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OmniVision Technologies, Inc.

F1Q13 Earnings Call

August 30, 2012 05:00 pm ET

Executives

Mary McGowan - IR

Shaw Hong - CEO & President

Ray Cisneros - SVP, Worldwide Sales and Sales Operations

Hasan Gadjali - VP, Marketing and Business Development

Anson Chan - CFO & VP, Finance

Analysts

Daniel Amir - Lazard

Paul Coster - JPMorgan

Harsh Kumar - Stephens Inc

Raji Gill - Needham & Company

Brian Peterson - Raymond James

Betsy Van Hees - Wedbush Securities

Operator

Ladies and Gentlemen, thank you and welcome to the OmniVision Technology’s conference call for the first quarter of fiscal 2013. At the time all participants are in a listen-only mode. Later we will open up the call for your questions. Instructions for queuing up will be provided at that time. As a remainder this conference call is being recorded for replay purposes. I would now like to turn the conference call over to Mary McGowan. Please proceed.

Mary McGowan

Thank you very much. Good afternoon everyone and welcome to our fiscal 2013 first quarter earnings conference call. On today’s call will be Shaw Hong, President and CEO; Ray Cisneros, Senior VP of Worldwide Sales and Sales Operations; Hasan Gadjali, VP of Worldwide Marketing and Business Development and Anson Chan, Chief Financial Officer.

During this conference call, we may make forward-looking statements regarding our business, including statements relating to revenues, earnings targets and our product plans. This is based on information as of today, August 30, 2012. Actual results may differ-materially from those set forth in such statements.

These and other forward-looking statements involve assumptions, risks and uncertainties that could cause actual results to differ materially. For a discussion of these risk factors, you should review the forward-looking disclosures in the earnings release we issued today as well as the risk factors and other disclosures in OmniVision’s SEC filings and reports, including the most recent annual report on Form 10-K and recent quarterly reports on Form 10-Q.

During today’s call, we will also discuss certain GAAP and non-GAAP financial measures, the latter of which excludes stock-based compensation expenses and related tax effects. A reconciliation between the two is available in our earnings release posted on our website.

With that, I’ll now turn the call over to Mr. Shaw Hong. Shaw?

Shaw Hong

Thank you, Mary. And welcome to all of you joining us on the call and webcast. Earlier this afternoon, we issued a press release describing our results for the first fiscal quarter of 2013. For those who have not read the release, I will provide you with a recap of our financial results.

In Q1, we recorded revenues of $258 million and we shipped $166 million image sensors. On a non-GAAP basis, gross margin was 19.5% and net income was $11.6 million or $0.21 per diluted share. Our cash balance decreased by $94 million to $237 million and our inventory balance increased by $112 million to $403 million.

These were results of a strategic decision to build inventory to support our fast growing business in the face of strong seasonal demand. Before I turn the call over to our management team to provide details on our Q1 financial results and our outlook, I would like to make a few comments of my own on the quarter and on our expectation to the seasonal cycle this year.

First, I am pleased to report that for the third consecutive quarter, we have exceeded the high end of our revenue guidance. More importantly, we have continued to raise the bar on our outlook for the next quarter and we have increased it by a significant degree. Based on our current visibility, we believe our first fiscal quarter is indicative of a strong seasonal cycle for fiscal 2013 and I am excited about the market opportunities available to us.

The mobile phone market has contributed the most to our first quarter revenues. Strong demand from smartphone applications is a major reason for our continued strength in this market. Separately, the entertainment market remains a significant contributor to our Q1 revenues. We believe one of the main drivers, it’s our leadership position in tablets, which we have been including as part of our entertainment business.

With that said demand growth from smartphone and tablet applications continues to accelerate. We believe our participation in the mobile phone market and the entertainment market will continue to be the major driver for our top line performance in fiscal 2013. In the past few months, we’ve been focusing our efforts on building inventory and increasing our supply chain throughput to make sure we deliver on our promises when our end use customers choose our designs.

We’ve been working closely with all of our supply chain partners to maximize all aspect of production. Our efforts range from prioritizing production schedules to expanding capacity to streamlining supply chain logistics. Given our strong cash balance we’ve also made a strategic decision to pre build inventory to further increase our ability to meet the strong seasonal ramp from our target markets.

Meeting this strong demand is an ongoing challenge. We have been diligently executing our plan to tackle this challenge. I would also like to add that while we have regained revenues momentum, our gross margin remained under pressure as a result of our current cost structure. We continue to take actions that we believe will lead to margin expansion over time. As we move forward, we remind ourselves and our investors that our investment in R&D is the leading differentiator for the company.

