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Fairchild Semiconductor International Inc. (NASDAQ:FCS)

Q2 FY08 Earnings Call

July 17, 2008, 9:00 PM ET

Executives

Dan Janson - Vice President of Investor Relations

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Mark S. Thompson - Chairman, Chief Executive Officer and President

Analysts

Ross Seymore - Citigroup

Romit Shah - JPMorgan

Steve Smigie - Thomas Weisel Partners

Tristan Gerra - FBR Capital

John Pitzer - Miller Tabak

Deutsche Bank - Craig Ellis

Lehman Brothers - Shawn Webster

Raymond James - Kevin Cassidy

Robert W. Baird - Craig Berger

Credit Suisse - Brendan Furlong

Operator

Good day and welcome to the Fairchild Semiconductor Second Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Daniel Janson. Please go ahead, sir.

Dan Janson - Vice President of Investor Relations

Thanks. Good morning and thank you for dialing into Fairchild Semiconductor's second quarter of 2008 financial results conference call. With me today is Mark Thompson, Fairchild's President and CEO; and Mark Frey, our Executive Vice President and CFO.

Let me begin by mentioning that we're attending a few Investor Conferences this quarter, including the Pacific Crest Technology Leadership Forum in Vail, the Citigroup Tech Conference in New York and the Deutsche Bank Tech Conference in San Francisco. Please mark your calendar to attend our Analyst Day event, which is scheduled for September 25th in San Jose. Our management team will review the progress on the company's transition to a higher value analog and power management business. We will review our end markets, key new products and operations plans to drive higher margins. We'll also update our financial target model.

We will start today's call with Mark Frey, who will review our second quarter financial results and discuss our forward guidance for the third quarter of 2008. Mark Thompson will then discuss our product line results, end markets, and operational performance in more detail. Finally, we'll reserve time for questions and answers. This call is scheduled to last approximately 60 minutes and is being simultaneously webcast from the Investor Relations section of our website at fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days.

Now, Fairchild management will be making forward-looking statements in this conference call. These statements, including all statements about future results and performance are made based on assumptions and estimates that involve risk and uncertainty. Many factors could cause actual results to differ materially from those expressed in forward-looking statements. A discussion of these risk factors is provided in the quarterly and annual reports we filed with the SEC. In addition, during this call, we may refer to adjusted or other financial measures that are not prepared according to Generally Accepted Accounting Principles.

We use non-GAAP measures, because we believe they provide useful information about the operating performance of our businesses that should be considered by investors in conjunction with GAAP measures that we also provide. You can find a reconciliation of non-GAAP to comparable GAAP measures at the Investor Relations section of our website at investor.fairchildsemi.com. The website also contains 2008 Q2 fact sheet, an updated financial section with updated unaudited financial highlights, including detailed break-outs of segment and regional revenues, gross margins, EBIT and EBITDA.

Now I'll turn the discussion over to Mark Frey.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Thanks, Dan. Good morning and thank you for joining us. I'm sure most of you had a chance to read our earnings press release, so I'll just focus on the key points. For the second quarter of 2008, Fairchild reported sales of $418.7 million, up 3% sequentially and 2% higher than the second quarter of 2007. We also reduced channel inventory by nearly a week and internal inventory by five days during the quarter. Gross margin was down 160 basis points from the prior quarter, due to a greater than expected inventory drain, higher energy related costs and a slightly less favorable mix.

The higher sales allowed us to sell off more of the inventory that we produced when our factories were underloaded in Q1, and that had a negative impact on Q2 gross margins, but positions us for improvement in Q3. These factors were partially offset by greater new product sales.

R&D and SG&A expenses were $88.9 million, down $1 million from the prior quarter and better than our expectations due to continued cost discipline and a reduction in equity compensation expenses. We recorded an $11.3 million charge related to restructuring and asset impairments as we continue to streamline our cost structure. The majority of these charges were related to various asset impairments, including some non-industry standard packaging capacity and simplification of our supply chain planning systems.

We also adjusted the workforce mix in our main fab as we converted to a more automated and technologically advanced 8-inch wafer production process. Finally, we reduced headcount in certain sales and marketing activities in the U.S., to further streamline our SG&A costs. We expect these actions to save us about $7 million per year beginning with a partial impact in Q3 and full impact by Q1, 2009.

Net interest and other expenses were $6.3 million in the second quarter, which includes about $400,000 in non-recurring expenses related to the refinancing of our convertible bonds. Our adjusted effective tax rate was 13.3% in the quarter, which was higher than our GAAP tax rate because the calculation of the adjusted rate excludes certain discrete tax benefits that were included in our GAAP results.

Now I would like to review second quarter highlights of our sales and gross margin performance for each of our product groups. In our PCIA group, sales increased 8% from the prior quarter due to strong demand for our high voltage MOSFETs, IGBTs, SPMs, PWM controllers and power factor correction products.

Gross margin decreased 3 points sequentially due primarily to greater-than-expected sales, which cleared more of our high cost inventory build when factories were underloaded, plus limited pricing actions towards some high-voltage MOSFETs and ramp up costs related to our in-sourcing programs. Our MCQ [ph] group recorded a 3% sequential decrease in sales as we undershipped distributor sellthrough, resulting in about a one-week decrease in channel inventory.

