National Semiconductor F2Q08 (Qtr End 11/25/07) Earnings Call Transcript

National Semiconductor Corporation (NSM)

F2Q08 Earnings Call

December 6, 2007 4:30 pm ET

Executives

Long Ly - Manager, Investor Relations

Brian L. Halla - Chairman of the Board, Chief Executive Officer

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

Donald Macleod - President, Chief Operating Officer

Analysts

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

Presentation

Operator

Good afternoon. My name is Brian and I will be your conference operator today. At this time, I would like to welcome everyone to the National Semiconductor second quarter fiscal year 2008 earnings conference call. (Operator Instructions) At this time, I would like to turn today’s conference over to Mr. Long Ly, Manager of Investor Relations. Mr. Ly, please proceed, sir.

Long Ly

Thanks. I would like to again welcome everyone to our call today. Joining me are Brian Halla, Chairman and Chief Executive Officer; Lewis Chew, Chief Financial Officer; and Don Macleod, President and Chief Operating Officer.

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

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

For those of you who may have missed the presentation or would like a replay of the call, you can find it on National’s IR website at www.national.com.

In today’s call, I will provide a recap of the second quarter financial results; Brian Halla will give an overview of the business environment 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 for the third quarter fiscal year 2008; Don Macleod will then discuss our products and business in more detail. We will then take questions until approximately 2:30 p.m. Pacific Time.

The second quarter results were as follows; sales were $499 million, 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 second quarter.

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

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

I will now turn it over to Brian Halla for an overview of the 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 Littles in the crowd, but business just isn’t that bad. We actually grew our revenue sequentially by 6% to come in at roughly $500 million, which was about the same level we enjoyed in this quarter last year.

This quarter’s $500 million also generated record gross margins of 64.4% versus last year’s margin of 58.9%. The improvement here comes mostly as a result of the richer mix of new high performance analog circuits launched within the last couple of years. These are products coming from our power management, audio and amplifier product organizations. Hey, the only possible explanation I can come up with is that people are going out to buy new cell phones so they can call their banks and tell them they are not going to default on their mortgages.

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

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

Overall, order levels reflected the same strength we saw in Q1. Our inventories, both internal as well as at our distributors were down again in the quarter. Our factories continue to be relatively under-utilized and yet we continue to see record gross margin improvements and continued reduction in manufacturing costs. Our ASPs improved in the quarter over last year, again reflecting that richer mix of new, higher value-added analog products launched within the last couple of years.

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

Based on the above, we’re currently projecting revenue in the 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 -- do we just hunker down and continue to turn the crank and enjoy our recently newfound peer group status? The answer is absolutely not.

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

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

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

Today, the server farms supporting video applications like YouTube consume about 62 billion kilowatts, or about a watt per gigabit of information transferred over the Internet. Unless YouTube and the other video intensive transmission applications are just a passing fad, the estimate of additional server farm capacity over the next four years just to keep up with the growth of this industry will require a doubling of today’s capacity or about 10 additional power plants which, by the way, could increase unwanted production of CO2, carbon dioxide, by thousands of tons. So the general pressure that the server farm industry feels to become more power efficient will I’m sure escalate over time as the market demands further efficiencies.

What does all this mean for the future of National Semiconductor? 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 now iconic law that has governed our industry since day one ignored power efficiency all together.

That law, simply stated, was the transistor count would double on the same size chip every two years, or even further simplified, said that gates are free. So the semiconductor industry has since that time thrown an 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 Nyquist Shannon method of at least a 2X oversampling of a given bit stream and then running the massive store of collected bits through a powerful DSP or microprocessor to determine what information is held in the stream of data.

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

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

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

Our nation is facing multiple crises. The most visible financial crisis is the sub-prime mortgage crisis which has not yet had any noticeable impact on our business, at least not on a global basis, though we certainly 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 initiatives or pressure on the energy consuming industries to find more efficiency. This energy crisis represents an opportunity for the semiconductor companies to step up and help solve a problem we helped create. It’s an opportunity particularly for National Semiconductor as we continue to add innovative power efficient circuits to a Power Wise family of products already now over 400 strong and growing.

Over to you, Lewis.

Lewis Chew

Thanks, Brian. I’m not sure I can adequately follow that but nevertheless, I will focus on three main topics in my commentary today. One, I’ll highlight some details from the business activity that occurred during the quarter that we just finished. Two, I’ll go over the major factors and assumptions that 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 metrics that you guys usually like to hear about.

So let me start with Q2 business activities. At the beginning of 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 wireless handset space. We also indicated that we were not baking in any sort of snap-back from other vertical markets, nor from the broader markets that are served through the distribution channels.

