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National Semiconductor Corporation (NSM)

Q3 2006 Earnings Conference Call

March 9, 2006, 10:00 AM PST-1:00 PM EST

Executives

Long Ly, Investor Relations Manager

Brian Halla, Chairman and Chief Executive Officer

Lewis Chew, Chief Financial Officer

Don Macleod, President and Chief Operating Officer

Analysts

Chris Casso, Friedman Billings Ramsey

Adam Parker, Sanford Bernstein

Michael Masdeay, Credit Suisse

Simona Genkowsky, Goldman Sachs

Mark Edlesfiln, Morgan Stanley

Tom Thornhill, UBS

Ross Seymour, Deutsche Bank

Torres Vanburg, Piper Jaffray

Presentation:

Long Ly, Investor Relations Manager

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, Don Macleod, President and Chief Operating Officer.

The purpose of today’s call is to discuss National Semiconductor’s 3rd Quarter Fiscal 2006 results which ended on February 26, 2006. 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 filing for a complete description of those risks and uncertainties. Also in compliance with SEC regulation FD, this call is open to all and is broadcast live over our investor relations website. For those of you who may have missed the press release or would like a replay of the call, you find it on our website at www.national.com.

In today’s call, I will provide a recap of the 3rd Quarter financial results, Brian Halla will provide an update of the company’s business model, Lewis Chew will expand on the 3rd Quarter results and provide an outlook for the 4th Quarter, and Don Macleod will discuss end market trends and our analog standard linear product progress. We will then take questions until 11 AM pacific time.

The 3rd Quarter results were as follows, sales were $547.7 million dollars, a slight increase from Q2 fiscal year 2006 and up 22% from last year’s 3rd Quarter. Gross margins were 60.7% up from 57.2% in the prior Quarter and up from 52.7% in last year’s 3rd Quarter. Operating expenses were $149.1 million dollars, down slightly from last Quarter. Interest income was $8.5 million dollars and the effective tax rate for the Quarter was 31.7%. As a result, National posted net earnings of $130.1 million dollars or $0.37¢ per fully diluted share. The fully diluted share count for the Quarter was 354.6 million shares. I would like to now turn it over to Brian Halla for an update of the company’s business model.

Brian L. Halla, Chairman and Chief Executive Officer

Thank you, Long. For the quarter just completed business conditions for us turned out better than expected. These conditions, combined with solid execution from the organization, gave us the feeling that we were hitting on all cylinders. It was also a quarter where we continued to gain market share and as you can see from our announcement this morning, our near term business model turned out to be nearer than we thought. In the next couple of minutes, I’ll review the model and our progress there. I’ll spend a little time talking about the market conditions as viewed from our perspective and I’ll finish up with an outlook and review of our shareholder value programs.

A couple of years ago in order to give clear and unambiguous direction to the organization, we challenged ourselves to hit a near term business model of 60/30/30 or 60% gross margin along with spending controlled the 30% for the combined SG&A and R&B to yield operating margin of 30%. I must say the troops rose to the occasion for 60.7 gross margin just achieved is a full 3 ½ point improvement over the prior Quarter. A good portion of the improvement came from a richer mix of analog products and revenues contributed from some of the newer analog products recently launched. These products continue to give us upward movement on our ASP’s. In addition, we continue to drive for and realize continuous improvement in our manufacturing cost efficiencies. For our customers who now occasionally tend to tune in to this call, we would like to thank you for your business and give you our commitment to continue to work hard and meet your needs and justify the position of one of your most important suppliers as many of you have indicated we have become. To our employees, many of whom listen to this call, we would like to sincerely thank you for your hard work and dedication in the achievement of this near term business goal.

Going forward we believe that our analog product portfolio and strategies are fully capable of getting our gross margin higher, along with our increasing emphasis on top line growth. Having said this though, it’s hard to coin a business model that rolls off the tongue like our last one. I promise to give you the new goal at the end of this Quarter. Meanwhile, the results just turned in demonstrate that our employees have not only embraced the direction set in that business model, but that they got us there faster than we expected.

As we move forward in the calendar year 2006, we feel the conditions are good in the analog sector and based on our continuous market share gains, particularly good for us. From our perspective, it also gives further testimony that Intel is not the spokesman for our part of the industry as we continue to see increasing strength in the demand for our products. Bookings were up in the Quarter and we put in place additional steps to rigorously validate that the bookings that we did accept for accurately reflected true end demand, those coming from our distribution channel. Our discipline in this respect is kept the inventories in the channel under control and still relatively low despite strong re-sales in the channel. Turns were strong in the Quarter and our book to bill was greater than 1. Standard linear portion of our bookings were up 8% with such superstars as amplifiers gaining 16% and interface coming in at 7%. New orders in the cell phone market for us were up in the Quarter. Distribution bookings which largely go to service the broad market were up 7% Quarter-on-Quarter. Sales of $547.7 million were 22% higher than in the same Quarter last year and up slightly over the prior Quarter despite the ongoing decline of foundry revenues associated with businesses previously sold on. Operating margins improved in the Quarter and came in at over 33%. As a final note, I am happy to point out that the results achieved in the Quarter give us an ROIC or return on invested capital of nearly 28% for the Quarter.

So as for the outlook, what do we see in front of us, given a higher backlog coming into this Quarter and expectations for normal terms, we are projecting revenue growth in the Quarter in the range of 2-4% which includes the expected continuing decline in foundry business. As to shareholder activity, during the Quarter we bought back another $200 million of our stock to bring the total for repurchases to $1.65 billion in the last couple of years. And we still have $350 million remaining in the board approved buyback program. We also declared a $0.03¢ dividend for the quarter.

