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Long Ly - Manager, Investor Relations

Brian L. Halla - Chairman of the Board, Chief ExecutiveOfficer

Lewis Chew - Chief Financial Officer, Senior Vice President- Finance

Donald Macleod - President, Chief Operating Officer


Simona Jankowski - Goldman Sachs

John Pitzer - Credit Suisse

Chris Danely - JP Morgan

Craig Ellis - Citigroup

Srini Pajjuri - Merrill Lynch

Uche Orji - UBS Securities

Ross Seymore - Deutsche Bank

Krishna Shankar - JMP Securities

Steve Smigie - Raymond James & Associates

Douglas Freedman - American Technology Research

National Semiconductor Corporation (NSM) F2Q08 Earnings Call December 6, 2007 4:30 PM ET


Good afternoon. My name is Brian and I will be yourconference operator today. At this time, I would like to welcome everyone tothe National Semiconductor second quarter fiscal year 2008 earnings conferencecall. (Operator Instructions) At this time, I would like to turn today’sconference over to Mr. Long Ly, Manager of Investor Relations. Mr. Ly, pleaseproceed, sir.

Long Ly

Thanks. I would like to again welcome everyone to our calltoday. Joining me are Brian Halla, Chairman and Chief Executive Officer; LewisChew, Chief Financial Officer; and Don Macleod, President and Chief OperatingOfficer.

The purpose of today’s call is to discuss NationalSemiconductor's second quarter fiscal 2008 results, which ended on November 25,2007. As a reminder, today’s call will contain forward-looking statements andprojections that involve risks and uncertainties that could cause actualresults to differ materially. You should review the Safe Harbor statementcontained in the press release published today, as well as our most recent SECfilings for a complete description of those risks and uncertainties.

Also, in compliance with SEC Regulation FD, this call isopen to all and is being broadcast live over our investor relations website.

For those of you who may have missed the presentation or wouldlike a replay of the call, you can find it on National’s IR website

In today’s call, I will provide a recap of the secondquarter financial results; Brian Halla will give an overview of the businessenvironment and an update on the company’s focus and priorities going forward;Lewis Chew will expand on the second quarter results and provide an outlook forthe third quarter fiscal year 2008; Don Macleod will then discuss our productsand business in more detail. We will then take questions until approximately2:30 p.m. Pacific Time.

The second quarter results were as follows; sales were $499million, up 5.8% from $471.5 million in Q1 fiscal year 2008 and down 0.5% from$501.6 million in last year’s second quarter. Gross margins were a record 64.4%in Q2, up from 53% in the prior quarter and 58.9% in last year’s secondquarter.

Operating expenses in the second quarter were $174.7million. Net interest expense was $13.6 million, and the effective tax rate forthe quarter was 30%.

As a result, National posted GAAP net earnings of $90.6million, or $0.33 per fully diluted share in Q2 fiscal year 2008. The fullydiluted share count for the second quarter was 271.5 million shares.

I will now turn it over to Brian Halla for an overview ofthe business environment and an update on the company’s focus and priorities.Brian.

Brian L. Halla

Thank you, Long. Well, not to disappoint the Chicken Littlesin the crowd, but business just isn’t that bad. We actually grew our revenuesequentially by 6% to come in at roughly $500 million, which was about the samelevel we enjoyed in this quarter last year.

This quarter’s $500 million also generated record grossmargins of 64.4% versus last year’s margin of 58.9%. The improvement here comesmostly as a result of the richer mix of new high performance analog circuitslaunched within the last couple of years. These are products coming from ourpower management, audio and amplifier product organizations. Hey, the onlypossible explanation I can come up with is that people are going out to buy newcell phones so they can call their banks and tell them they are not going todefault on their mortgages.

As a matter of fact, demand from the mobile phone handsetand personal mobile devices stayed strong and continued that way through theend of the quarter. Though we’ll hold short of being an industry spokesman forthat business, I must say that that sector continues to be optimistic aboutgrowth going forward.

It seems that our nation’s own sub-prime debacle isn’t quiteas important to the consumers in other countries around the world.

Overall, order levels reflected the same strength we saw inQ1. Our inventories, both internal as well as at our distributors were downagain in the quarter. Our factories continue to be relatively under-utilizedand yet we continue to see record gross margin improvements and continuedreduction in manufacturing costs. Our ASPs improved in the quarter over lastyear, again reflecting that richer mix of new, higher value-added analogproducts launched within the last couple of years.

The fundamentals described above could bode well forbusiness going forward; however, we’re basing our outlook for the quarter we’rein on two factors. In our fiscal Q3, we typically do see a post-Christmasdecline in revenues. In addition this year, there is that uncertain butpossible negative effect of the sub-prime debacle on consumer buying patterns.Again, the latter is uncertain and most likely less impactful in theinternational markets than in the United States.

Based on the above, we’re currently projecting revenue inthe quarter we’re in to come in at 1% to 5% down from the quarter just ended.

So business is okay, the market is somewhat uncertain -- dowe just hunker down and continue to turn the crank and enjoy our recentlynewfound peer group status? The answer is absolutely not.

First of all, the performance of the peer group has beenrelatively underwhelming in recent years. Second of all, we at National thinkthere is a very bright future for us in breaking away from the analog peergroup and facing and solving a problem which today is large and on its way tobecoming huge.

What problem? I continue to get a kick out of CNBC reporterstalking about the $100 a barrel oil crisis as if that price is somehow a rightparenthesis or the highest it goes. In fact, it’s more likely that oil isheaded towards $150 a barrel, on its way to $200, and that we have barely seenthe tip of the iceberg of what we today refer to as the energy crisis.

What does all this have to do with the semiconductorindustry? In a way, it’s a crisis we helped create and in another way, it’s acrisis that brings with it an opportunity for an explosion of demand for new energyefficient chips. Let me put a few things into perspective.

