Standard Microsystems F3Q08 (Qtr End 11/30/2007) Earnings Call Transcript

Standard Microsystems Corp (SMSC)

F3Q08 (Qtr End 11/30/2007) Earnings Call

December 19, 2007 5:00 pm ET

Executives

Steve Bilodeau - Chairman, President and CEO

David Smith - SVP and CFO

Aaron Fisher - SVP of Products and Technology

Carolynne Borders - Director of Corporate Communications

Analysts

Christian Schwab - Craig-Hallum Capital

Christopher Longiaru - Sidoti & Company

Vernon Essi - Needham & Company

Josh Baribeau - Canaccord Adams

Presentation

Operator

Good afternoon, ladies and gentlemen. And welcome to the SMSC Third Quarter Fiscal 2008 Results Conference Call. At this time I would like to inform you that this conference is being recorded, and all participants are in a listen-only mode. Following management’s discussion, we will open the conference up for questions and answers and instructions will follow at that time.

Now at this time, I would like to turn the conference over to your host, Ms. Carolynne Borders of SMSC. Please go ahead.

Carolynne Borders

Thank you. Good afternoon and thank you for joining us today for SMSC's third quarter fiscal 2008 conference call. You should have all received a copy of our press release issued this afternoon. You may also find the release on our website at smsc.com.

If you’ve dialed in on the phone line, please note that there is also a slide presentation that accompanies today's call, which can be found in the investor relations section of our website.

Representing management today are Steve Bilodeau, Chairman, President and Chief Executive Officer; David Smith, Senior Vice President and Chief Financial Officer and Aaron Fisher, Senior Vice President of Products and Technology.

Today's presentation includes non-GAAP financial measures, which should not be considered an isolation or as an alternative to results of operations data or any other measure of performance derived in accordance with U.S. GAAP.

However, these non-GAAP financial measures are presented because SMSC believes they provide useful supplemental information for management and investors and allow them to perform meaningful comparisons to the company's past and present results.

Guidance is presented on a non-GAAP basis only, given that the GAAP basis charges for equity based compensation related to stock appreciation rights cannot be projected reasonably. GAAP and non-GAAP numbers along with a reconciliation of the two are available in today's press release and in the appendix of this presentation.

Following management's discussion, we will open the call to a Q&A session and I'll also note that a replay of today's call will be available on our website. If you are participating in our online webcast, please move on to slide two for a quick note on our Safe Harbor Statement.

Certain matters discussed in this teleconference are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected or forecasted.

Such risks and uncertainties include but are not limited to, those discussed in this teleconference and those found in the companies Form 10-K, 10-Qs and other filings with the Securities and Exchange Commission. I’d also refer you to the forward looking statement language contained in today's press release regarding risks and uncertainties.

And with that, I'll ask you to advance to slide three in the presentation and I'll turn the call over to Steve Bilodeau.

Steve Bilodeau

Thanks, Carolynne. And thank you all for joining us today. We had a strong third quarter with $104.7 million in sales. This is a record for SMSC's semiconductor revenues overall and in fact exceeded the high end of our prior guidance by $3.7 million. This was even better than expected, primarily due to product sales and to consumer electronics, which jumped over 20% sequentially.

This time last year, we announced that we were in the process of a strategy refinement that we expected would significantly increase gross margins. This was a three-pronged initiative aimed at making sure that SMSC's margins more clearly reflected the quality of the business we have built.

First, we phased out about $30 million per year in low margin, low growth business, also, in the PC space. Secondly, we invested in a major upgrade to our test facility in order to reduce cost. And third, we started harvesting the fruit of years of robust R&D investment as SMSC sales mix shifts towards higher margin products.

You can see by our results for this past quarter and since announcing this program, that this initiative has been highly successful. Fiscal 2008, Q3 gross margin percentage is up over 5.5% on a year-over-year basis and by over 1.5% sequentially from the second quarter.

Non-GAAP diluted EPS of $0.53 in the third quarter was up from $0.40 last year. GAAP diluted EPS was $0.36 also up significantly from $.21 in the prior year. This quarter's non-GAAP and GAAP EPS also included a roughly $0.07 per share impact from a tax expense in unrealized foreign exchange loss associated with prior periods to be discussed later in the call.