Sales were also impacted by some limited pricing actions for MOSFETs, primarily in the Desktop PC segment and lower-than-expected micro-SerDes shipments. Gross margin was flat sequentially, which reflects our richer product mix offsetting the impact of selling off higher-cost inventory. Standard Product Group sales were up 5% and gross margin was down 80 basis points compared to the prior quarter due to inventory write-offs, lower factory loadings, as well as some pricing pressure.

Reviewing our balance sheet, we reduced internal inventories by $8.6 million resulting in about a five-day decrease from the prior quarter to less than 75 days. We continue to maintain one of the leanest inventory levels in the industry. DSOs decreased two days to 41 days. Cash and marketable securities decreased $28.8 million to $436.3 million in the second quarter, which reflected cash flow from operations of $83.4 million, capital spending of $57.9 million and the use of $50 million to reduce overall debt.

During the quarter, we successfully refinanced our $200 million in convertible debt by borrowing an additional $150 million under our existing senior credit facility and using $50 million in cash. This transaction went very smoothly and we were pleased with the significant level of oversubscription we received from investors.

Turning now to our forward guidance, we expect third quarter revenue to be up 2% to 5%. At the start of the quarter, we had more than 90% of the sales guidance booked and scheduled to ship. We expect gross margin to increase a 150 to 225 basis points sequentially as we benefit from higher factory loadings, better product mix and more assembly and test in-sourcing. We expect R&D and SG&A expenses to be approximately $89 million to $92 million and net interest and other expense to be about $5.5 million for the third quarter.

Now I will turn the call over to Mark Thomson.

Mark S. Thompson - Chairman, Chief Executive Officer and President

Thanks Mark. Fairchild delivered above seasonal sales growth in Q2 and we expect to do so again this quarter, as we gained share at a number of key customers with our higher valued analog and power management products. Our Q3 guidance reflects this acceleration in new product sales in addition to the normal seasonal strength in our served markets.

In addition to the solid top line performance, we expect to gain additional margin and earnings leveraged as the cost reductions from our package in-sourcing program and investments in advance silicon based technologies are reflected in second half results. In my remarks today, I'll review the demand environment for our major end markets as well as a number of the significant new products and design wins that are driving the sales growth.

End market demand was consistently strong during the quarter. We posted the highest order rates for our products that support computing, handset and power supply end markets. Our sales into the OEM channel were up 18% from a year ago, driven primarily by the new product sales and we expect this trend to continue into the second half of '08. We're focused on growing this OEM portion of our business by offering higher value analog and power management products coupled with a responsive global supply chain that can support the needs of these rapidly growing large customers.

In our distribution channel, sell through is up more than 3% sequentially in Q2, which resulted in nearly a one-week reduction in channel inventory, putting us around the midpoint of our target range. Overall product pricing was down between 1% to 2% sequentially which remains at a reasonable level. We held lead times in the stable 7 to 8 weeks during the quarter and expect to maintain this level during Q3. Factory utilization improved during the quarter as we adjusted starts to meet improving demand.

Turning now to our product line results. The PCIA group reported strong sales growth in the second quarter driven in part by greater new product sales for SPMs and power conversion products. We increased the shipments of our SPM products by more than 25% sequentially as we achieved another record sales for the quarter.

Our Suzhou facility made good progress increasing capacity for these products to support the strong customer demand. Customers are increasingly adopting our SPM solutions to simplify their transition to variable speed motors, which greatly improves energy efficiency, particularly in appliances. We continue to expand our market for these products as we increase our penetration into lighting, e-bikes and industrial applications in addition to our extensive product portfolio for motor control and appliances.

We recorded solid sales growth and a significant jump in bookings for our power conversion solutions used in a wide variety of power supply, battery charger and lighting applications. Fairchild is the largest supplier of advanced power conversion and power factor correction solutions in the world and we are benefiting from strong demand from customers seeking to improve their system efficiency. We also posted an 8% sequential increase in high voltage MOSFET and IGBT sales and even greater bookings due in part to new silicon based technologies that improve performance while reducing die size. We expect to ramp these new product over the next four to six quarters and we believe it will allow us to penetrate new sockets at high margins. In the MCQ group, we increased our sales into the analog solutions targeted to the handset and ultraportable market by 35% versus a year ago and expect this growth to continue during the second half of 2008.

Our fastest growing product line in this segment is our new high frequency voltage regulators. We grew sales of these high-performance voltage regulators significantly compared to the previous quarter as we increased our penetration at a key handset customer. We expect to increase sales for these products throughout the second half. We gained a number of design wins for our analog switches that we expect will drive significant sales growth in 2009 and 2010. Our USB switches continue to be a preferred solution for the top handset manufacturers as they move to standard Micro-USB connectors.

Sales for our latest video filters for set-top box applications continue to be strong as we benefit from the ongoing worldwide conversion to digital television. We posted robust bookings for our low voltage MOSFET solutions that are optimized for notebook PC applications and entered Q3 with a strong backlog position. In our standard product group, we recorded another record sales quarter for our innovative family of logic translators. Sales were up more than 60% sequentially as we extended our design wins and expanded our output.