Today, the server farms supporting video applications likeYouTube consume about 62 billion kilowatts, or about a watt per gigabit ofinformation transferred over the Internet. Unless YouTube and the other videointensive transmission applications are just a passing fad, the estimate ofadditional server farm capacity over the next four years just to keep up withthe growth of this industry will require a doubling of today’s capacity or about10 additional power plants which, by the way, could increase unwantedproduction of CO2, carbon dioxide, by thousands of tons. So the generalpressure that the server farm industry feels to become more power efficientwill I’m sure escalate over time as the market demands further efficiencies.

What does all this mean for the future of NationalSemiconductor? Let me explain -- it all goes back to the days of Moore’s law --days when oil was $16 a barrel and therefore, no one even noticed that the nowiconic law that has governed our industry since day one ignored powerefficiency all together.

That law, simply stated, was the transistor count woulddouble on the same size chip every two years, or even further simplified, saidthat gates are free. So the semiconductor industry has since that time thrownan infinite amount of gates at virtually every problem there was and is today.Enter the analog semiconductor way of doing real world signal processing,DSP-less and microprocessor-less.

This is dramatically different from the historic NyquistShannon method of at least a 2X oversampling of a given bit stream and thenrunning the massive store of collected bits through a powerful DSP ormicroprocessor to determine what information is held in the stream of data.

The analog way, by contrast, is simply to look at the analogsignals as they flow through the analog front end or receiver and pass throughthe ones that contain new information. Maybe not the best way to process aspread sheet, but who does that anymore?

Clearly by contrast, this analog to information processingmethodology is perfect for dealing with real world bit streams like images,video, light, heat, sound, and other forms of real world signals. And, by theway, at power requirements often a tiny fraction of the traditional DSP ormicro method of processing.

We as one of the analog to the rescue companies saw thisearly on as designers from our customers with a power budget are asking forNational Semiconductor first because we are the industry leader in powerefficient circuits, some 400 circuits under our Power Wise branded family ofthe most power efficient circuits available.

Our nation is facing multiple crises. The most visiblefinancial crisis is the sub-prime mortgage crisis which has not yet had anynoticeable impact on our business, at least not on a global basis, though wecertainly acknowledge that could be a future possibility.

The second crisis is coming at us like a freight train.Today we look at relatively benign solutions in the form of green initiativesor pressure on the energy consuming industries to find more efficiency. Thisenergy crisis represents an opportunity for the semiconductor companies to stepup and help solve a problem we helped create. It’s an opportunity particularlyfor National Semiconductor as we continue to add innovative power efficientcircuits to a Power Wise family of products already now over 400 strong andgrowing.

Over to you, Lewis.

Lewis Chew

Thanks, Brian. I’m not sure I can adequately follow that butnevertheless, I will focus on three main topics in my commentary today. One,I’ll highlight some details from the business activity that occurred during thequarter that we just finished. Two, I’ll go over the major factors and assumptionsthat we’ve made in our Q3 outlook for revenue and expenses, and then third,I’ll touch on some of the key balance sheet items along with operating metricsthat you guys usually like to hear about.

So let me start with Q2 business activities. At the beginningof the quarter when we provided our original Q2 outlook of revenue up 4% to 7%,we said at that time that we were seeing strength mostly from the wirelesshandset space. We also indicated that we were not baking in any sort ofsnap-back from other vertical markets, nor from the broader markets that areserved through the distribution channels.

While the actual activity during Q2 has largely played outin line with those original assumptions, most of the sales growth we achievedduring Q2 was attributable to wireless handsets and personal mobile devices,and much of that was driven by new products, and more from Don Macleod on thattopic during his segment of the call.

Our sales into the distribution channel were up onlyslightly in Q2, while distributor resales during the quarter were a bit higher,resulting in distributor inventories being down from the previous quarter.We’ve now seen distributor inventory go down for us each of the last fourquarters.

The total company orders, turns orders that we saw in Q2 wasfairly comparable to what we saw in Q1, while total company bookings were downvery slightly in Q2, which is not uncommon for the November quarter.

We saw bookings pause a bit in the middle of our Q2 but thenthe order rate increase in the last four weeks of the quarter collectively. Weended the quarter with lower opening backlog for Q3 compared to what we had inplace for the beginning of Q2, mainly driven by our OEM customer base. Andagain, I would say that this is a typical thing we see heading into theFebruary quarter, as our customers that serve vertical markets tend to build alower number of units right after the holiday season is over, so the short-termbacklog they place on us will usually reflect that pattern.

Regarding distributors in Q3, we are currently projectingthat their resales will be down during the quarter, mostly due to holidayseasonality. And although the inventory at distributors continues to run atvery low levels compared to history, the lower resales that we are projectingultimately would result in a lower amount of turns orders from distributors inQ3 compared to Q2.

So based on everything I just went over, we are anticipatingthat Q3 revenues will range from down 1% to down 5% sequentially.

Now let’s cover the remainder of the income statement,beginning with gross margin, which came in at 64.4% in Q2. This is the firsttime we’ve reported gross margins above 64% and that reflects the continuingimprovement and the value in our product portfolio, as well as the benefits ofhigher sales volume.

Our fab utilization in Q2 was up slightly at a little over65% based on wafer starts and our incremental fall-through gross marginpercentage during Q2 was in the high 80s.

Based on the revenue range that I went over a minute ago, weare projecting that Q3 gross margin percentage will decrease commensurate withthe sales decrease, which is anywhere from one-half to one percentage pointdown from Q2.

Our fab utilization percentage in Q3 is currently projectedto remain in the 60s.

I will note that although our gross margin takes a pause inQ3 because of the revenue, our gross margin leverage model is still intact,meaning that future advancements and the value of our portfolio, along withhigher revenue levels, would continue to drive our gross margins upward again.

Moving along to operating expenses, we are projectingR&D expense in Q3 to range from $92 million to $94 million. We areprojecting SG&A expense to range from $81 million to $83 million. Other incomeand expense is anticipated to be around $1 million of expense. Gross interestincome is projected to range from $7 million to $8 million, which is down fromQ2 because of lower short-term interest rates combined with lower average cashbalances. And gross interest expense should be a little below $23.5 million aswe repay a certain amount of debt principal each quarter.

