ON Semiconductor Corp Q2 2008 Earnings Call Transcript

Aug. 6.08 | About: ON Semiconductor (ON)

ON Semiconductor Corp (ONNN) Q2 2008 Earnings Call August 6, 2008 8:00 AM ET

Executives

Ken Rizvi - Director of IR

Keith Jackson - CEO

Donald Colvin - CFO

Analysts

Craig Ellis - Citi

Tristan Gerra - Robert W. Baird

Romit Shah - Lehman Brothers

Chris Danely - JPMorgan

Steve Smigie - Raymond James

John Pitzer - Credit Suisse

Ramesh Misra - Collins Stewart

Kevin Cassidy - Thomas Weisel Partners

Craig Berger - FBR Capital Markets

Patrick Wang - Wedbush Morgan

Suji De Silva - Kauffman Brothers

Auguste Richard - Piper Jaffray

Operator

Good morning my name is Cynthia and I will be your conference operator today. At this time, I would like to welcome everyone to the ON Semiconductor second quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session (Operator Instructions). Thank you.

I would now like to turn today's call to Ken Rizvi. Please go ahead, sir.

Ken Rizvi

Thank you, Cynthia. Good morning and thank you for joining ON Semiconductor second quarter 2008 conference call. I'm joined today by Keith Jackson our CEO and Donald Colvin our CFO.

This call is being webcast on the Investor Relations section of our website at www.onsemi.com and will be available for approximately 30 days following this conference call, along with our earnings release for the second quarter of 2008. The script for today's call is posted on the website and will be furnished via a Form 8-K filing.

Our earnings release and this presentation include certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable measures under GAAP are in our earnings release and posted separately on our website in the Investor Relations section. In the upcoming quarter, we'll present at the Morgan Stanley Conference on August 26th and the Citigroup Technology Conference on September 3rd.

During the course of this conference call, we'll make projections or other forward-looking statements regarding future events or the future financial performance of the company. The words “believe”, “estimate”, “anticipate”, “intend”, “expect”, “plan”, or similar expressions are intended to identify forward-looking statements. We wish to caution that such statements are subject to risks and uncertainties that could cause actual events or results to differ materially.

Important factors relating to our business, including factors that could cause actual results to differ materially from our forward-looking statements are described in our Form 10-K, Form 10-Qs and other filings with the SEC. The company assumes no obligation to update forward-looking statements to reflect actual results, changed assumptions or other factors.

Now, let's hear from Donald Colvin, our CFO, who will provide an overview of the second quarter 2008 results.

Donald Colvin

Thank you, Ken, and thanks to everyone who is joining us today. On Semiconductor Corporation today announced the total revenues in the second quarter of 2008 was a record $562.7 million, an increase of approximately 33% from the first quarter of 2008. During the second quarter of 2008, the company reported GAAP net income of $44.6 million or $0.11 per share on a fully diluted basis. Second quarter 2008 GAAP net income included net charges of $50.5 million or $0.12 per share on a fully diluted basis from special items. Second quarter 2008, non-GAAP net income was $95.1 million or $0.23 per share on a fully diluted basis.

On a mix adjusted basis, average selling prices in the second quarter of 2008 was down approximately 2% from the first quarter of 2008. The company's gross margin in the second quarter including special items was 34.1%. Non-GAAP gross margin in the second quarter of 2008 was 41.4%.

Well, we beat our revenue guidance for the second quarter. Our revenues were negatively impacted by approximately $2 million and cost of sales was reduced by approximately $5 million for a net gross margin benefit of approximately $3 million from the alignment of AMIS's into On Semiconductor accounting policies. This cost reclassification was due to ASIC development costs, which have been classified into operating expenses following On Semiconductor's accounting policies. As a result, our second quarter 2008 operating expenses were slightly higher than our May guidance by approximately $5 million.

Adjusted EBITDA for the second quarter of 2008 was a record $153.7 million. We exited the second quarter with cash and equivalent of approximately $321 million. At the end of the second quarter, total day sales outstanding were approximately 42 days. On Semiconductor, total inventory was approximately $328 million or 81 days. Included in the overall inventory is approximately $27 million of inventory associated with the write-off to fair value from a ration AMIS acquisition. Distribution inventories were down to approximately 10 weeks at the end of the second quarter. Cash capital expenditure during the second quarter were approximately $29 million.

Now, I would like to turn it over to Keith Jackson for additional comments on the business environment. Keith?

Keith Jackson

Thanks Don. Now for an overview on our end market. During the second quarter of 2008, our end market splits were as follows, computing represented approximately 23% of second quarter 2008 sales; automotive represented approximately 21% of second quarter sales; consumer electronics represented approximately 15% of sales; industrial, military and aerospace represented approximately 18% of sales. Medical represented approximately 4% of sales. Communication, which includes wireless and networking, represented approximately 19% of sales. Overall sequential sales growth in end-market splits were impacted by our recent acquisition of AMIS.

