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Executives

Riyadh Lai - Chief Financial Officer

Wallace Kou - President and CEO

Analysts

Quinn Bolton - Needham & Co., Inc.

Daniel Morris - Oppenheimer & Co., Inc.

Daniel Amir - Lazard Capital Markets

Bob Gujavarty - Deutsche Bank Securities

Daniel Berenbaum - Cowen & Co.

Dave Duley - Merriman Curhan Ford

Dunham Winoto - Avian Securities, LLC

Kevin Vassily - Pacific Crest Securities

Ray Rund - Shaker Investments

Timothy Lang - Citigroup

Silicon Motion Technology Corp. (SIMO) Q2 2008 Earnings Call July 30, 2008 8:00 AM ET

Operator

Welcome to the second quarter 2008 Silicon Motion Technology Corporation's earning call. (Operator's instruction)

This press release contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended. Such forward-looking statements include, without limitation, statements regarding trends in the semiconductor industry and our future results of operations, financial conditions and business prospects.

Although such statements are based on our own information and information from other sources we believe to be reliable, you should not place any undue reliance on them. These statements involve risks and uncertainties and actual market trends and our results may differ materially from those expressed or implied in these forward-looking statements for a variety of reasons.

Potential risks and uncertainties include, but are not limited to, continued competitive pressure in the semiconductor industry and the effect of such pressure on prices, unpredictable changes in technology and consumer demand for multimedia consumer electronics, the statement of any change in our relationship with our major customers and changes in political, economic, legal and social conditions in Taiwan.

For additional discussions of these risks and uncertainties and other factors, please see the documents we file from time to time with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements, which apply only as of the date of this press release.

I would now like to turn the presentation over to your host for today's call Mr. Riyadh Lai, Chief Financial Officer.

Riyadh Lai

Welcome to the Silicon Motion second quarter 2008 financial results conference call and webcast. With me here is Wallace Kou, our President and CEO. The agenda for today is as follows; Wallace will start with a review of some of our recent business development, I will then discuss our second quarter financial result and provide our outlook. We will then conclude with Q&A.

Please also note that we are using presentation slides for our webcast which offers highlights from the quarter so I would encourage anyone who has doubt into the conference call to check on the IR section of our website and view slides there. For more details on our financial results, please refer to our press release which was filed on form 6-K after the close of market yesterday. This webcast will be available for replay on our website, siliconmotion.com, for a limited time.

To enhance investors' understanding of our ongoing economic performance, we will discuss non-GAAP information during this call. We use non-GAAP reporting internally to evaluate and manage our operations. We have therefore chosen to provide this information to enable you to perform comparisons of our operating result in a manner similar to how we analyze our own operating results. The full reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued yesterday. We ask you to review it in conjunction with this call.

With that, I would now like to turn the call over to Wallace.

Wallace Kou

So, second quarter turns out to be an extremely challenging period for us. We certainly understand that a number of our shareholders are unhappy with us right now but I do want to make sure you all understand that our business and our long-term prospects have remained intact. This is also because our business model, [chief well struggle] and long-term prospects remain intact and we do not preannounce. We are trying to get away from making initial announcement and do focus on quarterly announcement unless there was an extraordinary issue. This is also the first time since our IPO that we have missed guidance.

Riyadh will take us through the financial in more detail but before that, I would like to take a moment to provide a very brief recap of our overall first half revenue performance. In the first quarter, we exceeded our revenue guidance by well over $6 million. In the second quarter, we fell below our guidance by $3 million to $5 million. In sum, our first half revenue performance came inline without internal expectations so, obviously, there were some volatility with our strong first quarter being largely offset by our weak second quarter.

With that said, our second quarter did not meet our expectations. Our revenue fell to $48.6 million which was below our guidance. Net income was $8.8 million or $0.26 per diluted share. Our gross margin was 47.3% while still strong, it was also below guidance. Again, Riyadh will discuss the numbers in more detail and provide guidance for the third quarter shortly. Overall, we state a few deeper in specific challenges but I will also like to reiterate that our key growth driver remain intact. Let me begin with the key challenges to our business.

Our mobile storage product did not perform according to our plan in the second quarter and that shows our overall revenue shortfall. Sales were unfavorably affected by weak demand from many of our customers. Those selling more on retail as well as bundle card controller segments. Strength in our first quarter in mobile storage revenue performance was partially offset by weakness in the second quarter. Retail card customers were naturally affected by both higher amounts of large prices during the early part of the second quarter as well as softening of end consumer demand primarily in Europe and the US starting this quarter.

Our sales into China manage expectations but they were naturally affected by devastating earthquake in Sichuan. In the second quarter, NAND flash vendor started reducing their capacity and therefore also reduced their sales to OEM cards. As a result, there procurement of controllers on us declined. Our handset bundle business also underperformed but mostly because of temporary product transition issue. Handset OEM begin taking advantage of improved affordability of the NAND flash late this quarter to transition from bundling lower density cards to bundling higher density cards.

Our storage product shipment were up 31% compared with the same quarter a year ago which happened to be a phenomenal quarter. Sequentially, our storage shipments were down about 11% but bare in mind, our first quarter of this year was also a strong quarter. Our second quarter storage shipments were also significantly higher than our fourth quarter of 2007 which was our biggest quarter last year. Clearly, our storage products are still growing and growing inline with the market. Based on our latest estimation of the memory card market, we believe the market would grow about 40% this year in yearly turn selling about 700 million cards last year to about 970 million this year.

We believe we should be able to maintain the same 35% market share that we had last year or higher. We believe our business remain intact that our card controller growth will be driven by camera phones with higher pixel count cameras that require memory cards. Our revenue for card controller business could grow approximately 5% a year for the next three years but could grow faster if captive player will begin outsourcing when next generation flash starts at 40 and 30 nanometer flash which has got more complicated controller start shipping in the fourth quarter.

And when preloaded and downloaded with multimedia content such as games, movie, TV shows and music player and even more important role in mobile devices, we strongly believe flash controller will play an even more important role in the future and our adjustable market can fare from being saturated. Our business also had all the important positive elements, the increasing affordable NAND flash continue to create new opportunity for us in SSD in that a flash and for non consumer applications. This quarter, we will embed a flash controller business at Hynix and Numonics for eMMC solution derived for tier one Google handset and GB/s orient. We also want embedded flash controller business in Micron with eUSB solutions targeting enterprise storage applications.