On our last call, we stated that we expected to achieve a 17% non-GAAP operating margin in the third quarter. We significantly surpassed that goal and delivered 19.7%. Further, we now expect to also exceed our target operating margin of 15% for the full year.

Now, let's move on to slide four, a high level update on the business strategy and outlook. As we approach the end of the fiscal year, we expect to report SMSC's fifth consecutive year of record semiconductor revenues even after pruning the approximately $30 million in low margin business mentioned previously.

At this point, we'd now expect full year sales to approach $380 million, the positive margin trend setting us up well in yield improvement next year. We are also reaffirming our expectation, an approximate 5 percentage point increase in gross margin of full FY '08 versus FY '07. Gross margin percentage increase for the first nine months of the year, is actually greater than 5% on a year-over-year basis.

As mentioned, we expect to exceed our previous non-GAAP operating margin target of 15% for the full fiscal year, and now believe fiscal 2008 non-GAAP EPS will be approximately $1.89 per share at the midpoint of our guidance.

Let's move on to Slide 5, take a look at our revenue distribution. You may recall in the second quarter, we had a seasonally high percentage of sales in Mobile & Desktop PC vertical.

Third quarter sales by vertical market have come back to a more consistent balance with the Consumer Electronics & Infotainment and Mobile & Desktop PC markets shaking out at about 41% of total sales each. This shift occurred because of strong CE sales, particularly in Ethernet and USB. I will also note that our automotive infotainment sales also hit a new high for SMSC in Q3.

And lastly, the industrial and other sales and revenues also remained steady. Overall, we think that the fourth quarter mix would look similar to the third quarter.

If you turn to slide 6 now, we'll walk through highlights in our target end markets. Sales into mobile and desktop PCs were generally flat on a sequential and year-over-year basis, with the current quarter being very slightly down from the previous quarter and very slightly up from last year's third quarter.

Keep in mind that both of the comparative quarters we would characterize as strong demand quarters. Hence, we feel that the underlying PC demand is still healthy. Our inventories are also less than normal and channel inventories appear fine.

Sales into notebook computers, which is the fastest growing segment of the PC industry, have now reached almost two-thirds of SMSC's PC sales. Our focus on this portion of the PC market would also command higher margins. This is based on supplying innovative microcontroller-based solutions and leading edge analog components.

Last quarter, we talked a bit about the launch of our latest family of thermal management products designed for 45 nanometer processor architectures. This award-winning analog product family is ahead of the competition in terms of availability and performance, and that's paying off.

True to history, we expect sales in the PC market to decline in the fourth quarter. As a reminder, SMSC's fourth fiscal quarter absorbs the impact of both Christmas and Chinese New Year, managing down of inventories by Asia customers and PC chipset transitions that often start to affect the demand profile during the quarter.

Let's move on to slide 7 and take a look at the Consumer Electronics market. Third quarter of fiscal 2008 was a record for SMSC's CE product sales with revenues surging 20% sequentially. We saw strength in Q3 for Ethernet and USB products, digital set-top boxes, LCD monitors and PC peripherals. Much of the strength came from Asia and Japan.

As with the PC market, the CE market is seasonal, and we expect to see our sales down in the next quarter, but we're generally speaking in-the-line markets for consumer electronics appear to be healthy at this time.

Let's advance to slide 8, an update on the automotive infotainment market. We recently announced a significant design win at Toyota, which launched MOST in its first model, the Mark X ZiO. This win represented our entrée into the Asia market.

As additional evidence of the MOST standard proliferating world wide, we're pleased to note that at the just completed MOST Cooperation Interconnectivity Conference held in Japan, it was announced that the Korean car makers, Hyundai and Kia, would officially be launching new car models based on MOST. These models are called the Genesis and the Mojave models respectively.

In addition, we also expect all three of the Asia-based car makers that are adopting MOST, Toyota, Hyundai and Kia to launch additional new models using MOST next year. Updating other geographies, Jaguar and Volvo also recently launched new vehicle models with MOST, Jaguar for the XF and Volvo for the V70 and C70 series.

Lastly, we're excited about the reception by the car makers to the new MOST 150 speed grade, which adds network capabilities, a high-definition video and audio and offers an Ethernet channel for effective transport of IP-based packet data. This makes it simpler for the car makers to deploy new consumer electronics and applications into the car. See our website for more details on this important development.