Included in the projected Q3 gross margin and operatingexpense numbers I just went over are approximately $24 million of total stockcompensation expenses in Q3. This estimated $24 million can be broken down bycategories as follows: cost of sales, $6 million; R&D, $7 million; andSG&A, $11 million.

The Q3 effective income tax rate should be around 32%.

So let’s cover the balance sheet. Our capital expendituresin Q2 were about $29 million and in Q3, capital spending is expected to rangefrom $30 million to $35 million. Our days of inventory at the end of Q2 wasabout 77 days, down from about 86 days last quarter, as we reduced inventoriesby nearly $16 million in Q2.

Our days outstanding in receivables at the end of Q2 wasaround 34 days, which is comparable to where it was last quarter, and our cashreserves ended Q2 at about $834 million, as we bought back $280 million worth ofour stock during the quarter.

We began Q2 with about $880 million available under approvedstock buy-back programs, which means we have about $600 million remaining ofavailable buy-back authorization heading into Q3.

As Long mentioned, the weighted average share count dilutedended the quarter at 271.5 million shares. We anticipated that the acceleratedstock buy-back that we launched in June will be finalized and settled duringthe early part of Q3. The impact of that settlement will be a further reductionin our share count by roughly 6 million to 7 million shares.

Operating margin in Q2 was 29%, which is up from 27% in Q1and return on invested capital for the second quarter was about 23%. All ofthese figures include the impact of stock compensation expenses.

Now here’s Don Macleod. Don.

Donald Macleod

Thank you, Lewis. As usual, I’d like to expand further onthe drivers of our business in the quarter. Our 6% revenue growth sequentiallyessentially all came from sales to customers in the wireless handset andrelated personal mobile device markets. It came from new products that validateour power wise theme where our product focus is on enabling the highest analogperformance, or best signal integrity with the lowest power. It also reinforcedour view that those performance and power optimized analog products areincreasingly enabling system level differentiation in faster growing endmarkets for semiconductors.

In addition, somewhat uniquely for us, this analog systemlevel differentiation is provided by us to these fast-growing consumer drivenmarkets without eroding our business model and its gross margins.

To validate this margin improvement, you only need to lookat the sequential and year-on-year gross margin improvements already discussed.

To be specific, our sales to wireless handset customers grewabout 18% sequentially and over 30% year-on-year and represented a little morethan one-third of our total sales in the quarter.

From an end customer perspective, growth was broadly based.Our quarterly sales grew to all of the top five market share participants inthe wireless handset market. Our quarterly sales also grew to the leadingenterprise handset provider and to the new very visible music video wirelesshandset provider as they both expanded their product offerings.

What National Semiconductor products drove this widespreadgrowth? Well, a widespread list also.

Products that enabled power efficiency, such as highperformance linear regulators in entry level and application specific phones,power management units in CDMA phones, and applications processor PMUs forfeature rich phones.

Products that combine energy efficiency with high precision,such as our supervisory power management units for CG power amplifiers, RF detectors,temperature sensors, and finally products that drive the highest humaninterface performance, such as our audio subsystems, keyboard and other datainterfaces, lighting systems, and display drivers. We clearly have abroad-based analog set of expertise in this area and our customers see us asthe go-to guy for these analog solutions.

We see continuing growth in the mobile phone handsetmarketplace and we see it as the largest consumer electronics sector. Gartneralso agrees. In their report on the market released last week, they cited 10%to 15% growth year-on-year for the Christmas holiday selling season this yearand a very likely greater than 1.1 billion handsets should be sold in 2007.

Our focus on power and energy efficiency at National Semiconductoris not just targeted to mobile devices. We also see new disruptive energyefficiency growth opportunities in consumer and industrial lighting, where newhigh brightness LEDs can now replace fluorescent and incandescent lighting inall kinds of applications, from homes, automotive, street lighting, signage,agricultural, landscape, and consumer products, such as displays and TVs.

In early November, we launched several new power managementswitchers that are designed to efficiently power LEDs. We have the mostextensive range of high brightness drivers in the market and we also have thebest online design tools to allow lighting customers who might have little orno electronic design expertise to quickly and easily implement highly efficientLED solutions using our power products, and with a wide variety of commerciallyavailable LEDs.

In the first month, customers have already created about7,000 online LED designs using our web bench tool suite, and we see greatrevenue growth opportunities here, especially in the more energy consciouseconomies in Asia.

In the quarter, we also launched a new family of 10 powerwise switching regulators, our new LM20K family. These are the first in theindustry to feature both high power density and self synchronization. This selfsynchronization feature enables power supply designers to build more energyefficient and more complex power sequencing for applications such ascommunications, data storage, and automotive, where space and energyefficiencies are becoming more and more critical.

Our industry leading web bench suite of online design toolsis a significant demand creation enabler for us in this very broad market area.A few quarters ago, after the February 2007 launch of our fourth generation ofpower management simple switchers, I referred to the online web benchsimulation and product interest activity for the first month after launch. Weare seeing the same levels of interest for our LED lighting and LM20K familyimmediately post launch. Incidentally, we’re now up to about 40,000 web benchonline designs completed by our customers in the first 10 months after therelease of our fourth generation simple switchers.

Customer projects are now moving into production using thesenew switchers and as in previous generations, we expect revenue from thisfamily to ramp up steadily for the next five to seven years.

The global mega trend of power and energy efficiency is agrowth opportunity for National. Personal mobile devices are just one veryobvious current enabler, and this is evident in our business as our powermanagement product sales grew 12% sequentially and now represent 48% of ouroverall sales, up from 45% last quarter.

Our amplifier product area also grew about 9% sequentiallyand now represents 26% of our sales, up one percentage point sequentially.

Our interface products grew about 15% sequentially andrepresent 9% of our sales, also up 1% sequentially.

Data converter sales were flat in the quarter andrepresented 5% of our sales.

Application specific analog product sales were down from 8%last quarter to 4% of our sales this quarter and overall, 91% of the quarter’ssales came from analog products, the same percentage as last quarter.