We did however see sequential strength in ON Semiconductor’s historical automotive, computing, wireless and industrial end markets. The strong sequential growth in the computing and wireless end markets was driven by continued penetration of our VCORE controllers with key computing OEMs and ODMs and increased penetration of our protection devices and audio amps with four of the industry’s five major wireless customers.

During the second quarter, on a direct billings basis, no ON Semiconductor product OEM customer represented more than 6% of sales. Our top five standalone product OEM customers were, Continental Automotive Systems, Delta, Hella, Motorola and Sony Ericsson.

On a geographic basis, excluding ON Semiconductor’s historical manufacturing services revenue, our contribution from sales in Asia represented approximately 57% of sales. Our sales in the Americas, approximately 22% of sales and Europe represented approximately 21% of sales during the quarter.

Looking across the channels, excluding ON Semiconductor’s historical manufacturing services revenues, sales to the distribution channel were approximately 37% of second quarter sales. Direct sales to OEMs represented approximately 52% of sales and the EMF channel represented approximately 11% of sales.

During the second quarter, ON Semiconductor revenues broken out by our divisions were as follows: the Custom and Foundry Products Group represented approximately 30% of second quarter sales, the Standard Products Group represented approximately 23% of sales, the Automotive and Power Regulation Group represented approximately 20% of sales, the Computing Products Group represented approximately 19% of sales and the Digital And Consumer Products Group represented approximately 8% of sales. We republished a quarterly revenue, gross margin and operating margin breakout of these divisions in our Form 10-Q filings for this quarterly period.

Now I'd like to provide you with some details of other progress we've made. In the second quarter of 2008 we achieved record quarterly revenues and adjusted EBITDA. The integration of AMIS and the CPU Voltage and Thermal Products Group from Analog Devices continues to move ahead positively. In addition to our recently closed acquisitions, we announced the signing of a definitive merger agreement to acquire Catalyst Semiconductor in an all-stock transaction. By leveraging ON Semiconductor’s world-class operational capabilities and supply chain, we believe these acquisitions will help enable ON Semiconductor to continue delivering increased value to our shareholders, customers and employees.

From a computing end-market perspective, our acquisition of Analog Devices, CPU Voltage and PC Thermal Monitoring business, significantly expanded our same opportunities and we are beginning to see the incremental revenue leveraged to our business. As the latest generation of notebook and desktop computers begin to ramp for the back-to-school and holiday season, we continue to see strong booking and backlog trends for efficient products and solutions for desktop and notebook computing.

Our beginning backlog for the computing end-market in the third quarter was strongly ahead of normal seasonality, driven by our continued penetration of key accounts with our controllers, audio amplifiers in MOSFET products. We believe the computing end-market represents the largest opportunity for sequential growth for the company. We believe we have the leadership position for desktop controllers and have set our sights on growing our share in the notebook controller market.

While many North American auto manufacturers struggled, our overall automotive business performed well in the second quarter of 2008. We continue to gain traction with wins in telematics and Infotainment applications and the AMIS acquisition strengthens and balances our position in the automotive market globally.

In the second quarter, we experienced strong automotive growth in China and Europe, which offset slower sales in North America. While the automotive design cycles can be very lengthy, we are beginning to see strong interest from leading automotive customers who now understand the value we deliver with our unique capability to offer a broad portfolio of products including motor control, sensor, MOSFETs discrete, basic and (inaudible) products.

The communications end-market, which includes the wireless end-market and the networking end-market, was fueled primarily by the growth of our wireless products. In particular, we saw strong penetration of our over voltage ESD protection devices during the second quarter and expect to see continued strength in these products in the third quarter. New design wins for MOSFETs, audio amps, filters and analog switches also remain strong.

In the recent launch of leading next generation multi-media smart phones, we average approximately $1 per device. In the consumer end-market, we are expecting to see sequential growth from gaming consoles as our customer ramp production for back-to-school and holidays. We currently have approximately $4 to $5 and $1 to $2 of content respectively on two of the three major gaming console platforms.

Our products and solutions continue to win awards within the industry. E-times magazine readers recently awarded our PureEdge low jitter clock management device with the Ultimate Product of the Quarter Award for its capabilities as a crystal oscillator clock module replacement. We also recently won the Green Power Product Award from a leading Chinese electronics magazine. A leading Chinese mobile phone manufacturer also awarded us Best Supplier Award for the second year in a row.

Now I would like to turn it back over to Donald for other comments and our forward-looking guidance. Donald.

Donald Colvin

Thank you, Keith. Third quarter 2008 outlook. Based upon product grouping trends, backlog levels, manufacturing services revenues and estimated turns levels, we anticipate that total revenues will be approximately $570 million to $585 million in the first quarter of 2008, an increase of approximately 1% to 4% from the second quarter of 2008. Backlog levels at the beginning of the third quarter of 2008 were up from backlog levels at the beginning of the second quarter of 2008 and represent over 90% of our anticipated third quarter revenues.