So all-in-all, it was a good quarter and further confirmation that we are on track. The system products that drive semiconductor demand extend well beyond the traditional PC. Whether handsets, IPods, or blackberry’s, these products more and more communicate over networks, whether wired or wireless at higher and higher speeds with a job of cleaning, amplifying, and converting signals becomes more and more difficult; these signals want to be conditioned using the least possible amount of energy, whether that energy comes from a battery or a wall socket. The differentiating features of these system products include such things as brighter and higher resolution displays, awesome sound system, and the longest possible battery life. Our analog circuits enable this kind of differentiation and continue to allow us to gain share in these important markets. In addition, these circuits which provide the speed, precision, and low power now more and more open up additional broader market applications for us. Applications like instrumentation, power over Ethernet, medical diagnostic systems, digital copiers, test and measurement devices, and whole host of other broad market applications that depend on our analog circuits to create their respective WOW factors.

It’s a rewarding business, but increasingly technically demanding and just a few of us know how to do it. Even fewer can do it well. We think the results turned in to date, demonstrate our ability to add value to our customers’ system products. We are proud of this effort, but we think we can do more. Again, I would thank our employees for their execution during the most recent quarter and I would invite all of you to check back at the end of this quarter to find out where we think we can go from here. Over to you Lewis.

Lewis Chew, Chief Financial Officer

Thanks, Brian. Well my section of the call today, I’ll start off with some comments on the revenue we achieved in Q3 and the business patterns that we saw during the quarter. In particular, I’ll go over the distribution channel, which tends to be an area that people are interested in hearing about. Then I’ll go over our Q3 gross margin and give some color on what drove such a significant improvement during the quarter, and then I’ll provide some details on the outlook we have for Q4 including how that outlook relates to the trends that we saw in Q3. Since our Q3 included the December holidays and also Lunar New Year, I will make some comments on what activity we saw in February once those holidays were over.

So as you know by now, our revenue in Q3 was 22% higher than last years Q3 and $3.7 million dollars above the revenues we recorded in Q2. If I break down that sequential increase between foundry revenue from the Super I/O and cordless businesses which we sold a couple of Quarters ago, and the rest of the company which I’ll refer to here as the ongoing business. Super I/O and cordless foundry revenues were down about $10 million dollars from Q2-Q3 ending up at around the mid $30 million dollar level, 4th Quarter. And that foundry revenue prompts Super I/O and cordless was actually down a little more than what we expected at the beginning of the Quarter. On the other hand, the ongoing business was up by about $13 million for the Quarter which is up a little more than we expected, and by-the-way this also helps our gross margin percentage but I’ll cover that later. The upside in Q3 revenue was driven mainly by higher than expected terms orders from distributors, in general our distributors’ experienced good re-sale rates during the Quarter. And if I normalize out the holidays that were in Q3 verses Q2, distributor re-sale rates were higher on a per day basis than they were in Q2. And given the fact that distributor inventories were relatively low at the beginning of the Quarter, these re-sales trends translated into terms being higher than we expected. By-the-way, we also noted that distributor re-sale rates picked up in the latter part of the quarter and I’ll comment more on that when I go over the Q4 outlook.

Distributor inventory weeks at the end of Q3 for us, were a little over 10-weeks, which is still at the lower end of their typical operating range. In comparison, at the end of Q2, distributor inventory week in total were a little under 10-weeks. Total company bookings were up about 2% sequentially in Q3 and within that, I think it’s worth noting that bookings from the foundry business for Super I/O and cordless were actually down in the Quarter.

So before I get into the revenue outlook, I’d like to make a few comments on the gross margin in Q3, which improved by 3 ½ percentage points in Q3 and ended up with 60.7% for the quarter. Of the total margin increase, more than half of that was driven by the analog portfolio through better mix in pricing. The rest of the improvement was driven by strong manufacturing performance through volume and cost efficiency. Our (inaudible) during Q3 was in the 80% range based on wafer start. You may recall that at the beginning of Q3, our days of on-hand inventory were 63 days which was actually at the very low end of our normal operating range. During Q3, we increased inventories by around $19 million dollars and ended the Quarter with about 76 days on-hand. And there are some very specific elements of that inventory growth that I want to highlight as follows: Of the $19 million dollar increase in inventory about $6 million dollars represents bridge bills that we did as part of our shut down plan for the Singapore plant which is in the final stages of transferring its equipment and volume to our other two assembly plants. Another $4 million dollars was for raw materials in the form of silicon and another $3 million dollars was for the cordless business as pipeline builds for the new owner who is in the process of transferring volume to other manufacture sources.

I mentioned earlier that on the product portfolio we continue to improve our mix and our pricing remains firm, and Don Macleod will provide more details on the analog portfolio later on in his commentary. So for now, I’d like to move on to the outlook for Q4. We are currently expecting Q4 revenue to be up 2-4% sequentially over Q3. Our opening 13-week backlog, as Brian mentioned, is higher compared to what it was at the beginning of Q3. Following up on a comment I made earlier about distributor patterns during the quarter, in other words, Q3, in Europe and North America we saw strong distributor re-sale rates in January and February after December holidays were over. And in Asia after a holiday dip in re-sales in the middle of the quarter, we saw strong re-sale rates in the month of February. So in Q4, we are expecting that distributor re-sales will continue at the healthy rate we saw in February, especially in Asia which is our largest geographical region for sales.

Within the overall revenue forecast, the foundry revenue for Super I/O and cordless is expected to drop a little in which case the ongoing business will grow a little more than the total company average. And now I’d like to talk about the gross margin outlook in relation to the revenue range that we are guiding to you. Our gross margin percentage in Q4 is expected to increase slightly and follow a more normal follow through pattern. Historically, we talked about incremental margins being in the 70% range. Now obviously the huge margin improvement in Q3 was driven by a combination of several positive factors that we wouldn’t expect to repeat every quarter or in the same scale. We will likely see continuing margin improvements when the analog product portfolio with less velocity of improvements from manufacturing efficiency. Regarding inventory plans for Q4, we will focus more on strategic build than (inaudible) to will give us flexibility in servicing customers, but we are not planning the increase finished goods. And also, as part of our project to convert certain capacity in Texas with the 8-inch wafers, we will be incurring some discreet costs and also building some buffer stock both associated with the transfer of a few manufacturing processes from Texas to Scotland to free up space in Texas.