Our strategy for FPG continues to be run the business for strong profitability and cash flow while augmenting sales with higher margin new products like logic translators. In summary, I believe the second half will mark a real inflexion point for Fairchild, with solid sales margin and earnings growth driven by new products. Our focus on growing our share at key large OEMs is also driving higher sales growth. We expect the investments we made over a year ago to reduce product costs, through greater assembly and test in-sourcing and develop new silicon based solutions will pay off in higher margins in Q3 in Q4. These actions are largely within our control and for this reason we feel confident in guiding for above seasonal sales and margin improvement for the third quarter.

Thanks, and back to you Dan.

Dan Janson - Vice President of Investor Relations

Thanks Mark, we'll now open the call to questions. I would ask that in order to allow more of you to ask questions, we limit each person to one question and one follow-up please, thanks. So, let's take the first question.

Question and Answer

Operator

Thank you. [Operator Instructions] Our first question today comes from Ross Seymore from Deutsche Bank.

Ross Seymore - Deutsche Bank

Hi, guys, and congrats on the strong results. Just wondering in the outlook, if you could give us a little bit of granularity by the three product segments you have and then maybe a little bit of end market color looking forward as opposed to the color you gave so far that was about the second quarter looking back?

Mark S. Thompson - Chairman, Chief Executive Officer and President

Okay, Ross. So, in terms of the granularity, the strength anticipated for the second half as reflected in our guidance for the third quarter is really pretty broadly based. If you look at the big chunks of things that are really driving the results, one is notebook computing, which is strong and we have a very good set of products, both power conversion products for adaptors, as well as regulations... board-level regulation for those. If you look at the SPM space, which goes into a wide variety of appliances, there is enormous conversions going on out there from standard AC solutions to DC motor solutions, and efficiency standards are flowing through those that's really driving SPM. And our content and penetration of handset has also been a big part of that. So, those would be the sort of the big three legs of the progress.

Ross Seymore - Deutsche Bank

Then I guess switching over to the gross margin side of things, it appears like there's a lot that's under your control with mix and cost cutting, how do those keep or slowdown in their impact as we head into the fourth quarter? Do we have the similar sort of benefits that are under your control or how should we generally think about gross margin there?

Mark S. Thompson - Chairman, Chief Executive Officer and President

Well, Ross, you are not going to trick me into guiding the fourth quarter. You're good but not that good. So we have a... there is really obviously two sets of things that work; a steady improvement in the quality of our mix and we have plans that prove [ph] that quality through this year and across 2009. Obviously, counterbalancing that... and we see those things as inside our ability to control. Clearly, everyone in the industry has been absorbing big costs in energy, it takes a lot of electricity to run a fab. We had big shipping surcharges. Gold has been very high. Metals and plastics in general have gotten very expensive. We are able to offset those. So, if they stay within some reasonable range, then we will more than be able to offset those going forward. But again, if you look at gold, it's been incredibly volatile, we buy a lot of it. And so that can either be a positive or a negative and will, for everyone, create a certain amount of extra challenge in predicting the out space because if gold goes to $1500 an ounce then it's going to be a different look than if it falls back to the $750.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

The in-sourcing loss will turn a ramp linearly through the middle of next year.

Ross Seymore - Deutsche Bank

Okay, great thank you.

Operator

Our next question will come from Craig Ellis from Citi.

Craig Ellis - Citigroup

Thank you. Nice job on the revenues guys. The first is a clarification, the comments on second quarter demand was that you had consistent strength, so I am trying to reconcile that with gross margin, which came in below the company's guidance. How do I put those two together?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Well, Craig as we shipped more than we originally planned, we depleted inventories. And the inventories are sort of on a FIFO basis. So the inventory that we build up was at Q1 costs and so the average cost per unit is higher. We flushed more of than out during Q2 and that leaves now a relatively more favorable unitized cost going into Q3. Then there was some more than expected pricing factors in our MOSFETs, some ramp-up costs in Suzhou for the in-sourcing. But most of the impact was really the velocity with which we roll those inventory costs.

Craig Ellis - Citigroup

And for the Suzhou impact, is that something that is behind you now or is that going to impact the third quarter's gross margins?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

That will also improve linearly, we've already seen improvements at the yield and the throughput level. And actually started in Q1 and had an impact on Q1, as we ramp production it impacted Q2, but we've seen that come under control.

Craig Ellis - Citigroup

Okay, so then my question would be, Mark is... Mark Frey, as we think about the 150 to 225 basis points of third quarter gross margin guidance, how does that really break out between utilization mix and the back-end in-sourcing that you are doing and what was the manufacturing utilization rate in 2Q and what do you expect it to be in 3Q?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Dan, why don't you handle the utilization and I'll do the gross margin.

Dan Janson - Vice President of Investor Relations

The utilization Craig was up slightly, in the second quarter and we think it will be fairly stable, maybe up a little bit more in the third quarter.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

And that kind of drives about half or even a little more than half of that margin. So, utilization is a little stronger but what you are really seeing is that the utilizations in Q2, which were stronger than or higher than Q1. Those parts actually end up as expenses in Q3 and that will drive the marginal improvement. And then we have the rest of it for mostly product mix improvements.

Craig Ellis - Citigroup

Okay. So in the past, the utilization has increased at about 2x the rate of gross margin when revenues are growing that... the magnitude that we are looking at as we move into the third quarter?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

I am not sure...