From a market segment point of view, as we discussedearlier, sales to the mobile phone handset market grew about 18% sequentiallyand over 30% year over year. Sales to all other markets, such ascommunications, networking, industrial, large displays, et cetera, weessentially flat with the preceding quarter.

Moving to a discussion on our gross margin improvementdrivers, company ASPs grew about 2% year over year. However, a key driver ofour gross margin was our new product revenue growth. This quarter, oursequential growth in new product sales dollars equaled our total companysequential revenue growth and this is the same trend as we saw last quarter.And here, new products are defined as those released by us in the last threeyears.

Looking forward to this third quarter, we expect sales tothe mobile phone handset and other similar portable consumer devices to be downon the second quarter and this is in line with our normal seasonalexpectations. As this market is now the mid 30s percent of our overall sales,it has a larger seasonal impact on our overall sales.

We have, however, anticipated this seasonality with ourinventory profile. As you can see, we ran our inventories down by about $16million in the quarter and this was mainly in our die bank. In Q3, we areplanning to run our wafer fabs at about the same wafer start levels as in Q2,as we are able to smooth out some of the seasonality through to our factories.

A notable for us in manufacturing in this second quarter wasthe start of our first production wafers in the month of November at our newTexas 8-inch module.

So looking beyond Q3 seasonality, our power wise focus thatenables higher performance analog solutions, maximizing energy or powerefficiency, is clearly positioning us to address fast-growing opportunities andat the same time, maintain our business models gross margin progress.

So over to you, Long, for Q&A. Long.

Long Ly

Thanks, Don. At this time, I will ask the operator to openup the lines to begin the Q&A session. Please limit yourself to onequestion and one follow-up so that we can accommodate as many people aspossible. Operator.



(Operator Instructions) Our first question comes from theline of Simona Jankowski with Goldman Sachs.

Simona Jankowski -Goldman Sachs

Thanks a lot. Don, I just wanted to follow up; I think yousaid that your app specific products were down from 8% to 4% of the total. Canyou just remind us what’s in that category and what drove that decline?

Donald Macleod

The two major categories that are in that product really aredisplay driver products, RF products, and some analog application specificproducts. The major part of that change was actually a combination of the RFproducts that we are deemphasizing over time and slightly lower sales of our displaydrivers as we move beyond the product launch and into the more sustainingdelivery for a very visible consumer product that’s in the market using thesedisplay drivers.

Simona Jankowski -Goldman Sachs

I see. So that’s something where you ramped up into aproduct at a customer and now you are -- that initial ramp is behind you?

Donald Macleod

That’s exactly right.

Simona Jankowski -Goldman Sachs

Okay, and then just as a quick follow-up on the inventory,it was pretty noticeable, the decline there, to 77 days. I mean, you arebasically very close now to the leader in terms of inventory management, whichis Linear, at 73 days and way lower than pretty much all of your other largeranalog competitors. Can you comment if this decline is entirely a function ofyour muted expectations for next quarter or are there any other reasons forthat or any other kind of operation or manufacturing efficiencies that areallowing you to reach these new lows?

Donald Macleod

Well, there are two things that you need to bear in mind.One is that the mobile phone and related device market, most of the customersin these areas give us forecasts that we work on and obviously we were able tosmooth out our production by building up some die bank in the summer quarter toanticipate those customers’ needs in this recently completed quarter and thishelps us, as we pointed out, balance out the loading of wafer starts in ourfactories so we smooth out these seasonal trends. We anticipated that.

The other is that as we’ve been going through this fabrationalization process, where we’ve been moving products from 6-inch to 8-inchcapabilities and moving between our factories, we’ve had some bufferinventories. These are working down, so our inventories are now at a reasonableprofile but there’s to take them down further but I think the seasonality isbuilt into the numbers that we have on the table today.

Simona Jankowski -Goldman Sachs

Thanks a lot.

Long Ly

All right, thanks, Simona. Operator, next question, please.


Our next question comes from the line of John Pitzer withCredit Suisse.

John Pitzer - CreditSuisse

Good afternoon, guys. Thanks for taking my questions. I havea couple. First, when you look at the normal seasonal trend in the fiscal thirdquarter, given the fact that your business has kind of changed year-on-year andit’s hard to do an apples-to-apples comparison, how would you guess the minus1% to minus 5% guidance kind of compares to normal seasonality, given thechange in your business?

Lewis Chew

You know, the first thing I would observe is in this lastthree years, it’s getting harder and harder to define anything called normalseasonality just because the cycles have come pretty quick. But when you lookat long-term averages, it’s not uncommon for us to be down let’s call it 2% to3% in the third quarter.

Now typically what drives the downward pressure is revenuesthat we sell into things that are heavy for the holidays do drop off in buildrates, and then sometimes you can anticipate possibly some offset fromindustrial markets which have some pick-up.

And right now, we’re seeing what everyone else is seeing,which is the broader industrial markets are relatively flat. They are not goingdown but they are not going up. So in terms of the outlook that we have goinginto this year’s seasonality, we certainly do anticipate that there will besome post-holiday drop-off from the verticals that we serve, and we also areanticipating that distributor activity will be down slightly as well, meaningthat there’s really no tick-up that we are baking in from the broaderindustrial markets.

So that’s what makes up the guidance that we have.

John Pitzer - CreditSuisse

Lewis, when you talk about distis, you guys have talkedabout four quarters in a row now where disti inventory has been down. Can youhelp me get a sense of how much of this you think is cyclical relative to macroconcerns versus sort of structural? I.E., are we expecting a quarter out therein the not-too-distant future where we see a relatively solid snap-back in thedisti channel? Or have these guys just learned to manage inventory structurallybetter?

Lewis Chew

Actually, Don and Long and Brian and I all took a vote andwe all voted for that snap-back to happen this quarter. And maybe you can getyour vote in on that one as well.

I think right now, what we see is that distributors havebeen very focused during calendar ’07 on their own metrics, which includeturnover metrics and asset velocity. So I do think that some of it is kind oftheoretically permanent in the sense that they are trying to run leaner. Butthey also support a very broad base of customers, so it’s safe to say that theyhave been relatively cautious about inventories as we head towards the end of ’07.