I mentioned earlier that FAB utilization for Q3 as a whole was in the high 80% range and the Q4 utilization rate should be roughly in the same range. Our capital expenditures were about $52 million dollars in Q3 included in this were expenditures for new analog capabilities in Maine and Texas and also some additional assembly and test equipment in Malacca for high running products and all sorts of some capacity bottleneck that we have there. In Q4 our capital expenditures are expected to range from $60-70 million dollars which would put our annual Cap X for Fiscal 2006 at somewhere around $160 million to $170 million dollars. This roughly equates to somewhere between 7-8% of annual revenues which fits nicely within our target operating model.

So with respect to the Singapore plant consolidation, we continue to make progress on this action during Q3. We are targeting all of the equipment transfer activities to Malacca and China by the end of our Q1 and Fiscal 2007 which ends in August, 2006. Our total quarterly savings from this action is targeted to be $4-6 million dollars per Quarter. Some of this has been realized and we anticipate full savings upon completion of the project. In Q4, R&D expense is expected to range from $82-84 million dollars as we continue to focus our development on analog standard linear growth opportunities. At the revenue range that we are projecting, that would put R&D expense at around 15% of sales, which well in line with our target ratio. SG&A expenses projected to be $71-73 million dollars in the 4th Quarter and as a percentage of sales the SG&A expense would be around 13% or so which is also in line with target ratio.

Other income expense should be relatively minor around $1 million dollars of expense and interest income is projected to be similar to the $8.5 million dollars that we had in Q3. The effective income tax rate for Q4 should be about the same as Q3 or approximately 31 ½ %, so let me wrap up with a couple of comments on the balance sheet and return on capital. During the 2nd Quarter we bought back another $200 million of our stock which is a little over 7 million shares and ended the Quarter with around $1 billion dollars cash reserve. Heading into Q4, we have about $350 million dollars remaining of approved buyback and receivables in Q3 went up but our days of receivables were still very good to 31 days. And also, I want to make a note that during Q4 we do plan to (inaudible) cash from foreign locations under the current guidelines. Our operating margin in Q3 went above 33% and for the Quarter a return on invested capital was nearly 28%. And this performance is clearly being driven by growth and leverage on our analog portfolio so to talk about that, let me turn it over now to Don Macleod.

Don Macleod, President and Chief Operating Officer

Thank you Lewis, I’d like to cover three topics. One is to expand on trends that we saw in the Quarter for the major end markets that we participated in and also internally the trends we saw in our analog product area. Two, to talk about our progress on market share in analog standard veneer, and third, now that we have achieved our 60% gross margin target, what do we see as the ASP product portfolio and cost drivers that will enable us to continue to drive our gross margin upward.

First, what do we see in the end markets and channels in the Quarter. As we expected shipments into the mobile phone market declined sequentially and went up slightly more than the level we saw in our Fiscal Q1, that is our August ending Quarter. Orders on us from the mobile phone customer based on the other hand grew Q3 over Q2 and our opening backlog of orders for this market segment going into the 4th Quarter is up over the previous quarter. This segment represented approximately 30% of our sales in the quarter. The overall display market which represents just under 10% of our sales with about flat shipments Q3 over Q2. At the end of life last time buys for some CRT pre amplifiers, offset a seasonal decline in FPD product. However, bookings for FPD products grew over Q2 as we ramp up shipment Taiwanese LCD TV flat panel customers.

In the communications infrastructure market, we increased bookings and shipments in the quarter over Q2. We started new strength in the wireless base station market. Here we provide data conversion and interface products into both 2 ½ and 3D base stations. In the quarter, we saw strong order activity from European market leaders, Japanese manufacturers for the local market, and new Chinese suppliers. The communications infrastructure market is also just less than 10% of our total sales. If you add up all of that, these three markets represented about 45% of our sales in the Quarter. In addition, we also shipped to broader markets through the distribution channel which accounted for just slightly over ½ of our sales in the Quarter. As Lewis already commented, our distributors enjoy the better than typical seasonal concession for the sales of our products into the 1st calendar Quarter of 2006.

We’ve been meaning to change what we saw in the quarter from the perspective of our analog product area. First, Power Management which represented 40% of our sales in the Quarter; new sales were down 2% sequentially but up 30% over last years Q3. Sequential sales were down due to seasonal patterns in the mobile phone market; on-the-other-hand, broader market, Power Management, products grew revenue sequentially. Bookings for the overall Power Management theory went up about 6% sequentially and nearly 60% over last years Q3. A broader market, new product momentum continues in Power Management. We continue to see design (inaudible) family of higher voltage products; in automotive applications, the override P phones, security cameras, power supply bricks, electric motor drivers, etc. With our broad portfolio, we see the sign winds and laser printers, hard disk drive, FPGA power supply, and other industrial applications. In our Power Management products for portable applications, we continue to build on our low drop out and high efficiency switching business. In the mobile phone space, with new applications we provide power to small farm factory displays, which is LCDs, LEDs, and OLED. Also, powering applications, processors, handsets, and other hand held devices and managing power to our RF power amplifiers and camera modules. We also have Power Management products on wireless handset reference designs from both a European and a US based trip set reference design supplier.

In the Quarter, we also announce the second generation PowerWise interface specification; PWI 2.0, along with Arm, Samsung, (inaudible), Phillips, and ST Microelectronics. This PWI 2.0 standard enables simple two wire implementation of advanced Power Management technologies such as adaptive voltage scaling to improve factory life. National plans to launch PWI 2.0 compliant to Power Management (inaudible) in the second half of calendar year, 2006.