Importantly we have already started shipping some of these embedded flash controllers. Our embedded flash controller with handset is on track to ship in the fourth quarter. We believe the embedded flash controller adjustable market is potentially at least as big as the memory business. Embedded flash could potentially be found in all mobile phones and other devices, both mobile and stationary. Embedded flash is a compelling product to device makers because increasingly just about every device in the storage for data and code, data storage requirement continue to grow and embedded flash in better storage; consequently, more important role managing the embedded flash in interacting with the data protocol of the whole devices.

SSD are the key growth driver and then further along than embedded flash controller to becoming a relevant contributor to our revenue and profit. This quarter we shipped over 1 million SSD controllers to actual low profitability and other applications. With the big part of our sales going to assume EDC and HB mini nodes, we also shipped increasing number of the SSD controller for industrial and enterprise applications. Separately, we are on track to release potential customer additionally in giving sample of recent announced series of packing product, MLC USB controller in the third quarter and we expect to begin production in fourth quarter.

The MLC controllers will play an important role in more widespread adoption of SSD by mobile PC manufacturers while therefore managing product or low cost products. We believe this year the size of the low cost mobile PC market will probably be smaller than expected in the six to eight mini uni range given limited availability of patent processor from Intel. We believe the SSD market will be more meaningful in 2009. Next year, we expect to see more meaningful adoption of SSD controller and applications.

Mobile TV IC revenue increased over 31% in this quarter. Our overall communication product now account for 21% of our total revenue. We continue to have the leading position in Korea, our home market for this business and have a developing presence in China with local handset OEM customer selling to ZTE and [MOE Hynix]. We remain excited about our mobile TV business and believe we have one of the most comprehensive and compelling portfolio of mobile TV solutions including for T-DMB, S-DMB in Korea, DVB-H in Europe and Asia, CMMB TMB [ph] in China and ITBT in Japan and Brazil in the global market.

We are investing and have our original technology roadmap for mobile TV. We are accelerating our pay ball on Europe products which resulting R&D spending that have higher than we have had in the past. I will like to point out that we think it is particularly important to take advantage of this point in the market to redouble our effort on R&D side. We do not and we will not flash R&D spending and risk our long-term growth to manage short-term expectation in the market. Within our R&D effort, we are accelerating our development and pay ball of more integrated solutions which combines tuner and demodulator in SIT or SOT [ph] form. Solution is more advance [1413], 30 to 90 nanometer and 35 nanometer. It is a multiple band such as UHF, VHF and L-Band and multiple mode products that combined for example DVB-H, T-DMB, DAB + and FM.

We acquired small to moderate company late last year and we are also developing our own demodulated technology and we have also license from Central Mobile and others and we continue to work aggressively with selected third party demodulated partners. In the second quarter, we taper our [PD&D SLC [1455] at 90 nanometer. This product is under going qualification test by OEM customers right now and we target to initiate mass production in the fourth quarter and the first quarter next year. Our DVB-H, I-TBT and CMMB SoC will take out either second half 2008 and in 2009.

We will like to caution that until our SOC products are shipping in volume, our mobile TV product margins can continue to be naturally affected. Lower gross margin of our communication product line track down our gross margin from now until early next year. Our mobile communication and mobile storage product are all facing strong competitive pricing pressure. Maintaining product margin and managing operation expense are all important factors in our business to date. For our mobile communication product, in order to add more value to customers, we are building our more integrated solution and best in cost in terms of the reception sensitivity, power consumption, right size and other factors. In order to reduce the costs, we are rapidly shipping our geometry to finding modes and more competitive manufacturing processes.

For our mobile storage products, we are also facing strong competitive price pressure. In order to reduce cost further in the second quarter, we began moving some production to September. We also actively redesigned the layout of our controller at the current technology mode to make them smaller and thereby even more buy on a single waiver. We have also chosen to be more selective about our choice of customers which has enabled us to keep mobile storage margin stable. We are actually reviewing our operation expense for the second half and put in place a global [1710] freeze though we will selectively upgrade as required.

To summarize, market conditions are increasingly challenging but we believe our growth drivers are intact especially for mobile TV and for SSD controllers. Our memory card controllers are still growing rapidly, still more in terms of volume and revenue. Our card controller growth will improve if certain factor materialized. We are also still at the initial stage of the embedded flash adoption. I may also add that we are also increasing focus on protecting our margin by increasing our value add, reducing manufacturing cost and selectively choosing business.

Finally and I want to say again we strongly believe that technology will now stay static so it is important for us to continue spending aggressively behind R&D to stay ahead of the curve and well position us when global economic conditions recover.

I will now turn the call to Riyadh.

Riyadh Lai

First I will outline our financial results for the second quarter and then I will provide our guidance for the third quarter and the full year. Our second quarter revenue of $48.6 million increased 2% year-over-year and decreased 7% sequentially. Mobile storage product accounted for 73% of sales, mobile communication 21% and multimedia SoC 7%. Mobile storage revenue of $35.4 million decrease 6% year-over-over and decrease 14% sequentially primarily because of the reduce memory card controller sales. Storage controller shipment increased 31% year-over-year and decrease 11% sequentially.

Mobile communication product of $10 million increased 126% year-over-year and increased 31% sequentially, primarily because of a significant increase in mobile TV sales. Multimedia SoC revenue of $3.2 million declined 43% year-over-year and increased 8% sequentially. In the second quarter, we do not have any 10% customers. Samsung was no longer a 10% customer. Our offer sales to Samsung declined sequentially because Samsung significantly reduced its manufacturer OEM memory cards. Mobile TV sales to Samsung however increased significantly sequentially.

Gross margin was 47.3% and well below our 52% to 53% gross margin guidance. The sharp decrease was due primarily to a rapid shift of communications products from higher margin tuners to lower margin SIP which combines our tuner with procured demodulators as well as a $1 million write off of mainly obsolete MP3 SoCs, image processor SoCs and card reader controllers. Gross margin for our mobile storage and multimedia SoC products in second quarter were unchanged from the first quarter.

Operating expenses were $14.5 million in the second quarter which was higher than in the first quarter. R&D expenditures were $8.9 million which was higher than in the first quarter mainly because of new project expenses. Selling and marketing expenses were $2.3 million in the second quarter, unchanged from the first quarter. General and administrative expenses were $3.3 million, unchanged from the first quarter. Stock base compensation was $2.2 million in the second quarter, unchanged from the first quarter. Acquisition related charges in the second quarter were $1.6 million, unchanged from the first quarter. Litigation expenses increased slightly from $0.6 million in the first quarter to $0.7 million in the second quarter.