Since OmniVisions’ inception the company has invested in R&D with the objective of capturing the position as the leading technology provider to our many end use customers in diverse target markets. OmniVision already has won the broadest product portfolios in the industry with product resolution ranging from sub VGA to 16 mega pixel. Our goal is to continue to provide the most comprehensive solutions to the current consumers and the commercial enterprise market. With that I will turn the call over to Ray who will provide and update on the quarters’ sales activities.

Ray Cisneros

Thank you Shaw, we are pleased to report on a strong fiscal Q1. Markets over the summer marched at a brisk pace and customers on a global scale continued to compete for novel and best in class imaging solutions. In our fiscal Q1, we ramped up several BSI-2 products as planned. This ramp up will continue through our fiscal Q2 and fuel our top line growth.

In our first fiscal quarter, we shipped 166 million units as compared to 147 million units in our prior quarter. The average selling price in our fiscal first quarter was $1.55 as compared to $1.48 in the prior quarter. The step up is due to an increase in higher resolution sensor product mix, in particular from our 8 megapixel and 5 megapixel sales.

In the first fiscal quarter, unit sales of sensors 2 megapixel and above represented approximately 37% of total shipments as compared to 31% in the prior fiscal quarter. This positive shift was driven by a strong 8 megapixel sensor growth and a steady increase from our 5 megapixel portfolio. We continue to see strength in these two categories in our fiscal second quarter.

3 megapixel remains steady and 2 megapixel showed an increase. Both of these are driven by an emergence of a low cost smartphone category in the Far East. Unit sales of 1.3 megapixel sensors represented approximately 31% of total shipments as compared to 14% in the prior quarter.

As usual, we remind you in this category, we incorporate our HD sensors which are the dominant form factor in this category. This step up in our first fiscal quarter was driven by the launch of two new BSI-2 base 720p HD sensors. The volume of this family of product will grow in our second fiscal quarter and drive top line growth.

Additionally, in this category, summer notebook sales drove a steady increase in our BSI-1 720p based OV9726 sensor. This calendar year, we believe this product is de facto standard in quality HD imaging for notebook computing.

Lastly, unit sales of sensors there were VGA and below represented approximately 32% of total shipments as compared to 55% in the prior quarter. We saw on an absolute scale a step down in sensors units shift in this category. We believe it’s a strong reflection of the multiple consumer markets transitioning into the HD format.

However, for VGA CameraCubeChip, we saw a steady increase albeit not enough to offset to down trend of the sensors. Additionally, similar to sensors OmniVision is sampling HD CameraCubeChip products and we may see the fast migration of VGA based to HD based CameraCubeChips just as we saw in the sensors.

In terms of product markets, our mobile phone cells represented approximately 48% of our revenues in the first quarter as compared to 52% in our prior quarter. This step down was driven by increases in notebook, entertainment and security. Our entertainment segment represented 27% of sales compared to 28% in our prior quarter.

On an absolute basis entertainment actually grew and remained strong. Our sales of sensors into to the notebook and webcam segment were approximately 15% of sales as compared to 11% in our prior quarter. Other categories balance out remainder. In the mobile market the smartphone category continue to feel the growth while brands name continue to battle for the high end segment of the smartphone category, now a low cost smartphone segment has emerged and generated a whole new opportunity for dozens of low cost mobile phone of OEM’s.

The business opportunity for a low cost smartphone markets is enormous, as a large portion of the feature phone market is rapidly transitioning into a smartphone product. We saw growth across the board in all resolutions in the mobile category except for VGA where there was a significant decline. We are particularly please to see strong growth in our one-third inch format 8 megapixel product line shipping to the smart phone tier-one brand name OEMs.

Our whole one quarter inch 5 megapixel product line continued a steady increase as well. We saw increases in lower resolutions to the mobile market including 3 megapixel, 2 megapixel and HD. Finally, volumes of our VGA CameraCubeChip continue to increase in early samples of HD CameraCubeChip products are attracting high interest for new products.

Meanwhile, we continue to engage with our key customers for next generation products. Surprised to say the array of innovative solutions fall into categories anywhere from moving up the resolution curve to novel solutions to across the conventional lines of thinking. In all cases we are happy in supporting all these new projects for future business.

In the notebook and webcam segment, we saw very strong growth of our HD OV9726 sensor. The majority of brand name notebook OEMs [procured] sensor typically to showcase their top of the line products.

Also released to this market is a new BSI-2 base HD sensor, in parallel our next generation smartphone factor HD sensor the OV 9724 has been well received for the ultrabook market to support the more [basal] mechanical designs. In the entertainment segment of our business we continue to see steady growth of the tablet segment.

We ship the (inaudible) of resolutions into the segment from HD up to 8 megapixel. Multiple players continue to rotate into this space and in many cases we are fortunate to able to serve many of them, permutation of tablet like devices are also entering into this segment, broadening the segment and adding opportunity for OminiVision.