Now, I'd like to turn the call over to David who would walk you through the financial highlights and fourth quarter outlook. David?

David Smith

Thank you, Steve. For those that are following along, we are now on slide 9. Sales have increased from the second to the third quarter for several years. As one part of the strategy shift, we've pruned roughly 8% of sales when compared to our fiscal 2007 to the current fiscal 2008. So, the Q3 year-over-year increase of 6.7% actually understated the sales growth of the product that we were selling at this time last year.

Our progress on gross margin enhancement continues. We've shed the really low margin business. ASPs are holding up well as we continue to add value we can get paid for, and our operational and supply chain strategies are working relative to our expectations entering the quarter.

Also, relative to our expectations, entering the quarter, mix was favorable both with the end market verticals and the between market verticals, which accounted from most of the margin lift.

We are very pleased with the operating margin improvements at 19.7%. We cleanly exceeded the 17% goal. After several years of high sales growth, we had compound growth in excess of 20% per year for five years and commensurate growth in operating expenses, including R&D investments.

The business model shift to a more deliberate and measured the higher margin performance is required to shift in culture and intense focus, and this is ongoing. We expect to continue to invest prudently in our product programs and infrastructure development to continue improving margins over the longer term.

In the third quarter, we booked two items to correct prior periods that the company determined were not material in the current or prior period. One is the tax credit issue and the other is foreign exchange related and both will be explained in more detail on the 10-Q for the quarter that we hope to file by the end of the week.

The tax rate relates to a complex issue about how the tax credit or incentive stock options is booked under the new FAS 123R rules, and the correction impacted the quarter by $1.3 million on the tax line. We have been getting the cash, and cash flow and shareholders' equity are not affected.

The foreign exchange issue is non-cash and relates to the accounting for dollar assets on the books of our euro functional currency subsidiary and the correction impacted the quarter by $600,000 in other expense or about $400,000 after tax. Both items combined to reduce Q3 GAAP and non-GAAP EPS by about $0.07. But despite this, as we previously noted, EPS was up sharply from the prior year and at the high end of our guidance.

Let's move on to slide 10 and take a look at the capital structure. This is one of our key areas as we continue to refine our strategy, focusing on cash generation. And this is another quarter of proof that our focus is delivering results.

Last quarter, we said we might decide to accelerate investment in additional test equipment this year. And in this quarter, we did so. Our test capacity is a strategic cost advantage, and we save money both short and long term when we in-source because of our test efficiency relative to outsourcing.

Two quarters of strong demand and confidence in future demand growth made this investment a fairly easy financial decision. I do want to reemphasize, though, that this year's capital spend rate is significantly below the level of 2006 and 2007 and should remain so.

Cash and equivalents increased meaningfully by $9.3 million, despite investment in working capital and stock buybacks. We are comfortable that we have working capital under control.

I'll comment on inventories. In the second quarter, demand was significantly stronger than expected. And the third quarter was also been in excess of expectations as well, which reduced inventories. We expect inventory to grow modesty in the fourth quarter to more normal levels.

We indicated last quarter that we're very comfortable with our level of cash, and therefore, we were in a position to be able to mitigate the impact of share dilution from option exercises. We more than offset that this quarter with 17.9 million in repurchases and the share count actually declined for the first time in years. The Board of Directors has also increased the shares authorized for repurchase by another 1 million shares. We have completed the prior authorization.

In keeping with our disclosure policy on the cash impact of our equity compensation programs, cash paid to employees are exercised stock appreciation rights in the quarter was 4.7 million, roughly equivalent to the cash we collected on option exercise. All of this is detailed in our public filings in the supplemental disclosure on the website.

So, please move on to the last slide. Now, I'll discuss our fourth quarter outlook. Last quarter based on our detailed third quarter guidance and the indications we articulated for the full year, we implied fourth quarter sales of about $95 million and our fourth quarter guidance is inline with that, perhaps, slightly higher if you take the midpoint.

Our backlog supports this number and is based on the expectations that PC and consumer electronic sales will be down seasonally with modest sequential quarterly growth expected in the other markets. At the midpoint of our guidance year-over-year revenue growth per fiscal year '08 is expected to be about 2.5%, which is actually very close to the overall semiconductor industry growth projection of about 2.9% for partner's recent update for the calendar year.