Net total other income was $0.6 million, unchanged from the first quarter. Foreign exchange losses was reduced from $2.7 million in the first quarter to $0.2 million in the second quarter. Net income of $8.8 million decreased 44% year-over-year and 43% sequentially. Diluted earnings per ADS of $0.26 decreased 44% year-over-year and 41% sequentially. GAAP net income of $2 million decreased 78% year-over-year and 76% sequentially. Diluted GAAP earnings per ADS of $0.06 decreased 78% year over year and 76% sequentially. GAAP net income was also negatively affected by a one-time $2.1 million 1048 tax charge which relates to uncertainties about income tax liabilities that has resulted from an offshore change in interpretation of tax codes by the Taiwan tax authorities following a routine review of our tax filings.

The full reconciliation of GAAP to non-GAAP financial measures can be found in our press release. At the end of the second quarter, cash, cash equivalent and short-term investments were $95 million, down from $112 million at the end of the first quarter. During the second quarter, the Company acquired $4 million of office space in Shanghai to house our expanding R&D team and repurchased $25.2 million of our American deposits or receipts. The Company has 78 days of average inventory in the second quarter, higher than our two months target but well below the 84 days of a year ago.

I will now move on to our guidance. When we provided our 2008 full year guidance earlier this year, we had factored-in the impact of the global economic slowdown. However, we believe we may have underestimated the severity of weak global consumer confidence for the second half of 2008 especially as it relates to our mobile storage products. We believe that since economic slowdown and related consumer confidence weakness is already leading to closures of all the NAND flash fab and push out of investment and new flash capacity, it is prudent that we take an even more conservative view regarding the second half of 2008.

That said, our sales in mobile TV solutions are tracking well and we expect sales of these products to scale further during the second half of 2008 and will become a larger part of our product mix by the end of the year. We are on track in terms of our 2350 MLTSS E controller sampling and production timetable. Sales on multimedia SoCs are expected to grow remarkably in the second half of 2008.

Third quarter revenue is expected to be approximately $44 million to $46 million which represents a 0% to 4% decrease year-over-year and a 5% to 9% decrease sequentially. Third quarter gross margin is expected to be in the 48% to 50% range. For the full year, we expect revenue to be approximately $200 million to $205 million which represents 11% to 15% increase year-over-year. Full year gross margin is expected to be within the 48% to 51% range. We now anticipate our full year EPS to be approximately $1.30 to $1.40 based on fully diluted shares of $33 million to $34 million.

We will now open the call for your questions.

Question-and-Answer Session

Operator

(Operator's instruction) And your first question comes from the line of Quinn Bolton of Needham & Co. Please proceed.

Quinn Bolton - Needham & Co., Inc.

Thanks. I just wanted to try and get a sense of you what you think your longer term gross margin. I know you spend a lot of time in the prepared comments saying that you do not think your long term growth is affected by the short-term weakness but it looks like you have taken a pretty big hit to gross margins certainly on the mobile TV side but just kind of trying to get a sense where you think long term margins. Should we be thinking something around the 50% level? It looks like it is going to be tough to get back to 52% to 53% that you were at for most of the past 2 to 3 years and then I got a couple of follow ups.

Riyadh Lai

Quinn, for the longer term we are shooting to have our gross margin in the 50% plus range but in the shorter term, obviously second half of the year, it will be difficult and we will certainly provide a better balance as we get closer to the end of the year but for the time being, what we are targeting is to get our gross margin up to the 50% plus range as our target for the foreseeable future.

Quinn Bolton - Needham & Co., Inc.

And in the mobile TV, you originally think the margins improved there early next year is that, at that point you will have integrated SSDs, like combined the demod and the tuner so you will not have to purchase third party demods and impact its debt and the system of the package solution?

Riyadh Lai

That is correct.

Quinn Bolton - Needham & Co., Inc.

Okay. Second question, can you just talk about the…, I think Wallace have mentioned some die shrinks across multiple product families but I am I guess particularly interested in the SD or MMC controller space. Can you sort of say where you are now and sort of what the road map is and what kind of cost reductions you think you can achieve with those die shrinks programs?

Wallace Kou

We are targeting the next three months on 10% reduction for SD and MMC controller panel line. We are moving certain line from SMIC to September so we believe we can feed our target volume around Q4 timeframe.

Quinn Bolton - Needham & Co., Inc.

Are these at this point are controllers bi-pad [ph] limited or do you see that the others they are still fairly significant cost reductions that you can do if you migrate down from say 0.16 to 0.13 ultimately the 90 nanometer? I mean are there limitations to scaling that you see in the core SD controller business?

Wallace Kou

I think SD controller, you have put packaging to the high end and low end for bundle. High end you will see in the future, it becomes more complicated because entering fourth quarter, we are going to see 40 nanometers, 30 nanometers and potentially basically come to the market. So, the controller require much more advance aero crashing engine 2833 from 8 bit mode to even up to 24 bit per 1 k bit crashing capability. So, controller become much more complicated. In order to be cost competitive, we have to move into potentially from 0.16 micron to even 0.13 micron. So, each moment because it is by pounding/di bounding limitation, because it is di bound only from two sides instead of four sides so there is a specific limitation primarily in the majority of panel line will all move to 0.16 micron for specific panel line when the k count move to a certain range, we will move to 0.13 micron.

Quinn Bolton - Needham & Co., Inc.

Okay, great and then just lastly can you talk about, you mentioned in your prepared comments about the embedded application with the design wins with micron newmonics and highlights/Hynex 2920 but can you sort of give us a sense of what kind of ramp do you think you will see especially in the mobile phone business for those solutions and what kind of kind of ammonization/cannibalization do you think you see on the memory card or the bundle card businesses and embedded solutions take off?

Wallace Kou

Well we started this from late Q3 and Q4, from Q1 mobile handset maker, we will move to mass production and we believe when the solution become more mature, we will see more adoption from mobile handset makers. But China, I think they probably will be a one monitoring embedded solution but we believe our top 5 handset makers will have embedded solution next year.

Quinn Bolton - Needham & Co., Inc.