Moving now to our signal pack product area, that is amplifiers, interface, and data converters. It made up in total 34% of our sales in the Quarter slightly up from 33% in the preceding 2nd Quarter. Looking at the individual product area verses amplifiers which accounted for 21% of our sales; new revenues grew sequentially about 5% and about 25% over last years Q3. Sequentially revenue growth and operational amplifiers more than offset a seasonal decline in audio amplifiers which was driven by the mobile phone market.

Overall, amplifier bookings grew about 16% sequentially in the Quarter and about 50% year-over-year. In the Quarter, we introduced another 15 new amplifier products including three based on our new silicon-on-insulator (inaudible). The define team for this process is by-the-way being nominated for EDNs Innovator of the Year Award, as you know EDN is a widely read electronics trade biweekly magazine. Now to our interface product line, which was 8% of our sales in the Quarter. New sales were down 6% sequentially but up 24% over last years Q3. Interface bookings were up about 7% sequentially and up 60% over last years Q3. New business across the broad range of applications with new products for wireless base stations, plasma and LDC TVs, broadcast studio equipment, routers, industrial motor modules, and servers all contributed to this bookings growth.

And now the final segment of our signal path area, data converters; accounted for 5% of our sales in the Quarter. New revenues were about flat sequentially and up 30% on last years 3rd Quarter. Our expanding data converter product portfolio addresses (inaudible) areas. Application specific data converters for wireless base stations, office equipment and printers, a new position in general purposes A/D and D/A converters, a family of ultra high speed 8-bit converters that went up to 3 gigahertz and a family of sigma-delta data converter base temperature sensors. In the two newest areas for us that is general purposely to the converters and ultra high speed A/D converters, we continue to gain market traction. We have new design winds in industrial and (inaudible), water control, military, medial, and automotive safety applications. Now let me move on to talk about our progress on market share.

Here I focus on the standard linear segment of the overall analog semiconductor market as defined by the SIA-WSTS market data and as a reminder standard linear products accounted for 74% of our sales in the 3rd Quarter. According to the December-end calendar year 2005 data released by the SIA-WSTS, the $11.7 billion world wide analog standard linear market declined slightly calendar 2005 over calendar year 2004. We at National Semiconductor actually grew at equivalent standard linear revenues about 5% calendar year 2005 over calendar year 2004, with like the overall market a much stronger second half of calendar year 2005.

To site even more up-to-date market share data, the January, 2006 monthly SIA-WSTS data just released last week, our market share growth has accelerated. For the first 8-months of our Fiscal Year, we’ve grown our standard linear revenues by nearly 20% and the industry world wide equivalent is only up by about 10% for the same 8-month period over the prior year 8-months. We’ve grown all segments of our standard linear business, amplifiers, data converters, interface, and Power Management appreciably better than the overall market. We are well on our way to fifth consecutive Fiscal Year market share gains for our standard linear portfolio.

Now my last topic before I wrap up, which is to talk about the various moving parts of our business model and we’re leveraging to get us above the 60% gross margin we achieved in the last Quarter. First, let me look at the factors that drove this Quarter’s gross margin improvement. Although our standard linear sales is a percent of our revenues, it did not change significantly Q2-Q3, our margins in this area improved. Overall, standard linear billing CSP did increase 4% sequentially, driven by increased sales of higher margin products in broad markets mainly through distribution. In addition, gross margin improvements in our factories came from production efficiencies and cost improvements. Moving forward, our goal is to grow our standard linear business and in particular to grow them as a portion of the total company from the 74% that they represent today. We want to replace the lower margin sales foundry products with mid 60s or higher margins standard linear products. We can also grow our standard linear business in absolute terms, we have gained market share in this market for the last four years and going forward based on the most recent Fiscal, February calendar 2006 SIA-WSTS semiconductor world wide market projection. Our largest segment, Power Management is addressing market that is forecast to grow 15% calendar 2006 over calendar year 2005.

In addition, a momentum in the amplifier product category is being enabled by a new focus on precision and high speed product. In amplifiers, according to the global standard linear market survey data for calendar year 2005 just released by Data Beams, a market research company we now have about 18% market share up from about 12% five years ago. And data converters and high speed interface, we now built a credible product foundation over the last two years to enable more market share gains in the future. So if standard linear products made up 74% of our sales in the Quarter and 6-7% of our sales for foundry sales to buyers who have recently sold businesses, what made up the remaining 19-20% of our sale.

A large portion of these sales are harvest products. Such older more mature products the CRT and TV sockets, RF products, custom and certain application specific products for Telecom and military markets all who we no longer invest in new product R&D. I expect these products to continue to decline in revenue and be replaced by a higher margin standard linear product (inaudible) 12-18-months from now, will these have this products with only account for 10-15% or our overall sales. At that point, are higher margins standard linear products could represent about 85% or more of our sales. And on the cost side of the equation, we still have additional gross margin opportunity. As Lewis said, our Singapore test and assembly plant closure is on schedule for completion in the 1st Quarter of Fiscal 2007; and we are also on schedule for the conversion of hardware Texas FAB from 6-8-inch operation with the 8-inch production ramp in late Fiscal Year 2007, i. e. next year.

Our standard linear product portfolio is today producing gross margins in the mid 60% or better. If we can grow it and have it replace declining lower margin harvest and much lower margin foundry sales and continue our progress on ESP improvements and product cost reductions, we really have a credible plan to drive our gross margins up further. With a wrap up, our standard linear business was stronger than the usual seasonally down 3rd Quarter. Growth and broader market areas mainly through distribution offset slower seasonal mobile phone revenue. Bookings and opening backlog grew sequentially going into the 4th Quarter. We continue to improve (inaudible) and reduce costs again, ESPs were up for our overall standard linear segment by 4% sequentially. Factory cost improvements also contributed to the 350 basis points improvements in gross margin. We continue to gain shares in the standard linear market and its core product segment. We can continue to drive up our gross margins by continuing the path we are already on, more standard linear sales and higher ESPs and a continuing harvest of revenues that do not fit that category.