We expect net average selling prices in the third quarter will be down approximately 2% sequentially we expect cash capital expenditures of approximately 40 million in the third quarter and total cash capital expenditures for 2008 of approximately $120 million to $130 million.

For the third quarter, we expect GAAP gross margin of approximately 37.5 to 38.5. Our GAAP gross margin in the third quarter will be impacted from among other things, expensing of appraised inventory fair market value step up associated with acquisition of AMIS. We also expect non-GAAP gross margin of approximately 41.5% to 42.5%. Non-GAAP gross margin excludes special items of approximately $23 million.

For the third quarter, we also expect total GAAP operating expenses of approximately 150 million to 156 million, with GAAP SG&A expenses of approximately 12% of sales and GAAP R&D expenses of approximately 12% of sales. Our GAAP operating expenses include the amortization of intangibles, restructuring asset impairment and other charges which totaled approximately 2% of sales. We also expect total non-GAAP operating expenses of approximately $150 million to $156 million or approximately 23% of sales.

Non-GAAP operating expenses, exclude special items such as the amortization of intangibles, restructuring, asset impairments, stock-based compensation expense and other charges of approximately $20 million.

We anticipate that net interest expense and other expenses will be approximately $10 million for the third quarter of 2008 and cash taxes to be approximately $2 million. In the second quarter of 2008, we received a benefit to cash taxes from refunds and reduced cash payments, which improved second quarter non-GAAP earnings by approximately $3 million or approximately $0.01 per fully diluted share versus our main guidance.

As a reminder, we have over $800 million of net operating losses in the US, and expect our cash taxes to average approximately $3 to $4 million a quarter for the next two years.

Taking into account, the build-up of our global cash balances, overtime and potential cash repatriation presenting one time, we think this tax rate should be approximately 10%. Our current fully diluted share count is approximately $410 million shares based on stock prices below $10 which includes approximately $397 million of common stock and approximately $15 million shares related to options convertibles in our issuance.

Further details on share count and EPS calculations are provided regularly in our 10-Qs and Ks.

With that I would like to start the Q&A session

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Craig Ellis with Citi.

Craig Ellis - Citi

Congratulation. Keith can you just go into a little bit more detail in terms of where you think the company, is with respect to Notebook and Desktop market shares your transition over to Montevina?

Keith Jackson

So we have a very strong position, in the Desktop arena. I would say that, the dominant market share at this point. On the Notebooks as they go into the Montevina. We are expecting significant gains, we have had design wins with many of the leading Asian manufacturers there. So at this point, certainly not a majority share. Again, it is growing very rapidly in the late third quarter and fourth quarter as that starts to ramp.

Craig Ellis - Citi

Okay and then can you also just recap some of the milestones, that we should be looking at in the back half of the year, with respect to the AMI integration, and the manufacturing operations?

Keith Jackson

Okay, we will continue obviously in progress if you will in integration. We did get an early start, if you will from a savings prospective moving very quickly. The rate of change will not accelerate in the second half. Again, we are expecting to be, in that leading the year in that $50 million a year range of synergies.

The bulk of the activities, frankly from a manufacturing prospective the next crunch of all of that, again I will remind you is in fact three close downs, which will be ongoing through 2009.

Craig Ellis - Citi

Okay. Then switching over to Don. Don at the Analyst Day, you talked about a target gross margin model of around 45%. Obviously, we have got an uncertain backdrop. However, the company seems to be tracking well towards that. Can you talk about your confidence in hitting that by the end of next year?

Donald Colvin

Craig, good morning everything we said at the Analyst Day still stands remember it was 45% gross margin, something like that 22% or so operating income. What we have been very public on starting in the first quarter of this year; we were faced with some very serious economic headwinds, currency depreciations of unparallel nature, big inflation in commodity costs, like oil. All that has now been absorbed in our business model and I think we have been very local and public in saying that cost us a lot something in the 300 basis points of margin.

When I look into the second half, Craig, I do not see the same headwinds. So, included in our second quarter actuals is the absorption of these headwinds. So, there is no relief from that. The currencies are now moving slightly positively and as we all know, oil is heading in the right direction as are commodity prices. So, we do not have these headwinds and we can now go back to working on our business ourselves.

Obviously there are some macroeconomic issues. However, we still maintain about 45% gross margin and a 22% operating income is the targets that we are marching towards and we are now happy that we do not have that horrible economic depreciating currency, high inflation and commodity that is absorbed and we can now look forward to working on it and growing our revenues to make it happen.

Craig Ellis - Citi

Thanks you. I will turn back into queue.

Operator

Your next question comes from Tristan Gerra with Robert W. Baird.

Tristan Gerra - Robert W. Baird

I think you mentioned on the call that DCP sales were about 37% which will be I think a five year low for you at least. Could you talk about the dynamics there and particularly relative to the previous quarter and compare that with the activities at OEMs?