Do you think this is at the very high end of the market and the external memory cards or card slots continue to penetrate a greater percentage of the mobile phones? So that right now, at least the first couple of years, the embedded solutions are not necessarily cannibalizing the opportunity for bundle flash cards on the mobile phone business?

Wallace Kou

I believe mobile handset were three type of business. One is for removal only, or embedded only or combination. So, embedded solution is a vehicle to allow the lower density mobile handset mode to adopt higher density NAND flash with a cheaper cost. So, embedded solution will allow handset manufacturer without changing software or hardware to immediately utilize 40 nanometer process and NAND flash. So, there is a breathing solution and we believe eventually embedded could be more than 70% to 80% of mobile handset adopt solution.

Quinn Bolton - Needham & Co., Inc.

Okay, thank you.

Operator

Your next question comes from the line of Dan Morris of Oppenheimer. Please proceed.

Daniel Morris - Oppenheimer & Co., Inc.

Hi, guys. I just wanted to touch on the topics that you had in your prepared remarks mainly about the pricing pressure. Could you talk about how much you are seeing this past quarter and if we need to update our expectations for what kind of full year SSD client we should be seeing?

Riyadh Lai

Yes, this is Riyadh. For this quarter, the second quarter, our ASPs for our storage products on average decline around 3 ½% or so. For the full year, we were expecting a decline of 30% or below for the full year.

Daniel Morris - Oppenheimer & Co., Inc.

A 30% for the full year up from 20%?

Riyadh Lai

Yes.

Daniel Morris - Oppenheimer & Co., Inc.

But the 3 ½% does not sound terribly onerous, I guess. Was there some pricing pressure in other segments as well that you are talking about?

Wallace Kou

We are more cautiously to flag the customer so in some business we turn down because the margin is very low.

Daniel Morris - Oppenheimer & Co., Inc.

Okay.

Riyadh Lai

Also prices had declined fairly sharply in the first quarter and as well as suspension. We have been more selective in our choice of business so that is helping stabilize our rate of ASP decline.

Daniel Morris - Oppenheimer & Co., Inc.

Okay. You had been more selective with your customers that obviously I guess implies a little bit of giving up some market share, I mean do you have any estimates where you think your market share was at the end of the quarter?

Wallace Kou

We believe for second quarter, we still maintained at least from 35% market share.

Daniel Morris - Oppenheimer & Co., Inc.

Okay.

Riyadh Lai

One of the indicators that we heard from our customers, a lot of our customers have this view that the card business, as a whole, declined round 20% to 30% in volume terms sequentially. Our volume in fact had declined by much below small amount so believe we had performed the market in general despite our focus on profitability in the second quarter.

Daniel Morris - Oppenheimer & Co., Inc.

Okay and turning to inventories, your inventories tip topped a little bit. Could you also comment on where you think inventories are in the channel and the retail?

Wallace Kou

I think in foreign customers for retail play, the feedback inventory in retail is still pretty high. So, that is why we are going to continue to see price decline in the coming third quarter but what are happening here is that all the media player are going to reduce their price so I think probably the movement could be continued in entering the fourth quarter. The major issue we see is that the market demands here is soft.

Daniel Morris - Oppenheimer & Co., Inc.

Okay.

Riyadh Lai

Let me also add, in this business, there are two types of inventory. You have legacy inventories and operating inventory. Most of the excess inventory in the market relates to legacy inventory. For us, our inventory is more on operating inventory. We have very little legacy inventory right now.

Daniel Morris - Oppenheimer & Co., Inc.

Okay, and so does that mean that there is not the chance for inventory write off on the storage product is not very high.

Riyadh Lai

That is correct. We are actively managing that and we are being quite disciplined on it but markets do change quite rapidly.

Daniel Morris - Oppenheimer & Co., Inc.

Okay, alright thank you very much.

Operator

Your next question comes from the line of Daniel Amir of Lazard. Please proceed.

Daniel Amir - Lazard Capital Markets

Thanks a lot. Thank you for taking my questions. A couple of things here, first of all, as we move at the mobile TV opportunity, can you highlight the key milestones that we should be looking here for the next six months as an opportunity for next year and what type of growth rate should we be looking at 2009 in terms of the mobile TV segment?

Wallace Kou

I think for this year, our growing momentum, one is in Korea for S-DMB and also second half in China of both TMMB and CMMB. Entering 2009, we are going to ramp DVB-H as well as ITBT or Japan market. I think that, we believe, we would double our shipment from '09 in mobile TV solutions.

Daniel Amir - Lazard Capital Markets

Okay and then if we look at Q3 here and now is the month into the quarter again what is your visibility like? Obviously this is more of a back end loaded quarter. What do you expect, in terms of how the shipment goes, throughout the three months here in the quarter?

Wallace Kou

For mobile communication product line, we have a much better visibility because we have a probably around 70% backlog in hand. For mobile storage product line for OEM business, we also have a very good visibility. The other 30% mobile storage, we do not have a good visibility.

Daniel Amir - Lazard Capital Markets

Okay and then if you like in Q4, by your guidance obviously you are expecting Q4 to be off compared to Q3. What is your visibility into Q4? What gives you confidence that Q4 could look potentially better than expected? I mean what are the key metrics that we should be looking at here potentially you business rebounds here off of the current environment?

Wallace Kou

Since we have several major OEM design in the pipelines so we have the confidence that would give us potential growth momentum entering Q4 but we cannot release specific design and major customers. We believe when we enter in late Q3 and moving into Q4 that will add the momentum to increase our confidence regarding our revenue forecast in Q4.

Daniel Amir - Lazard Capital Markets

And this is largely in the embedded space?

Wallace Kou

We are seeing embedded space, [3818], SSD as well as our mobile communication product line.

Daniel Amir - Lazard Capital Markets

Okay and then final question is-it seems like that the issues with your guidance is largely not growth related which is impacting many companies today in the market. We cannot really hide from it. Has anything changed on the competitive front? I mean, it seems like this is more macro but can you comment on any changes on that front I mean, assuming that they realize the mobile storage?

Wallace Kou

We really did not see any new competitors. We did not lose a single customer and we do not see we losing market share either. I think the whole Q2 is really very, very challenging and the beginning the Q2, we saw it is really normal but entering middle of the Q2, the demand was very soft. The movement in the channel was very, very slow. It is such a disappointment and we do not anticipate such a slow movement in the second quarter.