While the actual activity during Q2 has largely played out in line with those original assumptions, most of the sales growth we achieved during 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 that topic during his segment of the call.

Our sales into the distribution channel were up only slightly 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 four quarters.

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

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

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

So based on everything I just went over, we are anticipating that 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 first time we’ve reported gross margins above 64% and that reflects the continuing improvement and the value in our product portfolio, as well as the benefits of higher sales volume.

Our fab utilization in Q2 was up slightly at a little over 65% based on wafer starts and our incremental fall-through gross margin percentage during Q2 was in the high 80s.

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

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

I will note that although our gross margin takes a pause in Q3 because of the revenue, our gross margin leverage model is still intact, meaning that future advancements and the value of our portfolio, along with higher revenue levels, would continue to drive our gross margins upward again.

Moving along to operating expenses, we are projecting R&D expense in Q3 to range from $92 million to $94 million. We are projecting SG&A expense to range from $81 million to $83 million. Other income and expense is anticipated to be around $1 million of expense. Gross interest income is projected to range from $7 million to $8 million, which is down from Q2 because of lower short-term interest rates combined with lower average cash balances. And gross interest expense should be a little below $23.5 million as we repay a certain amount of debt principal each quarter.

Included in the projected Q3 gross margin and operating expense numbers I just went over are approximately $24 million of total stock compensation expenses in Q3. This estimated $24 million can be broken down by categories as follows: cost of sales, $6 million; R&D, $7 million; and SG&A, $11 million.

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

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

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

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

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

Operating margin in Q2 was 29%, which is up from 27% in Q1 and return on invested capital for the second quarter was about 23%. All of these 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 on the drivers of our business in the quarter. Our 6% revenue growth sequentially essentially all came from sales to customers in the wireless handset and related personal mobile device markets. It came from new products that validate our power wise theme where our product focus is on enabling the highest analog performance, or best signal integrity with the lowest power. It also reinforced our view that those performance and power optimized analog products are increasingly enabling system level differentiation in faster growing end markets for semiconductors.

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

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

To be specific, our sales to wireless handset customers grew about 18% sequentially and over 30% year-on-year and represented a little more than 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 in the wireless handset market. Our quarterly sales also grew to the leading enterprise handset provider and to the new very visible music video wireless handset provider as they both expanded their product offerings.

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

Products that enabled power efficiency, such as high performance linear regulators in entry level and application specific phones, power management units in CDMA phones, and applications processor PMUs for feature 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 human interface performance, such as our audio subsystems, keyboard and other data interfaces, lighting systems, and display drivers. We clearly have a broad-based analog set of expertise in this area and our customers see us as the go-to guy for these analog solutions.

We see continuing growth in the mobile phone handset marketplace and we see it as the largest consumer electronics sector. Gartner also 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 year and a very likely greater than 1.1 billion handsets should be sold in 2007.

Our focus on power and energy efficiency at National Semiconductor is not just targeted to mobile devices. We also see new disruptive energy efficiency growth opportunities in consumer and industrial lighting, where new high brightness LEDs can now replace fluorescent and incandescent lighting in all 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 management switchers that are designed to efficiently power LEDs. We have the most extensive range of high brightness drivers in the market and we also have the best online design tools to allow lighting customers who might have little or no electronic design expertise to quickly and easily implement highly efficient LED solutions using our power products, and with a wide variety of commercially available LEDs.

In the first month, customers have already created about 7,000 online LED designs using our web bench tool suite, and we see great revenue growth opportunities here, especially in the more energy conscious economies in Asia.

In the quarter, we also launched a new family of 10 power wise switching regulators, our new LM20K family. These are the first in the industry to feature both high power density and self synchronization. This self synchronization feature enables power supply designers to build more energy efficient and more complex power sequencing for applications such as communications, data storage, and automotive, where space and energy efficiencies are becoming more and more critical.

Our industry leading web bench suite of online design tools is 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 of power management simple switchers, I referred to the online web bench simulation and product interest activity for the first month after launch. We are seeing the same levels of interest for our LED lighting and LM20K family immediately post launch. Incidentally, we’re now up to about 40,000 web bench online designs completed by our customers in the first 10 months after the release of our fourth generation simple switchers.

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

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

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

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

Data converter sales were flat in the quarter and represented 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’s sales came from analog products, the same percentage as last quarter.

From a market segment point of view, as we discussed earlier, sales to the mobile phone handset market grew about 18% sequentially and over 30% year over year. Sales to all other markets, such as communications, networking, industrial, large displays, et cetera, we essentially flat with the preceding quarter.