Dan Janson - Vice President of Investor Relations

I don't know that... I don't know that we would see that big an increase, Craig. I think... keep in mind that for the... from the peak to the trough of this life cycle, our sale is roaming down 5 or 6 points. So we aren't seeing the big swings in factory loadings that we've seen in years past, things run a little more stably now and that's reflected in our utilization.

Craig Ellis - Citigroup

Okay. Helpful color. Thanks guys.

Operator

And we will move onto Romit Shah from Lehman Brothers.

Romit Shah - Lehman Brothers

Great. Thanks for taking my question. Just a clarification on the Q3 guide, the less than 10% turns, is that lower than what you guys typically do in the quarter and are you... are you just factoring in the environment into the overall equation?

Mark S. Thompson - Chairman, Chief Executive Officer and President

No. Typically, we come in with setting guidance at around... assuming a 90% fill and... or 90% filled and scheduled at the beginning of the quarter. So that's a fairly normal posture for us to take.

Romit Shah - Lehman Brothers

Okay.

Mark S. Thompson - Chairman, Chief Executive Officer and President

And obviously, the low end of the guidance is set by some accounting for the uncertainties of the current economic environment.

Romit Shah - Lehman Brothers

Okay. And then just on operating cash flow Mark, I saw that it improved quite significantly in the quarter, were there any one-time items impacting operating cash flow and would you expect it to grow again in Q3?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Well, the biggest item... there are a couple of big items. The contribution from working capital was 29 million, that obviously can go in different directions. It certainly reflected the inventory controls and the reduction in our accounts receivable, but it also reflected about a $19 million increase in accounts payable, which is typical because we had our highest capital expense related to the in-sourcing. This quarter, it was $57.9 million, and a good bit of that is still sitting in accounts payable. So that will flip depending on the amount of capital investment in Q3 and we expect Q3 to continue at about that level, and then we think capital spending, depending on other programs, would level off or come down. If we deliver the results and continue the asset management, we certainly won't repeat an $83 million cash flow from operations, but I think we can keep it positive

Romit Shah - Lehman Brothers

Great. Thank you.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

And actually free cash, we can keep positive as well.

Romit Shah - Lehman Brothers

Right. Okay, great. Thanks.

Operator

[Operator Instructions]. We'll move onto Shawn Webster from JPMorgan.

Shawn Webster - JPMorgan

Yes, good morning. Thank you for taking my question. The restructuring charge, can you go into a little bit more detail on what that is in terms of the percentage breakdown between a asset impairment versus expectations for headcount reductions and maybe share with us your thoughts on how you think it will evolve in Q3 and Q4?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Sure, Shawn. From the $11.3 million, about 8... almost $8 million of it was for impairments, and they covered two general areas. One was the series of production equipment that was related to some customized packaging that we had developed and we are moving more towards standard packaging in some of those applications. We also improved our planning processes. Previously, it was a fairly complicated IT structure that required actually three engines to run it, and we could only run it about once a week. We streamed that partly because we've reduced and simplified our product line, but we've also simplified our planning processes, which allowed us to move to a single engine, which we can now run multiple times per week to improve overall scheduling. And I think you see that reflected in our improvements in cycle time over time. That required us to write off software that had been specifically written to allow the system to run on three engines. Then about $4 million or $3.5 million was related to headcount reductions. The biggest was in May and about 80 people, but we also reduced sales and marketing structures in the US by about ten people.

Shawn Webster - JPMorgan

Okay. And do you expect any charges in Q3 and Q4?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

We continue to look at opportunities to reduce spending and right now, we're particularly looking at some logistics ideas that would not be of the kind of magnitude we saw in Q2. But we... our approach particularly to below the line spending is to continue to improve it wherever we see opportunities, and you've seen we've done IT at some points, we've done sales and marketing, we've had some decreases in finance, and we don't really try to time them as one big event.

Shawn Webster - JPMorgan

Okay. Thank you. And the last question from me is on what percentage of your sales were to OEM customers and did you have a 10% customer this quarter?

Mark S. Thompson - Chairman, Chief Executive Officer and President

So, first, we do not have any 10% customers at this point and the exact percent to OEM was just under 40%.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Yes.

Mark S. Thompson - Chairman, Chief Executive Officer and President

39?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

In the... in the high 30s.

Mark S. Thompson - Chairman, Chief Executive Officer and President

Yes.

Shawn Webster - JPMorgan

Okay. Thank you very much.

Operator

[Operator Instructions]. And we'll go next to Steve Smigie from Raymond James.

Steve Smigie - Raymond James

Great. Thanks a lot and congratulations on the solid revenue here. I think maybe you talked a little bit about CapEx and you answered the cash flow question, but just looking at it, it was about 14% of revenue, I think you guys had said [inaudible] something closer to 8% of revenue, CapEx expending, is that investment, the in-sourcing or can you help me understand that spending and I’ll come back?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Yes. Our strategic goal is between 6% and 8% and we operated pretty much at the midpoint of that goal from '05 through '06. When we instituted the in-sourcing program, we guided that we would be in more of the 8% to 9% for a year or two and then get back into our strategic goal, which we believe is possible obviously if we have unexpected sales growth in certain areas that actually might drive higher, but we don't expect. We believe we can live within that range after we get the in-sourcing back up to about 65% of capacity.