Riyadh Lai

Dan, let me also add as I previously mentioned, our card customers had expected the market to decline about, saw the market declining about 20% to 30% sequentially in the second quarter and our volume, in fact, had declined by much smaller amount so we believe we have actually done pretty good out of the challenging environment.

Daniel Amir - Lazard Capital Markets

Okay, great. Thanks a lot, guys.

Operator

Your next question of comes from the line of Bob Gujavarty of Deutsche Bank. Please proceed.

Bob Gujavarty - Deutsche Bank Securities

Hi, guys. Thanks, guys. Could you just talk about a little bit how you saw the quarter? You alluded to it a little bit, that the quarter started out pretty normal and then deteriorated. I mean, entering the quarter, you probably thought there was a little inventory build because the Q1 was so strong. Can you just think about the transition between to what happened in Q1 and Q2 and then how the linearity of the quarter went?

Wallace Kou

We cannot comment specific customer that we have but it could be some customer, they just book manufactured access flash memory card in the end of first quarter but the market condition changed. I think in the middle of second quarter it became soft and slow. We did a very broader customer check from US, Taiwan, Korea, Japan and China and Europe and particularly in the US, it is really slowing down quite a lot.

Bob Gujavarty - Deutsche Bank Securities

I see. Can you estimate your US exposure? It is pretty low, right?

Wallace Kou

Our US exposure is pretty low but the retail, some customers who are also manufacturing in China sell to OEM to the retail market in the US.

Bob Gujavarty - Deutsche Bank Securities

I see. So you are indirect exposure might be substantially higher.

Wallace Kou

Then direct…

Bob Gujavarty - Deutsche Bank Securities

Yes. Okay and then I guess the second question is, you commented that earlier you thought some movement of low density cards and now, it seems with the price declines, and the OEMs are moving up to higher density cards. Can you quantify that a little bit in terms of what are you seeing in average capacities and then moving, are they moved from like 256 to 512 or 512 to 1G? What are you seeing there?

Wallace Kou

We see in the past, majority of the bundle business for micro SD card are in 128MB and 256MB. Now, I see the transition move to 1G and 2G as the bundle business for top tier OEM customer. In China, it remains lower density but I think in the past because we are uni play, we focus on the volume areas that is why we focus on lower density product line. Now, we are in the transition to be re-qualified with higher density for the top tier OEM customer.

Bob Gujavarty - Deutsche Bank Securities

I see and since you are uniplay, is there any opportunity that the higher density card helps you or is it pretty neutral to your business since you are uniplay?

Wallace Kou

I think the total unit going to grow but just in the transition, we lost some of the lower density bundle card business. Now, we had transitioned into the higher density card.

Bob Gujavarty - Deutsche Bank Securities

Okay, great. Thank you.

Operator

Your next question comes from the line of Daniel Berenbaum of Cowen & Co. Please proceed.

Daniel Berenbaum - Cowen & Co.

Hi, thanks for taking my call. If I could just ask on the mobile communications product and help me clarify a little bit, I understand the gross margins were bad but from doing my math right, it looks like both unit and ASP actually went up in that segment. So is that the right way to think about it and was it just a margin problem or did ASPs actually go down?

Riyadh Lai

That is correct. Dan, both ASPs and volume went up significantly in the second quarter.

Daniel Berenbaum - Cowen & Co.

And then if you could clarify on the mobile storage ASPs, I mean if we get it. If I am doing my math right, looks like ASPs in the quarter were down about 22% year-over-year and you are now saying that we should expect the full year to be down 30% year-over-year. Do I understand that correctly?

Riyadh Lai

Up to 30%, yes.

Daniel Berenbaum - Cowen & Co.

Up to 30% but they were down 22% year-over-year?

Riyadh Lai

Yes.

Daniel Berenbaum - Cowen & Co.

Okay. And so then more broadly, I mean looking at your guidance, it seems to imply that units are going to be down pretty sharply in Q3, you are talking about unit demands slowing from your customers, what does that say about the industry and the perceived elasticity of demand for NAND product. I mean based on your guidance with…, even though we have heard from very large players in the space that they are slashing pricing and expect to push more units through the channel, your guidance would lead us to believe that your units are not going to the channel and in fact, overall NAND demand might not be as elastic as we thought. I mean if there is something specific here, were there was inventory buildup in one of your customers, how should I think about that?

Wallace Kou

Dan, our business model is different in system integrator. To system integrator, because they have liability for the flash, they also have an entry in the channel so they have to reduce the price to move the inventory but most of our customer, if they do not secure NAND flash, they do not play the PO2 controller maker. So, if there is a lot of inventory in the channel, that will slow down to build a new flash memory card.

Daniel Berenbaum - Cowen & Co.

So, does that mean that inventories building up in Di bank and wafer bank and I should ultimately expect all of that to sell-through? I mean is that that more, whereas now, we are starting to burn off inventory and finish goods and ultimately there will be slug of NAND that comes through from wafer bank and Di bank?

Wallace Kou

For the card business, for the flash memory card business, they were purchasing the wafer from NAND manufacturer or T soft [4633] because they have a bigger size of cards and purchase di from flash controller makers. However, the business model is they need to…, after they purchase, they will ship out within five days to the channel of their OEM customer. The current issue with the market, we believe there is a very single level of inventory in the channel, finished good products in the channel so the new build momentum for flash and memory card will be slowed down.

Daniel Berenbaum - Cowen & Co.

Okay that makes sense, could I then extrapolate that since the new build momentum is slow, inventory now is building up on the other side of the dam as inventory building up upstream in di form or wafer form.

Wallace Kou

No, the card, we are talking about the card, finished goods cards.

Riyadh Lai

Inventory is building at the card level which needs to clear before it starts rebuilding.

Daniel Berenbaum - Cowen & Co.

Right. So, the inventory is building at the card level which means that even though pricing has been cut, the industry is not seeing the demand elasticity on those cards that we expected.

Riyadh Lai

That is correct.

Daniel Berenbaum - Cowen & Co.

Okay, thank you.

Operator

Your next question comes from the line of Dave Duley of Merriman. Please proceed.

Dave Duley - Merriman Curhan Ford

I just wanted to quickly review on the card controller business. The two things that you seem to have highlighted as to why numbers were not achieved there where you see a soft retail demand environment with one segment of your customer which is mainly driven by US and European business slowing down and the other piece of the puzzle is your bundle business with your big handset OEMs like Samsung has slowed as well. Are those the two, is that the right summary way to talk about the controller miss?