In the automotive market, innovation is even more critical due to the fact that imaging is required for functional operation of the vehicle. After years of steady growth rested on delivering high quality VGA products, we are finally moving into HD or 1 megapixel mass production shipments or be it small in volume today, we like the upper trend long-term. In summary, we [exit] a strong first quarter and set the stage for another level of growth in the upcoming quarters.

Mary McGowan

Thank you Ray. I will now the turn the call over to Hasan who will provide an overview of the companies marketing efforts and opportunities.

Hasan Gadjali

Thank you Shaw for this quarter call. I would like to focus on the market acceptance of Omni BSI plus and Omni BSI-2 based products we have introduced in the last few quarters. OmniVision’s continued development of this advance pixel architecture has generated a very broad portfolio of products which has contributed significantly to our solid market position and revenue growth.

Our technologically strength and innovative products continue to rank OmniVision among the leaders in a highly competitive mobile and smartphone market. I will start out with our Omni BSI plus technology which has generated a wide variety of new camera chip products that deliver performance and image quality improvements for reducing the silicon footprint to continue reducing costs. As you may recall, over the past several quarters we introduced a number of image sensors including the OV ADA 25, OV9724 and OV2722. All these products have already secured design wins by top tiers OEM and are currently in mass production for next generation smartphones for this coming holiday seasons. The OV8825, our 8 megapixel sensor is compatible with the previous generation OV8820, making it a highly attractive option for smartphone and tablet manufacturers who seek to update their camera design.

Our recent launch of 5 megapixel OV5648 camera chip which is also an OmniBSI-Plus products offers significant performance and image quality improvements at a reduce die size. This makes it a highly cost competitive performance upgrade for smartphones and tablets manufacturer that are using our previous generation OV5647 sensor.

The brand new OV7695 is another strong addition to our secondary camera offering, using a 1.75 micron OmniBSI-Plus pixel, this high performance VGA sensor is ultra compact at only one-thirteenth of an inch, can fit in to a module with less than 2 millimeter in height.

Next, I would like to talk about some of the products using our most advanced OmniBSI-2 technology such as OV90772, OV5690, OV8850 and OV12830, which are now being selected for premium mobile device. This high performance sensor deliver best in class image quality, speed and power in a very compact form factor, validating the premium benefits these devices offers.

With faster frame rate and higher dynamic range, they narrowed the performance gap between cellphone cameras and point and shoot [disassociate] cameras. At only one quarter inch, our popular five megapixel OV5690 and eight megapixel OV8850 are well suited to fit modules as small as 4.2 millimeter in height. Looking beyond the eight megapixel range which is currently a highly popular resolution in premium handset and smartphone, our 12 megapixel OV12830 is ideally suited to support the next generation of premium devices, offering best in class performance at one-third inch.

Summarizing the current status of our OmniBSI-Plus and OmniBSI-2 technologies, we believe that the continuous advancement of performance factors and cost benefits of continued device string enable OmniVision to make a very broad and attractive product portfolio that position us well for both mass market and premium applications.

Moving on to our CameraCubeChip we are now introducing new products that use better optics and the latest OmniBSI-Plus sensor to expand our portfolio beyond just high volume VGA solution. Our recent new introduction of OV9724 and OV7695 OmniBSI-Plus sensors offer high quality, high performance VGA and HD video for secondary or front facing CameraCubeChip in smartphones and tablets.

With less than 2.4 millimeter in height this CameraCubeChip solution are extremely popular amongst platform partners and OEM customer looking for increasing small consumer devices. Concluding, we've an update on our emerging market markets. I would like to highlight some of the progress we have made in establishing a leadership position that we believe will offer substantial revenue growth in the years ahead.

On the automotive front, we recently announced the OV7955 sensor. This is an AEC-Q100 Grade 2 qualified low cost high performance analog and digital sensor designed specifically for mainstream automotive applications. In the light of Kid Transportation Safety Act which require all vehicles in the US manufactured up to 2014 to be equipped with rear view camera systems.

We are bringing to market a sensor 40% smaller than competing products at extremely competitive price and with exceptional performance. These competitive advantages make OV7955 an ideal camera solution for mass market rear view, surround view and blind spot detection systems.

The OV7955 is already shipping to major automotive manufacturers around the world for mainstream automotive designs. For all of our targeted emerging markets which include automotive managing, medical imaging and security and surveillance, we are making meaningful progress offered as a first mover. Over the long term, we continue to see these markets as providing significant and substantial growth opportunities.

Shaw Hong

Thank you Hasan. I will now turn the call over to Anson who will discuss our first quarter financial performance and provide guidance for our second quarter of fiscal 2013.

Anson Chan

Thank you, Shaw and good afternoon everyone. For the first quarter fiscal 2013, we are reporting revenue of $258.1 million, up 18.1% sequentially and down 6.5% on a year-over-year basis. Direct sales to OEMs and buyers accounted for 72.5% of our revenues in the first quarter of fiscal 2013, an slight decrease from 77.4% in the prior quarter.