Mark S. Thompson - Chairman, Chief Executive Officer and President

But maybe to add one more point to Mark's comment Steve is that the quarterly expenditures are not... they tend not to be linear. So, they are a bit lumpier and so there was a larger than average one in the second quarter and that's why the percent is the one that you see, but on the numbers that Mark put out would be what you... roughly what you would expect for the year.

Steve Smigie - Raymond James

Okay. That makes sense. On the Smart Power Modules, saw some pretty nice growth there, can you talk a little bit about the appliances, I know you’ve traditionally a lot of air conditioning stuff, is this more sort of a show up on refrigerators, stuff like that, and can you talk about more... in some more depth about some of the newer areas you are going after with those?

Mark S. Thompson - Chairman, Chief Executive Officer and President

Sure. So, there is a couple of pieces. So air conditioning continues to be a very strong area and continued conversion from sort of the old ways to the new. There are some very interesting things. So the proliferation of D.C. motors in some very… other places like HVAC and fans in general have been relatively slow to convert. And so something like a clean room fan can pay back inside... inside a 12 month. So we are just seeing application by application turnover, something as relatively mundane as a ceiling fan has hundreds of millions units that are sold every year and you have multiple benefits associated with converting to D.C. motors because the motor gets much smaller, reduces copper costs, easier to design, lighter, easier to hang from the ceiling, and we deliver turnkey solutions into those where you... typically your manufacturer doesn't have any ability to engineer with a D.C. motor. So those... it's a very broad, very relatively fragmented market, but huge end volumes.

Steve Smigie - Raymond James

Okay, thanks. And just a couple of housekeeping if I could. Could you give us some guidance on what the option expense will be in Q3 and what the tax rate will look like in Q3 and going forward tax rate?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Sure. The equity compensation expense will be slightly less than it was in Q2, but we expect them to stay kind of at the levels they are at now in the $5.5 million to $6 million range going forward. And the tax rate, again, that... that's something that varies quarter to quarter, but across the year, we view that as about on an adjusted basis 15%.

Steve Smigie - Raymond James

All right. Thanks a lot and congratulations.

Operator

Our next question today is Kevin Cassidy from Thomas Weisel Partners.

Kevin Cassidy - Thomas Weisel Partners

Good morning. Thanks. You mentioned special pricing on some MOSFETs, is there some additional ASP pressure in the market?

Mark S. Thompson - Chairman, Chief Executive Officer and President

So... I probably wouldn't generalize it as that. There were some specific places where we wanted to gain socket position for next-generation technologies, and we felt we could support the capacity, so we went after those sockets. So it was more of a targeted approach than a sort of general pricing ugliness, the pricing in aggregate was, I would say, right in the middle of average.

Kevin Cassidy - Thomas Weisel Partners

Can you say what that is, what is the average?

Mark S. Thompson - Chairman, Chief Executive Officer and President

It's 1% to 2%, and for the quarter, it was exactly in the middle of that at 1.5%, sequentially down.

Kevin Cassidy - Thomas Weisel Partners

Okay. How about turning to the channel inventory, do you expect that to continue to come down in the third quarter?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

That's... that's typically the pattern because of the computing demand that peaks at the POS level in Q3. So we saw that last year and that would be our typical seasonal model.

Kevin Cassidy - Thomas Weisel Partners

And what are the weeks of inventory in the channel right now?

Mark S. Thompson - Chairman, Chief Executive Officer and President

We were right in the middle of our 10 to 12 range, so in the 11-ish range.

Kevin Cassidy - Thomas Weisel Partners

Okay, thank you.

Operator

Our next question is from Tristan Gerra from Robert W. Baird.

Tristan Gerra - Robert W. Baird

Good morning. Looking at gross margin and trying to quantify the impact of various factors. How should we quantify the benefit of in-sourcing which you said would ramp linearity through mid of next year in terms of gross margin benefit with everything else equal? And also what material pricing impact of for Q3, you mentioned that was offset because of an increase in gross margin, how will we quantify this as well?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Okay, Tristan, now we’ve said in the past that our in-sourcing, our currently identified programs is about 1.5% impact on the company's margins obviously, in the areas where we are specifically in-sourcing is a much larger number. But to make it easier for people we've averaged it against the total company business. In terms of commodities, we view that as about 1 point to 1.5 point headwind that we've incurred so far. It really depends on what happens with gold and the speed with which we convert our designs from gold to copper. And so we feel, we've kind of mitigated that going forward, number one we're... we are sort of planning in the mid-900 range, which is baked into our guidance. And so unless gold falls north of that, we are probably okay. And now the last factor is currencies which most of them moved against us last year. But I'd say, so far this year in Malaysia, Korea and the Philippines, they've actually moved back a bit. You don't see the results in our operations because we hedge those currencies at least for near term result, but we should have some modest tail winds from that going into the second half.

Tristan Gerra - Robert W. Baird

Great and then a quick follow-up, there has been some stories around about Samsung potentially reducing inventories. What's your view on that and maybe generalizing the comment it was some other key customers in terms of their inventory report for the second half of the year?