And now I’d like to hand it over to Long to moderate Q&A.

Long Ly

Thanks, Don. At this time I will ask the Operator open up the lines to begin the Q&A session. Please limit yourself to one question and one follow-up that way we can accommodate as many people as possible. Operator.

Question-and-Answer Session

Operator

Our first question is coming from Chris Casso, Friedman Billings Ramsey

Chris Casso

Hi, thank you. I was wondering if you could expand on some of your comments with regard to distributor sell-through and what is going on with distributor inventory right now that’s something that obviously we are all watching pretty closely and we are interested in what you guys are seeing there.

Lewis Chew

Yes, let me take that one first Chris, it’s not surprising that that would be a topic of interest since there’s been a lot of talk. I guess the way we typically look at it is, in terms of weeks, and just maybe amplify or restate something I said in my commentary, we started off the Quarter with a little under 10-weeks and we ended up the Quarter at a little over 10-weeks. So, the inventory we did grow slightly during the Quarter, I think it was our view that just the inventory had been running at low levels. But the bigger comment I would make is that, that was really in our view driven by fact that just the re-sale activity was probably stronger through the Quarter than maybe they are in general people had anticipated we have a lot of holidays in our Quarter, so that’s why we look at it very carefully, but our probably the best data point is February. And you know, in February in Asia, because Asia makes up what’s called 45% of National, the re-sale rates were very strong once we cleared through both the Christmas type holiday and also Lunar New Year; and in America and Europe the re-sale rates are actually strong in January and February, so we took that as a cue for us.

Chris Casso

And with regard to what the distributors are expecting as you go forward into your May Quarter, in your guidance and I guess the conversations you’ve had with distributors, are you anticipating that they bring their own inventory up a little bit further?

Lewis Chew

In terms of the weeks, we probably see the weeks hanging at around this level, so we do see that the re-sale rate, you got to compare re-sale in Q4 against Q3 there does seem to be a very clear upward bias, part of that is because Q3 has some holidays, but maybe Don can add some more flavor to that.

Don Macleod

Yes, I can add more flavor to that. I think the important point to take into account here is we’ve taken both cautionary approach to that as we go into the 4th Quarter. Clearly our distributors broadly are seeing themselves in an inventory situation that probably isn’t optimum to meet the demand that we are seeing, Lewis referred to the improving re-sale activity. They are also seeing themselves in the situation where a lead time across the industry maybe are stretching a little bit and by-the-way that is not the case for us, but we’ve heard of lead times in passive areas and some commodity products and in some micro controlled areas where lead times are scratched out and distributors feel inclined to cover themselves with more forward backlog.

Through February we took a much more active view on managing distribution backlog to ensure that what we book for the 4th Quarter was represented with normal inventory rates and relatively known customer business, so I think we feel that business outlook from a distributor perspective is pretty good, but they also view that their inventories are low and we don’t want to get their anticipation before we actually go through our inventory for the Quarter, so I think we’ve gone much more kind of proactive view on that going into the 4th Quarter.

Brian Halla

Chris, in addition to that we not only looked at the orders coming in from the distribution but we’ve done a pretty rigorous validation of all the backlogs in place and as Donnie said, where we couldn’t identify in customer demand, in many cases we gave those orders back.

Chris Casso

And just one more, if I could, if you could compare the level of inventory in your distributors now to you know back in 2004 because it’s obviously you know something fresh and fresh in investors minds also.

Lewis Chew

I think we are still below that level.

Operator

Our next question is coming from Adam Parker, Sanford Bernstein.

Adam Parker

Sorry, I misunderstood you. Your answer there Lewis, were you were the (inaudible) weeks above 10 right in the fall of 2004?

Don Macleod

I think you are talking about the last time we reached; August of 2004 was the point in time where distributor inventories week. Our numbers (inaudible) were below the position we were in, in August of 2004 when the distributors clearly confessed having too much inventory.

Adam Parker

Ok, I think that is what he was asking. Can you talk about, I think Brian mentioned that he you guys put some more things in place to more accurately reflect the demand in the channel during the Quarter. I think that is what he said, can you comment, give me more color on what exactly you put in place here.

Brian Halla

That is just what I was talking about, in fact the name of the project internally was called Goldie Locks because we divided the demand for products into hot, cold, and just right and put a lot of emphasis on making sure we got the hot products delivered and the just right delivered but the cold products represented those that we couldn’t clearly see in customer demand for and we either didn’t except those orders, they were on their way in, or we turned those back if they were on the backlog. But there weren’t’ associated with any in customer demand.

Adam Parker

If we translated to, sorry I ask another short-term question here, but if we translated it into your guidance for May it does seem you know maybe it is off of a higher base than people expected coming into today, but it does seem a little bit below normal seasonality, so I am just trying to figure out if you are embedding lower turns, or more backlog cancellations, or why given some of the bookings you talked about the guidance wouldn’t be a little bit higher. I know you went through a little bit, Lewis, but you know just a little more color there.

Lewis Chew

Sure, and I do think that is fair question, Adam, and you already mentioned it in your question is, let’s be realistic. It is off a higher base, I think we do track our historical patterns very closely and most people would acknowledge that our typical Q3, the Quarter we just ended, would be down 3, and we not only were we not down 3 but we were slightly above flat and on top of the Brian just mentioned that we are taking great pains to make sure we don’t be part of the problem that gets created (inaudible) when they over swing on the demand. So right now I would say that we’ve approached the forecast of Q4 straight up as we always do, by the numbers, we look at our backlog, we look at what (inaudible) told us about re-sales, and we do acknowledge that part of that is coming off of a higher base. In fact, off of two Quarters of higher base, because the Quarter before this one we grew 10% sequentially which was above what we normally would.

