Altera Q4 2005 Earnings Conference Call Transcript (ALTR)

Altera Corporation (ALTR)
Q4 2005 Earnings Conference Call
January 25th 2006, 4:45 PM.

Executives:

Scott Wylie, Vice President of Investor Relations
John P. Daane, President, Chief Executive Officer, and Chairman of the Board
Nathan M. Sarkisian, Senior Vice President and Chief Financial Officer

Analysts:

Christopher Danely, JP Morgan
Timothy Luke, Lehman Brothers
Michael Masdea, Credit Suisse
Mark Edelstone, Morgan Stanley
Glen Yeung of Citigroup
Sumit Dhanda, Banc of America Securities
Hun Lee, Global Crown Capital
Bob Fujivardi, Deutsche Bank
Jeffrey Palmer, Friedman Billings Ramsey
Tristan Gerra, Baird Financial
David Wong, AG Edwards

Presentation

Operator

Thank you for standing by, good day everyone and welcome to today’s Altera Corporation’s Conference Call. Today’s call is being recorded. At this time I would like to turn the call over to Mr. Scott Wylie, Vice President of Investor Relations for Altera Corporation. Mr. Wylie, please go ahead sir.

Scott Wylie, Vice President of Investor Relations

Good afternoon. Thank you for joining us conference call which will be available for replay telephonically and on Alters’s website shortly after we conclude this afternoon. So listen to the webcast replay, please visit Altera’s Investor Relations web page where you will find complete instructions. The telephone replay will be available on 719-057-0820, US code 258-712. Before we begin this afternoon’s call, I want to remind you that as we indicated in our earnings release we will offer our first quarter update on March 6 after the market closes. This update will be, it should be a press release, it will be available shortly after the market closes.

During today’s call we will be making some forward looking statements and in light of the Private Securities Litigation Reform Act. I would like to remind you that these statements must be considered in conjunction with the cautionary warnings which appear in our SEC filings. Investors or cautions of all forward-looking statements in this call evolve risks and uncertainty and the future events may differ from the statement made. For additional information please refer to the company Securities and Exchange Commission Filings which are posted on our website or available from the company without charge. Nathan Sarkisian Senior Vice President, CFO will begin today’s call and John Daane, Altera’s CEO will then offer some brief remarks before we open up the call to your questions. Prior to the Q&A session the operator will be giving instructions on how you can access the conference call with your questions. I would now like to turn the call over to Mr. Sarkisian.

Nathan M. Sarkisian, Senior Vice President and Chief Financial Officer

Thank you, Scott. Fourth quarter revenues of $281.9 million decreased 3% sequentially, slightly below the lower end of our guidance. New products decreased 5% sequentially with transitions in major programs offsetting the strong 43% new product growth we experienced last quarter. The Mainstream and Mature product categories also declined, both were down a little bit more than 1% sequentially. CPLDs increased 4%, FPGAs declined 3%, and other was down 16%. We indicated in our original guidance that due to several programs transitioning and some taking a pause after an initial ramp, that this would be a challenging quarter at the top line. We came in slightly under the lower end of our guidance mostly due to the magnitude of the anticipated shift. Communication was relatively strong, growing 4% sequentially. Wireline was flat and wireless was up. As anticipated, computer and storage was down sharply, 20%. Consumer fell 11% sequentially, more than we had anticipated. The real swing for us relative to our guidance was industrial where we had anticipated growth, but instead it declined 3%.

Five of our top ten accounts grew in the quarter and they grew in aggregate, with the growth coming from communications accounts, as you might expect given the results of the quarter and the comm-centric nature of our top accounts. However, not all comm accounts in our top ten increased. Going forward, we will give top customer statistics for our top 18 accounts because we think this will give you a more accurate overall picture and a broader sampling. On this basis, the majority of accounts declined, and they declined overall.

Now for some specifics on our operating results. Gross margins were strong at 66.7% and slightly ahead of our mid-quarter guidance. Included in this result is $1.5 million of benefit relating to the sale of inventory written off in 2001, which was down from our original guidance of $2.5 million of benefit. As predicted, some of the high margin programs that were soft in Q3 came back in Q4. Also, product cost reductions and softness in some high volume programs at aggressive pricing contributed to improvement in our gross margins. These factors more than offset higher than normal provisioning for excess inventory. Our non-qualified deferred compensation plan experienced a net investment gain, unfavorably impacting R&D by $400,000 and SG&A by $500,000 and benefiting other income by $900,000.

Operating expenses came in at $112 million, including the $900,000 relating to the deferred compensation plan. Research and development spending was $53.6 million, taking a large jump from Q3 as we continued development on the Stratix II GX and HardCopy II families. SG&A was $58.3 million. Other income was $11 million, better than guidance due to the deferred compensation plan and also the favorable rate environment.