As we keep repeating so that no one can misunderstand our quarterly sales profile through the year, the fourth quarter is usually weaker than the third. We expect normal seasonal trends in the business and our guidance assumes that. Gross margins are stabilizing and our expectation is that they will be approximately flat at the third quarter.

We do expect some moderate increase in operating expenses this quarter, but we have shown good operating expense control and predictability on several quarters now. All of this leads to non-GAAP EPS guidance in the $0.46 - $0.49 range, but the biggest variable being sales.

We should note again that our fourth quarter visibility is hindered by the fact that the impact of the Christmas holiday and Chinese New Year and yearend inventory management by many of our aging customers is just difficult to predict.

As we've explained, we feel our underlying business fundamentals remain very strong and we look forward to providing insight into the next fiscal year on our next call.

So with that, I'll open the call up now to questions and after that Steve will have a few closing remarks. Operator?

Question-and-Answer Session

Operator

(Operator Instructions)

We will take our first question from Vernon Essi with -- I apologize we’ll return to Vernon. We'll go next to Christian Schwab, Craig-Hallum Capital.

Christian Schwab - Craig-Hallum Capital

Great, nice quarter, guys. I know we just talked about Q4, but in Q1 of next year: we would expect typical seasonality there as well?

David Smith

We haven't given any guidance on Q1, but yes.

Christian Schwab - Craig-Hallum Capital

Perfect. And when we look at, after we have shed some revenue in particular, walked away from the low margin business in the PC space: would we expect a year-over-year growth in fiscal year '09 in the PC business?

Steve Bilodeau

PC business?

Christian Schwab - Craig-Hallum Capital

The PC I/O business?

David Smith

We haven't given any guidance for --.

Christian Schwab - Craig-Hallum Capital

I know you haven't. My question is: in 2009 would we expect that business to resume growth that would be logical, correct?

David Smith

Yes, that would be logical.

Christian Schwab - Craig-Hallum Capital

That would be logical?

Steve Bilodeau

Yes.

Christian Schwab - Craig-Hallum Capital

Perfect, and then as we look at gross margins from here, from the 52% range looking forward: how much more room do we have there for future increases?

Steve Bilodeau

Well, we have been on a steady increasing path for margins, and our margins are higher than what you are talking about there already and we are expecting to see and I think we guided, the guidance were giving for next quarter is flat in this quarter. We haven't given guidance for next year, but our goal is to continue to drive the margins higher, and we expect though some lift next year we’re just not stating what our objective is at this time.

David Smith

We do expect to be able drive margins higher we are just not ready to give specific guidance on the point yet.

Christian Schwab - Craig-Hallum Capital

Right. I guess I was looking at product gross margins, which is just my assumption minus the Intel payments on the 52% range. But: we would expect gross margins to modestly improve in 2009 on a year-over-year basis?

David Smith

Yes.

Christian Schwab - Craig-Hallum Capital

Okay, great. And then after the slight increase here in operating expenses: we would expect that to remain tightly controlled give or take throughout 2009? Is that fair?

David Smith

Yes, I mean, we will continue over time to grow operating expenses because the company continues to grow but I think we've demonstrated over the course in the last several quarters that we have control on our operating expenses and we expect to continue to maintain tight prudent control on operating expenses going forward.

Christian Schwab - Craig-Hallum Capital

Perfect. And then one last question. When we look at the consumer electronic and infotainment business: what should we be thinking about what bigger picture the next two to three years? How fast do we think that that business can grow given the new design wins in the infotainment and the continued success that you have in introducing in particular USB chips that ramp nicely to production? Can you just give us some color there?

David Smith

Again, we really don't want to get out in front of our headlight here and specify growth rate for next year, but I will note just in general terms, we take those two separately. Our automotive infotainment business as you are aware with the additional announcements today for the two Korean launches, I mean: we’ve just made, I think, just great progress developing to market to expand and help evangelize the spread MOST and its adoption. And we're very, very happy with the progress.

The only negative is that the revenue doesn't happen for a while though we've been talking about a lot of wins and a lot of progress in that area. But frankly, we don't really get to see the fruits of that until it's probably more like our FY'10 and FY'11. So that's just a timeframe. It's like five years to ramp kind of revenue, and we've been at this for three years driving this.

