/5 inch, 1.3 megapixel camera chip has also wonmajor design socket wins in tier 1 OEM accounts, and we have begun a steep productionramp this fiscal quarter and we expect to continue. The 1/5-inch form factorrepresents a new standard for the market, offering a low cost upgrade for thetraditional VGA market. Our current VGA sensor is considered the most robustproduct of its type currently available, and it provides best in class imageperformance in the market.

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

A significant amount of expansion still remains in thesedeveloping markets. Although Chinaalready 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 handsetmarket should continue to expand in these markets. In addition, the demand forsecondary cameras for video conferencing in the 3G mobile handset market isalso helping to expand the total market demand for VGA sensors.

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

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

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

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

Let me turn now to what we have decided to call our emergingproducts. 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 PCcamera business. We are well positioned to take advantage of the surging demandfor sensors in the PC notebook market. In fact, during the quarter we securedseveral new design wins with multiple notebook OEMs. We believe the totalmarket for sensors in the PC notebook business will exceed 25 million units in2007, representing more than 25% share of all notebooks.

We are also seeing increased adoption of sensors instandalone webcams, as well as cameras embedded in PC monitors. Our significantshare in the PC market is attributable to our technology leadership and thewide range of products we offer, including sensors designed specifically forthis market that have a larger pixel size than our competitors' products, whichprovides much better low light sensitivities. It is also very encouraging tosee the PC market adopting in production higher resolution, including 2megapixels.

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

In the automotive market, we have been steadily addingdesign 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 ourcustomers with new and innovative products.

This quarter, we announced a significant new productdeveloped specifically for vehicles. This new sensor provides near infraredcapabilities and can be operated in dual mode, allowing it to function both inday and night vision applications. We continue to win programs in theautomotive segment for 360-degree viewing, forward and rearview applicationsand occupant sensing. We believe that the longer-term revenue contribution ofthis market will be significant.

In the medical market, we announced that our customerAvantis is using our smallest image sensor at 1/18 of an inch in their ThirdEye endoscope accessory to serve the colonoscopy market. The Avantis disposableproduct has already been cleared by the FDA. Avantis is building out adedicated salesforce to introduce this new device to colonoscopy specialistsnationwide.

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

I will now turn the call over to Peter.

Peter Leigh

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

Direct sales to original equipment manufacturers andvalue-added resellers accounted for approximately 70% of revenue in the secondquarter 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 shippedapproximately 120 million image sensors in the second fiscal quarter. Ourweighted average selling price was $1.92 as compared to $2.00 last quarter.

Gross margin for the second quarter was 25.2% compared to23.4% last quarter. Excluding stock-based compensation expense of $969,000included in cost of goods sold, gross margin was 25.6% compared to 24%. Theprincipal contributors to the increase in gross margin in the October quarterwere lower production costs and improved yields.

I should also mention that during the second quarter, werecorded additional excess and obsolete inventory reserves of $7.7 millioncompared to $4.7 million in the first quarter. So inventory reserves reducedgross margin by 330 basis points in Q2, versus 270 basis points in Q1. Revenuefrom the sale of previously reserved products was $1.5 million, versus $1.9million in Q1.

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

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

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

SG&A expenses in the quarter totaled $15.8 million, upfrom $15.2 million in the prior quarter. Our SG&A expense includesapproximately $3.5 million of stock-based compensation expense. Excludingstock-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 $25.6million. Excluding stock-based compensation, pre-tax earnings were $33.5million. Our GAAP tax rate in the quarter was 20%. When we exclude stock-basedcompensation expense, our non-GAAP tax rate falls to 13% and we think thatgoing forward, our non-GAAP tax rate will remain in the low double-digits.

Our GAAP net income in the second quarter was $20.5 millionor $0.36 per diluted share, compared to net income of $13 million, or $0.23 perdiluted share in the previous quarter. Net income in the second quarter of lastyear 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 incomewas $29.1 million, or $0.51 per diluted share. This compares to non-GAAP netincome in the second quarter of fiscal 2007, excluding $8.1 million ofstock-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 theprogress that we've made this quarter and we look forward to continuing thisprogress in the third quarter and beyond.

Let me turn now to the balance sheet, which remains inexcellent shape. The company ended the second quarter with cash, cashequivalents and short-term investments totaling $323.9 million. The increase incash from the previous quarter was mostly due to free cash flow generated fromoperations, 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 lastquarter. Overall, our accounts receivable remain in excellent shape, although Ido not think that we can necessarily assume that we can keep receivables as lowas 35 days.

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

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

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

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

Shaw Hong

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

Operator, we are now ready to take questions.

Question-and-AnswerSession

Operator

Your first question comes from Aaron Husock - MorganStanley.