Mark S. Thompson - Chairman, Chief Executive Officer and President

So I really couldn't even if I wanted to provide any specific color on our any particular customer. In general, people in the consumer space, whether you're talking handsets or computing, are constantly adjusting their build plans in response to the things that are selling versus the things that are not selling. So I think that all of our big OEMs in general maintain minimal inventory and have very sophisticated planning systems and allow their suppliers’ visibility into what it is that they want to buy. So the adjustments that they make are... they are really constant to build plans and that is one of the things that, again, we are focused very intensely on... Mark talked about the single planning engine before. So the moment we see a change in the build plan, we can... we see it prior to actual chain movement in the backlog and we blow it through our planning system. So those things are constantly ongoing and I think we've constructed a planning engine that does a pretty good job of keeping up with those so that we can move from one part number to a different part number as their build plans shift.

Tristan Gerra - Robert W. Baird

Right. Thank you.

Operator

And we will move onto Craig Berger from FBR Capital.

Craig Berger - FBR Capital

Hi, guys. Thanks for taking my question. So you said the in-house assembly tests will drive gross margins up by a 1.5, did you... on the restructuring piece, you said the $7 million a year of savings most of that is going to be in the COGS, is that the right way to think about that?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Yes, I would say about $5.5 million above the line and a $1.5 million below.

Craig Berger - FBR Capital

And so that is an annual savings number, right?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

[inaudible] basis points.

Craig Berger - FBR Capital

I see. Okay. Thanks for the clarification on that. And then did you say that your internal inventories were going to grow in the third quarter or what are they going to do?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

We're going to target them to stay about where they are now.

Craig Berger - FBR Capital

About flat?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Now we did that going into Q2 as well. So we were biased towards shrinking them, but we also have seasonal factors in some of our product lines, which generally cause us try to build inventories in some applications in Q2. And in other applications, we build inventories in Q3.

Craig Berger - FBR Capital

And on the – back to the gross margin, so 1.5 from the assembly tests, two or three points from the restructuring actions you just announced, that is 4 points. And so, we think about that as being incremental to the guidance you gave us for September?

Mark S. Thompson - Chairman, Chief Executive Officer and President

Craig 25 basis points for the restructure.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Not two to three.

Craig Berger - FBR Capital

Okay. Thank you.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

And everything in our horizon is baked into our guidance.

Craig Berger - FBR Capital

Okay. So basically a couple of points of gross margin opportunity expansion over the next few quarters from these results. What do you guys have in store to kind of get beyond that, or to close the gap versus your 37% target model? I know revenue growth is a part of that as well.

Mark S. Thompson - Chairman, Chief Executive Officer and President

Yes. There is a series of things. We continue to see that this wave of in-sourcing is not the last wave of in-sourcing that we will do. Again, we've tried... we are trying to do these things in a very orderly way and also not get too far ahead of ourselves in terms of our capital expenditures. So we certainly expect and are planning on another wave of in-sourcing activities for 2009. There is a very rich set of new products really across our key end markets that we'll be seeing rolling out across 2009. And again, we... as we've continued to simplify our business, we find opportunities to run it more efficiently, getting share and also reducing our cost, which a lot of the things like the planning engines wind up above the gross profit line. So, it's really a steady process where, again, on the part number side for example, we've gone over a three-year time from almost 50,000 part numbers down in the mid-teens for example. The piece volume, our ASPs have gone steadily up, that reduces our need for warehouse space. So there is a whole set of these things, each of which has a trigger point that we can then go back and find means for efficiencies, and we see no end in sight to that continued transformation.

Craig Berger - FBR Capital

Can you guys give us an update on the lowest 8% of your revenues, what is going on with that bucket?

Mark S. Thompson - Chairman, Chief Executive Officer and President

Could you please restate that? I want to make sure I answered your question...

Craig Berger - FBR Capital

Yes. I believe it's the Standard Products Group or the bottom 8% of your revenues, the lowest margin piece of your business, are you guys still keeping that maybe looking to solid... there is buyers out there, there are not buyers out there?

Mark S. Thompson - Chairman, Chief Executive Officer and President

There are definitely buyers out there. We are actively exploring and have been for the last couple of months, some potential to move slug [ph] at the low end as you call it come to a new more strategically appropriate home. We have a very clear picture of what the cash value of those businesses are to Fairchild and so the moment we have a transaction that delivers that or more to the company's balance sheet, then we will pull the trigger on those. So we are being quite active in exploring, there is interest in that space, and when we find the one that's above the hurdle we'll pull the trigger on it, and announce it at that time.

Craig Berger - FBR Capital

One more on the revenue growth stuff, you guys were talking about a lot of new products for next year, I know the semi industry has been a slower growing industry, it's been a tougher market [inaudible] point or two last year, you'll do the same this year. Should we expect faster revenue growth as a results of your new products next year. And if we don't see it, does that make you start to question your… whether your operating expenses are too high, and I just say that in light of the fact that you guys are spending $90 million a quarter now, you were spending $65 million a quarter back in '05.