I personally think that at some time down the road whendemand picks up, you will see distributors have to order more product becauseacross the board, you can see the distributors are running relatively low,especially the ones that operate in the public eye. Our two largest globaldistributors, as you know, are Arrow and Avnet, and although Arrow did come outthe other day and acknowledge that their business was doing better than theyhad expected, that doesn’t necessarily mean that they are going to growinventories this quarter.

John Pitzer - CreditSuisse

And then the last question for me; given the Novemberquarter gross margins are fairly close to that 65% margin target, I know theycome off again here in the fiscal third quarter but I guess as we startthinking about gross margin progression throughout calendar ’08, what should webe thinking about as a target beyond 65, if anything?

Lewis Chew

Well, as we’ve said consistently in the past, although I’mnot sure how steadfastly Brian sticks to this, we want to break through the 65before we start talking about any of the targets. Right now, we are verycomfortable with our business model that when revenue goes up, margin goes upwith it so that’s why you hear most of the company’s energy focused on energyefficiency growth.

We think that the margin will take care of itself and thatthe 65% target that we have today is very achievable.

Do you want to add anything to that, Don?

Donald Macleod

Well, there’s a lot of dynamics behind our margin. As Lewispointed out, we are running our factories at mid 60% capacity utilization atthis point. We’ve got room to improve the contribution on that side of thehouse.

And the other point that Lewis made is that over the pastfour quarters, we’ve been shipping less into our distributors than they’veactually been selling out as they de-inventory, and it’s a well-known fact thatthe in aggregate margin that we achieve from products that go into thedistribution channel are of the superior end in the scale, so when they getback to equilibrium, we are going to get more of our sales mix coming from thathigher margin position.

The other point I think is the key -- the new products thatwe are introducing to the market are clearly successful. This quarter justabout all the revenue growth in dollars we had was accounted for by revenuegrowth in new products and they have the superior margin characteristics thatwill add to the overall number going forward.

Not forgetting all of that, this is the pure volumedimension when the volume starts moving up, our margins clearly fall through,as you saw this quarter. So there’s a lot of room to grow here and it’s growingon a number of different factors. It’s not dependent on any one.

Long Ly

All right, thanks, John. Let’s move on, Operator.


Our next question comes from the line of Chris Danely withJP Morgan.

Chris Danely - JPMorgan

For the first five minutes, I thought I was listening to theExxon conference call. Anyway, can you just go through how you feel about thevarious end markets out there, which you are worried about and which you feelbetter about?

Lewis Chew

I’ll let Brian and Don add on. Right now, we have to becandid in saying that most of our growth is coming from this portable wirelesshandset space, which is very healthy. We haven’t seen a lot of growth, if any,over the last couple of quarters in the so-called broader markets, industrialspace. And as you know, we’re not a big participant in the PC vertical market.We’ve done that strategically because of the margins.

So looking out ahead, I guess one comment we could make isthat I don’t know that those other broader markets could get much worse,although I suppose anything could get worse. But we haven’t been getting a lotof growth from anything other than wireless. So we’ve got the seasonal impactfrom that space and then at some point, I think the other markets will end uphaving to pick up because I think you can’t paint a picture that says nobodyinvest in modernization forever, right?

Chris Danely - JPMorgan

What do you think will be the first to pick up?

Lewis Chew

Well, okay, since none of the other two guys took that one,when I talk to our CIO, he often points out that certainly infrastructure thatlies in the backbone of every company out there listening on to this call doesnot last forever and he’s probably listening to this call right now. Thebandwidth demands are increasing every day -- e-mail, video traffic, and maybehe’s just softening me up for a budget request but at some point, stuff thatgot put in place for Y2K is going to have to be replaced. And as Brian pointsout, a lot of the stuff that was put in place wasn’t all that energy efficientto begin with, so people are going to start looking at that as well.

But at some point, I think I believe that there’s got to besome spending in infrastructure space that’s got to occur.

Chris Danely - JPMorgan

Okay, and can you just comment on your preferential usage ofcash going forward, dividend versus buy-back?

Lewis Chew

I think at this point, we probably have a lean towardsbuy-back.

Chris Danely - JPMorgan

Okay, thanks.

Long Ly

All right, thanks, Chris.


Our next question comes from the line of Craig Ellis withCitigroup.

Craig Ellis -Citigroup

Thanks, guys. First a question on mix; I think about a yearago we would have expected that handset mix was on a trajectory to go fromabout 30% of sales to 25%, and you’ve been successful and it’s now back up toaround 33% of mix. Does this look like the level at which it levels out oractually headed higher from here?

Donald Macleod

Well, that’s actually a very appropriate question and yes, ayear ago we were wondering what direction our revenue into the portable mobiledevice or handset marketplace was going. I think as we said the theme at thetime, everyone viewed that integration was happening and low-cost handsetswould integrate people like us out.

The fact is over the last year, we’ve seen broad penetrationof our products into a whole raft of different handsets, you know, handsetsthat actually include even entry-level handsets today. As the handsetmarketplace at the entry level becomes more sophisticated, we find that some ofour analog building blocks are creeping back into that space.

But look at the high-end phones, look at these music videoother phones, look at these enterprise level phones, the BlackBerries, etcetera. We’re penetrating very broadly that marketplace with our analogcapabilities as you the consumers are looking for more differentiation --better displays, better audio, longer battery life, more bandwidth, et cetera.

And at this point, I listed to you the product areas wherewe saw growth in the quarter. I listed to you the company’s that we saw growthin the handset space. It’s not one handset, it’s not one customer and it’s noteven one capability at National that’s achieving all of that growth.

So we’re finding that the market is coming to the directionof differentiating itself based on our analog products, so the number is goingup and frankly at this point in time, I don’t see it going back down. I thinkwe have an opportunity to continue to move more products into the broadeningdefinition of personal mobile devices. I mean, I just talked about personalnavigation and other capabilities that are using all these sophisticateddisplays, even adding audio and obviously intensively using the batteryfunctions and power management.