Donald Colvin

Sure. So, actually our DCP sales continued nice sequential growth and that is varied a little bit in the percentages. The difference is our AMIS business is largely OME in fact majority of it is its very little distribution business. So, our mix has changed as an overall company. So, it is really not reflective of slowing DCP presence quite the contrary. However, it does reflect the new mix of the company with the predominantly OEM basis from AMIS.

Tristan Gerra - Robert W. Baird

Okay. What will be the expectation of utilization rates at Gresham let's say in Q1 of next year, when your foundry business potentially went down and also do you have any comment regarding potential migration to Gresham from outsourced manufacturing in the second half?

Keith Jackson

So, we actually would not expect to see any decrease in Gresham utilization as the LSI contracts expire, going into next year, we are offsetting all of those decreases with ON Semiconductor manufacturing growth. So, I would expect utilization rates in Q1 to be equal or greater than where we headed here in Q4, which is up from Q2 and Q3. Relative to other things coming in we are now qualified with several of our high running devices from outside foundries and that ramp is underway from outside foundries. That ramp is under way and so again it will continue on a quarterly basis going forward. So, I think, the message is pretty much what we have been giving you all along nice continued ramp of the internal products offsetting any drop in the LSI.

Tristan Gerra - Robert W. Baird

Okay, great. Then just a quick last one, given the ramp that you talked about in notebooks what is your expectation, in terms of notebook as a percent of DC revenues by year end?

Keith Jackson

I do not have an exact number Tristan. My guess is that our mix will move from a very dominant position say 80% plus desktop to something in the 70% desktop range possibly little less than the 65%. However, it will still be a moving target by the fourth quarter. Its really '09 I think, when you will get the bigger change.

Tristan Gerra - Robert W. Baird

Great, thank you.

Operator

Your next question comes from Romit Shah with Lehman Brothers.

Romit Shah - Lehman Brothers

Good quarter. Would you provide a breakdown of the revenues by the core ON foundry in EMI?

Donald Colvin

Sure. I think what we stated is EMI rating is run something like $155 million and foundry business runs about $13 million.

Romit Shah - Lehman Brothers

Okay. Don, do you expect the LSI foundry revenue to go to zero starting next year?

Donald Colvin

No. I do not think we have had a great working relationship with LSI and we did anticipate that business will go down. It is certainly will not go to zero and we are very happy to continue to support them. That is still a meaningful level per quarter. The business is on a plateau for this year running in approximately $10 million per quarter range and I can not emphasize the point that Keith made that we are doing other things and the other business that is ramping the integration. Next year, we expect our $10 million to go down to a number that is probably more than a mid single-digits but I do not have much more information on that. However, we will continue to supply as I am sure for several years and we will be very happy with the relationship there.

Romit Shah - Lehman Brothers

Okay. If I could lastly on the cash balance, it looks like your cash balance could improve quite significantly in the second half. Is it conceivable that the cash balance could be north of 500 million exiting the year and can you talk about some of the priorities at this valuation?

Donald Colvin

$500 million is maybe a little bit of a stretch, but when you can turn in $150 million or so EBITDA. You take off $40 million for CapEx and maybe another $10 million for interest expense, you can generate $70 million to $80 million per quarter. So two things, that $150 million plus $330 million is $480 million. I think between $450 million and $500 million rather than north of $500 million for the year end, is something that will strike a reasonable basis, but as you know we do not give forecasts. However, I mean everyone can calculate from an EBITDA perspective what cash we generate.

The use of our cash we are still debating and I think we have clearly stated that these are uncertain macroeconomic times. So we are a little bit more conservative because you do not really have access to many alternative sources of financing once you have spent your cash, but we have been warming to the idea of paying out some of the bank debt and that certainly would be accretive from an earnings perspective and also give us from a corporate finance perspective a lot more flexibility, and however to consider as a shareholder friendly actions like dividend.

So, these are the things we are studying. Also we continue to have a share buyback program. However, when talking to investors, they will try to gain a feedback we have had over the last several months has been more than telling us to look more in the debt pay down area rather than aggressively pursue share buybacks. So, these are the things we are thinking about. Board decision has been made and we continue to have an active discussion with our Board on these matters.

Romit Shah - Lehman Brothers

Thank you.

Operator

Your next question comes from Chris Danely with J.P. Morgan.

Chris Danely - JPMorgan

Thank you. Hey Donald, can you talk about your GAAP gross margin trends for the next few quarters, as some of these charges start to roll off?

Donald Colvin

Sure, but it is very complex. I must simulate our old inventory when we work over this. Remember that the step up of inventory, that is the biggest delta between our GAAP and non-GAAP, Chris. However, we do expect to see just like I showed on the non-GAAP, we do expect to see the GAAP improving; indeed it will improve even more as we go forward. If you look at the trends, certainly we should be comfortably in the 40s, in the 41% type range as we roll of the step up in inventory.