Mark S. Thompson - Chairman, Chief Executive Officer and President

So, a couple of… couple of questions. So, the first simple answer is categorically we expect our growth rates to increase, both because the business reduction, so cutting off the low end of… is the end is inside for that. Putting significant new programs in place has a pretty long time constant [ph] it's easier to -- faster to shed revenue basically than it is to add it on. And so we also have definitely seen an acceleration in a number of key segments and we expect that to continue. So, again, it's all relative to what the market does. I also, and again, this is an original thought, that the space that we are targeting is, and will be the fastest growing space in the semi industry. Again, if you de-convolve the overall market, the impact of memory tends to swing the overall numbers a lot. Where as if you look at the sort of targeted analog plus discrete power management application specific ASICs and that sort of thing, it's expected to grow in the close to 10% per annum range over the next five years if you look at most of the views of the world and certainly our own insight into those is very consistent with that. Finally, on the OpEx piece, we've articulated pretty consistently that we want to migrate to a 20% of sales OpEx structure, which is quite lean for the quality of the business that we're targeting, and we're currently, for this quarter --

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Slightly over 21%.

Mark S. Thompson - Chairman, Chief Executive Officer and President

Slightly over 21%. So it's not a huge reach. When… if you look at our reported results, we have to be a little bit careful, because in 2005, we paid no incentives in any form in the company. So as a result, OpEx looks uncharacteristically low as a result of that.

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Nor did we expense equity.

Mark S. Thompson - Chairman, Chief Executive Officer and President

Right. So you have to make both of those corrections when you compare. In general, our OpEx structure has stayed constant as we've ramped R&D and taken down SG&A.

Craig Berger - FBR Capital

Thank you.

Dan Janson - Vice President of Investor Relations

Let's go ahead and move on to the next question.

Operator

And our next question comes from John Pitzer from Credit Suisse.

John Pitzer - Credit Suisse

Yeah. Good morning guys. Thanks for taking my questions. Just kind of curious, I think I thought you said that the low end of your guidance for September incorporates some conservatism around the macro. I guess in that, can you help me understand what you view as sort of normal seasonal going into the September quarter, because by our numbers, the low-end of your guidance is still above normal seasonal and I'm just kind of curious as what the offsets are? Is it low inventory, is it product cycles you expect to kick in the back half of the year? If you can get a little bit more detail, I'd appreciate it.

Mark S. Thompson - Chairman, Chief Executive Officer and President

So, if you average the last three years, it's about 2% sequential. But as we've commented in the past, we were a little bit about using history, because we've changed our operating model a lot. And so we've often seen swings that may not have been truly seasonal. If we look at the typical build plans for our biggest customers and the growing segments, the third quarter is a pretty strong quarter in terms of demand profile. And so there is some shifts. So if you look at the low-end as being a three-year average for us, but given the mix that we've got and the programs that we've won and the new accounts that we've added and the breadth in cellular and some other things, to say that we would expect to do average, it actually reflects quite a level of conservatism. So it's… the way to think about it is it averages 2%, the upside is a large set of well-defined orders on the book, new sockets and new products with the counter balance being the unknowable which is, to the extent to which the global markets may deteriorate. So, in terms of macro moving parts that’s the way to think about how we set the low end of guidance.

John Pitzer - Credit Suisse

I appreciate that guys. I guess my second question both you and the channel did a good job on the inventories in the June quarter. I apologize if I missed this, but any expectations you want to give out for September relative to either your balance sheet or what you think inventories would do in the channel in the September quarter?

Mark S. Thompson - Chairman, Chief Executive Officer and President

So, a couple of things is... roughly speaking, we are in very healthy shape. So, we don't have any over arching inventory goals. So the internal is right on target and the external is right in the middle of the range. And so to a large extent, we define ranges on those because there is a whole series of things that change opportunities that occur and it may move up a little bit and it may move down. And we wouldn't considered either of those to necessarily be events, I guess is what I would say. We've worked very hard to manage our inventories in a pretty tight range. Having said all that, the average for us in the third quarter over a couple of year period is to see channel inventories actually go down. And that's most heavily concentrated in computing and particularly heavily concentrated in notebook, which has quite a large third and then fourth quarter build. So, we do a certain amount of inventory staging in the first half of the year to try to smooth out production levels and so forth. So, inventory in those tends to be a bit high in the first-half and then get drawn down in the second half. So, again it's more likely to go down than up but I would say as we've done for the last ten quarters it will be maintained and controlled, which is a 11 plus or minus one weeks in the channel.

John Pitzer - Credit Suisse

And then my last question here, I understand the positive impact of mix going forward. I'm just kind of curious, I think you... cited energy cost as being one of the drags on margins in the June quarter. I'm kind of curious relative to the input costs and/or utilization levels, what the ASP outlook would be for the back half of the year. Are you… do you have the ability to raise pricing, either offset input costs or because cyclically utilization rates are at the level where you start to do that?

Mark S. Thompson - Chairman, Chief Executive Officer and President

So, I think the simple articulation I would make is that there is very... very little ability at this stage to raise prices in response to an energy cost or something like that, there is a pretty broad end market and pretty strong... a lot of the businesses is defined by contracts and such so... so again, it’s… if it softens a bit it's a benefit that we get and don't have to give back and if it gets worse, it's one that we have to eat.

John Pitzer - Credit Suisse

Great. Thanks guys.

Operator

And our next question is from Brendan Furlong from Miller Tabak.