The remainder of our revenues came from sales through out distributor channels. Our fiscal 2013 first quarter GAAP gross margin was 19.1% compared with 22.5% that we reported in our prior quarter. Excluding stock-based conversation expense of $1.1 million including cost of revenues, our non-GAAP gross margin was 19.5% compared with 22.9% in prior quarter. The decrease in our gross margin was primarily attributable to a change in product mix that included a higher volume of our BSI-2 products.

As we have indicated in our previous call, these products have higher production costs when compared to our older products because of additional assembly and manufacturing cost incurred by our supply change vendors in connection with capacity expansion. In the first quarter of fiscal 2013 we recorded approximately $1.4 million for the sale of previously written down inventory and $4.9 million as an additional allowance for excess and obsolete inventories with a net $3.5 million of unfavorable impact on our gross margin.

In the fourth quarter of fiscal 2012 we recorded approximately 1.2 million for the sales of previously written down inventory and $6 million as an additional allowance for excess and obsolete inventories with a net $4.8 million of unfavorable impact on our gross margin.

We anticipate a further weakening of our gross margin for our second fiscal quarter of 2013. If our shipment mix continues to ship towards BSI-2 devices, most particularly with our 1 megapixel or HD sensors. (inaudible) working us for our supply chain vendors to reduce the production cost of our BSI-2 sensors. However, our manufacturing process is long and complicated and the equipment investment is significant.

We do not expect to see any material effect from our cost reduction efforts in the near-term. R&D expense in the first quarter of fiscal 2013 totaled $28.8 million, a 6.2% increase from the $27.2 million in our fiscal 2012 fourth quarter.

The increase in R&D expense was driven by an increase in R&D headcount. We also recorded an increase in stock based compensation expense during the quarter. We currently expect our R&D expense in the second quarter of fiscal 2013 will increase further at a low double-digit percentage rate. This expected increase is mostly attributable to further increases in headcount and increases in take outs and other non-recurring engine expenses.

Once again, we believe that our investment in R&D is the leading differentiator for company and we will continue to do so in a controlled and targeted manner. R&D expense in the first quarter include approximately $4.8 million of stock based compensation expense, excluding stock based compensation expense, first quarter R&D expense was $24.1 million as compared to $23.3 million in the fourth quarter of fiscal 2012.

SG&A expenses increased from $16.2 million in the fourth quarter to $18.7 million in the first quarter. The increase in SG&A was driven by an increase in commission payment to our channel partners and an increase in stock based compensation expense.

We expect SG&A expenses to increase further in the second quarter of fiscal 2013 as our commission payments to our channel partners may increase.

Our first quarter, SG&A expenses include approximately $3.7 million of stock based compensation expense. Excluding stock based compensation expense, SG&A expenses in the first quarter totaled $15 million as compared to $30 million in the fourth fiscal quarter. The first quarter amortization expense for our acquired patent portfolio was $2.3 million the same as our prior quarter.

Our GAAP operating loss in the first quarter totaled to approximately $682,000 as compared to an operating income of $3.4 million in prior quarter. Our GAAP pre-tax loss in the first quarter totaled $206,000 as compared to a pre-tax income of $3.7 million in prior quarter.

Our GAAP tax benefit for the first quarter was $2.5 million. This compares with a provision for income taxes of $1 million in the prior quarter. Including the first quarter GAAP tax benefit was a reversal of certain previously recorded tax results when the statute of limitations for this legal tax matter expired.

This because we [recorded] in a one-time non-cash tax benefit of approximately $3.2 million. Given the small pre-tax loss and the tax reversal comparing tax rates between quarters is not meaningful.

Excluding the effect of stock based compensation expense; our non-GAAP tax benefit for the first quarter was $2.2 million. This compares to our non-GAAP tax provision for fiscal 2012 fourth quarter of $0.8 million. For the second quarter of fiscal 2013, we expect our GAAP and non-GAAP tax provision will be between $3 million to $4 million.

The relatively high dollar amount for Q2 estimated tax provision when compare to Q1 was driven by $3.2 million tax reserve released that we talk in our first quarter or the remainder of the fiscal year we expect our quarterly tax provision, we'll remain comparable to this range in absolute dollar terms.

In the first quarter, our GAAP net income was $2.3 million or $0.04 on a per diluted share basis. This compares to a GAAP net income of $2.7 million or $0.05 on a per diluted share basis in the fourth quarter of fiscal 2012.

Excluding stock based compensation expense and related tax affects, our non-GAAP income for the fiscal quarter was $11.6 million or $0.21 per diluted share, this compares to non-GAAP net income of $10.9 million or $0.20 per diluted share in our fourth fiscal quarter of 2012.