Again, it is difficult for me to be more specific because I do not have a perfect algorithm to tell me when this inventory step up will finally roll off. Hopefully at the end of the third quarter we will have expensed most of it and the difference between GAAP and non-GAAP will be the non-cash based stock and that we will be we will update at next quarter’s earnings, something that will allow us to get a better handle on that. So, I apologize for this, just one of these complexities that we are faced with when you do an acquisition.

Chris Danely - JPMorgan

Sure. The inventory should be definitely gone by Q1 of '09?

Donald Colvin

I think it is like nuclear waste. I think that we are long half way, so how we can be surprised that we still got some buy, in the middle of next year. It is just the nature of things but it will start to become immaterial by the first quarter of ’09 interest.

Chris Danely - JPMorgan

Great. How about options expensed, they are trending up. Did you think it, or do you expect it to continue to trend up or will it flat out at certain level?

Donald Colvin

Excellent question. We have a relatively modest expense, but it has increased and we put in place seven programs to identify certain actions to facilitate the integration of EMI, and that has resulted in a temporary increase in non-cash based stock compensation. So we see a one-off bump in Q3 and from then on it will go down in Q4, and we do not see any other major catalyst to drive it out.

So, we came in about $8 million of expense in the second quarter. Probably rise to something like $11 million in the third and it will bog down to something like $9 million in the fourth. So, it is probably a little bit negatively impacted by the large amount of activity, the key is related to the EMI integration. Indeed I have just have won a site that right now we have a lot of efforts going on and hundreds of people in the company working on this integration so that something that is something that is negatively impacting our cost until we get a harmonized fusion over IT systems plan for the first quarter of next year.

Chris Danely - JPMorgan

Believe me, I know all that integration over here, last question can you or Keith just comment on your overall thoughts on end markets out there in the general semiconductor environment?

Keith Jackson

Sure. You know, we continue to see pretty good PC environment driven by ever more affordable low-end models which from our perspective drives more units and that is a pretty significant thing for us. It is really a unit based economy that we have got in the consumer room. Handsets again continue to look stronger as we get into the third quarter and of course the gaming boxes are going to be much stronger as we get into the third quarter versus the second.

So those three areas continuing very strong, automotive, our content continues to go up and we have performed quiet well, we do think the end markets will continue to see more softening on a global basis, but again the wild card there is the rate of change on the content that we have got, you know from our perspective there, I think from a company perspective we will continue to see some pretty good performance. Market wise we are expecting more softening.

Chris Danely - JPMorgan

Great, thank you.

Keith Jackson

Okay.

Operator

Your next question comes from Steve Smigie with Raymond James.

Steve Smigie - Raymond James

Great, thank you. On your comments about your dominant position on the Desktop core power regulation, is that, by that do you mean you think you have more shares in the second largest percentage or you have over 51%?

Keith Jackson

Yes no, its just larger share.

Steve Smigie - Raymond James

Okay.

Keith Jackson

I am not giving any specific percentages, but we do think we are the larger share there at this point.

Steve Smigie - Raymond James

How do you measure? You simply look at your unit shift based on the overall industry stock.

Keith Jackson

Yes.

Steve Smigie - Raymond James

Alright and then any comments on, what you think about position of core power?

Keith Jackson

I mean, we got a pretty reasonable position there. Again, everything we have got from design a win prospective says, we will be picking up share, in all of the active platforms.

Steve Smigie - Raymond James

Okay and then lastly just on the strong computing, outlook that you have is that most of the fact all the share that you have been capturing. You also mentioned that the smaller less expensive units taking off. How of much if it is that versus maybe some seasonal trends are you seeing, basically seasonal demand? Or is it just..

Keith Jackson

Yes, no we are seeing much stronger than seasonal, Steve, and that is where we are basing the share gains on. Certainly, computing has been strong this year. I think it will remain strong in the third quarter. However, the trends we are seeing there are much stronger than seasonal.

Steve Smigie - Raymond James

Congratulations on the nice numbers.

Keith Jackson

Okay, thanks.

Operator

Your next question comes from John Pitzer with Credit Suisse.

John Pitzer - Credit Suisse

Yes, good morning. Congratulations. I have a couple of questions. Donald first, 90% booked for the September quarter, what is the usual backlog coverage going into the quarter? How does that compare?

Donald Colvin

With previous regard, like three elements in there, you have got your AMI business. You have got your manufacturing services, you have got your core on. Which is the historical business including the ADI I know, and so I think it is fair to see core on is actually very strong. It is actually higher than we had in previous quarters. So, and the AMI business there is still some terms there that not actually performing well and then the manufacturing services is usually 100% also covered. So, I would say that, looking at all the different elements. It is actually stronger, than we would normally expect.

John Pitzer - Credit Suisse

Then would you just… I just want to understand…

Donald Colvin

On the other hand, these are times when some things can change, and so it is comforting. I would not read anything special into that. It is just that maybe customers have been a bit slow in placing orders, and place more orders a bit later or whatever. So I would not see that as a pre-castor of any fantastic news. I just think it is just an observation that is all.