Tax rate was on guidance at 20%. Net income for Q4 was $69.7 million or $0.19 per diluted share. Cash and investments held steady at $1.3 billion, even after share repurchases of $195 million for 11 million shares, testaments to outstanding cash generation in the quarter. Total share repurchases for the year were 20 million shares at a cost of $370 million. Total pipeline inventories increased by 3/10ths to 3.7 months overall within our targeted range of three to four months. Distribution inventories accounted for the majority of the increase

Now, turning to guidance. John will highlight in further detail some of the program pauses and transitions that unfavorably impacted Q4 revenues. Most of these programs will resume growth and this puts us in much better shape as we enter first quarter. Our guidance is for a 4% to 7% sequential increase in sales. We will see continued strength in communications, particularly wireless. Computer and storage will grow, industrial will be about flat, and consumer will be seasonally soft.

Orders to re-sales were below parity in Q4, turns required to achieve our Q1 guidance as of the beginning of the quarter is in the low-70s. Gross margins will be in the range of 65.5% to 67.5%. Guidance on spending is given assuming that the non-qualified deferred compensation plan will have neither a gain nor loss; that is, no impact. I’m going to give spending guidance including the impact of equity compensation or share-based payments, but I will also note the estimated equity compensation expense

Before I jump into the specific numbers, I’m going to note a few items relative to our equity compensation plans for 2006. We grant equity to existing employees either in February or August depending on the organization and classification of the employees. Most officer grants are made in February. Grants to new employees are awarded shortly after they begin employment. In 2006, nearly all grants to continuing employees will be in the form of restricted stock units or RSUs. The notable exceptions to this will be John, who will receive only options, and myself, and I will receive a mix of options and RSUs. We believe that the shift to RSUs strikes a better balance between shareholder dilution and employee motivation and retention, at least in the present environment. Note that since we still have RSUs to grant in the quarter, that the estimate for impact to Q1 operating expense is subject to particular volatility.

I also want to alert you to a major program that will also impact spending, particularly SG&A in 2006. We have just launched a program to replace our ERP system in first half of 2007. In the early phases of this program, lasting into second quarter, we will be engaging consultants to help us do some process reengineering and design the implementation. These costs will be expensed. In the back half of the year as we move into the actual coding and development phases, the external consulting cost as well as some of our own internal labor spending will be capitalized as part of the cost of the new system. These capitalized costs will then be depreciated as the system is placed into service in 2007. Our estimated cost for the program is approximately $5 million in expense and $20 million in capital.

Given those assumptions, R&D will be approximately $62 million, including $8 million of equity compensation. SG&A will be approximately $76 million, including $12 million of equity compensation. We are guiding to $10 million of interest income and a diluted share count of 364 million shares. Total months of the inventory, including both distribution and Altera are expected to be in the range of 3.5 months to 3.8 months. For 2006, we are reiterating our prior gross margin guidance of 64% to 66%, and for our full-year operating expenses to be in the range of $545 million, including about $80 million of equity compensation. You will note that these full-year figures are very close to first quarter spending annualized. Let me explain.
First our payroll taxes and certain employee benefits, such as 401(k) matching, take a large jump of approximately $5 million in the first quarter as the year starts anew and all the employees earnings are below the maximum withholding amount. Then these cost diminish through the year as employees hit the various ceilings. You have the same effect for the expenses associated with our ERP replacement project. High spending in the first and second quarter, and then that spending is capitalized in the back half. Finally, with the roll outs of Stratix II GX and the HardCopy II completing in the first half, our mask and prototype wafer expenditures are going to be front-end loaded. Offsetting these front loaded expenses is a hiring ramp in R&D as we add staff to support the development and roll out of 65 nanometer and other future products.

Our core tax rate is estimated to be 14% to 16% for the year. The reduction from 2005 is primarily the result of two factors, first, we are earning a higher percentage of our income in lower tax jurisdictions, and secondly, the impact of expensing equity grants to employees on our statement of income has a favorable tax rate impact of 200 basis points to 300 basis points. Under the old accounting for equity compensation, APB 25, the corporation’s tax benefit of equity compensation expense was booked straight to shareholder’s equity. In the new regime, that tax deduction, essentially equal to the employees gain, is included in the effective tax rate.

One last note before I turn the call over to John. Effective in first quarter, we will be recomposing our product categories. New products will consist of Stratix II, Stratix II GX, Cyclone II, MAX II, and HardCopy. The Mainstream products will consist of Stratix, Stratix GX, Cyclone, and MAX 3000A. All products previously included in Mainstream will be added to Mature. With our Q1 call, we will present four quarters of data on this basis to enable you to do apples-to-apples comparisons through time. John.