Wallace Kou

Yes, it is seen in China, also we suffer the Sichuan earthquake in May. So, China business also in May slowed down quite a lot here.

Dave Duley - Merriman Curhan Ford

Okay and could you explain, I think I understand demand in US and Europe being slow and I guess the one question I will have for you is, with that in mind, I guess I would expect to see lots of electronics company listing their numbers given demand in US and Europe slow and not component people like yourselves but people that sell components to retail people. So a lot of retail device makers are going to be missing their numbers, would that be the way to look at what you are seeing in the marketplace?

Riyadh Lai

I do not think it would be appropriate for us to comment on other companies. We really do not know enough of how they operate their business. What we do see is the issues that we have on hand at our company.

Dave Duley - Merriman Curhan Ford

Okay and then the second piece of that was that your handset guides are slowing their bundling business. What is going on there? Why did the handset business not performed to what you expected?

Riyadh Lai

It is the transition issue that Wallace had talked about. The transition of bundling lower density products to bundling of higher density products, we use to sell primarily lower density and now, we are transitioning to supply higher density and in the meantime, we are going to a re qualification process.

Dave Duley - Merriman Curhan Ford

So, but Samsung is still buying lower density cards from somebody else? Are you transitioning? I do not understand what that means, could you..?

Wallace Kou

The Samsung is still buying controller bundle for some lower density however the volume decreased. So, in order to increase the volume, we need to qualify to the handset maker with higher density products. Also, all flash makers, they are in the transition to move to 40 nanometer and 34 nanometer so in the transition, the qualifications process takes time.

Riyadh Lai

We’re all, they are just buying less.

Dave Duley - Merriman Curhan Ford

So, and that particular customer, because this has been a point of contention for a long time, that particular customer, we are not going to read in Digitimes that someone else has taken the low density business.

Wallace Kou

I do not think anybody took over our low density business. The global lower density card business is just going down.

Dave Duley - Merriman Curhan Ford

Okay, I just wanted to clarify that. Now, just a couple of question, final questions from me, if you took an inventory write off, of I think a million dollars in the quarter if I recollect the number, and that impacted the gross margin but I think by about 200 basis points, why was the inventory write off now? Why was it taken now?

Riyadh Lai

As you know, starting late last year, we started ramping down some of our worse performing businesses like our MP3. Some of our MP3 products, despite not selling well we are still selling but in limited numbers and now, as we went into the second quarter, a lot of this MP3 SoCs, image processor, SoCs, card reader controllers, they just stop selling and so we required to write them off.

Dave Duley - Merriman Curhan Ford

Okay and final thing from me is, I noticed the R&D budget cranked up quite a bit in the current quarter, I think that was surprising versus where I was thinking the R&D number should be, what was the exact reason for that?

Wallace Kou

So, during the second quarter, we would take off 1.5, one joint project with 90 nanometer RFC mount cases. So, the 90 nanometer RFC mount cases just the map itself is about 900,000 dollars. So, the majority inquiry of R&D really to see map calls and R&D new development for SoC product line in mobile communication area. 5249

Dave Duley - Merriman Curhan Ford

So, what we now eventually you are going to have to send us money on MAX/MAT/MASK so it had to do accelerate this development because of the current market environment or because I do not think any one was expecting $10 million in R&D expense in quarter since you spend $7.5 million last quarter.

Riyadh Lai

That is correct. We have accelerated our spend.

Dave Duley - Merriman Curhan Ford

Okay, final thing for me is what was the rationale for not pre releasing this quarter?

Riyadh Lai

As Wallace had said at the start of the call, we were trying to get away from making interim announcements and focus on quarterly announcements. We are kind of run our business on a long term basis, focusing on long-term objectives and so from our perspective, it is all about focusing on what is important. If there is indeed was a very significant extraordinary change we will certainly pre announce but from our perspective, our growth drivers, our business model, our long-term growth opportunity; they are all pretty much intact. There is a lot of turbulence, granted. There is a lot of significant turbulence but we did not believe that it warranted us to start making pre announcements. We compete in a very dynamic market. We do not want to go down that route where every time there are bumps in the road where we are constantly making pre announcements.

Dave Duley - Merriman Curhan Ford

Okay, thank you.

Operator

Thank you, gentlemen and your next question will come from the line of Dunham Winoto from Avian. You may proceed.

Dunham Winoto - Avian Securities, LLC

Thanks, guys, for taking my phone call. Couple of questions, first of all, maybe this one is for Wallace. I know that you said in your press release that you guys are sampling your SSD controllers in the third quarter with mass production to start in the fourth quarter. Can you just clarify if that is the SSD controller that is for the mainstream notebook and I have got couple of follow ups on that?

Wallace Kou

I cannot comment whether it is mainstream notebook or low cost notebook but there is a MLC base SSD controller.

Dunham Winoto - Avian Securities, LLC

Okay, can you give us some idea? There has been news or reports out there that the net adoption of SSD might be pushed back a little bit more. Can you give us your input on that? Do you think the met adoption is still on track for say early '09 or has it been pushed back a little bit in your mind?

Wallace Kou

I think the, as I said, the low cost PC, low cost number, UNPC [ph] the prediction looked like it could be lower than expected. We believe that this year, it is about 6 to 8 million unit range. We also see because Intel still have a severe shortage in deliver autumn chipset so certain program are being push out on Q3 to Q4 and some OEM even they cancel the program. So that is one of the major factors slowing down. So there is no expectation and forecast. What is happening as we going through an economic situation, some low cost notebooks, there are also combinations with micro [5632] as also I am seeing there is also the factor to impact the current shortage forecast in '08.

However, with the NAND flash continue going down and moving to 40 nanometer and 34 nanometer in '09, we believe that is going to create a tremendous new momentum for low cost notebook as well as the mainstream because we believe there will be multiple solutions ready before end of '08 to support MLC base storage application.

Dunham Winoto - Avian Securities, LLC

How about on the mainstream side, I mean has there been any change in terms of the timeline for volume shipments?

Wallace Kou

I cannot comment specific OEM customers demand or their need, having everybody have their own strategy and sometimes they are based on specific times, they have very good deal and qualified certain solutions they will move on. Daphne [ph] is certain company that would be more aggressive to move to solid HR solution and I think 2009, we are going to see it is going to happen. You do not need to wait for 2010 but in 2009, you are going to see solid HR move to management PC.