Brendan Furlong - Miller Tabak

Good morning, guys. Thanks for taking my call. I just have one quick question related to the industrial end markets. A nice bump on a sequential basis. How sustainable do you expect that to be in the back half? I understand handsets and notebooks are going to be a nice growth market for you, but how sustainable do you think the industrial end market will be for you? And then kind of related question then on the PCIA gross margins, the majority of the margin increase in Q3 is going to come from the PCIA? Thank you.

Mark S. Thompson - Chairman, Chief Executive Officer and President

So a couple of things. We expect the industrial piece to be quite strong in the second half, again, driven sort of by two macros, is a great set of product portfolios that really have come together by the combination of our historic power conversion business, plus the acquisition of System General, that's going extremely well, and we are winning sockets for example, advanced lighting, there is a number of places that are growing very rapidly. Advanced lighting and some of the comments that I made earlier on conversion to D. C. motors, plus general drive for efficiency everywhere, is having those to be very, very attractive business and we expect growth to actually accelerate in the second half of the year in those places and then yes, we do expect particularly strong gross margin improvement in the PCIA space versus the second quarter.

Brendan Furlong - Miller Tabak

You can't quantify the... call it the 200 basis point movement for sake of argument, much [ph] of that is PCIA?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Well, I am not going to do that by segment, but all segments, we're looking at margin improvements, modest in FPG, the most in PCIA and MCQ is also pretty good, but less on a percentage basis in PCIA.

Brendan Furlong - Miller Tabak

Understood. And then I guess my last question. On the notebook side, Intel noting that low-end notebooks are growing particularly fast, does it make any difference to you guys low end versus high-end notebook?

Mark S. Thompson - Chairman, Chief Executive Officer and President

No. No.

Brendan Furlong - Miller Tabak

Thank you very much.

Dan Janson - Vice President of Investor Relations

Okay. Operator, we have time for one more question, please.

Operator

And that question will be a follow-up question from Craig Ellis from Citi.

Craig Ellis - Citigroup

Thanks. I'll try and make it quick. The questions are both for Mark Thomson. Mark, one, are acquisitions still on the table given the capital commitments to grow the packaging side of the manufacturing footprint? And secondly, we are all concerned about deceleration at a macro level, overall your business looks like it’s seeing solid order trends, but are you seeing any geographic pockets of weakness as you look around the globe?

Mark S. Thompson - Chairman, Chief Executive Officer and President

So... Craig, first on acquisitions, we absolutely remain what I'll call attitudinally acquisitive and it can so.

Craig Ellis - Citigroup

Good one.

Mark S. Thompson - Chairman, Chief Executive Officer and President

So Pete Groth who runs our business development has an… for example drove the System General acquisition. He looks at lots and lots of things and certainly there are a number of things out there that could make sense. And so we are actively kicking the tires any given time on several things. There is.. as we all know it’s a kind of an interesting market. Valuations are down quite a bit. On the other hand, nobody wants to accept their reduced valuation. And so, that's not hard to understand. So things look much more affordable than they were, but everybody thinks well, I will be back in six months time. So, it's an interesting market from that point of view. Clearly, in the cellular space for example, every single major handset manufacturer wants a tighter set of suppliers there. And so, there are a number of interesting opportunities for small companies that don't really have or they are too small to have a viable future in those markets that will need to become part of bigger entities. So, there is a number of strategic drivers that will definitely act to consolidate. We have one of our goals, obviously is to be one of those consolidators and we believe we have the financial wherewithal to go do that. Our recent debt event was very favorable, very heavily oversubscribed. So, we feel confident in our ability to raise money in the event of specific thing coming together to go do that. The second part of your question?

Mark S. Frey - Executive Vice President, Chief Financial Officer and Treasurer

Yes, the capital spending commitments. So Craig, we have been managing to lower our net debt over the course of the investments we have been making in in-sourcing. So, although we're spending slightly more than our targeted average, we still are staying ahead of that in cash flow. And these are the kind of investments that also have very quick paybacks. So, I view acquisitions as more of a strategic horizon and the paybacks on some of these programs is in the 1.5 year range.

Mark S. Thompson - Chairman, Chief Executive Officer and President

And then your question on the macro environment and what sort of structure we see to that, it's very difficult to divine any pattern. We've certainly tried and if we would take any of our large global OEMs, we have just no visibility into where when somebody makes a cell phone, who, is it a European or is it an American, is it a Chinese that buys that phone? We just don't have that visibility. And all of them are very, very global markets. And so, it's… again it's very difficult to divine any particular pattern to any softness that might exist.

Craig Ellis - Citigroup

Okay. So, overall you're not seeing any areas of weakness in the order book that would be related to some of the headwinds that we've seen, higher oil prices or some of the credit conditions in the U.S.?

Mark S. Thompson - Chairman, Chief Executive Officer and President

No, we have not

Craig Ellis - Citigroup

Okay. Thanks guys.

Mark S. Thompson - Chairman, Chief Executive Officer and President

Okay. Thanks.

Dan Janson - Vice President of Investor Relations

Thanks Craig.

Operator

And that is all the time we have for questions today. And that does conclude our conference call. We thank you for joining us today

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Source: Fairchild Semiconductor International, Inc. Q2 2008 Earnings Call Transcript
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