John P. Daane, President, Chief Executive Officer, and Chairman of the Board

Thank you, Wylie. As predicted in third quarter conference call, the fourth quarter was a temporary pause in our growth, driven by several customer program transitions. The Mainstream and Mature product categories each declined just over 1% sequentially, which is about what we would expect based on the product classification. Our new products declined 5%, or about $7.5 million. Nine customers declined in total over $17 million sequentially in new product purchases. Two of these customers drove most of the reduction in the computer and storage sector, one due to a production ramp pause, and the other due to inventory. Three of the customers were in communications, one had inventory and the other two paused because of the delay in purchases by an operator. The consumer segment declined due to cyclicality, but two specific customers drove a large majority, one due to inventory, the second due to a program end and note that we do have the chip in the new system which ramps this quarter. The final two of the nine customers were in industrial, one in military due to buying patterns and one in industrial due to inventory. By end market, the growth in communications and a decline in consumer and in computer and storage were forecasted; however, the decline in industrial was not and accounted for the miss-to-mid point of our guidance.

The revenue decline from these nine accounts primarily impacted the Stratix and HardCopy product families, and secondarily Cyclone. Stratix and Stratix GX declined 11%, Cyclone 4% and HardCopy 42%. Removing these nine accounts from our 130 nanometer, removing these nine accounts, our 130-nanometer products grew sequentially and we believe that peak for this node is still well into the future.

In Q4, our newest products grew sequentially with Stratix II up 30%, Cyclone II 69%, and MAX II 15% as we continued to add new prototyping customers and transition some to production. Of the nine accounts mentioned, we expect six of them to grow sequentially in Q1. Combined with the growth amongst our broad customer base in 130 nanometer products, and the continued strong ramp of our 90-nanometer products, we expect our new product category, as well as the company to resume growth in Q1. More on Q1 forecast in just a moment.

Our success in 130 nanometer and 90 nanometer products is the result of our change in strategy five years ago. The decline in the communications industry in 2001 reduced the number of start-ups, which in turn eliminated a portion of the PLD prototyping market. Additionally, the shift in focus from time-to-market to that of cost reduction in the general electronics industry eliminated much of the production business for programmable as our chips were costly. PLDs correspondingly under performed the semiconductor industry in 2001 and 2002. Compounding this, Altera had mis-executed in the mid-to-late 1990s and was losing market share in FPGAs and CPLDs. To renew Altera and to achieve sustained long-term PLD growth, we had to regain competitiveness in the FPGA prototyping market and offer cost effective volume products to match our customer’s requirements. Starting in 2002, we introduced a revamped product line with Stratix for prototyping and low-volume production, plus Cyclone and a redesigned HardCopy for volume production

Strategy wasn’t the only change. We needed to focus, execute and involve the customer. Engineering and manufacturing execution has been stellar. We’ve focused our R&D return on investment over the last five years has been the highest in the programmable industry. Issued US patents, a measure of innovation, were 172 in 2005, bringing our total to over 1,100 patents. We have three times the number of total patents we had in the year 2000 and we expect our patent issue rates to continue to climb.

The strategy change is paying dividends. For the third straight year, Altera was the fastest growing PLD company and by a wide margin in 2005. We added 2% PLD market share driven by FPGAs, which grew 13% year-over-year. Our new product category increased 73%, driving all of our growth in the year as Mainstream and Mature product categories declined 12% and 14% respectively. Year-over-year, Stratix and Stratix GX combined grew 40%, Cyclone 77%, HardCopy 167%, and we ramped Stratix II, Cyclone II, and MAX II. Products introduced since the year 2002 accounted for over 37% of revenues in 2005 and over 41% of revenues exiting the year.

Moving forward, we have growth opportunities in each vertical market that we estimate from 2006 through 2010 total 17% compound annual growth rate for programmables, 18% with the addition of HardCopy, and 20% with market share gains. As our market share in the 130 nanometer and 90-nanometer nodes, the current growth engine of PLDs is significantly higher than our overall market share. I expected for the year 2006 and onwards Altera will continue to gain market share.

For Q1, we are forecasting a 4% to 7% sequential increase in revenues with resumed new product category growth. We expect communications across wireless, telecom and enterprise and computer and storage to increase in the quarter. Industrial should be flat to slightly up, and consumer should decline due to cyclicality. Scott.

Scott Wylie, Vice President of Investor Relations

We would now like to take questions. Please limit your questions to one at the time so that we give as many callers as possible the opportunity to ask questions during the call. Operator would you please provide instructions required for questions.

Questions & Answers

Operator

Thank you. The question and answer session will be conducted electronically. If you would like to ask a question please do so by pressing the “*