Aaron Husock - Morgan Stanley

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

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

Peter Leigh

Let me deal first with your question about inventory. As youunderstand very well, unlike fine wine and certain cheeses, our inventorydoesn't get better with age. We have to look very carefully at our inventory ona quarterly basis. The relationship between the reserves we take at any quarterend and the sales of the previously reserved products, there is no realrelationship between those two numbers. They just happen to be numbers that doaffect 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 ofmaterial that you had on the books that you previously reserved for which youfind a market, albeit most likely at a price significantly lower than the priceat which the product was originally sold.

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

On the question of the stock buyback, as we say in all ourpublic filings, the stock buyback is something that we look at carefully on aquarterly basis. We make a decision on a quarterly basis. It's a little bitlike 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'tpublish the minutes.

Operator

Your next question comes from Tayyib Shah - LongbowResearch.

Tayyib Shah - Longbow Research

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

Peter Leigh

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

Tayyib Shah - Longbow Research

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

Peter Leigh

No, wait a minute.You've got to remember that there are reserves, that you take reserves everyquarter. 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 ifwe could have a quarter where we had no inventory reserves at all but that'snot altogether realistic in the business we're in.

Tayyib Shah - Longbow Research

I was wondering aboutyour guidance. When you say that margin improvement will be modest goingforward, what sort of forecast is implicit in that guidance?

Peter Leigh

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

Tayyib Shah - Longbow Research

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

Peter Leigh

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

Operator

Your next question comes from Kevin Cassidy - Thomas WeiselPartners.

Kevin Cassidy - Thomas Weisel Partners

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

Peter Leigh

Again, we don'tgenerally give guidance to that level of granularity, Kevin. But I think that you can take it that themix 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 prettysignificant quarter over quarter. Can you give some more granularity of whereyou saw that growth?

Ray Cisneros

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

Operator

Your next question comes from Paul Coster – JP Morgan.

Paul Coster - JP Morgan

The investor base for OmniVision is quick to price in thenext sort of cyclical downturn or seasonal downturn in the business, but itseems 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 seasonalityor cyclicality at this point?

Ray Cisneros

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

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

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

Paul Coster - JP Morgan

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

Ray Cisneros

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

Peter Leigh

Paul, let me just addto that. Ever since I've been with this company, I've looked to try and figureout what the impact is of seasonal influences. What you find is that yes, thereprobably is some seasonal influence but it seems to get offset, sometimescompletely offset, by other more specific things that are going on in themarketplace.

Paul Coster - JP Morgan

I think the stockanticipated four of the last three down cycles, et cetera. The other point Iwanted to make was on the competitive landscape front. Can you just talk aboutthat at the moment?

Bruce Weyer

Over the last few yearswe've seen a number of companies that have come into the market and quite a fewhave actually left the market as well. We really feel that our strength is ourtechnology and our ability to deliver the significant volumes of sensors thatcustomers need and support those customers to the best of our ability. Becauseof these factors we believe we've got a compelling story to our customers andwe 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 Chinahandset market? Changing order patterns, and perhaps tie this to your guidance?

Ray Cisneros

Obviously, like I mentioned, the key thing I want toreinforce here is I'm very pleased with our balance in all geographiesworldwide; as I mentioned, North America, Europe, and as well as Asia. Ofcourse, Chinais a very strong market for us and most of you who are aware of thismarketplace, or the market information, Chinadrives a very large number or volume of manufacturing of handsets, as well asthe 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 wellin it, it seems like any fluctuations, we'll be able to absorb those smallfluctuations in the context of our overall revenue.

Tristan Gerra - Robert W. Baird

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

Ray Cisneros

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

Operator

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

Quinn Bolton - Needham & Co.

I just wanted tofollow 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 seensome of those same issues?

Ray Cisneros

We are aware of theMediaTek situation, although MediaTek might play into a larger marketplace thanwe do simply because we're a subset of perhaps what they serve. Obviously, it'stough 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 Chinafor our business.

Quinn Bolton - Needham & Co.

Peter, on the gross margin guidance you said that you doexpect some continued growth or expansion in gross margin, but not to the samelevel as the fiscal second quarter. I just wanted to make sure that's comingfrom cost-reduction efforts, improved yields, product mix, rather than anyexplicit 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 inreserves. That is correct.

Quinn Bolton - Needham & Co.

So, you have some real cost-reduction efforts that kick in andthen to the extent you had no reserves -- and I understand that you takereserves every quarter -- but if you had no reserves, that's where that extra300-plus basis point number could factor in?