I think maybe in my wrap up comment is that we are seeing good, steady, stable demand for our products and we are trying to not get too caught up in making any one Quarter of being the end all deal, the forecast also included a slight drop off in revenue from foundry which maybe unique for us and I mentioned that that foundry revenue is still and again, to clarify everyone on the call here, what I mean by foundry revenue is, revenue that we get from supplying materials to the people who bought our two businesses that revenue is still sitting in kind of the mid $30 million dollar range and we do expect that to drop off over time and that drop off is based into our guidance.

Adam Parker

Can you provide the color there, mid 30s down to, are we talking about $5-10 million less this Quarter, or you can’t be specific?

Lewis Chew

Well, in that scale I would say we are not able into saying it is a 10 so maybe in the lower end of what you said. And again, a part of that too, Adam, is that you know we can only forecast there what they are telling us about their end in it.

Adam Parker

Ok, one last kind of longer-term question, maybe Don or whoever here, can you talk a little bit about the wireless handset market, I mean how there is a lot of news (inaudible) all over the place and I am just trying to figure out you guys are feeling about the 3G uptake so far this year, given you have exposure to some of the more complex phones, how do you think what percentage of your overall revenue do you think you could beat from 3G wireless say at the end of the year or several Quarters out.

Don Macleod

I think your question about the wireless marketplace handset marketplace in general, we felt very good about the season trend from our Q2-Q3, we are looking at sales in the handset marketplace of our products that we are down well below the 10% type numbers we would consider most seasonal, i. e. better than that. We also increased our backlog going into this Quarter. We see a very orderly marketplace, we see customers placing forecast with us for the product, we see forecast being sustained and being held very stably and we see them with the longer-term view that obviously the second half has usual seasonal effect with a long time from the second time at this point, but we are taking a view that we need to be well positioned to have (inaudible) to support that business because it started off the year pretty good runway and we did not see any erosion of our customer backlogs in that market.

So you know we are not experts in that marketplace but the customers are asking for products and they are taking that product and it looks good.

Operator

Our next question is coming from Michael Masdeay, Credit Suisse

Michael Masdeay

I just like to clarify what some, I guess it is the sentiment that I am getting from the call, I might be getting it wrong, I want you to have a chance to say something about it. But, if you look at some of what you said or what you see, your order growth is slowing a little bit, inventory receivables are up double digits a little bit less than seasonal guidance and talk about gross margin, incrementally starting to grow less, I guess I should say is this just a pause in the ramp or how do we think about this and how do we not translate that into being more 6th, 7th, and 8th inning in the National kind of turn around story.

Lewis Chew

Well let me start off with more than numbers, Mike, I am sure that my two brothers here will jump in, but first of all you know slowing down the revenue the margin growth rate I think should be fair. We have had a very steady improvement in margin for quite some time now and I took great pains to highlight that hopefully people out there wouldn’t expect 3 ½ points every Quarter. Our normal fall through is typically on incremental revenue in the 70-75% range and we are still committing to that.

In terms of the booking trend, I mean some of that is being affected by seasonal patterns as well as businesses that we are getting out of because I highlighted to you that we were actually down in bookings from this foundry business we are getting out of, but Brian and Don both mentioned that in the core business we are focusing on the booking for our company like 70% or 80%. I have now moved away, Mike, from talking about this in terms of innings because it does seem like the market continues to show signs of sustained demand and growth such that even these last couple of Quarters we didn’t quite see exactly the seasonality we always would. That’s how I would do it, because obviously you would loop it into an innings type of approach it gets very hard to answer.

Brian Halla

Mike, on the innings comment, first of all we did not attempt to generate any tone for the call other then to tell you what had happened in the Quarter which we felt great about. Business conditions were strong, handset orders improved as we said.

In terms of innings, if you look at what we tried to accomplish here and done pretty well, we are talking about head room in our data conversion space which is basically at ground floor now with some billion 8 that we can get market share from that we don’t have today and we just launched a whole new family of general purpose of data converters as well as have the highest performance of low power converters, so the growth opportunities are there, you know we could have done something superficial on the model like said 67 in 07 or 68 in 08 but I think that would have come off as superficial, we are going to spend a lot of time with our institutional shareholders over the next couple of weeks and make sure that their needs are line with our direction and we feel pretty good. In terms of innings, I look at our data conversion opportunities and combine that with the position we have in Power Management and I would say the game hasn’t’ even started yet as far as we are concerned.

Michael Masdeay

That is very helpful, and then, Lewis…

Don Macleod

On the bookings situation, I mean our bookings for our standard linear business are up actually 8% quarter-on-quarter also the headline number for the company is 2%. Lewis mentioned the foundry business is going away and that’s diluting the overall effect. I would not use the 8% bookings or quarter-on-quarter on the very possible book-to-bill ratio that we had; as an indication that we are slowing, and by-the-way, Brian mentioned in the discussion about the Goldie Locks program we have with distribution. That program served actually reduce the apparent booking numbers that we had in the Quarter down to the growth of 8% that we just recorded because obviously we did not take all the orders within normal circumstances might have hit their books in the month of February from a distribution channel so I think you have to contrast all that with a seasonal point in time we are at. This is normally a down Quarter for us and we are actually starting the calendar year off with a strong customer demand position widely across all the businesses within.

Michael Masdeay

Were there any in particular reason you felt you needed to take down that number a little bit more or was there any other area that you would highlight that was relatively weak outside of the foundry business?

Don Macleod

In terms of the major segments we play and we tend to look at what we do in wireless handset and displays in wireless infrastructure, the only area that we really don’t comment on today is the PC which is a very, very small part of our business so there are not other areas toward what you are (inaudible).

Michael Masdeay

And then Lewis, just a rehash just to make sure we understand fully on the inventory since this is such a hot topic and not that he didn’t do a great job of explaining about your own internal inventories, just walk us through how much is seasonal, how much is mix, how much is customer demand, and what you are doing next Quarter how that factors in to what we just saw.