John Pitzer - Credit Suisse

Then, Keith, just to get some clarification on your PC comments, you know, the area of biggest sequential growth in the September quarter. It sounds like that is more Desktop related than Notebook, and that the Montevina is really a late Q3, going into Q4 then for you?

Keith Jackson

I think that is true. I mean, obviously, there are some ramps, but we are seeing the major volumes trending later in the quarter on the Montevina rather than earlier.

John Pitzer - Credit Suisse

Relative to the trade-off between Desktop and Notebook for either dollar content or margins, and then, conversely, if PCs continue to be the growth drivers, PCs grows the percent of the overall business, is there a mix improvement or a margin improvement because of that?

Keith Jackson

We do have little better margins on the notebook side, although our Desktop margins again are at or above corporate averages. So there're certainly no negatives with increased desktop business. So yes, the mix going to notebooks will improve the overall numbers, but we do not degrade corporate performance with increased Desktop.

John Pitzer - Credit Suisse

PC strong handsets sound like they are picking up in September. Where are the offset? Is it more the industrial type end markets where second half normally slows or what is showing up sequentially down there?

Keith Jackson

Yes. We are expecting to see as I mentioned earlier a little deceleration in the automotive market and again I can not qualify that completely on a company basis because our content has been going out, but market vise we definitely are expecting more than seasonal slowing in automotive. They do seasonally slow in the third quarter, as they do model changeovers. However, we think this will be more than seasonal on the global basis this year. I would say that is one of the biggest negative headwinds.

John Pitzer - Credit Suisse

Donald as you look at these charges coming over the next few quarters are these predominantly non-cash charges or are there any cash charges that are lingering out there?

Donald Colvin

Mainly, things like step up in inventory and obviously non-cash based stock, amortization of intangibles, these are all non-cash and we spell these out into much detail. We published our Q2 this morning as well. So, you get full visibility. There is some residual tax charges, but these are mainly in a low single digit millions and our anticipation is that we do not see any big cash charges above the current level for the next few quarters.

John Pitzer - Credit Suisse

Perfect. Thank you. Congratulations.

Operator

Your next question comes from Ramesh Misra with Collins Stewart.

Ramesh Misra - Collins Stewart

Good morning. First question is in regards to your utilization level at Gresham and what are the near-term trends over there?

Keith Jackson

Again we are continuing to trend upwards. We are still left in 50% at this point but expect to be crossing over that in the near future. However, they are continuing to trend up I would say on a sequential basis something like a percent or two here in the third quarter and fourth quarter and then accelerating, as you get into '09.

Ramesh Misra - Collins Stewart

Okay. In regards to your non-GAAP gross margin improvement last quarter. Can you give us a sense of where that improvement came from? How much of it was organic? How much was it from ADI or EMI?

Keith Jackson

I think we again, we spell that we got benefits from the EMI gross margin, which is as we know much higher than ON's. They are doing custom ASIC and they enjoy much higher gross margins. We also got an unexpected benefit, which we spelled out due to the reclassification of some of their costs because they harmonized our accounting policies. So, I think it came in roughly in line with what we thought and we got a little uplift from reclassification. So, that is now all incorporated in our model and also last quarter, we still had some currency negatives and cost negatives, which we also incorporated in our model.

So, right now that looks like its stable. No more reclassification, currency and costs will be stabilizing and so the main driver as we go forward is just the top line growth and mix changes. Hopefully we can get a much cleaner perspective on a go forward basis and we will try our best to simplify that. Hopefully, we will not have the same as I said to Chris only the same amortization or the step up of inventory going into the fourth quarter and we will have a cleaner outlook and much closer GAAP and non-GAAP gross margin guidance when we go into the fourth quarter at the end of this quarter.

Ramesh Misra - Collins Stewart

Great. In regards to your Catalyst acquisition, one, I wanted to ask you about your commentary about it being EPS positive in about a year even though Catalyst has been profitable? Lastly, what were some of the reasons that drove you to acquire Catalyst?

Donald Colvin

Well, we obviously the deal was not done so we do not want to comment too much, but it just fits with an overall portfolio expansion. We have purchased two businesses recently and sure to say that we are very happy with how they have performed and they have been very accretive to our market penetration and the results if you, the last comment even on gross margin shows. We see this business as being another one that can integrate well into our infrastructure.

We would rather not comment too much on the specifics because the deal goal is still anticipated to close at the beginning of the fourth quarter. So, and from that experience we know that we can get some traction on revenue and we can save our cost particularly on the backend and the front end cost and a lot of their products will fit into the factories in general and Gresham in particular. I do not know, if you want to add anything, Keith?

Keith Jackson

No, I think that is very true. I will let you again look at some of the earnings side relative to ON is going to breakeven certainly you need to comprehend the cash impact for the company as well. So, net-net we do not want to comment more at this time, but we do think it will be very similar to the add-in models we did with our power business from ADI.