Peter Leigh

That is correct. Letme just, if I may, take the opportunity to say to all of you what a terrificjob the operating people in this company have done and do every single day onthe cost front. I think it is trulyremarkable 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 thecompetitive landscape. Obviously with Micron publicly stating that they'relooking to get out of the business and with MagnaChip having their sights seton going into the public market and probably are looking to be more profitable,how would you characterize the competitive landscape right now? Would you careto comment on Hynix's move by investing in SiliconFile? And what do you thinkthat 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 themoves at the corporate level for some of our competitors. I think what wereally want to always look at is you really want to reflect on your ownposition, your own technology, and your own execution.

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

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 marketaggressively would you say this is probably a more benign market, competitivemarket, right now, relatively speaking?

Bruce Weyer

If you look at the last couple of years, I think, you couldcharacterize the market as being pretty competitive. You certainly have seensome aggressive behaviors competitively. Two years later, you look at ourposition 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 attemptor a goal would be for MagnaChip. But again, if you look at history, I thinkwe'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 functionof a combination of being, let's say a CSP leader, being the first to executeon higher megapixels? Is it quality? On costs, how do you guys stack up?

Bruce Weyer

Well, if you look atthe full history of the company, of course, we founded this business. Weentered 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 peoplewould contend that our quality of our sensor relative to the competition hascontinued to improve over time.

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

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

Daniel Gelbtuch - CIBC

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

Ray Cisneros

There's a very, very strong demand, obviously, you've seenin 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 providethe delivery of product and volume. As Mr. Shaw Hong has described, ourdedication and our focus is to continue to build this capacity so we deliverproduct to the marketplace. But obviously, we're feeding to a very strongdemand 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 emergingmarkets from mobile handsets applications, are you seeing any evidence ofconsumers in those markets skipping over resolution levels? Say going from nocamera phone to 2 plus megapixel resolutions? Or is the adoption curve you areseeing following similar to what happened in more mature markets?

Ray Cisneros

I would say there's a pretty good pattern I think mostpeople that follow the handset market have seen. There is a continued expansionof the entry level handset market. That, obviously, picks up the VGA. The nextstep up we've been seeing as a trend is going to 2-megapixel, and that's whyyou might have followed our reports in the past, how the megapixel is not thefront runner. It goes from 2 megapixel and then VGA as being the twostrongest-selling products. Those are the trends so far.

Now going forward, however, most of you are aware the ¼ inch3 megapixel will be the big winner in calendar year 2008. Obviously, we'repositioning our company to take advantage of that.

Operator

Your next question comes from Doug Freedman - AmericanTechnology Research.

Doug Freedman - American Technology Research

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

Ray Cisneros

Obviously there's a lot of technology that goes into ourbusiness, everything from packaging to optics to sensors, as well as even someof 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 chipramp that you plan. I know it's for mid-2008. If you could talk a little bitabout what percentage of product you would like to see coming from power chipand how we should think of that ramp.

Peter Leigh

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

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

Doug Freedman - American Technology Research

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

Peter Leigh

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

Doug Freedman - American Technology Research

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

Peter Leigh

Is the market ready to pay? Let me attempt to answer, if Iunderstand the question. I think the answer is yes, because that really is whatlies behind the whole 3-megapixel initiative, and then the higher megapixelsthat come later. I think there is clear evidence now that a portion at least ofthe 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 ontheir cellphone have never printed a picture and never sent it by email, whichrepresents a huge opportunity because most of us who have ever owned a cameraat 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 morecomment about this subject. I think it's back to the roots of our businesswhich is technology. I think as Peter alluded to, the migration up theresolution ladder just doesn't mean you're adding more pixels; it actuallymeans you're developing deeper technology. So, going from 1.75 and then jumpinginto 1.4 micron pixels is not something every competitor can do. I would say itwould start whittling down the competition quite dramatically.

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

Doug Freedman - American Technology Research

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

Peter Leigh

Is that a logicalpossibility? 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 totalbusiness is a good proxy for your camera phone ASP movement, whether up or downfor the quarter. Was that the case for this quarter as well?

Peter Leigh

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

Adam Benjamin - Jefferies

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

Peter Leigh

I'm sorry; I didn'tquite understand the question.

Adam Benjamin - Jefferies

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

Peter Leigh

None that I think arereally noteworthy.

Adam Benjamin - Jefferies

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

Peter Leigh

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

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

Adam Benjamin - Jefferies

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

Peter Leigh

I think that's adistinct possibility.

Operator

Your final question comes from Hans Mosesmann - RaymondJames.

Hans Mosesmann - Raymond James

I have a strategic question, or a positioning question andI'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 betterand better.

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

Bruce Weyer

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

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

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

Operator

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

Shaw Hong

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

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

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