Dunham Winoto - Avian Securities, LLC

Okay just one last question on SSD. In terms of developing MLC base solutions on the controller side, has there been a change in terms of the challenges that has been talked about up to now that prevents wider adoption or wider volume shipments?

Wallace Kou

So, I think that our top chip PC maker, they look for no compromise as to these solutions to replace hard drive. So the challenge around several areas of reliability, endurance, performance, power cycling and mainly in security main thing, so I think controller maker have to overcome the fundamental issue from MLC NAND flash in order to provide no compromise solutions. So, it is very challenging. Qualification is all take time.

Dunham Winoto - Avian Securities, LLC

Okay, next question is I know that Samsung is no longer a top customer and as Riyadh said that there was no 10% customer during the quarter but can you provide us with additional color as to who might be your top customer during the quarter?

Riyadh Lai

Our card customers, it is pretty much the same group of customers that we have had quarter after quarter. There is always been changes from one quarter to the next but generally it is the same group of customers so for the second quarter, in fact, it has remained the same. On the topic of Samsung, they obviously have ramped down significantly. They are all manufacturer of OEM cards and ends ramped down procurement controllers from us but nevertheless our sales to Samsung for our other products primarily mobile TV related products have increased significantly so they remain very important customer of ours and we still maintain a very good relation with Samsung.

Dunham Winoto - Avian Securities, LLC

Okay, thanks. My last question has to do with share buyback. I know that you purchased the $25 million worth of shares during the second quarter. What is your plan going forward? Are you going to keep buying shares back or you are going to wait until things changed?

Riyadh Lai

It is our strategy and it is our intention to complete the buy back that our board has authorized us.

Dunham Winoto - Avian Securities, LLC

Okay. So, you have about $15 million worth of buy back left?

Riyadh Lai

That is correct.

Dunham Winoto - Avian Securities, LLC

Okay, that is all I have. Thanks.

Operator

Thank you, gentlemen and your next question will come from the line of Kevin Vassily from Pacific Crest Securities. Kevin, you may proceed.

Kevin Vassily - Pacific Crest Securities

Thank you for taking my call. So, just some clarification on kind of Q3 mix or second half of the year mix, you commented that you expected the mobile TV business to ramp fairly nicely through the second half of the year and I think by implication, it would grow faster than the rate of the mobile storage yet you, with guidance for Q3 to a gross margin that is roughly 200 basis points up, above where you were in Q2. So, help me with how that works if mobile TV is going to be a bigger part of the business and you had some margin challenges there, how are you able to get gross margins up in Q3 versus having them come down?

Riyadh Lai

Kevin, this is Riyadh. One of the big issues that we had in the second quarter was we had a $1 million write off of obsolete inventory. So, that hits our gross margin. $1 million is approximately 2 percentage points.

Kevin Vassily - Pacific Crest Securities

Okay, so that 47% did not include or did include the inventory write off?

Riyadh Lai

If we were to exclude that $1 million write off, our gross margin would be around 49%.

Kevin Vassily - Pacific Crest Securities

Okay so again go back to the next question, if that part of the business is growing faster than mobile storage, you would still expect to be a kind of negative gross margin impact on a blended basis versus even flat so again help me. Am I not taking about the way the businesses are growing or are you seeing a margin improvement in the mobile storage side of the business?

Riyadh Lai

There is some improvement up, they are actively working to reduce cost so the second half of the year, it is our plan to raise gross margins from our communications product line and so there will be some improvement as the year progresses.

Kevin Vassily - Pacific Crest Securities

Sorry to kind of keep harping at it, if I heard correctly kind of the gross margin improvement was going to come from some of the more highly integrated products which did not sound like it was going to have a real impact till fairly late in the year. It is not in early next year. Are there things in place besides that that kind of improve the margin profile there?

Riyadh Lai

We are also working to improve our yields and also to improve our cost from reduced testing time and so forth.

Wallace Kou

I think, Kevin, the issue regarding mobile communication margin was lower because we have a portion of our product at BMD [ph] with SIP. That is demodulator comes from our partner. They are not coming from us. So that specific product line has a much lower gross margin than the overall other product line. So I think moving, the reason, we have to use SIP because Samsung only qualify us as a supplier so to the end of the Q3, the issue will be resolved so we can sell only the tuner to other module maker to build SIP so that will also help us to improve the overall gross margin for mobile communication product line.

Kevin Vassily - Pacific Crest Securities

Okay, that is helpful. Thank you.

Operator

Thank you, gentlemen and your next question will come from the line of Ray Rund from Shaker Investments. You may proceed.

Ray Rund - Shaker Investments

Thank you. I was wondering can you give us some sense of how your R&D is going to play out over the rest of the year. I mean you had this major increase. Does it continue with that level? Does it comeback down to $7.5 million or $8 million? I mean can you help us understand that better?

Riyadh Lai

For the second and half of the year, we are going to keep our total OpEx fairly similar to what we have in the second quarter. Second quarter total OpEx was around $14.5 million so we will probably trim that for the second half of the year but obviously we have a higher increase in place, a global higher increase. We do not expect other than to, very selectively upgrade. We are also actively looking at our cost structure to see if we can better use what we have and take cost out of our system. So, as much as we do have fixed cost overhead, it is what it is. We have a lot of R&D program that need to ramp in order to support all our gross drivers but we are also actively looking to see if we can take cost out of our system.

Ray Rund - Shaker Investments

Okay, and can you also comment on what sort of tax rate we should be using for the rest of the year?

Riyadh Lai

We are internally using the 10%.

Ray Rund - Shaker Investments

Okay. I know you mentioned that the higher tax rate in Q2 was a one-time thing. Can you discuss that a little bit?

Riyadh Lai

Yes, a big part of our business is in Taiwan. We do a lot of R&D work in Taiwan at our Taiwan legal entity and we enjoy a lot of tax credits from doing R&D work and as part of the reexamination of our filings, even though tax legislation has not changed, it would seem that our tax filings needed to be reevaluated. So, it resulted in a 1048 potential liability. We are challenging that. We do not believe that tax reexamination is the fair one so we are challenging. We have a fairly conservative and prudent tax filing. This is in fact part of our regular application for tax credits for doing R&D. So, we believe that it is an arbitrary decision based on no change in tax legislation.