Moving to a discussion on our gross margin improvement drivers, company ASPs grew about 2% year over year. However, a key driver of our gross margin was our new product revenue growth. This quarter, our sequential growth in new product sales dollars equaled our total company sequential 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 three years.

Looking forward to this third quarter, we expect sales to the mobile phone handset and other similar portable consumer devices to be down on the second quarter and this is in line with our normal seasonal expectations. 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 our inventory profile. As you can see, we ran our inventories down by about $16 million in the quarter and this was mainly in our die bank. In Q3, we are planning 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 was the start of our first production wafers in the month of November at our new Texas 8-inch module.

So looking beyond Q3 seasonality, our power wise focus that enables higher performance analog solutions, maximizing energy or power efficiency, is clearly positioning us to address fast-growing opportunities and at 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 open up the lines to begin the Q&A session. Please limit yourself to one question and one follow-up so that we can accommodate as many people as possible. Operator.

Question-and-Answer Session

Operator

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

Simona Jankowski - Goldman Sachs

Thanks a lot. Don, I just wanted to follow up; I think you said that your app specific products were down from 8% to 4% of the total. Can you 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 are display driver products, RF products, and some analog application specific products. The major part of that change was actually a combination of the RF products that we are deemphasizing over time and slightly lower sales of our display drivers as we move beyond the product launch and into the more sustaining delivery for a very visible consumer product that’s in the market using these display drivers.

Simona Jankowski - Goldman Sachs

I see. So that’s something where you ramped up into a product 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 are basically very close now to the leader in terms of inventory management, which is Linear, at 73 days and way lower than pretty much all of your other larger analog competitors. Can you comment if this decline is entirely a function of your muted expectations for next quarter or are there any other reasons for that or any other kind of operation or manufacturing efficiencies that are allowing 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 customers in these areas give us forecasts that we work on and obviously we were able to smooth out our production by building up some die bank in the summer quarter to anticipate those customers’ needs in this recently completed quarter and this helps us, as we pointed out, balance out the loading of wafer starts in our factories so we smooth out these seasonal trends. We anticipated that.

The other is that as we’ve been going through this fab rationalization process, where we’ve been moving products from 6-inch to 8-inch capabilities and moving between our factories, we’ve had some buffer inventories. These are working down, so our inventories are now at a reasonable profile but there’s to take them down further but I think the seasonality is built 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.

Operator

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

John Pitzer - Credit Suisse

Good afternoon, guys. Thanks for taking my questions. I have a couple. First, when you look at the normal seasonal trend in the fiscal third quarter, given the fact that your business has kind of changed year-on-year and it’s hard to do an apples-to-apples comparison, how would you guess the minus 1% to minus 5% guidance kind of compares to normal seasonality, given the change in your business?

Lewis Chew

You know, the first thing I would observe is in this last three years, it’s getting harder and harder to define anything called normal seasonality just because the cycles have come pretty quick. But when you look at long-term averages, it’s not uncommon for us to be down let’s call it 2% to 3% in the third quarter.

Now typically what drives the downward pressure is revenues that we sell into things that are heavy for the holidays do drop off in build rates, and then sometimes you can anticipate possibly some offset from industrial 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 going down but they are not going up. So in terms of the outlook that we have going into this year’s seasonality, we certainly do anticipate that there will be some post-holiday drop-off from the verticals that we serve, and we also are anticipating that distributor activity will be down slightly as well, meaning that there’s really no tick-up that we are baking in from the broader industrial markets.

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

John Pitzer - Credit Suisse

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

Lewis Chew

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

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

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

John Pitzer - Credit Suisse

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

Lewis Chew

Well, as we’ve said consistently in the past, although I’m not sure how steadfastly Brian sticks to this, we want to break through the 65 before we start talking about any of the targets. Right now, we are very comfortable with our business model that when revenue goes up, margin goes up with it so that’s why you hear most of the company’s energy focused on energy efficiency growth.

We think that the margin will take care of itself and that the 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 Lewis pointed out, we are running our factories at mid 60% capacity utilization at this point. We’ve got room to improve the contribution on that side of the house.

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

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

Not forgetting all of that, this is the pure volume dimension 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 growing on a number of different factors. It’s not dependent on any one.

Long Ly

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

Operator

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

Chris Danely - JP Morgan

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

Lewis Chew

I’ll let Brian and Don add on. Right now, we have to be candid in saying that most of our growth is coming from this portable wireless handset 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, industrial space. 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 is that 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 lot of growth from anything other than wireless. So we’ve got the seasonal impact from that space and then at some point, I think the other markets will end up having to pick up because I think you can’t paint a picture that says nobody invest in modernization forever, right?