Lewis Chew

Sure, if you knit it all out what I would call the real growth and inventory was probably more like about $6 or $7 million dollar, Mike. Because we know that $4 million was just raw materials for silicon and you take that off the 19, and another $6 million is pretty natural right, we are shutting down a Singapore FAB which used to be 1/3 of our assembly and test capacity and moving all of that to Malacca and China and so for me $5-6 million of bridge built there is kind of nothing considering how well we’ve managed our balance sheet. And then I also highlighted that another $3 million was for the cordless business which is pipeline built for them, so you could kind of look at it as we grew inventory $19 million but the ongoing business growth if you will is about 6, most of that wasn’t finished goods that actually follows a very nice pattern because heading into Q4 as Adam pointed out we typically see Q4 as an up Quarter so we wanted to have finished business in place and then during Q4 we’ll probably put some more whip in place because we are actually a little bit low on the whip side.

Don Macleod

A little bit of flavor on the forward inventory. Our goals and we have 6-8 weeks of (inaudible) but actually it is the low end of that range at this point in time. Our goal is typically to have 2-4-weeks of finished goods but at the top end of that range. And Lewis mentioned some of the specifics that is also worth taking into account that the way we are managing our distribution backlogs at this point in time, it is our desire to have a little bit more finished goods on the shelf to deal with those distributor situation where they do need product in the short-term as we go through this Goldie Locks program so we have finished goods ready to deliver to them. Lewis, mentioned we actually going to increase our (inaudible) as we go through this 4th Quarter, part of that is the transitional stuff that Lewis talked about for the way for FAB this week start cleaning up space in our Texas FAB to upgrade to 8-inch and at the same time we are looking at making sure we have enough (inaudible) in position as we go into the middle and second half of the year; primarily to support the mobile phone distribution.

Operator

Our next question is coming from Simona Genkowsky, Goldman Sachs

Simona Genkowsky

Hi Lewis, just a quick question on the depreciation, it looks like there was a set on decline in depreciation this Quarter and I just wanted to get a sense of what drove that and also how you see depreciation in the next two Quarters.

Lewis Chew

Sure, actually what you see on the cash flow statement is all of the depreciation and amortization combined together so maybe a better way I could put it is that depreciation in an of itself went down by about $1 million dollars. Going forward as I said in the past, we see kind of a gradual decline in that but it will start to level off obviously we are not that’s not a big focus area of ours, I think most of our gains in margin nowadays are coming from the portfolio but that is the trend in depreciation and amortization there.

Simona Genkowsky

And just for a quick follow-up, I think you mentioned that lead times are sluggish, can you just kind of expand on that a little bit is that really what I heard and also how you see that by kind of various markets in which you participate.

Don Macleod

Simona, I’ll take that and as I said at your conference two weeks ago, our lead times have been pretty consistent from now to say 13-weeks ago when we had the last call and I think it is at that point I indicated that we had a certain percentage of our products that were available on 6-weeks or better. We are actually at about the same number, 83% of our products are available 6-weeks or better and that is very much in line with where we were 13-weeks ago. We would like to improve that a little bit, but at this point we are ok with our lead time.

Operator

Our next question is coming from Mark Edlesfiln, Morgan Stanley

Mark Edlesfiln

Good morning guys, nice job on the margin. Lewis, you gave us some nice details on the drivers of the gross margin in the Quarter of 350 basis points, I think you said that about ½ of that came from manufacturing efficiencies and as you step through the inventory and increase what you saw in the Quarter it sounds like some of that would have helped the gross margin but it sounds like the majority of the increase really came from just overall manufacturing execution and maybe the better utilization rates, can you give us a sense of based on your best guess as to how much the increase in inventory might have helped the gross margin verses the other operational fees?

Lewis Chew

Sure, if you look at the dollars quarter-on-quarter our gross margin dollars went up by about 20. We know that more than half of that came from our product portfolio because we can track that. In terms of specifically on the inventory bills, it was probably only a subset of the remaining amount because you did pick up on what we were trying to do, I guess we shouldn’t be so subtle in thinking out manufacturing or for doing a phenomenal job and we don’t think that stops going forward as well. The manufacturing efficiency did help us, it wasn’t just sheer volume, it wasn’t a matter of what some people might think of just putting overhead into the inventory shelves.

It is hard for me to be precise, Mark, I wouldn’t say well of the remaining half you’d split it half between growth and half between efficiency. If anything, I would say less than half of the inventory growth and a bigger part of what is due to the manufacturing performance.

Mark Edlesfiln

I appreciate that and then, Lewis, what kind of tax rate do you expect to accrue for Fiscal 2007?

Lewis Chew

You know we haven’t given guidance for 2007, but I suppose that it is always a fair question, right now we view, Mark, that the tax rate that we are at is kind of reflective of our organic rate. You know we took a big up in that tax rate this last year, but because the operations obviously performed so well we’ve managed to absorb that and right now I guess I mentally model us as about a 31½% tax rate company; and obviously we will give guidance every Quarter that is probably as good as I can answer that.

Operator

Our next question is coming from Tom Thornhill, UBS

Tom Thornhill

Staying in this gross margin theme, can we go back and review some of the factors that will impact gross margin in the coming Quarter including and finishing the transfer of test and assembly facilities in Asia and some of the product mix issues, but then you were mentioning inventory as likely not to be a material change in the next Quarter, if you could just review some of those factors that will impact gross margins in the coming Quarter.

Lewis Chew

Yes, Tom this is Lewis. I’ll try to go through this quickly because we are starting to run out of time and I am sure there’s more questions out there. Probably the biggest up factor going forward is still going to be the portfolio so I’ll set that one aside. The Singapore project we are looking to complete that in Q1 of 2007 and I think we’ll see another chunk of savings there. In Q4, we’ll have some incremental savings, I want to highlight though that some of that is being offset by some incremental spending that also goes through gross margin for some of those transferring activities, so it’s probably to some extent masking a little bit of that improvement, but eventually as we finish that stuff off the Singapore savings will show itself more clearly and I think those are probably the two main items. In terms of utilization rate, we are at a level right now where we are not going to see dramatic changes in that.