Ray Rund - Shaker Investments

Okay. Thank you.

Operator

Thank gentlemen and your next question will come from the line of Timothy Lang from Citigroup. You may proceed, Timothy.

Timothy Lang - Citigroup

Thank you very much for taking my questions. Hi, Wallace and Riyadh. Two questions from me here. I think someone mentioned that Samsung is no longer 10% customer and I think you have also answered a competitive landscape. Just to be clear, are you seeing any impact by the in sourcing by the memory cards makers and how will the Company try to gain market shares going forward with the mostly through the adding more technology onto your controllers or more for pricing?

Wallace Kou

I think our technology and our development very unique and differentiate comes with our competitor. We believe when the flash memory moves into 40 nm to 30 nm especially by three next year, it really requires much more complicated controller not only have global well leveling technology but also more advance error correction engine beyond BCH, maybe LDPC more than even 40 bit error correction from 1K byte. We also start to see outsourcing opportunity from cap of company. We cannot make the announcement right now as in we believe in near late Q4 we will enter the production stage with some of our very perspective customer. So, I think we are in developing with more future product line with our NAND flash makers except to Toshiba at the moment. So, we do see our leading potential and also from development process, we should see a continued growth of the market as we provide the value to our OEM customer.

Timothy Lang - Citigroup

Okay. Just one more question to follow up, I think Wallace you also mentioned that your customers are moving to a higher density such as 1G to 2G for your tier-one OEM customers. What would you see as a percentage of sales for your bundle business for these OEMs would be for 1G higher by the year end and thank you very much.

Wallace Kou

I think in our flash memory card business, it is from time to time, it is about 30% bundle business, 30% of our retail. Within the bundle business in China, the majority still maintain lower density so for other tier-one customer in mobile handset, they are shifting in second quarter from lower density to higher density so we are in the process qualification. We believe the volume will be back to the ramp up around late Q3 or early Q4 timeframe. So I think we should maintain the same volume or even higher potential than lower density controller business in the past.

Timothy Lang - Citigroup

So, would you say for the bundle business that your tier-one customers are going to be mostly in 1G to 2G by yearend?

Wallace Kou

Yes.

Timothy Lang - Citigroup

Thank you.

Operator

Thank you, gentlemen and your last question will come from the line of Daniel Berenbaum from Cowen & Company. Daniel, you may proceed.

Daniel Berenbaum - Cowen & Co.

Yes, hi. Just a quick follow ups to some of the tax rate questions and just in general between pro forma and GAAP, what are you excluding in the full year GAAP guidance? Is there more tax as more of these arbitrary tax charges that are excluded from pro forma that you are including in GAAP and what else is there in the pro forma that is excluded?

Riyadh Lai

The tax that is only one time item. We did not plan for this tax review. It came all of a sudden and it is the only tax item that differs between our GAAP and non-GAAP. So, other items different between our GAAP and non-GAAP of course stock base compensation, acquisition related charges from FDI as well as Mimer [ph], our Centronic acquisition. We also have litigation expenses related to the SanDisc litigation so it is both gains and expenses that related to litigation. We also have foreign exchange gains or losses from the other income line as the final piece. Foreign exchange, obviously we cannot predict and it does affect our financials and so for the purposes of managing our numbers, we exclude that. We do not actively hedge to manage our numbers.

Daniel Berenbaum - Cowen & Co.

Okay and then just one last question on the market and your place in it. So, what percentage of NAND controllers are for cards versus embedded or solid state drive and how should I think about your mix versus the market mix?

Wallace Kou

I think for our total mobile storage product line, our card controller is around about 78% to 80%. So, the remaining will be USB flat drive controller and the solid state drive controller.

Daniel Berenbaum - Cowen & Co.

Okay and then is that so card, when you say card that is external card and…

Wallace Kou

Card mean it is like a SD, MMC, compact flash.

Daniel Berenbaum - Cowen & Co.

Right, okay. So, and we talked about embedded potentially growing faster than card? I think you highlighted that card would grow about 5% annually; at least 5% annually over the next couple of years.

Wallace Kou

Revenue.

Daniel Berenbaum - Cowen & Co.

Right, revenue, if I heard that correctly. Okay so then the question is how much is your embedded business and it seems like your embedded businesses is very low percentage and then how fast do you expect that embedded business to grow?

Wallace Kou

So, I think embedded currently is still very low. Next year, we have not seen any forecast regarding embedded solutions. If you look in for even iPod, iPhone you can view as one of the embedded solutions today for mobile handset but we believe our major makers including Nokia, Samsung, LG, Sony and Motorola, they are going to have the embedded solution for either late this year or early 2009.

Daniel Berenbaum - Cowen & Co.

Okay and then just how does your mix compared to the industry mix of your 80% card, how does that compare to the overall industry mix?

Wallace Kou

The embedded solutions which will all belong to flash maker, Samsung have their own solution, Toshiba have their own solution, Sandisc also have their own total solution. Fortunately, we also work closely with Numonics, with Hynix and especially the Micron. So, we potentially can take part of the share for embedded solution into market. Besides the handset market, embedded could be in consumer like Sony devices which we do have a major design in certain GPS manufacturers in Taiwan as well as in US. We have a major design in portable DVD, we have major design in central electronic video camera, camcorder. So, embedded solution could be used as widely in our given type of consumer devices too.

Daniel Berenbaum - Cowen & Co.

So, you could see that business grow very rapidly for you.

Wallace Kou

We started some shipment right now. We see the adoption for embedded solution can grow very, very fast. There are a lot of consumers suddenly greater to use the current solution to bridge to the advanced new NAND flash components.

Daniel Berenbaum - Cowen & Co.

Okay, great. Thank you.

Operator

Thank you, gentleman. And at this time, sir, due to time restraints, there are no more questions in the queue so I would like to turn it over to the main speaker for closing remarks.

Wallace Kou

So, as we discussed in the past one hour, we are disappointed about our second quarter result. This was our first time that we missed our guidance. I really apologize for letting our shareholders down. However, we do have a high confidence in the main industry and our position as a leading controller maker. We know exactly what we need to do to manage through the near term challenges. We are very focused on mobile storage product line, embedded flash, flash safe drive and mobile TV product line. We are in the right direction and we are a solid company. We have confidence to get back to our growing track within six months. So, thank you for listening and then we will see you next quarter.

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