Donald Colvin

I think the key thing as well is we are not talking about anything like the same size of acquisitions as AMI. I mean, you are talking about a much, much smaller as that represents in the 2% of enterprise value for ON. May not a great thing but it is not a huge acquisition for ON. It does not take much to get those earnings neutral and stock to become positive.

Ramesh Misra - Collins Stewart

Understood. In regards to pricing, can you give some qualitative commentary as to what segments were worse or better overall?

Keith Jackson

No. There is not a lot of difference between the segments. There is enormous pressure on all of our customers and on us as you know with increasing inflation and currency movements. The pressure has been steady. It is not unreasonable. It has been flat at the 2% per quarter range for sometime now. So I would say there is no real delta vectors that we have seen yet. Frankly, there is no sector that is immune and no sector that is worse than the others.

Ramesh Misra - Collins Stewart

Okay, great. Thanks very much.

Operator

Your next question comes from Kevin Cassidy with Thomas Weisel Partners.

Kevin Cassidy - Thomas Weisel Partners

Thank you. The inventory dropped again this quarter. I wonder if you could comment on that and compare that to your lead times.

Keith Jackson

Yes. So our lead times have moved up a little bit but they are still well inside our targeted range if you will of less than ten weeks. We are seeing a little stretching. We usually do see a little stretching going into the third quarter, which tends to be a little more active, if you look at total units shipped. We are a bit leaner in the industry channel than we normally would be in the second quarter.

That is reflective of the distribution model now getting more sensitive to inventories, and they are doing a little better planning job. It is also represented the fact that, quite frankly what we have managed that a lot tighter. So, simple answer is, we are a lot leaner. I think it benefits the overall model and it is not dramatically distorted our lead time picture.

Kevin Cassidy - Thomas Weisel Partners

Okay. You have no concerns of not being able to react to a market uptick?

Keith Jackson

I have no concerns of that at all. I would welcome a market uptick to challenge us.

Kevin Cassidy - Thomas Weisel Partners

Okay, thank you

Operator

(Operator Instructions) Your next question comes from Craig Berger with FBR Capital Markets.

Craig Berger - FBR Capital Markets

Hello. Nice job. Thanks for taking the questions. Can you just remind us with your new company profile, what is your typical 4Q seasonality look like?

Keith Jackson

I do not know that I am going to be able exactly give you a number, but, we typically have been flattish. The acquisitions we made appear to be flattish. So, again we give guidance one quarter at a time Craig. However, I do not have any reason to believe the profile has changed dramatically.

Craig Berger - FBR Capital Markets

Okay. When does the ADI business get brought in-house?

Keith Jackson

Okay. So it is being brought in-house right now. Much of the assembly test is now inside our factories, going into Q3. From a wafer fab perspective, again, we pretty much purchased the ‘08 wafers we need from our agreement with ADI and it will be beginning of '09 that you will see the ramp in the ON supply chain.

Craig Berger - FBR Capital Markets

So that is going to drive the utilization boost aggression in the first quarter?

Keith Jackson

Yes it will help, I do not know how much in the first quarter, because again I do not know all the inventory profiles that we have got there that have to be burned off, but certainly by the second quarter.

Craig Berger - FBR Capital Markets

With respect to operating expenses, should we be thinking about the other cost opportunities from your Q3 guidance level? Should we be thinking flat up or down as we move through time?

Keith Jackson

I think I had given some comments on that. As we move through time, we do not expect it to increase and we have got some additional cost now related with the integration and we will have to bring in consultants in the fusion of our IT systems. These costs will go down. So we have given our model, our long-term model, which is 22%. Obviously, its a function of the revenue. However, that is a model we are working for.

We are running higher than that now. We have not added in the OpEx. It is just that there has been certain. As I am in the current season, the second quarter did not help. The reclassification helped the gross margin but increased our OpEx. So we are just digesting these things, so you should not expect it to rise as a percent and we will work to get it down to the targets that we exposed at the Analyst Day.

Craig Berger - FBR Capital Markets

How much is the quarterly run rate on those incremental system spends?

Donald Colvin

I do not think when looking at and these are just approximate numbers, probably brought $2 million, $3 million.

Craig Berger - FBR Capital Markets

Can you talk about share buyback; where are you, what are your plans?

Donald Colvin

I have mentioned, talking to investors and I mean we try to listen and we get very positive feedback, that is not as top priority retailers and they encourage us to look more on debt reduction and consider things like dividends, and that is where our actions are. We have made no definitive restating decision and we will obviously listen to what investors tell us and discuss with the Board, but that is the direction. I would say, Ken and I had some very frank inputs from investors and they were certainly winning more towards pay down of debt and de-leveraging the balance sheet and consider instituting a dividend and encouraging us to, look in that area, rather than aggressively pursue a share buy back.

Craig Berger - FBR Capital Markets

Last question, can you just remind us about your plans to close or consolidate facilities. How many facilities over the next say year and what?