Chris Danely - JP Morgan

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 that lies in the backbone of every company out there listening on to this call does not last forever and he’s probably listening to this call right now. The bandwidth demands are increasing every day -- e-mail, video traffic, and maybe he’s just softening me up for a budget request but at some point, stuff that got put in place for Y2K is going to have to be replaced. And as Brian points out, a lot of the stuff that was put in place wasn’t all that energy efficient to 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 be some spending in infrastructure space that’s got to occur.

Chris Danely - JP Morgan

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

Lewis Chew

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

Chris Danely - JP Morgan

Okay, thanks.

Long Ly

All right, thanks, Chris.

Operator

Our next question comes from the line of Craig Ellis with Citigroup.

Craig Ellis - Citigroup

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

Donald Macleod

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

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

But look at the high-end phones, look at these music video other phones, look at these enterprise level phones, the BlackBerries, et cetera. We’re penetrating very broadly that marketplace with our analog capabilities 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 where we saw growth in the quarter. I listed to you the company’s that we saw growth in the handset space. It’s not one handset, it’s not one customer and it’s not even one capability at National that’s achieving all of that growth.

So we’re finding that the market is coming to the direction of differentiating itself based on our analog products, so the number is going up and frankly at this point in time, I don’t see it going back down. I think we have an opportunity to continue to move more products into the broadening definition of personal mobile devices. I mean, I just talked about personal navigation and other capabilities that are using all these sophisticated displays, even adding audio and obviously intensively using the battery functions and power management.

So yes, I guess a year ago we were cautious, but it worked out 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 in low-end handsets that you wouldn’t have expected to keep a year ago.

Donald Macleod

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

Craig Ellis - Citigroup

Okay. Well, good for you guys on that front. Secondly, just on the flat capacity side, manufacturing utilization has been hovering in the 60% level for quite a long time now. National was one of the leaders in really rationalizing plant assets a number of years ago. Is there anything you can do on that front if we don’t get sustained revenue growth back in the next quarter or two, so that overall manufacturing utilization can move to a much higher level?

Lewis Chew

We actually took one step in that direction a quarter ago and as you pointed out, the one thing we can say from our history is we don’t hesitate to take steps that we think are necessary. But the good news is our business model today is very strong, so I would say that the small changes that we are a little bit more strategic about that these days and our manufacturing group absolutely paints a short-term, medium-term, long-term strategy. Eventually we will probably have to have more of our capacity coming from 8-inch versus 6-inch, and we took the first step this quarter as our first wave of 8-inch capacity at Texas came online.

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

As Brian has pointed out, it actually is somewhat of a luxury to realize that we ran utilization this quarter in the mid-60s and generated 64.5% margins. In the old National days, that number would have been down 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 days than we used to, Craig, but that doesn’t mean that we don’t look at the very question 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 current and the out-quarter capital spending, is that mostly going to the 8-inch conversion or is that going more on the back end and how should we think about the 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 between maintenance capital and then new capacity coming online and then also new capabilities, because don’t forget that at this low level of CapEx, we’ve been running what, 6% of revenue. There is always going to be a small piece of capital we spend for new capabilities, stuff that we haven’t released yet to the public but is some leading edge analog technology that we’re working on.

Long Ly

All right, thanks, Craig.

Operator

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

Srini Pajjuri - Merrill Lynch

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

Donald Macleod

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

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

So our visibility isn’t based on necessarily any view. It’s just the market forecast that they produce on a routine basis from the MRP systems.

Srini Pajjuri - Merrill Lynch

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

Donald Macleod

That’s actually a strategic choice on our part. We look at markets that will reward us for the value of the uniqueness of the analog solution and where we can bring unique solutions in the LCD space, we bring those unique solutions but very often when you move into volume production, of significant volume for those, it tends to be a cost plus driven market and we don’t play in those kind of solutions. I mean, for example, if you look at some of the new back-lighting initiatives in LCDs for notebooks and others, we are clearly leading in providing solutions in that space and we want to get paid for that value and I think that’s the way we focus on that market, rather than just be bigger in a marketplace where there isn’t a huge return on the R&D investment.

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

Srini Pajjuri - Merrill Lynch

Thank you.

Long Ly

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

Operator

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

Uche Orji - UBS Securities

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 - UBS Securities

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

Donald Macleod

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

Uche Orji - UBS Securities

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

Donald Macleod

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

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

Uche Orji - UBS Securities

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

Lewis Chew

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

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

Uche Orji - UBS Securities

Right. Okay, so should we just interpret the sequentially lower 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’t forecast any particular improvement in the mix per se until we actually achieve it, so for Q3, the margin guidance that I gave factors in the lower volume that we’re going to run, as opposed to any degradation in the portfolio.