Let me now turn to the balance sheet. We ended the first quarter with cash, cash equivalents and short-term investments totaling $236.6 million, this compares to $331 million at the end of the fourth quarter of fiscal 2012. The decrease in cash was primarily attributable to our build up of inventory to support our forecasted increase in sales.

As of July 31, 2012 inventory totaled $403.2 million, an increase of $111.9 million from the $291.3 million balance at the close of our fiscal 2012 fourth quarter.

Our quarter and inventory balance represented an annual inventory return of 2.1 times or 178 day sales. With the anticipated sales increase in the second quarter, our inventory turn should improve. We are still experiencing a mismatch between our customers’ production schedules and our capacity ramp up plan.

As such, we have to continue to build inventory to start. We currently expect we solve the mismatch by the end of this calendar year. Accounts receivable at the end of our first quarter net of allowances was $142.7 million; an increase of 32.4% from the $107.8 million at the end of our fiscal 2012 fourth quarter.

Our day sales outstanding increased to 51 days in the first quarter as compared to 44 days for prior quarter. This increase in DSO reflects a lack of linearity in our shipments during quarter. Lot of our customers has started to take delivery of their order parts towards the latter half of the quarter.

With that I will turn to outlook. For the second quarter of fiscal 2013 which ends on October 31 2012, we currently expect our 2013 second fiscal quarter revenues will be in the range of $355 million to a $390 million. Our GAAP EPS are expected to range from $0.06 to $0.22 per diluted share, excluding the estimate expense and related tax effects associated with stock based compensation, we expect our non-GAAP earnings will be in the range of $0.21 to a $0.37 per diluted share.

Mary McGowan

Thank you Anson. We are excited about our new fiscal year and our revenue momentum as well as opportunity to further expand our market share. However, we need to continue to address issues with our cost structure and we are focused on resolving these issues. All of us here and OminiVision are committed to improving the financial performance of the company as we camp here aggressively in our target market.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Daniel Amir with Lazard. Please proceed.

Daniel Amir - Lazard

I guess in terms of the guidance here it seems like there is trade off here of much higher sales on the expense of much lower margins you know, are we in kind of a new base year of sub 20% type of gross margin company or do you anticipate that at some point, you know, margins should increase again and I would appreciate if you can comment this both on the cost side and on the mix side. Thanks.

Anson Chan

Hi, Dan, it’s Anson. So we broached this subject last quarter about how our BSI-2 indeed represents a significant ramp for the company in demand. So what we have to do is look at our vendors to increase capacity. That BSI-2 also represents our transition from 8 inch to 12 inch. So that capacity expansion have indeed translated in to a significant equipment purchase for our vendors and these vendors basically have to pass the cost back to our product purchase and so that increase our cost structure.

So that’s what you are seeing tier one as we continue to increase our product shipment mix towards BSI-2, if these higher product cost translates in to a lower gross margin. What we have to do is basically have to work with our vendors in terms of negotiation and then basically we think about more we buy, the quicker our vendors get to amortize the investment cost, right.

And so as time pass by, as most of the investment cost get amortized, they’ll been more willing to come to the table and negotiate with us and give us a better price rate. So that will have a positive effect on the reported gross margin.

The other thing that we can think of in terms of gross margin trend or trajectory we call that, will be the factors such as market mix, where we do carry different margin profiles in the different target markets that we participate in. So as time goes by, as some of these markets contribute different percentage of revenues to our revenues, we will have different margin to report us well.

Another thing I can easily think of as well in this year in particular will be after our fiscal Q2, with some of the end user customers continue to buy the volume that they are buying in Q2 and alone those buying decisions will be dependant upon how good the sell through would be through the retail channel.

And given this year with all these macroeconomic concerns, it’s not easy to forecast. But all this can play a part in terms of the margin. One more thing I want to highlight is the fact that, actually you can see my balance sheet. We have purchased a lot of inventory already. So all the products that we ship in Q2 will be from the inventory on hand.

So any negotiation that we can accomplish in the coming quarters will not have any effect on those product cost because it is already paid for it and brought it, right. But if some of the negotiations would come through and we have favorable effect, it’s possible that may you just see a bottoming out of margin for second quarter and by Q3 that's possible that we can start to see some improvements.

But you know it will largely depend on the things I just mentioned you know namely negotiations, the market mix and some of the end demand that we anticipate.

Daniel Amir - Lazard

And just one follow up, can you just comment a bit about you know the notebook and ultrabook market, I mean what percentage of your business is now that PC side and is that a driving factor for your guidance here for the next couple of quarters?