Donald Colvin

We continue to do that and we invoke that at the Analyst Day and so a part of that was the ramp in Gresham. We are saving cost by rationalizing our subscale facilities. We closed the facility, last week here in Phoenix Com 1, which we have had for 20 years and so these are long but painful exercises. We have a facility that we purchased with AMI Fab 9 and we have already announced that will be consolidated into Fab 10 at the end of next year and we have also announced that our Piestany facility will close at the end of next year.

So, we have an active program of site rationalization. As we ramp all of our activities and Gresham and move our R&D activities mainly towards Gresham. So all these things are continuing and we'll get the benefits of these, as we outlined in the Analyst Day.

Operator

Your next question comes from Patrick Wang with Wedbush Morgan.

Patrick Wang - Wedbush Morgan

Good morning. Just a quick question on the Fab 9 consolidation into Fab 10, when is that supposed to happen?

Donald Colvin

So, Fab 9 we are targeting to close by the end of next year. And so, it isn't one of these things, where everything runs fine and then it just disappears one day. There is a ramp in cut over plan. So, we'll see savings in advance of that, but before closure into '09.

Patrick Wang - Wedbush Morgan

Ball park any cost savings on that?

Donald Colvin

I think every time you close the facility what happens is because you get some savings upfront and then we are usually talking in the $2 million or $3 million range per quarter for a small facility like the Fab 9 and something all in 4ish per quarter range for a bigger facility like Piestany.

Craig Berger - FBR Capital Markets

I think last quarter you were talking about target inventory to be under 85 days this quarter I think you are just ahead of that. Is that just a function of the shift in inventories I mean just to your balance sheet?

Donald Colvin

No, actually, not at all. I mean, basically, again we are controlling inventory down and the 81 days we talked about earlier includes all of the inventory write up. So we are actually running quite a bit leaner than we were in the second quarter on an apples-to-apples basis the way in AMI is similar. We only have revenue on a sell-through basis, and so we do not have any on balance sheet actions with this team.

So you have got to look at our end tunnel inventory which Keith mentioned and I think there we, on an apples-for-apples basis, we reduced it. Also, what is interesting is that of distribution inventory, we issued a separate measure because it is on their balance sheet, was just over 10 weeks. This is touching its all time lows, and that is something that puts us in a very good revenue position because they have not built up a lot of inventory in the third quarter.

Operator

Your next question comes from Suji De Silva with Kauffman Brothers.

Suji De Silva - Kauffman Brothers

Good morning, Keith and Don. Good job in the quarter. So, in terms of the linearity of the orders, can you talk about the orders placed on you, as you saw through into 3Q and then into 4Q, whether they were as expected or were there any trends you saw?

Donald Colvin

Yes, there is no they are as expected. They are pretty difficult for our 3Qs, and relatively linear.

Suji De Silva - Kauffman Brothers

Flowing into 4Q, it is progressing as expected as well?

Donald Colvin

Right now 4Q is projecting as expected.

Suji De Silva - Kauffman Brothers

Great. And then on gross margins, Don, perhaps, do you expect a steady track towards the target if revenue holds up or is there some inflection point given some of the restructuring that is the way you are doing?

Donald Colvin

I do not think that nothing is ever steady in this business. You can think one quarter at a time and a quarter is a history in itself. So, it just keep at it there is obviously seasons and we have seasonality in our business and so it is never a smooth and steady progress but I think what is nice to know is at least that these currency headwinds and cost and all that seems to be awaiting dramatically looking into the third quarter.

It is just out to watch to run our business which basically means grow our top line and keep our expenses under control. Not something we can do we do not to the impact. We do not know. It is not easy for us as if you have got 20% currency appreciation and doubling in oil prices and freight cost overnight that makes it very difficult. These elements are more incorporated in a model and behind us but I mean it is going to be a bumpy road because of the seasonality but we are still confident we can get to the target.

Operator

Your final question today comes from Auguste Richard with Piper Jaffray.

Auguste Richard - Piper Jaffray

Yes, thanks for taking my question. Just quickly how do we think about the R&D and SG&A going for the current quarter as the increase was between the two or any guidance, there?

Donald Colvin

We will the guidance of 12% for each of them in the script.

Auguste Richard - Piper Jaffray

Okay and then thinking about the re-classification of asset expenses is that ongoing 5 million a quarter from cost-of-goods to R&D?

Donald Colvin

No, that is no these are different we just are one-off harmonization so I was explaining why our OpEx were a bit higher and our gross margin was at the high end and we gave the details it was a $3 million gross margin impact for a $5 million cost impact so that is now all incorporated in our guidance going forward so that is build into a base model. It was just the harmonization of accounting policies.

Auguste Richard - Piper Jaffray

Okay. It is a reclassification of NREs that is the way to think about it?

Donald Colvin

Correct yes.

Auguste Richard - Piper Jaffray

Okay, all right. Thanks so much.

Operator

Ladies and gentlemen, thank you for participating in today's ON Semiconductor second quarter earnings release conference call. That does conclude today's conference. You may now disconnect your lines.

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