So yes, I guess a year ago we were cautious, but it workedout the other way around.

Craig Ellis -Citigroup

Okay, so clearly getting more than your fair share in mid-to high-end phones but also maybe being able to get good margin on product inlow-end handsets that you wouldn’t have expected to keep a year ago.

Donald Macleod

I think conventional wisdom, by the way, drives that whenyou penetrate those fast-growing consumer markets, your margins erode and we’vekept the discipline in place to ensure that that doesn’t happen and we get therevenue growth at the same time.

Craig Ellis -Citigroup

Okay. Well, good for you guys on that front. Secondly, juston the flat capacity side, manufacturing utilization has been hovering in the60% level for quite a long time now. National was one of the leaders in reallyrationalizing plant assets a number of years ago. Is there anything you can doon that front if we don’t get sustained revenue growth back in the next quarteror two, so that overall manufacturing utilization can move to a much higherlevel?

Lewis Chew

We actually took one step in that direction a quarter agoand as you pointed out, the one thing we can say from our history is we don’thesitate to take steps that we think are necessary. But the good news is ourbusiness model today is very strong, so I would say that the small changes thatwe are a little bit more strategic about that these days and our manufacturinggroup absolutely paints a short-term, medium-term, long-term strategy.Eventually we will probably have to have more of our capacity coming from 8-inchversus 6-inch, and we took the first step this quarter as our first wave of8-inch capacity at Texas came online.

So I think it will probably be driven by a combination ofwhat we need down the road, along with what’s the right size of manufacturingfor National.

As Brian has pointed out, it actually is somewhat of aluxury to realize that we ran utilization this quarter in the mid-60s andgenerated 64.5% margins. In the old National days, that number would have beendown in the 30s and we would have been forced to do something pretty dramatic.

So I think we have a little bit more flexibility these daysthan we used to, Craig, but that doesn’t mean that we don’t look at the veryquestion you’re asking and try to figure out the right thing to do.

Craig Ellis -Citigroup

Okay, that’s helpful, Lewis, and with regard to the currentand the out-quarter capital spending, is that mostly going to the 8-inchconversion or is that going more on the back end and how should we think aboutthe disposition of that capital?

Lewis Chew

It’s a pretty broad mix. Let me talk about Q2 instead of Q3.Q2, when I look at the money that we spent, it was pretty evenly spread betweenmaintenance capital and then new capacity coming online and then also newcapabilities, because don’t forget that at this low level of CapEx, we’ve beenrunning what, 6% of revenue. There is always going to be a small piece ofcapital we spend for new capabilities, stuff that we haven’t released yet tothe public but is some leading edge analog technology that we’re working on.

Long Ly

All right, thanks, Craig.


Our next question comes from the line of Srini Pajjuri withMerrill Lynch.

Srini Pajjuri -Merrill Lynch

Thank you. Hey, guys. A couple of questions, the first oneis the wireless market being seasonally soft in Q3. I’m just wondering if youare seeing anything different from different regions. In particular, if youcould talk about the local China market and how that’s behaving, that would begreat.

Donald Macleod

I’ll take that. Again, we participate in the local handsetbranding activity in China mostly through reference designs where we havecircuits that are on reference designs from well-known names or other base bandproviders, so we do see that marketplace. We did see some adjustments in ourbacklog from customers that play in that marketplace at the local level throughOctober and into the beginning of November. I think this was resulting insomewhat less market activity over the early October holiday period. But Ithink that’s kind of something that’s history by this point in time.

But I would make the point that the other customers in themarket tend to give us visibility, the larger ones, through forecasts and insome cases these forecasts are updated on a virtual daily basis. So what we arereacting to is what they are indicating that they will sell or build throughthe third fiscal quarter for us and to a great extent, what we are looking foris the reactual activity as they start working through the holiday period andtranslate that into real demand on a daily basis going forward.

So our visibility isn’t based on necessarily any view. It’sjust the market forecast that they produce on a routine basis from the MRPsystems.

Srini Pajjuri -Merrill Lynch

Okay. And then my second question is on the LCD business. Ican see why the comps in [the industry] is not growing for the past fewquarters but I’m just wondering -- I mean, it seems like the large LCD displaydemand seems okay and your business hasn’t really grown that much in the lastcouple of quarters -- just wondering what’s going on there.

Donald Macleod

That’s actually a strategic choice on our part. We look atmarkets that will reward us for the value of the uniqueness of the analogsolution and where we can bring unique solutions in the LCD space, we bringthose unique solutions but very often when you move into volume production, ofsignificant volume for those, it tends to be a cost plus driven market and wedon’t play in those kind of solutions. I mean, for example, if you look at someof the new back-lighting initiatives in LCDs for notebooks and others, we areclearly leading in providing solutions in that space and we want to get paidfor that value and I think that’s the way we focus on that market, rather thanjust be bigger in a marketplace where there isn’t a huge return on the R&Dinvestment.

We have other markets that we can address that do pay us forthat investment a lot better.

Srini Pajjuri -Merrill Lynch

Thank you.

Long Ly

All right, thanks, Srini. Operator, next caller, please.


Our next question comes from the line of Uche Orji with UBSNew York.

Uche Orji - UBSSecurities

Thank you for taking my questions. Can you hear me?

Lewis Chew

Yes, we can. Is that a secret ad for Verizon, Uche, or --

Uche Orji - UBSSecurities

Using an iPhone. ASP, you mentioned ASP was up year-on-yearin the quarter. Can you just tell me how that trended sequentially?

Donald Macleod

It wasn’t up sequentially. That’s the answer to thatquestion.

Uche Orji - UBSSecurities

Right, and if we look a little bit further with all thismacro headwinds and with your guidance being down, should we expect ASPs totrend down again sequentially next quarter?

Donald Macleod

No, I don’t think you should expect ASPs to be downsequentially in the next quarter. Obviously we look at the backlog that we haveand we look at the ASP activity on the bookings that we took into that backlogover the last quarter. That booking ASP was up sequentially and we would expectto see that translate into higher ASPs.