Ray Cisneros

Hi, this is Ray Cisneros. In terms of the guidance for our Q2 the percentage of the notebook businesses is not the majority for it. In other words there are other markets that provide the strength in our Q2 guidance such as the mobile market and the entertainment market which includes our tablet business. Going forward as many of you know, the jury is still out in regards to how well the PC notebook market will do through the remainder of the calendar 2012. There is a lot of mixed reports out there, how the market is faring and lot of it is mixed in with how the tablet market encroaches upon that space.

But for us what we reported was, it a good summer season in regards to the notebook business, but looking forward, it’s a little bit, it softened up a little bit going forward for us, but other strength comes from other markets for us.

Operator

Your next question comes from the line of Paul Coster with JPMorgan. Please proceed.

Paul Coster - JPMorgan

Anson I would like to go back to your comments on the gross margin outlook. I couldn’t quite figure out what tense you are using, past or present when you said that as BSI-2 volume exceeds expectations, that leads to more rapid amortization of that fixed cost and thus yielding the ability to negotiate a better price. It sounds like you have already negotiated a better price for some future point beyond the second quarter of course or are you expressing that as an intention rather than fact?

Anson Chan

Hi Paul, this is actually an ongoing process. It’s not a past tense, it’s not a future tense either. It’s actually going on as we speak, we continue to negotiate and get better and better cost structure for our products before we can produce better results.

Paul Coster - JPMorgan

Well it sounds reasonable that once they’ve amortized that cost, you should get a price break, but there is no contractual obligation for them to yield in that respect, is there?

Anson Chan

No there are no contractual obligations. While we have to rely on really is our long-term business relationships and frankly the volume that we are buying, look at our revenue guidance and you look at the reported ASP, it’s a significant volume. So I don’t think we consider a small customer, so we do have some negotiating power. Now there is no guarantee that we will generate positive results. So that’s all, we need to work hard basically.

Paul Coster - JPMorgan

Is there anything you can do to diversify the supply from the wafers, that’s it from me, question?

Anson Chan

That would be a future tense in that sense. I can tell you that every single BSI-2 device that we ship today is from existing supply chain. So first and foremost, we need to work with our existing suppliers and work down the cost structure. Any future products can be (inaudible), but today I can tell you everything is the same, same supply chain, same vendors.

Operator

Your next question comes from the line of Richard Sewell with Stephens Inc. Please proceed.

Harsh Kumar - Stephens Inc

Hi guys it is Harsh Kumar from Stephens Inc. I am going to ask you a question backup again on the previous two comments about gross margins. Most of the company, the understanding is when they see a pretty big volume our units increase. You typically see the gross margins go up. I am kind of curious as to why you are not certain about the fact that you should be able to either amortize things better or you should be able to bring your gross margins up. Why is there sense of uncertainty, when that’s not the case with every other semiconductor company?

Shaw Hong

With this is the same concept that I have been trying to describe. It has to do with the cost structure of our BSI-2 devices. The margin profile for the BSI-2 devices as of this moment is not as (inaudible) for investing in equipment that our vendors are patting down to us. So potentially we see (inaudible) is high compared to our (inaudible) products. So with said, as we continue to ship the (inaudible) you are going to see a downward pressure on the quarter’s

[Technical Difficulty]

Harsh Kumar - Stephens Inc

Okay, fair enough and then coming back to your guidance for revenues, which is by the way, great. Is it being driven by new phone models and larger megapixel or is it current products and current megapixel that’s you have in those existing products. Is it just volume of all products or is it actually new megapixel, higher megapixel than new products?

Ray Cisneros

Hi, this is Ray Cisneros. Our guidance is based on the ramp up in launch of our new products predominantly. If we take a high level view of our numbers, the biggest contributor to the upside in terms of our guidance is driven by our new BSI-2 based products and that’s resolutions but predominantly a BSI-2 products, 5 megapixel BSI-2 products and then 8 megapixel BSI-2 products and that’s the bigger driver from the product side. From the market side, we don’t know what our end customers will end up using these products for, but we could only conjecture or surmise that its definitely probably related to the mobile market and the entertainment market, probably tablet type devices but all of that is conjecture for now. So we see the products out there in the marketplace and then of course we have a variety of customers that are tier-one brand name customers that are relationships long-term and we're happy to see some of our products go to them.

Operator

Your next question comes from the line of Raji Gill with Needham & Company. Please proceed.

Raji Gill - Needham & Company

It seems that correct me if I am wrong that on the top line this is the highest quarterly revenue run rate in the history of the company at 372, but at the same time it’s one of the lowest gross margins in the history of the company also for the October quarter something like 16.5%. So I just want to clarify the gross margin guidance and you can specifically talk about but I am getting to something where margins are kind in that 16.5% range. So that would be the lowest level in the history of the company?