Operator

Our next question is coming from Ross Seymour, Deutsche Bank

Ross Seymour

Thanks guys, just a question again on the inventory side. If you had around 75-days that’s at the high end of the range that Lewis you talked about at the end of the November Quarter, one is that range going to change as you go forward and I guess where that question is coming from is most of the guys that you want to compete against in the high performance analog realm carry about 100-days of inventory, is there something unique to you either National’s business model or end market exposure that allows you guys to carry a lower amount?

Lewis Chew

Well, you know that is an interesting point Ross. You probably wouldn’t be surprised if we looked at the same thing our self, but right now we don’t have a new model to throw there at you, but internally within National we do have people who look at that fairly regularly. I think right now we are more tuned into customer needs, which is always what I hear from my next door neighbor, Don as he barks about these customers asking for stuff, but over the long haul we’ll look at that. I don’t think I would say anything unique about National per say, just that historically that is how we’ve operated and amazingly enough that’s what you say, that’s how you do it.

But in this last 6-months as demand has picked up, we certainly have seen some of the signs of stress that comes from potentially holding too little inventory and given the rest of our balance sheet being managed fairly well, it wouldn’t really cost us a lot to have more inventory per say but we want to make sure that if we were to do that, it’s the right approach. I mentioned that in Q4 we’re probably going to do some (inaudible) bills which is generally accepted as a strategically good move and probably cut back on the finished goods, which then gives us some more flexibility to fill out that part of what our customers want. But right now, I can’t say this model is necessarily going to change. And by-the-way, just to clarify, I said we finished this Quarter at 76-days, but the reason I highlighted those notable items is obviously all of those items are embedded in that 75-days, so I tend to look at it is from an operating standpoint. We’re still somewhere between 65-75 because the (inaudible) inventory is very unique and a bridge built for Singapore is very unique and that’s $9 million dollars right there.

Ross Seymour

Yes, that is very fair. And then on a bit of a different topic and maybe Donnie can talk to this, on the is (inaudible) side where you said at the end of February you were actually doing some of the Goldie Locks project and pushing out some of the orders that they had, do you get the sense that they are ordering in attempts to actually build there inventory to greater than that 10 1/2-weeks level, if you are able to push back on that then clearly they are ordering at a rate that is somewhat above their true consumption and maybe that is necessary for future growth, but nonetheless it seems like that would be a potential problem going forward.

Don Macleod

Well, I think if you heard Ross the theme from us in past calls, one was that we did think our distributors in the past recent Quarters were in our view carrying too low levels of inventory and that clearly evidenced itself when the re-sales started picking up and some of the distributors saw to put more inventory on the shelves than the prior models had enabled them. And clearly if you do make that kind of adjustment we do ask suppliers like ourselves to ship more product to you and tends to be I wouldn’t say too much disciplined to when they actually want the product very often its ASAP or right now. And the view we took was that we wouldn’t let that happen and our view is that we’re going to discipline distribution activity through this Quarter and through the summer to make surely we don’t’ get into the kind of position we were in, in the 3rd Quarter of calendar of 2004 where clearly inventories were left to a point when re-sales fell off in the second half of 2004, the inventories needed to be reduced. So, the answer is yes, inventories were too low and distributors did want to increase them to levels above where they were. We are working together to keep them in balance.

Ross Seymour

Is the right amount 11-weeks, or somewhere around there?

Don Macleod

Well you know, you can’t make a general statement because for example we have three large distributors that are global. Two of them are fairly aggressive models, one of them is actually inventory lead and that’s the 3-times turns model and (inaudible) inventory faster at this point in time, so you aggregate statement sound simple but the conditions vary by the kind of channel that you have and the departments you have. So, in our case typically we would be above 10-weeks.

Operator

Our final question is coming from Torres Vanburg, Piper Jaffray

Torres Vanburg

Yes, thank you and good morning. Two questions, first of all there is a perception out there I think as you get to higher margins revenue growth slows down, now that you are above 60% what would be your steady state longer-term growth rate at this point?

Don Macleod

Actually that is an interesting question; you have to then reflect that in a relative statement if revenue growth slows down that means the market we’re participating in, i. e. the standard linear market is slowing down. That’s absolutely not the case, if you look at the our industry’s forecast for the standard linear marketplace, and bear in mind that marketplace shrunk 1% according to the statistics last year 2005 over 2004 calendar. We are actually looking at a marketplace for standard linear world wide accordingly to the SIA-WSTS numbers from early February. It is expected to grow 11 ½% and again I’ll make the point that more than half of that market is voltage regulators and references which we call Power Management; and it’s forecast to grow at 15% and I’ll make the point again, we have 4 ¾ fiscal years worth of market share gains, so our views to grow are standard linear sales are better in that market number and we are fishing a at least a forecast in view that 2006 is going to be a stronger year than 2005 and it looks like it is starting off that way, you have to relate any growth statement to the market that we are playing in and so far we are gaining share in that market and it is growing.

Torres Vanburg

Very well and also just as a follow-up you know you talked a lot about increasing content in the cell phone sometimes you can get two, three, four X content in a high end 3G phone, could you talk a little bit about where we are in that whole process, you know if we are still in the early stages or if we’re getting towards the middle.

Don Macleod

I mean, I look at the mobile phone marketplace as a market of 900 million units. And I look at that marketplace as one because there are many analog opportunities that we serve. We are not necessarily serving 3G phones, we are serving I think broadly any kind of phone and the volume drives our business and our expertise and Power Management drives new applications in that business and these new applications are more and more pervasive and we talk all the time about these phones with larger displays, better audio, longer battery life, etc. and that’s where we play in that last feature is not going to change going forward.

Long Ly

Now we are going to end our call let me remind you that a replay is available on our website. Thank you.

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Source: National Semiconductor Corporation Q3 2006 Earnings Conference Call Transcript (NSM)

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