And you know, again there’s a mix element in ASPs that’sseasonal. When we ship more products into the distribution channel as a percentof our business, our ASPs tend to benefit more from that for obvious reasonsand I think seasonally, we will have that benefit on a relative basis nextquarter as the mobile phone vertical market is a lower proportion of ouroverall sales.

Uche Orji - UBSSecurities

Right, okay. Let me just ask you on the gross margins, theimprovement you saw sequentially. Is it possible to kind of attribute betweenASP mix and utilization rates what [inaudible] attributed to the higher grossmargins we saw this quarter?

Lewis Chew

Sure, Uche. Why don’t I do it this way -- instead of beingso granular as ASP versus the elements that you mentioned, usually the way welook at it is how much of it is driven by the portfolio, which is a combinationof ASP mix and all that, and how much of it is driven by things like volume andmanufacturing efficiencies. And I would say both have that equation andcontributed significantly this quarter. So it’s a good mixture of improvementin the portfolio as well as benefits we got from the higher volume, whichtranslates into a little bit better manufacturing performance as well.

And I would like to point out to you and everyone on thecall that that margin improvement came whilst also reducing inventory by $16million, so that’s a very -- I think a very solid incremental improvement thatwe showed that really, you would have to argue that some of that had to bedriven by the portfolio because there’s no possible way you could do that justfor manufacturing.

Uche Orji - UBSSecurities

Right. Okay, so should we just interpret the sequentiallylower gross margins for February quarter to just come from lower volumes?

Lewis Chew

Yes. I think it’s safe to say, Uche, that we typically don’tforecast any particular improvement in the mix per se until we actually achieveit, so for Q3, the margin guidance that I gave factors in the lower volume thatwe’re going to run, as opposed to any degradation in the portfolio.

Uche Orji - UBSSecurities

All right, great. Thank you very much.


Our next question comes from the line of Ross Seymore withDeutsche Bank.

Ross Seymore -Deutsche Bank

Thanks, guys and congrats on the strong margins, especially.With 35% of your business now in wireless, do you have any 10% customers there?

Lewis Chew

We currently don’t have any customers over 10% that we’vedisclosed, Ross, because as you know, that is an annual measurement. So theonly thing I could say is stay tuned for ’08 to see whether or not thatchanges.

Ross Seymore -Deutsche Bank

You must have a lot of guys right at 9%, huh?

Lewis Chew

Well, as Don and Brian and I have mentioned many times, weare pretty broadly exposed to the top guys in wireless and I think Don evenmade a comment in his prepared comments that we actually grew revenues with allfive of the top five wireless guys this quarter, so I think we believe thatwith the stuff we bring to the market, especially the energy efficiency stuffand the display stuff, that we are a player quite broadly and we are not reallyreliant on one guy per se, although there are guys that are bigger than others.

Ross Seymore -Deutsche Bank

And then finishing up on that them, 35% wireless, it’samazing versus what you guys said earlier this year about potentially wirelessbeing de-emphasized for margin reasons, that you’ve achieved such impressivemargins staying in it.

If I had to look at some of the other potential areas thatcould grow and that are strategic targets outside of wireless, how should Ithink about the ones you’re prioritizing, if any?

Donald Macleod

I think if you look at our current portfolio, the area thatwe’re talking a lot about is still broadly under this generic heading of energyconservation and I made a few references to some of the areas that we arelooking at. For example, driving LEDs for lighting in the home. I think lastquarter I made a reference to how we are working on driving LEDs for othermarkets, displays, et cetera and back lighting.

We see this whole industrial power, industrial lighting asan area of significant opportunity going forward. We also presented I think atour shareholder meeting just a couple of months ago the whole area of videodistribution is a current area where we are seeing significant opportunities.Everybody is talking about high definition everywhere. Interestingly enough, theleading player in the mobile phone marketplace was talking about HD to themobile phone by 2009.

We’re addressing that by first putting high definitionsolutions to the infrastructure market and then moving to the enterprise andsmall business and eventually, our interface silicon will all get to some formof prosumer and eventually to the consumer itself.

So we see these as areas where right now, we are seeinggrowth but frankly, I think what we are seeing in the personal mobile devicesis a whole proliferation of new devices and capabilities that is extending whatyou might have called wireless handset capability probably in that space.

Ross Seymore -Deutsche Bank

Great, and one real quick housekeeping one for Lewis; theESO expense by the three categories for the second quarter, could you give thatto us, please?

Lewis Chew

Yeah, cost of goods sold -- in other words, the amount inmargins was roughly $6 million; R&D was roughly 8, and SG&A was roughly14.

Ross Seymore -Deutsche Bank

Perfect. Thank you.


Our next question comes from the line of Krishna Shankarwith JMP Securities.

Krishna Shankar - JMPSecurities

Congratulations on the good execution and I have a couple ofquestions; you didn’t give us the revenue breakdown for the other end markets.I know cell phones was one; could you give us the others please? Industrial,networking, and others?

Lewis Chew

I can give you rounded off numbers really quickly; computingwas roughly 5; the whole networking infrastructure space, probably 8 to 10;displays, which is mostly the application specific stuff, roughly 5. I thinkthose are the primary markets we usually break out for you guys.

Krishna Shankar - JMPSecurities

And the rest would be horizontal industrial market?

Lewis Chew

It’s a broad mixture. As you know, a lot of our revenue goesto distribution, so we have to make guesses on where that goes, but yeah, thatwould include automotive, medical, industrial. We still have revenues to thegovernment. We have high reliability stuff that goes in the satellites, so it’sa whole broad -- but that’s not any different than what I was saying six monthsago.

Krishna Shankar - JMPSecurities

Okay, and as you sit here in December, as you look atFebruary, is there anything for the February quarter which does not lookseasonal to you, either in terms of cell phones or some of the other markets?Any comments or any color that you can give on the February quarter in terms ofend markets?

Lewis Chew

I think one of the comments I made earlier is that from anend market perspective, sometimes you can see some pick-up in these industrialmarkets in the first calendar quarter that offsets a little bit of theseasonality from verticals dropping off. And we’re not baking that in this yearbecause we, along with everybody else, have seen a relatively flat environmentthere.