Uche Orji - UBS Securities

All right, great. Thank you very much.

Operator

Our next question comes from the line of Ross Seymore with Deutsche 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’ve disclosed, Ross, because as you know, that is an annual measurement. So the only thing I could say is stay tuned for ’08 to see whether or not that changes.

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, we are pretty broadly exposed to the top guys in wireless and I think Don even made a comment in his prepared comments that we actually grew revenues with all five of the top five wireless guys this quarter, so I think we believe that with the stuff we bring to the market, especially the energy efficiency stuff and the display stuff, that we are a player quite broadly and we are not really reliant 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’s amazing versus what you guys said earlier this year about potentially wireless being de-emphasized for margin reasons, that you’ve achieved such impressive margins staying in it.

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

Donald Macleod

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

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

We’re addressing that by first putting high definition solutions to the infrastructure market and then moving to the enterprise and small business and eventually, our interface silicon will all get to some form of prosumer and eventually to the consumer itself.

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

Ross Seymore - Deutsche Bank

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

Lewis Chew

Yeah, cost of goods sold -- in other words, the amount in margins was roughly $6 million; R&D was roughly 8, and SG&A was roughly 14.

Ross Seymore - Deutsche Bank

Perfect. Thank you.

Operator

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

Krishna Shankar - JMP Securities

Congratulations on the good execution and I have a couple of questions; 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; computing was roughly 5; the whole networking infrastructure space, probably 8 to 10; displays, which is mostly the application specific stuff, roughly 5. I think those are the primary markets we usually break out for you guys.

Krishna Shankar - JMP Securities

And the rest would be horizontal industrial market?

Lewis Chew

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

Krishna Shankar - JMP Securities

Okay, and as you sit here in December, as you look at February, is there anything for the February quarter which does not look seasonal 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 of end markets?

Lewis Chew

I think one of the comments I made earlier is that from an end market perspective, sometimes you can see some pick-up in these industrial markets in the first calendar quarter that offsets a little bit of the seasonality from verticals dropping off. And we’re not baking that in this year because we, along with everybody else, have seen a relatively flat environment there.

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

Krishna Shankar - JMP Securities

And would you care to update your -- now that you are reporting 65% gross margin, what is the next milestone? Should we be looking at 70% 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 asked that earlier, probably John Pitzer. But anyway, I think what we’ll do is let’s get to 65 first before we talk about that. I think the fundamental thing that we stick to is that if you are willing to acknowledge that we have growth opportunities, we believe that our incremental gross margin follow-through will continue to be in the high 70s, into the 80s for the foreseeable future. And you can model yourself what that does to the margin. Brian, do you want to add on?

Brian L. Halla

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

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

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

Krishna Shankar - JMP Securities

Thank you.

Operator

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

Steve Smigie - Raymond James & Associates

Thank you. I was hoping you could talk a little bit more about Power Wise in general and how you are approaching the market with that now. Obviously there are a lot of people trying to get in on the handset. How do you differentiate yourself out there? Are there particular product classes that you focus on for power efficiency? Do you deliver a whole platform or is it just single one-off products?

Brian L. Halla

This Power Wise thing didn’t just occur to us in the middle of a dream at night or in the shower in the morning. We routinely do post-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 our business going through distribution that because the distributor has product coming 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 get multiple, as many additional chips per board as we can, just by focusing more attention on asking additional questions. And then one of the designs that came in was from an all electric car company where they have put 25 of our circuits on their motherboard and you start digging into how’d we get 25 circuits and you find out that first of all, we never called on the account with a direct sales guy but they went through Digikey and ended up with 25 of our circuits because they started out by saying we’re on a power budget.

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

So the Power Wise thing isn’t just going to be preserving battery life in handhelds but we think we can dramatically reduce the power requirements of server farms, routers, switches, where now we’re talking about very serious savings for our customers’ customer in terms of more energy efficiency and less cooling costs.

Steve Smigie - Raymond James & Associates

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

Brian L. Halla

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

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

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

Long Ly

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

Operator

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

Douglas Freedman - American Technology Research

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

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

Brian L. Halla

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

There’s a huge different out there in terms of companies that are run by purchasing and companies that are continuing to innovate and we have 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 by purchasing and worry about cash conversion cycles more than innovative products. And that has been very, very successful for us, even during times when the commodities kind of thinned out and the margins went up and the prices went up. We still stayed away from there because that’s -- those are the product areas that can drive your trough down in a peak to trough cycle.

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

Long Ly

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

Operator

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

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