So, we've got good things coming on, on the automotive front. It just takes a little time to really get rolling at the levels we'd like to proceed.

In the consumer electronics, you're tying the markets a lot faster. That business has been by far our fastest growing business for years and years now, and we had a dynamite current quarter we just ended. But we can't really say and I am not willing to say right now growth rate long term will be flat.

Christian Schwab - Craig-Hallum Capital

Right. Thank you.

Operator

We will go next to Christopher Longiaru with Sidoti & Company.

Christopher Longiaru - Sidoti & Company

Hi, gentleman. How are you?

Steve Bilodeau

Hi, Chris.

Christopher Longiaru - Sidoti & Company

I guess my first question is now you just spoke about the design wins at Hyundai and Kia not contributing till 2010. That's not the same case for the design wins in with Volvo recently and Jaguar, because there is some more share market with MOST. Am I right in saying that?

Aaron Fisher

Well, let me say, as Steve described it a little bit more, with the Hyundai what's unique about, what's really important about the Hyundai and Kia and the Toyota wins was those are the first models adopted by that brand.

Christopher Longiaru - Sidoti & Company

Okay.

Aaron Fisher

And each of those brands have dozens and dozens of car models.

Christopher Longiaru - Sidoti & Company

Right.

Aaron Fisher

And Volvo has been rolling out most on their models for years and years now. So they are already a very high volume consumer, and these two models they are launching are actually pretty nice volumes vehicles.

So what happens is as a new brand adopts MOST, its adoption is like an S curve. Typically, our model, the way we think of the business is it takes maybe seven, eight years for the first model to propagate across the whole brands line of models. And the first two years are very slow, and then momentum picks up, and it's very steep in years three, four and five, and then it starts to asymptotically approach hopefully a high penetration number.

So, these ones we've just announced, even though they are launching, but they are down here on the bottom of the S curve. So, the volumes are not high. The first models typically are very high-end luxury vehicles where they adopt us and then they cascade down to the prior volume models.

So: yes, we have got those three designs wins we just talked about. It's revenue. It's not a lot of revenue. It doesn't move the needle a lot this year or next year, but then the years after that, it starts to kick in. You understand?

Christopher Longiaru - Sidoti & Company

Okay. Got it. That was very helpful. Thank you. The other thing was, with the tax rate, it just kind of jumped around a little bit: are you still just guiding around the 30% range going out to fiscal '09?

David Smith

The guidance for the fourth quarter is around about 31%.

Christopher Longiaru - Sidoti & Company

Okay. All right. Thank you, guys.

Operator

We will go next to Vernon Essi, Needham & Company.

Vernon Essi - Needham & Company

Thank you very much. Just wanted a point of clarification here on in your presentation where you've given the breakout on slide 5: is that a all-in revenue number or is that just product revenues?

Steve Bilodeau

This is all revenue.

Vernon Essi - Needham & Company

Okay, all revenue.

Steve Bilodeau

And the IP revenue is in the industrial and other.

Vernon Essi - Needham & Company

Okay. And then, you discussed on your guidance, I just want narrow in on, you had said that most of it or at least your backlogs supports the guidance that you are giving, at least behind the things you are thinking about with the consumer and especially with more or less the PC market. I mean: you had an unusually strong market. Can you discuss with us just your confidence levels? That things haven't melted upwards a little bit too aggressively in terms of fulfillment out there and, sort of: how you are going to handle that going into the first half of next year, calendar year that is?

Steve Bilodeau

Well, it's easier for us to comment on the more immediate next quarter. I'll just note a couple of data points. I mean: we had a positive book-to-bill in Q3, which is usually a negative book-to-bill for us, because that's when it's start to turn. And so that was kind of surprisingly good book-to-bill for that.

And our backlog is pretty to close to highest level. So I mean: we have about as good a confidence heading into this murkier period where we have all the holiday seasons and all this other stuff. So it is a difficult quarter for us to forecast, but we are doing about as well as we can going into it and hence the guidance we gave.

Our inventories are lower than normal. We were uncomfortable at the levels they are at. So, we don't have a lot of inventory here. We don't have a complicated channel between us and our customers. And we think the channel inventories are just fine. So, we don't see any big bubble out there going to affect us near term.