So until we actually see the pick-up, you can’t really bankon that.

Krishna Shankar - JMPSecurities

And would you care to update your -- now that you arereporting 65% gross margin, what is the next milestone? Should we be looking at70% in 12 months? Or what are we looking at here over the next 12 to 18 months?

Lewis Chew

Asked and answered, your honor. I think someone else askedthat earlier, probably John Pitzer. But anyway, I think what we’ll do is let’sget to 65 first before we talk about that. I think the fundamental thing thatwe stick to is that if you are willing to acknowledge that we have growthopportunities, we believe that our incremental gross margin follow-through willcontinue to be in the high 70s, into the 80s for the foreseeable future. Andyou can model yourself what that does to the margin. Brian, do you want to addon?

Brian L. Halla

You kind of have to go back to what Donnie was talking aboutwhere the new revenue growth came from, and that’s the new higher value analogproducts that we’ve been banging out over the last several years. And everytime we ship a higher percentage of those, the margins go up.

Clearly as an analog company, we have pockets of businessthat are well beyond that 70% number you talked about and new higher valueanalog products, more and more coming every day.

So hitting the 65 is clearly not a problem. We’ve beentalking about that for a while. As Lewis said, it’s a little premature rightnow to put another number out there but you can guess what it will be when wedo put one out there.

Krishna Shankar - JMPSecurities

Thank you.


Our next question comes from the line of Steve Smigie withRaymond James.

Steve Smigie -Raymond James & Associates

Thank you. I was hoping you could talk a little bit moreabout Power Wise in general and how you are approaching the market with thatnow. Obviously there are a lot of people trying to get in on the handset. Howdo you differentiate yourself out there? Are there particular product classesthat you focus on for power efficiency? Do you deliver a whole platform or isit just single one-off products?

Brian L. Halla

This Power Wise thing didn’t just occur to us in the middleof a dream at night or in the shower in the morning. We routinely dopost-mortems on design wins as well as design losses and what we found out --I’ll give you a specific example. What we found out is particularly ourbusiness going through distribution that because the distributor has productcoming from all the analog guys, his job is over when he populates the board,whether it’s with Maxim or ADI or TI or us.

So we have an internal design win contest going to getmultiple, as many additional chips per board as we can, just by focusing moreattention on asking additional questions. And then one of the designs that camein was from an all electric car company where they have put 25 of our circuitson their motherboard and you start digging into how’d we get 25 circuits andyou find out that first of all, we never called on the account with a directsales guy but they went through Digikey and ended up with 25 of our circuitsbecause they started out by saying we’re on a power budget.

So you look at what’s coming at us in terms of this energycrisis and you say well, are there other areas where designers are going to beon power budgets, and the answer that comes back is almost everybody now.

So the Power Wise thing isn’t just going to be preservingbattery life in handhelds but we think we can dramatically reduce the powerrequirements of server farms, routers, switches, where now we’re talking aboutvery serious savings for our customers’ customer in terms of more energyefficiency and less cooling costs.

Steve Smigie -Raymond James & Associates

Okay. But there’s not -- again, is there like a specificapproach you take where you present -- maybe you do a reference design for beit a server farm customer, whomever, where you do the whole design yourself? Imean, is there a specific approach that you generate or is it --

Brian L. Halla

Sure. All of the above -- semiconductor industry 1A whereyou go lay out a prototype and demonstrate that, for example, with Power Wiserunning in key circuits in a server, that you can reduce -- in our case, we canreduce power consumption by up to 70% and all you have to do is show a simplecomparison and it’s pretty compelling.

So yeah, the infrastructure -- I mean, there’s tons of wasteout there for the reasons I articulated, which is Moore’s law has kind ofdictated designs over the years but take the example of the base station, thething that hangs out at the end of all of the edge servers and blade serversand shoots data wirelessly to the handsets -- those are 1.2% power efficienttoday and the reason is that they are constantly on 100% waiting just in casesome cell phone might need some data transmitted.

So there’s plenty of room for huge savings in theinfrastructure.

Long Ly

All right, thanks, Steve. Operator, let’s move on to thelast question, please.


Our next question comes from the line of Douglas Freedmanwith American Technology Research.

Douglas Freedman -American Technology Research

Great. Thanks. Just under the wire there. If you guys couldtalk a little bit about the competitive landscape that you are seeing out thereright now. Clearly I think there’s a bunch of -- it makes it really hardmeeting those sort of long-term growth goals and I was wondering if you arestarting to see any price competition.

And Brian, at one of the meetings you held recently, youmentioned that you guys had been saying no to people as far as pricingrequests, only to have them coming back. Can you talk a little bit about ifthose trends are continuing? Thanks and congratulations on a good quarter.

Brian L. Halla

Thanks, Doug and those trends are continuing. I think whatmy statement was even bolder than that, that we didn’t lose any business as aresult of stiffening up on demanding to get paid where we add value. Thatcontinues.

There’s a huge different out there in terms of companiesthat are run by purchasing and companies that are continuing to innovate and wehave always been consistent over the last five years in our 60-30-30 [market],saying we’d just as soon not do any business with companies that are run bypurchasing and worry about cash conversion cycles more than innovativeproducts. And that has been very, very successful for us, even during timeswhen the commodities kind of thinned out and the margins went up and the priceswent up. We still stayed away from there because that’s -- those are theproduct areas that can drive your trough down in a peak to trough cycle.

So it’s been very successful for us and quite frankly, whenyou go to a customer and say we think that we should get enough margin to plowback into R&D so that we can offer you new innovative products in your nextcycle and the next cycle after that, that’s a pretty reasonable argument thatyou can make and it hasn’t been rejected yet.

Long Ly

All right, thanks, Doug. Operator, with that, we are goingto end the call today. Let me remind you that the replay is available on ourwebsite. Thanks.


Ladies and gentlemen, thank you for your attendance intoday’s National Semiconductor second quarter fiscal year 2008 earningsconference call. This does conclude today’s program. You may now disconnect.

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