Shaw Hong

I cannot confirm whether you come with your model because our company of policy only keeps our guidance on the top line of EPS, but I will say that we are aware of the margin issue and we are doing everything we can to go through negotiations of vendors. And we also trying to work on the other markets and [tougher] markets (inaudible) as I mentioned earlier, we do have different margin profiles in these markets. So some of this mix will come through their opportunities for outside. And its just like Ray was talking about where they are the products that we are working hard to get into us well and some of them are indeed to (inaudible) be a tier-two but they have margin profile to a extend that they turn into designs and the customers not to build these designs, they will also help us as well.

Raji Gill - Needham & Company

And then my follow-up you saw a huge increase in 1.3 megapixel as a percentage of units. Ray you talked about 31.1% of units. So if I do the math that essentially means that the number of units of 1.3 in the July quarter versus the previous quarter was up like 150% almost doubled, and I am just wondering where that strength is coming from which end market primarily is it coming from the 1.3 megapixel?

Ray Cisneros

It’s actually an exciting time to be in the imaging business because what’s going on is the nature of the use of an HD type device and that is backing into just about any device out there in the world and obviously the biggest markets are the wireless devices and so honestly speaking I can’t tell you exactly what they are going to back into, we will have to wait and see to our end customers produce those devices on the [storage] shelves but the trend is there for everything to go to high definition 720p and then beyond that 1080p and its prevailing and it’s just not even wireless devices you could see in and obviously in the computers and you could see them even in automotive for that matter. So something that we all have to get used to but on the other hand OmniVision backs into this market with a pretty deep product portfolio for the HD segment, everything from an FSI to BSI-1 to BSI-2, so we are going to get use to this and we need to keep producing more of it and we will wait and see what our customers show us products.

Raji Gill - Needham & Company

And just a quick follow-up there 1.3-megapixel again are you saying that adoption on the frontend cameras for notebooks, frontend cameras for smartphones that are upgrading from VGA where are you seeing that?

Ray Cisneros

Right and it’s mix to be honest with you, every company has their own philosophical trend on how to use it, but there is a very strong space of the high definition camera being used for a video and if you can image video is everywhere you need to basically come online and talk to the other person on the other side of the connection whether it is a computer, whether it is a smartphone, whether it is a tablet and so that‘s sort of on a macro scale the trend of HD cameras, and so it’s a revolution going on quite fast.

Operator

Your next question comes from the line of Hans Mosesmann with Raymond James. Please proceed.

Brian Peterson - Raymond James

Hi, this is Brian Peterson stepping in for Hans. Just wanted to get some clarity on the inventory trends this quarter, it was all the build related to BSI-2 or we could see a little bit of a build related to some legacy products?

Shaw Hong

We have actually mixed, I would say though the vast majority of them indeed represented BSI-2 build that just got back into my earlier comment about how our Q2 shipment a lot that will be of BSI-2 based devices which then backs into my comment about how the high cost structure will pool down the average gross margin for the quarter as well. The FSI have devices of BSI-1, we do have ongoing business for those pixels as well.

Brian Peterson - Raymond James

And just lastly how do you get to with the inventory build? How do you get comfortable with customer inventory levels and what kind of visibility do you have there? Thanks.

Hasan Gadjali

We have sufficient visibility to the extend that we are willing to come up with current quarter guidance that helps and obviously there will be some volatility and true to end demand that all our customers they do have to come back with a build plan while back when we got the design wins and lot of times we have to build to those forecast that they give us those bill plans.

Whether or not, they'll all be shipped or there will be a shortage or would be excess, that's where the (inaudible) will come through. So at the end of the day, we do carry some inventory risks that we’ve been in the business for, that we are now 17 years. So some of that experience will come in to play when deciding how much and accepting what’s skews we have to order from our supply chain.

Operator

Your next question comes from the line of Betsy Van Hees with Wedbush Securities. Please proceed.

Betsy Van Hees - Wedbush Securities

I am sorry if I asked some things that have already been asked, we had a fire drill that went offline. If I missed something, I apologize. I am trying to understand just how high your revenues have to be to improve your cost and your supply chain because if you get to the midpoint of your guidance, it’s 372 million, which gets you up with a 42% quarter-over-quarter.

And what's mentioned in my earlier question about this is going to be record revenue for you. So how much revenue generation do you have to do to get some cost reductions in your supply chain and then I have a follow up question.

Anson Chan

Hi, Betsy, it’s Anson. It’s not an absolute dollar amount of purchase that our vendors are quoting or citing that we have to hit. It’s more an ongoing negotiation process. What we have already purchased in our inventory that represented a higher cost base inventory because our vendors will not have projected how much we will buy.

Now that we have indeed purchased $400 million of inventory on our hand, we do have a much better chance to get them to give us a price break. The degree of the price break will be largely dependent on how much more investment they want to amortize through the product sales or wafer sales to us and how much they are willing to concede and so that you know we all have a win-win situation between us and our suppliers.