Our business is run as pretty diversified, our consumer electronics businesses. And we have thousand of customers where it isn't dominated by any one or two companies. I mean I don't think we have anybody that's a really big customer all buy themselves in consumer electronics.

Vernon Essi - Needham & Company

No. I appreciate it. You're certainly not the only company going through this sort of inventory trailing off and realizing this is more secure position somewhat going into this and also, just the robustness of the order rate through the end of the year is not a lot of you were experiencing it, and of course, may not have great answers either.

I mean: where is this demand specifically coming from? And I am just curious to get any additional color just to put it into the mosaic; that was all. So: it's hard to tell, I suppose?

Steven Bilodeau

Yes, I think we noted a few areas like in the TVs and monitors and we are selling into mobile phones now, and we're seeing some business there. So it's a pretty broad range of applications.

Vernon Essi - Needham & Company

And on that mobile phones side of (inaudible): do you have any idea of sort of the penetration rate of handsets for your specific connectivity? I mean: what percentage penetration do you think you have right now or do you see that market evolving towards --?

Steven Bilodeau

I think our penetration right now is infinitesimal, and the market adoption is just starting to occur, and it's being adopted at the very high-end phones. And it's a newer market for us, but we're pretty focused on it. And we think we have some good opportunities for us, and we expect this to grow a lot over the next couple of years.

Vernon Essi - Needham & Company

Okay. All right. Thank you very much. Good quarter.

Steven Bilodeau

Thank you.

Operator

We will go next to Jed Dorsheimer with Canaccord Adams.

Josh Baribeau - Canaccord Adams

This is actually Josh Baribeau for Jed. He is apparently in and out of cell phone coverage right now. A couple of questions for you on the MOST business: how was your progress in other non-automotive applications?

Steven Bilodeau

Well, again, we've got our tiger by the tail, trying to grow our automotive business three different ways, both by increasing the numbers of nodes to additional applications, increasing the number of car miles and penetrating more brands. So, we've got significant initiatives in all three areas.

Although, some of the technology we're developing, for example, this MOST150 had some potential nice applications in non-automotive areas that I think we are just not in a position to talk publicly about what we are doing in that area. But, I think we have benched it just about at that level but – and so we think the technology is useful in several niche areas in the consumer space we are just not ready to talk about it.

Josh Baribeau - Canaccord Adams

Okay, again on the MOST. The Q4 is typically still a little bit slower we've noticed seasonality here. It is the ramp in Asia at least somewhat offsetting this? Or: is it still to soon to see that effect?

Steve Bilodeau

But, as I was explaining, I think it was Chris, we were talking about: how does the revenues ramp for automotive? And, when we pick up the first model, our first brand, I mean, its very small revenue for a while it's so like a classic S curve. So, you know, Toyota is shipping and these two Korean brands are about to ship or shipping I don't know the exact status.

They’re just not contributing anything that catches my attention when I look at the numbers at this quarter and that I do feel they might be -- maybe we can notice from next year and then they start kicking in the bigger numbers in 10 and 11, I mean, it is just that just the way the model works, again the product.

Josh Baribeau - Canaccord Adams

And finally, that the foreign exchange loss: if I heard that correctly that was non-cash?

Steve Bilodeau

Correct.

Josh Baribeau - Canaccord Adams

And so: should we not expect anything like that going forward? Or: is that sort of a run rate we should expect?

Steve Bilodeau

No, I don't expect that level going forward.

Josh Baribeau - Canaccord Adams

Okay, great, that's it for me. Thanks.

Operator

And there are appear to be no further questions at this time, I would like to turn things back to Mr. Bilodeau for any additional or closing comments.

Steve Bilodeau

Thank you operator, one year ago, we announced our new margin expansion initiatives and laid our plans to significantly enhance the profitability and margin profile of SMSC. This initiative has been a great success and we are pleased to have achieved and surpassed our Q3 operating margin target. Prospects for continued improvement look bright and we look forward to discussing full year results and our outlook into the next fiscal year with you on our next call. Thanks everyone.

Operator

Thank you. And that does conclude today's conference call. Thank you for your participation. You may disconnect at this time.

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