It’s a fluid situation. It is almost impossible for me to say exactly at what milestone from the revenue’s perspective we need to hit and then you see a margin improvement. But as I have commented a little earlier, we do hope to see Q2 bottom out in terms of margin because there are negotiations happening currently.

The price break will affect inventory that we are purchasing now and which can be shipped in Q3. There are indeed product mix shift and how the market shift is happening for Q3 as well. So those can come to play in terms of gross margin. I hope that helps.

Betsy Van Hees - Wedbush Securities

And than in regards to your inventory in that question before that, so you mentioned that you built a lot of BSI-2 inventory, but you also have a lot of BSI-1, but if your customers are moving to BSI-2, what's going to happen to that BSI-1 inventory and what's the risk there in terms of having to write it down because you are not able to sell it because of your customer base moving to BSI-2. It seems rather high given the significant amount of inventory that you’ve already built for BSI-2.

Ray Cisneros

Let me, this is Ray Cisneros. I would like to make a few comments about how the inventory is broken up. I mean right now stepping into our current quarter fiscal Q2 we have a balance mix of BSI-2 BSI-1 and even FSI and all of that is basically backing in to customers that were fully engaged with active projects. Some of it like Anson described, is supply chain whip, there is a whip effect. You know you bring into business several months ago, you march into the design and you start building the plant together with your customer and then you have to make sure you are on top of the numbers on how each project goes with each customer and I can say I mean, I could confidently say that the BSI-1 and FSI is not a sort of the picture I think you may be are, you feel that is there some kind of risk there, there isn’t in the BSI-1 FSI. They are backed up by projects that we are currently active in moving product through.

Anson Chan

I will add little bit to that as well because if you think to how well look at the Q2 guidance compared to our on hand inventory, yes we are not indicating that we will completely [repeat] our inventory in Q2 that we do have a 12 to 14 weekly time and we do have to have carry some degree of safety stock before we can service our customer so they (inaudible) this level. So these things are what’s creating this, the way you put assumingly excess inventory go back to some of the earlier comments from two years ago.

We do have I think even in a very efficient throughput we need about 90 days inventory on hand anyway, so we do have to carry inventory. Now back to the second part of your question about potential indicators for inventory right off to extend that the seasonal demand continues to be strong, I think logically dictate that the chance was to have too much inventory that we cannot sell will be less.

We go to our inventory assessment at the end of every quarter on a skew-by-skew basis and we compared on hand inventory to generally 12 months demand. So if the 12 months forecast continues to be strong, the chance for us carrying too much inventory on hand for any particular skew would be less but of course there is no guarantee we have to go the assessment at the end of every quarter.

Betsy Van Hees - Wedbush Securities

And consecutive seasonality is October going to be your peak seasonality quarter now or and then January is going to be less so how is your seasonality working these days?

Anson Chan

It is going to be comparable, I can have Ray comment a bit as well and generally the second fiscal quarter we will be shipping out to customers that are building devices for the [holiday] season and they will continue on the third fiscal quarter for Asian market.

Ray Cisneros

I would like to say few comments about the seasonality. There is a big portion of the consumer world that starts building up material even as early as the summer months on the calendar year which backs into the late Q1 of our fiscal year and then we are right into the [pros] of it heavily and in our fiscal Q2 to build up for that Christmas season and then as you start marching towards the Far East, they build up a lot of product and business channels leading to the Chinese New Year. So you have to be prepared for that kind of business mix as well which backs into our fiscal Q3.

So we do have a spread of business and inventory material in sales through that we have to manage to through our tail end of Q1, Q2 and Q3.

Betsy Van Hees - Wedbush Securities

I think I have one last question. In terms of your guidance you mentioned the mobile phones and entertainment has been the growth drivers which is going to be, are they both going to grow the same or is mobile phones going to be bigger grew at a greater percent or entertainment in terms of if you could help us out with that?

Ray Cisneros

It’s again; it’s hard for us to predict exactly how it’s going to split up specifically because we don’t really know as we speak today what the products are going to back into for our customer products for the Christmas season.

Like I said, we do have strong mobile customers around the globe and then we have extremely strong customers as well in the entertainment segment around the world and those are our two biggest segments that are driving quite a bit of our revenues now. The notebook and computing segment, as I mentioned, is a little bit soft going forward but we're happy to always be engaged with those top customers and then it takes a step down from there for other revenues by markets but we do have some strength now in the automotive building up long-term.

So it’s sort of a broad answer to your question. I myself would love to know what exactly is going to show up on shows in a few months from now.

Operator

This now ends the Q&A session. So I will turn the call to Ms. McGowan for closing remarks. Please proceed.

Mary McGowan

Thank you all for joining us on this call and webcast. We anticipate holding our second quarter fiscal 2013 conference call on Thursday, November 29, 2012. Thank you and good day.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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